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Federal
Reserve Bank of
New York
Quarterly Review
A utum n 1986 Volum e 11 No. 3
1
R e sp o nsive n e ss of In te re st Rate S preads and
D e p o sit F low s to C hanges in M arket R ates
11
W age R ig id ity in W est G erm any: A C om parison
W ith the U.S. E xp e rie nce
22
The C ycle in P ro p e rty /C a s u a lty Insurance
31
Tax R eform and the M erger and A cq u isitio n
M arket: The R epeal of G e n e ra l U tilitie s
36
43
Treasury and Federal R eserve
Foreign E xchange O p e ra tio n s
A u g u s t-O c to b e r 1986
M a y-Ju ly 1986
The Quarterly Review is p u blished by the
Research and Statistics Group o f the
Federal Reserve Bank o f New York.
Am ong the m em bers o f the staff who
contributed to this issue are JOHN
WENNINGER (on the responsiveness of
interest rate spreads and deposit flows to
changes in m arket rates, p a g e 1); LINDA
A. BELL (on w age rigid ity in West
Germany com pared to the U.S.
experience, page 11); R O B E R T ! McGEE
(on the cycle in property/casualty
insurance, pag e 22); and CHARLES
STEINDEL (on the effect o f the repeal of
General Utilities on the m erger and
acquisition market, page 31).
Two quarterly reports on Treasury and
Federal Reserve foreign exchange
operations for the periods A ugust through
O ctober and M ay through July begin on
pages 36 and 43.
Responsiveness of Interest Rate
Spreads and Deposit Flows to
Changes in Market Rates
Changes in interest rates have long been recognized as
an influence on the growth of transactions balances
(M1). As market rates rise, depositors have typically
reduced their money holdings because the interest
income they forgo in holding money balances increases
as market rates rise. When the Monetary Control Act of
1980 set a tim etable for a gradual deregulation of
interest rates on consumer deposits, it was widely rec
ognized that the demand for transactions balances
would probably respond differently to changes in market
rates than it had in an environment where deposit rates
were subject to officially imposed ceilings.1 But it was
not certain whether these balances would become more
or less sensitive to changes in market rates because it
would depend to a much larger degree on the rate-set
ting policies of the banks. It now appears, however, that
banks have adjusted the rates on deregulated accounts
(both on time deposits and transactions accounts) in
such a way that the demand for transactions balances
has been considerably more interest-sensitive than it
was prior to 1980. If these banking practices continue,
M1 is likely to speed up or slow down far more than it
did in the past in response to decreases or increases
in market rates. Deregulation has produced an envi
ronment in which changes in market rates have con
tinued to affect the attractiveness of holding M1 bal
ances relative to m arket instrum ents. In addition,
changes in market rates now can affect the attractive
ness of holding M1 balances relative to time deposits
by causing spreads between the rates paid on time
deposits and M1 balances to narrow or widen.
’ For a detailed listing of the steps in the deregulation of consumer
deposits, see R. Alton Gilbert, "Requiem for Regulation Q: What It
Did and Why It Passed Away,” Review, Federal Reserve Bank of St.
Louis, February 1986, p. 31.
Since the third quarter of 1984 (when short-term rates
peaked) these interest rate spreads have narrowed
considerably (see Chart 1). At the same time, M1’s
growth rate accelerated from 5.4 percent in 1984 to over
11.5 percent in 1985 and the first half of 1986, and its
velocity dropped from a 3 percent increase in 1984 to
a negative 5.25 percent over the past year and a half.
By comparison, during the 1960s and 1970s M1’s
growth averaged about 5 percent and velocity increased
about 3 percent per year.
Because changes in these rate spreads seem to affect
M1 and velocity growth so dramatically, a question
arises about how these rate spreads adjust to changes
in market rates in a deregulated (flexible-rate) environ
ment. In other words, the responsiveness of M1 growth
to changes in market interest rates now depends on
how rate spreads (between market rates and the rate
paid on M1 balances as well as between the rates on
time deposits and M1 deposits) adjust to changes in
market rates. The large changes in these rate spreads
as interest rates fell in 1985 and the first half of 1986
demonstrated that banks do not adjust the rates on
various types of deposits in step with market rates,
leaving rate spreads (and hence the incentives to shift
funds) unaffected as might have been expected in a
deregulated structure.2
In a regulated environment, the spreads between the
market rate and various consumer transaction and time
deposit rates tended to move in step with market rate
changes because the rates on bank deposits did not
change as long as market rates were above the ceiling
2For more on this aspect of deregulation, see R.G. Davis, "Monetary
Targeting in a Zero Balance World," in Interest Rate Deregulation
and Monetary Policy, Asilomar Conference, Federal Reserve Bank of
San Francisco, November 1982.
FRBNY Quarterly Review/Autumn 1986
1
Chart 1
S ele cted In terest Rate Spreads and D eposit Flows
As m arket and tim e deposit rates fe ll, rate spreads re la tive to NOW accounts narrowed and
M1 grow th accelerated . . .
Percent
Percent
16 ------------------------ 1
--------------------------1------Growth rate from tw elve m onths e a rlie r
12 -
\
10-
Treasury bill rate
j /
\
\
v ' Six-month *
_ small time _ V
deposit rate \
\J / \
" \ \ - .............
account rate
■
NOW account
rate
III
,1 1.J I 1 1 1.1 1 1 1 1 1 11 1 1 1 11 1 1
1984
1985
1 1 1 1 1..J—1—L.. I l l ,
1986
. . . re fle c tin g the more rapid grow th in NOW accounts, w h ile sm all tim e deposits
sto pp ed grow ing.
Percent
30 --------Growth rate from tw elve months earlie r
Percent
20-
Growth rate from tw elve months e arlie r
Small time
deposits
10
5l I I I I I I I l I I I
1984
II I I I II I II1 I I I II I I II I I I
1985
1986
-5I l l I I I I I I I I I I I I l l I I I I I 1 l
1984
Sources: Federal Reserve Board, Statistical Release H.6; Federal Reserve Bulletin
2
FRBNY Quarterly Review/Autumn 1986
1985
1986
specified by Regulation Q. Therefore, even though
consumers did have incentives to shift funds between
market instruments and bank deposits, they had little
incentive to shift between time deposits and transactions
accounts because these rate spreads tended to remain
constant. As long as banks were paying the ceiling rates
on deposits, the spreads between the rates on various
types of deposits did not change even when market
rates increased or decreased.
But now that banks can pay the rate the market dic
tates on consumer transactions and time deposits, it is
important to study the effects that changes in market
rates will have not only on (1) the spreads between
market rates and the rates paid on bank deposits, but
also on (2) the rate spreads between the different types
of bank deposits (between time deposits and transac
tions deposits, for exam ple). This second point is
important, of course, because time deposits are part of
the M2 definition of money while transactions balances
are in M1. The dramatic slowdown in time deposits in
1985 and the first half of 1986, along with the concur
rent acceleration in M1 growth as the spreads between
the rates offered on time deposits and transactions
deposits narrowed, suggest that substitution between
M2 components could cause the demand for M1 to be
more interest-sensitive in a deregulated environment
(Chart 1).3 Of course, when rate spreads change con
sumers can move funds not only between time deposits
or market instruments and M1 balances, but also into
and out of money market deposit accounts (MMDAs)
and money market mutual funds (MMMFs). These
components of M2 could be alternatives to holding M1
or time deposit balances as interest rate spreads
change.
In the first section of this article, the responsiveness
of various rate spreads to changes in market rates is
reviewed on the basis of some econometric results. By
and large, banks, with a lag, have fully adjusted the rate
on time deposits to reflect changes in market rates. But
they have made only a partial adjustment to their MMDA
rates and have been very slow to adjust the rate on
deregulated transactions balances (Super NOWs).
Hence, even though rates on deposits have been de
regulated, consumers still have had an interest rate
incentive to reduce their liquidity when market rates rise
and increase it when market rates fall.4
In the second section of this paper, we review the
problems of estimating the responsiveness of deposit
*For more detail, see J. Wenninger and L. Radecki, "The Monetary
Aggregates in 1985,” this Review, Winter 1985-86.
4Of course, now that the rates on consumer deposits are competitive
with market instruments, the demand for bank deposits might be
affected to a larger degree than in the past by changes in
inflationary expectations or changes in the expected returns on
other investments such as stocks.
flows to changes in rate spreads. As a general note of
caution, we have had too little time in a deregulated
environment to make very precise estimates. But even
with more time, the high correlations among the interest
spreads that would affect the deposit flows will make
estimates difficult. Nevertheless, we can anticipate the
direction of response that some of the components of
M2 will make to changes in market rates, based on the
way interest rate spreads have responded to changes
in market rates.
Responsiveness of interest rate spreads
Ten interest rate spreads are studied in this article:
(1) Six-month Treasury bill less six-month time
deposit.
(2) Six-month Treasury bill less Super NOW.
(3) Six-month Treasury bill less MMDA.
(4) MMDA less Super NOW.
(5) Six-month time deposit less Super NOW.
(6) Six-month time deposit less MMDA.
(7) Six-month Treasury bill less MMMFs.
(8) Six-month time deposit less MMMFs.
(9) MMMFs less MMDAs.
(10) MMMFs less Super NOWs.5
The table in the box shows the results when the
weekly changes in these ten rate spreads are regressed
on current and lagged changes in the six-m onth
Treasury bill rate. Based on these results, Charts 2
through 6 illustrate the response over time of the rate
spreads to changes in market rates.
Chart 2 (bottom line) shows the response over time
of the spread between the six-month bill rate and the
six-month time deposit to changes in the six-month bill
rate. In other words, we want to see what happens to
the spread between the market rate and the time
deposit rate when the market rate changes. The chart
shows that initially the spread widens considerably, but
after about ten to twelve weeks banks have adjusted the
rate on time deposits to reflect completely the change
in market rates.
At the other extreme, banks are very slow to adjust
the Super NOW rate when market rates change.6
*ln theory, the spreads between the rates earned on longer term time
deposits and these deposits could be important as well. To keep the
number of rate spreads manageable, however, longer term rates on
time deposits were not included. For an analysis of longer term
deposit rates as well as short-term rates, see Paul O’Brien,
"Deregulated Deposit Rate Behavior," Board of Governors of the
Federal Reserve System, April 1986, unpublished.
•As of March 31, 1986, the distinction between conventional NOW
accounts and Super NOWs was no longer meaningful. By that time,
the minimum balance requirements for Super NOWs had been
eliminated and the interest rate ceilings on savings deposits
FRBNY Quarterly Review/Autumn 1986
3
The top line in C h art 2 show s that even a fte r tw elve
w eeks the Super NOW rate has changed by only about
25 percent of the change in m arket rates, and therefore
changes in m a rket rates have had lo n g -la stin g effe cts
on the spread betw een m a rke t rates and the S uper
NOW rate. (T his can also be seen from C hart 1.)
Between these two extrem es is the responsiveness of
the MM DA rate. The ce n te r line in C hart 2 show s that
after a tw elve-w eek period, the spread between market
and MM DA rates has a d ju ste d about 60 perce n t of the
w ay to the ch ange in m arket rates, as com pared with
25 p ercent fo r S uper N O W s and 100 perce n t fo r tim e
d e p o s its . T h u s , a lo n g th e liq u id ity s p e c tru m fro m
transactions accounts to tim e deposits, there have been
in cre a sin g ly fu lle r a d ju s tm e n ts to changes in m arket
in te re st rates.
A pparently, banks have not m ade rapid ad ju stm e n ts
to the Super NOW rate, either due to lack of experience
in pricing th ese a cco u n ts, or relu cta n ce to m ake fre
qu ent ch a n g e s to the te rm s o ffe re d on tra n sa ctio n s
accounts once they set a com bination of fees, minimum
balances, and an interest rate on Super NOWs. In other
words, banks may have wanted to market Super NOWs
not as flexible rate accounts, but as fixed-rate accounts
on w hich the te rm s do not change fre q u e n tly but co n
sum ers still earn a fa ir rate of return on a verage over
the long er run.
On the other hand, banks have had considerably more
experience with offering flexible rates on time deposits.
Indeed, for several years the ceiling rates on six-month
tim e d e p o sits w ere linked d ire c tly to changes in the
Treasury bill rate. H ence, banks w ere q u icke r to adjust
tim e d e p o sit rates to fo llo w m arket rates a fte r the c e il
ings rates on tim e deposits were elim inated. In addition,
w ith tim e d e p o sits banks are ad ju sting only the rate
o ffered on m aturing or new d e p o sits; the rate on the
no nm a tu rin g stock re m a in s unchanged. H ence, th e ir
c o s t o f fu n d s fro m th is s o u rc e a d ju s ts g ra d u a lly to
changes in m arket rates even if they quickly match any
change in m a rke t rates w ith a change in tim e dep o sit
rates. In co n tra st, w ith S uper NOW s any change in the
rate offered by banks affects the entire stock of deposits
since S up er N O W s fo r all p ra ctica l purposes do not
have a m aturity like tim e deposits do. Therefore, banks
may feel th a t the y have b e tte r co n tro l over the cost of
fun ds from th is sou rce if th e y prom ote them as fixed-
rate accounts or acco u n ts on w hich the te rm s change
only infrequently. In any case, it a ppears th a t M1 has
retained a sig n ific a n t, if not a la rg e r in te re s t e la sticity
o ver the last few years as a re su lt of the w ay banks
h ave a d ju s te d th e ra te s on S u p e r N O W s a nd tim e
d e p o s its .7
MM DAs, as a c o m b in a tio n sa v in g s /c h e c k in g in s tru
m ent, p ro b a b ly in v o lv e a c o m b in a tio n of th e above
considerations for banks. MMDAs were introduced as a
m eans fo r banks to com pete e ffe c tiv e ly w ith M M M Fs.
H ence, th e y w ere view ed from the s ta rt as a fle xib le rate deposit, and banks may have been predisposed to
7This result may not hold in the very long run, of course. If market
rates changed and then held steady for a very long period, banks
would probably over time adjust the Super NOW rate to reflect this
change fully, after allowing for the cost of required reserves. Over
shorter periods of time in a less stable interest rate environment,
however, it appears that significant changes in rate spreads can
occur that strongly affect M1's growth. The overall responsiveness of
deposit flows to changes in market rates depends, of course, not
only on how rate spreads change but also on how responsive
consumers are to a given change in these spreads. In this article,
we are focusing primarily on how much rate spreads adjust to
changes in market rates.
Chart 2
Responses of the Spreads Between the
Treasury B ill Rate and the Time Deposit,
MMDA, and Super NOW Rates to Changes
in the Treasury B ill R ate*
Cum ulative percentage points
Footnote 6 continued
(including conventional NOWs) were no longer effective. For most of
the three-year period studied in this article, however, the distinction
between Super NOWs and conventional NOWs was important
because banks could vary the rate on the former, while there was a
ceiling rate on the latter. How banks varied the interest rate on
Super NOWs during this period in response to changes in market
rates is of interest because it gives some insights into how they are
likely to administer all NOW accounts now that they are deregulated.
4
FRBNY Quarterly Review/Autumn 1986
Weeks
^C u m u la tive responses of the spreads between the
six-m onth bill rate (TB) and the six-m onth time deposit
rate (TD), MMDA rate (MDA), and Super NOW rate (SN)
to a change in the bill rate (percentage points).
Estim ating the Response o f Rate Spreads To Changes in Market Rates
To illu s tra te ho w v a rio u s in te re s t rate s p re a d s have
re s p o n d e d to c h a n g e s in m arke t rates, th e ch a n ge in
each sp re a d w as re g re sse d on the c u rre n t and lagged
ch a n g e s in th e s ix -m o n th T reasury bill rate (see ta b le ).
T he sum of th e c o e ffic ie n ts , w h ich rep re se n ts the total
resp o n se o v e r th irte e n w eeks, is show n at th e bottom
of each c o lu m n . For exa m p le , the to ta l resp o n se of the
spread betw een the six-m onth bill rate and the six-m onth
tim e de p osit rate to a change in the bill rate is zero. That
is, w hen th e b ill rate in cre a se s by a give n am o u n t, so
does th e tim e d e p o s it rate, le a vin g the sp re a d a fte r
th irte e n w e e ks u n a ffe cte d (colum n 1). In co n tra st, the
to ta l re sp o n se o f th e sp re a d betw een the s ix-m o n th bill
rate and the S uper NO W rate to a change in the bill rate
is 0 .7 7 (c o lu m n 2 ). T h u s , if th e T re a s u ry b ill ra te
increases one percentage point, after thirteen weeks the
sp re a d b e tw een the T reasury bill rate and the Super
NO W rate w ill be a b o ut th re e -q u a rte rs of a p e rce n ta g e
point wider than it was before the change in the bill rate.
In o th e r w ords, the S u p e r NO W rate o n ly a d ju sts by
ab o ut 25 p e rce n t (1-0 .7 7 ) of the ch a n g e in the m arket
rate, leaving the spread a b o ut 0 .75 p e rce n ta g e p o in ts
wider. The rem a in in g e ig h t co lu m n s in the ta b le show
w hat happens to o th e r rate sp re a d s w hen the bill rate
ch a n ge s.*
"In the table, there are four basic equations (shown in
columns 1, 2, 3 and 7) which determine how -the rates on
time deposits, Super NOWs, MMDAs and MMMFs adjust to
changes in the market rate. The response of the six
remaining spreads to changes in market rates can either be
estimated, as was done here, or calculated from the results
obtained from the four basic equations
Response of Various Rate Spreads to Changes in Treasury Bill Rate*
(1)
Six-Month Bill Less
Six-Month Time Dep
t
t-1
t-2
t-3
t-4
t-5
t-6
t-7
t-8
t-9
t-10
t-1 1
t-12
Total
R2
D.W.
0.81
-0 .2 0
-0 .1 3
-0 .0 7
-0 .0 4
-0 .0 5
-0 .0 7
-0 .0 8
-0 .0 7
-0 .0 5
-0 .0 5
0.01
0.01
0.02
0.94
1.48
(41.0)
(10.4)
(6 3 )
(3.7)
(2.1)
(2.3)
(3.3)
(3.8)
(3.5)
(2.4)
(2.4)
(0.6)
(0.5)
(6)
Six-Month Time Dep.
Less MMDA
t
t-1
t-2
t-3
t-4
t-5
t-6
t-7
t-8
t-9
t-10
t-11
t-12
Total
R2
D.W.
0.15
0.13
0.05
0.03
0.01
- 0 01
0.001
0.01
0.004
0.02
-0 .0 0 8
-0 .0 2
-0.0 1
0.366
0.50
1.32
(7.7)
(6.5)
(2.6)
(1.7)
(0 7 )
(0 5 )
(0.8)
(0.8)
(0.2)
(1.2)
(0.4)
(0.9)
(0.6)
(2)
Six-Month Bill
Less Super NOW
0.99
-0.01
-0 .0 3
-0 .0 2
-0.01
-0 .0 3
-0 .0 5
-0 .0 3
-0 .0 3
-0.0 0 2
-0 .0 3
0.02
0.001
0.769
0.96
1.80
(58.0)
(0.9)
(1-8)
(1.1)
(0.8)
(1.6)
(2.8)
(1-8)
(1.6)
(0.1)
(1.6)
(1.0)
(0.06)
(7)
Six-Month Bill
Less MMMFs
1.04
-0 .2 6
-0 .1 3
-0 .1 3
-0 .1 2
-0 .0 8
-0 .0 5
-0 .0 4
-0 .0 7
-0 .0 3
-0 .0 6
-0 .0 2
-0 .0 2
0.03
0.92
2.42
(36.0)
(9 1)
(4.4)
(4 3)
(4.1)
(2.7)
(1.8)
(1.3)
(2.3)
(1 0 )
(20)
(0.7)
(0.7)
(3)
Six-Month Bill
Less MMDA
0.95
-0 .0 8
-0 .0 7
- 0 04
-0 .0 3
-0 .0 5
-0 .0 5
- 0 06
-0 .0 6
-0 .0 2
-0 .0 5
- 0 006
-0 .0 0 2
0.432
0.94
1.67
(45.8)
(3.8)
(35)
(19)
(13)
(26)
(2.4)
(2.9)
(3.1)
(1.2)
(2.6)
(0 1)
(0.3)
(8)
Six-Month Time Dep.
Less MMMFs
0.23
-0 .0 6
-0.0 0 2
- 0 05
- 0 08
-0 .0 3
0.01
0.04
0.0001
0 02
-0.0 1
-0 .0 3
-0 .0 3
0.008
0.27
2.28
(72)
(18)
(0.07)
(16 )
(2.4)
(1.0)
(0.4)
(1.1)
(0.004)
(0.6)
(0.4)
(0.9)
(0.9)
(4)
MMDA Less
Super NOW
0.03
0.06
0.04
0.02
0.01
0.03
0.003
0.03
0.04
0.03
0.03
0.02
0.001
0.344
0.43
1.83
(24 )
(5.0)
(3.2)
(16 )
(09)
(2.1)
(0.2)
(2.3)
(2 8 )
(2.0)
(2.1)
(1.7)
(0.1)
(9)
MMMFs Less
MMDA
-0 .0 8
0.18
0.05
0.09
0.09
0.02
0.00
-0 .0 2
0.004
0.004
0.004
0.01
0.02
0.452
0.33
2.12
(24)
(5 3 )
(15 )
(25)
(2.7)
(0.7)
(00)
(0.7)
(0.1)
(0.1)
(0.1)
(04 )
(0.5)
(5)
Six-Month Time Dep.
Less Super NOW
0.18
0.19
0.09
0.06
0.03
0.02
0.02
0.04
0.04
0.05
0.02
0.005
-0.0 1
0.735
0.70
1.30
(94 )
(99)
(48 )
(2.8)
(0.9)
(0.9)
(0.9)
(23)
(21)
(2.6)
(1.0)
(0.3)
(06 )
(10)
MMMFs Less
Super NOWs
-0 .0 5
0.25
0.10
0.11
0.11
0.05
0.004
0.007
0.04
0.03
0.03
0.04
0.02
0.741
0.49
2.12
(16)
(73 )
(2.8)
(3.1)
(3.1)
(1.5)
(0.1)
(0.2)
(1.2)
(09 )
(0.9)
(1 1 )
(0.5)
1
*T-statistics in parenthesis.
Source: Bank Rate Monitor. Estimation period: weekly 10/12/83 to 7/23/86.
FRBNY Quarterly Review/Autumn 1986
a d ju s tin g th e ra te on M M D A s w h e n m a rk e t ra te s
changed more than the rates on Super NOWs. However,
lik e S u p e r N O W s, th e ra te on th e e n tire s to c k of
MMDAs changes when banks adjust the rate offered on
M M DAs. A gain banks m ight be slow er to adjust the
rates on M M DAs than on tim e d e p o sits in an e ffo rt to
avoid large flu c tu a tio n s in the costs of fu n d s from this
source. On bala nce, it is not su rp risin g th a t the rate on
M M DAs has show n a re sp o n se to changes in m arket
rates that is between the responses of the tim e deposit
and the S up er NOW rates.
W hen m arke t rates change, the rate spreads change
not on ly betw een m a rke t rates and va rio u s bank lia b il
itie s but also betw een the typ e s of bank lia b ilitie s . And
ch a nge s in th e se spre a d s m ight induce sh ifts betw een
co m p o n e n ts of M2, p erhaps a ffe ctin g the grow th of M1
as a result.
C hart 3 (botto m line) illu s tra te s the e ffe ct on the rate
spread betw een M M DAs and S uper NOW s w hen the
m arket rate change s. Initially, banks are slow to adjust
both of these rates to changes in market rates, but after
Chart 3
Responses of the Spreads Between the
MMDA and Super NOW Rates and Between
the Time D eposit and Super NOW Rates to
Changes in the Treasury Bill R a te *
a tw e lve -w e e k period, the spread changes by about
33 percent of the change in m a rke t rates, c re a tin g an
in ce n tive fo r co n su m e rs to s h ift fu n d s betw een M M DAs
and S uper NOW s. T hese sh ifts could have som e e ffe ct
on th e g ro w th o f M1 b u t w o u ld le a v e M 2 g ro w th
unchanged. We w ould exp e ct the e ffe c t on M1 grow th
to be sm all because the rate spread does not appear
responsive enough to changes in m arket rates to cause
large su b s titu tio n s betw een MM DAs and S u p e r NOW s.
The top line in C hart 3 show s m uch m ore d ram atic
e ffe cts on the rate spread betw een tim e d e p o s its and
S uper NOW s w hen the m arket rate changes. As in the
previous case, there is little effect in the first week. But
a fte r tw e lv e w e e k s , th e ra te s p re a d b e tw e e n tim e
deposits and Super NOWs has moved by 75 percent of
the am ount th a t the m arket rate changed. T h is re flects
the te n d e n cy fo r the tim e d e p o s it rate (w ith a lag of
twelve weeks) to follow the m arket rate much more fully
than the S uper NOW rate does. As a re su lt, s u b s titu
tions between tim e deposits and Super NOW s are likely
to have size a b le e ffe cts on M1 grow th w hen m arket
Chart 4
Response of the Spread Between the Tim e
D eposit Rate and the MMDA Rate to
Changes in the Treasury B ill Rate*
Cumulative
percentage points
1 0--------------------------------------------------------------
Cumulative percentage points
0 .9 -----------------------------------------------------------------------------------------
0 . 9 -----------------------------------------------------------------------------------------
0.8
0 . 8 -----------------------------------------------------------------------------------------
1.0-----------------------------------------------------------------------------
0.7 ----------------------------------------------------------------------------------------0.6 ----------------------------------------------------------------------------------0.5 -----------------------------------------------------------------------------------------
1
2
3
4
5
6
7
8
Weeks
9
10
11
12
13
Weeks
♦Cumulative responses of the spreads between money
market deposit rate (MDA) and the Super NOW rate (SN)
and between the time deposit rate (TD) and Super NOW
rate to a change in the bill rate (percentage points).
6
FRBNY Quarterly Review/Autumn 1986
Cumulative responses of the spread between the
six-month time deposit rate (TD) and the money market
deposit rate (MDA) to a change in the bill rate
(percentage points).
rates change. As noted earlier, th is w ould in a sense
be a new so urce of M1 grow th w hen m arket rates
change and could well be contributing to M 1’s increased
responsiveness to interest rate changes in recent years.
Moreover, changes in m arket rates might also prompt
som e sh iftin g of fund s from tim e d e p o sits into more
liquid MMDAs. This w ould not affect M1 or M2 but would
affect the overall liquidity of the consumer sector. Chart 4
show s th a t the spre ad betw een the tim e d e p o sit rate
and the MM DA rate a fte r tw e lve w eeks changes by
about 40 percent of the am ount that the m arket rate has
c h a n g e d . T h e re fo r e , w h ile c o n s u m e rs m ig h t a ls o
respond to low er rates on tim e d e p o sits by in cre a sin g
th e ir h o ld ings of M M DAs, th e ir response is not like ly to
be very large because the im pact on the rate spread
when m arket rates change is quite small (about 50 per
c e n t o f th e s iz e o f th e im p a c t on th e ra te s p re a d
betw een tim e d e p o sits and S uper NOW s in C hart 3).
F in a lly , c h a n g e s in m a rk e t ra te s a ffe c t th e ra te s
e arned not only on va rio u s typ e s of bank d e p o sits, but
a ls o on a v e ry c lo s e s u b s titu te fo r b a n k d e p o s its ,
MM M Fs. C hart 5 show s th a t a change in m arket rates
does not re su lt in a p e rm anent change in the rate
spreads betw een m arket in stru m e n ts and the M M M Fs
or betw een tim e d e p o sits and the M M M F s.8 However,
more sizeable changes in rate spreads between MMMFs
and M M D A s o r S u p e r N O W s h a ve o c c u rre d w h en
m a rk e t ra te s c h a n g e (C h a rt 6 ). H e n c e , c h a n g e s in
m arket rates could result in som e fu n d s flo w in g into or
out of M M M Fs and out of or into NOW acco u n ts or
MM DAs. M oreover, since fa irly large sp re a d s betw een
the rates on MMMFs and MMDAs have occurred, it does
not a p p e a r th a t the rates being offered by M M M Fs are
the prim ary fa c to r d e te rm in in g how banks set the rate
on MMDAs.
8This result should be expected from the basic way MMMFs operate.
That is, as their market instruments mature and are gradually
reinvested at the prevailing interest rate, the average rate of return
on their overall portfolio gradually moves toward the market rate.
Chart 6
Chart 5
Responses of the Spreads Between the
MMMFs and MMDA Rates and Between the
MMMFs and Super NOW Rates to Changes
in the T reasury B ill Rate*
Responses of the Spreads Between the
Treasury Bill Rate and MMMFs Rate and
Between the Time D eposit Rate and MMMFs
Rate to Changes in the Treasury Bill R ate*
Cum ulative percentage points
Cum ulative percentage points
1 . 0 -----------------------------------------------------------------------------------------------
0.9
\
\
0 . 9 ----- *
_ o .i I___ I___ I___ I___ I___ I___ L
5
6
7
I
Weeks
10
11
12
13
W eeks
*C u m u la tiv e resp o n se s of the spreads between the
six-m onth b ill rate (TB) and money m arket mutual funds
ra te (M F ) and betw een the time deposit rate (TD) and
MF to a change in the bill rate (pe rce n tag e points)
*C um ulative responses of the spreads between the
money market mutual funds rate (MF) and the money
market deposit rate (MDA) and between MF and
the Super NOW rate (SN) to a change in the bill
rate (percentage points).
FRBNY Quarterly Review/Autumn 1986
7
Responsiveness of deposit flow s
In terms of very broad trends, Chart 1 shows how
deposit flows have responded to changes in interest rate
spreads. However, this section will give some reasons
why precise estimates of how strongly deposit flows will
respond to changes in these spreads are not possible
now. Since MMDAs and Super NOWs were introduced
in 1983, we have data for only about three years in
which all four flexible-rate instruments were available—
too short a period to estimate money demand equations
with monthly or quarterly statistics, particularly since the
equation for each type of deposit (MMDAs, Super
NOWs, MMMFs, and time deposits) would in theory
include four interest spreads and seasonal dummies, as
well as some other variables as explanatory variables.
(Table 1 shows which of the ten rate spreads would
appear in each of the demand equations as well as the
expected signs on the coefficients.)
Even when more statistics become available, serious
problems will arise in estimating the responsiveness of
deposit flows to changes in the various rate spreads.
These rate spreads, since they all respond to changes
in market rates in a deregulated environment, tend to
be correlated with one another, creating the problem of
m u ltic o llin e a rity among the rate spreads used as
explanatory variables. Table 2 shows the degree of
correlation among the rate spreads that would be used
in the equations shown in Table 1.
The most striking result from Table 2 is the high
degree of correlation among the spreads that would be
included in the demand equation for Super NOWs.
Since the rates on the other three types of deposits
adjust more fully and quickly to changes in market rates
than the Super NOW rate, a high degree of correlation
exists among the rate spreads that would logically be
included in a demand equation for Super NOWs.
Indeed, the correlation (multicollinearity) is so high and
so extensive that it appears very unlikely that reliable
estimates of the responsiveness of Super NOWs to
changes in these spreads could be obtained.
Table 2
Correlation Between Rate Spreads*
Monthly Levels and (Changes)
Time Deposits
TD-TB
TD-MDA
TD-MF
TD-SN
1.00 (1.00)
TD-TB
TD-MDA 0.00 (0.02)
TD-MF
0.25 (0.07)
TD-SN
0.00 (0.00)
1.00 (1.00)
0.02 (0.06)
0.74 (0.85)
1.00 (1.00)
0.06 (0.01)
1.00 (1.00)
MDA-TB
MDA-TD
MDA-MF
MDA-SN
(1.00)
(0.43)
(0.16)
(0.01)
1.00 (1.00)
0.87 (0.62)
0.45 (0.29)
1.00 (1.00)
0.48 (0.36)
1.00 (1.00)
MF-TB
MF-TD
MF-SN
MF-MDA
(1.00)
(0.39)
(0.07)
(0.05)
1.00 (1.00)
0.15 (0.11)
0.24 (0.17)
1.00 (1.00)
0.78 (0.88)
1.00 (1.00)
SN-TB
SN-TD
SN-MF
SN-MDA
(1.00)
(0.54)
(0.34)
(0.20)
1.00 (1.00)
0.98 (0.82)
0.91 (0.68)
1.00 (1.00)
0.90 (0.71)
1.00 (1.00)
Money Market Deposit Accounis
MDA-TB
MDA-TD
MDA-MF
MDA-SN
1.00
0.53
0.30
0.19
Money Market Mutual Funds
Table 1
Rate Spreads fo r Demand Equations*
Types of Deposits
Rate
Spreads
SNOWs
TD-TB
TD-MDA
TD-MF
TD-SN
MDA-TB
MDA-MF
MDA-SN
MF-TB
MF-SN
SN-TB
MMDAs
x( -)
MMMFs Time Deposits
X (-)
x(-)
x( -)
x(-)
X( + )
X( + )
X (+ )
X (-)
X (+ )
X (+ )
X( + )
8
=
=
=
=
=
rate
rate
rate
rate
rate
on
on
on
on
on
six-month time deposit
six-month Treasury bill
MMDA
MMMFs
Super NOWs
FRBNY Q uarterly Review/Autumn 1986
1.00
0.54
0.06
0.10
X( + )
X( + )
X( + )
X( + )
*The x’s indicate which rate spreads should be included in the
demand equation for each type of deposit. The + or - signs
in parentheses indicate whether a widening in the spread
would cause more rapid ( + ) or slower ( - ) growth in a given
type of deposit.
Where:
TD
TB
MDA
MF
SN
MF-TB
MF-TD
MF-SN
MF-MDA
Super NOWs
SN-TB
SN-TD
SN-MF
SN-MDA
1.00
0.87
0.80
0.78
‘ The R2s that result when the interest rate speads that would
appear in each of the demand equations are regressed on
one another. Since four rate spreads would appear in each
demand equation, there are six combinations of possible
interest-rate-spread regressions for each type of deposit. The
estimation period is from October 1983 to June 1986.
TD
TB
MDA
MF
SN
=
=
=
=
=
six-month time deposit rate
six-month Treasury bill rate
MMDA rate
MMMF rate
Super NOW rate
Source: Bank Rate Monitor.
The multicollinearity problem is somewhat less severe
for the other three categories of deposits, but probably
still serious enough to raise questions about whether
reliable demand equations could be estimated. In par
ticular, Table 2 shows that for the time deposit demand
equation there would be strong correlation between the
(TD-SN) and the (TD-MDA) spreads. For the MMDA
demand equation, there would be a strong correlation
between the (MDA-MF) and the (MDA-TD) spreads, and
somewhat weaker correlations between the (MDA-TD)
and the (MDA-TB) spreads, the (MDA-SN) and the
(MDA-TD) spreads, and the (MDA-SN) and the (MDAMF) spreads. And for the MMMFs demand equation,
there would be a strong correlation between the (MFMDA) and the (M F-SN) spreads and a somewhat
weaker correlation between the (MF-TD) and the (MFTB) spreads.9
This multicollinearity among the interest-rate-spread
variables in all the equations is at least in part a by
product of a deregulated financial structure. When
ceiling rates were fixed in a regulated structure, the
spreads between the interest rates on deposits tended
not to change when market rates changed. Now all
these spreads can change as market rates change, and
particularly in the case of Super NOWs, the outcome is
an environment where it will be extremely difficult to
estimate demand equations using rate spreads. Never
theless, general trends (as shown in Chart 1) strongly
suggest that these rate spreads are sig n ifica n tly
affecting M1.
Though we cannot estim ate precisely how much
deposit flows will respond to changes in interest rate
spreads, we can infer from the responses of interest
spreads to changes in market rates the direction that
deposit flows are likely to move:
(1) Time deposits should grow more rapidly as market
rates increase. Since the rate on time deposits
adjusts fully to the change in market rates, there
should be no net loss of funds into m arket
instruments. Likewise, there should be no net
inflow or outflow of funds from MMMFs into time
•In practice, some of the rate spreads could probably be eliminated
in estimating demand equations. At the minimum, the opportunity
costs with respect to market instruments and the other components
of M2 should be included in each equation. Hence, for the MMDA
and Super NOW equations, it probably would not be necessary to
include both the spread with time deposits and MMMFs since both
of these are components of M2 and fully adjust to changes in
market rates with a similar pattern. That is, either rate spread could
be used as a general proxy for the spreads that fully adjust to
changes in market rates. In the case of Super NOWs, however,
serious multicollinearity problems would still remain, whereas for
MMDAs the problem would be considerably reduced. In some cases,
taking the first differences of the spreads tends to reduce the
degree of correlation somewhat, but in other cases it becomes
greater.
deposits because the rate on MMMFs over a
twelve-week period also fully adjusts to changes
in market rates. However, time deposits should
grow more rapidly as market rates rise because
of shifts of funds from MMDAs and Super NOWs
into time deposits. The rates earned on MMDAs
and Super NOWs do not fully adjust to changes
in market rates, causing their spreads with time
deposits to change as a result.
(2) Super NOWs should grow more slowly as market
rates increase. Funds should flow from Super
NOWs not only into market instruments but also
into time deposits, MMMFs, and MMDAs because
the rates on these three other deposits adjust
more fully and rapidly to changes in market rates
than the Super NOW rate.
(3) MMDAs will probably grow more slowly as market
rates increase. MMDAs would lose funds to
market instruments, time deposits, and MMMFs
when market rates rise, but perhaps gain some
funds from Super NOWs.
(4) MMMFs should grow more rapidly as market rates
increase. In the longer run, MMMFs should not
lose any funds to market instrum ents or time
deposits (the rate on MMMFs fully adjusts to
changes in market rates) and should gain some
funds from MMDAs and Super NOWs, since the
rates on these types of deposits do not fully adjust
to changes in market rates.
Overall, as market rates increase, time deposits and
MMMFs should grow more rapidly and NOW accounts
and MMDAs should grow more slowly. Chart 7 shows
that these patterns have generally held over the last
three years. Time deposits showed their most rapid
growth relative to trend at about the time interest rates
peaked in 1984 and have slowed since then. In contrast,
NOW accounts and MMDAs showed their weakest
growth at about the time interest rates peaked and have
accelerated as interest rates have fallen. By and large,
MMMFs have displayed a pattern sim ilar to tim e
deposits, but the chart suggests that the main flows as
market rates change are between time deposits and
NOW accounts or MMDAs.
Conclusions
The experience of the last few years offers some gen
eral insights into how monetary aggregates are likely to
respond to future changes in interest rates (provided
that banks continue to behave in the same way) and
raises some interesting questions. The demand for M1
has retained a significant, and probably larger, interest
rate elasticity even though checking accounts for con
sumers have been deregulated. The traditional interest-
FRBNY Quarterly Review/Autumn 1986
9
rate channel is still open whereby movem ents in market
rates cause changes in the desired level of transactions
balance s by a ffe ctin g the spread betw een m arket rates
and the rate paid on M1. In a d d ition , the d e re g u late d
environm ent has provided a new channel through which
changes in m arket rates can narrow or widen the spread
betw een the tim e d e p o s it rate, as well as the MMDA
and MMMF rates, and the rate on transactions balances.
S ince m any of th e se flo w s are w ithin M2, M 2 ’s in te re st
Chart 7
Response of D eposit Flows to
M ovem ents in In te re s t Rates
Percent deviation
0.6
Six-m onth bill rate from mean
lagged one quarter .
0 .2
-
0-
0.2
I
- 0 .4
0.10
-0.05
0.10
I
I
I
I
NOW a cco u n ts from
I
----------
i X
I
I
rend
.
I I U
1
Time d e p o sits from trend
1
0.05
0-
-0 .1 0 L
0 .10-
I
1
1
1
1
1 . 1...I,
1
1
MMDAs from trend
0.05 -
0
-0.05
- 0 .1 0 L
0 .10-
MMMF s from trend
0.05
o-O.O5 IL
1
1983
i j V
1984
m
.
1985
:
i
1986
1
re s p o n s iv e n e s s has not b een in c re a s e d . In d e e d , it
p robably has been co n s id e ra b ly reduced com pared to
a re g u la te d e n v iro n m e n t, b e c a u s e to an in c re a s in g
degree the rates paid on its co m p o n e n ts respond at
least p a rtia lly (and tim e d e p o sits and M M M Fs fu lly) to
changes in m arket rates.
W hile the exp e rie n ce of the last three years can p ro
vide som e in sig h ts, in te re st rates have not m oved over
a s u ffic ie n tly large range in both d ire c tio n s fo r th e re to
be much co n fid e n ce th a t the p ro ce ss by w hich these
rate spreads are affe cte d is w ell unde rsto o d . Indeed, it
is likely th a t banks have been learning how to price
co nsum er d e p o sits in a d e re g u la te d e n v iro n m e n t over
these last few years, and th a t as th e y gain m ore e xp e
rience th e y may behave in a d iffe re n t way. In the sam e
way, consum ers w ill becom e m ore fa m ilia r o ve r tim e
with deregulated deposits and could respond differently
in the future. And both banks and consum ers m ight not
respond as stro n g ly if rates w ere g ra d u a lly in cre asin g
rather than fa llin g by a large am ount as th e y did over
the past few years in response to the sharp fa ll in the
rate of inflation. In other words, their response might not
be sym m e trica l to rising and fa llin g m arket rates, or to
g ra d u a l ra th e r th a n la rg e c h a n g e s in m a rk e t ra te s .
Moreover, we have no exp e rie n ce w ith how banks and
consum ers m ight behave in a situ a tio n w here the yield
cu rve fo r m arket in stru m e n ts becam e inve rte d .
And even in a stable interest rate environm ent, banks
may find it profitable to reprice these various accounts,
thus a ffe ctin g M1 as w ell. For exam ple, if banks begin
to believe that a large volum e of the funds held in NOW
accounts are re la tiv e ly in a ctive sa vin g s ba la nce s that
have been sh ifte d into NOW acco u n ts as in te re s t rates
fell, they may design c o m b in a tio n s of a cco u n ts w ith
tra n s fe r fe a tu re s th a t w ould induce co n su m e rs to hold
th e s e in a c tiv e s a v in g s b a la n c e s in n o n tra n s a c tio n s
accounts in ord e r to avoid re se rve re q u ire m e n ts. Then
M1 could a ppear u n u su a lly w eak re la tive to GNP fo r a
period of time, instead of appearing unusually strong as
it has in recent years w hen sa vin g s ba la nce s w ere
a d d e d to M 1. In d e e d , if b a n k s s h o u ld s tro n g ly e n
courage co n su m e rs to keep only fric tio n a l tra n s a c tio n s
balances in M1, M 1’s in te re s t e la s tic ity could begin to
a ppear very low com pared w ith the e xp e rie n ce of the
past few years. W hile we do understand a few features
of this new environm ent, it continues to be im portant to
monitor changes in the banking system that m ight affect
the b e h a vio r of the m onetary agg re g a te s. T here are
many reasons to e xp e ct th a t the recent past m ight not
be a good guide to the future.
John W e n ninger
10
FRBNY Q uarterly Review/Autumn 1986
Wage Rigidity in West Germany
A Comparison With the
U.S. Experience
Even though inflation seems to be well under control in
West Germany, many policymakers and economists
continue to be pessim istic about the ability of the
economy to sustain a substantial domestic demand
expansion. To a large extent, such pessimism is based
on the view that the German economy is afflicted by
severe labor market rigidities which leave virtually no
scope for expansionary policies. Presumably the con
cern is that any demand expansion, even at today’s
record high unemployment levels, would simply rekindle
in fla tio n w ith o u t s ig n ific a n t gains in o u tp u t and
employment.1
This article provides some fresh evidence on labor
market rigidities in West Germany, focusing on one of
the most important aspects of these rigidities, namely
the behavior of wages. Specifically, using both aggre
gate and disaggregate (industry level) data, this article
examines the flexibility of wages in West Germany.
Although other sources of rigidity may be potentially
important, the relatively narrow approach of this article
is appropriate, given that the behavior of wages is
I wish to thank M. A. Akhtar, A. Steven Englander, Ethan Harris, and
Peter Rappoport for helpful discussion, and Elizabeth A. Hall for her
excellent research assistance.
’ Several arguments are believed to be relevant, the most common of
which rests on the view that wages respond asymmetrically to
conditions of excess demand and supply in the labor market. If
wage structures are rigid, then wages are unresponsive to
unemployment and unlikely to fall in the appropriate market-clearing
way. If unemployment is classical (resulting from already too high
wage levels) and wages are rigid, then a demand expansion could
perversely result in higher wages (and prices) with little or no gain
to output and employment. Wage flexibility prevents this scenario
from occurring because unemployment exerts continued downward
pressure on wages at the same time that the economy is expanding.
widely believed to be the driving force for most other
labor market rigidities.2
Because it is difficult to gauge precisely what flexibility
implies for wage responsiveness, we evaluate wage
behavior in West Germany, and wherever possible
contrast it with wage performance in the United States.
We begin with the assumption, inspired by the literature
in this area, that real wages in the United States
through the 1970s and 1980s have been flexible and
that the pattern of U.S. real wage response has aided
output and employment expansion.3
The analysis in this article extends the work of pre
vious studies in its consideration of industry wage
behavior and in the distinct way it treats pre- and postOPEC aggregate wage behavior. The key finding of our
analysis is that wages in West Germany, at both the
aggregate and industry level, have been flexible in recent
years. As a consequence, the pace of real wage growth in
West Germany has moderated, and unit labor costs have
grown at* about two-thirds the U.S. rate since 1980.
The industry patterns offer new and additional evi
dence of wage flexibility. Industry wages were highly
responsive to industry-specific performance in West
German manufacturing, particularly in the short run.
Over the long run the data indicate greater flexibility in
2This article does not evaluate, to any significant extent, more
microeconomic aspects of labor market rigidities, such as minimum
wage laws, unemployment insurance rules, labor mobility, and the
costs of hiring and dismissing workers.
*There are many studies which characterize real wages in the U.S. as
flexible. The most comprehensive study, and reference to other work
in this area, may be found in M. Bruno and J. Sachs, The
Economics of Worldwide Stagflation (Cambridge: Harvard University
Press, 1985).
FRBNY Quarterly Review/Autumn 1986
11
the United States, although to a degree not statistically
d istin g u is h a b le from W est G erm any. Taken as a w hole,
the d ata o ffe r co n vin cin g e vid e nce th a t in d u stry w ages
w ere fle x ib le in W est G erm any.
T he next se ctio n o f th is a rtic le co m pares a g g regate
wage, productivity, and cost trends in the United States
and W est G erm any, and e va lu a te s the la b o r dem and
and su p p ly p re ssu re s in flu e n c in g e q u ilib riu m w ages in
each country. T he fo llo w in g s e c tio n s e xp lo re a g g regate
and in d u s try w a ge fle x ib ility in W est G erm any, draw ing
com parisons w ith the U.S. experience. A brief sum m ary
of the m ain fin d in g s and th e ir im p lic a tio n s fo r m acroecon om ic p o licy are p re se n te d in the fin a l se ctio n .
The aggregate data: labor supply and demand in
wage responsiveness
W est G erm an u n e m p lo ym e n t, u n like u n e m p lo ym e n t in
the U nited S tates, has in cre a se d since 1982 (Table 1,
top panel). M ost analysts attribute this divergence to the
b e h a vio r o f a g g re g a te w a g e s and co n clu de th a t w ages
on average in W est G erm any have been more inflexible
d o w nw a rd , p re ve n tin g la b o r m a rke ts from cle a rin g and
re su ltin g in re la tiv e ly high u n em ploym ent.
S ince we e va lu ate w age re sp o n sive n e ss in both the
U nited S ta te s and W est G erm any, it is useful to co m
pare la b o r m arket b e h a v io r in the tw o co u n trie s. The
firs t q u e stio n is w h e th e r th e re is a n ything in the trend
of la b o r s u p p ly or de m a n d gro w th th a t can e xplain
d iffe re n c e s in o u tp u t and e m p lo ym e n t grow th in W est
G erm any, in d e p e n d e n t of w age fle xib ility.
Table 1
Unem ploym ent S ta tistics
The Civilian Unemployment Rate
(annual averages)
1965-85
United States . .
West Germany .
6.2
3.8
1965-73 1974-79 1980-85
4.5
1.1
6.8
4.1
8.1
7.5
1986*
7.0
9.0
Share of Unemployed Prime Age
Male Workersf
4ln the United Kingdom and France, for example, female participation
rates in 1984 were 59 and 55 percent, respectively.
(calculated as a percentage of
total unemployed)
1965-85
United States . .
West Germany .
23.6
26.6
1965-73 1974-79 1980-85
20.5
22.3
22.3
27.6
28.7
30.7
‘ Averages include the first ten months of 1986.
fM ale workers aged 25-54.
^Includes first ten months of 1986.
§1985 figure.
12
FRBNY Quarterly Review/Autumn 1986
On the supply side, labor market demographic trends do
not explain the pattern of West German unemployment.
W hile an in flu x of fem ale, p a rt-tim e , you th , or fo re ig n
workers could conceivably lead to greater unemployment for
any given level of aggregate demand, the evidence sug
gests that these changes have not been the leading cause
of unemployment in West Germany.
C onsider for exam ple women in the labor force. W hile
fe m a le labor fo rce p a rtic ip a tio n grew ra p id ly o ve r the
1970s in the U nited S tates (in cre a sin g from 49 pe rcent
in 1970 to 65 p e rce n t in 1984), in W est G e rm a n y over
the same period it increased just one percentage point.
With only 49 percent of women in the labor force, West
G erm any has one of the lo w e st fe m a le p a rtic ip a tio n
rates in the m ajor E uropean O E C D c o u n trie s .4
In the sam e w ay th a t the e n try of w om en m ay a ffe ct
the shape or position of the labor supply curve, changes
in the mix of p a rt-tim e and fo re ig n w o rke rs m ay a lte r
a g g regate supply. T h is su g g e sts th a t the e m p lo ym ent
data should be adjusted for these workers, to see if the
e m p lo y m e n t re co rd o f e ith e r c o u n try is q u a lita tiv e ly
altered. W hile this adjustm ent results in a stronger trend
decline in West German em ploym ent, it has only modest
e ffe cts on the pattern of e m p lo ym e n t grow th in the
U nited S tates (C h a rt 1). As a tool e ith e r fo r sm o o th ing
em p lo ym e n t or fo r m in im izin g e m p lo ye r co sts, W est
G erm an firm s have e m ployed c o n s id e ra b ly m ore parttime workers than U.S. firm s.5 Excluding teenagers and
older workers from the em ploym ent analysis, so that we
consider the unem ploym ent patterns of prime age male
w o rke rs only, leads to the sam e c o n c lu s io n — the core
of the W est G erm an u n em ployed are p e rm a n en t labor
force m em bers (Table 1, bottom panel).
The broad d e m o g rap h ic d ata do not su g g e st m ajor
d iffe re n c e s in a g g re g a te la b o r s u p p ly b e h a v io r and
th e re fo re p ro b a b ly do n o t e x p la in re la tiv e ly h ig h e r
un e m ploym ent in W est G erm any than in the U nited
S tates. However, o th e r su p p ly -re la te d fa c to rs are re le
vant. One o b vio us source of d iffe re n c e could be the
u n e m p lo y m e n t in s u ra n c e sy s te m . In W est G erm any,
incom e re p la ce m e n t ra tio s from u n e m p lo ym e n t in s u r
ance are, on average, about two tim es greater, and the
period of e n title m e n t is about three tim e s lo n g e r6 than
1986
30.1*
32.2§
5Part-time workers typically are paid less than full-time workers and
have fewer fringe benefit provisions. In addition, certain payroll tax
exemptions are associated with part-time workers.
6The replacement ratio in West Germany for a single worker with
average earnings is approximately 65 percent of previous earnings,
and benefits last at this rate for three years By contrast, the same
worker in the United States receives an average first-year
replacement ratio equal to 35 percent of his base earnings, and
benefits are exhausted, on average in the United States, after 52
weeks.
in the U nited S tates. As a conse q u e n ce , costs to the
u n em ployed w o rke r are lo w e r in W est G erm any than in
the U nited S tates, and the in centive to rem ain unem
p lo y e d is th e re fo re m u ch g re a te r. W h ile th e W est
G e rm an u n e m p lo y m e n t sy s te m m ig h t a c c o u n t fo r a
h ig her o ve ra ll level of u n e m p lo ym e n t at any p oint in
tim e, it can not exp la in the trend through tim e. W est
G erm an b e n e fits have tra d itio n a lly been g enerous, and
the cu rre n t law has been in effect, ro ughly w ith o u t
c h a n g e , s in ce 1969. T h e re fo re , un le ss a s ig n ific a n t
change has o ccu rre d in the a ttitu d e of W est G erm an
workers tow ard work, higher unem ploym ent must reflect
e ith e r lo w e r e x p e c te d b e n e fits of s e e k in g w o rk or
greater inability of the unem ployed to find suitable jobs.
S ta tistics on u n e m p lo ym e n t du ra tio n su p p o rt the view
th a t there is ch ro n ic excess supply in W est G erm an
labor m arkets. W hile only 8.5 perce n t of W est G erm an
workers were unemployed for one year or more in 1973,
by 1985, 31 percent w ere u nem ployed fo r lo n g er than
one year. By co n tra st, only a bout 15 p e rce n t of unem
ployed workers in the United States were idle for longer
than six m onths in 1985.
F inally the re la tio n sh ip betw een u n e m p lo ym e n t rates
and jo b v a c a n c ie s in W e st G e rm a n y (th e s o -c a lle d
Beveridge Curve, Chart 2), suggests that the historically
high recent rates of unem ploym ent in West Germ any are
not su p p ly-sid e induced. S h ifts of this cu rv e are a s so
c ia te d w ith s tru c tu ra l c h a n g e s and s tru c tu ra l u n e m
ploym ent and are taken to re fle ct a m ism atch of jobs
and w o rke r skills; m ovem ents along the cu rve re flect
Chart 1
E m ploym ent G rowth
M illions of persons
M illions of persons
2 8 .0 ------------------------West G erm any
1 1 0 -------------------------
United States
27.5
27.0
55L..I
1965
I I 1.1. 1...1...1..i .. I
67
69
71
73
1 1 1 1 I I
75
77
79
1....1 „J
81
83
85
1965
67
69
71
73
75
77
79
81
83
85
* Data rep re se n t total employment (as m easured by the C urrent Population S urvey) minus p a rt-tim e employment.
+ Data rep re se n t total employment minus employm ent of foreign and sh o rt-te rm workers.
Sources: U.S. Departm ent of Labor, Current Population Survey; Deutsche Bundesbank, S tatistical Supplem ent to the Monthly
Report, and staff estim ates.
FRBNY Quarterly Review/Autumn 1986
13
de m a n d -in d u ce d chan g e s. W hile the cu rv e a ppears to
have sh ifte d in the U nited S tates, it is m ore sta b le in
W est G erm any. However, the la b o r m arket situ a tio n in
W e st G e rm a n y, as re fle c te d by th e p o s itio n on th e
B eve ridge C u rve in the m ost recent years, has su b
s ta n tia lly w o rsen ed. In 1962, fo r exam ple, there w ere
m ore than tw o va ca n t jo b s fo r e ve ry u nem ployed W est
G erm an w orker, but by 1985, fo r every tw o va ca n t jobs
th ere w ere roug hly 50 un e m p lo ye d w o rk e rs .7
Because supply-side developm ents do not explain why
the e m p lo ym e n t situ a tio n is re la tiv e ly w orse in W est
G erm any than in the U nited S tates, we next c o n sid e r
the degree to which wages, productivity, and costs may
have adversely influenced West German labor demand.
Since the mid-1960s real wages in West Germany have
grown at nearly four tim es the U.S. rate. More moderate
7Vacancy data are unreliable and need to be interpreted with care. In
the U.S., no vacancy series exists as a time series; we have used
the Medoff technique of adjusting the help-wanted advertising data
as a proxy for vacancy rates. In West Germany, vacancies are
registered through the German central agency. It is likely that more
vacant jobs will go unreported when unemployment is high, since
available openings are filled immediately and with ease by
employers. For a discussion of the stability of the U.S. Beveridge
Curve, see J. Medoff, “ U.S. Labor Markets: Imbalance, Wage
Growth, and Productivity in the 1970s,” Brookings Papers on
Economic Activity, Vol. 1 (1973), pp. 87-128.
nominal w age settlem ents in West Germ any since 1980
have caused the pace of change in real wages to be
more equal in the two countries (Table 2), although the
latest available data indicate some change in early 1986.
Despite the recent slowdown of real wage growth in West
German m anufacturing, rapid acceleration in the mid1960s and early 1970s led to real w ages that are now,
on average, tw ice their 1965 level. By contrast, U.S.
m anufacturing w orkers now earn w ages only about 20
percent higher than th e ir 1965 level.0
W hile the a cce le ra tio n of w ages th ro u g h the 1970s
suggests real w age levels th a t are both re la tiv e ly and
a b so lute ly high in W est G erm any, fo cu sin g e x c lu s ive ly
on the b e h a vio r of the w age se rie s m asks m ore im p o r
tant labor market trends. The growth of unit labor costs
represents the excess of wage over productivity growth
and p ro b a b ly is a b e tte r m easure of the p re ssu re s on
8Another potential source of difference between real wage patterns in
the two countries results from the importance of minimum wages in
influencing the pattern of real wage movement. In West Germany,
the union-legislated minimum wage sets an effective floor on real
wages at a relatively high level which is binding on the employer. In
the United States, by contrast, the legislated minimum wage has
been allowed to erode considerably in real terms and nearly all full
time workers in manufacturing currently receive wages well in
excess of this level. As a consequence, the U.S. minimum wage is,
in practice, not binding on the employer.
Chart 2
B everidge Curve
Vacancy ra te *
Vacancy rate
3 .0 ----------------
2.0
W est Germ any
United States
2.5
74 79
0 8 '------------------------ 1-------------------------1
------------------------ 1
------------------------- 1
----------------------- 1
------------------------ 1
-------------------------1
' 3
4
5
6
7
8
Unemployment rate
9
10
J _____ I_____I_____I---3
4
5
6
7
Unemployment rate
*T h e vacancy rate was constructed by taking the average of the monthly help-wanted index fig u re s for each year
(1967 = 100) and dividing by the number of em ployees on non-agricultural payrolls.
Sources: The Conference Board; U.S. Department of Labor, Current Population Survey and Establishm ent Survey;
Deutsche Bundesbank, S ta tistica l Supplement to the Monthly Report, Series 4.
14
FRBNY Quarterly Review/Autumn 1986
prices stem m ing from labor m arket conditions. From an
e m p lo y e r’s p e rsp e ctive , fa s te r real w age gro w th does
not m atte r ne a rly as m uch if it is o ffse t by la b o r p ro
d u c tiv ity advan ce. T his a p p e a rs to be the lo n g er run
trend supported by the growth pattern of unit labor costs
in W est G erm a ny (Table 3). W h ile w ages a c ce le ra te d
ra p id ly in W est G e rm a n y in the late 1960s and e arly
1970s, and un it lab o r co sts grew so m e w h a t fa s te r than
in the U nited S ta tes, by the m id-1970s m ore m odest
w age ga ins in W est G erm a n y had reversed the e a rlie r
tren d. As a result, the c u m u la tiv e grow th of un it labor
costs since 1965 has been s lo w e r in W est G erm any
than in the U nited S tates.
F inally the e vid e nce on w age grow th in the n on
m a n u fa ctu rin g s e c to r is also in c o n s is te n t w ith w ages
being the key determ inant of em ploym ent trends in West
Germany. A lthough nonm anufacturing wage growth was
som ew hat fa s te r in W est G erm any than in the U nited
States until the late 1970s, it has been more modest in
W est G erm an y th an in the U nited S tates since 1980
(Table 4). M oreover, the pace of n o n m a n u fa ctu rin g re l
ative to m a n u fa ctu rin g w age grow th has been c o n s is t
e n tly slo w e r in W est G e rm a n y (Table 4). D espite these
trends, nonm anufacturing em ploym ent in West Germany
has grow n at a fa r w e a k e r pace than in the U nited
S tates.
In sum , the da ta do not reveal ra d ic a lly d iffe re n t
changes in labor m arket conditions in the United States
and W est G erm an y since the 1970s. We next exam ine
w h e th e r d iffe re n ce s in w age fle x ib ility m ay lie behind
W e s t G e r m a n y ’s p o o re r o u tp u t p e rfo rm a n c e a nd
e m ploym en t gro w th record.
The fle x ib ility of aggregate wages
In th is se ctio n , we apply som e standard m easures of
w age fle x ib ility to the U.S. and W est G erm an d a ta to
gauge w age re sp o n sive n e ss in each country. D espite
the c o n tin u in g d ebate a bout the re la tio n s h ip betw een
w a g e fle x ib ility and e m p lo y m e n t p e rfo rm a n c e , m o st
a n a lysts assum e th a t a m ore fle x ib le w age system w ill
allow faster and more com plete adjustm ent to econom ic
shocks and will therefore perm it faster econom ic growth
and g re a te r le ve ls of em ploym ent.
We c o n sid e r firs t the sim p le s t and m ost s tra ig h t
forw ard m easure of w age fle xib ility. In a fle x ib le real
w age system , w ages a d ju st fre e ly to sh ifts in labor
supply or dem and, w ith the re su lt th a t m a rke ts e q u ili
brate quickly. T his im plies th a t d u ring p eriods of la bo r
m arket flux wages should be more variable in a flexible
than in an inflexible system. Given this description, one
test of wage flexibility is to calculate the variance of real
w age grow th around tre n d . A fle x ib le system should
produce high va ria tio n generally, w ith in cre a sin g v a ri
ation during p e riods of u n sta b le ag g re g a te dem and or
su p p ly behavior.
Two m e a s u re s o f re a l w a g e s a re u s e d : (a ) th e
re a l c o n s u m p tio n w a g e , m e a s u re d as th e ra tio of
nominal wages to the personal consumption deflator and
(b) the real product wage, measured as the ratio of nominal
w ages to the p ro d u ce r price index. These m easures
show that the variability of real consum ption and product
w age changes in m a n u fa ctu rin g has been g e n e ra lly
greater in West Germ any than in the United States; the
cle a re st d iffe re n ce betw een the tw o co u n trie s re su lts
from the relative long-run stability of real wage changes
Table 2
Table 3
Wages in M anufacturing
Unit Labor Costs in M anufacturing
Nominal Wage Growth in Manufacturing
Growth in Unit Labor Costs
(average annual rates of change
in average hourly earnings)
(average annual rates of change
in unit labor costs in manufacturing)
1965-85
United States . .
West Germany .
6.5
8.5
1965-73 1974-79 1980-85
5.5
10.3
8.7
8.9
5.9
5.4
1986*
2.1
4.5
1965-85
United States .
West Germany .
4.7
4.2
1965-73 1974-79 1980-85
3.5
5.3
8.2
4.2
3.2
2.4
Real Wage Growth in Manufacturing!
Cumulative Unit Labor Cost Growth
(average annual rates of change)
(1965 = 100)
1965-85
United States . .
West Germany .
0.7
4.3
1965-73 1974-79 1980-85
1.2
6.3
0.6
4.1
0.1
1.6
1986*
0.2
5.3
*For the U.S. the figure represents 1986-111/1985-III; for West
Germany the figure represents 1986-11/1985-11.
fR eal wage is calculated by deflating the average hourly
earnings index in manufacturing by the implicit PCE deflator.
United States .
West Germany
1986
0.1
3.7
1972
1975
1979
1986
129.5
136.0
164.7
175.1
210.0
189.3
261.0+
224.4*
‘ For the U.S. the figure represents 1986-111/1985-III; for West
Germany the figure represents 1986-11/1985-11.
fThree-quarter average.
i:Two-quarter average.
FRBNY Quarterly Review/Autumn 1986
15
Table 4
Wage G rowth in N on-M anufacturing Industries
Wage Growth
Relative Wage Levels*
1971-73
1974-79
1980-85
1985
1971-73
1974-79
1980-85
1985
United Statest
Wholesale t r a d e .............
Retail t r a d e ......................
B a n k in g .............................
Insurance .........................
............
.............
............
............
5.8
5.3
4.8
5.0
7.8
6.6
7.2
6.5
6.5
4.9
8.1
6.6
4.6
1.5
5.7
3.6
0.9
1.4
1.2
0.8
0.9
1.5
1.2
0.9
1.0
1.7
1.2
0.9
1.0
1.8
1.2
0.9
West Germany^
Wholesale t r a d e ............
Retail t r a d e ......................
B a n k in g ............................
Insurance .........................
.............
.............
.............
.............
10.8
10.5
10.4
10.6
7.4
7.2
7.2
8.4
4.2
3.5
4.7
5.1
3.2
2.7
4.5
5.2
1.3
1.4
1.1
1.2
1.3
1.4
1.2
1.1
1.3
1.5
1.2
1.1
1.3
1.5
1.2
1.1
•Relative wages calculated by dividing the wage level in manufacturing by the wage level in each non-manufacturing industry.
fWage and salary workers.
^Data represent a weighted average of male and female earnings.
in the U nited S tates (Table 5). T his is tru e generally,
both b efore and a fte r the O P E C oil shocks.
W hile the v a ria b ility o f w age changes in the United
States and W est G erm any is relatively unaffected by the
choice of deflator, the c o n su m p tio n and product w age
m e a s u re s o ffe r in d e p e n d e n t in fo rm a tio n a b o u t th e
in s titu tio n a l b e h a vio r of w ages. Product w ages more
a c c u ra te ly m easure e m p lo ye r co sts; high v a ria b ility in
this series may indicate greater flexibility on the part of
e m p lo y e rs in s e ttin g w a g e s . T h e re a l w a g e s e rie s
d e fla te s n om inal w age grow th by the personal co n
sum ption deflator in each country and therefore reflects
the p u rch a sin g po w e r gains of nom inal w age s e ttle
m ents. If, as m any econ o m ic m odels suggest, w orkers
d e s ire a c o n s ta n t s tre a m o f re a l e a rn in g s o v e r th e
cou rse o f th e ir w orking liv e s ,9 then va riatio n in this
se rie s m ay be a signal of w eakness on the part of
w o rkers or unions in se cu rin g real wage gains. In any
case, the substantial degree of variability in the pattern
of W est G erm an w age grow th is co n siste n t w ith there
being som e fle x ib ility in w age setting.
V ariation in real w age grow th does not n e cessarily
im p ly th a t w a g e s w e re fle x ib le in any e c o n o m ic a lly
m e a n in g fu l w ay. E v id e n c e o f w a g e re s p o n s iv e n e s s
requires a system atic link between movements in wages
and key econom ic variables. Real wage variability alone
does not e xp la in the source of w age m ovem ents and
th e re fo re ca n n ot pro vid e evid e nce of any such link.
im p lic it contract models of the labor market are based on this
assumption. While these models have been criticized on many
grounds, including their failure to make an adequate distinction
between real and nominal wages, most subsequent work has
assumed that it is constancy in real earnings that workers seek in
their bargaining demands.
16
FRBNY Quarterly Review/Autumn 1986
However, our e ffo rts at eva lu ating the source of w age
m o v e m e n ts re v e a l a u n ifo rm in c re a s e in re a l w a g e
fle x ib ility in W est G erm an m a n u fa c tu rin g in re c e n t
ye ars.
To d em onstrate th is fle xib ility, we estim ate equ a tio n s
lin k in g g ro w th ra te s o f a v e ra g e h o u rly e a rn in g s in
m anufacturing to inflation and unem ploym ent rates. Real
wage fle x ib ility is m easured by com paring the re sp o n
siveness of w ages to expected price in fla tio n and the
unem ploym ent rate; in a fle x ib le real w age stru ctu re ,
nominal wages react weakly and with a lag to expected
p ric e m o v e m e n ts b u t s tro n g ly to m o v e m e n ts in th e
u n e m p lo y m e n t ra te . T h is m e a s u re c o m b in e s th e
standard view tha t real w age fle x ib ility re su lts from
inertia in the response of nom inal w ages to p rice s and
the view th a t w ages should be responsive to excess
d e m a n d o r s u p p ly in th e la b o r m a rk e t. In a d d itio n ,
combining the two flexibility criteria in a single equation
y ie ld s a m e a s u re o f th e d e g re e o f a c c o m m o d a tio n
necessary to keep the in fla tio n rate c o n s ta n t.10
According to this flexibility measure, real wages have
been increasingly responsive in W est Germ any in recent
years (Box 1). The main reason is the lack of any strong
response of w age grow th to p rices in W est G erm any
over the recent period, m ost like ly reflectin g the d e te
rioration of real w age grow th. In general, the larg e st
difference between the pattern of wage response in the
10The standard framework for evaluating real wage responsiveness,
based on the concept of nominal wage inertia, is discussed in
J. Sachs, “ Wages, Profits, and Macroeconomic Adjustment. A
Comparative Study," Brookings Papers on Economic Activity, Vol. 2
(1979), pp. 269-319. An alternative approach, which stresses the
role of unemployment, is discussed in D. Grubb, R. Jackman, and
R. Layard, "Wage Rigidity and Unemployment in the OECD
Countries,” European Economic Review, Vol. 2 (1983), pp. 11-40.
two countries is in the reaction of nominal wages to
expected price movements, not in the overall respon
siveness of real wage changes to the unemployment
rate. In fact, the response of wages to unemployment
in the two countries is similar.
Additional tests of aggregate wage flexibility, based on
commonly used variants of the general specification
reported here, broadly confirmed these results.11 Our
analysis shows that wages in West Germany, while more
rigid than in the United States in the early 1970s, were
quite flexible by the late 1970s. Previous studies may
have failed to isolate this tendency because they did not
distinguish the pattern of wages in West Germany in the
most recent years.12
The fle x ib ility o f in d u s try wages
There is no stra igh tfo rw ard relationship between
aggregate and industry wage flexibility. Aggregate wage
flexibility does not necessarily imply that industry wages
are free to vary; aggregate wages may be flexible at the
same time that institutional restraints prevent industry
wages from moving to equilibrate labor markets.
Box 1: F le xib ility o f Aggregate Wages
Data from 1966-1 to 1985-IV were used to analyze wage
flexibility in the United States and West Germany. The
full period data were analyzed over subperiods chosen
to capture the recent changes in nominal wage patterns.
Alternative specifications were estimated over each
subperiod; the results presented here were chosen for
general fit. The equations are specified in four-quarter
growth rates of both the dependent and independent
variables. The dependent variable in all equations is the
change in the natural log (In) of average hourly earnings
in manufacturing. The price expectations variable in all
equations is estimated as a fitted lag on past price
changes (see A.S. Englander and C. Los, Federal
Reserve Bank of New York Research Paper, No. 8305,
August 1983), and the unemployment rate is the rate for
the economy as a whole. All equations have been cor
rected for fourth-order serial correlation. Standard errors
appear in parentheses below the estimated coefficients.
Table A
"Includ in g both a productivity growth variable and a dummy variable
to serve as a proxy for shifts in the structural Phillips Curve relation
did not significantly affect the coefficient estimates on inflation and
unemployment in either country. While the productivity term did
figure significantly in the West German equations and did raise the
explanatory power of the equation, it did not affect the size or
significance of either the price expectations or the unemployment
variable.
12More recent work has concluded that greater wage flexibility
characterizes the West German economy today. See F. Klau and
A. Mittelstadt, “ Labour Market Flexibility,” OECD/ESD Working
Papers, No. 24 (July 1985).
Table 5
Variation* in M anufacturing Wage Growth
Real
Real
Product Wagesf
Consumption Wagesf
United
West
West
United
States
Germany
Germany
States
1965-85
.
2.8
3.5
1.2
3.4
1965-78
1979-85
.
.
. .
3.2
2.1
2.8
2.4
1.1
0.8
3.3
1.7
1965-73
1974-85
.
.
2.6
3.0
2.6
2.6
1.3
1.0
3.5
2.5
Mean wage growth
(1965-85)
0.9
4.6
0.7
4.3
'Calculated as the standard deviation in the arithmetic annual
growth rate of average hourly earnings in manufacture.
-(-Deflated by producer price index.
^Deflated by the personal consumption deflator in manufacture.
Dependent Variable:
Change in AHE (In AHEt- In AHEt^)
United States
West Germany
(2)
(3)
(4)
(5)
(6)
(1)
1966-85 1974-85 1979-85 1966-85 1974-85 1979-85
.813
(.158)
.949
(.232)
.954
(.031)
1.18
(.335)
.761
(.193)
.392
(.215)
InU, . . . . -.0 3 4
(.011)
-.0 5 0
(.016)
-.0 5 2
(.005)
-.0 3 4
(.005)
-.0 4 6
(.006)
-.0 4 7
(.005)
Flexibility
coefficient 23.91
18.98
18.35
34.71
16.54
8.34
.387
.001
1.97
.980
.0002
2.23
.351
.017
1.73
.700
.005
1.89
.760
.003
2.01
•p,e
R2 . . . .
SSE
DW . . . .
.255
.003
1.95
The wage flexibility coefficient listed in Table A above
is calculated by taking the ratio of the long-run elasticity
of wages with respect to past price inflation and the
elasticity of wages with respect to the unemployment
rate. This statistic may be interpreted for any given price
change as the change in the In of unemployment nec
essary to keep the nominal wage constant (i.e., to
ensure a fall in the real wage). It is sim ilar to the
measure adopted in D. Coe, “ Nominal Wages, the
NAIRU and Wage Flexibility,” OECD Economic Studies,
No. 5 (Autumn 1986).
FRBNY Quarterly Review/Autumn 1986
17
The eco nom ic sho cks of the 1970s affe cte d sp e cific
in d u strie s d iffe re n tly. The ones th a t relied to a large
e xtent on oil as an inpu t to p ro d u ctio n w ere m ade p a r
tic u la rly vu ln e ra b le . In a w ell fu n c tio n in g c o m p e titive
econom y, the re spo nse of in d u s try w ages to sh o rt-te rm
d is tu rb a n c e s sh o u ld re fle c t s p e c ific p e rfo rm a n c e — in
industries particularly affected by the OPEC oil shocks,
w ages should have fa lle n .
There are good reasons to suppose that the industrial
w age stru c tu re of W est G e rm a n y m ight be rigid. W hile
collective bargaining is highly decentralized in the United
S ta te s (w ith th o u s a n d s of in d iv id u a l e s ta b lis h m e n ts
setting wages), it is highly centralized in West Germany
(w ith n e a rly all ba rg a in in g ta kin g place at the in d u stry
and reg io n a l le ve ls). W h ile unions are a m in o rity p re s
ence in the U.S. w o rkp la c e (w ith less than 25 perce n t
of U.S. w o rke rs covered by a union co n tra ct), th e y are
a p ow erful m a jo rity pre se n ce in W est G erm any (w here
m ore than 90 pe rce n t of w o rke rs are em ployed in s e c
tors covered by collective bargaining agreem ents).13 The
co m b in a tio n of th e se tw o fa cts im plies, all else the
sam e, th a t the stru c tu re of w ages am ong in d u strie s is
m ore like ly to be rigid in W est G erm any than in the
U nited S tates.
To te st fo r w age rig id ity am ong W est G erm an in d u s
tries, we have assem bled m anufacturing data at the twod ig it level fo r the U nited S tates and W est G erm any on
w ages, p rices, productivity, and e m p lo y m e n t.14 These
d a ta allow fo r a new a n a lysis of w age fle x ib ility w ithin
the econom y that yields independent and more detailed
in fo rm a tio n abou t the b e h a vio r of labor m arkets than
can be le arned from the a g g re g a te data. To the exte n t
that industry wages are flexible, structural labor market
problem s are more likely to be short-lived, since wages
help to allocate labor appropriately among industries in
the long run.
Ind ustrial w age fle x ib ility is defined as the re sp o n
s iv e n e s s o f in d u s try w a g e s to in d u s try -s p e c ific p e r
form ance. A rigid in d u s tria l w age stru ctu re has fixed
13For the statistics on union coverage and membership, see the
chapter on West German collective bargaining in OECD, Collective
Bargaining and Government Policies in Ten OECD Countries (Paris,
1979), In West Germany there is a statistically large difference
between the number of workers who are union members (which for
years has been slightly greater than one-third of all workers) and
those who are covered by union contracts. By contrast, the
difference between union coverage and union membership is
modest in the United States.
14Data for West Germany were kindly provided by the West German
Bundesbank for 29 manufacturing industries over the period 197082. The U.S. data, except where otherwise noted, cover 22
manufacturing industries at the two-digit level and are from the
National Income and Products Accounts Series We focus on
industry wage patterns over the period 1970-82 in this section
because more recent data for West German industries are not
available.
18
FRBNY Quarterly Review/Autumn 1986
re la tive w ages, so th a t e xistin g w age d iffe re n c e s are
p re se rve d across in d u strie s th rough tim e. In the m ost
rigid s tru ctu re , w a g e s am ong in d u strie s w ould respond
e q u a lly to e co n o m y-w id e p ro d u c tiv ity shocks but w ould
show little or no re sp o n se to in d u s try -sp e c ific p ro d u c
tivity movements. As a consequence, wages, on average,
would grow equally among industries through time.
One obvious in d ic a to r of a c o u n try ’s in d u stria l w age
fle x ib ility is th e d e g re e o f d is p e rs io n , a s ta tis tic a l
m easure of the in e q u a lity of w ages am ong in d u stries,
adjusted fo r the m ean w age level. One w ay of d e riving
th is m easure is to ca lcu la te the sta n d a rd d e v ia tio n of
the natural log of wages among industries in each year;
a more flexible system should produce greater variation
generally, with a trend of rising dispersion during periods
of econom ic flux. Higher levels of wage dispersion imply
g re a te r in d u stry w age fle x ib ility because w ages re fle ct
the specific circum stances of each industry. By contrast,
modest and constant levels of dispersion signal equality
in wage response characteristic of an inflexible system.
In dustrial w age d isp e rsio n has risen in the U nited
S ta te s a nd W e s t G e rm a n y s in c e 1 9 7 0 ( C h a rt 3 ).
While the rise is far more pronounced in both level and
trend in the United States, the rise in West Germany stands
out, p a rtic u la rly in lig h t of its highly ce n tra liz e d system
of co lle c tiv e b a rg a in in g . The tre n d in the W est G erm an
Chart 3
Wage D ispersion in M a n u fa ctu rin g
Standard deviation in log wage
0.28---------------------------------------------------------------
................................................................I
1970
72
74
76
78
I
I
80
I
82
* Data for West Germany available in even-num bered
years only.
Sources: U.S. Departm ent of Commerce, National
Income and Product Accounts; Deutsche Bundesbank.
series is also unusual in comparison with other major
European countries, where industry wage dispersion has
either remained roughly stable or declined somewhat.15
While rising wage dispersion is consistent with wages
being flexible, it does not indicate that wages are flex
ible in responding to economic events. Rising dispersion
can occur due either to a mixing of industries within the
wage ranking, or to an increase in the differential
between wages paid to workers in high and low wage
sectors. It may reflect institutional changes in union
concentration or bargaining power within industries, or
it may be economically motivated by structural changes
in industry-specific productivity performance. Therefore,
we measure the responsiveness of industry wages to
evaluate the importance of economic factors in deter
mining industry wage patterns.
Industry wage movements are im portant in labor
markets because they send signals to workers about
where and how to supply their labor. If workers have
complete information about wages in other industries
and can move freely among industries to higher paying
jobs, then wages will be responsive to specific produc
tivity developments in the short term but will respond
only to economy-wide productivity shifts over longer
periods. This pattern results because over the long run
the mobility of workers should be sufficient to equalize
inter-industry wage differences.
With this basic model of labor market behavior as a
guide, we measure statistically the responsiveness of
industry wages to specific performance using data on
wages, productivity, and output prices at roughly the
two-digit level for both U.S. and West German manu
facturing industries. Equations linking annual changes
in industrial wages to annual changes in industrial pro
ductivity and output prices show that wages in West
Germany were very responsive to short-run shifts in
industrial performance (Box 2). While the magnitude of
this effect may appear larger in West Germany than in
the United States (based on the productivity estimates),
these differences are not statistically significant. In any
case, the U.S. and West German regressions are not
strictly comparable—the industry samples differ, and the
periodicity of the data is not the same.16 For each
1sSee L. Bell and R. Freeman, "Does a Flexible Industry Wage
Structure Increase Employment?: The U.S. Experience," National
Bureau of Economic Research Working Paper, No. 1604 (April 1984).
The analysis in this section for the U.S. replicates the Bell-Freeman
tests and methodology.
’ •Because West German industry wage, productivity, and price data
were available for even-numbered years only, we report two-year
changes in wages and sectoral performance in Box 2. While
statistical tests may be unreliable due to lack of comparability in
data and specification across countries, standard tests reject the
notion that wage response was different across countries, largely
due to the relative imprecision of the West German estimates.
country, analysis reveals that short-run movements in
industry wages were highly responsive to industry per
formance, suggesting that industry labor markets func
tioned efficiently in both West Germany and the United
States in the short term.
If workers are not free to move across industries, then
industry wages should be correlated with specific pro
ductivity and price movements over the long- as well as
the short-run. For example, in a labor market with many
barriers to switching jobs and obtaining training, labor
mobility will be constrained. Thus in institutional settings
where union rules govern the workplace, industry wage
patterns may reflect both short- and long-term industry
productivity trends.
A second test of industrial wage flexibilty confirms the
view that industrial performance influences wages over
longer periods of time (Box 2). Over the period 197082, we found that long-run industry wage movements
were related to long-run industry productivity movements
in both the United States and West Germany. To the
extent that industrial productivity movements reflect
inter-industry changes in the skill mix, sex mix, or
occupational structure, the link between productivity and
wages can be understood as a competitive labor market
revaluation of the rewards to work. If instead productivity
movements reflect long-run labor demand shifts or
movements along the demand schedule, then the
explanation must be either that worker mobility is
imperfect across sectors or that wage patterns reflect
at least some noncompetitive factors.
If worker mobility is limited across industries, then any
shift in the industry labor demand curve must result in
wage movement in the same direction—thus wage and
employment growth should be positively associated
among industries. In the United States, this does not
seem to be the case, suggesting that the pattern of
industry wage response is unlikely to be driven by longrun constraints to worker mobility. In West Germany, by
contrast, industries with above average wage growth
over the period 1970-82 exhibited above average
employment growth. Although suggestive at best, these
results imply that workers may, in fact, be inhibited from
moving freely across industries in West Germany.17
While both disaggregate tests reveal that industry
wages in West Germany were flexible over the 1970s
17To evaluate the relationship between wage and employment
response, we correlated long-run changes among the 22 U.S.
manufacturing industries over the period 1970-82, and performed
the same analysis among the 29 West German industries. The
correlation statistics in these tests were equal to - .0 9 for the United
States and .24 for West Germany. More complete analysis of the
implications of these tests for labor market performance can be
found in L. Bell, "Essays in Labor Market Efficiency and
Comparative Macroeconomic Performance," Ph D dissertation,
Harvard University (June 1986).
FRBNY Quarterly Review/Autumn 1986
19
Box 2: F le x ib ility o f In du stry Wages
Industry-specific data for manufacturing industries from
1970-82 were used to analyze industrial wage flexibility
in the United States and West Germany. The data were
estimated linking both short-run changes in wages by
industries (a panel study of 29 industries for West Ger
many and 22 U.S. industries) and long-run 13-year
changes in wages among industries (a cross-sectional
study of wage behavior). Annual data were used for the
analysis in all cases. The dependent variable is the
change in the natural log of the wage in the manufac
turing industry, and the independent variables include
industrial productivity and output price changes, which
serve as proxies for industrial performance. The gen
erally lower explanatory power of each test is standard
to cross-sectional wage regression. Standard errors
appear in parentheses below the estimated coefficients.
1970-82 to long-run changes in specific performance,
measured in the same way as above. This test shows
that value productivity movements by industry influenced
industry wages in both countries. Decomposing these
effects, we find that while industrial output prices influ
enced wages in the United States (column 2), they were
insignificant in determining wage patterns in West Ger
many (column 4). In both countries, industry wage
movements were positively associated with industry
productivity movements.
Table C:
Dependent Variable:
Change in wage by industry (In wM982-ln wM#70)
United States
(1)
Short-run flexibility
Standard competitive theory requires that industry wages
be responsive to short-run movements in industrial per
formance, as a means of allocating labor efficiently
across sectors. To test for short-run industry wage flex
ibility, we link annual changes in industry wages to
annual changes in industry value productivity (two-year
changes for West Germany due to data limitations),
which we decompose into industry productivity per
worker and output prices. Our results (Table B) indicate
a statistically significant degree of wage responsiveness
in both West Germany and the United States.
Table B:
Dependent Variable:
Short-run change in wage by industry (Inwu-lnw,^)
United States
A In (VA/L)tt
(1)
101
(.017)
A In (Q/L)it . . . .
West Germany
(3)
.238
(.031)
.118
252
.077
.021
.235
252
.077
.021
(4)
.334
(.044)
.184
(.035)
.039
(.019)
.191
(.021)
A In P „ ................
R2 ......................
N .........................
. .
Mean (A In w)
S.D. (A In w)
. .
(2)
.262
174
.155
.049
.299
174
.155
.049
Long-run flexibility
Although the standard competitive model assumes that
industrial wages will be linked only to aggregate per
formance in the long term, industrial performance may
in fact influence industrial wages over longer periods of
time. To test the extent to which industrial performance
matters for industry wages over the long run, we link
long-run changes in industry wages over the period
FRBNY Quarterly Review/Autumn 1986
A In (V A /I)i......................384
(.113)
A In ( Q /L ) ,................
A In P ) ......................
R2 .................................. 378
N ...............................
21
Mean (A In wage) . .077
S.D. (A In wage) . . .009
(2)
West Germany
(3)
.143
(.078)
.206
(.081)
.083
(.080)
.338
(.142)
.411
(.125)
.388
21
.077
.009
(4)
.110
29
.078
.006
.230
29
.078
.006
Pooled analysis
The equations listed below test for the statistical equiv
alence of the industry wage-productivity link in the United
States and West Germany by pooling data from the two
countries. The equations are estimated using Weighted
Least Squares (with the assigned weights equal to the
standard errors from each of the individual regressions),
and the relevant explanatory statistics have been recal
culated to conform with the scaling procedure. We
cannot reject, based on the pooled regression results
below (data are from equations 2 and 4, Table C above),
the hypothesis that the relationship between industry
wages and industry-specific performance is statistically
the same in the United States and West Germany over
this period. The implication of this test is that industry
wages were equally flexible in the two countries.
Pooled U.S.-W.G: (R2 = .234)
(1a) A In (Wj) = .277 A in (Q t/I_i) + .209 A In (Ps)
(.075)
(.072)
Individual U.S.-W.G.: (R2 = .322)
(1b) A In (w() = .206 A In {QJU)wg + .338 A In (Qi/Lt)us
(.090)
(.125)
+ .083 A In (P ^g + .411 A In (P ^ ,
(.089)
(.110)
The F-statistic for this test is 2.85.
and early 1980s, they do not explore the relative flex
ibility of the U.S. and West German industrial wage
structures. To make this comparison, it is necessary to
pool the data for West Gemany and the United States
and estimate a single equation. In fact, the link between
industry wage and value productivity movements was
statistically indistinguishable in the two countries
(Box 2). Even though industry output price movements
had a stronger impact on wages in the United States,
the combined impact of the industry performance vari
ables in influencing wages was the same in the two
countries.18 Therefore, the response of industry wages
to industry performance was, on average, just as strong in
West Germany as in the United States. In sum, the indus
trial wage structures in both countries were flexible.19
1*This test is not perfect. Missing variables may be of greater significance
in determining wage behavior in one country than in another and
therefore may bias the coefficient estimates and the statistical tests. For
example, changes in the inter-industry mix of skill, sex, or age that are
correlated with both industry wages and industry productivity will bias the
point estimates on the industry performance variables. If the omission of
these controls is more important in one country, then the pooled results
will be biased as well.
’T his section explores inter-industry wage patterns, but does not evaluate
/nfra-industry wage flexibility. There is reason to believe that the pattern
of wages within industries among establishments is far more rigid in
West Germany than in the United States. While firms in the United States
vary their wages according to size, with large firms paying 25 to 30%
more than small ones, firms in West Germany are generally forced to
pay the union scale wage, and there is no sizeable difference between
what small and large firms pay their workers. For a comprehensive
discussion of firm size effect, see OECD Economic Outlook (September
1985).
Conclusion
The key finding of our analysis is that wages, at both
aggregate and industry levels, have been flexible in
West Germany, at least since the late 1970s.
There appear to be strong similarities in both real and
nominal aggregate wage flexibility in the United States
and West Germany. While real wages responded equally
to unemployment rates in both countries, nominal wages
responded to prices differently. Although price inflation
was an important influence on nominal wage growth in
West Germany through the late 1970s, it has been rel
atively unimportant recently.
At the industry level, wages were flexible in the United
States and West Germany as well. In the two countries,
over both the short- and long-run, industry wage
movements reflected changing industrial performance
and showed some variation. Despite major differences
in industrial structure and collective bargaining institu
tions in the United States and West Germany, the
degree of wage responsiveness at the industry level was
similar.
Since wages in the United States and West Germany
have behaved similarly in recent years, wage rigidity
seems unlikely to be the dominant cause of persistently
high West German unemployment. Even more impor
tantly, with reduced wage rigidity since the late 1970s
the West German economy may be able to sustain a
faster demand expansion over the next year or two
without risking a resurgence of inflation.
Linda A. Bell
FRBNY Quarterly Review/Autumn 1986
21
The Cycle in Property/Casualty
Insurance
Property/casualty insurance companies hold about five
percent of all financial assets in the United States.
Currently they are recovering from one of their worst
cyclical downturns in the post-World War II period. The
industry is divided about evenly between personal and
commercial lines of insurance. It is very competitive with
fairly easy entry and exit and there are now more than
3000 companies operating in the United States. The
vast majority of property/casualty coverage is written by
a few hundred of these companies. But no single com
pany supplied as much as five percent of the $85 billion
of coverage written in the first half of 1986. Deviations
from competition tend to be the result of regulation,
particularly rate regulation, which is extensive in per
sonal and workers’ compensation lines. Commercial
lines other than workers’ compensation, and especially
commercial reinsurance, are the focus of the current
problems in the industry. Reform efforts are introducing
rate regulation into these traditionally less regulated
lines as well.
This article focuses on the underlying reasons for the
p rofitability cycle in the property/casualty industry.
Changes in interest rates are the primary force behind
the recurrent swings in the industry’s profitability. After
describing the link between interest rate fluctuations and
the insurance cycle, we look more closely at the most
recent cycle. Its relative severity was primarily the result
of the industry’s response to the unprecedented swings
The author would like to thank Paul Bennett for many helpful
discussions while developing this article.
22
FRBNY Quarterly Review/Autumn 1986
in interest rates over the past ten years. Consequently,
the return of interest rates and inflation to more normal
historical levels should eventually ease the "crisis” in
the industry.
Interest rates and the insurance cycle
The cyclical behavior of the property/casualty insurance
industry results from the extreme interest-sensitivity of
the competitive price for insurance. The key to this
sensitivity is the basic nature of the insurance product.
Companies receive money (premiums) in exchange for
promises to pay future claims. As interest rates rise,
companies can lower premiums to meet the same future
claims because the interest accumulated with premiums
will be greater.
As a starting point for analyzing the insurance cycle,
it is helpful to think of the insurance market as char
acterized by a fairly stable demand curve and a supply
curve that shifts with interest rates. As rates rise, the
supply curve shifts to the right, companies are willing
to offer more insurance at the same price, and prices
fall until enough new demand is induced and/or sup
pliers withdraw to clear the market.
This fundamental economic relationship between
policy pricing and interest rates implies that insurance
companies will raise prices when interest rates fall, and
lower them when interest rates rise. The magnitude of
these price changes will vary with the magnitude of
interest rate changes. It is not a coincidence that the
intense price competition of the late 1970s and early
1980s came at the same time as the unprecedented
increase in interest rates. Likewise, the enormous pre
mium rate increases of recent years have coincided with
the large declines in interest rates.1
The magnitude of these price changes also depends
on how far competitive pressures push these firms
beyond prudent underwriting practices when interest
rates rise. Because the industry is quite competitive with
easy entry and exit, it tends to overshoot the price level
dictated by changes in interest rates.2
Inflation also has an impact on the relationship
between the competitive price of insurance and interest
rates. If costs of settling claims are expected to rise
through time, a higher premium or investment return will
be necessary to cover future costs. To the extent that
rising interest rates reflect anticipated inflation, they
should not affect insurance premiums. The insurance
company must therefore incorporate expectations of
future inflation, or more specifically future claims costs,
into its pricing policy.
Uncertainty about the inflation outlook can amplify the
cycle in premium pricing by widening the range of
inflation expectations. Firms with lower than average
expectations about future inflation will price policies
more cheaply than those that expect higher rates of
inflation. The lower price will draw an increasing market
share to companies that anticipate low inflation, unless
other firms match their prices. In either event, prices will
tend toward the level dictated by a lower than average
inflation outlook.3 If the average level of inflation
expectations is more near the mark, prices will end up
too low and the extent of the ultimate industry shakeout
will vary directly with the gap between actual inflation
and the lower range of inflation expectations.
A corollary to the basic inverse relationship between
interest rates and competitive premium pricing is greater
volatility of premiums in longer tailed lines of insurance
'O ther factors besides interest rates affect insurance prices. The
trends toward wider liability and higher settlements are obvious
factors. Insurance prices declined despite these trends, when
interest rates were at the high levels of the late 1970s and early
1980s. With interest rates lower now, the trend toward higher claims
costs exacerbates the rise in competitive insurance prices. Policy
measures to contain increases in the scope and size of insurance
settlements could conceivably act as a partial offset to the interest
rate pressure for higher premiums. Unfortunately, price data is not
widely available. Constructing price data is difficult because there is
no standardized unit of insurance. For example, deductibles can be
increased and coverage limits lowered in lieu of raising the
premium.
2See Paul L. Joskow, "Cartels, Competition and Regulation in the
Property-Liability Insurance Industry,” The Bell Journal of Economics,
Vol. 4, No. 2 (Autumn 1973), for a discussion of competition in the
property/casualty industry.
3This assumes that there is adequate capacity among firms expecting
low inflation to absorb more market share. Firms with a low-inflation
outlook and capacity to write more business will be among the most
aggressive price cutters.
(e.g., general liability) versus shorter tailed lines (e.g.,
auto liability). Tail length refers to the amount of time
between the premium payment and the expected claims
payout. Other things equal, the longer the time between
the premium payment and the expected claims payout,
the bigger the effect of interest rate changes on the
competitive price of insurance. This corollary helps
explain why certain insurance lines are more cyclical
than others. It also provides a theoretical basis for the
greater cyclicality of reinsurance compared with primary
insurance. Reinsurers typically have a longer tail length
or emergence pattern in their claims payments than
primary insurers.4
Combined ratios and the
interest rate-insurance cycle
Property/casualty companies’ profitability is divided into
two broad categories— underwriting profits and invest
ment income. Rising interest rates increase the invest
ment income from each premium dollar. As discussed
earlier, this higher investment income allows firms to
charge a lower premium for the same level of coverage.
Premium cutting due to rising interest rates erodes
underwriting profits.
Underwriting profitability is judged by a measure
called the combined ratio. This measure adds together
the ratio of losses incurred over premiums earned and
the ratio of commissions and other expenses incurred
over premiums written and multiplies the result by 100.5
It shows the cash outflow from underwriting operations
relative to the cash inflow. When the combined ratio is
greater than 100, it means underwriting expenses
exceed revenues. Unless investment income makes up
the difference, the firm will lose money.
A practice called "cashflow underwriting" relies on
investment income to meet part of underwriting expenses
and causes the combined ratio to exceed 100. Tradi
tionally, this practice has been regarded as unsound.
Investment income, in this view, is considered a buffer
against unexpected underwriting losses, not a source of
cashflow for anticipated claims costs. Property/casualty
company aversion to cashflow underwriting was seriously
♦Reinsurance is insurance for insurers. It allows them to cede parts
of the risk they assume to other insurers. Emergence patterns show
the time path of the cumulative claims associated with policies
written at a particular time. For example, if 10 percent of the claims
ultimately made on a set of policies are paid out each year over a
ten-year period the emergence pattern would show 10 percent after
one year, 20 percent after two years, and so on, reaching 100
percent at the end of the tenth year.
‘ Premiums written include earned premiums and an unearned
premium reserve. The earned portion of premiums written is the
property of the insurance company and is based on the expired
portion of the policy period. For example, an annual premium of
$400 paid in advance would initially be allocated to the unearned
premium reserve. After six months, $200 or half the payment would
remain in the unearned premium reserve.
FRBNY Quarterly Review/Autumn 1986
23
underm ined by the unusually high level of interest rates
in the late 1970s and ea rly 1980s.
The com b in ed ratio is ve ry cyc lic a l and m oves (w ith
v a ry in g la g s) a c c o rd in g to in te re s t rate m o ve m e n ts.
C yclica l peaks in the co m b in e d ratio are u su a lly a sso
ciated w ith in te re st rate peaks. As rates de clin e , the
co m bined ra tio tend s to d e clin e (C hart 1).6
B e ca u se p re m iu m in co m e is w e ig h te d to w a rd the
present com pared with investm ent income, the trade-off
o f c u rr e n t (p re m iu m ) in c o m e fo r im p ro v e d fu tu re
(in ve stm e n t) incom e raises the com bined ratio, as c u r
re n t e x p e n s e s ris e re la tiv e to c u rre n t u n d e rw ritin g
in c o m e . F u rth e rm o re , b e c a u s e g a in s in in v e s tm e n t
incom e o ccu r w ith a lag, exp e n se s also rise re la tive to
to ta l revenue . T hus, d e c lin in g u n d e rw ritin g incom e is
a sso cia te d w ith d e clin in g to ta l incom e (C hart 2).
E ventually, how ever, as in ve stm e n t incom e increases
to ta l incom e should im p ro ve . But if un d e rw ritin g s ta n
d a rd s d e te r io r a te in re s p o n s e to c o m p e titiv e p ric e
6The cycle beginning in 1976 is somewhat different because the
combined ratio continued to go up even as interest rates began
their descent in 1982. This may reflect the large increases in
expensive, long-tailed liability settlements. These underwriting losses
pressure, the im provem ent in investm ent income will be
in s u ffic ie n t to s e rvice the increased cla im s a sso cia te d
w ith taking on g re a te r u n d e rw ritin g risks. If the price
cutting is excessive, total income will deteriorate despite
the rise in in ve stm e n t incom e. O nly w hen losses fo rce
more prudent u n d e rw ritin g and an in d u stry sh a ke out
occurs does the cycle reverse and incom e im prove.
T he s ig n ific a n c e o f in te re s t ra te m o v e m e n ts fo r
underwriting perform ance has increased dram atically in
the past 25 years. U ntil the p ro tra cte d rise in in te re st
rates th a t began in the late 1960s, in te re s t ra te s had
fluctuated around a sufficiently low level that investm ent
in c o m e re m a in e d a m uch le s s im p o rta n t s o u rc e of
cashflow than it becam e in the 1970s. As the level of
in te re st rates rose th rough each su cce ssive b u sin ess
cycle, the im p o rta n ce of in te re st incom e fo r c a sh flo w
increased threefold. In 1967, prem ium income w as over
eighteen tim e s in te re st incom e. By 1985, th is ratio had
dropped to less than seven.
Footnote 6 continued
emerge later on average, and therefore the combined ratio
continues to deteriorate for a longer time. Special factors associated
with the most recent cycle are discussed in more detail below.
Chart 2
Chart 1
P roperty/C asua lty Incom e as a Percent of
P o lic y h o ld e rs ’ S u rp lu s*
Three Month Treasury B ill Rates and
C om bined Ratios fo r P roperty/C asualty
Insurers
Combined ratio
Percent
Percent
3 0 -------
1 2 5 -----------------------------------------------------------------------------------------------------16
4 0 1— I— I---- 1— 1— I---- 1— I— I---- 1---- 1— I— I— I___ I___1___I___I__ I___
1967
1935
40
Source:
24
45
50
55
60
65
70
75
B e s t’s Aggregates and Averages.
FRBNY Q uarterly Review/Autumn 1986
80
85
69
71
73
75
77
79
81
83
♦P olicyholders’ surplus is the net worth of an insurer
as reported in its annual statement.
Source:
Best's Aggregates and Averages.
85
If the disinflation-induced decline in interest rates over
the past fo u r yea rs m arks a return to m ore norm al h is
torical levels, prem ium s will rise simply because interest
incom e w ill co ve r a m uch s m a lle r part of the o verall
costs of insu ra n ce . If the c u rre n t lo w -in fla tio n scenario
persists, the co m bined ra tio fo r p ro p e rty /c a s u a lty co m
p anies co uld return to the lo w e r average levels that
p revaile d p rio r to the 1970s. A lso, if the sharp in te re st
rate flu c tu a tio n s of the late 1970s and ea rly 1980s are
replaced by the m ild e r flu c tu a tio n s of e a rlie r years, the
c y c lic a lity of the in d u stry co u ld dim inish.
M aturity stru ctu re of claim s and the
interest rate-insurance cycle
The e ffe cts of in te re s t rate flu c tu a tio n s on prem ium s
should be g re a te r in lines of in surance w ith longer
in te rv a ls b e tw e e n th e re c e ip t o f p re m iu m s and th e
paym ent of claim s. Consequently, the com bined ratio for
long-duration lines of insurance should move more than
the ratio fo r s h o rt-d u ra tio n lines over the in te re st rate
cycle, and the m ix of in su ra n ce by lines w ill a ffe ct the
tim ing and v o la tility of the p ro p e rty /c a s u a lty cycle.
T he d u ra tio n of the cla im s payout is illu s tra te d by
em ergence patterns (C hart 3). For example, autom obile
lia b ility in su ra n ce claim s are g e n e ra lly s e ttle d sooner
after the insured event than general liability or w orkers’
com pensation claim s, w hich m ight not even be reported
until years after the prem ium s are paid (e.g., asbestosis
claim s). W ithin th re e ye a rs of occu rre n ce, a bout 75
percen t of a u to m o b ile lia b ility claim s have been paid,
while only about 25 to 40 percent of general liability and
w o rk e rs ’ co m p e n sa tio n cla im s have been paid. Even
a fter nine years, on ly a bout half of w o rk e rs ’ co m p e n
sation cla im s have been paid out.
Over the past 10 years, the com bined ratio for general
lia b ility insu ra n ce has risen m ore than fo r a u tom obile
lia b ility insu ra n ce w hen in te re s t rates rose, and has
fallen more when rates fell. Since general liability is the
lo nger taile d line, this is co n s is te n t w ith the notion that
lines w ith a slo w e r em e rg e nce pattern w ill be more
in te re st-se n sitiv e .
O th e r fa c to rs can c o m p lic a te th is p rin c ip le . For
exam ple, w o rk e rs ’ co m p e n sa tio n lines are lo n g -ta ile d ,
b u t th e ir c o m b in e d r a tio d o e s n o t b e h a v e as th e
in creased in te re s t-s e n s itiv ity p rin cip le w ould suggest.
A m o n g th e in c e n tiv e s th a t w o rk e rs ’ c o m p e n s a tio n
insurers offer to prom ote safety is the return of premium
d o llars to e m plo ye rs w ith a fa vo ra b le loss record.
As a result, w o rk e rs ’ c o m p e n sa tio n in su re rs pay a
large part of all the dividends property/casualty insurers
return to p o licyh o ld e rs each year.7 S ince the com bined
7For more on special factors affecting various insurance lines, see
1985-86 Property Casualty Fact Book, Insurance Information
Institute.
ratio is based on premium income before distribution of
dividends, underwriting perform ance in this line is often
less fa vo ra b le than the co m bined ratio w ould indicate.
F u rth e rm o re , re g u la tio n is m uch m o re s trin g e n t in
w o rk e rs ’ co m p e n sa tio n than in g e neral lia b ility in s u r
ance, perhaps re stra in in g co m p e titive e x c e s s e s .8 In this
case, interest rate effects are outweighed by other factors.
In past cycles the differences in perform ance between
co m m e rcia l and p e rsonal lines, prim a ry in su re rs and
re in su re rs, and lo n g -ta ile d and sh o rt-ta ile d lines w ithin
8There are extensive laws at the state level providing performance
standards for workers' compensation insurance. In recent years
these laws have changed to meet standards recommended in 1972
by the National Commission on State Workmen's Compensation
Laws.
Chart 3
Emergence Patterns by Line of Business
Percentage of ultimate
loss payments
✓
wy -----------------------------------------------------------0I______I______ I______I______ i______i______I______ I______ I
1
2
3
4
5
6
7
8
9
Report pe rio d (Y ears)
Explanatory notes:
1 Emergence is defined as the sum of two items:
(1) claim s outstanding at the end of each report
period and (2) the cumulative payments that have
been made up to the end of that report period.
2 The ratio of emergence to ultimate loss payments is
expressed in percentage form and is plotted for
each report period shown.
3 The usual range of points is 0 percent at inception to
100 percent (ultim ate), a point which is reached after
many years or report periods.
Source: 1980 Reinsurance Association of Am erica
Loss Development Study.
FRBNY Quarterly Review/Autumn 1986
25
these categories were much less pronounced. But sharp
d iffe re n ce s arose w ith the u n u su a lly high and v o la tile
level of in te re st rates d u ring the past 10 years. For
exam ple, th e p e rfo rm a n ce of co m m e rcia l lines d e te ri
orate d m a rke d ly in rela tio n to personal lines o ve r the
past se ve ra l years. C o m m e rcia l insurance w as very
a g g re s s iv e ly p riced in the last cycle and has e x p e ri
enced som e of the big g e st rate in cre a se s in the past
two years. Both the longer tailed nature of the business
and rising costs of insu ra n ce se ttle m e n ts have c o n trib
uted to th is vo la tility.
Likew ise, re in s u re rs ’ p e rfo rm a n ce d e te rio ra te d much
m ore than the ove ra ll p e rfo rm a n ce of p rim a ry insurers
in the last cycle. An im p o rta n t d iffe re n ce betw een re in
surers and p rim a ry in su re rs is the large am ount of
“ e x c e s s -o f-lo s s ” co ve ra g e th e y retain. T hat is, re in
surers are m ore expose d to cla im s th a t exceed large
d e d u c tib le s o r s o m e lim it th a t a n o th e r in s u re r is
re sp o n sib le for. Thus re in su ra n ce is lo n g er ta ile d since
the e x c e s s -o f-lo s s com p o n e n t of losses is g e n e ra lly
slo w e r to deve lop . As a re su lt, prem ium s in th e se lines
are m ore in te re s t-s e n s itiv e .
Beyond the cyclica l issue th e re is also an im p o rta n t
longer term issue. There has been a secular lengthening
in loss em ergence across lines. For example, the claims
payout on m any re in su ra n c e lines has slow ed s u b s ta n
tia lly in recent years. C la im s are com ing la te r and in
Table 1
Stages of the P/C Insurance Business Cycle*
Insurers'
View
Stage
Number
Consumers*
View
Upturn. Rising reve
nues, lower combined
ratios, lower average
risk.
1
Crisis. Scarcity, rapid
price increases, un
availability of some
lines.
Peak. Best underwriting
results, highest overall
profit.
2
Consolidation. Fixing of
new price plateau,
highest ratio of price to
actual cost of providing
protection.
Decline. Influx of new
capital lured by high
profits, price cutting,
lower earnings.
3
Upturn. Easing of
prices, greater avail
ability, more willingness
to tailor products to
consumer demands.
Crisis. Massive under
writing losses, ruinous
price competition, major
risk of insolvencies.
4
Peak. Rampant price
cutting, ample avail
ability, full buyer’s
market.
*From Insuring Our Future, April 7, 1986, Report of the
Governor's Advisory Commission on Liability Insurance, New
York State.
26
FRBNY Quarterly Review/Autumn 1986
b ig g er am ounts than actu a ria l c a lc u la tio n s based on
h isto rica l exp e rie n ce w ould in d ica te. As a re su lt, loss
re s e rv e s have g e n e ra lly been in a d e q u a te in re ce n t
years. W he th e r th is is due to the ch a n g e s in legal and
social a ttitu d e s to w a rd in su ra n ce or to o th e r fa c to rs, it
implies that the industry is more sensitive to interest rate
flu c tu a tio n s than in the past. To reduce th is lo n g -ta ile d
exposure, in su re rs have begun to w rite m ore co ve rage
on a c la im s-m a d e b a sis.9 C la im s-m a d e p o lic ie s m ake
the in d u stry less se n s itiv e to in te re s t rate flu c tu a tio n s.
Stages of the cycle
Table 1 show s how the in te re st rate s e n s itiv ity of p re
mium pricing tra n s la te s into the sta g e s of the p ro p e rty/
ca su a lty insurance cycle. The upturn (stage 1), w here
the in d u stry is now, is the re co ve ry stage w hen prices
m ove back into line w ith costs and a v a ila b ility of c o v
erage is a problem, as bigger risks are dropped. For the
consum er, this is the problem phase of the cycle. For
the insurer, it is the im p ro ve m e n t phase. It g e n e ra lly
co in cid e s w ith fa llin g in te re s t rates.
At the peak (stage 2), p ro fita b ility fo r the in su re r is
highest, se ttin g the stage fo r the d e clin e (stage 3) as
new capital comes in and price com petition reverses the
p ro fit cycle. H igher in te re s t rates, should th e y em erge,
w ould provide fu rth e r im petus fo r price cu ttin g at this
stage. In the crisis stage, p rice c u ttin g gets out of c o n
trol and com panies begin to fa il (stage 4). The m ost
recent cycle began stage 1 from a trough in 1975, rose
to a peak around 1978, and began a d e clin e th a t c o n
tin u e d into 1984. D uring the d e c lin in g phase, prices in
som e co m m e rcia l lines w ent dow n 50 pe rce n t or m ore.
P ersonal lines w ere not as se rio u s ly a ffe cte d . Som e
firm s attempted to raise rates in the declining phase but
lost m arket share as a result. By 1984, price in cre a ses
and th e re c o v e ry p h a s e had b e g u n . T h e b ig p ric e
increases have been in the lines where com petition was
m ost e xce ssive in the c ris is stage.
The rate of return on p ro p e rty /c a s u a lty c o m p a n ie s ’
ca p ita l tra cks this cycle q u ite closely. The peak in p ro f
ita b ility around 1978 a ttra cte d m any new firm s into the
industry, se ttin g off the price w ars (C hart 4).
What made the recent cycle different?
The cycle that began in 1976 was longer than usual and
more p ronounced. A tra d itio n a l rule of th u m b fo r the
pro p e rty /c a s u a lty cycle is three ye a rs up and three
dow n. The m ost recent cycle w as th re e ye a rs up and
9A claims-made policy covers only claims initiated during the policy
period. Traditionally, coverage has been on an occurrence basis, so
that an insurer covering the policy period 1987 would still be liable
for claims filed in 1995 based on damages arising out of incidents
occurring in 1987. Under a claims-made policy, any claims would
have to be initiated by the end of 1987.
six dow n, b otto m ing in 1984. W hat m ade the d ow nturn
so long and sharp?
Five fa cto rs seem to a cco u n t fo r the s e v e rity of the
re cen t cycle and su g g e st th a t the recovery phase w ill
also ta ke longer than usual:
• the unusually large sw ings in interest rates over the
last 10 years;
• the re la tiv e ly w orse c y c lic a l p e rfo rm a n ce in lo n g
tailed co m m e rcia l lines;
• the u n e xp e cte d ly rapid grow th in cla im s costs;
• the 1979 e n try of c a p tiv e insurers into th ird party
business fo r tax re a s o n s ;10 and
• the large inflow of fo re ig n re in su ra n ce capital.
The m agn itu de of in te re s t rate changes alone w ould
have guaranteed a longer and sharper cycle since 1975.
B ecause the peak phase of the in surance cycle g e n
e ra lly does not o ccu r until in te re s t rates have begun
their cyclical upswing, the recovery phase of the current
property/casualty cycle will probably be extended by the
unusual behavior of interest rates in the present general
business expansion. N orm ally interest rates would have
begun to rise this fa r into an e xpansion. If rates are in
a secular return to a more norm al pattern, the insurance
reco very phase m ay be e xte n d e d as firm s c o n tin u e to
raise prem ium s to o ffse t fa llin g in ve stm e n t incom e.
10Captive insurers are set up by firms to provide themselves with inhouse insurance services.
Chart 4
Average Annual Rates of Return on Net
W orth A fte r Taxes
Percent of net w orth
2 0 ----------------------------
The relatively greater severity of the last cycle in long
ta ile d co m m e rcia l and re in su ra n ce lines also w orks to
prolong the re co ve ry phase of this cycle. C laim s a sso
ciated with policies underw ritten in the aggressive pricecu ttin g phase of the last cycle (1 9 7 8 -83 ) w ill c o n tinue
to haunt in su re rs w ell into the fu tu re . To som e extent
c om panies have prepared fo r th is by h olding large loss
reserves. But the g e neral co n se n su s seem s to be that
th e in d u s try has in s u ffic ie n t re s e rv e s fo r the fu tu re
claims arising from coverages written in the last cycle.11
B esides the usual cyclica l fa llo u t from poor u n d e r
w ritin g , the u n e xp e cte d ly rapid grow th in cla im s costs
in the long-tailed com m ercial and reinsurance lines has
e xa ce rb a te d the situ a tio n . A re ce n t Rand C o rp o ra tio n
study blam es the rising co sts of the p e rsonal injury
system ra th e r than the volum e of cases fo r the e x p lo
sio n in in s u ra n c e lo s s e s . A c c o rd in g to th is study,
dam age aw ards and in su ra n ce se ttle m e n ts in personal
injury cases have increased on average twice as rapidly
as in fla tio n during the past five y e a rs .12 The vo lu m e of
la w su its file d in creased an average of only 3.9 p e rcen t
a ye a r during th is period, a ccording to the study. In
essence, the high nominal interest rates of recent years
were insufficient to protect insurers against rising claim s
costs. The u n u su a lly high level of in fla tio n in the late
1970s and e arly 1980s m eant th a t the real return on
insurers’ investm ents was much lower than the nominal
return. The even greater rate of increase in claim s costs
m ade the problem th a t m uch m ore severe.
M any a n a lysts also a ttrib u te the s e v e rity of the last
cycle to the special role of ca p tive in su re rs. In 1979,
ca p tive s w ere forced to seek third party b u sin ess to
maintain their special tax status as insurers. Some claim
these relatively inexperienced insurers pushed prices too
low by a g g re s s iv e ly bidding fo r o u tsid e business.
Finally, the U.S. has tra d itio n a lly been a net im p o rter
of re in su ra n ce from W estern E urope, w ith about onefourth of reinsurance coverage supplied from abroad. In
the late 1970s high re tu rn s to ca p ita l in the p ro p e rty/
c a s u a lty in d u s try c o m p a re d w ith o th e r in d u s trie s
attracted an in flo w of E uropean capital th a t put a d d i
tional com petitive pressure on prem iums and contributed
to the seve rity of the cycle.
Capital adequacy and failure
The am ount of p o lic y h o ld e rs ’ surplus (ca p ita l or net
w orth) in the p ro p e rty /c a s u a lty in d u stry m ore than
QI-------1------ 1-------1-------1------ 1-------1------ 1------ 1-------1------- 1----1975
76
77
78
79
80
81
82
83
Source: 1985-86 P roperty/C asualty Fact Book,
Insurance Information Institute.
84
85
11See Insuring Our Future, April 7, 1986, Report of the Governor's
Advisory Commission on Liability Insurance. New York State. See
also, "Second Thoughts About Loss Reserves,” Institutional Investor
(May 1986).
12See James S. Kakalik and Nicholas M. Pace, “ Costs and
Compensation Paid in Tort Litigation: Testimony Before the Joint
Economic Committee of the U.S. Congress,” Rand Corporation,
Institute for Civil Justice (July 1986).
FRBNY Quarterly Review/Autumn 1986
27
dou bled as it rose from the cyc lic a l low point of 1974.
The sta ndard re g u la to ry m easure of ca p ita l ad e q u a cy
is the prem ium -to-surplus ratio.13 A com pany with a low
ra tio is in a p o s itio n to w rite a d d itio n a l b u s in e s s .
A lth ough it has increased s o m e w h a t as m ore le verage
has been accepte d ove r the ye a rs, the rule of thum b is
a ratio of three- or four-to-one. Regulators may consider
a com pany w ith a h igh er ratio to be o v e re xte n d e d and
not in a positio n to w rite new b usiness. O f course, the
s ig n ifica n ce of any p a rtic u la r p re m iu m -to -s u rp lu s ratio
depe nds on o th e r fa c to rs as w e ll. For exam ple, a co m
pany w ith am ple loss re s e rv e s is in a b e tte r p o sition to
expand its b u sin ess p ru d e n tly than a com pany w ith
in a d e q u a te re s e rv e s . B a s ic a lly , th e u n d e rre s e rv e d
co m pa ny has o v e rsta te d its true capital.
P ro b le m s w ith the p re m iu m -to -s u rp lu s ra tio as an
indicator of capital adequacy arise because the volume
of prem ium s is an im p e rfe c t m easure of p o te n tia l loss
e xposure. The sam e a m o u n t of prem ium s could re fle ct
e ith e r a la rge a m ount of co ve ra g e at a low price or a
small am ount of coverage at a high price. Obviously, the
la tte r s itu a tio n is less risky than the form er. In the c u r
rent re co ve ry phase of the cycle, w ith prices high and
coverage hard to get, p re m iu m s have risen re la tive to
the am ount of coverage. A high prem ium -to-surplus ratio
is less w o rriso m e un de r th e se co n d ition s.
W hile there is w ide variation in the prem ium -to-surplus
ratios of in d ivid u a l co m p a n ie s, the a g g regate ratio fo r
the in d u stry d e clin e d th ro u g h the last cycle until 1983.
T he re co ve ry phase of the in su ra n ce cycle is m arked
by a c a p a c ity sh o rta g e w h ile th is ratio in cre a se s and
co m p a n ie s are c o n stra in e d from w ritin g new business.
T his helps the re co ve ry of prices.
The prem ium -to-surplus ratio masks another important
d im ension of risk. Two co m p a n ie s may have the sam e
p re m iu m -to -su rp lu s ratio , yet one may have a much
shorter average tail length on its policies than the other.
C om pan ies w ith lo n g e r ta ile d business w ill g e n e ra lly
carry a larger proportion of loss reserves to assets than
co m pan ies w ith s h o rte r ta ile d b usiness. T h e ir ca p ita l is
more leverage d as a re su lt. To m easure th is asp e ct of
capital adequacy, analysts use the ratio of loss reserves
13The idea behind the premium-to-surplus ratio as an indicator of
capital adequacy is straightforward. The presumption is that the
amount of risk that may be safely assumed by an insurance
company should be related in some way to its net assets.
Policyholders' surplus is the capital cushion firms have to pay
policyholders' claims if premiums prove insufficient to cover future
claims costs.
A few words about property/casualty accounting conventions may
be useful at this point. A major liability on the books of property/
casualty companies is loss reserves. Property/casualty loss reserves
are fundamentally different from loss reserves at life insurance
companies or other financial institutions like banks. Property/casualty
loss reserves are set up after events causing losses have occurred.
Life insurance and bank loss reserves are set up in anticipation of
events causing losses.
28
FRBNY Q uarterly Review/Autumn 1986
to surplus. T his m easure show s the size of exp e cted
losses in relation to capital or surplus. It has more than
doubled over the past 20 years. The in cre a se in the
ratio of loss re se rve s to su rp lu s is the prim a ry fa cto r
behind the declining capital-to-asset ratio in the industry.
The re s e rve -to -su rp lu s m easure of ca p ita l a d equacy
is also im perfect. If a firm d e lib e ra te ly u n d e rre s e rve s,
it w ill a ppear to be in b e tte r shape than it a c tu a lly is.
But as a rough in d ica to r th is ratio is useful. F irm s g e n
e ra lly re se rve w ith in a s u ffic ie n tly clo se m argin of th e ir
actual needs to m ake large d iffe re n c e s betw een firm s ’
r e s e r v e - t o - s u r p lu s r a t io s u s e f u l f o r c o m p a r i
son purposes.
There is wide dispersion in the ratios of loss reserves
to surplus am ong p ro p e rty /c a s u a lty co m p a n ie s. A c o m
pany w ith a high ratio has less m argin fo r e rro r in its
loss re se rve co m p u ta tio n . For exam ple, a firm w ith a
tw o -to -o n e ratio, u n d e rre se rve d by 10 percent, w ould
have 20 percent less capital than reported, while a firm
w ith a fiv e -to -o n e ratio, u n d e rre se rve d by 10 percent,
w ould have 50 pe rce n t less ca p ita l than its acco un ts
would show. Because there is a general consensus that
firm s are u n d e rre se rve d fo r the cla im s like ly to re sult
Chart 5
Involuntary R etirem ent of
P ro p e rty/C a su a lty Insurers and
C om bined Ratios
Combined ratio
Number of retirem ents
1 2 0 ------------------------------------------------------------------------------------- 30
■ Retirement
I S c a le ------ ►
Combined ratios
1965
67
69
71
73
75
77
79
81
Source: B est’s Aggregates and A verages;
Best's Management Reports.
83
85
from cove ra g e w ritte n in re ce n t years, firm s w ith high
ra tio s o f lo s s re s e rv e s to s u rp lu s d e s e rv e s p e c ia l
atten tion .
Failures or involuntary retirem ents in the property/cas
ualty industry generally move with the com bined ratio.
This has been especially true in the high interest-rate
environm ent of the past 12 years. The two most recent
cyclical low points (1975 and 1984) coincide with peaks
in the num ber of failures in the industry (Chart 5).
Chart 6
D is trib u tio n of Best’s
P roperty/C asua lty Ratings
♦ -O th e r*
'•*—Fair
F airly good
♦ -G ood
O utlook
The in d u stry is c u rre n tly e n jo yin g a s e lle rs ’ m arket.
S u rp lu s in c re a s e d s u b s ta n tia lly o v e r th e p a s t year,
m ainly as a re su lt of e q u ity issuance and ca p ita l gains
from the stock and bond m a rke t rallies. E arnings also
c o n trib u te d to su rp lu s as firm s c o n tin u e d to increase
prem ium s and stopped w riting coverages in areas where
legal u n c e rta in tie s p re clu d e sound a ctu a ria l e va lu atio n
of risks.
A v a ila b ility of co ve ra g e p ro b le m s are c o n fin e d p ri
marily to product liability, d ire cto rs’ and officers’ liability,
p ro fe ssio n a l liability, and e n viro n m e n ta l dam age c o v
erage. In th e se lines co ve ra g e above c e rta in am ounts
is now often w ritte n on a cla im s-m a d e ra th e r than an
o c c u rre n c e b a s is . T h is e lim in a te s th e lo n g e r ta ile d
exp osu re by c o n fin in g in su ra n ce com pany losses to
c la im s m ade during the p o licy period.
A look at the distribution of property/casualty com pany
ratings also su g g e sts th a t the w o rst of the in d u s try ’s
problem s m ay be ove r (C h a rt 6). The s te a d y d e te rio
ration from 1981 to 1985 s ta b ilize d in 1986, and the
strong e a rn in g s re porte d th is ye a r su g g e st the 1987
d istrib u tio n of ra tin g s w ill show som e im provem ent.
The m ost v u ln e ra b le area of the in d u stry is re in s u r
ance, w here high cla im s aw ards have hit hardest. T his
less re gulated area has also been the fo cu s of fraud in
the industry which, as in other financial industries, is an
im porta nt cause of in so lv e n c ie s . U nfortunately, these
problem s have cre a te d u n c e rta in ty a bout the q u a lity of
reinsurance on the books of many prim ary insurers. The
a d ve rse c o n s e q u e n c e s of u n c o lle c ta b le re in s u ra n c e
w hich erode s su rp lu s and lim its ca p a city to w rite new
b usiness should re in fo rc e the effe cts of lo w e r in te re st
rates in p ro lo n g in g the re co ve ry phase of this cycle.
P a rtly o ffs e ttin g th is , h o w e v e r, are th e e x c e p tio n a l
o p p o rtu n itie s fo r new e n tra n ts and th o s e firm s th a t
escaped the w o rst co n se q u e n ce s of the last dow nturn.
The com bination of unusually high and volatile interest
rates w ith the o th e r fa c to rs cited e a rlie r— the re la tive ly
poor p e rfo rm a n ce of lo n g -ta ile d lines, the grow th in
cla im s costs, the role of ca p tive s, and the inflow of
fo reig n re in su ra n ce c a p ita l— seem s to acco u n t fo r the
se ve rity of the re ce nt re ce ssio n in the industry. C o n
sequently, the next d ow n tu rn should be less severe if
-•—Very good
E xcellent
-Superior
1982
1983
1984
1985
1986
*T his category includes but is not limited to
com panies w ith large reinsurance exposures.
Source:
A.M. Best Company.
Chart 7
Loss and Loss A d ju stm e n t Expense
Reserves fo r all U.S. P roperty/C asua lty
Insurers and Reinsurers
Percent of nominal GNP
4 .0 --------------------------------
Source:
B est’s Aggregates and Averages.
FRBNY Quarterly Review/Autumn 1986
29
three current trends continue. First, the return of inflation
to low and less volatile levels should clarify the outlook
for future claims costs. High and volatile inflation rates
mask the real cost of future claims, making it more likely
that some firms will price insurance inadequately to
meet future obligations. Competition pressures other
firms to make the same mistake. By reducing uncer
tainty about future costs, price stability eliminates one
important source of volatility in the industry.
Second, and critically related to the inflation outlook,
stability in interest rates around lower, more normal
historical levels will reduce the pressure for excessive
cashflow underwriting. The relationship between pre
miums and claims is less variable when rates are stable.
Market determined prices are more likely to match the
costs of providing coverage when the cloud of interestrate uncertainty is lifted.
Finally, the legal uncertainty surrounding future claims
costs is also a barrier to efficient pricing. The broad
ening of the legal concepts of liability and damages over
30
FRBNY Quarterly Review/Autumn 1986
the past 25 years is associated with an ever-growing
share of national output devoted to insurance losses
(Chart 7). More than 30 states have adopted elements
of tort reform to stem this long-run increase in the real
burden insurance costs place on the United States
economy. These reforms incorporate recommendations
from consumer groups and the insurance industry.
Similar efforts are under way at the federal level. The
unexpected claims costs associated with the broadening
scope and size of insurance settlements contributed to
the severity of the most recent down cycle. Successful
reform efforts should mitigate the next down cycle.
Taken together, these trends, along with the shift of
extraordinary risks to claims-made policies, should aid
the industry as it continues to improve its financial
condition.
Robert T. McGee
Tax Reform and the
Merger and Acquisition Market:
The Repeal of General Utilities
The 1986 Tax Reform Act repeals the so-called General
Utilities doctrine— the principle that corporations liqui
dating their businesses are not subject to capital gains
tax on the appreciation in the value of their assets.1 This
change, along with the new corporate tax rate structure,
reduces the benefits and raises the costs of many
mergers and acquisitions (M&A’s), especially those
involving firms with undervalued assets. The repeal of
General Utilities takes effect after the end of 1986
(except for generous transition rules), and along with
other tax changes, may help to explain the surge in
M&A activity in the second half of 1986 (Chart 1).2
A liquidating corporation, using General Utilities,
escapes the tax liability that comes with appreciated
assets. This can be an important element of a liqui
dation, since the purchaser of the firm’s assets will wish
to acquire them with an increased (stepped-up) tax
value (basis) in order to claim larger depreciation and
’ The General Utilities doctrine derives its name from a 1935 Supreme
Court case, General Utilities and Operating Co. v. Helvering. The
Court’s decision in the case was ultimately incorporated into the
Internal Revenue Code. For an overall look at the pre-reform tax
implications of mergers, see Joint Committee on Taxation, Federal
Income Tax Aspects of Mergers and Acquisitions (JCS-6-85), March
29, 1985.
“Other elements of tax reform have affected M&A activity. The
January 1, 1987 increase in the personal long-term capital gains tax
rate— raising the maximum from 20% to 28%—created an important
incentive to accelerate the completion of sales from 1987 to 1986.
New rules on the transfer of net operating loss carryforwards and
changes in the corporate minimum tax will make complex changes
to the tax implications of many proposed mergers, favoring some
and impeding others.
depletion allowances. Ordinarily, a step-up implies that
a corporation will incur a capital gains tax liability (the
corporate capital gains tax rate, currently 28%, will rise
to 34% in 1987).
General Utilities is relevant to the M&A market
because, under Section 338 of the Internal Revenue
Code, the purchaser of at least 80% of the stock of a
corporation may treat the transaction, for tax purposes,
as liquidation of the corporation and purchase of its
assets.3 By using General Utilities and Section 338, a
corporation can obtain the advantages of a basis stepup without paying capital gains tax and without truly
liquidating assets—a firm can stay in the same business
with the same capital stock, managers, and workers.
The tax saving arises solely from the change in own
ership of a firm ’s stock. The prospect of such tax sav
ings has been an important spur to the M&A market.
A step-up in the basis of an acquired firm’s assets
may not always be in a purchaser’s interest, however.
Even though an acquired firm escapes capital gains tax
on the appreciation of its assets, it still has to pay tax
on that part of the basis step-up that represents the
“ recapture” of past depreciation allowances. That is,
because depreciation allowances are intended to cap
ture the decline in an asset’s value, sale of an asset
for an amount greater than the depreciated book value
implies that allowances taken in the past overstated the
3The transaction must subject the selling shareholders to capital
gains tax on the appreciated value of their stock. In general, a
takeover involving the exchange of securities for stock is not taxable
while a cash purchase is.
FRBNY Quarterly Review/Autumn 1986
31
Chart 1
Chart 3
L a rg e S to c k T ra n s a c tio n s
N um ber*
Billions of dollars
A c tu a l D e p r e c ia tio n C o m p a re d to
D e p re c ia tio n o n a S te p p e d -u p B a s is
Billions of dollars
5 1____ I____ I____ I____ I____ I____ I------- 1-------1-------1-------1-------1------ lo
J F M A M J
J A S O N D
1986
Includes p u b lica lly-d isclose d tra n sa ctio n s completed
or cu rre n tly pending for sto ck or assets of U.S.
nonfinancial corporations. Data through
Novem ber 19, 1986.
* D o lla r amount greater than $250 million.
Source:
Securities Data Company.
Chart 2
F ix e d R e p r o d u c ib le T a n g ib le A s s e ts
C urrent c o st less h isto ric cost
B illions of dollars
100 0 -------------------------------------------------------------------------U.S. non finan cia l co rp o ra tio n s
Source: Federal Reserve Board, Balance Sheets
for the U.S. Economy 1946-1985, October 1986.
32
FRBNY Quarterly Review/Autumn 1986
gQ |-------1------- 1------- 1------- 1------- 1-------1------- 1------- 1------- 1------- 1
1976
77
78
79
80
81
82
83
84
85
Source: Federal Reserve Board, F low -of-Funds: Federal
Reserve Bank of New York staff estim ates.
true decline in value. This recapture tax may offset the
advantages of the basis step-up.4
Because detailed study of a corporation’s assets is
often necessary to calculate the costs and benefits of
a basis step-up, purchasers are allowed one year to
decide on carrying out a Section 338 liquidation. In the
case of those buyouts involving a firm’s management,
the acquirers are likely to know the costs and benefits
of a Section 338 liquidation well in advance of sale.
Although the Treasury Department has no data on the
overall use of Section 338, the device seems to be used
often in the aftermath of leveraged buyouts.
But in general, Section 338 and General Utilities is
more advantageous the greater the proportion of the
acquired firm ’s overall purchase price that can be
assigned to its depreciable and depletable assets, and
the larger the basis step-up relative to the original cost
of the assets. Many firms in the manufacturing and
natural resource sectors fit this description. The inflation
of the 1970s greatly increased the difference between
the market value of tangible corporate assets and their
tax basis, and in conjunction with the acceleration of
depreciation schedules in 1981, allowed for dramatically
increased depreciation allowances on existing assets.
♦Investment tax credits and certain other deductions, along with
depreciation, are also recaptured.
The w ave of large-scale mergers and leveraged buyouts
in the last fe w years, e s p e c ia lly in m a n u fa ctu rin g and
m ining, is p a rtly due to th e a ttra ctio n of the ta x -fre e
basis ste p -u p un der S e ctio n 338 and G e n e ra l U tilitie s.
D uring the h ig h -in fla tio n era o f the late 1970s and
early 1980s, the potential size of basis step-ups surged.
C h art 2 p lots the d iffe re n c e betw een the va lu e of nonfinancial corporate plant and equipm ent on a current (or
re p ro d uctio n ) co st basis and on a d e p re cia te d h isto ric
cost basis. C u rre n t co st can be co n sid ere d an a p p ro x
im atio n of m a rke t va lu e and h is to ric co st an a p p ro x i
m ation of the b a s is .5 W h ile th e se a p p ro xim a tio n s are
ro u g h , th e d iffe re n c e b e tw e e n th e tw o p ro v id e s an
in d ica tio n o f th e p o te n tia l a m o u n t of ste p -u p a va ila b le
on p la n t and e q u ip m e n t. T h e c h a rt s h o w s th a t th e
potential step-up did increase substantially in the 1970s,
peaking at n e a rly $1 trillio n in 1981. The d iscre p a n cy
has been red uced so m e w h a t in re ce n t ye a rs as old,
u n d e rva lu e d c a p ita l has been re tired from se rvice .
sThe historic cost data used in Chart 2 are derived from expenditures
on new capital and straight-line depreciation schedules. The tax
basis of capital would be calculated from expenditures on new and
used capital and actual depreciation schedules, which can be
Table 1
Effect of Merger (Before Tax Reform)
Pre-merger
First year
Cashflow from
operations . . . .
Depreciation . . .
Interest ................
Pre-tax profits . . .
Taxes ......................
After-tax cashflow^
Post-merger*
$2,000,000
$ 500,000f
$
0
$1,500,000
$ 690,000
+
$2,000,000
$3,850,000
$2,200,000
($4,050,000)
($1,863,000) (on profits)
$1,380,000 (on recaptured
depreciation)
= ($ 483,000)
$1,130,000
$ 283,000
Following years
Cashflow from
operations . . . .
Depreciation . . .
Interest ................
Pre-tax profits . . .
Taxes ......................
After-tax cashflow^
$2,000,000
$ 500,000
$
0
$1,500,000
$ 690,000
$1,310,000
$2,000,000
$3,850,000
$2,200,000
($4,050,000)
($1,863,000)
$1,663,000
Present value of
after-tax
cashflow s§. . . .
$5,518,197
$5,703,274
’ Purchase price $22 million, financed at 10%.
fO riginal purchase price $10,000,000; current basis
$7,000,000.
^Cashflow from operations less interest and taxes.
§Years 1 to 5, evaluated at a 6% rate.
A firm w ill w ish to step up the basis of asse ts to
obtain higher depreciation allowances. Chart 3 plots the
a ctual d e p re cia tio n a llo w a n ce s ta ke n by n o n fin a n cia l
c o rp o ra tio n s in th e last d e cade and co m p a re s them to
an estim a te of the firs t y e a r’s a llo w a n ce th a t could be
o b ta in e d by ste p p in g up the basis of p la n t and e q u ip
m ent to c u rre n t cost, and d e p re c ia tin g u nder p re va iling
ru le s . T h e p o te n tia l b e n e fit o f a s te p -u p g ra d u a lly
increased d u ring the late 1970s as in fla tio n heated up.
More importantly, the sharp reduction in taxable service
lives in tro d u ce d in 1981 d ra m a tic a lly in cre a se d the tax
a d va n ta g e s of a ste p p e d -u p b a s is .6 In c o n ju n c tio n w ith
the p o st-1 9 8 2 d e clin e in in te re s t rates, w hich reduced
the cost of raising the funds used to finance takeovers,
th is o p p o rtu n ity to a cce le ra te d e p re c ia tio n and avoid
capital gains tax has probably facilitated many mergers.
An e xam ple can illu s tra te in m ore d e ta il how the
sp e c ific c h a ra c te ris tic s of the pre -re fo rm tax law c o n
trib u te d to the fe a s ib ility of c e rta in d eals. The ta rg e t
c o rp o ra tio n d e scrib e d in Table 1 pu rch a se d its assets
fo r $1 0 ,0 0 0 ,0 0 0 , and its cu rre n t basis in th e se assets
is $7,0 0 0 ,0 0 0 . The c o m p a n y ’s pre -ta x p ro fit (ca sh flow
fro m o p e ra tio n s le s s in te re s t and d e p re c ia tio n ) is
$ 1,5 0 0 ,0 0 0 , and it pays ta xe s at the p re -re fo rm 46%
ra te .7
The sto ck o f the ta rg e t is p urchased by a n o th e r c o r
po ra tio n fo r $ 2 2 ,0 0 0 ,0 0 0 . The a c q u ire r b o rro w s this
m oney at 10%. The ta x basis of the a cq u ire d firm ’s
assets is stepped up from $ 7 ,0 0 0 ,0 0 0 to $22,0 0 0 ,0 00,
and using post-1981 rules, the d e p re c ia tio n rate on
th e se assets is in creased from 5% to 17.5% (fo r s im
plicity, d e p re cia tio n is assum ed to be on a s tra ig h t-lin e
s c h e d u le ).8 T h u s, th e a n n u a l d e p re c ia tio n d e d u c tio n
rises from $500 ,0 0 0 to $ 3 ,8 5 0 ,0 0 0 . The in cre a se in
Footnote 5 continued
considerably different from hypothetical straight-line schedules.
Thus, the historic cost data is likely a very rough approximation of
the true basis.
•The hypothetical depreciation line in Chart 2 is based on the first
year’s depreciation from accelerated schedules. The depreciation
deductions in subsequent years tend to decline. In present value
terms, the depreciation benefits enacted in 1981 were less
substantial than the surge in the hypothetical line may suggest.
7For simplicity, the slight progressivity in the corporate tax schedule
is ignored.
•A reasonable estimate, one used in the Federal Reserve Board's
macroeconomic model, is that the useful life of equipment for tax
purposes was reduced from an average of 10.5 years prior to 1981
to 4.6 years today, and structures from 40 years to 19 years. Thus,
the example's assumption of a 12.5 percentage-point increase in the
tax depreciation rate is a bit high, but not unrealistic. On a straightline basis, the first-year depreciation rate on a capital stock equally
divided between equipment and structures is now 14% as compared
to 6% prior to 1981. Tax reform will increase the useful life of most
structures to 30 years and slightly increase the lives of some
categories of equipment. These changes will further reduce the
attractiveness of stepping up the basis of assets following a merger.
FRBNY Q uarterly Review/Autumn 1986
33
d e p re cia tio n , co upled w ith the in te re st expense of the
borrow ed money, re su lts in a d e duction a g a inst the
acquirer’s earnings of more than $4 million and a credit
of nearly $2 m illion ag a in st its tax liability.
In the year follow ing the merger, the target firm (which
is technically selling its assets to the acquirer) will have
to pay tax, at the ordinary corporate rate of 46%, on $3
Table 2
Effect of New Tax Rates
(General Utilities D octrine Intact)
Pre-merger
F irst year
Pre-tax profits . . . $1,500,000
Taxes ...................... $ 510,000
Post-merger
After-tax cashflow*
($4,050,000)
($1,377,000) (on profits)
+ $1,020,000 (on recaptured
depreciation)
= ($ 357,000)
$1,490,000
$ 157.000
Follow ing years
Taxes ......................
After-tax cashflow*
$ 510,000
$1,490,000
Present value of
after-tax
c a s h flo w s !. . . $6,276,422
($1,377,000)
$1,177,000
$3,995,688
'Cashflow from operations less interest and taxes.
fYears 1 to 5, evaluated at a 6% rate.
m illio n w o rth of re c a p tu re d d e p re c ia tio n .9 T h is ta x
reduces the com bined firm ’s tax cre d it in the firs t year
after the m erger to ju s t under $ 5 0 0 ,0 0 0 ; the a fte r-ta x
c a s h flo w a c c ru in g to th e c o m b in e d firm fro m th e
fin a n c in g o f th e ta k e o v e r and th e o p e ra tio n of th e
acquired firm w ill be $283,0 0 0 . In the fo llo w in g years
the after-tax cashflow will am ount to $1.7 m illion— larger
th a n th e flo w to th e ta rg e t firm b e fo re th e m e rg er,
d espite the rise in in te re st e xpense a sso cia te d w ith
fin a n cing the deal.
In present value term s, over a fiv e -y e a r h orizon the
a fte r-ta x ca sh flo w th e se assets yield to the com bined
firm is greater than that to the target before the merger.
(The 6% d isco u nt rate used is arbitrary, but is ro ughly
the a fte r-ta x return earned by a h ig h -in co m e in d ivid u a l
who can invest 10% pre-tax and pays federal, state, and
lo c a l in c o m e ta x ) . T h u s , if e q u ity m a r k e ts p ric e
according to fiv e -y e a r e x p e cta tio n s, the e q u ity va lu e of
the com bined firm w ill be g re a te r than the sum of the
e q u ity v a lu e s o f th e tw o firm s b e fo re m e rg e r. T h is
com es about even though no in crease in the ca sh flow
from o p e ra tio n s of e ith e r firm has been assum ed, and
even though in te re st on the debt raised to fin a n ce the
purchase exceeds the cashflow from the acquired firm ’s
o p e ra tio n s . A fte r six y e a rs , w h e n th e d e p re c ia tio n
allowances are assumed to expire, the merged firm will
need to a ugm ent its cashflow , sell a ssets, or re fin ance
9The actual rules on depreciation recapture are more complex than
those in the example. Furthermore, the example ignores the
recapture of any investment tax credit taken on the purchase of
these assets.
Table 3
Effect of General Utilities Repeal
No change in tax rates
Post-merger
Pre-merger
$1,500,000
$ 510,000
After-tax c a s h flo w * ...............................
($4,050,000)
($1,863,000) (on profits)
+ $1,380,000 (on recaptured
depreciation)
+ $3,360,000 (on $12 million
capital gain)
= $2,877,000
$1,310,000 ($3,007,000)
F ollow ing years
Taxes .........................................................
After-tax cashflow*
$ 690,000
$1,310,000
F irst year
Pre-tax p ro fits .........................................
Taxes .........................................................
Present value of after-tax cashflows!
$1,500,000
$ 690,000
. $5,518,187
‘ Cashflow from operations less interest and taxes.
tYears 1 to 5, evaluated at a 6% rate.
34
New tax rates
Pre-merger
FRBNY Quarterly Review/Autumn 1986
Post-merger
($4,050,000)
($1,377,000) (on profits)
+ $1,020,000 (on recaptured
depreciation)
+ $4,080,000 (on $12 million
capital gain)
= $3,273,000
$1,490,000 ($3,923,000)
($1,863,000)
$1,663,000
$ 510,000
$1,490,000
($1,377,000)
$1,177,000
$2,533,463
$6,276,422
$ 141,914
to cover the interest expense. In effect, the increase in
depreciation expense gives the combined firm a long
grace period to achieve operating economies.
Tax reform greatly reduces the incentives for this
transaction to take place, both by changing the cor
porate tax rate structure and by repealing General
Utilities. Table 2 shows the effect of reducing the cor
porate tax rate from 46% to 34%. The after-tax cashflow
of the target firm rises (because its tax bill falls), while
that of the merged firm falls (the after-tax value of the
interest and depreciation deductions declines as the tax
rate falls). The present value of the cashflow of the
combined firm falls below the sum of the cashflows of
the two firms separately.
Repeal of General Utilities sharply reduces the value
of the combined firm (Table 3). The end of General
Utilities means that capital gains tax is levied on the $12
m illion of the basis step-up that is not subject to
recapture tax. The first year after-tax cashflow of the
combined firm falls substantially, given the pre-reform
corporate capital gains tax rate of 28%. Moreover,
combining the new tax schedule (which, as mentioned
above, includes a 34% rate on corporate capital gains)
with the repeal of General Utilities produces a dis
counted cashflow for the combined firm only slightly
larger than for the acquirer alone.
This example overemphasizes the impact of the
General Utilities doctrine and its repeal— M&A activity
is also motivated by non-tax factors and tax consider
ations other than depreciation. Nonetheless, elimination
of General Utilities may harm investors who have taken
positions based on the assumption that a corporation
will be liquidated, since the end of General Utilities will
raise the costs of liquidation. It is not clear how great
the impact will be, and whether any investors will
experience outright losses. On the other hand, tax
reform could cause buyers to be more interested in the
underlying earnings potential of merger candidates than
in their tax attributes.10
10Repeal of General Utilities, along with the increase in the personal
capital gains tax rate, may also mean that cash deals—which are
usually necessary to use Section 338 but subject selling
shareholders to capital gains tax—will become less common.
Charles Steindel
FRBNY Quarterly Review/Autumn 1986
35
(This report was released to the Congress
and to the press on December 8, 1986)
Treasury and Federal Reserve
Foreign Exchange Operations
August-October 1986
After declining without interruption for nearly a year and
a half, the dollar steadied during the period under
review. Although the dollar continued to ease against
most of the industrialized countries’ currencies through
August, it moved up subsequently to close the threemonth period mixed on balance (Chart 1). From August
to October, it appreciated against some currencies—
61/4 percent against the Japanese yen, 53U percent
against sterling, and 21A> percent against the Swiss
franc. It declined, however, by about 1 percent against
the German mark and other currencies of the European
Monetary System (EMS). There were dollar purchases
by foreign central banks, but no intervention by the U.S.
authorities during the period.
As the period opened early in August, the dollar was
declining. Market participants had come increasingly to
question whether the major industrialized countries
would be able to work together to redress their large
external imbalances. The huge trade deficit of the
United States and the enormous trade surpluses of
Japan and Germany had shown little adjustment, not
withstanding the considerable movements in exchange
rates between the dollar and both the Japanese yen and
German mark. Moreover, there was growing disap
pointment that the sharp, $20-per-barrel drop in oil
prices that occurred between November 1985 and July
1986 was failing to provide much of a boost to business
activity in the oil importing industrialized countries.
A report by Sam V. Cross, Executive Vice President in charge of the
Foreign Group at the Federal Reserve Bank of New York and
Manager of Foreign Operations for the System Open Market Account.
36
FRBNY Quarterly Review/Autumn 1986
Doubts developed that our major trading partners were
likely to expand domestic demand vigorously enough to
provide a global environment within which the United
States could markedly improve its balance of payments
position. Market participants considered seriously the
possibility that the U.S. authorities might welcome a
continued decline in the dollar on the grounds that
central banks abroad might thert cut interest rates in
their countries more quickly.
Under these circum stances, market participants
expected the trend toward lower interest rates to con
tinue, with the United States setting the pace and other
industrial countries perhaps following later on. Although
there were already a few signs that the U.S. economy
was regaining some momentum from the slow first half
of the year, market participants still were struck by the
areas of weakness in U.S. economic performance.
Output and investment remained sluggish, manufac
turing employment continued to decline, and retail sales
were generally stagnant. At the same time, prospects
for price and wage stability appeared to be good for the
short term, despite some concern about the longer term
inflationary implications of recent rapid monetary growth.
In this environment, expectations resurfaced from time
to time throughout the first few weeks of August that the
Federal Reserve might again cut its discount rate, per
haps operating unilaterally as it had done in July
(Chart 2). As a result, in August interest rates on
deposits denominated in U.S. dollars fell, and their
decline was sharper than the decline in interest rates
in other currencies (Chart 3). The Federal Reserve did
cut its discount rate by one-half of one percentage point,
Chart 1
During the period, the d o lla r paused in
its long-term decline a ga inst other
m ajor currencies.
Percent *
5
-1 5
-2 0
-2 5
-3 0
N D
1985
J
F
M
A
M J
1986
J
A
S
O
* Percentage change of weekly average rates for
dollars from the average rate for the week ending
November 1, 1985. Figures calculated from New York
noon quotations.
to 5 1/2 p e rc e n t, e ffe c tiv e A u g u s t 21. T he e x c h a n g e
market reaction was muted, partly because many m arket
p a rticip a n ts expected the a u th o ritie s in G erm any and
Japan to provide som e fu rth e r s tim u lu s to th e ir e c o n
omies— either with m onetary or other measures— before
the annual m eetings of the International Monetary Fund
(IM F) and W orld Bank at the end of S eptem ber.
E conom ic s ta tis tic s released in m id -A u g u st began to
paint a c o n tra s tin g p ictu re betw een the G erm an and
Japanese economies. The German economy, which had
co n tra cte d sh a rp ly e a rly in the year, seem ed to be
staging a robust re co ve ry; and o fficia l G erm an p ro je c
tio n s of an a cce le ra tio n in grow th began to be given
widespread credence in the financial markets. Japan, on
the o th e r hand, appeared to be having much m ore d if
fic u lty a d ju s tin g to th e a p p re c ia tio n of its cu rre n cy.
A lthough both the mark and the yen had risen by about
the sam e am o u n t a g a in st the d o lla r since early 1985,
on a tra d e -w e ig h te d basis the y e n ’s a p p re cia tio n had
been much g re a te r than the a p p re cia tio n of the m ark
(C hart 4). W hereas G erm an m a n u fa ctu re rs lost little
com petitiveness in their m arkets in other EMS countries,
J a panese e xp o rt in d u strie s w ere hit hard. T h e y lost
c o m p e titive n e ss not only in the U nited S ta te s but also
in im portant East Asian markets. With business statistics
released in August showing continued stagnation in the
Chart 2
Chart 3
The Federal Reserve reduced its d isco u n t
rate in August. At the end of O ctober, the
Bank of Japan announced a reduction in
its lending rate.
S hort-term in te re s t rates closely m irrored
exp e cta tio n s of in te re st rate cuts.
Percent
8.5
Percent
8 ----------------------------------------------------------------------------
7.0
5 - — i ---------m,
I Japan
I----- -
I
Germany
4.0
O
N D
1985
J
F
M
A
M
J J
1986
A
S
O
_ 1 ____ I____ I____ I____ I____ I____ I____ I____ I____ I____ I
J
F
M
A
M
J
J
1986
A
S
O
N
Weekly average of interest rates on three-month
E urocurrency deposits.
FRBNY Quarterly Review/Autumn 1986
37
Ja pane se m a n u fa ctu rin g s e c to r (C hart 5), m arket p a r
tic ip a n ts began to q u e stio n w h e th e r the yen should
a p p re cia te m uch m ore.
In th e s e c irc u m s ta n c e s , tra d e rs b e g a n to s e n s e
around m id -A u g u st th a t th e d o lla r had m ore room to
declin e a g a in st th e G erm an m ark and the o th e r c u r
rencie s o f co n tin e n ta l E urope than a g a in st the yen.
W hen a large U.S. trade deficit for July was announced
at the end o f A ugust, tra d e rs sold d o lla rs a g g re ssive ly
a g a inst both m arks and S w iss fra n cs. T he d o lla r co n
tin u e d to d e c lin e a g a in s t th e E u ro p e a n c u rre n c ie s
thro u g h the end of A u g u st, even though it sta b ilize d
a g a inst the yen.
By m id -S e p te m b e r, th e re w a s fu rth e r e v id e n c e of
im p ro ve m e n t in the U.S. e co n o m ic ou tlo o k. G ains in
e m p lo y m e n t d u rin g A u g u s t w e re m o re b a la n c e d ,
industrial activity w as a little firmer, and retail sales were
m o re b u o y a n t. T h e s e d e v e lo p m e n ts , to g e th e r w ith
c o n firm a tio n of stro n g g ro w th fo r the G erm an econom y
in th e s e c o n d q u a rte r, s e e m e d to s u g g e s t th a t an
a tm o sp h e re s u p p o rtive of renew ed co o p e ra tio n w ould
surround th e m e e tin g s o f the G roup of Five (G -5) and
Group of Seven (G-7) industrial countries in Washington
at the end o f the m onth. W ith Ja panese p ro d u ctio n for
e xp ort d e clin in g , G erm an d o m e stic dem and replacing
exports as the m ajor source of growth, and U.S. output
app e a rin g to grow at a m ore s a tis fa c to ry pace, the
process of a d ju stm e n t app e a re d to be underw ay at
long last.
In response to these developm ents, foreign exchange
dealers concluded that the need for the U.S. authorities
to seek further exchange rate adjustm ent had lessened,
and the im m e d ia te p re ssu re on d o lla r exch a n g e rates
sub sided . A t th e sam e tim e , in the w ake of repeated
c o m m e n ts by G e rm a n o ffic ia ls , m a rk e t p a rtic ip a n ts
becam e reconciled to the view that the Bundesbank was
u n lik e ly to ease m o n e ta ry p o licy soon. As a result,
e xp e cta tio n s of a fu rth e r reduction of in te re st rates
fa d e d — not only in G erm any, but also in the U nited
S tates and o th e r co u n trie s . U.S. in te re st rates a ctu a lly
backed up so m ew h at. As d o lla r e xchange rates and
interest rates both started to move up, foreign exchange
p ro fe s s io n a ls b e g a n to c o v e r s iz e a b le s h o rt d o lla r
po sitions. B idding fo r d o lla rs becam e intense, at tim es
exagg e ra te d by rum ors th a t u n re a lis tic a lly good U.S.
e c o n o m ic s ta tis tic s w e re a b o u t to be re le a s e d . By
S e p te m b e r 12, the d o lla r w as sw ept up to DM 2.1030
to m atch its high e a rly in the th re e -m o n th period.
A fte r m id-S e ptem ber, th e d o lla r show ed little trend.
M arket p a rtic ip a n ts re m a in e d ske p tica l that, o ve r the
longer term, the dollar had declined sufficiently to correct
the U.S. balance of payments deficit. But over the shorter
term, market participants perceived the dollar to be con
solidating its position around mid-September rate levels.
38
FRBNY Quarterly Review/Autumn 1986
Chart 4
In tra d e -w e ig h te d term s, the a p p reciatio n
of the Japanese yen since S eptem ber 1985
has been far greater than the a p p re cia tio n
of the German mark . . .
Index February 1985 = 100
150
T rade-w eighted e x ch a n g e rat
ss
140
Japanese f
yen r j
/
130
/
/
120
/
/ -----
J
/
110
mark
i
i
100
i
i
.L.
I
I
1985
I I J 1 ..1
1986
1
T rade-w eighted value of the Japanese yen and the
German mark v is-a -vis 17 other industrial co u n trie s
derived from the International M onetary Fund’s
M ultilateral Exchange Rate Model (MERM); indices
resca le d to February 1985=100, the month of the
lowest value during the rece n t period.
Source:
International Financial Statistics.
Chart 5
. . . and the im pact on the Japanese
m anufacturing in d u stry was also greater.
Percent
Index 1980=100
104
C ap acity utilization in manuf acturing
S
Germany
m V
S c a le ------► ..
V
v
100
86
N
-83
s
\
\
\
Japan \
■*------Scale
96 1— ........1 .........
1
1985
1
,
1986
Sources: Japan, Ministry of Industry and Trade;
Germany, Ifo Econom ic Trends Survey.
J80
They were sensitive to any evidence that U.S. and other
m o neta ry a u th o ritie s w ould be w illin g to su p p o rt such
a sta b iliz a tio n of exch an g e rates. In th is e n viro n m e n t,
th e y to o k n o te o f s ta te m e n ts s u c h as th e o n e by
C h a irm a n V o lc k e r on S e p te m b e r 24 th a t c u rr e n t
excha nge rate re la tio n s h ip s place our in d u stry in a fa r
b e tte r c o m p e titiv e p o s itio n th a n fo r s o m e y e a rs .
Accordingly, the dollar fluctuated w ithout clear direction.
But it w as so m e tim e s su b je ct to a b ru p t m ovem ents,
especially against the mark between a range of DM 2.00
and DM 2.08. T hese abru p t s h ifts cam e in response to
sta te m e n ts, a ctio n s, or rum ors of a ctio n s th o u g h t to
re fle ct o ffic ia l a ttitu d e s to w a rd e xchange rates.
The vie w th a t the d o lla r w as e ntering a period of
g re a te r s ta b ility w as ca lle d in to q u e stio n se ve ra l tim es
between m id-S eptem ber and mid-October. The first such
o ccasio n cam e in respon se to s ta te m e n ts th a t b rought
o ffic ia l a ttitu d e s abo ut e xch a n g e rates into que stio n.
Bundesbank President Poehl was reported to have said
that the Bundesbank w ould not cut its interest rates but
th a t G e rm a n y w o u ld a c c e p t a s tro n g e r m a rk as its
c o n trib u tio n to in te rn a tio n a l e c o n o m ic a d ju s tm e n t.
S u b s e q u e n tly , T re a s u ry S e c re ta ry B a k e r s a id th a t,
althoug h it w as p re fe ra b le not to rely on exch a n g e rate
a d ju stm e n ts alone to reduce trade im b a la n ce s, th e re
w ould need to be fu rth e r e xchange rate ch a n g e s in the
a b s e n c e o f a d d itio n a l m e a s u re s to p ro m o te h ig h e r
grow th abroad. In response, the d o lla r m oved down
Table 1
Federal Reserve R eciprocal Currency
Arrangem ents
In millions of dollars
Institution
Austrian National Bank
National Bank of Belgium
Bank of Canada
National Bank of Denmark
Bank of England
Bank of France
German Federal Bank
Bank of Italy
Bank of Japan
Bank of Mexico
Netherlands Bank
Bank of Norway
Bank of Sweden
Swiss National Bank
Bank for International Settlements:
Dollars against Swiss francs
Dollars against other
authorized European currencies
Total
Amount of Facility
October 31, 1986
250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
700
500
250
300
4,000
600
1,250
30,100
decisively, declining on S eptem ber 19 to DM 1.9845 and
¥ 151.77, its low fo r the p e riod a g a inst the yen. But it
soon recovered m ost of th is d e clin e a fte r a European
C om m unity (EC) m eeting of fin a n ce m in iste rs and c e n
tral bank g o ve rn o rs at G le n e a g le s, S cotland, the fo l
low ing day. M arket p a rtic ip a n ts in te rp re te d sta te m e nts
about th a t m eeting as in d ica tin g th a t the EC co u n trie s
had agreed to use exch a n g e m arket in te rv e n tio n , if
necessary, to p ro te ct the EMS from s tra in s w hich they
fe lt w ere a sso cia te d w ith th e d e clin e in the dollar.
The next p oint of u n c e rta in ty o ccu rre d at the end of
Septem ber. The w eekend G-5 and G -7 m eetings in
W ashington ended w ith o u t a s p e cific agreem ent, w hich
some observers had been looking for, that G erm any and
Japan w ould cut in te re s t rates in return fo r a U.S.
c o m m itm e n t to s ta b iliz e the dollar. M arket p a rticip a n ts,
se nsing th a t no a rra n g em e n t w as in place to pre ve n t a
resum ption of the dollar’s decline, moved to reestablish
sh o rt d o lla r p o sitio ns. As a result, the d o lla r d e clined
s h a rp ly a g a in s t th e c o n tin e n ta l E u ro p e a n c u rre n c ie s
throughout the first half of October, hitting its low against
the G erm an m ark of DM 1.9690 on O cto b e r 17.
M eanw hile, the d o lla r had co n tin u e d to trade in a
re la tive ly narrow range a g a inst the Ja p a n e se yen. In
early September, news of a meeting between Secretary
of the Treasury B aker and J a p a n ’s Finance M in ister
M iyazaw a g e n erated som e a n tic ip a tio n th a t an a g re e
m ent on e xchange rates m ight be fo rth co m in g . Later in
S e p te m b e r, fo r e ig n in v e s to rs , d is c o u ra g e d by th e
w o rse n in g b u sin ess clim a te in Japan, began to sell
h oldings of sh a re s on the Tokyo sto ck m arket. This
outflow , com bined w ith a gro w in g p essim ism about the
likelihood of a reduction in the Bank of Japan’s discount
rate, co n trib u te d to a sharp drop in the Tokyo stock
m arket in the m iddle of O ctober. Ja p a n e se in stitu tio n a l
investors, a tte m p tin g to o ffs e t the re su ltin g losses on
th e ir yen e q u ity p o rtfo lio s p rio r to th e e n d -O c to b e r
re p orting date, re a lize d p ro fits on th e ir d o lla r-d e n o m i
nated assets by u n w inding hedges th a t had been put
in place w hen the d o lla r w as m uch higher. These v a r
ious factors generated a demand for dollars throughout
most of October and reinforced sentim ent that the dollar
had reached a ne a r-te rm bottom a g a in st the Japanese
currency.
Late in O cto b e r evid e nce w as a ccu m u la tin g th a t the
U.S. economy had strengthened significantly during the
third q u a rte r and th a t the U.S. tra d e p o sition had at
least begun to stabilize. A prelim inary estim ate showing
that real GNP in cre a se d by 2.4 pe rce n t in the third
q u a rte r w a s fo llo w e d by a re p o rt th a t U .S . d u ra b le
goods orders had in cre a se d 4.9 perce n t in S eptem ber.
M oreover, p re lim in a ry tra d e s ta tis tic s fo r S e p te m b e r
indicated a second m onth of d e clin e in the U.S.
trade de ficit.
FRBNY Quarterly Review/Autumn 1986
39
A t th e s a m e tim e , m a rk e t p a rtic ip a n ts b e c a m e
increasingly impressed with European officials’ apparent
intention to buy dollars to resist depreciation of the U.S.
cu rre n cy and a sso cia te d s tra in s on the EMS. There
were several reports of B undesbank and other European
central bank intervention to buy dollars during October.
In a d d ition , repo rted s ta te m e n ts from G erm an o fficia ls
th a t any fu rth e r declin e of the d o lla r th re a te n e d e c o
nom ic grow th in E urope c o n trib u te d to the perception
th a t there m ight also be a lim it to the d o lla r’s d e p re c ia
tio n a g a in s t the c o n tin e n ta l c u rre n c ie s . A c c o rd in g ly ,
w hen the dem and fo r d o lla rs a g a inst the yen s tre n g th
e n ed la te in O c to b e r, a nd th e d o lla r b e g a n to firm
ag a inst th a t currency, it also firm e d som ew hat against
the E uropean cu rre n cie s.
As th e pe riod drew to a close, the d o lla r received a
final boost of support from the announcem ent of a onehalf p e rce n ta g e p oint cut in the Bank of J a p a n ’s d is
count rate and an econom ic policy accord between U.S.
Treasury S e cre ta ry B aker and Ja panese Finance M in
iste r M iyazaw a. The accord ou tlin ed fisca l policy in iti
atives, in clu d in g tax reform plans in Japan, and u n d e r
scored the U.S. co m m itm e n t to reducing the budget
d e ficit. The tw o c o u n trie s ju d g e d the e xchange rate
re a lig n m e n t ach ie ved b e tw een th e ir c u rre n cie s since
S e p te m b e r 1985 to be b ro a d ly c o n siste n t w ith present
underlying econom ic fundam entals, and they reaffirm ed
a w illin g n e ss to co o p e ra te on exch a n g e m a rke t issues.
N o tw ith sta n d in g s ta te m e n ts by Treasury o ffic ia ls tha t
U.S. intervention policy had not changed, some market
p a rticip a n ts in te rp re te d the accord to be a pact for
concerted in te rv e n tio n to su p p o rt the dollar.
Thus the dollar continued to rise through end-October.
T h is ris e in d o lla r e x c h a n g e ra te s w a s le d by an
in c re a s e a g a in s t th e yen b u t w a s a c c o m p a n ie d by
increases ag a inst o th e r m ajor c u rre n cie s. The increase
in the d o lla r at the end of the period left it h ig h er on
balance against some currencies and limited its decline
ag a inst the G erm an m ark. On the tra d e -w e ig h te d basis
of the Federal R eserve Board d o lla r exch a n g e rate
index, the d o lla r closed the period 13/s p e rce n t higher
than at the end of July.
The pound ste rlin g w as the only cu rre n cy a g ainst
w hich the d o lla r rose c o n s is te n tly d u ring the period
under review. Som e of s te rlin g ’s d e clin e w as seen in
fo re ig n exchange m arkets as re fle ctin g the im p a ct of
w eak oil prices on B ritish e xp o rt re ve n u e s and g o v e rn
m ent incom e. But m arket p a rtic ip a n ts w ere also co n
cerned about the d ire ctio n of the g o v e rn m e n t’s o ve rall
m onetary and fisca l p o licie s, as w ell as a bout p re
e le c tio n p o litic a l u n c e rta in tie s . W ith th e a u th o ritie s
d eciding fo rm a lly to abandon m o n e ta ry ta rg e ts as a
Table 2
Drawings and Repayments by Foreign Central Banks under Regular Reciprocal Currency
Arrangem ents
In millions of dollars; drawings ( + ) or repayments ( - )
Central Bank Drawing on the
Federal Reserve System
Outstanding as of
August 1, 1986
August
September
October
Outstanding as of
October 31, 1986
0
+ 210.2
-6 6 .8
0
143.4
Bank of Mexico
Data are on a value-date basis.
Table 3
Drawings and Repayments by Foreign Central Banks under Special Swap Arrangem ents w ith the
U.S. Treasury
In millions of dollars; drawings ( + ) or repayments ( - )
Central Bank Drawing
on the U.S. Treasury
Amount of
Facility
Outstanding as of
August 1, 1986
August
September
October
Outstanding as of
October 31, 1986
100.0
75.0
273.0
37.0
*
75.0
*
*
-7 5 .0
+ 211.0
0
*
-6 7 .0
*
*
0
*
0
+ 22.2
0
*
144.0
22.2
Central Bank of Bolivia
Central Bank of Ecuador
Bank of Mexico
Central Bank of Nigeria
Data are on a value-date basis.
'N o facility
40
FRBNY Quarterly Review/Autumn 1986
policy tool, expectations strengthened that the govern
ment might adopt an exchange-rate guide for policy
instead. As a result, discussion of sterling’s joining the
intervention arrangements of the EMS became even
more widespread than before, both in the press and in
financial markets. But no new policy initiatives along
these lines emerged during the period under review. By
the end of October, sterling had depreciated by almost
6 percent against the dollar and by even more against
the continental European currencies.
During the period, the exchange rate mechanism of
the EMS was at times subject to strain. The Irish pound
was caught between the decline of sterling on the one
hand and the rise of continental currencies on the other.
With Irish exporters experiencing a loss of competi
tiveness in the United Kingdom, Ireland’s primary export
market, the Irish authorities devalued the Irish pound on
August 2 by 8 percent against the bilateral central rates
of the other EMS currencies.
Later on, as the German mark appreciated against the
dollar, it also moved up against other currencies. By late
August the mark reached the top of the narrow band,
a position it held throughout the remainder of the period.
At times during September and to a lesser extent during
October, the narrow band was fully stretched to the
21/4 percent intervention limit as the mark benefitted
more than the others from the d o lla r’s decline. In
response to these pressures, EC finance minister and
central bank governors, at their Gleneagles meeting,
agreed to try to stem the rise of the member currencies
against the dollar, largely in an effort to preserve sta
bility within the EMS. By late October, tensions within
the EMS joint float had subsided substantially.
*
Chart 6
In August, the German mark m oved to
the top of the narrow EMS band.
P e rce n t'
3.0
2.5
2.0
15
1.0
0.5
*
*
*
At the beginning of the three-month period, the only
drawing outstanding on the credit arrangements of the
U.S. Monetary Authorities was $75.0 million drawn on
May 16, 1986 by the Central Bank of Ecuador against
a $150.0 million U.S. Treasury Exchange Stabilization
Fund (ESF) short-term swap facility. On August 14, the
swap arrangement was terminated pursuant to the
agreement.
In the period from July through October, the U.S.
Monetary Authorities provided short-term bridging
facilities to Bolivia, Nigeria, and Mexico:
Bolivia. The U.S. Treasury through the ESF on Sep
tember 17 extended a $100.0 million financing facility
to the Central Bank of Bolivia. There were no drawings
made against this facility during the period under review.
0
- 0 .5
Table 4
-
1.0
- 1 . 5
I______I______ I______ I_____ I______ I______I______ I______ I______ I______I______ I______l---------- 1----------1
1
8
15 22 29
Aug
5
12 19
Sept
1986
26
3
10 17 24 31
Oct
Weekly averages of 9 a.m. rates in New York fo r the
weeks ending on dates shown.
♦Percentage deviation of each cu rre n cy from its ECU
central rate. Dotted lines correspond to the System's
214 percent lim it on movement from bilateral central
exchange rates fo r all particip a tin g currencies except
the Italian lira. The lira may fluctuate 6 percent from
its central rates against other EMS currencies.
"I"On August 2, the Irish pound was devalued by
8 percent against the b ila te ra l central rates of the
other EMS cu rre n cie s.
Net P rofits ( + ) or Losses ( - ) on
United States Treasury and Federal Reserve
Current Foreign Exchange Operations
In millions of dollars
United States Treasury
Exchange
Federal
Stabilization
Reserve
Fund
Period
August 1, 1986—
October 31, 1986
Valuation profits and
losses on outstanding
assets and liabilities as
of October 31, 1986
0
0
+ 1,341.3
+ 1,290.1
Data are on a value-date basis.
FRBNY Quarterly Review/Autumn 1986
41
Nigeria. The U.S. Treasury, through the ESF, agreed
on October 24 to provide a $37.0 million short-term
facility to the Central Bank of Nigeria as part of a
$250.0 million multilateral facility organized under the
leadership of the Bank of England. On October 31, a
drawing of $22.2 million was made on the U.S. portion.
Mexico. On August 27, the U.S. Monetary Authorities
agreed jo in tly to a m ultilateral arrangement in the
amount of $1.1 billion with the Bank for international
Settlements (acting for certain central banks) and the
central banks of Argentina, Brazil, Colombia, and Uru
guay to provide a near-term contingency support facility
for Mexico’s international reserves. Drawings on the
fa cility were made available in light of agreement
between Mexico and the IMF concerning a proposed
stand-by arrangement, the expected receipt by Mexico
of disbursements under loans from the International
Bank for Reconstruction and Development (IBRD), and
the agreement by Mexico to apply drawings from the
IMF and disbursements from the IBRD to the balances
on outstanding drawings on the facility. On August 29,
$850.0 million was made available to Mexico. On this
date Mexico drew $211.0 million from the Treasury
through the ESF and $210.2 million from the Federal
Reserve through its regular swap facility with the Bank
42
FRBNY Quarterly Review/Autumn 1986
of Mexico. On September 30, Mexico repaid $67.0 mil
lion to the ESF and $66.8 m illion to the Federal
Reserve.
During this period the Federal Reserve and the ESF
realized no profits or losses from exchange transactions.
As of October 31, cumulative bookkeeping or valuation
gains on outstanding foreign currency balances were
$1,341.3 million for the Federal Reserve and $1,290.1
for the Treasury’s ESF. These valuation gains represent
the increase in the dollar value of outstanding currency
assets valued at end-of-period exchange rates, com
pared with the rates prevailing at the time the foreign
currencies were acquired.
The Federal Reserve and the ESF invest foreign
currency balances acquired in the market as a result of
their foreign operations in a variety of instruments that
yield market-related rates of return and that have a high
degree of quality and liquidity. Under the authority pro
vided by the Monetary Control Act of 1980, the Federal
Reserve invested $2,868.0 million equivalent of its for
eign currency holdings in securities issued by foreign
governments as of October 31. In addition, the Treasury
held the equivalent of $3,980.1 million in such securities
as of the end of October.
(This report was released to the Congress and to the
press on September 4, 1986)
Treasury and Federal Reserve
Foreign Exchange Operations
May-July 1986 Report
The dollar declined against most major currencies during
the three months ended July. The dollar’s downward
movement proceeded against the background of slug
gish U.S. economic growth, expectations of continued
monetary easing in the United States, and doubts that
large payments im balances among the developed
countries were being reduced. There was no interven
tion by the U.S. authorities during the period but there
were sizable dollar purchases by some other central
banks. The dollar’s depreciation was temporarily inter
rupted in May only to resume in June and July. By the
end of July, the dollar was at its low point of the period,
having declined approximately 9 percent against the
Japanese yen and Swiss franc, and nearly 5 percent
against the German mark and other Continental Euro
pean currencies.
Com ing into the period, the d o lla r had already
declined substantially from its highs of February 1985.
Market participants had noted that officials in several
foreign industrial countries were expressing concern
over the adjustments that their own industries were
beginning to experience. In the face of the appreciation
of their currencies, foreign exporters increasingly com
plained of a squeeze on profits as they sought to
maintain market shares. Indeed, a number of commen
ta tors questioned w hether increases in dom estic
demand in Germany and Japan would be sufficient to
offset the decline in export orders and sustain prospects
for economic growth in these two countries.
A report by Sam Y. Cross, Executive Vice President in charge of the
Foreign Group at the Federal Reserve Bank of New York and
Manager of Foreign Operations for the System Open Market
Account.
Many in the exchange markets anticipated that the
governments of the seven major industrial countries
m ight use the occasion of the Economic Summit
meeting in Tokyo during early May to outline measures
to stabilize dollar exchange rates. The Tokyo Economic
Declaration noted that there had been a significant shift
in the pattern of exchange rates which better reflected
fundamental economic conditions. It stated that the
Group of Seven (G-7) countries had agreed to develop
a process to review trends for a number of economic
variables, including exchange rates, in order to achieve
more effective policy coordination. But the declaration
did not call for specific measures or concerted actions
to prevent the dollar from declining further. Instead,
there were reported remarks by some G-7 officials which
seemed to imply that there was still room for further
appreciation of nondollar currencies, especially the
Japanese yen.
In reaction to the absence of an announcement of
specific measures, the dollar resumed its decline after
the Tokyo Summit. It depreciated most against the
Japanese yen, trading as low as ¥159.99 on May 12,
some 381/z percent below its peak of about a year
before. Contributing to this decline in the dollar was the
narrowing of favorable long-term interest differentials. In
addition, the dollar was undermined by the persistent
current account imbalances manifested by a large U.S.
deficit and Japanese surplus. Market participants per
ceived that the U.S. Administration hoped that a high
level of economic activity and rising imports abroad
would set the stage for a sizable narrowing of the U.S.
trade deficit, given that the dollar had already declined
substantially during the past year. But the most recent
data were seen by the market as showing little progress
in redressing the trade imbalance. Strong protectionist
FRBNY Quarterly Review/Autumn 1986
43
sentiments persisted in the U.S. manufacturing industry,
even as the U.S. authorities sought to reduce restrictive
trading practices abroad and resist pressures for pro
te ctio n is t m easures at home. Market participants
believed that so long as the imbalances were not
diminishing, market pressures in favor of the yen would
remain strong and that the authorities, at least in the
United States, would accept further declines in dollar
exchange rates.
In early May, the dollar’s decline against the German
mark was more muted than its decline against the yen.
Political and econom ic uncertainties following the
Chernobyl nuclear accident of late April weighed against
the mark for a time. There were also heavy reflows of
funds into the French franc and Italian lira following an
April realignment of the European Monetary System
(EMS) and, in the case of the franc, in response to the
exchange market’s favorable reaction to initial plans for
privatization of French public-sector firms. Thus, the
mark traded at the bottom of the EMS.
Before long, however, many in the market came to
interpret official views as indicating that a period of
consolidation was appropriate. Dealers anticipated that
Chart 2
Interest d iffe re n tia ls favorable to the
dollar in itia lly widened but then resumed
th e ir d e clining trend.
Percent
Ten-year U.S. Treasury bonds
/
V
•
German public-sector
hnnrtc;
Japanese Government b o n d s \
'" \
s'
EIII I I II I I I 11 I I I I 1I ! I I 11I I 111l 1l 111l l l i 1 l 111 l 1 11 l I I l 1
J A S O N D J
F M A M J
J
1985
1986
C hart 1
The d o lla r continue d to d e cline against
most m ajor fo re ig n currencies.
Percent *
Pound sterling
Swiss franc
French franc
------ A ------20
German
—mark Japanese yen
- 3 5 .......... ............ .......
A
S
O
N
1985
M
A
1986
M
J
*Percentage change of weekly average rates for
dollars from the average rate for the week ending
August 2, 1985. Figures calculated from New York
noon quotations.
44
FRBNY Quarterly Review/Autumn 1986
J
many of the governm ents abroad, facing local or
national elections, would welcome a period of exchange
market tranquility. Also, time was needed to evaluate the
effects on economic activity and trade flows of the
changes in exchange rates and declines in interest rates
that had occurred during the preceding year.
After mid-May, perceptions about the relative strength
of the U.S. economy temporarily brightened, expecta
tions of further drops in U.S. interest rates faded, and
the dollar appreciated more or less steadily for the rest
of the month. Faster-than-expected growth in U.S.
monetary aggregates appeared to lessen the scope for
a near-term easing of U.S. monetary policy. Repeated
denials of any need to ease monetary policy by officials
of the Bundesbank and the Bank of Japan led dealers
to believe that there was little chance of a coordinated
cut in interest rates. For the first time in several months,
dollar interest rates increased, with the rate on threemonth Eurodollar deposits exceeding 7 percent. A
strong upward revision in first quarter real GNP and
other statistics on U.S. economic activity were inter
preted favorably by the exchanges. By June 2, the dollar
reached ¥177.05 and DM2.3445, levels which were the
highs for the dollar during the period under review.
But the dollar began to edge down again in early June
as new evidence suggested that the anticipated boost
to U.S. exports and growth was not being sustained and
e xp e cta tio n s of a n o th e r d ow nw ard a d ju stm e n t in U.S.
in te re st rates w ere revived. A fte r the s ta tis tic s of late
May, an in cre a se in U.S. une m p lo ym e n t cam e as a
d isa p p o in tm e n t and w as the s ta rt of a se rie s of fig u re s
p o in tin g to o n ly la c k lu s te r U .S . e c o n o m ic a c tiv ity .
S ta tem e nts by C ha irm an V olcker w ere in te rp re te d as
running co u n te r to the idea th a t the Federal R eserve
needed to w ait to cut its discount rate again until central
banks in other countries eased monetary policy. Market
p a rticip a n ts sta rte d to c o n s id e r the p o s s ib ility th a t the
U.S. authorities m ight w elcom e a renewed decline in the
d o lla r on the g rou nds th a t ce n tra l banks abroad m ight
cut th e ir in te re st rates m ore q u ickly in such an e n vi
ronm ent. In the m eantim e, th e re w ere co n ce rn s that
som e of the h e a vily inde bte d Latin A m erican co u n trie s
w ere co n sid e rin g im po sin g a d ebt se rvice m oratorium
o r lim itin g d e b t p a y m e n t to a p e rc e n ta g e of e x p o rt
earnings. Thus, for dom estic and international reasons,
m arket participants thought that a further easing of U.S.
m o n e ta ry p o lic y m ig h t be im m in e n t. W ith the p o s s i
b ility th a t such a U.S. m ove m ig h t not be m a tch e d
Chart 3
Attention in the fo re ig n exchange m arket
continued to focus on the persistent large
trade im balances of the United States,
Germany, and Japan.
Billions of dollars
Monthly trade b a la n c e s *
elsew here, the d o lla r cam e under dow nw ard pressure.
For several weeks in June, pressures to sell the dollar
w ere well con ta in e d . D ealers p erceived th a t a u th o ritie s
abroad w ere prepared to in te rve n e to p re ve n t a fu rth e r
d ecline in d o lla r rates for a w hile. In particular, there
were numerous reports of dollar purchases by the Bank
of Japan, and m arket p a rtic ip a n ts seem ed to believe
th a t th e J a p a n e s e c e n tra l b a n k w o u ld s tre n u o u s ly
atte m p t to lim it the y e n ’s rise before Ja p a n e se p a rlia
m entary e le ctio ns on July 6. D ealers also th o u g h t that
the Bundesbank might intervene if the mark threatened
to rise too strongly.
In July, th e d o lla r b e g a n to m o ve d o w n q u ic k ly ,
e s p e cia lly a g a inst the Ja p a n e se yen and the Swiss
fra n c . M a rk e t p a r tic ip a n ts d o u b te d th e J a p a n e s e
a u th o ritie s w ould be able to co n ta in fo r long the y e n ’s
rise in the face of m ounting trade su rp lu se s. (B ecause
of the su b sta n tia l d e p re cia tio n of the d o lla r since Feb
ruary 1985 and the d e clin e in w orld oil prices, J a p a n ’s
trade surplus co n tin u e d to grow in d o lla r term s, even
though Japanese e xports in 1986 w ere a ctu a lly low er
in volume term s than in the previous year.) As a result,
tra d e rs started to e sta b lish large long p o sitio ns in yen
and com m ercial leads and lags swung in favor of Japan.
The Swiss fra n c also began to be view ed as a p a rtic
ularly a ttra ctive a lte rn a tiv e to the dollar. It w as not as
Chart 4
Oil prices again moved low er.
Dollars per barrel
United States [ ^ \ \ | Japan
|
| Germany
1 0 --------------------------------------------------------
v\
\
\v
X\ v
West Texas
interm ediate crude
>\
/ \
^
'
\
'A
J K '
V
Brent crude
Y
\ __
* Balance of payments basis for the United States.
Census data for Japan and Germany.
+ U.S. data for June on a balance of payments basis were
unavailable at the time of publication.
Li i i i I i i i
Nov
Dec
1985
1 1 1m
1 1 1 1 1 m 1 1 1 1 1 1 1 1 1 1 1 1 1 1 11
Jan
Feb Mar Apr
May
Jun Jul Aug
1986
j j
FRBNY Quarterly Review/Autumn 1986
45
a ffected as the G erm an m ark by p o litica l u n ce rta in tie s,
and by June had d evelop e d an in te re st rate advantage
over the mark. Moreover, m arket participants felt that the
S w iss N a tio n a l B ank w o u ld m a in ta in re la tiv e ly tig h t
m o n e ta ry co n d itio n s w h a te v e r the in te rn a tio n a l e n v i
r o n m e n t a n d w a s n o t lik e ly to in te r v e n e in th e
exch a n g e s to lim it the a p p re c ia tio n of its currency.
The G erm an m ark, too, began to gain m ore strength
as the d o lla r d e clin e d d u ring July. A fter the Federal
R eserve cut its d is c o u n t rate a half of one percentage
point, e ffe ctive Ju ly 11, a num ber of G erm an o ffic ia ls
co m m ented th a t a fu rth e r d e clin e in G erm an in te re st
rates would be inappropriate inasm uch as their dom estic
econom y had picked up in the second q u a rte r and the
grow th of ce n tra l bank m oney rem ained above target.
In a d d ition , the G erm an g o v e rn m e n t indicated it w ould
not d e p a rt from its e a rlie r fis c a l ta rg e ts. The m ark also
strengthened against other European currencies around
this time. Flows into France that had occurred after the
A pril EMS re a lig n m e n t and had w eighed on the m ark
began to subside as F rench re sid e n ts re p o rte d ly too k
advantage of an easing of exchange controls. The mark
also b enefited from s h ifts in in v e s to r p re fe re n ce aw ay
from sterling-denom inated assets, previously viewed as
a principal alternative to dollar investments. As B ritain’s
e conom ic o u tlo o k dim m ed w ith oil p rice s reaching new
lows and the g o ve rn m en t of P rim e M in iste r T h a tch e r
fa c in g c o n s id e ra b le p o litic a l c ritic is m , in v e s to rs and
tra d e rs both sh ifte d fu n d s in c re a s in g ly out of ste rlin g
and into m arks. D uring July, the G erm an m ark m oved
from near the bottom to near the top of the EMS to
em erge as the th ird s tro n g e st c u rre n c y in th a t a rra n g e
ment; it also gained 7 1A> p e rce n t a g a in st ste rlin g .
In late July, the d o lla r’s d e clin e a c c e le ra te d . T here
w as p re s s c o m m e n ta ry to th e e ffe c t th a t, fo r o th e r
in d u s tria liz e d c o u n trie s , th e b o o s t to re a l in c o m e
resulting from the oil price decline was not yet showing
thro u g h ; these co u n trie s w ere going to have to expand
more q u ickly and im p o rt m ore vig o ro u s ly fo r the U nited
States to achieve a su b sta n tia l balance of paym ents
Chart 5
Chart 6
In July, the Federal Reserve low ered its
disco un t rate but was not jo ine d by some
other c e n tra l banks.
The German mark strengthen ed w ith in
the EMS jo in t flo a t.
Percent *
Percent *
9.0
1
1
8.5
1
1
8.0
Bank of France
7.5
7.0
Federal Reserve
6.5
6.0
5.5
5.0
1 Bank of Japan
1---------------I
1
tm—mmmm
Bundesbank
4.5
4.0
1
1
1986
3.5
3.0 1
1
Jan
|
1
Feb
Mar
.
Apr
1986
1
i
May
1
Jun
1
Jul
♦Percentage change in the discount rates of the central
banks of the United States, Germany, and Japan and the
money market intervention rate of the Bank of France.
46
FRBNY Q uarterly Review/Autumn 1986
W eekly averages of 9 a.m. rates in New York for the
weeks ending on dates shown.
* Percentage deviation of each currency from its ECU
central rate. Dotted lines correspond to the System's
2% percent limit on movement from bilateral central
exchange rates for all participating currencies except
the Italian lira. The lira may fluctuate 6 percent from
its central rates against other EMS currencies.
Table 1
Federal Reserve Reciprocal Currency
Arrangements
In millions of dollars
Amount of facility Amount of facility
July 31, 1985
July 31, 1986
Institution
Austrian National Bank
National Bank of Belgium
Bank of Canada
National Bank of Denmark
Bank of England
Bank of France
German Federal Bank
Bank of Italy
Bank of Japan
Bank of Mexico
Netherlands Bank
Bank of Norway
Bank of Sweden
Swiss National Bank
Bank for International
Settlements:
Swiss francs-dollars
Other authorized European
currencies-dollars
250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
700
500
250
300
4,000
250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
700
500
250
300
4,000
600
600
1,250
1,250
Total
30,100
30,100
as c a lcu la ted by the Federal R eserve B oard, the d o lla r
closed the period 3 percent below its level of end-April.
On May 14, the U.S. Treasury, thro u g h the E xchange
S ta b iliza tio n Fund (E S F), agreed to p rovide sh o rt-te rm
fin a n cing to the C entral Bank of E cuador to ta lin g $150
m illion until E cuador could fin a liz e n e g o tia tio n s fo r a
new fin a n cin g fa c ility from co m m e rcia l banks and a d d i
tio n a l loans from in te rn a tio n a l fin a n cia l in s titu tio n s. On
May 16, the C entral Bank of E cuador m ade a draw ing
of $75 m illion.
T he F e d e ra l R e s e rv e and th e E SF in v e s t fo re ig n
currency balances acquired in the market as a result of
their foreign exchange market operations in a variety of
instrum ents that yield market-related rates of return and
th a t have a high d e g re e of q u a lity and liquidity. U nder
the a u th o rity provided by the M onetary C ontrol A ct of
1980, as of July 31 the Federal R eserve had invested
$ 2 ,9 4 1 .2 m illio n e q u iv a le n t o f its fo re ig n c u rre n c y
holdings in securities issued by foreign governm ents. In
a d dition, the Treasury held the e q u iva le n t of $ 4 ,0 8 3 .6
m illion in such se c u ritie s as of the end of July.
Table 2
a d justm en t. Yet a U.S. o ffic ia l’s call for s tro n g e r grow th
abroad had elicited replies from German and Japanese
officials indicating that stim ulative policies would not be
fo rth co m in g in the near term . As fo r the U nited S tates,
rapid grow th in the U.S. m o n e ta ry a g g re g a te s and a
su sta in e d d e clin e in U.S. in te re s t rates in d ica ted that
m onetary p o licy w as not a co n s tra in t on U.S. grow th.
But long-term U.S. interest rates had actually firm ed as
short-term rates eased during the last half of July. Under
th e s e c irc u m s ta n c e s , m a rk e t o b s e rv e rs w o n d e re d
w h e th e r fo reign dem and fo r U.S. se c u ritie s w as being
su stained s u ffic ie n tly to fin a n ce the U.S. d e fic its and
th e re b y avoid a n o th e r sh a rp d e clin e in d o lla r rates or
a fu rth e r rise in in te re s t rates. S im ultaneously, release
o f U.S. trad e s ta tis tic s su g g e stin g the d e fic it had w id
e n e d in J u n e re in fo rc e d th e v ie w th a t th e d e s ire d
a d ju stm e n ts w ere slow in m a te ria lizin g . As m arket p a r
tic ip a n ts in c re a s in g ly q u e s tio n e d w h e th e r th e m a jo r
in d u stria liz e d c o u n trie s w ould be able to w ork to g e th e r
to redress th e ir large eco n o m ic im balances, the d o lla r
declined to close the period at DM2.0890 and ¥153.65.
A t the end of July, the d o lla r had d e clin e d 9 percent
a g a inst the Jap a n e se yen and S w iss franc, as well as
a lm o st 5 percent a g a inst the G erm an m ark and other
E M S c u rre n c ie s . It h ad re m a in e d s ta b le , h o w e ver,
a g a inst the C ana dian d o lla r and had risen a g a inst the
pound ste rlin g . T h e re fo re , on a tra d e -w e ig h te d basis
against the currencies of the m ajor industrial countries,
Net Profits ( + ) or Losses ( - ) on U.S. Treasury
and Federal Reserve Current Foreign Exchange
Operations
In millions of dollars
Period
May 1, 1986July 31, 1986
Valuation profits and losses
on outstanding
assets and liabilities
as of July 31, 1986*
Federal
Reserve
U.S. Treasury
Exchange
Stabilization
Fund
0
0
+ 1,398.6
+ 1,470.4
Data are on a value-date basis.
'Valuation gains represent the increase in the dollar value of
outstanding currency assets valued at end-of-period exchange
rates, compared with the rates prevailing at the time the foreign
currencies were acquired.
Table 3
Drawings under Special Swap Arrangements with
the U.S. Treasury
In millions of dollars; drawings ( + ) or repayments ( - )
Drawings on U.S.
Treasury facilities for
Central Bank of Ecuador
Total
facility
150
May 16, Outstanding
1986 July 31, 1986
+ 75
+ 75
Data are on value-date basis.
FRBNY Quarterly Review/Autumn 1986
47
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