Full text of Economic Policy Review (Federal Reserve Bank of New York) : Summer 1980, Vol. 5, No. 2

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Federal
Reserve Bankof
NewYbrk
Quarterly Review




Sum m er 1980

Volum e 5 No. 2

1

United States and the W orld Econom y

6
9

C urrent developm ents
The business situation
The financial developm ents

14

R eform ing New Y ork C ity’s Property
Tax: Issues and O ptions

21

Perspective on the United States
External Position Since W orld W ar II

39

The Pricing of S yndicated E urocurrency
C redits

50

M onetary P olicy and Open M arket
O perations in 1979

65

Treasury and Federal Reserve Foreign
Exchange O perations

The Quarterly Review is published by
the Research and Statistics Function
of the Federal Reserve Bank of New
York. Remarks by ANTHONY M.
SOLOMON, President of the Bank, on
the United States and the world
economy, begin on page 1. Among
the members of the function who
contributed to this issue are MARK A.
WILLIS (on the issues and options of
reforming New York City’s property
tax, page 14); STEPHEN V.O. CLARKE
(with a perspective on the United
States external position since World
War II, page 21); LAURIE S.
GOODMAN (on the pricing of
syndicated Eurocurrency credits,
page 39).
A report on monetary policy and open
market operations in 1979 starts on
page 50.
An interim report of Treasury and
Federal Reserve foreign exchange
operations for the period February
through April 1980 begins on page 65.




United States and the
World Economy
This is my first opportunity since arriving at the New
York Fed to give my views about the international
situation. It is a special pleasure to do that for this
knowledgeable audience. I recognize that many of
you here this evening derive considerable profes­
sional benefit from having an unceasing stream of world
problems to report on. Looking ahead, I can predict
one thing with some certainty. There will be no short­
ages of raw materials for your industry.
We are confronted by the reality of intractable infla­
tion, the certainty of massive payments deficits among
oil-consuming countries, and the likelihood of economic
contraction, or at best a prolonged slowing of economic
growth. The key point to consider is that these prob­
lems are not simply cyclical in origin. They cannot be
attacked adequately by traditional demand manage­
ment policies developed over the short term. They are,
in part, consequences of oil price and supply instabili­
ties which are not going to go away and may grow still
worse during the next five years. Since these problems
are medium- or long-term in character, it will take not
only imagination and skill to deal with them, but also
determination and perseverance in a broad range of
policy areas. Above all, we need the guts to propose,
to debate, and to take unpopular actions whenever
necessary— and certainly until a broad constituency
for discipline and self-restraint is secure.
The economic outlook is pessimistic. But this does
not mean the situation is hopeless. To the contrary,

Remarks of Anthony M. Solomon, President of the Federal Reserve
Bank of New York before the Reuters annual dinner on Wednesday,
May 14, 1980.




we are impelled to seek ways to bridge the gap be­
tween today’s dilemmas and what might be a more
hospitable future. The energy vise can be loosened
by development of alternative energy sources and by
decisive cutbacks in our energy consumption, even
greater than we are now achieving. On both fronts, I
expect us to remember the lessons we should have
learned since the first oil shock and put them to good
use.
I recognize there are those who differ, and who are
not terribly worried about the outlook, or at least say
they are not. They claim that the world came out of the
first oil shock not too badly— that yes, there was a se­
vere, synchronized recession, but we recovered from
that. The banking system recycled surplus oil revenues
reasonably well. The OPEC (Organization of Petro­
leum Exporting Countries) surplus declined fairly
quickly because large amounts of imports were ab­
sorbed. After the initial price shock, the oil price, ad­
justed for general inflation— the real oil price— actual­
ly fell. All this could happen again, they say.
Some go even further. This time, they say, the initial
conditions may be less troublesome. There are no big
current account surpluses among industrial countries
to compound the adjustment problem, as there were
last time. The business cycle is less synchronized, and
since we did not have a simultaneous boom (as in
1972-73) there is little risk of a simultaneous world re­
cession. Finally, the recycling process itself could go
more smoothly because many developing countries have
built up sizable reserves and have been able to gener­
ate impressive export growth.
I would admit there is clearly something to each of
these points. But, taken as a whole, the argument

FRBNY Quarterly Review/Summer 1980

1

doesn’t wash. It neglects the fact that there is an over­
riding difference between the first oil shock and the
situation we are in now. There have been fundamental
changes in the perceptions and policies of OPEC and
its members. Because of those changes, I cannot fore­
see any early decline in the OPEC surplus or any
meaningful reduction of real oil prices. If anything,
real oil prices could go up further.
Bear in mind these four key factors:
First, OPEC import demands are not likely to expand
anywhere near as fast, or as much, as they did before.
Several countries have learned the practical limits to
their absorptive capacity. They are unwilling to repeat
past mistakes of taking on too many complicated proj­
ects all at once. The social implications of rapid de­
velopment have been a source of concern to many
countries, especially where large numbers of immi­
grant workers are involved. In addition, some countries
have not been able to run profitably the expensive
plants and technology they installed in the first flush
of new oil wealth. And other special circumstances,
such as the Iranian upheaval, have had direct and in­
direct consequences on import demand that will not
quickly disappear.

The economic outlook is pessimistic. But this does
not mean the situation is hopeless. To the contrary, we
are impelled to seek ways to bridge the gap between
today’s dilemmas and what might be a more hospitable
future.

Second, OPEC’s attitudes toward supplying oil have
changed. The OPEC members have learned a great
deal about how to create and perpetuate a tight supply
and demand situation in the short term. A number of
countries have made it known that they are prepared
to hold back production if that helps force real oil
prices higher. That threat is not an idle one, given
recent levels of world demand.
Third, the more moderate OPEC members have come
under criticism within their own countries for taking a
relatively accommodative attitude, specifically toward
oil pricing and production, and more broadly toward
the United States and our interests. This atmosphere
of criticism has tended to mute the voices in favor of
moderation. And, as a result, the more strident ele­
ments within OPEC have strengthened their position.
They will seek to use that preeminence to secure
larger real revenues by keeping continual pressure
on the oil market.
Finally, many OPEC members have been disap­
pointed by the earnings they have made on financial
Digitized 2
for FRASER
FRBNY Quarterly Review/Summer 1980


assets. They claim those earnings were eroded by in­
flation and currency fluctuations, while had they kept
the oil in the ground they would have done better.
Ex post, that is a hard argument to contradict. But I
can envisage a different outcome in the future. Once
convincing efforts, even if long run, are under way to
develop alternative energy sources and to achieve
drastic cuts in oil consumption, the immediate arith­
metic can be radically changed. At that point, we can
expect a major change in attitudes in favor of selling
oil rather than leaving it in the ground.
But we are far from that point now. The clear, un­
avoidable conclusion is that the OPEC surplus is
going to remain massive. Therefore, the rest of us
will face an increasingly difficult struggle to sustain
tolerable levels of trade and economic activity while
combating inflationary pressures stemming from higher
oil prices. If we cavalierly treat the second oil shock
as self-adjusting and self-limiting, we risk incalculable
long-term damage. We must prepare policies that offer
the best chance of minimizing the economic damage—
almost sure to be mounting year by year through the
entire period of oil vulnerability. We cannot count on
OPEC behavior to bail us out again. However, it is
defeatist to conclude that the problems are too difficult
to confront and that all we can do is ease the pain.
We have the capacity to put together a workable pro­
gram of collective actions to deal with these common
problems. In general terms, the necessary ingredients
of such a program can be readily identified.
First, we must manage our domestic economy and
our currency better. We must avoid the kind of stop-go
policies that have tended to amplify the cyclical be­
havior of the economy. In particular, we must rid our­
selves of an inflationary bias that comes from stops
that are fairly short and from go periods that last too
long.
A firm commitment to eliminate inflation, along with
the biases that tend to sustain it, is essential. The
United States was built on a foundation of mutual trust
and consent. That foundation risks being eroded by
prolonged inflation. It gnaws away at the financial
assets that average citizens have painstakingly tried to
build up for themselves and their families. In the pro­
cess, inflation ridicules the saver and rewards the im­
patient. A country can go only so long pitting one
group against another— which of course is the very
essence of inflation— without tearing apart the fabric
of social cohesion that underlies democracy.
Moreover, no country can, for very long, maintain
its political influence around the world, maintain its
military credibility, protect its vital interests abroad,
or promote its ideals and principles if it must rely on
inflation as an expedient to avoid resolving competing

claims within its society. I wonder if we can seriously
expect other countries to take us, our power, or our
words seriously if we are incapable of self-restraint,
discipline, and constructive compromise at home.
These considerations also feed back on the dollar
in the exchange markets. I am convinced that the im­
pact on a currency of differential inflation rates among
countries is much more elemental and profound than
many believe. To be sure, the economic dynamics are
important. Excessive inflation starts by undermining
industrial competitiveness, then leads to deterioration
in trade, and inevitably to exchange rate weakness,
unless interest rates are high enough to pull in capital.

There have been fundamental changes in the
perceptions and policies of OPEC and its members.
Because of those changes, I cannot foresee any early
decline in the OPEC surplus or any meaningful
reduction of real oil prices. If anything, real oil prices
could go up further.

But I would appeal to a broader perspective. The
basic factor influencing the decision to buy or sell a
currency is whether the country issuing it can be
counted on to fulfill its end of the bargain. Chronic
inflation undermines the source of confidence which,
once lost or diluted, cannot easily be restored.
And so today we can no longer ignore international
developments as we decide on the proper course of
domestic monetary policy. We know from experience
that a falling dollar compounds our inflation problems,
worsens inflationary expectations, and further weakens
our ability to get support from those OPEC members
which are moderates toward oil price increases.
But now, a new factor has come into play. A re­
cession in the United States entails a slowing in credit
demands. Thus, there are fewer market pressures on
interest rates. This already had led to sharp declines
in short-term rates, and potentially could lead to
further declines. The market knows that since last
October 6 the Federal Reserve, in achieving its mone­
tary targets, has put greater emphasis on tracking
the reserve aggregates and less emphasis on main­
taining interest rates at any particular level. The mar­
ket knows this intellectually, but it seems to me there
is still an instinctive tendency on the part of many
traders to read Federal Reserve policy from the course
of short-term interest rates, rather than from what is
happening to money supply and credit creation.
This may be an unfortunate anachronism. Yet, it is
imbedded in market behavior, and we cannot dismiss
it as we seek to achieve reasonable stability for the




dollar. Once appropriate monetary and credit targets
are set, we cannot repel all market pressures toward
lower interest rates. But we should ensure that rate
declines are orderly and consistent with holding to
our monetary targets over a longer time. Moreover, no
one should forget that we have adequate means for
preventing exchange market instability as this process
develops. We have been, and are, prepared to use
those means whenever appropriate.
Experience shows that exchange markets eventu­
ally look beyond movements in short-term interest
rates to the economic fundamentals— our balance-ofpayments position and our inflation performance.
Confidence will be achieved on a permanent basis
only if we are able to convince the markets that we are
determined to maintain monetary discipline judiciously
over time. To do that, we must not move back and
forth between unsustainable restriction and unsustain­
able ease. Stop-and-go policies must go.
Second, from the international perspective, we must
work to maintain tolerable levels of world trade and
economic activity during the period of oil vulnerability.
That means we must work cooperatively with other
major countries and, within the context of the Inter­
national Monetary Fund, to make sure that the pattern
of deficits confronting protracted OPEC surpluses is
fair and appropriate. The burden should not be al­
lowed to fall excessively on any one country or group
of countries. And no country should pursue policies
designed to unload its deficits onto others. A failure
to harmonize our policies could gravely threaten the
prospects for maintaining trade and growth.

From the international perspective, we must work to
maintain tolerable levels of world trade and economic
activity during the period of oil vulnerability. That
means we must work cooperatively to make sure that
the pattern of deficits confronting protracted OPEC
surpluses is fair and appropriate. The burden should
not be allowed to fall excessively on any one country
or group of countries.

Right now, economic activity is still expanding in
most countries abroad, although more slowly than last
year. No signs of general recession have appeared.
However, inflation rates have been rising virtually
everywhere. Thus, a basic emphasis on monetary re­
straint continues to be reasonable. In my view, it is
the increase in inflation rates and the monetary re­
sponse to that increase which accounts for most of
the recent interest rate rise abroad. Only to a very
minor degree is there an element of validity in the

FRBNY Quarterly Review/Summer 1980

3

concern about so-called “ interest rate wars” for com­
petitive exchange rate appreciation.
But I believe it is of the upmost importance for
the authorities to avoid any temptation, or even the
appearance, of a competitive interest rate escalation.
The exchange markets are nervous and volatile. It
cannot be a contribution to stability to leave the im­
pression that monetary policy is directed toward nar­
row parochial objectives and is indifferent to the need
for cooperation and harmony. Indeed, since interest
rates in the United States have declined markedly, it
may now be timely for other countries to consider
whether their current rate structure is still appropriate.
In its surveillance of the adjustment process, the
IMF can play a special role to help prevent backsliding
into “ beggar-thy-neighbor” policies. We must all do
our part to reject inward-looking policies on interest
rates and exchange rates, as well as to resist protec­
tionist forces. Otherwise, we risk permanent harm to
the liberal trading environment that still forms the basis
for expanding world trade and adequate economic
growth. If that basis is undermined, any hopes we have
for reducing world inflation will evaporate. It is strong,
healthy competition in the marketplace that provides
the surest defense mechanism against the inflationary
biases in each of our domestic economies.
Third, we must assure that there is adequate financ­
ing for the deficits caused by the oil shock. Both
official and private sources of financing must be kept
open. There is no reason why commercial banks
should not continue to lend in sizable amounts, as long
as they perceive that countries are managing their
economies prudently and keeping deficits from getting
unsustainably large. The best way of assuring that con­
tinued flow is for the IMF to be in a position to meet
its responsibilities, providing balance-of-payments
financing conditioned on countries pursuing agreed
stabilization programs. To that end, the IMF must have
sufficient resources to lend, and that depends on
approval of proposed member quota increases. For us
to do our part and to maintain our influence in the
organization, the United States Congress should ap­
prove the legislation now pending to increase our
quota.
The quota increase is a necessary first step. Other
steps may be needed later to strengthen the IMF’s role
in the recycling process, either through new facilities
or new operating procedures. For example, the IMF
could supplement its own resources by borrowing
directly from OPEC members to lend additional funds
to countries pursuing stabilization programs.
But well before other options are considered, one
thing seems essential. As oil surpluses mount, the
OPEC members must respond by placing substantial
4

FRBNY Quarterly Review/Summer 1980




and increasing amounts of money directly with devel­
oping countries, particularly the ones without ready
access to private markets. OPEC cannot stand back
from the economic and financial consequences of Its
oil-pricing decisions by simply investing through finan­
cial intermediaries.
I see no reason why these investments could not be
structured so as to further the interests of individual
OPEC members in having a diversified portfolio.
Various types of instruments could be developed which
would provide features not ordinarily obtainable in
private financial markets. Imagination and experimen­
tation would be required. But that should be forth­
coming once OPEC members have recognized that
they bear responsibility for investing their surpluses
more broadly, and that to do so is in their own in­
terests.
Finally— and, from a long-term perspective, most
importantly— we need to build on the useful first steps
that have been taken to achieve a truly effective na­
tional energy policy. And our allies need to strengthen
their own efforts as well. The only credible way of
curing OPEC-caused deficits is to produce more energy
domestically, and to conserve significantly more energy
here and in all industrial countries.
Facing up to energy reality was an agonizingly slow
process, but now the basic consensus in favor of price
decontrol seems to be in place. We have already seen
results. Over the past year, the painful, but necessary,
increase in domestic crude oil prices has amounted to
almost 80 percent. As prices of final products have
risen, total United States petroleum consumption has
gone down by more than 10 percent, with industrial
consumption dropping more than 15 percent. And this
adjustment occurred even as the economy was still
growing. The recession should induce further conser­
vation efforts.

Finally— and, from a long-term perspective, most
importantly— we need to build on the useful first steps
that have been taken to achieve a truly effective
national energy policy.

But more must be done. I believe the United States
should provide strong leadership in helping develop
important new energy policies with our allies. The
Venice Summit should provide an opportunity to make
a start. We have to achieve substantial cutbacks in oil
consumption. To do so will require controversial and
painful measures. I have no illusions about the un­
popularity of such steps, or the natural reluctance even
to talk about them on the ground that they are politi­

cally not feasible. But we cannot close off discussion.
And we cannot be dogmatic about what may or may
not be politically feasible once a solid case is made
and strong leadership is applied.
Our objectives should be to take out of OPEC’s
hands the ability to force real oil prices higher, to
unblock OPEC restraints on oil production, and to retain
in our country the money that would otherwise be paid
as a tax to OPEC members in the form of higher oil
prices. The approach we should be considering can
justifiably be called “ domestic recycling” . Instead of

Our objectives should be to take out of OPEC’s hands
the ability to force real oil prices higher, to unblock
OPEC restraints on oil production, and to retain in our
country the money that would otherwise be paid as a
tax to OPEC members in the form of higher oil prices.

paying increasing taxes to OPEC, which merely proves
to them that we are addicted to their oil and will there­
fore pay even more heavily for it, we can pay taxes to
ourselves and recycle the proceeds domestically— to
support energy development, to encourage cost cutting
in industry, and to remove deeply rooted inflationary
biases from the economy.
Domestic recycling can be done in different ways.
The most obvious is through substantial excise taxes
on gasoline. To set in motion rapid adjustment, we
would have to announce a schedule of yearly in­
creases in those taxes— so much per gallon this year,
so much more the year after and the year after that.
Simultaneously, we would have to structure the do­
mestic recycling effort to neutralize most of the ad­
verse impact on the overall inflation rate, and to
assure that the burden of adjustment does not fall too
heavily on the weakest in our society. Clearly, the
task would be formidable.
But this kind of approach can work quickly. Higher
prices of oil products induce lower consumption; the
recent experience proves that the elasticities are there.
Moreover, the approach gives us the leverage to assure
that complementary conservation measures are adopted
at the same time by our allies. Oil demand could then
begin to drop sharply, hopefully beyond the amounts
that OPEC is prepared to counter with production cut­
backs. There is a good chance that the increasingly
heavy production declines that would be required to
keep the oil market from softening would seriously test
the determination of the cartel. That is a prerequisite




for shaking OPEC out of its present attitude that oil
prices will do nothing but rise in the future.
Equally important is to generate concrete progress
toward developing alternative energy sources. That
may well take much longer to achieve than reducing
consumption. But we must speed the process, and
that makes it all the more imperative to pursue do­
mestic recycling so that resources are available for
this national effort.
Clearly, taxes on domestic oil use would add to
measured inflation in the short run and the adjust­
ment process will be difficult. But by retaining these
tax revenues at home rather than paying them out to
foreign producers we can best ease the harmful ef­
fects of rising real oil prices. The domestic recycling
of these funds can provide several direct benefits to
our economy. To the extent they augment general
Government revenue, these funds would permit tax
cuts elsewhere and a less inflationary financing of
existing Government programs. Some of the revenues
could be directed to the weakest sectors of our econ­
omy and those most seriously affected by the higher
oil price to ease the adjustment burden. Also, tax
revenues recycled into alternative energy source de­
velopment or energy conserving investment would
both ease the adjustment burden by generating new
employment and more quickly reduce our dependence
on foreign oil. Finally, domestic recycling, to the ex­
tent that it reduces the resource drain to OPEC, im­
proves our balance of payments and relieves pressure,
both direct and indirect, on the dollar.
I recognize that the domestic recycling approach
initially would be painful. But the potential rewards
are worth the pain. It is far better to act now than to
acquiesce to continuously higher oil prices for the in­
definite future. And it is far better— for the United
States and for the world economy— to recycle the
wealth of our citizens at home rather than to transfer
that wealth to OPEC.
Some people fall back on cynicism when they look
at the outlook. Either things will take care of them­
selves, or they will be so bad that nothing much can
be done except to prescribe painkillers. I reject this
reasoning. Loosening the OPEC vise will take time but
can be done if we can adopt the decisive energy mea­
sures that are needed. Holding the world economy
together in the meantime can also be done, and done
fairly well, if we exercise discretion in our domestic
policies and cooperation in an international frame­
work. I will continue to work toward these goals, and
I hope you will too.

FRBNY Quarterly Review/Summer 1980

5

Chart 1

Economic indicators during the opening
months of 1980 signaled the beginning
of a recession . . .
Billions of 1972 dollars

The
business
situation
Current
developments

. . . and inflation began to ease in the
second quarter.
Percent (annual rates)

Sources: United States Department of Commerce,
Bureau of the Census; United States Department of
Labor, Bureau of Labor Statistics; and Bureau of
Economic Analysis, Business Conditions Digest.

6

FRBNY Quarterly Review/Summer 1980




In the opening months of 1980, the long-awaited
recession began. The sharp decline already evident in
the housing and automotive sectors spread rapidly
throughout the economy. As demand dropped, so did
production and employment. By late spring, capacity
utilization fell to the lowest level in four years, and the
unemployment rate, particularly among blue collar
workers, rose sharply. All in all, the economic data
released during the spring and early summer suggest
that the decline in economic activity in the second
quarter was one of the largest on record. Indeed, the
severity of the downturn prompted the National Bureau
of Economic Research to set January 1980 as marking
the onset of the recession. As business activity de­
clined, signs of a.significant easing in the inflation rate
began to appear in April, with both producer and con­
sumer price increases slowing from the very rapid
rates posted in the first quarter (Chart 1).
Nowhere were the signs of a recession more evi­
dent than in the housing and automotive sectors. Al­
though these sectors have been declining for some
time, in the late spring housing starts and domestic
automobile sales fell to levels comparable to the low­
est recorded in the 1973-75 recession (Chart 2). Re­
flecting the production cutbacks, unemployment in the
construction industry surged to 16.5 percent by June
and in the automobile industry to 25 percent. High fi­
nancing costs and, in some cases, reduced credit
availability had contributed to the declines in these
sectors.
Consumers have cut back on other purchases as well.
From January to May, retail sales excluding auto­
mobiles declined 5.7 percent in constant dollars. This
is in sharp contrast to 1979 when consumers con-

tinued to increase spending, despite falling incomes,
by borrowing more and reducing their rate of saving.
Now consumer behavior has shifted dramatically. The
savings rate increased to 4.5 percent in April from 3.7
percent in the first quarter, and during April and May
consumers reduced outstanding instalment debt by a
record $5.4 billion.
The weakening in consumer demand along with
the increasing certainty of a recession led manufac­
turers to curtail output sharply. Industrial production
declined steadily from January through June. Most
major market groupings posted sizable declines. Even
business equipment production, which had been strong
through March, showed some signs of weakening,
reflecting a cutback in new orders for capital equip­
ment.
As the economy entered the recession early in the
year, inventories appeared in rather good balance
with sales. In April, however, inventories rose sharply
while sales plummeted, and the constant dollar
inventory-sales ratio for manufacturing and trade
soared to a level approaching the maximum attained
in the 1973-75 recession. This sudden buildup in
inventories increases the likelihood that production
will be cut further until inventories are worked back
in line with sales.
The extent of unintended accumulation of stocks,
however, is likely to be much less severe than in the
1973-75 downturn. Despite the large increase in the
inventory-sales ratio in April, stocks have not swelled
nearly so much over the past year as occurred in the
comparable period of the 1973-75 recession. During
that time, firms continued to expand inventories be­
cause of shortages of materials and expectations of
rapidly rising prices. Also, many businesses expected
the downturn to be short-lived. In contrast, during 1979
and early 1980, businesses were very sensitive to in­
ventory levels because of high financing costs and ex­
pectations of a decline in demand. As a result, firms
have been adjusting stocks much sooner than in the
previous recession. Reflecting this, the overall decline
in output is likely to be concentrated in the early part
of the downturn.
With firms cutting production to avoid accumulating
large stocks of inventories, unemployment has risen
sharply. The unemployment rate increased to 7.7 per­
cent in June from 6 percent in February. For blue col­
lar workers, whose joblessness is more cyclically sen­
sitive, the unemployment rate rose almost 4 percentage
points from February to June to a level of 11.5 percent,
the highest rate posted since early in the 1975 recov­
ery. Total employment declined precipitously by almost
one and a half million from February to June, and the
average workweek edged down as well— all pointing




Chart 2

The sharp decline in business activity
was led by the housing and automotive
sectors . . .
Millions of units
H ous ing sta r ts

J

A\
\

.iiliiliilii iiL in lii liliiliiin lillllllll] iliiiJ lilu lllllllllll lllllllllll

iilnJ

Millions of cars

. . . and unem ployment in these
industries surged.
Percent

Sources: United States Department of Commerce, Bureau
of the Census; United States Department of Labor, Bureau
of Labor Statistics; and Board of Governors of the
Federal Reserve System.

FRBNY Quarterly Review/Summer 1980

7

to a large decrease in income during the second quar­
ter. This sharp drop in employment early in the down­
turn is in marked contrast to the 1973-75 recession
when employment was maintained during the early
stages of the downturn as firms continued building in­
ventories.
The weakness in the labor market was mirrored by the
drop in capacity utilization during the opening months
of 1980. Capacity utilization, as measured by the Fed­
eral Reserve Board’s manufacturing index, fell sharply
during the second quarter. Since peaking in March 1979
at a level just below the maximum attained in 1973, ca­
pacity utilization has declined about half of the peak-totrough drop of 19 percentage points that occurred dur­
ing the 1973-75 recession.
Along with the recent decline in economic activity
has come some relief from the rapid rate of inflation.
Producer prices slowed to an average annual rate of
6.2 percent in April, May, and June, compared with an
18 percent rate of increase in the first three months of
1980. The easing in producer prices, coupled with
declining mortgage rates, should result in a slowing
of inflation at the consumer level as well over the
next several months. Already in April and May the
rise in consumer prices showed some signs of mod­
erating, but this was largely the result of a marked
slowing of energy prices.
The 1980 recession began with a sharp contraction
in economic activity, raising the question of how the
overall downturn will compare with the 1973-75 de­
cline. In that recession, output dropped by the largest
amount in the postwar period. There are important dif­
ferences, however, that suggest the current recession
will be less pronounced. The most important differ­

8

FRBNY Quarterly Review/Summer 1980




ence is the rapid decline in interest rates since late
April. As a result, deposits at thrift institutions— the
primary source of financing for the housing market—
have strengthened somewhat following only very weak
growth earlier this year. At the same time, the average
cost of deposits for these institutions has dropped
sharply from the extremely high levels during the first
quarter. Reflecting the recent easing in the cost of
funds to thrift institutions as maturing six-month cer­
tificates are rolled over at far lower rates, mortgage
rates began to decline laying the groundwork for a
recovery in housing. With inventories of unsold homes
at relatively low levels, any strength in demand should
translate fairly quickly into new production. A turn­
around in this sector along with the elimination of
the March 14 credit control program could lead to
some strengthening in the demand for other consumer
durables as well. Also, consumption could be bolstered
somewhat during the summer months by the large in­
crease in social security benefits resulting from a costof-living adjustment for the rapid rise in the consumer
price index over the past year.
Lower interest rates will contribute to a turnaround
in the business sector as well. Because financing de­
mands have not been increased significantly as a result
of a large buildup of inventories, short-term credit is
readily available either at banks or in the commercial
paper market. Moreover, capital spending may not
weaken all that much. Most businesses had allowed for
a recession in their long-range plans. With financing
available in large amounts in the bond market again,
many firms are likely to proceed with those plans—
although at a reduced pace in some cases— despite
the current downturn in business activity.

Chart 1

With M-1B below the FOMC’s o bjective s . . .
Billions of dollars

The
financial
markets
Current
developments

1979

1980

. . . and w ith M-2 close to the lower bound
during the spring . . .
Billions of dollars
1600
M2
9.0 percent
Upper bound

^

1580

1560
/

-

^ X
Actual

1540
6.0 percent
Lower bound

1520

1500

I

.......................................................

I
Nov
Dec
1979

Jan

Feb

Mar
Apr
1980

May

Jun

. . . short-term interest rates plummeted
from th e ir peaks.
Percent

Nov
Dec
1979

Jan

Feb

Mar
Apr
1980

May

Source: Federal Reserve Bank of New York and the
Board of Governors of the Federal Reserve System.




Jun

Financial market developments during the spring and
early summer were dominated by the unexpectedly
severe downturn in business activity. After surging to
all-time highs earlier in the year, money market interest
rates plummeted in the second quarter as the demand
for money and short-term credit contracted along with
economic activity. Long-term rates also plunged, as the
bond markets rebounded vigorously from the chaotic
conditions of March. Borrowers took advantage of the
lower long-term yields in May and June by issuing
massive volumes of new bonds. Around mid-June,
however, rates in both the money and the bond markets
showed signs of backing up somewhat.
With the demand for bank credit softening, the credit
restraint program instituted on March 14 was gradually
phased out. In early May, the Federal Reserve System
eliminated the 3 percent surcharge on certain discount
window borrowings by large banks. Later in the month,
the Federal Reserve Board partially dismantled the
credit controls— principally by halving the special de­
posit requirements and easing the reporting rules
for various large financial and nonfinancial institutions.
Then in early July, the Federal Reserve Board an­
nounced plans to complete the phase-out of the spe­
cial credit restraint program by the end of that month
and to eliminate the 2 percent supplementary reserve
requirement imposed in November 1978 on large time
deposits of member banks. Meanwhile, in two separate
steps, the Federal Reserve lowered the discount rate
from 13 percent in late May to 11 percent in mid-June.
As the weakening economy undercut the demand for
money, the Federal Reserve continued its efforts to
supply enough reserves to achieve the 1980 objectives
of the Federal Open Market Committee (FOMC) for
the growth of the money stock, and short-term inter-

FRBNY Quarterly Review/Summer 1980

9

est rates tumbled from the all-time highs reached
earlier in the year (Chart 1). After reaching 16 percent
at the end of March, for example, the rate on threemonth Treasury bills fell almost continuously to less
than 7 percent by early June— far below the 10.4 per­
cent rate recorded the week before the Federal Re­
serve’s October 6 policy initiatives. Around the middle
of the month, however, the Treasury bill rate started
to rise, climbing more than 11A percentage points over
the next two weeks. Other money market rates paral­
leled the movements in the Treasury bill rate.
In response to the lower cost of funds, commercial
banks have cut prime lending rates, which had peaked
at 20 percent in the first half of April. By early July,
the prime lending rate had been reduced to 11V2 per­
cent, but it was about 3 percentage points above the
rates on commercial paper or certificates of de­
posit (CDs)— a much larger spread than usual. Ap­
parently, banks are trying to protect their profit
margins. The rates on existing as well as on new bank
loans are generally linked to the prime lending rate.
Thus, in a recession when loan demand is weak, a
decrease in the prime lending rate will not generate
enough new loan demand to compensate for the loss
in earnings on the portfolio of existing loans. More­
over, insofar as banks’ liabilities consist of money
market certificates or CDs which were issued several
months earlier, the average cost of funds for commer­
cial banks tends to lag behind prevailing market rates.
Prompted by the wide spread between the prime
rate and the commercial paper rate, many corpora­
tions borrowed short-term funds in the commercial
paper market rather than from banks. From April 2
to June 25, the amount of commercial paper issued
by nonfinancial companies rose $5.3 billion whereas
bank loans (including loans sold to affiliates but ex­
cluding bankers’ acceptances) declined $4.8 billion.
While the demand for short-term credit languished,
activity in the longer term debt markets has been
robust. Just last March, the bond market had al­
most totally collapsed as investors, alarmed by the
sudden flare-up in inflation and afraid that it would
worsen, abandoned the market. Since then, however,
the capital markets have rebounded. Indeed, assuaged
by the mounting evidence of recession and a slowdown
in inflation, inflationary expectations eased and in­
vestors showed renewed interest in longer term issues.
In response to the vigorous bidding, long-term yields
backed off sharply from the record heights of
March. Rates on five-year and twenty-year Govern­
ment issues fell as much as 4 and 21A percentage
points, respectively, from the end of March to early
May. With short-term rates dropping even more sharp­
ly, the yield curve resumed an upward slope for the

10

FRBNY Quarterly Review/Summer 1980




Chart 2

Long-term yields declined . . .
Percent
14

Aaa-rated
corporate bonds
(Moody’s )'

Twenty-year
Government securities*

State and local
government bonds
(Bond Buyer Index)

1979

1980

. . . and the volume of new bond
issues soared.
Billions of dollars
10

Municipal

1980
Data on new bond issues in April, May, and June
1980 are preliminary.
*T h is yield is adjusted to twenty-year maturities and
excludes bonds with special estate tax privileges.
Sources: Federal Reserve Bank of New York, Board of
Governors of the Federal Reserve System, Moody’s
Investors Service, Inc., and The Bond Buyer.

first time since the end of 1978. Similar rallies occurred
in the markets for corporate bonds and tax-exempt
securities.
As long-term yields have fallen, the volume of new
bond issues has ballooned (Chart 2). New corporate
bond offerings surged to $7.5 billion in May and $8.2
billion in June, many times larger than those issued
during February and March when the debt markets
were in extreme disarray. Companies are evidently
using the proceeds from their bond issues in large
part to repay their short-term borrowings. Around
mid-June, however, the market began to show signs of
strain under the continuingly heavy flow of new issues.
In the tax-exempt market, the volumes of new bond
issues for May and June were also much greater than
those of February and March. Many of these issues
had been postponed earlier in the year when interest
rates had risen to such high levels that they actu­
ally exceeded the statutory ceilings at which some
state and local governments were permitted to
borrow.
The mortgage market also showed signs of renewed
life with the reflow of deposits into thrift institutions.
In March and early April, faced with sharply rising
interest rates, the thrift institutions were offering mort­
gage commitments at rates which averaged about 161/2
percent— up about 31/2 percentage points since the
start of the year. Few potential home buyers actually
took commitments at those rates, and the outstanding
commitments of the thrift institutions declined by al­
most 30 percent over the first four months of the year.
By May, however, the situation had begun to improve.
Investors reacted to the steep decline in short-term
rates by shifting funds away from Treasury bills and
six-month money market certificates and into passbook
accounts and thirty-month special floating-ceiling ac­
counts (the so-called small saver certificates) offered
by the thrift institutions. Savings inflows strengthened
while withdrawals eased, and mortgage rates plunged.
By early June, the prevailing rate on new commitments
stood at 131/2 percent.
Overshadowed to some extent by the stunning swings




in interest rates was the enactment on March 31 of the
Depository Institutions Deregulation and Monetary Con­
trol Act of 1980. This new law is a legal milestone
which will greatly overhaul the structure of the United
States financial system (box). Under the new legal
framework, financial institutions will look and function
much differently than they do today. For instance, the
Federal Reserve System is accorded a more central role
within the financial structure inasmuch as certain provi­
sions of the new law extend reserve requirements to
cover all depository institutions. The new reserve re­
quirements are to be gradually phased-in over a period
of eight years for financial institutions that are not
members of the Federal Reserve System and over four
years for member banks. At the same time, nonmember
depository institutions were also given access to the
Federal Reserve’s discount window.
Other provisions of the new law will improve the
competitive balance among financial institutions. The
Regulation Q ceilings on interest rates paid by financial
institutions are to be entirely removed by March 31,
1986. In the interim, the newly created Depository
Institutions Deregulation Committee (DIDC) will pre­
scribe rules for the payment of interest. Still other pro­
visions of the new omnibus law eliminate or liberalize
the restrictions on the lending activities of Federally
chartered savings and loan associations and mutual
savings banks.
In its brief tenure, the DIDC has promulgated several
new rulings on interest rates. One of its rulings revised
the schedule of ceiling rates on six-month money mar­
ket certificates (MMCs). Under the new schedule effec­
tive June 5, the ceiling rates that commercial banks
and thrift institutions may pay on their MMCs are equal
when Treasury bill rates are either above 8 % percent or
below 7 1/4 percent. In addition, MMCs now carry a slight
premium over the Treasury bill rate, thus making MMCs
more attractive to certain kinds of investors. Another
of the DIDC’s rulings raised the interest rates that com­
mercial banks and thrift institutions may pay on their
small saver certificates-in relation to the prevailing rate
on Treasury two and one-half year securities.

FRBNY Quarterly Review/Summer 1980

11

Highlights of the Depository Institutions Deregulation and Monetary Control Act of 1980
Monetary Control Act
To facilitate control of the monetary aggregates, the
Board of Governors can require all depository institu­
tions (commercial banks, savings banks, savings and
loan associations, and credit unions) to submit directly
or indirectly reports of assets and liabilities.
Each depository institution must maintain reserves
against transaction
accounts— demand, negotiable
order of withdraw al (NOW), share draft, deposits sub­
je ct to autom atic and telephone transfer— in a ratio of
3 percent for amounts of $25 m illion or less and,
initially, 12 percent for amounts in excess of $25
m illion. The statutory range for amounts in excess of
$25 m illion is 8 percent to 14 percent. Reserves on
nonpersonal time deposits must be held initially at a
ratio of 3 percent. The legal range is 0 percent to 9
percent.
The $25 m illion level of transaction accounts will be
adjusted annually by the Board depending on the
growth of the total level of transaction accounts
nationwide.
If five Board members find that extraordinary circum ­
stances exist, the Board may, after consultation with
Congressional banking committees, alter reserve ratios
from the statutory ranges fo r renewable 180-day
periods.
Five Board members also may impose a supplemental
reserve requirem ent of up to 4 percent on an institu­
tio n ’s transaction accounts.
The supplemental reserves may be held as vault cash
or placed in an “ earnings participation account” , which
will earn interest at a rate not exceeding what the Sys­
tem open market account portfolio earned during the
previous calendar quarter. No interest w ill be earned
on supplemental reserves in the form of vault cash.
The Board may impose reserves on any depository
institution’s borrowings from its foreign offices, loans
to United States residents by its foreign offices, and
assets purchased by its foreign offices from its do­
mestic offices.
Reserve requirements for nonmember depository

12

FRBNY Quarterly Review/Summer 1980




in­

stitutions will be phased-in evenly over seven years.
Starting September 1, 1987, all nonmember depository
institutions, except those in Alaska and Hawaii, w ill be
subject to full reserve requirements. But reserves will
be required immediately for any new types of deposits
or accounts authorized by Federal law after April 1,
1980. The necessary adjustments in reserve require­
ments fo r member banks will be phased-in over a threeyear period.
Reserves must be in the form of Reserve Bank bal­
ances, but also, with Board consent, may be vault cash.
Nonmembers may keep balances with correspondents,
a Federal Home Loan Bank, or the National Credit
Union Adm inistration Central Liquidity Facility, if those
institutions maintain balances at Reserve Banks.
Depository institutions with transaction accounts or
nonpersonal time deposits are entitled to the same
discount window privileges as member banks.
The Board must publish fo r comment a set of pricing
principles and a proposed schedule of fees for Reserve
Bank services by September 1, 1980. By September 1,
1981, the Board must begin to put a schedule of fees
for services into effect.

Depository Institutions Deregulation A ct
The act provides fo r the phase-out of lim itations on
interest and dividend rates paid by depository institu­
tions by extending the authority to impose such lim ita­
tions for six years, subject to specific standards
designed to ensure the ir replacement by market rates.
During the six-year period, the 1/4 percent interest rate
differential payable on certain accounts by commercial
banks and th rift institutions continues.
A new Depository Institutions Deregulation Committee
(DIDC) w ill asume authority to prescribe rules for pay­
ment of interest.
Voting members of the DIDC are the secretary of the
Treasury, the chairman of the Board of Governors, the
chairman of the Board of the Federal Deposit Insurance
Corporation (FDIC), the chairman of the Federal Home
Loan Bank Board, and the chairman of the National

Credit Union Adm inistration (NCUA) Board. The Comp­
trolle r of the Currency is a nonvoting member.
The DIDC must exercise its authority to provide fo r the
phase-out and ultimate elim ination of interest and divi­
dend rate ceilings as rapidly as permitted by economic
conditions.
The DIDC must increase all interest and dividend rate
ceilings to market rates as soon as feasible during the
six-year period following March 31, 1980.
W ithin eighteen months of March 31, 1980, the DIDC
must vote on at least a Va percent increase in the
passbook account limit. It must vote on a Vz percent
increase in the lim it on all accounts not later than the
end of the third, fourth, fifth, and sixth years after
March 31, 1980.

Consumer Checking Account Equity Ac!
Member banks and FDIC-insured nonmember banks
may continue to provide automatic transfers from sav­
ings to checking accounts.
NOW accounts w ill be permitted nationwide Decem­
ber 31, 1980 at all depository institutions fo r individuals
and certain nonprofit organizations.
Federally insured credit unions are authorized to offer
share draft accounts.
Federal deposit insurance at comm ercial banks, sav­
ings banks, savings and loan associations, and credit
unions is increased to $100,000 per account.
Federal credit unions can make residential real estate
loans on residential cooperatives.

Up to 20 percent of the assets of a Federal savings
and loan association may consist of consumer loans,
com m ercial paper, and corporate debt securities.
Federal savings and loan associations may make real
estate loans w ithout regard to the geographic area, as
well as acquisition, development, and construction
loans.
Federal savings and loan associations may issue credit
cards.
Federal savings and loan associations may exercise
trust and fiduciary powers.
A Federal mutual savings bank may have up to 5 per­
cent of its assets as com m ercial, corporate, and busi­
ness loans, if the loans are made only within the state
where the bank is located or within seventy-five miles
of the bank’s home office.
A Federal mutual savings bank may accept demand
deposits in connection with a commercial, corporate,
or business loan relationship.
State Usury Laws
Effective April 1, 1980, state residential first-m ortgage
real property, co-op, and m obile home usury ceilings
were rendered inapplicable, unless prior to April 1,
1983 a state adopts a new usury ceiling or certifies
that its voters have voted in favor of or to retain the
state constitutional provision imposing a usury ceiling.
A state may adopt a law placing lim itations on discount
points or other charges on residential real estate, co­
ops, and mobile homes.

A Federal credit union can charge up to 15 percent
annually on loans. The NCUA Board may establish a
higher loan interest ceiling fo r periods not to exceed
eighteen months.

Between now and April 1, 1983, unless state law pro­
vides otherwise, a lender may charge an interest rate of
not more than 5 percent in excess of the basic Federal
Reserve discount rate (including any surcharge) on busi­
ness and agricultural loans in amounts of $25,000 or
more, in states where the usury loan rate is lower than
that rate.

Powers of Thrift Institutions
Federal savings and loan associations may invest in
shares or certificates of open-end investment com­
panies registered with the Securities and Exchange
Commission, if the portfolio of the investment company
is restricted to certain investments that savings and
loan associations may invest in directly.

Federally insured state-chartered com m ercial and mutual
savings banks, branches of foreign banks, savings and
loan associations, credit unions, and small business in­
vestment companies may charge interest on loans at a
rate equal to 1 percentage point above the basic
Federal Reserve discount rate. This excludes any sur­
charge imposed by a Reserve Bank.




FRBNY Quarterly Review/Summer 1980

Reforming New York City’s
Property Tax:
Issues and Options
In 1975 the New York State Court of Appeals upheld
the state law requiring property to be assessed at full
market value for tax purposes.1 Prior to the ruling, few
localities had been enforcing this standard. In fact, in
many communities residential properties were assessed
at a lower fraction of market value than were nonresidential. The switch to “ full value” assessment since
1975 has been slow. To date, only a small part of the
state’s real estate has been brought into compliance. In
addition to the high cost of revising the property tax rolls,
communities are reluctant to make a major tax change
when it is possible the state legislature will amend the
law. Since the property tax accounts for over two out
of every three dollars of locally raised revenues in the
state, the potential tax reallocations are of major im­
portance to taxpayers. The ramifications of the court’s
decision are readily illustrated by examining New York
City which annually raises more than $3 billion in rev­
enues through its property tax.2 Such an examination
1 Hellerstein v. Assessor of Islip, 37 N.Y. 2d 1, 332 N.E. 2d 279,
371 N.Y.S. 2d 388 (1975).
* This examination of New York City’s property tax was based on
property sales from July 1, 1977 to June 30, 1978. After making
adjustments to the data recorded by the city to allow for only trans­
actions that appeared indicative of "true” market prices, there were
close to 26,000 sales. The procedures used, as well as the short­
comings of the resulting data, are discussed in technical appendixes
to the report filed by this author with the city’s Business Tax Task
Force and the Department of Finance. Although there seems little
reason to doubt the overall findings of the study regarding dispersion
in effective tax rates, data limitations suggest that caution should be
exercised in relying on any particular number as a precise estimate.

FRBNY Quarterly Review/Summer 1980
Digitized 14
for FRASER


also provides a basis for evaluating the relative advan­
tages of the various alternative ways to reform the
property tax.

Complying with the law
State law calls for all property to be assessed at full
market value and to be taxed at the same statutory rate.3
Because tax liability is determined according to the
property’s assessed value, such a uniform tax sys­
tem means that every property is subject to the same
effective tax rate, i.e., the same taxes per dollar of
market value.
Current property tax practices In New York City con­
trast sharply with these requirements of state law.4
Properties in the city are assessed at differing percent­
ages of market value. These assessment variations, in
turn, produce wide differences in effective tax rates,
particularly between residential and nonresidential
properties. For example, the property taxes paid by
owners of single-family houses in the city are only
about half of what they would be if the property tax
3 N.Y. Real Property Tax Law, § 306.
4 As a result of a recent court ruling, there is now a question of
whether the provision of New York State's Real Property Tax Law re­
quiring "full value” assessments governs in New York City. The court
found the appropriate standard to be the one embodied in the city’s
Administrative Code. Colt Industries Inc. v. Finance Administrator and
Tax Commission of the City of New York, 183 N.Y.L.J. 108 (Sup. Ct.,
New York Co., June 4, 1980), pages 10-11. If this decision stands,
then the city will not need any further legislation to implement a
classified system as discussed in the text.

were levied on the basis of market values (Chart 1).
At the other extreme, owners of office buildings tend
to pay a relatively large share of taxes— over 60 percent
more than they would if the tax burden were distributed
according to actual property values. These and other
disparities in effective tax rates mean that a switch to a
uniform tax system would result in a major reallocation
of the tax load among the different property groups. The
size of these tax shifts underscores the potential for
economic disruptions from the court’s mandating of
full market value assessment.
Not only do effective tax rates in New York City
differ by property type, but they also differ by borough.
For example, single-family houses in Manhattan are
assessed on average at a much higher percentage of
market value than houses in other boroughs. In fact,
Manhattan appears to be the most heavily taxed bor­
ough overall (Chart 2). Consequently, a switch to a
uniform tax system would reduce the share of taxes
paid by owners of Manhattan properties by some 30
percent. At the opposite end of the scale, Staten Island
property owners would face a two-thirds increase since
they now pay only a fraction of their proportional share.
Part of the sharp divergence in the effective tax rates
paid in the two boroughs is due simply to differing

property mixes. Manhattan contains a large proportion
of office buildings which are relatively heavily taxed,
while Staten Island consists largely of houses which
are relatively lightly taxed. However, after taking ac­
count of these differences, there is still a wide gap
among the boroughs (Chart 2). One striking feature of
adjusting for the differing properties in each borough
is the change in the relative position of the Bronx.
Rather than appearing to be taxed at about the citywide average, this borough turns out to be taxed at an
effective tax rate almost as high as Manhattan’s.
A switch to a uniform tax system would do more than
change real estate taxes; it would likely affect prop­
erty values. Increases in taxes tend to lower the de­
mand for a property, thus depressing its market price.
This in turn leads to a downward readjustment in
assessed value, which offsets part of the initial tax
increase. The opposite happens for those properties
experiencing a tax reduction. Thus, with a reallocation
of taxes, the owner may receive a capital loss or gain
which is then realized when the real estate is sold.5
5 The tax shift estimates presented assume that a property’s
market value is unaffected by the level of taxes. Factoring in changes
in market value has only a relatively small impact on the size of
the tax shifts.

Chart 1

Effective Property Tax Rates Vary W idely Across Building Types
Effective tax rates fo r selected building types
relative to cityw id e average
50% above

Citywide
average

50% below —

Source:

Estimates derived by the author from data furnished by the New York City Department of Finance.




FRBNY Quarterly Review/Summer 1980

15

Other alternatives
To avoid the enormous tax shifts associated with full
market value assessment, the state legislature has a
number of options to modify the present property tax
law.6 The simplest and most direct way to lessen the
tax shifts among property groups is to establish a
classified tax system. Under this scheme, properties
are divided into selected tax groups. The assessment
standard or tax rate can then be adjusted to the
current effective tax rate so that the total taxes paid
by each group of properties are unchanged. Thus, the
share of total taxes borne by single-family houses in
New York City could be kept from rising by treating
these houses as a separate property class.
Another option available to hold down the taxes
paid by homeowners is to combine a homestead ex­
emption program with a uniform tax system. This would
allow each homeowner to exempt the same fixed
amount of the assessed value of the property from
taxation. Taxes are then paid only on the assessed
value of the property in excess of the exemption. Such
a tax program, however, dramatically affects the dis­
tribution of taxes within this group. Unlike a classified
tax system in which all properties within a class pay
at the same effective rate, the more valuable proper­
ties pay taxes at effective rates much higher than the
present average. The degree of progressivity with re­
spect to assessed real estate values varies with the
size of the exemption. In New York City the exemption
would have to be very large— about half the average
assessed values of houses— in order to prevent any
increase in taxes on homeowners as a group. With such
a large exemption, the resulting tax would be highly pro­
gressive.
A similar program, also introducing some element
of progressivity to the tax system, is the circuit
breaker. Named after its electrical counterpart, it limits
homeowners’ taxes by providing credits that can be
applied against other taxes (usually against the state
income tax).7 The main difference between the circuitbreaker program and the homestead exemption is that
the tax relief under the circuit breaker is contingent on
property taxes exceeding some percentage of the
homeowner’s income. Thus, even for two properties of
equal assessed values, the property tax for the owner

* Because little is known at present about how property and other taxes
now levied in New York City affect economic decisions, the analysis in
the text of the various options for reform does not rely on any
theoretical model of an optimal tax system but focuses solely on the
question of tax shifts.
7 New York State now offers a limited circuit-breaker program. The
maximum credit available is $200 for the elderly poor and $20 for
other low-income households.

Digitized for
16 FRASER
FRBNY Quarterly Review/Summer 1980


Chart 2

E ffective property tax rates vary
across boroughs . . .
Boroughwide effective tax rates relative to
citywide average
50% above — —

------------------------------------------------------

Citywide
average

50% below

. . . even after allow ing for differences
in property mix.
Effective tax rates for each borough computed
by using the citywide mix of properties
50% above -------------------------------------------------------------------------

Citywide
average

50% below

Source: Estimates derived by the authbr from
data furnished by the New York City Department
of Finance.

with the lower income may be at a lower effective,
after-credit rate. In this way, a circuit-breaker program
causes the property tax to be progressive with respect
to income.
Another way to limit property tax increases is to find
a substitute for some or all of the revenue now raised
by this tax. However, since adoption of this alternative
by New York City could result in a major realignment
of its overall taxes, careful study is required. The
effects of the new taxes may not be any less harmful
than those resulting from going directly to a uniform

tax system. As an example of the magnitude of the
revenues involved, take the case of single-family home­
owners. To prevent taxes from more than doubling on
this group, the city would have to cut its reliance on
the property tax by more than half, thus forcing it to
replace some $1 1/2 billion or one fifth of its locally
raised funds.
A different approach to the problems posed by
full market assessment is to minimize its adverse
effects simply by easing the transition. Relief to the
taxpayer can be provided in at least two ways: (1) the in­
crease can be phased-in to give the taxpayer time to
adjust or (2) part or all of tax payments can be deferred
until the property changes hands.
However, the more substantial the tax shifts, the less
attractive these programs become from the point of
view of both the city and the taxpayers. With a phasein, the larger the increase, the larger will be some or
all of the steps. To hold down annual jumps, the city
would have to lengthen the transition period. For ex­
ample, to keep the annual tax increase for homeowners
as a group to 10 percent or less, a uniform tax would
have to be phased-in over eight years. The longer the
period, however, the longer the initial disparities are
perpetuated. Furthermore, since tax decreases are
likely to be granted immediately and thus not phasedin, collections from the property tax will drop tempo­
rarily. The revenue loss will most likely be made up by
raising other taxes.
For the deferral of tax payments to be effective, eli­
gible taxpayers, usually limited to the elderly, must
accept a tax lien against their property as an alternative
to selling their property. Thus, the larger the tax in­
crease, the greater the ultimate size of the encumbrance
and hence the less the appeal of this alternative. After
all, for most people a house is a major asset and an
important source of security.
More than classification is needed
Preventing any reallocation of property taxes re­
quires each property now taxed at a different effective
rate to be in a separate class. However, there are prac­
tical limits on the number of classes that can be es­
tablished.8 Therefore, it may not be possible to elim­
inate all tax shifts through classification. In fact, this
8 The number of classes is limited by administrative, legal, and political
considerations. The larger the number of classes, the more difficult
it would be for the assessors to make the distinctions required.
Record-keeping problems would also multiply as classes abound.
Furthermore, as the bases for drawing the lines become more
intricate, they become more vulnerable to legal challenge as violat­
ing the equal protection provisions of the state and Federal
constitutions. Also, by allowing a large number of classes, the
legislature would open itself up to pleas from every special interest
group for favorable treatment.




seems to be the case in New York City where even
similar properties are taxed at different effective rates.
This dispersion in effective tax rates is readily illus­
trated by examining the range of assessment ratios—
assessed value over market value— for single-family
houses in Brooklyn. Most of these properties have as­
sessment ratios around 20 percent, i.e., the assessed
value is approximately one fifth of the market value.
However, the range is wide. As a result, many proper­
ties are taxed much more heavily than others. For
example, over one sixth of the properties are assessed
at more than 30 percent of their market values. These
properties pay effective tax rates that are at least twice
those of the 9 percent of the houses assessed at less
than 15 percent of their market values (Table 1). This
lack of uniformity can be measured by the coefficient
of dispersion. The United States Bureau of the Census
recognizes a coefficient of 0.20 as indicative of un-

Table 1

Distribution of Assessment Ratios for
One-Family Houses in Brooklyn
Total number of sales: 2,166

■ ■' ; ;

'

Percentage
Assessment ratios*------------------------------ of total

--------------------------------- ---

Cumulative
distribution
(in percent)

..

0.10-0.11 ........................................
0.11-0.12 ........................................
0.12-0.13 ........................................
0.13-0.14 ........................................
0.14-0.15 ........................................
0.15-0.16 ........................................
0.16-0.17 .......................................
0.17-0.18 ........................................
0.18-0.19 ........................................
0.19-0.20 ........................................
0.20-0.21 ........................................
0.21-0.22 ........................................
0.22-0.23 ........................................
0.23-0.24 ........................................
0.24-0.25 ........................................
0.25-0.26 ........................................
0.26-0.27 ........................................
0.27-0.28 ........................................
0.28-0.29 ........................................
0.29-0.30 ........................................
0.3-0.4 ............................................
0.4-0.5 ............................................
0.5-0.6 ............................................
0.6-0.7 ............................................
0.7-0.8 ............................................
0.8-0.9 ............................................
0.9-1.0 ............................................
.0-2.0 ............................................

0.4
0.9
1.6
2.5
3.4
4.6
6.0
6.7
8.4
6.1
7.4
6.9
5.0
5.0
4.4
4.2
2.7
2.4
2.1
1.8
9.3
3.0
1.9
1.1
0.6
0.4
0.3
0.7

0.4
1.3
2.9
5.4
8.9
13.4
19.5
26.2
34.6
40.7
48.1
54.9
60.0
65.0
69.4
73.6
76.3
78.7
80.8
82.6
92.0
95.0
97.0
98.0
98.6
99.0
99.3
100.0

Assessed value divided by market value.
Source: Estimates derived by the author from data furnished
by the New York City Department of Finance.

FRBNY Quarterly Review/Summer 1980

17

Table 2

Coefficients of Dispersion*
By major building type and borough
Building type

Manhattan

The Bronx

Brooklyn

Queens

Staten Island

One-family houses ........................................
Two-family houses ........................................
Walk-up apartments ......................................
Elevator apartments ......................................
Warehouse buildings ...................................
Factory buildings ..........................................
Garages ..........................................................
Hotels ...............................................................

.....................
.....................
.....................
.....................
.....................
.....................

0.35
0.35
0.40
0.30
0.46
0.47

0.34
0.33
0.53
0.24
0.45
0.42
0.78

0.34
0.40
0.46
0.23
0.34
0.38
0.51

0.24
0.31
0.35
0.20
0.39
0.32
0.54

0.27,
0.26
0.55

.....................

0.41

Store buildings ..............................................
Loft buildings ................................................
Office b u ild in g s ..............................................
Condominiums ................................................
Vacant la n d ......................................................
Miscellaneous ................................................

.....................

0.34

t
t
0.52

t
t
0.40

t
t
0.39

t
t
0.67

.....................
.....................
.....................
.....................

0.37
0.23
0.55
0.46

t
t
0.13
0.97
0.70

t
t
t
0.77
0.58

t
0.38
0.15
0.84
0.41

t
t
t
0.80

t
t
t
0.73

t

* The coefficient of dispersion measures the deviation of the individual assessment ratios from the average assessment ratio
for the group as a whole. It is computed by dividing the average amount of these deviations by the average assessment ratio,
thereby making it useful for comparing degrees of dispersion between groups with different average ratios. A coefficient of 0.20
or above is considered indicative of unacceptable assessment practices by the United States Bureau of the Census.
t No coefficients of dispersion shown because of only ten or fewer observations.
Source: Estimates derived by the author from data furnished by the New York City Department of Finance.

acceptable assessment practices. The coefficient for
these Brooklyn properties was considerably higher
at 0.34.
Similar degrees of dispersion exist within virtually
all property groups in the city (Table 2). In only two
cases does the coefficient fall below the acceptable
level of 0.20, and in most cases it ranges far above it.
The message is clear: there are wide variations in the
effective tax rates paid on similar properties.
The variation in assessments within a real estate
class limits the effectiveness of a classification scheme
to prevent tax shifts. Since each property cannot be
assigned its own class, individual taxpayers will still
face tax changes. However, the changes in taxes under
a classified system are in general less extreme than
those caused by a switch to a uniform tax. In some
cases the tax change may actually be in the opposite
direction. For example, taxes on properties now as­
sessed at ratios above the citywide average but below
the average for their class will rise instead of fall. As
an example, if factory buildings were assigned a sep­
arate class, one fifth of them would face a tax increase
of 50 percent or more. In contrast, since the average
assessment ratio for factory buildings now exceeds

18

FRBNY Quarterly Review/Summer 1980




the citywide average, the switch to a uniform tax sys­
tem would result in major tax increases for only a few
of these buildings. Indeed, the group as a whole would
benefit from a 23 percent tax reduction.
Since classification cannot moderate, let alone elim­
inate, all tax increases on property in New York City,
additional tax relief seems appropriate. To soften the
effects of these remaining intraclass shifts, however, it
may be necessary only to ease the transition with a
phase-in program that also offers tax deferral for the
elderly.9
A tax freeze in disguise
Workable options exist for dealing with the problems
posed by full market assessment. However, much of the
public debate over what to do about revaluing proper­
ties and the resulting potential for large tax shifts has
focused on a totally different approach. This involves
adjusting the assessed values of a large number
of properties as a group. When all the properties
9 By allowing the payments of taxes to be deferred, the local government
may be forced to borrow the cash it needs to meet its expenses.
This may pose a problem for New York City in view of its fragile
fiscal condition.

in the group are assessed at the same fraction
of market value, this use of a single multiplicand
brings assessed values to the desired standard. For
example, if properties were assessed at one fifth of
market value, then multiplication by a factor of five
would ensure compliance with a “ full value” standard.
Because this process works by multiplying each of
these properties by the same constant, it is called
mathematical revaluation. By using a different factor for
each group, disparities in assessment ratios between
groups can be eliminated.
Although appealing in its simplicity, mathematical
revaluation suffers from a critical flaw— it leaves intra­
group variations in place. For New York City, this cre­
ates a problem because of the apparent impossibility
of dividing its tax'rolls into groups within which the ra­
tios are uniform.10 Mathematical revaluation merely per­
petuates existing assessment disparities within groups,
and so similar properties would continue to be taxed at
different rates. In fact, when combined with a classified
tax system, mathematical revaluation may serve only to
prolong the present distribution of taxes. When the
same groupings are used as the basis for both the re­
valuation process and the classification scheme, every
property continues to be taxed as before.
By temporarily freezing taxes in this way, mathe­
matical revaluation may also prompt more of the own­
ers now relatively overassessed to appeal, thus clog­
ging the appeals process and ultimately undermining
the city’s tax base. The reason is that a property now
assessed at a ratio of 0.22, if in a group with a factor
of 5, will end up assessed at 10 percent above its
market value (5 x 0.22 = 1.10). While under current
assessment procedures an owner may fail to realize
his relative overtaxation, once the assessed value ex­
ceeds the property’s worth it is very likely that the
owner will become aware of the relative overestimate.11
The increase in the number of appeals could be
enormous. A rough estimate, based on the use of fif­
teen building classes, projects over a quarter of a
10The possibility of devising a scheme to divide the city’s tax rolls
into groups containing uniform assessment ratios appears remote.
Attempts to construct such groups using the building classifications
and geographic locations available were unsuccessful. The data
provided for the subdivision of each of the fifteen major building types
into as many as nine subgroups and each borough into as many as
eighteen community planning districts.
11 By enlarging the overassessment from 2 percent of market value
(22 percent minus 20 percent) to 10 percent, mathematical revalua­
tion also increases the visibility of the gains to be won through
appealing the assessment. However, the actual tax reduction possible
remains the same as long as the total tax on the group is un­
changed. Thus, while the amount of the overassessment for a
property worth $40,000 would increase from $800 to $4,000, the
tax rate needed to raise the same revenue would have fallen by
four-fifths.




million appeals, including 180,000 homeowners.12 This
number is many times the current average of about
40,000 per year— only a few thousand of these are
homeowners— and so would greatly overburden the
city’s Tax Commission which must hear each appeals
If fewer classes were used, the number of appeals
could be even higher. In addition, to the extent the
appeals are successful, mathematical revaluation will
reduce the city’s tax base. If the assessed value re­
ductions are granted in all the appeals estimated
above, the loss to the city’s taxable rolls could amount
to almost 17 percent.

Reform of the property tax rolls
To reduce the potential for appeals, it is necessary
to eliminate the disparities in assessment ratios. The
only way to do this is to reappraise individually each
property. This is a lengthy and expensive undertaking.
However, it is not all that is required. In the future,
these assessments must be maintained over time to
keep them in line with the official standard. Through
careful planning the tasks of reappraising properties
and of establishing a system to maintain the integrity of
the tax roles can be combined, thus reducing substan­
tially the cost of doing each separately.
At present, the city’s Real Property Assessment Bu­
reau does not appear able to handle the tasks of ap­
praisal and of updating assessments. In fact, this study
and others have found it deficient in even the most
basic kinds of bookkeeping functions.13 Not all re­
sponsibility for the present disarray of the tax rolls
rests with the Bureau’s procedures. It has only some
125 field assessors to review annually the assessments
on the city’s 830,000 parcels. Priorities have had to be
set, with the result that some properties were not re­
assessed even when they were sold.
As a test for carrying out any reform program, the
city has set up a separate organization to investigate
the feasibility for using techniques such as computer-

12These estimates were calculated by extrapolating the results obtained
from the sales data to the tax rolls as a whole. All owners of properties
relatively overassessed by 10 percent or more compared with their
class average (there were fifteen classes based on building type)
were assumed to appeal. To arrive at the estimated loss to the city’s
tax base, it was assumed that each of the appeals resulted in a
reduction of the property’s assessed value to a level commensurate
with the average assessment ratio for the class as a whole. The
percentage reductions of total assessed value for each of seventy-five
subdivisions of the sales data (fifteen building types in five boroughs)
were then extrapolated to cover all the properties on the tax rolls.
w See, for example, Office of the Comptroller, State of New York,
Assessment Practices of the Bureau o l Real Property Assessment,
New York City Department of Finance, Audit Report NYC-66-76

(November 1,1978).

FRBNY Quarterly Review/Summer 1980

19

assisted mass appraisal (CAMA) systems which are
being used elsewhere. If this computerization effort is
successful, it will help alleviate much of the paperwork
and eliminate many of the value judgments now in­
volved in appraisal work. The same level of staffing
will then be able to monitor more closely the assess­
ments of a larger number of properties. Greater use of
computers to store and process data on each prop­
erty should also help control one of the major sources
of dispersion in assessment ratios— the delays in re­
assessing properties following changes in their market
values.14

A need for action
Moving to a more equitable tax without creating ma­
jor problems is possible, but the reform will not be
14 Lags in reassessing properties cause assessment ratios to fall (rise)
as their values in the marketplace increase (decrease). Although the
exact importance of lags is hard to show without information on the
movements over time of price and assessed value for specific proper­
ties, many characteristics of the tax rolls suggest that lags are a major
source of the dispersion. For example, the generally high level of the
ratios for properties in the Bronx may reflect a failure by the city to
readjust promptly and fully the assessed values as properties fall in
price. In fact, many of the properties found to have high assess­
ment ratios seem to have depreciated in value inasmuch as they have
relatively low selling prices for their property type. In contrast, the
low average assessment ratios for most one- and two-family houses
seem attributable to the absence of any comprehensive program since
World War II to reassess these properties. The one area of the
city which apparently has received the most attention from the Real
Property Assessment Bureau is Manhattan, and its high average
assessment ratio, the nearest of all the boroughs to the "full value”
standard, reflects this fact.

painless. Reappraising properties will be costly and
some owners will face tax increases. Classifying real
estate into groups, however, can prevent shifts in taxes
among these groups, thereby reducing the extreme
changes in taxes. A phase-in program with tax defer­
ral for the elderly could then ease the adjustment to
the tax changes that remain.
Continued delay in reforming the property tax could
itself prove costly. The inequalities in the present
system have spawned appeals which even now rep­
resent outstanding claims against the city of over $1.5
billion, or almost half of the yearly collections from
the property tax. Unless changes are made, this
amount could rise even higher. The uncertainties over
future taxes also discourage economic activity. With
the shape of the tax system in doubt and with no clear
assessment standard, households and businesses shy
away from making further investments in structures
and in related activities in New York City. Finally,
continued noncompliance with existing law could
force the courts to impose immediate deadlines, caus­
ing a too hasty revamping of this complex and
important tax.
For reform to proceed, the legislature must act de­
cisively. Past attempts to legalize the status quo have
merely prolonged the period of uncertainty. Once the
legislature establishes a viable set of programs, New
York City and other municipalities in the state can then
get on with the difficult job of reforming their property
taxes with a minimum of disruption to taxpayers and
the economy.

Mark A. Willis

20

FRBNY Quarterly Review/Summer 1980




Perspective on the
United States External Position
Since World War ll*
During the past generation, the international economic
position of the United States has been transformed.
In the years immediately following World War II, this
country was perceived as the world’s most powerful
nation— the center country, the stabilizer of the inter­
national economy. In this role, its initial function was
to provide leadership and vital resources for the
postwar recovery. Thereafter, its task was to maintain
a strong but noninflationary domestic economy as
well as open goods and capital markets. If international
imbalances occurred, it was the task of other countries
to adjust. During the seventies, and particularly after
the breakdown of Bretton Woods, this perception of
the United States as the center country faded. It is
still acknowledged as the world’s largest economy and
still seeks most of the same economic objectives as
before. However, it no longer dominates the world
economy and must, like other countries, participate
in the international adjustment process. This greatly
complicates the function of stabilization which— if it
is to be performed at all— must be shared among a
group of major countries, of which the United States
is only one.
This shift in the position of the United States has
* Stephen V.O. Clarke, Research Officer and Senior Economist, is the
author of this article. Many others contributed to its development.
Among them, special mention must be made of William Diebold, Jr.,
Edward J. Frydl, Robert G. Hawkins, Roger M. Kubarych, Peter B.
Kenen, Robert E. Lipsey, and Samuel Pizer. The author, of course,
takes responsibility for any mistakes that remain and also for the
views expressed which do not necessarily reflect those of the
Federal Reserve Bank of New York or the Federal Reserve System.
In preparing the statistical material, the author has benefited from
the assistance of Guido Cipriani, Larry Katz, Sophia Oh, and Vera
Shturman.




been closely associated with a corresponding change
in the international role of the dollar. For twenty-five
years after the war, the stability of the American
currency was widely regarded as essential to world
prosperity. For most countries, an increase in official
claims on the United States was viewed as a sign of
success in economic policy. The dollar’s stability in
terms of gold was almost unquestioned. It was the nth
currency in terms of which other currencies would
adjust.
In practice, the setting of the exchange rate of the
dollar by foreign countries involved two distinct but
related asymmetries. One involved a devaluation bias
against the American currency. Many nations devalued
their currencies against the dollar, but countries
whose currencies were strong normally preferred to
accumulate dollars— sometimes in large amounts—
rather than risk the deterioration in competitive
strength that was expected to result from appreciation.
The other side of the coin was another asymmetry,
seen by some as giving the United States an “ exor­
bitant privilege” and by others as weakening external
discipline on its economic policy. When foreign cur­
rencies weakened, the countries concerned lost
reserve assets, which signaled the need for measures
to correct the external imbalance. In contrast, the re­
luctance of foreign monetary authorities to accept cur­
rency appreciation and their related willingness to
accumulate dollars meant that the discipline imposed
by losses of reserve assets was felt only infrequently
by the United States.
Along with the fading of the perception of the United
States as the center country came a reappraisal by

FRBNY Quarterly Review/Summer 1980

21

foreign countries of their attitude toward the American
currency. This reappraisal was stimulated, in the most
immediate sense, by the American authorities them­
selves: by the closing of the gold window in August
1971, by the devaluations of the dollar negotiated late
in that year and again in early 1973, and by subsequent
indications that the administrations in Washington
were little disposed to intervene in the exchange mar­
kets in order to defend the external value of the Ameri­
can currency and even hankered, on occasion, for
some further depreciation of the dollar against major
currencies. When such attitudes in Washington were
accompanied by continuing massive increases in foreign
claims against the United States, it was hardly surpris­
ing that monetary authorities abroad began to seek
ways to diversify their international reserves into as­
sets other than the dollar. Toward the close of the
seventies, a few important countries came to see
appreciation as a means of curbing domestic inflation
at about the same time that the United States authori­
ties began to recognize how much dollar depreciation
was adding to America’s inflationary difficulties. Thus,
the willingness of foreign monetary authorities to in­
tervene in support of the dollar declined just as the
Administration became more fully aware of the bene­
fits of such support for the United States.
These changes in the position of the dollar reflected
more fundamental developments here and abroad
that may be viewed from several angles. From the
narrow perspective of this country’s balance of pay­
ments, the weakening of the dollar can be attributed
to a growing disequilibrium between other countries’
demand for the American currency and the supply of
that currency flowing into foreign markets. Especially
in the 1970s, the total of dollars that foreigners desired
both to pay for net imports of goods and services from
the United States and to increase their official reserves
tended to fall well below net financial outflows from the
United States.1 The causes of this disequilibrium are
numerous and not fully understood but clearly lie
in both financial and goods markets. On the financial
side, it has long been accepted that a wealthy econ­
omy is likely to be a supplier of capital, on balance, to
the rest of the world. This has, in fact, been true of the
United States throughout the postwar period. During
the 1970s, however, these financial outflows became
exceptionally large by historical standards. The expan­
sion was associated with a variety of developments,
including the depreciation of the dollar against other
major currencies and increased borrowing by nonoil-

i Financial outflows are defined hereafter as remittances, direct in­
vestments, official and private grants and loans, and the statistical
discrepancy in the balance-of-payments accounts.

Digitized 22
for FRASER
FRBNY Quarterly Review/Summer 1980


producing countries. These countries, being faced with
sharply rising import costs, turned to dollar markets
here and abroad to finance payments deficits (espe­
cially for oil) as well as to increase their international
reserves.
But, while the world continued to rely heavily on
dollar financing, the relative economic position of the
United States was changing fundamentally from what
it had been in the earlier postwar years. With growth
abroad more rapid than in this country, the United
States share of world production dropped from about
two fifths in 1950 to only a little over one fifth at the
close of the seventies. Abroad, high levels of savings
and investment expanded productive capacity and
narrowed the technological lead that had previously
been enjoyed by American industry. Increasingly,
technologies and managerial methods employed by
foreign firms became equal to, or even surpassed,
those employed by their United States competitors.
At the same time that the industrial lead of the United
States was narrowing, its dependence on foreign
sources for primary commodities, particularly petro­
leum, was increasing. This tendency reached back
into the fifties and sixties but became a matter for
broad public concern only after 1973 when the sharp
rise in oil prices began.
The upshot of these various developments was that,
for sustained periods during the seventies, dollar trans­
fers from the United States for imports of goods and
services and financing exceeded— sometimes by
substantial amounts— the total that foreigners spent on
purchases of goods and services from this country and
desired to add to their dollar assets. This disequili­
brium resulted, of course, in downward pressure on
dollar exchange rates which raised questions about
the advisability of continuing to hold existing stocks
of dollars. Bearishness about the dollar thus tended
at times to become self-aggravating and cumulative.
These difficulties could, in theory, have been han­
dled by appropriate international adjustments. How­
ever, throughout most of the sixties and seventies,
the adjustments that were in fact achieved— although
sometimes substantial— nevertheless fell far short of
those required to restore and to maintain equilibrium
between the United States and the rest of the world.
The causes of this shortfall are complex and many of
the explanations are controversial. However, two long­
term causes are generally accepted. In the United
States, economic policy has provided inadequate in­
centives for saving and productive investment. This
lack has had adverse effects on both the financial and
goods sides of the balance of payments. On the finan­
cial side, the weaker incentives to invest in the United
States than abroad led to larger private capital outflows

than would have occurred with more appropriate
economic policies. In the goods market, the interna­
tional competitive strength of the United States has
been impaired because the growth of productivity has
been far lower here than in most other major coun­
tries. The other long-term obstacle to the improve­
ment of this country’s balance on goods and services
has been the various tariff and other barriers to im­
ports maintained by Japan, most developing coun­
tries, and— as regards agricultural products— the Euro­
pean Community (EC). In attempting to persuade other
countries to reduce such barriers, American negotia­
tors have been handicapped because special interests
here— ranging from dairy producers to steel makers—
have themselves obtained various degrees of protec­
tion against foreign competitors. Although several
rounds of multilateral trade negotiations made pro­
gress in reducing them, such barriers were still creating
significant difficulties for international adjustment at
the close of the seventies.
At various times, other difficulties also worsened the
international economic problems of the United States.
A majority of economists would probably agree that
international adjustment was complicated prior to
1971 by the rigidity of the exchange rate structure and,
particularly, by the reluctance of such surplus coun­
tries as Germany and Japan to appreciate their curren­
cies against the dollar. Most observers would also
agree that the inflationary financing of the Vietnam war
contributed significantly to the weakening of the dollar.
After the breakdown of Bretton Woods, the United
States authorities failed, more often than not, to
accompany dollar depreciations with policies designed
to release domestic production in order to strengthen
the trade balance. Major countries abroad also played
a role in the adjustment difficulties. Giving high priority
to curbing inflation, they were reluctant to adopt
expansionary policies either when this would have
been appropriate because of the appreciation of their
currencies or when they were urged to follow the lead
of the United States during the recovery from the
1974-75 recession.
At the beginning of the 1980s, a new perception of the
international economic role of the United States was
coming into focus. It was no longer the center coun­
try but only one— albeit still the largest— of a growing
number of industrial countries. The change was sym­
bolized by the reduced willingness of foreign coun­
tries to add to their balances of American currency
as well as by the related need for the American au­
thorities to borrow key foreign currencies in overseas
bond markets in order to reinforce their ability to sup­
port the exchange rate of the dollar. Throughout the
postwar years, other countries had defended their




currencies primarily by drawing down their foreign
exchange reserves. Now, the same was becoming true
for the United States, although still on a relatively
small scale.
These borrowings to strengthen its international re­
serves reflected a growing recognition in the United
States of the importance of exchange stability in
national stabilization policy. Bitter experience had
forced many countries abroad to see the link between
exchange depreciation and domestic inflation and to
adopt stabilization policies that sought— not always
successfully— external as well as domestic objectives.
In the United States, the experience of the 1970s
underlined the interdependence of these two aspects
of stabilization policy: not only did the outcome of
Government programs to reduce inflation partly de­
pend on the avoidance of exchange depreciation, but
the success of official intervention in the exchange
markets rested in large measure on the adoption of
sound domestic economic policies. Thus, the final
years of the 1970s saw Federal Reserve policy influ­
enced more than at any previous time since the war
by the need to support the dollar in the exchange
markets. Other policies were also being influenced
increasingly by external considerations. For example,
changes in tax policy aimed to strengthen the interna­
tional competitiveness of United States industry by
providing greater incentives to invest while energy
policy sought to reduce dependence on imported pe­
troleum. In these and other ways the United States was
attempting to strengthen its external position and to
adjust to the ever-changing international economy.
In the pages that follow, the developments that have
contributed to the change in the international economic
position of the United States are analyzed in greater
detail. The analysis begins with a brief survey of de­
velopments in the overall balance of payments of the
United States since 1950. The growth and cyclical
pattern of the financial outflows as well as the various
factors that have influenced the balance on goods and
services are then reviewed. The large role of cyclical
and other temporary factors in the strengthening of
the United States balance of payments during 1979 is
underlined. Against this background, the conclusion
emphasizes that this improvement, while welcome, did
not diminish the urgent need fo r policies designed to
provide more enduring strength to this country’s ex­
ternal position.

United States balance of payments, 1950-79
Net financial outflows from the United States exceeded
net exports of goods and services by $168 billion dur­
ing the years 1950-79 inclusive (Table 1). Such ex­
cesses— reflected in reserve transactions— occurred In

FRBNY Quarterly Review/Summer 1980

23

Table 1

Balance of Payments of the United States, 1950-79
Annual averages in billions of dollars
1950-57

1958-64

1965-69

Goods and services ..........................................................

Component

3.6

5.5

5.4

of which:
Merchandise trade balance ..................................................
Investment income ................................................................

3.1
2.7

4.5
4.0

2.8
5.5

1970-74

1975-76

5.3
-

2.1
9.9

-

1977-78

— 8.9

5.3

0.1
14.4

- 3 2 .3
19.8

- 2 9 .4
32.3

Financial transfers ............................................................

-4 .5

-8 .0

-5 .5

-1 8 .6

-2 6 .7

-2 6 .5

Unilateral transfers (excluding military) ...........................
United States Government (excluding reserve assets) . . .
United States banks, net ......................................................
United States claims reported by United States banks ..
United States liabilities reported by United States banks .
Other United States private assets .....................................
Other foreign private assets in United States ...................
Errors and omissions ............................................................

-2 .8
-0 .3
0.1
-0 .3
0.4
-2 .3
0.5
0.3

-2 .5
— 1.1
-0 .2
— 1.1
0.9
- 4 .1
0.5
-0 .5

-3 .0
-2 .0
3.5
- 0 .1
3.6
-6 .9
3.1
- 0 .2

—
-

— 4.8
— 3.8
-1 1 .6
-1 7 .5
5.8
-2 2 .5
7.9
8.1

— 4.9
- 4.2
-1 0 .4
-2 2 .2
11.8
-2 2 .2
10.2
4.9

4.4
1.5
4.1
6.6
2.5
— 11.4
6.1
- 3.2

1979

16.3

9.8
—
—

5.6
3.8
6.6
— 26.1
32.7
-3 2 .4
16.4
28.7

Allocation of special drawing rights ...............................

—

—

Allocation of SDRs plus total financial transfe rs..........

-4 .5

-8 .0

-5 .5

-18.1

-2 6 .7

-2 6 .5

11.0

Reserve transactions, total ............................................

0.9

2.5

0.1

12.9

10.5

35.4

-1 6 .3

United States reserve assets ( + — decline) .................
Claims of foreign monetary authorities
on United States, ( + — increase) ...................................
of which: changes in liabilities reported
by United States b a n k s ...........................................................

0.1

1.2

0

0.7

1.7

0.2

0.7

1.3

0.2

12.2

12.2

35.2

- 1 5 .2

0.6

0.5

0.6

2.1

0.6

3.1

6.6

0.5

—

—

—

-

1.1

—

-

1.1

Because of rounding, figures may not add to totals.
Sources: United States Department of Commerce, Survey ol Current Business, various issues. Data for 1950-59 are from the
October 1972 Survey, 1960-78 from the June 1979 issue, and 1979 from the March 1980 issue. Banking flows and
changes in claims of foreign monetary authorities on the United States for 1950-59 are partly estimated. Short-term
liabilities to foreign monetary authorities reported by United States banks for 1950-59 are from the Board of Governors
of the Federal Reserve System, Banking and Monetary Statistics, 1941-70, page 932.

twenty-four of the twenty-nine years ended 1979— the
five exceptions being years of monetary stringency in
the United States (Chart 1). Until 1979, the excesses
tended to increase, not only in current dollar terms,
but also relative to United States gross national prod­
uct (GNP) (Table 2).2 The transfer gap— as it may be
called— between financial outflows and the surplus on
goods and services averaged about 1/4 percent of
United States GNP in the fifties and sixties but well
over 1 percent in 1970-78. In 1979, the transfer gap
was reversed as financial movements shifted to heavy
inflows while the balance on goods and services
strengthened.
The growth of the transfer gap, until last year, was
* The general approach to the analysis of the balance of payments
follows Fritz Machlup’s paper on “ The Transfer Gap of the
United States” , Banca Nazionaie del Lavoro Quarterly Review
(September 1968).

Digitized 24
for FRASER
FRBNY Quarterly Review/Summer 1980


reflected principally in increased claims on the United
States by foreign monetary authorities. Only about one
twentieth was settled by United States reserve assets,
primarily gold sold by the Treasury during the late
fifties and during the sixties before the breakdown of
Bretton Woods. In contrast, foreign official claims on
the United States, which were reported at less than
$3 billion at the end of 1949, amounted to $31 billion
in mid-1971, before the closing of the gold window,
and to $143 billion in December 1979.3 Including an
additional $61 billion of balances of central banks
in the Euromarkets, the total of official dollar assets
comprised 63 percent of reported foreign exchange
reserves at the end of 1979, compared with only 27
percent thirty years earlier.

3 Includes Bank for International Settlements and European Fund.
United States Treasury Bulletin (May 1980, Table IFS-3), page 91.

Chart 1

C yclical Movements in the United States
Balance of Payments
Percent of GNP

Table 2

Major Components of the United States
Balance of Payments
In percent of gross national product
Balance on
goods and
services

Financial
transfers*

Reserve
transactions*

1950-57 .......... ..................... 0.95
1958-60 ................................ 0.65
1961-69 ................................ 0.94
1970-74 ................................ 0.43
1975-78 ................................ 0.29
1975-79 ................................ 0.28
1979 ......................................0.22

— 1.22
- 1 .2 7
— 1.12
— 1.61
- 1 .4 9
— 1.11
0.42

0.28
0.62
0.18
1.14
1.20
0.82
-0 .6 9

Period

The periods selected generally cover full business cycles
as measured by the National Bureau of Economic Research.
The first year of each period is that in which the trough
occurs, the final one includes the peak or, in the case of 1979,
the most recent data. However, the 1950-57 period covers
virtually all of the two cycles of which the first trough is
dated October 1949.

1950 52 54 56 58 60 62 64 66 68 70 72 74 76 78 80

‘ Allocations of SDRs (special drawing rights) are included
in reserve transactions but excluded from financial transfers;
this inclusion has negligible effects on the ratio of reserve
transactions to GNP, reducing it by 0.04 percent in 1970-74
and increasing it by a similar amount in 1979.

Shaded areas represent periods of recession, as defined
by the National Bureau of Economic Research.
Sources: Balance-of-payments data are from the
sources cited for Table 1. GNP data are from the
Economic Report of the President (January 1980),
page 203; recent data have been updated.

The great bulk of these foreign official dollar gains
reflect financial outflows from the United States. In
only three years— 1972, 1977, and 1978— did deficits
on goods and services contribute to such foreign of­
ficial gains. Over the rest of the period, net sales of
goods and services absorbed dollars from abroad.
Although total financial outflows have expanded great­
ly in current dollar terms, in relation to United States
GNP they have shown remarkable stability. Measuring
them over full business cycles, as is done in Table 2,
the outflows have fluctuated in the neighborhood of
1-11/4 percent of GNP, except in 1970-74, when the
breakdown of the Bretton Woods arrangements doubt­
less explains most of the rise to 1.6 percent. Within
each cycle, striking shifts have occurred. Outflows have
surged in periods of monetary ease but have subse­
quently declined sharply— sometimes changing to in­
flows— under monetary stringency. Illustrative are the
large outflows in the recession years 1970 and 1975
and the virtual drying-up of such flows in 1969, when




monetary conditions were tight. Although other fac­
tors played a role, the successive moves toward in­
creased monetary restraint, made in late 1978 and
during 1979, were essential in bringing about the
dramatic reversal of financial flows last year.
In contrast to the general stability over the cycle
of financial outflows, the average annual surplus on
goods and services declined to only 0.3 percent
of United States GNP in 1975-79 from almost 1
percent in the fifties and sixties. Within the total of
goods and services, the two most important compo­
nents are the merchandise trade balance and income
on account of foreign investments (Table 1). The latter
has shown a rising surplus throughout the period under
review, reflecting earnings on the large placements
abroad of American capital.4 On the other hand, the

4 Only part of the income from foreign investments is repatriated
to the United States, the rest being plowed back into foreign
economies. The reinvestment abroad of such earnings is taken into
account as an increase in United States private assets abroad, i.e.,
as a financial outflow from the United States. Under an earlier
presentation of the United States balance-of-payments statistics,
reinvested earnings were omitted from both the balance on goods
and services and the capital account. The change in the presenta­
tion of the balance of payments does not, of course, affect the size
of the gap between financial outflows and the surplus on goods
and services.

FRBNY Quarterly Review/Summer 1980

25

merchandise trade balance has tended to weaken.
Showing expected cyclical fluctuations, the surplus
peaked in 1964 at almost $7 billion, then declined,
shifting to a deficit in 1971 for the first time since 1893.
After recovering to a record surplus of $9 billion in the
recession year 1975, the balance again shifted to
heavy deficit as the United States economy moved
back to full capacity in 1977 and 1978, while the re­
covery in other industrial countries lagged. Despite the
depreciation of the dollar and a reversal of cyclical
pressures, the deficit— though smaller than in the two
previous years— remained substantial in 1979. The
problems behind the weakness in the United States
merchandise trade balance occupy the bulk of this
paper, following a discussion of financial outflows.
Financial outflows from the United States
Financial outflows from the United States over the past
twenty-five to thirty years are explicable in terms of
this country’s wealth relative to the rest of the world,
the commitment of successive United States adminis­
trations to the principles of a market economy, the
rapid recovery and growth of most major countries
abroad and many smaller ones, and the reluctance of
most of these countries to go very far in dismantling
restrictions on capital outflows. The upsurge in out­
flows during the seventies was, at times, associated
with private portfolio shifts out of the depreciating
dollar into assets denominated in currencies that were
expected to appreciate5 as well as with increased bor­
rowing by foreigners to finance payments deficits, par­
ticularly with the Organization of Petroleum Exporting
5 H.R. Heller, International Reserves and World-Wide Inflation,
International Monetary Fund Staff Papers (1976), pages 68-70.

Countries (OPEC), and desired increases in interna­
tional reserves.
Despite the wealth of the United States, the private
markets here were slow in beginning to supply re­
sources to the rest of the world after World War II
(Table 3). Many financial institutions still held bonds
and other claims on which foreigners had defaulted
during the depression of the 1930s. The American
banking system, chastened by the unhappy experi­
ences of the interwar years, had retreated from the
foreign field.
With recovery among the war-torn countries and
impressive growth elsewhere, the attractions of foreign
markets increased. Dollar financing, funneled through
official grants and loans both from the United States
Government and international institutions, was support­
ing expansion in the world economy. Closely related
to United States financial support, American policy
was committed to reducing the barriers to trade and
payments that had sprung up during the depression
and the war. As international prospects improved,
United States companies increasingly ventured abroad.
Often they established manufacturing subsidiaries
overseas to avoid barriers such as the external tariff of
the EC as well as to benefit from relatively favorable
labor market conditions in host countries. Keeping
pace with the growing international activity of Amer­
ican manufacturing firms, United States commercial
banks increasingly established branches and offices
abroad, strengthening their links with foreign financial
markets. Foreign banks followed suit by setting up
numerous offices in the United States. At the same
time, the New York bond market— with resources
several times greater than those of the largest foreign
competitor— gradually reopened to foreign borrowers.

Table 3

Composition of Private Capital Flows, 1950-79
Annual averages as percentage of gross national product

Period

Direct
investment
(net)

1950-57 ............................................................ — 0.43
1958-60 ............................................................ - 0 .4 5
1961-69 ............................................................ - 0 .5 4
1970-74 ............................................................ - 0 .5 7
1975-79 ............................................................ — 0.58
1979 ................................................................ -0 .7 2

Banking
flows
(net)
0.02
0.03
0.19
- 0 .3 8
— 0.44
0.28

Other recorded
nonofficial
capital (net)
- 0 .0 3
- 0 .1 7
- 0 .0 4
0.12
— 0.16
0.04

Totals may not add because of rounding.
The sources are the same as in Table 1 and the periods selected are for full business cycles
as described in the note to Table 2.

26

FRBNY Quarterly Review/Summer 1980




Total recorded
private flows
— 0.44
- 0 .5 9
— 0.39
- 0 .8 3
— 1.18
- 0 .4 0

Statistical
discrepancy
0.09
- 0 .0 2
- 0 .0 8
- 0 .2 9
0.53
1.21

Total
— 0.36
-0 .6 1
— 0.47
— 1.12
— 0.64
0.81

The reinvolvement of our financial markets with the
rest of the world has not always been regarded as
an unmixed blessing. The expansion of United States
private lending abroad in 1958-60 came at a time when
this country’s merchandise trade balance was showing
distinct signs of weakness. Having rebuilt their hold­
ings of dollars, some major central banks abroad be­
gan to convert continued inflows of dollars into gold.
Some $5 billion of the metal was bought from the
Treasury in the three years ended December 1960.
Although its gold stock still totaled almost $18 billion,
greatly exceeding the holdings of any other country,
the continued rise in United States liquid liabilities to
foreign monetary authorities raised questions about
the future stability of the dollar. As part of a program
to calm these fears, the United States authorities insti­
tuted various restrictions on capital outflows, begin­
ning in 1963 with a tax that discriminated against bor­
rowings by most of the industrial countries. This tax
was subsequently reinforced by so-called voluntary
controls on specified lending abroad by commercial
banks and by large nonbank corporations. Finally, in
a classic example of the tendency of controls to
spread, mandatory restrictions were imposed in 1968
on a wide range of United States direct investments
abroad.
Whether these controls did more than divert financial
flows into uncontrolled channels has been much de­
bated. What does seem clear is that monetary condi­
tions in the United States continued to have the pre­
dominant influence on private capital flows (Chart 2).4
Such outflows contracted sharply during the 1966
credit crunch and, after recovering somewhat the fol­
lowing year, changed into substantial inflows under
the pull of taut monetary conditions in 1968 and 1969.
Thereafter, when the boom gave way to recession in
1970, the flows were again reversed, becoming heavily
outward. This, combined with a shift of the United
States trade balance into deficit and the breakdown
of the par value system, led to the explosion of private
capital outflows in 1971. After the closing of the gold
window, the collapse of Bretton Woods, and the float­
ing of the major currencies removed the original basis
for the attempts to restrict capital outflows from the
United States, the controls were lifted in early 1974.
From then on, the flows responded freely to the in­
creased demands of foreigners for financing as well
as to changes in relative monetary conditions and
exchange rate expectations. Outflows in the recession
year 1975 were almost as large as during the 1971

« Private capital flows exclude private remittances and Government
grants and loans which are counted in the broader category of
financial flows considered above.




Chart 2

Private C apital Flows in the United States
Balance of Payments
Percent of domestic investment

Percent

1952 54 56 58 60 62 64 66 68 70 72 74 76 78 80
Billions of dollars

"Private capital flow s” are the total of changes in the
United States private assets abroad, net (line 47), other
foreign assets in the United States, net (line 64), and
the statistical discrepancy (line 75) from Table 1 of the
"United States International Transactions” , published in the
Department of Commerce, Survey of Current Business
(March 1980 and earlier issues). ''Domestic investment”
is gross private fixed nonresidential investment as given
in the Economic Report of the President. January 1980,
page 219. Data for 1979 have been updated.
Shaded areas represent periods of recession, as defined
by the National Bureau of Economic Research.

FRBNY Quarterly Review/Summer 1980

27

Table 4

Role of the Dollar in International Finance
International claims
(1)

Increase in gross external claims* as reported by banks in major
financial markets (billions of d o lla r s ) t ......................................................
of which:
Percentage denominated in dollars ............................................................

(2)

Gross international bond issues (billions of d o lla r s ) ^ .............................
of which:
Percentage denominated in dollars ............................................................

(3)

Total (1) + (2) (billions of d o lla rs )!........................................................
of which:
Percentage denominated in dollars ............................................................

1974

1975

1976

1977

1978

1979

90

140

117

156

256

278

78

79

77

54

59

63

7

20

33

34

34

41

63

51

61

56

38

42

97

160

150

190

290

319

77

76

73

55

57

61

* Includes claims both in domestic currency on nonresidents and also in foreign currency on residents and nonresidents.
t Includes Belgium-Luxembourg, France, Germany, Italy, the Netherlands, Sweden, Switzerland, United Kingdom, Canada, Japan, and the
United States plus the United States offshore centers in the Bahamas and Cayman Islands for the entire period. Austria, Denmark, and
Ireland are included in 1977 and thereafter.
t Includes Eurobond issues as well as issues on behalf of nonresidents in the major national markets.
§ Increases in gross external claims and in gross international bond issues are not strictly comparable because refinancing is treated
differently. Refinancing of bank-reported external claims leaves the total of such claims unchanged. As regard the bond series,
comprehensive data on maturities and refinancing are not available, it is therefore not possible to distinguish between issues that
are for refinancing purposes and those that provide new money.

crisis. The outflows then receded as the economy re­
covered during the following three years. Within the
generally declining trend, however, there were outward
surges in the final quarters of 1977 and 1978, when
pessimism about the outlook for the dollar became
pronounced. The change in market sentiment after the
November 1, 1978 measures, as already noted, shifted
the financial movements to heavy inflows in 1979.
Standing back from short-term fluctuations, two
points are worth noting. In contrast to the previously
observed stability of total financial flows, recorded
private capital outflows have tended to increase in re­
lation to United States GNP over the five business
cycles covered in this study (Table 3). The tendency is
gradual for net direct investment abroad but is pro­
nounced for bank flows which were generally inward
during the fifties and sixties, subsequently shifting to
substantial outflows in the seventies. However, the
rising tendency of recorded private outflows was
checked by the shift in the statistical discrepancy—
believed to reflect primarily unrecorded capital move­
ments— from outflows in the troubled period around
the breakdown of Bretton Woods to substantial inflows
in the latter half of the seventies.
The second striking feature is the continued heavy
dependence of the world economy on dollar financing,
not only from the United States, but also from the

FRBNY Quarterly Review/Summer 1980
Digitized 28
for FRASER


Euromarkets. Despite the shift in the United States
international economic position, two thirds of interna­
tional lending was still denominated in dollars in
1974-79 (Table 4). True, the dollar proportion showed
a declining trend during those years. Part of this de­
cline was doubtless structural, in the sense that it
reflected the desire of lenders to diversify at the mar­
gin into assets denominated in such currencies as the
Deutsche mark and the Swiss franc. But another signifi­
cant part of the decline was almost certainly a cyclical
phenomenon, associated with the tightening of United
States monetary conditions relative to those in other
major financial centers. To the extent that it was
cyclical in origin, the recent decline in the dollar pro­
portion of international financing is likely to be re­
versed when the balance of monetary pressures moves
against the United States.
Although the high proportion of dollar financing was
to be expected in the early postwar years, the extent
of the continued dependence seems somewhat anoma­
lous now. In the early years, major countries abroad
were still reconstructing their economies. Almost uni­
versally, controls were maintained to channel national
savings into the building of domestic productive capac­
ity. By so doing and by attracting capital (mainly in
the form of dollars) from abroad, foreign countries
strengthened their economies to the point where sev­

eral of them now vie in per capita wealth with the
United States. Yet, until the recent abolition of ex­
change controls in the United Kingdom, few were
willing to go as far as the United States in opening
their financial markets to international pressures. Even
those countries which were most devoted to market
principles still maintained informal controls over for­
eign access to their financial markets. Where devotion
to such principles was less strong, the authorities
severely restricted foreign borrowing, not only from
their bond markets, but also from their commercial
banks. Experience suggests, it is true, that such con­
trols rarely succeed in attaining their full objectives.
Nevertheless, they probably did divert a significant
proportion of the demand for international capital to
the huge and freely accessible dollar markets. Al­
though restrictions on capital flows have now been
significantly reduced by Britain’s recent move, foreign
reliance on dollar financing is likely to remain exces­
sive until other major countries follow suit.

Weakness of merchandise trade balance
While one aspect of the expanding transfer gap has
involved large financial outflows from the United
States, another concerns, as previously noted, the
weakness of this country’s merchandise trade balance.
This weakness has resulted from numerous related
factors:
(1) More rapid growth and technological ad­
vance abroad;
(2) An exchange rate structure that, until the
depreciation of the dollar in the early seven­
ties, gave a strong competitive advantage to
foreign countries;
(3) The adverse shift in the terms of trade of the
United States since 1969, i.e., prices of im­
ports increased more rapidly than those of
exports;
(4) The increased dependence of the United
States on imported raw materials, particu­
larly petroleum;
(5) The prevailing domestic orientation of United
States firms resulting in general lack of in­
terest in export markets, in contrast to com­
petitors in other countries, more dependent
on international trade, and
(6) Foreign barriers against some products in
which the United States has a significant
competitive advantage.
All these factors have had a bearing on the weakness
of the merchandise trade balance at one time or an­
other since World War II, but their influence has varied.




The following analysis will discuss them separately and
suggest how, in successive periods, each interacted
with the others.
More rapid growth and technological advance abroad
More rapid advance in many foreign countries than in
the United States tended to weaken this country’s mer­
chandise trade balance. This result was the outcome
of opposing tendencies. While certain tendencies
strengthened America’s external position, others— yet
more powerful— impaired it.
The strengthening tendencies are clear. In the early
postwar years, the United States was the w orld’s
economic colossus, accounting for almost 40 percent
of global GNP. Its undamaged and highly produc­
tive economy was the source from which the rest
of the world sought the materials, plant and equip­
ment, and above all the advanced technology with
which to repair the damage of hostilities and to lift
living standards, often from poverty levels. In this
period, recovery abroad improved the merchandise
trade balance of the United States— huge foreign de­
mand for our products was circumscribed only be­
cause financing was limited. Even after the worst
shortages of the early postwar years had been relieved,
relative demand pressures continued to favor the trade
balance of the United States because the economic
growth of many foreign countries was more rapid than
here. Although the 3.8 percent average annual increase
in the real GDP (gross domestic product) of the United
States in 1950-73 was in line with this country’s histori­
cal performance, its growth rate was less than three
quarters the corresponding weighted average expan­
sion in the thirteen other principal industrial countries.
However, such favorable influences from the de­
mand side were countered by opposite pressures from
the side of supply. The view that more rapid growth
abroad favors the trade balance of the slow-growing
country assumes that productive capacity, technology,
and product design are not changing in the competing
economies or are everywhere changing at the same
rate. As regards economic behavior since the war,
such an assumption is erroneous. For many foreign
countries, the wealth and prosperity of the United
States established a standard toward which economic
policy was directed; their aim was to narrow the gap
in productivity and technology that lay between them
and the American colossus. A related aim, encouraged
by the United States especially in the Marshall Plan
years, was the restoration of external economic
strength to bring an end to dependence on American
aid. Thus, rapid growth abroad involved, above all, the
expansion of capacity that embodied advanced tech­
nology and the designing of superior products that

FRBNY Quarterly Review/Summer 1980

29

would penetrate foreign markets, particularly those of
the United States. For these purposes, governments
abroad encouraged saving and productive investment
which absorbed, in many countries, a substantially
larger proportion of GDP than in the United States, the
contrast with Japan being especially striking (Table 5).
For this as well as other reasons, productivity per manhour in manufacturing grew substantially more rapidly

in major foreign countries than here,7 thus helping
strengthen their competitiveness in relation to the
United States (Table 6).
Policies to stimulate saving, investment, and tech­
nological advance bore fruit across a wide spectrum
7 Angus Maddison, Long Run Dynamics of Productivity Growth,
Banca Nationale Del Lavoro Quarterly Review (March 1979).

Table 5

Table 6

Gross Domestic Investment in Selected Countries

Output per Man-hour in Manufacturing,
Selected Countries

As percentage of gross domestic product

Average annual growth rates
Country

1960

1976

1977
Country

Industrial countries:
F ra n c e ........................................
Germany ....................................
Italy ............................................
Japan ........................................
United K in g d o m .......................
United States ...........................

___
___
___
___

1960-72

1973-78

1979

1.8
4.8
5.2
4.9
1.1
4.3

1.6
8.3
5.2
5.4
2.2
8.7
0.8

24
27
24
34
19
18

23
24
18
33
17
16

24
22
21
32
19
18

United S ta te s ...........................
Japan ........................................
Germany ..................................
France ......................................
United Kingdom .....................
Italy ..........................................
Canada ....................................

3.2
10.4
5.9
5.9
4.0

22
13
17
11
20
16
21
20

26
24
19
25
26
31
24
28

22
24
21
26
20
30
23
27

Source: United States Department of Labor, Bureau of
Labor Statistics, Internationa/ Comparisons of Manufacturing
Productivity and Labor Costs.

6.2
4.2

3.2

Developing countries:
B r a z il..........................................
Egypt ..........................................
India ..........................................
Korea, Republic of .................
Mexico ......................................
Philippines ...............................
Spain ..........................................
Taiwan ......................................

___
___
___
___
___

Source: The World Bank, World Development Report, 1978,
pages 84-85, and 1979, pages 134-35.

Table 7

United States Balances of Trade in Technologically Intensive Manufactures*
Selected years; annual averages in billions of dollars
1962

1970

1971-74

1975-76

1977-78

1979

Western E u ro p e ....................... .............
Japan ........................................ .............

1.6
0.3

2.4
— 1.0

1.6
-3 .1

4.0
-5 .4

1.8
-1 1 .7

2.9
-1 4 .1

Total, all c o u n trie s ................... .............

6.6

7.2

16.0

22.0

15.3

19.9

Area

* Technologically intensive manufactures include chemicals, nonelectrical and electrical machinery
and equipment, transportation equipment, ordinance, and instruments and controls.
Sources: Peter G. Peterson, United States in the Changing World Economy, Vol. 2 (United States
Government Printing Office, 1971), Charts 30 and 32; United States Department of Commerce,
Bureau of the Census, "Highlights of U.S. Export and Import Trade", FT 990 (December 1977,
December 1978, and December 1979).

30

FRBNY Quarterly Review/Summer 1980




of countries, from the older industrial ones to others
like Brazil, South Korea, the Philippines, and Taiwan
that previously had little or no industrial base. Many
lines of production, for which the United States was
the only, or one of the few, suppliers in the early
postwar years, were replicated abroad. With a view to
capturing export markets, foreigners not infrequently
manufactured products incorporating more advanced
design and technology than those of their American
competitors. Indeed, the rapid rise in exports was a
major force behind the faster growth of foreign coun­
tries than of the United States. The counterpart of the
growing share of foreign countries in world GNP was,
therefore, a decline in the share of the United States
in world exports of shoes, steel, automobiles, motor­
cycles, tools, and various types of machinery. Even in
the field of technologically intensive manufactures,
where its lead has been the greatest, the United States
trade balance, while remaining strong overall, has
weakened sharply in relation to Japan (Table 7). In­
creasingly, therefore, the United States has become
only one— albeit still the largest— of a number of in­
dustrial economies competing for a share of the world
market.
Structure of exchange rates
The recovery and expansion of the rest of the world
was fostered by the exchange rate structure that
characterized the twenty to twenty-five years immedi­
ately following World War II. Particularly after the
devaluation of sterling and numerous other currencies
in September 1949, prices— measured in dollars— in
major countries abroad were substantially lower than
in the United States. How large this disparity was is
open to debate, but the evidence suggests that the
gap remained significant until the United States closed
the gold window and the dollar depreciated on the
exchanges in the early 1970s.
Evidence of this disparity in prices— while far from
complete— relates, not only to particular manufactures,
but also to traded goods generally. Dollar prices of
iron and steel products averaged 15-27 percent less
in Germany than in the United States in 1953-64, 8-24
percent less in the United Kingdom, and 25-30 percent
less in Japan, for which available data cover only
1961-64. Somewhat smaller but still significant dispari­
ties existed for machinery and transportation equip­
ment.8 For traded goods generally, estimated prices in
1970 were 7-17 percent lower in major foreign coun­
tries than in the United States (Table 8). An exception
8 Irving B. Kravis and Robert E. Lipsey, Price Competitiveness in
World Trade (New York: National Bureau of Economic Research,
1971) and “ Export Prices and the Transmission of Inflation” ,
The American Economic Review (February 1977), pages 156-57.




was Germany which had eliminated the estimated dis­
parity by means of an 8.5 percent appreciation of its
currency against the dollar in the fall of 1969. No
comparable figures for traded goods are available
for earlier years, but the rise in the general price level
shown in Table 9 suggests that the disparities are
likely to have been significantly larger in the early
fifties, particularly in the cases of Germany and Japan.9
The disparity in prices between the United States
and its major competitors was only one of the several
key elements in a policy environment that favored the
recovery and growth of countries abroad. In the early
postwar years and, for many observers, even in the six­
ties, it was unthinkable that the gold value of the dollar
would change. Accordingly, entrepreneurs in foreign
countries could feel assured that their competitive
positions in dollar markets would not be impaired by
devaluation of the United States currency. This, com­
bined with the commitment of successive American
administrations to the reduction of tariffs and other
barriers to trade, gave foreigners strong encourage­
ment to invest in capacity designed to produce not
only for their domestic markets but also for export.
Thus, the advantageous structure of prices along with
expectations about stability in the gold value of the
dollar and about commercial policy all created an inter­
national environment that facilitated rapid economic
advance abroad. At the same time, this environment
probably also contributed to the relatively low rate of
business investment in the United States as well as to
the attractiveness for United States corporations of
direct investments abroad.
Although, in retrospect, the competitive advantage
that the price structure of the fifties gave to countries
abroad seems clear, it was less so to contemporaries.
9 In a perceptive note appended to a study of the United States
balance of payments published in 1960, Theodore O. Yntema wrote:
"On the basis of fragmentary evidence, it seems to me that our
exchange rates are incompatible with the fundamental relation
between costs of production here and abroad. The effects on our
balance of payments resulting from the disparities in costs here and
abroad are limited now by market imperfections— by lack of knowl­
edge, inadequate procurement arrangements abroad by U.S.
purchasers, and inadequate distribution systems here for foreign
producers. In the future the effects of these disparities in costs
will be felt increasingly as foreign capacities expand, as economies
of scale in production and distribution of foreign products increase,
as more U.S. know-how is exported, as U.S. procurement abroad
becomes more efficient (and more extensive) and as distribution
systems for foreign products in the U.S. improve . . .
“ The balance-of-payments problem we have now results mainly
from the phenomenal recovery and the great forward surge in
productivity in the economies of Western Europe and Japan. This is
cause for rejoicing. We should not be ashamed or afraid to make a
readjustment in our exchange rates when it is necessitated by such
good fortune. Price fixing (even in exchange rates) cannot long
ignore the realities of costs. . .
Committee for Economic Develop­
ment, National Objectives and the Balance of Payments Problem
(February 1960), pages 3-4.

FRBNY Quarterly Review/Summer 1980 31

Table 8

Relative Prices of Traded and Nontraded Goods for
Selected Countries, 1970 and 1973
Level of United States prices = 100

Traded goods*
Country
Japan .....................
Germany .................
France .....................
Italy ..................... ; .
United Kingdom . . .

Nontraded goods*

1970

1973

1970

1973

83
100
93
93
86

112
139
119
110
97

52
63
65
53
58

75
91
82
64
69

* Traded goods are defined to cover all commodities. Construc­
tion and all services are included under nontraded goods.
Source: Irving B. Kravis, et al, International Comparisons of
Real Products and Purchasing Power (published for the World
Bank by the Johns Hopkins University Press, 1978), page 126.

Table 9

Dollar Cost of Representative Baskets of Goods in
Selected Foreign Countries
Cost of basket of goods in United States = 100
Country

1950

1955

50
72
74
67
70

*

Japan .....................
Germany ...............
France ...................
Italy .......................
United Kingdom ..

70
95
69
77

1970

1973

1977

1978

67
82
80
73
72

94
116
101
87
84

103
121
103
84
85

127
135
114
92
96

These estimates represent for each country the local currency
cost, converted into dollars at the exchange rate of the rele­
vant year, of representative baskets of goods that would cost
$100 in the United States. The baskets reflect the whole range
of goods and services in each country’s gross domestic
product.
* Not available.
Sources: Milton Gilbert, et al., Comparative National Product
and Price Levels (Paris, Organization for Economic Coopera­
tion and Development, 1958) pages 29-31, is source for 1950
and 1955 estimates for European countries; Michael Boretsky
of the United States Department of Commerce provided the
figure for Japan in 1950; Irving B. Kravis, et a!., International
Comparisons of Gross Product and Purchasing Power (Johns
Hopkins University Press, 1978), page 21, provided the esti­
mates for all countries for 1970 and 1973; for other years the
estimates are based on the Kravis figures which are adjusted
for changes in GDP deflators (from the Organization for Eco­
nomic Cooperation and Development, Main Economic Indica­
tors) and in exchange rates (from the Annual Statistical
Digest of the Board of Governors of the Federal Reserve
System).

In the early postwar years, indeed, the opposite im­
pression prevailed. The competitive strength of the
United States was regarded as unassailable; many
expected that it would continue indefinitely as a
chronic problem for other countries. Such impressions
had some basis in fact. While reconstruction abroad
was progressing, many countries still suffered severe
shortages of coal, certain types of steel, and other
industrial materials.10 Many foreign firms still lagged
far behind their United States competitors in technol­
ogy and design. Basic materials and advanced Ameri­
can products were frequently bought almost regard­
less of price.11 Consequently, quantitative restrictions
were required abroad throughout the early postwar
years to prevent dollar imports from exceeding the
limits established by reconstruction and development
programs and by foreign authorities’ desire to rebuild
their international reserves.
With the rapid recovery of economies abroad, the
shortages and bottlenecks of the early postwar years
gradually disappeared. By the midfifties, the industrial
countries had removed most quantitative restrictions
against imports of nonagricultural products from dol­
lar sources. Their competitive strength justified them in
doing so. True, prices in the United States generally
rose more slowly in the decade ended 1963 than in
the other industrial countries. However, although the
price advantage enjoyed by foreigners was smaller
than it had been in the early fifties, it was still signifi­
cant in the midsixties. Thereafter, rising inflationary
pressures growing out of the Vietnam war combined
with devaluations by other countries— notably Britain
in 1967 and France in 1969— shifted the relative price
advantage further against the United States. Thus, on
the eve of the breakdown of Bretton Woods, prices
measured in dollars among most of our major com­
petitors were still substantially lower than in the United
States, although not so much as they had been twenty
years before.
This disparity in prices between the United States
and abroad was generally removed by the realignment of
exchange rates during the seventies. In some cases,
indeed, the opposite disparity developed, giving rise—
as many American tourists have discovered— to sub­
stantially higher prices in such countries as Germany,
Switzerland, and Japan than in the United States.
The question whether the exchange rate crises of
the early seventies could have been avoided or, at
least, mitigated is of course surrounded by contro10 Hal B. Lary, Problems of the United States as World Trader and
Banker (National Bureau of Economic Research, 1963), page 52.
11 Geoffrey Crowther, Balances and Imbalances of Payments (Harvard
Graduate School of Business Administration, 1957), page 46.

32

FRBNY Quarterly Review/Summer 1980




versy. With major countries abroad catching up with
the United States in capacity to produce technological­
ly advanced goods, international monetary arrange­
ments that had been appropriate in the early postwar
years inevitably required modification. Even so, the
necessary adjustments might have been achieved
within the basic framework of the Bretton Woods ar­
rangements had the major countries followed more '
appropriate policies. If, for example, the authorities
had succeeded in maintaining inflation in the United
States below that in other countries and also in pro­
viding greater stimulus to productive investment in
American industry, the strengthening of this country’s
trade balance that occurred in the early sixties might
not have been aborted. Likewise, if surplus countries
such as Germany and Japan had been more willing to
accept imports and/or to appreciate their exchange
rates, the essentials of the par value system estab­
lished at Bretton Woods might have survived. At least
the adjustment crisis, when it came, would probably
have been less severe and disruptive. In the absence
of appropriate stabilization policies, however, a sharp
depreciation of the dollar was probably the only prac­
ticable alternative by which to restore the external
competitive position of the United States. But this gain
came at the cost of an aggravation of inflation which,
itself, added to the economic uncertainties and dis­
turbances experienced later in the seventies.
Worsening terms of trade
Since 1969, increases in the dollar prices of United
States imports have been substantially greater than
those of exports, reversing the tendencies that pre­
vailed during most of the fifties and sixties. Although
this broad conclusion seems clear, measurement of
the changes is more than usually imprecise because it
depends on unit value indexes whose deficiencies are
well known. Judging by these indexes, export prices
were 151 percent higher in 1979 than they were a
decade earlier, while import prices were up no less
than 230 percent (Chart 3). The rise in import prices
was primarily attributable to the devaluation of the
dollar, to the huge jumps in oil prices, and to smaller,
yet significant, increases in the cost of coffee, cocoa,
and various other imported foods and raw materials.
Since the volume of United States imports was about
75 percent larger last year than in 1969, our export
volume would have had to rise 135 percent to achieve
a merchandise trade surplus comparable to that of
a decade earlier. In fact, the volume of United States
exports increased some 93 percent over the period.
Although this was no small accomplishment, the short­
fall amounted to $33 billion, somewhat more than the
merchandise trade deficit in 1979.




Increased dependence on imported oil
Increased dependence on imported oil was by far the
largest single element in the worsening of the mer­
chandise trade balance of the United States during
the seventies. This increase went a long way toward
setting the stage for the quadrupling of oil prices by
OPEC in 1973 and for the previously noted deteriora­
tion of our terms of trade since that time. With rises
both in the physical volume of oil imports and in
prices, the value of the oil obtained from abroad in
1979 was $50 billion higher than it had been six years
before, greatly exceeding the improvement in our bal­
ance of trade in other commodities over the same
period.
Although oil became a subject of broad public con­
cern only in 1973, the increase in United States
dependence on imports of that commodity began
a generation before. Early in the postwar period,
the United States changed from a net exporter of oil
to a net importer. Although domestic oil production
rose in the fifties and sixties, domestic consumption
grew even faster (Chart 4). Yet in 1970, when it peaked,
domestic output still met 77 percent of United States
consumption. Thereafter, however, the gap between
domestic production and consumption widened dra­
matically.
A small part of this widening was attributable to
declining production. Domestic petroleum supplies that
could be exploited profitably at existing market prices
were diminishing and even such exploitation was dis­
couraged by Government price controls. Consequently,
domestic oil production stopped rising in 1970, then
declined until 1976, recovering only part of the drop
when output from the North Slope of Alaska began
to flow in 1977.
The bulk of the increase in net oil imports stemmed
from rising domestic demand which, despite rising
prices, was 25 percent higher in volume at the end
of the seventies than at the beginning (Chart 4). By
the close of the decade, almost half of United States
consumption of petroleum was being met from abroad,
compared with 23 percent in 1970 and only 11 percent
in the early fifties.
The international economic position of the United
States was adversely affected, not only by increased
dependence on imported oil, but also because this
country was perceived to be dealing less successfully
with the oil problem than other major countries. It is
true that, in the late seventies, most major countries
abroad remained dependent on imported oil for a
larger proportion of their energy needs than the United
States (Table 10). Consequently, such countries as
France, Germany, Italy, and Japan were more exposed
to the uncertainties of the international oil market. For

FRBNY Quarterly Review/Summer 1980

33

Chart 3

Chart 4

Prices of Exports and Imports of the
United States

United States Petroleum Supply and Demand
Millions of barrels per day

1967=100, unit values
350

20 -----------------------------------

0

I 11I I I I 1I I I I

1950

55

I I I

60

II
65

I I I

II

I I

70

1I I

I

I I

75

79

* Includes changes in reported private stocks and in Strategic
Petroleum Reserve.

100

^"Includes natural gas liquids.
Source: Data for 1950-74 from American Petroleum Institute,
Basic Petroleum Data Book (Washington, D.C., 1977);
data for 1975-79 from Department of Energy,
Monthly Energy Review.

Source: International Monetary Fund.

Table 10

Dependence on Net Petroleum Imports* of Major Countries, 1973-79

Country

Millions of barrels per day
1973
1978
1979

United States ..................................................... 6.0
Japan ........................................................ .......... 5.5
France ...................................................... .......... 2.6
Germany ............................................................. 2.9
Italy .......................................................... .......... 2.1
United Kingdom ....................................... .......... 2.3

8.0
5.3
2.2
2.7
1.9
0.9

7.8
5.6
2.4
2.8
2.0*
0.4

Percentage of total
energy requirements
1973
1978
17
83
71
55
79
52

* Net imports of petroleum and petroleum products,
t GDP for France, Italy, and United Kingdom,
t January-September.
Sources: Central Intelligence Agency, International Energy Statistical Reivew, April 23, 1980, pages 9-11;
International Energy Agency, Energy Balances of OECD Countries, 1974/1978, pages 149-50; and

International Monetary Fund, International Financial Statistics.

34for FRASER
FRBNY Quarterly Review/Summer 1980
Digitized


22
73
59
53
69
20

Ratio to real GNPf
(1973 = 100)
1978
1979
118
80
73
84
81
37

112
80
77
84
81
16

this reason, perhaps, the pressure to reduce depen­
dence was felt more keenly abroad than here. In any
event, dependence on imported oil declined signif­
icantly in most of the major countries abroad in the
five years following the OPEC shock. In contrast,
despite last year’s dip in domestic demand, United
States dependence on imported petroleum was sub­
stantially greater at the close of the decade than in
1973.
The failure to deal successfully with its oil problem
undermined the United States international economic
position in several ways. At the most basic level,
America’s voracious appetite for petroleum was, as
already noted, the largest force expanding imports. In
addition, it pushed up oil prices not only for the United
States but for the world at large. Such upward pres­
sure on prices was tolerable for a time because the
process of adopting an effective energy program in­
evitably involved prolonged debates, negotiations, and
compromises within the political arena. By the late
seventies, however, the time for decisive action was
long past. By then, the failure to adopt an energy pro­
gram designed substantially to reduce dependence
on imported oil suggested that America had not
faced the realities of the country’s vulnerability to
shocks from unstable foreign sources of petroleum.
Viewed from abroad, America was perceived, not as a
leader in dealing with the international oil problem but
as unwilling or incapable of responding to the chal­
lenge from OPEC. Resistance to the adoption of effec­
tive energy policies thus undermined the Government’s
efforts both to reduce the trade deficit as well as to
enlist the cooperation of other major countries in deal­
ing with a variety of other international concerns.
Two illustrations may be given of the way in which
the international economic position of the United States
was injured by the inadequacies of cooperation. De­
spite the declared intentions of the major countries to
curb oil imports,12 the prospect of inadequate supplies
and of rising prices in 1979 induced buyers to build up
oil inventories, in some cases to the limits of storage
capacity. Such precautionary buying, undertaken by
many countries, drove up oil prices in the spot mar­
kets and so contributed to the enlargement of the
United States deficit. In addition, the inflation of oil
prices complicated the efforts of the United States
authorities to support the dollar in the exchange mar­
kets, not only because of the widening of the trade
deficit but also because market participants feared that
other countries might pursue exchange market policies
incompatible with our own. More specifically, foreign
u Declaration of June 29, 1979 at the Economic Summit in Tokyo,
United States Department of State Bulletin (August 1979), page 8.




countries, faced with increases in the dollar price of
oil, might better resist inflation in their economies if
their exchange rates were allowed to appreciate
against the dollar. Indeed, such tendencies added to
other domestic and international pressures that in­
duced the United States monetary authorities to play a
relatively enlarged role during 1979 in the conduct of
official intervention in dollar exchange markets.
The continental economy of the United States
The continental market is a mixed blessing for the
international economic strength of the United States.
It is advantageous because it provides American firms
with huge potential demand for their output. Long
production runs and economies of scale are there­
fore possible. However, these very advantages are in
some ways a handicap in international trade. Although
there are notable exceptions, many American firms
feel little incentive to venture into uncertain foreign
fields because their capabilities are adequately, and
frequently fully, occupied in the domestic market. In
contrast, firms in many foreign countries— especially
the smaller ones— can secure long production runs
and economies of scale only by exporting to world
markets. Such firms are therefore more willing than
their potential American competitors to seek out for­
eign customers aggressively, to learn their languages,
to tailor their products to foreign tastes, and to provide
after-sales service.
This gap between the performance of American and
foreign firms was especially wide in the early postwar
years when the prestige of the United States products
was unsurpassed— when, indeed, some were virtually
the only ones of their kind available. American firms
had no need to search foreign markets for customers;
buyers came to America. However, the complacency
of many American firms tended to outlast their com­
petitive strength. The recovery and growth of countries
abroad was based on rising sales, not only in domestic
but also in foreign markets. In capturing such markets,
these countries frequently had the advantages of cur­
rencies that were undervalued against the dollar, at
least until 1973. Although this advantage receded dur­
ing the seventies and the United States was exporting
a greater proportion of its output, most American firms
still have a long way to go before they match the ef­
forts of their foreign competitors in world markets.
Barriers to trade
Trade barriers are a long-standing problem for Amer­
ican exporters. They consist not only of tariffs and
quantitative restrictions but also of various other de­
vices, including Government regulations designed
ostensibly to protect the health and safety of buyers.

FRBNY Quarterly Review/Summer 1980

35

Table 11

Ratios of Imports of Manufactured Goods to Gross National Product
Annual or annual averages

Year
1960 ....................................... .......................
1966-72 ................................. .......................
1973-79 ................................. .......................

United
States

Germany

Japan

Canada

United
Kingdom

1.3
2.5
4.0

5.8
8.4
10.8

2.3
2.4
2.5

10.1
13.3
16.0

5.5
8.4
14.5

France
3.9
7.3
10.3*

* 1973-78.
Source: United States Department of Commerce, International Economic Indicators.

The incidence of all these barriers was most severe in
the early postwar years, when most foreign countries
were attempting to employ their limited dollar resourc­
es for priority purposes, including the rebuilding of
their international reserves. As foreign countries gained
in economic strength, many barriers were removed or
reduced, particularly as the result of successive
rounds of multilateral trade negotiations. However,
some of the gains were offset by the erection of other
barriers, notably the external tariff of the EC which
discriminates against imports from nonmember coun­
tries and in favor of the products of certain ex-colonial
countries. EC restrictions against agricultural im­
ports— where the competitive strength of the United
States is great— are especially severe. Elsewhere,
protective devices, established on infant industry
grounds by developing countries and by Japan, have
remained in effect long after the infants became
hardy young giants. The case of Japan is especially
notable because of the difficulty that American firms
have experienced in penetrating its market. The prob­
lem is illustrated by Table 11 which shows the ratio
of imports of manufactured goods to GNP in the
major countries. This ratio increased significantly
during the sixties and seventies in all major coun­
tries except Japan, where it stayed virtually flat.
It remains to be seen whether the reduction of barriers
achieved under the recently concluded multilateral
trade negotiations will increase the accessibility of the
Japanese market to foreign products.
Conclusion
Just as the problems of the United States balance of
payments arose from developments both in this coun­
try and abroad, so the correction of these problems
involves the adoption of appropriate policies here and
in other major countries. Inevitably, the prime respon­
sibility falls on the United States. The task is formida­
ble but probably not more so than a number of earlier

36 forFRBNY
Digitized
FRASERQuarterly Review/Summer 1980


payments adjustments successfully accomplished by
other major countries. In some of these earlier in­
stances, once vigorous corrective measures were
adopted, the shift from external weakness to strength
came with dramatic rapidity.
Insofar as the responsibility of achieving such a cor­
rection falls on the United States, the broad aims of
policy are simply stated. The transfer gap must be
narrowed to the point where foreign monetary authori­
ties are accumulating no more dollars than they wish.
Conceivably, they might wish, not to increase their dol­
lars, but to run them down. In this case, the United
States would need to absorb official dollars from
abroad by running a surplus on goods and services
that exceeded its financial outflows. However, it seems
likely that, were the United States to adopt a vigorous
and sustained adjustment policy, the appetite of for­
eign monetary authorities for dollars would strengthen.
For purposes of exposition, this analysis takes the
middle position, assuming that adjustment policies
result over the longer term in the elimination of the
transfer gap through some combination of reduced
financial outflows and increased surpluses on goods
and services.
Without going into detail on how to accomplish such
an adjustment, some general pointers for policy are
in order. The adjustment of the United States balance
of payments calls for both medium- and longer term
measures. For the medium term, fiscal and monetary
measures are required to restrain domestic spending
and thus make available an enlarged proportion of
output for sales abroad. For the longer term, a strength­
ening of policy in at least two major fields is required.
A great deal remains to be done to conserve energy
use as well as to develop domestic energy supplies
in order to reduce significantly this country’s depen­
dence on foreign sources of petroleum, especially from
the Middle East. In addition, a substantial increase is re­
quired in the proportion of output devoted to productive

investment not only to increase the country’s energy
independence but also to strengthen the competitive­
ness of United States goods in domestic as well as for­
eign markets. Since such enlarged investment should
be financed from noninflationary sources, a corre­
sponding increase in the proportion of saving to GNP
is also required. In short, policy should be directed
toward reducing the proportion of GNP devoted to
personal consumption and government so that the
proportion allocated to domestic investment and net
exports of goods and services can be increased.
Even if adjustment policies could be precisely speci­
fied, it would, of course, not be possible accurately to
predict their effects on the balance of payments. How­
ever, it may be useful, for illustrative purposes, to
compare one hypothetical outcome with the actual
situation in the late seventies. Thus, the transfer gap
might be eliminated through a decline in financial
outflows to 1 percent of GNP, matched by an equiva­
lent surplus on goods and services. This compares with
actual financial outflows averaging 1.3 percent of GNP
in the two years 1977-78 and actual deficits on goods
and services averaging 0.45 percent.
As events developed, the strengthening of United
States external payments in 1979 accomplished almost
half of the hypothesized adjustment for goods and
services and far overshot that for financial flows. The
balance on goods and services swung to a $5.3 billion
surplus, equal to 0.22 percent of GNP, from the sub­
stantial deficits of the two previous years. As already
noted, financial movements shifted from the outflows
that had previously been characteristic to substantial
inflows in 1979— with large inward movements both
in the early months of the year and in the final quar­
ter, partially offset by outflows only during JuneSeptember.
Unfortunately, past experience cautions against pre­
mature rejoicing over last year’s strengthening in the
United States external position. The improvement was
based to an uncomfortably large extent on temporary
factors, most notably the substantial depreciation of
the dollar in earlier years, the more rapid growth of
major countries abroad in 1979 than of the United
States, and the relative tightness of monetary condi­
tions here. If shifts from balance-of-payments weak­
ness to strength can occur with surprising rapidity, so
too can shifts in the opposite direction. Financial out­
flows virtually disappeared in 1969 under the pressure
of stringent monetary conditions in the United States,
but then ballooned when monetary policy relaxed
during the 1970 recession. Similarly, the surplus on
goods and services rose to a record high in the re­
cession year 1975, only to give way to the heavy
deficits of 1977 and 1978. Clearly, these earlier swings,




combined with recognition of the role that temporary
factors played in last year’s improvement in America’s
external position, underline the need for fundamental
measures designed to stimulate saving and productive
investment and to decrease dependence on foreign
energy supplies. While some steps in these directions
have already been taken, additional vigorous measures
are required to hold as much as possible of the
ground gained in 1979 and to provide an enduring
foundation for America’s external strength.
Viewed from a longer term perspective, the task that
now confronts the United States is in some ways simi­
lar to that which faced foreign countries in the early
postwar years. The need then, as now, was to re­
direct resources into productive investment in order
to redress the imbalance in the international econ­
omy and to provide the basis for higher standards
of living. In the early postwar years, it was the de­
struction and neglect of hostilities that had to be made
good so that countries abroad could compete on more
equal terms with the United States. Now, the earlier
imbalances have long since been corrected but others
have taken their place. For a generation or more, the
proportion of GNP devoted to productive investment
in major foreign countries has been far above that in
the United States. As a result, technology in some
American industries trails that of their foreign rivals
and a growing proportion of many goods consumed
by Americans is produced not in this country but
abroad. This penetration of the American market, while
generally beneficial to consumers, has not always
elicited a positive response from producers. Some, like
those in textiles, have revitalized their industries to
meet foreign competition. In contrast, others have
sought various forms of Federal protection. Against
this contingency, foreign firms have sometimes found
it desirable to locate production facilities in the United
States. In doing so, they followed the earlier example
of American firms that established subsidiaries abroad
in order to surmount foreign barriers against imports.
Likewise, the increased competitiveness of American
wages and other attractions seen by foreign firms in
this country’s labor market during the seventies are
reminiscent of similar attractions that induced United
States firms to invest abroad in the fifties and sixties.
The transfer of advanced technology and managerial
know-how has thus become two-way. Benefits that the
rest of the world obtained from international direct in­
vestments in the earlier postwar years are now being
shared by the United States.13
Although the similarities are clear, handling the task
13 See Dorothy B. Christelow, “ International Policies toward Foreign
Direct Investment” , this Quarterly Review (Winter 1979-80),
pages 21-32.

FRBNY Quarterly Review/Summer 1980

37

that confronts the United States is in many ways more
difficult than that which faced policymakers abroad
after World War II. At that time, the penalties for
failure were stark: low living standards, hunger, and
always the threatened loss of political independence.
Now, the penalties for the United States— even when
they are recognized— seem less compelling: a drop
in American living standards below those of the most
advanced industrial countries and declining influence
in the world political arena. Clearly, the motivation
for economic discipline and international cooperation
was f^r stronger thirty years ago than now. Moreover,
the United States— the dominant economy in the early
postwar years— had a clear view of its role: to stimu­
late and to assist in the reconstruction of a prosperous
and integrated world economy. Today, leadership is
divided among a number of major industrial and oilrich countries which— while generally agreeing on the
desirability of an open, stable, and expanding inter­
national economy— frequently differ about the most
desirable means to attain these objectives.
Yet another handicap is that, with most countries
struggling to reduce inflation and to adjust to sharply
rising oil prices, the prospects for economic growth
are far less bright than a generation ago. In the 1950s
and 1960s, shifts from external weakness to strength
were facilitated by widespread and rapid economic
growth as well as by the progressive reduction of trade

FRBNY Quarterly Review/Summer 1980
Digitized38
for FRASER


barriers— itself a development that was heavily de­
pendent on the prosperity of the world economy. If
growth does indeed slacken significantly in the 1980s,
the accommodation of a significant and lasting shift
from deficit to surplus in the United States balance on
goods and services may well present difficult problems
to foreign countries. Such difficulties would be likely
to test the ability of the authorities both here and
abroad to work together in handling mutual problems
and to avoid further serious slippage into protection­
ism.
By the same token, slackening growth, combined
with an increase in the attractiveness of the United
States economy for long-term investors, would further
complicate the financial problems of debtor countries
abroad at a time when their borrowing needs are likely
to be rising. In this area, accommodation of the re­
quired adjustment in the United States external posi­
tion calls for a further loosening of restrictions on
capital outflows from major financial centers abroad
to reduce the excessive dependence of foreign bor­
rowers on dollar markets. Clearly, the accommodation
could also be facilitated by such institutions as the
International Monetary Fund and the World Bank. While
their resources will doubtless be adequate to meet ap­
propriate borrowing needs in the immediate future,
further substantial increases in their lending capacities
are likely to be required in the years ahead.

Stephen V. O. Clarke

The Pricing of Syndicated
Eurocurrency Credits
In recent years the syndicated Eurocurrency bank loan
has become one of the most important instruments for
international lending. These publicly announced loans
have grown rupidly, totaling over $80 billion in 1979,
and now comprise approximately half of all Euro­
currency credits. Syndicated credits are an important
pillar in the recycling process whereby surpluses from
oil-exporting countries (in the form of deposits) are
channeled to oil-importing countries (in the form of
loans) to finance their deficits.
The pricing of syndicated Eurocurrency credits is a
subject of particular interest to banks and their
supervisors. The loans are generally priced as a spread
over the interbank interest rate in the Euromarkets.
The interest rate paid by the borrower is adjusted every
three or six months as market rates vary. Spreads for
all borrowers have narrowed sharply from those pre­
vailing in 1974-75, while maturities have lengthened.
There are concerns that, at the rather narrow spreads
currently prevailing (% to 11/2 percent, depending on
the borrower), these loans may not yield an adequate
return on bank capital after adjusting for risk and
expenses. To the extent that this is true, the capacity
of commercial banks to continue to play an important
role in recycling could be impaired.
This article investigates the pricing of syndicated
loans. It examines the factors which analytically should
be important and empirically are important in deter­
mining the spread. The paper does not attempt to
hypothesize whether the spreads are in some sense
correct or reasonable; instead, it concentrates on the
events and influences that have contributed to the
currently narrow spreads.




An overview of the sydicated loan market
A syndicated credit is a loan in which a group of finan­
cial institutions makes funds available on common
conditions to a borrower. This type of lending com­
monly occurs in both the Eurocurrency market and
in the United States domestic market, although in the
latter it is a bit less frequent and is done under slightly
different institutional arrangements. In the domestic
market, as a normal part of business practice, a cor­
poration will usually have a banking relationship with
a number of institutions. If the corporate borrower
needs more funds than a single bank can or will pro­
vide, rather than opting for a syndication the borrower
will often draw down its credit lines at other banks,
sometimes at less favorable terms. By contrast, in the
Eurocurrency market, if a given borrower needs a
large amount of funds, a syndicate will usually be
formed and all banks in the syndicate will participate
in the loan on the same terms.
Growth and development of the market
The syndicated Eurocredit is a relatively new market
development dating from the late 1960s. Prior to this
innovation, large Euromarket financings were all in the
form of Eurobonds. Bank credits were, just as now,
priced as a percentage over the interbank interest rate
but were issued by a single bank. Hence, the size of
the credits were constrained by the prudent lending
limits of the bank. Using the syndication mechanism,
credits of over $1 billion have been handled with rela­
tive ease.
Since its inception, the market has grown rapidly
from $4.7 billion in 1970 to $82.8 billion in 1979 as

FRBNY Quarterly Review/Summer 1980

39

Germany, Hungary, and Poland. It was widely believed
that the Soviet invasion in Afghanistan early this year
would adversely afreet the borrowing ability of the
Communist countries. So far the evidence is incon­
clusive. Rumania and Hungary recently borrowed on
terms which, taking into account market conditions,
are no different from those they would have obtained
in 1979. However, the volume of loans to Eastern bloc
countries is much lower than in previous years.
Up until late 1979, OPEC countries were also active
borrowers in the Eurocredit market. The bulk of the
OPEC borrowing was done by the group of countries
known as high absorbers, those with current account
deficits and small current account surpluses. The lowabsorbing group, consisting of the countries with the
massive current account surpluses, namely, Saudi
Arabia, Kuwait, Libya, Qatar, and the United Arab
Emirates, do relatively little of the borrowing. OPEC
borrowing is used primarily to finance energy-related
and other development projects.
As the syndicated loan market has matured, it has
become much less concentrated. While in 1970 the
top ten borrowers accounted for 84 percent of total
Eurocredits, by 1974 this figure had declined to 66 per­
cent and by 1979 was only 54 percent (Chart 1).
Syndicated Eurocredits comprise only about half of
Eurocurrency bank lending. The other 50 percent is
lent by individual banks, is not publicized, and is con­
tracted for a shorter maturity than its syndicated
counterpart. These credits are primarily to the private
sector for trade financing or internationally related
business loans.

shown in the table. This twentyfold increase does not
all represent new money being made available, since
there were considerable refinancings in 1978 and 1979
when spreads narrowed. Nonetheless, the growth is
impressive. Syndicated credits now provide somewhat
more than half of the medium- and long-term borrow­
ings in international capital markets. (Eurobonds and
foreign bonds account for the rest.) However, they
accounted for more than 85 percent of the mediumand long-term funds for developing countries and 98
percent for centrally planned economies in the 1973-79
period.
In the wake of successive oil price increases and
the resulting balance-of-payments deficits for most
nonoil-producing less developed countries (LDCs), the
Eurocurrency market allows for recycling of funds to
many governments that have little or no access to other
international capital markets. The relative share of
non-OPEC (Organization of Petroleum Exporting Coun­
tries) LDC borrowing follows very closely the pattern
of aggregate current account deficits of these coun­
tries. Non-OPEC LDCs accounted for 21 percent of the
market in 1972-73, rising to 39 percent in 1975,
dropping to 32 percent by 1977, and rising again to 43
percent in 1979. The aggregate deficit for non-OPEC
LDCs was approximately $7 billion in 1972-73, rising
to $32 billion by 1975. As a result of the declining real
price of oil, and the recovery of the developed coun­
tries from the 1974-75 recession, the aggregate deficit
declined to $14 billion in 1977. But for 1979 the aggre­
gate deficit is estimated at about $35 billion and is
projected to go up to about $50 billion-$55 billion in
1980.
The Communist countries have also increased their
commercial bank borrowing dramatically since 197273. The bulk of this borrowing has been done by East

Why are syndications so prevalent in the
Eurocurrency market?
Syndicated Eurocredits have emerged as a popular

New Syndicated Eurocurrency Bank Credits
In billions of dollars
January-

Group
Total ...............................................
Industrialized countries ................
Non-OPEC L D C s...........................
OPEC countries ...........................
Communist countries ....................

1970

1971

1972

4.7
4.2
0.3
0.1
0

4.0
2.6
0.9
0.4
0.1

6.8
4.1
1.5
0.9
0.3

Because of rounding, figures may not add to totals.
Source: Morgan Guaranty Trust Company, World Financial Markets.

FRBNY Quarterly Review/Summer 1980
Digitized40
for FRASER


1973
21.9
13.8
4.5
2.8
0.8

1974
29.3
20.7
6.3
1.1
1.2

1975
21.0
7.3
8.2
2.9
2.6

1976
28.8
11.3
11.0
4.0
2.5

1977
41.8
17.4
13.5
7.5
3.4

1978
70.2
29.1
26.9
10.4
3.8

1979

April
1980

82.8
27.5
35.4
12.6
7.3

18.4
9.2
4.9
3.1
0.8

vehicle for international lending because they contain
advantages from the point of view of both lenders and
borrowers. From the lenders viewpoint, the syndication
procedure is a means for banks to diversify some of
the unique risks that arise in international lending. In
part, these risks reflect the heavy concentration of
public-sector borrowers in the market. Information
compiled by the World Bank since 1975 indicates that
credits to the public sector comprise approximately
75 percent of the syndicated lending.
The legal protection available to a bank is much dif­
ferent if a private borrower defaults as opposed to the
case in which a public borrower defaults. If a private
borrower defaults or otherwise fails to fulfill the
obligations stipulated in the loan agreement, credi­
tors can pursue various legal remedies. There is a
considerable legal framework in each country to safe­
guard the claims of creditors if a borrower has declared
bankruptcy. When commercial banks lend to publicsector borrowers, there is much more uncertainty about
legal recourse. For instance, there are questions about
which public-sector borrowers are covered by sovereign
immunity.
There also are special political uncertainties, in­
cluding the risk, however remote, that a public-sector
borrower will choose not to repay loans from individ­
ual banks or a group of banks in a particular country.
The syndication process tends to magnify the pen­
alty associated with selective defaults. In the case
of a widely syndicated loan from banks in several na­
tions, unwillingness to repay debts could effectively
preclude the borrower from entering the credit market
in the future. It would be surprising if a lender in the
earlier syndicate would be willing to participate and
other lenders would be reluctant. In addition, unwill­
ingness to repay debts would bring political pressure
from several countries as opposed to only one or two.
In addition to developing syndication procedures,
banks have taken other steps to protect themselves
against these risks. For example, the risk of selective
default on credits encourages banks to include a cross­
default clause in the loan agreement. This clause
states that, if one public borrower from a country de­
faults, the loans of other public borrowers from that
country may be called into default as well. In that case,
the loans of those borrowers become due and payable.
To recapitulate, syndication of public credits allows
banks to reduce risk in two ways. First, it allows banks
to diversify their loans to the public sector, which is
more essential than with loans to the private sector
due to the banks’ lack of control over and protection
against default by sovereign entities. Second, it pro­
vides more protection against selective defaults.
The syndication procedure is advantageous from




Chart 1

Percentage of Syndicated Eurocredit Market
Captured by the Top Ten Borrowers
Percent
90 --------------- ----------------------------— --------------------------------------

40 I------- 1------- 1------- 1------- 1------- 1------- 1------- 1------- 1------- 1------- 1-----1970 71
72
73
74
75
76
77
78 79 80
Source: Morgan Guaranty Trust Company,
World Financial Markets.

the lenders’ viewpoint as it allows different-sized banks
to function in the market simultaneously. That is be­
cause a Eurocurrency loan is underwritten by a small
group of banks who resell portions of the loan to
other banks. The larger banks can underwrite a loan
and earn underwriting fees. Smaller banks can simply
purchase participations from the underwriting banks.
From the borrowers’ viewpoint, syndication allows
for the efficient arrangement of a larger amount of
funds than any single lender can feasibly supply. This
factor is crucial in explaining the popularity of shared
credits in both the domestic market and the Eurocur­
rency market. In the latter, however, syndicated lend­
ing becomes less of a convenience and more of a
necessity. The financing needs imposed by the re­
cycling process, coupled with the lack of alternative
financing arrangements in the Eurocurrency market,
create the demand on the part of borrowers for huge
bank loans. In the United States domestic market, if
a business needs a large amount of long-term funding,
bank loans are only one, albeit often the most viable,
of several options. The firm may also arrange for debt
or equity financing. In external markets, however,
there are fewer options. Industrial country borrowers,

FRBNY Quarterly Review/Summer 1980

41

both governmental and private, may have access to the
international bond markets, but LDC borrowers by and
large do not. The only alternative source of financing
for the latter group is the syndicated Eurocredit market.
The underwriting procedure used in the syndication
of Eurocurrency credits may allow the borrower to ob­
tain better terms than those that would otherwise be
available. The syndicated credit is essentially a hybrid
instrument, a cross between traditional bank lending
and the underwriting function of investment banking. By
underwriting, major banks show their confidence in the
credit, thereby making it more attractive to smaller
financial institutions. This blending of the investment
banking and commercial banking functions is prohib­
ited in many national markets including the United
States, Japan, and Italy. In recent years, however,
there has been some blurring of these activities in the
United States. There are several examples of commer­
cial banking practices which are not strictly speaking
underwriting activities but which involve syndication
procedures. Moreover, municipal debt is often under­
written by commercial banks. In the London market,
where a majority of the Eurocurrency syndications are
arranged, underwriting is standard for both commercial
banks and their merchant banking affiliates. These
affiliates operate much like investment banks in the
United States.
The syndication procedure1
There are generally three levels of banks in a syndicate:
the lead banks, the managing banks, and the participat­
ing banks.2 Most loans are led by one or two major
banks who negotiate to obtain a mandate to raise
funds from the borrower. Often a potential borrower
will set a competitive bidding procedure to determine
which lead bank or banks will receive the mandate
to organize the loan.
After the preliminary stages of negotiation with a
borrower, the lead bank will begin to assemble a man­
agement group to underwrite the loan. The manage­
ment group may be in place before the mandate is
received, or may be assembled immediately afterward,
depending on the loan. The lead bank is normally
expected to underwrite a share at least as large as
that of any other lender. If the loan cannot be under­
written on the initial terms, it must be renegotiated or
1A more detailed description of the syndication procedure can be
found in an article by Henry Terrell and Michael G. Martinson,
"Market Practices in Syndicated Bank Euro-currency Lending” ,
Bankers Magazine (November 1978).
2 In some of the larger credits, there are four or more levels of banks:
the lead banks, the co-managers, the managing banks, and one or
more levels of participating banks. The co-managing banks under­
write more than a prespecified amount of funds.

Digitized
42for FRASER
FRBNY Quarterly Review/Summer 1980


the lead bank must be willing to take a larger share
into its own portfolio than originally planned.
Once the management group is firmly in place and
the lead bank has received a mandate from the bor­
rower, a placement memorandum will be prepared by
the lead bank and the loan will be marketed to other
banks who may be interested in taking up shares (the
participating banks). This placement memorandum de­
scribes the transaction and provides information about
the borrower. The statistical information regarding the
financial health of the borrower given in the memoran­
dum is generally provided by the borrower. The
placement memorandum emphasizes that reading it
is not a substitute for an independent credit review
by the participating banks. Bank supervisory authori­
ties normally require sufficient lending information to
be lodged in the bank to allow bank management to
make a reasonable appraisal of the credit.
In a successful syndication, once the marketing to
interested participants is completed, the lead and man­
aging banks will keep 50 to 70 percent of their initial
underwriting share.
Not all credits are sold to participants. In smaller
credits to frequent borrowers, cfub loans are often
arranged. In a club loan the lead bank and managers
fund the entire loan and no placement memorandum
is required. This type of credit is most common in
periods of market uncertainty when all but the largest
multinational banks are reluctant to do business.
It takes anywhere from fifteen days to three months
to arrange a syndication, with six weeks considered the
norm. Generally speaking, the more familiar the bor­
rower, the more quickly the terms can be set and the
placement memorandum prepared; the smaller the
credit, the shorter is the time needed for negotiating
and marketing.
After the loan is arranged, one of the banks serves
as agent to compute the appropriate interest rate
charges, to receive service payments, to disburse these
to individual participants, and to inform them if there
are any problems with the loan. The lead bank usually
serves as agent, but another member of the manage­
ment group may do so.
The most common type of syndicated loan is a term
loan in which the funds can be drawn down by the
borrower within a specified period of time after the loan
agreement has been signed (the drawdown period).
The loan is usually repaid according to an amortization
schedule, which varies from loan to loan. For some
loans it may begin as soon as the loan is drawn down.
For other loans, amortization may not begin until as
long as five years after the loan agreement has been
signed. The period before repayment of principal begins
is known as the grace period. This is one of the most

important points of negotiation between a borrower and
a lead bank, and borrowers are normally willing to pay
a wider spread in order to obtain a longer grace period.
Another type of loan less frequently used is a re­
volving credit. The borrower is given a line of credit
which can be drawn down and repaid with more flexi­
bility than the term loan. The borrower must pay a
fee for the undrawn portion of the credit line.
The vast majority of syndicated credits are denom­
inated in dollars, but loans in German marks, Swiss
francs, Japanese yen, and other currencies are also
available.

The pricing of syndicated loans
Interest on syndicated loans is usually computed by
adding a spread to the London interbank offer rate
(LIBOR). LIBOR is the rate at which banks lend funds
to other banks operating in the Euromarket. Occasion­
ally, however, a loan may be priced as a spread over
the United States prime rate. Less frequently, pricing
is done both as a percentage over LIBOR and over
the United States prime rate; the banks have the option
to shift from LIBOR to prime pricing at their discretion.
Pricing over the United States prime rate occurs when
the syndicate is comprised primarily of United States
banks who prefer to book the loan out of their head
office rather than at an offshore branch. Strictly speak­
ing, dollar loans booked in the United States are not
Eurocurrency loans. However, these loans may be
organized by offshore merchant bank subsidiaries.
The spread is negotiated with the borrower at the
outset and either remains constant over the life of the
loan or changes after a set number of years.3 For ex­
ample, a fifteen-year loan was recently syndicated at
a spread of % percent over LIBOR for the first five
years, V2 percent for the next five years, and 5/a per­
cent for the last five years. Loans priced over the
United States prime rate generally carry a spread of
Vb to 1/4 percent less than loans priced over LIBOR.

3An

innovation in the pricing of syndicated credits has recently
surfaced: a loan with a floating spread. This novel mechanism is
being tested for a relatively small loan. For the first year the spread
was set at Vb percent over LIBOR, but after the first year the floating
concept takes over. Each year the banks in the syndicate will quote
a spread based on their assessment of what the market would
require of the borrower if it was to seek a loan for the amount and
maturity outstanding. The actual spread will be a weighted average
of the quotes, with a maximum of 1% percent and a minimum of
5/s percent. If the borrower objects to the spread quoted by the
banks, he has the option of repaying the loan without notice.
This floating rate spread has advantages for both borrower and
lenders. The borrower will benefit because each requote will be
for a shorter maturity, that is, seven years in twelve months, six
years in twenty-four months, etc. Lenders, on the other hand, can
adjust the spread if the creditworthiness of the borrower changes. In
addition, the lenders will be in a position to take advantage of any
widening of spreads that may occur in the market.




The LIBOR is changing continuously. However, the
rate on any particular loan is readjusted only every
three or six months. This is known as pricing on a roll­
over basis. The borrower is usually given the choice
between a three-month or a six-month readjustment
period. A six-month period is normally selected be­
cause in a period of generally rising interest rates, as
had been the case until recently, it is desirable for a
borrower to lock in rates for as long a period as pos­
sible. The new base rate is calculated two days prior
to the rollover date as the average of the offer rates of
several reference banks in the syndicate. The reference
banks are carefully specified in the loan agreement.
The spread above the LIBOR paid by the borrower
understates the bank’s actual return on a loan. The
LIBOR is generally Ve to 1A percent above the rate at
which banks purchase funds from large depositors
(the bid rate). The London interbank bid (LIBB) rate is
roughly equal to the interest rate on certificates of
deposit (CDs) in the United States domestic market,
adjusted for reserve requirements. In some situations
the bid rate may even exaggerate the cost of funds to
Eurobanks. The main example of this occurs when a
single depositor (or group of closely related deposi­
tors) already hold significant funds in the bank and
would like to deposit more.
Other fees
In addition to the interest costs on a Eurocurrency
loan, there are also commitment fees, front-end fees,
and occasionally an annual agent’s fee. Commitment
fees are charged to the borrower as a percentage of
the undrawn portion of the credit and are typically
V2 percent annually, imposed on both term loans and
revolving credits. Front-end management fees are
one-time charges negotiated in advance and imposed
when the loan agreement is signed. Fees are usually
in the range of V2 to 1 percent of the value of the
loan.4 These front-end fees include participation fees
and management fees. The participation fees are di­
vided among all banks in relation to their share of
the loan. The management fees are divided between
the underwriting banks and the lead bank.5 The
agent’s fee, if applicable, is usually a yearly charge but
may occasionally be paid at the outset. These fees
are relatively small; the agent’s fee on a large credit
may run $10,000 per annum.
To protect their margins, banks require all payments
of principal and interest to be made after taxes im-

4Borrowers are sometimes willing to pay higher fees in return for a
lower spread on the loan.
and Martinson, loc. cit., for a more complete description
of the method by which the front-end fees are divided among the
financial institutions.

5See Terrell

FRBNY Quarterly Review/Summer 1980

43

posed in the borrower’s country have been paid. If
those taxes are not creditable against the banks’
home country taxes, the borrower must adjust his
payments so that the banks receive the same net
repayment. The decision as to whether the borrower
or lender absorbs any additional taxes imposed by the
country in which the loan is booked is negotiated
between the parties.
Also, usually inserted is a reserve requirement
clause, stipulating that an adjustment will be made if
the cost of funds increases because reserve require­
ments are imposed or increased. This clause was in­
voked for loans booked in the home office of United
States banks when marginal reserve requirements
were imposed in late 1979.
There is generally no prepayment penalty on Euro­
credits. In 1978 and 1979 when spreads narrowed,
many borrowers chose to refinance the loans initially
obtained in 1975 and 1976 at a higher spread. Banks
then tried to impose prepayment penalty clauses on
new loans, but borrowers were reluctant to go along
with these. At least for the moment, banks have backed
off because prepayment penalties have little relevance
in a period of low spreads.
The charges on syndicated loans may be summa­
rized as follows:
Annual payments = (LIBOR + spread) X
amount of loan drawn
+ (Commitment fee) X
amount of loan undrawn
+ tax adjustment (if any)
+ Annual agent’s fee (if any)
Front-end charges = participation fee X
face amount of loan
+ management fee X
face amount of loan
+ initial agent’s fee (if any)
Front-end changes are an important component of
the banks’ total return on a credit. Consider a $100
million seven-year credit with no grace period. If the
loan is priced at 100 basis points over a LIBOR of
10 percent, annual payments of interest and principal
repayment total slightly over $21 million. A 1 percent
fee requires that $1 million be paid to the banks in
the syndicate at the outset. This raises the effective
interest to the borrower from 11 percent to 11.31 per­
cent per annum. If banks’ paid, on average, 9.75 per­
cent for their funds, the front-end fees increase their
margin on the loan from 125 basis points to 156 basis
points. This represents a 25 percent increment to their
return on a credit.

44for FRBNY
Digitized
FRASERQuarterly Review/Summer 1980


Trends in spreads and maturities
The history of syndicated credils may be divided into
four periods, two “ borrowers markets” and two “ lend­
ers markets” depending on terms and conditions.
During borrowers markets, spreads were low and ma­
turities were long— attractive terms from the point of
view of the borrowers. During lenders markets, the
situation was reversed.
•
•
•
•

Lenders market, 1970 to late 1972
Borrowers market, late 1972 to mid-1974
Lenders market, mid-1974 to mid-1977
Borrowers market, mid-1977 to present.

This division is depicted in Chart 2 where a time series
for spreads and maturities from 1972 through the
third quarter of 1979 is shown for the four major
groups of borrowers: industrialized, OPEC low ab­
sorbers, high-income developing, and low-income de­
veloping.6 Information on loans syndicated prior to 1972
are not available on a basis consistent with later data.
The lenders market from 1970 through late 1972 is
best characterized as a period of market development.
Spreads remained relatively constant during 1970 and
1971, and many borrowers entered the market for the
first time.
By mid-1972, lenders had developed confidence in
the market, credit volume rose, spreads began to nar­
row, and maturities lengthened. Bullet loans— credits in
which there is no amortization over the life of the
loan and the principal is entirely repaid at maturity—
made their debut in the market during this period. This
borrowers market continued until the Herstatt collapse
in June 1974. The market bottomed out in mid- to late
1973. In the third quarter of 1973, weighted average
spreads for the industrialized and high-income devel­
oping countries were 0.68 and 0.93 percent, respec­
tively, coupled with maturities of nine and eleven and
a half years. After the quadrupling of oil prices, there
was a small but perceptible tightening of terms, as
loan demand outstripped the supply of funds at the
record low spreads. Even so, by the summer of 1974,
spreads were low and maturities were averaging about
eight and a half years.
All this changed, however, after the failure of Bankhaus Herstatt and the subsequent demise of Franklin

‘ This classification scheme is similar to the one used by the World
Bank. High-income developing countries are those the World Bank
classified as high, upper, and intermediate middle developing at the
end of 1978. Low-income developing countries are those the World
Bank classified as lower middle developing as well as lower develop­
ing at end-1978. Industrialized and oil-exporting countries correspond
to the World Bank group with those titles.

National Bank. Depositors reacted by seeking to hold
only very short-term funds in the safest and largest
banks. Responding to this sudden shift in depositors’
attitudes, banks sought to shorten the maturity of their
lending. They were unwilling to commit themselves
to long-term loans at prevailing spreads. The result
was a sharp tightening of lending terms; the weighted
average spreads for industrialized countries doubled
from 63 basis points in the second quarter of 1974 to
129 basis points in the fourth quarter. The deteriora­
tion in terms for the OPEC borrowers and the develop­
ing countries was equally dramatic.
In 1975, spreads widened further to the IV 2 to 2
percent range and maturities dropped to about five and
a half years. Very few new loans with a maturity longer
than eight years were agreed to by lending institutions.
This lenders market lasted until mid-1977. At that point,
confidence in the market began to strengthen as a re­
sult of the banking system’s successful role in the re­
cycling process. In addition, German and Japanese
banks entered the syndicated market on a large scale,




vigorously soliciting business. Hence, spreads began to
narrow. The weighted average spread for industrialized
countries dropped from 1.25 percent in the third quar­
ter of 1977 to 0.79 percent in the first quarter of 1978.
Spreads for the developing countries fell correspond­
ingly. By the fourth quarter of 1977, average maturities
had lengthened to nearly seven years.
The borrowers market which began in mid-1977 is
still present. In 1978 and the first three quarters
of 1979, maturities rose and spreads narrowed further.
By the third quarter of 1979, spreads for high-income
developing countries reached a record low of 0.86 per­
cent. But, in the wake of the freeze on Iranian assets
in November 1979 and the series of oil price increases
in late 1979 and 1980, market perceptions of risk have
been altered and a two-layered market has developed.
In this period of market uncertainty as reflected in the
slowing of new syndication activity, prime borrowers
continue to borrow on terms not dissimilar to what they
were receiving late last year (spreads of % to % per­
cent). Other borrowers are, however, confronted with

FRBNY Quarterly Review/Summer 1980

45

somewhat higher spreads and lower maturities than in
m id-1979.7

Determinants of spreads
There are several basic questions that consistently
appear in any analysis of spreads.
• What causes a borrowers market or a lenders
market?
• How are interest rates, spreads, and maturities
related?
• What are the systematic differences in spreads
between groups of countries?
This section considers certain economic factors
which are important in the determination of spreads
for syndicated Eurocredits: the level of interest rates,
the volatility of interest rates, maturity, and risk. There
are, however, other important factors which are diffi­
cult to quantify, such as increased competition from
German and Japanese banks and relative loan demand
pressures at home. These supply side influences were
not explicitly included in the statistical analysis.
Level of interest rates
Narrow spreads are associated with a high level of
interest rates for two reasons. The first reason is that
banks would be expected to equate the marginal cost
of all sources of funds. In periods of high nominal in­
terest rates, the opportunity cost of reserve require­
ments is higher. Hence, the absolute differential be­
tween Euromarket and domestic market interest rates
will widen because the former has no reserve require­
ments. Thus, more funds will be shifted into the Euro­
market and, with an unchanged demand for funds, this
would be sufficient to reduce spreads.
The second reason that a high level of nominal in­
terest rates implies a narrower absolute spread relates
to the return on capital. A bank should be concerned
about the consolidated return on capital. It can be
shown that, when LIBOR rises, the rate of return on
capital increases. Thus, if the cost of capital remains

7 Another factor contributing to the slight tightening of terms for some
borrowers is the freeze and slowdown of Japanese bank participation
in the market. In October 1979 the Japanese Ministry of Finance
effectively banned Japanese participation in syndicated credit until
April 1980. They were able to reenter the market in April, but they
are limited to an estimated $5 billion in credits for April 1980-March
1981, only a small fraction of their participation in the first nine
months of 1979. Since the market is relatively competitive, there have
been enough non-Japanese banks willing to participate in syndicates
so that this has had little influence on the spreads of most bor­
rowers. However, because of internally imposed country exposure
limits, the slowdown of lending by Japanese banks has had an
adverse effect on the spread for some heavy borrowers.

46

FRBNY Quarterly Review/Summer 1980




constant, spreads will be lowered to maintain the same
rate of return on capital. The rate of return on capital is
computed by assuming the loan is funded propor­
tionately by capital and borrowed funds. Thus, if we
hypothesize a capital/total assets ratio of 5 percent,
this implies that the average loan is funded 95 percent
from deposits and 5 percent from capital. Assuming
the bank has no overhead or loan-processing costs
and it purchases funds in the interbank market at
LIBOR, the return on capital is derived as follows:
Return on capital = [return on the loan —
(the cost of deposits) X
(deposits/assets)]
X assets/capital
All terms are expressed in percentage per annum.
If the capital/asset ratio is 0.05, the spread is 1 per­
cent and the LIBOR is 16 percent, we have:
Rate of return on capital = [LIBOR + 1 —
(0.95 X LIBOR)] X 20
= 1.8 X 20 = 36
Assuming a marginal tax rate of, say, 50 percent, this
36 percent pretax rate of return is equivalent to an
aftertax rate of return of 18 percent. If the capital/
asset ratio and spread remain constant, and the LIBOR
increases to 20 percent, the before-tax rate of return is
now 40 percent and the aftertax rate of return is 20
percent. If the bank wished to achieve an 18 percent
aftertax return on capital with a LIBOR of 20 percent,
it would charge a spread of 80 basis points.
Since both effects work in the same direction, in
theory higher interest rates should be associated
unambiguously with lower spreads. Empirical work,
shown in the appendix, confirms the theoretical hy­
pothesis. Each 100 basis point (or 1 percentage point)
increase in the level of rates over the relevant range
will, all other things being equal, narrow spreads by
7 basis points.
Variation of interest rates
The more volatile are interest rates, the larger should
be the spreads on Eurocurrency loans because banks
do not eliminate interest rate risk by perfectly match­
ing assets and liabilities. Since liabilities on average
have shorter maturity than the rollover period for
assets, the bank may have to fund the assets for the re­
mainder of the rollover period with more expensive
money than anticipated. The evidence indicates that
this is important. Bank of England data for November
1979 show that 23 percent of foreign currency liabilities

Risk Protection Features of Syndicated Eurocredits
One of the most interesting features of a syndicated
Eurocurrency loan is the degree it is tailored to mini­
mize the risks that financial institutions participating
in this market would otherwise face. Compared with

the fixed rate credit arranged by an individual bank,
the rollover syndicated Eurocredit reduces risk in sev­
eral notable ways, as summarized below.

Lending Risks

Risk

Source of risk

Risk reduction strategy

Country risk .............

The ability and willingness of borrowers
within a country to meet their obligations

Syndication of the credit and diver­
sification of bank’s loan portfolio

Credit r i s k .................

The ability of an entity to repay its debts

Syndication of the credit and diver­
sification of bank’s loan portfolio

Interest risk .............

Mismatched maturities coupled with
unpredictable movements in interest rates

Matching assets to liabilities by
pricing credits on a rollover basis

Regulatory r i s k ..........

Imposition of reserve requirements or
taxes on the banks

A clause in the contract which forces
the borrowers to bear this risk

of banks in the United Kingdom (including a number
of United States bank and other Euromarket partici­
pants) was for eight days or less, 19 percent between
eight days and one month, and 28 percent between
one and three months. Thus, the vast majority of the
liabilities which fund these loans are of a shorter ma­
turity than the rollover period for the loans themselves.
A bank will tend to demand a risk premium for incur­
ring this interest rate risk.
Empirical work supports this supposition. Each 0.01
increase in the quarterly coefficient of variation (the
standard deviation as computed from daily figures,
divided by the mean) translates into a 3 basis point
increase in spreads.
Maturity
The relationship between maturity and spread depends
on whether one is examining individual loan data at a
single point in time or aggregate data across time. In
a cross-sectional analysis, which examines individual
loan data at a single point in time, there should be a
positive relationship between the two variables. With
other factors constant, a longer maturity loan should
carry a wider spread in order to leave the lenders in­
different. This is true because, if spreads widen, lenders
are locked into a long maturity loan at the old spreads.
If spreads narrow, the borrower can refinance. In addi­
tion, bankers attempt to analyze both the economic and



political risks associated with a loan. It is more difficult
to analyze the economic and political risks over a
twelve-year horizon than over a five-year horizon. Thus,
for each additional year of maturity, lenders will require
compensation in terms of spread, fees, or grace period.
Borrowers also prefer longer maturities and are willing
to compensate lenders for such a loan because they are
assured of the availability of funds at a prespecified
spread, even if market conditions tighten. If market
conditions loosen, a borrower can often refinance.
However, by averaging spreads and maturities for
each risk group in each quarter, the trade-off on an in­
dividual loan is not visible. At any point in time, a
lender might be willing to make a six-year loan to the
borrowers of a certain risk class at % percent, an
eight-year loan at 3A percent, or a ten-year loan at
% percent. If equal numbers of borrowers opted for
each maturity, in the aggregate we would simply ob­
serve an eight-year loan at 3A percent.
Looking at aggregate data on spreads and maturities
over time, as this article has done, there should be
an inverse relationship between the two variables as
maturity will serve as a proxy for market confidence.
During periods of low confidence in the market,
spreads should be wide and maturities short. For
example, in the two years following Herstatt, banks
were worried about the continued availability of funds.
This was reflected in wide spreads and low maturities.

FRBNY Quarterly Review/Summer 1980

47

In fact, it was found that each one-year increase in
maturity is associated with a 9 basis point decline in
spread.
Risk
The higher the perceived risk associated with a bor­
rower, the greater the debt service difficulties antici­
pated by the lenders, hence the wider the spread
that would be required. Thus, low-absorbing OPEC
borrowers would be expected to pay a bit more than
industrialized countries, high-income developing coun­
tries would be expected to pay more for borrowings
than OPEC borrowers, and low-income developing
countries would be expected to pay more than highincome developing countries. The data seem to bear
this out. Holding other factors constant, OPEC coun­
tries borrow at 15 basis points more than industrialized
borrowers, high-income developing countries at 38
basis points more, and low-income developing coun­
tries at 48 basis points more.
Risk premiums may be related to maturity. Since there
is less certainty about the economic and political state
of a given economy ten years from now, as opposed to
next year, a risk-averse bank may charge a maturityrelated risk premium to less than prime customers. It
was found that for high-income developing countries
each additional year adds to the spread 5 basis points
over what an industrialized country would pay. Thus,
on a seven-year loan, a high-income developing coun­
try would pay 35 basis points more than an industrial­
ized country. For low-income developing countries,
each additional year adds to the spread 7 basis points
over what an industrialized country would pay. Thus,
for a seven-year loan, a low-income developing coun­
try would pay almost 50 basis points more than an
industrialized country. For OPEC countries, each addi­
tional year adds 2 basis points or about 15 points on
a seven-year loan.
The perceived risk of lending to nonoil LDCs de­
clined during 1975-79, as reflected in the spread dif­
ferential between industrialized countries and nonoil
LDCs. The large OPEC surplus in 1974 evaporated more
rapidly than even the optimists in the market had pre­
dicted, and nonoil LDC deficits declined sharply in real
terms from their 1975 peak of $32 billion. In addition,

a number of nonoil LDCs— major borrowers like Korea
and Brazil, for example— have developed their export
potential rapidly. However, with the renewed widening
of the OPEC surplus, the corresponding deficits for
the LDCs are likely to be larger and more long lasting
than had been thought. This is leading to a reassess­
ment of relative risk.

Summary and Outlook
This article has attempted to explore the factors which
are theoretically and empirically important in the pric­
ing of syndicated loans. It was found that, if the level
of interest rates increases, the volatility of rates de­
clines, or, if the maturities on loans lengthen, then the
spreads on syndicated loans tend to narrow. Banks
clearly recognize risk differentials between borrowers.
Those from OPEC countries borrow at about 15 basis
points more than those from industrialized countries.
Those from high-income developing and low-income
developing countries pay a risk premium of nearly
40 and 50 basis points, respectively.
Thus far in 1980 there has been a slight tightening
of terms for many borrowers. With the United States
moving into a recession, interest rates have fallen. This
has caused spreads to widen. The October 1979 deci­
sion of the Federal Reserve to place greater emphasis
on bank reserves in day-to-day operations and less
emphasis on short-term movements in the Federal
funds rate resulted in wider interest rate swings. This
increased rate volatility has been reflected in wider
spreads. Maturities have dropped as well, demonstrat­
ing concern on the part of some lenders about the
effects on the banking system of another round of
large-scale deficit financing.
In the next two or three quarters, spreads on loans
to a number of LDC borrowers could widen consid­
erably more than spreads for industrialized borrowers.
Nonoil LDCs already have a large amount of debt
which must be serviced, as the outstanding debt of
developing countries has more than doubled since
1974. Furthermore, this debt is concentrated in the
largest United States and foreign banks, some of which
are reviewing lending limits for certain borrowers. Con­
sequently, banks may be more hesitant to participate
in large new syndications unless lending margins widen.

Laurie S. Goodman

48

FRBNY Quarterly Review/Summer 1980




Appendix: Spreads
It is postulated that spread depends upon the level of
interest rates, the volatility of interest rates, the ma­
turity of the credits and risk variables as shown in
equation ( 1 ).
(1) Spread = f (interest rates, volatility, maturity, risk)
The construction of a series which captures the
volatility of interest rates without also capturing their
level presents a bit of a problem. Using the variance
or standard deviation of interest rates over the quarter is
not satisfactory, as we would expect either to be highly
correlated with the level of interest rates. For example,
a standard deviation of 0.5 may reflect a great deal of
volatility when interest rates are 5 percent, and reflect
relatively little volatility when interest rates are 13 per­
cent. Using the coefficient of variation (which is the
standard deviation divided by the mean) rather than
the variance or standard deviation mitigates this
problem.
To investigate the impact of the variables mentioned
above, a pooled cross-section time series regression of
the following form was performed:
(2) Spread = constant + b, rate +b» CV rate
+ ba mat + b< Di + b.- Du + bo D3
where:
rate
CV rate
Mat
D,
d2
Da

= the six-month Eurodollar interest rate
= coefficient of variation of the six-month
Eurodollar interest rate
= maturity
= 1 if the observation is that of a highincome developing country; 0 otherwise
== 1 if the observation is that of a lowincome developing country; 0 otherwise
— 1 if the observation is that of an oilexporting surplus country; 0 otherwise

of the four groups (industrialized, OPEC, high-income
developing, and low-income developing) were calcu­
lated from the World Bank’s B o rro w in g in In te rn a tio n a l
C a p ita l M a rk e ts data base. Regressions were performed
from the third quarter of 1973 to the third quarter of
1979, and the results are given below (t statistics in
parenthesis):
(3) Spread = 2.093 - 0.072 rate + 3.092 CV rate
(16.00) (-5 .5 9 )
(2.49)
-0 .0 8 6 mat + 0.376 D,
(-5 .2 5 )
(5.62)
+ 0.484 D, + 0.147 0 3
(7.25)
(2.09)
R -(adj) = 0.635; S.E. = 0.236; DW = 1.36
Note that all coefficients have the expected sign, all are
significant at the 5 percent level, and the regression
explains 64 percent of the spread. While strictly speak­
ing this Durbin-Watson statistic is meaningless, as this
is a pooled cross-section time series, it may indicate
autocorrelation as, out of 99 error differences, only
three are across groups.
This relationship is flawed because it does not take
account of changes in relative risk over time. To handle
that problem, a slightly different equation was estimated.
The dummy variables were weighted by maturity, on the
assumption that the risk premium for less than prime
customers should be higher for longer maturities. The
regression results are:
(4) Spread = 2.365 - 0.078 rate + 3.080 CV rate
(10.32) (-6 .1 3 )
(2.51)
—0.118 mat -f- 0.051 (D, x mat)
(-6 .9 7 )
(5.74)
+0.069 (D,. x mat)
(7.64)
+ 0 .02 3 ((Ds x mat)
(2.40)
R-’ (adj) = 0.644;

The dummy variables were used to investigate if, on
average, there are systematic differences in spreads
between groups of countries. The coefficients on the
dummy variables can be interpreted as risk premiums
over what industrialized borrowers would pay.
The weighted average spread and maturity for each




S.E. = 0.234;

DW = 1.42

Note that all the coefficients are the correct sign, all
are significant at the 5 percent level, and the regression
explains 64 percent of the dependent variable. The
Durbin-Watson improves marginally and the R 2 and
standard error remain basically unchanged.

FRBNY Quarterly Review/Summer 1980

Monetary Policy and Open
Market Operations in 1979

Efforts to dampen inflationary pressures dominated
monetary policy in 1979, as prices of goods and ser­
vices surged with an intensity not evident since 1974.
In the first four months, the Federal Open Market Com­
mittee (FOMC) maintained its Federal funds rate objec­
tive at just over 10 percent, despite a further weaken­
ing in monetary growth from the already sluggish pace
of the previous quarter and indications that the econ­
omy might be sliding into recession. In the spring,
rapid monetary growth resumed, and sharp increases
in imported oil prices boosted inflationary expecta­
tions. The dollar, after strengthening in response to the
support initiatives taken the previous November, once
again came under downward pressure against major
currencies in the foreign exchange markets.
The FOMC responded by raising its Federal funds
rate objective— gradually at first as economic activity
faltered in the second quarter, and then more rapidly
as evidence mounted of a strong rebound in the sum­
mer. By September, the Federal funds rate was at
about 111/2 percent, but the dollar was slipping badly

Adapted from a report submitted to the Federal Open Market
Committee by Peter D. Sternlight, Senior Vice President of the Bank
and Manager for Domestic Operations of the System Open Market
Account. Fred J. Levin, Manager, Securities Department, Ann-Malrie
Meulendyke, Chief, Securities Analysis Division, and Christopher J.
McCurdy, Senior Economist, Securities Department, were primarily
responsible for preparation of this report, with the guidance of
Paul Meek, Monetary Adviser. Connie Raffaele, Robert Van Wicklen,
and Diane Heidt, members of the Securities Analysis Division staff,
participated extensively in preparing and checking information
contained in the report.

Digitized
FRASERQuarterly Review/Summer 1980
50for FRBNY


in the exchange markets and a speculative run-up in
gold prices was spilling over to other commodities
prices and threatening to spread to the general econ­
omy. With money and credit expanding rapidly, the
nation’s resolve to fight inflation was widely questioned.
On Saturday, October 6, the Federal Reserve an­
nounced a comprehensive program for gaining better
control of money and credit, curbing the speculative
excesses in the foreign exchange and commodities
markets and thereby helping counter inflationary forces
over time and inflationary expectations more immedi­
ately. To slow monetary growth and contain it within
the 1979 ranges previously adopted, the FOMC an­
nounced that open market operations would follow a
supply-oriented approach to managing bank reserves,
while allowing wider short-term fluctuations in the
Federal funds rate. The Board of Governors of the
Federal Reserve System unanimously approved a 1
percentage point increase in the discount rate to 12
percent and imposed an 8 percent marginal reserve
requirement on the managed liabilities of member
banks and certain other institutions to slow the growth
of bank credit.
At its October 6 meeting the Committee established
annual growth rates of 41/2 percent for Mx and V h
percent for M2 as its monetary objectives for the
September-December interval, although it was willing
to tolerate somewhat slower growth to offset the earlier
excesses. To guide Trading Desk operations under the
new procedures, the staff derived paths for total re­
serves and for the monetary base. In doing so, the staff

had to estimate the growth of currency, the demand for
excess reserves, and the growth of required reserves
necessary to support the expansion of deposits in line
with the Committee’s objectives for the monetary ag­
gregates. After constructing a path for total reserves, a
path for nonborrowed reserves was derived by sub­
tracting from total reserves the $1.5 billion initial level
of member bank borrowings specified by the Com­
mittee. As new deposit data became available each
week, a decision had to be made whether deposit
flows were deviating significantly from earlier esti­
mates, warranting a change in the paths.
In carrying out the new procedures, the Account
Manager’s immediate focus of attention shifted to man­
aging the supply of nonborrowed reserves, the reserve
measure over which the Trading Desk has the most con­
trol within a statement week. The Committee’s instruc­
tions allowed Federal funds, on a weekly average basis,
to vary within a range of 11V2 to 151/2 percent. The basic
strategy called for the Desk to aim initially for weekly
path levels of nonborrowed reserves, but with adjust­
ments made to speed a return to the average path for
total reserves. When monetary growth was running
more rapidly than desired in October, for example, the
demand for total reserves began to exceed its path.
With the Desk providing only the nonborrowed reserves
allowed by the path, member bank borrowings rose,
money market conditions tightened, and banks were
encouraged to restrain their investment and lending
policies and to slow the growth of money and credit. In
fact, the Desk aimed for nonborrowed reserves even
below initial path levels, trying to slow monetary growth
and to bring total reserves back to path levels more
quickly. Although there were problems at times, the
Desk was able to achieve nonborrowed reserve levels
over the October-December period broadly consistent
with the Committee’s monetary aggregate objectives.
In the financial markets, the reaction to the Federal
Reserve’s October 6 announcement was dramatic. While
market participants had anticipated a support program
for the dollar, the move to a reserve targeting proce­
dure was unexpected. In the days that followed, in­
terest rates rose sharply across the maturity spectrum,
stock prices tumbled, and the dollar improved con­
siderably in the foreign exchange market without cen­
tral bank support. Prices of debt securities became
much more volatile, as dealers sought to minimize
their risk exposure, so that even small changes in in­
vestor demand had large effects on prices. Later in
October, yields soared to new record levels in most
sectors, as participants responded to incoming data
showing greater than expected economic strength and
initial indications of continued rapid growth of the
monetary aggregates. By the year-end, as monetary




growth slowed and participants accumulated experi­
ence with the System’s new approach to operations,
yields had receded somewhat and the markets had
regained considerable composure. Still, the markets
were a good deal more sensitive than before October
6, with yields well above their earlier levels.
Growth of the monetary aggregates slowed signifi­
cantly in the fourth quarter, although it was difficult
to gauge how much of the moderation reflected the
new reserve operating procedures, the general tighten­
ing in money market conditions, or other factors. After
expanding at an annual rate of more than IOV2 percent
over the previous six months,
rose at a 3.1 percent
rate over the October-December interval,1 somewhat
below the 41/2 percent rate set by the Committee but
in line with its general objectives. Growth of the
broader monetary aggregates moderated as well, with
M2 increasing at a 6.8 percent rate— down from about
12 percent in the previous two quarters.
For the year ended in the fourth quarter of 1979, the
FOMC achieved most of its monetary obectives. Ma ad­
vanced by 5.5 percent (Chart 1), within the Committee’s
range of 3 to 6 percent, which reflected adjustments
for the effects of shifts out of demand deposits into
automatic transfer (ATS) accounts and negotiable
order of withdrawal (NOW) accounts in New York State.
The sharp rise in market interest rates over the year
led to withdrawals from time and savings deposits with
fixed rate ceilings. However, banks and thrift institu­
tions were able to offset the deposit losses by stepping
up their issuance of money market certificates (MMCs)
whose yields were tied to auction rates on six-month
Treasury bills. Indeed, some of these high rate deposits
came out of lower rate accounts at the same institu­
tions. Commercial banks captured an increasing share
of new certificates following the mid-March regulation
change eliminating the ceiling rate advantage of 1A per­
centage point on MMCs issued by thrift institutions
(when the six-month bill rate was above 9 percent).
Partly as a result, the growth in M2 of 8.3 percent over
the four quarters of 1979 was slightly above the top of
the Committee’s 5 to 8 percent range, while M3
growth, at 8.1 percent, was within its corresponding
6 to 9 percent range. The growth of bank credit also
slowed significantly in the fourth quarter, as the ex­
pansion of business loans moderated from the rapid
pace shown earlier in the year. For the year as a whole,
however, the 12.3 percent growth of bank credit far
1 Money stock data in the body of the report include the effects of
bench-mark revisions incorporated in January 1980; no further
revisions to seasonal factors were made as the series were replaced
by new money stock measures in February 1980. The chronological
sections make use of data as published at the time, since Federal
Reserve decisions were based on them.

FRBNY Quarterly Review/Summer 1980

51

exceeded the range of 71/2 to 101/2 percent which had
been associated with the Committee’s monetary aggre­
gate ranges.
The remainder of this report devotes special attention
to the Federal Reserve’s new reserve targeting ap­
proach for conducting open market operations. After
highlighting economic and financial developments over
the year and reviewing monetary policy over the first
nine months, it turns to a more detailed discussion of
how the reserve paths were formulated and how the
Desk went about implementing the new procedures to
achieve the paths.

Chart 1

Growth of Money Supply Measures
and Bank Credit
Seasonally adjusted annual rates
Percent

1979
The bands reflect the FOMC’s yearly objectives for money
and credit growth for 1979. The annual target for M1 was
originally set at 11/2 to 41
/2 percent based on the assumption
that growth of ATS and NOW accounts in New York State
would reduce M1 growth by 3 percentage points. Since the
actual reduction was only about 11/2 percentage points, the
equivalent range for M1 is 3 to 6 percent.

Digitized52
for FRASER
FRBNY Quarterly Review/Summer 1980


The economy
The economy continued to expand in 1979, but its per­
formance was marred by a further acceleration in infla­
tion. Prices, as measured by the GNP (gross national
product) deflator, rose 9 percent during the year, up
from 8.2 percent in the previous year and the highest
level since 1974. Consumer prices rose more rapidly,
although for technical reasons the 12.7 percent advance
in the consumer price index probably overstated the
increase in cost of living for most households. The
acceleration of inflation could be traced in part to
sharply higher petroleum prices imposed by the Orga­
nization of Petroleum Exporting Countries (OPEC) after
several years of stability. But it also reflected continued
strong demand pressures pushing against supply con­
straints that are typical of an economy already running
at near-capacity levels.
Despite widespread forecasts of impending reces­
sion, the economy proved surprisingly resilient. After
faltering briefly in the spring, amid a jump in fuel prices
and sporadic gasoline shortages, economic activity
rebounded strongly in the third quarter and continued
to move ahead in the final months. Over the four
quarters as a whole, real GNP advanced by 1 percent,
down substantially from the 1978 pace but in marked
contrast to declines of V2 to 2 percent projected by
most private and official forecasters at midyear. Gains
in employment about matched the continued substan­
tial growth of the labor force, so that the unemploy­
ment rate remained in the range of 5.7 to 5.9 percent.
Although this was high by historical standards, demo­
graphic and social changes, coupled with increased
Government income maintenance programs, have
served to raise the unemployment rate associated with
any degree of labor tightness. Significantly, the pro­
portion of the work-age population employed continued
to rise to new record levels, and there were widespread
reports of labor shortages among many skilled worker
categories during the year.
The consumer sector provided the major thrust to
the economy. Even as inflation cut into their purchas­
ing power, consumers stepped up spending, evidently
on the view that prices would only be higher later on.
Thus, the personal savings rate fell to its lowest level
in thirty years. The foreign sector also added to de­
mand. The volume of exports rose strongly, while im­
ports in real terms leveled off, as the earlier deprecia­
tion of the dollar made United States goods more
attractive relative to goods produced in foreign mar­
kets. Although housing expenditures declined from the
high levels reached in 1978, the drop was much less
than experienced during previous periods when interest
rates were rising sharply. The perception that the pur­
chase of a house is a good hedge against inflation

helped sustain demand. Moreover, recent innova­
tions in the financial markets— like the MMCs— cou­
pled with the elimination or liberalization of usury
ceiling limits on mortgage interest rates by many states
facilitated the continued flow of funds to the housing
sector.2
Financial developments
While the financial markets were relatively calm and
steady early in 1979, conditions became increasingly
turbulent as the year progressed. Interest rates soared,
amid rising inflationary expectations and continued
strong credit demands. At the same time, participants
responded to wide swings in monetary growth and
rapidly changing, and often conflicting, signals of the
prospects for the economy and for inflation. As a re­
sult, market sentiment shifted repeatedly over the year,
with participants alternating between the view that
yields were at or close to peak levels and the feeling
that they would go still higher. In this environment,
yields fluctuated over an unusually wide range, under­
going several major changes in direction (Chart 2).
The largest increases and most dramatic changes
occurred in the fourth quarter. The markets’ adjustment
to the Federal Reserve’s policy actions announced on
October 6 was complicated by unsettled conditions in
the economy and sizable revisions to the weekly
money stock statistics for October. The sharp increase
in yields that followed on the heels of the October 6
announcement partly reflected indications that the
economy was stronger than expected and that the
monetary aggregates were continuing to advance at a
rapid pace. When revised and subsequent data showed
that monetary growth had actually slowed in October,
yields retraced a portion of their earlier advances— al­
though they were on the rise again at the year-end.
In November and December the markets were also
weighed down by concern over the growing tensions
in the Middle East. Yields in almost all sectors of the
debt markets reached record high levels in late October
or early November. (However, most of these were easily
eclipsed in the early months of 1980.) The weekly av­
erage effective Federal funds rate reached a peak of
15.61 percent in the week of October 31, up from its
pre-1979 high of about 131/2 percent in the summer of
1974. By the year-end, funds were trading mostly in a
2 Mortgage rates began to bump against ceiling limitations in a number
of states toward the year-end, as credit conditions tightened further.
On December 28, the President signed Public Law 96-161 that
exempted from state usury limits rates on residential first mortgages
by most types of lenders until March 31, 1980, unless revoked by
state action. The Depository Institutions Deregulation and Monetary
Control Act of 1980, signed by the President on March 31, 1980,
eliminated permanently state limits on rates on first mortgage
residential loans, co-op loans, and residential mobile home loans,
unless revoked by state action before April 1, 1983.




Chart 2

Selected Interest Rates
Percent

range of 131/2 to 14 percent, still about 3Vz to 4 per­
centage points above the year-earlier level. In the
Government securities market, rates on three-month
Treasury bills advanced by about 2% percentage
points over the year. Yields on intermediate- and long­
term Treasury coupon securities increased by 1 to V /2
percentage points.
Business demands for short-term credit were espe­
cially strong in 1979. Faced with the need to raise sub­
stantial funds, many corporations borrowed heavily at
banks and in the commercial paper market rather than
issue long-term debt at prevailing yield levels. The vol­
ume of business loans at commercial banks over the
first nine months of the year rose at an annual rate of
more than 20 percent, up from the already rapid in­
crease of 16 percent in all of 1978. In the fourth quar­
ter, however, following the Federal Reserve’s October
6 policy initiatives, business loan growth slowed to a 6
percent rate. In contrast to the experience earlier in the
economic recovery, much of the business borrowing
over the year was concentrated at the major banks. To

FRBNY Quarterly Review/Summer 1980

53

meet the needs of their business and other customers,
banks relied heavily on managed liabilities— large cer­
tificates of deposit (CDs), Eurodollar borrowings, secu­
rities repurchase agreements, and Federal funds bor­
rowings from nonmember institutions. Indeed, the
expansion of managed liabilities financed about one
half of the increase in total bank credit in the third
quarter. In the final quarter the growth of these liabili­
ties slowed along with business loans. Banks’ prime
lending rates rose to a peak of 15% percent in Novem­
ber, before easing to 151A percent by the year-end.
The volume of nonfinancial commercial paper out­
standing rose by more than 50 percent over the year
to nearly $31 billion.
Net Treasury borrowing, at $37.4 billion, fell below
the $53.7 billion level of the previous year, although
it remained substantial considering that 1979 was the
fifth consecutive year of economic expansion. The
Treasury added $29 billion to outstanding publicly held
marketable coupon issues in the United States, while
replacing $54.9 billion of publicly held maturing cou­
pon securities. It also raised the equivalent of $3.7 bil­
lion in foreign markets through sales of two German
mark-denominated and one Swiss franc-denominated
issues. Treasury bills held outside the Federal Reserve
and Government accounts increased by $8 billion. Ad­
ditions to Treasury bill offerings were concentrated in
the fourth quarter when the Treasury’s new cash needs
were large and there was a sizable volume of coupon
issues maturing. In line with the Treasury’s ongoing
program of lengthening the debt, a long-term bond issue
continued to be a standard feature of the quarterly
refundings; the average maturity of interest-bearing
marketable issues held by the public (i.e., excluding
the Federal Reserve and Government accounts) rose
five months to three years nine months. Twice during
the year— first in mid-March through early April and
then more briefly in late September through early Octo­
ber— the Treasury was forced to postpone scheduled
auctions because of Congressional delay in raising the
national debt ceiling. In late March, the Treasury bor­
rowed $2.6 billion from the System for several days
through a special nonmarketable issue to help meet
expenses until the debt ceiling legislation was passed
by the Congress.3
3 An amendment to the Federal Reserve Act, Public Law 96-18, signed
by the President on June 8,1979, extended for two years the System’s
authority for lending to the Treasury through direct purchase of
securities, but under more restrictive conditions than formerly. As an
alternative, the System was also provided with the authority to lend
securities to the Treasury for sale in the open market, subject to the
approval and rules and regulations of the FOMC. The total amount
of securities loaned to and purchased directly from the Treasury at
any one time may not exceed $5 billion, according to the new law.
At its regular meeting on August 14, the Committee set a limit on
such purchases of $2 billion.

Digitized 54
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FRBNY Quarterly Review/Summer 1980


The increase in Treasury debt securities outstanding
was scattered among a number of sectors, including
corporations, private pension funds, and individual
accounts. The Federal Reserve System’s outright
Treasury holdings rose by about $10 billion (com­
prised of increases of $ 6 1/4 billion in bills and
$3% billion in coupon issues), while commercial banks
were net purchasers of a modest amount. In marked
contrast to the previous year, foreign central bank
demand was not a source of funds to the Treasury.
Indeed, foreign official institutions ran down substan­
tial amounts of both marketable and nonmarketable
Treasury issues over the first five months of the year
to finance the sale of dollars in foreign exchange mar­
kets as the value of the dollar was rising. Later,
as the dollar came under renewed downward pressure
in the summer and fall, they added to their Treasury
securities, but their holdings again fell following the
Federal Reserve’s October 6 actions. By the year-end,
total foreign official holdings at the Federal Reserve
of marketable and nonmarketable Treasury securities
amounted to $108.8 billion, down $22.1 billion over
the year. (In 1978, they had risen by more than $31 bil­
lion, financing over one half of the Treasury’s net
borrowings.) State and local governments also re­
duced their holdings of Treasury securities in 1979.
In 1978 many municipalities had taken advantage of
lower yield levels to prerefund substantial amounts of
debt, investing the proceeds in special nonmarketable
Treasury issues as allowed by the less restrictive
Treasury rules governing these operations that pre­
vailed at the time.
Markets for financial futures contracts, which call
for future delivery of financial instruments, grew rap­
idly in 1979.4 At times, they exerted substantial in­
fluence on the cash markets for the underlying secu­
rities. Trading of ninety-day Treasury bill contracts on
the International Monetary Market (IMM) in Chicago
expanded to 2Vz times its 1978 pace during the year,
averaging the equivalent of about $71/2 billion of threemonth bills per day. Trading in the most active Trea­
sury bond contract nearly quadrupled while activity in
the most active GNMA (Government National Mortgage
Association) contract increased by one half. The Com­
modity Futures Trading Commission also approved
additional contracts, mainly more bill, bond, and
GNMA contracts on new exchanges but also including
new contracts for Treasury notes.

* For further information on the financial futures markets, see Treasury/
Federal Reserve Study of Treasury Futures Markets (May 1979). See

also Marcelle Arak and Christopher J. McCurdy, "Interest Rate
Futures", this Review (Winter 1979-80), pages 33-46.

The futures market for bills strongly affected the
cash market during some periods. In the spring, fu­
tures rates dropped dramatically as speculators
bought contracts in the belief that interest rates had
peaked. Some firms in the cash market, who had sold
futures contracts short against long positions in cash
bills, had to scramble to cover their positions in both
markets and, in the process, caused disparate move­
ments in the cash and futures markets— in turn, caus­
ing sizable losses to some participants who had con­
sidered themselves reasonably hedged.
Sizable open positions in bill futures contracts also
exerted influence on the cash market, especially as
those contracts neared expiration. Open interest was
particularly large on the June and December contracts.
The three-month bills deliverable against those con­
tracts traded at slight premiums to bills with adjacent
maturities. On those contracts deliveries were very
heavy as well. In December they amounted to $1 bil­
lion, nearly half the available trading supplies of the
deliverable bills— the total amount outstanding exclud­
ing holdings by the System and foreign accounts and
awards to noncompetitive bidders.
Federally sponsored agencies raised $20.1 billion
in net funds from the public over the year, up from
$17.6 billion in 1978 and a new record. The Federal
housing agencies— including the Federal National
Mortgage Association and the Federal Home Loan
Banks— borrowed heavily to provide direct and indi­
rect support to the housing market. The farm credit
agencies also stepped up their borrowing during the
year.
The gross volume of domestic corporate offerings
totaled $37.6 billion in 1979, up slightly from the pre­
vious year. Corporate bond yields rose about 1.6 per­
centage points, somewhat above the advances regis­
tered in the Treasury coupon sector as investors
showed a greater preference for risk-free debt. Gross
sales of state and local government long-term issues
amounted to $42.3 billion, compared with the $46.2 bil­
lion sold in 1978 (which was inflated by the prerefund­
ing issues). A sizable portion of total state and local
government offerings in 1979 represented bonds is­
sued to finance the purchase of single-family homes
at subsidized mortgage rates. The sale of these issues
dropped off following the introduction in April of legis­
lation in the Congress that would remove their taxexempt status, but resumed in the summer when there
were indications that issues which had already been
planned would be allowed to proceed. Yields on highgrade municipal securities rose about Vi percentage
point over the year; however, they remained below the
peak levels reached in 1975 in the wake of New York
City’s financial crisis.



Monetary Policy and Its Implementation
In formulating monetary policy for 1979, the FOMC
retained its goal of gradually reducing growth of money
and credit over a period of years to curb inflationary
expectations and inflation. It was recognized that
given the strong upward price momentum which had
built up in the decade of the 1970s— and especially
in light of the steep rise in energy prices in 1979— the
economy faced a difficult period of adjustment as
monetary growth slowed. In the interest of promoting
an orderly adjustment, the Committee adopted ranges
for growth of the monetary aggregates for 1979 that
provided for a moderate slowdown from the pace of
the previous two years.
Through midyear, expansion of the monetary ag­
gregates ran close to the Committee’s objectives, on
balance, as the speedup in the spring about offset
the sluggish behavior in the early months. By the fall,
however,. after the aggregates had continued to ad­
vance rapidly despite repeated increases in the Sys­
tem’s Federal funds rate objective, it was clear that a
significant reduction of growth was necessary in the
fourth quarter if the Committee were to achieve its
monetary targets for the year as a whole. At the same
time, the economy was showing surprising strength,
the dollar was under substantial pressure in the foreign
exchange markets, and inflationary psychology was
building in response to the run-up in energy prices.
Against this background, the Committee felt that a
new approach to monetary control was needed.
Since the early 1970s, the FOMC had sought to
exercise control over the monetary aggregates by tar­
geting the Federal funds rate, generally permitting it
to move up or down in response to deviations from de­
sired monetary objectives. While the procedure had
certain advantages, in recent years the Committee had
repeatedly found monetary growth outpacing its ob­
jectives against a background of significant institu­
tional and regulatory changes and high inflation rates.
Moreover, the attention that came to be placed by the
markets on the Federal funds rate seemed to inhibit
the Committee from making significant changes in it
over a short period. Typically, adjustments in the Fed­
eral funds rate objective were made in steps of 1A per­
centage point or less from one statement week to the
next, with changes only occasionally as large as 1 per­
centage point over a month. In this environment, it
appeared that the Federal funds rate procedure itself
could be contributing to excessive money and credit
growth by fostering the view among banks and other
market participants that credit would always be avail­
able at a price not much different from that prevailing
at the time.

FRBNY Quarterly Review/Summer 1980

55

nificantly. Fluctuations were particularly sharp imme­
diately after the October 6 announcement, but nar­
rowed somewhat as the markets gained more experi­
ence with the new reserve approach (Chart 3). By
focusing on reserve supplies, while permitting greater
variation in the Federal funds rate, the Committee
hoped to contain money and credit expansion within
the 1979 ranges previously adopted.

Chart 3

Money Market Conditions and
Borrowed Reserves
Percent
18.0Federal funds:

range of daily

17.0- — effective rates excluding _
reserve settlement days—

16.015.014.0-

Weekly averageeffective rate

4

13.0-

-

12 . 0 -

Discount rate
11.0 -

FRBNY

10 . 0 -

9.0 Li i i i i i i i I i i i I i i i i I i i i I i i
Millions of dollars
3500

Nov

Dec

Jan
1980

The new reserve approach to policy, announced by
the FOMC on October 6, provides for a potentially
quicker response in money market conditions to devia­
tions in monetary growth from the Committee’s ob­
jectives. The Committee’s directives to the Manager
over the October-December period permitted variation
in the Federal funds rate on a weekly average basis
within an 11% to 151/2 percent range. As the Desk
focused on achieving path levels for reserves consis­
tent with the Committee’s monetary objectives, the
Federal funds rate rose by about 4 percentage points
to around 151/2 percent by the end of October, when
the monetary aggregates appeared to be advancing
rapidly. As it became clear that monetary growth had
slowed, the Federal funds rate fell back and closed
the year in a range of 131/2 to 14 percent. Day-to-day
changes in the Federal funds rate also increased sig­
Digitized56
for FRASER
FRBNY Quarterly Review/Summer 1980


Long-term targets
The FOMC’s formulation of objectives for money and
credit growth in 1979 was undertaken for the first time
within the framework of the Full Employment and Bal­
anced Growth (“ Humphrey-Hawkins” ) Act of 1978. The
act requires the Board of Governors to report to the
Congress by February 20 and July 20 of each year on
the Federal Reserve’s objectives for money and credit
expansion for that calendar year; the July review is
also to include preliminary plans for the following year.
In addition, these objectives are to be related to vari­
ous short-term goals set forth in the most recent
Economic Report of the President.
The key feature of the act with respect to the
FOMC’s monetary aggregate targeting procedures is
the specification of growth rates for calendar years.
Since 1975, the FOMC had set new yearly targets each
quarter, using actual levels of the previous quarter as
the starting point. Under that procedure, any over­
shoots (shortfalls) in quarterly growth raised (lowered)
the base level from which the next yearly objectives
were specified. Consequently, when persistent misses
occurred in one direction, the procedure tended to
cumulate the impact on monetary growth. The new ap­
proach, by fixing the base period as the fourth quarter
of the previous year, should reduce this problem of
“ base drift” .
The Committee faced more than the usual uncer­
tainties concerning the forces affecting the demand
for money when it met in February to consider its 1979
money and credit objectives. A staff analysis suggested
that shifts in funds from demand deposit balances to
ATS accounts and NOW accounts in New York State,
first authorized in November 1978, were likely to re­
duce Ma growth by about 3 percentage points over the
year, but that projection was based on only limited
experience. Moreover, the rise in market yields that
had occurred since the time the Committee last set
yearly targets in October 1978 was expected to en­
courage the public to economize further in its cash
balances relative to income, but the magnitude of the
effect on Mx was difficult to gauge. While growth of the
broader monetary aggregates was not expected to be
significantly altered by ATS, there were doubts about
the volume of funds that might be attracted to money

market instruments from time and savings deposits
with fixed rate ceilings.
To deal with these uncertainties, the Committee
chose annual ranges for growth of the money stock
measures for 1979 that were somewhat wider than
usual (although, in the case of
not so wide as the
yearly range set in October immediately before ATS
accounts were first instituted). In keeping with its
longer run objective of moving gradually toward rates
of monetary expansion consistent with general price
stability, the growth ranges for all the money and
credit aggregates were lowered somewhat from those
established in October, with the midpoints of the
ranges set below the growth actually experienced in
1978 (table).
By the time the Committee met in July to review
the 1979 growth ranges and to set preliminary objec­
tives for 1980, it was apparent that the flow of funds
into ATS accounts was running below earlier projec­
tions. While data suggested that shifts of funds from
demand deposit balances into ATS accounts and NOW
accounts in New York State had reduced the annual
rate of
growth by nearly 3 percentage points in the
first quarter, as had been expected, the impact in the
second quarter was about half that amount. Mean­
while, in April the United States Court of Appeals had
ruled that ATS and certain other payment services
were inconsistent with current laws and would be pro­
hibited as of January 1, 1980 unless the Congress ex­
plicitly enacted new legislation authorizing these ser­

vices.5 In the wake of that decision, banks and thrift
institutions began promoting these services less ag­
gressively than before. In view of the uncertainty over
the form and timing that such legislation might take,
the Committee decided to leave the 1979 growth range
for Mx unchanged, while also maintaining the same
ranges set in February for growth of the broader
money stock measures and bank credit. It was under­
stood, however, that growth of Mx would be expected
to vary in relation to the range to the extent that the
actual ATS/NOW impact deviated from the 3 percent
figure projected earlier. By the fall it appeared that
expansion of such accounts would reduce measured
growth of Mx over the year by 1 1/2 percentage points,
so that the effective range for Mx growth was 3 to 6
percent.
For 1980, the Committee decided in July 1979 that
it was appropriate, tentatively, to maintain the same
ranges for money and credit expansion specified for
1979. In reaching that decision, the Committee noted
that adjustments might be required because of pos­
sible Congressional legislation affecting interest5 On December 28, 1979 the President signed legislation extending the
authority for these accounts until March 31, 1980. The Depository
Institutions Deregulation and Monetary Control Act of 1980, signed
March 31, established permanent authority for ATS accounts at
member banks and Federally insured commercial and savings banks,
and for share drafts at Federal credit unions. NOW accounts,
previously authorized for institutions in New York, New Jersey, and
the New England states, are to be extended nationwide as of
December 31, 1980.

Federal Open Market Committee’s Annual Growth Ranges for
Monetary and Credit Aggregates Set in 1978-79
Seasonally adjusted annual percentage rates

Month
established

Period
1977-IV
1978-1
1978-11
1978-111
1978-IV
1978-IV

to
to
to
to
to
to

1978-IV
1979-1
1979-11
1979-111
1979-IV
1979-IV

...............
................
................
................
................
................

Mx
4 to 6 V2
4 to 6 V2
4 to 6 1/2
2 to 6
3 to 6 *
3 to 6 *

February1978
April 1978
July 1978
October 1978
February 1979
July 1979

1979-IV to 1980-IV ................July 1979

t

Actual
7.2
5.1
4.8
5.3
5.5
5.5

M,
6 1/z to
6 1/s to
6 1/2 to
6 V2 to
5 to
5 to

9
9
9
9
8
8
t+

Actual
8.7
7.6
7.7
8.2
8.3
8.3

Mn Actual
1'h to 10
71/z to 10
71/2 to 10
7 1/s>to 10
6 to 9
6 to 9

9.5
8.7
8.6
8.7
8.1
8.1

Bank credit

Actual

7 to 1 0
71/2 t o 10 1/2
8 1/2 to 1 1 1/ 2
8 1/2 to 1 1 1/2
7 1/2 t o 101/2
7 1/2 t o 10 1/2

13.5
14.1
13.6
13.8
12.3
12.3

t

* Originally, the Committee set a growth range for Mx of 1V2 to 4 1/2 percent, with the expectation that the flow of funds from demand
deposits to ATS accounts and NOW accounts in New York State would reduce the growth of Mj by 3 percentage points over
the year. Since the impact turned out to be about 1V2 percentage points, the equivalent range is 3 to 6 percent.
f The Committee anticipated that growth might be within the same ranges adopted for 1979, depending upon emerging economic
conditions and appropriate adjustments that might be required by legislative or judicial developments affecting interest-bearing
transactions accounts.




FRBNY Quarterly Review/Summer 1980

57

bearing transaction accounts and, in any case, the
objectives would be reconsidered in February in light
of information on economic conditions prevailing at
that time. Moreover, a reexamination of the definitions
of the monetary aggregates in view of institutional
changes in the payment system, was under way, which
was expected to lead to new and improved measures
of the money stock.6
Open Market Operations in 1979
January to early July
Open market operations, by outward appearances,
held a relatively steady course over the first half of
the year. The average Federal funds rate held around
10 percent through April. The funds target was then
raised once to around 101/4 percent, but the discount
rate remained at 91/2 percent. This stability, however,
belied both the conflicting array of influences the
Committee faced and the shifting nature of the policy
outlook. By recent standards the securities markets
were also fairly steady during the interval (Chart 2),
reacting only modestly to the System’s one firming
move.
Early in the year, the economy gave off signs that
it was slowing and that the long expansion, which had
begun about four years earlier, might reverse course
during the year. Income, sales, and production were
growing sluggishly. This picture was not fully reflected,
however, in the labor sector as the unemployment rate
continued to hover around 5% percent. The value of
the dollar on foreign exchange markets generally held
its ground or improved. Mx declined in the first quarter
and M2 posted a very modest rate of growth. The
Committee recognized that this might reflect the im­
pact of ATS, NOW accounts, and money market mu­
tual funds and felt there might be some downward
shift in the demand for money in relation to income.
Inflationary pressures remained a constant worry as
the rate of price increases accelerated from its 1978
pace.
In view of these conflicting influences the Commit­
tee, at the first three meetings, chose not to alter its
Federal funds rate objective from that prevailing as
the year began— in the area of 10 percent or slightly
higher. At the very end of 1978 the members had de­
cided in a special wire vote not to lower the funds
6 New definitions of the money stock measures were announced by the
Board on February 7, 1980. Among the most significant changes were
the inclusion of NOW and ATS accounts in one of the narrow
measures (M-1B) and the addition of money market mutual fund
shares and repurchase agreements issued by commercial banks in
the broader measures. For more details, see "The Redefined Monetary
Aggregates", Federal Reserve Bulletin (February 1980), pages 97-114.

FRBNY Quarterly Review/Summer 1980
Digitized 58
for FRASER


objective when projections of M2 growth fell well be­
low its specified range and Mx was in the lower part
of its range. (This stance was reaffirmed in a sched­
uled telephone conference on January 12.) Following
the February meeting, when
appeared moderately
below its range and M2 just below, the Committee
voted not to change the objective in light of the con­
tradictory evidence on the economy. Subsequent to
the March meeting, the aggregates again turned in a
sluggish performance but the projections were not
viewed as sufficiently weak to call for a change in the
objective.
In contrast, the projections of the aggregates
strengthened relative to their ranges following the
April meeting. Late in the month, projections sug­
gested that
and M2 would grow at rates that were
close to, or above, the upper limits of their ranges.
Following consultation with the Committee, the Ac­
count Management began aiming for Federal funds
trading around 101/4 percent. Additional projections
indicated further strength, but no change was made
in the objective in view of the sensitive state of the
financial markets, the uncertainties surrounding en­
ergy supplies, and the extent of the rapid monetary
growth apparently due to transitory forces. The ob­
jective remained at 101/4 percent when projections
showed the same outlook in mid-May as the Chairman
reaffirmed this stance and a majority of the Commit­
tee, in a consultation, concurred.
The securities markets retreated a bit in the face
of the upward shift in the Federal funds rate. The
moderate overall reaction mirrored the modest size
of the System’s policy move. Short-term bill rates
moved higher by about 1A to V2 percentage point from
mid-April through mid-May while longer term rates
showed small mixed changes. By mid-April, short-term
interest rates had been, if anything, slightly lower
than at the beginning of the year. Most long-term in­
terest rates, on the other hand, had worked a bit higher
on balance through the first part of the year, prob­
ably reflecting advancing inflationary expectations.
At the May meeting, the Committee decided not to
change its approach. The economy still appeared to be
at or near a cyclical peak while the dollar had re­
cently been doing better in foreign exchange markets.
However, inflation remained the great concern, and
there was a widespread feeling that, if it were not
brought down, the next expansion would begin with a
higher base rate of inflation than the current expan­
sion. Monetary projections at the time of the meeting
suggested that growth over the May-June interval
would be slow. The rapid expansion in April was at­
tributed to delays in processing income tax checks
and the bunching of refunds. As it turned out, incom­

ing data on the aggregates after the May meeting in­
dicated especially rapid growth, with growth projected
above the specified ranges. This behavior would nor­
mally have called for some firming in the funds rate.
However, the Committee voted on June 15 not to
change the objective in view of the weakness of eco­
nomic activity and the general uncertainty about the
behavior of the aggregates, the difficulty in interpret­
ing the data in those circumstances, and the condition
of the financial markets.
The securities markets rallied considerably in the
late spring and early summer. From the higher rate
levels reached in mid-May to the lows set at midyear,
three-month bill rates fell about 1 percentage point
and long-term bond yields fell about Vz percentage
point. Prices advanced because many participants
felt that the economy had reached a cyclical peak.
This view stemmed from a wide array of weakening
economic statistics, along with a steady System pol­
icy stance. In this setting the markets seemed to give
only passing notice to bearish developments.

Early July to early October
The economic situation appeared to deteriorate in the
third quarter at the same time that the pace of infla­
tion stepped up. There was widespread concern, at
least initially, that a cyclical contraction might be
getting under way. The foreign exchange value of the
dollar sagged around midyear and again late in Au­
gust. The growth of the monetary aggregates remained
high. Against this background, the Committee adopted
a stronger, but still cautious, approach to policy. Its
instructions to the Manager leaned increasingly to­
ward resisting monetary expansion over the third quar­
ter. In turn the Desk sought progressively tighter con­
ditions in the money market. In addition, the Board of
Governors approved increases in the discount rate in
three Vz percentage point steps to 11 percent.
In late July, the funds rate objective was raised to
101/2 percent, the top of the Committee’s intermeeting
range, following some strengthening in the aggregates
and following Committee consultation. The members
expressed a willingness to tolerate some trading on
the high side of that rate in view of the unsettled con­
ditions in the foreign exchange markets. A week later,
after further indications of excessive monetary
strength, the Committee voted to raise the upper end
of the band to 103/4 percent and instructed the Man­
ager to aim for a rate in a range of 101/2 to 10% per­
cent, depending on the subsequent behavior of the
aggregates, conditions in foreign exchange markets,
and the Treasury’s quarterly financing. The Desk
sought a funds rate objective of 10% percent for the
rest of the intermeeting interval.




In August the Committee decided at its meeting to
raise its funds rate objective to 11 percent in a range
of 10% to 111/4 percent. When growth of the aggre­
gates turned out high, compared with their ranges,
the Desk managed reserves so that the Federal funds
rate moved toward the top of its range. In a telephone
meeting at the end of August, the Committee raised
the upper limit to 111/2 percent but with the under­
standing that not all the additional leeway would be
used immediately. That use would depend on the be­
havior of the aggregates and developments in foreign
exchange markets. Open market operations fostered
a rate of about 11% percent. At the September meet­
ing, the Committee raised its obective to 111/2 percent.
Following that meeting the objective was maintained
at 111/2 percent, although the rate was generally some­
what higher than that in the week preceding the spe­
cial meeting on October 6.
Despite these actions, many participants in the
securities markets came to feel over the third quarter
that the United States was not dealing effectively with
inflation. The nation’s efforts to establish a comprehen­
sive energy policy lagged, and increases in world oil
prices continued to work their way into wages and
prices generally. While the President’s cabinet re­
alignment generated considerable uncertainty, the mar­
kets took heart and rallied in late July when President
Carter named Paul Volcker to be the new Chairman
of the Board of Governors of the Federal Reserve
System, anticipating a strengthened System effort to
combat inflation.
For the most part, though, the markets were de­
pressed by the System’s inability to slow the rapid
growth of money even as money market rates rose.
Over the summer, prices in the domestic securities
markets tumbled as expectations of recession gave
way before the realities of economic strength and in­
flationary pressures. Rates on some Treasury bills and
coupon securities reached new peaks (although these
were to be eclipsed in October and again in early
1980).
In the late summer, speculative forces gathered
strength in many markets as participants lost confi­
dence in official efforts to deal with inflation. The dol­
lar came under renewed attack in the foreign exchange
market. The price of gold rose by nearly 50 percent
to about $400 an ounce. In the futures markets, prices
of commodities advanced rapidly, for both agricul­
tural products and industrial metals. The price in­
creases reinforced fears that inventory building and
consumer buying binges would set off a further round
of escalating prices. Instability in the foreign exchange
markets also threatened the efforts to achieve mod­
eration in world oil prices. Moreover the weakening

FRBNY Quarterly Review/Summer 1980

59

in the value of the dollar exacerbated domestic infla­
tion by adding to the prices of imports in general.

New techniques for implementation of monetary policy
The FOMC’s shift on October 6 to a supply-oriented
strategy of managing bank reserves fundamentally
changed the procedure for specifying the Desk’s oper­
ational objectives. The new approach established vari­
ous reserve measures as its primary short-run oper­
ating objectives, so long as the weekly average
Federal funds rate remained within certain broad
constraints— H V 2 to 151/2 percent initially. Previously,
the Desk had managed nonborrowed reserves as nec­
essary to achieve the Committee’s Federal funds rate
objectives.7 The Committee’s dissatisfaction with the
excessive growth of money in the second and third
quarters provided much of the impetus for adopting a
new approach.
Because the new approach differs significantly from
earlier techniques, a systematic review will be pre­
sented of the procedures involved as they have
evolved thus far: from the Committee’s specification
of objectives, through the Board staff’s translation of
those objectives into intermeeting operating paths, to
Desk strategies for achieving these paths.

Formulation of operating paths and objectives
The Committee begins the process of establishing
operating guides for the Desk by choosing objectives
for the monetary aggregates. In October it chose
growth rates for a calendar quarter that appeared
consistent with achieving its annual growth objectives.
At the November meeting, it specified growth rates
for the remainder of the quarter that were generally
consistent with the earlier objectives, although accept­
ing some of the shortfall that had already occurred.
The Board staff uses these growth objectives as the
basis for constructing paths for total reserves and the
monetary base. The object is to derive paths that will
provide the amount of reserves needed to support the
desired money growth. This estimation process is
rather involved because of the complex relationship
between reserves and deposits in the United States
banking system. Required reserve ratios vary with de­
posit size and the membership status of banks, as
well as the maturity structure of deposits; reserves
are also required on deposits that are not included
within the aggregates for which the Committee has
established objectives. While the reserve-deposit ra­
tios have a reasonable degree of stability over ex­

7 See "The

Implementation of Monetary Policy in 1976” , this Quarterly
Review (Spring 1977), pages 37-49, for a discussion of techniques
of implementing policy under the previous operating approach.

FRBNY Quarterly Review/Summer 1980
Digitized60
for FRASER


tended periods of time, considerable variation is pos­
sible over a month, or a quarter. The Board staff has
developed techniques that allow for the likelihood of
such variation.' Initially, the staff must decide on how
to divide the Committee’s two- or three-month growth
objectives into monthly increments. Other things equal,
there is a preference for steady monthly growth rates,
seasonally adjusted, within the quarter although some
modifications normally will be made if there is sub­
stantial evidence that monthly behavior will be notably
different. The monthly pattern for money growth is then
translated into seasonally unadjusted weekly levels.
The weekly patterns (based on time series models with
judgmental adjustments) are constrained to average
to the goal over the whole period. The weekly figures
are, in turn, broken down into currency, demand de­
posits, other deposits and liabilities at member banks,
and such deposits and liabilities at nonmember banks.
Once this breakdown is achieved, required reserve
ratios are applied to the member bank deposit com­
ponents to derive the required reserves needed to
support money growth. The total reserve and monetary
base paths can then be completed by adding an esti­
mate of excess reserves.9
From the total reserve path, the nonborrowed re­
serve path is derived by subtracting the level of mem­
ber bank borrowings from the Federal Reserve
indicated by the Committee at its meeting. Typically,
the Committee has chosen levels close to the recently
prevailing average— though the level chosen on Oc­
tober 6 was shaded higher to impose some additional
initial restraint. Ideally, the assumed initial borrowing
level should be such that the resultant mix of borrowed
and nonborrowed reserves would tend to encourage
bank behavior consistent with the emergence of de­
sired required reserves, and hence of desired mone­
tary growth. In practice, there seem to be significant
short-term variations in the willingness or desire of
banks to turn to the discount window. This adds to the
difficulty of choosing an appropriate level for path
construction purposes, and may necessitate adjust-

• See the statement by Chairman Volcker before the Joint Economic
Committee on February 1, 1980, section entitled "The New Federal
Reserve Technical Procedures for Controlling Money” .
9 It had been anticipated that excess reserves would continue to vary
within a restricted band in most weeks, as they had before the change
in procedures. Beginning around the time of the introduction of re­
serve requirements on foreign, agency, and Edge Act subsidiaries at
the start of November, however, preliminary figures on excess
reserves seemed to become more volatile, and tended to be above
previous levels by more than the amounts that would be expected
to be held by the foreign-related institutions. Subsequent revisions
have reduced the volatility and lowered the average to a level more
consistent with expectations.

ments in a path in response to changes in bank atti­
tudes toward the discount window.

Translating reserve paths into weekly objectives
Although the process described above produces
weekly path levels, the Manager is more concerned
with achieving reserve objectives for a period that
averages several weeks— either an average over the
intermeeting period or for two separate subperiods
when the meetings are relatively far apart. Each week
the Desk has an objective for nonborrowed reserves.
In the initial week after a Committee meeting, the
operating objective for nonborrowed reserves gener­
ally will be the same as the weekly path level. In sub­
sequent weeks the reserve paths are reviewed by
senior Committee staff and the Desk, as described be­
low, typically each Friday morning, and a nonborrowed
reserve objective is determined for that week with a
view to achieving the average nonborrowed reserve
path over the intermeeting period or relevant sub­
period.
As part of the weekly review of paths, fresh esti­
mates are made of the mix of currency and member
and nonmember deposits and other liabilities. If the
distribution among these items has shifted, the appro­
priate level of required reserves may differ from that
originally estimated as consistent with the Committee’s
chosen growth rates. The assumption for excess re­
serves may also be changed on the basis of recent
experience. If the aggregate adjustments from these
sources is deemed significant, the practice has been
to modify the path accordingly.
Once the average total reserve path for the interval
has been reaffirmed or revised, it is compared with
the projected demand for total reserves— i.e., required
reserves based on actual or estimated deposits plus
excess reserves. This demand may be above or below
path, generally depending on whether the chosen ag­
gregates are running stronger or weaker than targeted
by the Committee. If demand exceeds (falls below)
the path, then hitting the nonborrowed reserve path
would be expected to produce member bank borrow­
ings at the discount window above (below) that ini­
tially assumed in building the path. If the projected
demand for total reserves is significantly above (below)
the path, then after consultation with the Chairman
the nonborrowed reserve path may be lowered (raised)
to encourage a more rapid adjustment in bank be­
havior. If, for instance, total reserves are rising well
above path, then lowering the nonborrowed reserve
path will force increased borrowings at the discount
window and tend to set in motion forces that restrain
additional expansion of deposits and reserves.
Having determined the average path level for non­



borrowed reserves for the period, and knowing the
levels achieved so far, the levels to be achieved in the
remaining weeks of the interval can be determined.
This is done in a way that tends to even out the
amount of borrowings expected in each week. Also,
with a fixed averaging period, deviations early in the
period could call for a nonborrowed reserve objective
consistent with a large change in borrowings in the
final week, compared with what had been prevailing
or what the Committee might choose at its next meet­
ing. Accordingly, some modification to the nonbor­
rowed reserve objective might be made to avoid pur­
suing a nonborrowed reserve level that implies very
sharp short-term changes in the level of borrowings.

Achieving weekly objectives
Given the week’s nonborrowed reserve objective, along
with an awareness of the excess and borrowed re­
serve assumptions, the Desk devises an operating
strategy. Each day, the Desk receives projections of
nonborrowed reserve supplies for the statement week
based on the factors that influence the Federal Re­
serve balance sheet. The projected supply is compared
with the objective to see whether reserves will need
to be added or absorbed. A few of the factors are
hard to predict and are primarily responsible for large
errors that occur in the forecasts. The most volatile
and difficult to forecast in 1979 was Federal Reserve
float. This factor, which results from credited but un­
collected checks, is affected by weather-related and
other transportation delays, the volume and distribu­
tion of checks presented for collection, and staffing
levels. Over 1979 as a whole, the average revision to
all operating factors between the estimate available
at the beginning of the statement week and the final
number was about $840 million (using Federal Reserve
Bank of New York forecasts). The average errors de­
cline as the week goes on, but even on the settlement
day, the final day on which offsetting adjustments are
possible, the average miss to the weekly average figure
was about $150 million (equivalent to a projection
miss on the final day’s reserve level of about $1.0
billion).
The Desk also derives some information from the
Federal funds market as to the accuracy of the reserve
forecasts. It had been hoped, once the Desk was
not pegging the Federal funds rate, that movements
In the rate would tend to signal more clearly the state
of reserve availability and the accuracy of the fore­
casts. In fact, the Federal funds rate has often failed
to indicate excesses or deficiencies until rather late
in the week unless the reserve "misses” are very large.
The Desk is thus left with imperfect reserve projec­
tions and uncertain guidance from the money market.

FRBNY Quarterly Review/Summer 1980

61

Typically, if the projections suggest a need to supply
or absorb reserves that is large relative to the average
projection error, the Manager generally will get an
early start on the task.10 In such cases, the Federal
funds market may well provide some confirmation in
terms of the reported availability of funds in the market.
The expected distribution of reserve excesses or de­
ficiencies through the week may also affect the money
market and pattern of Desk activity. If reserve avail­
ability is especially short or plentiful in the early part
of the week, the Desk may time its operations so as to
even out availability.
Market participants have sometimes misread the
Desk’s tendency to absorb reserves when the rate is
falling or to inject reserves when the rate is rising as
implying a return to a Federal funds rate target. In fact,
though, the Desk would not be concerned with the
rate level per se (unless it were threatening, on a
weekly average basis, to breach the broad range
selected by the Committee) but with whether its move­
ments point to an abundance or shortage of non­
borrowed reserves— thus confirming, or conflicting
with, the projections. Moreover, the same factors that
cause rate movements often also cause the Desk to
take what appears to be offsetting open market oper­
ations. For instance, the funds rate would ordinarily
be falling when there is a large “ excess” supply of
nonborrowed reserves relative to path, so that the Desk
would be absorbing reserves at the time. Such oper­
ations would not be directed at maintaining a partic­
ular rate level, but rather at achieving the objective
for nonborrowed reserves.

Early October to the year-end
The Desk began to implement the new procedures on
October 9, focusing on the path levels for the first four
weeks of the intermeeting period. Achieving the non­
borrowed reserve path implied that borrowings would
rise to an average of about $1.5 billion, a level that
was expected to lead to Federal funds trading around
13 to 131/2 percent, a greater spread over the new
discount rate than had prevailed before October 6.
Over the rest of the statement week that was under
way— just two days— the Desk remained on the side­
lines because reserves initially were estimated to be
about in line with the weekly objective and because
the securities markets were unsettled in the wake of
the new program.
10 The Desk may also take advantage of foreign account outright
purchase or sell orders to move toward appropriate reserve avail­
ability, giving weight to the longer term as well as to the immediate
outlook. Calculations of reserve availability assume foreign repurchase
orders will be arranged with the System. If they are instead passed
through to the market, this will raise the estimated supply.

Digitized62
for FRASER
FRBNY Quarterly Review/Summer 1980


The remaining three weeks of the first subperiod
were complicated by continued sharp price swings
in the securities markets and volatile changes in esti­
mated monetary growth, partly reflecting large re­
porting errors. Early in each of the next two statement
weeks, new data on money and reserves underwent
successive upward revisions that lifted them first mod­
erately above, and then far above, the objectives. Con­
sistent with achieving desired nonborrowed reserves, it
appeared that member bank borrowings would need
to rise substantially— at first to $1.8 billion and then
to the area of $2.5 billion to $2.9 billion.
Operations to restrain reserve availability tended to
push up the Federal funds rate to around 131/4 to 13%
percent, but borrowings at the discount window lagged
behind expected levels for a time. At the start of the
October 24 statement week, the Desk moved to achieve
its reserve objectives through an outright sale of Trea­
sury bills in the market. In response to this action,
which was regarded as underscoring the System’s
intention to impose firm restraint, and the unexpected­
ly large increase in the preliminary money supply
figures reported for the October 10 week, the market
reaction intensified. The Federal funds rate moved up
to and then briefly above the 151/2 percent upper limit
of its allowable range.
In these circumstances, the Committee in a tele­
phone conference affirmed its willingness to see
Federal funds trade in the upper part or even occa­
sionally above the range. After a major downward
revision to the money supply for the October 10 week
and more modest reductions in surrounding weeks,
the estimated values of the aggregates and reserves
still appeared, for a time, to be stronger than desired.
Pursuit of nonborrowed reserves close to the path level
(or indeed a little below the initial path level in order
to induce a speedier return to path for total reserves
and monetary aggregates), continued to imply a high
level of borrowings in the October 31 week. The Fed­
eral funds rate and borrowings both peaked in that
week, with an effective Federal funds rate of 15.61
percent and average borrowings of $3,056 million. Fig­
ures available immediately following the interval sug­
gested that, over the four weeks ended October 31,
total reserves were $390 million above path, while
borrowings averaged $2.1 billion and nonborrowed
reserves were $230 million below path. (Final figures
were essentially the same.)
When the second subperiod began in early Novem­
ber, sharp downward revisions brought the monetary
growth rates down to, or below, rates in line with the
three-month objectives. Accordingly, achievement of
the reserve path levels for the three weeks ended
November 21 implied a decline in discount window

borrowings back to the $1.5 billion area, although sub­
sequent revisions lifted the implied borrowings mod­
estly. Borrowings did come down considerably, as the
Desk provided reserves more generously than in earlier
weeks, although they stayed slightly above anticipated
levels. The Federal funds rate also eased off during
the period, to an average effective rate of 13.10 per­
cent in the final statement week. Total reserves again
were well above path, this time by about $340 million
on preliminary estimates, while nonborrowed reserves
were about $40 million below path and borrowings
close to $1.9 billion. (Final figures for total and non­
borrowed reserves show, respectively, about a $270
million overshoot and a $115 million shortfall.)
The seven-week period between the November and
January Committee meetings was also divided into
two subperiods. In November the Committee voted
for Mj growth at a 5 percent annual rate over the two
remaining months of the year and M2 growth at an
8 V2 percent rate. In the initial subperiod, which cov­
ered the four weeks ended December 19, the Desk
focused on total reserve paths consistent with the
relatively slow growth of the monetary aggregates for
November that had already emerged by the time of
the November 20 meeting. Money growth was close
to desired levels through most of the four-week period,
although some weakness emerged toward the end of
the interval. On balance, there was no reason for re­
vising the paths, as the net revisions to technical fac­
tors were deemed modest. Total reserves came out
about on path. By the final week of the subperiod, it
appeared that achieving the nonborrowed reserves
path would have called for a rise in borrowings to about
$1.9 billion. However, preliminary figures for the second
subperiod suggested that the monetary aggregates
were running below the objective and that total re­
serves were likely to fall short of the path so that
borrowings might be expected to drop off to around
$1.5 billion. Rather than induce a one-week bulge in
borrowings, the Desk aimed in the final week of the
first subperiod for nonborrowed reserves consistent
with borrowings of around $1.5 billion, thus anticipating
that nonborrowed reserves for the four weeks ended
December 19 would average about $100 million above
path. This period ended with the reserve measures
close to their path averages, with both total and non­
borrowed reserves initially estimated to be around
$50 million above path, while borrowings averaged
close to $1.7 billion. (However, final data indicated
overshoots of about $100 million for total reserves and
$150 million for nonborrowed reserves.)
Moving into the second subperiod— the three weeks
ended January 9— the impact on the paths of the
weakness in the aggregates became more pronounced.



The total reserves path was revised downward by $100
million to take account of a net shortfall in certain
nonmoney items, which was only partially offset by
estimates of increased demand for excess reserves.
Even so, estimates suggested that total reserves were
likely to fall short of the path by about $450 million on
average. The extent of this shortfall was sufficiently
large that the path for nonborrowed reserves was
raised by $150 million to encourage an expansion in
deposits and required reserves." This adjustment,
combined with the shortfall in required reserves, meant
that the Desk initially aimed for nonborrowed reserves
consistent with average borrowings of $ 1.1 billion.
Additional upward revisions were made to the excess
reserve assumption in the following two weeks, leading
to further modest changes in the paths. Total reserves
did not turn out to be so weak as initially thought, on
average falling short of the revised path by around
$200 million for the three-week subperiod. Hence, the
implicit figure for borrowings edged back up, although
it remained below that of the earlier period. As it
turned out, nonborrowed reserves exceeded even the
revised path, as the Desk accommodated to some ex­
tent the sharp temporary drop in demand for borrow­
ings in the January 9 week. (Final figures show total
reserves $265 million below path and nonborrowed
reserves about $155 million above path.)
The behavior of the Federal funds rate during Nov­
ember and December was somewhat puzzling, as it
often did not follow a usual relationship to the volume
of discount window borrowings. The Federal funds
rate did decline in early November, when borrowing
dropped, but then continued to fall through the rest of
the month, while borrowings stabilized around $ 1.8
billion to $1.9 billion (Chart 3). The average funds rate
slipped as low as 121/2 percent in the final week of the
month, compared with about 13% percent at the start.
However, in December, when borrowings declined fur­
ther, though irregularly, ranging between $1.2 billion
and $1.7 billion after the first week, the funds rate
jumped back up to around 13% to 14 percent through
December and into January.
Normally, one would not have anticipated a drop in
the Federal funds rate in late November when borrow­
ings were steady. Nor would one have expected the
rate to rise and then stay up in December as borrow­
ings resumed their decline. Part of the reason for the
initial sharp decline may have been the emergence of

11 It was recognized that, with a period as short as three weeks and
with lagged reserve accounting predetermining requirements in two
of them, little progress could be expected within the period toward
achieving the path average for total reserves.

FRBNY Quarterly Review/Summer 1980

63

expectations during November that interest rates might
be about to peak. This set off a rally in the securities
markets, which became dramatic in the final week of
the month. Some of the yield declines in other sectors
may have spilled over to the Federal funds market. As
mixed economic signals emerged in December, the
anticipation that rates had peaked began to be held
with less conviction, and uncertainty reemerged. An­
other factor that may have been lifting the funds rate
in December was the fact that Federal funds purchased


64 FRBNY Quarterly Review/Summer 1980


from member banks were free of marginal reserve re­
quirements and at that point appeared to be a good
substitute for CDs and other borrowing, especially if
rates were likely to fall early in 1980. Finally, the very
heavy borrowings in October and relatively high bor­
rowings in November may have contributed to a reluc­
tance to borrow late in the year, as a number of banks
had been making fairly frequent use of the window,
and they may have sought to reduce that reliance for
a time.

February-April 1980 Interim Report
(This report was released to the Congress
and to the press on June 2,1980.)

Treasury and Federal Reserve
Foreign Exchange Operations
Coming into the February-April period under review,
the exchange markets were caught up in various cross­
currents. Market participants were troubled by the
persistent rise in OPEC (Organization of Petroleum Ex­
porting Countries) oil prices, the rapidly moving events
in Iran and Afghanistan, and the deterioration in
United States-Soviet relations. For the United States
the higher oil price appeared to add further to the mas­
sive oil import bill already expected for this year.
Proposals for additional defense expenditures raised
the prospect of an enlarged budget deficit. Inflationary
expectations showed signs of intensifying. But many of
these developments raised difficult problems for other
industrial countries as well. The continuing rise in
international oil prices threatened to add to uncom­
fortably large current account deficits in Germany and
Japan, among others, and to exacerbate inflation gen­
erally. The political tensions both in the Middle East and
between the United States and the Soviet Union were
thought to be as serious for the economic and military
security of Western Europe and Japan as they were for
the United States. These various uncertainties made
traders especially cautious about taking positions and
making markets, thereby adding to exchange rate vol­
atility.
By February, the dollar had firmed somewhat from

A report by Scott E. Pardee. Mr. Pardee is Senior Vice President
in the Foreign Department of the Federal Reserve Bank of New
York and Manager of Foreign Operations for the System Open
Market Account.




the lows of early January, but the recovery had been
tentative and bouts of selling pressure occasionally
emerged. On two occasions when the dollar came on
offer during the first two weeks of the month the United
States authorities intervened, selling a total of $240.8
million equivalent of marks and $22.5 million equiva­
lent of Swiss francs. Most of these sales were financed
out of balances of the Federal Reserve and the Trea­
sury, but the sales of marks also entailed drawings by
the Federal Reserve in the amount of $115.4 million
equivalent under the swap line with the German Bun­
desbank. These operations raised the System’s total
mark swap debt to the Bundesbank to a peak of
$2,746.3 million equivalent.
With the economic outlook for the industrial coun­
tries obscured by major uncertainties, market partici­
pants increasingly focused on interest rate develop­
ments here and abroad. The demand for money and
credit in the United States increased quite rapidly, as
inflationary expectations mounted and as the domestic
economy appeared to be strong despite widespread
forecasts of recession. Inflationary expectations also
gripped the longer term financial markets, and bond
yields rose sharply. As part of the efforts of the United
States authorities to curb inflation, the Federal Reserve
continued to adhere to the monetary policy approach
adopted last October 6, placing greater emphasis than
before on the supply of bank reserves and less empha­
sis on the Federal funds rate in seeking to moderate
the domestic growth of money and credit. With the
Federal Reserve thus restraining the growth of bank

FRBNY Quarterly Review/Summer 1980 65

reserves in the face of the sudden increase in demand
for money and credit in the United States, short-term
dollar interest rates began to rise sharply. The Fed­
eral Reserve followed up by raising the discount rate
by 1 percentage point to 13 percent in mid-February,
but market rates continued to climb.
Interest rates abroad were also advancing but not so
sharply as in the United States, and funds began to be
switched into dollars in response to the increasingly
favorable interest rate differentials. As the dollar thus
came into demand in the exchanges, frequently in the
form of large buy orders, foreign central banks were
quick to intervene as sellers of dollars out of their own
reserves. Inasmuch as these pressures occurred during
the normal trading hours abroad, the Desk’s activities
in the New York market for account of the United
States authorities were small, with purchases of $60
million equivalent of marks on two occasions through
early March. Meanwhile, however, the United States
authorities bought substantial amounts of marks from
correspondents, mainly from the Bundesbank, and
used those marks to reduce swap debt with the Bun­
desbank.
By March, dollar exchange rates had advanced
by some 2V4 percent against the German mark and
other currencies within the European Monetary Sys­
tem (EMS), 1/ 2 percent against the pound sterling,
and 51/4 percent against the yen, with trading becom­
ing increasingly one way. The Japanese authorities
were particularly concerned about the heavy selling
pressure on the yen, and on March 2 they announced
a package of measures which included agreement by
the Federal Reserve, the German Bundesbank, and the
Swiss National Bank to cooperate in an effort to avoid
an excessive decline of the yen. For its part, the Fed­
eral Reserve agreed to purchase yen in the New York
market for its own account and to provide resources
to the Bank of Japan if needed under the existing $5
billion swap arrangement.
In view of the continuing buildup of inflationary
psychology and of strong credit demands in the United
States, reports began to circulate that the United
States authorities might impose credit controls as a
supplement to the policy of monetary restraint. A
scramble for funds ensued as businesses attempted to
secure lines of credit and as banks sought to fund their
commitments, thus pushing up United States domestic
and Eurodollar interest rates further. As interest differ­
entials favorable to the dollar progressively widened,
the dollar came into even greater demand in the ex­
changes. Investors adjusted their portfolios, commer­
cial leads and lags swung heavily in the dollar’s favor,
and OPEC members increasingly placed surplus funds
in dollar-denominated rather than in foreign currency
66 FRBNY Quarterly Review/Summer 1980


denominated assets. Professional and corporate bor­
rowers, seeking an alternative to high-cost dollar
financing, turned to money and capital markets abroad,
where interest rates had risen far less rapidly, and
converted their loan proceeds into dollars.
This turn of events evoked a vigorous response
abroad. By then the authorities in other major coun­
tries were openly concerned that the sharp deprecia-

Table 1

Federal Reserve System Drawings and
Repayments under Reciprocal Currency
Arrangements
In millions of dollars equivalent;
drawings ( + ) or repayments ( — )
System
swap
commit­
ments
January 31,
1980

Transactions with
Bank of France

-0-

........

German Federal Bank . . .

System
swap
commit­
ments
April 30,
1980

February
through
April 30,
1980
+

73.9

73.9

2,630.9

f + 502.9
| — 2,838.3*

296.4

2,630.9

f - f 576.8
\ — 2,838.3*

370.3

Because of rounding, figures may not add to totals.
Data are on a transaction-date basis.
* Repayments include revaluation adjustments from swap
renewals, which amounted to $0.8 million for drawings
on the German Federal Bank renewed during the period.

Table 2

Drawings and Repayments by
Foreign Central Banks and the Bank for
International Settlements under
Reciprocal Currency Arrangements
In millions of dollars; drawings ( + ) or repayments ( — )

Outstanding
Bank drawing on
January 31,
Federal Reserve System
1980
Bank for International
Settlements (against
German marks) ........

February 1,
through
April 30,
1980

Outstanding
April 30,
1980

( + 143.0
|- 1 4 3 .0

Data are on a value-date basis.
* BIS drawings and repayments of dollars against
European currencies other than Swiss francs to meet
temporary cash requirements.

-0-

tions of their currencies in the exchanges would add to
domestic inflationary pressures through higher prices
for oil and other imports. Consequently, central banks of
several major countries stepped up their intervention in
the exchanges. In addition, concern about inflation led
many central banks to raise official interest rates, but
money market rates for the dollar went up faster. In
some cases, the authorities liberalized previous re­
strictions on capital inflows. The authorities of several
countries negotiated actively with foreign official institu­
tions, most notably those from OPEC, to gain invest­
ments in their respective currencies. For their part the
United States authorities continued to acquire marks,
purchasing another $35 million equivalent in the market.
These marks, together with $2,751.7 million equivalent
purchased from correspondents since the beginning of
the period, were used to liquidate in full the Federal
Reserve’s outstanding swap debt with the Bundesbank
and to make interest payments on the Treasury’s se­
curities issued in the German capital markets.
On March 14, President Carter announced a broad
anti-inflation program that included action aimed at
balancing the fiscal 1981 budget deficit, a surcharge
on imported oil, and authorization for the Federal Re­
serve under the terms of the Credit Control Act of
1969 to impose special restraints on credit expansion.
Accordingly, the Federal Reserve asked the commer­
cial banks to hold their growth of lending to United
States residents to 6-9 percent during 1980, required
special deposits from nonmember banks and other
lending institutions, and raised the marginal reserve
requirement on managed liabilities from 8 to 10 per­
cent for large member banks and United States agen­
cies and branches of foreign banks. In addition, the
Federal Reserve imposed a 3 percentage point sur­
charge on large member banks’ discount window bor­
rowings. Following these measures, United States
short-term interest rates continued to climb through
late March and into early April, reaching unprece­
dented highs.
By late March the bidding for dollars had become so
generalized that demand pressures, which had previ­
ously been concentrated more heavily in markets
abroad, began erupting at any time during the 24-hour
trading day. To counter disorderly conditions, the Desk
entered the New York market in March and the first
week of April as a buyer of German marks on thirteen
occasions, of Swiss francs on four occasions, and Jap­
anese yen on ten occasions. In early April the Desk
also intervened on one occasion to purchase marks in
the Far East. Between mid-March and early April, the
Desk purchased an additional $761.6 million equivalent
of marks in the market, which— combined with an
additional $684.4 million equivalent acquired from cor­



respondents— were added to System and Treasury bal­
ances. Between February 1 and early April the Federal
Reserve purchased $185.1 million equivalent of Swiss
francs, including $140.4 million equivalent in the mar­
ket, which were added to System balances. Following
up on the March 2 agreement with the Japanese au­
thorities, the Federal Reserve bought a total of $216.8
million equivalent for its own account as part of joint
operations with the Bank of Japan in the New York
market. The Bank of Japan did not draw on the swap
line.
In the five weeks through April 8, the dollar had
advanced a further 111/4 percent against the German
mark, 5% percent against the pound sterling, and 4%
percent against the Japanese yen to reach the highest
levels recorded in some two and a half years. Never­
theless, the scramble for funds in the United States
had about run its course, and an increasing number
of economic indicators were suggesting that overall
economic activity in the United States was slowing
rapidly. Under these circumstances, market partici­
pants began to sense that domestic interest rates would
soon turn down. Meanwhile, foreign money markets had
tightened up considerably, in part as a result of the
recent heavy exchange market intervention.
Against this background, once United States interest
rates showed clear signs of declining in early April, the
dollar came under immediate and heavy selling pres­
sure. At this time also, dwindling prospects for a solu­
tion to the hostage situation seriously heightened
political tensions between the United States and Iran,
adding to the market’s concerns about the dollar. On
April 8-10 the dollar dropped sharply across the board,
declining about 5 percent against the major European
currencies in only twenty-four hours. To cushion the
decline, the Trading Desk intervened in size, operating
in German marks and Swiss francs. The Desk also sold
French francs, in consultation with the Bank of France,
to avoid aggravating the weakness of the mark relative
to the franc within the EMS.
Nevertheless, as interest rates continued to decline
in the United States, and the sequence of weekly indi­
cators showed that the key monetary aggregates were
contracting, the dollar came under periodic selling
pressure. Traders generally recognized that the Fed­
eral Reserve’s policy of restraint on money supply
growth was consistent with some easing in financial
market conditions, particularly as demands for money
and credit weakened and evidence of recession
mounted. There were expectations that the momentum
of inflation would slow in the months ahead, but
traders remained concerned that interest rates were
dropping more rapidly than anticipated. Abroad, inter­
est rates generally held firm so that favorable interest

FRBNY Quarterly Review/Summer 1980

67

Table 3

Net Profits (+ ) and Losses ( — ) on
United States Treasury and Federal Reserve
Current Foreign Exchange Operations
In millions of dollars

United States Treasury
Period

Federal
Reserve

Exchange
Stabilization
Fund

February 1 through
April 30, 1980 ...............

+34.9

+

Valuation profits and
losses on outstanding
assets and liabilities
as of April 30, 1980 , , .

-2 1 .8

-3 6 0 .8

11.7

General
account

+

3.7

-1 3 7 .9

Data are on a value-date basis.

differentials for the dollar were rapidly eroding. The
United States authorities stepped in fairly quickly to
cushion the decline whenever the dollar came on offer
in late April. These operations were closely coordinated
with similar intervention by the Bundesbank and other
foreign central banks and helped restore two-way
trading in the exchanges.
Gradually over the month, market participants focused
somewhat less on interest rate considerations and
more on broader economic developments. Monthly
data showed that the United States trade position was
improving, while some evidence suggested a slowing
in United States inflation. As a result, dollar rates in the
exchange market steadied. By the end of April, although


68 FRBNY Quarterly Review/Summer 1980


the dollar had declined as much as 9 to 11V2 percent
from its peaks against the major Continental currencies,
it was still 2 to 31/2 percent higher on balance for the
three-month period under review. Against the Japanese
yen and the pound sterling, the dollar ended the period
about Vz percent higher on balance.
During April the United States authorities intervened
on nine occasions in marks, selling a total of $1,183
million equivalent shared between the Federal Reserve
and the Treasury. Most of these operations were fi­
nanced out of balances, but System sales of $387.6 mil­
lion equivalent were financed by drawings under the
swap line with the Bundesbank. At the same time the
Federal Reserve was able to buy $50.4 million equiv­
alent of marks in the market on two occasions and
$91.1 million equivalent from correspondents, thereby
adding to System balances and reducing System swap
debt to $296.4 million equivalent by the month end.
During April, the System also operated in Swiss francs
on three occasions, selling $80.2 million equivalent fi­
nanced out of balances. In addition, the Federal Reserve
intervened in French francs on three occasions, selling
a total of $73.9 million equivalent financed by drawings
on the swap line with the Bank of France.
During the period under review the Federal Reserve
and the Treasury both realized profits on foreign ex­
change operations. Table 3 shows that the System
realized $34.9 million, the Exchange Stabilization Fund
realized $11.7 million, and the Treasury’s general ac­
count realized $3.7 million in profits. On a valuation
basis, however, as of April 30 the System showed $21.8
million in losses on outstanding foreign exchange hold­
ings and commitments. The Exchange Stabilization
Fund and the Treasury’s general account, respectively,
showed $360.8 million and $137.9 million in losses on
outstanding assets and liabilities.

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