Full text of Economic Policy Review (Federal Reserve Bank of New York) : Winter 1979, Vol. 4, No. 4

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Federal
Reserve Bankof
NewYbrk




W inter 1979-80
1

Volum e 4 No. 4

The M onetary Base as an Interm ediate
Target fo r M onetary P olicy

11

The Debate over R egulating the
E urocurrency M arkets

21

N ational P olicies tow ard Foreign
D irect Investm ent

33

Interest Rate Futures

47
50

The business situation
C urrent developm ents
Effectiveness of the first-year pay and
p rice standards

54
58

The financial m arkets
C urrent developm ents
Treasury and Federal Reserve Foreign
Exchange O perations

This Quarterly Review is published by
the Research and Statistics Function
of the Federal Reserve Bank of
New York. An article by RICHARD G.
DAVIS, senior economic adviser, on
the monetary base as an intermediate
target for monetary policy begins
on page 1. Among the members of the
staff who contributed to this issue
are EDWARD J. FRYDL (on the debate
over regulating the Eurocurrency
markets, page 11); DOROTHY B.
CHRISTELOW (on national policies
toward foreign direct investment,
page 21); MARCELLE ARAK and
CHRISTOPHER J. McCURDY (on
interest rate futures, page 33); PAUL
BENNETT and ELLEN GREENE (on the
effectiveness of the first-year pay and
price standards, page 50).
An interim report of Treasury and
Federal Reserve foreign exchange
operations for the period August
through October 1979 starts on page 58.




The Monetary Base as an
Intermediate Target for
Monetary Policy
The potential usefulness for various purposes of the
monetary base— roughly m ember bank reserves and
cash in the hands of nonmember banks and the pub­
lic— has been urged by a number of observers for many
years. One set of suggestions has involved proposals
that the monetary base be used as a short-term tactical
tool in the Federal Reserve’s efforts to achieve its
longer term money and credit objectives. In its Octo­
ber 6, 1979 announcement of a series of new policy ac­
tions, the Federal Reserve indicated that it did in fact
intend to place “greater em phasis” on the bank re­
serves component of the base in day-to-day operations
aimed at containing “growth in the monetary aggre­
gates over this year within the ranges previously
adopted” . A second set of proposals regarding the
monetary base, however, conceptually and practically
quite distinct from its possible use as a short-term
tactical objective, has been to replace the traditional
monetary measures with the base in formulating the
long-term targets themselves. Interest in the base as a
possible replacem ent for the traditional measures in
long-term targeting has become more prominent over
the past year or two. This increased interest repre­
sents mainly a response to developing problems in
interpreting the traditional money supply measures—
problems stemming, in turn, from innovations in the
use of deposits and deposit substitutes.
In advocating that the monetary base replace the tra­
ditional monetary series for long-term targeting pur­
poses, a number of points are often made. One is sim­
ply that data on the base become more quickly avail­




able and are less subject to error and revision than
data on the money supply. The main points are less
narrowly technical, however. Thus the claim has been
m ade that the monetary base is about as closely re­
lated to aggregate demand as the monetary measures
and that it is therefore at least as suitable a target
for achieving broader economic objectives. And, it is
argued, the recent developments cited above that have
tended to loosen the relationship between the tradi­
tional money stock concepts and aggregate demand
have not had comparably damaging effects on the
monetary base. The implication is that for the future,
at least, the relationship between the monetary base
and aggregate nominal demand is likely to be more
stable and predictable than the corresponding rela­
tionship involving the various money supply measures.
Finally, it has also been argued that the monetary base
is much more readily am enable to Federal Reserve
control than are the money supply measures and that
the base would make a superior target for this reason
as well. The purpose of this article is to take a fresh
look at the possible value of the monetary base as a
long-term target.
Defining and measuring the monetary base
The monetary base is most conveniently thought of as
the sum of three items: (1) mem ber bank reserves
(about 28 percent of the total base), consisting of
member bank deposits at the Federal Reserve Banks
and mem ber bank vault cash, (2) coin and currency
in the vaults of nonmember banks (about 2 percent),

FR B N Y Q u arterly R e v ie w /W in te r 1979-8 0

1

C h a rt 1

G row th of the M o netary Base and the M oney S to ck
P e rc e n ta g e c hanges from four q u a rte rs e a rlie r
P erc e n t

1960

61

63

64

65

66

67

68

69

70

72

73

74

75

M o n e ta ry b ase d a ta a re a d ju s te d for the e ffe c ts of c h a n g e s in re s e rv e req u ire m e n ts by the s ta ff o f the B oard of
G o v e rn o rs of the F e d e ra l R e s e rv e S ystem .

2 FR B N
Y Q u arterly R e v ie w /W in te r 1979-80


77

78

and (3) currency and coin held by the nonbank public
(about 69 percent). The monetary base therefore con­
sists of Federal Reserve liabilities in the form of mem­
ber bank deposits and Federal Reserve notes, and
Treasury liabilities in the form of outstanding Treasury
coin and currency. The monetary base can thus be re­
garded as the consolidated, noninterest-bearing mone­
tary liabilities of the Treasury and the Federal Reserve.
As such it can be derived directly from their balance
sheets in a m anner similar to the derivation of mem­
ber bank reserves.1
Since data on the monetary base are derived pri­
marily from Federal Reserve and Treasury balancesheet items and from vault cash data received from
member banks, estimates of the base become avail­
able the day after the end of each banking statement
week and are subject to only minor further revisions.
These revisions mainly reflect quarterly bench-m ark
estimates of nonmember bank vault cash and revisions
in seasonal adjustment factors. Thus the figures on the
base are available more promptly and are substantially
less subject to revision and to estimation problems
than are the money supply figures.
A somewhat thorny problem which confronts the
user of statistics on the monetary base as an analyti­
cal tool is just how to adjust for the impact of
changes in reserve requirements. Any change in legal
reserve requirement ratios— whether levied on de­
posits or on “ nonmonetary” liabilities such as Euro­
dollar borrowings— obviously affects the amount of
money (however defined) and bank credit that can be
supported by a given level of reserves or the monetary
base. Since the analytical significance of the monetary
base for economic behavior lies primarily in the vol­
ume of money and credit it can support, the raw
figures on the monetary base need to be adjusted
somehow for the impact of changes in legal reserve
requirement ratios.2 To the extent that movements in

1 A com plication arises from the fact that, in the m em ber bank reserve
com ponent, present rules count tow ard m em ber bank reserves in a
given statem ent w eek vault cash held two w eeks earlier. H ence any
definition of the m onetary base as the sum of m em ber bank reserves,
nonm em b er bank vault cash, and nonbank holdings of coin and
currency m ust include not this w e e k ’s m em ber bank holdings of
vault cash, but vault cash held two statem ent weeks ago. This is the
convention the Board of Governors staff has adopted in its published
series on the m onetary base and is also the one used in this
article. T h e St. Louis R eserve Bank has chosen, instead, to include
the current w eek's m em ber bank vault cash. For most purposes,
the resulting differences are not im portant.
2 In som e analytical fram ew orks, the m onetary base, in representing
the noninterest-bearing liabilities of the G overnm ent, is treated as part
of the net w ealth of the private sector. For this purpose, no ad ju s t­
m ent for reserve requirem ent changes is appropriate, but this aspect
of the base is ignored in this article as being of only s e c o nd-order
im portance.




the monetary base are regarded as a measure of the
active impact of monetary policy, moreover, it also
seems reasonable to adjust for the im pact of regula­
tory reserve requirem ent changes since such changes
obviously do represent policy decisions.
W hile the need to adjust for reserve requirement
changes is clear, there are in practice many ways in
which this adjustment can be carried out. The choice
among alternatives is not always obvious and depends
in part on the analytical purposes for which the data
are to be used. The adjusted monetary base data used
in this article are those produced by the Federal Re­
serve Board staff. These data are designed to reflect
adjustments only for regulatory changes in legal re­
serve requirement ratios. The adjustment procedure
does n o t correct for changes in effective required
reserve ratios that result m erely from shifts in the
composition of bank liabilities among categories with
different reserve requirements. The four-quarter growth
rate of the monetary base as adjusted by the Board
staff, together with the corresponding growth rates of
M j and M 2, is shown in Chart 1. The growth rates of
the reserve and currency components of the base are
compared in Chart 2.
Relationship of monetary base to GNP
As noted at the beginning of this article, a m ajor issue
in the possible use of the monetary base as a long-term
target is the closeness and stability of its relationship
to aggregate demand. The im portance of this issue is
obvious. Movements in financial measures, whether of
money, credit, or the monetary base, have no intrinsic
interest. They are of significance only to the extent
that they are related to fundamental economic ob­
jectives through their influence on aggregate demand.
One procedure for measuring the possible relation­
ship between financial variables and aggregate demand
that has become fairly standard over the past decade
is simply to regress quarterly changes in demand as
measured by nominal gross national product (GNP) on
current and lagged changes in the financial measure
in question. There are many reasons for treating the
results of such regression equations with caution. First,
experience shows that the results tend to be sensitive
to such details as the tim e period over which the
equations are estimated and the precise form in which
the equation is estim ated— e.g., with or without fiscal
policy variables, whether in percentage change or firstdifference form, and so forth. Second, however for­
mulated, there are substantial problems in attempting
to assess “causal” significance from these equations—
i.e., the extent to which an em pirical relationship dis­
covered between nominal GNP and a particular finan­
cial measure provides evidence that manipulation

FR B N Y Q u arterly R e v ie w /W in te r 1979-80

3

of the financial measure by the authorities would in­
fluence aggregate demand.
Despite these problems, it remains of some interest
to see how the relationship of GNP to the adjusted
monetary base as estim ated in such statistical equa­
tions compares with the corresponding relationships
derived from equations using the conventional money
supply measures. The results of estimating equations
using quarterly data on percentage growth in current
dollar GNP and current lagged growth of M x, M 2> the
monetary base, and its m ajor components are shown
in Table 1. Results are shown both for the full 1961-78
period for which data on the adjusted base are avail­
able and for each half of this period. The results sug­
gest that both for the full 1961-78 period and for each
half of this period the adjusted monetary base has a
w eaker relationship to GNP than does either
or M 2.
Indeed for the most recent nine-year period, there is
no statistically significant relationship between growth
of GNP and current and lagged growth of the adjusted
base.3 It is also of interest to note that, even for the
period as a whole, such relationship between the ad­
justed base and GNP as does exist is apparently due
entirely to the currency component. In the formulation
used here, at least, there is n o statistically significant
relationship between GNP and the adjusted reserve
component of the monetary base. The apparent de­
pendence of the relationship of the total base to GNP
on its currency component is of interest since the
volume of coin and currency in circulation is com­
pletely demand determ ined. That is, the banks supply
whatever volume the public desires and, in turn, draw
on the Federal Reserve to replenish their vaults. Thus
it is difficult to see how any statistical relationship be­
tween the currency component of the monetary base
and GNP could be interpreted as a “casual” relation­
ship running from currency to aggregate demand.
In any case, the results reported in Table 1 certainly
provide no reason for preferring the base over the
conventional monetary measures.4 Indeed, by them-

* T h e results using the m onetary base as adjusted by the Federal
Reserve B ank of St. Louis m ethod, w hich is so constructed as to
p arallel m ovem ents in M i and M 2 m ore closely, are som ew hat better
than those for the B o ard -staff series but a re still g enerally inferior^
to the m oney stock m easures them selves, especially to M i. T h e RJ for
the St. Louis adjusted base m easure over the full 1 9 6 1-78 period is
0.16, w ell below that for M i and M 2. T h e St. Louis series does
about as w ell as the m onetary m easures in the first subperiod (with
an R l of 0 .2 4 ), but the RJ drops to 0 .0 9 for the 1970's.
4 Equations sim ilar to those reported in T a b le 1 w ere run in w hich
m easures of changes in full-em p lo ym en t Federal expenditures and
full-em plo ym ent taxes and m an-days lost due to strikes w ere included
along with the various financial m easures. T h e inclusion of fiscal
and strike v ariables im proves the explanatory pow er of all the
equations, but the qualitative conclusions regarding the base versus
M i and M 2 rem ain the sam e. T h e base perform s notably worse than

 Y Q u a rte rly R e v ie w /W in te r 1979-80
4 FR B N


selves they suggest that the monetary base would have
made an inferior interm ediate target, relative to these
conventional monetary measures, over the eighteenyear period covered by the statistical results.
An alternative statistical “ horse race" that can be
run between the m onetary base and the conventional
money supply measures consists of com paring their
ability to “forecast” GNP on the basis of statistical
relationships estim ated from past data. In the particu­
lar “ race” run here, equations treating G NP growth as
a function of current and lagged quarterly growth rates
in, alternatively, M lt M 2I and the adjusted monetary
base were estim ated on data from 1961 through 1971.
Using actual values of the growth rates of these finan­
cial measures, “forecasts” of quarterly changes in
GNP for the four quarters of 1972 w ere then made
from the equations. The (algebraic) average forecast
errors for the four quarters of 1972,are reported in the
first line of Table 2 in annual rates. Next, the estim at­
ing equations w ere updated to include 1972 data and
similar “forecasts” w ere then m ade of GNP growth in
the four quarters of 1973— and so on through forecasts
of 1978. At the bottom of Table 2, averages of the
resulting annual averages of quarterly forecast errors
are reported in both algebraic and absolute terms.5
The results presented in the table seem to justify
the following conclusions: (1) All three measures pro­
duce fairly sizable forecast errors on average and in
many individual years. (2) For the 1972-78 period cov­
ered by the “forecasts”, all three measures show a
tendency to underforecast the growth rate of nominal
GNP. (3) In terms of the absolute values of the fore­
cast errors, the monetary base performs less well on
average over the 1972-78 period than either M j or M 2
(but the differences are not statistically significant).
Overall, these results again fail to point to any superi­
ority of the base over the conventional money supply

Footnote 4 (c o n tin u e d ):
M i and M 2 in the full period and both subperiods. In d eed , th e base
does not m ake a statistically significant additional contribution, once
the im pact of the fiscal and strike v ariables are accounted for, at the
95 percent level accordin g to the “ F” test in any of the periods tested.
5 The procedure used here is essen tially the one adopted by Leonall C.
A ndersen and D enis S. Karnosky in "S o m e C onsiderations in th e
Use of M onetary A ggregates for th e Im plem entation of M o n e ta ry
I
P olicy” , Federal Reserve B ank of St. Louis R eview (S e p te m b e r 1 9 7 7 ),
pages 2 -7 . The present procedures differ from theirs w ith respect to
(a ) the use of B oard-staff d a ta for the adjusted m onetary base, (b ) the
period over w hich th e equations w ere estim ated, (c ) th e period over
w hich the "fo recasts” w ere com puted, (d ) th e inclusion in the
St. Louis p a p e r of strike variables in the equations, and (e ) the
num ber of lagged values used in the equations. As in th e St. Louis
paper, the results shown here w ere com puted after a search for an
optim al num ber of lagged values for the individual financial m easures.
In the present case, the n u m ber of lagged values included is four
for each of the three financial m easures.

Ta b le 1

Regression Equations Relating GNP Growth to Current and Lagged
Growth of Financial Measures
R 2*

R 2*

1961-1
to
1 9 7 8 -IV

0 .2 5
0.08
-0 .0 2
0.11

Financial m easure

M2 .........................................................................................................
M onetary base a d ju s t e d .............................................................
Total reserves adjusted .............................................................
C urrency plus nonm em ber bank vault c a s h ..................

1961-1
to
1 9 6 9-IV

R2*
1970-1
to
1 9 7 8 -IV

S E E *t
1961-1
to
1 9 7 8 -IV

0.19
0 .0 8
-0 .0 6
-0 .1 1
+ 0.01

2 .9 6
3.07
3.41
3 .5 9
3.35

0.23
0.27
0.01
0.19
0.13

SEE*
S E E *t
1961-1
1970-1
to
to
1 9 6 9 -IV
1 9 7 8 -IV
2 .2 5
2.19
2.56
2.31
2.40

3.64
3 .8 8
4.16
4.26
4.03

C urrent and four lagged percentage changes for the financial variables w ere used in the equations
with unconstrained coefficients. Ail variables are m easured as quarterly percentage changes at annual
rates using seasonally adjusted data. The m onetary base and m em ber bank reserve m easures are
adjusted for the effect of changes in required reserve ratios by the Federal Reserve Board staff.
* R* is the square of the "co efficien t of m ultiple co rrelatio n ” (adjusted for “ degrees of fre e d o m "). R2
m easures, on a scale of zero to one, the proportion of the variation in gross national product (G N P )
growth that can be accounted for by the regression equation on the basis of variations in the current
and lagged growth of the financial m easures. The “ standard error of estim a te " (S E E ) is the square
root of the average squared error m ade by the equation in estim ating G N P growth rates over the sam ple
period on the basis of the current and lagged growth rates of the financial m easure. As is apparen t
from these definitions, the association of m ovem ents in G N P growth rates with current and lagged
m ovem ents in the growth rates of the financial m easures is the closer, the larg er is the RJ and the
s m aller is the SEE.
f In percent at annual rates.

wr m m .
n

T ab le 2

T a b le 3

Errors in Forecasting Quarterly GNP Growth
Rates Averaged over Four-quarter Periods

Fourth-Quarter to Fourth-Quarter
Growth Rates in Selected Aggregates

Errors m easured in percentage annual rates

Period

F o re c a s t e rro rs fro m e q u a tio n s using
A djusted
m onetary
base
M2
Mi

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

2.2
1.7
-0 .9
3 .0
0.9
1.5
2.9

2.1
1.7
— 1.3
2.2
-0 .5
1.9
4.2

3.5
0.9
-2 .7
2.1
1.7
2.9
2 .9

A verage error ...............................
Average absolute e r r o r ...........
Root mean square e r r o r ------

1.6

1.5
2 .0
2.2

1.6
2.4
2 .5

1972
1973
1974
1975
1976
1977
1978

Y ea r

Total
m onetary
b ase*

1970 ..................

1.9
2.0

M2

4.1

3.9

3.2

6.5

3.1

Mi

4.8

7.2

8.0

...........

6.6

11.3

1972 .................. ...........

8.6

9.0

8.4

11.2

1973 .................. ...........

8.0

8.7

6.2

8.8

1974 .................. ...........

7.9

9.3

5.1

7.7

1975 .................. ...........

6.7

5.7

4.6

8.4

6.7

1978 .................. ..........

9.2

5.8

10.9

8.3

1976 ..................

As described in the text, all forecasts are com puted from
equations estim ating quarterly G N P growth on the basis of
current and four-lagged values of growth rates of financial
m easures based on data from 1961 to the final quarter of the
year just prior to the year for w hich the forecasts are m ade.
The forecasts are m ade using actual values of the financial
data.




N on­
borrowed
base*

7.9

9.8

9.1

7.2

8.4

* A djusted for changes in reserve requirem ents.

F R B N Y Q u arterly R e v ie w /W in te r 1979-80

5

measures in terms of past performance and suggest
that, if anything, the base does less well than the con­
ventional measures.6
This sort of statistical evidence aside, there are
some plausible reasons to think that the monetary
base, even after adjustment for changes in reserve
requirem ent ratios, might be less closely related to
nominal aggregate demand than the money supply
measures. Every development that shifts the “demand
for m oney”— the amount of money balances people
wish to hold under given interest rate and GNP con­
ditions— must also shift the demand for the monetary
base, since it must affect either the demand for the
currency or the reserve component of the base. But
there could be some developments that would shift
the demand for the base that would n o t affect the
demand for money. One such possible source of com­
paratively greater instability in the demand for the
base would be shifts in the public’s desired currencydeposit mix. Such shifts could result, for example,
from shifts in the c o m p o sitio n of aggregate demand
toward transactions that involve a higher proportion of
cash payments relative to checking transactions. De­
velopments of this kind would have no effect on the
total demand for the money, but they would shift the
demand for the base.7
Alterations in bank demands for excess reserves
would also be reflected in a shift in the demand for
the base but not for money. M em ber bank excess re­
serves have for many years been close to frictional
minima, so that this cannot have been an important
factor influencing the closeness of the b a se /G N P re­
lationship. But any legislative changes that tended to
reduce legally required reserves below the levels de­
sired by the banks themselves could make potential
shifts in the demand for “excess” reserves a more

4 The root m ean square errors for the tw en ty-eight individual quarterly
forecasts are 3.5 percent for M i, 3 .8 percent for M 2, and 4.4 percent
for the adjusted m onetary base. These root mean square errors are
c o m p a ra b le in m agnitude and a re the sam e in rank order as the
standard errors reported in T a b le 1. T h e app e a ra n c e of a contrast
betw een a substantially w orse perform ance for the base as reported
in term s of RJs in T a b le 1 and th e only m oderately w orse perform ance
reported in T a b le 2 seem s to reflect th e fact that relatively large
differences in R2s a re associated with relatively m odest differences in
standard errors and the fact that, in T a b le 2, annual a v erag e forecast
errors are reduced to th e extent that positive and negative forecast
errors w ithin the y e a r offset each other. This results in the sm aller
root m ean square errors reported for all three m easures at the bottom
of T a b le 2.
7 H istorically, shifts in the p u b lic ’s dem and for currency relative to
deposits have on occasion had a dram atic effect on the relationship
betw een the base and agg re g a te d em and. For exam ple, from 1929 to
1933 th e m onetary base actually rose as the pu b lic ’s dem and for
c urrency relative to deposits and the b anks’ dem and for excess
reserves sw elled; yet agg re g a te dem and along with standard de fin i­
tions of m oney fell sharply.

Y Q u arterly R e v ie w /W in te r 1979-80
6 FR B N


significant factor in the future than it has been in
recent decades. Finally, shifts in interest rate ceilings
or other m arket factors affecting the demand for reservable, nonmonetary bank liabilities shift the demand
for reserves, and thus for the base, without any corre­
sponding destabilizing effects on the demand for the
conventional money stock measures.8
Does the monetary base offer a way out of current
problems with conventional money supply measures?
The most important issues concerning the stability of
the relationship of the monetary base to aggregate de­
mand involve not the past, but the present and the
im mediate future. W hile some support has been voiced
in the past for replacing money supply measures as
long-term policy targets with the m onetary base, most
support for such a move is of quite recent date. The
upsurge of interest in the base stems basically from
the large number of recent institutional, regulatory,
and market innovations affecting the demand for
money in its various definitions.
One group of developments has involved the trans­
formation of deposit categories other than demand
deposits into the functional equivalent of transactions
accounts. Examples include the inauguration of NOW
(negotiable order of withdrawal) accounts in some
states, the authorization to use savings accounts for
automatic transfer account purposes, and telephone
transfer procedures for comm ercial bank savings and
thrift accounts. Developments of this kind have had
their primary effect on reducing the demand for de­
mand deposits and thus for the narrow
definition of
money. To a lesser extent they have involved shifts
out of a ll types of comm ercial bank deposits to thrift
institution deposits and, to that extent, they have also
had some depressing effect on the demand for M 2.
They have probably had little effect, however, on the
M 3 definition, which includes both bank and thrift in­
stitution deposits.9
A second, and related, set of developments has in­
volved the increasing use of close nondeposit substi­
tutes for “ money” , instruments not included in a n y of

8 For exam ple, larg e negotiable certificates of deposit (C D s )— $ 1 0 0 ,0 0 0
or over— fell by roughly $ 1 6 billion betw een January and July 1979,
apparen tly larg ely reflecting relatively unfavorable cost relationships
(e s p e c ia lly relative to E urod ollar borrowings, w hich rose substantially
over the sam e p e rio d ). W h ile exact figures are not available, it
appears that this d e c lin e in larg e C D s m ay have reduced required
reserves by about $1 billion over this period. O ver th e sam e period,
total reserves de c lin e d by about $1.7 billion.
’ For an analysis of recent d evelopm ents affecting conventional
definitions of the m oney supply, see "D e fin in g M oney for a C hanging
Financial S ystem ” , by John W ennin ger and C harles M . Sivesind,
this R eview (S pring 1 9 7 9 ), pages 1-8.

the conventional monetary definitions. This second set
of developments has therefore tended to depress the
demand for a ll the conventional measures of money.
Most prominent among these developments is the dra­
matic expansion beginning in late 1978 of money mar­
ket mutual funds, which usually provide checking
privileges. Other examples include the increased use
of corporate repurchase agreements, which appear to
be close substitutes for demand a n d /o r short-term
tim e deposits, and of United States resident holdings
of Eurodollar deposits. The problem with these vari­
ous developments so far as monetary aggregate tar­
geting is concerned is that they clearly require some
adjustment of the published numbers on the conven­
tional monetary measures to arrive at a realistic
assessment of what these numbers mean for aggregate
demand as interpreted in the light of past relationships.
Now if one knew exactly to w h a t e x te n t these vari­
ous developments had reduced the demand for the
various conventional monetary measures— i.e., the ex­
tent to which the raw figures on current movements
in the aggegates need to be raised to make them
com parable to past movements in terms of their
broader economic significance— these developments
would create no particular problem. A problem is cre­
ated, however, by the existing uncertainty about the
appropriate size of the needed adjustments in the
conventional money stock figures. Just to give one
example, money market mutual funds rose by $9.6 bil­
lion between Septem ber 1978 and March 1979. How
much of this large rise should be regarded as coming
out of M ,? How much out of M 2, or M 3? How much of
the increase represents a true shift in the demand for
these aggregates under given economic conditions
and how much m erely reflects the normal substitution
out of money into other short-term earning assets that
always occurs when market interest rates rise?
W hile estimates are of course possible, no one can
give precise and certain answers to these questions.
And, to the extent that uncertainty about the appropri­
ate adjustment exists, problems are created for inter­
preting the actual movement of the conventional money
measures and in setting appropriate targets for them.
Moreover, as long as the process of innovation in the
use of money substitutes continues, such problems
will also continue.
It is in the context of these problems with the mone­
tary aggregates that some have suggested a shift to the
monetary base for targeting purposes and for analyzing
the thrust of policy. But it seems difficult to make a
convincing case for such a recommendation on this
basis. The same developments that create problems
for the conventional monetary measures also create
problems for the monetary base. As is the case with



the money supply measures, the stability and predicta­
bility of the relationship of the monetary base to aggre­
gate demand depends upon the stability of the demand
for the monetary base under “given” economic condi­
tions (which usually means given interest rate and ag­
gregate demand conditions). But the demand for the
monetary base is derived from essentially two sources:
(1) the public’s desire to hold coin and currency and
(2) the banks’ desire to hold reserves. And, since mem­
ber bank holdings of excess reserves are essentially
zero, the banks’ “dem and” to hold reserves is for the
most part just the level of required reserves they must
hold against deposit and nondeposit liabilities. So the
demand for reserves is directly related to the public’s
demand to hold these liabilities.
The implication of this is that the recent develop­
ments that have shifted the demand for money by
unknown amounts must also have shifted the demand
for the base by unknown amounts because they will
have shifted the demand for reserves. To be sure, the
larger weight of currency in the base relative to its
weight in the various money supply measures means
that, in a purely arithmetic sense, the affected portion
of the base (required reserves) is smaller than the
affected portion of the money supply (deposits). But
this arithmetic truism would seem to be of little com­
fort to the user of the monetary base. The impact of
the monetary base on the economy will be subject to
less uncertainty than the monetary measures as a
result of shifts in the demand for deposits only if a
dollar o f c u rre n c y is assumed to be just as “ im portant”
as a dollar of reserves even though the latter supports
multiple dollars of money and credit. This does not
seem likely to be true. In short, the monetary base
does not seem to offer a way out of the problems cre­
ated by recent innovations that have affected the
demand for the conventional monetary measures.
Indeed, in one respect, the problems created for the
base may be more severe than those created for at
least the broader money supply measures. For exam ­
ple, if automatic transfer accounts represent in part
shifts out of demand deposits, the demand for M x will
be reduced by an amount that can only be estimated
since some of these funds may have come out of
ordinary passbook savings accounts or out of some
other type of deposit. But the resulting problems for
M j could be circumvented by working with a broader
aggregate, such as M 3, that includes a ll the potentially
affected deposit categories.
Sim ilar solutions are not available to get around the
problem as it affects the monetary base. Under current
law and regulations, required reserve ratios against
demand deposits may be as high as 16.25 percent
while the required reserve ratio for m em ber bank sav­

FR B N Y Q u arterly R e v ie w /W in te r 1979-80

7

ings accounts is only 3 percent and, of course, there
are currently no required reserves for accounts at
thrift institutions. Thus the shift of unknown magnitude
out of demand deposits and into automatic transfer
accounts will create a shift, also of unknown magni­
tude, in the demand for the reserve portion of the
monetary base altering its prospective relationship to
aggregate demand relative to past relationships.
Controllability of the monetary base
One argument that is sometimes made for the mone­
tary base as a long-term target measure is that its
growth could be more accurately controlled by open
m arket operations than can the various money supply
measures. In part, the argument for the superior con­
trollability of the base rests on the point noted earlier
that incoming data on it are substantially less subject
to error and subsequent revision than are the money
supply figures. More fundamentally, however, the argu­
ment for the superior controllability of the base is that
the Federal Reserve can use open market operations to
offset the so-called “operating” or “ m arket” factors
(such as float) that influence bank reserves and the
base. Given the ability to offset these factors, the non­
borrowed portion of the monetary base— i.e., the total
excluding m em ber bank borrowings from the Federal
Reserve Banks— can be controlled over any desired
tim e horizon subject only to errors in estimating the
behavior of the operating factors. Such errors tend to
be self-canceling over more than a few weeks.
W hile the Federal Reserve can indeed control the
nonborrowed portion of the monetary base with rea­
sonable precision over a period of weeks, the depen­
dence of mem ber bank borrowings on the decisions
of the banks (subject to the rules of discount window
administration) makes the controllability of the to ta l
monetary base a more complex problem. It is useful
in this connection to distinguish between short-run
control periods, which can be identified with the
roughly one-month periods between Federal Open
M arket Comm ittee (FOM C) meetings, and long-run
control periods, which can be identified with the fourquarter spans over which the long-run monetary aggre­
gate targets are defined.
In the short-run context, a critical point is that mem­
ber bank excess reserves tend to average close to
frictional minima over a period of weeks and to show
little systematic sensitivity to interest rate movements.
Consequently, movements in the total reserve compo­
nent of the base tend largely to mirror movements in
required reserves. And in the short period of a few
weeks between FOM C meetings, required reserve
movements tend to be only m arginally responsive to

8 FR B N Y
 Q u arterly R e v ie w /W in te r 1979-80


the volume of nonborrowed reserves supplied.1 Thus,
0
with both excess and required reserves largely unre­
sponsive to the behavior of nonborrowed reserves
in the short run, the volume of reserves supplied
through open m arket operations in the short run main­
ly affects the extent to which member banks are forced
to meet their reserve requirements through borrowings
at the discount window. For example, the larger the
volume of nonborrowed reserves supplied through
open m arket operations, the smaller will be the banks’
recourse to the discount window in meeting reserve
requirements. The effect on to ta l reserves, nonbor­
rowed plus borrowings, and on the to ta l monetary base
appears to be quite small over these short periods.
Hence, most of the problems of predicting and influ­
encing required reserves that make short-run control
of the money supply so difficult also com plicate efforts
to achieve short-run control of the total monetary base.
Over an “ interm ediate” period of several weeks or a
few months, it is plausible to believe that the total
monetary base or total reserves should be more accu­
rately controllable than measures such as M, and M.,.
At least this is true to the extent that emphasis in dayto-day and w eek-to-week open m arket operations is
placed on the volume of nonborrowed reserves or the
nonborrowed base rather than on particular levels of
interest rates such as the Federal funds rate. The su­
perior controllability of the total base under these con­
ditions is plausible simply because the only source of
slippage between n o n b o rro w e d reserves or (allowing
for currency) the nonborrowed base and the to ta l base

16 U nder the “ lagged reserve a c c o u n tin g ” procedures currently in
effect, deposits in a given w eek determ ine required reserves two
statem ent w eeks later. Thus, at the beginning of any statem ent w eek,
required reserves for the current and follow ing statem ent w eek are
already determ ined and by definition com pletely unresponsive to
the level of nonborrow ed reserves. H ence, the im pact of this w e e k ’s
level of nonborrow ed reserves on m oney m arket conditions and on
public and bank portfolio adjustm ents can affect required reserves
only in the third follow ing w eek at the earliest. Even if reserve
requirem ents this w eek w ere levied on this w e e k ’s deposits, the
volum e of nonborrow ed reserves supplied this w eek w ould affect
this w e e k ’s deposits and required reserves only to the extent that
bank and public portfolio adjustm ents respond prom ptly to the im pact
of changes in reserve a vailability and to concom itant changes in
m oney m arket conditions. If such portfolio adjustm ents tend to take
place only gradually, how ever, then changes in nonborrow ed reserves
in the current w eek m ight have little effect on required reserves, and
hence on total reserves, in the current statem ent w eek even in the
a b sence of a lagged reserve accounting system . The exact speed of
response of such portfolio adjustm ents to changes in current reserve
availability, and therefore the extent of the actual influence of lagged
reserve accounting in slow ing the response of deposits and required
reserves to changes in nonborrow ed reserves is a m atter of contro­
versy. W hatever the answer, it does seem c le ar that portfolio
adjustm ents unfold over tim e. Thus the full im pact of changes in
nonborrow ed reserves on deposits, required reserves, and total
reserves will be felt only over a period of w eeks or even months.

is mem ber bank borrowings. But, in the case of m ea­
sures such as M lt M 2, or bank credit, there is a second
slippage between nonborrowed reserves or the non­
borrowed base in the form of potential changes in the
“m ultiplier" relationship between the total base and
any one of these money or credit measures. Clearly,
unforeseen movements in the m ultiplier represent an
additional source of difficulties in controlling money
and credit measures relative to controlling the base.
In any event, from the point of view of influencing
ultimate economic objectives, and certainly from the
point of view of choosing long-term targets, it is the
relative controllability over periods of perhaps six
months or longer that is relevant in comparing the
base with money and credit measures. Over horizons
as long as the four-quarter spans used currently to
define long-term targets, problems of controlling both
money supply measures and the monetary base are
considerably less acute than they are in the short or
even interm ediate run— at least from a purely techni­
cal point of view. Indeed, there seem to be grounds
for believing that, over periods as long as a year, prob­
lems of achieving targets for any of these measures
may be not so much technical as they are the result
of substantive policy dilemmas.
But, from a purely technical point of view, the rela­
tive controllability of the monetary base versus the
money supply measures over a one-year horizon de­
pends significantly on the tactical m odus o p e ra n d i of
open market operations. To the extent that the tactical
approach chosen is one of inducing the desired aggre­
gate growth rates by influencing money m arket condi­
tions, as measured, for exam ple, by the Federal funds
rate, the problems of controlling the base would prove
essentially the same as those encountered in attem pt­
ing to control the money supply measures. And they
would be no easier to solve. For all these various
aggregate measures, planning to achieve stated tar­
gets requires projections of the interest rate path ex­
pected to be associated with the desired growth rate
of the financial aggregate. In practice, the needed
projections must encompass projections of mutually
com patible paths for interest rates, the financial aggre­
gates, and aggregate demand. The difficulties of mak­
ing such projections are substantial. And they do not
appear to be significantly less substantial for the mon­
etary base than for money and credit measures.
A different approach to the problem of long-run
control would be to attempt to control the monetary
base over one-year horizons by setting objectives for
the n o n b o rro w e d base, a measure which should itself
be controllable over a one-year period with a very
high degree of accuracy for reasons already given.




Since the difference between the nonborrowed and
total monetary base is simply m ember bank borrow­
ings, a relatively small proportion of the total,1 one1
year growth rates in the total base do, in fact, tend
to show a reasonably tight relationship to correspond­
ing growth of the nonborrowed base (see Table 3).
Even so, the slippages have been significant on occa­
sion, reflecting substantial year-to-year variability in
m em ber bank borrowings. These variations, in turn,
prim arily reflect sometimes sizable shifts in the rela­
tionships of the discount rate to m arket interest rates.
On balance, it appears that, from the point of view
of longer run control, increased emphasis in day-today actions on reserves and reduced emphasis on
interest rates, such as was announced by the Federal
Reserve on October 6 to enhance control of the long­
term money supply targets, would tend to enhance the
long-run controllability of the base to an even greater
degree. Thus in this respect the new procedures tend
also to enhance the relative attractiveness of the total
base as a long-term target.
Conclusion
In evaluating the potential merits of the monetary
base or any other m easure for long-term targeting
purposes, a number of considerations should be taken
into account. The strongest argument for the base is
that it does seem more amenable to control than the
conventional money measures, at least beyond the
very short run and provided the focus of tactical oper­
ations is on nonborrowed reserves rather than on In­
terest rates. But this advantage has to be qualified by
the comment that, over periods as long as a year,
problems of control for any of the m ajor money and
base aggregates may not be prim arily technical. With
respect to its relationship to aggregate demand, the
statistical evidence reported here suggests that in the
past the base has been at least somewhat less closely
related to nominal GNP than has been the case for
the conventional money measures. The weight to be
given to this sort of evidence needs to be supple­
mented with more general considerations. Shifting
public preferences as between deposits and currency,
shifting bank demands for excess reserves, and chang­
ing m arket developments affecting nondeposit liabili­
ties are all potential sources of instability in the rela­
tionship of the base to aggregate demand. And such

n

Excluding exceptional borrow ings, such as those to the Franklin
N ational B ank prior to its collapse, quarterly average borrowed
reserves in recent years have rarely e xceeded $2 billion or about
1.4 percent of the current level of the base of roughly $ 1 5 0 billion.

FR B N Y Q u arterly R e v ie w /W in te r 1979-80

9

sources of possible instability tend to count against the
base as a possible long-term target.
Finally, there should be no illusion that the base is
immune to the problems of interpretation that have
recently been created for the conventional money
measures by innovations in the use of deposits and
deposit substitutes. The new developments do create
real problems in setting long-term targets, both for
the money measures and for the base. There are prob­

10 FR B N
 Y Q u a rte rly R e v ie w /W in te r 1979-80


ably no com pletely satisfactory solutions to these
problems. But the replacem ent of ail money stock
measures in long-term targeting by a single target for
the monetary base does not appear to be a particularly
attractive option. The development of new money
stock measures that take account of the recent finan­
cial innovations appears a more promising approach
to dealing with the implications of these innovations
for formulating long-term policy targets.

Richard G. Davis

The Debate over Regulating
the Eurocurrency Markets
The Eurocurrency markets have long been the focus of
controversy, and debate over how the markets are
functioning has become even more spirited recently.
The m arkets’ size, their persistently rapid growth, and
their relative freedom from regulation by national mon­
etary authorities are at the root of present concerns.
But the debate about the Euromarkets is often confus­
ing, and the arguments made frequently appear diffuse
and abstract.
The divergence of views has two dimensions. At one
level commentators disagree about what economic and
financial problems, if any, are caused by Eurobanking
operations. At another level, even among those who
identify the same problems, sharp differences exist re­
garding appropriate remedies. Those parties most di­
rectly concerned— depositors, final borrowers, interna­
tional banks, and monetary authorities of major
countries— approach the markets from differing per­
spectives, and so it is quite natural for them to differ
on both their analyses and their prescriptions.
This article seeks to offer some perspective on the
Euromarket debate and to indicate current differences
in viewpoint about the problems involved. The objec­
tive is not to survey comprehensively all responsible
opinion in the controversy; nor is it to identify official
positions of specific institutions. Rather, the article
examines attitudes toward the three broad issues that
underlie the debate about the Euromarkets:
• Have the Euromarkets contributed
inflation by complicating efforts
control for national authorities or
a too ready source of financing
tures?




to worldwide
at monetary
by providing
for expendi­

• Have the Euromarkets contributed to exchange
rate instability?
• How safe are Eurobanking operations?
Inflation and the Euromarkets: monetary control
A number of critics claim that the Euromarkets can
undermine or at least com plicate national monetary
policies in ways that tend to worsen inflation. Basically,
that view rests on variations of the argument that the
Euromarkets can create money over and above what is
created in domestic banking systems. Since this line
of thought plunges directly into all the ambiguities
surrounding the concept of money, care must be taken
in choosing the m easure of domestic money to com ­
pare with Euromarket liabilities.
It has long been recognized that a shift of deposits
from a domestic banking system to the corresponding
Euromarket (say from the United States to the Euro­
dollar market) usually results in a net increase in bank
liabilities worldwide. This occurs because reserves
held against domestic bank liabilities are not dimin­
ished by such a transaction, and there are no reserve
requirements on Eurodeposits. Hence, existing re­
serves support the same amount of domestic liabilities
as before the transaction. However, new Euromarket
liabilities have been created, and world credit availa­
bility has been expanded.
To some critics this observation is true but irrele­
vant, so long as the monetary authorities seek to reach
their ultimate economic objectives by influencing the
money supply that best represents money used in
transactions (usually M ,). On this reasoning, Euromar­
ket expansion does not create money, because all
Eurocurrency liabilities are time deposits although

FR B N Y Q u arterly R e v ie w /W in te r 1979-80

11

frequently of very short maturity. Thus, they must be
treated exclusively as investments. They can serve the
store of value function of money but cannot act as a
m edium of exchange. For instance, if Eurodollars must
be converted into United States demand deposits to
be used in purchase of goods, services, or assets, and
if a reliable relationship holds between the amount of
domestic transactions balances and the level of do­
mestic expenditures, then national monetary authori­
ties could in principle influence those expenditures by
controlling the domestic money supply.
Yet this point can also be pushed too hard. First,
it is possible that shifts of funds from domestic markets
to the Euromarkets increase the velocity of circulation
of the domestic money supply, although not neces­
sarily in any predictable way. To the extent this is true,
the relation between domestic money and expenditures
may be unstable. Like other investments that serve as
money substitutes, Eurocurrency deposits allow de­
positors to econom ize on their money balances. Con­
sequently, the rate of utilization, or velocity, of the
domestic money stock may increase. Any given level
of economic activity can then be transacted with less
money. That can have inflationary consequences if
the increase in velocity is not offset in time by the
authorities.
Second, w hether Eurocurrencies can play the role of
transactions balances is basically a m atter of m arket
practice. For exam ple, in the Caribbean offshore Euro­
dollar market, it is customary for branches of United
States banks to transfer overnight Eurodollar deposits
into im m ediately available funds without penalty. Under
such conditions, overnight Eurodollars are a very close
substitute for transactions balances in checking ac­
counts at United States banks. For sophisticated multi­
national corporations, it is not a large step from the
present situation to doing transactions directly among
themselves in Eurodollars or other Eurocurrencies.
The im portant general point is that accepted con­
cepts of money are being changed by practices in the
Euromarkets, and not just domestically. This recognition
that financial markets are undergoing rapid structural
change underlies much of the official concern about
Eurom arket growth. Potentially, such change can dis­
rupt traditional relationships between money stock
measures and expenditure flows. As a result, monetary
authorities may end up either seeking to control an
inappropriate money measure or finding it difficult to
decide how much weight to give to alternative m ea­
sures of the money stock.
Nearly all observers would concede that rapid Euro­
m arket growth in an inflationary environment makes
life difficult for monetary authorities. But many argue
that it is not necessary to slow the growth of the Euro­
 Y Q u a rterly R e v ie w /W in te r 1979-80
12 FR B N


markets to attain better control over world inflation.
Rather, traditional dom estic monetary policy opera­
tions are seen as sufficient to control the growth of
bank liabilities worldwide. Any faster than anticipated
expansion of the Euromarkets need only be offset by
further domestic monetary restraint. This could be
achieved more or less m echanically by incorporating
Eurocurrencies into domestic monetary aggregate tar­
gets in some appropriate fashion.
There are, however, practical reservations about this
prescription. First is the problem of estimating any
stable statistical relationship between a monetary ag­
gregate that includes some Eurodeposits and national
expenditures. Second is the problem of collecting suffi­
ciently reliable and tim ely data about changes in Euro­
m arket liabilities to be of use to monetary authorities
in their policy operations. Such detailed information is
not fully available. In principle, of course, it can be
obtained, but the practical difficulties of obtaining com­
parable, tim ely information from many different coun­
tries poses no small problem.
Another important problem is the distribution of the
effects of greater domestic monetary restraint. Gov­
ernor W allich of the Federal Reserve Board has raised
this point in the context of United States monetary
policy.1 W hile conceding that theoretically the effects
of Eurodollar expansion can be offset by tighter
Federal Reserve open m arket operations acting on the
domestic money supply, W allich argues that this is
not a practical alternative since the incidence of tighter
monetary policy would fall disproportionately on ex­
penditures financed by United States banks and bor­
rowers not well connected to the Eurodollar market.
Direct measures to control the Euromarkets, such as
reserve requirements, would in his view spread the
burden of tighter monetary policy more equitably
among different kinds of borrowers and lenders.
Inflation and international adjustment
Another im portant charge made against the Euro­
markets is that they contribute to inflationary pressures
w orldwide by increasing credit availability to deficit
countries and thereby impeding adjustment of inter­
national payments imbalances. Specifically, deficit
countries are said to be able to obtain balance-ofpayments financing from banks operating in the
Eurocurrency markets without having to take actions to
reduce their deficits. As a result, worldwide expendi-

1 Statem ent by H enry C. W allich before the S ubcom m ittees on D om estic
M onetary P olicy and on International Trade, Investm ent, and M onetary
P olicy of th e H ouse C om m ittee on B anking, Finance, and U rban
Affairs, July 12, 1979. S ee also G overnor W a llic h ’s testim ony before
the S en ate S ubcom m ittee on International Finance, D e c e m b e r 14, 1979.

tures— in particular, consumption expenditures— are
maintained at high levels, putting upward pressure on
prices in world markets.
In this view, Eurocurrency loans serve to displace
credits that carry with them conditions on national
economic policies— most importantly, borrowings from
the International Monetary Fund (IM F). On the de­
mand side, borrowing countries are seen as reluctant
to submit to Fund involvement in their policies. As a
result, they have a marked preference for bank financ­
ing of balance-of-paym ents deficits. On the supply
side, banks are seen as wary of exerting leverage
against borrowers by withholding new loans since
such a step might jeopardize prospects for repayment
of earlier loans and because they are naturally reluc­
tant to get involved in domestic political arguments.
To the contrary, banks have competed aggressively in
recent years in extending new Eurocredits and, at least
until very recently, at terms increasingly favorable to
borrowers. In any case, individual comm ercial banks
have no m andate for tailoring their lending activities to
promote international balance-of-paym ents adjustment.
At heart, these criticism s apply to international bank
lending practices generally. They become specific
charges against the Euromarkets only because the bulk
of bank lending to sovereign borrowers takes place
in those markets (especially the Eurodollar market).
However, the Euromarkets do have a natural compara­
tive advantage in handling this business.
First, sovereign borrowers frequently need large
amounts of funds at once. The most convenient, and
often the only, way to accom m odate such large loans
is the syndicated bank credit. This financing technique
has reached its fullest development in the Euromarkets,
and it is not clear whether the technique is readily
adaptable to domestic banking markets.
Second, both borrowers and lenders often prefer that
loans be syndicated across a network of banks from
different countries. In that way, borrowing costs may
be minimized while the risk of the transaction is spread
as widely as possible.
Third, from the point of view of the commercial
banks, there are often tax advantages in Euromarket
lending, com pared with strictly domestic lending. In
some cases, earnings on loans shifted from the Euro­
m arkets to bank head offices would become subject to
additional domestic taxes, which would serve at the
margin to discourage banks from extending such loans.
For exam ple, earnings on loans booked through the
overseas branches of New York City-based banks
would be subject to state and local taxes if shifted to
the home office books.
Consequently, while international lending could in
principle be made from domestic offices instead of



Eurom arket branches, in practice the transition would
be uneven. Thus, it is argued, regulation of the Euro­
markets could result in less balance-of-paym ents fi­
nancing, smaller deficits, and a possible reduction in
inflationary spending.
This line of argument is sharply criticized by many
bankers as well as officials of a number of deficit
countries. To them, the problem is not that financing
deficits is too easy. Rather, the problem is that, be­
cause of successive oil price shocks, international
payments im balances have become so large and in­
tractable that reasonable stability for the world econ­
omy requires adequate financing through the Euro­
markets. Moves to restrict growth of the Euromarkets
would inevitably raise the cost of funds to borrowers.
But countries borrowing to offset the im pact of higher
oil prices or of a recession in the industrial world are
not in a strong enough position to be very sensitive
to borrowing costs in the short run. Hence, such re­
strictive measures would do little to promote adjust­
ment and would simply make recycling a more costly
proposition for borrowing countries. In short, those who
make this argument say that, without provision of al­
ternative private and official financing sources, m ea­
sures to restrict Eurolending would disrupt the recy­
cling of oil funds, cause added difficulties for deficit
countries, and contribute little or nothing to the reduc­
tion of oil price-induced inflation.
Between these two extrem e views— the Euromarkets
as undermining balance-of-paym ents discipline and the
Euromarkets as essential to the recycling process— is
an interm ediate one. In that view, the Euromarkets
have been a m ajor positive factor in smoothing the
im pact of balance-of-paym ents disruptions which
could otherwise have led to serious economic hardship
for many countries. But access to the Euromarkets has
also led certain countries to delay fundam ental adjust­
ments in economic policies past the point where ad­
justments could take place gradually. The results then
were abrupt constraints on borrowing capacities and
economic dislocation when the magnitude of the pay­
ments imbalances becam e apparent. The proponents
of this interm ediate view would seek some mechanism
to m oderate the growth of bank lending in the Euro­
markets and correspondingly increase balance-ofpayments credits through the IMF. W hile this general
approach has been widely endorsed, specific proposals
for striking an appropriate balance between private
and official sources of financing have proved difficult
to formulate, especially since there is considerable
disagreem ent over what policy conditions should be
attached to IM F loans.

FR B N Y Q u arterly R e v ie w /W in te r 1979-80

13

Exchange market instability
The coincidence of recurrent exchange market dis­
turbances and rapid Eurom arket growth in the past
decade has prompted a tine of criticism that the Euro­
m arkets serve to amplify, or even generate, foreign
currency crises. Few other aspects of the Euromarket
controversy have been so confusing as the debate on
this point. Often such charges refer to factors that
have little to do with the special characteristics of the
Euromarkets.
The arguments can commonly be broken down into a
number of propositions. First is the claim that the
Euromarkets serve as a source of finance for exchange
m arket speculation or hedging activities. Although this
proposition has frequently been advanced, it is practi­
cally impossible to confirm or deny em pirically. Apart
from that, however, the proposition has no clear policy
im plication unless it is assumed that no other source
can replace the Euromarkets in financing currency
speculation. Yet even a casual analysis of recent eco­
nomic history suggests that there are many ways to
finance speculation and hedging activities, notably
through leads and lags in comm ercial transactions.
Another line of thought starts with the presumption
that recent foreign exchange crises are dominated by
the problems of the dollar. By facilitating the expan­
sion of worldwide dollar liquidity, the Euromarkets
have magnified the exchange rate effects of other
factors tending to weaken the United States currency:
trade problems, increasing dependence on imported
oil, stubborn inflation, the longer term relative eco­
nomic decline of the United States, and official reserve
diversification. This argument, however, comes down
to being just another version of the earlier claim that
Eurodollar banking operations have com plicated the
conduct of United States monetary policy in a way that
promotes excessive credit creation.
A commonly voiced criticism is that Euromarket
operations, by virtue of their technical efficiency, have
increased the international mobility of capital. As a
result, any factor influencing the exchange m arket in
a particular way may induce destabilizing capital flows
and greater swings in rates than would occur without
the Euromarkets.
It is difficult to know what to make of this charge.
It is certainly true that the Euromarkets are highly effi­
cient. That is one reason they have grown so fast in
recent years. It also is true that the Euromarkets have
enhanced international capital mobility, both between
countries and between currencies. However, to speak
of what might have happened in the absence of the
Euromarkets is not helpful. A fter all, the Euromarkets
grew to maturity as a response to the various types of
barriers that w ere put in place in the 1960’s to impede
 Y Q u a rterly R e v ie w /W in te r 1979-80
14 FR B N


international capital movements. Since then, these bar­
riers have been widely relaxed. The conclusion must
be that the Euromarkets are less im portant in facili­
tating capital movements now than they once were.
W hat the critics seem to be saying is that a world
of free capital movements and exchange rate flexi­
bility is inherently difficult to manage, because sudden
shifts in m arket psychology are capable of producing
sharp changes in exchange rates. Sometimes those
changes cum ulate in one direction. However, skeptics
feel there is no evidence that marginal adjustments in
the growth of the Euromarkets would do anything to
m ake the exchange m arkets less volatile. In their view,
justification for Eurom arket regulation must lie else­
where.
Safety of Eurobanking operations
The last broad area of argument about the Euro­
m arkets covers questions regarding the safety of
banking operations. These are questions traditionally
raised by bank supervisors about domestic banking
but extended to the international context. The most
obvious issue is whether banks are adequately assess­
ing the creditworthiness of borrowers to whom they
are making loans. After many years of experience,
both banks and supervisory authorities have found
that the standards of evaluation commonly applied at
home can be usefully applied in international lending
as well. But, in addition, some characteristics of inter­
national banking com plicate prudential oversight. Con­
sequently, several issues are seen to deserve special
attention. These include maturity mismatching and
interest rate risk; “country” or, as it is sometimes
referred to, “transfer” risk; capital adequacy and bank
earnings; foreign exchange risk; interbank or “nam e”
risk; and the question of who fulfills the role of "lender
of last resort” in the Euromarkets.
Maturity mismatching and interest rate risk
Sudden sharp increases in short-term money m arket
rates can result in serious difficulties for banks by
driving up the cost of funds used to back longer term
loans whose rates are locked in at lower levels for a
period of time. Banks are subject to such interest rate
risk from the normal banking operations of borrowing
short and lending long. However, mismatching of ma­
turities on assets and liabilities becomes a serious
problem when some prudent limits are exceeded. The
definition of prudence is likely to change in accord
with a wide variety of factors, including the variability
of m arket rates. Most of the debate in this area reflects
different perceptions of what is prudent banking prac­
tice in the present m arket environment.
The maturity mismatching of Eurobanking operations

is singled out by some observers as an object of con­
cern. The structure of Eurobank liabilities is dominated
by short-dated money. Bank of England data indicate
that about 40 percent of Eurobank liabilities in London
is of one-month maturity or shorter, with half of this at
eight days or less. The weighted average maturity of
total liabilities in London is probably between three
and four months. By comparison, the typical syndi­
cated bank loan in the Euromarkets calls for the
interest rate to be adjusted at six-month intervals.
This fact alone, however, says nothing about the
safety of present balance-sheet structures, which is a
m atter of interpretation. Defenders of present practices
dismiss concerns about maturity structure as exagger­
ated, pointing out that no unambiguous trend toward
greater mismatching can be seen. Others argue that
increased variability of interest rates has compounded
the risk of maintaining current maturity structures and
that present mismatching practices should be curtailed.
It is im portant to note that, although the Euromarket
portion of bank balance sheets shows m aturity mis­
matching, the risk faced by any given bank depends
on the structure of the consolidated balance sheet.
W hile available evidence is inconclusive, the maturity
structure of domestic office assets and liabilities, ap­
propriately adjusted for stable demand deposits, may
tend to reduce any interest rate risks resulting from
Eurocurrency operations.
Country risk
Country risk identifies a set of banking problems deal­
ing with the exposure of Eurobanks to official or pri­
vate borrowers and lenders from countries other than
the banks’ home countries. The general focus of con­
cern is whether banks have made an excessive amount
of loans to countries that are likely to repudiate debt,
to impose controls on outflows of funds, to delay repay­
ments, or to take other actions to jeopardize the capi­
tal value of bank assets or the earnings on loans. The
specific country borrowers that are sources of con­
cern change with economic and political events. In
principle, however, payments difficulties may arise with
any borrower, so that the problem is a general one
and not confined to any group of countries.
An important aspect of the country risk problem is
identifying the appropriate extent of comm ercial bank
involvement in recycling oil funds. This problem can
be distinguished from the one cited earlier concerning
the Euromarket role in delaying international adjust­
ments in payments imbalances. Few would suggest
that oil-im porting countries should take restrictive mea­
sures to elim inate the balance-of-paym ents effects of
oil price increases in the short run. Since such ad­
justments must involve longer term changes in energy



demands and supplies, financing oil deficits in the short
run is appropriate. So debate centers less on w hether
recycling should occur than on whether it should occur
prim arily through the Eurobanking system.
It is commonly accepted that the international bank­
ing system performed very efficiently as an intermedi­
ary of oil funds after the first round of extraordinary
petroleum price hikes. Although debt-servicing prob­
lems did develop in a number of well-known cases,
such as Zaire, Peru, and Turkey, the absence of any
general debt problem is cited as a factor supporting
the role of comm ercial bank recycling. In fact, actual
losses on international lending have been relatively
small.
Com m ercial banks are probably in a better position
to m anage their international exposures that they were
a few years ago. A number of them have taken steps
to upgrade internal information systems and their anal­
yses of econom ic conditions abroad. Information avail­
able to regulatory authorities on the country exposure
of bank loans has also been improved in recent years,
most notably through country exposure lending survey
reports coordinated by the Bank for International Set­
tlements (BIS) that cover banks in major countries.
Hence, monetary authorities are seen as having suffi­
cient information to monitor international lending and
to detect excessive concentrations of lending before
severe problems arise that could threaten the solvency
of an individual comm ercial bank.
Critics of private sector recycling argue that the
very success of the com m ercial banks during the last
round masks the severity of the problem. The general
extent of the debt problem has not been revealed in
widespread debt-servicing problems only because
banks have extended further loans or rescheduled old
ones to maintain servicing flows. Furthermore, the
case of Iran reveals that payments disruptions cannot
be easily anticipated.
In essence, critics of recycling through the Euro­
markets argue that the sheer size of the prospective
problem— estimates of the 1980 OPEC (Organization
of Petroleum Exporting Countries) surplus run as high
as $80 billion-$100 billion— and the fundamental un­
certainty regarding political elements of country risk
combine to put the international banking system in
an increasingly precarious position. Based on this, they
recommend that controls on the Euromarkets to limit
the involvement of the banking sector in the recycling
process should be combined with expanded official
methods of interm ediating the flow of oil funds and
with incentives to promote direct lending by OPEC
countries themselves. To advocates of this approach,
the answer to the problem of country risk exposures
in the future lies in spreading the risks across a greater

FR B N Y Q u arterly R e v ie w /W in te r 1979-80

15

number of institutions and toward the official sector.
The deposit rather than the loan side of bank bal­
ance sheets may also raise what amounts to a country
risk problem. Recycling of oil funds has resulted in a
heavy concentration of bank deposits in the hands of
official institutions of OPEC countries. The chief risk in
this situation is that one or more oil exporters may for
political reasons withdraw their funds from some in­
dividual bank or from the banking system of some
nation. A popular m isconception views such a with­
drawal as analogous to a run on a bank by depositors,
having all the deflationary effects associated with
hoarding. This view, which becam e prominent again
during the threat of Iranian withdrawal of funds from
United States banks, is misleading and exaggerates
the costs of deposit transfer. The withdrawn funds are
not hoarded but are redeposited in other Euromarket
banks that are then in a position to supply funds to
the institutions suffering the original withdrawals.
As a result, the original banks exchange direct de­
posits for interbank borrowings. This, however, is not
without costs; the original institutions may have to pay
a premium to raise an extraordinary amount of funds
in the interbank m arket and their profits may fall as
a result. So some risk attaches to concentrated de­
posit holdings by country as well as to concentrated
claims positions.
Adequacy of bank earnings and capital
Another prudential concern is the adequacy of re­
turns to banks on international lending and the associ­
ated implications for bank capital. This m atter has
come to the forefront with the easing of terms on
syndicated Eurocredits. In the past few years the
average maturity of Euroloans has increased and the
average spread over LIBOR2 for loan rates has fallen
steadily to levels near the historic lows of late 1973
and early 1974. Furthermore, the markets have been
characterized by a narrower range of loan spreads
across different borrowers than prevailed in that ear­
lier period of easy terms. This relaxation of lending
terms has occurred in step with a strong expansion of
Eurocredit volume.
M arket observers differ on the reason for the em er­
gence of a borrowers’ market. One view sees the
spread as a price that balances the supply of and
demand for loanable funds in the Euromarkets. It puts
the responsibility for lower spreads on the increased

2 LIB O R is the w idely used acronym for the London interbank offer
rate, the rate at w hich banks operating in the Eurom arkets lend funds
to each other. In Eurobanking practice, loans to nonbanks are
priced as a m arkup or “ s p re a d ” over LIB O R .

Digitized 16 FRASERY Q u a rte rly R e v ie w /W in te r 1979-80
for FR B N


supply of loanable funds in Euromarkets created by
deficits in the overall United States balance of pay­
ments. As a corollary, the correction for narrowness in
spreads lies chiefly in policy measures to reduce the
United States deficit rather than in imposition of any
controls on Eurom arket operations. However, there
are serious problems with this view. It is questionable
why an increase in the amount of funds supplied to
the Euromarkets should affect spreads on loan opera­
tions rather than rate levels. In any case, this theory
cannot account for the continued erosion of spreads
in the first half of 1979 when the United States re­
corded a sizable surplus on combined current and
private capital accounts.
Another view looks to greatly increased competition
among lending institutions for international business
as the cause of narrower spreads. New entry and
aggressive pricing to expand m arket share by Japa­
nese and European banks are frequently cited as the
factors behind easier terms.
Still others maintain that the reduced spreads are an
appropriate reflection of lower risk resulting from the
generally good repayment record on international loans
and therefore pose no problem. This view is strongly
disputed, however, by those who are concerned by
the easing of credit conditions in the Euromarkets.
They feel that it impairs bank earnings, thereby re­
ducing the banks’ ability to maintain adequate capi­
talization ratios. Some m arket participants have also
stressed the need for caution. A number of prominent
United States banks announced their reluctance to
lend at narrower margins in 1978, and the volume of
international credits extended by United States char­
tered banks and their overseas branches expanded at
a much slower rate in 1979 than in earlier years.
These steps are cited by some as indications of
market limitations to the erosion of lending terms that
make unnecessary formal Eurom arket controls. It is
also suggested that decreasing spreads exaggerate the
change in total costs to borrowers by neglecting the
behavior of fees and other charges that may have
increased to offset the fall in spreads. Moreover, some
expect spreads to widen in response to the m arket
pressure of increased demand stemming from the
latest round of oil price hikes.
Critics of present Euromarket pricing practices find
little reassurance from these arguments. They point
out that spreads remain narrow despite strong demand
for credit, and they question w hether bank earnings
are adequate compensation for whatever increases in
risk may be associated with a period of greatly en­
larged deficits over the next couple of years. In short,
there is virtually no consensus on this issue at the
moment.

Foreign exchange risk
Banks assume foreign exchange risk in their opera­
tions when the currency composition of their assets
does not match that of their liabilities, thereby leaving
them vulnerable to losses from unanticipated changes
in exchange rates. W hile this area has remained a
background concern in the recent Euromarket debate,
it does not claim the prom inence as an issue that it
had earlier. Monetary authorities have already taken a
wide range of measures to address concerns about
bank foreign currency exposures. These actions
stemmed in large part from the collapse of Germ any’s
Herstatt Bank in 1974, which had a deep effect on offi­
cial and market attitudes toward Eurobanking opera­
tions generally and foreign exchange operations in
particular. In the wake of that bank failure, authorities
in many countries imposed quantitative restrictions on
open currency positions of their commercial banks or
required considerably expanded reporting of such
open positions. These steps, together with heightened
caution on the part of many banks, have muted foreign
currency exposure as a major issue.
Interbank positions
Interbank depositing is a prominent feature of the
Euromarkets. Using the difference between gross and
net measures of the markets according to BIS defini­
tions, about half of gross Euromarket liabilities is ac­
counted for by interbank positions. Despite its size, the
interbank market is only infrequently an object of dis­
cussion in the Euromarket debate.
In part, this is undoubtedly because interbank posi­
tions are neglected as a m atter of course in discus­
sions dealing with the inflationary consequences of
Euromarket expansion. Most analyses treat interbank
Eurodeposits in the same way as interbank domestic
deposits, which leads to their exclusion from any
“ Euro” monetary aggregate. Only a few unconventional
critics would treat interbank deposits as ordinary
nonbank deposits and argue that their growth leads to
growth of spending on goods and services. A second
factor dampening concern about interbank positions is
a general characterization of them as highly liquid and
easily reversible balance-sheet items that arise out of
the natural arbitrage operations of an efficient market.
Nevertheless, this extensive network of interbank po­
sitions does translate the risks faced by any one bank
on its operations into risks faced by all other banks.
That this kind of risk— name risk, for short— is a real
matter of concern was also demonstrated by the Her­
statt failure, which tem porarily resulted in a com pli­
cated tiering in the structure of interbank rates on
the basis of the perceived quality of bank names.
However, questions remain about whether the



amount of interbank business has become excessive
in recent years. Some would say that the stability over
tim e in the ratio of gross to net measures of the
Euromarkets argues that interbank positioning is not
aggravating risks in Eurobanking. Others would reply
that this stability in the aggregate measures is reassur­
ing only if the structure of interbank positions has not
changed in a marked way— that is, only if banks with
risky features on the rest of their balance sheet are
not becoming relatively more active borrowers of funds
in the interbank market.
Even under detailed supervision and reporting re­
quirements it is difficult for monetary authorities to as­
sess the structure of name risk on a timely basis. At the
very least, it calls for continuing, frequent international
consultation among bank supervisors, a process that
has gone forward under the auspices of the BIS.
Lender of last resort provisions
One of the traditional responsibilities of any central
bank is to act as lender of last resort— to supply funds
to a solvent bank or to the banking system generally
in an emergency that threatens a sharp contraction of
liquidity. This role normally has been framed with re­
spect to comm ercial banks in the domestic banking
system. But the em ergence of the extraterritorial Euro­
market created ambiguities about which central bank
would be responsible for providing lender-of-last-resort
support for overseas operations.
No final resolution of those ambiguities has yet been
reached, and it is doubtful that central bankers will
ever codify their respective roles or lay down con­
ditions for lender-of-last-resort assistance. It is im­
portant that techniques of assistance be free to evolve
as institutional arrangem ents and forms of financial
activity in Euromarkets change. Moreover, it could be
counterproductive to specify what banking behavior
would or would not qualify a bank for emer­
gency assistance.
Important steps have nonetheless been taken to
elim inate needless ambiguities and anxieties about
central bank preparedness should liquidity problems
threaten. Central bankers from m ajor industrial coun­
tries, who meet regularly at the BIS, have examined
the issues involved and concluded that “means are
available for that purpose [i.e., providing temporary
liquidity] and will be used if and when necessary” .
In addition, major central banks have recognized the
status of foreign branches as integral parts of banks:
for example, the Federal Reserve has declared its
readiness to extend to a solvent parent appropriately
secured funds when tem porary liquidity is needed to
relieve strains encountered in foreign as well as do­
mestic markets. Furthermore, central bankers and

FR B N Y Q u arterly R e v ie w /W in te r 1979-80

17

other regulators have developed a cooperative fram e­
work within which they share views about their pru­
dential and lender-of-last-resort responsibilities.
Although ambiguities do remain, a common under­
standing of the problem is emerging from the delibera­
tions of responsible authorities. It emphasizes the
mutual interests of all central banks, which extend
beyond national borders.
Positions and policies
Eurobanking operations are not governed by any sys­
tem atic regulations achieved through international
agreement. This does not mean, however, that they
are completely free from regulations. National authori­
ties have occasionally put in place rules or have
reached gentlem en’s agreements with private market
participants that have affected the operations of Euro­
banks. By and large, however, such steps have been
taken with only national policy considerations in mind
and little regard has been given to fashioning rules in
a wider international context.
A prerequisite to an international agreem ent on
regulatory action is the achievement of a consensus
on the overall role of the Euromarkets. But the variety
and technical complexity of the issues in the Euro­
market debate make it difficult to move from individual
arguments on specific issues to a broader synthesis—
what might be called a “ position” toward the markets
in general. Indeed, a number of thoughtful analysts
have admitted (with some candor) to having views on
one or more of the issues but having no overall posi­
tion. However, in the interest of summarizing where
the debate now stands, it might be useful to define
a few stylized positions that do not necessarily repre­
sent anyone’s expressed position but do give the
flavor of the range of judgments. The list is by no
means exhaustive and certainly does not presume to
anticipate new ideas that might emerge.
The juggernaut view
At one extrem e is the judgment that the Euromarkets
are fundamentally out of control, generating excessive
credit creation globally and fostering overly compe­
titive lending practices that pose a threat to the sta­
bility of the international monetary system. Out of this
view come recommendations for internationally coor­
dinated policies to limit directly the growth of Euro­
market operations and to impose restraints on the
structure of Eurobank balance sheets as well as the
types of loans that can be made.
The hybrid banking system view
In this judgment, the essential problem is that the Euro­
markets frustrate the intention of monetary authorities
 Y Q u arterly R e v ie w /W in te r 1979-80
18 F R B N


who recognize the growing internationalization of bank­
ing markets but want to preserve distinct elements of
their domestic banking systems. In one sense, this
intention represents a clear, but less than w hole­
hearted, break from the official consensus of the 1960’s,
when separation of a “dom estic” banking m arket from
an “ international” banking market was an explicit pol­
icy goal. The hybrid system arose as capital controls
programs of the 1960’s w ere dismantled while most
national regulations on domestic operations were kept
in place. The Euromarkets remained, by and large,
free from those domestic regulations. That freedom
created incentives to shift banking operations from
domestic markets to the Euromarkets. With monetary
policies placing greater emphasis on aggregates man­
agement, these shifts in banking operations cam e to
be seen as a growing problem for monetary control.
To those subscribing to this position, the contradic­
tions created by such a hybrid banking system could
be remedied in three ways. Regulations could be im­
posed on the Euromarkets to make them more like
domestic banking markets. Or, regulations could be
elim inated on domestic banking markets to make them
more like Euromarkets. Or, both Euromarkets and
domestic banking markets could be changed in a
variety of ways to assure a convergence of practice
and incentives. In any case, the markets would tend
to become unified and could then be treated as such
from the point of view of monetary policy. The choice
of approach would depend on what is feasible and
what is compatible with national laws and customs on
bank regulation.
The “ take it to the Cooke Committee” view
This position sees the Euromarkets as basically w ellfunctioning markets without need for systematic regu­
lation. The extraterritorial nature of the markets,
however, demands an organized fram ework for ongoing
close cooperation among the interested national mone­
tary authorities to coordinate supervisory practices
and share information. The Comm ittee on Banking
Regulations and Supervisory Practices (the “Cooke
Com m ittee”, named after its present chairman, a Bank
of England official), set up under the auspices of the
BIS, is seen as providing a sufficient degree of official
involvement. Proponents of this view would support
improved reporting requirements and would try to
strengthen supervisory practices as warranted to deal
with prudential concerns.
The status quo view
Finally, at the other extrem e is the position that the
Euromarkets have demonstrated not only their efficient
functioning as financial markets but also their indis­

pensability as a mechanism for dealing with the prob­
lems of recycling surpluses and financing international
trade and economic development. In this view, there
are no equally suitable alternatives for achieving these
ends. Any attempts to tamper with the Euromarkets
would run the risk of seriously upsetting the recycling
mechanism or even driving much of the business now
conducted through the international banking system
into nonbank channels that are less regulated and
not systematically monitored. According to this judg­
ment, it has not been proved that the Euromarkets
pose problems of monetary control but, if further evi­
dence pointed to such problems, they could be ade­
quately handled by traditional monetary policy.

Conclusion
Obviously, this characterization of the range of posi­
tions is a strong abstraction. It does not capture all
possible positions nor does it serve as the only pos­
sible characterization. But it does give a flavor of the
range of views that underlie the discussion about
what steps, if any, should be taken to control the Euro­
markets.
One lesson comes through clearly from the Euromar­
ket debate up to this point: there is little chance that
progress can be made in designing specific regulatory
measures until there is agreement among the princi­
pals involved about the ultimate objectives of Euro­
market regulation. So far, that has proved elusive.

Edward J. Frydl

Principal Features of the Euromarkets
T h e E u r o c u r r e n c y m a r k e ts a r e a g lo b a l n e tw o r k of
b a n k s , b a n k b r a n c h e s , a n d o th e r b a n k a ffilia te s th a t
m a k e lo a n s a n d a c c e p t d e p o s its in c u r r e n c ie s o th e r
th a n th a t o f th e c o u n tr y in w h ic h th e b u s in e s s is
b o o k e d . E u r o m a r k e t tr a n s a c tio n s a re g e n e r a lly fo r la rg e
a m o u n ts , a n d v ir tu a lly no r e ta il b a n k in g is d o n e . T h e
m a r k e ts o v e r la p in la rg e p a r t, b u t a re n o t s y n o n y m o u s ,
w ith in te r n a tio n a l b a n k in g m a r k e ts . F o r e x a m p le , a
s te rlin g lo a n m a d e b y a b a n k in L o n d o n to a firm o u t­
s id e th e U n ite d K in g d o m is c le a r ly an in te r n a tio n a l
b a n k in g tr a n s a c tio n b u t n o t a E u r o m a r k e t tr a n s a c tio n .
A d o lla r lo a n m a d e by th e s a m e b a n k to a n o th e r B ritis h
r e s id e n t is a E u r o m a r k e t tr a n s a c tio n b u t n o t s tr ic tly
s p e a k in g an in te r n a tio n a l b a n k in g tr a n s a c tio n .

S ize
E s tim a te s o f th e s iz e o f th e E u r o c u r r e n c y m a r k e ts v a ry
s o m e w h a t d e p e n d in g on w h ic h b a n k c la im s o r lia b ili­
tie s a r e c o u n te d a n d on w h ic h c o u n tr ie s a re c o v e r e d .
A c o m m o n d e fin itio n c o n s is ts o f to ta l fo r e ig n c u r r e n c y
lia b ilitie s , in c lu d in g th o s e to d o m e s tic re s id e n ts , r e ­
p o r te d b y b a n k s in E u ro p e , C a n a d a , a n d J a p a n p lu s th e
e x te r n a l lia b ilitie s r e p o r te d b y b r a n c h e s o f U n ite d S ta te s
b a n k s in s e le c t e d o ffs h o re fin a n c ia l c e n te r s , p r in c ip a lly
th e B a h a m a s a n d C a y m a n Is la n d s . O n th is m e a s u re ,
g ro s s E u r o c u r r e n c y lia b ilitie s (in c lu s iv e o f in te r b a n k d e ­
p o s its ) to t a le d a b o u t $ 9 0 0 b illio n in m id -1 9 7 9 , b a s e d on
d a ta c o lle c te d b y th e B a n k fo r In te r n a tio n a l S e ttle m e n ts




( B IS ). N e t o f in te r b a n k d e p o s its a m o n g r e p o rtin g b a n k s ,
th e E u r o c u r r e n c y m a r k e ts to t a le d s o m e $ 4 5 0 b illio n .
H o w e v e r , e v e n th is n e t s iz e e s tim a te in c lu d e s s u b s ta n ­
tia l a m o u n ts o f lia b ilitie s to b a n k s , p r im a r ily to th o s e
o u ts id e th e B IS re p o rtin g a r e a . T h u s , E u r o c u r r e n c y lia ­
b ilitie s to n o n b a n k s w e r e le s s th a n $ 2 0 0 b illio n a s o f
m id -1 9 7 9 .

G ro w th
T h e E u r o m a r k e ts g r e w r a p id ly d u rin g th e 1 9 7 0 's . A ll th e
m e a s u re s o f E u r o m a r k e t s iz e in c r e a s e d a t a n n u a l ra te s
a b o v e 2 5 p e r c e n t. B y c o m p a r is o n , a b r o a d m e a s u re o f
th e U n ite d S ta te s m o n e y s u p p ly th a t in c lu d e s la rg e
n e g o tia b le c e r t if ic a t e s o f d e p o s it (C D s ) a n d tim e d e p o s its
g r e w a t a n a n n u a l r a te o f a b o u t 1 0 p e r c e n t b e tw e e n
1 9 7 0 a n d m id -1 9 7 9 , a s d id a b r o a d m e a s u r e o f th e
G e r m a n m o n e y s u p p ly .

C u rre n c y c o m p o s itio n
B y fa r th e la r g e s t E u r o c u r r e n c y m a r k e t is in U n ite d
S ta te s d o lla r s , a c c o u n tin g fo r n e a r ly 7 5 p e r c e n t o f a ll
E u r o c u r r e n c y d e p o s its . T h e E u r o - G e r m a n m a r k m a r k e t,
a c c o u n tin g fo r a b o u t 1 2 p e r c e n t o f th e to ta l, is th e n e x t
la rg e s t. T h e E u r o -S w is s fr a n c m a r k e t a c c o u n ts fo r
s o m e w h a t le s s th a n 5 p e r c e n t, a n d o th e r m a jo r c u r r e n ­
c ie s r e p r e s e n t e v e n s m a lle r s h a re s . R e c e n tly , h o w e v e r ,
a E u r o - J a p a n e s e y e n m a r k e t h a s b e g u n to g r o w r a p id ly ,
fo llo w in g r e la x a tio n o f c e r ta in o ffic ia l r e s tric tio n s on
th e in te r n a tio n a l u s e o f th a t c u r r e n c y .

FR B N Y Q uarterly R e v ie w /W in te r 1979-80

19

L o c a tio n

N a tu re o f d e p o s ito rs

L o n d o n is th e c e n te r o f E u r o m a r k e t a c tiv ity , a c c o u n tin g
fo r m o r e th a n o n e th ir d o f E u r o c u r r e n c y b u s in e s s . L o n ­
d o n w a s a n a tu r a l fo c a l p o in t fo r th e d e v e lo p m e n t o f
E u r o m a r k e ts , r e fle c tin g th e c o m b in a tio n o f r e la tiv e fr e e ­
d o m fro m r e g u la tio n o v e r fo r e ig n b a n k in g o p e r a tio n s ,
a fa v o r a b le g e o g r a p h ic lo c a tio n , a n d th e c o n s id e r a b le
fin a n c ia l e x p e r t is e in th e L o n d o n b a n k in g c o m m u n ity .
In r e c e n t y e a rs , th e o ffs h o re E u r o d o lla r m a r k e t, c e n ­
te r e d in N a s s a u , h a s b e c o m e a m a jo r riv a l to L o n d o n
fo r d o lla r b u s in e s s b e c a u s e o f o p e r a tin g a d v a n ta g e s
(e .g ., th e s a m e tim e z o n e a s N e w Y o r k ) a n d r e la tiv e ly
fa v o r a b le ta x fe a tu r e s . T h e o ffs h o re E u r o d o lla r m a r k e t
is d o m in a te d b y U n ite d S ta te s m o n e y c e n te r b a n k s ,
w h o in fa c t c o n d u c t th e ir b u s in e s s o u t o f th e ir h e a d ­
q u a r te r s in N e w Y o r k , C h ic a g o , o r C a lifo r n ia a n d
s im p ly b o o k lo a n s a n d d e p o s its to th e ir C a r ib b e a n
b r a n c h e s — w h ic h a re c o m m o n ly s h e ll b r a n c h e s r a th e r
th a n o r d in a r y fu ll-s e r v ic e o n e s .
T h e m a jo r c e n te r o f th e E u r o -G e r m a n m a r k m a r k e t
is L u x e m b o u r g , w h ic h s ta n d s in r e la tio n to G e r m a n y
m u c h a s th e C a r ib b e a n m a r k e t d o e s to th e U n ite d
S ta te s . G e r m a n y its e lf h o s ts v e ry little E u r o m a r k e t a c ­
tiv ity b e c a u s e o f lo c a l r e s e r v e r e q u ir e m e n ts a n d o th e r
r e g u la tio n s th a t d is c o u r a g e E u ro c u r r e n c y b u s in e s s .
O t h e r E u r o m a r k e t c e n te r s in c lu d e P a r is , A m s te r d a m ,
a n d Z u r ic h in E u r o p e , S in g a p o r e a n d H o n g K o n g in
th e F a r E a s t, B a h r a in in th e M id d le E a s t, a n d P a n a m a
in L a tin A m e r ic a .

O il-e x p o r tin g c o u n tr ie s , n o t s u r p ris in g ly , h a v e b e c o m e
a p r in c ip a l s o u r c e o f fu n d s to th e E u r o m a r k e ts , b u t th e
in d u s tr ia l c o u n tr ie s a s a g r o u p a r e s till th e m a jo r
s o u r c e o f fu n d s . M o s t o f th e s e d e p o s its flo w th r o u g h
th e in te r b a n k n e tw o r k , b u t d ir e c t d e p o s its b y n o n b a n k s
a c c o u n t fo r p e r h a p s 2 0 p e r c e n t o f g r o s s E u r o m a r k e t
lia b ilitie s . T h e d e v e lo p in g n a tio n s a s a g r o u p a r e a ls o
a n im p o r ta n t s o u r c e (a s w e ll a s u s e r) o f fu n d s . T h is
r e fle c ts to a g r e a t e x te n t th e d e p o s itin g o f p a r t o f th e ir
o ffic ia l r e s e r v e s in E u r o b a n k s . T h e c e n tr a l b a n k s o f
s o m e in d u s tr ia l c o u n tr ie s a ls o p la c e p a r t o f th e ir fo r ­
e ig n c u r r e n c y r e s e r v e s in th e E u r o m a r k e ts , a lth o u g h
b y a g r e e m e n t m a n y d o n o t.

N a tu re o f b o rro w e rs
P u b lic b o r r o w e r s — g o v e r n m e n ts , c e n tr a l b a n k s , n a tio n ­
a liz e d o r p u b lic -s e c to r c o r p o r a tio n s a n d fin a n c ia l in ­
s titu tio n s — p r e d o m in a te . T h e y h a v e a c c o u n te d fo r a b o u t
8 0 p e r c e n t o f a ll b o r r o w in g s th r o u g h s y n d ic a te d b a n k
c r e d it s in r e c e n t y e a rs .
W h ile b o r r o w e r s fr o m d e v e lo p e d c o u n tr ie s s till a c ­
c o u n t fo r th e b u lk o f o u ts ta n d in g E u ro b a n k c r e d its , th e
p a tte r n o f n e w b o r r o w in g h a s c h a n g e d n o tic e a b ly in
r e c e n t y e a rs . In 1 9 7 9 , in d u s tr ia l c o u n tr y b o r r o w e r s a c ­
c o u n te d fo r a b o u t o n e th ir d o f n e w E u r o c u r r e n c y
c r e d its , c o m p a r e d w ith 7 0 p e r c e n t in 1 9 7 4 . O v e r th e
s a m e p e r io d , th e s h a r e s o f c re d its g o in g to n o n o il d e ­
v e lo p in g c o u n tr ie s a n d to c o m m u n is t b o r r o w e r s b o th
d o u b le d — to 4 0 p e r c e n t a n d 1 0 p e r c e n t, r e s p e c tiv e ly .
O P E C m e m b e r s (O r g a n iz a tio n o f P e tro le u m E x p o rtin g
C o u n tr ie s ), w h ic h a c c o u n te d fo r le s s th a n 5 p e r c e n t o f
E u r o c r e d its in 1 9 7 4 , to o k m o r e th a n 1 5 p e r c e n t o f to ta l
b o r r o w in g s in 1 9 7 9 .

N Y Q u arterly R e v ie w /W in te r 1979-80
20 FR B


N a tu re o f E u ro b a n k as s e ts
S h o r t-te r m fin a n c in g is c o m m o n ly e x te n d e d b y E u r o ­
b a n k s th r o u g h lin e s o f c r e d it . M e d iu m -te r m lo a n s , m o s t
c o m m o n ly o f th r e e to fiv e y e a r s ’ m a tu r ity , a r e u s u a lly
e x te n d e d o n a r e v o lv in g c r e d it b a s is , a n d c r e d it s a r e
“ r o lle d o v e r ” e v e ry th r e e o r s ix m o n th s . In a d d itio n ,
la r g e lo a n s a r e e x te n d e d th r o u g h w h a t a r e c a lle d s y n ­
d ic a te d c r e d its . T h e s e s y n d ic a te s in v o lv e th e p a r t ic ip a ­
tio n o f m a n y b a n k s fr o m d iffe r e n t c o u n tr ie s . L o a n s a r e
fo r fix e d m a tu r itie s (u s u a lly th r e e to s e v e n y e a r s , b u t
o c c a s io n a lly a s lo n g a s te n y e a rs o r s o ), b u t in te r e s t
r a te s a r e re v is e d e v e r y s ix m o n th s in lin e w ith c h a n g e s
in m a r k e t c o n d itio n s . S o m e lo a n a g r e e m e n t s h a v e a
m u ltic u r r e n c y o p tio n th a t a llo w s th e b o r r o w e r s to d r a w
fu n d s in a n u m b e r o f d iffe r e n t c u r r e n c ie s .
In te r e s t r a te s a r e e x p r e s s e d a s a m a r k u p , o r s p r e a d ,
o v e r L IB O R , th e L o n d o n in te r b a n k o ffe r r a te . It is th e
ra te a t w h ic h E u r o b a n k s le n d fu n d s to o n e a n o th e r .
S p r e a d s v a ry a c c o r d in g to b a n k a s s e s s m e n ts o f th e
c r e d it w o r th in e s s o f th e b o r r o w e r . O n s y n d ic a te d lo a n s ,
b o r r o w e r s a ls o p a y a d d itio n a l fe e s , s u c h a s a fr o n t-e n d
m a n a g e m e n t fe e to th e b a n k s p u ttin g t o g e t h e r th e
s y n d ic a te o r a c o m m itm e n t fe e oh a n y u n d r a w n p o r tio n
o f a lo a n .

N a tu re o f d e p o s its
E u r o m a r k e t lia b ilitie s r a n g e fr o m o v e rn ig h t a n d c a ll
d e p o s its a t th e s h o r t e n d o f th e m a tu r ity s tr u c tu r e to
tim e d e p o s its o f fiv e y e a r s o r o c c a s io n a lly lo n g e r . T h e
b u lk o f d e p o s its is r e la tiv e ly s h o r t d a te d . A b o u t o n e
th ir d o f d e p o s its to n o n b a n k s h a v e m a tu r itie s o f e ig h t
d a y s o r le s s a n d n e a r ly 9 0 p e r c e n t h a v e m a tu r itie s o f le s s
th a n s ix m o n th s . In a d d itio n , E u ro b a n k s in L o n d o n
h a v e is s u e d s o m e $ 4 0 b illio n o f n e g o tia b le C D s th a t
c a n b e tr a d e d o n a s e c o n d a r y m a r k e t.

National Policies toward
Foreign Direct Investment
Throughout the 1970’s the United States attracted a
growing inflow of foreign direct investment as ex­
change rate changes and other developments spurred
foreign companies to establish facilities here. For in­
stance, between 1973 and the third quarter of 1979,
direct investment inflows totaled $29.5 billion, or over
three and one-half times the amount that flowed in dur­
ing the preceding thirteen years. Moreover, the degree
of foreign participation in the United States economy is
larger than these statistics might suggest since foreign
companies finance much of their activities locally
rather than with funds brought in from abroad.
The rising foreign direct investment inflows to this
country, long accustomed to being the w orld’s largest
source of international direct investment outflows, has
generally been welcom ed, especially in the states and
cities where they have been concentrated. Employ­
ment opportunities have been increased, both directly
and indirectly. Often new technology has been brought
in. State and local tax bases have been expanded. At
the same time, however, questions have been raised
about the appropriate role of public policy in influ­
encing foreign direct investment. The central issue is
whether foreigners’ direct investment should be sub­
sidized, as it is in some states through tax and other
incentives, restricted under some circumstances, or
left free to respond to market forces.
In other industrial countries, policies and attitudes
toward inward direct investment have been debated
throughout the postwar period. The degree of encour­
agem ent or discouragem ent to foreign direct invest­
ment has varied considerably both across countries
and over time.
This article reviews the evolution of national policies
toward inward foreign direct investment. It examines




how the larger industrial countries differ in their
approaches and how United States policies compare
with them. That review is prefaced by a description of
recent trends in foreign direct investment and the
shortcomings in the data that hinder full analysis of
the presence of foreign companies in an economy.
The main conclusion is that, among m ajor industrial
countries, national policies toward foreign direct in­
vestment appear to be converging although differences
in attitudes and approaches have by no means disap­
peared. All countries restrict foreign direct investment
to some extent. Most of them seem to follow the
sometimes conflicting principles of encouraging invest­
ment in weak sectors of the economy or in industries
where domestic investment is inadequate, while re­
sisting increased foreign dominance of any important
industry. The growing similarity of policies does not
mean, however, that the potential for friction has been
eliminated. Difficult questions remain— for example,
harmonization of industrial subsidy programs as well
as the regulatory treatm ent of multinational corpora­
tions. Their resolution will require a sustained coopera­
tive effort by governments and international agencies.
Recent trends in international direct investment
Direct investment flows
International direct investment has been defined as
‘‘investment that is made to acquire a lasting interest
in an enterprise operating in an economy other than
that of the investor, the investor’s purpose being to
have an effective voice in the management of the en­
terprise” .1 That contrasts with what are called portfolio
1 International M onetary Fund, B a la n c e o f P aym e n ts M a n u a l (fourth
edition. 1 9 7 7 ).

FR B N Y Q u arterly R e v ie w /W in te r 1979-80

21

investments, where investors buy stocks or bonds of a
company in order to diversify their assets rather than
to exercise control.
Direct investment may take a number of forms. One
is the creation of a new wholly owned business enter­
prise, accom panied by investment in plant and equip­
ment. W ell-known examples are Volkswagen’s recent
establishment of an auto assembly plant in the United
States or United States auto m anufacturers’ establish­
ment of factories in Canada in the 1960’s. A sec­
ond common form is the takeover of an existing
domestic company, such as the purchase of control­
ling interest in Gimbels and Saks Fifth Avenue by the
British firm, British-American Tobacco. A third form is
the acquisition of a substantial minority interest in a
company. The French government-owned firm, Renault,
has recently initiated such an investment, leading to an
eventual 22.5 percent interest in Am erican Motors. And,
finally, there is the joint venture whereby two or more
independent investors of differing nationalities collabo­
rate in a specific enterprise. A very recent exam ple is
the creation of Sony-Prudential Life Insurance Com­
pany to underwrite life insurance in Japan.
There has long been an active interchange of direct
investment among the major industrial countries, as
well as between those countries and the rest of the
world. Chart 1 presents the statistics on international
direct investment as reported by the large industrial
countries. The data are not strictly comparable since
the United Kingdom, Germany, France, Canada, and
Italy report as direct investment a varying but narrower
range of capital flows than do the United States and
Japan.2 But the broad trends are clear from the figures.
Foreign direct investment flows into the United
States have risen much more rapidly in recent years
than similar flows into other industrial countries.
Meanwhile, outward direct investment of the other six
industrial countries has risen much more rapidly than
outward investments from the United States. Allowing
for their narrower definitions, it is likely that combined
outward investment from the other six exceeded the
$16.7 billion reached by the United States in 1978. At
the same time, foreign investment flows into the
2 The International M onetary Fund (IM F ), w hich collects and
publishes balan ce-o f-p aym en ts statistics com piled by m em ber
countries, has proposed a standard definition. This includes: equity
investm ent, reinvestm ent of retained earnings, long-term loans, and
(except for banks) short-term loan transactions betw een the affiliate
and the foreign parent and other related foreign com panies. The
U nited States and Japan have accep ted this definition. The United
K ingdom has also a ccep ted it but in so doing has found it im possible
to provide any statistics at all on direct investm ent in three
e spe c ia lly im portant industries: oil, banks, and insurance com panies.
C anada, Germ any, France, and Italy report a narrow er range of
transactions. They om it som e or all loans and, in the case of C anada
and Italy, retained earnings as well.

Digitized 22 FRASER Y Q u arterly R e v ie w /W in te r 1979-80
for FR B N


United States, at over $6 billion, w ere rapidly ap­
proaching the magnitude of foreign investment flows
into the other major industrial countries combined.
These developments have produced important
changes in patterns of international net direct invest­
ment flows, the difference between outward and inward
flows. In the ten years ended in 1967, the United States
was the preponderant net investor, investing abroad
about ten times as much as foreigners invested here.
The only other consistent net investors w ere the
United Kingdom, which made a modest contribution,
and Japan, whose contribution was insignificant. The
other industrial countries were net recipients of direct
investment, receiving nearly three times as much inward
investment as they invested abroad. Since that tim e the
investor status of the United States and the other six
has been converging gradually. All but France and
Italy now report net outward investment. In 1978, the
ratio of outflows to inflows for the six as a group was
2.1, only m oderately lower than the 2.6 ratio for the
United States.
Outstanding foreign direct investments
Because this convergence of direct investment experi­
ence is fairly recent, the book value of outstanding
investments by foreigners in the United States is still
substantially less than in the other six countries. The
latest information available (Chart 2) records foreign
investments in the United States at $41 billion as com­
pared with over $100 billion recorded as outstanding in
the five other large industrial countries for which in­
formation is available. Again, the data are not strictly
comparable from country to country, so the figures
should be viewed as illustrative rather than as precise
measurements.
The importance of two-way direct investment among
the major industrial countries is also apparent. In the
five countries for which full country source informa­
tion is available, the proportion of total foreign invest­
ment coming from other large industrial countries
ranges from 53 percent to 94 percent. Adding invest­
ments from four smaller industrial countries— the
Netherlands, Belgium-Luxembourg, Switzerland, and
Sweden— pushes the percentage close to 90 percent
or more in all cases. Thus the main source of foreign
direct investment in all industrial countries remains
other industrial countries. Developing nations, includ­
ing OPEC (Organization of Petroleum Exporting Coun­
tries) members, account for only a minor share.
Foreign-controlled firms in national economies
The importance of foreign-controlled firms in the major
industrial countries is even greater than the book
value of foreign investment outstanding might sug­

C h a rt 1

In te rn atio n a l D ire c t In vestm en t Flows from and to M ajor In dustrial C o u n tries
A v e ra g e annual rates
Billions of dollars

1 9 5 8 -6 2 *

1 9 6 3 -6 7

1 9 6 8 -7 2

1 973-77

1978

* 1 9 6 0 -6 2 only fo r th e U n ite d S ta te s and France.
S o u rc e s :

Inte rn a tio n a l M o n e ta ry Fund, B a lan ce of P aym ents Y ea rb o o k through 1977; co u n try s o u rc es for 1978.

gest. The reason is that such firms obtain a major
portion of their financing from sources other than the
foreign parent. These sources include:
• Borrowing from banks in the host country, in
Eurocurrency markets, or at times even from
the host government,
• Securities issued in the host country or else­
where,
• Trade credits from unaffiliated suppliers, and
• Equity positions of host country residents.
In Germany, for example, a recent survey indicates
that in 1976 foreign equity and loans from parent
companies accounted for only 27 percent of foreignaffiliated firms’ total balance-sheet liabilities.3 And in
the United States, the 1974 Benchmark Survey of
foreign-affiliated firms showed the direct investment
* "T he Level of D irect Investm ent at the End of 1 976” , M o n th ly
R e p o rt o f th e D e u ts c h e B u n d e s b a n k (April 1 9 7 8 ).




position of foreigners to be only 15 percent of those
firms’ assets.4
The most recent information on the importance of
foreign-controlled firms in the major industrial coun­
tries is assembled in the table on page 26. In the indus­
trial sector, where this influence is generally strongest,
foreign-controlled firms accounted for close to 20
percent of total sales or output in Germany, France,
and the United Kingdom. The percentage was much
higher, nearly 60 percent, in Canada, but only 5 percent
in Japan. In the United States, the percentage was
also only 5 percent in 1974 but, given the rise in
foreign investment since then, is almost certainly
higher now.5
4 Report of the Secretary of C om m erce, B e n c h m a rk S urvey, 1974,
F o re ig n D ire c t In v e s tm e n t in th e U n ite d S tates, Vol. 2 (U nited States
D epartm ent of C om m erce, April 1 9 7 6 ).
5 A D epartm en t of C om m erce sam ple survey of foreign-controlled
firms (the B E -15 ) for 1977, taken to coincide with econom ic
censuses for that year, will eventually perm it verification of this
im pression. A com prehensive survey is planned to cover 1979.

FR B N Y Q uarterly R e v ie w /W in te r 1979-80

23

The areas of greatest foreign influence were much
the same in most countries: petroleum, chemicals,
rubber, transportation equipment, electrical machinery,
and other engineering. These are all high-technology
industries where the economies of the scale in produc­
tion and distribution have been conducive to the devel­
opment of large multinational enterprise.
For other economic sectors, information is incom­
plete. But the evidence available for Germany, Japan,
Canada, and the United States suggests that the for­
eign influence in other nonfinancial sectors is lower
than in industry. In the United States, where concern
over foreign investment in farmland has increased
recently, prelim inary results of a comprehensive De­
partm ent of Agriculture survey4 indicate that foreigners
own less than Vz percent of United States land classi­
fied as agricultural.
F a cto rs c o n trib u tin g to c h a n g in g inve stm e nt p a tte rn s
The declining com parative importance of the United
States as a source of international direct investment,
along with its growing host country role, has a number
of causes. A rise in the wealth of other industrial
countries and their large business firms, relative to the
United States, greatly increased their potential for in­
vestment throughout the world. During the 1970’s, a
significant share of that investment was attracted to
the United States as numerous factors raised the ex­
pected profitability of investing in this country.
One sign of the growing wealth of other industrial
countries and their potential for investing abroad was
their sustained stronger output growth. From 1955 to
1975 the yearly rise in real gross national product
(GNP) averaged 5 percent in all OECD (Organization
for Economic Cooperation and Development) countries7
other than the United States but only 3 percent in the
United States. At the sam e tim e the scale of operations
of firms outside the United States rose much more
rapidly than that of United States firms. In 1958, for
example, the average sales of the fifty largest industrial
corporations outside the United States, as reported by
F ortune, was only about 40 percent as large as the
average sales of the largest fifty United States indus­
trials. But by 1978 this ratio had risen to about 80

‘ P relim inary results from reports of foreign land ownership required
by the A gricultural Foreign Investm ent D isclosure Act of 1978. U nder
th e act, all foreign ow ners of U nited S tates farm , range, and forest
land are required to report these holdings to the D epartm en t of
Agriculture.
7 O E C D has tw en ty-four country m em bers: eighteen industrial
countries in Europe plus C an ad a, Japan, A ustralia, N ew Z ealand,
Icelan d, and the U nited States.

Digitized 24 FRASERY Q u arterly R e v ie w /W in te r 1979-80
for FR B N


percent.8 Part of this growth of sales was based on
increased exports to the United States, in some cases
reaching a level that justified large-scale m anufactur­
ing facilities in the United States.9
Equally important in fostering changes in direct in­
vestment patterns have been shifts in profit incentives
during the 1970’s. These stem from several sources:
• Exchange rate-related changes in relative labor
and capital costs,
• Depressed stock m arket values in the United
States,
• A decline in United States petroleum costs rela­
tive to other countries due to United States
price controls in this area,
• Foreigners’ fears that United States trade policy
was becoming more restrictive,
• Rising im portance attached to ownership of
raw materials in view of international supply
and price developments, and
• A spurt in United States growth beginning in
1975 which raised expectations regarding the
growth of the United States market.
Exchange rate changes appear to have had a lasting
effect on international wage differentials. M easured in
dollars, average hourly earnings in United States man­
ufacturing w ere 36 percent higher than in Germany, 74
percent higher than in Japan, 80 percent higher than in
the United Kingdom, and 2.6 times the level in France
in 1973. But, by 1978, United States average earnings
were only 6 percent higher than in Germ any and Ja­
pan, whose currencies had appreciated most relative
to the dollar, 65 percent higher than in the United King­
dom and 95 percent higher than in France. Because of
the close economic ties between Canada and the
United States, wage differentials between the two have
long been small.10
Exchange rate changes also tended to reduce the
cost to foreigners of purchasing existing manufacturing
facilities in this country. And, in addition, depressed
prices in United States stock markets may have en-

8 The fifty-largest lists used in this com parison w ere derived by
elim inating foreign-ow ned c o m panies operating in the U nited
S tates and United States com panies operating abroad from
Fortune's 1958 and 1978 lists of the 500 largest United States
industrial corporations, ranked according to sales, and its s im ilar
lists for industrial com panies operating outside the U nited States.
9 For a m ore d etailed discussion of these developm ents, see
A ppendix G of Foreign D ire c t Investm ent in the U nited States
(U nited States D epartm en t of C om m erce, A pril 1 9 7 6 ).
10 A verage hourly earnings in d om estic currency as published in
M onthly Bulletin o l S tatistics, U nited N ations, converted to dollars at
average exchange rates. United Kingdom data is for m ale w orkers only.

C h a rt 2

C o untry S ources of Foreign D ire c t In ve stm en t O utstan d in g in S e le c te d In d u s tria l C o u n tries
In p e rc e n t

United States
($ 4 0 .8 b illio n )
197 8

Canada
( $ 3 6 .5 b illio n )
1 9 7 6 :1 9 7 5

O th e r
Germany
( $ 3 4 .5 b illio n )
1976

United Kingdom
($ 1 9 .9 b illio n )*
1978: 1974

O th e r larg e
in d u s tria l
v c o u n trie s 3
*^
\
1 8 .9 % /

U n ite d S ta te s
41.1%

O th e r la rg e
in d u s tria l
c o u n tr ie s *
13.2%

Fo u r sm all
in d u s tria l
c o u n tr ie s *
3 4 .5 % #

Italy
($ 7 .9 b illio n )
197 8

Fo u r sm all
in d u s tria l
c o u n tr ie s *
4.6%

Fo u r s m all
in d u s tria l
c o u n tr ie s *
18.3%

5.5%
Japan
($ 2 .8 billion)
1978: 1977
O th e r larg e
in d u strial
c o u n tr ie s *

U nited
67.

22 . 0 %
U n ite d
18.8

T

O th e r
1.3%

Four sm all
in d u s tria l
c o u n trie s *
9.2%

W hen tw o d a te s a re given, th e firs t d a te re fe rs to o u ts tan d in g s (a ll lo cal c u rre n c y d a ta c o n v e rte d at e n d -1 9 7 8
e x c h a n g e ra te s ). S e c o n d d a te refe rs to p e rc e n ta g e distrib u tio n s.
♦ O th e r la rg e industrial c o u n trie s a re C a n a d a , Japan, U nited K ingdom , G erm any, F ra n c e , and Italy.
+ Four sm all industrial c o u n trie s a re th e N e th e rla n d s , B e lg iu m -L u x e m b o u rg , S w itze rla n d , and S w e d e n .
^ E x c lu d e s d ire c t in v e s tm e n ts in oil, banking, and in s u ra n c e.
S o u rc e s :

L a te s t co u n try d a ta a v a ila b le .




FR B N Y Q u arterly R e v ie w /W in te r 1979-80

25

The Relative im portance of Foreign-Controiled Enterprise in Large Industrial Countries
P ercentage of total sales or outp ut*
U nited
S tates
1974

S ecto r

Canada
1976

U nited
Kingdom
1975

Japan
1977

G erm any
1976

France
1977

4

16fl

t

5

1911

1911

23

2

14

12

.*
33

All business firms ....................................................................

2

35f

2t

Industrial sector§ ......................................................................

5

58

Of w hich:
Food and kindred products ......................................................

7

36

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

12

82

6

25

28

R ubber ....................................................................................................

2

90

20

**

**

30

E lectrical m achinery ........................................................................

2

68

3

23

25

35

Transportation equipm ent ...........................................................

tt

87

**

26

26

1844

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

2

67

6

21

18

21

Petroleum exploration, extraction, and refining .............

18

96§§

49

58§§

87

59

M ining and sm elting .....................................................................

6

66 III

**

4

4

12

4

3

4

4

13

C h em icals and allied products

O ther nonelectrical m achinery

O ther
O f w hich:
C onstruction

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

tt

14

Distribution

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

2

21

**
* *

IF Industrial, construction, and distribution.

* United States: gross product; U nited Kingdom: gross output;
Germ any: turnover; o ther countries: sales.

* * Not reported separately,

t N onfinancial corporations only.

f t Less than 0.5 percent.

4 Not available.
§ M anufacturing, m ining, and petroleum exploration, extraction, and refining.

44 A utom obiles only.

I! M an ufacturing only. If petroleum extraction were included, foreign operations
in North Sea oil would probably raise the im portance of foreign-controlled firms in
United Kingdom industry as a w hole.

§§ Processing of petroleum and coal.
Illl Includes m ineral fuels.

Sources: U nited States: "G ro ss Product of U.S. Affiliates of Foreign C o m p an ies", S urve y o f C u rre n t B u s in e s s (January 1 9 7 9);
Japan: C u rre n t S ta te o f F o re ig n a n d F o re ig n -A ffilia te d F irm s O p e ra tin g in J a p a n — 1979 (12th series) for year ended M arch 1978
(M inistry of International Trade and Industry press rele a s e ); G erm any: "T h e Level of D irect Investm ent at the end of 1976",
M o n th ly R e p o rt o f D e u ts c h e B u n d e s b a n k (April 1 9 7 9 ); France: L 'lm p la n ta tio n E tra n g e re d a n s L ’ln d u s trie a u le r J a n v ie r 1977
(M in istere de I'lndu strie, S T IS I, July 1 9 7 9 ); United Kingdom: Census of Production, 1975, as reported in Trade a n d In d u s try
(July 27, 1979 and M arch 2, 1 9 7 9 ); C anada: C o rp o ra tio n s a n d L a b o u r U n io n s R e turn s A ct, R e p o rt to r 1976, P art I C o rp o ra tio n s
(Statistics C anada, M arch 1 9 7 9 ).

couraged foreigners to acquire controlling interest in
United States companies. Both of these developments
increased the expected profitability of operating in the
United States rather than exporting to this country.
As for petroleum costs, prior to 1973 the price of
petroleum in the United States had been held above
world leve!s by import quotas. Since then, however, a
complicated set of United States price controls has
kept average domestic prices somewhat below the
world price levels imposed by OPEC policies. Thus in
the first half of 1979 the United States wholesale price

26

FR B N Y Q u arterly R e v ie w /W in te r 1979-80




index for crude petroleum was 2.6 times the 1970 level.
But for Japan, which is almost entirely dependent on
imports for its oil supply, the wholesale price index for
petroleum products and coal (converted to a dollar
basis) increased 5.5 times over the same period. These
price trends have reduced relative energy costs in the
United States.
New restraints on imports into the United States
include stricter enforcement of antidumping legislation
and negotiated restrictions on exports to the United
States. These restrictions have produced some immedi­

ate investment responses from foreign exporters di­
rectly affected. For example, a three-year orderly
marketing agreem ent between the United States and
Japan in 1977, limiting Japan’s exports of color tele­
vision sets to the United States to 1,750,000 annually,
induced five m ajor Japanese companies— Matsushita,
Mitsubishi, Sanyo, Sony, and Toshiba— to switch to the
United States a part or all of their production for this
market. These restrictions may have also created the
impression abroad that the United States is moving
toward greater protectionism. Consequently, some
foreign firms in industries considered possible targets
for future restraints may have chosen direct investment
rather than exports as a method of expanding their
sales in this country.
Foreign interest in raw m aterials has been especially
strong in the case of oil, coal, and forest products. The
British and Dutch influences have been strong in oil
and coal. The Japanese have lumber interests in the
Northwest.
Finally, the spurt in the United States growth rate
beginning in 1975 at least tem porarily reversed the
long-standing relationship between the United States
growth rate and that of other industrial countries.
United States real GNP growth averaged 5.2 percent
between 1975 and 1978, nearly 1 percentage point
above the average for other OECD countries. The ex­
pectation of expanding markets that accom panied this
shift appears to have been especially encouraging to
foreign investment in wholesale and retail trade. In the
three years ended in 1978, foreign investment out­
standing in that sector increased by 83 percent, com­
pared with 40 percent in other sectors.
Host country policies in major industrial countries
The issues
Country policies on foreign direct investment inflows
reflect in varying degrees three diverging views— each
extensively developed in academ ic, political, and busi­
ness forums. The views are (1) that direct investment
should be left to respond to market forces, (2) that it
should be encouraged by subsidies or other means, or
(3) that it should be restricted, possibly severely.
Those commentators who favor leaving foreign di­
rect investment to m arket forces usually have the same
attitude toward other international capital flows and
trade. The belief is that allowing owners of capital to
m axim ize its rate of return, without policy barriers or
inducements, will maxim ize the productivity of capital
in the world as a whole. In the process, capital will
flow from countries where it is more plentiful relative
to labor to countries where it is less so, thereby
maximizing labor productivity in the world economy.
Since international direct investment is often associ­




ated with the transfer of new technology, world output
is also increased by the investing firm ’s efforts to maxi­
mize returns from technology.
These are the standard free trade arguments, as re­
fined over the past fifty years by a host of leading
economists, extended to cover the case of free capital
flows. An early contribution to this line of argument
was made by R. A .M undell,1 who pointed to the role
1
that free capital flows can play in maximizing world
income, substituting for trade flows when that trade
is restricted. This analysis does not imply that leaving
direct investment to market forces necessarily m axi­
mizes the income of each country and income group.
But countries following this prescription generally be­
lieve that their economies will benefit on balance.
Those favoring subsidies or other devices to attract
foreign investment do not accept the view outlined
above. Instead, they believe that the extra foreign
investment generated by the subsidy will increase in­
com e for the country offering it by an amount greater
than the cost of the subsidy.
In a variation of the infant industry argument, it has
been suggested that an import tariff imposed to en­
courage direct investment could increase income in
the tariff-imposing country and the world at large, so
long as the foreign investment introduced economies
of scale in production. It has also been argued that a
country would gain from foreign direct investment be­
cause of increased tax revenues from foreign profits
(reduced by any tax concessions given), “external”
economies as local firms were forced to adopt more
efficient methods in order to remain competitive, and
increased employment opportunities.1 However, recent
2
writers have warned that subsidies or tax concessions
offered to attract new investment may well prove to be
greater than the benefits derived from the investment.1
3
The third view— that foreign direct investment should
be restricted— differs fundamentally in its analysis of
the costs and benefits of foreign direct investment. It
does not deny that foreign direct investment can in­
crease income, raise employment, disseminate new
technology, and ease attendant balance-of-paym ents
pressures in the host country. But it holds that all these
benefits can be achieved by external borrowing and

” R.A. M undell, “ International Trade and Factor M o b ility ” , Am erican
Econom ic R eview (June 1 9 5 7 ). R eprinted in Readings in International
E conom ics (R .E . C aves and H .G . Johnson, e d s .), 1968.
12 G .D .A . M acD o u g all, "T h e B enefits and Costs of Private Investm ent
from A broad: A T h eo retical A p p ro ach ", The Econom ic R ecord
(M arch 1 9 6 0 ). R eprinted in R eadings in International Econom ics.
’ 3 For exam ple, J. B hagw ati, “ The Theory of Im m iserizing Growth:
Further A p p lic a tio n s ” in M .B. C onnally and A.K. Sw oboda, eds.,
Intern atio n al Trade a n d M o n e y (U niversity of Toronto Press, 1 9 7 3 ).

FR B N Y Q u arterly R e v ie w /W in te r 1979-80

27

purchase of foreign technology, provided the host
country has or can hire people with the necessary
m anagerial skills. This alternative would avoid some
of the econom ic and social costs associated with for­
eign direct investment.
C anada’s “Gray Report”1 has presented an exten­
4
sive analysis of these costs. The report distinguishes
two types: (1) the distortions which result from govern­
ment policies (such as tariffs) in host or home country,
which encourage an inefficient use of both domestic
and foreign capital, and (2) drawbacks inherent in
foreign direct investment itself. Examples of the first
type of costs include plants too small to realize econ­
omies of scale or “truncated” operations, such as min­
eral extraction without metal fabrication facilities.
Examples of the second type of costs include the
possibility that foreign-controlled firms would be less
responsive than domestic firms to national policy ob­
jectives and that a large-scale foreign presence in a
country might have unfortunate effects on domestic
cultural institutions.
The notion that multinational companies are less
controllable than purely domestic firms is quite widely
held throughout the world. It is based in part on the
sheer size of the multinationals and the geographic
distribution of their production facilities. These factors
may allow them to shift output from one country to
another, at least in the medium to longer term. Another
serious difficulty appears to be that a host country gov­
ernm ent may see itself as competing with other pos­
sibly stronger national governments, which also play
host or home to the same multinationals. Each govern­
ment may attem pt to control or manipulate the activities
of m ultinationals to its own advantage, only to find its
efforts neutralized or overriden by others.
Country policies'5
These three views of inward direct investment a p p e a r
to lead to strikingly different policy prescriptions. But
in fact country policies usually encompass strands of
all three of them. In the United States, for instance,
this is partly because policies affecting direct invest­
ment are m ade by state and local governments, as well
as by the Federal Government. And policy positions at
the various government levels have sometimes differed.

14 Foreign D ire c t Investm ent in C anada, report by a working group
assisting the H onorable H erb G ray, P.C., M .P., G overnm ent of
C a n a d a , 1972.
15 Tw o good sources of inform ation on host p olicies of foreign
industrial countries a re th e P rice W aterhouse series on D oing
Business in (c o u n try ) issued in 1975 and “ P olicies and Laws in
O ther C ountries” , A ppendix N of Foreign D ire c t Investm ent in the
U n ited States (U nited States D ep artm en t of C om m erce, A pril 1 9 7 6 ).

Digitized28 FRASER Q u arte rly R e v ie w /W in te r 1979-80
for F R B N Y


It is also true that each view may be considered perti­
nent to some industries or regions but not others. Con­
sequently, a country may see no inconsistency in pre­
venting some direct investments, encouraging others,
and being neutral to the rest.
The policy of leaving direct investment to free mar­
ket forces has long been stronger in the United States
and Germ any than elsewhere. These are the only two
large industrial countries that have not subjected in­
coming investment to a formal review process at any
tim e in the postwar period. Nevertheless, policies that
encourage or restrict foreign investment do exist in
both countries.
In all countries except Japan, there are inducements
to foreign investors to enter areas where investment
is especially wanted: depressed geographic areas or
new industries or technologies where domestic invest­
ment is lagging. This encouragem ent, in the form of
tax concessions and a wide variety of other subsidies,
is offered by the central governments in all countries
except the United States and Japan and also by local
governments in the United States, Germany, France,
and Canada.
Such inducem ents are generally available to both
domestic and foreign investors. However, some govern­
ments, including numerous state governments in this
country, have gone out of their way to bring their
offers to the attention of foreign investors, even es­
tablishing promotional offices in likely investor coun­
tries. Further, many multinational firms contemplating
new foreign investment routinely shop host countries
for the best subsidy offer tailored to their needs. The
size of these offers has escalated in recent years.
As already noted, tariff policy can also have the
effect of encouraging direct investment in the pro­
tected area. This has been true of Canadian tariffs.
The creation of the European Common M arket, a uni­
fied market with no internal tariffs but surrounded by
a common tariff wall, may have had a similar but
possibly unintended effect. The recent international
rounds of reciprocal tariff reductions have reduced this
sort of inducem ent to foreign direct investment. But
other negotiated trade restraints, especially those be­
tween Japan and other industrial nations, are ap­
parently encouraging Japanese direct investment in
Europe as well as in the United States.
However, all industrial countries also restrict foreign
direct investment in differing degrees. All countries
bar foreign-owned firms from industries considered to
be of strategic national im portance. The barriers are
sometimes the result of nationalization of certain in­
dustries— most commonly the telephone, railroads, and
public utilities. But foreign firms are also excluded
from other strategic industries, most frequently air

transport, shipping, broadcasting, and defense-related
industries. In addition, Canada and Japan limit the
permissible percentage of foreign ownership of any
given firm in certain other industries considered of
special national interest. And France and the United
Kingdom sometimes subsidize domestic firms to
strengthen their com petitive position relative to foreignowned firms.
At times during the postwar period, all countries
except the United States and Germ any have also sub­
jected foreign direct investment to a review process,
ranging from severely restrictive in Japan to largely
formal in Italy. In recent years, Britain, France, and
Canada have used the review process as a means of
favoring investments which increase employment and
introduce new technology. Since 1972 the federal and
certain provincial governments in Canada have reduced
their dependence on foreign capital by buying out
foreign firms.
Since the early 1970’s, countries that form erly pur­
sued policies of extrem e restriction or encouragem ent
in regard to direct investment have tended to moderate
them. Japan, whose very low levels of foreign direct
investment attest to the form er restrictiveness of its
policies, has relaxed them somewhat during the seven­
ties. On the other hand, Canada, which has historically
given strong encouragem ent to foreign direct invest­
ment, adopted a more discriminating attitude in the
1970’s. For countries occupying a middle ground, there
has been a trend toward less emphasis on restrictions
and more on encouragement. A closer look at country
policies follows.
The U n ite d S ta te s government is committed to gen­
eral policies of noninterference with foreign direct in­
vestment as such. W hat percentage of this investment
has received state or local subsidies is unknown. How­
ever, the sudden growth of liquid funds in the hands
of OPEC countries in 1974 and 1975 aroused public
fears of possible OPEC takeovers of United States
firms, and this in turn led to minor modifications in
Federal Government policy. In 1975, an interagency
Com m ittee on Foreign Investment in the United States
(CFIUS) was created by executive order and required
to (1) analyze trends in foreign investments, (2) con­
duct advance consultations with foreign governments
wishing to make investments in the United States (for­
eign governments w ere requested to inform the United
States government of any intended direct investment),
(3) review investments which might, in its opinion, have
major implications for United States national interests,
and (4) consider proposals for new legislation or regu­
lations of such investment. However, both the Carter
and Ford administrations have been reluctant to inter­
fere with international direct investment flows, and



little use has been m ade of these powers.1
4
The G erm an governm ent is also basically committed
to a policy of nonintervention. But the sudden rise in
OPEC financial wealth has prompted some modifica­
tion of policy. Following several large direct invest­
ments from OPEC countries, the authorities established
an informal notification system w hereby banks and
m ajor companies report to them large impending for­
eign acquisitions. The governm ent has in a few in­
stances quietly encouraged purchase by Germ an in­
vestors of the equity interests being offered for sale;
Further, Germ any’s antitrust policy, probably the
most stringent in Europe, has necessarily affected
foreign direct investment since those making such in­
vestments are ordinarily large multinational firms. The
strength of the multinationals in Germ any is clear evi­
dence that anticartel policy has not been employed
to effect a wholesale embargo. But, over the years, a
number of Federal Cartel Office decisions have served
to set limits on the expansion of foreign enterprise in
Germany.
In Ita ly , policy is to encourage direct investment.
A law enacted in 1956 requires that all proposed in­
ward direct investments be screened to determine
whether or not they are “ productive” , in the sense of
increasing national output. W hile no investments are
barred, only those determ ined to be productive are as­
sured of unlimited rem ittance of earnings and capital
repatriation. The law provides that other investors
may be limited in their transfer of earnings or profits
to 8 percent a year and barred from repatriating cap­
ital until two years after the original investment. But
in fact, under long-standing administrative procedures,
no restrictions have been applied, even in periods of
heavy external deficit, on either capital repatriation or
remittance of earnings.
U n ite d K in g d o m 1 policy has combined encourage­
7
ment to foreign investment with concern for its impact
on the balance of payments and on the competitive
position of domestic firms. Until October 1979, au­
thorities used their extensive powers (under the
w C F IU S has review ed several investm ent proposals but has found
no reason to intervene. It has also reacted negatively to two
proposals to expand the governm ent’s pow ers to requlate
foreign direct investm ent: a 1976 proposal by the Federal Energy
A dm inistration that fore ig n e rs ’ investm ent in energ y resources be
regulated, and a 1978 proposal that foreign investm ent in farm land
be restricted. For further details, see S tatem ent by the Hon. C. Fred
Bergsten, A ssistant S ecretary of the Treasury for International
Affairs, before the S ubcom m ittee on C om m erce, C onsum er, and
M onetary Affairs, C om m ittee on G overnm ent O perations, House of
R epresentatives, July 30, 1979.
17 The m ost com prehensive history of U nited K ingdom policy in the
postw ar period is M .D . S te u e r and others, The Im p a c t o f Foreign
D ire c t Investm ent on the U n ite d K ingdom (D e p a rtm e n t of T rad e
and Industry, H M S O , 1 9 7 3 ).

FR B N Y Q u arterly R e v ie w /W in te r 1979-8 0

29

Exchange Control Act of 1947) to protect the balance
of payments by requiring that some portion of for­
eigners’ direct investment be financed by converting
foreign currency into sterling. However, the severity of
conversion requirements fluctuated with the balanceof-payments situation, the type of investment, and in
later years the nationality of the investor. Investment
in manufacturing, especially in depressed areas, was
treated more leniently than other investments. O cca­
sionally, the government also used its review powers
under the Exchange Control Act to obtain assurances
from multinationals on crucial policy matters. These
included output goals, employment, exports, imports,
and British representation on boards of directors. In
some cases, when a proposed takeover would have
produced an undesired foreign concentration in an
industry, approval was delayed and domestic counter­
offers encouraged. In 1973, following British entrance
into the European Community, all EC residents were
perm itted to borrow sterling to finance investment in
Britain. In 1977, the same privileges were given to all
foreigners making direct investment in manufacturing.
In October 1979, all remaining financing restrictions
were elim inated as part of the overall scrapping of
exchange controls.
Foreign direct investments will continue to be
affected by various industrial policy measures. Over
the years, the government has made loans to foreign
firms, either to encourage their investment in the
United Kingdom, as in the case of depressed areas of
Scotland, Wales, and Northern England, or to discour­
age their departure, as in the case of a loan to
Chrysler-United Kingdom in the years before its sale
to Peugeot. The government has subsidized foreign
investment in depressed areas on the same basis as
domestic investment. But, in a few strategic industries
such as computers, it has subsidized domestic firms to
strengthen their position in competing with foreigncontrolled firms operating in the United Kingdom.
These aspects of industrial policy will most likely
continue.
In F ra nce , host policies also combine encourage­
ment and restraint. All foreign direct investments are
subject to review by the authorities, although those
from other EC countries can be blocked only for
balance-of-paym ents reasons. For others, additional
criteria used in judging investment desirability include
the investment’s contribution to increased output, em­
ployment, exports, and improved technology.
The government has subsidized foreign investment
in depressed areas and growth industries. But it has
also resisted foreign domination of any given indus­
try, subsidizing dom estically owned firms or joint
foreign-dom estic ventures in an effort to restrict or to
 Q u a rterly R e v ie w /W in te r 1979-80
30 FR B N Y


reduce the role played by strong wholly foreign-owned
firms. One important recent case has been the govern­
ment subsidies provided to CM Honeywell Bull (a com­
puter firm formed by the m erger of the French
Compagnie Internationale pour L’lnform atique with
the United States-controlled Compagnie Honeywell
Bull) to allow it to com pete effectively against IB M .1
8
C anada traditionally encouraged foreign direct in­
vestment, especially in manufacturing, whose develop­
ment has tended to lag relative to the United States.
However, as foreign-affiliated corporations gained
prominence in the Canadian economy there was grow­
ing concern about the implications of this developm ent
for the governm ent’s econom ic sovereignty. Concern
was also prompted by extraterritorial application of
the United States antitrust laws and the Trading with
the Enemy Act and other similar regulations during
the 1960’s.19 These problems generated a series of
government reports, the last and most influential being
the “Gray Report” of 1972 already mentioned. The
report drew attention to the very high levels of foreign
ownership and control of Canadian industry. And it
concluded that, despite the benefits of foreign invest­
ment, the investment had also brought the social and
economic costs enum erated earlier.
One immediate consequence was the enactm ent of
the Foreign Investment Review Act in 1973. W hile
foreign entry had previously been restricted in a few
industries, the new act required a case-by-case review
of proposed new direct investment in all industries. It
also specified the broad criteria for acceptance to be
considered by the new review agency in making rec­
ommendations to the government that the application
be accepted or rejected. These criteria included: the
effect of investment on output and employment, new
technology introduced, compatibility with national ob­
jectives, contribution to industry competitiveness, and
Canadian participation in ownership and management.
The agency has recommended acceptance of 90
percent of all applications received. However, it seems
likely that only projects considered to be roughly in
line with the published criteria have been submitted to
the agency.
At the provincial level, Manitoba, Saskatchewan,
and Alberta have enacted legislation to regulate foreign
or nonresident ownership of land. And Ontario enacted
a land transfer tax, applying to foreigners’ purchases of
land but exempting purchase of land for com m ercial
or industrial use.
18 B u s in e s s W eek (M arch 21, 1 9 7 7 ), page 48.
U nder the act, the U nited States Treasury ap p lied its licensing
authority to transactions betw een C an ad ian affiliates of U nited States
com panies and governm ents or nationals of China, North Korea, and
V ietnam . O ther regulations covered s im ilar transactions with C uba.

The federal government has also moved to reduce
C anada’s dependence on foreign capital by establish­
ing the partly government-owned Canada Developm ent
Corporation (CDC). The CDC has made equity invest­
ments in strategic sectors which might otherwise attract
foreign capital— petrochemicals, oil and gas, health
care, pipelines, venture capital, and mining. The min­
ing investment takes the form of a 30 percent interest
in Texas Gulf Corporation, a United States firm with a
m ajor stake in Canadian mining. The government has
also purchased from foreigners companies operating in
the aerospace and petroleum industries .20 Moreover,
the province of Saskatchewan has taken over foreign
firms in the potash and oil industries and Quebec is
currently attempting to purchase a foreign asbestos
company.
In part as a result of these policies, net foreign in­
vestment flows into Canada have declined. On the
basis of C anada’s narrow definition of direct invest­
ment (i.e., excluding retained earnings and short-term
financial transactions between parent and affiliate), the
direction of net direct investment flows has reversed
from inward to outward. However, partial information
on broadly defined direct investment flows, provided
by United States statistics on United States-Canada
bilateral balance of payments, suggests that direct in­
vestment flows more broadly defined continue inward
but at a substantially reduced rate .2
1
Japan, the only large industrial country to have
maintained stringent restrictions on foreign direct
investment during much of the postwar period, has
moved toward liberalization in the 1970’s.22 The restric­
tions on inward investment, an integral part of its
broader policies for industry and trade, w ere motivated
by a strong drive to catch up with the West, a distrust
of foreign ownership and control, and a fear of foreign
competition with fledgling domestic industries. How­
ever, exceptions w ere made in the case of petroleum
refining and distribution and the rubber industry, where
major international companies were permitted to make
substantial investments.
20 In O cto ber 1979 the governm ent announ ced its intention to seek
private C an a d ia n buyers for the governm ent-ow ned corporations. In
N ovem ber it announ ced a plan to red uce its ow nership in the C anada
D evelop m ent C orporation. A proposal to give shares in Petrocan to
each C an ad ian is also under consideration. In all cases, there is
a proviso that ow nership rem ain in C an ad ian hands.
21 U nited States bilateral paym ents statistics show net direct investm ent
flows from the U nited States to C a n a d a w ere 1975: $2.4 billion,
1976: $ 1 .9 billion, 1977: $ 1 .2 billion, and 1978: $ 0 .8 billion.
22 For an extended discussion of J a p a n ’s policies, see Robert S. O zaki,
C ontrol of Im ports a n d Foreign C ap ita l in Japan (P raeger, N ew
York: 1 9 7 2 ): and O E C D , L iberalization of International C apital
M ovem en ts: Japan (C om m ittee for Invisible Transactions, O E C D ,
Paris, 1 9 6 8 ).




The governm ent was also liberal in authorizing the
importation of technology. In this way, Japan obtained
one of the m ajor benefits often associated with direct
investment. During the decade ended in 1978, for ex­
ample, Japan’s payments of patent royalties to foreign­
ers totaled $ 6 .8 billion, nearly three times as much as
foreigners’ earnings from direct investments in Japan.
Restraints on inward investment have been of two
types: ( 1 ) designation of the percentage of foreign
ownership of any given firm allow able in each industry
and ( 2 ) a required “validation” of each investment pro­
posal. The validating authorities have in the past re­
quired that would-be investors meet certain conditions
such as limitations on the scale of output, marketing
arrangements, and the number of Japanese directors
and senior executives in joint enterprises.
Liberalization got under way in 1967 in response to
pressure from other countries. The process was accel­
erated in the 1970’s (possibly in part to forestall re­
taliatory restrictions on Japanese investment by other
countries as Japan becam e an important outward di­
rect investor). By 1976, liberalization reached the stage
where 100 percent foreign ownership of Japanese firms
was permissible in most industries. However, foreign
investment is limited to 50 percent ownership in min­
ing. And investment in leather and leather products,
agriculture, forestry, fisheries, and petroleum is se­
verely restricted .23
For industries where 100 percent foreign ownership
is permitted, validation is still required but is often
fairly automatic. However, validation of takeovers
requires the consent of the Japanese firm being taken
over. Most are traditionally reluctant to consent to any
takeover bid, even from Japanese firms. Thus foreign
firms not prepared to organize new companies have
been limited to joint ventures with, or acquisitions of
strong minority positions in, Japanese firms. A recent
exam ple of the latter is Ford’s acquisition of a 25
percent interest in Toyo Kogyo, m aker of M azda cars.
Even when a foreign firm proposes a new wholly
owned venture in a liberalized industry, the validation
procedure has occasionally proved tim e consuming.
In one exceptional and w ell-publicized case, validation
of a proposed investment in a new plant by an Am eri­
can chem ical company was delayed for two years,
reportedly because of opposition from Japanese com­
petitors.
23 The ch an g e in attitude tow ard the petroleum investm ent m ay
reflect an official desire to red uce the influence of foreign-controlled
firm s in that sector. In fact, the foreign presence in the petroleum
industry has been reduced from nearly two thirds (m easured by
s a les ) early in the 1 9 6 0 ’s to less than half now through govern­
m ent support of dom estic firm s, increased direct dealings betw een
O P E C suppliers and J ap an ese com panies, and the operations of the
governm ent’s own N ational Petroleum Corporation.

F R B N Y Q u arterly R e v ie w /W in te r 1979-80

31

Since liberalization got under way, the position of
foreign-controlled firms in the Japanese economy has
gradually increased but remains quite small. For all
industries including services, the sales of foreign firms
grew from 1.4 percent of sales made by all firms in
Japan in 1967 to 2.2 percent in 1977. In manufacturing,
the ratio rose from 2.8 percent to 4.7 percent despite
a loss of shares for foreign petroleum companies.
Some unresolved issues
Traditionally, policy discussion has focused on the do­
mestic consequences of inward direct investment. But,
in the past few years, greater recognition has been
given to international implications and, in particu­
lar, the need to construct mutually compatible national
policies. This is true of both national inducements to
inward investment and restrictions against them. It also
applies to the conflicts between home and host country
regulation of multinational firms.
National inducements and restrictions have been
studied extensively by the OECD and by the United
Nations. But concrete progress in harmonizing policy
remains modest. As far as inducements to inward in­
vestment are concerned, the industrial countries are
well aw are that competitive escalation of subsidy offers
makes them more expensive for everyone and reduces
the gain that the successful bidder can hope to realize
from the foreign direct investment that it attracts.
In 1976, an OECD Declaration on International
Investment and M ultinational Enterprise stressed the
need to strengthen international cooperation in this
field, but stopped short of agreeing to any specific ac­
tions or guidelines. Three years later, in October 1979,
the OECD Com m ittee on International Investment
tackled the problem once again, this time embarking
on a three-year study. The study will begin by catalog­
ing investment incentive programs in all countries and
the amount of the subsidies given. It will then analyze
their effect on recipients and their broader economic
effects on home, host, and third countries.
The OECD comm ittee will also study discrimination
against increased foreign investment. Governments
have been requested to submit descriptions of their
activities in this field. The comm ittee apparently hopes
for frank statements on such matters as the support
given to domestic companies to fend off foreign take­
over bids or other foreign attempts to enter or dom­
inate important industries.
The third area of conflict— home and host country
regulation of multinational firms— raises the problem
of extraterritoriality. As already mentioned in the dis­
cussion of Canadian policy, foreigners have been irri­

 Q u arte rly R e v ie w /W in te r 1979-80
32 FR B N Y


tated by the occasional attempts of United States
agencies to regulate the trade of foreign affiliates of
United States companies. Some have also been an­
gered by law suits brought against foreign enterprises
in United States courts on the grounds that the actions
of those firms had consequences within the United
States. A recent case is a suit brought by W estinghouse against an alleged international uranium cartel.
The suit was filed against twenty-nine uranium pro­
ducers, twelve of them foreign. The foreign defendants
claim that their price-stabilizing activities had the sup­
port of the governments of Canada, South Africa,
Australia, Britain, and France. Such episodes have
stimulated Australia to enact legislation blocking en­
forcem ent of foreign court judgments on companies
based in that country. Sim ilar legislation is being
considered in the United Kingdom and C anada .24
However, the United States approach to these prob­
lems is by no means unique. The European Economic
Community Commission maintains that its rules on
competition extend to actions outside the Community if
they affect competition within it. And the Supreme
Court of the Federal Republic of Germ any has sup­
ported the right of that country’s Federal Cartel Office
to require that foreign subsidiaries of Germ an com­
panies notify that Office of its foreign acquisitions .25
Although these international conflicts remain unre­
solved, the desirability of harmonizing national policies
in this area is widely recognized. An important reason
is the converging patterns of direct investment flows in
the m ajor industrial countries. Now that nearly all in­
dustrial countries are important as both host to inward
investment and home country for outward investment,
their policy perspectives are both broader and more
similar to one another than in the 1960’s. For exam ple,
the new sense of urgency animating OECD discussion
of inducements to some inward investment and restric­
tions against others is largely due to a United States
interest in those topics. This interest is a new one,
stimulated by our recent experience as an important
host to inward direct investment. On the other hand,
the increasing im portance of outward investment for
Japan, Germany, and Canada is likely to have modi­
fied their approach to conflicts between home and
host countries. Thus, there is some prospect that in­
dustrial countries will eventually move from study to
action in harmonizing policies toward direct invest­
ment and the regulation of multinational firms.

24 The E conom ist (S e p te m b e r 5, 1 9 7 9 ), pages 79-82.
25Fin a n c ia l Tim es (N o v e m b e r 29, 1 9 7 9 ), page 12.

Dorothy B. Christelow

Interest Rate Futures

On a typical day in 1979, futures contracts represent­
ing about $ 7 1 billion in three-month Treasury bills
/2
changed hands in the International M onetary M arket
(IM M ) of the Chicago M ercantile Exchange in Chicago.
This m arket and several other new markets for in­
terest rate futures have very quickly become active
trading arenas. For example, at the Chicago Board of
Trade (CBT), futures contracts representing $820 mil­
lion of long-term Treasury bonds w ere traded on a
typical day; also, at the CBT, futures contracts repre­
senting $540 million of GNMAs (Government National
Mortgage Association securities) changed hands on an
average day.
Besides these three well-established interest rate fu­
tures contracts, several new financial futures contracts
have recently received the approval of the Commodity
Futures Trading Commission (CFTC) and have begun
trading. Futures contracts for interm ediate-term Trea­
sury notes comm enced trading in the summer of 1979;
in the fall, the Comex (Commodity Exchange, Inc.),
which had traded many metals contracts, inaugurated
a three-month bill futures contract, and the ACE (Amex
Comm odities Exchange, Inc., an affiliate of the Am eri­
can Stock Exchange) introduced a bond futures con­
tract; in addition, the New York Stock Exchange is
intending to start a financial futures unit.
W hat accounts for the rapid growth of interest rate
futures? Who are the most active participants in these
markets? Some businesses such as financial institu-

The authors wish to thank Jam es Kurt Dew, Ronald Hobson, and
Anthony V ignola for inform ation and helpful com m ents. The
foregoing do not necessarily agree with the views expressed
herein, nor do they bear responsibility for any errors.




tions and securities dealers use it to hedge or m anage
interest rate risk. By and large, however, participants
are involved for other reasons and help provide much
of the m arkets’ liquidity. A large portion of the activity
in these markets is speculative— people and institu­
tions betting on which way interest rates will move
and how the interest rate in one month will move rela­
tive to another. Others are involved in these interest
rate futures markets for tax reasons.
Both the enormous size of these futures markets
and the nature of the participants are a m atter of con­
cern for the regulatory authorities. The Treasury and
the Federal Reserve System have become aware of
potential problems for the functioning of markets in
Government securities; these problems include the pos­
sibility of corners or squeezes on certain Treasury
issues and the disruption of orderly cash markets for
Treasury securities. In addition, the regulatory authori­
ties have become concerned that the substantial num­
bers of small investors participating in the markets
may not be fully aware of the risks involved.
What is a futures market?
For as long as mankind has traded goods and services,
people have m ade contracts which specify that com­
modities and money will change hands at some future
date, at a price stated in the contract. Such contracts
are called “forw ard” contracts. A forward contract
tailored to one’s needs offers obvious advantages—
one can pick the exact date and the precise commod­
ity desired. On the other hand, there are disadvan­
tages. It may be difficult to locate a buyer or seller with
exactly opposite needs. In addition, there is a risk that
the other party to the transaction will default.

FR B N Y Q u arterly R e v ie w /W in te r 1979-80

33

A futures contract is a standardized forward contract
that is traded on an exchange. Usually the type and
grade of commodity is specified as well as the date
for delivery. Once a bargain is struck, the clearing­
house of the futures exchange itself becomes the op­
posite party to every transaction. Thus, it is the sound­
ness of the exchange’s clearinghouse rather than the
creditworthiness of the original buyer (or seller) that
is of concern to the seller (or buyer) on the other side
of the transaction. To ensure its viability, futures ex­
changes and their clearinghouses set up rules and reg­
ulations. These include the requirements that a clearing
member firm and its customers put up “ margin” , that
the contracts be marked-to-market daily, and that trad­
ing cease if daily price fluctuations move outside cer­
tain limits.
Among the oldest futures markets in the United
States are those for wheat and corn which date back
to the middle of the nineteenth century. Thereafter,
futures markets for other farm products and raw mate­
rials gradually developed. One of their major purposes
was to provide producers and processors with price
insurance. Suppose a farmer expects to harvest wheat
in July. Nobody knows with certainty what the price will
be then; it depends upon the size of the harvest and
conditions elsewhere in the world. However, by selling
a futures contract for July wheat, the farmer can
indirectly guarantee receiving a particular price. This
is illustrated in Box 1.
Futures markets for commodities not only provide a
forum for hedgers, but they also provide information.
This information— about prices expected to prevail
on future dates— is printed in the financial section of

Box 1

Hedge in W heat Futures
A farm er planning to harvest w heat in July sells a
July w heat futures contract at $2.98 in M arch.
(1) Suppose the price in
July turns out to be . . .

$2.50

$3.00

$3.50

(2) Gain or loss from
offsetting futures con­
tract [S2.98 — row (1)]

.48

-.0 2

many daily newspapers. The farmer, for example, can
use these futures prices to decide whether to plant
corn or wheat. The food processor can gear up to can
corn or beans depending upon the expected prices
and the prospective consumer demand at those prices.
Interest rate futures are a relatively new develop­
ment. In the fall of 1975, the CBT inaugurated a GNMA
contract. Shortly thereafter, in early 1976, the IMM
introduced a contract for ninety-day Treasury bills,
and this was followed in 1977 by the CBT’s Treasury
bond futures contract. These three contracts— the
CBT’s original GNMA, the CBT’s Treasury bond, and
the IMM’s three-month Treasury bill contract— have
proved to be the most popular and heavily traded fi­
nancial futures contracts. The amount of contracts out­
standing, or open interest, in these markets has ex­
panded significantly since their inception (Chart 1).
Moreover, trading volume has also become quite large
in relation to the underlying cash market securities. In
1979, daily average trading in the eight ninety-day
Treasury bill contracts on the IMM was equivalent to
about $71 billion (at $1 million per contract), not
/2
much different from the daily volume of Treasury bills
traded in the dealer market for United States Govern­
ment securites.1 Some interest rate futures contracts,
however, have failed to attract much trading activity.
For example, activity in the ninety-day commercial
paper contract has remained quite light.2

How financial futures m arkets operate
The financial futures markets operate in the same man­
ner as other futures markets. Their terms and methods
are very different from those used in the money and
bond markets. One of the most active financial futures
markets is that for three-month Treasury bills at the
IMM. Through this exchange, a customer could, for
example, buy a contract to take delivery of (and pay
for) $1 million of three-month Treasury bills on
March 20, 1980. In all, there are eight contract de­
livery months on the IMM, extending at quarterly
intervals for about two years into the future.
A customer places his order with a futures com­
mission merchant— a firm registered with the CFTC
and permitted to accept orders from the public— which

-.5 2
1 That m arket is described in “ The D e a le r M arket for U nited States
G overnm ent S ecurities", by C hristopher M cC urdy in this B ank’s
Q u a rte rly R e view (W inter 1 9 7 7 -7 8 ), pages 3 5 -4 7 .

(3) Sales price of w heat
in cash m arket
[sam e as row (1)] . . .

2.50

3.00

3.50

(4) Total earnings
per bushel
[row (2) + row (3)] . .

2.98

2.98

2.98

 Quarterly Review/Winter 1979-80
34 FRBNY


2 One of the problem s with this contract has been that com m ercial
paper issuers have at tim es tended to sell p ap er with m aturities much
shorter than ninety days. Also, because the paper of a large num ber of
com panies is d eliverable against the contract, this generates substan­
tial uncertainty about w hich paper will be delivered. In addition, the
original technical specifications of the contract engendered som e
confusion.

sends the order to the trading floor of the exchange.
There, a member of the exchange enters the trading
pit and announces his intention to purchase the March
1980 contract. Another member who has an order to
sell that contract shouts out his offer and, if the two
can agree on a price, the trade is consummated. The
trading in the pit is by open outcry, which is typical
of futures exchanges and very unlike the over-thetelephone negotiations in the cash market for Treasury
securities.
The contract’s price is quoted as the difference
between 100 and the discount rate on the bill in ques­
tion. Thus, a contract fixing a bill rate of 8.50 percent
would be quoted at 91.50. This index preserves the
normal futures market relationship in which the party
obligated to take (make) delivery profits when the
price rises (falls). The contract quote is not the price
that would actually be paid for the bill at delivery.
That price is computed by using the rate of discount
in the standard bill price formula.
The clearinghouse interposes itself between the
buyer and the seller, so that the buyer’s contract is
not with the seller but with the clearinghouse. (In the
same fashion, the seller’s contract is with the clearing­
house and not with the original buyer.)
A key ingredient in the financial viability of the
clearinghouse is the margin that the clearing member
firms must post on their contracts. For each outright
purchase or sale of a three-month Treasury bill con­
tract on the IMM, the firm must post margin of $1,200
per contract, which can be in the form of cash or bank
letter of credit. The clearing member firm must, in turn,
impose an initial margin of at least $1,500 on the cus­
tomer. This may be posted in the form of cash, se­
lected securities, or bank letters of credit. Futures
firms can and often do require higher than the mini­
mum margins of their customers. Margins formerly
were more lenient, at one point down to $800 initial
margin, but were raised following the greater volatility
that emerged in the financial markets in the wake of
the Federal Reserve System’s policy actions in Oc­
tober 1979.
For as long as the position is outstanding, the con­
tract will be marked-to-market by the clearinghouse
at the end of each business day. For example, a clear­
ing member with a long position in the March contract
would have its margin account credited with a profit if
the price rises, or debited with a loss if it declines.
The prices used in the calculations are the final settle­
ment prices, which are determined by the exchange
by examining the prices attached to the trades trans­
acted at the end of trading each day.
Profits in the margin account may be withdrawn im­
mediately. When losses occur and reduce the firm ’s




C h a rt 1

G row th o f In te re s t R ate Futures M arkets:
G N M A s, T rea s u ry Bills, and
T rea s u ry Bonds
E nd-of-m onth open in te re s t
N um ber of contracts
8 0 ,0 0 0
6 0 ,0 0 0
4 0 ,0 0 0

20,000

10,000
8,000
6,000
4 ,0 0 0

2,000

1,000

S e e Box 2 for s p e c ific a tio n s .
S o u rces: In te rn a tio n a l M o n e ta ry M a rk e t and
C h icag o B o ard of T ra d e .

margin below $1,200, the firm must pay the difference
to the clearinghouse in cash before trading opens the
next day. It is permissible for the value of a customer’s
margin account to fall below the initial $1,500 but, once
the margin account falls below the $1,200 maintenance
margin, the account must be replenished in full—
brought back up to $1,500. Since the value of a 1 basis
point change in the futures bill rate is $25 per contract,
relatively small changes in interest rates can result in
large changes in the value of a margin account.
The exchanges impose rules that prices may not
change by more than a certain maximum amount from
one day to the next. At the IMM, for example, no bill
futures trades may be cleared if the price is more than
50 basis points above or below the final settlement
price on the previous day although, if the daily limit

FRBNY Quarterly Review/Winter 1979-80

35

Box 2

3
6

Futures Contracts on Treasury S ecurities (Currently Trading)

FRBNY

Treasury bills

In te rm e d ia te -te rm T re as u ry
c o u p o n s e c u ritie s
IM M
CBT

Quarterly
Review/Winter 1979-80

ACE

C O M EX

IM M

IM M

$1 m illion par
v alu e of Treasury
bills w ith 90, 91,
or 92 days
to m aturity

$1 m illion par
value of Treasury
bills w ith 90, 91,
or 92 days
to m aturity

$1 m illion par
value of Treasury
bills with 90, 91,
or 92 days
to maturity

$ 2 5 0 ,0 0 0 par
value of Treasury
bills due in
52 w eeks

$ 1 0 0 ,0 0 0 par
value of T re a ­
sury notes and
n on callab le
bonds with
4 to 6 years
to m aturity

$ 1 0 0 ,0 0 0 par
value of T re a ­
sury notes
m aturing b e ­
tw een 3 12 years
/
and 4 1 years
/2

$ 1 0 0,0 0
value of
sury b
w ith at
20 yes
ma

$800

$800

$1,500

$60 0

$ 900

$50 0

$

$600
5 0 basis
points

$600
60 basis
points

$1,200
50 basis
points

$40 0
50 basis
points

$600
1 point
( 3 2 /3 2 )

$30 0
% point
(4 8 /6 4 )

1
(32

January, A pril,
July, O cto b er

February, M ay,
August,
N ovem ber

M arch, June,
Septem ber,
D ecem b er

M arch, June,
S ep tem ber,
D e c em b er

M arch, June,
S ep tem ber,
D e c em b er

February, M ay,
August,
N ovem ber

February,
Au
Nove

106
Ju n e 26, 1979

913
O c to b e r 2, 1979

36,495
January 6 ,1 9 7 6

435
S ep te m b e r 11,
1978

715
June 25, 1979

265
July 10, 1979

Novem bf

•
D e live ra b le i t e m s ------

nitial m a rg in *
per c o n tra c t) ................
M a in te n a n c e m arg in *
per c o n tra c t) ................
D aily lim its^ ..................
Delivery m onths
e ach y e a r) .....................

Total open interest
D e c e m b e r 31, 1 9 7 9 ) .
D ate trading b egan . . .

$1

Non-Treasury S ecurities Futures

C B T ( o ld )

C B T (3 0 -d a y )

C o lla te ra lized
depository receipt
c overing $ 1 0 0 ,0 0 0
p rin cip al b a la n c e of
G N M A certificates

$1 0 0,0 0 0 principal
b alance of G N M A
certificates

$ 1 0 0 ,0 0 0 principal
b a la n c e of G N M A
certificates

$ 1 0 0,0 0 0 principal
bala n c e of G N M A
certificates

$3 m illion face value
of prim e com m ercial
p ap er rated A-1 by
S tandard & P oor’s and
P-1 by M o o d y ’s

$2,000

$2,000

$2,000

$ 1 ,50 0

$ 1 ,50 0

$ 1 ,5 0 0
1 1 points (4 8 /3 2 )
/a

$1 ,50 0
1 Va points (4 8 /3 2 )

$ 1 ,125
1 point (6 4 /6 4 )

$1,200
5 0 /1 0 0 point

M arc h , June,
S ep te m b e r, D e c e m b e r

M arch, June,
S ep tem ber, D ecem b er

February, M ay,
A ugust, N ovem ber

8 8 ,9 8 2
O c to b e r 2 0 ,1 9 7 5

4,478
S ep tem ber 1 2 ,1 9 7 8

3,248
S ep te m b e r 1 2 ,1 9 7 8

D e live ra b le item s . .

nitial m a rg in *
per c o n t r a c t ) ...........
M a in te n a n c e m argin*
p er c o n t r a c t ) ...........
D aily lim its^ .............
Delivery m onths
each y e a r) ................

G o v e n m e n t N a tio n a l M o rtg a g e A s s o c ia tio n
(m o d ifie d p a s s -th ro u g h m o rtg a g e -b a c k e d c e rtific a te s )
C B T (n e w )
ACE
COM EX

Total open interest
D e c e m b e r 31, 1 9 7 9 )
D ate trading b egan . .

$ 1 ,50 0
% point ( 2 4 /3 2 )§

January, April
July, Octoberll
64
N ovem ber 13, 1979

M arch, June,
S ep tem ber, D e c em b er
12

M ay 14. 1979

All spe c ific atio n s a re as of y e a r-e n d 1979.
T h e spec u la tiv e m argin is show n w h e re m argins vary according to w hether the contracts cover speculative, hedged, or spread positions,
f For all contracts but those w h ich m ature in current m onth. Then initial m argin is increased to $ 2 ,5 0 0 and m aintenance m argin is raised to $2,00 0 .
: E xchang es fre q u e n tly have rules allow ing expansion of d aily limits once they have been in effect for a few days (m argins m ay change a ls o ).
Lim its in suspension as of the y e a r-e n d .
Digitized forPFRASER
rincipal trading m onths; rules allow trading for current plus two succeeding months.



restricts trading for a few days, then wider limits may
be imposed on subsequent days. Margins are often
tem porarily increased during such periods.
When the customer wishes to get out of his contract
before maturity, he must take an offsetting position.
To cancel the contract he bought, he must sell another
contract. His order is forwarded to the pit and a sales
contract is executed, but not necessarily with the party
who sold it to him in the first place. Once again, the
clearinghouse interposes itself between the two parties
and the latest sale will be offset against the original
purchase. The custom er’s overall position will be can­
celed, and the funds in the margin account will be
returned to him.
The lion’s share of all contracts traded are term i­
nated before maturity in this fashion. Only a very
small percentage of contracts traded is delivered. In
the case of Treasury bills, delivery takes place on the
day after trading stops. The customer who has sold
the contract (the short) delivers $1 million (par value)
of Treasury bills that have ninety, ninety-one, or ninetytwo days to maturity, and the customer who bought
the contract (the long) pays for the bills with im medi­
ately available funds. The price paid for the bills is the
settlem ent price on the last day of trading. (With the
daily m arking-to-m arket, almost all losses and gains
have been realized before the final delivery takes
place.)
Variations in procedures exist on different contracts
and exchanges, but they generally adhere to the same
principles: open outcry trading, interposition of the
clearinghouse, posting of margin, and daily markingto-m arket. Box 2 delineates the key specifications on
financial futures contracts. Probably the most impor­
tant difference among contracts is that some allow
delivery of a variety of securities. The active Treasury
bond contract, for example, permits delivery of bonds
from a “m arket basket” of different bonds, all with
maturity (or first call) beyond fifteen years. This has
the effect of substantially increasing the deliverable
supply of securities but generates some uncertainty
among those taking delivery as to which bonds they
might receive.
The formal organizational structure of futures trad­
ing stands in contrast to the informal nature of forward
trading. Dealers in the m arket for United States Govern­
ment securities often agree to transact trades that call
for forward delivery of Treasury issues. These trades
are negotiated in the sam e fashion as trades for im­
m ediate delivery. There is no standardized contract as
in the futures market: the two parties must agree to the
specific security involved, the exact delivery date, the
size of trade, and the price. These terms are set ac­
cording to the mutual convenience of the two parties.




Often, there is no initial margin and no m arking-tom arket to account for gains and losses. Thus, each
participant must size up the creditworthiness of the
other. Finally, these agreements, for the most part, are
designed to result in delivery. (Some GNM A forward
trades among a few firms can be offset through a
clearinghouse arrangem ent.) If either side wishes to
cancel the trade, it must go back to the other side
and negotiate a term ination.
Participants in the interest rate futures markets
Many types of financial institutions participate in the
markets for interest rate futures, but private individu­
als not acting in a business capacity account for the
major part of interest rate futures positions in the three
most active contracts (Chart 2).
According to a survey by the CFTC of positions out­
standing on M arch 30, 1979, businesses other than the
futures industry, commonly called “comm ercial trad­
ers”, accounted for only about one quarter of open
interest held in the most active contracts (ninety-day
Treasury bills on the IM M , and Treasury bonds and
the original G N M A contract on the CBT). In an earlier
survey, such participants had held about three eighths
of those contracts outstanding on Novem ber 30, 1977
(Table 1). The involvement of com m ercial traders is
important because they"are the only group that can
use futures contracts for hedging cash m arket posi­
tions to any meaningful extent. (See next section.)
Moreover, some of the businesses who participate in
these futures m arkets are probably not trying to
elim inate risk completely. Consider securities dealers,
for example, who have been very active in interest
rate futures markets— they held about 7 percent of
total GNM A positions and about 18 percent of total
bond positions in March 1979. Securities dealers are
generally risk takers, trying to benefit from interest
rate change, or arbitrageurs, trying to benefit from
interest rate disparities, rather than hedgers. But, in
meeting customers’ needs and making a m arket in
Government securities, they do make use of interest
rate futures markets to manage their risk exposure.
Among other business participants, m ortgage bank­
ers and savings and loan associations combined held
about 7 percent of total positions in GNMAs. Their
participation in GNMAs is to be expected in view of
their involvement in generating and investing in mort­
gages. A total of sixty-eight of these firms held posi­
tions on March 30, 1979, not much above the number
reported in the earlier survey. Few com m ercial thanks
have been active in interest rate futures— twenty-four
had open positions in bill futures, and fourteen in bond
futures on March 30, 1979— accounting for a small
fraction of total positions in these markets. Their rela-

F R B N Y Q u arterly R e v ie w /W in te r 1979-80

37

T a b le 1

Futures M arkets Participants
N ovem ber 30, 1977 and M arch 30, 1979
A verage open interest; num ber of contracts

G overnm ent National M ortgage Association
contract (old)

Type of participant

Treasury bond contract

1977
as per1977 centage
am ount of total

1979
am ount

1979
as p er­
centage
of total

1977
as per­
1977 centage
am ount of total

7,226
. 3,395
.
263

36.5
17.1
1.3

10,899
4,270
655

18.3
7.2
1.1

2,025
1,534
99

.
494
. 1,198
. 1,875

2.5
6.1
9.5

2,500
1,472
2,003

4.2
2.5
3.4

63.5
37.1
14.4
12.0

48,705
21,113
11,097
16,495

8 1 .7
35.4
18.6
27.7

989
477
254
258

Three-m onth Treasury bill contract

1979
as p er­
1979 centage
am ount of total

1977
am ount

1977
as per­
c entage
of total

1979
as per­
1979 c entage
am ount of total

C om m ercial traders
(to ta l) ..........................
S ecurities dealers . .
C om m ercial banks .
Savings and loan
associations .............
M ortgage bankers . .
O ther ............................

N oncom m ercial
traders ( t o t a l ) .......... 12,588
Futures industry . . . . 7,353
C om m odity pools . . . 2,8 62
Individual traders . . . 2,373

Total .......................... 19,814

100

59,604

100

67.2
5 0.9
3.3

12,393
8,226
1,472

27.4
18.2
3.3

4 ,9 50
2,758
326

32.8
18.3
2.2

14,992
5 ,596
1,581

33 .6
12.5
3.5

_

__

154
238

5.1
7.9

394
330
1,971

0.9
0.7
4.4

56
44
1,767

0.4
0.3
11.7

136
974
6,7 06

0.3
2.2
15.0

32.8
15.8
8.4
8.6

3 2 ,8 2 6
12 ,924
9,484
10,418

72.6
28.6
21.0
23.0

10,154
2,765
1,520
5,868

67.2
18.3
10.1
38.8

29,661
8 ,434
5,640
1 5 ,586

66.4
18.9
12.6
34.9

3,014

100

45,219

100

15,104

100

44,654

100

B ecause of rounding, am ounts and percentages m ay not add to totals.
S ource: C om m odity Futures Trading C om m ission Surveys. The 1977 survey covered all positions, but the
1979 survey exclu ded positions of few er than five contracts.

tively low level of participation may have reflected
regulatory restrictions on their involvement in the
futures market or some confusion about the regulators’
policies.
Futures industry personnel and firms held a signif­
icant fraction of the open positions. This group includes
many who are speculating on rate movements in gen­
eral or on the spread relations between rates on
successive contracts. Or they might be operating in
both the cash and futures markets, arbitraging differ­
ences between the two markets.
Individuals and commodity pools— funds which pur­
chase futures contracts— are very important partici­
pants in financial futures markets. They held almost half
of the open positions in 1979, a substantial increase
from their already significant participation in the earlier
survey. Indeed, their 1979 share of total positions in
financial contracts was certainly higher than that be­
cause positions of less than five contracts were not
included in the second survey and individuals tend to

38 FRBNY
 Quarterly Review/Winter 1979-80


hold the vast majority of such small positions.3

Services provided by interest
rates futures m arkets
It is commonly believed that futures markets provide
certain benefits— in the main, an inexpensive way to
hedge risk and generate information on expected
prices. Interest rate futures markets also provide these
benefits.
Several observers have noted that interest rate
futures markets are not necessary to provide infor­
mation on future interest rates or as a hedging mech­
anism. They point out that one can obtain information
3 Sm all positions in the bill futures contracts am ounted to about 8,000
contracts at th e end of M arch 1979 and thus w ould raise the com ­
bined share of individuals and com m odity pools to a bit m ore than
half of the bill futures m arket. C o m p arab le calcu lations cannot be
m ade for the C B T ’s bond and G M N A contracts because som e small
positions are posted on a net basis (i.e., long positions are offset
against short positio n s), com pared with a gross basis as in the
bill contracts.

on future interest rates by comparing yields on out­
standing securities which have different maturities.
However, the interest rate futures markets do provide
future interest rate information in a more convenient
form.
It is also true that outstanding securities could be
used to hedge market risk. Again, however, the futures
market can provide a less cumbersome and expensive
hedge. Suppose, for example, that a firm is planning to
issue short-term securities three months in the future
and is worried about the prospective short-term inter­
est rate. The short sale of a Treasury bill with more
than three months to maturity is one way to hedge the
risk.4 In the futures market, the interest rate risk on
this prospective issue could be hedged by selling the
Treasury bill contract for the month closest to the
prospective issue date. If all short rates moved up,
the hedger would make a gain on the futures market
transaction which would offset the loss on the higher
interest rate he would have to offer.
Banks, dealers, and other such financial institutions
may find futures markets helpful in achieving a partic­
ular maturity structure for their portfolios while having
adequate supplies of cash securities on hand. For ex­
ample, a dealer may need to hold supplies of a sixmonth bill to be ready for customer orders. However,
he may not want the risk exposure on this particular
maturity because he thinks its rate is likely to rise. Or, a
mortgage banker may wish to hedge the risk on rates
between the time of the mortgage loan and the time of
its sale as part of a large package of loans. By selling
a GNMA futures contract while assembling the mort­
gage package, the banker can be insured against rate
changes. If rates rise, the value of the mortgage port­
folio will fall, but that will be offset by the profits on the
short sale of the GNMA contract. If, on the other hand,
rates fall, the gain on the mortgage portfolio is offset
by the loss on the sale of GNMA futures. In this hedge,
the banker foregoes the possibility of additional profit
(or loss) and is content to profit from the origination
and servicing fees associated with assembling the
mortgages.
Not every financial transaction has an exact hedge
in the futures market. When the cash asset is different
from the security specified in the futures contract, the
transaction is called a “ cross hedge” and provides
much less protection than an exact hedge. For ex­

4 The prospective issuer could borrow a six-m onth Treasury bill and
sell it im m ediately; three m onths hence he would buy a bill with the
sam e m aturity date to return. If interest rates for that future tim e
interval rise, the security w ould be purchased more cheaply three
months hence than is currently expected. The gain on this transaction
would then offset the loss connected with issuing securities at the
higher interest rate.




ample, a securities dealer might find it profitable to
buy some certificates of deposit (CDs) and finance
them for one month. To protect against a decline (in­
crease) in the price (rates) of CDs over the interval,
the dealer might sell Treasury bill futures contracts,
assuming the movements in bill rates and CD rates
will be similar over the interval. So long as the rates
move in the same direction the dealer will be pro­
tected at least to some degree against adverse price
movements. It is conceivable, however, that the rates
could move in opposite directions. Thus, a cross hedge
is really a speculation on the relationship between the
particular cash market security held in position and
the particular futures contract involved. In a cross
hedge, the participants cannot deliver the cash secu­
rity against the contract, so there is no threat of delivery
that can be used to drive the prices on the two securi­
ties back into line as the expiration date approaches.
In contrast to financial businesses, nonfinancial
businesses and private individuals are less likely to
find a useful hedge in the interest rate futures market.
Consider the typical nonfinancial business which is
planning to issue securities to finance some capital

C h a rt 2

Futures M a rk e ts P a rtic ip a n ts ,
M arch 3 0 , 1 9 7 9
S h a re s of open in te re s t held by variou s groups

S o u rc e :

C o m m o d ity F utu res Tra d in g C om m ission.

FRBNY Quarterly Review/Winter 1979-80

39

purchase or inventory. If the rate of inflation acceler­
ates, the firm will typically be able to sell its output at
higher prices. Thus, its nominal profit and return from
the investment will typically also rise.5 This means
that a rise in inflationary expectations, which is re­
flected in the nominal rate of interest, will tend to
affect profits in the same direction as it does financing
costs. Thus, to some extent, the firm is automatically
hedged against inflation-induced changes in the interest
rate.
A similar intrinsic hedge may be available to in­
vestors on any new funds they plan to invest. Presum­
ably they want to be sure that their investment pro­
duces a certain real income or purchasing power in the
future. If interest rates move down because anticipated
inflation has fallen, then the return on any funds
invested at the lower rate will be able to buy the same
quantity of goods and services that they would have
in the circumstance where inflation and interest rates
were higher. (The real return on past savings, however,
will move in the opposite direction as inflation.)
Thus, to the extent that interest rate changes reflect
revisions in inflationary expectations, many businesses
and persons will not be in a very risky position with
regard to saving or investment plans. If, as some con­
tend, the variation in interest rates is largely con­
nected with inflationary expectations, these groups
would typically not obtain a very useful hedge in the
interest rate futures market.

Speculation
While some participants use futures markets to hedge
risk, others use them to speculate on price movements.
Speculators like the high leverage obtainable and the
low capital required for trades in futures markets rela­
tive to trades in cash markets. Speculation on interest
rates could be accomplished in the cash markets but
would typically involve greater costs than in futures
markets. For example, suppose one thinks that the
three-month interest rate in the June-September pe­
riod will be higher than the implicit forward rate for
that time interval. The short sale of a September bill in
March and its repurchase in June can produce a profit
if those high rates materialize. The costs involved in
these transactions include the dollar value of the bidask spread as well as the charges for borrowing a
security. In addition, one must have sufficient capital
to put up collateral equivalent in value to the securities

5 The firm does not, however, tend to earn nom inal profits in proportion
to prices because the tax structure collects more in real term s during
inflation. See M. Arak, "C an the P erform ance of the Stock M arket Be
Explained by Inflation C oupled with our Tax S ystem ?” (Federal
Reserve Bank of N ew York Research P a p e r).

 Quarterly Review/Winter 1979-80
40 FRBNY


borrowed or the credit standing to borrow the securi­
ties under a reverse repurchase agreement.
In futures markets, one does not pay for or receive
money for the commodity in advance. The cost of
trading in the futures market is the foregone interest
on the margin deposit (if in the form of cash) plus the
commission fees. Assuming a $70 commission, this
would amount to about $125 on a three-month bill
futures contract at current interest rates, if the contract
were held for three months. A change in the discount
rate on the futures contract of 5 basis points would
therefore recompense the speculator for his costs
(Table 2).
Besides speculating on the level of rates, some fu­
tures market participants may be speculating on the
relationship among interest rates. Such speculation
can take the form of a “ spread” trade whereby the
participant buys one contract and sells another, hop­
ing that the rate on the contract bought will fall by
more than (or rise by less than) the rate on the con­
tract sold. Also, if participants believe that the
slope of the yield curve will change in a predictable
way when the level of the yield curve changes, a
spread transaction (which involves a lower margin)
can be a less expensive way to speculate on the
level of rates.
Frequently, traders will take positions in futures con­
tracts that are related to positions in cash market
securities. A trader might think that the rate in the
futures market is out of line with cash Treasury bills.
If he feels the futures rate is low relative to the rates

T a b le 2

Change in Discount Rate on a Three-M onth
Treasury Bill Futures Contract Necessary
to Cover Cost of a Futures M arket Transaction
In basis points

Commission (in dollars)
H olding period
O ne month ............................
Three m o n t h s .......................
Six m onths ............................
Twelve months .....................

$30
.............
.............
.............
.............

$50

$70

2.0
3.4
5.7
10.2

2.8
4.2
6.5
11.0

3.6
5.0
7.3
11.8

□ •
■. U
o , h (.0 1 i)m
Basis point ch an g e = C H— ------------ .
25
w here h is the num ber of m onths the contract is held, i is the
rate of interest ob tain ab le over the period h, m is the cash
m argin, and C is the com m ission on the futures trade.
The num bers shown are based upon i = 15 percent
and m = $1,500.

on outstanding bills, he might sell the futures contract
and buy the bills in the cash market. He could then
carry the bill in position until the two rates move back
to their more normal relationship. Then the bills would
be sold and the short bill futures contract offset. These
types of trades are often called “arbitrages” by par­
ticipants in the cash m arket although they are not
arbitrages in the strict sense in which a security is
bought in one m arket and at the same time sold in
another, thereby locking in an assured return. In fact,
most arbitraging activity generally reflects speculation
on the relationship between cash and futures rates.
Use of futures markets to reduce tax liability
Individuals and institutions have also used interest
rate futures markets to reduce their taxes. One means
was through spread transactions.
Until November 1978, spread transactions in the
Treasury bill futures m arket w ere a popular means of
postponing taxes. An individual would buy one con­
tract and sell another, both for the next calendar year.
For example, in 1976, the participant might have
bought the March 1977 contract and sold the Septem­
ber 1977 contract. An important assumption was that
interest rates on all contracts would tend to move to­
gether so that the net risk was relatively small. At
some point before the end of 1976, whichever position
had produced a loss would be closed out. (In the
above example, the short position or the sale of the
Septem ber 1977 contract was the item that showed a
loss during the latter part of 1976.) That loss could
then be deducted from other income for 1976, reduc­
ing the 1976 tax bill. The contract for March 1977, on
which the gain had accrued, was not closed out until
1977 when it no longer affected the 1976 tax liability .4
W hat made Treasury bill futures particularly attrac­
tive for such spreads was the belief of many taxpayers
that, just like actual Treasury bills, they were not capi­
tal assets. In contrast, it was clear that other types of
futures contracts, not held exclusively for business
purposes, were capital assets .7 If Treasury bill futures
were not capital assets, then losses on them could be
fully subtracted from other ordinary income (providing
that n e t ordinary income did not become negative).
Capital losses, in contrast, could be subtracted from
ordinary income to a very limited extent .8
4 After the S ep te m b e r 1977 contract w as offset, another contract for
1977 w ould be sold to m aintain a balanced position. In our exam ple,
the June 1977 contract w ould be sold to counterbalance the M arch
1977 contract that w as still being held. Then som etim e in early 1977,
these two contracts would be closed out.
i E.g., Faroll v. Jarecki, 231 F.2d 281 (7th Cir. 1 9 5 6).
•C a p ita l losses can be offset against capital gains with no lim itation,
but the excess of loss over gains that m ay be deducted from ordinary
incom e in a single year is currently lim ited to $3,000.




This attraction of the Treasury bill futures m arket for
tax postponement was elim inated in November 1978
when the IRS declared that a futures contract for Trea­
sury bills is a capital asset if neither held prim arily
for sale to customers in the ordinary course of busi­
ness nor purchased as a hedge .9 Further, the IRS,
amplifying on an earlier ruling ,10 stated that the mainte­
nance of a “spread” position, in transactions involving
futures contracts for Treasury bills, may not result in
allowance of deductions where no real economic loss
is incurred.
A way that individuals can reduce taxes through
the futures m arket is by indirectly converting part of
the interest income on Treasury bills into long-term
capital gains. Suppose that the discount rate on a
bill is expected to fall as it matures. Since the mar­
ket usually regards longer dated bills as less liquid
(or as having more interest rate risk), an investor
would typically expect that a bill maturing in, say,
March 1981 would offer a higher annual discount rate
in June 1980 than it would in February 1981. Similarly,
the interest rate on futures contracts would tend to
fall as they approach expiration (their price would rise).
Pursuant to the November 1978 IRS ruling, the price
increase in a Treasury bill futures contract should,
in nonbusiness circumstances, be treated as a capital
gain for an investor. In contrast, since a Treasury bill
itself is not a capital asset, all the price appreciation
on it— from date of purchase to date of sale— would
be treated as ordinary income for tax purposes.
An investor would clearly prefer to have the price
appreciation treated as a long-term gain rather than
as ordinary income, since the long-term capital gains
tax rate is only 40 percent of that for ordinary income.
If a long position in a bill futures contract w ere held for
more than six months, the profit would be a long-term
capital gain. (Gains and losses on short positions in
futures are always treated as short-term regardless of
the holding period.) Consequently, some investors who
might normally purchase 52-week bills would have an
incentive to purchase distant futures contracts and, as
those contracts matured, sell them off to take their
capital gains. They could then invest their funds in
three-month bills. These activities would tend to raise
the discount rate on the 52-week bill. It would also tend
to reduce the required discount rate on distant futures
contracts. Thus, the discount rates on futures contracts
would be pushed below the im plicit forward discount
rate on cash bills.
There are, of course, limits on the size of the wedge
that can be driven between the forward rate on
’ Rev. Rul. 7 8 -414, 1978-2 C.B. 213.
’ 0 Rev. Rul. 77-185, 1977-1 C.B. 48.

FR B N Y Q u arterly R e v ie w /W in te r 1979-80

41

cash securities and the rate on futures contracts.
Financial businesses cannot treat profits in bill futures
as capital gains. For them, the futures contract has
no tax advantage over a cash bill. When the wedge
produced by investors exceeds the cost of arbitrage,
these financial businesses will buy long-term bills and
sell futures contracts to profit from the disparities in
rates.
Relationship between the cash and futures markets
For many commodities, the spot price and the futures
price are very closely related. Part of the explanation
is that, if a commodity is storable, it can be bought
today, stored, and sold at a future date. If the futures
price were to exceed the spot price by more than the
costs involved, arbitrageurs would buy the commodity
in the spot market— raising the spot price— and would
sell it in the futures market, lowering the futures price.
These activities would reduce the disparity between
the future price and the current price.
The relationship between cash and futures markets
for bills is somewhat different from that for other com­
modities. A three-month Treasury bill cannot be stored
for more than three months; it matures. However, a
longer term bill could be “stored” until it has three
months left to run. It is the cash market for that lo n g e r
term b ill which bears a relationship to the futures mar­
ket that is typical of agricultural and industrial com­
modities. In the case of note and bond contracts, the de­
liverable item exists throughout the life of the contract.
For example, consider what cash market securities
correspond to the IM M ’s June 1980 three-month
Treasury bill contract. This contract calls for delivery
of bills which have ninety-one days to run on June 19,
1980. Treasury bills having this maturity date will be
sold by the Treasury in two auctions— as six-month
bills on March 17, 1980 and as three-month bills on
June 16, 1980. During the first three months of its life,
the six-month bill issued on March 20, 1980 is the
commodity that could be “stored” for delivery on the
futures contract.
The funds used to purchase the six-month bill when
it is initially issued could have been invested in threemonth bills which mature on the contract expiration
date. One measure of the interest cost involved in stor­
age is therefore the foregone interest on the shorter bill
— this is the “opportunity cost” of the decision to invest
in the longer bill which is deliverable on the futures
contract. It is common to subtract that opportunity cost
from the bill price to get the “forward” price and the
corresponding “forw ard” rate; this rate can then
be com pared with the discount rate on the futures
contract.
Because in the past only three-month and six-month

42 FR B N
 Y Q u arte rly R e v ie w /W in te r 1 979-80


bills matured on Thursdays, only bills originally issued
as three-month or six-month bills could be delivered
on a ninety-day bill futures contract .11 In fact, at any
date, there was only one bill issue in existence that
could be delivered on an IM M bill futures contract.
That particular bill had between three and six months
to maturity and could be delivered on the closest threemonth bill futures contract. For longer bill futures
contracts, there was usually no exact correspondence.
There is no cash bill in existence today that could be
delivered on the Septem ber 1980, Decem ber 1980,
March 1981, and subsequent contracts traded on the
IM M . However, there are bills which have a maturity
date that may be quite close. For example, the 52week bill maturing on Septem ber 16, 1980 will have
eighty-nine days to run on June 19, 1980, while the
June futures contract calls for bills which have ninety
to ninety-two days to run on that date. By comparing
the rate on this 52-week bill with the rate on the 52week bill which matures twelve weeks earlier, a forward
rate which covers an interval close to that of the futures
contract bill can be calculated. Through this method,
a rough forward rate in the period nine months prior
to the contract’s expiration can be obtained.
How does the rate on a three-month Treasury bill
futures contract com pare with the im plicit forward rate
in the cash m arket? The futures rate on the June 1979
contract and the “forw ard” rate on the corresponding
cash bill (which matured Septem ber 21, 1979) moved
very similarly in the last ninety-one days before the
futures contract expired (Chart 3). Typically, the
spread between the two rates was less than 25 basis
points, with the forward rate somewhat higher than
the futures rate. On most other futures contracts for
three-month Treasury bills as well, the futures and
forward rates w ere fairly close in the last ninety-one
days or so before expiration.
When the contract’s expiration date was far in the
future, however, the link between its rate and the
com parable forward rate was much weaker. In fact,
spreads between forward and futures rates have at
times been over 1 00 basis points in the three to nine
months before the contract expired. Generally, in
recent contracts, futures rates have been substantially
below forward rates, and the spread between the two
appears to have been wider than it was in earlier
contracts.
Within three months of the expiration of the futures
contract, futures and forward rates appear to be kept
in reasonable alignment by investors and arbitrageurs.
An investor, for example, can on the one hand hold a
” Now that the Treasury has begun to issue 5 2 -w e e k bills m aturing on
Thursdays, there will be som e occasio ns on w hich bills issued as
5 2 -w e e k bills will be d eliverable against the three-m onth bill contracts.

six-month bill, or, on the other hand, hold a threemonth bill plus the futures contract for the month in
which the three-month cash bill matures. If the sixmonth bill is yielding more than the other combina­
tion, investors will tend to prefer six-month bills. And
their demand will tend to reduce its discount rate,
bringing the forward rate down toward the futures
rate. Similarly, if investors find the three-month cash
bill plus the futures contract more profitable, their
buying pressure on the futures contract will tend to
reduce its discount rate, bringing it down closer to
the forward rate.
Another group of market participants who help keep
rates in line are arbitrageurs. If they observe that the
six-month bill provides a forward rate which is high
relative to the futures rate, they could buy six-month
bills and sell them under a repurchase agreement
for three months;1 at the same time, they would
2
sell a futures contract. They would then have no net
investment position: the bill returned to them in three
months corresponds to the commitment to sell in the
futures market. But they would earn a profit equal to
the futures price minus the six-month bill price, the
transaction cost, and the financing cost. As arbitrageurs
conduct these activities, they put upward pressure on
the six-month b ill’s price by buying it and put downward
pressure on the futures price by selling the futures
contract. These activities of the arbitrageur usually tend
to keep the forward and futures rates within certain
bounds.
On contracts other than the nearest, however, there
is no deliverable bill as yet outstanding— that is, no
security exists that can be purchased, stored, and
delivered against the contract. Consequently, arbi­
trageurs cannot lock in a profit by taking exactly off­
setting positions in the two markets. If there is an
order flow in the futures market that is persistent,
sizable, and at variance with the prevailing view in the
cash market, it is possible for speculators to drive a
wedge between the rates on futures contracts and the
implicit forward rates in the cash market.
One notable example occurred in the spring of 1979.
Apparently, many small speculators purchased bill
futures contracts due in mid-1980, in the belief that
short-term interest rates had reached a cyclical peak
and would begin to fall sometime within a year or so.
From the end of April to the end of June, their hold­
ings rose from about 25 percent to 35 percent of the
total open interest and their net long positions ex­
panded sharply. As a result of this buying pressure
and purchases by those trying to get out of large
12 A repurchase a greem ent specifies that the seller will rebuy at a
prespecified date and price.




C h a rt 3

D iscoun t Rate on the June 1 9 7 9 Treasury
Bill Futures C o n tra c t (IM M ) and the
F o rw ard R ate in the Cash M a rk e t
P erc e n t
11. "

11.
10.
10.0

9 .5
9 .0

8

.

8.
P ercent
1.5

S pread

1.0

.5
0
_

........

5

^

I I I I I 1 ,1.11 1.11 ,1 1 1.11 111 1 ! ! 1 1 1 1 1 1 1 11 i 1 ! 1 I
O ct

Nov

1978

D ec

Jan

Feb

M ar

A pr

M ay

Jun

1979

S p re a d e quals fo rw a rd rate minus fu tu res rate.

short positions, rates dropped sharply, with the March
1980 and June 1980 contract rates falling by nearly 1%
percentage points from mid-May to the end of June.
Rates also fell on contracts with shorter maturities—
those due in the latter half of 1979.
Many other participants were net short, and some
of these were firms that felt they were arbitraging
between the cash and futures market, holding in this
case long positions in the cash bill market against
short positions in futures contracts. One of the several
cash futures operations they engaged in was a long
position in bills in the six-month area (i.e., due in
November for the most part) versus a short in the
September contract (calling for delivery of the bill to
mature on December 20 which had not been auctioned
yet). As the rates on futures contracts fell, those with
short positions faced sizable margin calls. To the ex­
tent that they then bought futures contracts to offset
their short positions and also sold their cash bills, they
greatly enlarged the wedge that was being driven be­

FRBNY Quarterly Review/Winter 1979-80

43

tween the rates in these two markets in late May and
early June (Chart 4).
The widening wedge between the forward and fu­
tures rates made arbitrage involving futures contract
sales even more profitable. But, after the shock of
seeing large losses mount on short positions and show
up in quarterly income statements, financial businesses
were reluctant to expand their short positions. The
futures and forward rates did not come back into
alignment until late in the summer when interest rates
started rising again.

Pros and cons of interest rate futures markets
Many observers of the new financial futures markets
argue that these markets permit investors to obtain
flexibility in ownership of securities at a very low cost.
Someone who expects to have funds to invest in the
period from mid-June to mid-September 1980, for ex­
ample, can lock in an interest rate by purchasing a
June Treasury bill futures contract. (For those who plan

C h a rt 4

D iscoun t R ate on the S e p tem b e r 1 9 7 9
T rea s u ry Bill Futures C o n tra c t (IM M ) and
the Fo rw ard R ate in the Cash M a rk e t

to purchase or issue other securities such as commer­
cial paper or CDs, the links between the movements
of rates in the bill futures market and the rates that
obtain on these other instruments can be weak.)
By transferring the interest rate risk to those most
willing to assume it, interest rate futures may in­
crease the commitment of funds for some future
time intervals. This could reduce the premium attached
to funds committed for that future interval relative to
funds committed for the nearer term. For example,
the yield on 52-week and nine-month bills might fall.
The resulting greater liquidity represents a gain to
investors, while the lower interest rate on Government
debt reduces the taxes necessary to service that debt.
While the provision of hedging facilities is a desir­
able aspect of interest rate futures markets, much of
the activity appears to be speculative, and this has
created some concern. One such concern is that
speculation in the futures markets might push the
prices of certain Treasury bills out of line with the

C h a rt 5

Open In te re s t in Treasury Bill Futures
C o n tra c ts for June 1 9 7 8 and June 1 9 7 9
N um b e r of c o n tra c ts

P e rc e n t

P erc e n t

W e e k ly a v e ra g e s , w e e k ending e a c h W e d n e s d a y .
Total open in te re s t as of last trading day
is in d ic a te d by dots.
S p re a d e q u a ls fo rw a rd rate minus futures rate .

 Quarterly Review/Winter 1979-80
44 FRBNY


S o u rc e :

In te rn a tio n a l M o n e ta ry M a rk e t.

prices of other securities. Because speculation is very
inexpensive, entry into the futures market could be
much more massive than entry into the cash market.
Heavy demand in the futures market could be trans­
mitted to the cash market by arbitrageurs. According
to some analysts, the bill deliverable on the June 1979
contract was influenced by activities in the futures
market. The June contract specified delivery on the
Treasury bill due September 20 and only that bill. While
the Treasury had sold $5.9 billion of bills with that
maturity date, the Federal Reserve, foreign official ac­
counts, and small investors held about one half. Thus,
it appeared likely that the available trading supplies
would amount to about $2 billion to $2 1 billion.
/2
However, open interest in the June 1979 contract
stood at about 4,300 contracts, the equivalent of about
$4.3 billion of bills at the end of May (Chart 5). This
substantially exceeded the prospective trading sup­
plies. During the spring, dealers reported that trading
supplies in the September 20 bill were very thin and
that it traded at a rate that was out of line with other
bills. For example, it averaged about 4 basis points be­
low the rate on the bill that was due a week earlier.
Since investors usually require a higher rate when ex­
tending the maturity of their bill holdings, the 4 basis
point difference provides a rough lower limit on the
pressure that was exerted on the June contract and its
spillover on the cash market.
Some observers argued that some investors were
desirous of taking delivery because they thought there
would be further declines in interest rates. Others
pointed out that some people who had booked gains
on long positions wanted to qualify for long-term capi­
tal gains. In any event, about a week before the
contract expiration there was news of large increases
in the money supply and industrial production which
the market interpreted as indicating that a recession
was not imminent and that interest rates would not fall
immediately. This view probably contributed toward
reducing pressure on the contract, and it was liqui­
dated in an orderly fashion. Deliveries turned out to be
a then record high of $706 million of bills due Septem­
ber 20, 1979, about a third of the available trading sup­
plies of that bill. Deliveries on the September contract
were somewhat lower, although still sizable (Chart 6),
and deliveries on the December contract amounted to
$1 billion.1 Over the last month before delivery, the
3
rate on the bill deliverable on the December contract

13 A part of the large am ount of deliveries on the three 1979 contracts
m ay reflect investors’ preference for ordinary incom e losses instead of
capital losses, a transform ation that can be achieved by taking delivery
on a contract on w hich one has booked a loss. See Arak, "Taxes,
Treasury Bills, and Treasury Bill Futures’’.




averaged 8 basis points below the rate on the bill due
one week earlier. As a result of these events, the
question arises whether supplies of the deliverable
bill are sufficient to prevent pricing dislocations.
In contrast to bill futures, other futures contracts,
notably in notes and bonds, have adopted a market
basket approach to deliverable supplies. By allowing
a variety of issues to be delivered, the contracts greatly
reduce the possibility of a squeeze. If, for example,
the September 13 bill had also been deliverable against
the June contract, then traders would have had no
incentive to deliver the September 20 bill at a rate
that was below that on the September 13 bill. The
mere availability of the other bill would therefore have
provided a floor for the rate on the September 20 bill.
This analysis of bill futures has led some to suggest
that, instead of a single deliverable issue, the deliver­
able security should be any one of a “ basket” of
Treasury bills with different maturity dates. However,
others see disadvantages with the “ basket” approach.
In any event, the CFTC has authorized the new ex­
changes such as the ACE and the Comex to trade

FRBNY Quarterly Review/Winter 1979-80

45

futures which involve bills maturing in a different week
of the quarter than the IMM bill contracts. If these mar­
kets grow and become more active, there should be
less likelihood of pressure on the one particular March,
June, Septem ber, or Decem ber bill whose futures
contract is traded on the IMM.
Finally, to many of the regulators, the size of the
required margin deposit is a key issue. Larger margins
would help insure the exchanges against possible de­
faults as well as discourage excessive speculation with
little capital. Moreover, they might make participants
more aware of the possibilities of loss inherent in
trading in interest rate futures. In early October 1979,
the minimum initial margin on Treasury bill futures
contracts at the IMM was only $800, and a 32 basis
point move in the rate on one of those contracts
could have wiped out the entire margin. Now that
margin is $1,500, which gives better protection to the
exchange and the contract.
Concluding remarks
Interest rate futures markets have generated much
new activity within a very short time; they have also
generated some apprehension on the part of those
concerned with orderly marketing and trading of the
United States Government debt. Thus far, neither the
extrem e enthusiasm nor the worst worries appear to be
justified.
Interest rate futures markets can provide inexpen­
sive hedging facilities and flexibility in investment.

Digitized46 FRASERY Q u arterly R e v ie w /W in te r 1979-80
for FR B N


But, to date, participation by financial institutions that
might have such a need has not been large. Rather, it
appears that participants have so far been primarily
interested in either speculating on interest rates or
reducing tax liabilities. These participants have been
encouraged by fairly low margins. Until recently, the
exchanges had shown a penchant for reducing these
margins, but in O ctober 1979 when interest rates
fluctuated widely following the Federal Reserve Sys­
tem ’s adoption of new operating procedures, several
exchanges raised margins substantially.
Most of the time, the financial futures m arkets have
operated fairly smoothly. In general, there has been no
greater volatility in the prices of bills which are deliver­
able on futures contracts than in the prices of other
bills. And despite the huge run-up in open interest in
some of the bill futures contracts, actual deliveries have
not been large enough to disrupt the operation of the
cash market. However, on several bill futures con­
tracts, the price of the deliverable bill was pushed
slightly out of line with prices on other issues with
adjacent maturities. The CFTC, the Treasury, the
Federal Reserve, and m arket participants themselves
will have to continue to observe futures m arket activ­
ities to assure that significant problems are not build­
ing up.
Interest rate futures m arkets have already provided
an arena for some institutions to m anage interest rate
risk. And, as these markets mature, their economic
usefulness may come to be more widely appreciated.

M arcelle Arak and Christopher J. McCurdy

C h a rt 1

Incom e grow th slow ed in late 1 9 7 9 . . .
B illions of 1972 dollars

. . . but consum er spending c o n tin u ed
to rise . . .
B illions of 1972 dollars

. . . as consum ers sharply redu ced th e ir
rate of saving.
P e rc e n t

^ C e n te r e d th re e -m o n th m oving a v e ra g e .
S o u rc e : U n ited S ta te s D e p a rtm e n t of C o m m e rc e ,
B ureau of E co nom ic Analysis.




The
business
situation
Current
developments
The economy ended 1979 with an unexpected display
of strength. Despite a weakening in automobile sales
and production and in housing, consumer spending
advanced quite strongly, and employment posted sur­
prising gains. At the same time, the sudden heightening
of world political tensions at the year-end raised the
possibility of new upward forces spreading from a
defense buildup. Nevertheless, the weakness in the
automobile industry and in housing, the sharp fall in
the savings rate, and the stubborn persistence of in­
flation pose uncertainties over the prospects of further
gains in business activity.
Consumer spending provided most of the strength to
the economy during the final quarter of 1979. Purchases
of apparel, general merchandise, and services
paced the gain. In contrast, sales of new domestic
cars fell sharply to an annual rate of 7.2 million units,
1.3 million units below the sales rate posted in the
third quarter.
With the drop in new car sales, stocks of unsold
models mounted quickly, and United States automak­
ers closed the year with a heavy inventory of
cars. In response to the inventory imbalance, auto­
makers curtailed production and laid off nearly 200,000
workers. Outside the automotive sector, however, there
was little evidence of imbalances. Indeed, because
businesses have generally followed cautious inventory
policies, the surge in year-end sales depleted stocks
of some products so that isolated shortages were
reported.
In spite of the major employment layoffs in the auto­
mobile industry, employment continued to expand in
the final quarter. In fact, although the automobile lay­
offs increased over the course of the quarter, the
monthly gain in payroll employment accelerated and,
in December, amounted to more than 300,000 persons.

FRBNY Quarterly Review/Winter 1979-80

47

C h a rt 2

T ig h ten in g m ortgage m arkets . . .
P e rc e n t
13.0
P rim a ry m o rtg ac e ra te s

C om m itm ents

12.0

tw e n ty -fiv e y e a r)

11.0

f
J

*

1 ____

10.0

losed loans

9.0
8.0

I I I I I I 1 1 1 ,1,-1,
1977

..................I n

I I i 1 1 1 .1 1 1 1 L1979

1978

. . . have co n trib u te d to the w eakenin g
in h o m e -b u ild in g a ctiv ity . . .
M illion s of units
3 .5
H o u s in g s ta rts and p e rm its
___~ ____ I
.A
3 .0
*__ , / -V- W ----

I
P erm its
V,
1967 = 100
S c a le — ►

2 .5
2.0

1.5
1.0

P e rc e n t

111

111!
1977

m

n

, /
S ta rts
\
^ A nnual rate
— S c a le
I I I I I I I lL l l
1978

I I I I I I I I I LJ_
1979

. . . and ad d ed to the rise in the
consum er price index.
P e rc e n t
14
12

10
8
6

4

1977

1978

1979

S o u rc e s : F e d e ra l H om e Loan B ank Board;
U n ited S ta te s D e p a rtm e n t of C o m m e rc e , B ureau of
the C e n s u s ; U n ited S ta te s D e p a rtm e n t o f L a b o r,
B ureau of L a bor S ta tis tic s .

The overall rate of joblessness stayed within the nar­
row 51 to 6 percent range of the past eighteen
/2
months and ended the year at 5.9 percent. At the
same time, the ratio of employment to population rose
to a record high in the final quarter.
The growth of employment bolstered earnings, but
the gain in income was outstripped by inflation, which
eroded the purchasing power of households’ incomes.

48 FRBNY Quarterly Review/Winter 1979-80


Consumers kept up their spending by continuing to
borrow and by reducing savings, and the overall rate
of savings declined sharply further (Chart 1). A key
question in the outlook, of course, is whether consum­
ers can continue to borrow so much and save so little.
In the last inflationary outburst, in 1974, the savings rate
held up in part because of the widespread expectation
that double-digit inflation would soon disappear. This
time around, in contrast, the fear that inflation is un­
likely to diminish soon appears to be pushing consum­
ers to spend ahead of their incomes notwithstanding
the growing strains on family budgets.
While consumer spending rose, business spending
on fixed capital weakened in the final quarter of 1979.
Shipments of nondefense capital goods dropped
sharply, led by a decline in truck and automobile
deliveries. Other near-term barometers of capital
spending, however, are mixed— new orders have risen,
while contracts for commercial and industrial build­
ings have declined. Looking to 1980 as a whole, the
November-December Commerce Department survey of
planned plant and equipment spending points to an
advance of 10.9 percent. This would represent a marked
slowing from the spending gain of 14.7 percent posted
in 1979. After allowing for the effect of rising prices,
the planned increase suggests only very modest real
growth.
Residential fixed investment also weakened in the
closing months of 1979, as mortgage credit became
less available and available only at substantially high­
er interest rates. Housing starts, as well as permits to
build in the future, declined sharply in the closing
months of the year (Chart 2), and sales of new and
existing homes slumped. New single-family house
sales in November actually posted their sharpest de­
cline in almost a decade.
In the face of weakening demand, signs of a soften­
ing in housing prices began to appear. Indeed, several
broad measures of house prices recorded actual de­
clines in November. A sustained weakening in home
prices could, of course, affect the economic outlook.
In the inflationary environment of the 1970’s, housing
had emerged as a primary hedge against ever-rising
prices and the rapid run-up of home prices served to
buttress inflationary expectations. In the process, con­
sumers tapped their ballooning housing equity—
through stepped-up borrowing and home sales— to
finance increased expenditures. To the extent that
future increases in real estate values become less
certain, an important base of inflationary expectations
and consumer spending would be eroded.
Some continued weakening in housing activity
seems likely as a result of the tightened mortgage
market. Interest rates on mortgage loan closings have

risen to record levels, and rates on new mortgage
commitments have increased even more sharply. In
December, the rate on a 25-year mortgage with a 25
percent downpayment was close to 13 percent— up
about 2 1 percentage points since the start of the year
/2
and more than 1 percentage point in just the last two
months. At the same time, deposit flows at thrift insti­
tutions have slowed markedly. Part of this slowing
could be offset if the newly introduced 2 1 2 -year sav­
/
ings certificate proves successful in attracting funds to
thrift institutions (see article beginning on page 54).
The temporary Federal suspension of state usury mort­
gage rate ceilings could also cushion the prospective
decline in housing to some extent.
The rise in m ortgage rates added substantially to the
upward spiral in the consumer price index in the clos­
ing months of 1979. The rise in the homeownership
component of the index accelerated markedly, not just
because of rising m ortgage costs but also because of
continuing increases in the housing prices that are
used in the construction of the index. (These are Fed­
eral Housing Administration m arket price data which
tend to measure the lower priced segment of the
housing market. They differ from other measures of
housing prices— Census Bureau and National Associa­
tion of Realtors— not used in the index, which appear
to be much broader and have recently shown declines.)
Over the first eleven months of 1979, the consumer
price index rose at an annual rate of 13 percent.
Excluding the homeownership component, however,
the rise in consumer prices slowed late in the year
(bottom panel of Chart 2). From Decem ber 1978
through November 1979, consumer prices other than
homeownership costs rose at an annual rate of 10.4
percent.
Measuring changes in consumer prices is a difficult
undertaking. Last year’s run-up in mortgage rates and
house prices appears to have led to an overstatement
in homeownership costs. Only current prices of houses
and current m ortgage interest rates enter the consum­
er price index. In a period of rapid inflation the index
also tends to exaggerate underlying price changes be­
cause it measures the cost of purchasing a fixed mar­




ket basket of items whose composition does not
change. Consumers do change their spending habits
and tend to cut back on items whose prices rise par­
ticularly rapidly. Recent reductions of energy con­
sumption by households are the most striking example.
The deflator of personal consumption expenditures, an
alternative measure of consumer buying power used in
the construction of national income accounts and now
published monthly, avoids both these problems of the
consumer price index. The deflator uses a measure
of current homeownership costs which is more difficult
to construct and which takes account of changes in
consumer spending patterns. In the first eleven months
of 1979 this measure showed a consumer price infla­
tion of 10 percent at an annual rate, or 3 percentage
points below the consumer price index.
The consumer price index is the nation’s most promi­
nent barom eter of price change. As such, its overesti­
mate of the rise in the cost of living can create actual
upward price pressures. It tends indirectly to raise in­
flation by reinforcing expectations of high rates of
price advance and strengthens workers’ demands for
large catch-up wage increases. At the same time, the
exaggerated increase in the index directly aggravates
inflation by raising the wages of more than 8 V2 million
workers who are covered by cost-of-living adjustments.
Regardless of the problems of measurement,
price pressures remain intense. Despite evidence of a
weakening in some components of aggregate demand,
inflation continues to pose the greatest threat to pros­
perity in the 1980’s. Prospects for any quick reduction
of inflation are limited not just by the jump in world
oil prices but also by the legacy of inflation in the past
decade. Over these years expectations of virulent in­
flation have become increasingly entrenched. The ap­
parent softening in home prices is one straw in the
wind pointing to the possibility of dampening these ex­
pectations. More concretely, the monetary actions of
late 1979 which were designed to slow the growth of
the monetary aggregates will act to reduce the under­
lying rate of inflation in the 1980’s. M aintaining judi­
cious monetary discipline is a prerequisite for a re­
turn to sustained price stability.

F R B N Y Q u arterly R e v ie w /W in te r 1979-80

49

Effectiveness of
the first-year
pay and price
standards
In O ctober 1978 the Administration introduced a vol­
untary program of pay and price standards as part of
a larger initiative against inflation. Even though the
program was aimed at restraining inflation, the rate
of increase in the consumer price index accelerated
from 8.4 percent in the year prior to the standards to
12.2 percent in the program ’s first year. This sharp
jump, however, largely reflects an acceleration in
prices outside the pay and price guidelines. Indeed,
looking at the sources of inflation and the pattern of
pay hikes during the past year suggests that the pro­
gram has had some effect in restraining inflation.
The interdependence of wages and prices plays a
crucial role in the inflation process. In general, labor
compensation accounts for the largest part of the cost
of producing goods and services, while prices deter­
mine the purchasing power of wages. Accordingly, the
guidelines set a standard of 7 percent maximum annual
increases in labor compensation, and maximum annual
price increases averaging roughly 5.75 percent. The
ceiling on average price rises was set below the pay
standard to reflect a long-run trend in labor productiv­
ity increases.1 In addition, alternative rules were de­
vised for situations in which compliance with the basic
price standard would not have been feasible.
Prices and the price standard
The im pact of the price standard needs to be gauged
in light of the flexibility of the program.2 Essentially,
1 For a discussion of recent productivity trends, see Paul Bennett,
“ A m erican P roductivity Growth: Perspectives on the S lo w dow n” , this
Q uarterly R eview (Autum n 1 9 7 9 ), pages 25 -3 1 .
2 The first-year standards are discussed in detail in C ouncil on W age
and Price Stability, P ay a n d P rice S tandard s: A Com pendium
(June 1 9 7 9 ).


50 FRBNY Quarterly Review/Winter 1979-80


each company was asked to limit increases in its
average selling price of goods to 0.5 percent below
its own average rate of price increase during 1976
and 1977. Alternatives to the basic price deceleration
standard w ere specified for cases where companies
experienced large, uncontrollable cost increases (e.g.,
for energy and raw m aterials costs), w here producers
could not effectively control the price of their output
(e.g., raw food prices), or where controlling a price
would have been inconsistent with the overall objec­
tive of reducing inflation (e.g., interest rates).3 In these
instances, directly limiting price increases would have
been an unrealistic or counterproductive strategy, and
other standards w ere designed to place some limit on
how much a com pany’s final selling price could ex­
ceed its costs.
In short, com pliance with the price guidelines did
not always require companies to reduce their rates of
price increase. Indeed, depending on the sources of
the price increases, the rate of inflation could rise
without firms necessarily being out of com pliance. In
fact, the acceleration of the consumer price index dur­
ing the first year of the program largely resulted from
extraordinary increases in the costs of energy and
home buying which w ere effectively outside the direct
influence of the price standard. In response to OPEC
(Organization of Petroleum Exporting Countries) price
increases, consumer energy prices jumped 35 percent.
Due to the run-up of house prices and higher m ortgage
interest rates, the costs of purchasing a home rose 18
percent. Food prices, also outside the standard, posted
3 The link betw een higher interest rates and low er rates of inflation
is discussed in a talk by Peter Fousek, entitled "M o n e ta ry Restraint,
Interest Rates, and Inflation” , this Q uarterly R eview (Autum n 1 9 7 9 ),
pages 11-12.

a 10 percent increase in the first year of the program.
This substantial rate of increase was down only slightly
from the exceptionally large food price rise in the pre­
vious year.
Aside from the price run-ups for energy, home buy­
ing, and food, which combined represent about half
of the consumer price index, consumer price increases
were more moderate. The prices of items such as
rent and most manufactured goods and services—
which were more directly under the influence of the
first-year price standard— advanced at about a 7 per­
cent rate during the first year of the program, only
slightly more than in the year before (Chart 1). The
small acceleration in these prices is not surprising
since higher energy costs raise production and distri­
bution costs. Despite this slight price acceleration,
there is little evidence that many companies flagrantly
violated the price standard.

C h a rt 1

C o nsu m er P rices
During the firs t y ear o f the pay and price
g u id e lin e s , the consum er price index
ju m ped sharply . . .
P e rc e n t
14

All item s
12
10
8

6
4
2

I

0

O c to b e r 1 9 7 7O c to b e r 1978

Pay and the pay standard
Since labor compensation is by far the largest single
cost of production for most companies, moderation
in pay increases can play a key role in any effort to
restrain inflation. Compliance with the first-year pay
standard basically required that average increases in
compensation be held to no more than 7 percent an­
nually. Legally mandated labor costs, such as employer
contributions to social security, were exempt from the
pay standard, as were increased costs associated with
maintaining existing health and pension plans without
improvements in benefits. Because of these exemp­
tions, the most visible impact of the pay standard
should be on money wages, excluding fringe benefits.
Average wage increases slowed slightly during the
first year of the pay standard. According to the em­
ployment cost index, private nonfarm hourly wages
rose 7.7 percent in the year ended September 1979,
compared with an 8.0 percent increase in the previ­
ous year. Similarly, average hourly earnings (adjusted
for overtime and interindustry shifts in employment)
also show a moderation in wage gains. Compensation
per man-hour, which is a broader pay measure includ­
ing fringe benefits and payroll taxes in addition to
wages, shows a slight acceleration in the past year.
Part of this acceleration reflects higher social security
contributions.4
The overall moderation in pay reflects a wage slow­
down in the nonunion sector, which represents three
fourths of the work force. Nonunion wages rose 7.3
percent in the first year of the program, compared
with 8.0 percent in the preceding year. In contrast to
4 All th e se pay m e a s u re s are p u b lis h e d by the B ureau of L a b or
Sta tis tic s.




O c to b e r 1 9 7 8O c to b e r 1 979

. . . larg ely re fle c tin g in crea s es in p rices
ou tsid e the in flu e n ce of the program . . .
P e rc e n t
18

Energy, food, and hom e buying
16
14

12
10

8
6
4
2

j

0

O c to b e r 1 9 7 7O c to b e r 197 8

O c to b e r 1 9 7 8 O c to b e r 1979

. . . o th e r price in crea s es w ere
m ore m o d e ra te .
P e rc e n t
8

O ther item s

6
4
2

0

—
O c to b e r 1977O c to b e r 1 978
S ource:

..... I
O c to b e r 1 9 7 8 O c to b e r 1979

U nited S ta te s B ureau of L a bor S ta tis tic s .

FRBNY Quarterly Review/Winter 1979-80

51

the nonunion sector, union workers’ wages accelerated,
rising 8.4 percent following a 7.9 percent increase in
the year before (Chart 2).
The slowdown of nonunion wages is unexpected,
given economic developments in the past year. An im­
portant factor affecting nonunion pay is the demand for
labor relative to the supply. When there are many job
openings relative to the number of individuals seeking
work, employers generally offer larger pay increases to
attract and maintain adequate work forces. During the

year following the announcement of the pay standard,
the labor market was fairly tight, as employment con­
tinued to grow and the unemployment rate held steady.
Yet, despite the continued growth of demand for labor
relative to supply, nonunion wage increases slowed.
It therefore seems likely that nonunion wages were
restrained by the pay standard.
Further support for the view that the pay standard
restrained nonunion wage gains comes from private
surveys of compensation plans and practices for white-

C h a rt 2

E m p lo y m e n t C o st In dex
P e rc e n ta g e cha n g e s
9 .5

9 .0

□

S e p te m b e r 1977S e p te m b e r 1978

Wage increases slowed under
the pay standard . . .

S e p te m b e r 1 9 7 8 S e p te m b e r 1979

. . . due to smaller nonunion raises.

Union wages accelerated.

8 .5

8.0

7.5

7 .0

6 .5

6.0

5 .5
S o u rc e :

U n ite d S ta te s B u rea u of L a b o r S ta tis tic s .

Average W hite-Collar Salary Increases*
In percent

C om pensation survey
Sibson & Co., Inc., Princeton, N ew Jersey ................................................. ...........
C om pensation Resources, Franklin Park, New Jersey .......................... ..........
H ew itt A ssociates, Lincolnshire, Illinois ........................................................ ..........
A m erican C om pensation A ssociation, S cottsdale, A rizona ................

ly /ts
actual
increase
8.1
8.2
8 .3 -8 .5
8 .4 -8 .5

1979
planned
in c re a s e f
8.3
8.4
8 6 -8 .7
8.6

* In creases vary from one survey firm to another because of the different com panies in their sam ples
and m inor d efinition al d ifferences. M ost com panies use ca len d a r-y e a r budg et periods,
t As of S ep tem ber 1978 (prior to pay sta n d a rd ).


52 FRBNY Quarterly Review/Winter 1979-80


1979
actual
increase

N u m b er of
com panies
surveyed

7.7
7 .6 -7 .7
7 .8 -8 .0
7.8 -8 .2

459
524
414
1,100

collar employees (table). W hite-collar workers m ake
up over half of the nonunion work force. These surveys
show that in Septem ber 1978, just before the an­
nouncement of the pay standard, firms planned to
raise w hite-collar pay scales in 1979 by more than the
increases granted for 1978. Under the program, how­
ever, actual 1979 salary increases on average turned
out to be between Vi and 1 percentage point less than
originally planned.5 These actual 1979 pay increases
were sm aller than the 1978 increases. Responses to
additional questions in several of the surveys indicated
that a majority of firms w ere paying close attention to
the pay standard and that a large proportion had re­
duced their salary budgets to comply.6
In contrast to the nonunion sector, union wages ac­
celerated during the first year of the program. As a
result, judging the effectiveness of the guideline is
more difficult. The acceleration of union wage in­
creases reflects, to a degree, factors outside the con­
trol of the voluntary pay standard. Sizable cost-of-living
adjustments (COLAs) w ere received by many workers
whose contracts w ere not even scheduled for renego­
tiation, w hereas the pay standard applied only to new
contracts. The unusually large number of collective
bargaining agreements scheduled for negotiation in
1979 also raised average union wage increases. Typi­
cally, multiyear labor contracts “front load” wage in­
creases; that is, a large proportion of the contracted
w age increase is paid at the start of the contract term.
One reason for the larger average union pay raises
during the first year of the program is that more work­
ers received front-loaded wage increases in 1979 than
in 1978.
Due to the design of the pay standard, even those
union wage settlements which w ere very high could
technically be in com pliance with the program. In fact,
virtually all the m ajor contracts reviewed by the Coun­
cil on W age and Price Stability were found to comply.
The apparent inconsistency of high w age agreements
with a program of pay restraint reflects alternative
methods of measuring the COLA. While the pay stan­
dard assumed a 6 percent annual rate of inflation in
the calculation of the COLAs, most new contracts w ere
negotiated under the assumption that 8 or 9 percent
5 In the past, average planned and subsequent actual pay hikes had
been about equal.
* T w o surveys directly asked w h e th e r com panies had reduced salary
increases in response to the pay standard; affirm ative responses
w ere given by 63 percent of the com panies in the Sibson survey
and 48 percent in the H ew itt A ssociates survey.




rates of inflation would prevail over the next few years.
Indeed, the three-year contracts in the trucking, rub­
ber, electrical equipment, and auto industries provided
for large compensation increases, ranging from 30 to
40 percent, well over the 22.5 percent allowed under
the standard.7 Yet each of these three-year contracts
assumed a 9 percent annual rate of inflation. Because
over two thirds of the wage increases will be generated
by COLAs, the official 6 percent inflation assumption
reduces the computed costs of these contracts by 6 or
7 percentage points, bringing them closer to technical
com pliance levels. Further reducing official cost esti­
mates of the contracts was the standard’s exemption
of certain costs associated with health and pension
benefits.
Conclusion
Despite the spurt in consumer prices, the pay and
price standards can be credited with some success in
their first year. The pay standard appears to have
restrained w age increases for a m ajority of workers.
Potentially, this has m ade the price standard more
feasible for firms with large labor costs. Prices have
certainly accelerated in some sectors during the past
year, but these extraordinary increases largely reflect
developments outside the domain of the program.
The voluntary standards were never expected to
succeed single-handedly in reducing the inflation rate.
Rather, they w ere aimed at helping fiscal and mone­
tary policy restrain inflation. Without moderation of
underlying demand pressures, the long-run effects of
voluntary guidelines would be negligible. To the extent
that the standards reduce the upward momentum of
wages and prices and lower inflationary expectations,
fiscal and monetary restraint can have a greater im­
pact on inflation, and adverse effects on unemploy­
ment and real economic growth will be reduced.
The greatest challenge for the program in the com­
ing year is to set attainable standards that resolve the
pay im balances which arose in the first year, while still
acting as an effective constraint on overall pay and
price increases. Union workers on average received rel­
atively large pay hikes. This sets a precedent for other
unions in upcoming negotiations and for nonunion
workers to get catch-up raises. In the context of the
overall effort to achieve price stability, the standards
will play a demanding but potentially very useful role.

1 The contracts in these four industries covered nearly 40 percent
of all w orkers w ith new contracts negotiated in 1979.

Paul Bennett and Ellen Greene

FR B N Y Q u arterly R e v ie w /W in te r 1979-80

53

The
financial
markets
Current
developments
C h a rt 1

S h o rt-te rm rates changed direction
s e v e ra l tim es during the fourth quarter,
refle c tin g u n s e ttled conditions in the
m oney m arke ts .

5.00L-L
* T h is y ie ld is a d ju s te d to tw e n ty -y e a r m a tu ritie s and
e x c lu d e s bond s w ith s p e c ia l e s ta te tax p riv ile g e s .
S o u rc e s : F e d e ra l R e s e rv e B ank o f N ew Y o rk , B o a rd of
G o v e rn o rs of the F e d e ra l R e s e rv e S ys te m , and M o o d y ’s
In v e s to rs S e rv ic e , Inc.

54 FRBNY Quarterly Review/Winter 1979-80



The financial markets went through a period of turbu­
lent adjustment during the fourth quarter, as market
participants reacted to the Federal Reserve’s Octo­
ber 6, 1979 policy package, shifting views of the econ­
omy’s prospective performance, and a series of
unsettling developments in the Middle East. On Octo­
ber 6, the Board of Governors of the Federal Reserve
System unanimously approved an increase in the dis­
count rate to a record 12 percent, and imposed an 8
percent marginal reserve requirement on the managed
liabilities of member banks and certain other institu­
tions. On the same day, the Federal Open Market Com­
mittee (FOMC) announced that open market operations
would be conducted with greater emphasis on mea­
sures of bank reserves to slow monetary growth and
achieve the 1979 targets for the monetary aggregates,
while permitting the Federal funds rate to vary within
a broad range. The markets’ adjustment to the greater
variability in short-term interest rates which followed
the System’s actions was complicated by large revi­
sions to the October money supply data as well as
unexpected and often conflicting signals of the under­
lying strength in the economy. In this uncertain en­
vironment, it was not surprising to see interest rates
change direction several times during the course of the
fourth quarter (Chart 1).
Short-term interest rates moved sharply upward im­
mediately following the October 6 policy actions and
showed considerable variability, as market participants
adjusted to the greater volatility in the Federal funds
rate. For years, the financial markets had viewed the
Federal funds rate as a clear yardstick of the Federal
Reserve’s policy intent. Now the markets had to find
their own levels. In the five-day period following the
Federal Reserve’s policy actions, the Federal funds rate
increased to an average level of 13.0 percent from 11.9
percent in the preceding five-day period. At the same

time, the spread between the high and low daily rates
during the course of a week increased from 84 basis
points in the five-day period prior to the October 6
policy actions to 182 basis points in the week following
these actions. The spreads between the high and low
daily rates within a week remained quite large for the
next few weeks, but began to narrow again by midNovember as the financial markets adapted to the new
operating procedures.
The stock market, like the money market, was very
unsettled for several days following the October 6
policy actions. Stock prices plunged amid often heavy
trading, reaching the lowest levels since June 1979.
By late October, the stock market began to stabilize
and prices gradually moved upward, attaining by midDecember the pre-October levels.
Following the sharp increases in short-term interest
rates after the October 6 policy actions, rates declined
considerably from late October to late November,
although not totally reversing the initial upward swing.
Most strikingly, the Federal funds rate— for which the
FOMC specified a broad range of 111 to 151 percent
/2
/2
— declined to about 13 percent from rates near the top
of the range. In part, this reversal was due to a sub­
stantial reduction of monetary growth, which became
apparent in late October, from the very rapid pace pre­
vailing on average over the previous six-month period.
The slower monetary growth was accentuated by large
revisions to the weekly data. With monetary growth
showing evidence of slowing, it appeared that monetary
policy would not need to become more restrictive amid
signs of slowing economic activity and moderating
credit demands.
In late November and early December, the financial
markets’ assessment of the outlook for rates shifted
once again. Not o n ly did the in co m in g d ata suggest
continuing rapid inflation, but retail sales and employ­
ment showed unexpected strength. Meanwhile, the
dollar suffered from bouts of severe weakness in the
foreign exchange markets, and the prices of commodi­
ties, particularly of precious metals, began to spiral
rapidly upward once again. The financial markets were
further unsettled by developments in Iran during this
period. Upward pressure on short-term rates resumed,
and the Federal funds rate increased to about 13%
percent by late December. In the final two weeks of the
year, the market seemed to ignore the rather strong
increase in personal income and began to stabilize,
partly because of evidence of some weakening in the
housing market.
Long-term rates and rates in the Treasury bill
futures market generally mirrored the pattern in short­
term rates, although the swings in the long-term rates
over this period were not nearly so large. Rapid




inflation continued to be the predominant concern in
the long-term markets. Unlike the initial reaction to
the November 1978 policy initiatives, long-term sectors
moved higher immediately following the Federal Re­
serve’s October actions, suggesting that the market
was skeptical whether these policy moves would be
adequate to break the inflationary spiral. The market
for three-month Treasury bill futures— while moving up
and down with developments affecting the cash market
— continued to suggest a market expectation of grad­
ually declining short-term rates through mid-1981. The
yield on the September 1981 contract fluctuated in a
range from 8.35 percent to 9.40 percent while, on the
December 1979 contract, rates ranged from 10.19
percent to 12.51 percent.

C h a rt 2

G row th of the m onetary a g g re g a te s slow ed
in the fourth q u a rte r. For the year, the
F e d e ra l R e s erv e a tta in e d M1 and M 3 grow th
c o n s is ten t w ith the a nnual ta rg e ts.
P e rc e n t
10

FO M C ta rg e t ran ge

M1

^

~

I

I

^ 3%

I

.... .

I

FO M C ta rg e t ran ge

£

M3

FO M C ta rg e t ran ge
\ - ---4
9%
^ '8 .1
^ 6%

10
*

_L

±

±

I

u
IV

1979

IV 1978
to
IV 1979

D a ta re fle c t Jan u a ry b e n c h m a rk revisio n s.
* T h e annual ta rg e t fo r M1 w a s o rig in a lly s e t at 112 to 4 ’/ 2
/
p e rc e n t, b a s e d on the a s s u m p tio n th a t grow th of A TS
and N O W a c c o u n ts w ou ld re d u c e M1 g ro w th 3 p e rc e n ta g e
points. S in c e the a c tu a l re d u c tio n w a s only ab o u t 11
/2
p e rc e n ta g e p o in ts, the e q u iv a le n t a d ju s te d ta r g e t for
M1 is 3 to 6 p e rc e n t.
S o u rc e :
S ys te m .

B o a rd of G o v e rn o rs o f th e F e d e ra l R e s e rv e

FRBNY Quarterly Review/Winter 1979-80

55

In the second and third quarters of 1979, any pros­
pects for an immediate decline in short-term interest
rates had been dimmed by very rapid growth of the
monetary aggregates, the pace of inflation, and the
strength of the economy. In the fourth quarter, how­
ever, growth of the monetary aggregates slowed
considerably. Mx growth, which had averaged almost
9.0 percent in the second and third quarters, slowed
to 5.1 percent in the fourth quarter. Moreover, growth
of time deposits at banks and thrift institutions also
slowed in the fourth quarter, resulting in more mod­
erate expansion of the broader aggregates as well. At
the October FOMC meeting, the Committee established
an objective of 4.5 percent for
growth for the final
three months of 1979 and 7.5 percent for M2 and M3
growth. The FOMC was willing to accept somewhat
slower growth than this to counterbalance the exces­
sive rates of expansion in the second and third quar­
ters. As a result of attaining monetary growth below
these objectives during the October-December period,
the Federal Reserve also achieved its objectives for
Mj and M3 over the period from the fourth quarter of
1978 to the fourth quarter of 1979, while M2 growth was
slightly above the upper end of its range (Chart 2).
Throughout 1979, the broader aggregates were
bolstered by substantial flows of funds into six-month
savings certificates. In October, largely because of
the widespread attention given the rapid increase in
short-term rates following the Federal Reserve’s Octo­
ber 6 policy actions, the public’s holdings of six-month
certificates at banks and thrift institutions increased
a re co rd $31.7 b illio n , c o m p a re d w ith an average
monthly gain of $12.2 billion over the previous three
months. This large sum, however, did not represent a
substantial amount of additional funds for these insti­
tutions. Savings deposits and small time deposits other
than six-month certificates were converted into highyielding six-month certificates, leading to slower growth
of small time and savings deposits even while sixmonth certificates expanded rapidly (Chart 3).
The sharp reduction of deposit growth at thrift
institutions during the fourth quarter— along with the
greater reliance of thrift institutions on the high-cost
six-month certificates as a source of funds— made
mortgage money very tight. Moreover, in many states
the cost to thrift institutions of acquiring additional
funds at market rates exceeded usury ceilings. This
made it unprofitable to lend even if thrift institutions
could acquire high-cost funds. As a result of these
financial developments, housing starts slowed sharply
in the fourth quarter, and a large drop in building
permits suggested future weakness in the housing
market as well. Near the end of December, however,
the Congress enacted legislation suspending state ceil-

Digitized 56 FRASER Quarterly Review/Winter 1979-80
for FRBNY


C h a rt 3

W ith s h o rt-te rm in te res t rates at record
levels, the pub lic placed funds in m oney
m arke t m utual funds . . .
B illions of dollars

1979

. . . and in m oney m arke t c e rtific a te s . . .
B illions of d ollars

1979

. . . w h ile redu cing savings dep o sits . . .
B illions of dollars

1979

. . . and sm all tim e dep o sits o th e r than
m oney m arke t c e rtific a te s .
B illions of dollars

1979
S o u rc e s :

D o n o g h u e ’s M oney Fund R e p o rt (H o llis to n ,

M a s s a c h u s e tts ) and th e B oard of G o v e rn o rs of the
F e d e ra l R e s e rv e S ys te m .

ings for mortgage rates during the first quarter of 1980.
This action will attract some additional funds into the
m ortgage markets, although at very high rates of in­
terest.
The mortgage market will be further bolstered in
1980 by a new type of money m arket certificate autho­
rized beginning January 1980, but it remains to be seen
whether this 2 12 -year certificate will be as popular as
/
the six-month certificates. For the new certificate, thrift
institutions are perm itted to offer a yield 50 basis
points below the yield on Treasury securities with two
and one-half years to maturity, while commercial banks
are limited to a rate 75 basis points less than the yield
on these Treasury securities. The ceiling rate will be
set once a month based on data announced by the
Treasury during the last three business days of the
month. There is no minimum deposit required by law,
although individual institutions may set minimum de­
nominations. Other changes in Regulation Q included
an increase of 25 basis points on the ceiling rate for
tim e deposits with maturities of ninety days to one
year. With the new ceilings, banks may pay 5% percent
and thrift institutions 6.0 percent
While the Federal Reserve was successful in attain­
ing the 1979 targets for M i and M 3, bank credit in­
creased at an annual rate of about 12 percent in
1979, a rate well above the 7V2 to 101 percent range
/2
associated with the monetary targets. In the fourth
quarter, however, growth of bank credit slowed as
business loans, both at banks in New York and outside
New York, w eakened dram atically immediately follow­
ing the Federal Reserve’s October 6 policy initiatives.
The 8.0 percent marginal reserve requirement on man­
aged liabilities typically used by commercial banks
to finance loans contributed to upward pressure on
the prime rate during October and part of November.
In late November, however, as a result of the weaker
demand for business loans, as well as some easing
in the cost of funds to banks, the prime rate edged
down from the record level of 15% percent.
Despite the weakening in loan demand and the mar­
ginal reserve requirem ent on managed liabilities, banks
increased by $6.2 billion the outstanding level of large
negotiable certificates of deposit (CDs) from Septem ber
to Decem ber. With deposit growth slowing dram ati­
cally in the fourth quarter— in part due to the very
rapid growth of money market mutual funds in October
and November— banks were under pressure to bid for
CDs as well as other sources of managed funds just
to maintain their overall liability base. Assets of money
m arket mutual funds increased over $10 billion in the
final three months of 1979 to a level of $45 billion, over
11 percent of M! and 4.5 percent of M 2. To the extent




that banks are issuing CDs to recover funds lost to
money m arket mutual funds— which in turn are sub­
stantial holders of CDs— it appears that money market
mutual funds provide an effective mechanism to avoid
the effects of Regulation Q. That is, money market mu­
tual funds draw small tim e and savings deposits as
well as some demand deposits away from the banking
system by offering market rates of interest and then,
in effect, sell the funds back to the banking system in
the CD market at m arket rates of interest. Viewed in
this light, it appears that Regulation Q will become
less meaningful over time, as small investors become
more sophisticated and other means to avoid the ef­
fects of Regulation Q are developed.
The Congress is currently considering legislation
that would phase out Regulation Q over an extended
period of time. Other legislation likely to be consid­
ered during 1980 includes a bill dealing with the prob­
lem of the Federal Reserve’s declining membership
and some perm anent legislation authorizing ATS (au­
tomatic transfer service) accounts, credit union share
drafts, and nationwide NO W (negotiable order of
withdrawal) accounts. In the final days of 1979, the
Congress extended for ninety days the ability of com­
mercial banks to offer ATS accounts and credit unions
to offer share draft accounts. Last April, a United States
Court of Appeals had ruled these and certain other
financial services illegal under current laws but gave
the Congress until the end of 1979 to pass legislation
legalizing these accounts.
Membership legislation, in contrast to ATS accounts
and share drafts, raises many difficult issues. On the
one hand, member banks view the income foregone
by holding reserves as a costly tax— a tax some banks
are willing to leave the System to avoid. The Federal
Reserve, on the other hand, needs a broad reserve
base to conduct monetary policy effectively. At the
same time, the interest earned on the System ’s hold­
ings of securities— holdings funded in part by the re­
serve balances of mem ber banks— is an important
source of revenue for the Treasury. This makes it diffi­
cult to solve the membership problem simply by paying
m arket rates of interest on reserves, and also raises
the question of whether the Federal Reserve should
charge for the services it currently renders free to
member banks if it pays any interest at all on reserves.
Alternatively, if parity of sorts between mem ber and
nonmember institutions is attained by requiring non­
members to hold some reserves, the question arises
whether nonmembers should have access to Federal
Reserve services, and how these services should be
priced. All these conflicting considerations must be
balanced in some sense to attain equitable legislation.

F R B N Y Q u arterly R e v ie w /W in te r 1979-80

57

August-October 1979 Interim Report
(T h is re p o rt w as re le a se d to the C ongress
a n d to the p ress on D e ce m b e r 4 ,1 97 9 .)

Treasury and Federal Reserve
Foreign Exchange Operations
Coming into the August-October period under review,
exchange market participants were concerned over the
outlook for the dollar, as progress toward reducing the
United States trade deficit stalled and inflationary pres­
sures in this country intensified further. United States
exports continued to expand smartly, but import growth
also remained strong, reflecting the unexpected re­
bound in domestic economic activity as well as the
upsurge in international oil prices which added mas­
sively to our oil import bill. The rise in oil prices was
also aggravating United States inflation at a time of
considerable talk of an impending recession in this
country. Market participants thus increasingly ques­
tioned the credibility of the United States authorities’
stated policy emphasis on the need to combat inflation,
to curb oil imports, and to foster a strong dollar and
stability in the exchange markets.
In this regard the markets focused on relative mone­
tary conditions here and abroad. Interest rates in other
major industrial countries had moved higher through
1979 in response to growing credit demands and ac­
celerating inflation. The German economy in particular
had built up a head of steam, and the Bundesbank had
acted to slow the growth of money and credit. As
German interest rates rose, the authorities of other
European countries whose currencies were linked di­
rectly or indirectly to the German mark also moved
to increase domestic interest rates. For those coun-

A report by Scott E. Pardee. Mr. Pardee is Senior V ice President
in the Foreign D epartm en t of the Federal Reserve Bank of N ew
York and M an ag er of Foreign O perations for the System Open
M arket A ccount.

Digitized for 58 FRBNY Quarterly Review/Winter 1979-80
FRASER


tries where economic activity remained sluggish, the
decision to tighten monetary policies was especially
difficult. But the authorities stressed the need to raise
domestic interest rates at least in line with the increase
in domestic inflation rates rather than risk an erosion
of the external values of their currencies that would
aggravate domestic inflationary pressures. In the
United States, strong growth of the monetary aggre­
gates had resumed in the late spring and early sum­
mer and the Federal Reserve also acted to raise the
Federal funds rate. Nevertheless, interest rates here
did not advance by as much as interest rates in most
other industrial countries, and differentials in favor of
dollar placements narrowed accordingly. Moreover,
many market participants had become increasingly
concerned that United States interest rates had not
risen sufficiently to take account of the surge of infla­
tion and of inflationary expectations in this country.
By early August, heavy intervention by the United
States authorities in the early summer had blunted
the selling pressures on the dollar and was reflected,
in part, by an increase in the Federal Reserve’s out­
standing swap drawings to $2,053.3 million equivalent
of marks and $31.7 million equivalent of Swiss francs
as of end-July. Moreover, President C arter’s appoint­
ment of G. William M iller as Secretary of the Treasury
and Paul A. Volcker as Chairm an of the Federal Re­
serve had been welcom ed in the markets as indicating
the Government’s resolve to deal with inflation and the
dollar problem. Against this background the exchange
markets turned quieter during most of August. Even so,
confidence in the dollar remained tenuous, and a sub­
stantial reflux of funds into dollar-denom inated assets

did not materialize. The United States authorities
sharply reduced their intervention, operating in the ex­
change markets on only three occasions and selling a
total of $448.1 million equivalent of marks. At the same
time the Federal Reserve was able to purchase
through transactions with correspondents enough
marks and Swiss francs to make small net repayments
on previous swap drawings with the Bundesbank and
to liquidate drawings with the Swiss National Bank.
By late summer, market sentiment had deteriorated.
Although market interest rates in the United States
continued to firm, interest rates elsewhere also ad­
vanced further, particularly in Germany. Moreover,
even though the dollar had not recovered to earlier
levels, some central banks began to support their cur­
rencies by selling dollars and other currencies. Many
in the market interpreted reports of official dollar sales
as indicating an unwillingness to let the dollar rise
should it come into demand and, more broadly, as a
breakdown in central bank cooperation. With the latest
price indicators for the United States still rising at
double-digit annual rates, the dollar was left vulnerable
to selling pressure. Thus, by early September, the dol­
lar came on offer once again against the German mark
and other European currencies. The demand for marks

T able 1

Federal Reserve Reciprocal Currency Arrangem ents
In m illions of dollars
Institution

A m ount of facility O cto ber 31, 1979

Austrian N ational Bank .............................................................
National Bank of Belgium ........................................................
Bank of C an ad a .............................................................................
N ational Bank of D enm ark ......................................................
Bank of E n g la n d .............................................................................
Bank of France ...............................................................................
G erm an Federal B a n k .......... ........................................................
Bank of Italy ....................................................................................
Bank of Japan ..................................................................................
Bank of M exico .............................................................................
N etherlands Bank ..........................................................................
Bank of Norway .............................................................................
Bank of S w eden ............................................................................
Swiss National B a n k .....................................................................
Bank for International Settlem ents:
Swiss francs-dollars ................................................................
O ther authorized European c u rre n c ie s -d o lla rs ____
Total

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

•In c re as e d by $34 0 m illion, effective August 17, 1979.




S

250
1,000
2,000
250
3,000
2,000
6,000
3,000
5.000
700*
500
250
300
4,000
600
1,250

$ 30,100

also swelled on expectations of a near-term revalua­
tion of the mark against other currencies within the
European Monetary System (EMS). Intervention to
maintain the exchange rate limits within the EMS
mounted rapidly, and the participating central banks
sold increasingly large amounts of marks. Neverthe­
less, the demand for marks was so strong that it pulled
up EMS currencies as a group against the dollar.
As the decline in the dollar gathered momentum, the
United States authorities intervened forcefully once
again, seiling substantial amounts of marks almost
every day during September. In view of the continuing
excessive growth of the monetary aggregates, the Fed­
eral Reserve raised the Federal funds rate further
and hiked the discount rate Vi percentage point to
a record 11 percent on September 18. But, in the at­
mosphere of concern over United States resolve to
combat inflation, market participants reacted more to
the fact that the discount rate increase was approved
by a split 4-3 vote of the Board of Governors than to
the tightening in monetary policy. Consequentiy, sell­
ing pressure continued as commercial leads and lags
shifted against the dollar, corporations intensified
efforts to hedge exposures before the quarter end, and
some asset holders moved to diversify their portfolios.
In this environment the formal realignment of EMS cur­
rencies over the September 22-23 weekend relieved
the tension among the participating currencies but not
the broader pressures against the dollar.
Meanwhile, speculative excesses began to show up
in a number of other financial and commodity markets
in the United States and abroad. Concern over inter­
national price stability heightened, as spot oil prices
advanced once again and as OPEC (Organization of
Petroleum Exporting Countries) members began to
raise their contract prices above the range agreed last
June. The price of gold soared to as high as $447 per
ounce in early October. This explosion in commodity
prices was widely interpreted not just as a shift out of
the dollar but as a shift out of currencies generally
into tangible assets. In the exchange markets, the
Japanese yen in particular declined in response to the
oil situation and to Japan’s sudden shift into current
account deficit. Otherwise the brunt of the speculative
pressures fell on the dollar as the world’s major trading
and reserve currency. In this atmosphere, market par­
ticipants, the financial press, and politicians here and
abroad were calling generally for improved monetary
policy coordination among major industrial countries
and, in particular, for the United States to take more
effective action to bring United States inflation under
control.
By Tuesday, October 2, the dollar had declined by 4
percent against the German mark and by 1 to 5 per-

FRBNY Quarterly Review/Winter 1979-80

59

Ta b le 2

Table 3

Federal Reserve System Drawings and
Repayments under Reciprocal Currency
Arrangem ents

Drawings and Repayments by
Foreign Central Banks and the Bank for
International Settlem ents under
Reciprocal Currency Arrangements

In m illions of dollars equivalent;
draw ings ( + ) or repaym ents ( — )

Transactions with

In m illions of dollars; draw ings ( + ) or repaym ents ( — )

System ..
sw ap
c om m itAugust
m ents
through
July 31,
O ctober 31,
1979
1979

G erm an Federal Bank . .

2 ,0 53 .3

Swiss N ational Bank . . .

31.7

Total .........................................

2,085.1

System
swap
com m it­
ments
O cto ber 31,
1979

^ ^ 1 492 -| *
(4 <_

3 '4 4 3 -9

44 2
76Q

{ i^ s o *

-0 -

3.443.9

B ecause of rounding, figures may not add to totals.
D ata are on a transaction-date basis.
Repaym ents exclude revaluation adjustm ents from swap
renew als, w hich am ounted to $38.6 million for drawings
on the G erm an Federal Bank renew ed during the period.

August 1
through
O cto ber 31,
1979

‘ Bank for International
Settlem ents (against
G erm an m arks) .......................

Outstanding
O cto ber 31,
1979

(+ 3 9 .0
( — 39.0

O utstanding
Banks drawing on
July 31,
Federal Reserve System
1979

-0 -

-0 -

D ata are on a v a lu e -d a te basis.
* B IS draw ings and repaym ents of dollars against
E uropean currencies other than Swiss francs to m eet
tem porary cash requirem ents

T able 6

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

Table 4

United States Treasury Drawings and
Repayments under Swap Arrangement
with the German Federal Bank

A m ount of
com m itm ents
July 31, 1979

F e d e ra l
R e serve

Period

In m illions of dollars equivalent;
draw ings ( + ) or repaym ents ( — )
August 1
through
O cto ber 31, 1979

A m ount of
com m itm ents
O cto b er 31, 1979

+ 3 3 7 .7
|-3 3 7 .7

U n ite d S ta te s T re as u ry
E xchange
S tabilization
G eneral
Fund A ccount

August 1 through
O cto ber 31. 1979 ................

-1 2 .6

+

Valuation profits and
losses on outstanding
assets and liabilities
as of O cto ber 31, 1979 . .

+

-3 5 8 .8

56.5

+

16.2

-0 -

-0-

1.2

-1 2 3 .9

D ata are on a v a lu e -d a te basis.

D ata are on a valu e-d ate basis.

T a b le 5

United States Treasury Securities, Foreign Currency Denom inated
In m illions of dollars equivalent; issues ( + ) or redem ptions ( — )
A m ount of
com m itm ents
July 31, 1979

Issues

August through
O cto ber 31, 1979

A m ount of
com m itm ents
O cto b er 31, 1979

P u b lic se rie s :
-0 -

S w itzerland .....................................................................
G erm any .............................................................................
Total

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

D ata are on a v a lu e -d a te basis.

Digitized for60 FRBNY Quarterly Review/Winter 1979-80
FRASER


-0 4,1 49 .7

-0 -

1,203.0
2 ,9 46 .7
4 ,1 49 .7

cent against other European currencies, compared
with eariy-August levels. In their intervention during
Septem ber and early October, the United States author­
ities sold a further $3,720.9 million equivalent of marks
shared about evenly between the Federal Reserve and
the Treasury. The Federal Reserve financed most of its
mark intervention by drawing an additional $1,762.2
million equivalent under the swap line with the Bundes­
bank, bringing total drawings to $3,746.0 million after
allowing for further repayments and revaluation adjust­
ments from swap renewals. The remainder of the Sys­
tem ’s mark sales and all the Treasury’s intervention
was financed out of balances. The Treasury’s $337.7
million equivalent drawing and repayment on the swap
line with the Bundesbank reflected temporary financing,
while Treasury holdings of German government secu­
rities were being liquidated. The Federal Reserve also
resumed intervention in Swiss francs, selling $44.2 mil­
lion equivalent drawn on the swap line with the Swiss
National Bank.
By that time, however, the exchange markets w ere
alive with rumors of a new support package for the
dollar. M arket participants followed closely the news
reports surrounding the Hamburg meeting between
United States and German officials and the annual
meetings of the International Monetary Fund and World
Bank in Belgrade, Yugoslavia, in the first week of
October. When it was learned in the market that Chair­
man Volcker had left Belgrade early to return to Wash­
ington, dollar rates rallied on expectations of dram atic
new policy action, and the Trading Desk had no further
need to intervene. On Saturday, October 6, the Federal
Reserve announced a series of complementary actions
to assure better control over the expansion of money
and credit, to help curb speculation in financial, for­
eign exchange, and commodity markets, and thereby
to dampen inflationary forces. The actions included a
1 percentage point increase in the discount rate to 12
percent and the imposition of an 8 percent marginal
reserve requirement on increases in managed liabil­
ities. In addition, the System announced that it would
place greater emphasis on the supply of bank reserves
in its open market procedures and less emphasis on




the Federal funds rate in seeking to reach its monetary
aggregates objective.
In the days following these measures, interest rates
in the Eurodollar and domestic markets moved up
sharply. Although there was considerable uncertainty
at first, the exchange markets reacted positively on
balance both to the announced Federal Reserve ac­
tions and to the subsequent rise in dollar interest
rates. Through the rem ainder of O ctober the dollar
traded more firmly despite the continued advance of
interest rates abroad, the lack of improvement in the
latest United States trade and inflation figures, the
escalation in international oil prices, and growing un­
certainties over the political situation in Iran. Com­
pared with early-October lows, the dollar was up 2
percent to 5 percent on balance against the Euro­
pean currencies by the month end. Against the Japa­
nese yen and Canadian dollar the dollar rose 5 percent
and 2 percent, respectively, during the period under
review.
With the dollar on much better footing following the
October 6 measures, the United States authorities did
not intervene as a seller of foreign currencies through
the rest of the month. Rather, the improvement in the
dollar enabled the Federal Reserve to step up repay­
ment of swap debt through purchases of foreign cur­
rencies from correspondents. As a result, by the month
end the Federal Reserve had repaid $314.3 million
equivalent of swap drawings on the Bundesbank, re­
ducing the total to $3,443.9 million, and had arranged
acquisition of a sufficient amount of Swiss francs to
liquidate outstanding drawings in that currency.
During the period under review, the System realized
net losses of $12.6 million on its exchange market
operations. The Exchange Stabilization Fund (ESF)
realized net profits of $56.5 million, while the Trea­
sury’s General Account realized net profits of $16.2
million. Valuation losses were $358.8 million for the
ESF and $123.9 million for the General Account, while
the System had valuation profits of $1.2 million. Also
in August the Federal Reserve’s reciprocal swap ar­
rangement with the Bank of Mexico was increased by
$340 million to $700 million.

F R B N Y Q u arterly R e v ie w /W in te r 1979-80

61

FE D E R A L R E S E R V E R E A D IN G S ON IN F L A T IO N
Inflation remains one of the most bedeviling phenomena of
our time. Despite being readily observed and easily measured,
inflation has been relatively impervious to containment, and
the consequent damage to the social, economic, and political
fabric of our society is far reaching.
The Federal Reserve Bank of New York has compiled, in
one volume, a selection of speeches and articles by officials
and staff economists throughout the Federal Reserve System
which is designed to provide a comprehensive explanation of
the inflationary process, its effects and its policy implications.
This 272-page book is primarily intended as a teaching
resource for college economics teachers and all interested
economy watchers. It will also be of use to high-school social
studies teachers.
The price for Federal Reserve Readings on Inflation is two
dollars ($2.00), prepaid. Checks and money orders (please do
not send cash) must be made payable to the Federal Reserve
Bank of New York and sent to:
Public Information
33 Liberty Street
New York, N.Y. 10045
Foreign residents must pay in United States dollars with a
check or money order drawn on a United States bank or its
foreign branch.

FRBNY Quarterly R eview /W inter 1979-80



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