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Federal
Reserve Bankof
NewYbrk
Quarterly Review
A u tu m n 1978
1
3
7
16
24
26
31
34
V o lu m e 3 No. 3
W a g es and In fla tio n
T he m in im u m w a g e : a p e rs p e c tiv e
F ed era l pay s c a le s : h ow m uch is
to o m uch ?
In d e x a tio n o f w a g e s and re tire m e n t
in c o m e in th e U n ite d S tate s
The b u s in e s s s itu a tio n
C u rre n t d e v e lo p m e n ts
T he e c o n o m y o f u p s ta te N ew Y o rk
T he fin a n c ia l m a rk e ts
C u rre n t d e v e lo p m e n ts
N o n c o m p e titiv e te n d e rs in T re a s u ry
a u c tio n s : h ow m uch do th e y a ffe c t
s a v in g s flo w s ?
39
In te rn a tio n a l B a nk L e n d in g :
A G u id e d T o u r th ro u g h th e D ata
47
T re a s u ry and F ed era l R eserve F o re ig n
E x c h a n g e O p e ra tio n s
This Quarterly Review is published by
the Research and Statistics Function
of the Federal Reserve Bank of New
York. Among the members of the
function who contributed to this issue
are ROBERT T. FALCONER (on the
m inimum wage, page 3); SHARON
P. SMITH (on Federal pay scales,
page 7); MARCELLE V. ARAK (on
indexation of wages and retirem ent
income, page 16); RONA B. STEIN
(on the economy of upstate New York,
page 26); CHARLES M. SIVESIND (on
noncom petitive tenders in Treasury
auctions and savings flows, page 34);
and GENIE D. SHORT and BETSY B.
WHITE (on international bank lending,
page 39).
A semiannual report of Treasury and
Federal Reserve foreign exchange
operations for the period February
through July 1978 begins on page 47.
Wages and Inflation
Wages play a crucial role in the transmission of infla
tionary impulses through the economy. This observa
tion does not depend upon any particular theory of
the causation of inflation. Rather, it rests upon the
structure of productive processes: labor compensa
tion accounts for about two thirds of total costs of
production in the private business sector and more
than half of total government expenditures for goods
and services. Hence, any attack on inflation that does
not rely exclusively on aggregate demand restraint
must work more or less directly on wages.
Why not rely solely upon policies to restrain aggre
gate demand? To be sure, the case for demand re
straint is overwhelming. After three and one half years
of relatively rapid economic growth in the United
States, most of the slack in the economy has been
absorbed. Effectively full employment of experienced
workers has been achieved, and shortages of certain
skills have emerged. The growth of output during the
past two years has continued to outstrip the growth
of productive facilities, so that the rate of utilization of
capacity in the manufacturing sector is now well above
its long-run average. The pressure of demands for
goods and services against limited potential for in
creased supplies is being reflected in a step-up in the
underlying rate of inflation. Clearly, careful demand
management is needed to avert unhealthy excesses
and accelerating inflation.
But our inflation problem runs deeper than the
recently emerging pressures of aggregate demand.
Rapid inflation persisted throughout the severe reces
sion of 1973-75 and the early stages of the subsequent
recovery, when substantial excess capacity existed
virtually throughout the economy. Such deeply im
bedded inflation responds only slowly to restraint on
demand. Most estimates indicate that it would take
several years of slack in the economy— with high un
employment and sizable losses of potential output—
to restore general price stability through demand
management alone. Recognition of this predicament
has given rise to searches for ways to hasten the
return to price stability in the context of a prosperous
and growing economy. The search has turned up vari
ous proposals for incomes policies such as wage and
price guideposts or standards, use of regulatory and
procurement policies to encourage moderation in wage
and price setting, and tax-oriented incomes policies.
The President’s anti-inflation program incorporates ele
ments of all these proposals, which recognize that wage
moderation need not penalize labor, provided a compe
titive climate is maintained to hold profits in check.
In searching for ways to influence private-sector
behavior in the interests of price stability, other steps
the Federal Government can take to influence labor
costs ought not to be overlooked. The following three
articles touch on selected aspects of the wage-price
problem and the Government’s involvement in it. The
first article provides a perspective on the minimum
wage. Perhaps the most serious unintended side effect
of the minimum wage is to restrict employment oppor
tunities for relatively unskilled workers, especially
youths. In addition, increases in the minimum wage
raise costs of production and hence prices. It has been
estimated that the initial effect of the 15 percent boost
in the minimum wage at the beginning of 1978 was
an increase of about V3 percent in the general level of
FRBNY Quarterly Review/Autumn 1978
1
prices. A similar result is expected from the 9.4 percent
boost in the minimum wage that is scheduled to take
effect on January 1,1979. Admittedly, that is not a large
impact in the context of the nation’s overall inflation
problem. But the effect does not stop there. By helping
to cement inflationary expectations, continual increases
in the minimum wage work at cross purposes with poli
cies to contain inflation. It seems clear that a prompt
review of minimum wage policy is called for.
The Federal Government did take a step to foster
an atmosphere of wage moderation in holding the
October 1, 1978 increase in the General Service sched
ule for Federal white-collar workers to 5.5 percent (and
in imposing a similar cap on pay increases for bluecollar workers). That was significantly below the 8.4
percent increase that the President’s pay agent had
found would be needed to maintain comparability with
private-sector wages. Are Federal workers thus being
asked to bear an unfair share of the burden of wage
restraint? The second article in the collection reviews
this issue. Using an analytical approach fundamentally
different from that employed in establishing pay com
parability, it marshals evidence that, at least through
1975, Federal workers on average were generously
compensated, compared with workers having similar
personal characteristics in the private sector. These find
ings certainly do not mean that all Federal workers are
overpaid, but they do suggest that the Government’s
example of wage restraint will not penalize unfairly the
average Federal employee.
There is one important qualification to the foregoing
generalization. High-level professional and managerial
positions in the Federal Government are not compen
sated comparably to those in the private sector. This
situation could have an adverse effect on the quality
Digitized for
2 FRASER
FRBNY Quarterly Review/Autumn 1978
of the high-level Federal work force. Good government
requires a pay policy that enables the government to
attract and to retain exceptionally qualified individuals
for professional and managerial positions.
The third article deals with the automatic linking of
wages and retirement income to the price level. Index
ation of wages has become increasingly widespread
with the persistence of rapid inflation in the United
States, and many retired persons enjoy indexed gov
ernment pensions or social security benefits. Such
indexation at least partially protects the incomes of
some from the ravages of inflation and mitigates some
of the inequities inflicted by inflation. At the same
time, however, indexation may tend to perpetuate or
even aggravate inflation and to exacerbate inequities
vis-a-vis those who are not protected by indexation.
Moreover, indexation, by making inflation relatively
painless for some, narrows the constituency for price
stability.
If inflation continues unabated, pressures will grow
for more widespread linking of wages, pensions, finan
cial instruments, and taxes to prices. The pressure for
indexation stems from an understandable quest for
security in an uncertain world. But it would be far
better to conquer inflation than to multiply devices to
make inflation more palatable to some. The example
of wage moderation shown by the Federal Govern
ment will be fruitless unless it can mark a step toward
eventual price stability. Review of policy toward the
minimum wage could be another auspicious step. Ul
timately, of course, responsible fiscal and monetary
policies are essential for inflation to be brought under
control. Given that fundamental, the path to price
stability can be smoothed by the exercise of wage
moderation in the public and private sectors.
The
minimum wage
a perspective
The Federal minimum wage was established in the
depression conditions that gripped the United States
economy in the late 1930’s. Aimed at bolstering the
paychecks of low-wage workers, the law not only has
continued but has been expanded. Now, forty years
after the initial legislation, the minimum wage provi
sions cover nearly two thirds of the nation’s employees.
More than AVz million workers, or about one in every
twenty workers, were directly affected by the 15 percent
jump in the Federal minimum wage to $2.65 on
January 1, 1978. While such increases in the legal
wage floor have the beneficial effect of raising the earn
ings of particular segments of the working poor, they
also entail certain social costs as well. Increases in
the minimum wage contribute to raising the underlying
rate of inflation. At the same time, because laws can
not mandate increases in worker productivity, a higher
wage floor can exceed some employees’ productivity
so that employers cut back on their payrolls, creating
unemployment for some. Recent research suggests that
increases in the minimum wage serve to raise the job
lessness of teenagers, particularly minority youths.
The minimum wage forty years later
The Fair Labor Standards Act (FLSA) of 1938 was de
signed to improve the working conditions of American
labor. Among other features, the legislation introduced
a minimum wag« of 25 cents per hour that would serve
as “a floor under wages”. At first, the minimum wage
was limited to employees in industries engaged in the
production of goods for interstate commerce. It is esti
mated that initially the legislation covered about 11 mil
lion workers, or about 25 percent of total employment.
Over the ensuing forty years, various amendments
and revisions raised the minimum wage (table). As
a result of the 1977 amendments, the legal wage floor
rose to $2.65 per hour and, on January 1, 1979, the
wage floor is legislated to rise to $2.90 per hour. Sub
sequent increases are slated to bring it to $3.35 per
hour at the beginning of 1981.
As the wage rate was raised over the years, the
coverage of the legislation has been broadened to
the point that coverage has expanded markedly in
low-wage industries.1 By 1976, some 56 million workers,
or close to two thirds of total employment, were cov
ered by Federal minimum wage legislation. The con
tinued expansion of coverage of the minimum wage
provision of the FLSA was reversed by a 1976 Supreme
Court decision. In a ruling, referred to as the National
League of Cities decision, the Court held that state
and local government employees who are engaged in
traditional governmental functions are not subject to
the minimum wage provisions. As a consequence, an
estimated 5 million workers were removed from the
coverage of the legislation.
From the start, the FLSA allowed employers to
apply the value of board, lodging, and other facilities
traditionally furnished to employees toward meeting
minimum wage requirements. In 1966, when the cover
age of the minimum wage was extended to many
workers whose compensation depended importantly on
tips, the amendment permitted employers to count
employees’ tips as meeting up to one half of the mini
mum wage. In addition to raising the minimum wage,
the 1977 amendment provided for a step-by-step re
duction in this “tip credit” from the current 50 percent
to 40 percent by 1980.
Coverage of the FLSA’s minimum wage provisions
i As the coverage of the minimum wage has been expanded, the pay
of newly covered workers has not been immediately brought
into parity with the wages of those already covered. Instead, wage
schedules have been established to bring the newly covered
workers gradually into equality with the general minimum wage
over a period of several years.
FRBNY Quarterly Review/Autumn 1978
3
Chronology of Federal Minimum Wage
and Worker Coverage, 1938-81
Effective date
Minim um wage
($ per hour)
W orker coverage
(in thousands)
O ctober 24, 1938 ......................
.25
11,000
O ctober 24, 1939 ......................
.30
12,500
O ctober 24, 1945 ......................
.40
20,000
January 25, 1950 ......................
.75
20,900
March 1, 1956 .............................
1.00
24,000
September 3, 1961 ....................
1.15
27,500
September 3, 1963 ....................
1.25
27,500
February 1, 1967 ......................
1.40
40,400
February 1, 1968 ......................
41,600
May 1, 1974 ...............................
1.60
2.00
January 1, 1975 ........................
2.10
57,400
56,100
January 1, 1976 ........................
2.30
56,100
January 1, 1978 ........................
2.65
51,900*
January 1, 1979 ........................
2.90
January 1, 1980 ........................
January 1, 1981 ........................
3.10
3.35
t
t
t
* National League of C ities decision elim inated most
state and local governm ent coverage.
t Not available.
Source: United States Department of Labor, Employment
Standards A dm inistration.
has always varied with respect to industry and occupa
tional groups. In many industries, such as m anufactur
ing and transportation, the coverage is nearly complete.
Institutions of higher education, as well as cer
tain other employers of full-tim e students on a parttime basis, may offer wage scales at special rates
below the minimum. In addition, in order not to burden
small businesses, the Congress exempted retail and
service firm s with annual sales of less than $250,000
from the minimum wage. As a result of the 1977 FLSA
amendments, this sales level was raised to $275,000 on
July 1, 1978 and is scheduled to rise further, ultim ately
reaching $365,500 on December 31, 1981. With respect
to occupations, executive, adm inistrative, professional,
and outside sales jobs, as well as casual baby-sitting
and serving as a companion for the aged and infirm,
are exempt from minimum wage legislation.
Hurting some it aims to help
Concern for the well-being of low-income Americans
led the Congress to enact and to expand the minimum
wage legislation. Underlying these Congressional ac
tions was the view that any employed American should
be able to enjoy a standard of living above the poverty
Digitized for
4 FRASER
FRBNY Quarterly R eview/Autum n 1978
level. There is little question that, for the m ajority of
workers whose wages are close to the minimum, an
increase in the minimum wage increases th e ir pay
checks and they are better off than they would be
otherwise. But that is only one effect of an increase
in the minimum wage. While lawmakers can raise wage
rates, incomes may not necessarily increase since the
higher wage w ill result in some w orkers being unable
to find jobs or working fewer hours. The central prob
lem is that laws cannot mandate increased w orker
productivity.
If the minimum wage is raised above the pay level
consistent with a w orker’s productivity, employers
respond by reducing their payrolls. Who w ill bear the
burden of the higher minimum? It w ill be the least
productive, low-skilled workers— those whose produc
tivity is below the hourly wage floor. In the jargon of
economists, they are the “ m arginally productive” w ork
ers, many of whom are teenagers and m inorities, who
lack experience and suffer handicaps that lower their
productivity.
For the most part, econom ic theory has always rec
ognized that imposing a wage floor creates unemploy
ment for some. What econom ists were unable to
answer was whether the unemployment effects were
large or small. For many years, numerous studies tried
to evaluate the impact of the legislated wage on un
employment, but the results were inconclusive. The
problem centered on isolating the effects associated
with the minimum wage from the myriad of influences
that affect unemployment. More recently, however, the
inconclusive evidence of the past has given way to
research that has established a clear link between
unemployment among youths, especially m inority
youths, and increases in the minimum wage. The econo
metric evidence offered by Gramlich, Ragan, and
Mincer, among others, has clearly established that
teenagers’ employment is adversely affected by the
minimum wage legislation.2 Establishing this relation
ship meant using advanced statistical tools that were
designed to distinguish between the effects of the
minimum wage and the influence of other factors,
such as econom ic activity.
Why does the minimum wage affect teenagers? The
answer is simple: most young people are low-wage
earners and, as a result, raising the minimum wage
can be expected to have a more pronounced impact
on them than on other workers. In mid-1977, the average
2 Edward M. Gram lich, “ Im pact of Minim um Wages on Other
Wages, Employment, and Family Incom es” , B rookings Papers on
Econom ic A ctivity (II, 1976); James F. Ragan, Jr., “ Minim um
Wages and the Youth Labor M arket’’, Review of Econom ics and
S tatistics (May 1977); Jacob Mincer, “ Unem ploym ent Effects
of Minim um W ages” , Journal of P olitical Economy (August 1976).
teenager was paid $2.58 per hour, some 28 cents above
the 1977 minimum and 7 cents below the 1978 minimum.
Black youths were paid even less, on average.
Although the estimates of the effect of a raise in the
minimum wage on youth joblessness differ, a reason
able estimate suggests that by itself raising the mini
mum wage to $2.65 per hour added about 1 percentage
point to the unemployment rate of all teenagers and 3
to 4 percentage points to the jobless rate of black
youths. In addition, on the basis of historical experi
ence, the increase in the minimum wage may be ex
pected to reduce substantially full-time employment of
teenagers and to force many of them into part-time
employment.3 Although these youths will be denied
full-time employment, they will be employed on a parttime basis and will not be included among the jobless.
With increases in the minimum wage serving to re
duce job gains, teenage joblessness, especially among
minorities, remains an important social problem. In
September 1978, the teenage unemployment rate stood
at 16.6 percent, remaining unrelentingly high. Among
black and other minority youths, the official rate of
joblessness hovered close to 35 percent in September
1978. Moreover, the official rate of unemployment prob
ably understates the actual unemployment of youths,
particularly among blacks and other minorities. This
understatement is because many minority youths, faced
with such limited prospects of finding employment,
simply withdraw from the labor force by ceasing to
look for work, and thus are no longer counted among
the unemployed. The result is that a much smaller
proportion of minority youths are in the labor market.
For example, the participation rate of young black
males is around 40 percent, compared with some 65
percent of white youths who are in the labor force.4
A high rate of joblessness among youths is not new,
nor is it unique to the United States.5 The rate of
unemployment among young people should be ex
pected to be greater than for adults. In part, this is
because youths are not closely tied to the labor market
and are also searching alternative job opportunities.
3 On this point, see Edward M. Gramlich, “ Impact of Minimum
Wages on Other Wages, Employment, and Family Incomes” ,
Brookings Papers on Economic Activity (II, 1976).
4 The labor force participation rate is the proportion of the
noninstitutionalized population 16 years of age and above in the
labor force, i.e., the proportion of the population of working
age who are either employed or seeking employment. The
participation rate can be determined separately for the popula
tion as a whole or for any particular demographic group.
For more on this topic, see “The Changing Composition of the
Labor Force” in this Bank's Quarterly Review (Winter 1976).
5 For an overview of this important social ill, see Walter E.
Williams, Youth and Minority Unemployment, a study prepared
for the Joint Economic Committee, July 6, 1977.
But the current rate of joblessness is unacceptably
high. What is particularly distressing is that early ex
periences in the labor market are likely to affect life
time earnings and employment behavior. Thus, the lack
of jobs means failing to gain on-the-job training, work
experience, and the opportunity to develop work habits.
Government programs such as the minimum wage
inhibit the efficient functioning of the markets, tending
to raise the rate of unemployment.
The “need” to limit low-paying jobs
One point made by some in support of the Federal
minimum wage is that increasing the legal wage floor
is a way of eliminating menial, or so-called “dead-end”,
jobs. Employers respond to the increase in wages by
substituting capital for labor inputs. Such capital out
lays serve to raise productivity, or output per manhour, which means a higher standard of living for the
nation. Advances in the nation’s potential to produce
are to be desired, but the unemployment associated
with such changes as the replacement of manually op
erated elevators by automatic elevators is not neces
sarily welcome. Many of today’s high school seniors, let
alone the large number of dropouts from school, lack
the basic reading, writing, or computational ability nec
essary to obtain entry to skilled jobs. In view of these
realities, there is clearly a need for jobs to accommo
date the many youths who have but limited skills.
In any case, labeling jobs as dead-end positions
is unwarranted. Jobs that are so labeled can be an
important opportunity for many disadvantaged youths.
Unskilled jobs are entry-level jobs, positions from which
individuals can progress and advance. These jobs offer
a chance for many of the nation’s disadvantaged youths
to obtain some of the rudimentary skills that many lack.
Inflation and the minimum wage
In addition to affecting employment, increases in the
minimum wage also increase prices, since the rise in
the wage floor represents an important rise in employ
ers’ wage costs. The Department of Labor estimates
that the 1978 increase directly added more than $2
billion to the annual wage bill of the economy. In addi
tion to the nearly 5 million workers whose wages were
directly affected, the minimum wage can also lead to
a rise in the wages of others as the entire pay structure
of many firms or industries is adjusted to the higher
base pay.6 With labor productivity growth unlikely to
be affected in the near term, these higher wage costs
mean increased unit labor costs. This, in turn, leads to
*T o some extent, this indirect effect could be offset by a
lowering of wages in those sectors of the economy not covered
by the legal minimum. This would be due to an inflow into
those sectors of workers who were displaced by the higher wage.
FRBNY Quarterly Review/Autumn 1978
5
increased pressure on prices as businesses act to pass
on these higher costs to customers.
How much have prices risen? While precise esti
mates are beyond economists’ abilities, the M.I.T.Penn-Social Science Research Council econometric
model provides a rough measure. This large econo
metric model contains about 200 equations that attempt
to capture the behavior of various economic sectors.
Based on historical relationships embodied in the
model, the measurable direct and indirect effects of
the 1978 increase in the wage floor resulted in an
increase in the overall level of prices of about Vz per
cent. Price pressures are, of course, relatively greater
in those sectors that make greater use of low-wage
labor. Thus, for example, prices of food away from
home show larger increases since reportedly 30 per
cent of the food service industry’s payroll is composed
of low-wage teenagers.
In addition to these inflationary impacts, the mini
mum wage legislation also works against reducing in
flation in other ways. By helping to cement inflationary
expectations into the wage structure, it reinforces the
persistence of inflation. The legislated wage increases
through 1981 represent close to a 10 percent annual
rate of increase, well above the 7 percent private sec
tor wage growth posted in recent years. By confirming
the prospects of continued wage hikes, it becomes
increasingly difficult to reduce the rate of inflation, as
inflation is a dynamic problem in which the conditions
inherited from the past feed the inflation process. The
process becomes sustained when the expectations are
deeply ingrained in society’s thinking— in its contracts
and laws.
The jump in the legal minimum is only one of sev
eral governmental influences that have exacerbated
the rising cost pressures on businesses. The 1978
rise came at a time when important payroll taxes—
namely, social security and unemployment insurance
— were also increased. While the impact on prices of
Digitized for
6 FRASER
FRBNY Quarterly Review/Autumn 1978
each of these increases separately may be small,
taken together these government-mandated increases
are likely to have added as much as 1 percent to labor
costs, thus widening the gap between compensation
and productivity. Looking ahead, the 9.4 percent in
crease scheduled for 1979, which will raise the wage
floor to $2.90 per hour, appears to be less inflationary
than this year’s 15 percent hike. However, after taking
into account the level of wages of affected workers in
relation to the minimum wage floor, the impact on the
aggregate wage bill in 1979 will be about the same
as this year.
Conclusion
The Federal minimum wage law raises the income of
millions of marginally productive workers. But the
benefits of the minimum wage are not without social
costs. Among these costs are higher rates of youth
joblessness and greater inflation. The price of ignoring
these negative influences is high— both for the econ
omy and for society. Unquestionably, people who lack
the ability to earn a decent living must be helped. The
issue is whether the minimum wage is an effective tool
with which to alleviate poverty. While research may
never be able to provide a definitive answer, it seems
that increases in the legal wage floor offer at best an
imperfect solution to important social concerns, since
remedying the ills of some poor people comes at the
expense of others who are equally impoverished.
Clearly, alternatives need to be explored in greater
depth. Attempting to ameliorate some of the harmful
effects of the minimum wage legislation by allowing a
subminimum differential for teenagers or newly hired
workers is one possible solution. Another alternative
might be a wage subsidy program, whereby the
government pays part of the wages of low productivity
workers. In any case, efforts to raise the level of mar
ketable skills by improving and expanding training and
educational programs should be intensified.
Robert T. Falconer
Federal
Day scales:
now much
is too much?
On October 1, Federal white-collar workers received a
general pay increase of 5.5 percent. In a separate ac
tion, a similar 5.5 percent cap was placed on bluecollar wage increases as well. Were such limitations
warranted to balance excessive increases in the past,
or do they make the Federal work force a scapegoat
in the fight against inflation?
Between 1956 and 1977, average annual earnings in
Federal civilian government grew 262 percent in con
trast to a growth of 201 percent in annual earnings in
all private industries (chart). The annual payroll cost
for the Federal civilian work force of 2.8 million is now
approximately $59 billion. Officials report that there
are, on average, eleven applicants awaiting every Fed
eral opening. Since 1962, major reforms have been im
plemented in the Federal pay-setting systems to assure
that Federal workers receive pay comparable to that
given private-sector workers performing similar work.
The question then arises: were the pay increases ac
companying these reforms necessary to bring Federal
workers to comparability with their private-sector
counterparts? Certainly, equity considerations require
that Federal workers receive pay similar to what they
could have in private employment. At the same time,
however, efficiency considerations require that this be
achieved at minimum cost to the Government employer.
The purpose of this article is to consider whether these
twin goals have been achieved. This is not intended to
provide an alternative system of pay determination.
Instead, it is meant as an independent evaluation of
the present system. The approach used here— exam
ination of the pay relationships between comparable
Federal and private-sector workers— is entirely differ
ent from that used by the agencies charged with the
task of setting Federal pay levels. Whereas this article
compares pay levels for comparable individuals in the
two sectors, the pay-setting agencies compare pay
levels for comparable jobs in the two sectors.
The results reviewed here show that during the pe
riod 1960-75 Federal workers, on average, were paid
significantly more than their private-sector counter
parts.1 The estimated Federal wage advantage was 15
percent for males and 21 percent for females in 1975.
In part, this results from less discrimination in the public
than in the private sector. In more general terms, how
ever, this Federal differential appears to reflect the
intrinsic nature of Government employment. It is also
partially attributable to the problems associated with
the pay reforms of the 1960’s. These results relate to
the bulk of Federal workers. They do not in any way
contradict the well-known underpayment of upper level
professional and managerial personnel in Government.
Federal pay systems
Federal civilian workers are paid under a number of
different pay systems. Some of these are established
by individual laws, while others are administratively
determined. Although there are more than fifty sep
arate pay systems, they fall into four principal catego
ries. In 1977 (the most recent available data), ap
proximately 56 percent of Federal civilian employees
were paid under the General Schedule (GS). This
statutory pay system covers most Federal white-collar
employees. Approximately 19 percent of Federal work
ers were covered by the Federal Wage System. The
employees covered under this administratively deter
mined schedule generally are blue-collar workers or
foremen or supervisors. Approximately 21 percent of
Federal workers are covered by the administratively
established schedules of the Postal Service in which
wages are set through collective bargaining. The ap-
1 For a full discussion of these results, see Sharon P. Smith,
Equal Pay in the Public Sector: Fact or Fantasy (Research Report
Series No. 122, Industrial Relations Section, Princeton University,
Princeton, N.J., 1977).
FRBNY Quarterly Review/Autumn 1978
7
Average Annual Earnings of Workers
by Sector
Index 1956=100
4 0 0 ............................................................................... ....... —
1956
58
60
62
64
66
68
70
72
74
76 77
^E xcludes employees of government enterprises, e.g., United
States Postal Service, Tennessee Valley Authority, etc.
Source: United States Department of Commerce, Bureau
of Economic Analysis, Survey of Current Business.
proxim ately 5 percent remaining Federal w orkers are
paid under a variety of plans— both statutory and ad
m inistratively determined. These include pay plans
fo r the Tennessee Valley Authority (TVA), the Central
Intelligence Agency, the Foreign Service, top officials
in the executive branch, etc.
Two broad characteristics of pay determ ination in
the Federal Government (as well as in other govern
ment entities) distinguish it from the private sector
and contribute to a Federal/private pay differential.
The first characteristic is that, by the nature of gov
ernment, there are neither incentives to maximize prof
its nor m arket pressures to affect wages. Thus, if the
Federal Government pays its workers higher wages
than com parable private-sector workers receive, it
may obtain higher quality w orkers and queues may
form for Government jobs. However, there is no strong
force short of taxpayer revolt that w ill lower Federal
wages or even vigorously resist further wage in
creases.2 By contrast, if a com petitive private-sector
2 The recent passage of Proposition 13 in C alifornia suggests that
"taxpayer revolt” is not the remote po ssib ility it once appeared
to be. Nevertheless, it remains true that reactions of this type are
more probable at the lower levels of government, where the
association between increases in governm ent w orkers’ salaries and
taxes w ill probably be much more direct in the minds of tax
payers than at the upper levels of government.
Digitized for
8 FRASER
FRBNY Quarterly R eview/Autum n 1978
employer pays higher than comparable wages, he also
may obtain higher quality workers. But, unless the
quality differential at least equals the wage differential
or the production process is more efficient, he w ill be
at a com petitive disadvantage and be unable to con
tinue in business.
The second characteristic distinguishing the wagedeterm ination process in Government is the presence
of political considerations. The ultim ate decision mak
ers on questions concerning Government pay are
elected officials who must consider the impact of their
decisions on the votes they anticipate in the next elec
tion. Because inform ation on legislative questions is
not costless, it is expected that voters w ill obtain in
form ation only on questions of most concern to them.
Consequently, since Federal workers are more likely
to have and to express an opinion on Federal pay
questions than voters and taxpayers who are not
Government employees, the Federal employer may be
expected to be relatively more responsive to pressure
for wage increases than to suggestions fo r wage re
straint. However, political activity among these other
tax-paying voters w ill provide some check on the
upward pressure on wages by Government workers.
Comparability principle
Given the existence of so many pay systems fo r Federal
workers, is there one theme that unites all these
systems? The pay reforms of the 1960’s were an
attempt to apply to all Federal w orkers the prin
ciple that Federal w orkers should receive pay com pa
rable to that given to private-sector workers per
form ing sim ilar work. (Subsequently, this principle
has been extended to the pay systems of many states
and m unicipalities.) The com parability principle has
been applied to Federal blue-collar w orkers since
1862 when these wages were required by law to
conform “ with those of private establishm ents in the
immediate v ic in ity ” . However, prior to 1962, there was
no provision fo r the regular adjustment of the wages
of Federal w hite-collar workers to reflect labor-m arket
conditions in the private sector. Indeed, the impetus
for these reforms came from the difficulties the Gov
ernment was experiencing in attracting professional
and technical workers at that time.
A pplication of the com parability principle to Fed
eral pay determ ination seems appropriate if Govern
ment and private-sector employers demand the same
time and effort of their employees and provide the
same benefits. Although the concept of com parability
is simple, its implem entation is complicated.
Comparability in practice
The mechanisms fo r determ ining comparable pay rates
vary by pay system. GS salaries are set annually on
the basis of comparisons with private-sector pay from
information in the National Survey of Professional,
Administrative, Technical, and Clerical Pay— the PATC
survey— conducted by the Bureau of Labor Statistics.
Salaries under a number of other schedules (such as
the Foreign Service schedules and the salary system
for physicians, dentists, and nurses in the Department
of Medicine and Surgery of the Veterans Administra
tion) are also linked to the GS.3 Policy requires that
Federal pay rates satisfy both internal and external
alignment criteria: that is, wages must not only be
comparable to those paid for similar jobs in the pri
vate sector but must also maintain internal pay dif
ferentials in accordance with work and responsibility
distinctions.
The results of the pay comparison process are
reported to the President by the Civil Service Com
mission (CSC) and the Office of Management and
Budget (OMB), along with the views of the Federal
Employees Pay Council. On the basis of these reports,
the President’s pay agent— consisting of the Director
of OMB, the Chairman of the CSC, and the Secretary
of Labor— suggests a pay increase to maintain com
parability. For fiscal 1979, this recommendation came
to 8.4 percent.4 However, at the President’s recom
mendation and with the Congress not disapproving, the
Federal white-collar general pay increase (which took
effect October 1) was held to 5.5 percent as part of the
fight against inflation.5
Prior to 1970, postal salaries were set by linkage
with the GS. Since the establishment of the United
States Postal Service in 1970, pay has been set through
collective bargaining. Similarly, blue-collar employees
3 Salaries of top executives in the Executive Branch (except the
President), members of the Congress, and all Federal judges
are adjusted in every Presidential election year on the basis of
recommendations from the Quadrennial Commission on Executive,
Legislative, and Judicial Salaries. Between March 1969 and
February 1977, however, there was no general increase made in
the Executive Schedule (except for a cost-of-living increase
linked to the annual GS increase in 1975). The lowest level in
the Executive Schedule sets a ceiling on GS salaries. As a result,
salaries in the upper grades of the GS schedule have been
compressed.
4 This was an average percentage increase in the entire GS
(of eighteen grades, with ten steps at each grade), though the
specific recommended increase varied by grade, ranging in
size from 6.15 percent at GS-1 to 13.27 percent at GS-15.
s This is a uniform increase for the entire GS (except at the upper
grades where this increase would raise salaries above the ceiling
level). There are two additional sources of pay increases for indi
vidual workers: the regular within-grade increase and the quality
step-increase. Historically, 98 percent of all GS employees have
received regular within-grade increases (the specified time for the
increase varies by step from one year of service in steps 1
through 3 to three years of service in steps 7 through 9) while
only 2 percent have received, in addition, quality step-increases
each year.
of such Federal agencies as the TVA also have their
wages set through collective bargaining.
All the above pay systems are national salary sched
ules. The Federal Wage System, by contrast, sets
Federal blue-collar wages so that wages conform with
the average prevailing private-sector wage in the local
labor-market area. Area pay levels, like those for the
blue-collar workers, would give a more accurate repre
sentation of the labor market for most lower level
white-collar positions.
The comparability process of pay determination
seems, in principle, to be “fair” to both Federal em
ployer and employee. However, on closer examination,
it appears that this principle has been insufficient to
achieve these goals. There are both conceptual and
technical difficulties that seriously undermine this pay
process.
Shortcomings of the comparability process
Use of the comparability process to determine Federal
wages implicitly acknowledges that the absence of
profit considerations in Government eliminates the
establishment of a market-clearing wage through com
petitive conditions. However, it does not necessarily
follow that the prevailing private-sector wages reflect
the free play of competitive forces. Instead, these
wages may show the influence of licensing regulations,
discrimination by race or sex, etc. These influences
on wage rates will be carried over into the Federal
sector through the comparability process.
In addition, it appears that in the application of the
comparability principle there has been some confusion
of goals. The original aim of this policy was to improve
the efficiency of Federal pay determination by equal
izing Federal and private-sector wages for similar jobs.
However, in certain instances, this goal has been com
promised because there has been, in addition, a norma
tive concept of what Federal pay “should be”, regard
less of what prevailing private-sector rates are. This
tendency may be reinforced by the political nature of
the pay process and in particular by the relatively
strong political influence of the employee.
A much greater conceptual difficulty with a pay sys
tem that equates pay in the Federal and private
sectors is that jobs in the broadest sense may not be
the same in both sectors— that is, they may differ with
respect to job security, working conditions, social
status, etc. If the nature of a job is different in the two
sectors but tastes remain the same among individuals,
then there should be compensating differentials be
tween the sectors. Indeed, the view that there were
greater nonpecuniary returns for working in Govern
ment had been a past justification for paying lower
wages for Government jobs.
FRBNY Quarterly Review/Autumn 1978
9
Difficulties in effecting comparability
Among the technical shortcomings of the comparability
process is the fact that comparisons are based on
wages only, even though an increasingly important part
of employee compensation consists of fringe benefits.4
This approach was justified on the grounds that early
studies indicated that the total benefit package was
approximately equal in Federal and private sectors.
In addition, the difficulties associated with collecting
such data were judged to be overwhelming. However,
more recent studies have pointed out that benefits (in
particular, provisions for leave time and retirement
programs) are higher in Federal employment. In addi
tion, the steadiness of hours worked in Federal bluecollar jobs is probably greater than in the private
sector since Federal workers are not subject to sea
sonal layoffs. Thus, if Federal and private-sector wages
were equated, Federal workers would still enjoy an
advantage in total compensation.
The entire process of comparability is based on a
comparison of jobs in the two sectors. Although this
approach is often used in private industry, it is a highly
complex process, which can result in erroneous wage
comparisons unless carefully administered and con
tinuously monitored. For one, job matches must be
properly established and then be constantly reas
sessed. Because matches are not made for every job
in a grade level, the correct grade classification of
Federal jobs is also of particular importance. This re
quires job evaluation systems through which jobs are
ranked in importance according to their requirements
and responsibilities.
The comparability process also requires that the
jobs surveyed in the private sector be representative
of the pay and employment conditions prevailing there.
If the survey oversamples relatively high-paying em
ployers, the resulting Federal pay rates will be exces
sive. It appears that the present surveys do suffer from
these problems. All surveys exclude state and local
government workers (this is a statutory requirement)
even though, for many jobs, these are the Federal
Government’s principal competitors. The surveys also
exclude nonprofit institutions and certain industries
(a number of which are relatively low paying). All es
tablishments below a specified minimum size likewise
are not examined. Study of private-sector pay patterns
has shown that there is a positive relationship between
size of establishment and pay rate.7
The surveys used to set blue-collar wages in local
labor-market areas often “import” wages from higher
paying labor markets. This occurs because the under
lying legislation— commonly referred to as the Monroney Amendment— permits Federal blue-collar wages
to be determined on the basis of private-survey results
from the nearest wage area most comparable in man
power, employment, population, and industry. This is
allowed if there are no comparable private-sector jobs
in the local labor-market area in question and if the
inclusion of this other area’s wages does not result in
lower Federal wages. In practice, it has been observed
that this procedure may raise the wages of all Federal
blue-collar workers in the wage area, not just those for
whom there are data problems. The Congressional
Budget Office estimated that, as a result of “importing”
wages from other areas, wages in 1976 for 17 percent
of Federal blue-collar workers were as much as 25
percent higher than local private-sector wages.8
Federal pay rates must be maintained at levels suffi
cient to attract qualified manpower but, at the same
time, be compatible with an internal structure. How
ever, problems arise when this internal structure is not
consistent with common practice in the private sector.
For example, the pay system for Federal blue-collar
workers defines a schedule of fifteen grades with five
steps at each grade even though very few privatesector employers follow such multiple-step schedules.
The wage at step 2 of each grade is set to conform
with the average prevailing private-sector wage in the
local labor-market area. However, estimates indicate
that as of June 1977 nearly 80 percent of Federal bluecollar workers were above step 2. Thus, their pay was
4 to 12 percent above the prevailing private-sector
rate average.9
Federal/private wage comparisons
What is the relative pay position of Federal workers?
With all the problems associated with the job compari
son surveys, an independent means of evaluating rela
tive pay positions can provide some light on this
question. The method used here is to study the wages
of many individual Federal and private-sector work7 See Richard A. Lester, "Pay Differentials by Size of Establishment” ,
Industrial Relations, 7 (October 1967), pages 57-67.
8 Congressional Budget Office, The Costs ot Defense Manpower:
Issues tor 1977 (Government Printing Office, January 1977), page 111.
4 This is also true of the comparability process at lower levels of
government. An interesting exception is California where
comparisons are made of “total equivalent compensation” , which
includes both salary and benefits. The CSC has developed and
is testing a total compensation comparability process before
the plan is submitted to the Congress.
10FRASER
FRBNY Quarterly Review/Autumn 1978
Digitized for
9 Furthermore, Federal blue-collar workers are paid a night shift
differential (a percentage of their regular wage, increasing with
the lateness of the hour worked) which generally exceeds
private-sector rates. For example, in 1976 in the Washington, D.C.
area, the average Federal differential for the second shift was nearly
twice as large as the average private differential.
Table 1
Table 2
Estimated Gross Federal/Private Pay Differentials
Estimated Net Federal/Private Wage Differentials
Ratio of mean Federal- to mean private-sector wage
Ratio of Federal- to private-sector wage for com parable workers
Year
Males
Females
W h ite s ....................................................................
1.13
1.07
N o n w h ite s .............................................................
1.30
1.23
W h ite s ....................................................................
1.17
1.32
N o n w h ite s ..............................................................
1.28
1.35
1973 ........................................................................
1.44
1.63
1975 ........................................................................
1.39
1.46
1960:
Year
Males
Females
1960:
1970:
N o n w h ite s .........
......
1.17
1.27
....................
1970:
'' fe: ■
■
Sources: Smith, Equal Pay in the Public Sector: Fact or Fantasy,
pages 55, 59, 63, and "G overnm ent Wage D ifferentials” , Journal
of Urban Economics 4 (July 1977), page 260.
ers.10 Using detailed inform ation on individuals em
ployed in the two sectors and regression analysis, it
can be determined w hether comparable workers (not
jobs) receive the same wage in the two sectors. (The
number of individuals examined in this analysis varies
according to the data source, ranging from nearly
40,000 to over 130,000.)
An examination of gross Federal/private wage d if
ferentials for these individual workers (the ratio of
mean Federal to mean private-sector hourly wage rates)
indicates that the average Federal wage has been con
sistently higher than the average private-sector wage
(Table 1).11 For example, in 1960, Table 1 shows that the
average wage of white male Federal workers was 13
percent higher than the average wage of white male
private-sector workers. However, this alone does not
necessarily indicate that Federal workers are overpaid.
Pay varies among individuals according to differences
in qualifications as well as differences in many socio
econom ic factors. Thus a more highly paid group of
workers may sim ply be more qualified (for example,
more highly educated). However, the same qualifica
10 To be com plete, this exam ination should consider nonwage
com pensation, as well. This would give allowance for com parable
workers receiving the same total com pensation, but with
different mixes of wage and nonwage items. However, because the
data used for this analysis do not contain inform ation on
benefits, attention is lim ited to wage differentials.
11 Because of the nature of the data used for this analysis, there
is a time lag between the collection of the data, its availability
for pu blic use, and its availability for use in this particular
analysis. A ccordingly, the estim ates presented here for 1975 are
the most recent available. However, viewed in conjunction with the
results for 1960, 1970, and 1973, they provide a consistent picture.
N o n w h ite s .........
1973
..................
1975 ....................
......
.........
1.04
1.08
.........
1.15
1.15
.........
1.20
1.38
.........
1.15
1.21
Source: Smith, Equal Pay in the P ublic Sector: Fact or Fantasy,
page 68.
tions may pay different returns in different sectors: for
example, a high school education may pay a higher re
turn to an individual worker in the Federal than in the
private sector. Thus, the key question is to determine
what portion of the gross differentials reported in Table 1
is due to differences in the characteristics of Federal
and private-sector w orkers and what portion is due to
differences in the returns on these characteristics.
How is the breakdown done? The first step is to
estimate for each sector the returns in wages an indi
vidual will receive, on average, for his qualifications
(years of education and of w ork experience) and socio
econom ic characteristics (such as m arital status, num
ber of children born, race, Spanish origin, veteran
status, union membership, broad occupational cate
gory, geographic region of residence, city populationsize of residence, health status, part-tim e status, dual
job-holding status).12 Prior study has suggested that
each of these factors may have an im portant effect
on the wage rate an individual may receive. For ex
ample, being of Spanish origin may reduce an individ-
12 This is done by estim ating for each sector a pay structure which
is a regression equation of the form In P = XB fitted to
detailed data on individuals, where In P is the natural logorithm of
the in d ivid u a l’s pay (estimated hourly w ages), X is a matrix of
explanatory variables, and B is a vector of estim ated coefficients.
In an equation of this form, each B may be interpreted as the
percentage effect of the associated explanatory variable on pay,
that is, the return to that characteristic. The data used to
estim ate this model consist of representative sam ples of Federal
and private-sector workers throughout the nation from the
censuses of 1960 and 1970 and from the May Current Population
Surveys of 1973 and 1975. For further discussion of this
model and these data, see Smith, Equal Pay in the P ublic Sector:
Fact o r Fantasy, pages 35-49.
FRBNY Quarterly Review/Autum n 1978
11
ual’s anticipated wage rate because of both ethnic dis
crimination and language difficulties that reduce the
worker’s productivity.
At the same time, Federal and private-sector work
ers do differ in these qualifications and characteristics.
Therefore, the second step in the analysis is to
estimate the wage each group of workers would receive
if the rewards for their qualifications were the same in
both sectors. In this way, an estimate is made of the
wage Federal workers would receive if the rewards for
their qualifications were the same as in the private
sector. This calculation shows that a part of the differ
ence between the wage of Federal workers and the
wage of private-sector workers is attributable to differ
ences in the qualifications and characteristics of the
workers in the two sectors. The remaining difference—
the net differential that persists between workers of
comparable characteristics— provides an estimate of
the wage advantage Federal workers have because they
work for the Federal Government.13 It is true that the
measure of the net differential is a residual: it is the
portion of the gross differential remaining after account
ing for differences in characteristics between workers.
Thus some part may be due to characteristics that have
not been considered. However, the net differential is
primarily considered to be a return attributable to the
individual’s sector of employment.
Estimated net differentials for 1960, 1970, 1973, and
1975 are presented in Table 2. These estimates can
be thought of as snapshots taken at different points
during the fifteen-year period between 1960 and 1975.
They indicate that Federal workers of either sex have
consistently been paid more than private-sector work
ers of comparable qualifications, as here defined. The
estimates range from a low of a 4 percent wage ad
vantage for white males in Federal employment in 1970
13 This analysis of the gross Federal/private pay differential is done
under two alternative assumptions: (1) that the estimated private pay
structure would apply to all workers, or (2) that the estimated
Federal pay structure would apply. Then, under assumption (1 ), the
pay Federal workers would receive is obtained by multiplying
the mean values of the explanatory variables for Federal workers by
the estimated coefficients for private workers. The difference
between this estimated wage variable for Federal workers and the
mean of the observed wage variable for private workers is a
measure of the wage differential attributable to differences in
qualifications between workers in the two sectors. The remainder of
the gross differential— the difference between the mean of the
observed wage variable and the estimated wage variable for Federal
workers— is a measure of the net differential, the wage differ
ential between comparable workers. A similar analysis can be made
under assumption (2 ). The net differentials that are presented
in Table 2 represent the midpoints of estimates made under assump
tions (1) and (2 ). It should be noted that these are proportional
differentials, since they are antilogarithms of differences between
wage variables expressed in logarithms.
Digitized 12
for FRASER
FRBNY Quarterly Review/Autumn 1978
to a high of a 38 percent wage advantage for females
in Federal employment in 1973.
At every point in time considered, the wage advan
tage is least for the majority group: white males in
1960 and 1970, males in 1973 and 1975. These results
suggest that the impact of both race and sex discrim
ination on wage rates is less in Federal than in privatesector employment. This may result from the use of
open competitive examinations to fill many Federal
jobs and from more effective affirmative action pro
grams. Thus, a minority worker in the Federal Govern
ment enjoys a wage advantage over a comparable
minority worker in the private sector. At the same
time, however, it should be emphasized that further
study has shown that white males in the Federal
Government in 1973 and in 1975 also enjoyed a wage
advantage over comparable white males in the private
sector. Thus, the Federal net differential is not solely
a reflection of relatively less race and sex discrimina
tion in Federal wages.
The decrease observed in the net wage differentials
between 1973 and 1975 is probably a consequence of
the rapid inflation that occurred during this period.14
One major group of Federal workers who have been
unaffected by inflation in this way consists of Postal
Service employees who have had a cost-of-living
adjustment (COLA) in their contract since 1973 (see
the article beginning on page 16). A separate examina
tion of the Federal/private wage relationship for postal
and for Federal nonpostal workers (using the same
data sources) indicates that, while the wage advantage
for these other Federal workers decreased somewhat
between 1973 and 1975, the wage advantage enjoyed
by postal workers over comparable private-sector
workers remained fairly constant during this period.
The observation of a significant wage advantage for
postal workers is further confirmed in a recent study
by Adie who observed that postal pay rates now
exceed general pay levels by 35 percent.15
Thus, it seems that, on average, Federal workers of
either sex have been paid more than comparable
workers in the private sector both before and after the
implementation of the pay reforms. However, this does
not indicate that each individual Federal worker is
14 This decrease probably reflects the fact that, because of the set
timing for increases under most of the Federal pay systems,
these schedules respond to inflationary pressures with a lag. As a
result of the inflation that occurred subsequent to 1975, the
net wage differentials may have decreased further. However, the
persistence of long queues awaiting Federal jobs suggests
that some positive net wage differential remains.
15 See Douglas K. Adie, An Evaluation of Postal Service Wage Rates
(Washington, D.C.: American Enterprise Institute for Public Policy
Research, 1977).
one researcher found that out of nearly 15,000 occu
pational titles only one was missing from the Govern
ment: stripteaser. A structure of wage differentials by
occupation may be observed in both Federal and
private-sector employment. An exam ination of the
Federal impact on wage structures in individual occu
pational categories provides inform ation on whether
the Federal wage advantage reported in Table 2 ac
crues only in certain occupations or exists across oc-
overpaid since variation is expected by occupation,
region, sex, etc. To understand better these possible
variations, the F ederal/private wage relationship w ill
be examined at more detailed subdivisions.
Occupational variation in the Federal wage advantage
With the growth of Government employment, there has
also been an increase in the diversity of occupations
represented. Indeed, in a study of Federal employment,
Table 3
Estimated Federal Wage Advantage by Occupational Group, 1975
In percent
Professionals
Sex
Males
...............
Females
...........
Managers
Clerks
Service
Craft: men
Operatives
Laborers
14
*
15
t
*
14
12
27
36
21
25
t
:
* There were an insufficient number of Federal workers in this occupational category to estim ate
■i Feder il d fferent 3l
t Positive but not significa ntly different from zero in a statistical sense.
Source: Smith, Equal Pay in the P ublic Sector: Fact or Fantasy, pages 80, 81.
Table 4
Estimated Postal and Other Federal Wage Advantage by
SMSA Population Size, 1975*
In percent
Standard Metropolitan Statistical Area of
Type of Federal
em ployment
NonSMSA
Less than
250,000
250.000 to
500,000
500,000 to
1 m illion
t
11
t
22
t
13
Postal Service ......................... ...... 53
69
46
Other Federal ......................... ...... 22
18
16
1 m illion to
3 m illion
More than
3 m illion
Males:
Postal Service ......................... ...... 13
Other Federal ......................... ...... 17
12
22
f
f
42
42
21
17
19
t
Females:
* In general, a Standard M etropolitan S tatistical Area (SMSA) consists of a county or group of counties
that contain at least one city w hich has a population of 50,000 or more plus the adjacent counties
that are m etropolitan in character and are econom ically and socially integrated w ith the central city.
In this analysis, categories are differentiated according to the population size of SMSA in w hich the
individual resides as follows: outside an SMSA, in an SMSA of less than 250,000 residents, in an
SMSA of between 250,000 and 500,000 residents, in an SMSA of between 500,000 and 1 m illion
residents, in an SMSA of between 1 m illion and 3 m illion residents, or in an SMSA of more than
3 m illion residents.
f Positive but not significa ntly different from zero in a statistical sense.
Source: Smith, Equal Pay in the P ublic Sector: Fact or Fantasy, page 100.
FRBNY Quarterly Review/Autum n 1978
13
cupational categories (Table 3).16
These estimates indicate that, while there is con
siderable variation by occupational group, Federal
workers in 1975 received at least the same wages as
comparable private-sector workers (the occupations
with this relationship are male laborers and female
operatives) and more often enjoyed a substantial wage
advantage. The largest Federal wage advantage for
males and the second largest for females are observed
in service occupations (27 percent for males, 25 per
cent for females).
These estimates do not appear to support observa
tions made in other studies of wage disadvantages
for upper level professionals and managers. Two fac
tors probably account for this discrepancy. The first
is that, since the data used here pertain to a ll profes
sional and managerial workers (undifferentiated by
level), there may be an insufficient number of obser
vations at these upper grade levels in the data to
observe these disadvantages. The second is that, if
pay scales at these levels are too low, they may have
influenced the more experienced and qualified Federal
jobholders to seek private-sector positions compara
ble to the high-level Government jobs. Then a Federal
wage advantage may still be observed for the upper
grade levels if above a certain level of experience
individuals shift to the private sector to earn the
greatest return to their qualifications. The upper level
positions in Government may be filled by less experi
enced individuals than comparable private-sector po
sitions.
Location and the Federal wage advantage
Wages in the private sector have been observed to
show substantial variation across labor-market areas,
reflecting the effects of differences in cost of living
and in pecuniary and nonpecuniary opportunities.
However, while blue-collar Federal wages vary across
labor-market areas, white-collar Federal pay is uniform
throughout the nation. Accordingly, it is appropriate
to consider how location affects the relative wage
position of Federal workers.
The estimated wage advantage of postal and other
Federal workers over comparable private-sector work
ers in 1975 did vary greatly according to the popula
tion size of the Standard Metropolitan Statistical Area
16 These estimates are obtained using a somewhat different equation
form than that employed for the estimates reported in Table 2:
here a wage structure is estimated for all workers (both public and
private sector) in a particular occupational category. By includ
ing a variable for Federal employment, an estimate is obtained for
the percentage wage advantage a Federal worker enjoys over
a comparable private-sector worker.
FRBNY Quarterly Review/Autumn 1978
Digitized14
for FRASER
(SMSA) in which the individual resides (Table 4).17
However, there is no evidence that either group of
Federal workers is paid less than private-sector work
ers of comparable qualifications. With only one excep
tion (nonpostal workers residing in an SMSA with a
population of more than 3 million), women working for
the Federal Government enjoy a substantial wage ad
vantage over their private-sector counterparts. By
contrast, male postal workers in most SMSA sizes and
nonpostal workers residing in the largest SMSA size
receive approximately the same wages as their privatesector counterparts. Among both males and females,
this wage advantage is largest in non-SMSAs. Thus,
these results support the view that Federal wages
should be set on an area basis for a ll workers to
reflect local labor-market conditions, since present
national salary schedules lead to wage advantages
for Federal workers in certain areas.
Summary and conclusions
The estimates presented here have shown that during
the period from 1960 through 1975 Federal workers,
on average, received pay that was at least similar
and usually superior to that of comparable privatesector workers. The net advantage has usually been
greater for women than for men. In part, this reflects
the fact that the impact of discrimination on wages is
less in the Federal than in the private sector. Although,
as expected by the national pay schedules, the esti
mated Federal wage advantage varied by place of resi
dence, no evidence was found of a wage disadvantage
for Federal workers. These net differentials are not
solely the consequence of the comparability legislation
of the 1960’s but were present before these reforms
were enacted. However, the legislation does appear
to have helped reinforce the upward bias already
present in Government pay. The net result was Federal
wages that may be regarded as “too high”, that is,
higher than wages paid to comparable private-sector
workers and higher than necessary to attract qualified
manpower.
As previously indicated the results of this study do
not imply that every individual employed by the Federal
Government is overpaid. There are undoubtedly many
individuals in Government service who could command
larger compensation in the private sector. This is par
ticularly true among upper level professionals and
managers. Indeed, the findings of this study suggest
that the Government may have to improve compensa17 These estimates are obtained using an equation form similar to
that employed for the estimates reported in Table 3: here a wage
structure is estimated for all workers in each SMSA and separate
variables are included for postal and nonpostal Federal employment.
tion at the upper levels in order to attract and to retain
qualified personnel.
In a Government that is distinguished by its checks
and balances, it is surprising that the system for pay de
termination for its workers did not show more checks
on the accuracy of wage comparisons or more balances
on the relatively greater political power of Govern
ment employees in the pay decision process. Unless
such checks and balances are strengthened, Federal/
private wage differentials will likely persist in the
future, as will queues of workers awaiting Federal jobs.
Moreover, the interrelationships of Federal- and privatesector pay setting through the comparability process
suggest the possibility of spiraling wage increases, as
workers in each sector seek to equal or to exceed the
wage increases granted in the other sector.
The means to buttress the checks and balances
in the pay process are available. The most important
of these is to take into account another factor besides
private-sector pay rates— manpower availability. If, for
example, the comparability process suggests a pay
increase for certain Government jobs, but there already
are long queues of qualified individuals awaiting such
jobs, the increase is unnecessary to attract the re
quired manpower. This could act as a check to prevent
the Government from paying higher wages than are
necessary to attract qualified manpower as well as a
balance against the relatively greater influence of
Federal workers on lawmakers in these pay decisions.
It is in the interest of all that Government be assured
of attracting and retaining necessary manpower. How
ever, it is also in everyone’s interest that this be done
at least cost to the Government. Except for problems
in filling upper level managerial and professional po
sitions, the first of these two goals appears to have
been achieved throughout most of the Federal Govern
ment. Attention should now be directed to the latter
goal, as well.
Sharon P. Smith
FRBNY Quarterly Review/Autumn 1978
15
Indexation of wages
and retirement income
in the United States
Should wages be automatically adjusted in line with
the cost of living? Should pension benefits be tied
to a price index? These questions have been de
bated at union meetings, labor contract bargain
ing sessions, and in the legislatures of local, state,
and national governments. Economists, too, have ex
amined indexation and raised some provocative ques
tions about the desirability of indexation from the
viewpoint of inflation and unemployment.
The idea of indexing income is more than two cen
turies old and has been used in many nations. During
the American Revolution, Massachusetts linked sol
diers’ pay to an index composed of beef, corn, wool,
and leather prices. In nineteenth century Britain, some
firms offered wage scales which were tied to the prices
of certain staple commodities. In Belgium, many wage
indexation plans date back to the 1930’s. Then, dur
ing the two decades following World War II, a large
number of other European countries experimented with
wage indexation of one form or another; Israel and
Brazil also put extensive indexation programs into
effect. In the United States, several major unions nego
tiated wage escalators during the 1950’s. Over the
past ten years, however, a new surge of interest in
cost-of-living protection has developed in the United
States, as the inflation rate accelerated sharply. Among
unionized workers, escalator clauses have now become
more common. As for the retired, social security bene
fits are now indexed, and many of those who worked
for Federal, state, or local governments are entitled to
price-linked retirement benefits.
Is indexation a desirable thing? Indexation may make
the individual feel more secure about the purchasing
power of income. But, under some circumstances, in
dexation of wages might make layoffs more common
and actually reduce workers’ well-being. As regards
inflation, there is the question of whether indexation
16FRASER
FRBNY Quarterly Review/Autumn 1978
Digitized for
would make it easier to curb inflation or whether it
would aggravate it.
What is the purpose of indexation?
Indexation ties the dollar size of a payment to an index
of prices. For example, wage indexation typically
provides for the hourly wage rate to rise automatically
by 1 cent whenever the consumer price index in
creases by a certain amount. The basic purpose of
this linkage is to provide an automatic mechanism for
protecting the purchasing power of income if prices
should rise. Its major use has been in long-term con
tracts, particularly long-term union contracts. Index
ation is not so common in short-term wage contracts,
since wages and salaries can adjust to changing prices
without long delays.
In long-term union contracts, indexation is basically
an insurance policy protecting the worker against un
expectedly high rates of inflation. Insight into the
nature of wage indexation can be gained by consider
ing the wage negotiations in two contracts which differ
only in one respect— one has a cost-of-living adjust
ment clause or “COLA” and the other does not. In the
wage contract without a cost-of-living escalator clause,
the negotiating parties must estimate the likely infla
tion rate and provide for a wage pattern that reflects
this inflation adjustment. For example, if prices are ex
pected to rise at a 6 percent annual rate, and the par
ties decide on a real wage increase of 2 percent a
year, annual wages would be slated to rise 8 percent in
each year of the contract; 8 percent would allow a
6 percent “purchasing power adjustment” plus a 2
percent “real” increase. Consider next a contract
with a cost-of-living clause which provides that the
wage rate will increase by the same percentage as the
cost of living. (The hypothetical escalator for this ex
ample gives 100 percent protection, whereas most
escalator clauses fall short of complete protection. See
page 18.) For this wage contract, only the real wage
increase of 2 percent per year would need to be
specified; the COLA would provide whatever adjust
ment in the nominal wage rate that was necessary for
an annual real wage increase of 2 percent.
In the contract without the COLA, the actual real
wage increase depends upon the inflation rate. If
prices rose at 6 percent per year over the duration of
the contract, workers would get a 2 percent real wage
increase. In contrast, if prices rose at a 7 percent an
nual rate, they would gain a real wage increase of only
1 percent per year (the 8 percent increase in wages
less the 7 percent increase in prices), a full percentage
point less than expected.
The importance of a COLA clause depends upon the
duration of the contract. In a short contract without a
COLA, say of one-year duration, the loss (or gain) would
typically be small. For example, a 1 percent per year
error in the price forecast would cost the worker a
dollar amount equal to only V2 percent of annual wages
over the course of a one-year contract. (The real wage
falls short by a full 1 percent only at the end of the
year.) The same incorrect inflation estimate over a
three-year contract, however, would cost the worker a
total of 41/2 percent of annual wages: V2 percent in the
first year, 11/2 percent in the second, and 2V2 percent
in the third.
For employees whose expenses depend upon cur
rent prices, a COLA clause reduces the employee’s
uncertainty about the likely purchasing power of wages
from his job over the ensuing contract period. Does
it also reduce the uncertainty of the employer? If the
employer’s expenses and sales revenues were closely
related to the general price level upon which the COLA
is based, real profits might be more certain under a
contract with a COLA: both the price of the goods sold
and the wage rate paid would move together. In an
alternative contract without a COLA, the employer
could do better than one with the COLA, if prices
rose at 7 percent, but might also do worse if prices
rose at only a 5 percent rate.
Thus, under generalized inflation— all prices in
creasing at the same rate— indexation might insure
both parties against unexpected loss. However, higher
inflation usually absorbs some resources, detracting
from the economy’s productivity, so that it is rarely pos
sible for everyone to remain as well off. Of great con
cern to the firm is the possibility that inflation will not
proceed at the same pace in all sectors. If the prices
of other goods rise more rapidly than expected while
the price of the goods the firm is producing does not,
the COLA clause would erode real profits.
Who has cost-of-living protection in the United States?
Escalator clauses of one form or another appear in
a wide variety of circumstances today. According to
the Bureau of Labor Statistics, about half of the United
States population is affected in some way. Food stamp
allotments are based upon an index of food costs,
eligibility for some governmental assistance programs
is based upon a poverty line linked to the price level,
and business contracts for the delivery of goods and
services may specify that payments depend upon the
level of certain prices. The focus here is on two major
concerns of the typical American worker— whether his
or her wage rate keeps pace with inflation and what
the outlook is for the purchasing power of retirement
benefits.
Wage COLAs
The union sector in the United States consists of 19.4
million workers. Of this group, more than 8 V2 mil
lion workers are covered by contracts that call for
automatic adjustments of wage rates based upon
changes in the cost of living.1
In “major” bargaining agreements— private nonfarm
sector agreements which cover 1,000 or more workers
— COLA clauses are fairly common. Of the roughly
10 million workers who are covered by such agree
ments, about 6 million currently have some form of
escalator clause. The United Automobile Workers was
the first major union to gain cost-of-living protection;
its COLA with General Motors Corporation dates back
to 1948. Since then, there have been ups and downs
in the number of contracts containing COLAs. Periods
of inflation typically have led to the adoption of es
calator clauses, while periods of price stability have
resulted in the dropping of such clauses (chart). After
the run-up of prices associated with the Korean war
several other major unions got COLAs, and by 1958
some 4 million workers covered by major agreements
had cost-of-living provisions. Then, in the early 1960’s
several large unions, including the steel and communi
cations workers, dropped the COLA from their con
tracts, and the number of workers covered by COLAs
declined to below 2 million in 1963.
Beginning in the late sixties, however, accelerat
ing inflation created renewed interest in cost-of-living
provisions. The steel and communications workers
had their COLA clauses reinstituted, and other large
unions obtained cost-of-living provisions. Particularly
noteworthy was the surge in COLA coverage between
1974 and 1976; 2 million workers covered by major
1 A good review of wage escalator clauses may be found in an
article by Nicholas S. Perna, “The Contractual Cost-of-Living
Escalator” , Monthly Review (Federal Reserve Bank of New York,
July 1974), pages 177-82.
FRBNY Quarterly Review/Autumn 1978
17
Inflation
Covered
Nonfarm
or More
Rate and the Number of Workers
by Escalator Clauses (Private
Agreements Involving 1,000
Workers)
Percent
G r o w t h in c o n s u m e r p r i c e i n d e x
10
8642-
M illions of w orke rs
7
* P relim inary fo r 1978.
Source: United S tates D epartm ent o f Labor, Bureau of
Labor S ta tis tic s .
agreements obtained COLAs, bringing the total to 6 m il
lion workers for this sector of the union w ork force.
There are now many private-sector industries in which
virtua lly all m ajor labor contracts contain COLAs
(Table 1).
As m ight be expected, unions with longer contracts
are more frequently covered by escalators. In bargain
ing units with three-year contracts, for example, about
71 percent of w orkers were covered by COLAs in
1978, whereas in bargaining units with annual con
tracts only 9 percent of w orkers have COLAs.
COLA clauses have also been obtained by unions
representing w orkers employed by state, county, and
city governments. The Bureau of Labor Statistics sur
veyed the collective bargaining agreements of many
o f these governmental units in 1975.2 About 25 percent
of the state, county, and local government w orkers
covered by the survey had wage escalators.
2 C haracteristics of Agreements of State and Local Governments
(B ulletin 1947). The survey covered all states and those counties
and cities with population of 100,000 or more but excluded
agreem ents covering workers in pu blic education.
Digitized 18
for FRASER
FRBNY Quarterly Review/Autum n 1978
Federal Government w orkers do not have a COLA
clause for salaries, although since 1967 they have nor
mally received an annual structural increase which was
judged to be comparable to wage increases in the pri
vate sector. (See article on Federal pay scales begin
ning on page 7 of this issue.) However, the Postal
Service, now a quasi-independent agency, does have a
COLA clause in the agreements with four postal unions
which represent about 570,000 employees.
What are the escalator clauses that cover Am erican
workers like? Although, in principle, an escalator
clause could be designed to compensate the em
ployee fully for rises in the price level, most escalators
provide substantially less than 100 percent protection.
One feature which leads to less than full compensation
is the adjustment formula. This is usually specified as
1 cent per hour for each 0.3 or 0.4 percentage point
rise in the consumer price index— over half the w ork
ers with escalators under m ajor contracts have this
type of formula. Another popular type of form ula
gives cost-of-living increases in the base wage. These
types of form ula seldom compensate high wage workers
fully and usually do not compensate even the aver
age w orker fully for cost-of-living changes. For exam
ple, consider a w orker with hourly earnings of $7.75
per hour in July 1977. Between July 1977 and July 1978
the consumer price index rose 7.7 percent. By the 1
cent per 0.4 percentage point formula, the COLA would
be 35 cents, equivalent to a 4.5 percent wage increase.
With the 1 cent per 0.3 percentage point formula, the
w orker would get a 47 cent COLA, equivalent to a 6.1
percent wage increase.
Second, many COLAs require that the rate of infla
tion exceed a minimum level (called the “ trig g e r”
level) before workers get any adjustm ent at all; others
specify a range w ithin which the usual escalator
form ula does not hold; and some escalators have “ caps”
or maximums on the size of the allowable cost-of-living
adjustment. Alm ost 11/2 m illion w orkers covered by
m ajor contracts in 1978 had capped escalators.
Finally, there is generally some time lag between the
occurrence of inflation and the compensation fo r it.
Of workers covered by m ajor agreements, about
2Vz m illion receive annual adjustments and 0.9 m il
lion receive semiannual adjustments; only 2.3 m illion
get quarterly adjustments. If inflation accelerates,
the time lag in receiving the corresponding wage ad
justm ent causes some loss in real income. One analyst
estimated that these features have restricted wage
increases from escalator clauses to about 50 percent
of the consumer price index rise.3
3 H.M. Douty, C ost-of-Living Escalator Clauses and Inflation
(C ouncil on Wage and Price Stability, August 1975), page 28.
Another way that unionized workers with long-term
contracts have tried to reduce price uncertainties is
through “ reopener” clauses which allow renegotiation
during the contract period under certain circum stances.
In fact, some contracts specify that cost-of-living in
creases greater than some amount permit reopening.
Although in some circum stances the reopening w ill
produce a wage adjustment sim ilar to a COLA clause,
other factors such as m arket conditions and firm profits
may come into play when the wage discussion reopens.
Because of this, reopener clauses may avoid some of
the problems associated with COLAs. (See page 21.)
Table 1
Industries with Escalators Covering
Over 50 Percent of the Workers
C ollective bargaining agreem ents in the private
nonfarm sector covering 1,000 or more workers
W orkers covered by escalator clauses
(in thousands)
(in percent)
Industry
Metal m in in g ..........................
51
97.5
...............
2
100.0
Bitum inous coal and
lignite m ining ........................
120
100.0
Ordnance and
a c c e s s o rie s .............................
25
Anthracite m ining
74.3
Tobacco m a n u fa c tu re s .........
Printing and p u b lis h in g ___
94.9
58.1
37
Rubber and plastic
products .................................
86
89.8
Primary metal industries . . .
555
96.1
79.1
Fabricated metal products .
70
Machinery, except
electrical .................................
267
89.5
Electrical equipm ent ...........
432
91.6
Transportation equipm ent . .
1018
R ailroad transportation . . . .
94.8
100.0
Local and urban t r a n s it ___
115
M otor freight transpor
tation ........................................
97.6
551
98.1
Transportation by a i r ...........
101
62.3
Transportation s e r v ic e s ------
2
100.0
C o m m u n ic a tio n s ....................
679
93.7
W holesale t r a d e ....................
44
61.8
Food s to r e s .............................
400
72.6
Finance, insurance, and
real e s ta te ...............................
51
65.1
Source: United States Department of Labor, Bureau of Labor
Statistics, M onthly Labor Review (January 1978).
Retirement income COLAs
Many retired w orkers receive social security benefits
plus a pension from their previous employer. Oldage and survivors benefits provided by the social
security system have been adjusted upward many times
since 1965, and public-sector employees frequently do
receive cost-of-living pension adjustments. However,
private pension plans with COLAs are extrem ely rare.
Adjustm ents that have been made to the benefits of
retired persons collecting social security are shown
in Table 2. Until 1972, each of these increases required
special legislation. Now, however, benefits are auto
m atically increased annually to reflect cost-of-living
changes. Belgium, Canada, France, Germany, Norway,
and Sweden also provide automatic cost-of-living
adjustments to social security payments. According to
the United States Public Law 92-336, passed in 1972,
automatic cost-of-living adjustments are paid in years
when there is no legislation giving a general social
security benefit increase.11 Special legislation raised
OASDI benefits in the years 1972-74; the first cost-ofliving increase was effective June 1975. C ost-of-living
adjustments were also paid in 1976, 1977, and 1978. A
cost-of-living adjustment would be made only if the
consumer price index were at least 3 percent higher
than it was when the most recent adjustment was made.
In February 1978, about 18 m illion people were re
ceiving retirem ent benefits from the social security
system. Also, those qualifying for survivors benefits
and disability benefits under OASDI— about 16 m illion
persons— got sim ilar cost-of-living adjustments. The
social security system as a whole, therefore, is pro
viding 34 m illion people with price-linked benefits in
1978. By 1985, about 40 m illion persons w ill be receiv
ing such benefits, according to projections.
Because social security benefits were frequently
changed p rior to their indexing in 1972, there never
was a long lag between inflation and an increase in
benefits. What then was accom plished by indexing
benefits? The price linking of social security benefits
may prevent the tem porary losses in real income of
the retired that could occur when special legislation
was required and may thereby make people feel more
secure. In addition, it may save the United States
Congress some time.
The situation regarding private pensions is very d if
ferent: th eir purchasing power has been greatly eroded.
Very few companies provide indexed pension benefits.
Indeed, a 1972-73 Conference Board survey indicated
that only 4 percent of the firm s questioned provided
4 The 1977 am endm ents to the Social Security Act corrected
a feature that "d o u b le -in d e xe d ” newly retired people’s benefits,
giving payments w hich rose with wages and w ith prices.
FRBNY Quarterly R eview/Autum n 1978
19
Table 2
The Consumer Price Index and OASDl* Benefits for a Person Who Retired in 1959
OASDI benefits*
Date
Percentage change
January 1965 ..........................................................................................
C um u lativet
7 .0 f 7.0
7 .8 f
February 1968 .......................................................................................... ........ 13.020.9
January 1970 .......................................................................................... ........ 15.0
January 1971
Consumer price index
Percentage change
7.8
9.3
39.0
Cumulative}:
17.8
10.8
30.6
.......................................................................................... ........ 10.053.0
5.1
37.2
Septem ber 1972 .............................................................................................. 20.0 83.5
5.8
45.2
March-June 1974 ............................................................................................ 11.0
103.7
16.4
9.4
69.0
June 1975 .................................................................................................
8.0 120.0
84.9
June 1976 .................................................................................................
6.4 134.1
5.9
95.8
June 1977 .................................................................................................
5.9 147.9
6.8
109.1
June 1978 .................................................................................................
6.5 164.0
7.5
124.8
* OASDI = old-age, survivors, disab ility, and hospital insurance system under the Social Security A dm inistration.
t Since 1959. There were no adjustm ents between 1959 and 1965.
$ Because of com pounding, exceeds the sum of the items in previous colum n. For example,
(1.07) (1.13) = 1.209 w hich yields the 20.9 percent for the second item in colum n (2 ).
Sources: OASDI benefits: S ocial Security Bulletin, selected issues. Consumer price index for all urban consumers,
seasonally adjusted: Bureau of Labor Statistics.
pension benefits that were price linked.5 (However, 17
percent of the plans did allow some portion of the pen
sion to be taken in the form of an annuity, whose an
nual payment would vary with an investment portfolio of
stocks and bonds.) The tremendous erosion of pension
purchasing power in recent years has led some firms to
raise voluntarily the pensions of the already retired.
However, such adjustments have been insufficient to
maintain purchasing power. Few unions have expressed
interest in obtaining indexed pensions. And those in
dexed pensions that have been negotiated typically
provide only for new retirees.
There are two m ajor exceptions to the general lack
of price linking for pensions. One is the College Re
tirem ent Equities Fund (CREF), a nationwide plan for
college teachers that was established in 1952 by the
Teachers Insurance and Annuity Association of Amer
ica (TIAA). Many United States colleges make pension
contributions to this plan on behalf of their faculty,
rather than provide their own pension plans. CREF
invests pension money in common stocks and pays
retirem ent benefits based upon the earnings of its
portfolio. When it was established, economists believed
that the stock m arket would keep pace with the cost
5 M itchell Meyer and Harland Fox, Profile of Employee Benefits
(Conference Board, 1974).
Digitized for
20 FRASER
FRBNY Quarterly Review/Autum n 1978
of living so that CREF would in effect provide a pricelinked pension. As it turned out, however, stock prices
have not kept pace and CREF beneficiaries have not re
ceived dollar benefits sufficient to compensate for the
cost of living. The pension plan fo r retired railroad
w orkers is the second m ajor exception to the general
lack of price linking for pensions in the private sector;
this plan did in fact provide a pension with price pro
tection. Railway workers have been covered by spe
cial Federal legislation since 1937 and so in many
respects are more sim ilar to public employees than
to private ones. According to the 1974 amendments to
the Railroad Retirement Act, retired railway workers
receive a substitute for social security, which provides
identical price-linked retirem ent benefits, plus an
added payment which is partially price linked.6 About
1 m illion workers are receiving retirement benefits
under this program.
In sharp contrast to the private sector, the public
sector does provide extensive cost-of-living protection
to retired workers. The first COLA for Federal pensions
was legislated in 1962. However, no adjustment was
called for in the years 1962, 1963, and 1964 under the
original wording. The procedures were changed in 1965,
6 Prior to the 1974 am endm ents, many railway workers received both
social security and a full pension from the railway retirement system.
1969, and again in 1976.7 According to the 1976 legis
lation, increases based upon the June-December con
sumer price index change are given each March 1 and
increases based upon the December-June change are
given to retired civil service workers each Septem
ber 1. Retired military personnel are also entitled to
indexed pensions. About 2.8 million retired Federal
civil service workers and military personnel and their
survivors were receiving such pensions at the begin
ning of 1978.
At the state and local level, there is some indexation
of pension plans, although considerably less than at
the Federal level. A recent Bureau of Labor Statistics
study of the municipal pension plans of twenty-seven
large cities found that about one third of the plans
provided benefits connected to movement in the con
sumer price index. However, most of these cost-ofliving adjustments were limited to a maximum of 5
percent a year.
Why have private companies not indexed their pen
sion plans, while the Federal Government and many
state and local governments have indexed theirs?
Perhaps this difference reflects the fact that retired
persons are voters and so retain influence on Govern
ment decisions whereas their influence on the com
pany and/or union ceases when they retire. The
company management and union leadership may feel
that it is not in their interest to distribute money to the
retired that might instead be used to boost the pay of
current workers.
The outlook for indexation
Because the union sector is relatively small in the
United States, compared with many other industrial
ized countries, escalator clauses p e r se are unlikely to
apply to the bulk of the work force. For example, there
is a total of 19.4 million unionized workers, com
pared with a work force of 100 million. This comparison,
however, understates the possible impact of wage in
dexation in the United States. For one thing, there is a
tendency to maintain wage differentials by giving sim
ilar increases to nonunion employees in the firm and
for some nonunion firms to give cost-of-living adjust
ments to keep in line with other firms’ wages. Second,
governmental units frequently award civil service work
ers increases comparable to those in the private sec
tor. As for the future, there are some unions with
out COLAs who have expressed some interest and there
are some groups who would like to tie the minimum
7 The 1969 amendment (Public Law 91-93) gave an extra 1 percent each
time there was an adjustment to compensate for the time lag. However,
because this 1 percent became part of the base, there was over
compensation for the cost of living.
wage to the general wage level. Further wage indexa
tion may, therefore, occur unless inflation abates.
There is very little indexation of private pensions cur
rently, and it is not apparent whether there will be much
movement in this direction. The public sector, which
had been fairly generous with providing price-linked
retirement benefits, appears to be under pressure to
cut costs. In addition, many localities have discovered
that their pension plans are underfunded even under
current provisions. Finally, there is new awareness of
possible pitfalls in designing pension escalators; bene
fits were inadvertently indexed for both prices and
wages, i.e., “double-indexed”, in the 1972 Social Se
curity Act and there was a “kicker” in the 1969 civil
service retirement amendments which overindexed pen
sion benefits. These factors suggest that public pension
plans will probably not move further toward indexation
very fast in the near future. As far as private pensions go,
there is relatively little movement toward indexation, al
though this may change if inflation continues at current
high levels. There has already been an increased
awareness of the possibility that pension benefits may
become severely eroded. Combined with the rising
average age of the work force, this may cause wider
interest in pension indexation. On the other hand, if
people work longer years because of the rise in the
mandatory retirement age, erosion of pension values
will be a less serious problem.
Consequences of indexation
Economists and policymakers, union leaders, and cor
porate representatives have all argued about the de
sirability of indexation. The differences in opinion arise
not only from differences in their respective interests
but also from certain implicit assumptions about how
the economy works and what causes prices to change.
One important characteristic of indexation is that
it speeds up the response of prices and wages to
changes in the economy. In some circumstances this
faster response may be desirable, but in other circum
stances it is not.
Several economists, including Milton Friedman and
JoAnna Gray, have argued that the fast response is
desirable in the case where the money supply grows
faster or slower than expected.8 Without indexation,
nominal wages are set to provide some compensation
for expected inflation. If nominal wages have been set
to provide for a large inflation adjustment, then a de
celeration in money growth and in price inflation would
8 See Milton Friedman’s article “ Using Escalators to Help Fight
Inflation” , Fortune Magazine (July 1974), pages 94-96, 174-76,
and JoAnna Gray’s article "Wage Indexation: A Macroeconomic
Approach” , Journal of Monetary Economics (April 1976),
pages 221-35.
FRBNY Quarterly Review/Autumn 1978
21
cause the real wage rate to rise. Under these circum
stances, firms could no longer afford to maintain the
same employment and output. In contrast, with indexed
wages, a slowing of money growth and inflation would
not have this effect on the real wage and employment.
Therefore, the indexed wage scenario is less likely to
produce changes in employment and output when the
money Supply shifts.
Friedman goes one step further, arguing that a tight
monetary policy to curb inflation would be more palat
able in an indexed economy, because a reduction in
money supply growth would cause less unemployment.
If money growth were reduced, the inflation rate might
actually be lower under indexation. The Friedman argu
ment is indeed intriguing, and there are some econo
mists who agree with his argument and are in favor of
wage indexing for just this reason. However, others
point out that numerous political forces impinge on our
policies toward inflation. If large well-defined groups
who have strong lobbying power are protected against
accelerations in inflation, the pressures to restrain it
could be much moderated. Already, a large fraction of
the union sector and a substantial portion of workers in
the government sector have wage and salary protec
tion. Moreover, through social security, many of the
elderly receive price protection, and those who had
government jobs commonly have indexed pensions.
These groups who could contribute to an effective
campaign against inflation no longer have a big incen
tive to do so.
A more fundamental difficulty with indexation is
its affect on the economy’s ability to adjust to changes
in output, productivity, or international competitiveness
— situations which usually require a change in the real
wage rate. Consider, for example, the situation in 197374. Food prices skyrocketed in 1973, because world
grain harvests were much smaller than normal. The
price of petroleum, an important United States import,
was doubled by the Organization of Petroleum Export
ing Countries in the fall of 1973 and again in early
1974. As a result, the overall cost of living, which in
cludes food and energy, increased much more than the
price of domestic nonagricultural goods. United States
producers of nonagricultural goods could not afford to
maintain the same employment if workers insisted on
wage increases commensurate with the overall cost of
living. Yet, with wage indexation, wages increase auto
matically with the overall cost of living. This forces
nonagricultural business to lay off workers, leading to
more unemployment. Furthermore, if monetary and
fiscal policy are more stimulative— to ease the un
employment problem— then there is much more infla
tion in this scenario of wage indexation.
The damage on the price front might be offset dur
22 FRASER
FRBNY Quarterly Review/Autumn 1978
Digitized for
ing periods when farm prices fall or when imported
goods become cheaper. However, in the short run,
indexation does make changes in the supply of certain
goods and services much more painful for the econ
omy, both in terms of unemployment and in terms of
inflation. Indeed, Finland abandoned wage indexation
in 1968, shortly after it devalued, to prevent some of
these consequences.
The faster response of wages produced by indexa
tion has led to criticism on other grounds. Some peo
ple argue that an economy without indexation has a
second line of defense against rampant inflation. They
postulate the following example: the demand for goods
and services expands beyond the economy’s ability to
produce, and prices begin to rise. Clearly, one defense
against this excessive demand situation is restrictive
fiscal and monetary policies. But sometimes there are
difficulties in sizing up the near-term situation, or there
are delays in obtaining necessary legislation. (And, in
some cases, political forces prevent the implementa
tion of restrictive policies.) In these cases the redis
tribution of real income caused by inflation might help
to curb it: If wages were not indexed, the price rise
would lower the real income of workers who have
wage contracts and raise the real profits of firms and
the real tax revenue of the government. (The govern
ment gains both from inflation p e r se and from the fact
that corporate profits are taxed at a higher marginal
rate than the typical wage or salary income.) As a
result of their real income loss, workers will cut their
purchases of goods and services. But the gainers of
real income— business firms and government— do not
usually step up their purchases much when real income
is higher than expected. The cut in spending by work
ers therefore exceeds the rise in spending by business
and government and, on balance, total spending de
clines, helping to curb inflation.
Turning to a different perspective, some people
argue that indexation permits the lengthening of union
contracts, thereby saving on negotiation time and the
danger of strikes. However, longer terhn contracts build
in a real wage structure for the length of the contract
that may turn out to be unsuitable. For example, sup
pose the demand for good A increases and that for
good B declines. Typically, wages in industry A will
increase, as the industry tries to attract workers, while
wages in industry B fall relative to the average. A long
term contract tends to postpone the relative wage de
cline in industry B and may therefore lead to more
layoffs and higher unemployment. Generalizing tiiis
phenomenon, changes in relative demand and supply
for various goods could lead to more unemployment
under a system of long-term contracts.
To the extent that escalator clauses provide only
partial cost-of-living compensation, all these problems
may not be very serious at the present time. However,
if indexation becomes more widespread and fuller price
protection for those with escalators develops, the
economy may have a higher unemployment rate and
periods of more rapid inflation.
Problems with the consumer price index
as the basis for COLAs
While the potential increases in inflation and unem
ployment have concerned the majority of analysts,
some economists are concerned about the use of the
consumer price index in escalator clauses. They point
out that at least some of the other problems mentioned
above could be either aggravated or mitigated by the
particular price index that is used.
From the perspective of the consumer, the consumer
price index faiis_to^measure the true cost ofTivma~on
a qmmber oLscores. One problem is t^at sales taxes
and property taxes are treated as consumer prices;
income taxes, on the other hand, do not affect the in
dex. Therefore, if a state or local government replaced
an income tax with an excise or property tax or vice
versa, the index would change when in fact there was
no change in the cost of living. Or, if a state or local
government were to impose a new excise or property
tax and undertake provision of some service that was
formerly provided by the' private sector, the index
would rise, even though the consumers’ true purchas
ing power at the current level of income is in fact un
changed. Thus, decisions that should be based upon
efficiency considerations may be hampered; with in
dexing based upon the consumer price index, these
decisions will have wage and price ramifications.
Perhaps more important are factors that cause
changes in the consumer price index to overstate
changesjn the true cost of living. For one thing, the
indexlises the same market basket of goods and ser
vices to determine the price level at different times.
But, other things being equal, people will try to sub
stitute cheaper goods for the ones whose prices have
risen more rapidly. Thus, the fixed market basket prob
ably gives too much weight to items with rapid price
increases.
Another source of upward bias is the way the cost
of home ownership is calculated. When inflation ac
celerates and higher inflation is expected to continue,
the mortgage interest rate, like other interest rates,
tends to rise. As currently calculated, home-ownership
cost reflects the rise in home prices and the entire
rise in mortgage interest rates even though most of
the interest rate increase is offset by the greater ex
pected appreciation in home prices. Thus, the rise in
the cost of home ownership is overstated. (The Bureau
of Labor Statistics is currently working on a revised
“user cost” of homes to correct for this problem.) ^
Turning to even tougher criticism, it is argued that
price linking should not be based upon a cost-of-living
index at all. A cost-of-living index jadjl reflect Import
prices, but domestic producers are in a poor position
to give wage increases based upon import prices.
(More detailed arguments on this issue can be found
on page 22.) Instead of a cost-of-living index, some
economists propose that a price index of domestic
goods and services be used. While this would have ad
vantages from some viewpoints, there has been little en
thusiasm on the part of workers when it was proposed
in other countries.
Conclusion
The worsening of inflation in the United States over
the past decade has sparked interest in the price
linking of wages and retirement incomes. Many
Americans are now favorably disposed toward index
ation, regarding escalator clauses as a good protec
tion mechanism against inflation. From an economywide perspective, however, the merits of indexation are
questionable. In many circumstances, indexation could
have undesirable effects on inflation and unemploy
ment. There are some circumstances where it could
protect the incomes of those who have escalator
clauses with relatively few harmful ramifications for
unemployment and inflation— in economywide inflation
where all prices are rising in proportion. In such general
inflation, however, there would be other groups who
suffer inequities and certain economic costs that could
not be avoided. Consequently, indexation will not make
inflation either equitable or costless. Moreover, if
indexation reduces the political pressures to curb infla
tion, price inflation could be worse in an economy with
indexed wages. Faster inflation would, of course, be
more costly for the nation as a whole.
Marcelle V. Arak
FRBNY Quarterly Review/Autumn 1978
23
The
business
situation
Current
developments
The widely expected slowing in the pace of the eco
nomic advance materialized in the third quarter. As
measured by'real gross national product, the growth
of the nation’s output of goods and services slowed to
an annual rate of 3.4 percent from 8.7 percent in the
second quarter (chart). Nevertheless, the economy
continued to display impressive elements of strength
in demands for consumer goods, housing, and capital
goods. The rate of increase in the price level also
slowed during the summer. Unfortunately, the relief on
the price front largely reflected declines in some vola
tile agricultural prices following sharp increases earlier
in the year. The underlying rate of inflation, as indi
cated by prices of nonfood goods and services, showed
no signs of improvement.
Consumer spending exhibited surprising strength in
the third quarter. After dipping slightly in July, retail
sales posted solid gains during August and September.
Some of this buying undoubtedly was stimulated by
anticipation of price increases in the future. Even
as consumer buying was speeding up, the growth of
personal income slowed appreciably in August and
September as employment growth faltered. Personal
saving in the third quarter amounted to only 5.1 percent
of disposable income, significantly below the long-run
average of about 6 percent. Unless the growth of per
sonal income speeds up considerably, the growth of
consumption is likely to slow down eventually as house
holds seek to restore a more normal relationship of
savings to income. The rapidly increasing share of
consumers’ incomes devoted to repaying instalment
and mortgage debt may cut further into spending on
goods and services.
Inflationary expectations also undoubtedly have
played a role in the strength of demand for housing.
For many households, real estate is the best— perhaps
24 FRASER
FRBNY Quarterly Review/Autumn 1978
Digitized for
the only— available hedge against inflation. Conse
quently, historically high mortgage interest rates have
done little to dampen the demand for housing. Private
housing starts were running at an annual rate of
nearly 2.1 million units in September, continuing the
two million-plus rate of starts generally maintained
since July of last year. The high rate of permits for
new residential buildings issued in September suggests
a continuation of brisk construction activity for a
while longer.
There appears to be little evidence of speculative
fever in the business sector. With memories of the pain
ful recession of 1973-75 still vivid, most firms have con
tinued to maintain a relatively cautious approach to
investment decisions. Inventories have generally been
well aligned with sales, except in some retail lines
where stocks appear to have been on the high side
through much of the summer. Characteristic of the cur
rent business expansion, orders were cut back quickly
when the growth of retail sales slackened for a time in
the spring. Hence, production of consumer goods
barely inched upward from April through September.
Production of business equipment and defense and
space equipment, by contrast, continued to rise strong
ly through the summer. Thus, even with very sluggish
growth of consumer goods output, capacity utilization
in the manufacturing sector as a whole climbed to
85 percent by September, well within the range that
historically has stimulated substantial investment in
new productive facilities. New orders for nondefense
capital goods did rise sharply in August after fluctuat
ing around a plateau for six months. Construction con
tracts for commercial and industrial buildings also are
substantially above year-ago levels. On balance, it
appears that capital spending will continue to be a
source of strength to the economy for some time to
Economic growth continued in the third
quarter, although at a slower pace.
Percent
1 2 -------------------- --------------------- ----------------------------------------- ---------
Real GNP
10
8
■
6
4
1; In II!i l
2
0
-2
-4
I1
Ml
1
-6
-8
-1 0
1974
1975
1976
1977
1978
Gross national product is exp ressed as annual rates of
change in 1972 dollars, seasonally adjusted.
Source: United States D epartm ent of Commerce, Bureau
of Econom ic A nalysis.
come, but no real boom is in prospect.
Signs of the third-quarter slowing in the rate of
econom ic growth were clearest in the labor market. A c
cording to the survey of households conducted m onth
ly by the Bureau of Labor Statistics, there was virtually
no net growth of employment from June to September,
follow ing the addition of 2.2 m illion persons to the
employment rolls during the first six months of the
year. Unemployment in September represented 6 per
cent of the civilian labor force. After peaking out at
9.1 percent in early 1975, the unemployment rate had
fallen to 6 percent last April and has been fluctuating
narrowly about that level ever since. While this rate is
rather high by historical comparison, it is generally
recognized that dem ographic and social trends, to
gether with liberalization of various income m ainte
nance programs, have tended to raise the overall rate
of unemployment associated with any given degree
of tightness in labor markets. In fact, reports of short
ages of particular skills have been on the rise. The
econom ic expansion appears to have entered the zone
where inflation, form erly growing mainly out of struc
tural and expectational factors, is now being sustained
by aggregate demand pressures in some areas of the
economy.
The news on the price front certainly has not been
heartening. To be sure, the rate of overall price in
crease did slow during the summer as everyone had
expected. The broadest measure of prices— the im plicit
price deflator for gross national product— rose at an
annual rate of 7 percent in the third quarter, compared
with 11 percent in the second. The improvement was
centered in food prices. Retail food prices rose only
slightly during the summer, after surging upward at an
annual rate of 18 percent during the first half of the
year. The relief for the consumer may well be only
short-lived, however. Producer prices of finished food
products rebounded sharply in September, and prices
of both crude and interm ediate food products also
posted large increases. Outside the food sector, prices
have shown little sign of moderation. Consumer prices
of nonfood goods and services continued to rise in July
and August at an annual rate in excess of 8 percent—
in line with the experience of the first half of the year.
And producer prices of crude industrial m aterials con
tinued to soar at double-digit annual rates during the
third quarter.
On the other hand, the rate of increase in wages may
have slowed somewhat. Average hourly earnings
of production and nonsupervisory workers in the pri
vate nonfarm business sector, adjusted to remove the
effects of overtime in manufacturing and of shifts in
employment among industries, increased at an annual
rate of about 6 V2 percent in the third quarter, com
pared with 8 V2 percent during the first six months of
the year. As stressed in the comm entary that begins on
page 1, a sustained m oderation in the growth of
wages would be highly auspicious for the outlook for
controlling inflation. While there is room fo r optimism
on this score, there are some imposing obstacles to
moderation of labor costs. The price inflation that has
already occurred w ill trigger automatic wage increases
for m illions of w orkers covered by cost-of-living agree
ments (COLA) in collective bargaining contracts (see
the article beginning on page 16). Many more workers,
both union and nonunion, who are not protected by a
formal COLA w ill be granted wage increases in re
sponse to the ongoing rapid rise in the cost of living.
The boost in the minimum wage scheduled to take
effect on January 1, 1979 w ill push up the wage struc
ture. The increase in the social security tax rate and
base, also scheduled to take effect at the beginning of
1979, w ill further raise costs of production by increas
ing payroll taxes on employers. Perhaps most im por
tantly, a number of m ajor collective bargaining
agreements w ill come up for renegotiation in
1979. The degree of m oderation shown in these
forthcom ing settlem ents w ill figure heavily in the
outlook fo r inflation over the next three years. The
President’s program is in large part aimed at this
particular problem.
FRBNY Quarterly Review/Autum n 1978
25
The economy
of upstate
New York
New York City’s economy often tends to dominate per
ceptions of the entire economy of New York State. By
many measures, however, the economy of upstate
New York (which for purposes of this article is defined
to include all New York State outside the city) is
bigger than the city’s. Indeed, it accounts for about 60
percent of the state’s population and personal income.
While many upstate communities face the same basic
economic problems as New York City, including a high
cost of living, burdensome taxes, and a deteriorating
physical plant, overall business conditions in upstate
New York have tended to mirror those of the nation
more closely than those of New York City.
Economic downturns in the upstate economy have
approximated those in the nation but, during upturns,
recovery in upstate New York with its older, less
efficient plants generally has not kept pace with na
tional expansions. In the current economic recovery,
the lag has been especially pronounced. As a result,
joblessness in upstate New York is more severe than
in the nation and activity in some major industries
remains below pre-recession levels. In part, this slug
gish revival reflects the belated turnaround in New
York City’s economy, since economic conditions in
the counties surrounding the city are tied closely to
those in the city. Despite these difficulties, the upstate
economic recovery, although lagging, is firmly im
planted. Unemployment is declining and business
activity has been picking up. Additional impetus for
the state’s economic expansion may be provided by
the state government’s new initiatives in fostering
private-sector growth. A stepped-up tourist campaign
has been launched, and a series of tax cuts has been
enacted which aim to make the business environment
in New York State increasingly competitive with other
states.
FRBNY Quarterly Review/Autumn 1978
Digitized26
for FRASER
Overview of the economy
Business activity across upstate New York is diverse,
ranging from agricultural to industrial and commercial
activities. In some areas, concentrations of specific
industries tend to dominate the local economic scene.
Among the prominent features of the economic land
scape in Buffalo, for example, are heavy industries
such as primary metals and transportation equipment,
while Rochester leads the nation in the manufacture
of photographic and optical equipment. The NassauSuffolk region is noted for its aircraft, electronic com
ponents, and precision instrument manufacturing as
well as for other defense-related industries. At the
same time, scattered throughout the state are many
large administrative and research facilities. Most no
table among these are the nineteen headquarters of
the nation’s 500 largest industrial companies located
in the upstate area. Largely clustered in the counties
surrounding New York City, four of these corporate
headquarters are in the city of White Plains— the same
number as in Boston, a city whose population is more
than thirteen times larger.
While corporate headquarters are prominent in the
upstate region, a multitude of smaller service firms
employ a growing proportion of the area’s labor force.
As in the rest of the nation, a decreasing proportion
of the labor force is engaged in manufacturing. This
trend away from manufacturing has also had a deep
effect on the New York City economy. The city, how
ever, is not so dependent on factory work as either
upstate New York or the nation. Indeed, the overall
distribution of employment activities upstate is much
more akin to that of the nation than it is to the city’s.
Factory payrolls comprise one quarter of nonagricultural employment both in the nation and upstate,
although in such areas as Binghamton and Rochester
the concentrations are even greater. There, m anufac
turing accounts for more than one third of employment.
By comparison, factory employment in New York City
is only 17 percent of total employment.
Upstate m anufacturing facilities, moreover, tend to
differ from those in New York City in that they are
generally larger and employ many more workers.
Based on data from 1975, two thirds of the factories
in New York State employing 250 or more workers
were located upstate although the area accounts for
just one third of the total number of manufacturing
establishments. In New York City, the m anufacturing
establishments average under thirty employees, less
than half the average employment in upstate factories.
Due to this larger plant size, an industrial closing in
many upstate comm unities is more likely to create
econom ic dislocations than one in m etropolitan New
York City. In 1976, fo r example, the Elmira region was
adversely affected by the closing of an electronic com
ponents factory. It displaced 1,200 workers who repre
sented 3 percent of total employment in the area. Thus
this single closing sharply depressed the local job
market and resulted in a high rate of joblessness.
The largest private nonmanufacturing sectors are
trade and m iscellaneous services (which include such
diverse occupations as advertising, legal, and personal
services). These sectors account for 22 percent and
19 percent, respectively, of total upstate employment,
about the same proportion as in the nation. In New
York City, trade is 19 percent and services 25 percent
of total employment. The financial industries employ
only a small segment of the total work force in both
upstate New York and in the nation (about 5 percent).
In New York City, the nation’s leading financial center,
they account for 13 percent of payroll employment.
In total, the private sector employs about 80 percent
of all w orkers in upstate New York, with the remaining
20 percent in the public sector. This is about the same
proportion as in the nation and slightly above the
16 percent in New York City. By far, the largest con
centration of government workers is in the AlbanySchenectady-Troy region, the site of the state capital,
where government accounts for nearly 30 percent of
total payroll employees.
Because many people’s perception of the state is
dominated by an impression of corporate headquar
ters, heavy m anufacturing, and large cities, the agricul
tural sector is often overlooked. Nevertheless, New
York is an im portant agricultural area, ranking among
the top ten states in the production of such diverse
products as apples, potatoes, fresh vegetables, grapes,
maple syrup, and milk. More than 100,000 w orkers are
employed in agriculture in upstate New York, slightly
more than in 1974.
Jobs and the business cycle
Over the years, em ploym ent in upstate New York has
roughly followed the pattern of national business
cycles. During downturns, the contractions in upstate
employment have been about the same proportionate
size as the nation’s. During national upswings, how
ever, upstate recoveries have been less robust. Indeed,
in each of the last three expansions, the gap between
national and local employment growth has widened
(Chart 1). C ontributing to this slower growth is the loss
of both large and small businesses from the area’s
older urban centers. The large number and high rates
of business and personal taxes, and the high cost of
living compared with other areas are among the prob
lems faced by local businesses.
In this expansion, total employment in upstate New
York— which began to recover in mid-1975, about the
same time as in the nation— has risen at slightly less
than half the national rate (Chart 2). More recently,
increases in upstate em ploym ent have moderated
Chart 1
During recessions, employment in upstate
New York has contracted at about the same
rate as in the nation . . .
Percentage change
1
0
-1
-2
Apr 1960Feb 1961
Dec 1969Nov 1970
Nov 1973Mar 1975
. . . while in recoveries, employment growth
has lagged.
40 —----------------------------------------------------------------------
30
20
10
Feb 1961Dec 1969
Nov 1970Nov 1973
Mar 1975Aug 1978
New York data are seasonally adjusted by the Federal Reserve
Bank of New York.
Sources: United States Department of Labor, Bureau of Labor
Statistics, and New York State Department of Labor.
FRBNY Quarterly Review/Autum n 1978
27
Rochester, it is closer to 40 percent below the 1973
area averages.
Table 1
Nonagricultural Employment in Upstate New York
Not seasonally adjusted; thousands of persons
Average em ployment
JanuaryJanuaryAugust
August
1978
1977
Sector
Change
from 1977
to 1978
932.2
911.9
20.3
. . . 2,010.6
1,950.5
60.1
....................
134.0
117.6
16.4
Finance, insurance, and
real estate ........................
166.0
162.8
3.2
W holesale and retail
trade ...................................
816.2
794.1
22.1
M anufacturing
......................
Private nonm anufacturing
C onstruction
Transportation and
public u tilities ..................
168.1
165.1
3.0
Services
721.6
705.3
16.3
Total private ....................... . . 2,942.8
2,862.4
80.4
..........................
790.9
754.5
36.4
Federal ...............................
78.9
78.0
0.9
Government
.............................
State
...................................
186.3
179.5
6.8
Local
.................................
525.8
497.0
28.8
Total nonagricultural ........
3,733.7
3,616.9
116.8
Because of rounding, figures may not add to totals.
Source: New York State D epartment of Labor.
further. W ithin the private sector, growth has been
relatively slower, although jobholding in both factory
and nonfactory positions has been rising. Because of
New York C ity’s many problems employment there did
not stop declining until about two years after upstate
New York.
There are presently about 950,000 factory employees
in the upstate region, approxim ately the same number
as in 1971 but some 100,000 below the record level
posted in 1969. At that time, manufacturing em ploy
ment represented 31 percent of total jobholding, w hile
it now accounts for 25 percent.
Outside m anufacturing, employment in the private
sector has grown each year since 1969 with the excep
tion of 1975, and all m ajor components of this sector
have edged upward in the latest recovery. During the
first eight months of 1978, employment in each industry
was higher than in the same period of 1977 (Table 1).
The very large gains in wholesale and retail trade
and in m iscellaneous services may be partially a ttribut
able to a statewide upturn in tourist activity. Jobs for
building trades w orkers have also risen, although con
struction employment remains about 30 percent below
its 1973 peak; in both Albany-Schenectady-Troy and
Digitized for
28FRASER
FRBNY Quarterly R eview/Autum n 1978
Local labor markets
Labor market conditions in upstate New York have
improved in line with the growth of payroll em ploy
ment. Unemployment among upstate residents has
decreased, while the labor force has expanded moder
ately. Joblessness is still, however, more severe locally
than nationwide (Chart 3).
W ithin each of the m ajor labor market areas, the
jobless rate has generally been lower during 1978 than
at any time since 1974, although it still exceeds pre
recession rates (Table 2). To be sure, because of the
different industrial and com m ercial activities which
characterize each labor area, both the degree of re
covery and the rates of unemployment vary greatly
throughout upstate New York. Joblessness during the
first eight months of 1978 ranged from a low of 5.3
percent in Poughkeepsie to a high of 8.3 percent in
Buffalo, which is still below New York C ity’s 8.9 per
cent rate. The high level of unemployment in Buffalo
is in part due to its dependence on heavy industry.
The relatively sluggish perform ance of business fixed
investment during this recovery unquestionably has
served to constrain the Buffalo economy. This phenom
enon, coupled with other problems facing American
steel producers, has resulted in about 3,500 direct
layoffs at one of the Buffalo area’s large production
Table 2
Unemployment Rates in Major Labor Market Areas
Average of January-August data; not seasonally adjusted
1974
1975
1976
1977
1978
4.5
6.9
8.3
7.8
6.0
4.5
7.4
8.0
7.7
6.5
6.5
10.5
11.1
10.0
8.3
6.2
9.2
9.4
11.0
8.0
New York C i t y ..........................
7.2
10.5
11.3
9.8
8.9
New York City suburban area*
5.7
7.9
9.3
8.8
7.0
Poughkeepsie
3.1
5.3
6.9
6.2
5.3
A lbany-Schenectady-Troy . . .
Bingham ton ...............................
..........................
3.7
7.1
8.6
7.6
6.2
4.7
8.8
10.0
8.7
6.8
...............................
5.7
9.0
11.0
10.4
7.3
Upstate New Y o r k ....................
5.4
8.4
9.8
5.3
8.8
7.9
9.1
7.4
7.2
United S ta te s .............................
Utica-Rome
6.3
* Nassau, Putnam, Rockland, Suffolk, and W estchester counties.
Sources: New York State Department of Labor; United States
Department of Labor, Bureau of Labor Statistics.
facilities. While the im portant role of the steel industry
in Buffalo’s economy has thus far impeded its recovery,
growing strength in other heavy manufacturing indus
tries may offset some of this weakness. Expectations
by automakers of continuing strong car sales have re
sulted in rising activity in the large transportation
equipment sector. This, in turn, may provide a much
needed fillip to Buffalo’s lagging economy.
In the suburban counties surrounding New York City,
the recovery has been gradual, with the rate of jobless
ness still hovering around 7 percent. In contrast to the
rest of the upstate region where the fortunes of a par
ticular m anufacturing industry typically determ ine the
econom ic well-being of the surrounding community,
the economy of this area is not dependent on a few
large production fa cilitie s— only 20 percent of its resi
dents hold m anufacturing jobs. Rather, the suburban
counties are tied to the central city of New York as a
m ajor source of employment. Due to the sharp deterio
ration of New York C ity’s economy in recent years, this
dependency has slowed the area’s recovery. Since
1969, the city has lost one payroll job in every six,
about 600,000 in all. It was only in late 1977 that payroll
employment in New York City stopped shrinking.
The greatest improvement in labor market conditions
has occurred in the Utica-Rome area. There, the un
employment rate has averaged 7.3 percent thus far in
1978, 3.1 percentage points below what it was in the
same period last year. In the past, the Utica-Rome area
has tended to lag the rest of the state in its recovery
largely because so much of its employment is concen
trated in secondary manufacturing industries, i.e., those
dependent on expansion in other fields to spark their
own activity. The area’s recent improvement is due to
an upturn in the m anufacture of such products as pneu
m atic tools, transportation equipment, and machinery.
Construction activity
Employment among construction workers has been
p articularly slow in recovering, due to the continuing
low level of building activity. A fter showing signs of a
limited upturn in 1977, new construction this year has
fallen. In 1977, the number of residential building per
mits issued— a key indicator of new housing activity—
rose for the first time since 1972, although the number
of perm its issued was only about half the 1972 level.
Over the first months of 1978, however, the number of
permits declined a bit from what it had been in the
same period in 1977. The current slackening has been
concentrated in the four suburban counties surrounding
New York City, w hile building activity in the more
northern counties remains about level w ith last year.
Prominent among the possible explanations for the
lagging revival in construction work is the state-
Chart 2
Employment in upstate New York began to
rise in m id-1975, well before New York C ity’s
employment stopped declining.
1970=100
8011 1 1 1 1 ' ' 1 1 ' 1 ' 1 1 ‘ 1 ‘ 1 1 ‘ 1 1 1 1 ' ' 1 1 ‘ ‘ 1 ' ' 1 '
1970
71
72
73
74
75
76
77
78
New York data are seasonally adjusted by the
Federal Reserve Bank of New York.
Sources: United States Department of Commerce,
Bureau of Labor Statistics, and New York State
Department of Labor.
Chart 3
While the rate of unemployment in upstate
New York has declined, it is still above
the nation’s.
Percent
The unemployment rate shown is the average of January-August
data, not seasonally adjusted.
Source: United States Department of Labor, Bureau of
Labor Statistics.
FRBNY Quarterly Review/Autum n 1978
29
mandated ceiling on mortgage interest rates. While the
interest rate on home loans has been rising nationwide,
the 8 V2 percent limit in New York State is the lowest
such ceiling imposed in the nation. The State Legisla
ture, however, is presently considering a bill to raise
the ceiling on conventional mortgages by 1 percentage
point to 91/2 percent, a rate still lower than in fortyseven other states.1
Nonresidential construction also remains weak.
While there are some projects under way in most up
state areas, there are many less than in the early 1970’s.
Among the larger of the commercial projects is the
enclosed shopping mall being built in White Plains,
which when completed will be one of the largest in the
New York metropolitan area. It is the final part of a
large-scale urban renewal program undertaken by that
city. This project is particularly noteworthy, because it
is being built at a central city rather than at a suburban
location. Furthermore, the commitment by so many
major retailers to the mall provides some testimony to
the strength of the area’s sales prospects.
State government assistance
One of the most notable changes that has occurred in
the state’s economy is the increasingly active role
being taken by the state government in promoting pri
vate business activity. Among the most visible of its
new programs is a national marketing campaign aimed
at strengthening the state’s tourist industry. Based
on the limited data available, this effort appears to have
been successful. During the prime summer months of
1977, travel volume in New York was up almost 4 per
cent over the comparable period in 1976, when tourism
was bolstered by the nation’s bicentennial celebrations.
Besides promoting tourism, the state government has
taken other steps to nurture private-sector growth, al
though the scope of these actions is restricted some
what by the state’s own budget limitations. Within these
constraints, however, there have been important at
tempts to improve its reputation. Once better known
for creating “red tape” and levying numerous business
taxes at high rates, the state now is trying to reshape
the governmental environment into one which is more
conducive to private enterprise. Toward this end, a
variety of business tax modifications and reductions
have been enacted. These include the expiration of
' New Jersey imposes a 9 1/2 percent upper limit, while in South
Carolina there is a range of ceilings which begins at 9 percent.
FRBNY Quarterly Review/Autumn 1978
Digitized 30
for FRASER
surcharges to the corporation franchise tax and the
bank tax, lowering of the insurance tax, phasing-out of
the unincorporated business tax, increasing the invest
ment tax credit, and cutting the pari-mutuel tax rate.
While it is too early to know to what extent these mea
sures will stimulate business activity, any actions which
bring the state tax burden more into line with that of
other states can have only a positive impact.
Similarities to New York City
Upstate New York has performed better than New York
City during the last decade. Nevertheless, there are
many similarities between the two regions. Many up
state cities, and indeed the Northeast in general, suffer
from problems similar to those of New York City and
other older urban centers— a deteriorating physical
plant, lagging job growth, burdensome taxes, and a rel
atively high cost of living. For example, the cost of liv
ing in the Buffalo metropolitan area for an intermediatelevel family of four in autumn 1977 was estimated by
the Bureau of Labor Statistics to be $18,298, nearly 5
percent or $800 above the $17,498 annual average of
other metropolitan areas. In the New York-Northeastern
New Jersey region, the same standard of living for a
family of four would have cost $19,972 each year, an
additional 14 percent or $2,474 more than the national
urban average.
Local governments in the upstate region also suffer
from financial problems which may be of smaller mag
nitude than New York City’s but are nonetheless sig
nificant. In both Buffalo and Yonkers, the second and
fourth most populous cities in the state, evidence of
fiscal strain surfaced at about the same time as in
New York City. Buffalo continues to grapple with the
problems of budgetary imbalance and, in Yonkers,
budgetary matters remain under the supervision of an
outside monitor similar to that which oversees New
York City’s fiscal affairs.
Thus, although the upstate economy is different
in both its composition and past behavior from New
York City’s econqmy, there are inescapable simi
larities. Upstate municipalities, like the city, will be
affected by the success of the various measures
adopted by the state government to promote private
business enterprise. More important, however, is the
course of the national expansion, now in its fourth
year. As in the past, national economic conditions will
continue to exert a strong influence upon the economy
of upstate New York.
Rona B. Stein
The
financial
markets
Current
developments
Chart 1
Recent Changes in Interest Rates
Percent
9 .5 0 ---------------------------------------------------- r
4.00 ‘— '— '---- ---------------------- l— L—J---- 1 1 1 1 ---- ^ ---- L—
J F M A M J
J A S O N D J F M A M J J
1977
1978
1---- L—1—
A S O
*T h e s e yields are adjusted to five- and tw enty-year
m aturities and exclude bonds with special estate
tax privileges.
Sources:
Federal Reserve Bank of New York, Board of
Governors of the Federal R eserve System, and Moody’s
Investors S ervice, Inc.
The summer was a volatile period in the financial
markets. Interest rates, particularly those on longer
term securities, fluctuated more w idely than they had
in some time. Growth of the monetary aggregates,
which for a w hile showed signs of moderating, was
again quite rapid. Indeed, the broader monetary ag
gregates— M2 and M:j— advanced at a faster pace than
they had in nearly a year. An im portant contributing
factor to this resurgence was the introduction of a new
savings instrum ent— the six-m onth money market cer
tificate of deposit— by com m ercial banks and th rift in
stitutions.
As the summer began, interest rates across the
maturity spectrum extended the rise that had resumed
in April (Chart 1). Following the June 20 Federal Open
Market Committee (FOMC) meeting the Federal funds
rate increased from about IV 2 percent to 7% percent,
and during the next month it rose a further notch to
7% percent, as the Federal Reserve pursued its efforts
to moderate monetary growth. Over this period, other
short-term rates generally moved up in line with the
funds rate.
Toward the end of July there was a shift in market
sentiment. Two successive weekly declines in the
money supply data led m arket participants to believe
that an additional firm ing move by the Federal Reserve
could occur later than had been expected. Furthermore,
a series of Government reports suggested that, after
the sharp rebound from the weather- and strike-plagued
winter, business activity was returning to a more sus
tainable pace. The adjustment to the new outlook
caused rates on many money m arket instruments to
decline by around 20 to 30 basis points w ithin ten
days, and they then remained relatively steady.
In mid-August, short-term interest rates turned up-
FRBNY Quarterly Review/Autum n 1978
31
ward again. As it became evident that monetary growth
was continuing above the Federal Reserve’s longer run
objectives, the System steadily tightened its policy
stance and by the middle part of October Federal funds
were trading around 9 percent. Other short-term rates
advanced by a similar 11/s percentage points or a bit
more during this interval.
The rise in money market rates, together with other
domestic and international financial developments, led
the Federal Reserve Banks to raise the discount rate
on four separate occasions during the summer and
early fall. The cumulative effect of these actions was to
increase the rate by V/2 percentage points to a record
level of 8 V2 percent. In announcing its approval of the
latest change at nearly all Reserve Banks on Octo
ber 13, the Board of Governors of the Federal Reserve
System stated that the action was taken to bring the
discount rate into closer alignment with increased
short-term market interest rates and in recognition of
continued high inflation, the recent rapid rate of mone
tary expansion, and current international financial con
ditions.
Yields on longer term instruments also varied widely
during the summer, but for these securities there was
little net change in the level of rates for the period as
a whole. Evidence of a firmer Federal Reserve policy
initially depressed the capital markets, but they soon
recovered on the realization that the firming moves
had been more modest than expected. Subsequently,
a strong rally developed as there was a view in some
quarters that bond yields might be nearing a cyclical
peak. The buying rush gathered momentum as some
investors sought to capture current high yields, while
many participants scrambled to cover short positions.
The effects of the improved market atmosphere were
widespread. In the corporate sector, where the supply
of new securities was light, yields on recently offered
Aaa-rated utility bonds fell by approximately 50 basis
points in the two-month period beginning in mid-July.
Slightly smaller, but still substantial, declines were
recorded in the Treasury and tax-exempt markets. For
example, over the same two-month interval Moody’s
index of yields on high-grade municipal bonds dropped
from 5.85 percent to 5.40 percent. This decrease was
particularly noteworthy, as a record volume of nearly
$6 billion of new municipal securities was sold in
August. The surge reflected an effort by state and local
governments to bring issues to market in advance of
rulings, effective September 1, tightening the regula
tions on the interest-arbitrage operations of borrowers
in the tax-exempt bond market. These regulations were
originally published by the Treasury in 1973 and have
been amended several times since then.
Not only did interest rates fall further in the capital
32
FRBNY Quarterly R eview/Autum n 1978
Chart 2
G row th o f M onetary A g g re g a te s
Seasonally adjusted
Percent
M1
TT
i
I
15
I
I
I
M2
105-
0l
20-
M3
15
10
-
1972
1973
1974
1975
1976
1977
I
II
1978
III
The annual grow th rates represent the percentage change
from the fourth quarter of one year to the fourth quarter
of the next. The quarterly growth rates represent the
percentage change from the preceding quarter, expressed
at annual rates.
markets than in the money markets, but the rally lasted
somewhat longer— until the middle of September. For
a while, the increases in the Federal funds rate during
the latter part of August were compatible with the view
that bond yields were close to a cyclical peak. In ad
dition, investor sentiment was bolstered by a reduction
in estimates of the Treasury’s future borrowings in the
market, partly reflecting sales of securities to state and
local governments and foreign central banks. However,
in the face of a continuing rise in short-term rates and
the prospect that still higher rates might be necessary
to slow money growth and contain inflation, bond mar
ket participants began to reassess their interest rate
outlook. The end of the rally came suddenly, and by
mid-October most of the gains, particularly those in
the corporate and Treasury sectors, were erased.
Unexpectedly rapid growth of the monetary aggre
gates contributed to the turnaround in the bond mar
kets. Growth of the narrow money stock, M1( did ease
some from its record second-quarter pace (Chart 2).
Nevertheless, the slackening was less than some ob
servers had expected and was at least partially offset
by an upward revision in previously reported data.
Moreover, it came at a time when the broader money
measures— M2 and M3— were accelerating.
On September 21 the Board of Governors announced
revisions in the monetary aggregate data to incorpo
rate benchmark adjustments based on the March 1978
call report for domestic nonmember banks and to cor
rect for a cash items bias. The adjustment for the cash
items bias related to certain transfers of funds by
some agencies and branches of foreign banks in New
York City. The principal effect of the revisions was to
raise the growth rate of M2 over the first two quarters
of this year from 7.6 percent to 8.1 percent, which rep
resents a slight acceleration from 1977. Initially Mx
growth appeared to be moderating significantly during
the third quarter, but it picked up sharply near the end
and for the period as a whole came to a 7.6 percent rate.
While this is slightly less than the average growth rate for
the previous six quarters, it remains above the 4 to 6 V2
percent range that the FOMC had projected for all of
1978 and for the year ending in 1979-11.
The September revisions also produced slight re
ductions in previous estimates of the growth of M2 and
M3. However, any favorable impact this might have had
on the credit markets was overshadowed by the third
quarter’s surge in these aggregates. During that period
M2 rose at a 9.0 percent rate, up 11/2 percentage points
from the advance over the first half of the year and at
the top of the 6 V2 to 9 percent range projected by the
FOMC for 1978 and for the year ending in the second
quarter of 1979. The acceleration in M3 was even
sharper. The growth rate of this aggregate jumped from
7.7 percent in the first half of the year to 10.0 percent
in the third quarter, which is at the upper end of the
7 V2 to 10 percent range projected by the FOMC for
1978 and for the 1978-11 to 1979-11 period.
With the growth of Mx slowing somewhat, the pickup
in the broader aggregates reflected a strong gain in
time and savings deposits (other than large CDs) at
banks and thrift institutions. The increase was par
ticularly sizable at thrift institutions and to a very
important extent was due to the favorable reception of
the new six-month money market certificates of deposit.
Effective June 1, the Board of Governors of the Federal
Reserve System, the Federal Deposit Insurance Corpo
ration, and the Federal Home Loan Bank Board
authorized their member institutions to begin issuing
these certificates with ceiling interest rates on new de
posits that vary with the average rate on new issues of
six-month Treasury bills. In keeping with the existing
differentials in deposit ceiling rates, savings and loan
associations and mutual savings banks are allowed to
pay 1/4 percentage point more on the certificates than
commercial banks.
At the time of their introduction, there was a ques
tion as to how effective the new instruments would be
in maintaining the growth of consumer-type time and
savings deposits. The available data indicate that thus
far they have, indeed, contributed to this objective.
In the four months before the money market certifi
cates were available, deposits at savings and loan
associations and mutual savings banks increased at
an almost constant 6 V2 percent annual rate. In each
of the four subsequent months, deposit growth steadily
accelerated and by September was approaching a
16 percent rate.
One means of judging the attractiveness of the new
certificates is to compare their growth with that of in
vestments in money market mutual funds, which have
been important substitutes for consumer-type time
and savings deposits for some time. In the more than
four years that shares in the money market funds
have been actively sold, total assets of the funds have
risen to about $8.5 billion. In contrast, sales of the sixmonth certificates have averaged $8.5 billion a month
since their introduction.
Most of the certificates have been issued by thrift
institutions where, as noted above, the ceiling interest
rate is 1/4 percentage point above that at commercial
banks. In fact, savings and loan associations and mu
tual savings banks are estimated to have issued more
than 70 percent of the nearly $34 billion of money
market certificates outstanding at the end of Sep
tember. So far it appears that the certificates have
helped to maintain the flow of credit into housing.
It remains to be seen, however, whether this effect
will persist.
FRBNY Quarterly Review/Autumn 1978
33
Noncompetitive tenders
in Treasury auctions:
how much do they
affect savings flows?
At each Treasury auction investors may purchase se
curities through either competitive or noncompetitive
tenders, a unique combination of bidding alternatives.
Unlike competitive bids, noncompetitive tenders do not
state a price or yield. Instead they are simply offers to
buy a given amount of Treasury securities at a price
which will be determined by competitive bidders in the
auction.1 This feature makes them attractive to many
investors who are not regular participants in the dealer
market for Government securities. The most obvious
advantage is that buyers need not expend time and
effort determining what the market rate is likely to be
on a forthcoming issue. Moreover, bidders are pro
tected against the risk of paying a price that is far
above the market, yet are assured their tenders will
be accepted in full. As market interest rates rise above
deposit ceiling rates at banks and thrift institutions, in
vestors begin to step up their purchases of all types
of securities yielding market rates of interest. Non
competitive bids for Treasury issues respond particu
larly strongly. In the first nine months of this year,
investors submitted noncompetitive tenders for $32
billion in Treasury securities, $7 billion more than the
amount submitted in the comparable period of 1977.
The convenience of noncompetitive tenders and the
attractiveness of Treasury securities encourages a
broad range of investors to participate at each auction.
However, since the Treasury limits the size of noncom
i A competitive tender states the price (or yield) the bidder is offering
for a stajed amount of securities. The Treasury satisfies all non
competitive tenders first and then fills the remainder of the offering
from the competitive tenders proceeding from highest to lowest
price until the issue is fully subscribed. Tenders submitted below the
lowest accepted price, the stop-out price, are not filled. Non
competitive tenders are awarded at the average price of accepted
competitive tenders.
34for FRASER
FRBNY Quarterly Review/Autumn 1978
Digitized
petitive tenders accepted from any bidder, institutional
investors with large sums to place must purchase
Treasury securities either through competitive bids at
Treasury auctions or from dealers in the secondary
market. In Treasury bill auctions, these ceilings were
raised from $200,000 to $500,000 in June 1975. In cou
pon auctions, the maximum size of the noncompetitive
tenders is announced each auction and is usually
somewhat greater than the limit in the bill market; a
ceiling of $1 million has been customary since October
1976. In contrast, the average size of com petitive ten
ders submitted in one recent bill auction was $28
million, and many institutional investors submitted more
than one tender.
Treasury securities are offered in minimum denom
inations, ranging from $10,000 for bills to $1,000 for
many coupon issues. Investors are attracted to Treasury
bonds and notes not only by the United States Govern
ment guarantee, but also because secondary markets
in these instruments are much more active than second
ary markets in municipal or corporate bonds, enhanc
ing the liquidity of Treasury issues relative to other
securities. Moreover, Treasury issues may be pur
chased without brokerage fees by tenders submitted
directly to any Federal Reserve Bank or branch. The
relatively small minimum denomination of Treasury se
curities has made them attractive to individuals, who
have in the past faced somewhat limited options for
direct investment in short-term money market instru
ments issued by the private sector, most of which are
normally sold and traded in round lots of $100,000 or
more. In addition to such minimum-size conventions,
per-unit brokerage fees are typically higher on small
orders, taking the form of fixed fees for orders below
the standard trading size or price adjustments above
quoted dealer spreads for odd-lot transactions.
In recent years, however, financial institutions have
developed to meet the needs of investors with
smaller amounts of funds to invest. Money market
mutual funds, municipal and corporate bond funds,
and similar, more diversified investment vehicles have
begun to offer small savers access to investments
in financial instruments at transactions costs compa
rable to those available to large savers. These funds
offer the additional advantage of broad risk diversifica
tion formerly available only to the largest institutional
investors, and most offer fast redemption on shares in
minimum amounts of only a few hundred dollars. These
funds, as well as other institutional changes, allow
smaller investors to purchase indirectly a wide variety
of money market assets that are available directly
to large-denomination investors. Recent regulatory
changes also permit commercial banks and thrift in
stitutions to offer six-month money market certificates
at rates related to those of six-month Treasury bills.
Since these certificates may be offered in minimum de
nominations of $10,000, they are well suited to the
needs of many individual investors. Such institutional
developments have allowed individual savers access to
a variety of instruments that yield market rates of inter
est, reducing their reliance on noncompetitive pur
chases of Treasury issues.
Who submits noncompetitive tenders?
Noncompetitive tenders are submitted by all types of
investors, ranging from individuals to bank and non
bank financial intermediaries and even to nonfinancial
corporations. Since 1973, the Treasury has collected
detailed data on the size of bids and types of pur
chasers of coupon securities.2 Although comparable in
formation is not collected for Treasury bills, the ten
ders submitted in the Second Federal Reserve District
for the six-month Treasury bill dated July 20, 1978 were
classified by size and type of purchaser. Analysis of
noncompetitive tenders submitted in both bill and cou
pon auctions suggests that large-denomination tenders
submitted by a variety of investors make up most of
the dollar volume.
Individuals typically submit a large proportion of
the total number of tenders, but other types of inves
tors, who generally submit bids in larger denomina
tions, account for a substantial amount of the dollar
volume. For example, in the November 1, 1977 auction
of the 7% note of 1987, about 3,300 noncompetitive ten
2 These data classify tenders by twenty investor classes, bid size,
and price or yield. Only tenders submitted for the investment and
trading accounts of banks and reporting dealers are attributed
to them; bids made by these agents for their clients’ accounts are
attributed to the final purchasers.
ders were made by individuals, representing 78 percent
of the total number of tenders submitted throughout
the country (Chart- 1).3 Despite the large number of
these tenders, individuals’ bids accounted for only
about one fourth of the dollar amount raised noncompetitively.
This disproportionately small share of the dollar
volume reflects the smaller average bid size of indi
viduals relative to other investor categories. Nonethe
less, even among individuals, denominations below
$10,000 are not particularly popular, although the
Treasury often offers coupon issues in minimum de
nominations of $1,000 or $5,000. Usually the greatest
number of individuals’ tenders is submitted in the
$10,000 to $24,000 category, closely followed by the
$25,000 to $100,000 category in which the greatest
dollar volume from individuals is generally raised. For
the 7% note, only 2 percent of the dollar volume of
noncompetitive tenders was denominated below
$10,000 and only about one fifth of the total dollar
volume was denominated in the $10,000-$100,000
range. Most institutional investors, on the other hand,
submitted larger bids. Overall, three fifths of the dollar
volume of total noncompetitive tenders fell in the
$500,000 to $1 million range.
Although individuals play a relatively more important
role in noncompetitive bidding for Treasury bills than
for coupon issues, denominations over $100,000 ac
count for most of the dollar volume. Individuals in the
Second Federal Reserve District submitted over 1,300
noncompetitive tenders for the six-month bill dated
July 20, 1978, more than 85 percent of the District’s
total number of private noncompetitive tenders
(Chart 2). Individuals’ tenders accounted for 70 percent
of the total dollar volume of noncom petitive bids, al
most three times the percentage attributable to in
dividuals in the long-term market. Among individuals’
bids, the size distribution is particularly revealing—
tenders for amounts of $100,000 or more made up
40 percent of the dollar volume. Many of these
large-denomination tenders represent estates and per
sonal trust accounts managed by commercial bank
trust departments. Institutional investors, such as banks,
insurance companies, and other corporations, who ac
counted for the remaining dollar volume, typically
submit tenders in large-sized denominations as well.
s The Federal Reserve may purchase securities noncompetitively in any
quantity to replace maturing issues in its portfolio and the portfolios
of foreign official institutions for which it acts as agent. Government
agencies have similar privileges. Foreign central banks may
also replace maturing issues or, at the Treasury’s discretion, purchase
additional 52-week bills, notes, and bonds through noncompetitive
bids. Since this discussion focuses on tenders from the private
sector, tenders submitted by these public purchasers were excluded.
FRBNY Quarterly Review/Autumn 1978
35
Chart 1
Although individuals submit the most tenders
in coupon auctions . . .
N u m b e r o f n o n c o m p e t it iv e t e n d e r s
T h rift institu tions and
com m ercial banks
C orporations
B roke rs and dealers
Pension funds
Other
. . . other investors account for most of
the dollar volume . . .
P e r c e n t a g e o f d o lla r v o lu m e
Brokers and dealers
Pension funds
Other
T h rift institu tions
and com m ercial
banks
. . . and large-denomination tenders play
the major role.
S iz e o f te n d e r as a p e r c e n t a g e o f d o lla r v o lu m e
2% U nder $10,000
$10,000 - $24,000
$2 5 ,0 0 0 - $100,000
$101,000 - $4 99,0 00
Total n o ncom p etitive tenders fo r the 7 5 /8 pe rce n t note
of 1987, net of Federal R eserve and foreign
o ffic ia l purchases.
Source: United States Department of the Treasury.
36 forFRBNY
Quarterly R eview/Autum n 1978
Digitized
FRASER
Noncompetitive tenders and disintermediation
During periods of high interest rates, sharp increases
in the gross volume of noncom petitive tenders have
coincided with slow growth, or outright declines, in
savings deposits at banks and th rift institutions sub
ject to interest rate ceilings. This led many analysts
to assume that most noncom petitive tenders reflect
direct sw itching from savings deposits into Treasury
securities during high interest rate periods. To dis
courage depositors from substituting Treasury bills
fo r sm aller sized deposits and to lim it the cost of small
awards, the minimum tender size in bill auctions was
increased from $1,000 to $10,000 early in 1970. It is
difficult to assess the impact of this requirement. Even
in coupon auctions where the minimum denom ination is
$1,000 to $5,000, only a small proportion of the total
number or dollar volume of noncom petitive tenders sub
mitted by individuals is denominated under $10,000.
Thus, the total volume of deposit sw itching is likely to
have been only m arginally reduced by the $10,000 m ini
mum for Treasury bills.
To discover how much of the deposit shortfall during
high interest rate periods is attributable to noncom
petitive tenders and to gauge the sensitivity of these
tenders to movements in interest rates, gross tenders
must be adjusted by subtracting maturing b ills pre
viously purchased noncom petitively to arrive at an esti
mate of net investment (Chart 3).4 These estimates may
then be summed over appropriate time intervals to
compute changes in the outstanding stock of bills
acquired noncom petitively.
High and rising bill rates stim ulate noncom petitive
investment in Treasury bills. These funds are quickly
withdrawn as rates begin to decline, even when rates
are still well above passbook ceilings and gross tenders
are large by historical standards.5 This rapid runoff
suggests that many investors, who submit noncom peti
tive tenders when they wish to shorten the average
maturity of their portfolios as rates rise, switch to
longer term issues as rates begin to fall.
This cyclical investment pattern is illustrated in the
early 1970’s when interest rates declined from their
4 This calculation is necessary since a constant rate of gross
investment of, say, $100 m illion per week in three-m onth Treasury bills
w ould result in an outstanding stock of $1.3 b illion by the end
of the thirteenth week. Since the initial stock of bills would have
matured during this period, a constant level of gross investment
may disguise either net investment or net disinvestm ent.
A fter the thirteenth week, the same $100 m illion rate of gross
investment would be sufficient only to maintain the $1.3 billion
stock by just replacing maturing issues.
5 Over the 120 months from February 1968 to February 1978 the
correlation between net noncom petitive tender investment in short
term Treasury bills and the level of Treasury bill rates is .60. The
correlation between net noncom petitive tender investment and the
change in the Treasury bill rate from three months earlier is .72.
cyclical peaks and over the course of the 1973-74 cycle
and its aftermath. Between February 1970 and Febru
ary 1972, investors pulled nearly $7.8 billion out of
short-term Treasury securities purchased through non
competitive tenders, but as rates rose toward their
record 1973-74 peaks the investment outflow was re
versed. From August 1972 to the peak investment
level in September 1974, there was a net investment of
$9.2 billion in Treasury bills through noncom petitive
tenders. As short-term rates fell sharply in the fourth
quarter and then dropped steadily through 1975, in
vestors again quickly w ithdrew these funds from the
bill market. In the twelve months ended September
1978, increases in interest rates again encouraged in
vestors to place an additional $2.1 billion in the bill
market through noncom petitive tenders.
Total deposit growth has m irrored the movement of
noncom petitive tenders to some extent, but the behav
ior of passbook accounts and time deposits has differed
(bottom panel of Chart 3). Large-denomination pass
book deposits appear to be particularly sensitive to
interest rates, and analysts have often discussed how
quickly these funds can be shifted when market rates
rise above regulatory ceilings on passbook dep'osits at
banks and th rift institutions.6 The regulatory ceilings on
these short-term, highly mobile accounts thus play a
critica l role in determ ining when funds at banks and
th rift institutions w ill begin to be shifted into various
instruments yielding market interest rates.
Passbook savings flows at commercial banks, mutual
savings banks, and savings and loan associations
turned into outflows through most of 1969, and there
were only slight inflows in the 1973-74 period. In each
period, savings flows remained sluggish until short
term bill rates fell close to the ceilings on passbook
accounts. On the other hand, time deposits increased at
a quarterly average of $11 billion in the 1973-74 period,
owing to longer average m aturities on time deposits,
to higher ceilings on long-term deposits, and also to
an estimated average increase of just under $4.5 b il
lion per quarter in comm ercial bank tim e deposits over
$100,000 (excluding negotiable certificates of deposit)
which were not subject to interest rate ceilings.
Although noncom petitive tenders increase during
high interest rate periods, they account for only a
fraction of the shortfall in time and savings deposit
flows at banks and th rift institutions. For example, be6 One study of C alifornia savings and loan associations in 1974 found
the biggest disinterm ediation im pact in accounts over $25,000.
Most of the 1974 savings outflow at savings and loan associations
nationw ide was concentrated in a small number of large metropolitan
areas where most deposits were in accounts over $10,000. See
T.A. Goldman, “ D isinterm ediation Under a M icroscope1’, Journal
(Federal Home Loan Bank Board, December 1975), pages 13-15,
and D.L. Smith, “ Regional Im pact of D isinterm ediation” , Journal
(Federal Home Loan Bank Board, June 1977), pages 20-24.
Chart 2
In bill auctions, individuals submit
the most tenders . . .
N u m b e r o f n o n c o m p e t it iv e te n d e r s
3% Thrift institutions and
com mercial banks
^Corporations
1% B rokers and dealers
1% Pension funds
1% Other
. and account for the most dollars.
Percentage of dollar volume
Thrift institutions
and com m ercial ~ y
banks
C orporations
Even for individuals, large-denomination
tenders dominate investment activity.
S iz e d is t r ib u t io n o f te n d e r s s u b m it te d b y in d iv id u a ls
$3 05 ,0 0 0 $5 00,000
N oncom petitive ten ders sub m itted in the Second Federal
R eserve D is tric t fo r the six-m o nth T reasu ry bill dated
July 20, 1978, net of Federal R eserve and foreign
o ffic ia l pu rchase s.
S ource:
Federal R eserve Bank o f New York.
FRBNY Quarterly Review/Autum n 1978
37
Chart 3
As interest rates rise . . .
Percent
Ceiling rate on passbook .
accounts at th rift institutions
8 —T r e a s u r y b ill r a te (b o n d e q u iv a le n t b a s is )
7
V5 ^
4
_
. -
---------------------
___ Ceiling rate on passbook accounts at commercial ba nks'
J__L
j ___I___i___i___i___1___i___i___i___I___l___i___i___I___I___i___i___I___i___i___I___ I
. . . investors purchase Treasury bills through noncompetitive tenders.
Billions of dollars
4 - N e t in v e s t m e n t * in th r e e - a n d s ix -m o n th T re a s u ry b ills th r o u g h n o n c o m p e titiv e te n d e r s .
2---------0-2
—
But the slowdown in savings deposit growth exceeds the increase in bills purchased noncompetitively.
Billions of dollars
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
♦ G ro s s noncompetitive tenders for three- and six-month bills less maturing three- and six-month bills previously purchased noncompetitively.
^T o tal time deposits at thrift institutions and commercial banks excluding negotiable CDs at weekly reporting banks.
^ Total savings deposits at thrift institutions and commercial banks.
Sources: Board of Governors of the Federal Reserve System and Treasury Bulletin.
tween August 1972 and September 1974, tim e and sav
ings deposit growth fell short of the increase posted
over the previous two-year period by more than $36
biliion, w hile net investment in Treasury bills through
noncom petitive tenders increased $9.2 billion, only
about one quarter of the deposit shortfall. Even this
proportion probably overstates the deposit shortfall
attributable to direct sw itching into three- and sixmonth bills, since a relatively small part of these non
com petitive tenders is subm itted by the type of inves
tors who also maintain nonnegotiable interest-bearing
deposits at banks and th rift institutions.7
7ln regressions relating net noncom petitive tender investment to
changes in savings and tim e deposits, interest rates, and the threemonth change in Treasury bill rates for February 1968 through
February 1978, neither time nor savings deposits were found to be
closely related to noncom petitive tenders. Indeed, a $1 billion
decline in passbook deposits was estim ated to produce only a $33
m illion increase in net noncom petitive tender investment. Of the
two interest rate terms, the three-m onth change in interest rates
proved to have a stronger im pact on noncom petitive tender
investment than the level of rates, confirm ing the view that tender
activity in the bill market is related not only to the level of rates
but also to the direction of current trends.
38 forFRBNY
Digitized
FRASERQuarterly Review/Autum n 1978
Noncom petitive tenders provide a means for a w ide
variety of investors to purchase securities yielding mar
ket rates of interest. The volume of these tenders is
sensitive to changes in m arket rates of interest, and
some of this volume reflects transfers of funds be
tween Treasury securities and deposits at banks and
th rift institutions. However, large-denom ination tenders,
which account for most of the dollar volume, probably
do not result from such deposit switching. Moreover,
since many alternative investment vehicles are avail
able, changes in the volume of noncom petitive tenders
are small, relative to deposit shortfalls, and offer few
clues to current or future deposit flow s.8
8 For example, in regressions relating changes in savings deposits to
the three-m onth Treasury bill rate, net noncom petitive tender
investment, and a linear tim e trend over the February 1968 to February
1978 period, the estim ated im pact of noncom petitive tenders on
deposit flows is not significa ntly different from zero, but a 1 percentage
point increase in the bond-equivalent bill rate is estim ated to
reduce the m onthly savings flow by about $700 m illion.
Charles M. Sivesind
International Bank Lending:
A Guided Tour through the Data
The rapid growth of international bank lending over
recent years has whetted the appetite of bankers, fi
nancial analysts, economists, and the public at large for
more detailed and timely information on this activity.
Comprehensive data are needed to come to grips with
a wide range of important questions. Here are just a
few examples:
• What is the volume of bank lending in world
markets?
• How much of it is being done by United States
banks?
• Do United States bank practices differ from
practices of other banks?
• Are United States bank loans concentrated
among a few borrowers?
• What is the exposure of United States banks
in individual countries?
Interest in issues such as these naturally has been
keen among government officials and bank supervisors
both in this country and abroad. However, they have
found that the available data series, which were devel
oped to address particular problems in the past, were
not fully adequate to deal with the broader scope of
concerns that have emerged in recent years.
Consequently, considerable resources have been de
voted to expanding and refining data sources. Progress
so far has been encouraging, although there are still
gaps in the data that make it impossible to answer
every question a researcher might wish to ask. This
article describes what kinds of information are now
available and how they can be used.
Data on United States banks’ foreign lending
The Treasury and the Federal Reserve have greatly
increased the scope of their data on international bank
ing activities over the last several years. Originally, the
Treasury collected information on foreign lending by
banks in the United States for the purpose of measur
ing the United States balance of payments. In April
1978 the Treasury changed the format of these data to
improve their usefulness in analyzing bank behavior.
Among the changes made by the Treasury the most
important is the segregation of claims on foreigners
held by banks for their customers from banks’ own
claims on foreigners.1 Because that distinction was
not made before, earlier data moderately overstate the
volume of bank lending to foreigners. Treasury data,
available back to 1934, are published in the Treasury
Bulletin. (See box on page 40 for sources of data on
international bank lending.) Changes in the Treasury
international capital series are described on pages
612-13 of the July 1978 Federal Reserve Bulletin.
The Federal Reserve began in 1969 collecting
monthly information on the activities of foreign
branches of United States banks for supervisory pur
poses. These data are published monthly in the Fed
eral Reserve Bulletin. In 1975, the Federal Reserve
extended the coverage of branch activities to permit
quarterly analysis of the geographic distribution of
branch lending. These supplementary data are pub1 The term “claims" is a more inclusive concept than "loans", which
are one component of claims. Other components include acceptances
made for foreigners, items in process of collection, demand and time
deposits held by banks, certificates of deposit, promissory notes, and
related assets.
FRBNY Quarterly Review/Autumn 1978 39
lished in the Statistical Release E.11 of the Board of
Governors of the Federal Reserve System.
By com bining Treasury and Federal Reserve data,
the researcher can analyze changes in the volume of
foreign claims. But there are problems with this
method. One has already been mentioned: until this
spring, Treasury data have included custom er claims
on foreigners held in custody at United States banks.
In addition, the Treasury numbers include the foreign
claim s position of foreign-owned agency and branch
banks located in the United States. Consequently, the
researcher cannot distinguish between lending by
United States-chartered banks and other bank lending
originating in this country.
Sources of Data on International Bank Lending
United States banks
E co n o m ic
D e p a rtm e n t, “ E u ro -c u rre n c y and
O th e r
In tern atio n al B an king D e v e lo p m e n ts ” : g re a te r d is
(1) U n ite d
S ta te s
T re a s u ry
B ulletin ,
T a b le s
C M -ll-1
th ro ug h C M -ll-6 : fo re ig n claim s of U nited S ta te s lo c a te d
banks;
m onthly.
S e le c te d
d a ta
also
in
F e d e r a l R e s e rv e B u lletin , T a b le s 3 .1 6 -3 .1 8 .
(2) F e d e ra l
R es e rv e
B u lletin ,
T a b le
3.1 3:
c la im s
a g g re g a tio n of d a ta d e s c rib e d in (6); q u a rte rly .
(8) B ank fo r In tern atio n al S ettle m e n ts , M o n e ta ry and
Ex
E co n o m ic D e p a rtm e n t, "In te rn a tio n a l B an king :
te rn a l P osition s of C o m m e rc ia l B an ks in G ro u p of
of
Ten C o u n tries , S w itze rla n d , A ustria, D e n m a rk and
o v e rs e a s b ran ch e s of U nited S tates banks; m onthly.
Ire la n d and of C ertain o f T h e ir Fo reign A ffilia te s ” ,
(3) B o a rd of G o vern o rs of th e F e d eral R es e rv e S ystem ,
Ju ly 1978: s e m ia n n u al in tern atio n al banking survey.
“ G e o g ra p h ic a l D istrib u tio n of A ssets and L ia b ilitie s
of M a jo r Fo re ig n B ra n ch es of U. S. B a n k s ” , S ta tis
(9) B ank o f E n g lan d , Q u a rte rly B u lle tin : fo re ig n
cu r
rency c la im s on fo re ig n e rs o f banks in th e U n ited
tic a l R e le a s e , E .11: c la im s on fo re ig n e rs by fo reign
K ing do m — d e ta il on lo catio n of b o rro w ers ; d is tin c
b ra n c h e s
tion b e tw ee n b a n k and no n b an k b o rro w e rs . M a tu
of U nited
S tates
banks
by
co u n try
of
rity an alys is of fo re ig n c u rre n c y c la im s by ty p e of
bo rro w er; q u arterly.
(4) B oard of G o verno rs of th e F e d eral R ese rv e S ys
te m ,
“ C ou ntry
E xpo su re
Lending
S u rv e y ” , Press
R e le a s e (thus fa r, relea sed on J a n u a ry
16, 1978
and Ju ne 8, 19 78): fo re ig n claim s of U nited S ta te s ow ned banks and th e ir overseas affiliates.
U n ited
K in g d o m -lo c a te d
banks,
co nso rtium
o f ov erseas b ran ch e s of F e d eral R ese rv e m e m b e r
banks; y e a r-e n d d a ta a v a ila b le with a v a ria b le lag
(u su a lly six to nine m onths after th e y e a r-e n d ).
(e .g .,
U nited
A m e ric an
K ing do m
con
trib u tio n to re c e n t B IS lending su rvey (S o u rc e 8).
(10) D e u ts c h e B u n d es b an k, M o n th ly R e p o rt o f th e
D e u ts c h e B u n d es b an k: fo re ig n cla im s of G erm an
ba nks— d e ta il
(5) F e d e ra l R ese rv e B u lletin , “ A n n o u n ce m en ts” : assets
bank
ba n ks ).
on
as set ty p e
can
be
d e riv ed
by
su b trac tin g in tern al assets from to tal assets.
(11) D eu tsch e B u n d es b an k, S ta tis tic a l S u p p lem en ts to
the M o n th ly R ep o rts o f th e D e u ts c h e B un d es b an k,
S eries 3: fo re ig n c la im s of G erm an b a nks— sh o rt
term
vs.
lo n g -term ;
D eu ts c h e
m a rk -d e n o m in a te d
vs. all oth ers; c la im s on nonb anks vs. c la im s on
Banks in major industrial countries
banks. S om e d e ta il on lo cation o f b o rro w er.
(6) B an k fo r In tern atio n al S ettlem ents, A n n u al R e p o rt:
(12) B an k of C a n a d a , B an k o f C a n a d a R e v ie w : fo reign
e x te rn a l cla im s of banks in th e G roup of T en co u n
cu rre n c y cla im s on fo re ig n e rs by C a n a d ia n b a nks
tries, S w itz e rla n d , and b ran ch e s o f U nited S tates
— so m e d e tail on lo cation of b o rro w e r; d istin ctio n
banks in th e C a rib b e a n and Far East; gross E u ro
b etw een
c u rre n c y c la im s by banks in B e lg iu m -L u xe m b o u rg ,
tw e en
F ra n c e , G erm an y , Italy, th e N eth erlan d s, S w ed en ,
S w itz e rla n d , and th e
U nited
K ingdom
(th e E u ro
ba n k
and
U nited
term
distin ctio n
a re a . S e le c te d d a ta also rep o rted in B an k of E ng
all o th er claim s.
C o o p eratio n
and
D e v e lo p m e n t
F in a n c ia l
S tatistic s.
(7) B an k fo r In tern atio n al S ettlem en ts, M o n e ta ry and
Digitized40
for FRASER
FRBNY Quarterly R eview/Autum n 1978
and
be
cla im s
and all o th e r cla im s ; m onthly.
pean repo rting a re a ); es tim a te d net uses of E u ro
land Q u a rte rly B u lle tin and in O rg an izatio n fo r E c o
b o rro w e rs
d o lla r-d e n o m in a te d
(1 3) B an k of J a p an , E c o n o m ic s S tatistic s M o n th ly: sh o rt
c u rre n c y fu nd s by banks in th e E urop ean repo rting
n o m ic
n o n b an k
S tates
c la im s on fo re ig n e rs
(14) W o rld
b e tw e e n
B ank,
by J a p a n e s e
ye n -d e n o m in a te d
B o rro w in g
in
b a n ks—
c la im s
In te rn a tio n a l
M a rk e ts : s y n d ic a te d b a n k c re d its — d e ta ile d
m atio n
and
C a p ita l
in for
ab o u t in d ivid u a l c re d its as w ell as su m
m ary d a ta; q u a rte rly .
Federal Reserve and Treasury data, moreover, were
not designed for identifying the country exposure
of United States banks. For one thing, exposure in
cludes what are called contingent claims, binding com
mitments of banks to extend credit in the future. For
another, a loan to a borrower in one country guaran
teed by an institution in a second country is considered
an exposure to the second country, not the first.
To deal with these problems, the Federal Reserve,
together with the Office of the Comptroller of the
Currency and Federal Deposit Insurance Corporation,
developed the country exposure lending survey
(CELS). This survey provides foreign lending informa
tion for United States banks on a consolidated basis,
that is, for a bank’s domestic offices plus all of its over
seas affiliates including majority-owned subsidiaries.
These data, available semiannually (but with certain
modifications) from June 1977, provide detailed countryby-country information on the types of borrowers, the
maturity distribution of claims on foreigners, the ulti
mate guarantor of borrowings (when applicable), and
commitments by banks to lend to foreigners.2
Data published by the BIS
Although United States banks make up the largest
group of market participants, banks from other indus
trial countries have played a major and growing role
in international banking. Since the early 1960’s, infor
mation on the foreign lending activities of banks in
major industrial countries has been published by the
Bank for International Settlements (BIS). Over the
years, the scope and detail of these data have ex
panded greatly. Today, BIS figures, published in the
quarterly “Euro-currency and Other International Bank
ing Developments” and in the BIS Annual R eport, cover
banks in fourteen industrial countries and selected
bank branches in the Caribbean area and Far East.3
As a source of information for analyzing the country
exposure of banks, these BIS figures share many of
the drawbacks of the Treasury international capital
series and the Federal Reserve foreign branch data.
No distinction is made among types of bank assets.
Guaranteed credits and contingent claims on for
eigners are not identified. Nor is there sufficient
detail to distinguish, on a country-by-country basis,
2 For a more detailed discussion of this survey, see "A New Super
visory Approach to Foreign Lending” , this Quarterly Review (Spring
1978), especially page 6.
* Reporters consist of banks in the Group of Ten Countries— BelgiumLuxembourg, Canada, France, Germany, Italy, Japan, the Netherlands,
Sweden, the United Kingdom, and the United States— plus Switzer
land, Austria, Denmark, and Ireland plus United States bank branches
located in the Bahamas, Cayman Islands, Hong Kong, Panama, and
Singapore.
between claims on other banks and claims on nonbank
borrowers. To remedy some of these problems, BIS
reporting countries agreed to collect more detailed
information.4 The Federal Reserve’s contribution to
this effort evolved into the country exposure lending
survey discussed above, which provides greater infor
mation on banking system exposure than does its BIS
counterpart. The BIS international banking survey data
are collected semiannually and reported under the title
“ International Banking: External Positions of Commer
cial Banks in Group of Ten Countries, Switzerland,
Austria, Denmark and Ireland and of Certain of Their
Foreign Affiliates”. The initial survey covered bank
positions at the end of 1977 and was published in
July 1978.
Data published by other industrial countries
Although the BIS data provide the most comprehensive
coveragfe of international bank lending activity, the
level of aggregation hides important information. In
comparing the activities of banks in different countries,
it can be useful to refer to national data series. From
these, the researcher usually can derive greater infor
mation on type and location of borrower, maturity and
currency composition of claims, and asset types. Im
portant sources of national data series are listed in the
box, (9) through (13).
Data on syndicated bank credits
Bank lending takes many forms: straight loans, trade
financing (e.g., acceptances), deposits with other
banks, purchases of corporations’ commercial paper
or promissory notes, acquisition of securities and cer
tificates of deposit, and so on. One of the more popu
lar lending vehicles in the international market has
been the syndicated credit— a line of credit extended
by a group or syndicate of banks rather than by a
single bank. Participation in syndicated credits often is
viewed by banks as a sign of international prestige. As
a result, these credits are usually publicized in “tomb
stones” that appear in major financial newspapers and
magazines. Several groups, including private banks
and trade publications, compile tabulations on syndi
cated credits from such publicized information. Perhaps
the most comprehensive tabulation on new syndicated
credits is published by the World Bank in its quarterly
4 Reporters consist of banks in the Group of Ten countries, Switzerland,
Austria, Denmark, and Ireland, as well as (a) all foreign affiliates
(including branches) of United States banks, and (b) affiliates of
other reporting banks (except those reporters in BelgiumLuxembourg) located in the Bahamas, Barbados, Bahrain, Bermuda,
Cayman Islands, Hong Kong, Liberia, Lebanon, the Netherlands
overseas territories, New Hebrides, Panama, Singapore, Virgin
Islands, and other British West Indies.
FRBNY Quarterly Review/Autumn 1978 41
Table 1
Bank Claims on Foreigners
"In
Ifll
_j;,,
b illio n s of dollars
•' ■
Claims by banks in
----
---------
u u is ia.anair
n a m g ai
Mid-1977
End-1977
-
United States*
I
Treasury-Federal Reserve s e r ie s .............
228.1
251.1
Country Exposure Lending Survey ___
164.2
194.6
■
Industrial countries
BIS ( q u a r t e r ly ) t ..........................................
572.1
657.3
BIS ( s e m ia n n u a l)* ......................................
§
217.0
* Excludes intrabank cl.
f Reporters include banks in the Group of Ten countries and
Switzerland and branches of United States banks in the
Bahamas, Cayman Islands, Hong Kong, Panama, and
Singapore. See (6) and (7) in the box on page 40.
* Reporters include those in above footnote as well as banks
in Austria, Denmark, and Ireland and certain foreign
affiliates in other countries. See (8) in the box.
§ Not available.
'
Borrowing in International Capital Markets. These data
are available back to 1973.
Because syndicated credits are lines of credit, they
reflect commitments to lend by the participating banks,
not just actual disbursements. Further, numbers cited
in tombstone announcements and in the World Bank
publication represent new commitments rather than
total credit commitments. For these reasons, figures
on syndicated credits are not comparable to the bank
claim s data in other reports, such as the TreasuryFederal Reserve series, which cover total credit actu
ally extended by banks.
Volume of bank claims
One frequently asked question about international bank
lending is simply “ How big is it? ” Surprisingly, even
w ith the improvement and refinement in data sources,
that is not easy to answer definitively. As shown in
Table 1, different data sources can provide different
answers. This results from differences in coverage
among them.
The two sets of figures on United States bank claims
on foreigners differ by about $60 billion. Several dif
ferences in coverage that are only partially offsetting
account fo r this large discrepancy. Figures in the coun
try exposure lending survey cover overseas subsidiaries
of United States banks and not just their overseas
42
FRBNY Q uarterly Review/Autum n 1978
branches. They also include some holdings of long
term securities issued by foreigners, which are ex
cluded from Treasury claim s data. (Although pur
chases and sales of foreign securities are reported in
the Treasury Bulletin, these data do not show bank
activity separately.) However, these factors are more
than offset by other differences in coverage. The ex
posure survey excludes claim s on foreigners by United
States-located agencies and branches of foreign banks,
which are included in the Treasury international
capital series. As noted, Treasury data prior to the
1978 changes also included bank-held but custom erowned claim s on foreigners; these are excluded from
the lending survey numbers. Finally, the exposure
survey publishes only cross-border and cross-currency
claims on unaffiliated foreigners. That means, for ex
ample, the cruzeiro-denom inated claim s of United
States bank branches located in Brazil on Brazilians
are not shown.
The difference between the two BIS data sets is
even more striking than the United States data. How
ever, almost the entire $440 billion difference between
the quarterly BIS external claim s figure and the semi
annual BIS international banking survey number results
from the exclusion in the semiannual data of bank
claim s on borrowers located in other reporting coun
trie s .5 That means a loan by a British bank to a German
resident is not picked up by the BIS international bank
ing survey. Obviously, such activity accounts for a very
large portion of total international lending.
The volume of bank lending to final borrowers
In addition to lending to foreign governments and cor
porations, banks also lend to each other. However, in
analyzing international econom ic activity, the research
er is generally interested in the change in claim s on
final borrowers, such as individuals, corporations, and
governments, and would wish to deduct claim s on other
banks from total bank claims. That adjustm ent is pos
sible in varying degrees with the available data.
Treasury-Federal Reserve data can be adjusted to ex
clude interbank activity using the Treasury data dis
aggregation presented in the Federal Reserve Bulletin
as well as the overseas branch figures presented in
5 C la im s on b o rro w e rs in th e fo llo w in g c o u n trie s are e x c lu d e d : A u s tria ,
B e lg iu m -L u x e m b o u rg , C an a d a, D enm ark, France, G e rm a ny, Ire la n d ,
Italy, Ja pa n , th e N e th e rla n d s , S w eden, S w itz e rla n d , th e U nite d
K in g d o m , th e U nite d S tates, th e B a h am a s, B a rb a d o s, B a h ra in ,
B e rm ud a , C aym a n Is la n d s , H ong K ong, L eb a n on , L ib e ria , N e th e rla n d s
o verse a s te rrito rie s , N ew H e b rid e s , P anam a, S in g a p o re , th e V irg in
Is la n d s , and o th e r B ritis h W est In d ie s . T h e re are m a ny o th e r d iffe r
ence s betw e e n the q u a rte rly a nd s e m ia n n u a l data , in c lu d in g d iffe r
en c e s in co v e ra g e a m on g re p o rtin g b an ks. For a d e ta ile d d is c u s s io n
o f th e se d iffe re n c e s , see (8 ) in th e box.
Table 2
Summary of Data on Foreign Claims of Banks in the United States and Other industrial Countries*
Sources
M aturity
breakdown
(years)
M aturity
determ ination
Borrower
breakdown
Interbank
activity
External
guaran tee !
C ontingent
claim s and
unutilized
credits^
Currency
breakdown
Attributes of United States bank claims
Treasury-Federal Reserve data
(p rior to A pril 1978) ...............................
Treasury-Federal Reserve data
(available A pril 1978) ...........................
Country Exposure Lending Survey
(CELS) ................................................
0-1; over 1;
Treasury
data only
From date
obligation
incurred
0-1; over 1;
quarterly
Treasury
data only
Time
remaining
0-1; 1 to 5;
over 5
(beginning
December
1977)
Time
remaining
Data
available
to
exclude
intra
bank
activity
Dollars
vs.
foreign
currency
claim s
Public
borrowers;§
foreign
banks
(unaffiliated
vs.
a ffilia te d );
all others
Data
available
to
exclude
intra
bank and
inter bank
activity
Dollars
vs.
foreign
currency
claim s
Public
borrowers;§
banks;
all other
borrowers
Excludes
intra bank
activity;
data avail
able to
exclude
interbank
activity
Externally
guaranteed
nonlocal
currency
claim s on
banks vs.
all other
borrowers
Available
Attributes of industrial countries’ bank claims
Bank for International Settlements
(BIS ) counterpart to TreasuryFederal Reserve d a t a ......................
BIS international banking s u r v e y ___
Foreign
officials;
foreign
banks;
others;
(only for
loans in
Treasury
data)
Possible
to net out
interbank
w ithin re
porting area.
Claim s on
nonbanks
exclude
central
monetary
authorities
0 - 1 ; 1- 2 ;
over 2
Time
remaining
A vailable
for
European
reporting
area only
:1
ft*’
Available
* For source references, see the box on page 40.
t "G u aranteed” claim s are those claim s of the reporting institution for w hich a third party form ally and legally
obligates itself to repay the reporting institution's claim s on the direct ob lig o r if the latter fails to do so.
t C ontingent claim s refer to binding contractual ob lig ation s to lend by the reporting institution.
§ The term “ pu blic borrow ers” refers to central governm ents and departm ents of central governm ents and the ir possessions;
central banks, stabilization funds and exchange authorities; corporations and other agencies of central governm ents; state,
provincial, and local governm ents and their departm ents and agencies, and international or regional organizations or subordinate
or affiliate agencies thereof.
II Not available.
FRBNY Quarterly R eview/Autum n 1978
43
that publication.6 The technique is documented in the
following example for May 31, 1978 (in millions of
dollars):
1. Head office claims on foreigners (Treasury
Bulletin, July 1978, page 95) .........................
88,171
minus
Head office claims on own foreign offices (Fed
July 1978, page A62) ..
e ral Reserve Bulletin,
— 35,476
minus
Head office claims on unaffiliated foreign banks
July 1978, page
A62) ................................................................
(Fed eral Reserve Bulletin,
-
28,153
equals
2. Head office claims on final foreign borrowers..
24,542
3. United States overseas branch claims on for
eigners (Federal Reserve Bulletin, August 1978,
page A56) .......................................................
241,788
minus
United States overseas branch claims on for
eign banks (Federal Reserve Bulletin, August
1978, page A56) .............................................
-
91,960
minus
United States overseas branch claims on other
branches of parent (Fed eral Reserve Bulletin,
August 1978, page A 56)..................................
— 52,722
equals
United States overseas branch claims on final
borrowers.........................................................
97,106
5. United States banks’ claims on final borrowers
(2 + 4) ...........................................................
121,648
4.
The netting-out of interbank claims can be performed
on these data only for total bank claims; it cannot be
done for claims on individual countries.
By contrast, the CELS figures were designed to pro
vide a country-by-country breakdown of claims on
public and private nonbank borrowers. The survey also
includes separately claims on unaffiliated banks but
excludes claims on affiliated foreign banking offices.
In addition, the survey provides separate information
on contingent claims on public and other borrowers
to allow the analyst to derive potential, as well as
current, bank exposure to a particular area.
* Prior to April 1978, only intrabank claims, that is, claims of one
office of a bank on another office of the bank, can be excluded. To
accomplish this, data provided in the Federal Reserve Bulletin on
foreign branch liabilities to United States parent banks (a proxy for
United States head office claims on own foreign offices) and
foreign branch claims against sister branches should be subtracted
from the gross Treasury-Federal Reserve foreign claims figures.
Digitized
FRASER Quarterly Review/Autumn 1978
44for FRBNY
Information on lending to final borrowers by banks
in the major industrial countries is provided in the BIS
quarterly series. However, three different net claims
concepts are provided, two of which overestimate and
one of which underestimates lending to final borrowers.
The first concept excludes interbank deposits or place
ments with other reporting banks from Eurocurrency
claims (i.e., claims denominated in a currency foreign
to the country in which the lending bank is located).7
However, interbank claims on nonreporting banks are
included, overstating the actual volume of lending to
final borrowers.
The second BIS measure of lending to final borrow
ers is similar to the first in that it excludes only inter
bank placements between reporting banks. However, it
differs in two respects. It deals with external claims
(i.e., claims in both domestic and foreign currencies on
borrowers residing outside the country in which the
lending bank is located) rather than Eurocurrency
claims. In addition, it covers lending by a larger group
of banks than the first measure.8 Again, because of the
inclusion of claims on nonreporting banks, this con
cept overstates the size of lending to final borrowers.
The last BIS measure of lending to final borrowers is
similar to the first in that it covers Eurocurrency claims
by banks in eight European countries.9 It differs from
both of the other two measures in that it covers only
claims on nonbanks, where “nonbanks” is defined to
exclude central monetary authorities. Thus, to the ex
tent that central monetary authorities borrow from
Eurobanks, this concept underestimates lending to
final borrowers.
Although the BIS semiannual international banking
survey provides no information on interbank place
ments, it is the only source of contingent claims on
foreigners by banks in industrial countries. As noted
above, such data are useful in determining total po
tential bank exposure to a given country.
Finally, national data sources (e.g., (9), (11), and
(12) in the box) provide additional detail on lending to
nonbanks by banks in certain countries. However, the
BIS data provide the most comprehensive coverage
of banks in industrial countries as a whole.
7 Reporting banks covered by this concept of net claims are those
located in Belgium-Luxembourg, France, Germany, Italy, the
Netherlands, Sweden, Switzerland, and the United Kingdom. These
data are presented in the table "Estimated Sources and Uses
of Euro-currency Funds” in (6) and (7) in the box on page 40.
8 Here, reporting banks are those located in the Group of Ten coun
tries and Switzerland and branches of United States banks located in
the Bahamas, Cayman Islands, Hong Kong, Panama, and Singapore.
These data are presented in the table "Estimated Lending in Inter
national Markets" in (6) in the box.
9 See the table entitled “ External Positions of Reporting European
Banks in Dollars and Other Foreign Currencies" in (6) in the box.
The borrowers
Another frequent question about international banking
is: “Who are the borrowers and where do they come
from?” Recent improvements in data sources allow
much more detailed answers to this question.
The Treasury has long published monthly informa
tion on the geographic distribution of foreign claims
held by banks located in this country. The data for
quarter-end months can be combined with the Federal
Reserve’s quarterly figures bn the claims of United
States banks’ foreign branches. Together, these data
show the magnitude of the United States banking
system’s foreign activity in about sixty countries and
five regions of the world. Beyond the geographic
breakdown, however, there is little detail on the
characteristics of the borrowers in each country. For
instance, the foreign branch data published by the
Federal Reserve do not distinguish on a country-bycountry basis between, say, public sector borrowers
and private sector borrowers. Distinctions among broad
classes of borrowers are important for several analyti
cal purposes, most notably for assessing the different
degrees of risk in international lending.
The information in the CELS provides some detail
about the characteristics of the borrowers. Data on
the country-by-country distribution of United States
banks’ foreign claims are divided into those on
public, bank, and nonbank private borrowers. Com
prehensive information is also provided on external
guarantees, an important factor not covered by the
other data series. The total amount of externally guar
anteed direct credit extended to a country is reported
separately. In addition, externally guaranteed claims
on bank and nonbank borrowers are reported by coun
try of ultimate guarantor. These figures are useful in
identifying the country of ultimate credit exposure.
For banks in industrial countries, the BIS quarterly
data and semiannual international banking survey data
provide a breakdown of external claims by country of
borrower.10 The detail is sufficient to isolate claims on
offshore financial centers— places like Singapore,
Hong Kong, and the Bahamas, where international
banks have established branches to funnel funds to
other countries. Claims on those centers are typically
on other banks. However, the BIS country-by-country
10 The Annual Report and “ Euro-currency and Other International
Banking Developments’’, in the table entitled “ External Positions in
Domestic and Foreign Currencies of Banks in Group of Ten Countries
and Switzerland and of the Offshore Branches of U.S. Banks” ,
provide year-end and quarterly data, respectively, on all external
claims by banks in the Group of Ten and Switzerland and by
United States bank branches in selected offshore financial centers.
The semiannual BIS international banking survey figures present
selected external claims by banks in fourteen countries and by
certain of these banks’ affiliates.
data do not differentiate between public and private
borrowers. They do not provide information about
loans guaranteed by residents of a third country, either.
Data on external foreign currency claims of banks
in eight European countries11 provided by the BIS
give a limited geographical breakdown in combination
with a distinction between bank and nonbank cus
tomers.12 The table “Estimated Sources and Uses of
Euro-Currency Funds” in (6) and (7) in the box pro
vides a limited geographical breakdown of Eurocur
rency claims (excluding those on other reporting
banks). Finally, some national data sources give bank
claims by country or region of borrower, e.g., (9), (11),
and (12) in the box.
Characteristics of foreign lending
In addition to the volume of bank lending and the
characteristics of the borrowers, available data can tell
the researcher something about the maturity distribu
tion as well as the currency and asset composition of
bank claims on foreigners.
M aturities
Some information is available in the Treasury Bulletin
on the maturity breakdown of the foreign claims of
banks located in the United States. The new Treasury
data series differentiates on the basis of time remain
ing to maturity between short-term (up to one year)
and long-term (over one year) foreign claims. By com
parison, in the Treasury data collected prior to April
1978, maturity is determined from the date the obliga
tion was incurred. Beginning in December 1977, con
solidated data on the CELS provide an additional break
down— over five years. The BIS semiannual data pro
vide a slightly different breakdown by time remaining
to maturity from the United States survey. Claims are
grouped into those maturing in one year or less, one
to two years, and over two years. The only other
reasonably comprehensive source on maturities is the
Bank of England Q uarterly Bulletin (see (9) in the box),
but these data pertain to only United Kingdom-located
banks (including United Kingdom branches of United
States banks). Nevertheless, that particular disaggrega
tion among maturities, between banks and nonbanks
and between residents and nonresidents, is unsur
passed in detail.
Currencies and asset type
The Treasury figures differentiate claims payable in
11 Belgium-Luxembourg, France, Germany, Italy, the Netherlands,
Sweden, Switzerland, and the United Kingdom.
These data are presented in Tables 3 and 4 in “ Euro-currency and
Other International Banking Developments”.
FRBNY Quarterly Review/Autumn 1978 45
dollars and those payable in all other currencies. The
foreign currency claims are not further separated
by type of currency.
As for types of assets, there are major differences
between the old and new Treasury international capital
series. Prior to April 1978, separate data on short-term
dollar-denominated loans, collections, acceptances,
and all other short-term dollar claims on foreigners
were published each month. Short-term claims payable
in foreign currencies were broken down into three cate
gories: bank deposits, foreign government obligations
plus commercial and financial paper, and all other
short-term claims payable in foreign currencies. In
addition, long-term dollar loans and all other long
term claims were distinguished.
However, the new Treasury data do not include as
much detail on asset types as the old Treasury series.
Banks’ own claims are not reported by asset types.
However, quarterly data on customer claims provide in
formation on dollar-denominated deposits, negotiable
and readily transferable instruments, customer liabili
ties on acceptances, collections, and all other dollar
claims. In addition, the foreign currency claims of do
mestic customers are split between deposit and all
other types of claims.
Federal Reserve foreign branch data provide limited
information on asset types. Branch claims by type of
asset are published annually in the Federal Reserve
Bulletin (see (5) in the box). However, these data do not
provide separate information on currency denomination
or maturity breakdown or on the type of borrower to
which credit is extended.
The BIS Annual R eport and “Euro-Currency and
Other International Banking Developments” provide
currency breakdowns only for banks in the European
reporting area. Gross external foreign currency claims
of these banks are given with a six-currency break
down. External claims on nonbanks (excluding central
monetary authorities) are disaggregated into dollar
and “other” foreign currencies.
Limitations of the data
Examined separately, these sets of data provide only
a partial picture of foreign lending by international
banks. Used together a more complete overview can
be fashioned of the international banking system as a
Digitized
FRASERQuarterly Review/Autumn 1978
46 forFRBNY
whole and the United States banking system’s inter
national activity in particular.
However, despite all the improvement in the variety
and scope of information on international bank lend
ing, many questions still are unanswerable with today’s
data. Very little is known about the terms and condi
tions of lending to specific countries or borrowers.
The World Bank provides information on interest rates
and maturities on individual syndicated credits. How
ever, such credits represent only a part of bank lend
ing and, in addition, there are commitment fees and
syndication charges that are rarely published. Nor is
it possible from existing data to determine if and to
what extent United States banks are offering different
terms and conditions on loans than banks from other
countries.
Another set of questions left unanswered concerns
foreign borrowing by United States nonbank corpora
tions. The available data do not tell how much of this
borrowing goes on, either by the parent company or by
foreign offices of United States multinationals.
The current data provide a great deal of information
about country exposure. However, they do not classify
corporate borrowers by industry. Do certain groups of
banks have large industry exposure? The possible risk
of this type of exposure was highlighted by the prob
lems banks have experienced with tanker loans in
recent years.
Finally, what forms does international bank lending
take? The researcher has only limited information on
the types of debt instruments used in the international
banking market. What role does trade financing play?
What proportion of new lending is extended through
syndicated credits? To what degree do Eurobanks in
vest in international bond issues? These questions are
left unanswered by today’s data.
One final observation might be in order. It is always
easier to ask questions than it is to collect data. Official
agencies have to be careful not to ignore the reporting
burden whenever launching a new data-collection
effort or revising an existing series. In the area of inter
national banking, however, the improvements in the
scope and usefulness of the data have paid real divi
dends to the public and the authorities— not to mention
to the reporters themselves who are eager to see how
they stand in the market.
Genie Dudding Short and Betsy Buttrill White
February-July 1978 Semiannual Report
(This report was released to the Congress
and to the press on Septem ber 6, 1978)
Treasury and Federal Reserve
Foreign Exchange Operations
During the six-month period under review, the ex
change markets remained in the grip of uncertainties
over the outlook for major currencies as serious
economic imbalances persisted among the industrial
countries. These imbalances were reflected in the slug
gishness of economic growth abroad relative to the
strong expansion under way in^the United States, the
continuing current account surpluses in countries such
as Japan, Germany, and Switzerland in contrast to our
current account deficit, and the indications that infla
tion was still abating elsewhere while accelerating
here. Determined efforts to correct the imbalances
were under way In most countries with further actions
taken over the course of early 1978. But by mid
summer the process was far from complete. At the
Bonn summit on July 16-17, Germany and Japan again
committed themselves to take additional stimulative
measures. For its part, the United States promised to
curb inflation and to press ahead on legislation to
reduce its dependence on imported oil.
Against this background, market sentiment toward
the dollar remained very bearish in early 1978, leaving
the dollar exposed to bouts of heavy selling pressure.
This was particularly true in February and March, when
the dollar declined across the board in frequently
disorderly trading. ‘Between late March and mid-May,
A report by Alan R. Holmes and Scott E. Pardee.
Mr. Holmes is the Executive Vice President in charge of the
Foreign Function of the Federal Reserve Bank of New York and
Manager, System Open Market Account. Mr. Pardee is
Vice President in the Foreign Function and Deputy Manager for
Foreign Operations of the System Open Market Account. The
Bank acts as agent for both the Treasury and the Federal
Reserve System in the conduct of foreign exchange operations.
the immediate pressures on the dollar eased, as market
sentiment became more positive following a series of
anti-inflation steps by the Administration and the
Federal Reserve. The dollar thus rose on an unwinding
of speculative short positions and the reversal of
previously adverse commercial leads and lags. Never
theless, in the late spring and early summer, bearish
sentiment resurfaced in the absence of further progress
on economic fundamentals, and by late July the dollar
was again under widespread selling pressure.
In line with the more active intervention tactics
adopted in early 1978, the United States authorities
continued to respond forcefully at times when ex
change markets became disorderly. As before, most
United States intervention was in German marks. For
the six-month period as a whole, the foreign exchange
trading desk of the Federal Reserve Bank of New York
sold a total of $1,511.0 million net of German marks, of
which $843.5 million was for the account of the Federal
Reserve and $667.5 million for the United States Trea
sury. Most of this intervention was carried out in Febru
ary and March. On March 13, as part of a broader
agreement between United States and German au
thorities, the Federal Reserve swap line with the
German Bundesbank was doubled to $4 billion. By late
March, the combined swap indebtedness of the United
States authorities in German marks had reached a
peak of $2,844 million equivalent, of which $1,844 mil
lion equivalent was drawn by the Federal Reserve and
$1 billion equivalent was drawn by the Treasury on its
facility with the Bundesbank. From the end of March
through mid-July, the United States authorities were
able to acquire substantial amounts of marks from
FRBNY Quarterly Review/Autumn 1978 47
Table 1
Federal Reserve Reciprocal Currency Arrangements
In m illions of dollars
Institution
Am ount of facility July 31, 1978
Austrian National Bank .........
$
250
National Bank of Belgium . . .
1,000
Bank of Canada ....................
2,000
National Bank of Denmark .,
250
Bank of England ....................
3,000
Bank of France ......................
2,000
German Federal B a n k .........
4,000'
Bank of Italy ............................
3,000
Bank of Japan
...................... .
2,000
Bank of M e x ic o ...................... .
360
Netherlands Bank ..................
500
Bank of Norway ......................
250
Bank of Sweden ....................
Swiss National Bank .........................................................
300
1,400
Bank for International Settlements:
Swiss francs-dollars ...........
Other authorized European c u rre n c ie s -d o lla rs ___
Total ............................................
600
1,250
$22,160
* Increased by $2,000 m illion, effective March 13, 1978.
Chart 1
The Dollar Against Selected
Foreign Currencies*
Percent
* Percentage change of weekly average of bid rates for dollars
from the average rate for the week of July 5-8, 1977. Figures
calculated from New York noon quotations.
Digitized
48for FRASER
FRBNY Quarterly R eview/Autum n 1978
correspondents and in the market to liquidate swap
debt. By end-July the System’s debt in marks had been
reduced by $1,193.4 m illion to $650.5 m illion and the
Treasury’s debt had been cut by $803.0 m illion of
marks to $197.0 m illion.
During the period, the Federal Reserve also inter
vened on a few occasions in Swiss francs, selling a
total of $82.1 m illion equivalent. Of this amount, $50.1
m illion equivalent was sold in February, which was
financed by drawings on the swap line with the
Swiss National Bank, and was fully repaid by late
May using francs acquired directly from the Swiss
National Bank. The remaining $32.0 m illion equivalent
of francs was sold in late June and July. Of this
amount, a part came from balances acquired from
correspondents and $22.9 m illion equivalent was
financed by new drawings on the Swiss central bank.
On the repayment of swap debt incurred in 1977-78,
the policy was to repay these drawings as soon as
feasible in conform ity with the short-term nature of the
swap facilities. Since dollar rates did not recover fully
to the earlier levels at which much of the debt was in
curred, the repayment resulted in net realized losses
on current operations during the first seven months of
1978. These amounted to $22.8 m illion for the System
and $2.2 m illion for the Treasury.
Finally, during the period the Federal Reserve and
the Treasury made further repayments to the Swiss
National Bank of Swiss franc debt incurred prior to the
suspension of gold convertibility for the dollar in
August 1971. The System liquidated $191.2 m illion of
its special swap debt, reducing the remaining total to
$278.8 m illion. The Treasury repaid $267.6 m illion of
foreign-currency-denom inated securities, leaving $850.4
million remaining. Repayment netted losses to the
Federal Reserve of $140.9 m illion and to the Treasury
of $196.1 m illion in the first seven months of 1978.
German mark
In contrast to the strong expansion under way in the
United States during 1977, economic recovery in Ger
many had been only moderate. To provide support
to the domestic economy, the government had adopted
a more stim ulatory fiscal policy, undertaking to pro
vide additional tax relief and government investment
into early 1978. Monetary policy had also been accom
modative. The German Bundesbank, which had inter
vened in the exchange markets to cushion the m ark’s
rise, had tem porarily accepted a sharp acceleration
of monetary growth well beyond its target of 8 per
cent for the year. Interest rates, too, had fallen to the
point that the central bank’s Lombard rate— which
forms the upper lim it of the day-to-day money rate in
the interbank market— was at a historical low of 31/2
series of international meetings of high-level govern
ment officials served to remind the m arket of the con
tinuing imbalances among the m ajor industrial nations.
Reports circulated of a renewed disagreement between
the United States and Germany on the need for further
stim ulus in Germany. Coming at a time when the mar
ket was already caught off guard by an 8 percent
devaluation of the Norwegian krone w ithin the Euro
pean Community (EC) snake, these reports spurred
heavy bidding for marks around m id-February. As
the m ark’s rise accelerated, rumors appeared that
members of the Organization of Petroleum Exporting
Countries (OPEC) had shifted substantial amounts of
funds out of dollars and that the Federal Reserve and
the Treasury were approaching their respective swap
lim its with the Bundesbank. With this talk spreading
through the exchanges, both professional and com
m ercial bidding for marks gathered force and drove
the rate higher in late February. In response to these
rapidly intensifying pressures, the Bundesbank stepped
up its purchases of dollars. Also, the Federal Reserve
Bank of New York operated on ten trading days be
tween February 10 and February 28, selling a total of
$714.5 m illion equivalent of marks net. These sales
were split evenly between the Federal Reserve and
the Treasury and were financed by drawings on their
respective swap lines with the Bundesbank.
By late February, the mark had risen 5 percent. With
the spot rate now approaching $0.50 (DM 2.00 to the
dollar), some traders feared that a clear breach of that
level would trigger adoption either in the United States
or Germany of exchange controls, as Switzerland had
percent and yields on outstanding bonds had plum
meted to their lowest levels since World War II. Mean
while, in the exchanges a sharp rise in the German mark
late in the year had threatened to present a severe
obstacle to further growth of econom ic activity. The
m ark’s appreciation had also set off a wave of anticipa
tory orders for German goods from abroad, in the event
that the mark would strengthen even more. On balance,
Germany ended the year with a trade surplus even
larger than in 1976 and little change in its current
account surplus.
More orderly trading conditions were established in
the exchanges follow ing the January 4 announcement
of a United States Treasury-Bundesbank swap arrange
ment and the shift to a more open and forceful inter
vention approach by the United States. Once these
operations, together with those of foreign central banks,
restored a sense of two-way risk in the market, large
interest rate differentials favoring the dollar began
to show through. As a result, the mark eased back
some 3 percent from its early-January peak to trade
at $0.4740 by end-January. Official intervention in the
exchanges was reflected in the $979 m illion increase
in Germany’s reserves during January to $40.7 billion.
Meanwhile, swap drawings by the Federal Reserve and
the Treasury were, by the month end, up to $1,251.2
m illion and $407.4 m illion equivalent of marks, respec
tively.
This respite was short-lived, however. Dea'ers were
disappointed that no new measures to bolster the dollar
were announced in the A dm inistration’s m ajor policy
addresses of late January. Talk in mid-February of a
m
s' r
ir u ir r ii
Vi
...it ' ~
ctr r r r •»it-i ir< •iff •• n m nm- uni i
i ■iiihtith i ■imbmiiiiihhhh ■
1978
July
System swap
com m itm ents
July 31, 1978
-3 9 3 .3
650.5
Table 2
Federal Reserve System Drawings and Repayments under
Reciprocal Currency Arrangements
In m illions of dollars equivalent; draw ings
( + )
or repayments
( — )
System swap
com m itm ents
January 1, 1978
1978
I
German Federal B a n k ...............................
800.1
+ 1,008.5
Swiss National B a n k .................................
-0-
T o t a l................................................................
800.1
Transactions with
+
69.0
+ 1,077.6
1978
II
f+
35.2
I —800.1
(+
{ -
4.8
69.0
f + 40.1
{-8 6 9 .1
+
18.0
+
18.0
I -3 9 3 .3
22.9
673.3
Because of rounding, figures may not add to totals.
Data are on a value-date basis with the exception of the last two colum ns w hich include
transactions executed in late July for value after the reporting period.
FRBNY Quarterly R eview/Autum n 1978
49
Chart 2
Chart 3
Selected Interest Rates
Germany
Movements in exchange ra te *
Dollars per mark
o'— 1— 1----- 1— 1— 1------— 1— 1------1— 1— 1----- '— '—
J
A
S
O N
1977
D
J
F
M
A
M
1978
J
J A
+
*W e ekly averages of daily rates.
oel
I
J
just announced. To the extent that such measures
might force a reversal of existing positions and thus
a snapback in dollar rates, some dealers were hesi
tant to take on new positions at prevailing exchange
rates w hile some others moved to cover th e ir out
standing positions. Consequently, although the mark
rate briefly rose above $0.50 in early March, it soon
settled back w ithout intervention by the United States
authorities. Meanwhile, both President Carter and
C hancellor Schm idt indicated that new consultations
on econom ic and financial policy were under way
between their two governments. With this sense of
movement on the policy front, some selling of marks
emerged.
Following their discussions, the United States and
German authorities issued on March 13 a join t state
ment reaffirming that continuing forceful action would
be taken to counter disorderly conditions in the ex
change m arket and that close cooperation to that
purpose would be maintained. To reassure the markets
that ample resources would be available to finance
United States intervention, the swap line between the
Federal Reserve and the Bundesbank was doubled to
$4 billion. Moreover, the United States Treasury an
nounced that it was prepared to sell SDR 600 m illion
to Germany and, if necessary, to draw on its reserve
position at the International Monetary Fund (IMF) to
acquire currencies that might be needed for interven
tion. The United States also indicated its comm itm ent to
conserve energy, to develop new sources of supply,
and to press for Congressional approval of its energy
bill. For its part the German government reaffirmed its
comm itment to support econom ic recovery at home.
50for FRASER
FRBNY Q uarterly Review/Autum n 1978
Digitized
*
I
A
I I I
S
O N
1977
I I
D
J
F
I I I
M
A
M J
1978
I I I
J A
Exchange rates shown in this and the following charts are
w eekly averages o f New York noon offered rates.
^C e n tra l rate established on O ctober 18, 1976.
But, because output in the first quarter had been ad
versely affected by transitory factors including indus
trial disputes, the authorities were to w ait to consider
the need for new measures until a clearer picture of the
state of the German economy would be available.
The m arket’s initial reaction to this statement was
one of disappointm ent. Most participants had been
looking for a more far-reaching agreement that would
have had an immediate impact on current payments
flows. As a result the mark, which had declined to as
low as $0.4788 just p rior to the release of the com
munique, was bid up sharply, rising over 2 percent to
as high as $0.4898 on March 13 in New York. In
coordination with the Bundesbank, this Bank again
intervened forcefully that day and the next, selling
a further $372 m illion equivalent of marks financed
through equal swap drawings by the System and
the Treasury. A fter this intervention, the m arket came
into better balance fo r a while. But then toward the
month end, news of the United States record m onthly
trade deficit of $4.5 billion for February and a rush into
Japanese yen brought the German mark again into
strong demand, driving the rate up as high as $0.5031
by March 31. The German and United States authorities
stepped up their intervention once more. The desk in
New York intervened on two more trading days in late
March, selling $120.2 m illion equivalent of marks. Of
that total, $98.7 million equivalent was financed by
equal drawings by the System and the Treasury on their
respective swap lines with the Bundesbank, and the
rest came from System balances. These swap drawings
raised the combined mark indebtedness of the United
States authorities to a peak of $2,844 million equiv
alent, of which $1,844 million equivalent was drawn by
the Federal Reserve and $1 billion equivalent by the
Treasury. In Germany, official purchases of dollars in
the exchanges contributed to a further $1.5 billion in
crease in Germany’s reserves to $42.2 billion.
During April, the Federal Reserve shifted to a less ac
commodative stance in the domestic money market.
Also, the Administration strengthened its efforts to
moderate price and wage increases and to reach
a compromise on the energy bill. These actions
prompted an improvement in market sentiment toward
the dollar. As a result, a heavy reflow of funds out
of marks into dollar-denominated assets developed,
a tendency that was encouraged by the exceptionally
wide interest differentials favoring the dollar and a
dramatic rebound of the United States stock market.
These flows, together with the reemergence for the
first time this year of long-term capital exports from
Germany, triggered a fall in the mark which brought
the rate down some 7 percent from its end-March
levels to $0.4681 by mid-May.
During this time, the Federal Reserve and the Trea
sury took the opportunity of a declining mark to pur
chase marks to liquidate outstanding swap debt with
the Bundesbank. These marks were bought mostly from
correspondents, but a small amount was purchased in
the market. Otherwise, the trading desk intervened on
only four occasions, selling $95.9 million equivalent of
marks from System balances and $1.6 million equiv
alent from Treasury balances. Overall, the Federal
Reserve repaid by May 18 $493.4 million of drawings,
reducing the amount the System had outstanding to
$1,350.4 million equivalent. The Treasury also repaid
$309.4 million equivalent, cutting its debt to $690.6 mil
lion equivalent. In addition, the Bundesbank sold dol
lars, particularly in connection with the conversion of
foreign DM bonds but also at times when the spot mark
was dropping rapidly.
In late May, however, the balance of market forces
suddenly tipped in favor of the mark once more. Con
cern over the United States economic performance re
surfaced as new data and forecasts were released,
pointing to both a further widening of the United States
current account deficit and an acceleration of our in
flation rate. Moreover, the excessive liquidity in the
German money market had been largely absorbed by
the outflows of capital and by heavy borrowings, in
excess of current needs, by the government and others
taking advantage of low interest rates. As part of its
efforts to provide liquidity, the Bundesbank announced
it would terminate the 100 percent reserve require
ment on the growth of commercial bank nonresident
liabilities, effective June 1. But the withdrawal of this
reserve requirement, which had been imposed to con
tain exchange market pressures in December 1977, as
well as disclosure of dollar sales by several central
banks, triggered a new wave of commercial and pro
fessional bidding for the mark. The rate jumped 3 per
cent, up to $0.4820, and to maintain orderly trading
conditions the Bundesbank returned to the market as
a buyer of dollars. The desk also intervened on two
occasions, May 18 and May 31, selling $74.4 million
equivalent of marks in the market, including $54.1
million equivalent out of System balances and $20.3
million equivalent out of Treasury balances.
These operations, together with the continued rise
in United States interest rates and quarter-end consid
erations, helped steady the market in early June. There
after, dealers became cautious about moving into
marks ahead of the EC summit in Bremen on July 6-7
and the summit of industrialized countries in Bonn on
July 16-17. Indeed, since Germany’s production figures
showed growth to be still disappointingly slow, expec
tations developed that the Schmidt government might
cut taxes to stimulate the economy before these meet
ings took place. With Germany’s bond market already
facing a heavy schedule of new issues by state and
local governments, the need for financing an increased
federal government deficit generated expectations of
rises in German interest rates and triggered flows of
funds out of German government securities to avoid
capital losses. Moreover, talk of an expansion of the
EC snake to include the currencies of all Common
Market countries also tended to divert funds flowing
out of dollars away from the mark and, in this case, into
the French franc, the pound, and the Italian lira— the
three major candidates for membership.
As a result, the mark lost some of its earlier buoy
ancy. Although the mark was well bid in early July fol
lowing the passing of quarter-end constraints and news
of the narrow decision by the Federal Reserve to raise
the discount rate by 1A percentage point to 71/4 per
cent, the rate generally lagged behind the rapid
advances of other European currencies and the yen
against the dollar through midsummer. After the Bre
men and Bonn summit meetings, news that a new
stimulatory package would be forthcoming intensified
the strains in Germany’s financial markets, and funds
continued to be shifted out of German bonds into
higher yielding sterling and French franc assets. But at
times when the mark was caught up in the pressures
surrounding the dollar’s decline, the Bundesbank
FRBNY Quarterly Review/Autumn 1978
51
bought dollars in the Frankfurt market. The Federal
Reserve trading desk also intervened on five days in
late June and during July, selling $132.4 m illion equiv
alent of marks. But, in addition, the desk continued to
buy marks from correspondents, thereby reducing out
standing swap debt to the Bundesbank to $650.5 m il
lion equivalent fo r the System and to $197.0 m illion
equivalent for the Treasury by July 31.
By the end of July the mark was trading against the
dollar at $0.4919, up nearly 4 percent over the sixmonth period. Against the yen and the Swiss franc,
however, the mark had fallen almost 19 percent and
10 percent, respectively. As of July 31, Germany’s
external reserves stood at $41.1 billion, down $1.1 b il
lion from end-March levels but up $371 m illion fo r the
period under review.
Japanese yen
Faced with a rapidly appreciating currency, a compara
tively slow growth rate, and a further w idening in an
already large trade surplus, the Japanese authorities
took further steps in 1977 to boost dom estic demand
and to turn around the balance-of-payments position.
Following the introduction of two supplem entary bud
gets late last year, the government was to provide
for a further expansion of public works expenditures in
the first half of the new fiscal year starting in April 1978.
Interest rates in Japan were lowered, both to reduce
the cost of capital to Japanese firms and to promote
capital outflows that would offset at least to a degree
Japan’s continuing current account surplus. In addi
tion, the Japanese government responded to threats
of rising protectionism abroad by finding ways to open
the Japanese economy more to foreign goods. In
bilateral trade negotiations with the United States
before the Tokyo round of m ultilateral negotiations, Ja
pan agreed to reduce ta riff and nontariff barriers,
to raise import quotas on several products, to stockpile
commodities, and to accelerate the purchase of some
imports. Following these policy initiatives in Japan and
the United States authorities’ announcement of a more
active intervention approach, the previously heavy,
speculative bidding for Japanese yen tapered off dur
ing January and the spot rate eased from its earlyJanuary peak of $0.004228 to trade at $0.004140
(¥241.5) by the month end.
But concern over Japan’s trade imbalance persisted.
In fact, the 22 percent rise in the yen during 1977 so
inflated Japan’s export values through the improvement
in the terms of trade that, even as the export volumes
were beginning to level off, the surplus fo r 1977 as a
whole reached $17.3 billion, up $7.4 billion from the
previous year. Meanwhile, with private forecasters still
skeptical that the governm ent’s fiscal 1978 target for
Digitized for
52 FRASER
FRBNY Q uarterly Review/Autum n 1978
real growth of 7 percent could be achieved, the m arket
had little confidence that a “ considerably reduced”
trade surplus would m aterialize. Also, inasmuch as the
rate of inflation in Japan’s chief export market, the
United States, showed signs of accelerating early in
the year, Japanese exports were no longer so seri
ously threatened by the rising yen as once feared.
In this atmosphere, the market remained highly sensi
tive to any new developm ent that m ight touch off
another increase in the yen. Although a better balance
was restored in the market by early February, there
was little unwinding of long yen positions or of non
resident holdings of “ free” yen deposits and govern
ment securities.
Then, in m id-February, a general decline in the dol
lar on the exchanges triggered a renewed rise in
the Japanese yen. At first, the yen moved in line
w ith the rise in European currencies. But, in view of
Japan’s awesome trade surplus, talk spread in the
market that the government would move to lim it any
further increase in Japanese exports. In response,
exporters rushed to speed up their shipments abroad
before the fiscal year-end in March and, as the yen
Chart 4
Japan
Movements in exchange ra te *
Dollars per yen
.uuoo
.0050
......—
— ...
.0045 -....
.0 0 4 0 -------------—
■UUJ3
J
I---I --A
S
I I
O N
1977
i
I
D
*S e e footnote on Chart 3.
J
F
i
i
M
A
i
i
M J
1978
i
l j
J A
advanced, they scrambled to cover anticipated receipts
partly in the forward market. As a result, the premium
on forward yen increased, providing an arbitrage
incentive to move funds into yen-denominated assets.
Indeed, by early March the inflows into bonds and freeyen deposits had swollen to enormous proportions.
Concerned that a further rise in the yen would ham
per economic recovery and delay even longer the
needed reduction in the trade surplus, the authorities
tried to counter the upward pressure on the currency by
intervening heavily both in Tokyo and in New York
through the agency of the Federal Reserve Bank of
New York. In addition, the authorities announced new
measures to reduce capital inflows, to stabilize the
yen, and to give a further boost to the domestic econ
omy. The Bank of Japan announced a % percentage
point cut in its official discount rate to a post-World
War II low of 3.5 percent and a rise from 50 percent to
100 percent in reserve requirements on increases in
nonresident free-yen accounts above the averages
of daily levels for mid-February. In addition, the gov
ernment announced a prohibition on sales to non
residents of yen bonds issued by domestic entities
with maturities of less than five years and one month.
Except for a brief respite following these announce
ments, the yen remained in heavy demand during the
rest of March. To some extent, foreign funds sought
outlets in longer term Japanese bonds and the Tokyo
stock market, which were not subject to the new con
trols. Also, despite the cost of new reserve requirements
on nonresident yen balances, banks were willing to
attract these funds in order to build up deposits for the
fiscal year-end. Moreover, by the end of March, the cur
rent account surplus ballooned to a seasonally ad
justed annual rate of $22 billion for the first quarter.
All in all, the pressure on the yen gained momentum
toward the month end, pushing the rate up 7% percent
to $0.004445 (¥225.0) by March 28. The Bank of Japan
continued to intervene heavily in the exchanges in
Tokyo and New York. Largely as a result, Japan’s offi
cial reserves rose $5.8 billion from end-January to $29.6
billion by end-March.
However, as the upward pressures on the yen began
to subside, the Bank of Japan scaled down its interven
tion toward the end of March. Thereafter, the rate rose
31/2 percent to as high as $0.004598 (¥217.5) in London
on April 3, before easing back as the passing of the
Japanese fiscal year-end led to a reduction in the cov
ering activity by Japanese exporters and an outflow of
foreign funds from free-yen deposits. Then, from early
April to late May, the yen fell back from the record
highs reached around the quarter end. Japanese ex
ports declined sharply. The tightening of controls on
capital inflows began to take hold. This development,
along with the decline in Japanese interest rates and
the rise in comparable rates in the United States money
market, produced some easing of capital inflows to
Japan. Moreover, yen borrowings by foreign govern
ments and international financial institutions rose
sharply during April. As a result, the yen declined with
the other European currencies against the dollar, drop
ping as much as 51/4 percent to as low as $0.004354
(¥229.7) on May 23.
Meanwhile, the government continued to seek ways
of achieving temporary reductions in exports and in
creases in imports until its expansionary fiscal and
monetary policies had time to work through the econ
omy and to generate an increase in consumer demand,
investment, and imports. During April the authorities
acted to restrain some exports through administrative
guidance, to increase imports through commodity
stockpiling, and to encourage a shift from dollar to yen
financing by offering to refinance import settlement bills
for the banks outside their regular rediscount ceilings.
Also, industrial production and consumer demand
picked up during the first quarter.
But Japanese trade and current account surpluses
continued to mount, reflecting the relative price ef
fects of the yen’s appreciation since February and the
continued adjustments of Japanese exporters to the
higher yen values. As a result, exchange market partic
ipants concluded that the yen would appreciate further
against the mark and other European currencies. The
yen therefore was bid up strongly, beginning in late
May, on a combination of renewed professional demand
and the covering of forward receipts by Japanese
exporters. Within six weeks it had appreciated over
14 percent, far outstripping the rise in other strong cur
rencies. As the yen approached the ¥ 20 0 level and as
exchange market participants focused in late June-early
July on the Bremen and Bonn summit meetings, the
yen’s rise slowed temporarily. But, in the aftermath of
those meetings, the talk of linking together all the
major European currencies in an expanded joint float
arrangement left the impression in the market that
the yen was more vulnerable to upward pressure than
those other currencies. Moreover, seasonal factors
pointing to a large volume of exports in July led traders
to anticipate that heavy commercial bidding for yen
would persist for the next several weeks. Therefore,
market professionals and Japanese exporters saw little
risk on the downside for yen over the near term.
Against this background, the yen became the imme
diate focus of speculative pressure and the inflows into
free-yen deposits swelled to large proportions, though
not to the extent of March. Thus, the yen came into de
mand again in July and burst through ¥ 2 0 0 on July 21
in the midst of a swift exchange market reaction to
FRBNY Quarterly Review/Autumn 1978
53
news that an OPEC special advisory panel had recom
mended pricing oil in terms of a basket of currencies.
Thereafter, the yen was bid up to successive new highs
each day, as the speculative surge in the rate con
tinued to be reinforced by another rush of Japanese
exporters to cover their forward receipts. Trading vol
ume mounted, and the yen was bid up to a high of
$0.005301 (¥188.6) on July 31. At this level the yen
had advanced 28 percent against the dollar over the
six-month period. Moreover, the yen had gained
23 percent against the German mark. To moderate this
rise in the yen, the Bank of Japan continued to inter
vene both in Tokyo and in New York through the
Federal Reserve Bank of New York, albeit to a lesser
extent than in March.
Swiss franc
In the face of generalized tensions in the exchange
markets, the Swiss franc came into increasingly strong
upward pressure during 1977, rising by the year-end
some 27% percent against the dollar and significantly
against the German mark as well as other currencies.
At least initially, Swiss firm s were able to take advan
tage of Sw itzerland’s low inflation rate— running slightly
above 1 percent per annum— to maintain their compet
itive position in w orld markets. Thus the current ac
count, bolstered by Sw itzerland’s traditionally large
earnings on overseas investments, remained in sizable
surplus and provided the m ajor contribution to growth
in a domestic economy just pulling out of recession.
But, by late winter, econom ic output flagged and the
prospects fo r further econom ic recovery came into
question when Swiss businessmen, responding to the
uncertainties generated by the accelerating apprecia
tion of the franc, began to curtail investment spending
plans.
Meanwhile, in the exchange markets, the Swiss
authorities had intervened forcefully and tightened up
controls on capital inflows to counter the pressures on
the Swiss franc. By late w inter the cumulative inter
vention in Swiss francs had added far more liquidity to
the dom estic money market than was called fo r by the
National Bank’s target for monetary growth of 5 percent
for the year. The central bank continued to absorb
some of this liqu id ity by selling dollars to nonresident
borrowers of Swiss francs under the official capital ex
port conversion requirement. But the National Bank
permitted a sharp expansion of liquidity in the short run
to prevent money m arket strains from pushing up the
Swiss franc even more, w hile recognizing that the per
sistence of such excess liquidity might generate trou
blesome inflationary pressures over time. Against this
background, the m arket sought to test the authorities’
resolve to avoid a renewed rise in the Swiss franc after
Digitized for
54 FRASER
FRBNY Quarterly Review/Autum n 1978
C hart 5
Switzerland
M ovements in exchange ra te *
D ollars per franc
.GG
.G2
. DU
M
J
A
S
O
1977
N
D
J
F
M
m
A
i
M J
1978
m
i
J A
*S e e foo tnote on Chart 3.
the announcement of more active intervention by the
United States authorities in early January. Thus, the
franc remained subject to bouts of buying that threat
ened to trigger broader unsettlem ent in the exchanges.
Consequently, the Federal Reserve resumed interven
tion in Swiss francs during January, financing its franc
sales with drawings of $18.9 m illion equivalent of francs
that remained outstanding as of the month end.
In mid-February, when the d ollar again came on
offer generally, the franc came under a new wave of
comm ercial and professional demand. Reports that
m ultinational corporations were buying francs to repay
Swiss franc loans gave further momentum to this rise,
propelling the rate 12 percent above early-February
levels to $0.5651 against the dollar and up 6% percent
to SF 0.88 per mark by February 24. In response, the
Swiss National Bank stepped up its intervention, not
only in Zurich but also in New York through the
agency of the Federal Reserve Bank of New York.
The Federal Reserve also sold a further $50.1 m illion
equivalent of francs on February 10-17 in New York,
financing these sales with additional drawings on
the swap line with the Swiss National Bank.
Toward the month end, the Swiss authorities took
further steps to halt the rise in the franc. Effective
February 27, the central bank cut by V2 percentage
point the official discount and Lombard rates to 1 per
cent and 2 percent, respectively, the lowest levels in
the history of the National Bank. Also, the Swiss au
thorities further tightened controls restricting foreign
inflows. In particular, they reduced the amount of non
resident Swiss franc deposits exempt from the negative
interest charge, extended the negative interest charge
to central bank holdings of francs (at m aturity of cur
rent deposit), banned nonresident purchases in p ri
mary and secondary markets of Swiss franc securities
issued by dom estic entities, and restricted nonresident
acquisitions of franc-denom inated bonds issued by fo r
eign entities to 35 percent of the total issue.
Following these measures, inflows of foreign funds
tapered off. Moreover, the market became sensitive to
the possibility that existing official franc holdings in
time deposits m ight be liquidated as they matured and
become subject to the negative interest charge. The
franc, therefore, fell back sharply against both the
d ollar and the mark. Although it recouped some of
these losses at the end of March and in early April
in response to quarter-end liquidity pressures and news
of the United States massive trade deficit in February,
the franc resumed its downtrend in m id-April, when
trading conditions in the exchange markets generally
became more settled. By mid-May, the franc dropped
111/2 percent from its early-M arch highs to $0.5002.
Taking advantage of this slide in the rate, the Federal
Reserve bought sufficient amounts of francs directly
from the Swiss National Bank to liquidate in full the
swap debt it had incurred with the Swiss central bank
earlier in the year.
Meanwhile, an official forecast of a SF 9 billion cur
rent account surplus for the year, second only to
Japan’s, attracted market attention. Also, as the franc
moved lower, selling became increasingly hesitant on
Table 3
Federal Reserve System Repayments under
Special Swap Arrangement with the
Swiss National Bank
In m illions of dollars equivalent
System swap
com m itm ents
January 1, 1978
506.5
1978
I
-9 5 .6
1978
II
-9 5 .6
1978
July
-3 6 .4
System swap
com m itm ents
July 31, 1978
278.8
Because of rounding, figures do not add to total.
Data are on a value-date basis with the exception of the last two
colum ns w hich include transactions executed in late July for
value after the reporting period.
the possibility that the authorities m ight take advan
tage of a more settled exchange market to relax some
of the existing or newly imposed exchange controls.
As it was, the Swiss National Bank sold more dol
lars under its capital export conversion program than
it bought in the market. When the National Bank
announced it had sold dollars in the m arket to mop
up liquidity generated by the heavy intervention earlier
in the year and, moreover, when figures were released
showing a 16.7 percent increase in the monetary aggre
gate for the year ended in March, m arket participants
began to question the authorities’ w illingness to inter
vene again should the franc strengthen.
Against this background, the Swiss franc soon came
into strong demand again, beginning in late May when
the dollar came on offer generally. In part, the demand
was generated by traders anticipating another rush of
nonresident covering of franc-denom inated loans. After
a rapid advance in late June, the franc leveled off as
the authorities provided tem porary quarter-end assis
tance to the dom estic money market through swapping
francs for dollars for short m aturities. But during July
the franc was bid up even more after news that an
OPEC advisory panel had recommended oil pricing in
terms of a basket of currencies and by further signs
of a pickup in the United States inflation rate. In re
sponse to the fra n c’s continued advance, the Swiss
authorities adopted a more flexible lim it for the expan
sion of central bank money and provided further assis
tance to relieve money m arket strains. But, over the
course of the month, the flow of funds out of dollars
and other currencies into francs gathered further steam,
and the franc emerged as the lead currency in the
advance against the dollar. By the month end, it had
soared 15% percent from mid-May levels to $0.5797
to close the six-m onth period as a whole up a net
15 percent against the dollar and 10% percent against
the mark.
Under these circum stances, the Federal Reserve re
turned to the market, on six trading days in June and
July, selling $32.0 m illion equivalent of Swiss francs
to maintain orderly trading. Of this amount, $9.1 m il
lion equivalent came from System balances which
had been replenished by purchases of francs from
correspondents. The remaining $22.9 m illion equiv
alent of francs was financed by drawings on the swap
line with the Swiss National Bank that remained out
standing as of the close of the period. The Swiss cen
tral bank also bought dollars against francs in the
market both in Zurich and through the Federal Reserve
Bank trading desk in New York.
During the period under review, the Federal Reserve
and the United States Treasury continued with the pro
gram agreed to in O ctober 1976 fo r an orderly repay-
FRBNY Quarterly Review/Autum n 1978
55
Table 4
Drawings and Repayments by Foreign Central Banks and the Bank for International Settlements
under Reciprocal Currency Arrangements
In m illions of dollars; draw ings ( + ) o r repayments ( — )
Bank drawing on
Federal Reserve System
Outstanding
January 1, 1978
1978
i
1978
II
1978
July
O utstanding
July 31, 1978
-0-
f + 2 9 5 .0
\ — 295.0
-0-
f + 2 2 .0
\ — 22.0
-0-
Bank for International Settlem ents*
(against German m a r k s ) ..........................
Data are on a value-date basis.
* BIS draw ings and repayments of dollars against European currencies
other than Swiss francs to meet tem porary cash requirements.
Table 5
Table 6
United States Treasury Drawings and
Repayments under Swap Arrangement
with the German Federal Bank
United States Treasury Securities
Foreign Currency Series
Issued to the Swiss National Bank
In m illions of dollars equivalent;
draw ings ( + ) or repayments ( — )
In m illions of dollars equivalent;
issues ( + ) or redem ptions ( — )
1978
II
1978
July
Am ount of
com m itm ents
July 31, 1978
( + 35.2
+ 964.8 ■
I —533.6
-2 6 9 .5
197.0
Am ount of
com m itm ents
January 1, 1978
-0-
1978
I
Amount of
com m itm ents
January 1,1 978
1,168.9
1978
I
1978
II
1978
July
A m ount of
com m itm ents
July 31, 1978
- 1 3 3 .8
- 1 3 3 .8
-5 0 .9
850.4
Data are on a value-date basis with the exception of the last two
colum ns w hich include transactions executed in late July for
value after the reporting period.
Because of rounding, figures do not add to total.
Data are on a value-date basis w ith the exception of the last two
colum ns w hich include transactions executed in late July for
value after the reporting period.
Table 7
Net Profits ( + ) and Losses ( —) on United States Treasury and Federal Reserve
Foreign Exchange Operations
In m illions of dollars
Net profits ( + ) and losses ( —)
related to current operations
Period
Federal
Reserve
Net profits ( + ) and losses ( ^ )
on liquidations of foreign currency
debts outstanding as of
August 15, 1971
Exchange
S tabilization
Fund
Federal
Reserve
Exchange
S tabilization
Fund
First quarter 1978 ........................
-
0.2
-58.7
- 8 1 .1
Second quarter 1978 ..................
-1 7 .2
— 2.9
-60.6
-8 4 .8
July 1978 ......................................
-
+
-
21.6
-3 0 .2
Data are on a value-date basis.
FRBNY Quarterly R eview/Autum n 1978
Digitized56
for FRASER
0.2
5.4
-
0.9
ment of pre-August 1971 franc-denom inated liabilities.
The Federal Reserve repaid $191.2 m illion equivalent
of special swap indebtedness, while the Treasury re
deemed $267.6 m illion equivalent of Swiss francdenominated securities by the end of July. Most of the
francs fo r these repayments were acquired directly
from the Swiss National Bank against dollars. How
ever, the Federal Reserve also bought francs from the
National Bank against the sale of $70.1 m illion equiv
alent of German marks and $13.5 m illion equivalent of
French francs, which were in turn either covered in
the market or drawn from existing balances. By endJuly, the Federal Reserve’s special swap debt to the
Swiss National Bank stood at $278.8 m illion equivalent,
w hile the Treasury’s Swiss franc-denom inated obliga
tions were reduced to $850.4 m illion equivalent.
Sterling
By 1977, fiscal, monetary, and income restraints in the
United Kingdom had produced positive results. During
the second half of the year, retail prices rose by well
under 10 percent per annum for the first tim e since
1973 and B rita in ’s current account swung into surplus.
In response to these improvements in B ritain’s financial
position, the pound was in heavy demand, and the au
thorities at first took advantage of the favorable shift in
market sentim ent to build up official reserves by pur
chasing dollars in the market. But, when continuing
inflows of funds threatened to undercut dom estic mone
tary policy last fall, sterling was allowed to float upward.
In view of the pound’s strength in the exchanges, Britain
was identified as one of those countries which could
contribute to an improved econom ic performance w orld
wide by providing some stim ulus to the dom estic econ
omy. Indeed, the government took advantage of a sharp
drop in the public sector borrowing requirement, well
below the level anticipated in B rita in ’s standby arrange
ment with the IMF, to propose in October a modest tax
reduction. Thus, by the year-end, private and official
forecasters expected a strong pickup in econom ic
activity this year. But, unlike previous British recoveries
from recession, the current account surplus was ex
pected to widen substantially in 1978, bolstered by a
continued expansion of oil production in the North
Sea. As a result, the pound soared to as high as
$1.9930 on January 4, before settling back to around
$1.9500 in late January. Meanwhile, the British authori
ties announced plans to repay and restructure exter
nal debt to reduce foreign obligations and to lengthen
m aturities.
During February, however, market sentiment over the
outlook for the pound turned more hesitant. As the rise
in retail prices slowed, the ensuing increase in real
incomes together with the O ctober tax cuts led to a
faster than anticipated increase in imports, and the
trade account showed a substantial deficit for January.
Also, the tax cuts contributed to a rise in the monetary
aggregates at a tim e when the slowdown of the infla
tion rates already appeared to be bottom ing out.
Against this background, concern surfaced over the
competitiveness of British industry at prevailing ex
change rates as well as over the prospects for a con
tinuation of the pay restraint policy. Meanwhile, further
reflationary measures were w idely expected to be con
tained in the governm ent’s April budget.
Under these circum stances, the financing of the
government’s borrowing needs became more difficult as
bond market participants, fearing a near-term jum p in
British interest rates, held off acquiring new govern
ment stock and shifted portfolio investments abroad.
Consequently, sterling came under occasionally heavy
selling pressure in February and March, falling by 4%
percent against the dollar to around $1.8650 and by
4.7 percentage points on an effective basis to 61.8 per
cent. The authorities intervened at times heavily to
moderate the decline of the rate.
In April, the British government announced a budget
that was only m ildly expansionary but brought the
public sector borrowing requirem ent up quickly to the
maximum suggested by the IMF. To help finance that
d eficit while still containing monetary growth, the Bank
of England’s minimum lending rate was raised a full
percentage point to IV 2 percent. Even so, m arket par
ticipants were doubtful that further fiscal stimulus
would be com patible with the new guidelines for mone
tary expansion, unless additional restrictive measures
Chart 6
United Kingdom
Movements in exchange ra te *
Dollars per pound
2 .0 0 ---------------------------------------- -------1.95--------------------------------------------- --1.90--------------------------------------
------
I I I III
J
A
S
O N
1977
D
LI
J
F
—
I I ...I I I
M
A
M J
1978
J A
* S e e footnote on Chart 3.
FRBNY Quarterly Review/Autum n 1978
57
were imposed. Data revisions suggesting further growth
in Britain’s monetary aggregates, combined with a con
tinued advance of United States interest rates, deep
ened doubts that the government would be able to
finance its debt at prevailing interest rates. In addition,
the imposition by Parliament of tax cuts in excess of
those proposed in the budget and prospects of an early
general election made this task seem increasingly
difficult.
In the exchanges, dealers were wary that nonresi
dents who had built up large-scale portfolios last year
might liquidate their holdings should British interest
rates rise further. Also, market participants had noted
that Britain’s trade figures, while fluctuating widely
between deficit and surplus, were on average show
ing a much smaller surplus than had been implied
in official forecasts, even after these forecasts had been
scaled back substantially. Under these circumstances,
sterling was subject to bouts of professional and com
mercial selling after mid-April. Against the dollar, spot
sterling fell another 3 1/s percent from end-March levels
to a low of $1.8057 by May 17, while also falling 0.3
percentage points on an effective basis to 61.5 percent.
To counter these selling pressures, the Bank of
England sold fairly large amounts of dollars at times
through early June. But at the same time the authori
ties proceeded to liquidate external debt while also
renegotiating terms and stretching out maturities on
some major loans to take advantage of more favorable
borrowing conditions in the Eurodollar market. Reflect
ing in part the intervention support for the pound and
net repayments of external debts of $600 million,
Britain’s external reserves fell over the four months
by $4.1 billion to $17.3 billion as of May 31.
Meanwhile, the Bank of England had abandoned its
market-related formula adopted in 1972 for determin
ing its minimum lending rate and reverted to its pre
vious practice of setting the official discount rate
administratively. The authorities kept the rate at 9
percent, but market expectations of an early hike in
interest rates were reflected in a considerable widen
ing in the discounts on forward sterling.
Then, in order to resume sales of gilt-edged securi
ties and to bolster the pound, on June 8 the British
government announced a package of measures to bring
the economy back on the course anticipated at the
time of the budget. The authorities reintroduced the
supplementary special deposit scheme restraining the
growth of interest-bearing eligible liabilities of the
commercial banks to curb the expansion of the money
supply. In addition, to offset the impact of the extra
cuts in income taxes on the public sector deficit, the
government increased the national insurance surcharge
levied on employers and announced it would seek to
Digitized for
58FRASER
FRBNY Quarterly Review/Autumn 1978
limit wage increases even further in a fourth phase of
voluntary pay policy to begin in July. Moreover, the
authorities raised the official discount rate 1 percent
age point to 10 percent. Finally, Chancellor Healey
reaffirmed the government’s commitment to keep the
public sector borrowing requirement and the expansion
of domestic credit within the limits agreed with the IMF.
Following these announcements, the pressures
against sterling subsided. The ensuing tightening in
the domestic and Eurosterling money markets helped
attract funds from abroad. Moreover, the pound was
buoyed by talk, ahead of the July 6-7 Bremen summit,
of the possibilities of the pound’s eventual in
clusion in an expanded EC snake. The widespread
press commentary over the various proposals for
achieving some new form of joint floating arrangement
frequently generated bidding for sterling by interna
tional investors shifting funds out of both the dollar,
which was declining, and the German mark. Sterling
thus advanced strongly with the other independently
floating European currencies and the yen over the last
two months of the period. By end-July the pound rose
to $1.9310 against the dollar, almost 7 percent above its
mid-May lows and just 1 percent down on balance from ’
end-January levels. On an effective basis, the pound
rose from a low of 60.9 percent in early June to 62.5
percent. Meanwhile, the Bank of England was able to
add dollars to its reserves in June and July while con
tinuing to repay and to prepay its external debts. Taking
these liquidations into account, Britain’s official re
serves rose $292 million during the last two months of
the period to $17.6 billion as of July 31, a net decline of
$3.8 billion over the six-month period.
French franc
By the end of 1977, inflationary pressures in France
were decelerating and France’s current account had
swung into surplus in response to more than a year of
fiscal, monetary, and price restraints. The cost to the
domestic economy had nevertheless been severe. Con
sequently, by September the government had taken
advantage of its stronger external position to adopt
selective measures to boost employment while still
giving priority to the fight against inflation and to the
maintenance of a sound balance of payments. Mean
while, performance of the economy was a key issue
in the upcoming elections scheduled for March 1978
and, by the time the period under review began, opinion
polls were suggesting that a coalition of the Socialist
and Communist parties was in a position to win a
majority in the French Parliament.
Amidst uncertainty over France’s economic and po
litical outlook, the French franc at times had come
under selling pressure in both the spot and forward
C hart 7
France
Movements in exchange rate *
Dollars per franc
* S e e footnote on Chart 3.
markets when adverse com m ercial leads and lags and
speculative short positions built up against the franc.
Such a spasm of nervousness broke out again in midJanuary. As the franc came on offer, the spot rate fell
to $0.2020 by February 6, w hile plummeting 5% per
cent to record lows against the German mark and
Swiss franc. The Bank of France scaled up its official
dollar sales and suspended its fa cility for rediscounting
Treasury bills and other medium-term paper, thereby
setting the stage for an abrupt upward adjustment in
short-term interest rates. These actions helped steady
the market, enabling the franc to rise somewhat against
the dollar. But this advance was insufficient for the
franc to keep pace with the German mark. In fact, just
before the first round of balloting on March 12, the
franc dropped to a record low of FF 2.3873 per mark,
even as the Bank of France intervened in marks and
dollars to moderate the decline.
Early reports indicating that the left-wing coalition
had failed to make its hoped-for electoral gains in the
first round prompted some quick covering of positions.
At about the same time, the market learned of a further
improvement in the French trade account and of a
pickup in industrial output. Buoyed by this news and
by an unexpectedly com fortable m ajority the govern
ment obtained in the final vote of the parliam entary
elections, the franc moved up sharply. But m arket sen
tim ent toward the franc remained cautious because of
expectations that the new government would now
shelve the austerity program in favor of more reflationary measures to reduce unemployment and to
placate the growing unrest within French labor’s rank
and file. Thus, following a short-lived rally, the franc
leveled off against other European currencies in late
March while continuing to rise against an easing dollar.
Meanwhile, during the first quarter, the current
account moved strongly into surplus. Industrial pro
duction was expanding and, with the elections over, in
vestment demand and stock building were expected to
spur output even more. At this point, President Giscard
d ’Estaing moved quickly to reaffirm his government’s
comm itment to continue current policies, with Pre
mier Barre heading the new government. Over the
course of the next month, Barre announced the govern
ment’s intention to reduce the growth of public financ
ing needs and to channel more personal savings into
business investment. These objectives were to be met
by increasing charges for certain public services, re
laxing gradually long-standing controls on industrial
prices and providing some form of tax relief for capital
gains. Although this program was expected to raise
prices over the next few months, the market viewed the
freeing-up of prices and the prospective slowdown in
the public sector deficit as courageous moves. More
over, news of a FF 1.2 billion trade surplus in March
pointed toward further progress in redressing the ex
ternal imbalance, even as the dom estic economy began
to recover.
Market confidence in the franc thus strengthened
generally. With French interest rates remaining rela
tively high, the franc benefited throughout the rest of
the spring from an unwinding of the adverse commer
cial leads and lags and speculative short positions
that had been accum ulated over many months p rior to
the elections. In addition, the exchange rate was aided
by conversions of some foreign borrowings by French
private corporations and by talk of a placement of a
large amount of funds in francs by a m ajor member of
OPEC. As a result, the franc rose 8% percent above its
pre-election level to $0.2215 by early April. Then, as
the dollar generally recovered, the franc eased back
only slightly to $0.2127 during April and May, while
gaining 3 to 5% percent against the mark and Swiss
franc. Meanwhile, after mid-March the Bank of France
bought sizable amounts of dollars and marks in the
market. These operations were partially reflected in a
$1.4 billion rise in France’s foreign currency reserves
over the three months to almost $6 billion by end-May.
In early June, the franc remained well bid. With in
terest rates remaining high even after they had de
clined from pre-election levels, there continued to be
large flows of interest-sensitive funds from abroad.
Meanwhile, the m arket gradually became aware of
the discussion, between French President Giscard
d ’Estaing and German C hancellor Schmidt, on ways
FRBNY Quarterly Review/Autum n 1978
59
to reduce exchange rate fluctuations between Euro
pean currencies. A late-June report from Luxembourg
suggesting the possibility that France’s rejoining the
EC snake might be discussed at the EC summit
meeting in Bremen on July 6-7 brought the franc
quickly into demand, not only against the dollar but also
against the mark. Although the French president
denied the next day that the franc would reenter the
snake as it was then constituted, talk of various pro
posals for some new jo in t floating arrangement kept
alive the possibility that the franc might be linked to
other EC currencies in some manner. As a result, a
com bination of speculative bidding and com m ercial
demand to cover payments needs by the end of the
half year pushed the spot rate up sharply against both
the dollar and the mark. As expectations of a nearterm agreement to link the franc with the other EC
currencies faded follow ing the Bremen summit, the
franc edged back briefly against both the German
mark and the dollar. However, when the dollar came
under renewed selling pressure, the franc was clim b
ing again as the period came to a close. Thus, by the
end of July, the franc had risen 8% percent over the
six-m onth period to $0.2293 and 4% percent on
balance to FF 2.1452 per mark. Meanwhile, the Bank
of France continued to buy dollars to moderate the
fra n c ’s rise. These acquisitions were reflected in a
$1.2 billion increase in France’s foreign-currency re
serves in June and July to $7.1 billion as of July 31, a
net gain of $2.3 billion over the six-month period.
Italian lira
Following the implem entation of a comprehensive
stabilization program in Italy— one that had served as
the basis for a new standby arrangement with the IMF—
substantial progress was made during the second half
of 1977 in turning around Italy’s balance of payments
and slowing the rate of dom estic inflation. For the
year as a whole, Italy’s current account had strength
ened sharply, swinging from a $2.8 billion deficit in
1976 to a $2.3 billion surplus for 1977. Moreover, the
inflation rate had been brought down from 19 percent
to 15 percent in just half a year. The com pletion of
a stabilization program and restrictions on the avail
a bility of dom estic credit had paved the way fo r more
private external borrowing in 1977. Bolstered by both
the current account and capital inflows, the lira thus
rose gradually against the dollar in the exchange
markets. In fact, the authorities were able to buy
substantial amounts of dollars in the market so that,
even after repayment of some official borrowings, Italy’s
foreign-currency reserves rose $4.8 billion in 1977 to
nearly $8.0 billion by the year-end.
But these improvements resulted in a considerDigitized 60
for FRASER
FRBNY Quarterly R eview/Autum n 1978
Chart 8
Italy
Movements in exchange rate *
Dollars per lira
* S e e footnote on Chart 3.
able slowing of the dom estic economy. Industrial pro
duction dropped below levels of the previous year,
unemployment rose, and with corporate profits
squeezed by the high cost of borrowing funds the
prospects for a strengthening of the labor m arket
seemed dim. Consequently, by the year-end, pressure
was building up for new action to stim ulate the
dom estic economy now that progress had been
achieved on the inflation and balance-of-payments
fronts. At the same time, however, the public sector
deficit exceeded the lim it specified in the standby
arrangement and subsequent discussions with the IMF.
The m inority government attempted to negotiate with
the opposition parties and the trade unions new mea
sures to increase public service prices and to reduce
expenditures. But, when the fall of the government in
January and subsequent political developments de
layed the approval of the budget and the adoption of
new measures, the budget deficit grew even larger,
thereby playing an im portant role in stim ulating eco
nomic activity in the early months of 1978.
These uncertainties overshadowed the m arket for
the Italian lira early in 1978. During February, sell
ing pressure on the French franc also spilled over
to unsettle trading in lire. Flows of funds into Italy
slowed, Italian banks repaid some of their external
borrowings, and the lira came on offer. As a result, the
lira lagged far behind the other currencies as the dollar
declined generally. On occasion the Bank of Italy
intervened forcefully, and these operations, together
with the awareness of Italy’s ample reserve position,
helped keep the selling pressures from cumulating. By
m id-February the lira was more nearly keeping pace
with other currencies, and the Bank of Italy was able
to buy dollars again.
Meanwhile, Italy’s trade account remained in surplus
even through the normally adverse period of the year
and despite a rapid recovery of economic activity. Un
like other periods of expansion, the recovery this
time was not accompanied by a large buildup of
inventories and hence of imports. Instead, imports
were sluggish, because the recovery was expected to
be only temporary in view of continuing discussion
about the need to curb the public sector deficit.
At the same time, exports continued to be buoyed by
the existence of excess industrial capacity and by the
competitive effects of the lira’s previous decline against
other European currencies. Looking ahead, the current
account was expected to remain strong because of the
bulge in tourist receipts over the spring and summer
months. Moreover, by March, a compromise worked
out between the two major political parties, in which
the Communists would function as part of the govern
ing coalition within the Parliament without actually
being in the Cabinet, set the stage for renewed dis
cussions on the government’s economic policy. The
strength of Italy’s reserve position was further high
lighted with the announcement of official repayments
amounting to SDR 300 million to the IMF, $500 million of
thre gold-dollar swap to the Bundesbank, and a planned
repayment of $350 million to the EC. In addition, an
extension of ceilings for domestic bank credit signaled
a continuation of the cautious monetary policy.
Against this background, the lira eased back against
the dollar more gradually than other currencies during
April and May. The relative strength in the lira rate,
combined with the continued tightness in the domestic
money market, generated a new rise in Eurodollar
borrowings by Italian residents. Accordingly, the Bank
of Italy bought steadily larger amounts of dollars in
the market to repay external debt coming due this year.
During June and July, Italy’s current account surplus
became even stronger, generating expectations that it
would exceed $3 billion for the year as a whole. At the
same time the renewed selling of dollars enhanced the
near-term prospects for lira stability and encouraged
further capital inflows. Notwithstanding the continuing
debate over ways of reducing inflation still further and
of curbing the public sector deficit, the lira remained
in heavy demand in the exchange markets. Thus the
authorities were able to intensify their dollar purchases
and continued to make substantial repayments of offi
cial debt to the IMF, the EC, and the Bundesbank.
They also liberalized foreign exchange controls by
removing the requirement that 25 percent of the financ
ing of exports be done in foreign currencies. Even so,
the lira advanced with the other European currencies
against the dollar, rising 3% percent to $0.001189 (Lit
841.04) by July 31. At this level, the lira was at its peak
for the six-month reporting period and at its highest
level since October 1976. Over the six months, Italy’s
foreign exchange reserves increased $1.7 billion to
$9.3 billion even after the authorities had liquidated
$1.3 million net of external debt.
EC snake
Late in 1977 the sharp rise in the German mark pulled
up the other four currencies in the EC snake against
the dollar. At times, these currencies had been caught
at the bottom of the 2V* percent band, prompting the
respective central banks to provide support through
intervention and by tightening up on domestic liquid
ity. Following more forceful United States intervention
in early 1978, the market became more settled gener
ally and, as the mark eased back against the dollar,
the pressures in the snake largely dissipated. The four
currencies at the bottom of the band all moved above
their lower intervention limits against the mark, thereby
enabling all the central banks to buy marks in the
exchange market to repay debt to the Bundesbank. In
addition, the central banks of the Netherlands, Belgium,
and Denmark took advantage of reflows into their cur
rencies to buy back dollars as well.
Among the snake currencies, the Norwegian krone
remained relatively weak, however. Norway’s trade
deficit had widened following Sweden’s withdrawal
from the snake in August 1977 and the subsequent rise
in the joint float as a group against the dollar. To
restore Norway’s competitiveness, after a meeting of
EC monetary officials on February 10, the Norwegian
authorities announced an 8 percent devaluation of the
krone against the other snake currencies. Immediately,
the krone rose to the top of the newly realigned EC
snake, and funds flowed back into Norway even as the
krone was pulled up further against the dollar by the
rise in the mark. But, by late March, the market was
concerned that some of the competitive gains from the
February devaluation against currencies outside the
EC band were being eroded by the snake’s rise against
the dollar. As a result, reflows from abroad slackened
and the krone dropped back to the bottom of the joint
float, occasionally coming under light selling pressure.
Meanwhile, the Danish krone, whose parity in the
joint float had remained unchanged in February, also
initially experienced some difficulty in keeping up with
the mark’s advance and required support through sales
of dollars and marks by the Danmarks National Bank.
But tight restrictions on the expansion of domestic
credit in Denmark prompted Danish companies to
finance domestic credit needs by borrowing heavily
abroad. Thus, the pressures on the krone soon eased,
and the rate rose more or less on its own with the mark
against the dollar during March. Then, once the mark
started easing back against the dollar in April, both
FRBNY Quarterly Review/Autumn 1978
61
the Norwegian and the Danish krone were bolstered
by reflows of funds out of marks and reversals of pre
viously adverse commercial leads and lags. The entire
snake thus narrowed to a width of as little as 1 per
cent, and the Danish krone was propelled to the top
half of the band, where it remained for the next two
months while the Danmarks National Bank took dollars
into its reserves.
By early May the Netherlands guilder and commer
cial Belgian franc eased lower in the joint float, partly
in response to seasonal declines in domestic interest
rates but also in reaction to growing concerns in the
market over the performance of the Dutch and Belgian
economies. Fueled by rising consumer spending,
Dutch imports rose, exports sagged, and the Nether
lands’ current account surplus thus was eroded. In Bel
gium, the domestic economy remained stagnant, unem
ployment continued high, and some within industry
were in favor of a depreciation of the franc as a
means of stimulating business activity. These factors
influenced market sentiment toward both currencies,
and the snake widened out again in the late spring
and early summer as the mark moved back up above
its mid-May lows against the dollar.
By June, trading relationships within the EC snake
were affected first by talk and then— following the
July 6-7 EC Bremen summit— by a commitment to
study the idea of bringing the currencies of all EC
countries back into a new joint floating arrangement.
On the one hand, currencies that were new candidates
for membership— sterling, the French franc, and to a
lesser extent the Italian lira— were buoyed by this possi
bility. On the other hand, present snake members were
affected by talk that the rules governing the snake
might be diluted. As a result, the Dutch guilder
weakened somewhat further in the joint float and
the commercial Belgian franc, which had already
fallen to the floor of the snake, came more heavily on
offer. Consequently, the National Bank of Belgium inter
vened forcefully to maintain the franc’s intervention
limits against the mark. In addition, both the Nether
lands Bank and the National Bank of Belgium raised
their official discount rates in mid-July to contain the
pressures on their respective currencies. These pres
sures were moderated by the tendency of the mark to
lag behind the advances of the independently floating
currencies against the dollar until early August.
Canadian dollar
Following the buildup of severe inflationary pressures
in the early 1970’s, the Canadian government had
adopted a medium-term and broad-based program of
restraint that remained in force coming into the period
under review. The modest stimulatory package of tax
Digitized for
62FRASER
FRBNY Quarterly Review/Autumn 1978
cuts, announced in October 1977, did not basically
change the cautious stance of fiscal policy. The annual
target for monetary expansion, also announced in
October 1977, represented the second consecutive re
duction— this year to a range of 7-11 percent. And, al
though Canada’s wage-price program was approaching
an end, the dismantling of controls was to be more
gradual than originally expected and was taking place
against the backdrop of clearly decelerating wage
pressures.
But, after more than two years of this stabilization
policy, the rate of economic growth in Canada slowed
to a pace insufficient to absorb a rapidly expanding
labor force, and unemployment continued edging up
to new postwar highs. Even so, the inflationary ex
cesses of earlier years had resulted in a deterioration of
Canada’s competitive position in world markets. For a
time, Canada’s sizable current account deficit was
more than covered by large inflows of long-term capi
tal. By 1977, however, the mounting debt service re
quirement added further strain to the current account.
Also, capital inflows declined from the record levels of
the previous year, partly because the cash-flow require
ments of Canada’s largest borrowers (the provinces and
municipalities) were lower. Moreover, uncertainties
arose in connection with political developments in Que
bec, and a narrowing of favorable interest differentials
vis-it-vis the United States reduced the incentive for
Canadian borrowers to tap capital markets abroad.
Thus, the Canadian dollar became exposed to down
ward pressure in the exchange markets. By endJanuary the spot rate, at $0.9031, was down by 12Vfe
percent from its peak in October 1976. The Bank of
Canada intervened to maintain orderly markets as the
rate declined. But, since these operations resulted in
large net dollar sales, they exerted a drain on Can
ada’s reserves. Meanwhile, in response to the depre
ciation of the Canadian dollar, rising import as well as
food prices aggravated price pressures in the domestic
economy, keeping the rate of inflation around the
9 percent level.
The Canadian dollar remained on offer in February.
With the drop in long-term placements abroad and an
absence of a full calendar of new foreign issues, mar
ket participants were even more sensitive than usual
to rumors about the timing of conversions of the few
large borrowings that were known to have been done.
A renewed tightening in the United States money mar
ket, which drove Eurodollar deposit rates above com
parable Canadian interest rates, inhibited capital inflows
even more. Reports that a major insurance company
was thinking of moving its head office from Montreal to
Toronto had also reinforced the market’s concern about
the possible political and economic consequences of
having in Quebec a government comm itted over the
long term to establishing the province’s independence.
In this atmosphere, professional and comm ercial selling
gathered force, driving the rate down still further. In
response, the Bank of Canada stepped up its support,
and Canada’s reserves fell $700 m illion during February
to $3.7 billion at the month end, the lowest level
since 1970.
By this time, a succession of monthly trade figures
pointed to a sharp improvement in Canada’s net export
position in response to the rapid growth of the United
States economy and to the large effective depreciation
of the Canadian dollar. The rise in the real trade bal
ance, together with a modest pickup of consumer
spending follow ing the tax cuts of last fall, suggested
some improvement in Canada’s overall growth per
formance. But the continuing decline in the Canadian
dollar was by now a serious political issue. Moreover,
the most recent statistics showed sharp jum ps in both
wholesale and consumer price indexes. The wage and
price control program was being phased out. Under
these circum stances the impact of further depreciation
on Canada’s cost structure was threatening to under
mine the governm ent’s efforts to achieve noninflationary growth fo r the Canadian economy.
The authorities, therefore, acted to shore up the
Canadian dollar. To supplement the net inflow of capi
tal, the government announced between late February
and early April an activation of the standby fa cility
arranged with Canadian banks last October, an in
crease in that credit line from $1.5 billion to $2.5 billion,
and a new government $750 m illion bond issue in New
York, its first external borrowing since 1968. Moreover,
the Bank of Canada, judging that short-term interest
rates could now be raised w ithout prejudicing the
achievement of an acceptable rate of m onetary expan
sion, increased its discount rate in two successive
Vz percentage point hikes to 8 V2 percent by April 4 to
moderate pressures on the exchange rate.
Nevertheless, m arket sentim ent toward the Canadian
dollar remained bearish. The impact of the announced
government bond issue was undercut by the news of a
sim ilarly sized drop in official reserves fo r February.
Moreover, market participants were expecting that,
with unemployment stubbornly above 8 percent and a
national election to be scheduled over the next year,
the upcoming budget would generally be stim ulatory.
Thus, the Canadian dollar continued to come heavily
on offer, with the pressures especially strong when
United States corporations came into the m arket to
repatriate funds to cover their quarter-end needs or
m id-April tax payments. As the selling continued, the
rate fell with increasing speed, declining virtua lly every
day in early April until it hit a 45-year low of $0.8663
on A pril 14. At this level, the rate was 4 percent below
early-February levels.
Meanwhile, Finance M inister Chretien presented on
April 10 a budget proposing a tem porary cut in the
sales tax and a modest increase in an already large
budget deficit. But, with these measures less stim u
latory than some in the market feared and in response
to a resumption of foreign borrow ings and conversions,
the market for Canadian dollars came into better bal
ance. The spot rate began to move off its lows. Around
the end of April the Canadian government announced
plans for three new medium-term mark placements,
Chart 10
Chart 9
Canada
Movements in exchange ra te *
Dollars per Can. dollar
Interest Rates in the United States,
Canada, and the Eurodollar M arket
Three-month m a tu ritie s*
Percent
♦ See footnote on Chart 3.
FRBNY Quarterly Review/Autum n 1978
63
totaling over $700 m illion equivalent, and a $3 b il
lion standby credit with a consortium of United
States and other foreign banks. The announcement of
these arrangements brought the total credits imm edi
ately available to the authorities to roughly $7 billion.
In addition, the announcement of a Can.$840 m illion
trade surplus for March indicated an underlying im
provement in that account. These developments gave a
boost to market sentiment, triggering the reversal of
some short positions and previously adverse comm er
cial leads and lags. The Canadian dollar thus advanced
further to recover all its losses since end-January, mov
ing back to as high as $0.9035 by mid-May. The Bank
of Canada continued to intervene, buying dollars in
May, thereby replenishing some of the reserve losses
of earlier months.
But before long, in the face of unsettling news about
prices and the Quebec issue, the Canadian dollar eased
back from its mid-May peak. An unexpected drop in
Canada’s trade surplus in April also contributed to the
m arket’s skeptical attitude toward the Canadian cur
rency. Moreover, the squeezing-out of interest rate
differentials favorable to Canada continued as United
States money rates rose further. Also, some United
States corporations were again in the market to hedge
their Canadian holdings ahead of the quarter end for
Digitized for
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FRBNY Quarterly Review/Autum n 1978
tax purposes. In this atmosphere, the Canadian dollar
eased back to $0.89 by end-June; the rate then flu ctu
ated narrowly around this level through most of July.
The market became unsettled again in late July
when, with the United States dollar coming under
increasingly heavy selling pressure, participants came
to expect that further increases in United States short
term interest rates would virtually elim inate the inter
est differential favoring Canada. Even after the Bank
of Canada raised its discount rate another Vi per
centage point to 9 percent on July 26, trading remained
unsettled. The announcement that Canada’s trade ac
count fell into deficit during June (later revised to a
small surplus) gave the market a further jolt. As a
result, the rate declined to $0.8813 on July 31, down
2% percent fo r the reporting period as a whole but
still almost 2 percent above its mid-April lows. Mean
while, the Bank of Canada intervened more heavily
again, selling dollars in June and July. But, at the same
time, since March it had drawn a total of $1.2 billion
on its credit facilities with Canadian and foreign banks.
Bolstered by these takedowns and the other external
borrowings in marks and dollars, Canada’s official re
serves rose nearly $900 m illion net above end-February
lows to $4.6 billion as of July 31, a net increase of
$186 m illion for the period.
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