Full text of Economic Policy Review (Federal Reserve Bank of New York) : Winter 1985, Vol. 10, No. 4

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Federal
Reserve Bank of
New York

Quarterly Review




Winter 1985-86 Volume 10 No. 4
1 Bank Supervision in a
Changing Financial Environment
6 The Monetary Aggregates in 1985
11

Japan’s Intangible Barriers to
Trade in Manufactures

19

Housing Reform in New Jersey:
The Mount Laurel Decision

28

Adjustments in Buffalo’s Labor Market

38

In Brief
Economic Capsules

45 Treasury and Federal Reserve
Foreign Exchange Operations

The Quarterly Review is published by
the Research and Statistics Function o f
the Federal Reserve Bank o f New York.
Remarks o f E. GERALD CORRIGAN,
President o f the Bank, on bank
supervision in a changing environment
begin on page 1. Among the members o f
the staff who contributed to this issue
are JOHN WENNINGER and
LAWRENCE J. RADECKI (on the
monetary aggregates in 1985, page 6 );
DOROTHY CHRISTELOW (on Japan’s
intangible barriers to trade in
manufactures, page 11); DANIEL E.
CHALL (on housing reform in New
Jersey and the Mount Laurel decision,
page 19); and FRED C. DOOLITTLE
(on adjustments in Buffalo’s labor
market, page 28).
Other staff members who contributed to
In Brief—Economic Capsules are LYNN
PAQU ETTE (on credit card balances—
debt or convenience use?, page 38);
and Two Capsules on the Auto
S ector... ETHAN S. HARRIS (on
forecasting automobile output, page
40); and JOANN MARTENS (on
projecting consumer expenditures on
automobiles, page 43).
An interim report on Treasury and
Federal Reserve foreign exchange
operations for the period August through
October 1985 starts on page 45.




Bank Supervision in a Changing
Financial Environment

Good afternoon, ladies and gentlemen. I am delighted to
have this second opportunity to address the Mid-Winter
Meeting of the New York State Bankers Association and I
want to use this occasion to discuss recent and prospective
initiatives by the Federal Reserve aimed at strengthening
(1) the supervision of banking organizations and (2) the
operation of the payments system. These subjects are
closely related, not only because banks are the dominant
institutions through which payments are made, but more
fundamentally because the safety and integrity of the bank­
ing system and the safety and integrity of the payments sys­
tem are inseparable, with both ultimately resting on that
great intangible—public confidence.
By way of background, allow me to highlight some of the
recent developments which seem to me to underscore the
need for further efforts in these areas. The last several
years have seen our banking and financial markets buffeted
by a complex interaction of cyclical and secular forces.
Some of these forces reflect changes in the economic
environment; some are prompted by technological consider­
ations; others stem from an intensely competitive environ­
ment in the financial marketplace fostered in part by
deregulation; and still others reflect changing structural
characteristics of our domestic and international economy.
In the end, however, all of these factors blend together in a
manner that makes it very difficult to distinguish causes
from effects and actions from reactions. Yet, whatever the
cause-and-effect relationships may be, the manifestations
of the interaction of these forces in the marketplace are
plain to see. For example:
Remarks of E. Gerald Corrigan, President, Federal Reserve Bank of New York,
before the 58th Annual Mid-Winter Meeting of the New York State Bankers
Association on Thursday, January 30,1986.




• Most measures of the quality of financial assets in bank
portfolios and elsewhere are at disturbingly low levels
given where we are in the business cycle. Some of this
is the inevitable fallout of imbalances in economic per­
formance and policies here and abroad, but some may
also be due to aggressive and short-sighted behavior of
individual financial institutions.
• Businesses and households continue to accumulate
debt at very rapid rates despite what look like very high
real rates of interest.

The safety and integrity of the banking system and the
safety and integrity of the payments system are
inseparable, with both ultimately resting on that great
intangible—public confidence.

• Isolated but often sensational problems in individual fi­
nancial institutions—almost always growing out of bad
or abusive management practices—inevitably raise
questions about the strength and stability of institutions
more generally.
• The explosion in new financial market practices and in­
struments—many of which are not reflected on conven­
tional accounting statements—strains the mental dex­
terity of even the best and the brightest among us.
• The apparent thinness of spreads and margins on indi­
vidual financial transactions raises questions as to
whether pricing adequately reflects risks.

FRBNY Quarterly Review/Winter 1985-86

1

• The internationalization of banking and financial mar­
kets has brought about a quantum leap in the degree of
financial interdependence and in the structural com­
plexity of the financial marketplace.

It is not uncommon for the value of large dollar
computerized payments processed by the New York
Federal Reserve Bank and by the New York Clearing
House to exceed $1 trillion in a single day.

• Finally, and reflecting all of the above, the volume,
speed, and value of financial transactions are growing
at a very rapid rate. For example, here in New York City,
it is not uncommon for the value of large dollar comput­
erized payments processed by the New York Federal
Reserve Bank and by the New York Clearing House to
exceed $1 trillion in a single day. To try to put that in
perspective, $1 trillion is:
• $35 million per second over an eight-hour day.
• Forty times the reserve balances held at the 12 Re­
serve Banks by all banks.
When we pull together these various elements one mes­
sage emerges rather powerfully: namely, that events have
undercut the effectiveness of many elements of the supervi­
sory and regulatory apparatus historically surrounding bank­
ing and finance. If it can’t be done onshore, it’s done off­
shore; if it can’t be done on the balance sheet, it’s done off
the balance sheet; and if it can’t be done with a traditional
instrument, it’s done with a new one. That is not to say that
these developments are bad. To the contrary, taken togeth­
er they are symptomatic of a vital and adaptive financial
marketplace. Yet, as this process unfolds, we must recog­
nize that the historic regulatory/supervisory apparatus asso­
ciated with banking—whatever its limitations—was a source
of restraint and discipline on individual institutions and on
the system as a whole. If, therefore, I am correct in postulat­
ing that events are undermining that source of restraint, a
key question that arises is what, if anything, should
replace it?
In response to this, some—perhaps many—would say
“ let market discipline do the job” . It’s very hard to argue with
that since all of us are powerfully attracted to the concept
and the reality of the marketplace as the optimal vehicle for
resource allocation. But, if in banking and finance we are to
accept that concept in its fullness, we had better take mar­
ket discipline out of the closet and take a good close look at
it and its implications. For example, if we really want unfet­
tered market discipline, then we must be prepared to accept

2

FRBNY Quarterly Review/Winter 1985-86




the ultimate discipline of the market—outright failures re­
gardless of their implications for other institutions and mar­
kets. Now, if that’s what we want, several things seem to
me, as a matter of logic, to go with it: we probably don’t
need the discount window; we don’t need the Fed effective­
ly guaranteeing large dollar payments; we don’t need depos­
it insurance at the $100,000 level; as a matter of fact, we
probably don’t need much at all by way of rules or regula­
tions, much less supervisory and examination programs.
Now at this point, I’m sure all of you are saying “ that’s a
straw man; that’s not what we really mean by market disci­
pline” . And you would be right, it was a straw man, but a
straw man with a purpose: namely, to make the point that I
have no sense that any of us are prepared to dismantle the
public safety net associated with our banking—and to a
lesser extent—other financial institutions. On the other
hand, I do have the clear sense that all of us recognize the
need to adapt the safety net in ways that are more respon­
sive to market realities of the day and more sensitive to the
need to avoid penalizing the strong and prudent because of
the mistakes and misfortunes of the weak and the reckless.
Above all, I have the sense and the conviction that we need
to adapt the safety net in ways that continue to protect the
system as a whole from the misfortunes of the few.
However, it is easier to say these things than to do them,
especially in the context of an intensely competitive and
tightly integrated financial market within which sophisticated
electronic payments systems provide the linkages by which
billions of dollars can move domestically or internationally
with the blink of an eye.

But, if in banking and finance we are to accept that
concept in its fullness, we had better take market
discipline out of the closet and take a good close look
at it and its implications.

To summarize to this point: if financial integration and
complexity have increased dramatically; if events and tech­
nology have undercut much of the restraint and discipline
associated with historic forms of financial regulation and su­
pervision; if we are not prepared to accept unfettered mar­
ket discipline as the sole or even the dominant source of
restraint on the system as a whole; if the strong should not
be penalized by the problems of the weak; and if we care
about the stability of the system as a whole, then the case
for strengthening the infrastructure supporting the operation
of our financial institutions and markets is overwhelming.
In the first instance, the primary responsibility for enhanc­
ing that infrastructure lies with the directors and officers of
individual banking organizations. And, the events of the past
several years have provided clear and unmistakable evi­

dence that individual institutions recognize this responsibility
and have risen to its challenge. Nowhere is that more evi­
dent than in the attitude of bankers toward strengthening
capital and reserve positions. For example, between yearend 1982 and the third quarter of 1985, the primary capital
of the 25 largest banking organizations in the United States
grew by $26.5 billion, or 57 percent. Over the same time
period the total capital of these institutions rose by $38.5
billion, or by more than 70 percent. And, these truly impres­
sive increases in capital were recorded despite historically
high levels of charge-offs. That enormously expanded
capital base will be a source of great strength for the
future but as large as it is, it does not reduce the need for
conservatism in capital building efforts and in banking
practices generally.

On the other hand, I do have the clear sense that all of
us recognize the need to adapt the safety net in ways
that are more responsive to market realities of the day
and more sensitive to the need to avoid penalizing the
strong and prudent because of the mistakes and
misfortunes of the weak and the reckless.

However, just as bankers have responsibilities to adapt to
the new environment, so too do the public authorities, in­
cluding the Congress and the bank supervisory agencies. In
that regard, some of you may recall that at this time a year
ago I said that the case for broad-based and progressive
federal banking legislation was urgent and I spelled out in
some detail the specifics of a near-term legislative agenda
which seemed to me both essential and pragmatic. In the
interest of time, I’m not going to repeat that agenda today,
but I do want to repeat—with an even greater sense of ur­
gency—that if we don’t get progressive federal legislation,
and get it soon, events may result in a helter-skelter of cir­
cumstances that will make none of us very happy.
As I see it, that danger was driven home all too vividly in
the Supreme Court ruling in the so-called “ nonbank bank
case” two weeks ago. In that opinion, the Court seemed to
me to be saying that while it had sympathy for the substance
of the Federal Reserve position, the proper remedy was leg­
islative, not judicial—which, of course, has been the Fed’s
position all along. Hopefully, the Court’s ruling will serve as a
catalyst for federal legislation, not just to deal with the defini­
tions of banks and thrifts but also to make progress regard­
ing product and geographic expansion, the appropriate role
of the states in banking structure and supervisory matters,
and in simplifying some of the supervisory provisions of the
Bank Holding Company Act.
However, even in a framework in which banks themselves
are adjusting to the new environment and one in which ap­




propriate federal legislation is forthcoming, it seems to me
essential that we continue the process of adapting our sys­
tem of prudential supervision to the realities of the new envi­
ronment. The Federal Reserve and the other banking super­
visors have been hard at work in that effort for some time
and over the balance of my remarks today I would like to
share with you some thoughts on several aspects of that
process which seem to me particularly important. Before
turning to some of the particulars, however, let me say a few
words on the principles which I personally believe should
guide this effort:
• First, the primary responsibility for the safety and
soundness of individual institutions lies with the direc­
tors and management of each institution, not with the
supervisors.
• Second, no system of official, prudential supervision
can be, or should be, fail-safe. If that’s what we want,
we might as well nationalize the banking system.
• Third, disclosure has a place—an important place—but
it’s not a panacea, and taken too far it can be destabilizing.
• Fourth, no set of rules, reporting requirements, guide­
lines, or disclosure requirements can substitute for the
on-site examination and inspection process.
• Fifth, supervisory initiatives must be sufficiently flexible
so as not to penalize the strong because of the mis­
takes and misfortunes of the weak.
• Sixth, to the extent possible, supervision should take
account of function rather than form.
• Seventh, supervisory efforts must take greater account
of the increased credit and operational interdependen­
cies among banks and between banks and other major
financial institutions, domestically and internationally.

If we don’t get progressive federal [banking]
legislation, and get it soon, events may result in a
helter-skelter of circumstances that will make none of
us very happy.

Against that background, the Federal Reserve has under­
taken a number of major initiatives aimed at strengthening
the bank supervisory process over the past year or so. While
time does not permit me to go into all of the initiatives, there
are several areas which seem to me to merit special
attention.

FRBNY Quarterly Review/Winter 1985-86

3

First, the Fed has adopted a new approach regarding the
scope and frequency of on-site examinations for large insti­
tutions and for problem institutions. Specifically, all problem
and potential problem institutions of $500 million or more
will be subject to one full scope and one limited scope ex­
amination per year. In addition, for institutions with more
than $10 billion in assets, the alternate year examination
program with New York State will be dropped in favor of
annual joint examinations. Finally, for all institutions over
$10 billion in assets, there will be one full scope examination
per year and one special or targeted examination per year.
Thus, the Fed will begin using the special or targeted ex­
amination but not at the expense of eliminating or reducing
the frequency of the comprehensive overall examination,
which I firmly believe must remain as the cornerstone of our
examination efforts. Insofar as the special or targeted exam­
inations are concerned, we expect that the point of empha­
sis will vary from institution to institution. For example,
depending on the institution, the emphasis might be on a
detailed look at operational systems, or off balance sheet
activities, or particular points of interest in the loan portfolio,
or patterns of worldwide funding activities. And, because
these targeted examinations can be highly specialized, we
have in mind augmenting our teams of examiners with spe­
cialists drawn from other areas of the Federal Reserve Bank
of New York to assist in these efforts. While the combination
of the comprehensive and the specialized examination will
entail some greater effort on our part and on the part of
affected institutions, we are confident that the mutual bene­
fits will far outweigh the costs and potential burdens of this
approach.
A second area of particular emphasis has been in regard
to prudential standards. Specifically, the events of the last
several years have made it clear that bank holding compa­
nies, as corporations in their own right, cannot always de­
pend on an uninterrupted flow of dividends and other
income from their bank and nonbank subsidiaries, or on
bank-like liability management practices to fund mediumand longer-term assets. Thus we are placing new emphasis
on holding company cash flow and liquidity in the inspection
process.

Thus, the Fed will begin using the special or targeted
examination but not at the expense of eliminating or
reducing the frequency of the comprehensive overall
examination, which I firmly believe must remain as the
cornerstone of our examination efforts.

In accordance with this emphasis we have developed,
field tested, and implemented revised and expanded exami­
nation guidelines relating to holding company cash flow and

4

FRBNY Quarterly Review/Winter 1985-86




liquidity. The revised cash flow guidelines focus on cash
flow in relation to operating expenses, debt service require­
ments, and dividends to shareholders. The holding company
liquidity guidelines focus on contractual and actual maturi­
ties of the parent’s assets and liabilities, the liquidity avail­
able in advances to subsidiaries, and the need for manage­
ment policies and contingency plans regarding the parent
company’s liquidity. Of course, the holding company cash
flow guidelines are broadly germane to the guidelines issued
late last year by the Federal Reserve and the Comptroller of
the Currency regarding circumstances in which the curtail­
ment or elimination of dividend payments by banks or bank
holding companies might be appropriate. We are also taking
a fresh look at examination and supervisory guidelines as
they pertain to loan concentrations and standards for judg­
ing the adequacy of loan loss reserves.
The single most important initiative on the table, however,
is the proposed risk based capital adequacy guidelines
which were issued for public comment by the Board of Gov­
ernors in mid-January. The proposed guidelines are a re­
sponse to events in the marketplace—such as the growth of
off balance sheet activities—which simply could not be ig­
nored. More importantly, these proposed guidelines are fully
compatible with the concept that supervisory norms should
take account of characteristics of individual institutions rath­
er than painting with such a broad brush so as to treat all
institutions more or less alike.
Because of its importance, the Federal Reserve has pro­
vided for a 90-day public comment period on this proposal.
Needless to say, I would hope that all affected institutions
would give us the benefit of their views on this subject. In
framing those comments, I believe it is important to keep in
mind that the approach is not intended to capture all of the
nuances of risk and risk management in banking operations.
Rather, it is a general framework designed to help bankers
and bank supervisors better gauge overall risks and capital
adequacy on the basis of four broad categories of relative
risk. Thus, while there will be a natural tendency to quibble
as to whether a particular item belongs in one category or
another, excessive fine-tuning must be resisted in part to
avoid undue administrative complexities but also to guard
against the dangers of expecting more from such an ap­
proach than it can deliver.
Another area of particular concern to the Federal Reserve
has been efforts to strengthen our examination and supervi­
sory personnel. In part, that has entailed stepped-up efforts
to recruit individuals with more diversified skills and to pro­
vide more intensive and sophisticated training programs for
our examination personnel. In addition, we are increasingly
looking to people drawn from areas of the Bank such as
open market operations, foreign exchange trading, comput­
er systems, legal, and research to help in framing superviso­
ry policies and, in some cases, even to participate in field
examination work. We have also been exploring ways in

which supervisory personnel can quickly and flexibly be
used to assist in dealing with particular problems when they
arise. For example, last year in the context of the problems
with state chartered thrift institutions in Ohio and Maryland,
large numbers of Federal Reserve examiners from all over
the country were utilized on-site to help contain and ulti­
mately stabilize those situations. The importance of all of
these efforts cannot be overstated because in the end, su­
pervisory policies are only as good as the people who ad­
minister those policies. Achieving that needed blend of tech­
nical skills, professionalism, and good old common sense in
our examination personnel was never easy but has never
been more important.

The single most important [supervisory] initiative on
the table, however, is the proposed risk based capital
adequacy guidelines which were issued for comment
by the Board of Governors in mid-January. The
proposed guidelines are a response to events in the
marketplace—such as the growth of off balance sheet
activities—which simply could not be ignored.

These initiatives—and others I have not mentioned—are,
in my view, broadly consistent with the principles I cited earli­
er that should guide our efforts. But, as important as they are,
they do not begin to capture all that needs to be done. For
example, I have not even mentioned the case for greater
international coordination of supervisory efforts and stan­
dards—a need that arises on both prudential and competitive
grounds. Looked at in that light, the initiatives I have men­
tioned should be viewed as stepping stones in the continuing
and very difficult process of seeking to keep the supervisory
process attuned to a rapidly changing market environment.
In closing, allow me to make a few brief comments about
the operation of the payments system and particularly large
dollar electronic payments systems. The speed and efficien­
cy of those systems are one of the marvels of our times.
But, speed and efficiency can bring vulnerability and, in the
case of large dollar electronic payments systems, those vul­
nerabilities can take many forms ranging from computer
problems to credit problems. Recognizing this, the banking
industry, in close cooperation with the Federal Reserve, has
been actively exploring ways in which greater elements of
discipline and control can be built into the operation of these
systems. As a result, caps or limits on intra-day extensions
of credit on Fedwire and on the major private wire transfer
systems have been or are being established by users of
these systems. As best we can judge, this process of estab­
lishing caps on the basis of self-appraisal is going well and
we are already seeing signs that it is having the desired
effect of focusing even greater top management and direc­




tors’ attention on the subject. We are also aware that a few
problems and glitches have surfaced and, where possible
and appropriate, we are working with individual institutions
to help remedy these problems. All in all, however, the pro­
cess seems to be proceeding in a generally satisfactory
manner.
In saying this, let me emphasize that these efforts are but
a first step in strengthening this vital element of the pay­
ments mechanism. I say they are a first step because day­
light overdrafts are the symptom, not the cause. Looked at
in that light, current efforts—while necessary—can probably
do little more than stabilize the situation. Since the object of
the exercise should be to enhance the reliability of the sys­
tem and ultimately reduce risk and exposure, we are going
to have to get at the underlying problems, not just their
symptoms.
That more penetrating effort will have to entail consider­
ations relating to (1) possible approaches to achieving a
higher level of operational reliability in the system; (2) more
comprehensive procedures to be followed in emergency sit­
uations; and (3) a greater willingness to reconsider market
practices in an effort to reduce daylight exposure and pay­
ment risk. Of course, in exploring these avenues for en­
hancement, we must take care so as not to undermine the
liquidity and efficiency of our markets. Achieving that bal­
ance will not be easy, but we must try.

The speed and efficiency of those systems are one of
the marvels of our times. But, speed and efficiency can
bring vulnerability and, in the case of large dollar
electronic payments systems, those vulnerabilities can
take many forms ranging from computer problems to
credit problems.

The agenda for the future is long and imposing, but my
colleagues and I at the New York Fed enthusiastically wel­
come the opportunity to play our part in helping to meet
these challenges. Indeed, as the arm of the Central Bank
located in the largest and most important financial center in
the world, we believe we have a special role to play in that
regard. That special role reflects not just a physical pres­
ence in the market, but rather a broad-based operational
presence. We examine banks, we buy and sell securities,
we operate in the foreign exchange markets, we are direct
parties to billions of dollars in electronic payments daily, we
clear checks; in short, we too are a bank. Thus, what we
bring to the arena of public policy is not just an intellectual
point of view, but a point of view that is tempered and condi­
tioned by our day-to-day presence in the marketplace. We
think that’s important and we hope you share that view.
Thank you.

FRBNY Quarterly Review/Winter 1985-86

5

The Monetary Aggregates in 1985

The monetary aggregates gave conflicting signals in 1985.
The growth of M1 (fourth quarter to fourth quarter) accelerat­
ed sharply from its 1984 pace, while M2’s growth held fairly
steady and M3’s slowed considerably. As a result, M1’s growth
exceeded M2’s and M3’s by a large margin, an infrequent
occurrence. Moreover, M1 ’s velocity posted a decline in 1985
about as large as the record drop in 1982. M2’s and M3’s
velocity, however, did not fall last year as sharply as M1 ’s, nor
were their declines nearly as large as in 1982. Clearly, M1’s
behavior was very unusual. In this article, we explore how the
strength in M1 was part of a general shift by the household
sector toward more liquid bank deposits, caused by the sub­
stantially lower interest rates on time deposits.

The relative performance of the monetary aggregates
M1 grew a rapid 11.6 percent (up from 5.2 percent in 1984),
while M2 increased a more moderate 8.6 percent (only a little
stronger than the year before), and M3’s growth was 8 percent
(down from 10.4 percent).1 Last year’s spreads between
M1 ’s growth rate and the growth rates of the broader aggre­
gates turned out to be far from ordinary (Table 1). On average,
the growth rates of M2 and M3 have exceeded M1’s by three to
four percentage points, but in 1985 the opposite was true
(Table 1, first two columns). While some variation from the
average spreads is normal and to be expected, the spreads fell
1 M1 consists primarily of currency and checking account deposits (NOWs and
demand deposits). M2 includes M1 plus savings deposits, money market
deposit accounts (MMDAs), noninstitutional money market mutual funds
(MMMFs), small time deposits, overnight repurchase agreements (RPs),
and Eurodollars. M3 equals M2 plus term RPs and Eurodollars, institutional
MMMFs, and large denomination ($100,000 or more) time deposits. This
study was prepared before the Board staff’s annual benchmark and seasonal
factor revisions.

6

FRBNY Quarterly Review/Winter 1985-86




beyond two standard deviations, a commonly used measure
of “ normal” bounds (Table 1, last two columns).
Of course, an extremely wide spread between the growth
of M1 and M2 or M3 does not necessarily imply that M1 is
the aggregate displaying unusual behavior. The income ve­
locities (ratios of GNP to each monetary aggregate) of the
monetary aggregates, however, do suggest that M1 was the
aggregate out of line with past experience (Table 1, bottom
ha lf). M1 ’s velocity was over two standard deviations below
its long-run average growth rate of about 3 percent. Hence,
normal year-to-year volatility in M1’s velocity cannot ac­
count for its behavior in 1985. M2’s and M3’s velocities,
while weak, were considerably closer to average than two
standard deviations. This means that the growth rates of the
broad aggregates were generally in line with the perfor­
mance of GNP.
The velocities of the monetary aggregates, however, have
been positively correlated in the past (in part because a
broader aggregate contains a narrower aggregate). As a
result, it is possible that the aberration in M1’s velocity
growth last year (7.9 percentage points below average) has
been overstated somewhat, given that the velocities of M2
and M3 were also below average. In the regressions on
page 7, the annual (fourth quarter to fourth quarter) growth
rates of M1’s velocity (VM1) are regressed alternatively on
the growth rates of M2’s velocity (VM2) and M3’s velocity
(VM3). (For the sake of comparison, M2’s velocity is also
regressed on M3’s velocity.)2
2 The regressions were also run with the non-M1 (or non-transactions)
components of M2 and M3 as the independent variables, respectively, in
equations (1) and (2). The estimated correlations were smaller, but
significant, and the 1985 forecast errors remained over two standard errors.

Durbin1985
Watson Standard forecast
R2 statistic
error
error
(1) VM1 =
(2) VM1 =
II

CM

(3)

2
>

Basically, the first two equations say that M1’s velocity
growth would be expected to be stronger (or weaker) than
its average of about 3 percent when M2’s or M3’s velocity is
stronger (or weaker) than its average. But even after allow­
ing for the weakness in M2’s or M3’s velocity in 1985, M1’s
velocity was still 6.4 or 7.3 percentage points below expect­
ed (far right column), well over two standard errors.

2.8 + 0.62 (VM2)
(7.7)
(4.5) ...............

0.46

1.4

1.8

-6 .4

3.3 + 0.60 (VM3)
(7.9)
(3.7) ...............

0.38

1.5

2.0

-7 .3

0.7 + 0.82 (VM3)
(1.9)
(5.9) ...............

0.60

1.8

1.7

-1 .7

Estimation period: 1960 to 1984.
Table 1

Comparison o f M1, M2, and M3 Growth
In percent

Annual rates (fourth-quarter
to fourth-quarter)
Long-run
average*

1985

Difference

Standard
deviationt

M2 growth less
M1 growth...........

3.0

- 3 .0

6.0

2.2

M3 growth less
M1 growth...........

4.0

-3 .7

7.7

2.3

2.4

M3 growth less
M2 growth...........

1.0

-0 .6

M1 velocity growth ..

2.8

-5 .2

1.6
8.0

1.9

M2 velocity growth ..

-0.1

-2 .6

2.5

2.7

M3 velocity growth ..

—1.0

-2 .0

1.0

2.5

* 1960-84.
t Computed from annual rates, 1960-84.
Table 2

Com position o f M3 Growth
In percentage points

Contribution to M3
by component
(fourth-quarter to
fourth-quarter)
M 1..............................................

1984

1985

Difference

1.0

2.2

1.2

Non-M1 components of M2:
S m alltim e.............................

3.9

-0 .2

Savings .................................

-0 .7

0.5

1.2

3.5

2.5
-0 .4

MMDA ...................................

1.0

-4.1

Noninstitutional money funds.

0.9

0.5

Other M2 components...........

0.2

0.4

Subtotal.....................................

5.3

4.7

-0 .6

Large tim e .............................

3.2

0.9

-2 .3

Institutional money fu n d s ___

0.5

-0 .3

Other M3 components...........

0.4

0.2
0

Subtotal.....................................

4.1

1.1

-3 .0

T o ta l......................................

10.4

8.0

-2 .4

0.2

Non-M2 components of M3:




-0 .4

The components o f the monetary aggregates in 1985
One reason why M1’s velocity dropped so steeply might be
that households were shifting funds into M1 from other M2
or M3 components. Such shifts would cause M1 to acceler­
ate and its velocity to decline, while M2 and M3 growth
would be unaffected and their velocities would be more sta­
ble. Hence, it seems worthwhile to look more closely at the
components of the broad aggregates.
Table 2 shows the contributions to M3 growth from its
major components in 1984 and 1985. The center part of
Table 2 shows that overall the non-transactions (or nonM1) components of M2 added about the same amount to
M3’s growth in both years. But individually, they differ
markedly. The least liquid of these components, small time
deposits, showed the largest reduction of any individual
component in its contribution to M3 growth. On the other
hand, many of the more liquid components of M3 (NOW
accounts, MMDAs, and even passbook savings accounts)
supplied considerably more growth to M3 in 1985. This re­
veals a stronger preference by individuals and firms for high­
ly liquid bank deposits.
Finally, the components of M3 not included in M1 or M2
also brought about M3’s weaker growth (Table 2, bottom
half). In particular, large time deposits contributed a much
smaller fraction of M3 growth in 1985 versus the previous
year. Apparently, the weaker demand for loans and the abili­
ty to attract “ retail” deposits led banks to issue fewer
“ wholesale” deposits, basically large negotiable CDs.
Therefore, the deceleration in M3 growth was caused by
slow growth of large time deposits. The acceleration in M1
growth, in contrast, resulted from an increased demand for
liquidity which did not affect M3 because most of the shifting
was among M3 components.
The fall in interest rates helps to explain this greater pref­
erence for highly liquid deposits (including checkable de­
posits in M1). Table 3 compares the current and maturing
yields for two popular small time deposit maturities, six
months and one year. During the first quarter of 1985 the
yield on new six-month certificates was 2.5 percentage
points below maturing six-month certificates. And in the third
quarter, the yield on new one-year certificates was 3.6 per­
centage points below maturing certificates, and the differ­
ence remained quite large (at almost 2.4 percentage

FRBNY Quarterly Review/Winter 1985-86

7

points) in the fourth quarter. Certainly, with such large de­
clines in these yields, investors accustomed to double-digit
rates would balk at rolling over these deposits. Apparently,
they put the funds into more liquid accounts, such as
MMDAs, Super NOW accounts, or conventional NOWs, ei­
ther on a permanent basis or temporarily while they
shopped for alternative investments.
Table 4 shows the rate spreads between time deposits
and these liquid deposits over the past two years. The
spreads were widest in the third quarter of 1984, when time
deposit rates exceeded the rate on Super NOWs by three
and one-half to four percentage points, conventional NOWs
by about six percentage points, demand deposits by eleven
to eleven and one-half percentage points, and MMDAs by
about one and one-half percentage points. One year later,

the rate spreads between time deposits and NOWs had de­
clined by over one-half, between time deposits and demand
deposits about one-third, and between time deposits and
MMDAs by one-third to one-half. Clearly, such a marked
narrowing in these spreads would induce many individuals
to put their maturing certificates into M1 balances (particu­
larly NOW accounts) or MMDAs, thereby gaining liquidity
with only a small sacrifice in yield. Likewise, new savings
that at higher spreads would have gone into time deposit
accounts would be placed in these more liquid accounts.
Developments in 1985 were considerably different from
what would have occurred prior to the extensive deregula­
tion of interest rates on bank deposits. As long as the inter­
est rate ceilings on the components of M2 were binding, the
relative rates on various M2 deposits could not change,

Table 3

Current versus Maturing Yields on Small Time Deposits
Annualized yields (in percent)

Six-month certificates
Date
1985-1..........................................
1985-11..........................................
1985-111........................................
1985-IV........................................

Current
8.7
8.2
7.6
7.7

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

Spread

Current

Maturing

Spread

11.2
10.0

-2 .5
-1 .8
-1 .1
-0 .5

9.3

10.0
10.8
11.6

-0 .7
-2 .0
-3 .6
-2 .4

8.7

8.2

1986-1 ..........................................
1986-11..........................................
1986-111........................................
1986-IV........................................

One-year certificates

Maturing

8.8
8.0
8.1

7.6
7.7

10.5
9.3

8.8
8.0
8.1

Source: Bank Rate Monitor.
Table 4

Selected interest Rate Spreads
In percentage points

Six-month certificates less:
Date
Difference in yield
1984-1......................................
1984-11......................................
1984-111....................................
1984-IV....................................
1985-1......................................
1985-11......................................
1985-111....................................
1985-IV....................................
Percentage change in yield
spread from one year earlier
1985-1......................................
1985-11......................................
1985-111.....................................
1985-IV.....................................

Super
NOWs

NOWs

Demand
deposits

MMDAs

4.2
5.1

9.5
10.4

6.0

11.2
10.0

07
1.1

2.0
2.9
3.6
2.5

4.7

1.7

3.4
3.0
2.4
2.5

8.7

-1 9 .6
-42.1
-6 0 .5
-4 7 .8

-8 .8
-2 0 .8
-3 2 .2
-2 2 .6

1.6
1.5

1.6

-18.0
-45.2
-59.1
-36 .6

Source: Bank Rate Monitor.

8

FRBNY Quarterly Review/Winter 1985-86




8.2
7.6
7.7

1.5
0.7

0.6
0.7
0.7

0.8

-8 .3
-38.1
-5 2 .9
13.8

One-year certificates less:
Super
NOWs

NOWs

25
3.3
3.9
3.0

4.7
5.5
6.3
5.2

2.2
2.1

4.0
3.5

1.9

2.0

10.8
-3 4 .9

-5 1 .6
-3 4 .2

Demand
deposits

100
10.8
11.6

MMDAs

1.2
1.5

10.5

1.8
1.2

9.3

1.2

2.8
2.8

8.8
8.0
8.1

1.1
1.2

-1 5 .7
-3 6 .2
-5 5 .8
-4 5 .4

-7 .4
-1 8 .6
-3 0 .5
-2 2 .6

2.9
-1 7 .6
-3 8 .2
-0 .4

1.3

even when market rates fluctuated widely. In the current
environment, however, banks have set the rates offered on
time deposits in line with market rates, resulting in significant
movements in the rate spreads between these deposits and
more liquid deposits, including those in M1.3 This suggests
that the responsiveness of the demand for M1 to market
interest rates could have increased in recent years because
individuals now have incentives to shift funds between non­
transactions M2 and M1. M2’s interest elasticity would not
increase in a similar fashion because these shifts are con­
tained within M2. Indeed, since the rates paid on a large
share of M2 deposits now move with market rates, house­
holds have less incentive to substitute between M2 deposits
and short-term market instruments. Disintermediation has
been greatly reduced, and M2’s interest rate responsive­
ness has probably declined somewhat.4

The liquid com ponents o f M3
In part, M1 appeared so strong in 1985 compared with M2
and M3 because of the way the various types of deposits
are grouped in the monetary aggregates (Table 5). M1 con­
tains currency and checking deposits, but M2 includes der
posits (or similar assets) with varying degrees of liquidity. A
large portion of M2 consists of immediately available depos­
its or overnight investments: M1, savings deposits, MMDAs,
MMMFs, and overnight RPs and Eurodollars. But another
sizeable portion of M2 (35 percent) is less liquid deposits,
i.e., small time deposits. M3 contains M2 (which makes up
about 80 percent of M3) plus time deposits of $100,000 and
over, institutional MMMFs, and term RPs and Eurodollars.
So M3 like M2 is comprised of both highly liquid and less
liquid assets. Therefore, shifts in liquidity preferences have
little effect on the growth rates of M2 and M3. As the aggre­
gates are now defined, only M1 would be much affected by
such shifts.
Table 6 compares the growth rate of the liquid compo­
nents of M3 (as defined in Table 5) with the monetary ag­
gregates. The liquid components of M3, like M1, accelerat­

In the case of Super NOWs, the narrowing of the spread reflected not only
the reduction of the rates on time deposits as market rates fell but also the
consideration that banks were slow to adjust the Super NOW rate downward.
Disintermediation is the diversion of savings from accounts with low fixed
interest rates to direct investment in high-yielding instruments.

Table 5

Components o f M3
In billions of dollars
Definitions of monetary aggregates
M1

Volume
617.9

Components grouped by liquidity
M1

+

Savings deposits and MMDAs

810.6

+

Overnight RPs and Eurodollars

69.6

+
+

+

Noninstitutional MMMFs

176.4

+

Noninstitutional MMMFs

+

Small time deposits

873.9

+

Institutional MMMFs

=

M2

2,548.4*

=

Liquid components of M3

Volume
617.9

Savings deposits and MMDAs

810.6

Immediate

Overnight RPs and Eurodollars

69.6

availability

176.4

or overnight

64.1

maturity

1,738.6*

+

Institutional MMMFs

64.1

+

Small time deposits

873.9

Longer than

+

Large time deposits

437.4

Large time deposits

437.4

overnight

+

Term RPs and Eurodollars

152.6

+
+

Term RPs and Eurodollars

152.6

maturity

=

M3

3,202.5*

-

M3

3,202.5*

Components do not add exactly to the total due to consolidation components. Dollar volumes are as of the fourth quarter of 1985.
Table 6

Recent G rowth Rates o f the Monetary Aggregates
Annual rates of growth (in percent)
Non-M1
components
of M2

Non-M2
components
of M3

Liquid
components
of M3*

Liquid
components
of M3 not
in M1*

Date

M1

M2

M3

1983-IV to 1984-1V .............................

5.2

7.7

10.4

8.6

11.7

5.4

5.5

1984-IV to 1985-IV.............................

11.6

8.6

8.0

7.7

7.1

14.0

15.4

* See Table 5 for definition.




FRBNY Quarterly Review/Winter 1985-86

9

ed sharply in 1985. Indeed, the acceleration was even more
pronounced than for M1. This suggests that individuals and
firms responded to the recent drop in interest rates and nar­
rower spreads by building up their liquid assets.

Summary
Seen in this light, the acceleration in M1 in 1985 looks less
puzzling. The contrasts in the growth of the narrow and
broad monetary aggregates stemmed in part from the differ­
ent behavior of the less liquid and more liquid components
of M2 and M3 as relative yields changed. In a regulated
environment, the relative yields on the components of M2

(or M3) did not change when interest rate ceilings were
binding—even when market rates fluctuated significantly.
Hence, the distinction between the less and more liquid
components of M2 and M3 was less important in under­
standing how the monetary aggregates responded to
changes in market rates. Individuals reacted by moving
funds between M2 (or M3) deposits and short-term market
instruments. In a deregulated structure individuals at times
still have incentives to shift funds, not only between market
instruments and the monetary aggregates but also between
M2 (or M3) components. This can contribute to growth in
M1 that appears very unusual compared with GNP or M2
and M3, as it did in 1985.

John Wenninger and Lawrence J. Radecki

10 FRBNY Quarterly Review/Winter 1985-86



Japan’s Intangible Barriers to
Trade in Manufactures

Mounting U.S. trade deficits over the past three years have
greatly intensified political and economic pressures for trade
protectionism. These pressures have subsided somewhat
following the recent decline in the dollar but will most likely
continue to be strong over the near-term. Japan has born
the brunt of the criticism because our bilateral trade deficit
with Japan—the largest with any country—has been grow­
ing very rapidly and now accounts for about one-third of our
total trade deficit. While Japan’s tariffs and quotas, at least
on manufactured products, are recognized as being similar
to or lower than other major industrial countries, many sus­
pect that what are sometimes called “ intangible” barriers to
imports contribute to Japan’s trade surplus.
Intangible barriers are mainly systems and regulations ap­
plying to both domestic and foreign producers which, by ac­
cident or design, work to the special disadvantage of im­
ports. In Japan those barriers provoking the most foreign
complaints have been product standards and testing proce­
dures, the wholesale and retail distribution systems, and
government procurement. Intangible trade barriers are
found in many countries and have attracted increasing inter­
national criticism as tariffs and quotas have gradually been
negotiated downward. In fact, reductions of some barriers
were included in the Toyko Round of multilateral trade
agreements that became effective in 1980. As a signatory,
Japan has adopted a series of measures designed to sub­
stantially reduce its intangible barriers. Because the chang­
es are being phased-in gradually between 1983 and 1988,
and because the trade response will take time, the results
will emerge slowly.
This article briefly describes the nature of intangible barri­
ers to imports of manufactures, the products principally af­
fected, the liberalization moves already made and those




planned for 1986-88, and systemic changes that could also
ease entry of foreign products. Finally, it offers rough esti­
mates of the long-run trade consequences of greatly reduc­
ing those barriers.
We find that these intangible barriers have probably been
important for a significant number of products. These in­
clude computers, sophisticated telecommunications equip­
ment, and other industrial machinery for which several in­
dustrial countries compete strongly with Japan. It is also true
of chemicals and some other products for which Japan is at
a comparative disadvantage. We estimate, very roughly, that
other things being equal, reduction of intangible trade barri­
ers, as defined here, for affected products to the level pre­
vailing in the United States and the European Community
(EC), could ultimately raise Japan’s imports by as much as
7 percent, or about $9 billion from the 1983 level. However,
because only partial barrier removal can be expected, the
actual increase in imports over the next five to ten years
would be smaller. About half of any gain would accrue to
U.S. exports to Japan.1

Japan’s import policy in perspective
Japan’s markets are sometimes perceived as relatively
closed to foreigners. But as far as tariffs and quantitative
restrictions on imports of manufactures are concerned, this
is certainly not true. In the early postwar years, Japan im­
posed high tariffs and stringent quotas to allow war-ravaged
industries to rebuild and to protect infant industries such as
automobiles as well as the relatively inefficient agriculture
sector. However, as basic industries like steel regained their
1 This is somewhat higher than differently derived estimates by W.F. Bergsten
and William R. Cline in The United States-Japan Economic Problem, Institute
for International Economics (October 1985).

FRBNY Quarterly Review/Winter 1985-86 11

footing and as the automobile and consumer electronics
industries became strong competitors in world markets,
Japan joined with other nations in mutual reduction of tariffs
and quotas on imports of manufactures. Before the latest
round of tariff reductions in 1980, Japan’s trade-weighted
average tariff on manufactured goods was around 10
percent, nearly identical to the EC average and slightly
higher than that of the United States.2 When the Tokyo
Round cuts are fully implemented, which in Japan’s case
has already occurred, Japan’s average tariff on
manufactures, at 2.9 percent, will be one and one-half to
four percentage points lower than the also low averages for
the other industrial countries.3
In the area of quantitative restrictions, Japan maintains 22
quotas on imports of agricultural products, rivaling the EC in
the protectionist thrust of its trade policy. But for manufac­
tures, its use of such restrictions is more limited: there are
quotas only on leather products and coal briquettes. And
Japan is a member, along with the United States and the EC
countries, in the multi-fiber agreement which limits exports
of textile products from developing countries to industrial
countries. However, unlike the United States, Canada, and
the EC countries, Japan has not requested that its trading
partners impose other “ voluntary” restraints on their exports
to Japan.
While quantitative restrictions apply to a limited range of
Japan’s imports of manufactures, the scope of intangible
barriers is broader. Foreign countries have complained that
restrictive product standards and related inspection and cer­
tification procedures, the wholesale and retail distribution
systems, and government procurement procedures make
Japanese markets for many manufactured products difficult
to penetrate. These barriers have included clear and specif­
ic elements of discrimination against imports. But beyond
this, some have limited market access to all newcomers,
domestic and foreign, and thus may have also served to
restrict imports. Pressures on the Japanese government to
eliminate these intangible barriers to imports have mounted
sharply as the country’s trade surplus has widened. The fol­
lowing three sections will describe these intangible barriers,
the Japanese government’s moves to reduce them, and
systemic changes working in the same direction.
2 Gary Saxenhouse, “ Evolving Comparative Advantage and Japan's Imports of
Manufactures” , in K. Yamamura, ed., Policy and Trade Issues of the Japanese
Economy (University of Washington Press, 1982). The averages included mine
products.
3 Alan V Deardorff and Robert M. Stern, “ The Economic Effects of Complete
Elimination of Post-Tokyo Round Tariffs", in W. R. Cline, ed., Trade Policy in
The 1980s (Institute for International Economics, 1983).
In those areas where industrial countries' tariffs are still protective (notably
apparel and footwear, where imports from developing countries are
considered a threat) Japan's tariffs are fully as high as those of all major
industrial countries except the United States. But for those products where
Japan has a clear competitive advantage, Japan's tariffs are significantly lower
than in other industrial countries. This reduces its average tariff relative to other
industrial countries.

12 FRBNY Quarterly Review/Winter 1985-86



Product standards
Product standards are frequently mentioned as Japan’s
most important intangible barrier to trade. Established by the
central government to cover most domestic and imported
manufactures, standards are of two kinds. First, there are
awards for excellence. The Japanese Industrial Standards
Committee awards the “ JIS” mark to products made in fac­
tories where production methods and quality controls meet
committee standards. Similarly, the Ministry of Agriculture,
Forestry, and Fisheries awards the “ JAS” mark (Japanese
Agricultural Standards) to processed foods and forestry
products from factories meeting its standards. The stan­
dards underlying the JIS and JAS marks are so rigorous that
many small- and medium-sized firms do not apply for them.
But the marks greatly increase product saleability and in
many cases have become mandatory for sales to public
bodies. Second, most products must meet required mini­
mum standards. These are set by various government de­
partments, with the advice of industry committees, and are
designed to protect the health and safety of consumers and
to assure overall product quality.
For foods and pharmaceuticals, where health and safety
are involved, Japanese and U.S. approaches to setting re­
quired minimum standards are generally similar. But for oth­
er products, Japanese standards-setting is more concen­
trated in the central government and more comprehensive.
In the United States, standards-setting is often left to local
governments (e.g., local plumbing and wiring ordinances)
or trade associations {e.g., standards for electrical appli­
ances). There is also greater reliance in the United States
on competition and consumer response, rather than elabo­
rate standards requirements, to assure quality—and per­
haps stronger industry resistance to central government
standards-setting.
Until recently, the Japanese system of standards overtly
discriminated against foreign suppliers. This was recognized
in an official report of 1981,4 and the barriers were described
in some detail in a 1980 report of an unofficial group drawn
from United States and Japanese business firms and gov­
ernment agencies.5 The major discriminatory features identi­
fied were the following:
• The coveted JIS and JAS marks were not available to
foreigners.
• Exporters to Japan were not members of the advisory
standards-setting committees and had no direct chan­
nels for making their views known to the authorities
since they were required to work through Japanese
importers.
4 Report of the Japan-United States Economic Relations Group (1981).
5 United States-Japan Trade Study Group, A Special Progress Report (April
1980).

• The standards themselves were often “ non­
transparent” —/le., vaguely worded, hard to understand,
and frequently not published in a readily available
source.
• Testing requirements were more burdensome and ex­
pensive for imports than for domestically produced
products. Japanese producers could choose among
three methods of meeting standards: “ type approval” ,
based on factory inspection and product testing; "lot
inspection” , i.e., testing samples from each lot; or indi­
vidual inspection of each product. For the large produc­
er, “ type approval” is usually the cost-efficient choice.
But until 1983, exporters to Japan could not use this
method. Instead they were required to pass "lot inspec­
tion” or even individual inspection, and to work through
a Japanese agent.6
Foreign exporters claiming to have been unfavorably affect­
ed by one or more of these restrictions have included for­
eign suppliers of plywood products, pharmaceuticals, agri­
cultural chemicals, cosmetics, forest products, automobiles,
electrical appliances, telecommunications equipment, and
some types of industrial machinery.
These discriminatory features did not conform to the stan­
dards agreement under the General Agreement of Tariffs
and Trade (GATT) that became effective in 1980. That
agreement specified that standards should avoid unneces­
sary obstacles to trade, be transparent, conform to interna­
tional standards where appropriate, and provide “ national”
treatment to foreign suppliers (i.e., treat foreign suppliers
the same as domestic suppliers). Although Japan initiated
limited moves toward compliance in 1980, major efforts be­
gan only in 1983. At that time 16 statutes were amended in
order to provide national treatment for foreign suppliers. Fol­
lowing the 1980-83 changes, foreigners were permitted to
apply for the JIS and JAS plant approval marks, to elect the
“ type approval” route to meeting required standards, to be­
come members of advisory committees, and to present their
views directly to official standards-setting bodies.
Despite these changes, product standards remained a
major irritant in Japan’s trade relations. As foreign and do­
mestic suppliers became subject to the same requirements,
foreign pressures for change shifted to the standards them­
selves. Complaints were focused on the complexity of Japa­
nese standards and their dissimilarity to international stan­
dards (where such existed), or to those in the supplier’s
own country. Objections were also raised to Japanese gov­
ernment inspection of factories outside Japan, and to the
need for product testing in Japan rather than by approved
foreign certification agencies. These aspects of Japanese
standards requirements did not always violate national treat6 Operations of the Trade Agreements Program, 35th Report (1983) and United
States International Trade Commission (June 1984).




ment precepts. However, they may have put a greater finan­
cial burden on foreign entrants to Japanese markets than
they did on Japanese producers. If so, they may have dis­
couraged imports of products for which foreign producers
had a comparative advantage.
The Japanese authorities had made a start at addressing
these complaints in 1983. But in 1985, spurred by a widen­
ing trade surplus and mounting tension with trading part­
ners, they initiated a new broad-scale program scheduled to
take effect gradually between 1985 and 1988. To meet the
criticism that standards were unnecessarily complicated,
some standards were to be eliminated altogether and many
others were to be simplified. Instead of requiring Japanese
inspection of foreign factories, Japan decided to accept ap­
proved foreign tests for many products and permit selfcertification by suppliers of numerous products. The govern­
ment also agreed to step up its study of international
standards and to consult with other interested countries and
international standards-setting bodies. For a few products,
Japan also agreed to accept a few international standards in
1985 and 1986. (Details of the 1985 program are given in
the appendix.) Since many aspects of the 1985 program
remained to be spelled out, official U.S.-Japan trade groups
continued to meet, hammering out specifics acceptable to
both sides.

The distribution system as a barrier to imports
As with product standards, the Japanese distribution system
has presented two types of barriers to imports: clear dis­
crimination against imports in a few areas, and more perva­
sive systemic barriers to new entrants, foreign or domestic.
Both sorts of barriers are crumbling—the discriminatory
ones at the insistence of foreign suppliers and the systemic
ones as part of a slow evolution.
The outstanding case of deliberate discrimination against
imports, per se, in the distribution system has been that
practiced by the government-owned Japan Tobacco and
Salt Public Corporation (JTS). In addition to monopolizing
the purchase of raw materials and the manufacture of to­
bacco and salt products, JTS controlled the distribution of
tobacco products until 1985. By limiting the number of retail­
ers permitted to sell foreign cigarettes and restricting adver­
tising expenditures, it limited imports to about 2 percent of
total sales. In April 1985, JTS was “ privatized” , becoming
Japan Tobacco (JT), a “ special corporation” under govern­
ment jurisdiction.7 In response to political pressure from
Japanese tobacco growers, it will continue to monopolize
purchases of tobacco and the manufacture of cigarettes
and other tobacco products. But it has relinquished its con7 In the foreseeable future, JT will not become privately owned, as the word
"privatized" (used in the official description of the change) might suggest. The
details of the privatization and market prospects for JT and foreign suppliers
are discussed in “ The Tobacco Monopoly Goes Private” , Economic Eye, a
Quarterly Digest of Views from Japan, Japan Institute for Social and Economic
Affairs (June 1985).

FRBNY Quarterly Review/Winter 1985-86 13

Table 1

D istribution o f Sales by Japan’s Retailers and
W holesalers by Number o f Persons Engaged per
Establishm ent
In percent of total sales
Retailers
Number of persons engaged *
One to four...............................
Five to forty-nine......................
Fifty and over...........................

1954
58.8
32.4
9.1

1960
48.3
38.6
13.1

One to four...............................
Five to forty-nine......................
Fifty and over...........................
1111i l l HMMIRSSH
H MH
SmmmmmmmMmmmmmtsmMMmmmimmmm

7.8
56.5
35.7

5.7
50.6
43.9

1974
34.1
44.8
21.2

1982
32.8
47.0
20.0

Wholesalers
4.0
39.0
57.0

5.3
41.3
53.4

Percentages may not add to 100 due to rounding.
* Includes proprietors, family members, and corporate officers.
Source: Japan Statistical Yearbooks.
SHHS H i! :HI! l i l i l 1:: iH

trol over the distribution of tobacco products and will allow
foreign cigarettes and other tobacco manufactures to com­
pete freely by allowing them unlimited access to wholesale
and retail distribution channels.
A wider-spread problem for foreign suppliers of many con­
sumer goods has been the barrier to new entry, domestic or
foreign, created by exclusive dealer arrangements. Such ar­
rangements thrived in the highly fragmented distribution sys­
tem of the early postwar years but are losing importance as
the distribution system changes.
In the early postwar period, the small store was predomi­
nant in Japanese retailing (Table 1). In 1960, for example,
nearly 50 percent of all retail sales were made in establish­
ments of one to four employees and only 13 percent in
stores with 50 or more employees. Linking manufacturers to
retailers was a network of national, regional, and local
wholesalers, which also tended to be small. Producers of
manufactured consumer goods easily dominated this frag­
mented distribution system, either by direct ownership of
some wholesalers or by exclusive dealer arrangements.
Wholesalers in turn often made exclusive agreements with
retailers. Given their small size, most retailers had little abili­
ty or incentive to resist such arrangements.
However, changes in the Japanese economy gradually
forced changes in the size of the distribution unit. As the
ownership of automobiles and refrigerators, rare in the
1950s and early 1960s, became common later in the 1960s
and after, the need for small retail stores close to home
diminished. At the same time, increasing competition in la­
bor markets in the 1960s increased the need for larger,
more labor-efficient distribution units. The government con­

14 FRBNY Quarterly Review/Winter 1985-86



tributed to the shift to larger distribution units by making lowinterest loans to wholesalers and retailers for relocating and
modernizing. By the mid-1970s, only 34 percent of all retail
sales were made in establishments with one to four employ­
ees and sales of stores with 50 or more employees had
risen to 21 percent of the total. The scale of wholesalers
increased correspondingly.8
Since the mid-1970s, however, the trend toward larger
retailers and wholesalers has slowed. At least part of the
explanation lies in changing government policy. As the growth
of employment opportunities in manufacturing diminished,
government policy shifted from fostering more efficient opera­
tions to protecting the small retailer and employment in retail­
ing by limiting the size of retailers. A 1974 law required Ministry
of International Trade and Industry approval for construction
of any retail store of 1,500 square meters or more (3,000
square meters in ten large cities). Since then, several pre­
fectures have enacted even more stringent regulations.
However, changes in the scale of retailing that had oc­
curred before the mid-1970s and the continued increase in
the proportion of mid-sized retailers were enough to loosen
the grip of exclusive dealer arrangements in some areas.
Many larger retailers, especially in consumer electronics,
have gone into high-volume discount sales, bypassing
wholesalers altogether and dealing directly with a number of
competing manufacturers.9 Wholesalers, fighting for their
existence, are also beginning to avoid exclusive marketing
agreements and are offering a wider variety of products.10
Developments of this sort should ease entry for all new
market participants, including foreign suppliers. However,
these trends seem to be strongest in consumer electronics,
where few if any foreign suppliers are competitive. In retail
areas where imports should be competitive, some distribu­
tion difficulties persist. A recent government survey of distri­
bution markups for domestic and imported products found
that for whiskeys, candies, edible oils, men’s overcoats, and
footwear, markups on imports were double those on domes­
tic products.11 Even after allowing for the inclusion of tariffs
in the markup on imports, the discrepancy between markups
for imports and those for domestic products remained large.
The difference in markups suggests the presence of exclu­
sive distribution arrangements. The resulting high price for
imports has probably limited the sale of imported products.
8 This description of the evolution of the Japanese distribution system draws
heavily on Edward J. Lincoln, “ The Zebra Stripes or a Tale of Distributus
Japanicus and the Economists” , in M. Harvey and R. Lusch, eds., Marketing
Channels: Domestic and International Perspectives (University of Oklahoma
Press, 1982). However, Lincoln focuses on the efficiency of the system.
9 “ Home Electric Appliances: High Volume Retailers are Changing Distribution
Patterns” , Daiwa Bank Monthly Research Report (December 1985).
10 "Wholesalers Struggle to Ride Out Stormy Rationalization in Distribution” ,
Mitsubishi Bank Review (May 1985).
11 A report by Japan’s Council on Price Stabilization, summarized in Japan
Economic Journal {November 23, 1985).

Government procurement
In Japan as in other industrial countries, government pro­
curement has favored domestic producers. To reduce this
discrimination, the Tokyo Round included an agreement on
government procurement, which Japan and most other in­
dustrial countries have accepted. This requires that foreign­
ers be permitted to bid on government contracts valued at
SDR 150,000 (about $165,000-U.S.) or more, and that bid­
ding procedures be "transparent” .
Interest in the Japanese government’s procurement of in­
dustrial products has been focused on Nippon Telephone
and Telegraph (NTT) which has purchased annually about
$2-3 billion of telecommunications equipment in recent
years. Following the Tokyo Round agreement and a special
bilateral agreement with the United States in 1981, NTT
opened its procurement to foreign bidders. The modest rise
in its foreign purchases that followed proved disappointing
to foreign suppliers. Judging from complaints registered with
GATT in 1983, Japan was especially remiss in its reliance
on single tendering, but was also criticized for short bid
deadlines, short delivery times, maximum price specifica­
tions, and complex qualification requirements. Somewhat
similar criticisms were made of other countries as well.12
In its market-opening package of 1985, Japan attempted
to meet these complaints. It promised to review single ten­
dering (acknowledging that this method should be used
only exceptionally), to increase bid times (from 30 to 40
days), and to simplify qualification procedures. It also ex­
panded the number of government agencies and corpora­
tions which would open their procurement to foreign bidding.
However, there are still some important omissions such as
the National Space Development agency, the sole govern­
ment purchaser of communications satellites.
In the meantime, however, the opportunities for marketing
sophisticated telecommunications equipment and comput­
ers have shifted to the private sector. This shift is partly
because NTT was “ privatized” 13 in 1985, thus moving a
major purchaser of computers and sophisticated telecom­
munications equipment from the public to the private sector.
But it is also because the telecommunications industry has
been transformed by breaking the NTT monopoly over tele­
communications and permitting the entry of foreigners.
In Japan the telecommunications industry is now divided
into two branches: common carriers and services known as
Value-Added Networks (VANs). The latter include data
processing, computer linkages, teleconferencing, and video­
tex. Foreign firms may hold no more than one-third interest
Italy, France, and the United States were faulted for short bid deadlines, and
Italy for publishing few tenders. The United States was criticized for
proliferation of “ Buy American" requirements. United States International
Trade Commission, op. cit., page 89.
The NTT Act of December 20,1984 made NTT a private company as of April 1,
1985. However, the government still holds all of NTT’s stock issued on that
date. It will be sold to the public gradually, beginning in 1986, but foreigners
will not be permitted to purchase it.




in common carriers but are permitted 100 percent owner­
ship of VANs. A number of large U.S. firms have entered or
are about to enter the VANs area, alone or with Japanese
partners including NTT. Since VANs were slow to develop in
the period of the NTT monopoly, experienced foreign firms
may have at least a temporary technological advantage.
Both common carriers and VANs (domestic and foreign)
constitute a rapidly expanding market for sophisticated tele­
communications equipment, computers, and software. NTT
has pledged to conform to the procurement policies to
which it had been committed as a government corporation
under the GATT agreement on government procurement.
Further, since private firms, including NTT, are now permit­
ted to buy foreign communications satellites, a market for
the U.S. product has been opened. In view of the impor­
tance of standards for computers and software in the com­
petitive and rapidly growing telecommunications market, a
U.S.-Japan committee was organized to negotiate the de­
velopment of standards. As a result, standards and stan­
dards procedures originally proposed by Japan have been
simplified.14 Manufacturer-generated test data will be ac­
cepted and standards will be limited to insuring that the
equipment does not harm the Japanese telecommunica­
tions network.15 Bilateral negotiations with the United States
covering these and other points were successfully conclud­
ed in January 1986.

Trade consequences of eliminating intangible barriers
to imports
Now that Japan’s intangible barriers to imports of manufac­
tures are falling, the natural question is how much of an
increase in imports of manufactures can be expected as a
result. We start with a very rough estimate of the maximum
increase in Japan’s imports of specified manufactured prod­
ucts that could ultimately come from reducing intangible bar­
riers to the levels prevailing in the United States and the EC
countries. These estimates are based on the presumption
that, in the absence of trade barriers or subsidies to domes­
tic output (or with uniform low trade barriers and subsidies
across countries), countries with roughly similar comparative
advantage in producing a given product will have similar pro­
pensities to import it.16 These propensities are measured as
14 Operation of the Trade Agreements Program, U.S. International Trade
Commission, Publication 1725 (July 1985), pages 148-149.
15 Annual Report on National Trade Estimates, The U.S. Trade Representative,
Executive Office of the President (1985), page 119.
16 It might be argued that Japan’s imports should not be expected to conform
exactly to our basic assumption (i.e., that countries with similar comparative
advantage in trade of a given product will have similar propensities to import
that product) since Japan's higher propensity to import raw materials might
lead to lower propensities to import manufactures. However, these basic
international differences in resource endowment are at least partially reflected
in Japan’s exceptionally high comparative cfeadvantages relative to other
countries for raw materials, and its exceptionally high comparative advantages
in some manufactured products.

FRBNY Quarterly Review/Winter 1985-86 15

;<$g§ggg

gg |ig g | I M i | §|§§

,v.:' .. ,,

mm

§ sg s

,,,

,.. .. ,

T ab le 2

Comparative Advantage Indicators* fo r Japan,
the United States, and the European Community
Selected industrial product groups
Products grouped according to
Japan’s comparative advantages
relative to the United States and the
European Community
Much stronger
Consumer electronics..................
Road vehicles...............................
Roughly similar or
somewhat weaker
Office and data processing
machinery.................................
Electrical machinery not
elsewhere specified ................
General industry machinery.........
Professional, scientific, and
control instruments..................
Much weaker
Chemicals....................................
Pharmaceuticals ......................
Essential oils and cosmetics . . .
Fertilizers .................................
Cork and wood products.............
Clothing........................................
Beverages ...................................
Tobacco and manufactures.........

Japan

United
States

European
Community

5.6
3.9

0.6
1.3

0.4
1.2

2.9

3.0

0.8

1.9
1.4

1.5
1.7

1.3
2.2

1.2

3.0

1.5

0.5
0.5
0.2

1.7
1.7
1.4
1.2
0.6
0.1
0.2
2.6

2.2
2.5
3.0
0.8
0.5
0.9
4.4
0.4

t
0.2
0.2
0.1
t

* Ratio of share in OECD imports of given product group to share in
OECD imports of all products. Based on data for 1983 as published in
OECD, Foreign Trade by Commodities, Volume II, Imports. IntraEuropean Community trade has been excluded from the OECD imports
total and the European Community share,
t Less than 0.05.

the ratio of imports to GNP. We approximate comparative
advantage in each product group by the ratio of the coun­
try’s share in supplying world imports of the product in ques­
tion to its share in supplying world imports of all products.17
A ratio significantly higher than one denotes comparative
advantage.
Table 2 provides a rough snapshot indicator of the com­
parative advantage of Japan, the United States, and the EC
in 1983 for those product groups affected by Japan’s intan­
gible trade barriers described in the preceding sections.18
For consumer electronics and road vehicles, it is clear
that Japan has an overwhelming comparative advantage
This measure was developed by Bela Balassa in “ Trade Liberalization and
‘Revealed’ Competitive Advantages” , Manchester School of Economic and
Social Studies (May 1965).
As a matter of convenience, OECD imports from all sources are taken as a
proxy for world imports. The year 1983, the latest for which the desired data
were available, has the advantage of being the year Japan seriously embarked
on reducing its intangible barriers to trade. Processed foods, though affected
by intangible barriers to imports, are omitted for lack of OECD trade data.

16 FRBNY Quarterly Review/Winter 1985-86



relative to the United States and the EC. For office machin­
ery (including computers), the comparative advantages of
Japan and the United States are quite similar. For electrical
machinery, a product group which includes both sophisticat­
ed telecommunications equipment and consumer electrical
appliances, Japan’s comparative advantage is slightly great­
er than the United States’. For general industrial machinery
and professional, scientific, and control instruments, Japan
has a weaker comparative advantage than the United
States and the EC. For chemicals, wood products, clothing,
beverages, and tobacco products, Japan has a decided
comparative disadvantage while the United States and the
EC have a strong comparative advantage in some of them.19
Table 3 shows strikingly lower import propensities for Ja­
pan than for the United States and the EC in virtually all
product groups. This is true not only in cases where Japan
has a strong comparative advantage but also in cases
where similar comparative advantage would lead one to ex­
pect similar propensities. It is also true in the case of prod­
ucts for which Japan has a comparative disadvantage while
the United States and/or the EC have a comparative advan­
tage. Since tariffs and quota restrictions are low in all of
these countries for most affected product groups, this asym­
metry between comparative advantage and propensity to
import in Japan suggests that its intangible barriers are in
fact restrictive.
Table 3 also gives an estimate of the potential long-run
increase in Japan’s manufactured imports from a lowering of
its intangible barriers for the products shown in the table to
the level prevailing in the United States and the EC. Total
manufactured imports could rise by 27 percent while total
imports could rise by 7 percent. (This would raise Japan’s
total manufactured imports by about three-quarters of a
percent of GNP.) Over half the increase should come in
chemicals (including pharmaceuticals), computers, data
processing equipment, and electrical machinery (including
sophisticated telecommunications equipment). On the basis
of current trading patterns, the United States’ share of the
overall gain should be at least half.
The foregoing estimate is a maximum in the sense that it
represents the rise in imports of specified products that
could be expected if Japan’s intangible barriers to those im­
ports were reduced to the generally lower U.S. or EC levels.
Since barrier reductions now in prospect are not complete,
their import consequences are likely to be lower than these
maximum estimates.
Conclusion
We have found that although Japan’s tariffs and quantitative
restrictions are lower than in other industrial countries, its
19 For wood products, clothing, and footwear, Japan, the United States, and the
EC are all at a comparative disadvantage (Japan more than the others)—which
may explain their universally high tariffs in those areas. Comparative
advantage in these areas belongs to the developing countries.

intangible barriers have remained significant. Such barri­
ers—product standards, the distribution system, and gov­
ernment procurement—have included elements of dis­
crimination against imports as well as systemic impediments
to all newcomers, domestic and foreign. As a result of heavy
pressure from its trading partners, Japan has already
reduced measurably many discriminatory features of
standards-setting and government procurement and is in
the process of doing more. In two programs announced in

1983 and 1985, the Japanese government has undertaken
to greatly reduce systemic barriers in standards by simplify­
ing the standards themselves and the certification proce­
dures required to meet them. Moreover, a natural evolution
of the wholesale and retail distribution system—mainly a
move toward larger, more enterprising, and independent re­
tailers—is gradually reducing systemic barriers in that area.
Other things remaining the same, reduction of intangible
barriers to U.S. or EC levels for affected products could

Table 3

Estim ating the Long-Run Consequences o f Elim inating Intangible Barriers to Japan’s Im ports
Products grouped
according to
Japan’s comparative
advantage relative to the
United States and the
European Community
Much stronger...............................
Consumer electronics......................
Motor vehicles.................................
Roughly similar or
somewhat w e a ke r....................
Office and data processing
machinery.....................................
Electrical machinery (not elsewhere
specified)....................................
General industrial machinery...........
Professional, scientific, and control
instruments...................................

Estimated change Induced by
lowering intangible barriers

Imports as percent of GNP
Japan’s
imports
in 1983
In millions
of dollars Japan
1,083
464
619

0.038
0.052

United
States

European
Community

0.352
1.138

0.284
0.444

Japan
Ratio of
(estimated, estimated/
intangible
actual
barriers imports for
Japan
lowered)*

0.038
0.052

1.00
1.00

5,178

Japan’s
estimated
imports
In millions In millions
of dollars of dollars

Percent
of total
1983
imports

Percent of
1983 imports
of manufacturers

1,083
464
619

0
0
0

8,834

3,656

2.9

11.6

1,068

0.090

0.211

0.416

0.211

2.34

2,504

1,436

1.1

4.6

2,051
1,004

0.174
0.085

0.392
0.150

0.382
0.231

0.209t
0.150

1.2 t
1.76

2,461
1,771

410
767

0.3
0.6

1.3
2.4

1,055

0.089

0.063

0.177

0.177

1.99

2,098

1,043

0.8

3.3

1.45
3.00
1.66$
1.91
2.00$

13,965
10,140
516
2,508
177
624

4,869
3,132
344
997
84
312

3.9
2.5
0.3
0.8
0.1
0.2

15.4
9.9
1.1
3.2
0.3
1.0

23,882

8,525

6.8

27.0

Much w eaker.................................
Chemicals........................................
Cork and wood products.................
Clothing............................................
Tobacco products...........................
Beverages......................................

9,096
7,008
172
1,511
93
312

Total of above...............................

15,357

Memorandum:
Imports of manufactures I I .......
Total imports..........................

31,532
125,017

0.593
0.015
0.127
0.045§
0.026

0.341
0.045
0.316
0.023§
0.089

0.660
0.083
0.369
0.066§
0.028

0.858
0.045$
0.210$
0.086
0.052$

Calculated percentages may not add to totals due to rounding.
* The basic assumption, that in the absence of barriers, countries with similar comparative advantage have similar import propensities (defined as imports as a
percent of GNP), is taken to imply the following:
• Products for which Japan has a strong comparative advantage: no change in import propensities.
• Products for which Japan's comparative advantage or disadvantage is roughly similar to that of the United States or the EC: Japan's import propensity
would rise to that of whichever has the more similar comparative advantage.
• Products for which Japan's comparative advantage is decidedly lower than that of the United States and the EC: Japan's propensity is raised to 1.3 times
the higher of the United States and the EC propensities. This seems conservative in light of differences in import propensities for products where
competitive advantages are similar.
Exceptions to this procedure are footnoted separately.
t In this heterogenous product group (which includes consumer and sophisticated industrial equipment) the difference in income propensities to import is too
large to be explained by Japan's slightly higher comparative advantage. Japan’s import propensity is therefore raised by 20 percent.
$ Some of the discrepency between Japan’s propensity to import and the propensities of the United States and the EC are due to higher tariffs, in the case of wood
products and alcoholic beverages, and to strict import restraints under the multi-fiber agreement for clothing. The increase in imports assumed to follow from
elimination of intangible barriers only is therefore somewhat arbitrary, but smaller than the increase that could be expected if all trade barriers were eliminated.
§ Tobacco and tobacco products. Trade in tobacco products not available separately.
II Standard International Trade Classifications 0.5, 0.6,0.7, 0.8, 0.11, and 0.122. Processed foods omitted because trade data unavailable.




FRBNY Quarterly Review/Winter 1985-86 17

raise imports by 7 percent in the long run. However, barrier
reductions on this scale do not seem likely.
These estimated long-term gains are not inconsequential.
But they are too small to suggest that intangible barriers are
the primary or even a major source of Japan’s external trade
surpluses—$56 billion total, and $42 billion of it with the
United States in 1985.20 Weak domestic demand growth and

a high savings ratio, especially relative to the United States,
and the strong dollar appear to have been much more im­
portant forces behind Japan’s rising trade surplus over the
past several years. Nevertheless, the gradual reductions of
intangible barriers now in view should contribute modestly
over time to reducing Japan’s external trade surpluses, both
total and bilateral with the United States.
Dorothy Christelow

20 Both balances are f.o.b. Japan.

Appendix:

Measures Introduced in 1985 to Liberalize Standards and Testing Requirements in Japan*

Industry
Flame-retardant material.........................................................................
Special log construction methods..........................................................
Laminated lumber, strand board, and wafer board.................................
Medical equipment for animals ..............................................................
Drugs for animals....................................................................................
Fertilizers.................................................................................................
Chemicals...............................................................................................
Pharmaceuticals......................................................................................
Medical equipment .................................................................................
Cosmetics...............................................................................................
Carbonated beverages...........................................................................
Electrical appliances...............................................................................
Radio equipment....................................................................................
Telecommunication terminals..................................................................
Cellular and cordless phones and pagers ..............................................
Microwave ovens....................................................................................
Boilers and high pressure gas equipment..............................................
Small boilers and steam cleaners...........................................................
Dust respirators......................................................................................
Fire fighting equipment...........................................................................
Measuring instruments...........................................................................
Motor vehicles (all)..................................................................................
Motor vehicles up to 1000 units per type per year...................................
JAS§ mark of factory approval for agricultural and forestry products----JISII mark of factory approval for other manufactured products.............

Conformance
to international
standards

Standards
eliminated
t
t
t

1986 (20%)

1988*
1985
1988
1985
t
t
1985*

t

t
t
t

t
1987|

1986
1986
1986
1986

t

t
t
t
t
t

1988
t

t

t
t
t
1985

t

1986

t

t
t
t
t

1985*

1988(10%)

1986
1985
1985
1988

t
1985

1988
t

1985
1986

1985
1986

1986
1988

t
t

1986
1988
1988
1988
1988
1988
1988
1988
1986

t
t
t
t

r

t
1986*
1985

t
t
t

1985
1988
1985
1985
1988

t

t
t
1986*

t
*

1985

t

Self­
certified

1986

t

1985

1988 (25%)

t

Approved
foreign tests
accepted

Standards
simplified

1986

1985
1986
1985
1986(10%)

1986
1986
1987

1985

t
1986

t
t

1985
1986

1986
1986
1985

* Actions usually apply to only some items in product groups specified. Percentages, when given, indicate affected proportion of items in product group. Years
indicate the maximum time frame within which Japan will act. Years are the fiscal year beginning in April.
t No action planned.
* Consultation or study.
§ Japanese Agricultural Standards.
II Japanese Industrial Standards.

18 FRBNY Quarterly Review/Winter 1985-86



Housing Reform in New Jersey:
The Mount Laurel Decision

New Jersey is in the process of establishing a unique and
complex approach to providing low-income housing on a
large scale. As a result of a State Supreme Court decision
called Mount Laurel II, and as modified by the recently en­
acted Fair Housing Act, many municipalities throughout New
Jersey could be obligated under a complex set of proce­
dures and conditions to change their land use laws to en­
courage the provision of low-cost housing for many thou­
sands of lower-income households.
The ramifications of the Mount Laurel decision are difficult
to understand because of the multiplicity of issues and ob­
jectives—legal, economic, and social—that have evolved
over the past 13 years. These issues and objectives include
the social policy objectives behind building low-income
housing in affluent suburbs, economic questions of financ­
ing such housing, technical issues of determining housing
needs and assigning “ fair share” obligations, and judicial
methods for enforcing them. No comprehensive review of
these various dimensions of Mount Laurel and the Fair
Housing Act has yet been published. This article provides an
overview of this diverse set of issues and objectives so that
all the implications of Mount Laurel can be more fully
understood.
In 1972, a trial court found that the zoning laws of the
township of Mount Laurel excluded housing for poor people,
and thereby violated the state constitution.1 In 1975, the
The author would like to thank William Fischel, James Jager, Karen Jezierny,
Alan Mallach, Beth Pollack, Jerome Rose, Carolyn Sherwood-Call, and Mary
Winder for their comments and suggestions on earlier drafts of this article.
1 Southern Burlington County N.A.A.C.P. v. Township of Mount Laurel, 67 N.J.
151 (1975) (Mount Laurel I). In this article Mount Laurel in normal type refers
to the Township; in italics it can refer to the court cases, the mandated housing,
or the general doctrine.




New Jersey Supreme Court ruled that not only Mount Laurel
but a ll “ developing” municipalities have an obligation to pro­
vide for their “ fair shares” of the surrounding regions’ lowerincome housing needs. The Mount Laurel decision led to a
great deal of litigation but little housing, so in 1980 the com­
plaint reached the New Jersey Supreme Court again, in a
case quickly labeled Mount Laurel II.2
After two years of deliberation, the Court handed down a
unanimous decision supporting the challenge to exclusion­
ary zoning practices. The opinion spanned 150 pages, and
its emotional language clearly reflected the Court’s dissatis­
faction with municipal compliance with the rulings of Mount
Laurel /. Finding strong measures necessary, the Court im­
posed a detailed enforcement mechanism intended to re­
duce the length of litigation and to encourage the provision
of housing.
While the decision imposed a strict judicial remedy, the
Court expressed a preference for legislative enforcement. In
July 1985, New Jersey’s Fair Housing Act was signed into
law.3 It set up an administrative process for resolving Mount
Laurel complaints outside the courts.
The intense controversy over Mount Laurel arises chiefly
from the magnitude of the obligations it imposes. But the
policy debate, complicated by the multiplicity of issues and
objectives, is far from resolved. While implementation of the
legislative remedy has not yet begun, judicial and legislative
2 Southern Burlington County N.A.A.C.P. v. Township of Mount Laurel, 92 N.J.
158 (1983) (Mount Laurel II). Five other cases were combined with the Mount
Laurel suit, and the Court indicated its belief that similar violations were
widespread. As of the last published count, 135 Mount Laurel-related cases
were on Court dockets, involving some 75 municipalities. New Jersey
Administrative Office of the Courts, Press Release (June 10,1985). There were
other related State Supreme Court rulings, which are not discussed here.
3 Public Law 1985, Chapter 222.

FRBNY Quarterly Review/Winter 1985-86 19

action continues. Legal challenges have been raised to
some provisions of the legislative approach, and constitutional amendments have been proposed in the legislature

that would abridge the State Supreme Court’s power to order Mount Laurel remedies. The Governor’s recent State of
the State address indicated his support for such an amend-

Box 1: D efinitions and Details
To encourage compliance with the Mount Laurel mandate,
and to reduce the scope of testimony and dispute, the Court
tried to specify municipal obligations closely. Accordingly, it
sought unequivocal definitions to the often-repeated lan­
guage of the Mount Laurel mandate, a realistic opportunity
for the construction of a municipality’s “ fair share” of the
present and prospective need for lower-income housing in
the surrounding housing region:
• A realistic opportunity is defined as one that is “ at least
sensible for someone to use” (page 261). The opinion
warned that simply providing developers an opportunity
to build low-income housing would not be satisfactory if
builders would still choose to build higher-income hous­
ing on the property (page 260, footnote); under those
circumstances affirmative measures would be required.

is the regional need that must be projected: the Court
specified that the objective is not to gauge a municipali­
ty’s likely future low-income housing needs with popula­
tion projections based on its own past growth (pages
257-258). Such a procedure would invalidly reward a
municipality for its past successful exclusion.
• A municipality’s “ fair share" of these regional needs, al­
though a fundamental concept of the Mount Laurel doc­
trine, is never defined in the opinion. Employment
growth (especially if accompanied by growth in tax
base) was cited as an example of a “ favored” factor
(page 256). Factors (not specified) that would allow a
community to benefit from past successful exclusion
would not be approved. Beyond this characterization,
“ fair share” is left to determination in trial court based
on expert testimony.

• Lower-income housing must be “ affordable” , defined as
costing no more than 25 percent of income (page
221 ).*

• Lower-income actually refers to two groups, called lowand moderate-income. Income cutoffs for these groups
are defined as 50 percent and 80 percent, respectively,
of the area’s median income, with adjustments for
household size (page 221 ) . f The relative proportions of
low- and moderate-income units must be appropriately
balanced, as determined by expert testimony.

• Housing need refers to low- and moderate-income
households currently housed in “ dilapidated” or “ over­
crowded” units (page 243), and to the projected growth
of households in these income classes.

• Present and prospective refers to the obligation to pro­
vide not only for existing lower-income housing need,
but also for the housing need projected into the future. It
* In the trial courts the income percentages used to gauge affordability
have been 28 percent and 30 percent for owner-occupied and rental
housing, respectively.
If provision of housing at these prices is not feasible, municipalities
must still provide an opportunity for the provision of "least-cost
housing” , defined as housing produced at the lowest possible price
consistent with sound planning principles and public health and safety.
The opinion portrays this measure as a last resort and a remedy which
would not be granted lightly.
t These definitions are used by the U.S. Deoartment of Housing and
Urban Development to define ‘‘low” and "very low” income. Still, the
opinion allowed that "other specifications may be more reasonable” .

20 FRBNY Quarterly Review/Winter 1985-86



• The housing region specifies the urban areas from which
a municipality derives its housing responsibility. The opin­
ion noted that in earlier cases, the arguments over the
specifics had prolonged litigation (page 256). The Mount
Laurel II decision provided no definitive criteria for region­
al delineations, but the Court believed that the trial judges
hearing these cases would soon reach consensus.
• The determination of land appropriate for development,
that is, the communities that must grow to accommo­
date a portion of its region’s housing needs, is based on
designation of “ growth area” in the State Development
Guide Plan.tt In Mount Laurel / the test of suitability for
new lower-income housing was based on whether the
municipality was “ developing” . Even though there were
six explicit characteristics of a developing municipality,
the Court found that this previous test neither eliminated
uncertainty nor guaranteed development only in accor­
dance with “ sound planning” (page 224).
t t New Jersey Department of Community Affairs, Division of State and
Regional Planning, State Development Guide Plan (July 1980). The
plan was not created expressly for use in Mount Laurel assignments.
The decision did not determine which municipalities falling under the
jurisdictions of the Pinelands Commission and the Division of Coastal
Resources have any obligations.
Litigants can challenge the "growth area” designation only on
limited grounds: they must show that the designation is arbitrary and
capricious, or that circumstances have changed to render the
designation inappropriate. Moreover, the maps must be revised every
three years (the first deadline expiring January 1985), or a
municipality’s designation can be changed based on its actual
behavior.

ment. The shift of majority power in the State General As­
sembly, and strong support in nonbinding referenda for such
an amendment indicate that a political battle is certain.
The next section of this article describes the provisions of
the Mount Laurel II opinion and analyzes its basic objec­
tives. Following that is a similar treatment of the Fair Hous­
ing Act which focuses on the similarities and differences
with the objectives of the judicial remedy.4 The final section
summarizes the remaining questions about implementing
Mount Laurel and the ensuing economic and social
consequences.

Mount Laurel II Court Rulings
The Mount Laurel If decision went far beyond previous rul­
ings in the detail and severity of its enforcement measures.
It called for determination of precise municipal obligations
based on specific definitions and formulas, which apply
even if exclusionary practices have not been identified in a
municipality. In general, the Court ruled that every municipal­
ity must provide for its “ fair share” of the surrounding re­
gion’s lower-income housing needs as follows:5
• Every municipality in the state must provide "a realistic
opportunity for decent housing” for the poor people
within its borders living in dilapidated housing (page
214).6 A major exception is made for those municipali­
ties in which the concentration of lower-income housing
need exceeds that of the surrounding region. These
generally urban areas need not provide for all of their
“ indigenous poor” living in substandard housing.
• In these cases, some other (generally suburban) mu­
nicipalities in the same housing region are obliged to
provide realistic opportunities to build housing for some
of those ill-housed poor. Only those municipalities con­
taining land labeled by State land-use policy as “ growth
areas” have any obligation beyond their “ indigenous
poor” obligation (page 215).
• Municipalities are obliged to provide not only for their
“ fair share” of the region’s “ present” housing needs
but also for "prospective needs” —those projected to
exist in the future (pages 215-216, 218-219).
• All the lower-income housing under these rulings must
Comparison of the goals of Mount Laurel II and the Fair Housing Act should not
be taken as legal analysis or as an opinion on the constitutionality of the Act.
Rather, its purpose is to identify the public policy implications of both
measures.
The details and definitions implementing these general characterizations of the
rulings are discussed in Box 1.
Page references in the text refer to the Mount Laurel II opinion unless otherwise
noted.




be “ affordable” to lower-income households (page
221, footnote).
Constitutional motivation
The New Jersey Supreme Court found that the Township of
Mount Laurel violated the State Constitution by using its
zoning power to exclude poor people.7 Noting that a munici­
pality’s zoning laws are a police power of the State (albeit
delegated to the municipality), the Court ruled that they
must be exercised not just for the interest of the municipali­
ty’s residents, but rather for the general welfare:
"When the exercise of that power by a municipality af­
fects something as fundamental as housing, the general
welfare includes more than the welfare of that municipality
and its citizens: it also includes the general welfare—in
this case the housing needs—of those residing outside of
the municipality but within the region that contributes to
the housing demand within the municipality. Municipal
land-use regulations that conflict with the general welfare
thus defined abuse the police power and are unconstitu­
tional. In particular, those regulations that do not provide
the requisite opportunity for a “ fair share” of the region’s
need for low- and moderate-income housing conflict with
the general welfare and violate the state constitutional re­
quirements of substantive due process and equal protec­
tion” (pages 208-209) .8
The Mount Laurel rulings applied only to low- and moderateincome housing; municipal exclusion of middle- or upperincome housing was explicitly left untouched by this deci­
sion. While recognizing that these income groups may also
have problems finding housing because of suburban landuse restrictions, the Court wrote that it was the lowerincome households that were totally excluded (page 212).
Enforcement and implementation
In Mount Laurel II the call for precise obligations came not
because the Court believed underlying obligations could be
precisely known, but because it believed their specification
would best implement the goals of Mount Laurel (page
257). Uncertainty in determining municipal obligations, the
Court found, weakened the constitutional doctrine (pages
252-253), permitting “ paper, process, witnesses, trials and
appeals” (page 199) to delay compliance. It was the
7 The practice of using land-use regulations to restrict or eliminate lower-income
housing is generally called "exclusionary zoning” , which the Court’s opinion
defined as "zoning whose purpose or effect is to keep poor people out of a
community" (page 201, footnote). These practices may include minimum lot or
house sizes and prohibitions of apartment buildings and trailer parks.
8 This finding generated a great deal of resentment on the part of municipalities
in part because of the conflict between the principles of “ equal protection" and
"home rule". The zoning power is delegated to municipalities, and many local
government officials argued strongly for the right to set their own policies. Even
the Mount Laurel II opinion recognized the "fundamental legitimate control of
municipalities over their own zoning, and indeed, their own destiny”
(page 214).

FRBNY Quarterly Review/Winter 1985-86 21

Court’s intention to begin a process that ^would eventually
eliminate this uncertainty (pages 252*253).
To this end, the Court called for assigning “ a precise re­
gion, a precise regional present and prospective need, and
a precise determination of the present and prospective need
that the municipality is obliged to design its ordinance to
meet” (page 257).9 Even the very existence of a remedial
obligation could not be readily challenged.
The detail required to specify the obligation without ambi­
guity demonstrates the complexity of the enforcement prob­
lem (Box 1). Nevertheless, under Mount Laurel II, determi­
nations of “ fair shafe” remained substantially dependent on
expert testimony. The Court relied on the eventual attain­
ment of judicial consensus on the controversial issues.
Sale or rental of Mount Laurel units at prices “ affordable”
to lower-income households, in most instances, will require
substantial subsidies. The Court suggested several ways
that these housing units might be financed. It noted that
government was becoming a less likely source of funds
(page 263) and called attention to the devices which did
not require explicit government subsidies. The Court’s sug­
gestions included:
• Providing density bonuses to builders. A density bonus
permits a developer to build middle- and upper-income
housing at higher densities (either with multifamily
buildings or with more single-family units to the acre)
than zoning laws would otherwise allow—in exchange
for providing additional lower-income housing units,
sold or rented below cost (page 266). In practice such
arrangements have typically called for one lowerincome unit for every four higher-density market-price
units. Where market-price units are scarce (due to zon­
ing or other reasons), permission to build such units
increases the value of the land; these gains are used to
help finance the lower-income units.10 In the language
of Mount Laurel implementation, the “ density bonuses”
are used to generate “ internal subsidies” for the
“ Mount Laurel units” .
• Using mandatory set-asides. If a density bonus does not
provide developers sufficient incentive to choose lowerincome housing over a middle-income development,
the Court ruled that the inclusion or "set-aside” of
lower-income units can be required within a land-use
zone (page 267).
This overturned a ruling from the Court’s earlier Madison decision, which
required only a realistic opportunity for some low- and moderate-income
housing, and in which precise formulas were deemed unnecessary (page
216). Also see Oakwood at Madison, Inc. v. Township of Madison, 72 N.J. 481
(1977). The reversal of this and related provisions was emphatic, as the Chief
Justice wrote that “ Madison has led to little but a sigh of relief from those who
oppose Mount Laurel" (page 252).
This mechanism is described in a slightly different context in the opinion (page
261, footnote).

22 FRBNY Quarterly Review/Winter 1985-86



• Providing tax abatements. The ruling expressly permit­
ted a trial court to order tax abatements for lowerincome housing (page 264).
• Obtaining Federal subsidies. Municipalities can actively
seek grants and take actions required for private groups
to obtain Federal aid (page 264).
Judicial enforcement measures
The Court also spelled out three judicial procedures to expe­
dite litigation. First, to speed consensus on the many techni­
cal issues, New Jersey was divided into three judicial
regions, with a single trial judge hearing all Mount Laurel
cases in a region. Second, Mount Laurel cases are generally
to be heard with one trial and one appeal. Before Mount
Laurel //, rulings on technical issues (such as whether the
municipality was “ developing” ) were contested individually,
leading to many appeals and remands.11 Third, when a tech­
nical issue (such as the levels of present and prospective
need in a region) is decided, the finding will have “ presump­
tive validity” for other cases in the same region (unless cir­
cumstances are substantially different). Municipalities will
be allowed to join in cases that would affect their own litiga­
tion, but the Court believed that most municipalities will be
willing to stay out and abide by the findings.12
The Court also took an action which would increase the
amount of Mount Laurel litigation. One of the most contro­
versial provisions of the Mount Laurel II rulings, the “ build­
er’s remedy” , was adopted to promote challenges to exclu­
sionary zoning ordinances. Under its terms, a court orders
that a municipality approve a specific development plan
(usually including some kind of density bonus) put forth by
a developer-plaintiff. The court may order such a remedy
even if the municipality can demonstrate that another site is
more appropriate for such a project (as long as the imposed
remedy is consistent with sound planning principles [page
2 8 0 ]).13 The “ builder’s remedy” attempts to give develop-

11 If a trial court finds a municipality’s zoning invalid, it can order that the code be
revised (generally within 90 days). To facilitate this revision the judge can
appoint a special master. The master would not have powers beyond making
recommendations, expressing opinions, and otherwise assisting the court.
After the 90-day period elapses, the court determines whether the new
ordinances meet the constitutional test, based in part on the master’s
testimony.
12 Mount Laurel II also provided some incentive for municipalities to expedite the
litigation. When a court finds that a municipality provides for its "fair share" of
regional lower-income housing need, it can grant a six-year repose from Mount
Laurel litigation, barring a “ substantial transformation" of the municipality. This
is a broader application of the res judicata doctrine than usual, since it is less
sensitive to changing circumstances in a municipality. This is another example
of the Court making a special case of Mount Laurel (pages 291-292).
13 The opinion warned, however, that the “ builder’s remedy” should not be
construed as an alternative to municipal procedures for seeking zoning
variances (pages 280-281).

Box 2: The Review and Mediation Process
The administrative process begins with the municipality filing
its "fair share plan” (as part of a “ housing element” ) and a
zoning ordinance to implement it, and then seeking the
Council’s approval or “ substantive certification” . If no person
files an objection within 45 days, the Council reviews the
municipality’s plan (Section 14). Substantive certification
shall then be issued if the Council finds that the municipali­
ty’s plan and ordinance are consistent with the Council’s
rules and criteria as well as the provisions in the Act, and that
achievement of the municipality’s “ fair share” is “ realistically
possible” . If approval is denied or conditionally withheld, the
municipality has 60 days to revise its petition in a manner
satisfactory to the Council.*
If any person does object to subjective certification within
the 45 day period, however, the Council must first attempt to
mediate a resolution of the dispute between the parties
(Section 15). If mediation is successful and the Council finds
that its criteria have been met, then it issues a substantive
certification.
If the Council’s mediation attempts are unsuccessful, how­
ever, the matter is transferred to the Office of Administrative
Law. The Fair Housing Act stresses expeditiousness, and
requires that the evidentiary hearing be held and the initial
decision issued no later than 90 days after the transmittal of
the matter (unless the Director of Administrative Law ex­
tends the time for “ good cause shown” ). The administrative
process ends with the ultimate decision made by the Council,
with appeals taken to the Appellate Division of the Superior
Court.
* Once certification is granted, the municipality has an additional 45 days
in which to adopt the proposed "fair share” housing ordinance
approved by the Council.

ers common interests with civil rights groups, making them
willing to bear the costs of litigation that the latter groups
cannot afford. Without this device, developer-plaintiffs had
no assurance that their land would be rezoned, even after a
successful challenge.14
Other social objectives o f Mount Laurel
In addition to enforcing the underlying Constitutional obli14 To encourage challenges to exclusionary zoning, the Court also stressed the
importance of a "liberal approach” with regard to allowing nonresidents to
sue. In other contexts it would be necessary first for a nonresident to
demonstrate injury resulting from the acts of a municipality. This demonstration
was often difficult because of the lack of a direct relationship with the
municipality. In Mount Laurel cases, however, the Court found that
exclusionary zoning by its very nature hurts nonresidents and prevents these
direct relationships with the municipality from forming (page 337). A summary
of the issues appears in William A. Fischel, The Economics of Zoning Laws,
(Baltimore: Johns Hopkins University Press, 1985), pages 54-55. Also see
Housing for AH Under Law, (Cambridge, Massachusetts: Ballinger Publishing
Co., 1978), pages 98-103.




gation, the Mount Laurel II remedies incorporated other ex­
plicit and implicit objectives. First, the rulings embodied an
explicit policy that poor people should live in adequate hous­
ing. Although the Court did not find that exclusionary zoning
was solely responsible for the inadequate housing of poor
people, it did rule that municipalities collectively must pro­
vide at least “ a realistic opportunity” for decent housing for
all lower-income households in the state.
Second, Mount Laurel also has the aspect of an income
distribution policy. The opinion graphically depicts the dis­
parity of lifestyle between the suburban well-to-do and the
urban poor (pages 209-210); the remedy is to require de­
cent housing to be provided at prices far below those typi­
cally paid by lower-income households, and generally well
below cost.
The most important social policies implemented by Mount
Laurel, however, explicitly involved land-use. Decrying
“ roads leading to places they never should be” , the Court
wrote that “ [sjtatewide comprehensive planning is no long­
er simply desirable, it is a necessity recognized by both the
federal and state governments” (page 236). To that end,
municipal obligations were designed to be consistent with
published state land-use policies. Moreover, allocation of re­
gional need to municipalities was characterized as a prob­
lem of “ conventional fair share analysis” (page 244), pref­
erably determined by administrative planning agencies
(page 250).
Perhaps the most controversial aspects of Mount Laurel
seem to incorporate land-use policies based on social equi­
ty. In fact, “ fair share” appears to be fundamentally a socio­
economic concept. For one thing, it refers to the social fair­
ness of the geographic allocation of housing, rather than to
the equitable assignments of financial costs. The opinion
explicitly referred to the fairness of the land-use implications
of assigning lower-income housing obligations to
municipalities:
“ As for those municipalities that may have to make ad­
justments in their lifestyles... they should remember that
they are not being required to provide more than their fair
share [emphasis in the original]” (page 219).
In contrast, the opinion clearly states that “ fair shares” of
lower-income housing do not result in fair assignments of
financial costs:
“ There may be inequities between and among these mu­
nicipalities located within growth areas, as there undoubt­
edly are between all of them and municipalities outside of
growth areas, for the tax and other burdens . . . will not be
fairly spread [emphasis added]” (page 239).15
To implement its social objectives, the Court ruled that
“ socioeconomic” zoning, permitting only low-income hous­
ing per se, may be required if “ social goals are to prevail
15 The Court found that these inequities were the consequence of state land-use
policies, and therefore compensation should be determined by the legislature,
not the courts.

FRBNY Quarterly Review/Winter 1985-86 23

over neutral market forces” (page 274, footnote). The opin­
ion attributes to municipalities an affirmative responsibility to
counter the destructive effects of economic segregation.16
Accordingly, the Court ruled that “ if sound planning of an
area allows the rich and middle class to live there, it must
also realistically and practically allow the poor” (page 211).
To this end, the decision calls for affirmative measures
when simply removing restrictions on multiunit structures
would result in the construction of only high-priced middle16 For example, the Court wrote that" [z] oning ordinances that either encourage
this process or ratify its results are not promoting our general welfare, they are
destroying it [emphasis added] ” (page 211, footnote).

income housing (page 261). The Court similarly tied a mu­
nicipality’s acceptance of factories to an obligation to pro­
vide housing for workers (pages 211, 256).17
Nowhere does the opinion suggest that these social goals
approximate the outcomes that would have prevailed in the
17 The Court, in giving special attention to tax base growth (Box 1), may have
sought to assign obligations based on “ ability to pay” . But the Court’s
description of the unfairly distributed costs argues against that notion (see
above text). The Court may instead have sought to attack the zoning practice of
encouraging fiscally profitable land uses at the expense of unprofitable uses,
such as lower-income housing. In fact, the Court may have sought to provide
fiscal incentives to encourage the construction of lower-income housing, by
tying a housing obligation to all desirable commercial and industrial
development.

Box 3: Legislative Policy on “ Fair Share”
Under the terms of the Fair Housing Act, the Council on Fair
Housing is responsible for specifying the criteria and guidelines
by which municipal housing elements will be judged, subject to
several qualifications:
Housing regions, determined by the Council, will consist of
two to four contiguous counties that exhibit significant similari­
ties. The regions should approximate Primary Metropolitan Sta­
tistical Areas (Sections 4b and 7a).*
The Act also carefully defined the methods for projecting pro­
spective need (Section 4j). Estimates are to be made of “ rea­
sonably likely” growth based on approvals of development
application, real property transfers, and economic projections
provided by the State Planning Commission. The governor’s
conditional veto message (which added this language)
stressed the need to avoid abstract or speculative theories.
The Act does not define “ fair share” , but specifies how these
shares must be “ credited” and “ adjusted” and how they may be
“ limited” , “ transferred” , and “ phased in". “ Fair shares” must be
computed after crediting on a one-to-one basis each current unit
of (affordable) lower-income housing of adequate standard
(Section 7c). Further, “ fair shares" must be adjusted to assure
suitability of development, including consistency with the desig­
nations of the State Development and Redevelopment Plan.t
Adjustments would be required if providing the full “ fair share”
obligations would drastically alter the pattern of community de­
velopment, or if vacant and developable land or adequate public
facilities and infrastructure capacities are not available.

The Council also is permitted to place a lim it on “ fair share”
allocations (Section 7e), based on a percentage of the housing
stock, employment opportunities, or any other criteria it deems
appropriate.
A municipality may propose the transfer of up to half of its “ fair
share” to another municipality—probably a central city—by
means of a voluntary contract (Section 1 2 ) .tt That is, it can
satisfy part of its obligation by paying for housing built in another
part of its housing region. This “ regional contribution agree­
ment” is subject to Council approval and must be in accordance
with “ sound comprehensive regional planning” and must pro­
vide for “ a realistic opportunity for low- and moderate-income
housing within convenient access to employment opportunities” .
If the agreement is subject to the scrutiny of a court, the Act
requires challengers to provide “ clear and convincing evidence”
it is not a valid part of a “ fair share” zoning ordinance.
The Act also provides for phase-ins of housing obligations
provided in inclusionary developments (i.e., those containing a
substantial proportion of housing units affordable to a reason­
able range of low- and moderate-income households) (Section
23e). Municipalities are given up to 20 years (for 2,000 lowerincome units or more), and at least six years (for fewer than
1,000 units), to meet their obligations. “ Fair shares” , whether or
not provided in inclusionary developments, can be phased in
with the timing based on the size of the share, infrastructure
considerations, available land, likely absorption rates, develop­
ment priorities, and past performance in providing lower income
housing. Trial courts must consider these criteria as well, but
retain the right to their own determinations.

* This provision takes a stand on a controversial issue. For example,
litigation involving the Township of Warren led to the use of an 11-county
area proposed by the challengers.
t Additional factors affecting suitability of development include historic and
environmental preservation, and the need for adequate land for open
space, recreation, conservation, and farmland.

24 FRBNY Quarterly Review/Winter 1985-86



t t The recommended compensation for the receiving municipality was a
weighted average of the costs of rehabilitation and new construction.
Payments may also include an amount to pay for infrastructure or other
costs generated by the development.

absence of past exclusion.16 The Court’s rulings instead
seem to aim for specific land-use allocations that might nev­
er have otherwise occurred, even in a non-exclusionary
housing market.
Mount Laurel II also allows municipalities some leeway in
setting their own socioeconomic land-use policies. The opin­
ion describes the state constitutional obligation to foster the
“ general welfare” as a regional concept (page 237). Munic­
ipalities must provide for a “ fair share” of the housing needs
of poor people only from the surrounding region, and are
explicitly permitted to exclude others under the provisions of
Mount Laurel II. That is, once a municipality has met its nu­
merical obligation, it may zone with explicit regard to its fis­
cal situation (pages 259-260).19 Although numerical obliga­
tions are imposed to promote enforcement, once they are
met Mount Laurel II grants municipalities wide latitude in us­
ing their zoning power to influence the socioeconomic pat­
tern of land use. This provision is not just a side effect of
Mount Laurel //; it plays an important role in its
implementation.20

The legislative response
Mount Laurel II expressed the Court’s desire for legislative
rather than judicial enforcement of the State’s constitutional
responsibility, and its dissatisfaction with prior legislative in­
action (page 213). In July 1985 (over two years later), the
Fair Housing Act provided a legislative response to this call.
An administrative alternative to litigation
The Act created the Council on Affordable Housing to ad­
minister a set of procedures providing an alternative to judiWhile the decision calls exclusionary zoning a major cause of socioeconomic
segregation, urban economists have argued that market forces, even in the
absence of private or municipal discrimination, also lead to such segregation.
For example, the standard Alonso-Mills-Muth model of land use leads to
separation of high- and low-income households based on income elasticities of
travel cost and the demand for housing. See, for example, Edwin Mills and
Bruce Hamilton, Urban Economics (Glenview, Illinois: Scott, Foresman and
Company, 1984). Along similar lines, John Yinger has argued that high-income
households are willing to pay more for public services than lower-income
households, leading to municipal segmentation along income lines. John
Yinger, "Capitalization and the Theory of Local Public Finance” , Journal of
Political Economy 90 (October 1981), pages 917-943.
Municipalities’ exclusionary zoning practices must be halted “ to the extent
necessary to meet their prospective ‘fair share’ and provide for their
indigenous poor (and in some cases, a portion of the region’s poor)" (page
259). Practices such as reserving areas for upper-income housing and zoning
"with some regard to their fiscal obligations" are expressly permitted once the
“ fair share” goal is met (page 260). While the opinion observed that zoning
laws must satisfy the general test of a "reasonable relationship to [a]
legitimate governmental goal", such determinations were said to be beyond
the scope of Mount Laurel.
These continued land-use restrictions may be crucial to the success of density
bonuses and mandatory set-asides in financing Mount Laurel housing. If
middle-class housing is to provide a subsidy for such units, they must earn an
above-normal profit. This profit can persist in the long run only with persistent
barriers to entry, such as zoning laws whose effect is to enforce scarcity of
middle-income housing.




cial enforcement (Section 5 ).21 To the municipality, these
administrative processes are entirely voluntary. In fact, the
Act contains no mechanism to enforce the Mount Laurel
obligation. Its principal purpose, rather, is to give municipali­
ties an opportunity to keep Mount Laurel cases out of the
courts (Section 2).
If a municipality submits to the Council its “ fair share
plan” and corresponding revisions to its zoning ordinance
(before certain deadlines), any challengers to municipal
zoning ordinances must exhaust the Act’s review and medi­
ation process before their complaint can be heard in the
Appellate Division of the Superior Court (Box 2).
Cases currently before a court may be transferred to the
Council’s jurisdiction if the court finds no “ manifest injus­
tice” is done (Section 16). Cases instituted after the Act’s
effective date (or two months earlier) cannot be heard until
the administrative remedies are exhausted. Even municipali­
ties not currently subject to Mount Laurel litigation may pre­
empt a prospective court challenge by seeking the Council’s
jurisdiction.22
The Act took the avoidance of judicial solutions one step
further by imposing a moratorium on builders’ remedies (de­
fined in the Act as including all court-ordered density bonus­
es and mandatory set-asides) until the administrative proce­
dures are operational (Section 28).23 Under its terms, no
builder’s remedy will be granted to a plaintiff in any exclu­
sionary zoning litigation filed after the Mount Laurel II deci­
sion, unless a final judgment has already been rendered.24
Assignment o f obligations
Under the Fair Housing Act, municipalities propose their
own "fair share” plans, subject to guidelines set down by
the Council on Affordable Housing. The Council is directed
to determine regions, estimate present and prospective
needs in each region, adopt the criteria by which “ fair
shares” are assigned, and review “ fair share plans” written
by municipalities. It must announce “ fair share” guidelines
and criteria, subject to specific requirements (Box 3), be­
fore August 1, 1986 (Section 7). A municipality’s plan must
21 The Council’s membership, nominated by the Governor subject to the approval
of the legislature, was required to reflect a specific balance across political
parties, geographic regions, and various public and private interests.
22 The advantage is that if the Council approves the plan, municipal compliance
with its Mount Laurel obligation is granted “ presumptive validity” in any
potential litigation. Furthermore, a challenger’s demonstration that the plan fails
to provide for the community’s “ fair share” requires “ clear and convincing
evidence” . Alternatively, a municipality can seek a declaratory judgment for a
six-year repose in the Superior Court, as if the municipality had reached a
satisfactory resolution in trial court.
23 The moratorium expires five months after the Council adopts its criteria and
guidelines for determining “ fair shares”—which is scheduled to occur no later
than August 1986. (Section 7; see also the Governor’s veto message (April 26,
1985), pages 6-7.
24 This qualification was added in the Governor’s conditional veto message, out of
concern for the unconstitutionality of a broader provision which would have
reversed prior court rulings.

FRBNY Quarterly Review/Winter 1985-86 25

state its determination of its present and prospective “ fair
share” for lower-income housing and its capacity to accom­
modate those shares (Section 10). Detailed analyses and
forecasts of the municipality’s demographic, housing, and
employment characteristics are required in support of
the plan.
The Fair Housing Act also allows a municipality to satisfy
up to half its “ fair share” obligation by paying for housing
located in another municipality. These “ regional contribution
agreements” are subject to Council approval on the basis of
several criteria (Box 3).
The Act also assigns a crucial role to the State Planning
Commission (Section 7). The legislation creating this body
was not enacted until January 1986 (Public Law 1985,
Chapter 398). The Commission will project statewide and
regional housing needs and demographic changes, and also
will devise the State Development and Redevelopment
Plan. This land-use document will be the first created with
an explicit role in the determination of Mount Laurel obliga­
tions (Section 7).
When enacting these new procedures, the legislature also
provided state subsidies for rehabilitation and new construc­
tion of lower-income housing (Sections 20 and 21). First,
an estimated $100 million from tax-exempt revenue bonds
from the New Jersey Housing and Mortgage Finance Agen­
cy (which must be repaid from project revenues or from
taxes) can be used for mortgage subsidies.25 An additional
$15 million from general revenues can be used for rental
programs, conversions and moderate rehabilitation, and
grants to municipalities or community groups.
In addition, $10 million was authorized for the Neighbor­
hood Preservation Program, to pay for rehabilitation, conver­
sions, acquisition and demolition, new construction, infra­
structure, and other housing costs. Two million dollars of
this total is appropriated from general revenues; the rest
comes from an increase in the realty transfer tax earmarked
for this program.26 Eligibility is limited to municipalities with
Council approval of their “ fair share plans” or regional con­
tribution agreements.27
Otherpolicy objectives
The general objectives of the Act and the means of achiev­
ing them are essentially the same as Mount Laurel II, but
there are significant differences. On the one hand, the Act’s
housing and income distribution policies are very similar to
those of the Court rulings. Like Mount Laurel II, the legisla­
tive remedy calls for adequate housing for all lower-income
households in New Jersey, provided at the municipal level.
This estimate comes from the Governor’s conditional veto message of the bill
originally sent to him.
Public Law 1985, Chapter 225.
This restriction applies only after the first year after enactment, a period
extendable by the Council.

26 FRBNY Quarterly Review/Winter 1985-86



Neither remedy calls for meeting lower-income housing
needs through “ vouchers” or other rent subsidies to be
used for existing housing, wherever the lower-income
households choose. 28 Similarly, neither method specifically
encourages “ filtering” (where lower-income households
move into existing housing vacated by middle-income
households) .29 As income distribution policy, the disparity of
lifestyle between the urban poor and suburban well-to-do is
addressed by providing housing to lower-income house­
holds (either sold or rented) below cost.
On the other hand, the Act’s land-use policies seem
somewhat different from those of the Court rulings. The Act
allows a municipality to satisfy up to half its obligation with
housing built in urban areas. It is therefore likely that the
lower-income housing provided under the Fair Housing Act
would be more geographically concentrated in urban areas
than under the judicial solution.30 Regional transfers “ maxi­
mize the number of low- and moderate-income units” ; to an
extent this may mean a tradeoff of some decentralization of
the poor in favor of urban rehabilitation and adequate hous­
ing possibly built at lower cost (Sections 2f and 2g).
The use of regional “ fair share” transfers indicates an
additional policy difference, in that suburbanites are asked
to help finance central-city housing. Any geographic alloca­
tion resulting from such transfers could have been specified
directly with nontransferable “ fair shares” . Assuming that
the allocation satisfies judicial standards of “ fairness” , the
major impact of this device is to redistribute the financial
costs from central city to suburb.
Even with these differences from the judicial remedy, fi­
nancial obligations still depend heavily on “ growth area”
designation. As mentioned above, the Court believed that
this allocation is not fair in a financial sense, and that it was
the responsibility of the legislature to correct it. The Act did
not address this issue, however, even though broader use of
“ regional contribution agreements” might have reduced the
importance of state land-use policy on municipal financial
burdens. Municipalities without land designated as “ growth
area” could have been assigned regional obligations (rather
than responsibility only for their “ indigenous” poor) to be
satisfied with housing built in other parts of the region.
The legislative solution also incorporates a policy that
28 While vouchers have been used to implement a "fair share” obligation within a
municipality, the Mount Laurel remedies are not set up to allow the geographic
distribution of lower-income households to be determined by consumer
choice.
29 Mount Laurel II mentions filtering when it required “ least-cost housing" if
“ affordable” housing were unfeasible (Box 1). Without the obligation for leastcost housing at a minimum, the Court found, filtering would not occur in
suburban areas (page 278).
30 This is potentially a big change from the Court’s conception. Many communities
are likely to seek such "regional contribution agreements” . However, it is
unlikely that transfers of the full, legislatively permissible 50 percent of all
Mount Laurel units will either be requested or approved.

communities should be rewarded for any prior provision of
affordable lower-income housing. Its one-for-one credit
against “ fair share” for existing affordable lower-income
housing has no counterpart in the Mount Laurel II decision.
Such credits have been used, however, in the trial courts.
This feature complicates the concept of “ fair share” .
Mount Laurel II defines present regional housing need in
terms of lower-income households living in inadequate
housing (page 243). If “ fair shares” before credits add up
to the estimated regional need, the sum of municipal obliga­
tions after credits for occupied units must fall short of the
desired total.31

Remaining questions
Politically, legally, and economically, it is difficult to predict
what will come of the Fair Housing Act. The Council on Af­
fordable Housing has not yet promulgated its guidelines;32
It is possible to design obligations such that after credits, the shares add up
properly. But the sum of pre-credit shares then would exceed 100 percent of
regional need. This makes the requirement of a “ one-for-one” credit less
meaningful.
Although at the time of this writing the Council’s guidelines have not yet been
released, examination of an earlier attempt at an administrative solution may
suggest what factors municipalities will be expected to incorporate into their
"fair share” determinations. A Revised Statewide Housing Allocation Report
for New Jersey Division of State and Regional Planning (May 1978) circulated
"fair share” formulas for public comment. Its formulas reflected physical
capacity (vacant land), ability-to-pay (nonresidential property and personal
income), and "relative responsibility" (job growth). Because the legal authority
for the document was rescinded in 1982 (moreover, the Division no longer
exists), the Court did not use its formulas to allocate “ fair shares".




confirmation of its membership was not completed until midJanuary 1986. The 9tate Planning Commission was also
created only in January 1986, and its membership must be
appointed before it can draw new land-use maps. Ten mu­
nicipalities have already sought Council jurisdiction only to
be refused by the courts; the New Jersey Supreme Court
heard their appeal in January. As the provisions of the Fair
Housing Act phase in, cases approved for transfer may go
through an administrative course of two years or longer, only
to return to the courts.
The issues discussed in this article will remain in the pub­
lic debate. Litigants will have to decide whether to seek
Council jurisdiction; courts will have to decide whether to
approve their requests. The State Supreme Court may rule
on the constitutionality of provisions of the Act. The legisla­
ture may seek to modify the administrative remedies or to
amend the state constitution to specify the Mount Laurel
enforcement more to its liking. Other states may seek Mount
Laurel-type remedies.
There are many economic questions as well. It is difficult
to estimate how much subsidy will be needed to induce de­
velopers to build below-cost, lower-income housing; it is
even harder to gauge the long-run effectiveness of density
bonuses and other measures in generating such funds. Also
unknown are the impacts on housing markets, central city
development, municipal finances, and the job prospects of
Mount Laurel households. Thirteen years after the first trial
court ruling, Mount Laurel’s impact on the New Jersey land­
scape is still uncertain.

Daniel E. Chall

FRBNY Quarterly Review/Winter 1985-86 27

Adjustments in Buffalo’s
Labor Market

Buffalo, a major manufacturing center in New York State,
provides a classic example of the difficult labor market ad­
justments that result when the demand for the output of a
region’s firms drops sharply. The employment decline in the
Buffalo metropolitan area1 during the early 1980s is the
most recent and severe example of long-term trends affect­
ing its economy. Buffalo was vulnerable to a severe down­
turn at the end of the 1970s because many of its earlier
strengths—location, early development, and well-paying
heavy manufacturing industries—proved to be serious
handicaps.
As a result, the back-to-back recessions of the early
1980s and the appreciation in the value of the dollar hit
Buffalo harder than the nation as a whole. While national
manufacturing employment dropped 15 percent between
1979 and 1983, the Buffalo metropolitan area lost about 30
percent of its total manufacturing employment. Unemploy­
ment at first rose sharply—to about 15 percent in late-1982.
But since then, adjustments to this economic decline have
occurred in the region’s labor market. In late-1985, the met­
ropolitan area’s unemployment rate stood at about 7.5 per­
cent, a six-year low. Nevertheless, many long-term econom­
ic problems remain for the region.
The purpose of this article is to discuss why these eco­
nomic problems endured. It begins by describing the pre1980 employment base in Buffalo, highlighting Buffalo’s ear­
ly role as a manufacturing center and its postwar changes in
employment. It then analyzes why Buffalo’s economy was
vulnerable to decline in the late 1970s and describes the
extent of job losses during the recessions of the early
1980s. Next, this article discusses the three major economic
1 The Buffalo metropolitan area consists of Erie and Niagara Counties.

28 FRBNY Quarterly Review/Winter 1985-86



adjustments that have occurred in Buffalo’s labor market
since the late 1970s:
• A drop in the area’s labor force.
• A decline in wages paid to Buffalo’s workers in most
industries and occupations compared with similar work­
ers elsewhere.
• Employment growth in industries paying workers much
less than the declining manufacturing industries.
The analysis concludes by showing that even with these
rather dramatic changes, Buffalo’s adjustment to its shrink­
ing manufacturing sector continues, and its economy re­
mains vulnerable.

Buffalo employment before the 1980s
For 150 years, Buffalo has been an important hub of
commerce.2 With the opening of the Erie Canal in 1825,
Buffalo quickly became a center of food processing, trans­
forming the agricultural products of the Midwest into goods
for eastern cities. By the late 1850s, Buffalo was emerging
as an important area for primary metal production, combin­
ing iron ore shipped across the Great Lakes or through the
Erie Canal with coal from western Pennsylvania. Abundant
hydropower from the Niagara River was harnessed to gen­
erate cheap electricity even before 1900. By the turn of the
century, the city of Buffalo had a population of 350,000, and
was the second largest rail terminal and third largest port in
the country.
2 For a general history of Buffalo, see Mark Goldman, High Hopes: The Rise and
Fall of Buffalo, New York (Albany: State University of New York Press, 1983).

Buffalo’s important heavy manufacturing industries devel­
oped soon after 1900. In 1904, the Lackawanna Iron and
Steel Company relocated from Scranton to just south of Buf­
falo. By 1930, 50,000 people were working in iron, steel, and
other primary metal industries. In that year, 10,000 people
also worked in auto factories and 4,000 in electrical machin­
ery manufacturing.3 In 1935, Bethlehem Steel, the new own­
er of the Lackawanna mill, modernized the plant to produce
sheet metal for cars. The investment paid off in 1937 when
General Motors built a new Chevrolet plant near Buffalo.
Buffalo’s employment peaked during World War II at nearly
460,000 workers; nearly 225,000 of them worked in warrelated industries producing steel, airplanes, tanks, and ships.
During the postwar period, private employment in the
3 United States Department of Commerce, Bureau of the Census, Fifteenth
Census of the United States: 1930, Volume III, Part 2 (Washington, D.C.: United
States Government Printing Office, 1932), pages 306-307.

Buffalo area has fluctuated between 375,000 and 425,000
(Chart 1). Buffalo’s manufacturing employment declined in
each postwar recession but never regained pre-recession
levels in the subsequent recoveries. The largest declines in
manufacturing employment before the 1980s occurred in
the recessions of the late 1950s and mid-1970s. Services
and other nonmanufacturing industries gradually became a
larger percent of jobs in the Buffalo area as manufacturing
declined in importance.4 In 1979, however, manufacturing
still remained more important in Buffalo than in New York
State and nationally (Chart 2). Buffalo’s shift toward non­
manufacturing jobs was similar to national trends, but for the
4 The employment categories used are those of the United States Census
Bureau and Department of Labor. Services include business and personal
services plus private sector health, education, and social services. Other
nonmanufacturing categories include finance, insurance, and real estate;
wholesale and retail trade; construction; and transportation and public utilities
(except the postal service).

C hart 1

C hart 2

Private Nonagricultural Em ployment
in the Buffalo Area

Private Em ploym ent by Industry for the
Buffalo Area, New York State, and
the United States

Thousands of jo b s

□

B u ffa lo
area

New York
VAX/A State

I------- 1 United
I_____ I States

Percent of em ploym ent
4 0 ---------------------------------

1951

1951

1955

1960

1965

1970

1975

1980

1985

Data fo r 1951-84 are annual averages. Data fo r 1985
are fo r June 1985. B u ffa lo area includes Erie and
Niagara Counties.
Shaded areas re p re s e n t p e rio d s of rece ssio n , as
defined by the N a tio n a l Bureau of Econom ic R esearch.
* ln c lu d e s construction, tra n sp o rta tio n , and public
u tilitie s (except the postal s e rvice ).
"^S ervices include business and personal se rvice s plus
private se cto r health, education, and social se rvices.
Sources: United S tates D epartm ent of Labor and
New Y ork State Departm ent of Labor.




goods

goods

and Finance
and related
industries

Data are annual a verages.
Sources: United States Department of Labor and
New York S tate Departm ent of Labor.

FRBNY Quarterly Review/Winter 1985-86 29

nation there was a crucial difference. For the economy as a
whole, manufacturing employment increased throughout
this period—albeit at a slower rate than nonmanufacturing—
whereas in Buffalo manufacturing steadily declined.

postwar period because producers did not have easy
access to the growing markets of the West and South.
This problem intensified as Buffalo’s markets in north­
eastern and midwestern states declined or grew slowly
in the late 1970s and early 1980s. Buffalo’s importance
as a Great Lakes port also declined in the 1960s and
1970s following the opening of the Saint Lawrence
Seaway.

Vulnerability o f B uffalo’s econom y in the late 1970s
By the late 1970s, Buffalo was on the brink of one of its
largest postwar reductions of employment. With hindsight, it
is not surprising that an area with nearly one-third of its man­
ufacturing jobs in the production of primary metals and
transportation equipment did not fare well in the early
1980s. Buffalo’s employment base included more than the
national share of jobs in slow-growing or declining durable
goods manufacturing industries. But, quite surprisingly, Buf­
falo’s unattractive industry mix accounted for only about one
and one-half percentage points of the thirteen percentage
point difference between Buffalo’s and the nation’s employ­
ment growth in the late 1970s.5 In other words, if each of
Buffalo’s industries had grown at the same rate as the na­
tional average for those industries, Buffalo’s growth in nonagricultural employment between 1974 and 1979 would
have been about 13.5 percent (almost equal to the national
average of 15 percent) instead of the 2 percent growth that
actually occurred.
Three other characteristics of the Buffalo economy, be­
sides industry mix, contributed to its vulnerablity to econom­
ic decline at the end of the 1970s:

• Many older plants and facilities had not been updated
sufficiently to compete with modern facilities built else­
where in the postwar period. Buffalo manufacturers did
invest in plant and equipment at the national rate in the
1970s.6 However, in Buffalo a larger-than-average por­
tion of gross investment was needed to prevent deterio­
ration of the old, existing capital stock in the area, so
net investment was lower.
• Wages in Buffalo, especially in manufacturing, were well
above the national average, and during the 1970s area
wages rose even further relative to the rest of the country.
In 1963 and 1967, Buffalo’s average wage for production
workers in manufacturing was about 20 percent above the
national average; in 1972 and 1977 this difference rose to
24 percent and 30 percent respectively (Table 1). Buffa­
lo’s industry mix—a large proportion of firms in high wage
durable goods industries—caused about 75 percent of
the difference between Buffalo’s manufacturing wages
and the national average. But even with an adjustment for
the industry mix, Buffalo’s average production wage was
still 3 to 5 percent above the national average in the
1960s, and rose to 7 percent above it in 1972 and 1977.7

• Buffalo’s location became a greater disadvantage in the
5 In the analysis, Buffalo’s employment change was separated into “ industry
mix” and "regional” components. Industry mix was calculated by comparing
national growth in each industry with growth in total employment nationally. The
regional component compared Buffalo’s growth in each industry with national
growth in that industry. Employment data used in the analysis was two-digit or
in some cases one-digit standard industrial code (SIC) industries. This
technique is sometimes labeled "shift-share” analysis. See Gregory Jackson
eta!., Regional Diversity: Growth in the United States, 1960-1990 (Boston:
Auburn House, 1981), Appendix B. In the early 1980s the regional component
continued to be the dominant influence.

6 This conclusion is based on real investment in new plant and equipment per
production worker or investment as a percent of the value of shipments. The
United States Census Bureau’s Annual Survey of Manufactures (through 1979)
and Census of Manufactures provide data on investment by county.
7 This analysis focuses on wage costs, which account for about 80 percent of

Table 1

Average Wages For Production W orkers in the Buffalo Area and the United States 1963-82

Year

United States
average wage
In dollars

Buffalo
average wage
In dollars

Buffalo as
percent of
United States

Buffalo corrected
for industry mix
In dollars

Buffalo as
percent of
United States

2.53
2.92
3.95
5.89
8.69

3.05
3.47
4.91
7.65
11.22

120.6
118.8
124.3
129.9
129.1

2.65
3.02
4.24
6.33
9.30

104.8
103.4
107.3
107.5
106.9

1963 ..............................................................
1967 ..............................................................
1972..............................................................
1977
1982

Wage rate is production worker payroll divided by production worker hours. The industry mix correction is a weighted average of Buffalo wages with the
weight for each industry being the percent of production workers in the category for the entire U.S. economy. The industry categories used were the most
disaggregated available in Census data. Where wage data for Buffalo were unavailable, a value was imputed from other sources.
Source:

Calculated by author using Census of Manufactures data for each year.

30 FRBNY Quarterly Review/Winter 1985-86



The area’s higher-than-average wage and the increase
in wages over the 1970s were due in part to the high
degree of unionization in Buffalo (Appendix 1).

Chart 3

Wages and Productivity in the Buffalo Area
Compared with the National A v e r a g e - 1 9 7 7
For tw o-digit Standard Industrial Code (SIC)
m anufacturing industries
Buffalo wage relative to U.S. average
CO
CVJ
•

As a result, several of Buffalo’s manufacturing industries
competed against firms in growing areas which operated
newer, more efficient facilities and paid lower wages. Buffalo
producers in chemicals, primary metals, transportation
equipment, and instruments not only paid higher-thanaverage wages but also had lower-than-average productivity.
Productivity estimates for Buffalo industries were made using
data from the Census o f Manufactures. In Chart 3, these
industries with the most severe wage/productivity problems
are shown in the shaded upper-left quadrant of the chart (SIC
28,33,37, and 38) .8Their value-added per production worker
is below the national average for their industry, and their
average wages are above the national industry average.
Buffalo’s nonmanufacturing firms, in contrast, did not
have such severe disadvantages. Services, trade, and fi­
nance and related industries grew throughout the national
economy because of changing consumption patterns and
business organization.9 The fixed capital in these industries
is less affected by physical deterioration and technological
advances than the factories of many manufacturers. There­
fore, the age of business facilities was less of a handicap for
local nonmanufacturing firms. In addition, wage costs for
Buffalo nonmanufacturing firms tended to be near the na­
tional average for metropolitan areas.10 Finally, competition
from outside the region was less important because these
industries generally serve local markets.

eign competition, caused a sharp decline in employment
and payroll in Buffalo’s vulnerable industries. The relative
prosperity of 1979 was followed by rapid decline in several
of the area’s major manufacturing industries. Because of
this manufacturing decline, by 1985 the industry mix of em­
ployment in Buffalo resembled that of the U.S. economy as
a whole (Chart 4).
As would be expected, those Buffalo industries with
wage/productivity problems that were competing in declin­
ing national markets were affected most by the recession.
The decline in primary metals was dramatic (Table 2, page
34). Between 1979 and 1983, when total local private em­
ployment bottomed out, employment in primary metals
dropped from about 22,000 to 8,400. Declining demand and
overcapacity in the world steel industry meant that the local
decline in primary metals employment continued even after
the rest of the local economy began to recover. Employ­
ment dropped to 5,500 in 1984 and 4,500 by September
1985. The employment declines in other manufacturing in-

•34

Buffalo em ployment in the 1980s
The back-to-back recessions of the early 1980s, along with
the difficulties of American manufacturing because of forFootnote 7 continued
total labor cost. Regional data on fringe benefits disaggregated by industry are
not available. Published information suggests that fringe benefits are highly
correlated with wage levels and that focusing on wages alone understates the
differences in total labor cost between locations. See Timothy Smeeding, "The
Size Distribution of Wage and Nonwage Compensation: Employer Cost Versus
Employee Value” , in Jack E. Triplett, ed., The Measurement of Labor Cost
(Chicago: University of Chicago Press, 1983), pages 237-277. The Bureau of
Labor Statistics Area Wage Surveys collect information on types, but not costs,
of fringe benefits offered by employers in a sample of metropolitan areas.
Buffalo employees received a wider range of benefits than workers in many
other areas in the sample.
The value-added figure for transportation equipment (SIC 37) suggests
Buffalo's situation was worse than it actually was. Buffalo had much more than
the national percentage of auto manufacturing, a part of the industry with valueadded per worker below the overall industry average.
For an analysis of the growing importance of business services, see Bobbie H.
McCrackin, “ Why Are Business and Professional Services Growing So
Rapidly?” Economic Review, Federal Reserve Bank of Atlanta (August 1985),
pages 14-28.
Among occupations included in the Bureau of Labor Statistics Area Wage
Surveys in the late 1970s, Buffalo office workers received wages well below
the national average for metropolitan areas while unskilled plant workers
outside manufacturing were paid slightly above the national average.




• 25
*3 6

•37

28*

38

• 32
30

- 35

2 2 '* " .
20

•2 6
t
I
I
......
I
I
0.4
0.6
0.8
1.0
1.2
1.4
Buffalo value added per production w o rke r hour
relative to U.S. average

I
1.6

Symbol numbers of SIC obse rva tio n s are: 20-fo o d
products; 21-tobacco; 2 2 -te xtile mill products; 23-apparel
and other te xtile products; 2 4 - lumber and wood
products; 2 5 -fu rn iture and fixtures; 26-paper and allied
products; 27-printing and publishing; 28-chem icals and
allied products; 29-petroleum and related products;
3 0 -ru b b er and p la stics; 31-leather and leather products;
32-stone, glass, clay, and concrete; 33-prim ary metals;
3 4 -fabricated metals; 35-m achinery excluding e lectrical;
3 6 -e le ctric and e le ctro n ic equipm ent; 37-transportation
equipment; 38-instrum ents; and 39-m iscellaneous.
No data for SIC 21, 27, 29, 31, and 39.
Source:

1977 C ensus of M anufactures-

FRBNY Quarterly Review/Winter 1985-86 31

dustries were also large between 1979 and 1983 (Table2).11
Buffalo’s employment outside of manufacturing changed
very little during the early 1980s. The sharp decline in Buffa­
lo’s goods-producing sectors (cutting sales to businesses
and households) and in area population (Appendix 2) limit­
ed the growth of local services and trade (Chart 5 ).12
The layoffs in manufacturing and the slow growth in ser­
vices produced a dramatic change in the Buffalo labor mar­
ket. Area unemployment stood at about 6 percent in mid1979. It rose to 10.5 percent in mid-1980 and 15 percent in
late-1982. Total private sector payroll adjusted for inflation
(a measure of real income growth) declined steadily from
1979 to 1983.
Adjustm ent to the decline
Buffalo’s labor market adjusted to this economic downturn
in two ways. Some workers responded to the sharp decline in
These declines in employment resulted in a one-third reduction in real terms of
manufacturing payroll between 1979 and 1983. Primary metals payroll
dropped to about one-third of its 1979 level. Nondurable goods industries
fared somewhat better than durable goods, with their payroll declining only 14
percent in real terms compared with a 37 percent decline for durables.
Manufacturing payroll fell from about 50 percent of the area’s payroll in 1979 to
about 40 percent in 1983.
Subsidized redevelopment of downtown Buffalo has expanded the supply of
top quality office space there, and many new retail developments have been
constructed throughout the region. For a discussion of the possible link
between manufacturing and service growth, see Aaron S. Gurwitz, “ New York
State’s Economic Turnaround: Services or Manufacturing", this Quarterly
Review (Autumn 1983), pages 30-34.

C hart 4

Private Em ployment in the Buffalo Area,
New York State, and the United S ta te s June 1 9 8 5

demand for labor by leaving the area’s labor force. Many
others continued to work in the same industry but gradually
accepted wages closer to—or even below—those paid similar
workers in other parts of the country. Differences in labor
demand also contributed to the decline in Buffalo’s average
wage. Growing sectors of the local economy tended to pay
wages well below the wages in declining industries.13
Labor force decline
A rapid 10 percent decline in the area labor force between
1979 and 1984 eased the labor surplus in the region. The
area’s labor force stood at about 580,000 workers in 1979.
By 1983 it had dropped to about 540,000 and it continued to
drop to 522,000 in 1984.14 (Nationally the labor force grew 8
percent during this period.) Some workers left the region to
seek jobs elsewhere,15 while some older workers dropped
out of the labor force by accepting early retirement.16 The
out-migration primarily involved younger workers without the
13 Buffalo still must contend with other disadvantages. It cannot move closer to
the growing markets of the West and South. The recent growth of the
northeastern economy, however, has lessened this problem. In addition, the
economic competitiveness of area factories and other physical capital may
have declined further compared with other areas. New investment is more
likely to be drawn to growing regions than to Buffalo with its economic
problems. The recessions of the early 1980s compounded Buffalo’s problems
by lowering local investment levels and forcing more plants to close.
14 New York State Department of Labor, Buffalo SMSA, Fiscal Year 1985, Annual
Labor Area Report, page 11.
15 This out-migration also occurred in earlier periods. See Louis Jacobson,' ‘A Tale
of Employment Decline in Two Cities: How Bad Was the Worst of Times?” , Indus­
trial and Labor Relations Review, Volume 37, No. 4 (July 1984), pages 557-569.
16 In 1980, about 20 percent of all Buffalo’s manufacturing workers were age 55
or older. The percent was even higher in industries about to experience large
layoffs such as primary metals and motor vehicles. See United States Census
Bureau, 1980 Census of Population, Volume 1, Chapter D, Part 34, Table 230.

By industry
P ercent of em ploym ent
6 0 ------------------------------------------------------------------------------------

50

U ^ j B u f f a l o area

Chart 5

Nonmanufacturing Employment Change in
the Buffalo Area and the United States
1979-83
P ercent change

goods

goods

and Finance
and related
industries

S o u rce s: U nited States D epartm ent of Labor and
New York S tate D epartm ent of Labor.

32 FRBNY Quarterly Review/Winter 1985-86



Trade

Finance and related
industries

S ervices

Sources: United States Department of Labor and
New York State Department of Labor.

option of early retirement, while older workers tended to
stay in Buffalo because of its low housing cost.17
C hart 6

Wage adjustment within industries
Manufacturing production wages showed only a slight ad­
justment by 1982, three years after the most recent eco­
nomic downturn started in Buffalo.18 Buffalo production
workers’ wages adjusted for industry mix remained about 7
percent above the national average (Table 1).
Since 1982, however, Buffalo’s wages have adjusted in
important manufacturing occupations.19 In the early 1980s,
Buffalo’s wages for skilled maintenance occupations in
manufacturing firms began a gradual decline compared with
other metropolitan areas and this decline continued through
1984, the latest year for which data are available (Chart 6).
Buffalo wages for unskilled plant workers in manufacturing
also peaked as a percent of the national average in 1980
(at an even higher relative wage) and a more pronounced
decline followed.20 In four years, Buffalo wages for unskilled
plant workers in manufacturing fell from about 15 percent
above the national metropolitan average to close to the na­
tional figure.21
Wages for Buffalo’s production and clerical workers out­
side of manufacturing adjusted much faster to the labor sur­
plus than wages for manufacturing production workers. By
1981, wages for important occupations in each nonmanu­
facturing category were below national metropolitan aver­
ages, in some cases at 90 percent of the national average
(Chart 7).
Five factors help explain why Buffalo’s wages in manufac­
turing adjusted so much more slowly than other categories.
The National Association of Realtors found that Buffalo had the lowest median
purchase price for existing single family housing of the 44 metropolitan areas
they studied in 1984. See Buffalo News (November 9, 1985), page A.6.
This conclusion is based on data from the most recent Census of Manufactures
taken in 1982.
The only detailed data on Buffalo’s wages after 1982 are from the Bureau of
Labor Statistics Area Wage Surveys, which are published annually. These
surveys report wages by occupation. The earlier analysis in this article used
data from the Census of Manufactures, which reports data by industry.
Buffalo’s 1984 wages for unskilled manufacturing workers were, as a result,
below other older industrial areas such as Detroit (136 percent of metropolitan
average), Dayton (119 percent), Chicago (104 percent), and Philadelphia (107
percent). However, they remained above Boston (88 percent) and New York
City (87 percent). Manufacturing growth in the United States, however, is
occurring primarily in areas with newer production facilities and wages
significantly below the national average. Massachusetts and New Hampshire
are the only northeastern states to register manufacturing growth over the last
five years. Their manufacturing wages—adjusted for industry mix—were under
90 percent of the national average in 1982. Many of the southeastern states
had adjusted wages at near 80 percent of the U.S. average. See Lynn Browne,
“ How Different Are Regional Wages? A Second Look” , New England
Economic Review, Federal Reserve Bank of Boston (March/April 1984), pages
40-47.
These conclusions for manufacturing workers must be tentative until detailed
information becomes available with the next Census of Manufactures. Efforts to
duplicate the analysis of manufacturing wages done earlier in this article, using
the less detailed data available between Census years, produced inconclusive
results.




Buffalo M an u factu rin g Wage as a Percent
of A verage for All M etropolitan Areas
P ercent
12 0 -----------------------------------------------------------------------------------------------

U n skilled
p lant w o rke rs

1969 70 71 72 73 74 75 76 77 7 8 * 7 9 80 81 82 83 84
*1 9 7 8 data not a va ila b le .
Sources: United S tates Departm ent of Labor, Bureau
of Labor S ta tis tic s , Area Wage Surveys.

Chart 7

Buffalo Nonm anufacturing W age
as a Percent of A verage
for All M etropolitan Areas
P ercent
110

U n skille d
p la n t w o rke rs
105
•^ ^

*

100

95
90
85

J__ L I I I I I I
80
196970 71 72 73 74 75 76 77 7 8 *7 9 80 81 82 83 84
*1 9 7 8 data not available.
S ources: U nited S tates D epartm ent of Labor, Bureau
of Labor S ta tis tic s , Area Wage S urveys.

FRBNY Quarterly Review/Winter 1985-86 33

• The union wage effect was stronger in manufacturing.
Most manufacturing production workers in Buffalo were
covered by collective bargaining agreements (Appen­
dix 1) and the percentage in most other metropolitan
areas was much less than in Buffalo. A much higher
proportion of manufacturing workers in Buffalo than
elsewhere, therefore, received a “ union wage” premi­
um. (For blue-collar and clerical workers in nonmanu­
facturing firms, however, Buffalo’s level of unionization
was similar to that of other metropolitan areas.)
• National collective bargaining agreements in manufac­
turing slowed the downward wage adjustment in Buffalo
by stabilizing local wages in some industries or causing
them to rise despite the local downturn. Primary metals,
transportation equipment, and machinery are important
local industries whose wage provisions are negotiated
nationally.22 In the first two of these industries, Buffalo’s
wages actually increased compared with other areas
between 1977 and 1982 as a growing portion of these
industries in other parts of the country became non­
union and paid lower wages.23 Only starting in 1982,
collective bargaining in the auto and steel industries led
to wage concessions and flexibility in local work rules to
These national agreements are not rigid, as the recent wage and benefit
concessions in the steel and auto industries illustrate. However, they are less
sensitive to local labor market conditions than either locally negotiated
agreements or nonunion wage-setting. See Freeman and Medoff, op. cit.,
Chapter 3.
The new independent mini-mills in steel and nonunion auto parts suppliers
under contract with major auto companies are examples of these
developments.

Chart

encourage recovery, and the expected wage adjust­
ment began.24
• The slow-changing wage expectations of workers in du­
rable goods manufacturing kept wages from adjusting
quickly. These production workers have become accus­
tomed to repeated layoffs and rehires over business cy­
cles, and their high hourly wages are viewed as com­
pensation for their intermittent unemployment.25 In
other words, Buffalo’s workers in cyclical durable goods
industries were slow to decide that the layoffs of 198082 were anything other than the latest round in the usu­
al pattern of layoffs and eventual recalls.26
• Average seniority increased among manufacturing
workers in durable goods industries as younger, lowerpaid workers were laid off. Because layoffs hit a larger
percent of the manufacturing workforce in Buffalo than
in the nation, Buffalo’s relative wages increased be­
cause of higher effective seniority. Nonmanufacturing
industries in Buffalo and elsewhere in the nation did not
experience similar large layoffs.

24 See Bureau of National Affairs, Layoffs, Plant Closing, and Concession
Bargaining (1983).
25 See Sherwin Rosen, "Implicit Contracts: A Survey", Journal o f Economic
Literature (September 1985), pages 1144-1175.
26 This attitude was most common among older workers. Some eligible for
retraining preferred to wait out the "cycle" and collect unemployment benefits.
See Walter Corson, Sharon Long, and Rebecca Maynard, An Impact
Evaluation of the Buffalo Dislocated Worker Demonstration Program,
Mathematica Policy Research (1985).

Table 2

8

Nonmanufacturing Employment Change in
the Buffalo Area and the United States

Manufacturing Employment in the Buffalo Area
Annual average 1979 and 1983 (in thousands)
Percent
change

Buffalo
employment

September 1983 to September 1985
Percent change

20 — — — --------------------------------------------------------□

Buffalo area
United States

industries
Sources: United States Department of Labor and
New York State Department of Labor.

34 FRBNY Quarterly Review/Winter 1985-86



Industry

1979

1983

Buffalo

United
States

Durable goods...............
Primary metals...............
Fabricated metals.........
Machinery, excluding

102.5
21.7
14.1

67.3
8.4
9.8

-3 4
-6 1
-2 5

-1 6
-3 7
-2 0

13.2
11.6

9.9
9.2

-2 5
-2 1

-1 8
-4

26.1
15.8
42.7

17.6
12.4
36.4

-3 3
-2 2
-1 5

-1 5
-1 2
-7

Electrical equipment___
Transportation
equipment ................
Other.............................
Nondurable goods .......
Source:

New York State Department of Labor.

• An oversupply o f office workers and market determina­
tion o f local wages reduced Buffalo’s relative wage for
office workers to well below the national metropolitan
average. With relatively slow growth in Buffalo’s service
sector, compared with national trends, the demand for
office workers grew more slowly than in many other
metropolitan areas. The supply, on the other hand, was
more than adequate. In 1982, the depth of the reces­
sion, there were eight jobseekers for each Buffalo area
job listed in the professional, technical, managerial, and

clerical categories in the state job data bank.27 The ratio
of jobseekers to jobs for office work exceeded even the
ratios for factory processing and benchwork, and pack­
aging and material handling—important lower-skilled
blue collar jobs.28
27 State of New York, Annual Planning Information for Manpower Planners, Fiscal
Year 1984, Buffalo SMSA, page 30.
28 Buffalo’s office workers were younger than manufacturing workers and hence
less likely to leave the labor market through retirement. This contributed to the
labor surplus. United States Census Bureau, 1980 Census of Population,
Volume 1, Chapter D, Table 221.

Table 3

Payroll Per W orker and Employment Change In the Buffalo Area 1979-84

Industry

1979 average
payroll per worker*
In dollars

Change In employment
1979-84

1984 average real
payroll per worker*
In 1979 dollars

Percent change
in real payroll
per worker 1979-84

In thousands

In percent

-1 7 .6

-4 .2

11,909

-1 0 .8
-2 .0

Average all sectors ............................................

13,345

Medical and other health services..........................

10,030

7.8

25.6

9,832

Business services.................................................

9,448

3.6

22.9

8,900

-5 .8

Social services.......................................................

7,278

2.4

39.0

6,899

-5 .2

Finance and related industries...............................

11,989

2.1

9.9

12,194

1.7

Education..............................................................

8,091

1.3

22.9

8,413

3.8

Construction..........................................................

17,051

1.3

7.5

15,612

-8 .4

Miscellaneous services to individuals....................

9,136

1.1

10.4

9,012

-1 .4

Agriculture, forestry, fisheries, and mining.............

10,924

1.0

44.2

10,075

-7 .8

Lodging.................................................................

5,889

0.9

28.1

5,766

-2 .1

Legal.....................................................................

11,720

0.8

29.7

12,796

9.2

Personal services .................................................

7,119

0.3

6.3

5,921

-1 6 .8

Retail trade............................................................

6,698

0.2

0.2

6,028

-1 0 .0

Printing and publishing..........................................

15,428

0

-4 .4

14,323

-7 .2

Membership organizations.....................................

5,669

0

-0 .5

4,966

-1 2 .4

Miscellaneous services..........................................

13,057

-0 .1

- 2 .0

13,899

6.4

Food and kindred products...................................

15,643

-0 .5

-5 .1

15,436

-1 .3

Rubber and plastic ................................................

16,540

-0 .6

-1 0 .2

17,263

4.9

Transportation and public utilities..........................

17,995

-0 .7

-2 .8

16,764

-6 .8

Wholesale trade.....................................................

15,184

-1 .0

-4 .0

14,137

- 6 .9

Electrical machinery..............................................

17,766

-1 .8

-1 5 .9

17,750

0

Chemicals..............................................................

19,657

-1 .9

-1 9 .6

20,291

3.2

Machinery, excluding electrical.............................

17,750

- 2 .2

-16 .1

17,048

- 4 .0

Miscellaneous nondurable manufacturing.............

13,850

- 2 .6

-2 5 .3

13,131

- 5 .2

Miscellaneous durable manufacturing..................

16,478

-3 .1

-2 4 .9

15,291

- 7 .2

Fabricated m etals.................................................

19,119

-3 .1

-2 1 .9

18,026

- 5 .7

Transportation equipment......................................

22,239

-6 .3

-2 4 .0

22,412

0.7

Primary metals.......................................................

22,918

-1 6 .6

-7 6 .6

19,822

-1 3 .5

* This figure is total annual payroll in an industry divided by the average number of people who worked in the industry during the year. As a result, differences in
payroll per worker reflect differences in wages and in the proportion of part-time workers.
Source: New York State Department of Labor.




FRBNY Quarterly Review/Winter 1985-86 35

Earnings in growing versus declining industries
Buffalo’s new nonmanufacturing jobs tended to be lowerpaying than the lost manufacturing jobs. Table 3 lists indus­
tries ranked by their employment change between 1979 and
1984. Many workers laid off from durable goods production
work who found new jobs in retail trade or services experi­
enced a large earnings decrease. Within the national service
sector, only certain types of professional and technical jobs
offer high pay. And these high-paying jobs tend to be con­
centrated in regional or national service centers such as
New York, Boston, or San Francisco—not Buffalo.

Table 4

Private Sector Employment in the B uffalo Area in
September 1983 and September 1985
In thousands
Sector
Total private
nonagricultural.........
Manufacturing................
Durable goods.............
Primary metals.........
Fabricated metals .. .
Machinery, excluding
electrical...............
Electrical
equipment...........
Transportation
equipment...........
Other durable...........
Nondurable goods —
F oo d ........................
Textile and apparel ..
Paper ......................
Printing and
publishing.............
Chemicals................
Rubber and
plastics.................
Other nondurable . . .
Transportation and public
utilities..........................
Wholesale trade...............
Retail trade......................
Finance and related
industries....................
Services..........................
Health..........................
Education....................
Social services ...........
Other...........................
Construction....................
Other...............................

Percent
September September
1983
1985 Change change
390.4

410.0

♦ 19.6

♦5

105.0
68.4
8.4
9.7

103.8
67.3
4.5
10.5

- 1 .2
-1 .1
- 3 .9
+ .8

-1
-2
-4 6
+8

9.9

9.9

0

0

9.2

9.0

-0 .2

-2

18.4
12.8
36.6
8.6
3.0
3.0

21.4
12.0
36.5
8.3
3.3
28

+3.0
-0 .8
-0 .1
-0 .3
+ 0.3
-0 .2

+ 16
-6

8.4
7.9

8.9
7.3

+ .5
-.6

+6
-8

4.9
0.8

5.1
0.8

+0.2
0

+4
0

25.3
24.8
85.6

25.0
24.9
92.8

-3
+0.1
+ 7.2

-1

23.1
108.5
35.5
8.2
8.4
56.4
17.4
0.7

24.8
117.6
38.1
8.2
9.8
61.5
20.3
0.8

+ 1.7
+9.1
+2.6
0
+ 1.4
+ 5.1
+ 2.9
+ 0.1

+7
+8
+7
0
+ 17
+9
+ 17
+ 14

* Less than 0.5 percent change.
Source: New York State Department of Labor.

*
-3
+ 10
-7

*
+8

Where Buffalo stands now
Over the last decade Buffalo’s economy has adjusted to the
decline in many of its traditional industries. Plant closings
and layoffs are the most visible part of this adjustment, but
the reduced labor force and wage adjustments are also
important.
The present labor market situation clearly is better than
anytime since 1980. The metropolitan unemployment rate
dropped from its peak of 15 percent in late-1982 to about
7.5 percent by mid-1985. The national economic expansion
and adjustments in the local economy increased employ­
ment in most sectors of the area economy except manufac­
turing (Table 4). And area payrolls have grown in real terms
during 1984 and 1985.
Unfortunately, this recent growth in Buffalo employment
does not represent a break with long-run trends. It is similar
to growth in the late 1970s and other periods of national
economic expansion. Moreover, Buffalo’s growth in the cur­
rent expansion could turn out to be weaker than in past
expansions because manufacturing has continued ,to de­
cline. (Only transportation equipment production has shown
employment gains through re-hires at local auto plants.)
And with the manufacturing sector declining overall, Buffalo
service and trade employment growth rates continue to lag
behind national figures (Chart 8, page 34).
In sum, Buffalo’s recent expansion has not been bal­
anced. For much of the last five years, manufacturing, popu­
lation, and real income have declined while retail and serv­
ice employment have grown. Currently, the proportions of
manufacturing, services, and retail employment are similar
to the nation’s economy. If manufacturing in Buffalo de­
clines further during the current recovery only to be hit se­
verely in the next recession, local retail and service indus­
tries may not be able to continue their growth and Buffalo
may once again face difficult times.
All the same, the adjustments to the economic decline
that have already occurred may set the stage for develop­
ment of new industries. Buffalo can offer low-cost housing,
electric power, office space, and, in many occupations,
trained labor. Industries that previously might have been
priced out of the Buffalo market may now find it more at­
tractive. Expansion in financial services for the regional mar­
ket has already occurred. Local development agencies are
encouraging the growth of medical research, high tech, and
new smaller manufacturing firms, though in the short run
these provide relatively few jobs. Furthermore, the current
economic growth in the Northeast is increasing the demand
for Buffalo’s goods and services. Given the long-term eco­
nomic problems facing the region, there is clearly a sense of
urgency to these efforts to develop a new “ product line” for
Buffalo’s economy.

Fred C. Doolittle

36 FRBNY Quarterly Review/Winter 1985-86



Appendix 1: The Im pact o f C ollective Bargaining on Wages
Past econometric research suggests that nationwide the “ union
effect” on wages became greater between the early 1960s and
the late 1970s.* In the 1960s when labor markets were tight,
wages of union jobs were about 10 to 15 percent above the
wages of similar nonunion jobs. With slower growth and higher
unemployment in the 1970s, this difference rose to roughly 20 to
30 percent. As the union wage effect grew in the 1970s, wages
in heavily-unionized Buffalo rose relative to the rest of the
country (table).

Workers in Firms of 50 or More Employees
Covered by Collective Bargaining Agreements, 1980
In percent
Manufacturing Nonmanufacturing
production
production
Office
workers
workers workers

/yrea
Buffalo.........................
AH metropolitan areas
Median......................
High..........................
L o w .........................

Source: Data are from the United States Bureau of Labor Statistics, Area
Wage Surveys, Selected Metropolitan Areas, 1980, page 115.

Collective bargaining developments in auto and basic steel
manufacturing were a source of wage growth in the entire manu­
facturing sector in Buffalo.t In autos and steel, national collec­
tive bargaining agreements caused industry wages to rise sharp­
ly as a percentage of the national average for all manufacturing
production workers. Auto workers’ wages rose from 30 percent
above the national average in 1970 to nearly 50 percent by the
late 1970s. At the same time, primary metal workers’ wages
rose from 22 percent above the national average in 1970 to 45
percent in the late 1970s. In the mid-1970s, these two important
Buffalo industries were paying high and rising wages to more
than one-fourth of the local manufacturing workforce. Other
manufacturing employers also had to pay higher wages to at­
tract and retain workers.
* See Richard Freeman and James Medoff, What Do Unions Do? (New York:
Basic Books, 1984), Chapter 3, for a survey of recent research. See also
Colin Lawrence and Robert L. Lawrence, “ Manufacturing Wage
Dispersion: An End Game Interpretation", Brookings Papers on Economic
Activity (1985), No.1, pages 47-106.
t See Otto Eckstein eta!.. The DRI Report on U.S. Manufacturing Industries
(New York: McGraw-Hill, 1984), Appendix; Jack Steiber, “ Steel", in
Gerald G. Sommers, ed., Collective Bargaining: Contemporary American
Experience (Madison: Industrial Relations Research Association, 1980),
Chapter 4; and Harry Katz, Shifting Gears: Changing Labor Relations in the
U.S. Automobile Industry (Cambridge: MIT Press, 1985).

Appendix 2: Changing Population in the B uffalo Area
Like many older metropolitan areas, Buffalo lost population
during the 1970s and early 1980s.

Year

_________________________

Buffalo area
population_________ Change

1960 ................................................. ............ 1,306,957
1970
............ 1,349,211
+42,254
1900
........................................ 1,242,826
-106,385
1984
....................... 1,204,800________ -38,026
* Not applicable.
Source: United States Bureau of the Census.




Most forecasts estimate that the area’s 1990 population will be
slightly less than in 1984. As the baby boomers have grown
older, the age structure of the population has changed. The
number of Buffalo area residents under 20 years of age has
declined: in 1980 there were about 380,000 people in this age
bracket, and the 1990 forecast is about 310,000. Residents from
20 to 64 years of age totaled 710,000 in 1980 and are expected
to drop to about 695,000 in 1990. Residents age 65 and over
totaled 155,000 in 1980 and are expected to grow to 175,000 in
1990.t
t Battelle Inc., An Analysis of Current and Short- Term Projections of
Economic Conditions in Erie County (January 1984), page 15.

FRBNY Quarterly Review/Winter 1985-86 37

In Brief
Economic Capsules
C redit Card Balances—
Debt or Convenience Use?
Over the past several years, consumer installment debt out­
standing has risen very rapidly relative to disposable person­
al income, causing the ratio of the two to reach an all-time
high of 0.188 in November 1985 (Table 1). Revolving debt,
which includes outstanding balances on credit card and
check credit accounts, constituted 21.5 percent of consum­
er installment debt in November 1985, and has been the
fastest growing component of consumer installment debt
over the past several years. However, some of the debt in­
cluded in revolving debt actually reflects the “ convenience
use” of credit cards. That is, some individuals use credit
cards as a convenient means of making transactions and
pay all charges in one billing cycle. Although an increase in
the convenience use of credit cards does not represent an
increase in debt in the ordinary sense, the outstanding bal­
ances of convenience users are included in the measure of
consumer installment debt outstanding. Therefore, this mea­
sure overstates the “ true” level of consumer debt.
Various analysts have attributed approximately 40 to 50
percent of the growth in revolving debt to the convenience
use of credit cards, based on industry and household survey
data that indicate that 40 to 50 percent of credit card users
pay their bills in full within the billing period.1 However, such
analyses overestimate the degree to which growth in the
convenience use of credit cards accounts for growth in
revolving debt outstanding. Although 40 to 50 percent of
extensions of revolving credit may reflect the convenience
use of credit cards, the percent of revolving credit outstand­
ing that reflects such use may be much smaller. Available
data indicate that the amounts charged in any given month,
1 See Charles A. Luckett and James D. August, “The Growth of Consumer
Debt", Federal Reserve Bulletin (June 1985) and Goldman Sachs Economics,
Pocket Chartroom (November 1985).

38 FRBNY Quarterly Review/Winter 1985-86



whether for convenience purposes or otherwise, account for
only a small portion of revolving debt outstanding in that
month. Much of the debt reflects charges that were incurred
by non-convenience users in previous months. Therefore, to
estimate the proportion of revolving debt outstanding, as op­
posed to the proportion of monthly charges, that reflect the
convenience use of credit cards, one must first estimate the
proportion of debt that has been outstanding for less than
one month, or more accurately, less than one billing cycle.
Suppose that, in any given month, on average half of the
charges in that month occur before that month’s billing date,
and half occur after. Then the amount outstanding at the
end of a given month that has been outstanding for less
than one billing cycle equals, at most, the amount extended
during that month plus one-half of the amount extended dur­
ing the previous month. That is, the time between the date
on which a charge is made and the date on which the first
payment is due ranges from one to two months, depending
on how close the former date is to the next billing date, and
averages one and one-half months.
Data from the years 1977 to 1982 indicate that, on aver­
age, extensions of revolving credit during a given month,
plus one-half of extensions during the previous month, ac­
count for roughly 30 percent of revolving credit outstanding
at the end of the month.2 If one assumes that 50 percent of
cardholders pay their bills in full in one billing cycle, and
roughly 30 percent of revolving debt outstanding has been
outstanding for* less than one billing cycle, then roughly 15
percent of revolving debt outstanding reflects charges that
will be paid in full within one billing cycle.
2 The Federal Reserve Board published estimates of monthly extensions of
revolving debt, as well as revolving debt outstanding, for the 1977-82 period
(Statistical Release G. 19). Data on extensions were not collected after 1982.

IN BRIEF—ECONOMIC CAPSULES

The estimate derived above is an approximation that does
not take into account a number of factors. First, the propor­
tion of monthly charges that are paid in full within one billing
cycle may be less than or greater than the proportion of
cardholders (taken to equal 50 percent) that pay in full
within one billing cycle. That is, charges incurred each
month by persons who then pay these charges in full may
be smaller or larger, on average, than the charges incurred
by those who do not. A person may be more likely to pay a
small monthly bill (i.e., $200) in full in one billing cycle than
a large monthly bill (i.e., $2,000). In this case, the propor­
tion of revolving debt outstanding that reflects the conve­
nience use of credit cards is less than 15 percent. On the

other hand, one might argue that wealthy persons tend to
incur large charges and then pay them in full while poorer
persons incur smaller charges and do not. Or one could
argue that persons who maintain outstanding credit bal­
ances are more likely to be restricted in the amount of addi­
tional monthly charges they can incur, due to credit limits,
than persons who pay their monthly bills in full. In these
latter cases, the convenience-use portion of revolving credit
outstanding would exceed 15 percent.
Second, the estimate presented above is based implicitly
on the assumption that convenience users of credit cards
pay their charges one month after they are billed. To the
extent that some persons pay their credit charges in less

Table 1

Growth o f Consumer Installm ent Debt, Revolving Debt, and Disposable Personal Income, 1978-85
In percent, seasonally adjusted
_______________Annual growth rates of:
Consumer
Disposable
installment
Revolving
personal
Year_______________________________________________________ debt*_________ debt*________ incomet
1978
1979
1980
1981
1982
1983
1984
1985
*
t
j
§

18.9
14.0
-3 .5
5.6
4.9
14.5
20.3
20.3

23.5
18.2
3.2
9.9
7.8
17.6
24.2
23.5

Revolving
Installment
debt as a percent
debt as a
of consumer
percent of income!______installment debt§

12.5
11.5
10.9
10.9
6.3
7.2
10.1
4.9

16.6
17.1
14.7
14.3
14.2
14.9
16.6
18.8

16.7
17.3
18.5
19.3
19.8
20.3
21.0
21.5

Growth rates are from December to December. For 1985, growth rate is from December to November, annualized,
Growth rates of annual income.
Debt is as of the end of the year. Income is fourth quarter disposable personal income on an annualized basis. For 1985, debt is as of the end of November.
Percents are as of the end of the year. For 1985, the percent is as of the end of November.
Sources: Federal Reserve Board, Statistical Release G.19 and Citibase.

Table 2

Growth o f Consumer Installm ent Debt, W ith and W ithout an Adjustm ent fo r the Convenience Use o f C redit
Cards, 1978-85
In percent, seasonally adjusted
Annual rate of growth of
consumer installment debt*
Adjusted for the
convenience use
Year__________________________________________________________________________ Actual________ of credit cards
197
197
198
198
198
198
198
198

8
9
0
1
2
3
4
5

18.9
14.0
- 3 .5
5.6
4.9
14.5
20.3
20.3

18.7
13.9
- 3 .7
5.5
48
14.4
20.2
20.2

Debt as a percent of
disposable personal
_________________Incomef

Actual

Adjusted for the
convenience use
of credit cards

16.6
17.1
14.7
14.3
14.2
14.9
16.6
18.8

16.2
16.7
14.3
13.9
13.7
14.5
16.1
18.2

’ Rates of growth are from December to December. For 1985, rate of growth is from December to November, on an annualized basis,
t Debt is as of the end of the year, as a percent of fourth-quarter annualized disposable personal income. For 1985, debt is as of the end of November.
Source: Federal Reserve Board, Statistical Release G.19, Citibase, and author’s calculations.




FRBNY Quarterly Review/Winter 1985-86 39

than one month, the estimate presented above overstates
the proportion of revolving debt that is paid in full in one
billing cycle.
Because of the simplifying assumptions made, including
the ones described above, the methodology used in this
capsule may slightly overstate or understate the importance
of the convenience use of credit cards. In any case, the
available evidence indicates that on the order of 15 percent,
rather than 40 to 50 percent, of revolving debt outstanding
reflects this convenience use. Unfortunately, very little data
are available on the degree to which the convenience-use
proportion of revolving debt may have changed over time.3
To the extent that the convenience use of credit cards has
been a roughly constant proportion of revolving debt over
time, taking into account this convenience use does not sig­
nificantly affect recent growth rates in consumer installment
debt, or the current level of consumer installment debt rela­
tive to income (Table 2).
3 The ratios of extensions of revolving debt to revolving debt outstanding
exhibited only a very slight downward trend over the 1977-82 period.
According to Luckett and August, op. cit., approximately the same proportion
of cardholders report "almost always” paying credit card bills in full in the
1983 Consumer Credit Survey as in the 1977 survey. However, it is not known
whether the monthly charges incurred by such persons have grown more or
less quickly over time than have average monthly charges.

Comparison o f Ward’s to A lternative Models
Bias*
(percent)f

Model

Accuracy*
(percent) f

Predictive
power*

0.381
(5.0)

0.498
(6.6)

0.859

Extrapolative....................

0.028
(0-4)

0.686
(90)

0.690

Econometric model...........

0.283
(3.7)

0.524
(6.9)

0.838

Combination model .........

0.209
(2.8)

0.368
(4.9)

0.886

"Bias" is the mean error and "Accuracy" is the mean absolute error.
t Millions of units at an annual rate. The numbers in parentheses are the
bias and accuracy as a percent of actual production.
♦ "Predictive power" is the coefficient of determination (i.e., the ft2). It
measures the percent of variation in actual production explained by
each model.

Chart 1

Lynn Paquette

W ard’s P ro je c tio n s and A ctual
A u to m o b ile P ro d u ctio n
S easonally a d ju ste d annual rates
M illio n s o f units

Two Capsules on
the Auto S e c to r...
. . . Forecasting
Automobile Output
As a share of GNP, the auto sector has been on the decline
since the early 1970s. Auto output accounted for only about
21/2 percent of GNP from 1980 to 1985, down from almost 3
percent in the 1970s. Judged in terms of its contribution to
GNP fluctuations, however, the auto industry remains a key
sector of the economy. In the last six years changes in auto
output accounted for 29 percent of the quarter-to-quarter
change in GNP, slightly more than its 27 percent contribuThe author would like to thank Cornelis Los for his timely programming and
econometrics advice and Daniel Hayes for his excellent research assistance.

40 FRBNY Quarterly Review/Winter 1985-86



1973 74

75

76

77

78

79

80

81

82

83

84

85

Shaded areas re p re se n t p e rio d s of re c e s s io n , as
defined by the N a tio n a l Bureau of Econom ic R esearch.
" A c c u ra c y ’’ is the mean ab so lu te e rro r and " b ia s ’’ is
the mean e rro r, each as a p e rce n t of actual p ro d u c tio n .
S ources: Various issues of W a rd ’s Autom otive
R eports (1973-85) and u n p u b lish e d data from the
Bureau o f Econom ic Analysis.

IN BRIEF—ECONOMIC CAPSULES

tion in the 1970s.1 In addition to its strong direct effect on
the economy, the auto sector continues to have substantial
spillover effects. Purchases of raw materials by the auto in­
dustry account for more than half of the rubber and lead
consumed in the United States, as well as a major portion of
the steel, aluminum, platinum, copper, and zinc. On the con­
sumer end, spending associated with buying and using auto­
mobiles has been running above 10 percent of GNP in re­
cent years.2
Because of its far-ranging importance, the auto sector is
central to any assessment of prospects for the economy as
a whole. The auto production plans published in Ward’s Au­
tomotive Reports provide a timely two-quarter projection of
this important sector, and, as a result, have become a popu­
lar tool in forecasting. In this capsule we examine the useful­
ness of the Ward’s projections for forecasting auto output
over the near term. Adjusted for systematic over-prediction,
In absolute value, the average change in real auto output was $4.5 billion from
1980 to 1985, compared with $15.8 billion for total real GNP.
Motor Vehicle Manufacturers Association, Motor Vehicle Facts and Figures
(1984), pages 60 and 72.

the projections compare favorably with those from some al­
ternative methods, but they do not provide the best overall
predictions. In particular, combining the Ward’s projections
with a simple econometric model significantly improves the
accuracy of the forecast.
Analysis o f the Ward’s projections
Each month Ward’s asks eight U.S. auto makers to state
their domestic production plans for the next three to six
months. Chart 1 plots domestic auto production and the
Ward’s projections made at the beginning of each quarter.3
Although the Ward’s projections generally track the up and
down movement of production they have two shortcomings.
First, they are not very accurate, with an average error of
about one-half of a million cars at an annual rate. Second,
they systematically over-predict auto output, by an average
of 0.42 million cars at an annual rate, or 5.5 percent of actu­
al production. The Ward’s projections, therefore, may be
3 The raw data are monthly, but the analysis has been simplified by aggregating
the three months of each quarter. In addition, the data is adjusted using
seasonal factors from the Bureau of Economic Analysis.

Estimates o f the Econom etric and Combination Models
Our econometric model is based on a simple supply and de­
mand model. Demand for autos increases when real disposable
income rises, the price of new autos falls, or the price of other
durable goods increases. The supply of autos expands when
inventories are low relative to sales or when the cost of borrow­
ing declines. Low interest rates also increase the demand for
autos.
Estimates for both the econometric model and the combina­
tion model are presented at right. Each variable is lagged one
quarter, since the actual value of each variable would not be
known at the time of each forecast. All the variables are signifi­
cant and have the correct sign in the econometric model.* Add­
ing the Ward’s projection to the econometric model significantly
improves the overall fit, reducing the standard error of the model
by 100,000 autos.t The Ward’s projection is the most significant
variable in this “ combination” model, although all the other vari­
ables, except “ other price” , remain significant.
The forecast comparisons reported in the text are not the
within-sample predictions of these models. Instead, each model
is estimated recursively over the sample, using data from 1967-11
* The coefficient on the own-price variable is positive, which suggests that it
is capturing supply-side effects.
t A formal F-test shows that the Ward's projections add significantly (at the 1
percent level) to the explanatory power of the econometric model. The
opposite test, of whether the econometric model improves the Ward's
projections, was also supported by the data (at the 5 percent level).
Together these tests confirm the results reported in the table in the text: the
best forecast combines the Ward’s projections with an econometric model.




to the quarter of the forecast. The prediction errors from these
one-quarter-ahead projections are then used to compare the
out-of-sample forecasting power of the models.
Variable
Constant................................... ...........
Incom e..................................... ...........
Prime rate................................. ...........
IS ratio....................................... ...........
Own price................................. ...........
Other p rice ............................... ...........
Ward's projection....................

.......

.............................. ...........
SEE.......................................... ...........
Durbin Watson.......................... ...........

Econometric

Combination

-22301.8
(-4 .5 )
12.9
(6.6)
-9 7 .8
(-3 .2 )
-1 9 .9
(-6 .1 )
230.4
(5.0)
6.0
(2.1)

-7931.4
(-1 .7 )
5.4
(2.6)
-9 0 .0
(-3 .7 )
-8 .7
(-2 .7 )
93.8
(2.1)
1.9
(0.8)
0.55
(5.3)
0.914
420
1.82

*
0.862
532
2.26

The sample period is 1973-1 to 1985-111. The t-values are in parentheses. All
independent variables, except the Ward’s projections, are lagged one
period. The dependent variable is units production (in thousands at an
annual rate) and the other variables are defined:
Income
IS ratio
Own price
Other price

=
=
=

real disposable income in 1972 dollars.
ratio of retail auto inventories to sales.
the CPI for new autos divided by the overall CPI.
the implicit deflator for non-auto durable goods sales,
divided by the overall CPI.

* Not applicable.

FRBNY Quarterly Review/Winter 1985-86 41

best viewed as production “ targets” rather than forecasts.4
We can analyze the Ward’s projections more rigorously by
estimating the relationship between actual production and
the Ward’s projections:
Auto output = 0.275 + 0.909 Ward’s + 0.277 error ( —1)
(0.59) (15.67)
(2.54)
Sample period=1973-l to 1985-111, SEE=0.431, R2=0.838
(The t-values are in parentheses.)
The statistical results from this regression suggest three
problems with the Ward’s projections. First, they provide
statistical confirmation that Ward’s systematically over­
predicts.5 Second, the errors are serially correlated; that is,
they tend to persist from one period to the next. This means
The projections are supposed to be “ actual production schedules” , as
reported by production planners, taking into account both production capacity
and market outlook. There are at least three possible reasons for systematic
over-prediction. First, the normal amalgam of strikes and bottlenecks may
thwart plans. Second, the market may be weaker than the (generally optimistic)
outlook embodied in the production plans. Third, as part of its marketing
strategy each firm has an incentive to exaggerate its plans. An optimistic
outlook may help promote sales and increase the stock market value of the
firm. Furthermore, by reporting strong production plans each firm may hope to
dissuade production by its competitors and thereby capture greater market
share.
If the projections were unbiased, with no tendency to predict too high or too
low, then the constant term would be close to zero and the slope coefficient

Chart 2

Forecast Errors of the W a rd ’s Projection
and the C ombination Model
Seasonally adjusted annual rates
M illions of units
2 .0

—

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

W ard’s error

the errors, as well as the projections themselves, can be
used to forecast production. It also implies that better fore­
casts could be achieved by adding economic variables to
the equation. Third, the large standard error means that
even adjusted for systematic over-prediction the projections
are not very accurate.
Ward’s in comparison with other forecasts
Despite these limitations, the Ward’s projections are useful
for forecasting auto output. The table (page 40) compares
Ward’s with three alternative models: an extrapolative fore­
cast in which next period’s production is assumed to equal
current production; an econometric model of the auto sector
including income, price, and cost variables; and a combina­
tion of the Ward’s projections and the econometric model.
(Details of the econometric and combination models are
given in the box.) Since there is no single criterion for a
“ good” forecast, we present three standard measures: a
good forecast should have little bias (small average over- or
under-prediction), high accuracy (small average absolute
errors), and high predictive power (explain a large portion
of the variation in production). Overall, the Ward’s projec­
tions perform about as well as the econometric model and
are clearly superior to the extrapolative model; among the
three basic forecasts they rank the worst on bias but the
best on the other measures.
A better forecast
To take advantage of the relative merits of the Ward’s and
econometric models, we tried to improve the forecast by
combining them. The last row of the table (box) shows the
results for a “ combination forecast” , constructed by adding
the Ward’s projections as a variable to the econometric
model. The combination model is better than its compo­
nents by all three criteria: it has the least bias, the greatest
accuracy, and the most predictive power. This suggests that
both the Ward’s projections and the econometric model
contain information valuable in forecasting.
Chart 2 plots forecast errors for the combination model
and compares them with the Ward’s projections. The combi­
nation forecast shows small errors and no tendency to overor under-predict.6 Of course, more complicated models
might provide better forecasts. It seems clear, however, that
the Ward’s projections will remain useful for assessing the
outlook for the auto sector and the economy as a whole.
Footnote 5 continued
would be close to one. A formal F-test of this joint hypothesis shows that
Ward’s does significantly over-predict. The F(2,49) value is 12.51, which is
more than double the 1 percent critical value.
6 The Ward’s projections appear to have performed better in the last two years.
This is more a reflection of the unexpected strength of demand than a
fundamental change in forecast accuracy. In fact, if we compare the period
1973-79 with 1980-85, the track record of Ward's actually deteriorates over
time while the combination model improves.

S ource: F ederal Reserve Bank of New Y ork
s ta ff estim ates.

42 FRBNY Quarterly Review/Winter 1985-86



Ethan S. Harris

IN BRIEF—ECONOMIC CAPSULES

. . . Projecting
Consumer Expenditures
on Automobiles
Consumer spending on automobiles is one of the largest
and most volatile components of personal consumption ex­
penditures. To gauge the strength of this demand, unit auto
sales and retail auto sales are closely watched as early indi­
cators of overall spending and economic activity. This cap­
sule examines the relationship between unit sales and retail
sales of autos and their link with consumer spending on
autos as measured in the National Income and Product Ac­
counts. Our analysis suggests only a weak link between unit
sales and retail car sales. Moreover, changes in retail sales
of autos convey little information about changes in consum­
er spending on autos in real terms. In contrast, unit sales are
much more closely associated with consumer spending on
autos, and therefore appear to be a reliable indicator of con­
sumer auto demand.
Demand for automobiles is measured in three ways: unit
sales, retail sales, and real personal consumption expendi­
tures (PCE). Unit sales data count the number of new do­
mestic and foreign passenger cars sold. Retail auto sales
data estimate the value of sales by automotive dealers. Per­
sonal consumption expenditures data measure the inflationadjusted spending by consumers on new cars.
These three figures are released at different times each
month. Unit sales precede the Census Bureau’s advance
retail sales report by about a week, and the Bureau of Eco­
nomic Analysis’s nominal and real consumption spending
releases by more than two and six weeks, respectively.
Since unit sales data are available shortly after the end of
the month and then every ten days, they often form the
basis for projecting movements in both retail sales and con­
sumer expenditures on cars.
On the whole, movements in unit sales accurately indicate
the simple change in direction for both retail sales and con­
sumption. Unit sales and retail sales of autos move together
about 75 percent of the time while unit sales and consumer
spending on autos move together about 85 percent of the
time. In months of declining unit sales, however, the link
between unit and retail sales weakens while the relationship
between unit sales and consumer expenditures remains
strong. When unit sales fall, retail auto sales follow only
about half of the time, slightly above the correlation predict­
ed by chance. In contrast, consumer spending on autos falls
about three-fourths of the time when unit sales drop.
Statistical analysis also indicates a quantitative relation­
ship between unit and retail automobile sales. Movements in
unit sales explain just under 60 percent of the total variation




in the growth of current dollar retail sales of autos. An in­
crease of 10 percent in unit sales seems to be associated
with a 4 to 5 percent rise in retail motor vehicle sales.1
These results do not improve substantially when real retail
auto sales replace nominal sales or when any time trend is
removed from the retail data. In both cases, unit sales ex­
plain less than two-thirds of the variation in retail car sales.
In fact, unit sales gains correspond to even smaller estimat­
ed increases in retail auto sales after the retail sales data
are adjusted for inflation or the rising trend over time in sales
volume.
In contrast, statistical analysis yields a good fit between
unit sales and real consumer expenditures on new autos.
Changes in unit sales explain about 90 percent of the varia­
tion in new car spending. Furthermore, a ten percentage
point gain in unit sales implies a similar gain in real personal
consumption of autos.2
Given the weak association between retail sales and unit
sales and the good relationship between unit sales and con­
sumer expenditures, it is not surprising that retail sales are
not very tightly related to consumer auto expenditures. Sta­
tistically, changes in nominal and real retail car sales explain
only about 60 percent of the growth in real expenditures on
automobiles.
A careful look at the definitions of the automobile sales
measures explains why unit sales and PCE on new cars are
more closely related to each other than to retail auto sales.
A unit sale records the title transfer to a new car, and real
PCE on new cars measures the dollar value of the units
which are sold to consumers. In fact, the Bureau of Eco­
nomic Analysis calculates personal automobile expenditures
by multiplying the average new car purchase price, in con­
stant dollars and adjusted for quality changes, by the num­
ber of units estimated to have been bought by households.
Changes unrelated to movements in unit sales are account­
ed for by shifts in business’ and government’s share of unit
purchases, price changes, and product mix shifts not yet
incorporated in the average purchase price paid by consum­
ers. Retail “ automobile” sales data, however, include sales
of used cars, parts, light trucks, motorcycles, and motor1 See Footnote 2 for the regression results.
2 The equations were estimated from January 1967 to September 1985 and
were corrected for autocorrelation using the Cochrane-Orcutt procedure.
The equations are:
RETAIL =
0.71 +
0.43 UNITS
(4.80)
(17.70)
ft2 = 0.58 Rho = -0.26 S.E. = 2.8
PCECAR =

0.22 +
1.04 UNITS
(1.63)
(44.23)
ft2 = 0.90 Rho = -0.42 S.E. = 2.8
where RETAIL is the one-month percentage change in retail sales by motor
vehicle and miscellaneous automotive dealers, PCECAR is the one-month
percentage change in real personal consumption expenditures on new foreign
and domestic automobiles, and UNITS is the one-month percentage change in
new domestic and foreign unit passenger car sales. T-statistics are reported in
parentheses; the UNITS coefficients are significant at the 5 percent level of
significance.

FRBNY Quarterly Review/Winter 1985-86 43

boats. Sales of new cars make up only about half of retail
automobile sales. In addition, retail sales are not adjusted
for inflation when first reported.3 Therefore, any movements
in retail automobile sales due to inflation or sales of non­
automobile items will be neither foreshadowed by the unit
sales data nor reflected in consumer spending on autos.
3 See Joann Martens, "Do Unit Sales Predict Car Sales?” , Federal Reserve
Bank of New York, Unpublished Working Paper No. 8508 (November 1985),
for details on these measures.

In sum, this analysis finds that movements in retail auto
sales are not very tightly linked to changes in consumer
spending on automobiles. The weakness of the relationship
suggests that analysts should be cautious in deriving impli­
cations for real auto expenditures from real auto sales data.
In contrast, unit sales can be a valuable early indicator for
both the direction and the magnitude of changes in consum­
er expenditures on new cars and perhaps for the overall
tone of the economy.

Joann Martens

44 FRBNY Quarterly Review/Winter 1985-86



IN BRIEF—ECONOMIC CAPSULES

August-October 1985 Interim Report
(This report was released to the Congress
and to the press on December 4, 1985)

Treasury and Federal Reserve
Foreign Exchange Operations

After rising for a time in August and early September, dollar
exchange rates dropped sharply after an announcement on
September 22 by the Ministers of Finance and Central
Bank Governors of the five major industrial nations. The
monetary authorities agreed to pursue additional, specific
policies to sustain and accelerate more balanced expan­
sion with low inflation, and to cooperate more closely in fur­
thering an orderly appreciation of non-dollar currencies. For
the August-October period as a whole, the dollar extended
the decline that had begun in early 1985, against a back­
ground of spreading perceptions that U.S. economic growth
was slowing while activity abroad was picking up. By endOctober, the dollar had fallen nearly 11 percent in terms of
the Japanese yen compared with its end-July level, by
about 6 percent relative to Continental currencies, and by 2
percent against the pound sterling. On a trade-weighted av­
erage basis, the dollar closed about 5yz percent lower than
its end-July levels, and 22 percent below its highs of late
February 1985.
As the period opened, the dollar continued the irregular
decline that had occurred during the previous five months,
but the pace of decline was slowing. Economic statistics
A report by Sam Y. Cross, Executive Vice President in charge of the Foreign
Group at the Federal Reserve Bank of New York and Manager of Foreign
Operations for the System Open Market Account. Patricia H. Kuwayama was
primarily responsible for the drafting of this report, assisted by Elisabeth
Klebanoff.




were still suggesting that growth of U.S. production and em­
ployment remained sluggish during the summer months. But
market participants doubted that U.S. interest rates would
extend the decline that had begun earlier in the spring, since
they viewed the Federal Reserve as likely to be increasingly
cautious in the face of continued rapid monetary growth.
Starting in late August, the dollar actually began to rise as it
appeared that the outlook for U.S. economic growth might
be more favorable than earlier predicted. Better-thananticipated trade and employment data prompted market
participants to change their expectations for the U.S. econo­
my and for interest rates. Under these circumstances, com­
mercial customers as well as professionals acted to cover
short positions and reduce hedges against dollar assets es­
tablished when the dollar had fallen. Moreover, evidence of
a renewed flow of private foreign capital into the U.S. securi­
ties markets during September, after a temporary slacken­
ing in August, helped to dispel concern that the dollar’s de­
cline since the spring would cause a major shift of investor
preferences toward non-dollar currencies. The dollar
reached its highest levels of the three-month period under
review during the second week of September, as traders
anticipated that upcoming “ flash” GNP estimates would re­
veal strong growth in the third quarter.
By mid-September, however, market participants began
to question whether the expected pickup in economic activi­
ty would be strong enough to sustain dollar exchange rates

FRBNY Quarterly Review/Winter 1985-86 45

Table 1

Federal Reserve Reciprocal
Currency Arrangem ents
In millions of dollars

Institution

Amount of
facility
October 31,
1985

Austrian National Bank..............................................
National Bank of Belgium..........................................
Bank of Canada.........................................................
National Bank of Denmark........................................
Bank of England.........................................................
Bank of France...........................................................
German Federal Bank................................................
Bank of Italy..............................................................
Bank of Japan...........................................................
Bank of M exico.........................................................
Netherlands B ank.....................................................
Bank of Norway.........................................................
Bank of Sweden .......................................................
Swiss National Bank.................................................
Bank for International Settlements:
Swiss francs-dollars..............................................
Other authorized European
currency-dollars.................................................

250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
700
500
250
300
4,000

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

30,100

600
1,250

at the levels they had reached, which were 4 to 9 percent
higher than those of early August. As these questions led
some professionals to take profits, the dollar fell, dropping
further when the “ flash” GNP estimate turned put to be low­
er than most market forecasts.
The dollar’s fall then gained momentum after September
22, when the G-5 Finance Ministers and Central Bank
Governors made their announcement following a meeting in
New York. The statement drew attention to changes already
occurring in fundamental economic conditions around the
world; in particular the shift to more moderate growth in the
United States, stronger growth in other countries, and the
convergence of inflation rates at a lower level. Recognizing
that these changes had not yet been fully reflected in ex­
change rates, the officials affirmed the strong prospects for
progress in reducing international economic imbalances and
the intentions of the G-5 governments to implement policies
to sustain and accelerate these improvements. Each of the
countries issued a specific statement of policy intentions to
intensify individual and cooperative efforts to achieve sus­
tained noninflationary expansion.
The G-5 announcement had an immediate and strong ef­
fect on dollar exchange rates. In part, the exchange market
reaction reflected the fact that the announcement was un­
expected. More importantly, market participants noted that
the initiative had come from the United States and viewed it

46 FRBNY Quarterly Review/Winter 1985-86



as a change in the U.S. government’s previously perceived
attitude of accepting or even welcoming the strong dollar. In
addition, the agreement was interpreted as eliminating the
likelihood that the Federal Reserve would tighten reserve
conditions in response to rapid U.S. monetary growth.
In these circumstances, the dollar dropped sharply on the
day following the G-5 announcement even before any
official intervention occurred. With Tokyo closed for a
holiday, the first central bank operations were in Europe; the
dollar had already fallen against major foreign currencies by
the time the Bundesbank stepped in to sell dollars at the
afternoon fixing in Frankfurt for the first time in more than
six months. Later the same day, the U.S. authorities
conducted their first operation during the period under
review, selling dollars against Japanese yen and German
marks in a visible manner to resist a rise of the dollar from
the lower levels.
During the next few days, there was some skepticism in
the market that the lower dollar levels would be maintained,
and a number of commercial customers responded to the
apparently attractive rates by buying dollars. This phenome­
non was most dramatic in Tokyo where, when the market
opened on Tuesday, September 24, after a three-day week­
end, dollar demand from corporations and investors spurred
the largest turnover on record for spot dollar/yen trading.
The Bank of Japan responded with massive dollar sales.
Even though these sales were partly offset by sizable nor­
mal interest earnings, Japan’s published foreign exchange
reserves dropped by nearly $1 billion in the month of Sep­
tember. Following these and other operations in subsequent
days by the Japanese and other G-5 central banks, market
participants came to believe that the authorities were firmly
committed to the joint effort and upward pressures on the
dollar abated. The U.S. authorities sold a total of $199 mil­
lion against German marks and $262 million against the
Japanese yen during the last week of September and the
first week of October, operating repeatedly and visibly at
times when the dollar showed a tendency to rise from the
lower levels it had reached.
In the two weeks beginning October 7, the dollar came
under heavier upward pressure, reflecting strong commer­
cial and investor demand. While impressed with the central
bank intervention, market participants still anticipated addi­
tional economic policy initiatives. The demand for dollars
was spurred when the annual World Bank/IMF meetings in
Seoul, Korea, passed without any such announcements. In
addition, some statements, attributed to monetary officials
at the Seoul meetings, were viewed as expressing satisfac­
tion with the extent of the dollar’s decline and suggesting
that it would not fall much further. Also contributing to up­
ward pressure on the dollar were growing perceptions that
U.S. economic activity was picking up and that new esti­
mates of third quarter GNP growth would show a substantial
upward revision.

Table 2

Drawings and Repayments by the Argentine Central Bank under Special Swap Arrangements
w ith the U.S. Treasury
In millions of dollars; drawings (+ ) or repayments ( - )

Outstanding
September 30, 1984

U.S. drawings on
Treasury facilities for:
$500 million ....................................

$150 million ....................................

.......

1984-IV

1985-1

+ 500

-2 3 0
-2 7 0
*

1985-11

1985-111

Outstanding
October 31, 1985

*
*

+ 75
+ 68

-7 1 .4
-7 1 .4

Data are on a value-date basis.
* No facility.

The demand for dollars, especially against the German
mark, intensified around mid-October when commercial
participants who had held off meeting their dollar needs
after the G-5 announcement re-entered the market. But
the dollar’s rise was largely held in check by coordinated
intervention by the United States and other monetary au­
thorities. On October 16, as the dollar staged its strongest
rebound since the G-5 announcement, the Desk sold
$797 million against German marks and $67 million
against Japanese yen, and on the next day it sold addi­
tional amounts as the dollar eased back when the upward
revision of the U.S. GNP statistics failed to live up to ex­
pectations. During the second two weeks following the
September 22 communique, the United States sold a total
of $1,550.2 million against German marks and $617.6 mil­
lion against Japanese yen. These operations, some of
which were conducted in Far Eastern markets as well as
in New York, were closely coordinated with those of the
Bank of Japan and European G-5 central banks in their
own centers.
During the last two weeks of October, much of the upward
pressure on the dollar relative to the European currencies
abated in response both to the intervention operations and
to a fading of optimism about the U.S. economic outlook.
The upward pressure on the dollar vis-a-vis the Japanese
yen, however, was slower to subside—even though the gov­
ernment of Japan had announced on October 15 a program
to increase the rate of growth of domestic demand. Accord­
ingly, the Desk’s dollar sales in this two-week period, while
more modest in size, were concentrated in yen. In all during
these two weeks, the U.S. authorities sold $482.9 million
against Japanese yen and $87 million against the German
mark.
Late in October the Bank of Japan allowed Japanese




money market interest rates to drift higher. It was then that
the dollar began to decline particularly sharply against the
yen. Many market observers viewed the Japanese actions
on interest rates as possibly representing the first of a series
of steps to be taken by the G-5 countries to lower interest
differentials favorable to the dollar. Despite denials by U.S.,
German, and Japanese officials that any agreement existed
for such coordinated interest rate policy moves, the idea
persisted, and the dollar declined across the board to close
near its lowest levels of the three-month period under re­
view. It ended October some 13 percent below the level at
which it had traded in the week before the G-5 meeting in
terms of the Japanese yen, 10y2 percent down in terms of
the German mark, and 8 percent down vis-a-vis sterling. To­
tal intervention sales of dollars by the U.S. authorities, which
were split equally between the U.S. Treasury and the Feder­
al Reserve, came to $3,198.7 million during the three
months. After September 22, the central banks of France,
Germany, Japan, and the United Kingdom sold about $5
billion. The central banks of other G-10 countries sold more
than $2 billion.
In other operations, Argentina repaid its drawing on its
swap agreement with the United States Treasury estab­
lished on June 19, 1985. The drawing was repaid as sched­
uled in two installments of $71.4 million each on August 15
and September 30. The payments coincided with Argenti­
na’s drawings from the International Monetary Fund under
its new economic stabilization program. Also completed at
the same time were the repayments of $460 million out­
standing credits to Argentina from twelve foreign central
banks, representing their part of the cooperative bridging
facility established in June.
In the period August through October the Federal Re­
serve and the Exchange Stabilization Fund (ESF) realized

FRBNY Quarterly Review/Winter 1985-86 47

Table 3

Net P rofits ( + ) or Losses ( - ) on
United States Treasury and Federal Reserve
Current Foreign Exchange Operations
In millions of dollars

Period
August 1, 1985—
October 31, 1985 ....................
Valuation profits and
losses on outstanding
assets and liabilities
as of October 31, 1985 ...........

Federal
Reserve

United States Treasury
Exchange
Stabilization Fund

0-

-0-

-451.0

-202.7

-

Data are on a value-date basis.

48 FRBNY Quarterly Review/Winter 1985-86



no profits or losses from exchange transactions. As of Oc­
tober 31, cumulative bookkeeping or valuation losses on
outstanding foreign currency balances were $451 million for
the Federal Reserve and $203 million for the Treasury’s
ESF. These valuation losses represent the decrease in the
dollar value of outstanding currency assets valued at endof-period exchange rates, compared with the rates prevail­
ing at the time the foreign currencies were acquired.
The Federal Reserve and the ESF invest foreign currency
balances acquired in the market as a result of their foreign
operations in a variety of instruments that yield marketrelated rates of return and that have a high degree of quali­
ty and liquidity. Under the authority provided by the Mone­
tary Control Act of 1980, the Federal Reserve had invested
$1,796.6 million equivalent of its foreign currency holdings
in securities issued by foreign governments as of October
31. In addition, the Treasury held the equivalent of $2,672.1
million in such securities as of the end of October.

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