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uarterly Review
Winter 1991
1
Volume 15 No. 3-4
The Decline in U.S. Saving and Its Implications
for Economic Growth
20
Comparing the Cost of Capital in
the United States and Japan: A Survey
of Methods
33
Bank Cost of Capital and International
Competition
60
In Brief: Equity Carve-outs in Tokyo
65
Optimal Monetary Policy Design:
Rules versus Discretion Again
80
86
Treasury and Federal Reserve
Foreign Exchange Operations
November 1990-January 1991
August-October 1990
Table of Contents
1
The Decline in U.S. Saving and Its Implications for Economic Growth
Ethan S. Harris and Charles Steindel
The authors document the trends in U.S. saving during the 1980s, giving
particular attention to those measures of saving that gauge the growth of
productive assets. They go on to assess the effects of these developments
on capital formation and the nation’s long-term economic potential.
20
Comparing the Cost of Capital in the United States and Japan: A
Survey of Methods
James M. Poterba
Recent years have seen the emergence of a sizable literature comparing
the cost of capital in the United States and Japan. This review of the
literature highlights the methodological differences of previous investiga
tions and seeks to isolate common conclusions. Emphasis is given to
underlying economic and institutional factors that may contribute to cost of
capital disparities.
33
Bank Cost of Capital and International Competition
Steven A. Zimmer and Robert N. McCauley
The rising share of U.S. corporate loans booked by foreign-owned banks
and the withdrawal of U.S. banks from foreign lending raise concerns about
the competitiveness of U.S. banks. This article investigates how differen
tial capital costs may have placed U.S. banks at a disadvantage relative to
their foreign competitors. The authors compare the capital costs facing
commercial banks in the United States and five other industrial countries
and present explanations for the observed differences.
60
In Brief: Equity Carve-outs in Tokyo
Ted Fikre
The author examines the pricing of U.S. subsidiaries and U.S. joint
ventures “carved out” and taken public on the Tokyo stock market in recent
years. In comparing the price-earnings multiples obtained by the carveouts with the contemporaneous multiples of their parent companies, he
offers some perspective on the broader pricing discrepancy between the
Japanese and U.S. markets in the late 1980s.
FRBNY Quarterly Review/Winter 1991
i
Table of Contents
65
Optimal Monetary Policy Design: Rules versus Discretion Again
A. Steven Englander
Should monetary authorities rely primarily on rules or their own discretion
in conducting monetary policy? The debate has recently been revived by
researchers who claim that discretionary monetary policy tempts policy
makers to exploit a short-run trade-off between output and inflation and
thereby leads to higher inflation expectations. This article evaluates the
arguments advanced in support of these views and tests them against the
empirical evidence.
Treasury and Federal Reserve Foreign Exchange Operations
80
A report for the period November 1990-January 1991.
86
A report for the period August-October 1990.
93
List of Recent Research Papers
94
New Publications from the Federal Reserve Bank of New York
ii forFRBNY
Digitized
FRASERQuarterly Review/Winter 1991
The Decline in U.S. Saving and
Its Implications for Economic
Growth
by Ethan S. Harris and Charles Steindel
By conventional measures the U.S. saving rate declined
dramatically over the last ten years. Household saving
averaged just 3.8 percent of GNP in the 1980s, down
from a 5.0 percent average over the previous thirty
years. Corporate saving has also fallen, and the govern
ment has become an increasing net borrower. Overall,
the net national saving rate— domestic funds available
for new investment— dropped to just 3.0 percent in the
1980s, less than half of its historical average of 7.5
percent.
Despite these dismal statistics, some would argue
that the drop in saving rates is not a cause for concern.
No apparent disaster has attended the low saving rate;
instead, in the 1980s the United States enjoyed the
longest peacetime expansion of the postwar period.
Spurred by booming stock and real estate markets, the
value of wealth rose dramatically during the decade.
Broader measures of saving incorporating government
capital investment and consumer durables show much
more saving than conventional measures. Furthermore,
even if saving has fallen, in a market economy the rate
of saving is no more than an expression of people’s
“time preference”— if consumers have chosen to spend
more today and to leave less for tomorrow, why should
we question their choice?
This article examines the saving data and finds that
concerns about the low saving rate are indeed well
founded. The first half of the article documents the
trends in a variety of measures of saving. We find that
any measure of saving that focuses on the actual
acquisition of productive assets shows a clear decline
in the 1980s. Broader measures of saving do show
higher levels of saving but also show the same down
ward trend as the conventional measures. Although
capital gains from the stock market caused some
wealth-based measures of saving to surge in the 1980s,
empirical tests reveal that these measures do not cap
ture the growth of productive capacity: stock price
appreciation is a poor substitute for real asset
accumulation.
The second half of the article explores the conse
quences of the saving decline. Low saving has not
caused a sudden collapse in the economy, but it has
caused a steady erosion of the nation’s growth potential
and it has been accompanied by a sharp increase in net
indebtedness to foreigners. A simulation model of the
economy suggests that low saving relative to past
trends has already cost the economy about 15 percent
of its capital stock, lowering the nation’s potential out
put by 5 percent. This drag on growth comes at an
inopportune time. In the next several decades declining
growth in the working age population will increasingly
constrain economic growth. At the same time, rising
environmental costs, increasing payments to foreign
owners of U.S. assets, and a growing retirement popu
lation will make an increasing claim on output. Con
tinued low saving and investment reduces the nation’s
ability to respond to this squeeze on living standards.
On the international front, low saving has contributed
significantly to the worsening of the nation’s trade and
investment position. This development in turn has
fueled support for restrictions on international trade and
investment. It may also have reduced investor confi
dence and increased vulnerability to shocks from
abroad. The U.S. appetite for foreign capital is espe
cially troubling in light of the growing capital needs of
FRBNY Quarterly Review/Winter 1991
1
the emerging market-oriented economies of Eastern
Europe and the developing world.
It is not too late to undo the damage of the 1980s. As
our simulation model shows, a recovery in the net
saving rate to its pre-1980s level would gradually rebuild
the capital stock and would tend to reverse the deterio
ration in the external debt position. This saving recovery
could be accomplished by balancing the federal budget
and raising the private saving rate by about 2 percent
age points, or by pushing the government balance into
surplus and buying down some of the debt accumulated
in the 1980s. Deficit reduction efforts in the last several
years, including the recent budget accord, are important
steps in this direction, but further action would be
needed to complete the process. In the short run, a
higher saving rate would mean lower current spending;
within a decade, however, consumption would recover
to well above its current path. Under reasonable
assumptions about people’s time preference— how they
value consumption today relative to consumption tomor
row— the delayed gratification would be well worth it.
The 1980s decline in U.S. saving
Saving is one of the most important but most widely
misunderstood topics in economic analysis. Looking at
the subject broadly, we can identify three overlapping
concepts of saving. All are useful in certain contexts,
but they are not equally useful measures of the long-run
health of the economy. The three are 1) saving as the
increase in net worth, 2) saving as unspent income, and
3) saving as the supply of capital.
These would be equivalent if all unconsumed income
were used to purchase capital and if all assets
remained fixed in price. But because these conditions
are not satisfied in the real world, it is important to
distinguish carefully between the concepts.
(1) W = PA.
Taking first differences, we can derive an expression for
the change in wealth (suppressing subscripts on lagged
values of variables for the sake of simplicity):
(2) A W = PAA+AAP.
The first term of equation 2, PAA, is the product of asset
prices and real asset accumulation. It is conceptually
equal to the conventional definition of saving as
unspent income, as exemplified in the U.S. National
Income and Product Accounts (NIPA). The second term,
AAP, is the product of the stock of assets and the
change in asset prices, and represents that portion of
wealth accumulation due to revaluations, or capital
gains.
Wealth accumulation clearly bears some causal rela
tionship to the asset accumulation concept of saving.
Not only does asset accumulation increase wealth, but
growth in wealth may also affect decisions to acquire
new assets. If people feel more wealthy because of
capital gains on their assets, they may decide to spend
more and put a sid e less re so u rc es for a s s et
accumulation.
Neither wealth accumulation nor asset accumulation
necessarily measures the growth of productive capital.
The assets viewed as components of wealth by the
residents of a nation may include items that are not
necessarily part of the productive capital stock, such as
government debt.1 Suppose the asset list consists of
two items, productive capital, K, and other assets, O.
Further suppose that each asset has a price associated
with it, PK for productive capital and PQ for other assets.
We can then rewrite the basic expression defining
wealth as
(3) W = P kK + P o0.
The relation between the three concepts
The most comprehensive way to gauge saving is to
trace changes in wealth or net worth. Some commen
tators argue that the rapid increase in wealth in the
1980s reflected an equally rapid increase in the nation’s
productive potential. To demonstrate why the wealthbased measure of saving may be a deceptive indicator
of changes in productive power, we trace the relation
ship of changes in wealth to saving and to growth in
capacity. Wealth is affected not only by saving out of
current income— the outright purchase of assets— but
also by changes in the value of existing assets. Con
sider the basic definition of wealth, W, as the product of
a real stock of assets, A, and a price per unit of assets,
P. (Clearly, wealth is equal to assets less liabilities. For
simplicity, we are using only the word “assets.”)
FRBNY Quarterly Review/Winter 1991
Digitized2for FRASER
Taking first differences, we have
(4) A W = P kA K + P oA 0 + K A P k + 0A P o.
The first two terms of this expression, PkAK + PoA0,
sum to total asset accumulation (the conventional defi
nition of saving). Note, however, that assets may be
’Considerable controversy exists in the economic literature over the
issue of viewing government debt as part of aggregate wealth.
Although an individual’s holdings of government debt are clearly
part of his or her wealth, it has been argued that some individuals
in the population take account of the future taxes that will be levied
to redeem the debt and feel poorer as a result. See Robert Barro,
"Are Government Bonds Net Wealth?” Journal of Political Economy,
vol. 82 (November-December 1974), pp. 1095-1118. For a
nontechnical discussion of Barro’s work and the literature it
spawned, see “The Public Purse," Economist, November 24, 1990,
pp. 77-78.
accumulated in both “productive” and “nonproductive”
forms. The last two terms represent the capital gains on
both types of assets.
Neither increases in wealth nor asset accumulation is
a precise measure of productive investment. The growth
of the productive capital stock is equal to purchases of
new capital, P kAK, plus the portion of the capital gains
on existing capital that can be associated with
increased productivity. Thus, total wealth accumulation
overstates productive investment because it includes all
capital gains and purchases of unproductive assets.
Asset accumulation alone also includes purchases of
unproductive assets but fails to account for any
increased productivity of existing assets.
In the actual data, asset accumulation— the conven
tional definition of saving— and wealth accumulation are
fairly readily observed. The supply of productive capital,
a primary focus of this article, is more difficult to mea
sure. Any division of assets into productive and non
productive categories must be somewhat arbitrary.
Likewise, a further division of capital gains on produc
tive assets into those reflecting additions to productivity
and a residual category will also be arbitrary.
The next portion of the article examines the data. As
we shall see, untangling the various measurements of
saving reveals a consistent pattern: a downtrend in the
supply of capital and in the growth of productive
capacity.
Saving as unspent income
The NIPA compiles data on saving defined as unspent
income. Income that is not spent is necessarily used
to acquire assets or repay debts. Sectoral saving is
merely sectoral income less the sum of transfers to
other sectors and spending on currently consumed
goods and services. Table 1 documents movements in
saving, defined this way, over the last generation for the
total economy and for the household, corporate, and
government sectors. It breaks down the postwar period
into four phases: the high-growth 1950s (1953-61), the
boom years (1962-73), the productivity slowdown
(1974-79), and the most recent period (1980-89, further
divided into 1980-84 and 1985-89).
Household saving
Household or personal saving as a share of GNP is
shown in the first column in Table 1. Personal saving is
usually measured as a percentage of disposable per
sonal income— the commonly reported personal saving
rate— but to facilitate comparison with other measures,
it is here shown relative to G N P It is clear that personal
saving was unusually low in the expansion of the 1980s.
Personal saving is arbitrarily defined in the NIPA. For
example, increases in corporate profits add to personal
income and saving only if they are distributed as divi
dends. But if corporate stock values reflect increases in
undistributed profits, household shareholders benefit
from retained earnings. Another anomaly arises in the
area of employee benefit plans. Employer payments into
the reserve funds of private retirement and insurance
plans are counted in personal income and saving, while
similar payments by government employers are not
included. Given these anomalies in the construction of
personal saving, it makes sense to focus on broader
measures of saving.2
Corporate and private saving
Corporate saving consists of corporate profits after pay
ment of taxes and dividends. Column 2 of Table 1 shows
that corporate saving, like household saving, was
2Personal saving is still a useful in d ica to r for other purposes. While
the level of the personal saving rate at any one tim e may be a poor
clue to overall saving (or even to saving by and in behalf of
households), changes in the personal saving rate may give some
indication as to the underlying strength of consum er dem and. In
general, although spe cia l factors such as governm ent pay raises
can d isto rt m onthly or qu a rte rly data, d e clin es in the personal
saving rate are associated w ith strong growth in con sum er dem and,
while increases are associated with w eakness in consum er dem and.
Table 1
U.S. National Saving
(Percent of GNP)
1953-61
1962-73
1974-79
1980-89
1980-84
1985-89
FRBNY Q uarterly R eview/W inter 1991
3
unusually low in the expansion of the 1980s. In part, the
weakness in corporate saving reflects the increasing
share of corporate revenues going toward interest
expense. However, rising corporate interest payments
help increase household income and saving. Nonethe
less, the sum of household and corporate saving, net
private saving, has also been unusually low in recent
years (column 3).
ment contributions to employee benefit plans are not
viewed as compensation of government workers. Since
both distortions are offset in the household sector, a
less deceptive idea of trends in saving can be found by
looking at total national saving— the sum of government
and private saving (column 5). These figures confirm
that national saving has reached exceptionally low lev
els in recent years.
Government saving
By NIPA definition all government outlays are either
spent on currently produced goods and services or
transferred to other sectors, so government saving is
simply tax receipts less spending— that is, the govern
ment surplus. As column 4 shows, the consolidated
government budget position (federal plus state and
local) went from approximate balance or small deficit for
the bulk of the postwar period into deep deficit in the
early 1980s. Somewhat surprisingly, the late 1980s saw
no improvement in government saving: partial success
in curbing the federal deficit was offset by a deteriora
tion in the state and local surplus.3
Like the definitions of corporate and household sav
ing, the definition of government saving is arbitrary. The
U.S. NIPA differs from the national income accounts of
some other countries in treating capital spending by the
government as a current outlay rather than saving.
However, including government capital spending in sav
ing and investment will not change the downtrend: gov
ernment spending on nonmilitary structures fell to 13A
percent of GNP in the 1980s from about 21/3 percent in
the 1970s.
The NIPA data on government saving contains other
distortions. Like corporate saving, government saving
has been held down by increased interest payments to
households. In addition, as mentioned above, govern
Saving as the increase in wealth
The Federal Reserve Board compiles detailed sectoral
data on wealth accumulation and holdings that can be
used to calculate both parts of equation 2— the asset
accumulation, or saving, portion and the revaluation
portion. However, a number of adjustments are neces
sary to make these “Flow of Funds” data useful for our
purposes.
A preliminary issue is the relationship of these data
to the NIPA. Information on sectoral asset accumulation
in the Flow of Funds differs from its NIPA counterpart
for definitional reasons (some saving flows are allocated
to different sectors in the two systems), although in
principle national saving is defined identically.4 There
are also statistical differences between the systems.
Table 2 uses Flow of Funds data to calculate saving
flows as defined in the NIPA. This procedure sup
presses the definitional differences between sectoral
saving in the two systems and makes it possible to
identify the pure statistical differences. A comparison of
Tables 1 and 2 shows that the decline in household and
private saving in the 1980s is less pronounced in the
Flow of Funds data than in the NIPA. With the govern
ment sector included, however, the national saving
3The annual data from 1986 to 1989 do show some reductions in the
overall governm ent deficit.
4The Flow of Funds counts purchases of consum er du ra b le goods in
asset accum ulation and saving. We do not follow this procedure
and have removed consum er durables from the data on household
asset accum ulation and wealth. The Flow of Funds treatm ent of
consum er du rable s does not add to the statistica l discre p a n cie s
between the Flow of Funds and the NIPA be cause the Flow of
Funds uses the NIPA data on d u rable goods spending.
Table 2
U.S. National Saving as Measured with Flow of Funds Data
(Percent of GNP)
4
(1)
(2)
(3)
(4)
Household
Saving
Corporate
Saving
Private
Saving
Government
Saving
1953-61
1962-73
1974-79
1980-89
5.6
5.6
5.6
4.7
1.9
2.2
2.7
1.5
7.5
7.8
8.3
6.1
-.9
-.5
-1 .5
-2 .9
6.7
7.3
1980-84
1985-89
5.5
3.9
1.6
1.4
7.0
5.2
-2 .9
-2 .9
4.1
2.3
FRBNY Q uarterly R eview/W inter 1991
(5)
Net
National
Saving
6.8
3.2
decline from the mid-1970s to the late 1980s is com
parable in the two systems (although the Flow of Funds
shows a decline of about 1 percentage point less if the
comparison is made from the 1960s).
We will use the Flow of Funds sectoral asset accumu
lation data without any definitional or statistical adjust
ments.5 We will, however, make some adjustments in
the Flow of Funds wealth data to derive a comprehen
sive national wealth accumulation series. Some of
these adjustments are conceptually simple and easy to
make; others, however, are more complicated. We pre
sent alternative ways of handling the more difficult
adjustments.
First, the data are adjusted for biases caused by
inflation. In an inflationary period, the nominal value of
wealth must grow at least at the rate of inflation to
maintain its purchasing power. Accordingly, for all our
measures of wealth accumulation we will deduct an
estimate of the inflationary component to get a more
relevant measure of wealth accumulation trends.6
Second, the data are carefully consolidated to avoid
double counting. There is no ideal way to measure
aggregate wealth accumulation, because one sector
may own a claim to the wealth accumulated by another
sector. (Household ownership of corporate stock is the
most obvious example.) The most natural way to con
solidate the nation’s balance sheet is to assume that
household wealth accumulation accurately represents
economy-wide wealth accumulation, since households
are the ultimate beneficiaries of the income generated
5Except for our removal of consum er durables from Flow of Funds
asset accum ulation and household wealth. See footnote 4.
6The inflation measure used in the calcula tions was the increase in
the im plicit price deflator for personal consum ption expenditures
S im ilar calcula tions were done in Carol Corrado and Charles
Steindel, "P erspectives on Personal S aving,” Federal Reserve
B ulletin, vol. 66 (A ugust 1980), pp. 613-26.
Table 3
Household Wealth Accumulation in Excess of
General Price Inflation
(Percent of GNP)
( 1)
(2 )
Total
Excluding
Government
Debt
(3)
Total, with
Corporate Equity
Valued on Net
Worth Basis
1953-61
1962-73
1974-79
1980-89
13.2
7.9
8.6
8.4
12.9
8.0
8.3
6.9
8.9
9.6
15.8
4.6
1980-84
1985-89
5.2
11.6
4.2
9.7
3.7
5.5
by productive assets. For example, corporate accumu
lation of productive assets should at least indirectly
increase the wealth of household shareowners.
To analyze the role of saving in economic growth, the
data should ideally be adjusted so that only assets
adding to the economy’s productive potential are
included in wealth. For example, household wealth
includes holdings of government debt. If this govern
ment debt is used to finance capital assets (such as
roads and bridges), then it should be included in economy-wide wealth, but if it is used to finance current
spending (such as government salaries), then it does
not add to economy-wide wealth. In practice, changes
in government debt, even at the state and local level, do
not appear closely related to changes in government
capital and therefore may be better left out of our wealth
calculations.
Another problem that may require adjustment of the
data is the inclusion of corporate stock at market value
in the standard household wealth measure. In the short
run, increases in plant and equipment owned by corpo
rations may not be reflected in stock market values.
There may also be swings in stock market values that
do not reflect changes in the productive potential of
firms. In particular, changes in tax laws and shifts in
investor sentiment can have as strong an impact on
stock prices as changes in true productive capacity.
To eliminate some of these distortions, Table 3 pre
sents a number of alternative measures of aggregate
wealth accumulation. All these measures net out the
increase in wealth necessary to maintain its purchasing
power. Column 1 shows the inflation-corrected increase
in the Flow of Funds measure of household wealth
(excluding holdings of consumer durable goods). This
measure includes corporate equity holdings in the form
of both direct h o u se h o ld o w n e rsh ip and indirect own
ership through mutual funds and fiduciaries. Column 2
removes the acquisition of government debt, federal as
well as state and local. Column 3 replaces the inflationcorrected increase in the market value of corporate
equity holdings with the increase in corporate net worth,
a measure which will more closely reflect corporate
accumulation of productive capital. (The corporate net
worth series values physical assets at their reproduc
tion cost, so it is affected by changes in asset prices in
relation to the general price level as well as by actual
investment.)
Column 1 shows a marked resurgence in the conven
tional measure of wealth accumulation in recent years.
In fact, wealth accumulation in the second half of the
1980s was stronger than in any period since the 1950s.
Column 2 shows that removing private sector accumula
tion of government debt makes a modest difference to
this result, but the resurgence in the late 1980s is still
FRBNY Q uarterly R eview/W inter 1991
5
evident. Changing the treatment of corporate wealth
accumulation, however, makes a crucial difference. Col
umn 3 shows that when corporate net worth is used in
place of stock market values, the 1980s as a whole
emerges as a period of pronounced weakness in wealth
accumulation, especially in comparison with the
strength of the 1970s.7
The distinction between columns 1 and 3 comes
essentially from radically different estimates of capital
gains. Table 4 shows capital gains (in excess of general
price inflation) on the market value of corporate equity
and on corporate net worth. In the second half of the
1980s, capital gains on corporate equity averaged
about 7 percent of G N P— compared with capital losses
of about 2 percent of GNP in the late 1970s. Capital
gains on corporate net worth were essentially zero in
the 1980s, after amounting to about 21/2 percent of GNP
in the late 1970s. The capital gains and losses on
corporate equity feed into the wealth accumulation
series shown in column 1 of Table 3, while those on
corporate net worth feed into the series shown in col
umn 3. The sharp divergence in the movement of the
two capital gains series in the 1970s and 1980s lies
behind the divergent movement of the two wealth
accumulation series.
Saving as the su pp ly of ca pita l
The decline in national saving in the 1980s did not
necessarily result in a one-for-one drop in productive
investment. First, the official data may misclassify some
categories of spending. On the one hand, although both
consumer durables and government capital expendi
tures are classified as current spending, they may be
more akin to investment. On the other hand, some
7ln d e e d , if g o v e rn m e n t d e b t a c c u m u la tio n is rem oved fro m the
c o lu m n 3 d a ta , th e 1 980s lo o k even m ore a n e m ic , w ith a d e c a d e a v e ra g e ra tio o f w e a lth a c c u m u la tio n to G N P of a b o u t 3 p e rc e n t.
components of investment may add less to productive
capacity than others. Plant and equipment investment
in some ways is very different from inventory and resi
dential investment. Second, foreigners are responsible
for a portion of capital formation in the United States. If
foreign capital inflows exceed outflows, then national
investment will exceed national saving. Third, as noted
earlier, increases in the value of existing assets may
implicitly add to the supply of capital if these revalua
tions reflect increases in their productive potential.
The contribution of foreign saving
Net national saving is one possible measure of the
supply of capital. This aggregate represents the
resources Americans make potentially available for
funding productive capital formation. However, capital
formation in the United States need not be financed just
from domestic sources. The first column of Table 5
repeats the data on trends in national saving shown in
Table 1. The second column adds net foreign invest
ment in the United States (excluding foreign purchases
of government debt) to net saving. We see that despite
the surge in foreign investment in the 1980s this mea
sure of the supply of capital has fallen well below its
pace in earlier decades.
The large net capital inflows of the 1980s were the
financing counterpart of the U.S. current account deficit.
In principle, current account deficits could stem from
high levels of domestic investment that draw in foreign
funds. In practice, however, the current account deficits
of the 1980s mainly reflected high U.S. consumption.
Thus, the foreign inflow simply offset part of the weak
ness in U.S. saving rather than contributing to a high
investment rate. Furthermore, in any circumstances,
foreign investment inflows are not perfect substitutes for
domestic saving. A foreign-owned factory might employ
just as many workers and produce as many goods as an
American-owned plant. However, the profits from the
factory’s operations will be earned by the foreign own-
Table 4
Household Capital Gains in Excess of
General Price Inflation
Table 5
Net Capital Supplies from Saving
(Percent of GNP)
(Percent of GNP)
Corporate
E quityt
Corporate
Net Worth
1953-61
1962-73
1974-79
1980-89
7.2
0.5
- 2.1
4.8
1.0
0.0
2.6
- 0 .4
1980-84
1985-89
24
7.2
- 0 .7
- 0.2
fln c lu d in g gains on holdings of insurance companies and
pension funds.
6
FRBNY Q uarterly R eview/W inter 1991
( 1)
From
National
Saving
(2 )
From National
and Foreign
Saving
1953-61
1962-73
1974-79
1980-89
6.9
7.9
6.8
3.0
6.4
7.1
6.0
4.0
1980-84
1985-89
3.8
2.2
3.9
4.1
ers, not by Americans. Thus, foreign investments will
not produce as much income for Americans— or U.S.
GNP— as otherwise equal American investments.8
It follows that neither of the two aggregate measures
in Table 5 precisely captures the saving available to
generate GNP growth.9 The column 1 measure (net
national saving) does not include foreign productive
investment in the United States and so understates the
accumulation of productive capital. The column 2 mea
sure overstates the accumulation of capital: all else
equal, capital owned by foreigners will generate less
GNP than capital owned by Americans. Nonetheless,
the decline in both measures in the 1980s suggests
strongly that the supply of capital to the United States
out of U.S. and foreign saving has fallen.
Redefining productive investment
On the expenditure side of the NIPA, national saving
equals the sum of net foreign investment, residential
and inventory investment, and nonresidential fixed
investment. Clearly, not all of these investment catego
ries contribute equally to the growth of productive
capacity— only the last is conventionally viewed unam
biguously as capital accumulation. For example, it is
plausible to argue that residential investment does not
add to the productive capacity of the United States in
the same way that other categories do.10 Although this
view may represent only a value judgment— homes
surely do add to economic well-being— many important
issues, such as the future external position of the
United States, would hinge more directly on the growth
of resources in the business sector of the economy than
on the growth of the housing stock.
An opposite problem arises with government invest
ment and spending on consumer durables. Government
spending on infrastructure clearly adds to the produc
tive capacity of the U.S. economy, but it is not counted
as saving in the NIPA (although in the household wealth
8These issues are discussed more fully in M.A. Akhtar, "Adjustment
of U.S. External Balances,” in Federal Reserve Bank of New York,
74th Annual Report, 1988.
9Another issue is the treatment of depreciation. All saving measures
used in this paper are net of depreciation. Net saving is available
for use in increasing the net capital stock. If productive capital is
defined in terms of the gross capital stock, then analysis might
better focus on gross saving trends (gross saving is net saving plus
depreciation). No definitive case can be made for the superiority of
the net capital stock to the gross stock as a measure of productive
U.S. capital. See A. Steven Englander and Charles Steindel,
“Evaluating Recent Trends in Capital Formation,” Federal Reserve
Bank of New York Quarterly Review, vol. 14, no. 3 (Autumn 1989),
pp. 7-19. However, the trends in gross saving are similar to those in
net saving.
10Of course, on an ex ante basis the saving flows invested in
residences could have been invested in other forms of capital.
data, infrastructure spending financed through debt
sales to the private sector would be indirectly counted).
The national income accounts in most other countries
address this problem by distinguishing between govern
ment consumption and investment. Consumer durable
spending, like housing, creates a stream of future ser
vices to consumers, yet it is counted as consumption
rather than investment. The failure to include these
investment-like expenditures could distort the saving
picture.
Although it is reasonable in principle to include
infrastructure spending in the supply of capital, in prac
tice actually counting such spending is difficult. Not only
is it difficult to classify government capital outlays as
productive or nonproductive, but it is also difficult to
calculate service lives and depreciation schedules for
such unique assets. (What is the true service life of an
airport?) Consumer durables pose similar problems.
Nevertheless, including these categories in saving does
not change the overall picture. While it is true that
government investment and consumer durable expendi
tures are fairly sizable, they also show the same down
ward trend as private saving in the 1980s, especially
outside the military. The decline in government spend
ing on structures was noted earlier; consumer durable
spending fell from over 12 percent of GNP in the middle
1970s to less than 9 percent in the 1980s.11
Are capital gains a form of saving?
A more critical issue in analyzing the connection
between saving trends and capital formation concerns
the treatment of capital gains. From an individual per
spective, capital gains can properly be included in sav
ing: the fun d am en tal purpose of saving is the
accumulation of wealth so that consumption may be
higher in the future, either for an individual or for his or
her heirs. Anything that adds to wealth can, from an
individual’s viewpoint, be considered saving. From a
policy viewpoint, the aggregate wealth accumulation
data shown in column 1 of Table 3 are important
because they give a sense of how rapidly or slowly U.S.
consumers are reaching targeted levels of wealth. The
acceleration of capital gains in the 1980s probably
played an important role in the strong growth of con
sumer spending in the period and the weakness in
"For a discussion of the importance of infrastructure spending, see
Michael J. Boskin, Marc S. Robinson, and Alan M. Huber,
"Government Saving, Capital Formation and Wealth in the United
States, 1947-85,” in Robert E. Lipsey and Helen Stone Tice, eds.,
Measurement of Saving, Investment, and Wealth, pp. 287-356
(Chicago: University of Chicago Press, 1988). It has been argued
that the decline in infrastructure growth has played a critical role in
the weakness of U.S. productivity growth since 1973. See David A.
Aschauer, “Is Public Investment Productive?” Journal of Monetary
Economics, vol. 23 (March 1989), pp. 177-200.
FRBNY Quarterly Review/Winter 1991
7
national saving. However, if rapid growth in household
wealth is due mainly to revaluations of existing assets,
or to government debt issuance, the increased wealth
may not represent increased productive capacity.
Hence, the supply of saving available for capital forma
tion may be inadequate, and increases in consumption
stemming from capital gains may not be sustainable.
Table 1 reflected this traditional view by omitting cap
ital gains and losses. However, some portion of aggre
gate capital gains will reflect increases in the true pro
ductive power of assets, and we may legitimately
include these gains when we compute saving as the
supply of capital available for increases in productive
capacity.
Table 6 attempts to construct comprehensive mea
sures of the supply of capital. In Table 6 a portion of
aggregate capital gains (as always in this article, over
and above overall price inflation) is added to the Table 5
saving flows.12 Gains and losses on residential real
estate are excluded because realistically they are not
part of and cannot be made available for productive
investment,13 but gains and losses on other assets are
included. Essentially, columns 1 and 2 of Table 6 corre
spond to columns 1 and 3 of Table 3 but exclude
changes in the value of government debt and capital
gains on residential real estate. Columns 3 and 4 of
Table 6 add to columns 1 and 2 changes in the value of
foreign asset holdings. Columns 1 and 3 use stockmarket-based valuation of corporations; columns 2 and
4 value corporations on a reproduction cost basis.
The key point in Table 6, as in Table 3, is that it
makes a crucial difference whether corporate wealth is
valued by the stock market or by reproduction cost. If
12The actual asset accum ulation flows used in Table 6 were taken
from the Flow of Funds. They differ from the NIPA saving series for
reasons d iscusse d earlier.
13A ctual purchases of residential real estate are includ ed in the
aggreg ate sup ply of cap ital calcula tions because ex ante they were
available to be invested in other forms.
we value corporations by the stock market, the increase
in productive wealth as a share of GNP in the 1980s was
sharply higher than in the 1970s and even somewhat higher
than in the 1960s. If we value corporate assets at repro
duction cost, the accumulation of wealth was quite low.
It seems natural to disregard the stock-market-based
data since, by construction, the reproduction cost
measures are more closely related to the increase in the
officially measured stock of physical capital. Neverthe
less, the stock market measures should be influenced
by expected future streams of earnings, and increases
in these measures may pick up expected future
increases in the productivity of the existing capital stock
(say from future improvements in technology). In this
sense, at least some share of capital gains in the stock
market may represent a form of “investment” and
“saving.”
A simple way to test whether all stock market capital
gains actually reflect future increases in productive
capacity and output is to use lagged changes in a
capital input measure derived from stock market data in
an aggregate production function. Details of this exer
cise can be found in the Box. In general, the results
indicate that stock-market-based series have had little
ability to predict future output. This finding means that
we can reject the hypothesis that all past stock market
capital gains and losses reflected changes in the future
productive power of capital. Thus, in the past, not all
changes in stock market wealth were a form of “invest
ment." Our finding further suggests that a measure of
the amount of saving actually available for capital for
m ation m ight well e xclude s to c k -m a rk e t-b a s e d c a p ita l
gains and losses, although it is certainly true that stock
market fluctuations will in part reflect changes in the
long-run potential of the economy. The problem is that
we can neither readily differentiate this source of mar
ket fluctuations from others, nor assume that all market
changes reflect changes in long-run potential.
Once we have recognized the limitations of the stock-
Table 6
Estimates of the Supply of Capital
(Percent of GNP)
Domestic
Sources Only
8
Domestic and
Foreign Sources
(1)
Equity Market
Valuation
(2 )
Reproduction
Cost Valuation
(3)
Equity Market
Valuation
(4)
Reproduction
Cost Valuation
1953-61
1962-73
1974-79
1980-89
13.0
7.0
5.7
7.8
8.7
8.7
12.9
4.0
12.6
6.8
5.2
8.9
8.2
8.6
12.8
5.0
1980-84
1985-89
6.1
9.5
4.7
3.4
6.5
11.3
5.0
4.9
FRBNY Q uarterly R eview/W inter 1991
Box: The Stock Market as a Measure of Saving
Measures of wealth based on the stock market rose more
rapidly in the 1980s than those based on the reproduc
tion cost of capital. If the increase in the stock market
represents a form of productive saving for the future,
then past experience should show that a measure of the
capital stock based on the stock market is a good indica
tor of future output growth.
We assume that output can be explained by a CobbDouglas production function, which in logarithmic terms
can be written as
ln Y = a + a l n L + (1-a) In K + Xt,
where Y equals output; L, labor input; K, capital input;
X, the rate of total factor productivity growth; and t, time.*
The expression can be restated as
Aln(Y/L) - (1-a)Aln(K/L) + X.
We estimated this equation for the nonfinancial corpo
rate sector, comparing a number of measures of the
capital input. One measure is the standard net nonresidential capital stock; the others are derived from stock
market pricing of the capital stock. We assumed that all
the difference between nonfinancial corporate net worth
and the market value of nonfinancial corporate equity
can be assigned to different valuations of the capital
tFor further details, see E nglander and Steindel, "E valuating
Recent Trends.”
stock. A constant-dollar valuation of the capital stock
based on the stock market was derived by dividing this
nominal value by the implicit capital stock deflator. If
changes in the stock market are truly indicative of future
increases in productivity and output (thus making these
changes a form of saving), a lag on this measure should
help explain output. Accordingly, simple three-year and
five-year moving averages of the real stock market cap
ital variable were used as proxies for K.
The estimated equations included a number of stand
ard corrections for cyclical productivity changes and
shifts in trend productivity growth. The table reports the
coefficients of the capital input variables and the equa
tions' residual standard errors. We see that the threeyear and five-year stock market variables show little sign
of being adequate proxies for the capital input. The
estimated coefficients on these variables, which ideally
should equal capital’s share of income (about one-third),
are barely positive. The coefficient on the net capital
stock, though considerably higher than anticipated, is
more plausible (it is possible that this term picks up the
effect of omitted variables such as inventories and natu
ral resources). Finally, the standard errors of the regres
sions with the stock market variables are quite high
relative to the standard errors in the regression using the
conventional capital stock variable.
Performance of Capital Input Measures in Production Relationships
Capital Input
Measure
Coefficient
Equation Residual
Standard Error
Net capital stock
.770
.01
Stock-m arket-based
measure (three-year average)
.005
.07
Stock-m arket-based
measure (five-year average)
.043
.07
Note: The estimated equations are of the form:
7
In(lprod) = ao + a,ln(caphrs) + a2 cycl + 2 a/T,,
where
Iprod
caphrs
cycl
T,
1-3
=
=
=
=
nonfarm business sector labor productivity
the ratio of capital to hours worked
a measure of capacity utilization (the ratio of actual to potential real GNP, as calculated by the Federal Reserve Board staff)
a set of time trends (allowing for breaks in 1952-61, 1962-68, 1969-73, 1974-79, and 1980-88).
FRBNY Q uarterly R eview/W inter 1991
market-based data, the evidence on U.S. saving trends
becomes clearer: saving, in the sense of supplying
capital for the expansion of the U.S. economy, has
reached extremely low levels. This conclusion is true for
all three concepts of saving; it is true whether we
include or exclude foreign capital; and it is true
regardless of how broadly we define investment.14
The case for higher U.S. saving
Clearly U.S. saving in the 1980s was low by just about
any measure, but should this be a cause for concern?
On the surface, the economy performed reasonably well
despite the low saving rate. Indeed, the declining sav
ing rate spurred consumption, contributing to the
cyclical recovery following the 1982 recession. For the
decade as a whole, annual growth in GNP per capita
averaged only about 0.5 percentage point below the
postwar average.15 U.S. external debt grew, but the
foreign investors brought in new capital, and net indebt
edness to foreigners remained small as a share of GNP.
If low saving has hurt the U.S. economy, the effects are
well disguised.
The remainder of this article uses a simulation model
of the U.S. economy to uncover, and quantify, the subtle
costs of low saving. The model links the three basic
components of growth— saving and investment, labor
force growth, and technological advance— to economic
growth and the U.S. external debt position. Three varia
tions of the model are employed to accommodate the
diverse views held by growth experts about the interac
tion between investment and technological change: the
traditional model that considers technology to be inde
pendent of investment and two alternative forms of the
model that regard new capital investment as a spur to
technological change. Details of the model are pre
sented in the Appendix.
With this model we ask: What has been the cost of
low saving in terms of economic output, living stan
dards, and external indebtedness? What would be
required to rectify the situation? Would the sacrifice of
current consumption be worth it? And finally, what are
the limits of what higher saving rates can accomplish?
relatively low capital stock, low output, and a large
foreign debt. A simple way to quantify the damage is to
compare two saving scenarios (using the NIPA saving
data). The first, a “status quo” scenario, assumes that
the net saving rate followed its actual path in the 1980s,
falling to about 2.0 percent in 1990, and will remain at
that level into the future. The second, the “1950-79
trend” scenario, assumes that the net saving rate never
fell from its 1950-79 average of about 71/2 percent.
Chart 1, using traditional model estimates, shows that
low saving made possible a surge in consumption in the
1980s but at considerable long-run cost. By 1989 low
saving had cost the U.S. economy about 15 percent of
its capital stock and about 5 percent of its potential
GNP. Furthermore, by the end of the century, the accu
mulated loss could grow to 28 and 10 percent, respec
tively. In fact, even the gain to consumption should be
short-lived: by the early 1990s weak economic growth
should push consumption below the 1950-79 trend
scenario.
The U.S. net external debt position suffered as well.
In the 1970s, with U.S. saving and investment roughly in
balance, the United States was a modest net capital
exporter. As the saving rate declined in the 1980s,
however, an increasing portion of investment was
financed by net foreign capital inflows. Of course, the
Chart 1
Impact of Low Saving
Ratio
r \
» \
tJ
v
,A,
\
V
YN
\
X
1
15Real GNP growth averaged 2.6 pe rcent from 1980 to 1989, down
from 3.6 pe rcent over the previous th irty years. In per c a p ita terms,
the de clin e was more m odest, reaching 1.6 percent in the 1980s
from 2.2 pe rcent in the previous period.
10
FRBNY Q uarterly R eview/W inter 1991
Consumption
GNP
The leg acy of the 1980s
Low saving in the 1980s left the U.S. economy with a
14The U nited States was not the only nation to see a de clin e in
saving in the 1980s. See Andrew Dean, Martine Durand, John
Fallon, and Peter Hoeller, "S aving Trends and Behavior in OECD
C oun tries,” OECD E conom ic Studies, no. 14 (Spring 1990),
pp. 7-58.
.
'
~
'-------
— -------------------
Capital stock
1111 111 11 111 i i i
1979
1985
1990
1 1 1m 1 1 i i i 1 1111
1995
2000
2005
i l u iiiiT fT I
2010
2015 2020
Note: The chart shows the status quo scenario relative to the
1950-79 trend scenario.
Table 7
U.S. External Position in Book and Market Value
(Percent of GNP)
Book Value
Assets
1979
1989
1999f
2009f
20.4
27.0
36.3
46.1
Market Value
Liabilities
Net Assets
Assets
Liabilities
Net Assets
16.6
39.7
55.6
68.9
3.8
-1 2 .7
-1 9 .3
- 22.8
26.0
42.2
48.5
58.3
17.9
44.7
63.5
81.2
8.1
-2 .5
- 1 5 .0
- 2 2 .9
fP rojecfions assume a status quo scenario with net capital inflows of 1.6 percent of GNP per year, GNP growth of 6.3 percent per year, and
growth in total capital flows of 8 percent per year.
causes of the surge in external debt are complex, but it
is reasonable to argue that low saving played a key
role.16 Foreign investments in the United States grew
fivefold in the 1980s, while U.S. investments abroad
grew less than threefold. As a result, the United States
went from a net creditor position of 4 percent of GNP in
1979 to a net debtor position of 13 percent a decade
later (Table 7). If net capital inflows continue at the
current pace of 11/2 percent of GNP, U.S. net indebted
ness will reach 19 percent of GNP by the turn of the
century and eventually grow to a peak of over 25
percent.17
The cost of low saving may be even greater than the
traditional model suggests. Many recent studies of eco
nomic growth have emphasized the link between capital
formation and technological change. If capital “embod
ies” new technology, a decline in saving may be a
double blow to the economy: not only is there less
capital, but existing capital also becomes increasingly
outdated. Chart 2 shows the GNP path under three
assumptions about technological change: the traditional
model, in which technology is independent of invest
ment; the “vintage” model, which assumes higher
investment lowers the average age and adds to the
productivity of capital; and the “learning-by-doing”
16The eco nom ic m echanism was as follows: low private saving and
high governm ent borrow ing put upward pressure on U.S. interest
rates; this m ade U.S. investm ents relatively more attractive,
encoura ging net c ap ital inflows; these inflows in turn took some of
the pressure off of interest rates. The overall result was that U.S. net
investm ent fell about one-third less than net saving during the
1980s, with the difference accounted for by increased capital inflows.
17A num ber of m easurem ent problem s plague the official data.
A djusting the data, however, does not alter the general picture of a
de teriorating trend. For exam ple, in the official data, direct
investm ent is measured at book values, a procedure w hich
understates the value of the generally older U.S. investm ents
abroad. When the data are adjusted to m arket values (as shown in
Table 7), the level of net de bt is much lower but the trend is nearly
as bleak: from 8 pe rcent in the black in 1979 to 3 percent in the
red in 1989, and 15 pe rce n t in the red by the turn of the century.
For de tails behind these calcula tions, see A ppendix.
Chart 2
Impact of Low Saving on Real GNP under
Alternative Models
Ratio
Traditional
\
Vintage
Learning-by-doing
^
^
II I I I I I I I I I I I I I I I II I l I I I I I I I l I I I I I I I I I II I I I
1979
1985
1990 1995
2000 2005 2010 2015
2020
Note: The chart shows the status quo scenario relative to the
1950-79 trend scenario.
model, which assumes that new investment not only
adopts the latest technology, but actually encourages
further innovations.
The alternative models suggest much stronger
impacts on GNP from lower saving than does the tradi
tional model. In both alternative models the level of
GNP is an additional 1 to 2 percentage points lower by
1989. In the vintage model these technology effects
eventually peter out.18 In the learning-by-doing model,
18As the econom y ap proaches its long-run growth path, growth in the
capital stock slows so that new cap ital is no long er a dispropor-
FRBNY Q uarterly R eview/W inter 1991
11
however, lower investment means a slower pace of
“learning” and technological innovation, permanently
reducing annual GNP growth by 0.3 percent.
The benefits of a saving recovery
It is not too late to undo the damage of the 1980s.
Charts 3 and 4 present traditional model estimates of
the impact of a saving recovery. Chart 3 shows the
impact on economic growth of a “recovery” scenario, in
which the net saving rate rebounds to its historical
average of about 71/2 percent over the next five years.
Chart 4 puts this recovery in perspective, comparing it
with the 1950-79 trend scenario (in which the saving
rate never declines) and with the status quo scenario
(in which the saving rate remains at its 1990 level of
about 2 percent). All three scenarios assume that the
labor force grows in line with the official projections of
the Social Security Administration. The simulations also
assume a 1 percent contribution to growth from techno
logical advance.
In the status quo case the economy continues along
its current low growth path until about 2010 (Chart 3).
Saving is just sufficient to replace worn out capital and
provide for net capital growth of about 2 percent. Real
output, consumption, and investment also settle into an
equilibrium growth path of 2 percent. Early in the next
century, as the “baby boom” generation begins to retire,
Footnote 18 con tinued
tion ate pa rt of the total. At this point the average age of the capital
stock stops d e c lin in g and tech n o lo g ica l advance returns to its longrun trend. See A p p e n d ix for details.
Chart 3
Impact of a Saving Recovery on Real Growth
Percent
5---------------------------------------
pi
I I I I I 1 I I I I 1 I I I I 1 I I I I 1 I II I 1 I 1 I 1 1
1990
1995
2000
2005
2010
2015
Note: Chart shows growth in net capital stock, GNP, and
consumption for the saving recovery scenario.
12
FRBNY Q uarterly Review/W inter 1991
2020
the labor force stops growing, pulling down GNP growth
to about V/2 percent. With the saving rate unchanged,
the United States continues to rely on foreign capital
inflows equivalent to V/2 percent of GNP.
An increase in the saving rate upsets this equilibrium.
Higher saving flows into investment, and net capital
stock growth surges, pulling up GNP growth as well.
The GNP growth acceleration is relatively modest but
can extend over a long period of time. In the first five
years of the saving recovery, GNP growth averages 0.5
percentage point higher than in the status quo; the
differential then notches up to 0.8 percent in the second
five years and declines thereafter. The growth expan
sion is self-limiting, however. In the years following the
saving rebound, the capital stock rises relative to GNP
but saving remains fixed as a share of GNP, so growth
in the capital stock tends to slow over time. As a result,
consumption, investment, and GNP all gradually settle
into a new path at higher levels, but with the growth rate
back at its original pace of about 2 percent (Chart 4).19
Eventually the temporary fall in saving is “forgiven,”
19ln the tra ditiona l m odel, perm anently raising the GNP grow th rate
requires an ever-increasing saving rate. For exam ple, raising growth
by 1 percent would require increasing the saving rate by ab out 0.4
pe rcentage point each year for as long as grow th is to be kep t
high er
in the sense that GNP returns to its 1950-79 trend path.
As Chart 4 shows, however, this recovery can take a
considerable period of time. By 2010, twenty years after
the saving rate rebounds, real GNP and the capital
stock are still 1.8 percent and 6.0 percent, respectively,
below their 1950-79 trend scenario levels.
The benefits of higher saving are greater if the new
investment also encourages technological change.
Chart 5 shows the recovery and status quo paths for
GNP under both the traditional model and the alter
native learning-by-doing model.20 The low saving of the
status quo scenario is especially damaging in models
with embodied technology. Unlike the traditional model,
in which the loss of output eventually stabilizes, the
learning-by-doing model shows GNP steadily dropping
relative to trend. Clearly a saving recovery is preferable
to this steady loss of output. Nevertheless, even with
the saving recovery, the learning-by-doing model never
fully forgives the saving shortfall of the 1980s: GNP
settles below the trend scenario because of the perma
nent lost learning of the 1980s.
A rise in the saving rate could also cause a dramatic
improvement in the U.S. external asset position (Chart
6). During the 1980s increased foreign capital inflows
replaced roughly one-third of the drop in net national
20To keep the cha rt uncluttered, the "v in ta g e " model is excluded. As
C hart 2 suggests, the vintage model behaves like the learning-bydoing m odel in the short run and the tra ditiona l model in the
long run.
Chart 5
Impact of a Saving Rate Recovery on Real GNP
under Alternative Models
saving, preventing an even more dramatic drop in net
national investment. As a reasonable first approxima
tion our model assumes that this process reverses
when net national saving rebounds. With saving
restored to its pre-1980s average, the United States
could again become a (modest) net capital exporter,
causing a steady decline in the net debt position as a
share of GNP.21 Note, however, that this improvement in
the nation’s net debt position does not eliminate our
dependence on foreign capital. Instead, continuing
efforts by investors to diversify their portfolios interna
tionally should mean continued rapid growth in both
external liabilities and assets, even as the gap between
the two narrows.22
The long-run consum ption reward
If the sole goal of economic policy is to maximize
output, a higher saving rate is always better, and the
only policy question is how to get it higher. Presumably
the principal goal of higher saving is not just higher
GNP, but higher living standards as well. The ultimate
test of saving policy, therefore, is whether it improves
the time profile of consumption.
21As the A ppe ndix shows, if net cap ital inflows do not d e clin e in
response to the saving recovery, the benefits to GNP from higher
saving are even greater.
“ In the 1980s, total cap ital flows, the sum of inflows and outflows,
grew at an annual rate of 12.7 percent, alm ost tw ice as fast as
nominal GNP growth of 7.6 percent. Our sim ulations assum e that
this diversification con tinues at a more m odest pace in the future,
with 8 percent growth in total ca p ita l flows and 6'/2 pe rcent growth
in GNP. See A ppe ndix for fu rth e r details.
Chart 6
Ratio
105—
International Capital Position in the
Recovery Scenario
Percent of GNP
70
1 00 ----
95Learning-by-doing
90-
85Assets
80-
75l I I I I I I I I I I l'l I I I I I I I I I I I I I I I I I I I I I I I I I LLLL
1979
1985
1990
1995
2000
2005
2010
2015
2020
Note: Each series is plotted relative to the 1950-79 trend scenario.
1995
2000
2005
2010
FRBNY Q uarterly Review/W inter 1991
13
Chart 7 compares aggregate consumption for the
status quo and recovery scenarios with aggregate con
sumption for the 1950-79 trend. A permanently lower
saving rate can have considerable immediate benefit to
consumption. Had the saving rate remained on trend in
the 1980s, consumption would have averaged 3.3 per
cent less than it actually was. Yet the payback for this
consumption binge is already being felt. By 1992, if the
status quo continues, the cumulative income loss from
low saving will already have pushed consumption below
the trend level. Most of the costs of the consumption
binge would be felt in the next century when consump
tion drops to 10 percentage points below trend and then
stays there forever. (This is what some commentators
mean when they say that low saving has “mortgaged”
our future.)
In the recovery scenario the excesses of the 1980s
are reversed in the 1990s. Consumption drops sharply
and then gradually converges back to the trend level. In
fact, in the traditional model the highest possible con
sumption path is achieved with gross saving rates of
close to 30 percent.23 If saving rises above 30 percent,
the gain to consumption from higher output is more than
offset by the need for more resources to maintain the
^ T h e growth literature calls this the “ golden rule" consum ption path.
Chart 7
Real Consumption under Alternative Saving
Scenarios
Ratio
V
t1
1
\ \
\
\
\^
\
----'
Status quo
^
\
/
✓
\
x
N.
Recovery
\
V
1111II 11111_L 1II 111111111 1 11 1 111 l ! 11 .11 11 l j j J
1979
1985
1990
1995
2000
2005
2010
2015 2020
Note: Each series is plotted relative to the 1950-79 trend
scenario.
14
FRBNY Q uarterly Review/W inter 1991
capital stock.
The consumption “reward” for higher saving can take
many years to materialize. For example, consumption in
the recovery scenario will not surpass consumption in
the status quo scenario until the turn of the century
(Chart 7). Determining whether this delayed gratifica
tion would be worthwhile requires some measure of
people’s time preference— the rate of discount that
equates the utility of current and future consumption.
The precise magnitude of this discount rate is a matter
of considerable dispute, yet under any reasonable
assumption the saving rate appears low. For example,
even if the discount rate is as high as 5 percent and if
people’s time horizon is only thirty years (they essen
tially do not care about unborn generations), society is
still better off under the recovery scenario than under
the status quo. Indeed, the status quo saving rate would
only be justified if the discount rate were as high as 10
percent.24
Difficult, but not im possible
Restoring the capital stock to its pre-1980s path will
require a sustained increase of more than 5 percentage
points in the national saving rate. This task appears
particularly daunting in view of the downward trend of
the last decade. Furthermore, with most studies show
ing only a limited response of private saving to incen
tives, the main burden of adjustment must fall on the
worst saver of all— the federal government.
Recent efforts to reduce the budget deficit suggest
that significant progress can be made. The Congres
sional Budget Office estimates that in the absence of
the fall 1990 budget accord the 1995 budget deficit
(excluding revenues from the sale of thrift assets) would
have been 2.8 percent of GNR The accord reduced this
to 0.8 percent of G NP— in other words, the agreement
goes roughly two-thirds of the way toward a balanced
budget. Continuing this process all the way to budget
balance would increase the national saving rate a total
of 3 percentage points from current values. By the end
of this decade this partial rebound in the saving rate
could add about W 2 percent to the U.S. capital stock,
increase real GNP by about 2 percent, and slow growth
in net external debt to the point where it would no
longer be increasing as a share of GNP.
Not only should the budget deficit be eliminated, but a
case can also be made for a budget surplus. With a
24lf saving is “sub o p tim a l,” why d o n ’t pe ople save more? In many
ways governm ent tax and spe nding po licy te n d s to d isco u ra g e
saving and redirect incom e to less productive uses. But even
w ithout these disto rtions, private saving d e cisio ns are p robab ly not
“socially o p tim a l.” By ensuring a healthy economy, w ith a grow ing
econom ic pie, saving co n trib u te s to social sta b ility and co n fidence
in the future. For these and other reasons, private d e cisio n s may
yield less saving than w hat is co lle ctive ly de sirable .
budget surplus the Federal government could begin
buying down debt accumulated in the 1980s, freeing up
resources for private investment. One way to generate a
surplus would be to balance the non-Social Security
portion of the budget. The annual surplus of the Social
Security System now offsets about one-fourth of the
deficit in the rest of the budget. By the turn of the
century, the Social Security surplus could reach 2 per
cent of GNP. Balancing the budget exclusive of Social
Security trust funds and pushing the unified budget into
surplus, therefore, could raise the saving rate almost 5
percentage points. This is close to the saving path
suggested by the recovery scenario discussed earlier.
Conclusion
The 1980s saw net national saving fall to its lowest rate
of the postwar period. All measures of saving that esti
mate the actual acquisition of productive assets confirm
this finding. The costs of this poor performance have
been subtle but quite real: temporarily higher consump
tion has been gained at the long-run expense of several
years’ worth of GNP growth and a complete reversal of
the U.S. external debt position. In particular, our simula
tion results show the following:
• Traditional model estimates indicate that the drop in
saving in the 1980s has already cost the U.S. econ
omy about 15 percent of its capital stock, lowering
potential output by about 5 percent. By the end of
this century, if the status quo continues, the accu
mulated loss in capital and output will grow to 28
percent and 10 percent, respectively.
• The actual cost may be even greater. In an alter
native, learning-by-doing model, which links capital
formation to the pace of technological innovation,
the estimated loss to potential output was over 7
percent in 1990 and could rise to about 15 percent
by the year 2000.
• Foreign capital inflows in the 1980s prevented an
even greater shortfall in the capital stock, but in the
process the United States has gone deeply into
debt. At current rates of net capital inflow, in ten
years the United States will pay more than 1 per
cent of its annual income to service this foreign
debt, an exact reversal of its position ten years ago.
• The U.S. net saving rate would have to climb 51/2
percentage points as a share of GNP to offset the
decline of the 1980s, restore the trend in capital
growth, and end the deterioration of our external
debt position.
• Most of this gap could be closed by balancing the
federal budget excluding the Social Security sur
plus. The recent budget accord is a significant step
in this direction.
• Raising the saving rate will require lower current
consumption. The present saving rate can be justi
fied only if people put a very low value on future
consumption compared with present consumption.
If we assume a reasonable “discount rate” of 2
percent per year— roughly the real return to govern
ment bonds in the postwar period— lifetime con
sumer satisfaction is maximized with a net saving
rate four times the current pace.
A higher saving rate is not a cure-all for the nation’s
ills. Higher saving means a higher level of output, but it
does not sweep away the inflation and unemployment
problems of the business cycle. Although higher saving
would probably reduce the nation’s net foreign indebt
edness, it will not mean an end to the gross inflow of
foreign capital. Furthermore, not all saving is equally
productive. The growth benefits of higher saving could
be greatly increased by eliminating tax distortions favor
ing less productive investments. Finally, in the 1980s
not only did private spending shift out of investment into
consumption, but public investment lost out to current
spending as well. A healthier economic outlook will
require redirecting all kinds of spending toward invest
ment— not only in plant and equipment, but also in
infrastructure, education, environmental safeguards,
and research.
FRBNY Quarterly Review/Winter 1991
15
Appendix: The Growth Model
All growth sim ulations in the text are based on a
detailed neoclassical representation of the U.S. econ
omy. This simple growth framework is a powerful tool for
exploring alternative paths for the economy. Offering a
clear connection between results and assumptions, the
framework can be easily manipulated, and it has a long
track record of use in previous research.* The model also
has some disadvantages. It is highly simplified, lumping
capital and output into very broad aggregates. It also
ignores the short-run costs of changing the saving rate,
focusing instead on the long ru n * This Appendix reviews
the main equations of the model and then tests the
robustness of the results to changes in model param
eters. Several notation conventions are followed: a “%”
before a variable indicates a growth rate, “ (-1)” means
“ lagged one period,” "A” signifies the change from a year
ago, and a “C” suffix means “ measured in constant 1982
dollars.”
capita terms also use the Social Security Administra
tion’s projections for total population.
Capital
The model treats the nominal gross saving rate as
exogenous, distributes saving among its various uses,
and then calculates the implied capital accumulation.
The basic saving identity determines the share of GNP
going to investment:
(2) l/GNP = S/GNP + NFI/GNP,
where S is gross national saving, I is gross investment,
and NFI is net foreign capital inflows. We assume that, in
line with the 1980s experience, net foreign capital inflows
decline by one-third of any improvement in the saving
rate:"
(3) NFI/GNP = [.015 - .333*(S/GNP - .13)].
Labor
Labor input is measured by aggregate hours worked.
Growth in hours is assumed to equal the growth in
working age population plus an add factor to account for
increased participation rates:
Investment is divided between residential (IR), nonresidential (IN), and inventories (IV). We assume that, con
sistent with the 1979-89 trend, a gradually declining
share of investment goes into the residential sector and
a fixed portion goes into inventories:
(1) %LAB = %POP + ADD.
Most simulations use the “ middle” population projections
of the Social Security Administration5 and assume an
add factor of 0.1 percent. Variables measured in per
(4) I = IR + IN + IV
= (.3 - .00178*T)*I + (.67 +
+ .03*1,
,00178*T)*I
where T is a time trend equal to 1 in 1991.ft
tThe ba sic fram ew ork was developed in Robert M. Solow, "A
C ontribution to the Theory of Econom ic Growth,” Q uarterly
Journal o f E conom ics, vol. 70 (1956), pp. 65-94. Recent
extensions of the m odel include Paul M. Romer, “ Increasing
Returns and Long-Run G row th,’* Journal of P olitical Economy,
vol. 94, no. 5 (1986), pp. 1002-37; Robert E. Lucas, “ On the
M e chanics of E conom ic D evelopm ent,’’ Journal of M onetary
Econom ics, vol. 22, pp. 3-42; and Maurice F. Scott, A New
View o f Econom ic Growth (O xford: Clarendon Press, 1989).
Two recent ap p lic a tio n s are a study of the Social Security
system , Henry Aaron et al., Can Am erica A fford to Grow
O ld? (W ashington D.C.: B rookings Institution, 1989); and a
study of de m o g ra p h ic trends, Keith Carlson, “ On M aintaining
a Rising U.S. Standard of Living into the Mid-21 st Century,"
Federal Reserve Bank of St. Louis Review, vol. 72, no. 2
(1990), pp. 3-16.
*A sharp increase in the saving rate cou ld cause the
econom y to weaken if slow er consum ption growth is not
im m ediately offset by increased investment. Policy makers
cou ld m itigate some of the short-run im pact. In any event,
these initial effects w ill be unim portant in the long run.
51988 Annual R eport o f the B oard o f Trustees o f the Federal
O ld-A ge an d Survivors Insurance an d D isability Insurance
Trust Funds (W ashington, D.C.: Government Printing Office).
16
FRBNY Q uarterly Review/W inter 1991
These nominal investment flows are converted to real
investment by subtracting the assumed rate of inflation of
4 percent. A portion of real nonresidential investment
(INC) is allocated to the farm (IFC) and “other” (IOC)
sectors, and the remainder goes to nonfarm business
(INFBC):
(5) INFBC = INC -IF C - IOC.
These investment flows, along with assumed deprecia
tion rates, determine capital accumulation. The key capi-
"From 1979 to 1989, net national saving de clin e d 5.1
percentage points as a share of GNP; over the sam e period,
cap ital inflows increased 2.0 p e rcentage points relative to
GNP, replacing 38 pe rcent of the lost saving.
t+To keep the m odel sim ple, we ruled out linking housing to
population growth. This sim p lifyin g assum ption has little
bearing on the results.
Appendix: The Growth Model (continued)
tal equation is for nonfarm business (KNFBC):
(6) KNFBC = INFBC + (1 - 8)*KNFBC(-1),
where “8” is the depreciation rate and is assumed fixed
at .111 for most of the simulation period. Residential
capital is similarly determined by adding new investment
(IRC) to lagged capital (KRC) and subtracting deprecia
tion, but with a .025 depreciation rate.**
and AGE depends on the rate of gross investment:®5
(11) AAGE = .84 - .92*(INFBC/KNFBC)*AGE(-1).
The vintage model implies that a one-year drop in the
average age of capital adds 2 percentage points to
output. In the learning-by-doing model, technological
advance is a linear function of the rate of investment:
(12) %TECH3 = .06*(I/GNP).
Output
Real GNP is divided into six components, value added
by nonfarm business (RNFBC), services from housing
(RRC), farm (RFC), government (RGC), “other” (ROC),
and the rest of the world (ROWC):
(7) GNPC = RNFBC + RRC + RFC + RGC + ROC
+ ROWC.
“ Other” and government are assumed to grow at the
same rate as aggregate hours plus a constant, and farm
output is assumed to grow at a fixed rate. The rest-ofworld component is a linear function of the accumulated
external asset position, and it assumes a 7.5 percent
return on new flows (see the next section). Residential
output (RRC) is measured as a simple product of the
return to housing services and the real stock of housing
(KRC):
(8) RRC - .085*KRC.
Nonfarm business output is modeled using the tradi
tional Cobb-Douglas formulation, as well as two varia
tions with different assumptions about technological
progress. The basic model is:
(9)
RNFBC
=
[1 + ,7*% LAB + ,3*%KNFBC
+ %TECH1]*RNFBC(-1),
where technological advance (%TECH1) is assumed to
add a constant 1 percentage point to output growth. In
the vintage model, %TECH2 depends on the average
age of the capital stock:
(10) %TECH2 = .01 - .02*AAGE,
**We assume that, exce pt for a transition period, inflation
is the same for investm ent and noninvestm ent goods
(4 percent) and that deprecia tion is constant. We also
assume that du ring the first ten years, in fine w ith recent
experience, nonresidentiat investm ent inflation is only 3
percent and the deprecia tion rate rises .001 per year. These
assum ptions have roughly an offsetting im pact on real capital
formation.
With an investment rate of, say, .18, this equation implies
a contribution to growth from new technology of 1.1
percent per year. The parameters for both the vintage
and learning-by-doing models are calibrated so that they
explain roughly half of the contribution to growth from
technology innovation in the postwar period. In other
words, half of technology advance is assumed to be
embodied in capital and the remainder is assumed to be
independent of capital formation.
External asset position
The U.S. external asset position is equal to last period’s
net assets minus the current period’s net capital inflows:
(13) NETA = NETA(-1) - NFI.
Net capital flows are determined as shown in equation 3
above. In addition, the net asset data are adjusted from
book value to market value to account for the undervalu
ing of direct investments. This undervaluing of invest
ment is particularly large for the older U.S. investments
abroad. The methodology, which relies on stock market
values, is drawn from a paper by Michael Ulan and
William G. Dewald."11 For all future years we assume that
average stock market values grow 6 percent per annum.
Model characteristics and sensitivity
With nonfarm business accounting for about 80 percent
of output, the model behaves very much like a pure
Cobb-Douglas model. Higher saving boosts growth,
although some of the effect is mitigated by the leakage of
capital abroad and the failure of some sectors to respond
to the higher saving and capital formation. Once the
saving rate stabilizes at a new higher level, the capitaloutput ratio and the growth in output, investment, and
ssThe coefficients are derived from a regression for the period
1949-89.
" " “ Deflating U.S. Twin D eficits and the Net International Invest
ment Position," U.S. D epa rtm e nt of State, W orking Paper
Series no. 12, 1989.
FRBNY Q uarterly Review/W inter 1991
17
Appendix: The Growth Model (continued)
consumption all settle on a roughly constant long-run
path. There is a minor tendency for growth to slow over
time because of the expected slowdown in labor force
growth as the “ baby boom ” generation reaches
retirement.
By necessity the simulation model adopts a number of
reasonable but somewhat arbitrary assumptions in order
to produce usable results. Here we show the GNP
response to the saving rate recovery under alternative
model parameters. These sensitivity tests illustrate the
robustness of the model results and give readers a
chance to see how their own prior assumptions change
the findings.
Most of the model parameters are not important to the
basic findings of the model. As Table A1 shows, changing
the labor force, technology growth, and depreciation
assumptions does not materially affect the results. The
most important assumptions in the model relate to the
link between capital and output. The estimates for the
alternative models in the table show that if technology is
partly driven by investment, the output effects of higher
saving can be considerably higher. Furthermore, the out
put effects are quite sensitive to the coefficient on cap
ital. Our model assumes a coefficient of .3; estimates in
the literature range from .2 to .33 and higher. Even with
the lowest reasonable parameter value, however, the
saving rebound has considerable output effects.
The international dimension
A second set of crucial parameters in the model relate to
the role o f fo re ig n c a p ita l in the e c o n o m y . In an e c o n o m y
open to foreign investment, such as the United States, a
drop in saving need not result in an equal loss of invest
ment and potential GNP. Instead, the GNP loss will be
mitigated to the extent that foreigners fill the saving gap
and that some of the output generated by their invest
ment accrues to U.S. residents rather than to the foreign
owners. Here we explore the sensitivity of our results to
two key assumptions: the capital flow response to
changes in saving and the return to foreign capital.
The capital flow assumption in the model (equation 3)
is a compromise between two extremes. One extreme is
to assume perfect capital mobility, with investors indif
ferent to the country and currency in which they invest. In
this environment, a drop in the U.S. saving rate will only
temporarily raise U.S. interest rates, causing a foreign
capital inflow that fully offsets the decline in U.S. saving.t+t The other extreme is to assume a closed econ
omy response, in which changes in U.S. interest rates
have no effect on net foreign capital flows.w In this
case, a drop in saving would raise U.S. interest rates and
cause a one-for-one drop in U.S. investm ent. The
assumption adopted in the article seems consistent with
actual experience in the 1980s: lower saving was partially
offset by foreign capital inflows but not enough to prevent
a rise in U.S. interest rates relative to other countries and
a drop in U.S. investment.
The assumed return to foreign capital is also a com
promise between extremes. Foreign investment probably
produces just as much output as domestic investment,
but it produces less gross national product. Part of the
income generated accrues to the owners, but part also
tttT h is result strictly holds only in the "small c o u n try " case. In
practice, U.S. investm ent w ould tend to fall in pro p o rtio n to
th e d ro p in th e g lo b a l p o o l o f s a v in g . For a d is c u s s io n o f
these issues, see M artin Feldstein and C harles Horioka,
“ D om estic Saving and International C apita l Flows,” E conom ic
Journal, vol. 90 (June 1980), pp. 314-29
#*H ere we assume that cap ital flows con tinue at histo rical rates
and do not respond to any cha nge in relative saving and
interest rates.
Table A 1
Impact of the Saving Recovery on GNP under
Alternative Assumptions
Table A2
(Percent Deviation from the Status Quo)
Traditional model
With 1 percent labor growth
With 2 percent technical advance
With 1 percent more depreciation
After
Ten
Years
After
Twenty
Years
After
Fifty
Years
6.0
10.7
15.6
Domestic Share*
(In Percent)
Closed
Economy
Compromise
Open
Economy
6.0
6.1
6.3
10.7
10,8
11.2
14.9
15.1
15.4
37
57
76
17.9
17.9
17.9
17.0
15.6
14.2
14.0
9.8
5.8
12.4
25.3
44.5
Vintage model
7.5
12.1
15.9
Learning-by-doing model
7.6
14.9
29.8
With 0.6 capital coefficient
Long-Run Impact of the Saving Recovery on GNP
under Alternative International Parameters
FRBNY Q uarterly R eview/W inter 1991
Digitized18
for FRASER
(Percent Deviation from the Status Quo)
'The portion of output that accrues to U.S. residents when
foreigners invest in the United States.
Appendix: The Growth Model (continued)
..
accrues to the government in the form of higher taxes
and to workers benefiting from the higher demand for
labor. The model assumes a 7Vz percent net return to
foreign investors, implying that about half of the output
gain from foreign investment goes to the investor and the
remainder is diverted to U.S. residents.
Table A2 shows the results of varying both assump
tions. Like the last column of Table At, Table A2 shows
the long-run (fifty-year) output gain under a saving recov
ery. The middle entry in the table shows the results for
;
5
.
:.. ■
the traditional model with the standard assumptions. The
greatest gain from saving is in the closed economy case,
where changes in the saving rate have a one-for-one
impact on domestic investment. The saving effect is
weakest in the case of a pure open economy in which a
very large domestic share of the output is generated by
foreigners’ investments (bottom right-hand corner of the
table). In this case, higher U.S. saving simply displaces
foreign investors, and the U.S. only gains to the extent
that foreigners no longer earn their (small) profit share.
FRBNY Q uarterly R eview/W inter 1991
19
Comparing the Cost of Capital
in the United States and Japan:
A Survey of Methods
by James M. Poterba
Wide U.S. trade deficits in the early 1980s prompted
policy analysts in government and industry to search for
the sources of declining U.S. competitiveness. Many
argued that U.S. managers failed to “take the long
view,” forgoing investment or market development proj
ects with high future yields to maintain their current
profits. Cultural factors, such as the weak implicit con
tracts between firms and workers, were often cited as
the cause of falling competitiveness, even though these
factors have evolved slowly while the U.S. trade posi
tion declined precipitously in the early 1980s.
During the last decade, a small but growing group of
academics, policy makers, and businessmen has
argued that the differential behavior of U.S. and foreign
firms is a rational response to disparities in their eco
nomic environments. For example, George Hatsopoulos
(1983) claimed that the cost of capital, or the pretax rate
of return that firms must earn to generate the returns
demanded by shareholders and creditors, was signifi
cantly higher in the United States than in Japan. He and
others have argued that as a result, Japanese manag
ers find it in their firms’ best interest to undertake some
long-horizon projects that U.S. managers would reject.
While the cost of capital is simple in concept, it is
quite complex in practice. It depends on the rates of
return demanded by shareholders and bondholders, the
tax system confronting corporations, and a variety of
auxiliary aspects of firm behavior. Any attempt to esti
mate the cost of capital must rely on a variety of
assumptions about corporate financing and investment
practices. Moreover, data for firms in different nations
are rarely comparable, requiring further assumptions
and approximations.
Given the central importance of the cost of capital in
corporate investment decisions, it is no surprise that
numerous studies have tried to compare the cost of
capital facing U.S. firms with that of their international
competitors. Given the estimation difficulties, however,
it is also no surprise that these studies do not reach
identical conclusions. Many but not all studies find that
the cost of capital has placed U.S. firms at a competi
tive disadvantage relative to firms in other nations.
This article surveys the sizable literature comparing
the cost of capital in different nations. It tries to isolate
common conclusions and to highlight the m eth
odological differences of previous investigations. The
article does not attempt to compute “definitive” esti
mates of relative capital costs. Rather, it draws on
earlier studies and emphasizes the underlying eco
nomic and institutional factors that may contribute to
cost of capital disparities.
The article illustrates alternative cost of capital meth
odologies by focusing on the United States and Japan.
Most previous studies have confined their analysis to
these nations because of a worsening bilateral trade
balance in the 1980s and the high visibility of Japanese
import penetration in several high-technology U.S. mar
kets.1 Limiting the present analysis to the United States
James M. Poterba is Professor of Economics, Massachusetts
Institute of Technology, and Associate Director of the Taxation
Research Program, National Bureau of Economic Research. The
paper was presented on December 6, 1990, at the fe d e ra l Reserve
Bank of New York Colloquium on the Cost of Capital in the
United States.
’ The principal exceptions are the studies by the U.S. Department of
Commerce (1983) and McCauley and Zimmer (1989). The former
considers only the cost of funds and does not report complete cost
of capital estimates. The latter analyzes capital costs in the United
States, Japan, Germany, and the United Kingdom.
20
FRBNY Quarterly Review/Winter 1991
and Japan makes it unnecessary to discuss the institu
tional complexities of other nations, while still highlight
ing measurement issues concerning the cost of capital.
Even when only two nations are compared, relative
capital costs can vary through time. This article con
cludes that Japanese firms have enjoyed a cost of
capital advantage over their U.S. competitors through
out most of the last two decades, although the source of
this advantage has shifted. At the beginning of the
1980s, for example, low costs of debt combined with
debt-equity ratios substantially above those in the
United States held down capital costs for Japanese
firms. The increasing integration of world capital mar
kets during the last decade has limited the differences
in borrowing costs, however, and today any cost of
capital advantage is due to lower costs of equity rather
than to differential borrowing costs.
The article is divided into six sections. The first pro
vides a brief overview of what the cost of capital is and
how it affects managers’ project evaluation. The analy
sis demonstrates that long-term projects are particu
larly affected by higher costs of capital.
The next two sections discuss the cost of funds, the
required return that investors demand the firm earn after
corporate taxes. The second section analyzes the cost of
debt, while the third considers the more complicated prob
lem of measuring the required return demanded by share
holders. Both sections present data on historical rates of
return in the United States and Japan and briefly explain
why required returns might differ across countries.
The fourth section discusses debt-equity ratios of firms
in the two nations, noting shifting patterns through time
and describing the institutions that have historically sup
ported higher leverage in Japan than in the United States.
The fifth section considers the influence of the cor
porate tax rate and the system of investment incentives
Table 1
Im pact of Discount Rates on
Long-Term Investments
Discount
Rate
Current Value of
$5 Cash Flow, Five
Years in the Future
Economically Profitable
"Waiting Time" for Hypo
thetical New P rojectt
4
6
8
10
12
$4.05
3.70
3.35
3.03
2.74
45.8 years
23.8
14.2
9.2
6.1
Source: Author’s calculations.
|T h e second column reports the waiting time for a project with
an up-front cost of $100,000 and annual profits of $25,000 once it
begins yielding returns. The estimates in this column answer the
question, How long could a firm wait until the profit flows began?
on the cost of capital. Contrary to some prior claims, tax
considerations do not appear to be central determinants of
capital cost disparities between the United States and
Japan. This section also reports the summary measures
of capital costs presented in previous investigations.
The article’s final section notes several policy options
that would affect the cost of capital. These include
changing the taxation of firms and shareholders as well
as raising the national saving rate.
What is the cost of capital?
The cost of capital is the pretax real return that a firm
must earn, gross of depreciation, to satisfy the
demands of its shareholders and bondholders. If new
projects do not earn a return at least as great as the
cost of capital, the equity market will penalize manag
ers for wasting corporate resources. The cost of capital
therefore directly affects the optimal investment policy
of corporations. As the cost of capital rises, firms will
find fewer projects yielding returns high enough to war
rant new investment. The cost of capital depends upon
the required returns investors demand, on the tax treat
ment of investment, on the depreciation of the invest
ment asset, and on the expected rate of appreciation for
the productive asset.
To understand the link between the cost of capital,
discount rates, and project choice, consider a simple
example of a manager confronting a project requiring a
onetime payment today that will return five dollars in
today’s prices five years in the future. How large an up
front payment will a manager be willing to make for this
project? This depends on the discount rate that inves
tors (and the manager) apply to the firm’s cash flows.
The first column of Table 1 presents the answer to this
question for several different values of the discount
rate.2 When the discount rate is 4 percent per year, the
manager is willing to give up $4.09 for each five dollars
he will earn in five years. With a discount rate of 10
percent, however, the manager will only forgo $3.03 to
earn $5.00 in five years.
A second example illustrates the same point. Con
sider a stylized project that costs $100,000 today but
does not yield returns for several years. There is no
uncertainty about the project’s cash flows; once the
project becomes productive, it yields $25,000 per year
(in the prices of the first year) forever. Chart 1 sketches
the cash flow pattern associated with this stylized proj
ect. The second column in Table 1 reports the number
of years that a manager will agree to wait before receiv
ing the project’s positive cash flows. If the discount rate
is 4 percent, the project will be profitable even if it takes
V a ria tio n s in the discou nt rate affect the cost of cap ital, although
not all dispa rities across countries or firms in costs of cap ital are
due to differential discou nt rates.
FRBNY Q uarterly Review/W inter 1991
21
forty-five years before positive cash flows materialize.
At a discount rate of 12 percent, however, any delay of
more than six years renders the project unprofitable.
These calculations illustrate that the discount rate is a
particularly critical determinant of the attractiveness of
long-term investments.
The cost of capital depends on the discount rate as
well as many other considerations affecting the attrac
tiveness of investment projects. It is a function of the
returns demanded by bondholders and shareholders,
the debt-equity mix used in financing new projects, the
corporate tax rate, and the generosity of tax allowances
on new investments. Formally, the expression for the
cost of capital (c) is
structure,3 plus the cost of physical decay on the asset.
The nominal cost of debt is multiplied by a (1 - t ) term to
reflect the tax deductibility of interest payments. Since
expected inflation is subtracted from this term, it effec
tively depends on real debt and equity returns. The
second term recognizes that investment incentives and
depreciation allowances reduce the cost of purchasing
capital goods. Thus, the cost of capital is lower as the
investment credit (ITC) or benefits of depreciation allow
ances (z) are larger. The division by (1 - t ) simply recog
nizes that profits are taxed, so that the post-tax return
that the firm must deliver to its investors is “grossed up”
by 1/(1 - t ). The next three sections focus on the compo
nents of this cost of capital formula.
(1) c = [req(1 - (3) + p(1
The cost of debt
The cost of funds is the rate of return that the firm must
promise to its creditors or shareholders when it raises
financial capital. Most firms use both debt and equity
capital. This section considers the cost of debt, defer
ring the more controversial cost of equity until the next
section.
The pretax cost of debt is the interest rate that a firm
must promise on new corporate borrowings. There is no
single borrowing rate for the corporate sector; different
firms can borrow at significantly different rates, depend
ing on their riskiness. Even a given firm does not borrow
at a single interest rate; rather, it faces a spectrum of
rates depending on the maturity of its debt issue and
the proposed application of funds. Most studies ignore
these sources of heterogeneity and use indexes of
yields on high-grade corporate debt (BAA or better) to
measure the cost of debt finance. This procedure is
justifiable if the structure of risk and maturity premia is
stable across countries and time. Such an assumption
is not particularly plausible, but an alternative, empiri
cally tractable methodology is difficult to find.
Nominal before-tax interest rates are not the key
determinants of corporate borrowing costs. Rather, the
cost of funds is affected by the real, after-tax cost of
debt, defined by
-T )rb+
8 - i T ]* [ (1 - I T C - t z ) / ( 1 - t ) ] ,
w here
req = nominal rate of return demanded by equity
holders
rb = nominal rate of return demanded by bond
holders
P
= debt-to-total capital ratio
t
= marginal tax rate on corporate earnings
8
= economic depreciation rate of capital good
it
= expected inflation rate
ITC = rate of investment tax credit
z
= present discounted value of depreciation
allowances on a new investment project.
This expression, though complex, is easy to under
stand. The first term in brackets is a weighted average
of the required returns demanded by equityholders and
bondholders, with weights p and (1-|3) equal to the
share of each type of financing in the firm’s capital
Chart 1
Hypothetical Long-Term Investment Project
Cash flow
25
(2) rAT = (1 —x)i -
I
-100
22
FRBNY Q uarterly R eview/W inter 1991
Time
tt,
where tt indicates the expected inflation rate. Variation
in expected inflation rates across countries can lead to
significant differences in nominal interest rates, even if
real interest rates are similar. It is therefore important to
3Kester and Leuhrman (1990) em phasize that the m arginal de btequity mix in financing a given project may d iffe r from the average
d e bt-e quity mix for the corpora te structure. They co rre ctly observe
that the average de b t-e q u ity ratio of a firm or corpora te se cto r may
not reflect the ap prop riate d e b t-e q u ity w eigh ting on m arginal
projects.
correct nominal interest rates, even if crudely, for infla
tionary expectations. Equation 2 also emphasizes the
link between the statutory tax rate and the after-tax
borrowing rate. Since nominal interest payments are tax
deductible, an increase in expected inflation that raises
nominal interest rates by less than 1/(1 —t ) times as
much as the inflation shock will reduce the after-tax cost
of borrowing.
There are at least three different ways to measure
expected inflation. The first assumes that actual infla
tion at any moment is a good proxy for what was
expected. While obviously erroneous in some situa
tions, this approach is simple and can also be inter
preted as the ex post real interest rate paid by firms in a
given period. A second strategy involves using either
survey data or macroeconomic forecasts. While these
data are somewhat arbitrary, especially if only one
firm’s forecast is being used, they are attractive pre
cisely because they are statements of expectations.
Finally, the most common approach is to compute a
weighted average of past inflation rates and to argue
that most individuals extrapolate the recent past to the
future. Like the use of actual inflation rates, this
approach will misstate expectations during periods
when policy shocks or other factors lead to rapid revi
sions in inflationary prospects.
Three cost of capital studies indicate the varied
approaches to measuring the real cost of debt. Hatsopoulos and Brooks (1987), who update and slightly
modify Hatsopoulos’ (1983) study, use Moody’s BAA
rate as the pretax interest rate for the United States, but
for Japan, they construct their own estimate of long
term borrowing costs using the yield on heavily traded,
low-risk Nippon Telephone and Telegraph bonds plus a
“risk premium” equal to the yield spread between BAA
bonds and Treasury bonds in the United States. This
procedure assumes that the risk premium for corporate
bonds is identical in the two nations. When paired with
the assumption that actual inflation rates are reason
able proxies for expected inflation, it yields real after-tax
interest rates in Japan that average more than 100 basis
points below those in the United States during the
1970s and early 1980s.
Bernheim and Shoven (1987, 1989) focus on short
term borrowing costs, since their analysis argues that
the capital market equates short-term risk-adjusted
returns in the bond and stock markets. They explore
several different measures of expected inflation and find
that for the early 1980s, Japanese real interest rates
were between 300 and 600 hundred basis points lower
than their U.S. analogues. They also present evidence
on long-term rates, finding disparities that, though
smaller, again suggest lower Japanese real borrowing
costs.
McCauley and Zimmer (1989) present the most sys
tematic analysis of borrowing costs. They recognize the
mix of long- and short-term borrowing in corporate
capital structures and take an average of the interest
rates on different maturity debt. They also correct
observed interest rates for the presence of compensat
ing balances, that is, requirements that borrowers hold
some fraction of a loan in a low-interest account at the
lending institution. These requirements effectively raise
the cost of borrowing. McCauley and Zimmer (1989)
follow Hatsopoulos and Brooks in subtracting the actual
inflation rate from nominal interest rates when con
structing the real after-tax cost of borrowing. Their
results, for a more recent time period than either of the
earlier studies, suggest no apparent differences in real
after-tax borrowing costs in the United States and
Japan. In part the difference in results is due to capital
market integration beginning in the early 1980s.
While different costs of borrowing may have played an
important part in historical differences between U.S.
and Japanese capital costs, they are unlikely to be
central today. Differences in real interest rates across
nations are inconsistent with a perfectly functioning
world capital market in which investors from a given
nation earn the same rate of return regardless of where
they invest their funds. Academic studies (surveyed, for
example, by Mishkin 1984 and Frankel 1990) neverthe
less suggest that there are differences in real interest
rates between some countries. The size of the U.S. and
Jap an ese m arkets and the active cro ss-b o rd er
arbitrage in fixed income markets make large dis
parities in these markets unlikely.
A firm in either the United States or Japan could, in
addition, try to exploit persistent differences in real
interest rates by issuing bonds denominated in the
other nation’s currency and marketing them to foreign
investors. This equilibrating force was absent in the
years before 1980, when the Japanese capital market
was relatively closed to outside investors or borrowers.
Today, however, firms routinely make cross-border
transactions of this type. This development reinforces
the view that interest rate differences are unlikely to be
a central component of the cost of capital differences
between Japan and the United States.
The cost of equity
Estimating the cost of equity is the most difficult part of
any cost of capital computation. The reason is that there
is little evidence on the risk premium that equity inves
tors require to hold stocks rather than less risky bonds.
The risk premium is likely to vary through time, making
it difficult to use historical data to assess this param
eter. Consequently, researchers have differed more in
their methods of measuring the cost of equity than in
FRBNY Quarterly Review/Winter 1991
23
their methods of measuring the cost of debt.
This section considers four approaches to measuring
the cost of equity. The first subsection considers esti
mates that assume that past returns on corporate stock
provide a good guide to required returns. The next three
subsections discuss various measures of expected
returns that are based on the ratio of actual earnings to
share prices or assets values. A concluding subsection
discusses the extent to which differences in equity cost
can persist in a world capital market.
Estimates using h istorica l data on equity returns
The simplest approach to measuring the required return
on equity is to assume that the historical average differ
ential in equity and debt returns indicates the extra
return that investors demand for holding risky equity
rather than riskless debt.4 If required returns were con
stant through time, and if the data sample on equity and
debt returns were long enough to measure the average
returns precisely, then this procedure would yield reli
able results. In practice, however, neither of these con
ditions is satisfied.
It is useful to begin with background information on
the equity risk premium computed this way. Table 2
reports the average excess return on equities relative to
government bills in the United States and Japan for
several different time periods. The findings highlight the
sensitivity of these results to the sample period.5 The
sharp rise in the Japanese equity market during the
mid-1980s implies that any estimate of ex post returns
4B e rn h e im a n d Shoven (1 98 9 ) p re s e n t so m e e s tim a te s b a s e d on th is
a p p ro a c h . B a ld w in (1986) a nd K e ste r a nd L e u h rm a n (1990) a lso
im p lic itly ta ke th is a p p ro a c h .
5B a ld w in (1986) w as a m o n g th e firs t to b rin g e q u ity re tu rns d a ta to
b e a r on c a lib ra tin g th e re q u ire d re tu rn; she c o n c lu d e d th a t, if
a n y th in g , th e risk p re m iu m w as h ig h e r in Ja p a n th a n in th e U n ite d
S ta te s. K e ste r a n d L u e h rm a n (1 99 0 ) p e rfo rm a m ore s o p h is tic a te d
s e t of te s ts , a s k in g w h e th e r th e m a rk e t p ric in g of p a rtic u la r
c a te g o rie s of risk d iffe rs in th e U n ite d S ta te s a n d J a p a n . They find
no e v id e n c e of su ch d iffe re n c e s , b u t th e ir te s ts are re s tric te d to
o n ly fo u r ye a rs of d a ta (1 98 2 -8 6).
that includes these years (and does not span a very
long period) will show that Japanese investors demand
higher equity returns than their U.S. counterparts. The
39 percent decline in the Japanese equity market dur
ing calendar 1990 has weakened, but not erased, the
apparent differential in required returns.
The problems with using relatively short samples of
historical returns are more fundamental than sensitivity
to a few years of data. To understand the first problem,
consider an economy in which institutional changes
within a single year reduce by half an equity risk pre
mium that has historically been constant. Share prices
will rise in response to this news, and ex post measures
of the equity risk premium will suggest that it has risen.
In this case, however, the actual movement is just the
opposite.
The second difficulty with ex post returns is that just
as real interest rates appear to fluctuate, there is evi
dence that required returns vary over the business cycle
and through time. Recent research in financial econom
ics (for example, Fama and French 1988) suggests that
a considerable share of the variation in equity returns,
particularly over long horizons, can be forecast using
the dividend-price ratio and related variables. Changes
in financial markets and practices are also likely to
affect the equity risk premium. The rise in the leverage
of some U.S. firms during the 1980s, for example, prob
ably raised their equity risk premia relative to what they
would have been otherwise; the gradual reduction in the
fear of deep and major depressions since the 1930s has
probably lowered the relative cost of equity during the
postw ar period.
A third drawback to using historical data to calibrate
required returns is the imprecision of the resulting esti
mates. During the last sixty years, the return on U.S.
equities has exceeded that on Treasury bills by 7.5
percentage points per year. Given the significant annual
variation in equity returns— the standard deviation of
returns on the U.S. market is approximately 20 percent
per year— the standard deviation of the mean return
a-UMi
Table 2
Excess Returns on Equities Relative to Bills:
United States and Japan, 1926-1990
U.S. Excess Return (In Percent)
S a m p le Period
1 9 2 6 -8 9
1 9 6 0 -8 9
1 9 6 0 -7 9
1 9 8 0 -8 9
M ean
S ta n d ard D eviation
7.5
3 .2
1.5
6.5
20.0
15.1
14 3
16.5
J a p a n e s e E xce ss R eturn (tn P ercent)
M ean
S ta n d a rd D evia tio n
_
_
7.2
3.8
14.0
16.6
16.9
15.9
S o u rce : A u th o r's ca lc u la tio n s , b a se d on Ib b o tso n A sso cia te s (1990), a nd M o rga n S ta n le y -C a p ita l In te rn a tio n a l Data.
24
FRBNY Q uarterly R eview/W inter 1991
estimated for the period since 1926 is approximately 2.5
percentage points. To specify a range with a 95 percent
chance of including the actual mean differential, one
would therefore need to admit possibilities from 2.5 to
12.5 percentage points. With such a range, convincing
conclusions about the cost of equity are very difficult.
For Japan, the data problem is even more severe.
Most analysts focus on returns in the Japanese equity
market during the period since 1960 because the mar
kets before the Second World War and in the early
postwar years bore little resemblance to the sophisti
cated market of today. With only thirty years of data,
however, the 95 percent confidence band for returns on
the Japanese equity market ranges from 1.2 percent to
13.2 percent per year.
Estimates based on price-earning ratios
A second (and probably the most common) approach to
measuring required equity returns relies on marketbased measures of prospective equity returns.
McCauley and Zimmer (1989a), Bernheim and Shoven
(1989), and Ando and Auerbach (1988a, 1988b, 1990)
all use some variant of this approach in studying cost of
capital disparities. They use the earnings-price ratio,
possibly corrected for international differences in
accounting or other features, to measure investors’
required returns.
Before considering the merits and difficulties of this
approach, it is useful to summarize the trends through
time in price-earnings ratios for the United States and
Japan. These data are shown in Table 3 and Chart 2,
without any adjustments. The rapid rise in Japanese
share prices during the mid-1980s made the priceearnings ratio in Japan much higher than that in the
United States. This is the basis for many findings that
Japanese firms faced lower required returns on equity
during this period.
There are both theoretical and empirical difficulties in
using price-earnings ratios or, more accurately, their
reciprocal (earnings-price ratios) to describe required
returns. One theoretical objection is that rather strong
assumptions are needed if the earnings-price ratio is to
equal the current required return. For example, if
required equity returns change through time, then the
earnings-price ratio equals an average of current and
future required returns, minus the expected growth rate
of earnings. Today’s required return is equal to the
earnings-price ratio only if the required return is con
stant through time, or if by chance future variations
offset each other and lead the average to equal the
current value. A second difficulty is that observed earnings-price ratios reflect the stock market’s expectation
of future corporate growth. A low earnings-price ratio
could therefore be the result of optimistic growth expec
tations rather than low costs of equity finance. In any
Chart 2
Price-Earnings Ratios for the United States
and Japan
Percent
Table 3
Price-Earnings Ratios for the United States
and Japan, 1975-1990
Year
United States
Japan
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
11.8
11.2
9.1
8.2
7.5
9.6
8.2
11.9
12.6
10.4
15.4
18.7
14.1
12.9
14.8
15.9
25.2
22.0
19.3
21.5
16.6
17.9
24.9
23.7
29.4
26.3
29.4
58.6
50.4
54.3
53.7
36.6
Source: French and Poterba (1991a, Table 6 ). U.S. price-earnings
ratios are taken from Standard & Poor's 500 index of actively
traded stocks; Japanese ratios are from the Nomura Research
Institute s 350 index of actively traded stocks.
o l— L.. I.
I
1975
77
I
I
79
I
I
81
I I
83
I
I
85
I
I
87
I
I
89 90
Source: Kenneth R. French and James M. Poterba, "Were
Japanese Stock Prices Too High?" Journal of Financial
Economics, forthcoming.
FRBNY Q uarterly R eview/W inter 1991
25
case, the resulting earnings-price ratio must be cor
rected for expected growth differentials to compare
required returns across countries.
A more practical objection to measuring equity
returns with earnings-price ratios is that these ratios
cannot be com pared in tern ation ally because of
accounting factors. Most studies relying on earningsprice information make some corrections to numbers
reported by corporations; the United States-Japan
comparison illustrates the type of corrections needed.
Consolidation of subsidiary earnings. Until the
mid-1980s, Japanese firms usually reported parent
company earnings, excluding the profits of wholly and
partly owned subsidiaries. Since more than half of the
shares on the Tokyo Stock Exchange are owned by
other traded corporations (see French and Poterba
1991a), omission of the retained earnings from partly
owned firms can substantially affect reported earnings.
This generates a downward bias in the earnings-price
ratio as a measure of required returns, since the stock
market will recognize the value of intercorporate equity
holdings but earnings will not reflect the relevant cash
flow. This problem can be corrected by inflating earn
ings (the approach in McCauley and Zimmer 1989a) or
by removing the value of intercorporate holdings from
the estimate of share value (French and Poterba 1991a).
Depreciation. In Japan, firms use the same deprecia
tion lifetimes in computing tax and accounting earnings.
In the United States, accounting depreciation is typ
ically slower than that for tax purposes. The same
project, if accounted for by a Japanese and an Ameri
can firm, would therefore show different earnings flows
in the two nations. The estimated return in Japan would
be lower in the early years of the project, when Jap
anese depreciation would exceed that in the United
States, and higher in later years, when the Japanese
firm would have fully depreciated the asset. These
accounting disparities need to be corrected in making
any comparison of earnings-price ratios across coun
tries. Ando and Auerbach (1990) and McCauley and
Zimmer (1989a) convert depreciation for both Japan
and the United States to an economic replacement-cost
basis; French and Poterba (1991a) try to restate Jap
anese depreciation on U.S. accounting principles.
Inflationary effects on earnings. Inflation has many
distorting effects on corporate earnings. It interacts with
nominal accounting conventions to make reported
accounting earnings a relatively poor proxy for eco
nomic profits. If nations have different inflation rates, or
even the same inflation rate but different investment
histories, then reported accounting earnings will be
differentially biased.
Ando and Auerbach (1988a, 1988b, 1990) and
McCauley and Zimmer (1989a) try to correct accounting
26
FRBNY Quarterly Review/Winter 1991
earnings for inflationary errors. This involves restating
depreciation allowances in terms of asset replacement
cost rather than historical cost, subtracting spurious
profits on goods in inventory sold at nominal prices that
exceed the nominal acquisition price by much more
than the real sales price exceeds the real purchase
cost, and estimating real rather than nominal interest
outlays. The relative importance and net effect of these
corrections on U.S. and Japanese accounting earnings
vary through time. The inflation rate in Japan was
higher than that in the United States during the 1970s,
but lower in the mid-1980s. In the 1970s, however, the
greater leverage of Japanese firms made the inflation
ary misstatement due to nominal interest rates more
important than that in the United States.
Other factors must be considered in correcting earn
ings-price ratios across nations, such as the treatment
of reserve accounts in Japan and the disparate proce
dures for funding retirement plans in different countries.
The factors discussed above, however, are the most
important ones.
After correcting earnings-price ratios for the various
considerations noted above, the ratios for Japan still
appear lower than those for the United States. Lower
earnings-price ratios in one country do not necessarily
signal lower required returns, since the disparity could
be due to differential growth expectations. One crude
way to assess the importance of the latter effect relies
on estimates of long-term real GNP growth published by
macroeconomic forecasting firms. These show average
Japanese long-term growth rates of approximately 4
percent per year, compared with values of approxi
mately 2.5 percent per year for the United States. Even
if discount rates were identical, one would therefore
expect lower earnings-price ratios in Japan than in the
United States. This is not a large enough growth dispar
ity, however, to account for the differences in earningsprice ratios, nor are there any striking changes in the
expected growth rate in the mid-1980s when the Jap
anese market soared.6 This evidence consequently
points toward lower required equity returns in Japan
than in the United States, particularly in the late 1980s.
Estimates of required returns based on market earnings-price ratios can change substantially in relatively
short time spans. This has occurred during the last year
with the sharp decline in the value of the Japanese
stock market. The earnings-price ratio in Japan has
risen by more than one-third since December 1989,
indicating a possible rise in required returns.
®This discussion draws on French and Poterba (1991a), which also
presents data on macroeconomic forecasts.
Estimates based on historical profit rates
A third approach to measuring required returns, one
which is related to the earnings-price calculations,
involves measuring the rate of return on corporate
assets— the profit rate. Rather than scale accounting
earnings by a market-based measure of asset values
such as the total value of outstanding equity, this
approach divides by an estimate of the replacement
value of the firm’s capital stock. It suffers from all the
difficulties of international comparisons that are associ
ated with earnings-price ratios, with the additional diffi
culty that data on the replacement value of assets are
not readily available and, when available, are often
estimated in different ways for different nations. Never
theless, computing the ex post profit rate can provide
some evidence on the level of required returns.
Sustainable growth analysis
A fourth approach to estimating the cost of equity, used
by Hatsopoulos (1983) and Hatsopoulos and Brooks
(1987), involves estimating the sustainable growth rate
for dividends that could be achieved by reinvesting
current earnings without altering debt policy. By adding
the sustainable growth rate to the current dividend
yield, this approach provides another estimate of the
required return on equities. Since this method is ulti
mately based on historical rates of return, not surpris
ingly it suggests that the cost of equity in Japan is lower
than that in the United States.
Can the costs of equity differ?
This survey of previous work suggests that several
different methodologies point to a similar conclusion:
the cost of equity has been lower in Japan than in the
United States for most of the last two decades.7 Just as
it was appropriate to ask if international differences in
real interest rates could persist over long periods, one
can ask whether arbitrage by investors and firms can
eliminate disparities in expected equity returns. There
are at least three reasons to suspect that differential
equity returns can persist.
First, structural factors may lead to fundamental dif
ferences in the riskiness of U.S. and Japanese firms.
Intercorporate share ownership in Japan and the signifi
cant role of banks in corporate finance affect firm
behavior and may cushion investors from particularly
adverse outcomes at a given firm.8 This would suggest
TThe earlier discussion suggested that because of the limited data
span, it is probably not possible to reject the hypothesis of similar
required equity returns in the two nations. The test being applied in
such cases, however, has extremely low power to detect deviations
because there is so little data.
•Hoshi, Kashyap, and Scharfstein (1990) provide evidence of the
resilience of investment and sales at “keiretsu" firms during
that even if the price of a particular type of security
market risk were equated in Japan and the United
States, the “real riskiness” of the Japanese corporate
sector would be lower and therefore would command a
lower total risk premium.
Second, the rapid increase in Japanese land prices
during the 1980s may (until recently) have provided a
ready source of collateral for Japanese corporate bor
rowing.9 The value of land holdings for Japan’s nonfinancial corporate enterprises rose from ¥ 2 5 6 .3 trillion
at the end of 1985 to ¥ 4 7 8 .2 trillion at the end of
1988— an appreciation of between $1.5 trillion and $2
trillion, depending on which exchange rate is used.10
This sharp rise in collateral value may have lowered
equity costs in recent years; it would not provide an
explanation for any lower equity costs in the 1970s and
early 1980s.
Finally, it is possible that the strong assumptions of
integrated world capital markets are inappropriate. Jap
anese investors are less well informed about U.S. than
about Japanese equities and may therefore prefer hold
ing domestic shares, even if the expected return on U.S.
equities is somewhat higher (see French and Poterba
1991b). As for the arbitrage by corporate suppliers of
equity, U.S. firms may face constraints on their ability to
issue equity in Japanese markets. Japanese investors
may convey low-cost capital to Japanese firms but not
to U.S. firms traded in Tokyo (whose shares are pri
marily traded and priced in New York).
One explanation of the difference in equity costs that
does not appear to explain the U.S.-Japanese case is
high turnover in the U.S. stock market. Table 4 shows
the turnover rates on the New York and Tokyo stock
exchanges during the years 1985-89. Turnover rates in
Tokyo exceed those in New York in some years. When
one recalls that the Tokyo market includes very sub
stantial blocks of cross-held shares that trade infre
quently, the implied turnover rate for the “in play”
shares is significantly higher than that in New York.
Weighting the costs of debt and equity: corporate
leverage rates
The results in the last two sections suggest that the
cost of debt may have been lower in Japan than in the
Footnote 8 continued
economic downturns, suggesting that financial practices affect real
behavior.
®Kashyap, Scharfstein, and Weil (1990) provide some evidence that
Japanese firms with greater land holdings have exhibited higher
investment rates during recent years. This evidence is consistent
with, although not definitive support for, the collateral explanation.
10Economic Planning Agency, Annual Report on National Accounts,
1990 (Tokyo: Economic Planning Agency).
FRBNY Quarterly Review/Winter 1991
27
United States until the early 1980s. The cost of equity
has been lower for most of the last two decades but
particularly in the late 1980s. The net effect on the cost
of capital depends on the relative weights placed on
debt and equity in the two nations. These debt-equity
ratios have not remained fixed over time but have
changed significantly during the last two decades.
There are several measures of the debt-equity ratio of
a firm or corporate sector. Although managers usually
focus on the ratio of book debt to the book value of
equity, this measure fails to capture the significant
swings in the relative prices of debt and equity securi
ties. The more natural measure is therefore the market
value of debt divided by the market value of equity.
Table 5 and Chart 3 show the recent history of an
imperfect measure of debt-equity ratios for nonfinancial
firms: the ratio of the book value of long- and short-term
debt to the market value of corporate equity.
The central conclusion to be derived from Table 5 is
that Japanese debt-equity ratios were significantly
higher than their U.S. counterparts in the early 1980s,
but that they have declined while U.S. leverage has
remained stable or, if anything, increased.11 In 1985, the
Japanese debt-equity ratio was 1.3 to 1, compared with
.67 to 1 in the United States. By March 1989, rising
Japanese share prices had reduced the ratio of book
debt to market equity to .55 in Japan, while the corre
sponding figure for the United States was still approxi
mately .67.
The convergence of U.S. and Japanese leverage was
due to two factors. First, U.S. nonfinancial corporations
repurchased nearly $100 billion in equities each year
between 1985 and 1990. Chart 4 shows the net secu" A n d o a n d A u e rb a c h (1 9 8 8 b ) re p o rt e s tim a te s of th e b o o k d e b t-to m a rk e t e q u ity ra tio fo r th e p e rio d s in c e 1970, a n d th e ir d a ta
s u g g e s t re la tiv e ly little v a ria tio n in e ith e r n a tio n d u rin g th e y e a rs
b e fo re 1985
Table 4
Turnover Rates for U.S. and Japanese
Equity Markets
Chart 3
Debt/Market Equity Ratios for U.S. and
Japan Corporations
(In Percent)
Year
New York Stock Exchange
Tokyo Stock Exchange
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
36
33
42
51
49
54
64
73
55
52
50
50
35
44
43
48
75
96
98
73
Percent
140 ----130
120
110
Sources: Column 1 data are drawn from the New York Stock
Exchange Fact Book; column 2 data are from the Tokyo Stock
Exchange Fact Book.
\
\
\
\
~~ \
100 ------------
\
Japan
\ ---\
90
_\ _
\
Debt-Equity Ratios (x100) for U.S. and
Japanese Nonfinancial Corporations
Year
United States
Japan
1985
1986
1987
1988
1989
1990
66.9
66.6
73.0
73.7
66.5
77.1
132.7
100.7
65.9
60.1
54.8
65.8
Source: U.S. data are drawn from the Board of Governors of the
Federal Reserve System, Balance Sheets of the U.S. Economy,
1990 edition. Japanese data are from Daiwa Analysts Guide, 1989
edition. Estimates show the ratio of the book value of corporate
long- and short-term liabilities to the market value of corporate
equity.
28
FRBNY Q uarterly Review/W inter 1991
Sources: Board of Governors of the Federal Reserve System,
Balance Sheets of the U.S. Economy. 1990; Daiwa Analysts
Guide. 1990.
Notes: Chart shows ratios of the book value of corporate longand short-term liabilities to the market value of corporate equity.
Japanese data are from end-March. U.S. data for 1985-89 are
from end-year; for 1990, from end-September.
rity issues during this period, with large equity pur
chases, both direct repurchases and takeover acquisi
tions, matching substantial debt issues in recent years.
Only rising equity values prevented the debt-equity ratio
from rising sharply during this period. Second, the rapid
increase in Japanese share values during the 1980s
was not matched by escalating debt values or debt
issue. Consequently, the debt-equity ratio of Japanese
firms on a market value basis declined during the
period.
Taxation and sum mary measures of the cost of
capital
The least controversial part of most cost of capital
studies is the treatment of tax incentives for new capital
investment. There is broad consensus both on the
approach to analyzing tax considerations and on the
underlying tax code provisions that are important. Dif
ferent studies have reached different conclusions, how
ever, regarding the net effect of tax provisions on the
relative costs of capital, primarily because of different
auxiliary assum ptions. This section sketches the rele
vant tax parameters— the statutory corporate tax rate
and the net tax-induced reduction in the price of capital
goods— then notes their values through time and
explains how they affect the cost of capital. It concludes
by presenting complete estimates of the cost of capital
from several different studies.
Tax param eters
The statutory tax rate affects the pretax returns that
firms must earn, other things equal, to satisfy their
owners. The magnitude of this effect depends on the
fraction of the corporation’s profits that are subject to
corporate tax, that is, on the relative importance of debt
and equity finance.
The generosity of tax depreciation schedules, includ
ing the availability of investment credits, is another key
aspect of the tax code. To provide a unifying framework
for comparing different depreciation schedules, most
economic analyses focus on the present discounted
value of tax depreciation benefits, given by
(3) ITC +t z =ITC + £ Tt+k*dt+k/(1 +p)k,
where Tt+k is the tax rate prevailing k years after the
investment is made, dt+k is the value of depreciation
allowances (per dollar of initial investment) that the firm
is allowed to claim, and p is the nominal discount rate
applied by investors to cash flows with the risk charac
teristics of depreciation benefits. The value of invest
ment allowances thus depends on the rate at which the
future tax savings are discounted, as well as the stat
utory corporate rate. Higher tax rates make a given set
of deductions more valuable.
The net effect of raising the corporate tax rate thus
depends on the time path of depreciation allowances
and the discount rate applied to these tax benefits. If
these depreciation benefits were worth one dollar (z = 1
and ITC = O), then changes in the corporate tax rate
would have no e ffe ct on the cost of capital: the after-tax
cost of a one-dollar project would be reduced, just as
the after-tax return from the project would fall. Only
when the value of depreciation allowances falls below
one dollar does raising the corporate tax rate increase
the cost of capital.
The tax parameters in both the United States and
Japan have shifted significantly during the last decade.
Table 6 presents the values of each tax component for
the beginning and end of the decade. The first column
shows the statutory corporate tax rate in each nation,
with the U.S. rate falling from 50 percent, including
federal as well as state taxes, at the beginning of the
1980s to 38 percent at the decade’s end. By compari
son, Japanese corporate tax rates are higher: the net
tax rate was 53 percent in 1980 and remained at 50
percent at the decade’s end.
The second column in Table 6 shows the depreciation
benefits accruing to a firm that invests in general indus
FRBNY Q uarterly Review/W inter 1991
29
Table 6
Tax Parameters in Cost of Capital Calculations
Japan
Parameter
United States
1980
1988
1980
1988
526
.499
.495
.380
Autos
465
.473
.534
.333
Industrial plant
.250
.355
.166
.142
Statutory corporate tax rate
Present value of tax reduction for new investment
Source: Bernheim and Shoven (1989, Table 5).
trial equipment, as well as industrial plant, in the two
nations. Although the tax lifetimes in the two nations are
similar, the tax benefits for the two examples of projects
given here are greater in Japan. The reason is that in
the late 1980s the discount rate applied to the cash
flows is lower, and the statutory tax rate to which the
deductions apply, higher, in Japan. The net effect of
U.S. tax policies during the 1980s was to lower
depreciation benefits by extending lifetimes, phasing
out the investment tax credit, and reducing the statutory
marginal tax rate. Consequently, these changes
brought about an increase in the cost of capital.
Most studies of capital costs have argued that tax
provisions in Japan are similar to those in the United
States and that therefore relatively little of the cost of
capital differential can be attributed to tax considera
tions. Bernheim and Shoven (1989) point out, however,
that similar tax provisions operating in different eco
nomic environments can yield different tax incentives.
Summary costs of ca pita l
Relatively few studies have made complete estimates of
the cost of capital, although many have examined its
components. Table 7 presents three sets of estimates
from studies using different methodologies to assess
U.S. and Japanese capital costs. The table shows the
estimated capital cost in 1980 for each study, as well as
the estimate for the most recent year available.
The studies compute somewhat different capital
costs; Hatsopoulos and Brooks estimate an average
cost of all capital services, McCauley and Zimmer the
cost of capital for a plant investment with a twenty-year
lifetime, and Bernheim and Shoven the cost of capital
for an industrial plant. In addition, the strategies for
estimating the cost of equity vary; Hatsopoulos and
Brooks use the sustainable growth method, while
Bernheim-Shoven and McCauley-Zimmer use estimates
based on adjusted earnings-price ratios.
Despite these differences in approach, all of the stud
ies conclude that the cost of capital is significantly
higher in the United States than in Japan. The precise
30
FRBNY Q uarterly R eview/W inter 1991
Table 7
Estimated Costs of Capital for the
United States and Japan
Study
Year
United States
(Percent)
Japan
(Percent)
1980
1985
14.1
9.7
4.0
3.8
1980
1988
11.5
11.2
8.8
7.2
1980
1988
18.7
11.1
11.0
4.1
Hatsopoulos-Brooks
McCauley-Zimmer
Bernheim-Shoven
Source: Hatsopoulos-Brooks values are estim ated by the author
from Figure 9 of Hatsopoulos-Brooks (1987) and correspond to
the cost of fixed asset services (before depreciation). McCauleyZimmer estimates are drawn from Table 2 of McCauley-Zimmer
(1989b) and correspond to the cost of a twenty-year plant.
Bernheim-Shoven estimates are drawn from Table 6 of BernheimShoven (1989).
magnitudes differ, with Hatsopoulos and Brooks finding
the largest differential (10 percentage points) in 1980,
compared with only 2.7 percentage points in McCauley
and Zimmer’s study. In more recent years, the results
suggest a cost of capital differential of approximately
5 percentage points between the two nations.
Conclusion and possible policy levers
Many different factors bear on a nation’s cost of capital.
This survey of previous work comparing the cost of
capital in the United States and Japan suggests that
differential costs of equity are the single most important
explanation of apparent cost of capital differences.
Many institutional and economic differences between
the two nations may contribute to this disparity— in
particular, Japan’s higher saving rate, less burdensome
taxation of equity returns, and greater flexibility in
spreading corporate risk.
Because the cost of capital depends on many param
eters, a wide range of policies can be used to affect it.
Several possibilities are indicated below.
Changing investm ent incentives is probably the most
direct way for policy makers to affect capital costs. An
investment tax credit, for example, reduces the cost of
capital and can be targeted to affect only some classes
of assets. While much of the discussion leading up to
the Tax Reform Act of 1986 stressed the need for a
“level playing field,” treating all assets equally for tax
purposes, some have argued that particular asset
classes should be subsidized because of their high
social returns.12 This is the basis for the research and
development tax credit, as well as subsidies to lowincome housing. The major disadvantage of more gen
eral investment incentives is their significant revenue
cost. To remedy this problem, policy makers might con
sider more revenue-efficient subsidies, such as “incre
mental” investment tax credits on a firm’s investment
above some history-based target.
The tax treatm ent of investors is a second obvious
source of policy leverage on the cost of capital. The
analysis above treated the pretax returns demanded by
debt and equity investors as fixed. These returns may
vary, however, with the tax treatment accorded to differ
ent securities. The lower pretax required return on taxexempt debt in contrast to taxable bonds rather clearly
12D e L o n g a n d S u m m e rs (1 99 0 ) s u g g e s t th a t e q u ip m e n t in ve stm e n t
y ie ld s p a r tic u la rly h ig h s o c ia l re tu rn s a n d th e re fo re w a rra n ts s u b s id y
b e y o n d o th e r c la s s e s of c a p ita l g o o d s . They p re s e n t in te rn a tio n a l
e v id e n c e s h o w in g th a t n a tio n s th a t e n c o u ra g e e q u ip m e n t in ve stm e n t
b y k e e p in g th e re la tive p ric e of e q u ip m e n t low g row m ore ra p id ly
th a n n a tio n s w ith h ig h e r e q u ip m e n t p ric e s .
demonstrates that investor-level taxes affect required
returns. In this regard, a change in the tax treatment of
dividends— for example, by reducing shareholder taxes
with an integration system— would reduce capital costs.
Similarly, a capital gains tax reduction would lower the
pretax return demanded on equities. A particularly costeffective form of capital gains reduction, from the stand
point of reducing the cost of capital, would follow the
Japanese experience and apply very low tax rates to
capital gains on corporate equities while taxing gains
on other assets at relatively high rates.13
Raising national saving is a third strategy for reduc
ing the cost of capital. Higher national saving would
expand the supply of saving relative to demand, lower
required returns on both debt and equity, and ultimately
reduce capital costs. While the direction of this effect is
clear, the magnitude of the cost of capital reduction
from a given saving increase is again controversial.
With partially integrated world capital markets, part of
any increase in domestic saving will flow abroad,
thereby blunting the effects on domestic required
returns. Although historical evidence suggests a rather
strong association between domestic saving and
domestic investment rates, international capital markets
have become much better integrated during the last
decade, and the leakage effects are therefore probably
larger today than in the past.
13The net e ffe c t of c a p ita l g a in s ta x re d u c tio n on c a p ita l c o s ts is
c o n tro v e rs ia l. W hile few d o u b t th a t low e r ta x ra te s w o u ld low e r
c a p ita l c o s ts , th e re is less a g re e m e n t on th e s iz e of th e e ffe c t.
S in c e m a n y g a in s on c o rp o ra te s to c k are re a liz e d lo n g a fte r th e y
a c c ru e , o r neve r fa c e ta x b e c a u s e of b a s is s te p -u p at d e a th , th e
e ffe c tiv e c a p ita l g a in s ta x ra te is s ig n ific a n tly lo w e r th a n th e
s ta tu to ry rate.
References
Ando, Albert, and Alan J. Auerbach. 1988a. “The
Cost of Capital in the United States and Japan:
A Comparison.” Journal of the Japanese and
International Economies 2: 134-58.
_______ 1988b. “The Corporate Cost of Capital in
Japan and the United States: A Comparison.” In
John B. Shoven, ed., Government Policy Toward
Industry in the United States and Japan
(Cambridge: Cambridge University Press).
_______1990. “The Cost of Capital in Japan:
Recent Evidence and Further Results.” Journal
of the Japanese and International Economies
4: 323-50.
Aron, Paul. 1981. Are Japanese PIE Multiples Too
High? Daiwa Securities America, New York.
_______1988. Japanese P/E Multiples: The
Shaping of a Tradition. Daiwa Securities
America, New York.
Baldwin, Carliss. 1986. “The Capital Factor: Com
peting for Capital in the Global Environment.” In
Michael Porter, ed., Competing in Global Indus
tries (Boston: Harvard University Press).
Bernheim, B. Douglas, and John B. Shoven. 1987.
“Taxation and the Cost of Capital: An International
Comparison.” In Charles E. Walker and Mark A.
Bloomfield, eds., The Consumption Tax: A Better
Alternative? (Cambridge: Ballinger Publishing).
FRBNY Q uarterly R eview/W inter 1991
31
References (continued)
_______ 1989. “Comparison of the Cost of Capital
in the United States and Japan: The Role of
Risk and Taxes.” Stanford University, Center for
Economic Policy Research, mimeo.
_______1990b. “The Role of Banks in Reducing
the Costs of Financial Distress in Japan.”
National Bureau of Economic Research, Working
Paper no. 3435.
Boone, Peter, and Jeffrey Sachs. 1989. “Is Tokyo
Worth Four Trillion Dollars? An Explanation for
High Japanese Land Prices.” Harvard University,
unpublished paper.
Ibbotson Associates. 1990. Stocks, Bills, Bonds,
and Inflation: 1990 Yearbook. (Chicago).
Brazzell, D., A. Robbins, G. Robbins, and
PC. Roberts. 1986. The Cost of Capital in the
United States and Japan (Washington: Institute
for Political Economy).
DeLong, J. Bradford, and Lawrence H. Summers.
1990. “Equipment Investment and Economic
Growth.” Harvard University, mimeo.
Fama, Eugene, and Kenneth French. 1988. “Divi
dend Yields and Expected Stock Returns.”
Journal of Financial Economics 22: 3-27.
Frankel, Jeffrey. 1989. “Quantifying International
Capital Mobility in the 1980s.” National Bureau of
Economic Research, Working Paper no. 2856.
French, Kenneth R., and James M. Poterba. 1991a.
“Were Japanese Stock Prices too High?" Journal
of Financial Economics. Forthcoming.
_______ 1991b. “Investor Diversification and Inter
national Equity Markets.” American Economic
Review. Forthcoming.
Hatsopoulos, George N. 1983. High Cost of
Capital: Handicap of American Industry
(Washington: American Business Conference).
Hatsopoulos, George N., and Stephen H. Brooks.
1986. “The Gap in the Cost of Capital: Causes,
Effects, and Remedies.” In R. Landau and
D. Jorgenson, eds., Technology and Economic
Policy (Cambridge: Ballinger Publishing).
_______ 1987. “The Cost of Capital in the United
States and Japan.” Paper presented at Interna
tional Conference on the Cost of Capital,
Harvard University, Kennedy School of Govern
ment, November 19-21, 1987.
Hoshi, Takeo, Anil Kashyap, and David Scharfstein.
1990a. “Corporate Structure, Liquidity, and Invest
ment: Evidence from Japanese Panel Data.”
Quarterly Journal of Economics. Forthcoming.
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Kashyap, Anil, David Scharfstein, and David Weil.
1990. “Land Holdings and Investment by
Japanese Firms.” Massachusetts Institute of
Technology, mimeo.
Kester, W. Carl, and Timothy A. Luehrman. 1989.
“Real Interest Rates and the Cost of Capital: A
Comparison of the United States and Japan.”
Japan and the World Economy 1: 279-301.
______ 1990. “The Price of Risk in the United
States and Japan.” Harvard Business School,
mimeo.
King, Mervyn A., and Don Fullerton, eds. 1984.
The Taxation of Income from Capital (Chicago:
University of Chicago Press).
McCauley, Robert N., and Stephen Zimmer. 1989a.
“Explaining International Differences in the Cost
of Capital.” Federal Reserve Bank of New York
Quarterly Review 14.2: 7-28.
_______1989b. “Explaining International
Differences in the Cost of Capital: The United
States and United Kingdom versus Japan and
Germany.” Federal Reserve Bank of New York,
Research Paper no. 8913.
McKee, M.J., J.J.C. Visser, and P.G. Saunders.
1986. “Marginal Tax Rates on the Use of Labor
and Capital in the OECD Countries.” OECD
Economic Studies 7: 45-101.
Mishkin, Frederic S. 1984. “Are Real Interest Rates Equal
Across Countries?” Journal of Finance 39:1345-57.
Shoven, John B., and T. Tachibanaki. 1988. “The
Taxation of Income from Capital in Japan.” In
J.B. Shoven, ed., Government Policy Toward
Industry in the United States and Japan
(Cambridge: Cambridge University Press).
U.S. Department of Commerce, International Trade
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the Cost of Financial Capital in France, the
Federal Republic of Germany, Japan, and the
United States (Washington, D.C.: Government
Printing Office).
Bank Cost of Capital and
International Competition
by Steven A. Zimmer and Robert N. McCauley
The rising share of U.S. corporate loans booked by
foreign-owned banks and the withdrawal of U.S. banks
from foreign lending (Chart 1) raise concerns about the
competitiveness of U.S. banks. The increasing fraction
of U.S. banking assets controlled by foreign banks is
paralleled by the rising share of U.S. manufacturing
assets or employment under the control of foreign
firms.1 Unlike U.S. banks, however, U.S. manufacturing
and commercial firms are not retrenching their foreign
operations.2 U.S. banks, then, are lagging U.S. indus
trial firms in international competition as measured by
asset growth.
This contrasting performance may reflect some
unique features of U.S. banking law and the very differ
ent profitability of banks’ and corporations’ foreign oper
ations. A fundamental economic force may also be at
work. If a relatively high cost of capital burdens both
U.S. banks and industrial firms but figures more criti
cally in financial than in industrial competition, then it is
understandable that U.S. banks might lag their indus
trial counterparts.
This article investigates how capital costs may have
contributed to the declining competitiveness of U.S.
’ Only in the rare industry such as chemicals, however, have foreign
firms reached the one-third share achieved by foreign banks in U.S.
corporate lending. See Ned G. Hownestein, “U.S. Affiliates of
Foreign Companies: Operations in 1988," Survey of Current
Business, vol. 70 (July 1990), pp. 127-43.
2Raymond J. Mataloni, "U.S. Multinational Companies: Operations in
1988,” Survey of Current Business, vol. 70 (June 1990), pp. 31-53.
This paper was presented on December 6, 1990, at the Federal
Reserve Bank of New York Colloquium on the Cost of Capital in the
United States.
banks. We compare capital costs facing commercial
banks in different industrial countries to determine
whether U.S. banks are in fact operating at a disadvan
tage. In addition, we seek to identify the factors that
account for differences in the cost of capital and explore
some of the implications of these disparities.
Our analysis reveals that Japanese banks enjoy a low
cost of capital, German and Swiss banks face a moder
ate cost of capital, and U.S., U.K., and Canadian banks
confront a high cost of capital. These differences can
be traced to shareholders’ valuations of bank earnings
in different equity markets. In effect, shareholders allow
banks from different countries to price their services at
different levels. What appears, then, to a banker with
dem anding s h a re h o ld e rs as ra zo r-th in m argins
designed to win market share may appear to another
banker with less exacting shareholders as a fully priced
transaction. We illustrate this point by calculating the
capital costs for three different financial products: a
straight corporate loan, a commitment to lend, and an
interest rate swap.
Differences in bank cost of capital may arise from
differences in national saving behavior, macroeconomic
stabilization policies, industrial organization, financial
policies, and taxes. Taxes can exert a more important
effect on bank cost of capital than on industrial cost of
capital, but they do not account for the differences
observed. Stronger official safety nets for foreign banks
may serve to cheapen subordinated debt and equity
costs.
The cost of capital differences assert themselves
forcefully in wholesale lending. In addition to the broad
shift of market share in lending to U.S. corporations
from U.S. banks to foreign banks shown in Chart 1,
FRBNY Quarterly Review/Winter 1991
33
country-by-country gains by foreign banks argue for the
importance of capital costs. The foreign banks with the
greatest capital cost advantage have increased their
market share most, while the foreign banks with little or
no capital advantage have showed scant if any gains.
Moreover, in the market for credit enhancement for
commercial paper and municipal bonds, where equity
capital costs are even more critical than in corporate
lending, foreign banks have left even less of the market
for U.S. banks. Banks with a cost of capital disadvan
tage experience particular difficulty competing in lowrisk and low-value-added products since they have less
potential to offset their disadvantage through lower
labor and overhead costs, better production economies,
and better risk management and assessment.
We begin by defining the cost of capital for banks as
the fee or net spread between bank borrowing and
lending rates that a financial product must generate in
order to increase the market value of the bank. While
usage of the term “cost of capital” in reference to banks
varies, our focus on a required spread (or fee) has much
Chart 1
Market Shares in Bank Lending
Percent
4 0 ----------------- ----------------------------- .---------------------------- -----------
U.S. Bank Share of Cross-Border Loans to Nonbanks
to recommend it in a world of multicurrency lending and
off-balance sheet banking. Since an international
standard on bank capital limits a bank’s ability to lever
age up its equity, a bank’s cost of capital is largely
determined by the value that the stock market assigns
to a bank’s earnings and, to a lesser extent, by the risk
premium paid on its subordinated debt.
Defining the cost of capital
The cost of capital for banks differs from the cost of
capital for industrial firms in two key respects. First, the
cost of equity facing a bank assumes paramount impor
tance, despite the fact that banks are more highly lever
aged than commercial firms. Second, if the international
accord on required capital ratios for banks binds at the
margin, the equity required for a given project is readily
quantified.
The p rim acy of equity
A bank’s cost of capital for a financial product is the
spread or fee that allows the required regulatory capital
to earn the rate of return demanded by the market. If a
bank prices a product below its cost of capital, the bank
inflicts a loss on its shareholders.
Over two years ago, bank regulators from the major
industrial countries established international regulatory
constraints on bank pricing.3 The so-called Basle
Agreement requires banks from 1992 to hold 4 percent
tier 1 capital, or shareholder equity, and 4 percent tier 2
capital, including subordinated debt, against riskweighted assets. In the discussion below, we concen
trate first on the more important tier 1 capital— hence
forth referred to as equity.
While regulation sets a minimum on equity required
for a bank product, the market determines the cost of
that equity. A simple example illustrates how bank man
agers assess the cost of equity from the market. Sup
pose that bank managers are weighing a proposed
corporate loan. For simplicity, assume that the credit
committee judges the contemplated loan to pose much
the same risks as the bank’s other assets.4 Bank man
agement should issue new equity to support the loan if
doing so promises at least to maintain the market value
3Com m ittee on Banking R egulations and S upervisory P ractices, Bank
for International Settlem ents, “ International C onvergence of C apital
M easurement and C apital S tand ard s," July 1988, in Raj Bhala,
Perspectives on R isk-B ased C apita l (R olling Meadows, III.: Bank
A dm inistration Institute, 1989), A ppe ndix, pp. 193-235.
4See A ppe ndix C for the effects of relaxing this assum ption.
Sources: Bank for International Settlements; Federal Financial
Institutions Council, Reports of Condition: Federal Reserve;
Federal Reserve Bank of New York staff estimates.
Note: 1989 datum is estimated.
34
FRBNY Q uarterly R eview/W inter 1991
sThe bank may raise new eq uity through retained ea rning s or free up
equity by asset sales. The cost of such eq uity is tan tam o unt to the
cost of new issuance if we interpret the ba n k’s action as forgoing
repurchase of its shares.
of its outstanding shares.5 For the share issuance not to
lower the bank’s share price, the return on the new
equity devoted to the contemplated loan must be at
least as great as the profit rate on the bank’s existing
equity. The profit rate is defined as after-tax earnings
divided by market value of equity.
Of course, making the loan runs up operating and
other expenses. Thus the spread on the loan must be
wide enough so that once labor costs, physical capital
costs, expected loan d efault losses, and other
expenses are accounted for, the after-tax earnings on
the loan stand in the same relation to the allotted equity
as overall bank earnings bear to the market value of the
bank’s outstanding shares. The net (after expenses)
spread required to generate this required equity return
is the bank’s cost of capital for the loan.
Suppose the stock market consistently assigns a
bank a share price twenty times earnings, and therefore
bank management takes its required profit rate to be 5
percent. In considering a loan of average risk, the
bank’s managers would require that the loan return an
annual profit of 5 percent on the 4 percent portion of
equity allotted to it. This is equal to an after-tax return
of 20 basis points on the value of the loan. If national
and local taxes claim 50 percent of earnings, the bank
needs a pretax net spread of 40 basis points just to
cover its equity costs. Thus, the bank’s cost of capital
for a corporate loan is 40 basis points.
The role of debt
If banks may leverage every dollar of equity with $25 of
assets, it may seem strange that the cost of capital as
defined does not include the cost of debt financing—
except the cost of subordinated debt in tier 2 capital. It
should be recognized at the outset that off-balance
sheet products such as letters of credit, commitments to
lend, and interest rate swaps require equity to support
them, in proportions set by the Basle Agreement, but no
funding with debt. Interest rates have no direct bearing
on the financial cost of these products to a selling bank.
We neglect deposit funding costs even for loans or
other funded products because internationally active
banks from different countries competing in the same
market tend to fund themselves at similar interest rates
at the margin. Under normal circumstances, one inter
nationally active bank will pay much the same as
another for deposits in London and other wholesale
markets. Acquiring and holding even low-cost consumer
deposits entail promotional and operating costs that
tend to raise marginal costs to wholesale funding lev
els. Banks compete on the basis of the markup they
charge over their cost of borrowed funds.
We readily concede that banks tend to enjoy a slight
home-court advantage in selling deposits in their home
currencies and in their home markets. Since the homecourt advantage is often misunderstood, however, the
following sections compare debt costs in the United
States and Japan and consider whether low real inter
est rates at home actually help banks.
Debt costs and competition in U.S. commercial lend
ing. Foreign banks ordinarily pay a 10-basis-point pre
mium on their Yankee (foreign bank) certificates of
deposit or purchased federal funds. Indeed, in late 1990
some foreign banks paid considerably more for endyear funding. If a foreign bank pays an extra 10 basis
points— about 6 basis points after tax— on 24/25ths of
its liabilities, it needs a 146-basis-point advantage in
cost of equity on the last 1/25th (4 percent) just to pull
even with its U.S. competitors.6
In the U.S. corporate loan market in particular, how
ever, it is by no means clear that large U.S. banks have
consistently enjoyed such a home-court advantage in
wholesale funding. Although foreign banks have had to
pay a premium to raise dollars in the United States,
they may well have enjoyed a funding advantage in
lending to U.S. firms in the late 1980s. Until December
1990, a U.S. bank had to hold a 3 percent Eurodollar
reserve against funds raised in the Eurodollar market if
the bank’s home
; had net obligations to the
bank’s foreign brai ll/l I C O . A 3 percent reserve was also
required on large certificates of deposit issued by U.S.
offices. Consequently, once the bank had brought
money into the United States from its foreign branches
on a net basis, it faced no reserve incentive for raising
funds offshore as opposed to onshore. A U.S.-chartered
bank could not get around the reserve requirement by
booking a loan to a U.S. corporation offshore because
such loans were included in the computation of the
required Eurodollar reserve. But since the consolidated
reporting required to enforce this provision was not
available for foreign banks’ branches and agencies
operating in the United States, they could avoid the
Eurodollar reserve requirement by booking a loan to a
U.S. firm offshore.
As long as the large U.S. certificate of deposit rate
remained well below the London Interbank Offered Rate
(LIBOR), the Eurodollar reserve requirement did not
work to the disadvantage of U.S. banks. But as the
United States drew in funds from the international bank
ing system to finance its current account, domestic
rates rose relative to offshore dollar rates. By mid-1987
a foreign bank able to borrow at LIBOR with no reserve
to fund a loan to a U.S. corporation could regularly
• 9 6 {10 * (1— .39)} = ,04*X, where .39 represents combined federal,
state, and local taxes. Solving for X, we have X = 146.4.
7See "Revision of Regulation D ,” Federal Reserve Bulletin,
September 1980, pp. 758-73.
FRBNY Quarterly Review/Winter 1991
35
access cheaper funding than a U.S. bank choosing
between issuing a reservable domestic certificate of
deposit or bidding for a reservable Eurodollar deposit
(Chart 2, shaded area). Data reported to the Bank for
International Settlements by industrialized countries
show that offshore claims on U.S. nonbanks reported by
foreign banks grew from $48 billion at end-1984 to $189
billion at end-1990 and to $194 billion by mid-1990.8 The
Eurodollar reserve requirement may have been neces
sary for monetary control, but its uneven application
surrendered some portion of the home-court advantage
possessed by U.S. banks in borrowing dollars.
D ebt costs and com petition in Japanese com m ercial
lending. The U.S. Treasury has argued that deposit
regulation has put foreign banks operating in Tokyo at a
disadvantage. Japanese banks have funded themselves
with (a falling proportion of) consumer deposits carrying
low, regulated interest rates, while foreign banks do not
have access to such funds. The practice of average cost
pricing on corporate loans has tended to pass through
the benefit of regulated rates to corporate borrowers
and to make foreign banks particularly uncompetitive.9
8Bank for International Settlem ents, International Banking and
F in ancial M arket D evelopm ents; and Federal Reserve Bulletin,
various issues, Table 3.14.
9As the Treasury notes, "Loan charges are based in part on the
blen ded co st of funds to dom estic institutions, which continue to be
below those of foreign ba nks.” Such p ricin g casts do ubt on the
Do low real interest rates at home help? In competing
to offer borrowers narrow spreads over the cost of
borrowed funds, a bank from a country with lower inter
est rates, whether or not adjusted for inflation, has no
direct advantage over banks from a country with higher
real interest rates. In this respect, competition among
banks differs from competition among industrial expor
ters, which gives the edge to those with access to
cheap money at home. A bank that borrowed in a lowinterest currency to lend in a high-interest currency
could expose itself to enormous risks. Only indirectly
can low real interest rates at home help by showing up
as cost of equity differences, but such differences are
captured in our cost of capital measures.
The cost of equity
The return on a financial product has to be high enough
to cover the required profit rate on the equity allotted to
it. This required profit rate is best conceived of as the
profit rate the bank can expect to sustain in the long term.
C onceptual problem s
Although long-term sustainable profit rates cannot be
Footnote 9 con tin u e d
notion that Japanese banks reap extraordinary profits from che ap
deposits at home that can be used to finance expansion abroad.
U.S. D epartm ent of the Treasury, N ational Treatment S tudy
(W ashington: G overnm ent Printing Office, 1990), p. 218.
Chart 2
Cost of the Eurodollar Reserve Requirement and the Spread between Adjusted CD Cost and LIBOR
Basis points
60
-80
1981
1982
1983
1984
1985
1986
Note: CD cost is adjusted for FDIC insurance cost and reserve requirement of 3 percent.
36
FRBNY Q uarterly Review/W inter 1991
1988
observed, we can observe prevailing profit rates and
adjust them to render them comparable across coun
tries. Before explaining these adjustments, however, we
consider three potential problems in using current profit
rates as proxies for long-term profit rates— growth,
cyclicality of profits, and undercapitalization.
Profitability. If investors expect a bank’s profitability to
rise, its current profit rate understates its true cost of
equity because investors are paying up for earnings not
yet in evidence. Thus, new firms perceived to have
extraordinary growth potential and therefore priced at
high multiples of current earnings are generally not
thought to enjoy particularly low cost of equity. One
must distinguish between growth in profits and growth in
profitability, however. A bank’s profits may grow simply
because the bank reinvests a high proportion of its
earnings or it issues new shares in volume. Growth in
profitability requires more earnings from a given amount
of capital and would have to result from a change in
market structure, a change in cost structure, or other
fundamental changes not easily achieved.
Japanese and U.K. banks’ earnings prospects may
raise the issue of profitability growth. In the United
Kingdom, the entry of building societies into main
stream banking and the maturation of the consumer
credit business point to lower bank earnings in the
future; in Japan, deposit deregulation signals a reduc
tion in profits for banks. In these instances, current
profits overstate future profits and cost of equity is
overstated. But if Japanese banks have, as some claim,
pursued a market share strategy abroad with a view
toward eventually raising spreads, then current profit
rates may understate the cost of equity. Since these
growth considerations are clearly difficult to quantify
and, in the case of Japan, work in offsetting directions,
no adjustment is made for growth in computing the cost
of equity, although the possibility of the need for such
an adjustment is recognized.
Cyclicality of profits. The second problem with using
current profit rates as a measure of the cost of equity
arises from the cyclicality of profits. If a firm is having a
bad year, its profits do not proxy future profits well. The
stock market may recognize a temporary downturn and
price the shares of the firm in anticipation of higher
future profits. In this case the current profit rate would
understate the cost of equity.
The cyclicality of profits represents a significant the
oretical shortcoming of the use of profit rates to mea
sure the cost of equity. In practice, however, the
cyclicality of profits is not problematic because of two
factors: the behavior of bank managers and the behav
ior of the equity market.
Bank managers, like most corporate managers, gen
erally seek to smooth reported profits because equity
markets tend to reward steady profitability. Bank man
agers command a considerable array of devices to
smooth reported profits, including setting reserves and
recognizing capital gains on, for instance, real estate. If
managers approximate current profits to sustainable
profits by realizing gains in bad years and not doing so
in good years, then stated profits may represent long
term earnings better than one might otherwise think.
A second factor mitigating the measurement prob
lems associated with the cyclicality of profits is the
apparent short-term horizon of most equity markets. If a
firm has an unusually poor year, then equity markets
might be expected to recognize that profits will recover
in the future and to price the equity accordingly. In
reality, equity markets appear to price shares largely on
current performance. Evidence for this observation can
be found in the fact that price-earnings ratios tend to be
either noncyclical or even procyclical.10
Undercapitalization. Cost of equity can easily be
overstated for an undercapitalized bank. If asset losses
reduce a bank’s equity to levels below international
capital standards, the bank must reduce assets or issue
new equity. A bank with $100 billion in assets but only
$2 billion in equity, for instance, faces the choice of
raising $2 billion in equity to meet the Basle standard or
selling off $50 billion in assets. If new equity is issued,
the current shareholders will share current earnings
with the new owners; if assets are reduced, the current
shareholders will lose the income earned by the assets.
In either case, earnings per share are set to decline.
Investors for their part should recognize the impending
dilution of their claim or asset shrinkage and value the
share in anticipation of reduced earnings per share. As
a result, the current earnings in relation to market cap
italization of an undercapitalized bank will tend to over
state its cost of equity.
The market value of a poorly capitalized bank is
reduced for two reasons other than anticipated asset
shrinkage. First, a poorly capitalized bank is riskier
because it is highly leveraged. Second, the loss of
value on a portion of a bank’s assets raises questions
about management. The effect of anticipated asset
reduction on the market value of the bank is almost
certainly greater than these other two effects since it
represents a first-order effect— reduction in future prof
its— as opposed to just an increase in volatility of profit,
a second-order effect. Thus, while it is often said that
an undercapitalized bank has a high cost of equity
because of its riskiness, it is probably more correct to
say that the appearance of a higher cost of equity will
10Robert N. McCauley and Steven A. Zimmer, “Explaining International
Differences in the Cost of Capital: the United States and United
Kingdom versus Japan and Germany," Federal Reserve Bank of
New York, Research Paper no. 8913, August 1989.
FRBNY Quarterly Review/Winter 1991
37
change as such a bank adjusts assets to equity.
M easuring the co st of equity
Reported profits of banks cannot be directly compared
across countries because of different accounting prac
tices, different economic conditions, and the interaction
of the two. We make four separate adjustments to
Table 1
Banks in Sam ple (by Country)
Japan
United States
Bank A m erica C orporation
Bankers Trust New York
C orporation
Chase M anhattan C orporation
C hem ical B anking C orporation
C iticorp
First C hicag o C orporation
J.P M organ and C om pany
M anufacturers Hanover
C orporation
S ecurity Pacific C orporation
Canada
Bank of M ontreal
Bank of Nova Scotia
C anadian Im perial Bank of
C om m erce
Royal Bank of C anada
Bank of Tokyo
D ai-lchi Kangyo Bank
Fuji Bank
Industrial Bank of Japan
Long-Term Credit Bank of
Japan
M itsubishi Bank
Sanwa Bank
Sumitomo Bank
M itsubishi Trust and Banking
Mitsui Trust and Banking
Sumitomo Trust and Banking
United Kingdom
B arclays
Lloyds Bank
M idland Bank
National W estminster Bank
Switzerland
C redit Suisse
Swiss Bank C orporation
Union Bank of Sw itzerland
Germany
C om m erzbank
D eutsche Bank
D resdner Bank
stated profits: an adjustment for the differential treat
ment of developing country debt by banks across the
different countries, an adjustment to impose equity
accounting on shares held by Japanese and German
banks, an adjustment for the interaction of growth and
inflation with banks’ net nominal asset position, and an
adjustment for discrepancies between stated deprecia
tion charges and economic depreciation.
The income data adjusted are taken largely from the
annual reports of banks in the sample. The banks in the
sample are listed in Table 1. Summary measures of the
adjustments appear in Table 2.
L o a n lo s s r e s e r v e s fo r d e v e lo p in g c o u n tr y
exposures. Losses on assets introduce greater difficulty
in measuring a sustainable profit rate for a bank than for
an industrial firm. When an industrial firm writes down
assets, appraisers can refer to next best use or even
scrap values. Valuing a substandard loan, by contrast,
requires a judgment of the borrower’s capacity to pay as
well as any collateral asset value. Bank stock analysts
as a result make larger errors in forecasting earnings
than industrial stock analysts.
One can adjust for asset quality problems by lowering
earnings over time after a problem becomes evident, as
banks generally do and as we do below. As an alter
native, one may restate earnings between the booking
of an ultimately problematic loan and the emergence of
the problem, so that an ex post appropriate reserve is
built up beforehand.
The banks in this study all have significant claims on
developing countries that have restructured their debts,
and all have reported lower profits as a result of making
Table 2
Sum m ary of Adjustm ents to Cost of Equity
(P ercentage Point A djustm ents)
.
.
Period Averages
1984-90
D eveloping cou ntry
C ross-holding
D epreciation
Net nominal assets
Total
U nited
States
Japan
United
K ingdom
4.95
0
-1 .5 1
-1 .1 6
- 0 .1 8
1.50
- 0 .0 5
- 0 .1 5
0.60
0
- 2.88
- 0 .2 3
2.28
1.13
- 1 2 .9 3
- 7 .6 3
-5 .5 9
54.19
- 1 2 .7 9
20.06
- 0 .7 3
-0 .7 1
-0 .7 2
- 0 .2 4
0.15
0.17
0.32
- 0 25
C anada
Germ any
S w itzerland
0.86
0
- 1 .3 9
- 1.10
0
1.53
-0 .6 4
-0 .6 7
0
0
- 0 .3 9
-0 .4 1
- 2 .5 1
- 1 .6 3
0.22
-0 .8 0
- 6 .4 6
- 3 .2 4
- 1 .4 7
7.44
- 1.00
8.32
-1 1 .9 1
- 6 .8 5
-3 .8 1
18.61
0.07
8.47
D eveloping C ountry
Year by Year
1984
1985
1986
1987
1988
1989
1990
38 forFRBNY
Digitized
FRASERQ uarterly Review/W inter 1991
provisions for possible losses. The extent of reserving
or charging-off of such developing country loans varies
by country and by bank— with the extremes ranging
from less than 50 percent reserved to 100 percent
reserved. Part of the difference in reserving against
losses reflects differences in portfolio composition, and
thus performance, and differences in bank commitment
to the relevant markets. Quite apart from such differ
ences in composition and bank strategies, however,
bank managements have reserved in accordance with
their own outlook for servicing and with national norms,
regulation, and taxation.
Increases in loan loss reserves reduce profits: banks
that have reserved heavily against restructured develop
ing country loans report, all other things being equal,
lower profits than banks that have not reserved as
heavily. To render bank profits more comparable, we
attempt to impose a uniform profile of reserving against
such loans. Reported profits are lowered in years that
banks have reserved less than is indicated by the uni
form profile; conversely, reported profits are raised in
years that banks have reserved more than is warranted.
Although only uniform treatment of restructuring
country exposures permits a comparison of bank earn
ings and thus of cost of equity for banks in the late
1980s, no definitive benchmark for reserving is avail
able. We set the uniform reserve ratio by end-1989
toward the high end of international usage to reflect our
understanding of German and Swiss practice. This
approach is the most practical, because standards of
disclosure for German and Swiss banks make it very
difficult to restate their accounts to any other standard.
In our adjustment we restate profit flows as if the
reserves were taken on an after-tax basis; that is, we
assume that the bank gets a full tax break on all
reserves. In reality the tax authorities in some coun
tries, notably the United States and Japan, have not
generally allowed their banks to reserve on an after-tax
basis (see equations, Appendix A). The effect of
national differences in tax treatment of developing
country reserves is often overstated: if losses are in the
event realized on such portfolios, U.S. and Japanese
banks share their losses with their respective govern
ments; if the loans provided against ultimately perform,
additional income will be recognized and taxes will be
paid. Thus, differences in tax treatment will ultimately
prove to be differences of timing. The time value of early
deductibility of potential loan losses is not trivial, but it
should be noted that transactions such as debt-equity
swaps serve to bring forward tax benefits.
The decline in the dollar since 1985 has tended to
shrink the developing country debt problem for foreign
banks. Because most of the claims on restructuring
countries were denominated in dollars, successive
rounds of reserving have cost foreign banks less. For
instance, reserving against 5 percent of their troubled
country claims cost eight Japanese banks an average
of 27 percent of their net income in the year to March
1985. After the yen appreciated from 250 to the dollar in
March 1985 to 124 in March of 1988, however, reserving
against 10 percent of the same banks’ restructuring
country exposure cost them only 31 percent of their net
income. The importance of the dollar-yen exchange rate
to Japanese banks was underscored by market reports
of Japanese banks’ bidding for $1.3 billion to cover the
loss of dollar assets entailed in the exchange of Vene
zuelan debt in December 1990.11
Cross-held shares. Banks in Japan, Germany, and
Switzerland hold substantial equity stakes in commer
cial and industrial firms. The dividends from these
shareholdings contribute to a bank’s income, but the
retained earnings associated with the shares do not.
Retained earnings show up in earnings only when cap
ital gains are harvested through the sale of shares.
Haphazard realization of capital gains can misstate
income quite seriously. A bank may go for extended
periods without realizing capital gains on its shares in
order to delay payment of taxes. In this case the profits
of the bank would be understated. We hold that, for the
correct statement of income, retained earnings associ
ated with bank shareholdings should be consolidated
with the bank’s income. In other words, retained earn
ings associated with shareholdings, as well as divi
dends actually received, contribute income in the long
term.
We correct for this problem in two steps. The first step
is to subtract from after-tax income the after-tax capital
gains from equity realizations. The second step is to
add the retained earnings associated with the shares
(less effective income tax on the earnings) to after-tax
income. For Japanese banks, the retained earnings
rates used are taken from our earlier estimates for
nonfinancial firms and reflect all other adjustments to
stated profits (see equation in Appendix A).12
Although such an adjustment serves consistently to
narrow the differences between price-earnings ratios of
Japanese and U.S. industrial firms, it bears on the
comparison of Japanese and U.S. banks in a markedly
different way. Japanese banks traditionally resembled
other Japanese firms in leaving long-held shareholdings
on their books at cost. As a result, their profit on sale of
equity holdings fell well short of the retained earnings
11Konosuke Kuwabara, “Dealers See Dollar Staying Close to the Level
of ¥ 1 3 2 ,” Japan Economic Journal, December 22, 1990, p. 22.
12Robert N. McCauley and Steven A. Zimmer, “Explaining International
Differences in the Cost of Capital," Federal Reserve Bank of New
York Quarterly Review, vol. 14 (Summer 1989), pp. 7-28.
FRBNY Quarterly Review/Winter 1991
39
associated with their shareholdings. As the shape of the
international agreement on capital adequacy became
clearer, however, Japanese banks stepped up their real
ization of gains on long-held shares, reportedly by sell
ing and repurchasing shares so as not to disturb the
pattern of cross-shareholdings.13 City banks in particu
lar stepped up their realizations since they had farther
to go to meet the Basle standard. By 1988 and 1989,
capital gains on shareholdings exceeded the retained
earnings associated with cross-held shares by a wide
margin and also accounted for a large portion of pretax
income (Chart 3).
Thus, the dormancy of Japanese city banks’ share
holdings into 1987 understated their earnings, but
heavy turnover in the three years to March 1990 over
stated earnings. Churning of the equity portfolio in
these years masked weak earnings and built up share
holders’ equity.14 We hypothesize that bank managers
13R obert Zielinski and N igel Holloway, U nequal Equities: Power and
Risk in J a p a n ’s Stock M arket (Tokyo: Kodansha International, 1991),
p. 187.
'♦R ecognition of the real w eakness of Japanese banks’ earnings for
five years is key to any assessm ent of the cost of equity through
accepted the tax costs of realizing the gains in order to
show enough earnings growth to market their equity in
quantity.
German banks appear to have realized gains on their
holdings of equities in the late 1980s much less often
than Japanese banks. So, even though the fraction of
German equities held by German banks represents only
about half the fraction of Japanese equities held by
Japanese banks,15 adjusting for cross-held shares
Footnote 14 con tinued
the a n ticip ated d ivide nd yield. Any growth in d ivid e n d s for the last
five years does not proxy earnings growth but instead represents a
rise in the effective payout ratio. For an a p p lica tio n of the
a n ticip ated d ivide nd m ethod that co n clu d e s that the required return
for Japanese banks is higher than that for U.S. banks, see Jack
Glen and Richard H erring, “ P/E M ultiples: C om parative E vidence for
Japan and the U nited S tates,” U niversity of Pennsylvania, A ugust
1990 (processed).
15A ccord in g to C laudio E.V. Borio, Leverage an d F inancing o f N onFinancial C om panies: An Interna tiona l Perspective, Bank for
International Settlem ents, Econom ic Paper no. 27, May 1990, p. 30,
German banks hold 8 pe rcent Germ an shares, although da ta on
pa rticip a tio n s in unlisted firm s are not available; Japanese banks
hold 17 pe rcent of Japanese shares. The sha reholdings of the
German banks may be more concentrated in the three sample banks.
Chart 3
Japanese Bank Earnings from Cross-held Shares
Billions of yen
3 5 0 -------------------------------------------------------------------------------------------------------------------------------------------------------------Profit on sale of
I
I Retained earnings associated
I
I Reported pretax
equity holdings
I
] with cross-held shares
|_____ | income
3 0 0 --------------------------------------------------------------------------------------------------------------------------------------------------------------
□
2 5 0 _______________________ Reported pretax income adjusted
for cross-held shares
Sources: Profit on sale of equity holdings is from Nikkei Newsletter on Bond and Money for 1988,1989, and 1990 and from Federal Reserve Bank
of New York staff estimates for previous years; pretax income is from annual reports; retained earnings associated with cross-held shares are
Federal Reserve Bank of New York staff estimates.
Notes: Chart plots averages of six city banks and two long-term credit banks. Results for the six months to September 1990 are doubled.
40
FRBNY Q uarterly Review/W inter 1991
boosts the cost of equity as much for German banks as
for Japanese banks in our sample period.
Swiss banks hold shares as well, but their standards
of disclosure render it very difficult to know how much
their reported incomes should be adjusted. Unlike Jap
anese banks, Swiss banks serve as market makers in
their domestic stock markets, so they turn over at least
some of their shares enough to realize capital gains and
thereby to show retained earnings on shareholdings in
their income statements. Moreover, because Swiss
firms pay out more of their earnings than Japanese
firms, the omission of retained earnings on crossheld
shares produces less downward bias in earnings.
A first glimpse of the hidden wealth of a Swiss bank
permits estimates to be made of the understatement of
earnings and thus the cost of equity for Swiss banks.
Union Bank of Switzerland disclosed hidden reserves of
2 billion Swiss francs at the end of 1989, as compared
with reported shareholders’ equity of 10.6 billion Swiss
francs without the newly disclosed amount. The
sources Of income on the hidden reserves reported by
the bank for 1989 connect the reserves to the bank’s
shareholdings: “premium income received from the
exercise of conversion rights and warrants as well as
the dividends on shares reserved for warrants.”16
Three different ways of assessing the understatement
of earnings associated with these heretofore unac
knowledged post-tax retained earnings yield strikingly
similar results.17 Whether our estimates of the cost of
equity are biased downward by undisclosed income of
Swiss banks depends on the degree to which investors
incorporate the hidden income in the price that they are
willing to pay for the shares. If they have paid for hidden
income, then our estimates understate the cost of
equity by about 1 percentage point for Swiss banks.
Inflation-related adjustments. Adjusting stated profits
to eliminate inflation effects will reveal a sustainable real
rate of return. The first adjustment aligns the different time
profiles of returns on real and nominal assets. A second
adjustment removes the portion of a bank’s earnings that
simply maintains the real value of the shareholders; stake.
Without the latter adjustment, Brazilian banks finish first in
the bank profit league. In reality, income runs just to keep
16Union Bank of Switzerland, Annual Report, 1989, p. 22.
17UBS reported that the hidden reserves generated income in 1989
that amounted to 1.0 percent of the bank’s market capitalization at
end-1989 and 0.7 percent after taxes. If the heretofore undisclosed
reserves grew at the 10 percent average annual growth rate shown
by assets from 1979 to 1989, then undisclosed income would have
ranged from 0.6 percent to 1.2 percent of market capitalization in
1984-89 and averaged 0.9 percent for the period. If the hidden
reserves instead grew in line with reported shareholders' equity,
then undisclosed income would have ranged from 0.4 percent to 1.3
percent in 1984-89 and averaged 0.9 percent of market
capitalization.
equity in place.
To see why the first adjustment is necessary, compare the
income flows from a nominal and a real asset in inflation. A
portion of the income flow from a nominal asset such as a
bond merely compensates for the inflationary erosion of the
real value of the principal. The income flow from a real asset
such as real estate or equity represents a real return since
inflation does not on average erode the value of the principal
over time.
If a nominal liability funds a real asset of equal value held
for two years in an environment of steady inflation and no
asset price risk, then accounting flows at first understate
income and then overstate income. In year one, the servic
ing cost of the nominal liability exceeds the receipt from the
real asset by the inflation rate, and the position produces a
loss. At the end of year two, however, the sale price of the
real asset has increased with two years? worth of inflation
and so exceeds the cost of retiring the nominal liability. This
gain from inflation overwhelms the net servicing cost in the
second year, and net income is reported. The investment
shows no net profit over the two years, and indeed the
theoretical net income each year is zero.
No problem arises with steady inflation and no asset
growth. Inflationary gains on real assets find their way into
the income statement either at sale or as the returns on the
assets grow with inflation. As a bank grows, however, or as
inflation varies, profits are misstated.
The effects of varying inflation and asset growth depend
on the balance sheet of the bank. U.S., U.K., and Canadian
banks tend to have more nominal assets than nominal
liabilities; that is, they hold net nominal assets. German,
Japanese, and Swiss banks, holding larger shares of real
assets such as equities or leasable assets, have more
nominal liabilities than nominal assets. This contrast reflects
the different banking traditions: strictly commercial banking
in the English-speaking countries as against a combination
of commercial and industrial banking in the continental and
Japanese economies, which industrialized later. Because of
these differences, U.S., U.K., and Canadian banks tend to
overstate profits if inflation rises or assets grow, while the
other banks tend to understate profits under these
circumstances.
The adjustment for the different time profiles of nomi
nal and real assets takes two steps. To adjust for the
misstatement of profit owing to shifting inflation, we
subtract from stated earnings the product of the net
nominal assets and the difference between the prevail
ing inflation rate and an average of the inflation rates
over the life of the bank’s real assets. To adjust for
growth, we subtract from stated earnings the product of
the inflation rate and the change in the net nominal
position (see Appendix A for equation).
The second adjustment is both simpler and more
important. With inflation, a bank’s equity must grow with
FRBNY Quarterly Review/Winter 1991
41
the price level just to maintain its real value. The portion
of a bank’s retained earnings that suffices to hold con
stant the real value of shareholder equity does not
contribute to real sustainable profits. Failing to reduce
profits accordingly biases upward the apparent required
profit rates of banks in high-inflation countries.
This adjustment is required only for that portion of
shareholders’ equity in excess of the bank’s depreciable
assets.18 As described below, the adjustment for the
difference between economic and stated depreciation
accounts for the cost of maintaining the real value of
assets subject to depreciation. So shareholders' equity
less depreciable assets is multiplied by the inflation
rate, and the product is subtracted from stated profits
(see Appendix A for equation).
D e p re c ia tio n a d ju s tm e n t. Stated depreciation
charges differ from true depreciation for two reasons.
Because depreciation is taken on the historical cost of
the physical asset instead of its replacement cost,
accounting depreciation charges understate true
depreciation costs in an inflationary environment. In
addition, the depreciation rates allowed for tax pur
poses may differ from physical depreciation rates.
To correct for the inflation bias, we first infer the age
distribution of the bank’s physical assets from past
depreciation rates and then mark them to current prices
by using cumulative gross national product price
deflators. Depreciation on the repriced physical assets
is substituted for the depreciation taken on the histor
ically priced assets.
For U.K. banks, corrections were made to reflect the
low depreciation rates on buildings in the 1980s that
resulted from earlier tax provisions practically allowing
the cost of buildings to be treated as an expense. For
Japanese banks, corrections were also made to offset
accelerated depreciation on some bank buildings.
Results
The cost of equity for banks over the sample period
1984-90 varies markedly across countries (Chart 4).19 In
interpreting the figures, one should focus on period
averages more than single years because the estimate
can be biased for any given year in isolation. This is
especially true for 1984 and 1985, when our adjustment
for developing country reserves sharply reduces
adjusted profits for U.S., U.K., and Canadian banks. For
1984-90 as a whole, equity markets in the United
States, United Kingdom, and Canada burden banks
with required returns of around 10 percent. German and
Swiss banks face moderate equity costs in the 6 per
cent range, while Japanese banks enjoy very low equity
costs of 3 percent.
Japanese bank share prices fell sharply in 1990, but
Japanese banks’ cost of equity remained low by interna
tional standards. The decline of Japanese bank share
prices in the first quarter of 1990 only served to restore
the cost of equity to its level of a year before. The
further decline of Japanese share prices through Sep
tember 1990, in conjunction with a half-year of flat
reported earnings, raised the cost of equity by 1 per
centage point in September to 3.1 percent. Even at this
level, Japanese bank equity costs remained low in
absolute or relative terms. The recovery of Japanese
bank share prices in the fourth quarter brought down
the cost of equity estimated for end-year. In retrospect,
the decline in the cost of equity for Japanese banks in
1987-89 is somewhat surprising since bank stocks
peaked in 1987 and have regularly underperformed the
Chart 4
Cost of Equity for Banks
P e rc e n t
Period A verages (percent)
United States
Japan
Germany
United Kingdom
Canada
Switzerland
United States
United Kingdom
Canada
/ Germany
18For an approach that does not acco unt for depreciable assets, see
William M. Peterson, “ The E ffects of Inflation on Bank Profitability,"
in R ichard G. Davis, ed., Recent Trends in Com m ercial Bank
P rofitability (New York: Federal Reserve Bank of New York, 1986),
pp. 89-114.
19Data for U.S., U.K., Swiss, and German banks are from endDecem ber, 1984-90: data for Japanese banks are end-M arch,
1985-90; data for C anadian banks are from end-O ctober, 1984-90
Income data are pa rtia lly estim ated for 1990. Results for the United
States and Britain do not includ e measures for Bank of A m erica
and M idland, respectively; both banks’ real an d nom inal assets were
shrinking over much of the sam ple period.
42
FRBNY Q uarterly Review/W inter 1991
\
Switzerland
1984
Source: Federal Reserve Bank of New York staff estimates.
market since. The apparent inconsistency of falling
share prices and falling cost of equity is resolved by
noting both the weakness of earnings apart from capital
gains and the substantial issuance of new shares.
The cost of lower tier 1 and tier 2 capital
The Basle Agreement permits internationally active
banks to mix a variety of forms of capital with share
holders’ equity in meeting the overall capital require
ment of 8 percent against risk-weighted assets. Tier 1
capital can include not only common equity but also
certain preferred shares. Qualifying as tier 2 capital are
instruments and balance sheet items at the border of
equity and debt: long-term preferred shares, revaluation
reserves, general loan loss reserves, debt securities to
be retired with equity, perpetual debt, and subordinated
debt.
The following sections examine the cost of tier 1
preferred shares, tier 2 preferred shares, loan loss
reserves, and subordinated debt. Tier 1 preferred
shares appear quite cheap by comparison with common
equity, although there may only be a market for these in
New York. Over time, subordinated debt is likely to
supplant loan loss reserves as tier 2 capital; national
differences in subordinated debt costs suggest the
importance of official support of banks to investors in
bank capital instruments.
The cost of tier 1 preferred shares
Preferred shares are somewhat less costly than equity.
This cost advantage reflects the lower risk and, in the
United States, the exclusion of most preferred share
dividend income from corporate taxation.
To qualify as tier 1, preferred shares must satisfy a
stringent standard that has made them relatively rare in
banking: they must be noncumulative. In other words, if
a bank reaches the point where it eliminates its com
mon share dividend and then eliminates its preferred
share dividend as well, it does not promise to make
good on the skipped preferred share dividend when and
if it resumes paying dividends.
Barclays successfully marketed tier 1 preferred to
U.S. investors in the summer of 1989 at a yield quite low
by comparison with bank common equity costs. The
yield to investors on the $180 million issue was 9.2
percent, and the cost to Barclays, payable out of post
tax income, was 8.2 percent.20 This latter cost is com
parable to subordinated debt costing 3.6 percent above
LIBOR and implies a required spread on a corporate
2°The wedge is introduced by the combination of the refundability
under the U.S.-U.K. tax treaty of the Advance Corporation Tax,
which integrates British corporate and investor income taxes, and
the same treaty's withholding tax of 15 percent (B arclays Bank PLC:
P rospectus Supplem ent, May 4, 1989, p. S3).
loan of roughly a quarter of that implied by British
banks’ cost of common equity.21 It is little wonder that
British banks are said to be looking to maximize the tax
efficiency of such issues.22
An important advantage to a British bank of such
equity is that it protects the bank’s capital adequacy
from exchange rate fluctuations 23 When the pound ster
ling approached parity with the dollar at the end of
1984, British banks with very substantial dollar books
watched their assets rise in relation to their sterling
equity. With equity in dollars, dollar appreciation works
to raise the sterling value of both assets and equity, so
that the ratio of the two is more stable.
If noncumulative preferred shares are marketable in
the United States but not abroad, foreign banks may
enjoy an advantage over U.S. banks in hedging their
capital adequacy. In the absence of a market for non
cumulative preferred shares in nondollar currencies,
U.S. banks could protect their capital adequacy from
dollar depreciation only by taking a long position in the
foreign currency. Such a position has the drawback,
however, of introducing variability in earnings and cap
ital even as it stabilizes the capital-asset ratio (see
Box, p. 50).
The cost of tier 2 preferred shares
The development of the market for variable-rate pre
ferred shares in New York provided banks with relatively
inexpensive tier 2 preferred, at least under normal cir
cumstances. For instance, on December 21, 1989, Mor
gan auctioned $250 million of cumulative preferred for
periods of forty-nine to seventy-seven days with an
interest rate of 6.75 percent 24 This yield, payable out of
after-tax net income, was equivalent to a deductible rate
of about 2.4 percent above three-month LIBOR. The
problem with auction-rate preferred, as some banks
learned in 1990, is that under adverse circumstances,
the bank can face the choice between watching the
21The pretax, floating-rate equivalent cost to Barclays was 3.6 percent
over LIBOR by the following calculation: R /(1 -t)- L , where
R ( = 8.156 percent) is the post-tax cost of preferred shares, t
(= 35) is the British corporate tax rate, and L ( = 8.91) percent is
the fixed-rate yield that can be swapped against LIBOR. Leveraged
up twenty-five times, the required spread to cover this tier 1 equity
would be about 17 basis points.
22Simon London, "Basle to Decide on Preference Capital," Financial
Times, January 23, 1991, p. 15.
23Brian Pearse, Barclays’ finance director, commented that "this issue
as dollar-denominated capital will help insulate us— as a sterlingbased bank— if the dollar suddenly appreciates further" (see John
Evans, "Barclays to Issue Preferred Shares in US To Boost Capital,
Reduce Currency Risk," Am erican Banker, May 9, 1989, p. 3).
24J. P. Morgan, A nnual Report, 1989, p. 47.
FRBNY Quarterly Review/Winter 1991
43
auction fail, paying a high rate, or retiring the preferred
shares.
The co st of general loan loss reserves
From some banks, general loan loss reserves will be
very expensive; for others, they will be essentially cost
less. An addition to loan loss reserves usually comes at
the expense of retained earnings, a component of
shareholders’ equity. As a result, the cost of general
loan loss reserves may be taken to be as high as the
cost of equity. (If a general loan loss reserve can be
established out of pretax funds, then its cost is reduced
by the time value of the early receipt of a tax reduction.)
To the extent that a bank reserves for reasons other
than meeting capital requirements (for instance, if reg
ulators compel the bank to raise nonspecific reserves or
if bank managers are simply underscoring their over
capitalization), then the reserves do not represent a
marginal capital cost to the bank.
The cost of subordinated d eb t
The cost of subordinated debt varies systematically with
the bond market’s perception of the strength of a bank.
Indicators of such strength include the ratings assigned
by rating agencies. Plotting the yields (in relation to
LIBOR) of fixed- and floating-rate notes in the Eurobond
market and fixed-rate notes of U.S. banks trading in the
U.S. corporate bond market highlights the premium that
investors demand for accepting subordinated status
(Chart 5). Nevertheless, four cautions are in order in
interpreting these observations: ratings are not univer
sally accepted as indications of bank strength, as evi
Chart 5
Subordinated Debt Costs, November 1990
Spread over LIBOR
(Deutsche mark)
Sources: Association of International Bond Dealers; International Financing Review: Morgan Securities; Morgan Stanley.
Notes: For fixed rate bonds and notes, spreads over LIBOR equivalent to spreads over Treasury yields were calculated using appropriate midpoints
of interest rate swap rates. Horizontal placement of observations within rating class reflects subdivisions of rating classes and any split in rating
by agencies.
44
FRBNY Q uarterly Review/W inter 1991
denced even by disagreements between rating agen
cies; yield information reflects indications by marketmakers, rather than transaction prices; secondary mar
ket yields do not necessarily reflect rates obtaining on
new issues; and these yields reflect a particular market
environm ent, rather than an average of market
environments.25
These qualifications aside, do banks from some
countries enjoy an advantage in raising subordinated
debt over banks from other countries? It appears that
foreign banks’ subordinated debt costs do not rise as
quickly in response to lower ratings as the costs of U.S.
banks. In Chart 5, foreign bank costs suggest a flatter
curve than that described by U.S. banks’ costs.
If foreign governments offer banks stronger support,
then investors in bank bonds do not bear as much risk.
(This interpretation is only strengthened by Ihe rating
agencies’ practice of factoring into their ratings their
perception of relations between banks and govern
ments.) Since Continental Illinois, U.S. policy has regu
larly permitted bondholders of failed banks to take
losses; foreign governments, by contrast, maintain
ambiguous policies in this matter. In addition, banks
with strong links to their industrial customers, including
shareholdings, may enjoy a built-in market for subordi
nated debt that holds down debt costs at higher risk.
If these subordinated debt costs are taken to be
representative of tier 2 capital costs, then tier 2 costs
add anywhere from 1 basis point to 10 basis points to
the equity cost of making a corporate loan. (Subordi
nated debt is capped at 50 percent of tier 1 capital but
may account for 100 percent of tier 2 capital at the
margin for some banks.) If a bank has to pay a pretax
premium of 25 basis points for subordinated debt, then
with a tier 2 requirement of 4 percent (1/25th) for a
corporate loan, the bank needs to build another basis
point into the loan spread before taxes. If a bank has to
pay 200 basis points over LIBOR on its subordinated
paper, it needs to charge an additional 8 basis points
more before taxes to cover its tier 2 debt costs.
Cost of capital for financial products
Once bank managers have calculated their cost of
equity, they can work out the spread or fee they must
charge on individual products to cover their equity
costs. If bank managers can identify the marginal
source or relevant mix of tier 2 capital, then they can
add its cost to the spread or fee needed to cover the
cost of equity. Tier 2 capital costs are not included in
capital costs as reported below.
“ November 1990 was by no means a typical market environment for
subordinated bank debt, but the sale by Japanese banks of
subordinated debt in late summer 1990 permitted a wider set of
observations.
The Basle Agreement has set the risk weight for each
product as follows:
Product
Weight
Corporate loan
100 percent
Commitment to lend 50 percent
Interest rate swap
5 percent of notional
amount plus
100 percent of positive
mark to market value
These weights mean that a corporate loan absorbs
shareholders’ equity at the rate of 4 cents on the dollar,
a commitment to lend absorbs at a rate of 2 cents per
dollar, and an interest rate swaps absorbs 0.2 cents per
dollar of contract initially. Given anticipated interest rate
movements, the effective weight on the interest rate
swap is more than double the initial weighting, so a
bank should price a swap as if it absorbs 0.4 cents of
equity.26
Cost of capital formulas for funded and unfunded
products
Armed with an estimate of the cost of equity, the overall
requirement of 4 percent equity, Basle risk weights, and
corporate income tax rates, the bank manager can
roughly calculate the required spread. The spread actu
ally charged must be high enough so that, after the bite
of income tax, the required return on the allotted equity
is covered:
(1) spread * (1-tax rate) = cost of equity
*
or S * (1 - t c t) = COE * RW * 0.04.
risk w
Consider a corporate loan. If the tax rate is 40 per
cent and the cost of equity is 10 percent, then the
required spread for the full weight loan would be 0.67
percent, or 67 basis points: spread * ( 1 - 0 .4 ) = 10 * 1.0
* 0.04.
In reality, the determination of the cost of capital is
slightly more complex because the bank is funding 4
percent of the loan with shareholder equity. The pay
ment to equity is therefore the spread on the loan plus
the real (net of inflation) after-tax return earned by
investing the shareholder equity in a riskless asset. If
the bank earns a positive (negative) real after-tax return
from the investment of shareholder equity, then the
required spread on its loans is narrowed (widened).
“ The bank should anticipate an average amount of capital it will
have to hold against the swaps. This average value reflects several
different factors, including the volatility of interest rates, the length
of the swap, and the term structure of interest rates. We estimate
the average risk weighting of the ten-year interest rate swap to be
11 percent.
FRBNY Quarterly Review/Winter 1991
45
Although the more complete equation looks quite
different27 the results are similar. If we assume the
same parameters as earlier, and in addition assume an
inflation rate of 5 percent and a riskless rate of 8
percent, then the required spread on the loan would be
71 basis points. A variation of this calculation for an
unfunded product with a 100 percent risk weight, such
as a standby letter of credit, Shows the required fee to
be 68 basis points.28 Appendix B shows how tier 2
capital costs enter into the cost of capital for financial
products, and Appendix C discusses the role of risk.
The role of taxes in bank cost of capital
Corporate income taxes play a rather different role in
bank cost of capital than they do in cost of capital for
nonfinancial firms. While corporate income taxes have
an ambiguous effect on the cost of capital for non
financial firms, they clearly work to raise the cost of
capital for financial firms. This difference results from
the fact that financial assets are not physically depreci
ated and, to a lesser extent, from the way we define
bank cost of capital.
Cost of capital for physical projects is defined as the
real rate of return an asset must generate to cover the
after-tax cost of the funds used to finance it. Corporate
income taxes increase the pretax return that must be
generated in order to meet a given after-tax return. At
the same time, a high corporate income tax rate raises
the value of the depreciation deduction and any invest
ment tax credit that the firm can claim, and thereby
reduces the required real rate of return. Moreover, the
” (2) 0.96 * S * (1 -fc ,) + 0.04 * { I ..t lr< ' (1 ~
-1 }
1+ 7T,
= COE * RW * 0.04,
where
S
= required spread on loan (net of noninterest expenses)
tc,
= marginal corporate income tax rate at time t
rt
= riskless nominal interest rate at time t
it ,
=
inflation rate at time t
COE = cost of equity
RW
= risk weighting.
» A variation of equation 2 applies to unfunded products such as
letters of credit, commitments to lend, or swaps. The bank does not
have to float debt to finance an unfunded product by definition, but
equity is still required to underwrite the risk of the product. The
proceeds from the required equity issue may be thought of as
placed at the riskless interest rate. Unlike the spread on the loan,
which is counted over the 96 percent portion of the loan financed
by debt, the fee counts over the entire value of the project:
(3) F * (1 -fc ,) + 0.04 * { 1 + If *
1 +TT,
- 1 } = COE * RW * 0.04
where F = required fee on an unfunded project.
If we solve for equation 3 using the same parameters as in
equation 2, we get 68 basis points as the required fee on a
standby letter of credit, an unfunded project with a 100 percent risk
weight.
46 for
FRBNY
Quarterly Review/Winter 1991
Digitized
FRASER
more leveraged a firm is, the less corporate income
taxes work to raise required returns because of the tax
deductibility of debt.
Generally, if the tax depreciation of an asset is slower
than the physical depreciation of the asset, then the
corporate income tax works to raise the cost of capital
for the asset. If the tax depreciation of the asset is
faster than the physical depreciation of the asset, then
corporate income taxes may have no effect or may even
reduce cost of capital, particularly if the firm is quite
leveraged. In practice, the tendency of tax codes to
permit physical assets to be depreciated faster than
assets are losing economic value makes the cost of
capital for physical projects less sensitive to corporate
income tax rates.
Since financial assets do not depreciate, the corpo
rate income tax raises the cost of capital by increasing
the pretax rate a project must generate to meet a given
required after-tax return. If the corporate income tax
rises from 25 percent, a rate near the low, Swiss end of
the spectrum, to 50 percent, a rate below the high,
Japanese end of the spectrum, the cost of tier 1 capital
rises by about 50 percent for a given cost of equity. By
contrast, corporate income taxes do not directly affect
the banks’ cost of subordinated debt.
Since banks are highly leveraged, it would appear
that their cost of capital should not be sensitive to
corporate tax rates. Recall, however, that bank cost of
capital is defined as a required spread or fee, and not
as an overall interest rate. For example, consider a rise
in the corporate tax rate that widens the required loan
spread from 30 to 50 basis points. All other expenses
aside, the bank needs to lend at a minimum of 8.5
percent instead of 8.3 percent at an interbank rate of 8
percent. Although this increase appears quite small,
bankers compete in terms of spreads. Moreover, taxes
show up directly in the required fee for products such as
letters of credit and swaps.
Empirical results
Combining cost of equity estimates with equations 2
and 3 (see footnotes 27 and 28) produces the required
spreads and fees on various financial products over the
period 1984-90. The source of the various parameters is
as follows: inflation is from the GNP deflator; the tax
rate combines federal, regional, and local top-bracket
corporate income tax rates; and the nominal interest
rate is a riskless rate, approximated by an annual aver
age of LIBOR less 1 percent.
We consider three different financial products: a
standard corporate loan, a commitment to lend with a
life greater than one year, and a ten-year dollar interest
rate swap. The standard corporate loan— a funded
financial product— is evaluated using equation 2, while
the commitment to lend and the swap— both unfunded
products— are evaluated using equation 3.
The required net spread on a corporate loan shows
substantial variation across countries (Chart 6). A U.S.,
Canadian, or U.K. bank needs net spreads of 60 to 80
basis points while a Japanese bank needs only 10 basis
points. It must be kept in mind that these spreads are
net of all other expenses. If a U.S. bank has to allow 25
basis points for expected loan losses and another 25
basis points for providing and servicing the loan, then
the bank will need a gross spread of about 130 basis
points on the loan.
While the pattern of required fees on a commitment to
lend in the different countries follows the pattern of
spreads on the corporate loan, the results for the inter
est rate swap merit particular attention. The required
annual net fee on this item is between 5 and 10 basis
points for banks in the United States, United Kingdom,
and Canada. Interest rate swap spreads can dip below
5 basis points. Thus, U.S., U.K., and Canadian banks
cannot even earn enough on swaps to cover the cost of
tier 1 equity. The problem is particularly acute when one
recalls that cost of capital represents the net fee— after
all expenses— required on the swap. Recent work by
Zimmer indicates that a bank needs about 3 basis
points to cover expected default losses on a ten-year
interest rate swap.29 Thus, even if we ignore compensa
tion of the swap team and any overhead, a U.S. bank
would need bid/ask spreads in excess of 15 basis points
on interest rate swaps to cover the costs of capital and
of expected defaults.
International taxation and bank co st of ca pita l
Internationally active banks generally go head to head
in various markets, and such competition brings more
than home country taxation into play. The cost of capital
measures given in Chart 6 reflect U.S. taxes for U.S.
banks, Japanese taxes for Japanese banks, and so on,
and thus only apply to banks lending from their home
country, whether engaged in home-court competition or
in foreign lending from the head office. A multinational
bank borrowing and lending in a number of markets
must pay attention to a variety of tax codes. The inter
action of tax codes, it turns out, tends to mitigate
somewhat the benefits of hailing from a home country
with low corporate taxes.
A multinational bank generally faces different effec
tive corporate income tax rates in the different countries
in which it does business. Since the cost of equity must
be met after taxes, a single bank therefore faces differ29The calcula tion assumes that the swap is not netted. See Steven A.
Zimmer, “ Credit Risk in Interest Rate and C urrency S w aps,” Harvard
University, 1988 (processed).
Chart 6
Spread or Fee Required to Cover Cost of Equity
Basis points
80 —
United States
Japan
Germany
2 United Kingdom
p m
Canada
Switzerland
Bank loan spread
Commitment to lend fee
Ten-year interest rate swap fee
Source: Federal Reserve Bank of New York staff estimates.
Note: Interest rate swap fee should be compared with one-half of swap spread as quoted in the market.
FRBNY Q uarterly R eview/W inter 1991
47
ent capital costs in different countries. As a result, the
relation of capital costs for two banks from different
countries varies across markets.
To assess the competitiveness of U.S. and German
banks, for example, one cannot merely compare the
cost of capital for a U.S. bank operating in the United
States with the costs of a German bank operating in
Germany. Consideration must also be given to the
banks’ capital costs in the same market, whether that
market is the United States, Germany, Britain, or
another country.
In calculating the effective tax rate for a bank in a
foreign market we start with the corporate income tax
payable at all levels of government in the foreign coun
try. Next, for subsidiaries, we compute withholding
taxes on dividends remitted, which tax treaties between
pairs of countries lower from general rates of, for
instance, 20 percent to 5 percent. Finally we factor in
the home-country treatment of foreign taxes paid: some
countries, such as the United States, give tax credits for
a portion of the foreign tax paid (usually capped at
comparable domestic taxes payable); other countries,
such as Germany, exclude foreign source income from
home-country taxation.30 A bank may establish itself in
30For general treatm ents of transnational taxation, see Julian S.
A lworth, The Finance, Investm ent an d Taxation D ecisions of
M ultinationals (O xford: Basil B lackw orth, 1988): and Edmund
Crooks, M ichael Devereux, Mark Pearson, and Charles Wookey,
“ Transnational Tax Rates and Incentives to Invest," Institute for
Fiscal Studies, W orking Paper no. 89/9, O ctober 1989.
a foreign market in the form of a branch or a subsidiary,
and in general the tax rate differs by corporate form.
Moreover, the taxation of a subsidiary’s earnings
depends on whether the subsidiary repatriates earnings
or retains them.31
Cost of capital, or required spread, for a corporate
loan thus depends not only on the cost of equity and
taxes at home but also on taxes in the market served,
the structure of tax treaties, and the corporate form of
foreign operation (Chart 7 and Table 3). Each horizontal
line in Table 3 represents a different market. For exam
ple, in the Japanese market (second line) a U.S. bank
branch faces capital costs of 95 basis points as com
pared with 10 basis points for a Japanese bank, 55
basis points for a German branch, and 72 basis points
for a Canadian branch.
Same-market capital costs can tell quite a different
story from home-market capital costs. Note that the
table repeats our earlier finding that U.S. and German
banks face capital costs of 76 and 65 basis points in
their respective home countries. A German bank oper
ating in the United States, however, faces capital costs
of only 40 to 51 basis points; these figures bear compar3'For instance, Bankers Trust reported in 1989 that it is saving U.S.
taxes by not repatriating foreign earnings (about 25 pe rcent of its
shareholders' equity takes the form of un d istrib u te d earnings of
certain foreign sub sid iaries) and that federal taxes am ounting to
about 4 percent of shareholders’ equity w ould have to be provided
for, even after foreign tax credits, were the earnings not
“ perm anently reinvested ou tside the United States" (A nnual R eport,
1989, p. 40).
Chart 7
Spread Required to Cover the Cost of Equity on a Loan to a U.S. Corporation
Basis points
1 0 0 -----------------------------------------—
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------From the home
Through a
Through a U.S. subsidiary with
country
U.S. branch
earnings dividend repatriated
□
U.S. bank
Japanese bank
German
Source: Federal Reserve Bank of New York staff estimates.
48
FRBNY Q uarterly R eview/W inter 1991
j Through a U.S. subsidiary
' with earnings retained
Canadian bank
Swiss bank
forward and back three years, while no such provision
exists for U.S. banks.
ison with the 76-basis-point cost for a U.S bank operat
ing at home (Chart 7). Conversely, a U.S. bank faces
capital costs of 100 to 119 basis points in Germany, as
compared with the 65-basis-point hurdle for a German
bank operating at home.
The general result is that national differences in cor
porate tax rates tend to be flattened somewhat in crossborder operations by virtue of the interaction of national
income tax codes and withholding taxes. In particular,
banks from low-tax countries invariably face higher tax
rates on their foreign operations. As a consequence,
the usefulness of tax policy as a tool for reducing the
U.S. disadvantage in cost of capital for banks compet
ing abroad is limited. (See Box for related point.)
Note that the computed capital costs neither compel
choice of corporate form nor exhaust relevant tax con
siderations. For example, British banks use both
branches and subsidiaries in their U.S. operations
despite the apparent advantage of branches. Further, it
should be pointed out that effective tax rates do not
reflect important aspects of certain tax systems. For
example, the U.S. and Japanese tax systems both give
tax credits for foreign income taxes paid up to the
amount of domestic taxes payable on foreign income.
For Japanese banks, however, the maximum credit for
foreign taxes is based on worldwide income, while for
U.S. banks foreign tax credits can only be applied to
income earned in separate income “baskets”— a condi
tion that restricts use of high withholding taxes levied by
developing countries such as Brazil and Mexico.32 In
addition, Japanese banks can carry foreign tax credits
32A transition rule was provided for interest on loans to thirty-three
troubled de btor countries. See Peat Marwick and Bank
A dm inistration Institute, The Banker's Guide to the Tax Reform Act
of 1986 (Rolling Meadows, III.: Bank A dm inistration Institute, 1986),
pp. 88-92.
Explaining international differences in bank cost
of capital
These measures of the cost of equity are broadly in line
with those of our earlier study of the cost of capital for
industry in four countries.33 The similarity suggests that
the reasons adduced for differences in the cost of
equity for nonfinancial firms may well carry over for
banks. This section explores the relevance of the fac
tors investigated empirically in the earlier study. In addi
tion, it considers whether the particular risk features of
banks introduce new sources of cross-country
differences.
M acroeconom ic and m acrofinancial differences
Income tax differences do not explain international dif
ferences in bank cost of capital. Differences in house
hold savings, macroeconomic stability, and relations
among corporations, banks, and governments are con
sistent with observed differences in bank cost of equity.
Bank incom e taxes. Bank income taxes can exert a
powerful influence on the cost of capital for banks, but
international differences in bank income taxation offer
very little help in making sense of international differ
ences in bank cost of capital. The power of taxes is
illustrated by Table 3, while the inadequacy of taxes as
an explanation emerges from the broad similarity
between country differences in the cost of capital
(Table 3) and country differences in the cost of equity
(Chart 4). In fact, if we consider average tax rates,
33See McCauley and Zimmer, “ E xplaining International D ifferences,”
Quarterly Review, for measures and em pirical evidence sup portin g
our explanations.
Table 3
Required Spreads on a Corporate Loan in Various International Markets
Branch / S ubsidiary: Earnings R epatriated / S ubsidiary: Earnings Retained
(In Basis Points)
Home Country of Parent Bank
Location
of Market
United States
Japan
Germany
U nited K ingdom
C anada
Switzerland
U nited States
95
119
68
82
62
/
/
/
/
/
76
90
107
76
95
76
/ 109
t 100
/ 76
/ 102
/ 76
Japan
9 / 11
10
12 / 17
9 / 10
10 / 13
9 / 10
/
G ermany
5
/ 16
/ 3
/ 7
/ 2
46 / 51
55 / 59
65
43 / 36
58 / 56
40 / 41
/ 40
/ 51
/ 36
/ 44
/ 32
U nited K ingdom
63 / 73 / 67
75 / 101 / 87
90 / 99 / 112
59
75 / 87 / 74
59 / 59 / 52
C anada
65
72
86
65
/
/
/
/
69
89
87
65
65
65 / 65
/
/
/
/
Sw itzerland
59
76
98
51
44
52
62
41
55
/ 46
/
/
/
/
/
50
67
66
38
63
38
/
/
/
/
/
47
59
74
42
51
Source: Federal Reserve Bank of New York staff estim ates.
Note: Required spreads are com pute d on the basis of 1984-90 average cost of equity, interest rates, inflation, and 1990 tax rates.
FRBNY Q uarterly R eview/W inter 1991
49
Box: Im plications of Currency Positioning of Shareholder Equity
In this Box we consider how the cost of capital for a
bank’s foreign affiliate depends on the net foreign
exchange exposure of the affiliate. The calculations for
Table 3 embody the assumption that the foreign affiliate
has no foreign exchange exposure. In other words, the
affiliate matches its foreign currency assets with fund
ing in foreign currency liabilities, and the excess of
assets over liabilities (shareholder equity) that supports
the assets is held in the home currency. The bank
invests shareholder equity in home-currency assets
and therefore obtains a return on it that reflects homecountry interest and inflation rates.
An argument can be made that the foreign affiliate
should hold a long position in the foreign currency
equal to 4 percent (required tier 1 capital ratio) of
foreign assets in order to maintain the ratio of share
holder equity to assets in the face of foreign exchange
movements. The drawback of such a position, of
course, is that it ultimately represents a currency
exposure to the parent, an additional source of volatility
to earnings and shareholder wealth.
The question whether a foreign affiliate should take a
long foreign exchange position in proportion to foreign
assets is of more than theoretical interest. International
capital standards requiring banks to hold capital
against open foreign exchange positions are under
negotiation. If international bank regulators decide that
a long foreign exchange position in proportion to for
eign currency assets represents an open foreign
exchange position, then foreign affiliates will have an
incentive to square foreign exchange positions and to
hold shareholder equity in home-currency assets.
Since the question is still unresolved, we recalculate
Table 3 on the assumption that the foreign affiliate
holds a proportional long foreign position. The table
below shows that the required spreads faced by many
banks change because a bank that invests in a lowinflation currency tends to earn a higher real after-tax
rate of interest* on riskless debt. Since the bank is
assumed to invest shareholder equity (excess of assets
over liabilities) in riskless debt, the higher real after-tax
rate of return earned on the debt works to reduce the
loan spread needed to cover the required return on
equity. Thus, banks from high-inflation countries such
as Canada can lower the cost of capital to affiliates in
low-inflation countries by holding proportional share
holder equity in the low-inflation currency. Similarly,
foreign affiliates of banks from low-inflation countries
such as Japan and Switzerland encounter higher cap
ital costs from holding proportional shareholder equity
in high-inflation currencies.
In calculating the required spreads for the table, we
implicitly assume that the parent bank defers realiza
tions of foreign exchange gains and losses on the open
position of the affiliate (typical for nonrepatriated earn
ings). Immediate realization would tend to shift the
required spreads toward those in Table 3 in the long
run. This shift arises from the tendency of a low-infla
tion currency to appreciate over time and thereby to
increase the tax liability of the parent bank.
fT h e real after-tax rate of interest is roughly defined as
{nominal interest rate * (1-tax rate)} - inflation rate. Since
real interest rates across the countries are sim ilar over the
period considered, and since a ba n k’s foreign affiliate
faces the same tax rates in either currency, inflation is the
prim e determ inant of the real after-tax rate of interest
facing the bank.
Required Spreads on a Corporate Loan in Various International Markets:
Proportional Long Position in Foreign Currency
Branch / S ubsidiary; Earnings R epatriated / Subsidiary: Earnings Retained
(In Basis Points)
Home Country of Parent Bank
Location
of Market
United States
U nited States
Japan
Germany
United K ingdom
C anada
S w itzerland
82
114
72
76
78
76
/ 79 / 94
/ 106 / 97
/ 81 / 81
/ 86 / 96
/ 93 / 93
Japan
21 / 2 5 / 1 5
10
24 / 30 / 28
2 8 / 3 1 / 15
16/22/11
37 / 40 / 25
Germany
50 / 54
45 / 48
65
54 / 40
57 / 52
55 / 59
/ 41
/ 42
/ 40
/ 39
1 48
United Kingdom
59 / 66 /
60 / 75 /
83 / 85 /
59
61/72 /
71 / 71 /
62
66
94
61
65
71
68
93
78
C anada
Sw itzerland
I
/
/
/
26
21
37
27
22
76
80
90
78
65
88 / 88
/ 65
/ 70
/ 100
/ 62
/
69
/
/
/
/
33
34
44
25
f 39
38
Source: Federal Reserve Bank of New York staff estim ates.
Note: Required spreads are com pute d on the basis of 1990 tax rates and 1984-90 average cost of equity, interest rates, and inflation.
50 forFRBNY
Digitized
FRASERQ uarterly Review/W inter 1991
/
/
/
/
/
30
28
50
29
27
Japan and Germany tax banks quite heavily, while U.S.
banks bear a tax burden more like that imposed by lowtax Switzerland.34
Household savings. Higher household savings rates
in Japan, Germany, and Switzerland, perhaps rein
forced by lower household access to bank credit, serve
to lower equity costs for banks in these countries.
However much the mobility of capital across borders
has integrated debt markets, equity markets remain
sufficiently distinct to allow differences in national sav
ings behavior to assert themselves in the valuation of
internationally comparable income streams.
Stability of growth. The particularly low equity costs
for Japanese banks can be ascribed in part to the
success of policy in smoothing growth. Japan’s econ
omy has grown markedly more steadily in the 1980s
than the U.S., German, or British economies. Banks
with heavy exposure to equity prices and high-leverage
firms may particularly benefit from stabilization policy,
which in the case of Japan works against a backdrop of
adaptive corporate responses to economic challenges.
Relations between banks and corporations. Industrial
organization in Germany and Japan tends to lower risk
premia on the debt of industrial firms and to permit
higher leverage at lower distress costs than would be
entailed in the United States, Canada, or the United
Kingdom. Close links between bankers and borrowers
in Germany and Japan may also serve to lower capital
costs for banks. The mixture of debt and equity claims
on bank customers may spread risk, improve informa
tion flows, and facilitate bank influence over troubled
debtor firms in ways that make German and Japanese
bank shares more attractive to investors. These consid
erations are complementary to, but distinct from, the tax
advantages of bank shareholding, especially in the
presence of inflation. In addition, banks with close links
to corporations may benefit from insensitivity of subor
dinated debt costs to bank risk.
Close links with corporations and other financial insti
tutions served Japanese banks well in 1987-89, when
the banks raised more equity than any other industry in
Japan. By one count, the city banks raised the equiv
alent of $43 billion, including convertible issues, and
each city bank in our sample raised between $3 billion
and $6 billion equivalent.35 Listings of the ten largest
shareholders of, for instance, Sumitomo and Mitsubishi
in March 1989 and March 1990 reveal the usefulness of
reciprocal shareholdings. Over the fiscal year Sumitomo
^Economic Advisory Committee of the American Bankers
Association, International Banking Competitiveness and Why It
Matters (Washington, D.C.: American Bankers Association, 1990),
pp. 16 and 84.
“ Zielinski and Holloway, Unequal Equities, pp. 184-6.
increased its outstanding shares by over 10 percent and
Mitsubishi by over 7 percent. Yet the top ten share
holders remained in the same order for each bank, and
indeed the stake of the top ten declined only 0.48
percent from 27.96 percent for Sumitomo and 0.72
percent from 29.00 percent for Mitsubishi.36
Capital constraints and financial deregulation may be
straining the cross-holding pattern. Industrial firms
among Sumitomo’s and Mitsubishi’s top ten share
holders did a bit better than the life and casualty insur
ers in taking up their share of new issues. Moreover,
according to a news report in early April 1990, repre
sentatives of life insurers were letting it be known that
they had had their fill of bank shares and could not be
counted on to absorb any more.37
Relations among banks, corporations, and govern
ments. Government policies to spread the costs of cor
porate distress beyond the immediately affected parties
reduce the potential for losses by banks and their
shareholders. If antitrust, trade, and industrial subsidy
policies bolster distressed industries and firms in Ger
many and Japan more predictably than in Britain, Can
ada, and the United States, then investors in bank
shares may face less risk and be willing to pay more for
a given earnings stream.
Bank-specific factors
A puzzle arises from the comparison of the cost of
equity for industry and banks in the United States,
Japan, and Germany (Table 4). U.S. banks confront
equity costs above those of U.S. industry, while Jap
anese and German banks enjoy a lower cost than those
of Japanese and German industry, respectively. Why do
Japanese and German banks seem to enjoy cheaper
equity than their industrial customers?38
Risk, deposit insurance, and the cost of equity. The
higher leverage characteristic of banks relative to indus
trial firms would seem at first glance to make banks
more risky than their corporate customers. Higher lever
age makes for more risky equity, and investors may be
expected to demand a higher rather than a lower rate of
return for bearing the extra risk. But deposit insurance
“ Annual reports.
37"Major Life and Casualty Insurance Companies Selling Large
Quantities of Stocks Formerly Considered ‘Stable Long-Term
Holdings,’ Centering on Bank Stocks, in Response to Falling
Markets,” Nikon Keizai Shimbun. April 2, 1990, p. 1.
“ Market misapprehension of the effect of inflation does not seem to
resolve the puzzle. Inflation delivers unaccounted income to
industry but gives a spurious boost to bank earnings. Investors'
misunderstanding of the effects of inflation, therefore, would tend to
raise industrial equity costs relative to bank equity costs. Yet
industrial equity costs are higher relative to bank costs in the lower
inflation economies of Germany and Japan.
FRBNY Quarterly Review/Winter 1991
51
in law and in practice allows a bank to operate at
considerable risk without paying the price in the debt
market that an industrial firm would pay.
Government support for bank debt funding reduces
the downside risk of holding bank equity. A commercial
or industrial firm that suffers losses large in relation to
equity finds itself on a downward spiral as the heavier
risk premia on debt put a greater burden on the firm’s
cash flows. A bank’s debt costs rise much less quickly
in response to loss of firm net worth. The value of
government support for banks, in other words, rises
precisely in bad times, and thereby reduces earnings
volatility.
D ifferences in official safety nets. Differences in the
strength and coverage of official safety nets may lower
bank equity costs abroad in relation to industrial equity
costs. As argued above, the cost of U.S. bank subordi
nated debt rises sharply as ratings are lowered, while
foreign banks’ subordinated debt costs seem much less
responsive to ratings. The greater sensitivity of U.S.
debt costs is understandable in light of losses that
holders of U.S. bank holding company bonds have suf
fered in bank failures since the failure of Continental
Illinois.
That the authorities in foreign countries rely less on
market discipline on banks39 finds expression not only
in subordinated debt costs but also in equity costs.
Lower sensitivity of subordinated debt costs to bad
news itself limits earnings volatility and thereby lowers
risk to equity holders. Moreover, less reliance on market
discipline means that bank customers take their busi^S ta te m e n t of E. G erald C orrigan in D eposit Insurance Reform and
F inancial M odernization, Hearings before the Senate Banking
Committee, 101st Cong. 2d sess. (Washington, D.C.: GPO, 1990)
pp. 3-109.
Table 4
Comparison of Cost of Equity
for Industry and Banking
(Percent)
Period Averages
Germ any
Japan
U nited States
U nited K ingdom
1984-88 Only
Industry
Banking
Industry
Banking
9 .8 t
6.7
10.5
10.6
6.9
3.0
11.9
9.9
7 .8 t
4.5
11.2
6.4
6.9
3.2
12.0
10.0
Source: Federal Reserve Bank of New York staff estim ates.
Note: Period is 1977-88 for indu stry and 1984-1990 tor
banking.
fG e rm a n industrial cost of eq uity includes estim ated crosshoiding adjustm ent not incorporated in McCauley and
Zimmer, “ E xplaining International D ifferences,” Q uarterly
Review.
52
FRBNY Quarterly Review/Winter 1991
ness elsewhere more slowly in response to bad news,
so that once again bank earnings show less volatility.
The recent experience of shareholders in large foreign
banks has no parallel to the total loss of share value
incurred by shareholders of Continental Illinois.
Whether a government comes to the aid of an ailing
bank itself or organizes a private sector rescue, share
holders in the rescued bank face less downside risk.
Are U.S. banks just riskier? Some observers would
reject the explanations offered and contend that U.S.
banks pay more for their equity because U.S. banks are
simply more risky. At the extreme, this argument could
posit a single international schedule relating bank cost
of equity to risk, with the higher cost of equity faced by
U.S. banks simply reflecting their greater risk. One
could try to measure bank risk by measuring asset
riskiness and leverage, but the difficulty of doing so is
quite daunting. First, the relation of asset risk and
leverage to bank risk is mediated by the official safety
net. Second, as noted earlier, it is difficult in practice to
separate the effects of asset risk and leverage from the
conceptual problem of measuring cost of equity for an
undercapitalized bank.
To understand the measurement problem, consider
the claim that U.S. money center bank assets are more
risky than their German and Japanese counterparts.
This claim must be reconciled with the fact that Ger
man, Japanese, and even Swiss banks hold much
larger equity positions— equities and participations—
than do U.S. banks (Table 5). The decline in the Tokyo
stock market in 1990 provided a reminder of how a
sharp market downturn can reduce the value of bank
assets and capital.
Direct measures of the market risk of bank equities do
not suggest much link between the relative cost of
equity and risk. Returns from U.S., Japanese, German,
and British banks, at least, tend to match those of the
Standard and Poor’s 500, Nikkei, Commerzbank, and
F in a n cia l Times indexes, respectively (Table 6).40 U.S.
banks’ shares do seem quite a bit more risky than the
^ U s e of the Tokyo Stock Price Index (TOPIX) rather than the Nikkei
index did not m aterially affect the Japanese bank betas. Further,
ad dition of a bond return varia ble d id not m aterially affect eith er the
U.S. or Japanese bank betas. The results for Japan are con sistent
with an analysis of daily returns in 1984-86 by R ichard H. Pettway,
T. Craig Tapley, and Takeshi Yamada, "The Im pacts of Financial
Deregulation upon Trading E fficiency and the Levels of Risk and
Return of Japanese B anks,” Financial Review, vol. 23 (A ugust 1988),
pp. 243-68; the results co n tra d ict the analysis of annual returns by
Edward J. Kane, Haluk Unal, and Asli D em irguc-K unt, "C a p ita l
Positions of Japanese B anks,” in Game Plans for the ‘90s,
P roceedings of the 26th Annual C onference on Bank S tructure and
C om petition (C hicago: Federal Reserve Bank of C hicago, 1990),
pp. 509-35. Our results for the U.S. money centers are con sistent
with Haluk Unal and Edward J. Kane, “ Two A pproache s to
Assessing the Interest Rate S ensitivity of D eposit Institution Equity
R eturns," in Andrew Chen, ed., Research in Finance, vol. 7 (1988),
pp. 113-37.
overall stock market only in 1990, a year in which the U.S.
economy entered a recession. Indeed, U.S. bank share
prices exaggerated the movement of general U.S. share
prices most markedly in late 1990, as the economy con
tracted. By contrast, in 1986, a recession year for the
Japanese economy, Japanese bank stocks seem, if any
thing, less risky than the market. This contrast is consis
tent with foreign banks’ enjoying lower downside earnings
volatility as a result of stronger official safety nets and, in
some countries, industrial organization.
The lim its of equity-m arket arbitrage
If equity costs are lower in Tokyo, why do firms from
other countries not raise equity there? The experience
of U.S. firms that have listed their shares in Tokyo
shows that the mere exchange trading of shares in
Tokyo does not result in share valuations different from
the New York norm. Public offerings of shares in Tokyo
by U.S. firms’ Japanese subsidiaries or joint ventures,
however, suggest that earnings streams in Japan as
well as the earnings of Japanese firms were priced at
Table 5
Equity Shareholding by Banks in Japan, Germany,
and the United States
(Percent)
Book Value of Equity
Securities Held as
a Share of B ank’s Book
Shareholder Equity
Market Value of Equity
S ecurities H eld as
a Share of Bank's
Shareholder Equity
A djusted for U nrealized
Gains on E quities
Market Value of
Equity S ecurities
Held as a Share
of Total A ssets
11.7
125.2
35.1
11.7 f
107.0
57.9
0.55
11.00
3.81
(75.3)
(83.5)
(5.37)
U nited States
Japan
Germ any
(in clu d in g book
value of equity
pa rticip a tio n s )
Sources: Annual reports; Federal Financial Institutions Examination C ouncil, Call Reports; International Bank C redit Analysis; N ikkei
N ew sletter on B ond a n d Money, Stephen Lewis, “ German Banks’ Ten-Month Results— A S olid P erform ance," Salomon Brothers
Germ any E quity Research, D ecem ber 19, 1990; Federal Reserve Bank of New York staff estim ates.
Notes: Data cover sam ple banks for Japan and Germany; data for U.S. average cover six sam ple banks in the seco nd Federal Reserve
d is tric t. Data for Japan are from March 1990.
IB o o k value of eq uity secu rities held is taken as a proxy for market value be cause of recent acq u isitio n and high turnover.
Table 6
Relation of Bank Share Returns to Returns on Respective Market Indexes in Four C ountries
U.S. Money
C enter Banks
Period
Beta
Standard
Error
1986-90
1986
1987
1988
1989
1990
1.14+
1.12
1.07
.92
1.16
1.521-
0.067
0.16
0.10
0.13
0.20
0.23
Japanese C ity Banks
R2
.52
.52
.70
.50
.40
.47
Beta
Standard
Error
R2
.92
.75
1.40
.68
■37f
.82
.084
.15
.27
.17
.18
.16
.32
.34
.35
.25
.08
.39
German Gross Banks
U.K. Banks
Beta
S tandard
Error
R2
Beta
Standard
Error
R2
1.03
1 .2 8 f
.94
1 .2 0 f
.89
.95
.037
.088
.052
.093
.10
.094
.75
.81
.87
.77
.60
.67
1.01
1.10
.97
•6 7 f
1.11
1.20
.053
.21
.084
.12
.11
.13
.57
.35
.73
.37
.66
.64
Sources: S tandard and Poor’s, Daiwa, D eutschebank, and Financial Times.
Notes: Data are weekly. Market indexes are Standard and Poor’s 500 and Nikkei, C om m erzbank, and Financial Tim es 100 indexes.
Standard and Poor’s money cen ter bank index is a c ap italization -w eigh ted average of the share p rice s of Bankers Trust, Chase
M anhattan, C hem ical, C iticorp, Manufacturers, and M organ. C ity bank index is a cap ita liza tio n -w e ig h te d average of all thirteen city
banks’ share prices. Gross bank index is a capitalization -w eigh ted average of the share p rice s of C om m erzbank, D eutsche, and
Dresdner. Financial Times bank index is a capitalization -w eigh ted average of the share p rice s of the four sam ple banks plus A bbey
National, Bank of S cotland, Royal Bank of Scotland, S tandard C hartered, and Trustee Savings Bank.
fB e ta s are sig n ifica n tly different from 1 on a tw o-tailed test at 5 pe rcent significance.
FRBNY Quarterly Review/Winter 1991
53
high multiples.41 Whether U.S. financial firms with sub
stantial presence in Tokyo could float equity in their
Japanese subsidiaries at favorable prices is not clear.
Implications of the cost of capital disadvantage of
U.S. banks
The measured cost of capital disadvantage of U.S.
banks offers a simple account of U.S. banks’ loss of
market share at home and abroad as displayed in
Chart 1. U.S. bankers would have had to offset rela
tively high capital costs with much better risk assess
ment or cost control to have maintained their share of
corporate loans.
Bank strategies do not really offer an alternative
explanation for U.S. banks’ loss of market share. If U.S.
bankers came to view wholesale lending as a com
modity business not worth room on their balance
sheets, then they would quite consistently shift their
strategies toward consumer lending or reorient their
corporate business to origination and risk management
products. Such strategies, however, can be considered
41See Ted Fikre, “ Equity C arve-outs in Tokyo,” in this issue of the
Q uarterly Review.
adaptations by banks burdened with high capital costs.
A more detailed look at commercial lending in the
United States reinforces the connection between com
petitive outcomes and capital costs in the late 1980s.
Here we consider only loans booked in the United
States to commercial and industrial firms in the United
States and take no notice of loans to U.S. businesses
booked abroad, despite their importance, because it is
not possible to decompose them by the nationality of
foreign bank. The percent change in market share of
sample banks from the six countries, that is, the share
in March 1989 as a percentage of the share in March
1984, shows quite marked differences. Japanese banks
almost tripled their share, Swiss and German banks
showed substantial gains, Canadian banks slightly
increased their shares, British banks lost market share
somewhat, and U.S. banks suffered a 36 percent loss of
market share (Chart 8). Banks with low capital costs
gained market share at the expense of banks with high
capital costs.
That foreign banks gained even more market share in
the standby letter of credit (L/C) market than they did in
commercial lending offers further evidence for the
importance of capital costs in wholesale banking com-
Chart 8
Change in Market Share in Commercial Lending to Firms in the United States, 1984-89, and
Cost of Capital for U.S. Loans
Basis points
--------------80
Percent
200 ----—| Change in market share
Scale
Cost of capital
S cale----- ►
150 -
— 60
100
— 40
-
50 -
—
-50
Japanese bank
Swiss bank
German bank
Canadian bank
U.K. bank
U.S. bank
Source: Federal Financial Institutions Examination Council, Reports of Condition, as analyzed by George Budzeika, "Competitiveness in
Commercial Lending in the United States," Federal Reserve Bank of New York working paper, appendix.
Note: Cost of capital bars show weighted average of the required spread for branch and subsidiary commercial loans, where weights reflect
shares of commercial loans booked in branches and subsidiaries by each country’s banks in 1989.
54
FRBNY Q uarterly R eview/W inter 1991
20
money by selling commercial or municipal paper
because buyers regard the writer of the standby L/C as
the ultimate obligor. Unlike a commercial loan, a
standby L/C is not funded under normal circumstances:
the issuer usually retires the obligation that the bank
petition in the late 1980s. In the standby L/C market a
bank sells a contract to pay a maturing obligation of a
company or a municipality should the issuer fail to pay.
Having paid for this contract, lower quality companies
and state and local government agencies can raise
Table 7
Market Shares in Standby Letters of Credit
C om m ercial Paper (Percent)
1985
Industrial Revenue B onds (Percent)
N um ber
Amount
Number
Amount
1985
N um ber
1989
N um ber
C anada
Germany
Japan
Switzerland
U nited Kingdom
U nited States
1
1
18
11
11
34
1
1
18
6
10
34
3
2
39
8
7
10
3
1
42
9
6
7
2
0
12
5
13
38
2
0
21
7
10
20
Memo:
All U.S. Banks
51
57
18
14
59
43
Sam ple Banks from
1989
Source: M oody's G lobal S hort-term Market Record, as analyzed by Pat Wertman, “ Letter of C redit E nhancem ent of C om m ercial Paper
Issues: A Case Study of the C om petitiveness of U.S. Banks," Federal Reserve Bank of New York w orking paper, January 1991.
Note: Data are for th ird -q u a rte r 1985 and 1989.
Chart 9
U.S. and Japanese Bank Stock Indexes
Index October 1989 = 100
Sources: Standard and Poor’s index of share prices of Banker’s Trust, Chase Manhattan, Chemical, Citicorp, First Chicago, Manufacturers Hanover,
and J.P. Morgan; Daiwa Securities data on Japanese bank share prices.
Note: Japanese index is a capitalization-weighted index of share prices of twelve Japanese city banks.
FRBNY Quarterly Review/Winter 1991
55
has in effect guaranteed. As a result, any disadvantage
faced by foreign banks in borrowing dollars in the
United States, a disadvantage which may partially off
set a cost of equity advantage in commercial lending, is
largely irrelevant to competition in the L/C market.
In the event, foreign banks’ cheaper cost of equity did
find forceful expression in the standby L/C market in the
1980s (Table 7). U.S. banks in the sample wrote an
estimated one-third by value of the $8 billion in identi
fied standby L/Cs backing U.S. commercial paper in
1985 but only about 7 percent of the $19 billion in
1989.42 Japanese banks’ cost of equity advantage
helped to raise their market share from 18 percent in
1985 to 42 percent in 1989. And much the same devel
opment is evident in the market for L/Cs backing indus
trial revenue bonds. It may be noted that some foreign
banks in the sample, such as Deutsche Bank, wrote no
L/Cs in 1989, although all sample banks had commer
cial loans outstanding then.
Should U.S. banks’ loss of market share owing to a
cost of capital disadvantage cause concern? Some
would answer that if foreign banks can keep their share
holders happy while lending cheaply to U.S. corpora
tions, then we should welcome the effect and not
bemoan the cause. A year ago, some might have gone
further to hold that foreign banks’ lending to U.S. firms
amounts to an insurance policy: should the capacity of
U.S. banks to extend credit to the corporate sector
become impaired, foreign banks could easily take up
the slack. The greater the penetration of foreign banks,
the more readily they could substitute for U.S. banks.
But events have called this view into question. Even
as U.S. banks experience asset price declines that may
dispose them to restrict corporate credit, the most
prominent foreign banks operating in the United States
have suffered their own asset price problems, in the
form of lower equity prices in Tokyo. The extraordinary
correlation of strains in the U.S. and Japanese banking
systems is illustrated by the parallel movements of the
42U.S. banks in total saw their market share shrink from 57 percent to
14 percent over the same period. See Pat Wertman, “Letter of
Credit Enhancement of Commercial Paper Issues: A Case Study in
the Competitiveness of U.S. Banks,” Federal Reserve Bank of New
York working paper, January 1991.
56 for
FRBNY
Quarterly Review/Winter 1991
Digitized
FRASER
share prices of money center and city banks (Chart 9).
U.S. and Japanese bank share prices bore no relation
to each other in the period 1987-89 but in 1990 showed
strikingly high correlation.
As U.S. corporations that have borrowed from foreign
banks or have backed their commercial paper with for
eign bank L/Cs experience difficulty, how will foreign
banks respond to private efforts and public policies
designed to maintain the flow of corporate credit? The
answer is important because a cost of capital disadvan
tage has shrunk U.S. bank market share.
Conclusion
Equity markets in different countries imposed very dif
ferent capital costs on banks in the late 1980s. New
York, London, and Toronto burdened U.S., U.K., and
Canadian banks with equity costs around 10 percent;
Frankfurt and Zurich presented German and Swiss
banks with equity costs in the 5 percent to 7 percent
range; and Tokyo gave Japanese banks an edge with
equity costs around 3 percent.
Subordinated debt costs appear to rise more quickly
in response to lower ratings for U.S. than for foreign
banks. For a U.S. average, higher cost of subordinated
debt worsens the cost of equity disadvantage.
Taxes can exert a more powerful influence on the cost
of capital for banks than on the cost of capital for
industry. Nevertheless, differences in the cost of capital
for banks appear to arise primarily from differences in
household savings behavior and from differences in
relations among banks, corporations, and governments.
For Japan, the success of macroeconomic policy in
smoothing economic growth may also help to cheapen
bank capital.
In the wake of the Basle Agreement, cost of equity
differences assert themselves as very different required
spreads or fees on specific financial products. Banks
facing a high cost of capital encounter substantial diffi
culty in competing in low-margin business lines. In the
1980s, banks with low capital costs gained market
share in the U.S. wholesale market, while those with
high capital costs suffered a loss of market share.
Whether equity market valuations will converge and the
current widening of spreads in banking persist long
enough to reverse this trend remains to be seen.
Appendix A: Cost of Equity Adjustments
The first three adjustments to reported earnings are
outlined in this appendix. For the depreciation adjust
ment, see our earlier articled
Adjustment for developing country reserves
For British and Canadian banks, we add the following to
stated profits:
(4) R '0 -~ tc t)-W R , (1 - tct),
where
R,
- reported addition to developing country reserve
tc, = effective corporate income tax rate
WRt = warranted addition to developing country
reserve
» (developing country exposure in or about 1985)
* .14(1-14)", n = year-1982.
For Japanese banks, no tax benefit is recognized for
reserves, so the following is added to stated profits:
(5) Rt - WR, (1 - tct) - (CO, * tc,) - NOL„
where
CO, = developing country charge-offs, including
losses recognized on debt-equity swaps
NOL,= net operating loss carry-forwards.
For U.S. banks, only a state and local tax benefit is
recognized, so the following is added:
(6) Rt (1 - tsl,) - WRt (1 - tc,) - (CO, * tc,) - NOLt,
where tsl,= combined state and local corporate income
tax rate.
Cross-holding adjustment
For both German and Japanese banks, we add the fol
lowing to stated profits:
(7) {[MVEt * (e v ,-d iv d ,)]-C G ,} * (1 -fc,),
where
M V E ,- market value of equity shares held at time t
ev, = true profit rate on cross-held shares as
calculated in McCauley and Zimmer,
“ Explaining International Differences.”
divd, = dividend payout rate on market value of equity
CG, = periodic realization of capital gains on cross
held shares
We calculate the market value of equity shares held by
German banks as follows:
fM cC a u le y and Zimmer, “ E xplaining International D ifferences,”
Q uarterly Review.
(8) MVEi 99Q= BVE19q0+
(1
gg0 )
where
BVE, = value of cross-held shares as carried on books
UCG,= value of accumulated unrealized capital gains,
given on after-tax basis.
Since accumulated unrealized capital gains for Ger
man banks are available only for mid-December 1990,$
we estimate the market value of equity for previous years
as follows:
(9) MVE,., = MVE, *
DAX,
- dMVEt * (
DAX,
where
DAX, = German stock market index at time t
dMVE, = net additions to equity portfolio - (divd, * MVEJ.
Here we move backward from MVE1990, iteratively
estimating the earlier equity positions.
Inflation-related adjustments
To correct misstatements of profit due to differing time
profiles of real and nominal returns, we make the follow
ing adjustments. First we adjust for the misstatement of
flows owing to growth of assets by subtracting the follow
ing from profits:
(10)
(N O M ,-WOMm) * [(1 + iT f)05 —1],
where
NOM, - nominal assets less nominal liabilities at time t
tt,
= inflation rate at time t.
To correct for the misstatement of profits owing to
varying inflation rates, we subtract the following from
stated profits:
(11) NOM, .
.
where
M
TV =
* TT( ]
i — t- k
^Stephen Lewis, “ German Banks' Ten-Month Resuits— A Solid
P erform ance," Salomon Brothers Germany E quity Research,
D ecem ber 19, 1990.
FRBNY Q uarterly R eview/W inter 1991
57
MHBfiSHHBSKHflHHBBHMHBHB
Appendix A (continued)
where
(12) (SEt - A d t]
t-1
/ = 1,
1> w >0,
i = t- k
1' +
TT,
where
SE, = shareholder equity
Adt - depreciable assets.
and k is the average life of real assets.
We then subtract from stated profits the amount that is
needed to maintain the real value of shareholder equity:
Appendix B: Tier 2 capital and the cost of capital for financial products
The way in which cost of tier 2 capital enters into the cost
of capital for a specific product varies with the source of
tier 2 capital. If preferred shares are used, then the
treatment is the same as tier 1 equity— the required
return will have to be met out of after-tax earnings as
shown for a funded asset in equation 3:
If the bank’s marginal source of tier 2 funds is
reserves, then the treatment is less clear. If the bank
voluntarily takes reserves from shareholder equity, with
out an associated tax benefit, then the cost of tier 2
capital is the same as that of tier 1 capital. If there is an
associated tax benefit, then the cost of capital can be
written:
(13) 0.92 * S * (1 —tC,) + 0.08 * {
(15) 0.92 * S * (1 - f c f) + 0.08 * {
-1 }
1 + (rtt * 0.5)
= (RW * 0.04) * (COE + CPS),
= (RW * 0.04) * {COE * (2— fcf)}.
where CPS = cost of preferred shares.
Note that inflation is halved to reflect the fact that prefer
ence shares typically carry a nominal coupon.
The corresponding equation for an unfunded asset is
similar except that the required fee is multiplied by 1
instead of 0.92. If the bank’s marginal source of tier 2
equity is subordinated debt, then we can rewrite equation
13 as:
(14) 0.96 * S * (1 - tc,) + 0.04 * {
(1: tC$ - 1}
1 + TTt
= (RW * 0.04) * {COE + [CSD * (1— fcr)]},
where CSD = cost of subordinated debt.
58
FRBNY Q uarterly Review/W inter 1991
.O riifrM
] + TT,
The inclusion of tier 2 capital raises the calculated prod
uct-specific cost of capital. To the extent that banks use
preferred shares or voluntary general loan reserves as
tier 2 capital, the tier 2 capital costs will be a significant
fraction of tier 1 capital costs. The cost of subordinated
debt is low for banks in most countries— with the possi
ble exception of the United States— and is unlikely to
change the results significantly.
Our observation that bank cost of capital is highly sen
sitive to corporate income tax rates is not true for certain
tier 2 capital. Subordinated debt and reserves with tax
benefits are both tax deductible and consequently paid
out of pretax income; the cost of these items is therefore
insensitive to tax rates. Since tier 2 capital costs are
likely to be much smaller than tier 1 costs, it will gener
ally be the case that the overall product-specific cost of
capital is still very sensitive to corporate tax rates.
Appendix C: Im plications of Risk for Required Returns
If bank cost of capital is positively related to risk,
then the required return on an individual product should
be adjusted to reflect its effect on the overall risk of the
bank. Specifically, we should determine the required
return as:
(16) S + { _dCOE_
dloan
1 —tct
} +
dCSD
dloan
SD.
The first term is the required spread or fee as calcu
lated with equation 5. The second term is simply the
change in the average cost of equity of the bank in
response to the addition of the product and the capital
allotted to it, multiplied by the value of outstanding
equity. The third term is the sensitivity of the cost of
subordinated debt to an additional unit of the loan, multi
plied by the amount of outstanding subordinated debt.
If the new product is particularly risky relative to the
capital allotted to it, then the third term will be positive
and the second term will probably be positive: if the
product is particularly safe, then the third term will be
negative and the second term will probably be negative.
Our earlier calculations implicitly apply to products with
average risk relative to allotted capital in the sense that
the second and third terms are zero.
Two important implications follow from the assumption
that bank cost of capital is sensitive to risk. First, banks
facing a high cost of capital cannot mitigate their disad
vantage by concentrating on products that have low regu
latory capital weight relative to their risk. Second, it may
be economical for some banks to carry excess capital.
■M i
FRBNY Q uarterly Review/W inter 1991
59
In Brief
Economic Capsules
Equity Carve-outs in Tokyo
by Ted Fikre
The gap between price-earnings ratios of Japanese
and U.S. stocks in the late 1980s has puzzled market
analysts and other observers. Since 1987, the value
assigned to a stream of corporate earnings has been
two to four times higher in Tokyo than in New York.
Although various accounting and economic factors have
been cited as explanations for this difference, little
effort has been made to determine which character
istics of “Japanese” equity attract pricing at such a high
multiple of earnings.
Some insight into this problem, however, can be
gained by examining the records of initial public offer
ings in Tokyo of shares of U.S. subsidiaries and joint
ventures between Japanese and foreign firms. These
so-called carve-outs reveal how Japanese investors val
ued the stock of a company operating in Japan but
owned, at least to some degree, by foreigners. The
pricing of seven such public offerings suggests that the
Tokyo market assigned a high pricing multiple to earn
ings generated in Japan. All seven of these Tokyo
carve-outs, which raised an aggregate of $0.7 billion
equivalent over four years, received a price-earnings
multiple significantly higher than the contemporaneous
price-earnings ratio of their U.S. parents. Although any
conclusion based on a very small sample must remain
somewhat tentative, the puzzle of Japanese stock
prices in the late 1980s gives these cases a particular
claim on our attention.
Background
Tokyo stocks had higher price-earnings multiples than
New York stocks throughout the 1980s, but pricing in
60
FRBNY Quarterly Review/Winter 1991
Tokyo yielded a particularly large cost of equity advan
tage after 1986 (see chart). While price-earnings multi
ples for U.S. stock indexes ranged between 10 and 20
during the latter half of the decade, comparable Jap
anese multiples skyrocketed from around 25 at the end
of 1985 to over 60 in 1987 and 1988. According to the
Morgan Stanley Capital International indexes, the cur
rent level of price-earnings multiples in Japan, around
31 at the end of December 1990, remains well above the
U.S. level of about 14, although adjustments for cross
shareholdings bring the price-earnings multiples signifi
cantly closer. Other broad indexes show similar results.1
Given the divergence of U.S. and Japanese priceearnings ratios in recent years, it is no surprise that the
number of U.S. firms with listings on the Tokyo Stock
Exchange grew from fifteen at the end of 1985 to sev
enty-two at the end of 1990. But if large, well-known
U.S. corporations obtained listings in Tokyo in order to
raise their price-earnings ratios, they were disap
pointed. A random sampling of twenty U.S. companies
listed on the Tokyo Stock Exchange yielded an average
price-earnings ratio of 12 as of December 31, 1990,
roughly equivalent to aggregate U.S. levels. It is true
that some of the benefits of listing shares in Tokyo, such
as greater investor access and heightened prestige,
1On December 31, 1990, the price-earnings ratio for the Standard
and Poor’s 500 was 15.2, while the corresponding ratio for the
Tokyo Stock Price Index was 38.3. Among narrower indexes, the
Dow Jones Industrial Average showed a price-earnings ratio of 13.6
and the Nikkei 225, a ratio of 38.5.
tion, a U.S. company involved in the direct marketing of
food products. In July 1986 Shaklee Japan K.K. issued
over 3 million shares on the Tokyo over-the-counter
market at a price of $25.38 (¥3,900). These shares,
representing a 22 percent stake in the Shaklee subsidi
ary, were valued at a price-earnings multiple of 59, quite
a contrast to the multiple of 22 assigned by investors on
the New York Stock Exchange to the parent company’s
stock.3 The Shaklee deal, underwritten by Goldman
Sachs and Nikko Securities, marked the first time that a
non-Japanese investment bank took the lead in a Jap
anese issue.
More than a year passed before another U.S. com
pany, Avon Products, took its Japanese subsidiary
public in Tokyo. At the end of 1987, Avon floated a
40 percent stake in its Japanese unit on the over-thecounter market in Tokyo. The total value of the deal,
underwritten by Morgan Stanley, was $218 million, mak
ing it the largest new issue in the history of the Jap-
may not be fully captured in price-earnings multiples. But
merely listing one’s stock in Tokyo does not suffice to achieve
a higher capitalization for a given stream of earnings.
Japanese subsidiaries of U.S. companies may be in a
better position to capitalize on the relative strength of
Tokyo equity prices because their earnings, unlike
those of U.S. companies listing shares on the Tokyo
Stock Exchange, are generated in Japan. Several U.S.
companies have in fact attempted to exploit the lower
cost of equity in Japan by floating stock in their Jap
anese subsidiaries on the Tokyo market. In some cases
the subsidiaries were wholly owned by the U.S. parent,
and in others they were jointly owned by a Japanese
and a U.S. company.2
Carve-outs of subsidiaries wholly owned by U.S.
companies
The first U.S. corporation to carve out and publicly offer
equity in its Japanese subsidiary was Shaklee Corpora-
3ln February 1989 Shaklee sold its rem aining 78 pe rcent stake in the
Japanese sub sid iary to Yamanouchi P harm aceutical for about $350
million, roughly 28 tim es earnings.
2One of the Tokyo carve-outs de scrib e d below involved a U.K.Japanese joint venture.
Price-Earnings Multiples of Equity Carve-outs Relative to U.S. and Japanese Markets
Ratio
100 -
Nippon Avionics
(Japan)
February 1988
<j> Subsidiary
i
i
?
* Parent
Kentucky Fried ■
Chicken Japan
August 1990
Shaklee Japan
July 1986
?
Hughes Aircraft _
* (United States)
Avon (United States)
I I I
_L_L
1985
^
'•Allied Lyons
(United Kingdom)
M I N I M I
I I II I I I I II I
1986
1987
I I I I I I I I I I I I. .1 1 I I I I I I I I I I I I I I I I I I I I
1988
1989
1990
Note: Price-earnings ratios for Japan and the United States are taken from Morgan Stanley Capital International; price-earnings ratios for the
subsidiaries, based on initial public offering prices, are computed using one-year lagged earnings.
* The parent company price-earnings ratio used for Levi Strauss is from September 1985, when management took the company private.
FRBNY Q uarterly R eview/W inter 1991
61
anese over-the-counter m arket. The shares were
offered in December 1987 at a price-earnings multiple
of 43, far above the multiple of 11 for the parent com
pany’s stock at that time.4
Another American company that took its wholly
owned Japanese subsidiary public in Tokyo was Levi
Strauss. In June 1989 the company offered a 15 percent
stake ($80.6 million) in its Levi Strauss Japan subsidi
ary on the Tokyo over-the-counter market. Of the 4.1
million shares floated in Japan at a price of $19.66
(¥ 2 ,8 3 0 ), 1.1 million were newly issued and the remain
ing 3 million were existing shares previously held by the'
parent company. Like the Shaklee issue, the deal was
underwritten by Goldman Sachs and Nikko Securities.
In the case of Levi Strauss a direct comparison of
price-earnings multiples for the parent company and its
subsidiary is impossible because the Levi Strauss par
ent had been taken private by management in Septem
ber 1985. Nevertheless, the price-earnings ratio of 50
that Levi Strauss Japan achieved in 1989 was well
above the multiple of 27 at which its parent exited the
U.S. market in 1985. The behavior of Levi Strauss,
going private in the United States and then taking a
subsidiary public in Tokyo several years later, has ele
ments of a long-term arbitrage strategy, designed to
capitalize on persistent pricing differentials between the
two markets.
Joint venture carve-outs
In addition to the wholly owned subsidiaries of U.S.
companies that issued stock in Japan, several joint
ventures between Japanese companies and U.S. or
U.K. companies have floated shares in Tokyo. In
December 1987 Allied Lyons, a U.K.-based food and
beverage company, made an initial public offering of 14
percent of B-R 31 Ice Cream on the Tokyo over-thecounter market. B-R 31 Ice Cream is a fifty-fifty joint
venture between Baskin-Robbins International (Allied’s
wholly owned subsidiary) and Fujiya of Japan. The 1.4
million shares were offered at $29.82 (¥3 ,61 0 ) each,
yielding a price-earnings ratio of 38, well above the
multiple of 10 at which Allied Lyon’s stock traded in
London at the time of the issue and below Fujiya’s
multiple of 83.5 The $36 million of net proceeds from the
deal, underwritten by Nomura, Daiwa, Nikko, and Gold
man Sachs, was split evenly between the two partners.
All of the carve-outs through 1987 were listed on the
over-the-counter market, not surprisingly given the strict
listing requirements of the Tokyo Stock Exchange. How
ever, in February 1988 Nippon Avionics, a joint venture
between Hughes Aircraft and NEC, floated a $78 million
issue on the second section of the Tokyo Stock
Exchange. At the initial offering price of $13.85
(¥1,760), the stock secured a price-earnings ratio of
87, making it the most expensive initial public offering of
all the equity carve-outs in Tokyo. The Nippon Avionics
issue, underwritten by Goldman Sachs, was met so
enthusiastically that within a week the shares were
trading at over 200 times earnings. At the time of the
Nippon offering, the stock of General Motors Hughes
Electronic (the U.S. parent company of Hughes Aircraft)
was trading at 18 times earnings in New York while
NEC’s stock was trading at a multiple of 102 in Tokyo.
In September 1989, just three months before the
Nikkei peaked at 38,915, another U.S.-Japanese joint
venture, NE Chemcat, issued shares on the Japanese
over-the-counter market. Before the issue, Chemcat
was 46 percent owned by Englehard Corporation and
54 percent owned by Sumitomo Metal Mining. The $90
million flotation, equivalent to a 15.6 percent share of
Chemcat, reduced the stake of each partner but did not
change the proportionate ownership. The 3.9 million
shares, of which 1.35 million were newly issued, sold at
a price of $23.13 (¥ 3 ,3 7 3 ) each, yielding a price-earn
ings ratio of 58, in between Englehard’s ratio of 15 and
Sumitomo’s ratio of 72 at the time.
A more recent equity carve-out is particularly impres
sive because of the market climate in which it was
executed. On August 21, 1990, with the Tokyo Nikkei
plummeting below 24,000 as the Middle East crisis
unfolded, Kentucky Fried Chicken Japan (KFCJ), a joint
venture between PepsiCo and Mitsubishi Corporation,
persisted in a previously planned listing on the second
section of the Tokyo Stock Exchange. The flotation
received an extremely strong reception by Japanese
investors, who bought all the shares at the maximum
value of ¥ 8 ,4 7 0 ($57.71) and then boosted the price up
to ¥11,000 ($74.83) during the first day of trading. The
resulting price-earnings ratio of 57 for KFCJ (based
upon the initial public offering price) was far above the
contemporaneous price-earnings ratio of 21 of PepsiCo
and even higher than the multiple of 49 at which Mit
subishi’s stock was trading in Tokyo.
4By the end of December, less than two weeks after the issue, the
stock was down 40 percent below the offering price.
5The B-R 31 issue demonstrated more strength in the ensuing period
than did Avon Japan. Several months after the offering, the stock
was trading at ¥ 3 ,9 5 0 , almost 10 percent above the initial price.
Inspired by the success of this first issue, Allied-Lyons and Fujiya
sold another 16 percent of B-R 31 Ice Cream on the Tokyo market
several months later.
62
FRBNY Quarterly Review/Winter 1991
The role of selection bias
It can be argued that the high price-earnings ratios
obtained by the carved-out subsidiaries in Tokyo, more
than double the parent price-earnings ratios on aver
age, are partly attributable to a selection bias. Accord
ing to this view, a company would choose to carve out a
subsidiary only if it expected the subsidiary’s stock to
be valued more highly than its own equity. Indeed, a
sampling of U.S. subsidiaries carved out in the U.S.
market appears to offer some support for this inter
pretation: the purely domestic carve-outs, like their
counterparts in Tokyo, on average tend to be priced at
higher price-earnings multiples than their parents.
Nevertheless, the size and regularity of the carve-out
premium is much less striking in the domestic than in
the Japanese carve-outs. A sample of eight U.S. carveouts during 1988 and 1989 yielded carve-out and parent
price-earnings ratios of 15.5 and 14.1, respectively (see
table). This 10 percent premium is far smaller than the
220 percent premium received by the Tokyo carve-outs.
Furthermore, unlike the Tokyo carve-outs, which all had
higher price-earnings ratios than their parents, three of
the eight U.S. carve-outs actually had lower price-earnings ratios than their parents. These results are consis
tent with evidence drawn from a broader sample by
Schipper and Smith.6 So, although carve-outs are gen
erally priced at higher multiples than are their parents,
the magnitude and consistency of the premium
obtained by the Tokyo subsidiaries suggests a funda
mental difference between the pricing of the U.S. and
Japanese carve-outs. Selection bias, in other words,
sFor seventy carve-outs undertaken between 1963 and 1983,
S chippe r and Smith reported a median sub sid iary price-earnings
ratio of 21.7 and a m edian parent ratio of 15. Furthermore, twelve of
the seventy carve-outs received price-earnings m ultiples below
those of their parents. Katherine S chippe r and A bbie Smith, “A
C om parison of Equity Carve-Outs and Seasoned Equity O fferings,”
Journal o f Financial E conom ics, vol. 15 (1986), pp. 153-86.
Average Price-Earnings Ratios for Carve-out
Parents and Subsidiaries
C a rv e -o u t Type
M a rket
A verage
N um b e r
P rice-E a rn in g s of C ases
R atios
S am pled
U.S. subsidiary of
U.S. company
U.S. pare n t
U.S. s u b s id ia ry
New York
New York
14.1
15.5
8
New York
Tokyo
20.0
5 0.7
3
New York or
L ondon
Tokyo
Tokyo
16.0
76.5
6 0.0
Japanese subsidiary of
U.S. company
U.S. pare n t
J a p a n e se s u b s id ia ry
Joint venture between
Japanese and foreign firms
U.S. o r U .K.
p a rtn e r
Ja pa n e se p a rtn e r
Ja pa n e se s u b s id ia ry
4
does not appear to be an important determinant of the
differential between U.S. and Japanese carve-outs.7
Conclusion
We have seen that U.S. and U.K. firms that own subsidi
aries or participate in joint ventures with Japanese
companies were able to float equity in those operations
on the Tokyo market at pricing in line with the broader
Japanese market. The price-earnings ratio differentials
between Japanese subsidiaries and their U.S. parents
depicted in the chart roughly match the overall market
discrepancies. While a simple comparison of priceearnings ratios between Japan and the United States
can be misleading, factors known to explain a portion of
the apparent pricing differential between the two mar
kets probably do not explain the huge carve-out pre
mium. The understatement of Japanese earnings
associated with extensive cross-holdings of shares and
low dividend payouts is known to boost reported Jap
anese price-earnings ratios somewhat misleadingly rel
ative to those in the United States. However, carved-out
firms, particularly the wholly owned subsidiaries of U.S.
companies, are likely to hold fewer shares than Jap
anese firms in general.
Beyond accounting differences, why are the equity
carve-outs of Japanese subsidiaries valued so highly?
The large pricing advantage achieved by these Tokyo
carve-outs over their U.S. parents does not appear to
stem from the tendency of corporations to select for carveouts those subsidiaries likely to be priced at a substan
tially higher price-earnings multiple than their own.
One interpretation points to general economic fac
tors, such as the potential for higher and more stable
growth and less business risk, that might lead to a
favorable capitalization for earnings generated in
Japan.8 But one would expect that Japanese investors,
S e le c tio n bias may, however, play a som ewhat larger role in the
case of Japanese joint ventures. Even if the U.S. parent of a jointly
owned com pany w ished to realize a carve-out premium , the
Japanese parent m ight be reluctant to take its su b sid ia ry pu blic
unless it was confident that it could achieve a p rice -ea rning s ratio
considered good by the standards of the Tokyo market.
Therefore, it is not surprising that the joint venture carve-outs
earned larger premium s than the carve-outs w holly owned by U.S.
com panies. On average, the price -e a rn in g s m ultiples of the joint
venture sub sid iaries were 280 percent higher than those of their
U.S. parents, whereas the w holly owned su b sid iaries com m anded
price-earnings ratios 180 percent higher than their parent
com panies. In addition, although only one of the four joint ventures
carved out in Tokyo was p rice d above its Japanese parent, three of
the joint venture carve-outs were price d above the overall Tokyo
market.
8For a fuller discussion of the explanations behind this cost of
capital advantage, see Robert N. M cCauley and Steven A. Zimmer,
“ Explaining International D ifferences in the Cost of C ap ita l," Federal
Reserve Bank of New York Q uarterly Review , Summ er 1989,
pp. 29-43.
FRBNY Q uarterly Review/W inter 1991
63
recognizing this potential, would bid up the parent’s
stock price before the carve-out took place. The par
ent’s stock price would then represent a weighted aver
age of the Japanese and U.S. multiples, with the
weights determined by the respective revenue shares of
the Japanese and U.S. components of the firm. If this
were the case, carve-outs would not raise total firm
value: a high price-earnings multiple for the subsidiary
in Tokyo would come at the expense of a lower multiple
for the parent in the United States.
However, the Tokyo carve-outs provide no evidence of
such a trade-off in pricing. Despite the high priceearnings ratios attained by the carve-outs, the parent
stocks did not drop in price. Various reasons, such as
imperfect or incomplete information, could be offered
for this anomaly, but the best explanation would appear
to be a preference on the part of Japanese investors for
companies with exclusively Japanese operations. In
64
FRBNY Quarterly Review/Winter 1991
buying the stock of these carved out subsidiaries and
joint ventures, Japanese investors are making a “pure
play” for Japanese operations and perhaps for Jap
anese management as well.9
The evidence from the carve-outs suggests that Jap
anese ownership is not a prerequisite for attaining the
high multiples associated with the Tokyo market in
recent years, although it does not preclude the pos
sibility that such ownership could be a factor in the
pricing of equity in this market. The valuation of these
carve-outs demonstrates that an earnings stream gen
erated entirely in Japan is sufficient to attract multiples
comparable to those of the broader Tokyo market.
9By virtue of the residual parent company ownership, significant
control of these subsidiaries and joint ventures remains in the
hands of foreigners. However, even if these carved-out operations
are not ultimately under Japanese control, they are probably under
Japanese management at some level. For example, KFCJ’s current
president and chief executive is Japanese.
Optimal Monetary Policy
Design: Rules versus Discretion
Again
by A. Steven Englander
Over the last fifteen years, the entire direction of the
debate on optimal monetary policy has been reversed.
Earlier literature held that an optimal monetary policy
could be devised by solving a “dynamic optimization”
problem. It assumed that given a set of policy objectives
and a model of the economy, the optimal path of infla
tion and GNP could be obtained.1 The current literature
argues that it is precisely the public’s recognition that
policy makers engage in such optimization that leads
the public to expect positive inflation in equilibrium,
even when both the public and the government view any
inflation as undesirable. According to this argument, the
public will perceive that the authorities are willing to
exploit a trade-off between inflation and output, and it
will adjust its expectations accordingly.
This article reviews and evaluates this newer liter
ature on optimal monetary policy design.2 It identifies
’ For example, J.H. Kalchbrenner and Peter A. Tinsley, “On the Use
of Feedback Control in the Design of Aggregate Monetary Policy,”
American Economic Review, May 1976 (Papers and Proceedings of
the 88th Annual Meeting of the American Economic Association,
December 1975), pp. 349-55.
2Several other reviews of this literature have appeared in recent
years. Nontechnical discussions can be found in Robert J. Barro,
“Recent Developments in the Theory of Rules versus Discretion,”
The Economic Journal, vol. 95 (1985), Supplement, pp. 23-37; Alan
S. Blinder, “The Rules-versus-Discretion Debate in the Light of
Recent Experience," Welwirtschafliches Archiv, Band 123, Heft 3
(1987), pp. 399-414; and Stanley Fischer, “Rules Versus Discretion
in Monetary Policy,” National Bureau of Economic Research,
Working Paper no. 2518, 1987, forthcoming in Benjamin Friedman
and Frank Hahn, eds., Handbook of Monetary Economics.
Somewhat more technical but largely readable are the surveys in
Keith Blackburn and Michael Christensen, “Monetary Policy and
Policy Credibility: Theories and Evidence," Journal of Economic
Literature, March 1989, pp. 1-45; Torsten Persson, “Credibility of
the key arguments of the recent studies and assesses
the realism of the author’s assumptions. Particular
attention is given to the intuitive underpinnings of the
models advanced in these studies. In addition, the arti
cle analyzes the suggested mechanisms for achieving
credible policies and considers whether the models’
empirical implications are borne out in practice.
The main thrust of the current academic literature is
to explain how a positive inflation rate can emerge on
average, even when all parties view this as an inferior
outcome that produces no extra output. The phenome
non that the authors are trying to explain is readily
apparent: in the postwar period, inflation has averaged
above zero in all countries belonging to the Organiza
tion for Economic C ooperation and D evelopm ent
(OECD), but few policy makers or economists believe
that these inflation rates have contributed to economic
well-being. The persistence of inflation at above desired
levels in most OECD countries has led analysts to
propose economic models yielding inflation as an equi
librium phenomenon explained by optimizing behavior
on the part of the public and policy makers rather than
happenstance.
Footnote 2 continued
Macroeconomic Policy: An Introduction and a Broad Survey,"
European Economic Review, vol. 32 (1988), pp. 519-32; Bennett T.
McCallum, “Credibility and Monetary Policy,” in Price Stability and
Public Policy, pp. 105-28, Federal Reserve Bank of Kansas City,
1984; and Kenneth Rogoff, “Reputational Constraints on Monetary
Policy,” in Karl Brunner and Allan Meltzer, eds., Bubbles and Other
Essays, Carnegie-Rochester Conference Series, no. 26, 1987. Of
these authors, Barro and McCallum are most sympathetic to the
policy thrust of the literature, and Blinder the least.
FRBNY Quarterly Review/Winter 1991
65
The proposed explanation is that the public views
policy making as opportunistic: policy makers are will
ing to exploit a short-run inflation/output trade-off even
if a long run trade-off neither exists nor is thought to
exist. This explanation also yields a strong policy con
clusion. If the public expects positive inflation because
it believes that policy makers are trying to exploit this
trade-off, the key to lowering actual and expected infla
tion is to guarantee that no such exploitation will occur.
The mechanism by which this can be accomplished is
to propose a readily visible rule that eliminates policy
makers’ discretion to inflate opportunistically. In large
part this literature argues that the mere ability of policy
makers to use discretion, even if the discretion is not
actually exercised, will lead the public to expect positive
inflation. Hence, the new monetary policy literature
examines the old question of “rules versus discretion”
from a new perspective.
The argument that the structure of the monetary
policy making process (that is, the presence of discre
tion) rather than the conduct of monetary policy is the
source of inflationary bias also points, as the authors
see it, to the solution. Changing the structure of policy
making to one guided by formal rules, they contend,
might yield lower inflation on average with a relatively
small loss of output. Implicit in such a recommendation
is the assumption that preventing policy makers from
responding to shocks or disturbances will yield only
small losses. Advocates of such rules generally argue
that feedback mechanisms can be incorporated in the
rules to offset shocks and that the magnitude of such
shocks might be lower if a consistent noninflationary
policy rule were installed.3
An alternative view attributes the prevalence of infla
tion in recent decades to a combination of mistaken
policies and adverse shocks, subsequently com
pounded by the unwillingness of policy makers to
accept the output costs of disinflation through much of
the 1970s. In this view, changing the structure of policy
making would not accomplish much if the public and
policy makers were unwilling to accept the costs of
policies aimed at lowering inflation.
Such considerations have a direct connection with the
issues surrounding the use of “intermediate targets” for
monetary policy. It can be argued that if policy makers
do not have a reputation for maintaining low inflation,
3Most of the literature is theoretical and does not make any effort to
calculate the benefits or losses of adhering to a rule. Bennett T.
McCallum, however, has written a series of articles proposing a
specific feedback rule and attempting to estimate the losses from
it. See, for example, McCallum, "The Case For Rules in the
Conduct of Monetary Policy: A Concrete Example,” Federal Reserve
Bank of Richmond Economic Review, September-October 1987,
pp. 10-17.
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FRBNY Quarterly Review/Wifiter 1991
they may find it necessary to pursue an intermediate
target rule that can be monitored easily and on a timely
basis by the public. This course may involve some loss
of output or inflation control if the intermediate target is
imperfectly linked to the final objectives. Nevertheless,
the visible pursuit of a nominal intermediate target may
provide sufficient offsetting benefits in the form of
improved credibility and lowered inflation expectations
to offset the imperfect linkage. In one sense, the rulesversus-discretion question involves comparing the
losses from the imperfect linkages of intermediate tar
gets to final objectives under a rules mechanism with
the losses due to the inflation bias alleged to arise from
discretion.
The focus of this article, however, is the interaction
between the policy makers' goals and the public’s
expectations and behavior in response to these goals.
Thus, intermediate targets will be discussed again only
as a potential means for improving credibility. Much of
the discussion below will assume that policy can suc
cessfully hit not only intermediate targets but also ulti
mate goal variables, such as inflation or nominal
income growth. More specifically, the discussion will
assume that policy makers can achieve their long-run
inflation target and hit an output target temporarily by
exploiting a short-term inflation/output trade-off. Over
the long term it is assumed that output growth is at
trend and is independent of policy.4
Recent literature has also examined the question of
optimal monetary policy under conditions of consider
able uncertainty about the structure of the economy
and the policy makers’ ability to hit targets on a periodby-period basis. In the face of such uncertainty, some
results are weakened because the public, as might be
expected, finds it more difficult to distinguish policy
moves from random shocks— and to distinguish policy
makers who are inflation prone from those who are not.
Uncertainty about the structure of the economy also
generally makes strict adherence to rules undesirable
because it is difficult to design rules suitable under a
broad range of conditions; in forming inflation expecta
tions during periods of uncertainty, the public will usu
ally place more weight on the policy makers’ past infla
tion record.
After examining the policy implications of the recent
literature, this article concludes that the policy rele
vance of this literature has been overstated. The the-
«This assumption can be identified with the Lucas supply curve,
which is common in the literature. See Robert E. Lucas, Jr.,
“Expectations and the Neutrality of Money,” Journal of Economic
Theory, vol. 4, no. 2 (April 1972), pp. 103-24; and Robert J. Barro
and David Gordon, “A Positive Theory of Monetary Policy in a
Natural Rate Model,” Journal of Political Economy, vol. 91, no. 4
(July 1983), pp. 589-610.
oretical insights emerging from this literature differ little
from those of the earlier literature and are achieved only
at the cost of analytical assumptions that are difficult to
sustain empirically. Moreover, outside of a few extraor
dinary episodes, it is very difficult to find any concrete
illustrations of the recent literature’s key policy predic
tion that a credible disinflation can be relatively
costless.
Some terminology
The recent literature on optimal monetary policy is diffi
cult for nonspecialists to read, in part because the
terminology is difficult. This section reviews the termi
nology and puts it in the context of the issues to be
discussed in greater detail subsequently.5
In common language, a “consistent” policy is one that
follows a well-defined set of rules over time. It would
normally be viewed as superior to an “inconsistent”
policy. Because the new literature on monetary policy
emerged out of the earlier optimal control literature, the
common usage has been altered. A time consistent
policy is one that results from solving a long-term
dynamic optimization problem without incorporating the
effect of current policy actions on the public’s expecta
tions of the future.6 The “consistency” that emerges in
solving such problems is that the optimal policy in all
future periods conforms to the policy determined in the
initial period, provided that there are no unexpected
occurrences or shocks to the economy. Put yet another
way, in the absence of shocks, the optimal policy path
laid out in time period 0 continues to appear optimal in
period 1, period 2, and so on.7 In no future period do
policy makers have any reason to alter the policy path
that they devised in period 0, again assuming that no
5The terminology and literature begin with Finn E. Kydland and
Edward C. Prescott, "Rules Rather Than Discretion: The
Inconsistency of Optimal Plans,” Journal of Political Economy, vol.
85, no. 3 (June 1977), pp. 473-91; and Guillermo A. Calvo, "On the
Time Consistency of Optimal Policy in a Monetary Economy,"
Econometrica, vol. 46, no. 6 (November 1978), pp. 1411-28. Willem
H. Buiter, “The Superiority of Contingent Rules over Fixed Rules in
Models with Rational Expectations,” Economic Journal, vol. 91,
no. 363 (September 1981), pp. 647-70, discusses the relationship
between the new literature on monetary policy design and the older
optimal control literature.
6Such models are often referred to as “causal” models since
behavior can be traced directly to past events. By contrast, “noncausal” models allow expectations of future events to affect current
behavior.
7Buiter, "The Superiority of Contingent Rules," citing Kydland and
Prescott, “Rules Rather Than Discretion," and R. Bellman, Dynamic
Programming (Princeton, N.J.: Princeton University Press, 1957),
states that “a sequence of policy actions is time consistent if, for
each time period, the policy action in that period maximizes the
objective function, taking as given all previous policy actions and
private agents’ decisions and as given that all future policy actions
will be similarly determined.
shocks have occurred. If such shocks do occur, the time
consistent policy path has the property that no currently
anticipated developments would lead policy makers to
contemplate changing their program in the future.
This type of consistency does not necessarily mean
that the resultant policy path is desirable, only that
policy makers see themselves as unable to do better.
Whether the outcome is desirable in fact depends on
how the public form ulates its expectations. The
assumption made by policy makers following a time
consistent policy is that the public’s behavior in each
period depends on past policy decisions only. If the
public’s expectations are rational, however, so that on
average the public correctly anticipates and reacts to
future policy actions, the policy makers’ decisions and
the public’s actions may be based on different views of
the impact of the policy decisions. The public may
correctly (on average) anticipate future policy moves
because it recognizes the incentives faced by policy
makers and incorporates these expectations into its
current behavior, while policy makers assume that the
public’s decisions are independent of their future
actions. In this situation, policy makers are aware of the
public’s current expectations but ignorant of how those
expectations respond to policy actions. In this respect,
the assumption of rational expectations on the part of
the public provides it with an informational advantage
over the policy makers.
The equilibrium that emerges is the outcome consis
tent with both views of the public’s inflation expecta
tions; it m axim izes the policy m akers’ objective
function, contingent on the public’s current expecta
tions. It is not necessarily the best outcome by any
means. The public may base its expectations on worst
case assumptions, and policy makers may find that the
“optimal” policy in this case has the effect of validating
these assumptions.
An example may illustrate this point. Assume that the
public correctly believes that policy makers wish to
lower the unemployment rate as much as possible pro
vided that inflation does not exceed some critical
threshold. For policy makers, the time consistent policy
is to remain expansionary as long as inflation is below
this critical value. The public, knowing that this is the
policy makers’ rule, will quickly adjust inflation expecta
tion to the critical level, since it recognizes that govern
ment policy will quickly bring inflation there. Hence, the
time consistent outcome is that inflation expectations
and actual inflation adjust upward to the critical level,
leaving the authorities little room in fact to implement
the expansionary policy— that is, to lower the unem
ployment rate below some “natural rate.”
In this example, the time consistent outcome has the
following properties:
FRBNY Quarterly Review/Winter 1991
67
a) Policy makers always follow their perceived
optimal rule of expanding output until inflation hits
a critical level.
b) The public is not fooled; it correctly predicts the
policy makers’ action.
c) The outcome, characterized by a rapid jump in
inflation expectations to the equilibrium level (the
policy makers’ threshold level), is unlikely to pro
duce the output gains sought by policy makers.
d) At the equilibrium inflation rate, policy makers have
no incentive to alter their policy.
By contrast, a time inconsistent policy path, which
may in fact represent the optimal long-term policy path,
does not necessarily appear optimal to policy authori
ties on a period-by-period basis.8 As a result, each
period policy makers would be tempted to renounce the
initial time inconsistent policy path and substitute a new
one. In the example above, the time inconsistent policy
is to resist the temptation to lower the unemployment
rate below the natural rate, even when the public’s
expectation is for zero inflation and expansionary policy
would appear desirable from the policy makers’
viewpoint.
The distinction between time consistent and time
inconsistent policies can be illustrated further in the
context of game theory. Consider the policy makers’
payoff matrix, which specifies the value of a given out
come under a variety of circumstances and which is
assumed to be known by the public (see the table).9
From the policy makers’ viewpoint, the best option is to
inflate when the public expects no inflation, thereby
gaining the benefits of faster growth (outcome C).10 The
worst option is to disinflate when inflation expectations
are high, thereby producing a loss of output (outcome
B).
In between these extremes are equilibrium outcomes.
When the policy and the public’s expectations are noninflationary (outcome D), the outcome is slightly worse
than when the inflation takes the public by surprise, but
better than when both public expectations and policy
are inflationary (outcome A).
The key point is that the public recognizes that the
government has an incentive to generate inflation
8ln Lectures in M acroeconom ics (C am bridge: MIT Press, 1989),
O livier J. B lanchard and Stanley Fischer offer the following
definition: “A po licy is dyn am ically inconsistent when a future policy
de cisio n that forms part of an optim al plan form ulated at an initial
date is no longer optim al from the view point of a later date, even
though no relevant new inform ation has appeared in the m eantim e."
9Keith B lackburn, “ M acroeconom ic Policy Evaluation and Optim al
Control Theory: A C ritical Review of Some Recent Developm ents,"
Journal of E conom ic Surveys, vol. 1 (1987), pp. 111-48, provides a
com prehensive review of the gam e theoretic aspects of this
literature.
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Payoff Matrix from the Policy Makers’ Viewpoint
Policy D ecision
P ublic's
E xpectation
High inflation
No inflation
H igh Inflation
No Inflation
2 (A)
4 (C)
1 (B)
3 (D)
Note: H igher num bers represent preferred outcom es.
whether the public expects high or low inflation. Out
come A is preferred to outcome B, and outcome C is
preferred to outcome D— that is, the high-inflation strat
egy dominates.
The time consistent outcome is A: policy and expec
tations match, creating an equilibrium, and the authori
ties can do no better given the public’s expectations.
Outcome D, however, is the time inconsistent equi
librium and is clearly superior to A, but this outcome
may be unsustainable. Once the public’s expectations
are decided, policy makers can do better by inflating.
The public will also recognize that if inflation expecta
tions are low, the authorities will choose C. Hence, the
public will never expect the low-inflation equilibrium
because policy makers’ optimizing behavior consistent
with that expectation yields high inflation.
Thus, in some instances adhering to a time inconsis
tent policy path is superior to following a time consis
tent path, provided that the public can be made to
believe that policy makers are sincere in their pursuit of
a policy that forgoes short-run optimization. In the
game theory example, the superior time inconsistent
outcome D could be achieved if policy makers could
guarantee that they would not try to achieve C, their
true optimum. Much of the policy makers’ problem con
sists of convincing the public of their resolve to follow
the time inconsistent path, when the public realizes the
temptation to reoptimize. The problem resembles that of
the Prisoner’s Dilemma in that the outcome without
cooperation between the players (in this case, the pol
icy makers and the public) is likely to be inferior to that
with cooperation. The absence of a mechanism to guar
antee the cooperative solution rules out the superior
outcome when cheating promises a better result for
policy makers acting on their own.
A key element of the coordination problem is that the
public is assumed to arrive at its expectation of current
period policy before policy makers reach their decision.
If the authorities moved first, the coordination problem
10The policy makers' ob je ctive function will be d iscusse d below in
greater detail.
would be mitigated because there would be no opportu
nity to fool the public. Paradoxically, the time consis
tency problem would be resolved because there would
be no incentive to deviate from preannounced plans.
Many of the proposed solutions to the time consistency
problem amount to removing “surprise” as a policy tool.
In the context of the table, they amount to forcing policy
makers to choose between the no-inflation equilibrium
(D) and high-inflation equilibrium (A).
To resolve the coordination problems that arise if the
time inconsistent policy path is superior, policy makers
may wish to commit or precommit themselves to the
time inconsistent policy, which they know to be superior
in the long term, and renounce the possibility of reop
timization. By committing themselves to the time incon
sistent policy, they may hope to convince the public that
they will not inflate, even when it would be advan
tageous to do so. A further difficulty may arise, how
ever. If policy makers face no sanctions for violating
their commitment or if the public cannot monitor on a
timely basis policy makers’ commitment, any commit
ment may lack credibility. Both the public and the policy
makers may agree that the committed policy is best, but
the public will not believe that the policy makers will
follow through because of the period-by-period tempta
tion to renege.
In practice, it may often be difficult to determine
whether policy makers are adhering to the precommit
ted policy. Targets can be missed either because of
random shocks to the economy or because policy
makers are reneging on their commitments. Because of
this ambiguity, advocates of precommitted policies often
argue that following fixed rules makes it easier for the
public to observe adherence to announced policies.11
The rules can be very simple (for example, constant
money growth rules) or more complicated, but they have
to be understandable, and compliance has to be readily
visible.
The requirement of ready visibility may make rules
with no feedback (open loop rules) at times superior to
rules in which policy actions are contingent on actual
events. The public may lose confidence in its ability to
monitor adherence to a rule if the rule permits action in
response to events not readily observable. For example,
assume that a particular monetary aggregate deviates
from its precommitted path. The central bank may claim
that it is merely accommodating a money demand
shock. But the public, having no way to ascertain that
such a shock has occurred, may assume that the devia
tion represents a policy easing and may therefore adjust
inflation expectations upward.
" S e e the papers in Federal Reserve Bank of New York, Intermediate
Targets and Indicators for Monetary Policy: A Critical Survey, 1990,
for extensive references to the literature on monetary policy rules.
To sum up, the long-run optimal policy may be time
inconsistent if the public can understand and predict
future policy responses (that is, if the public has rational
expectations). It may be preferable for policy makers
not to optimize on the basis of expectations that they
view as fixed, but rather to anticipate the negative effect
that such optimization will have on expectations of
future policy actions. More concretely, in the monetary
policy case, policy makers who are expected to take
advantage of low inflation expectations in order to pur
sue expansionary (and inflationary) policies may find
that expectations are extremely sticky at undesirable
levels in subsequent periods. Recognizing this, the pol
icy makers may wish to commit themselves to a series
of policy actions that may not be optimal on a period-byperiod basis, but that are consistent with low inflation
expectations in the long run. To succeed in the long run,
such a commitment must be credible, and credibility in
turn may depend on adherence to readily visible fixed
rules. Fixed rules with no feedback make it easiest for
the public to observe that policy is following its precom
mitted path.
Is there an inflationary bias to monetary policy?
This section considers the conditions under which posi
tive inflation may emerge as an equilibrium, even when
both the public and the policy makers view the outcome
as inferior to one of zero inflation.12 It examines the
circumstances under which dynamic optimization by
policy makers will produce an inferior result to a policy
following relatively fixed rules. After the presentation of
the basic model, a critical discussion of the assump
tions needed to yield the equilibrium inflation result is
presented. The section concludes with possible
approaches to mitigating the alleged inflationary bias of
policy.
How do inflationary biases emerge?
The basic structure of the models under discussion is
very simple.13 Policy makers try to achieve inflation and
output goals that are inconsistent. The desired output
level is greater than could be achieved at stable infla12For convenience of exposition and in common with the rest of the
literature, this article will treat zero as the inflation target. In
practice, measurement problems or nominal wage and price
stickiness may make a positive but low level of inflation preferable.
What is essential for the analysis is that the public view policy
makers as willing to inflate above the target, whether it is zero or
positive.
13Robert J. Barro and David Gordon, "Rules, Discretion and
Reputation in a Model of Monetary Policy,” Journal of Monetary
Economics, vol. 12, no. 1 (July 1983), pp. 101-21; Barro, “Recent
Developments in the Theory of Rules versus Discretion"; and
Blanchard and Fischer, Lectures in Macroeconomics, provide clear
descriptions of the analytical model underlying this section.
FRBNY Quarterly Review/Winter 1991
69
tion.14 Policy makers face the choice between maintain
ing stable inflation at an output level lower than they
would otherwise try to achieve or achieving desired
output levels at the cost of ever-increasing inflation.
Higher inflation emerges in the second ca&e because a
positive inflation surprise is the only mechanism
bywhich policy makers can increase output to desired
levels. In a multiperiod context, inflation surprises would
be needed each period to maintain desired output;
hence, spiraling inflation would emerge.
It is assumed that policy makers are less willing to
tolerate additional inflation when inflation rates are
already high. For example, going from 0 to 2 percent
inflation will cause policy makers some discomfort,
which may be offset by the temporary output gain. Each
successive increment of inflation causes additional dis
comfiture, until inflation ultimately reaches a point at
which policy makers are unwilling to accept the higher
levels, even if output can thereby be maintained above
the level corresponding to the natural rate. Thus, under
these assumptions, there is a strict upper limit to the
inflation rate policy makers would engineer, even if the
public’s inflation expectations were set naively. In many
cases this upper limit will also be the public’s equi
librium inflation expectation since the public knows that
policy makers would not intentionally raise inflation any
further.
It is also assumed that the public cannot be systemat
ically fooled or surprised by inflation. The public knows
policy makers’ preferences and the structure of the
economy, and knows that policy makers have an incen
tive to try to produce surprise inflation. The public also
knows the increasing discomfiture of policy makers at
high inflation rates. (The public’s preference function is
often assumed to be the same as the policy makers’—
that is, to eliminate conflicting preferences as an under
lying cause of equilibrium inflation.)
The public tries to predict the inflation rate by evaluat
ing how policy makers are likely to act. The public
recognizes that if policy makers observe low inflation
expectations, they will have an incentive to create sur
14Economists usually attribute this to some distortion that lowers
output below its potential. The most common example is the
distortionary tax that lowers supplies of labor and capital.
Alternatively, political considerations may lead to a greater
emphasis on short-term output gains as elections approach. See
Alberto Alesina, “Macroeconomic Policy in a Two-Party System as a
Repeated G am e,” Quarterly Journal of Economics, vol. 102, no. 3
(1987), pp. 651-78; Alberto Alesina and Jeffrey Sachs, “Political
Parties and the Business Cycle in the United States, 1948-1984,"
Journal of Money, Credit, and Banking, vol. 20 (1988), pp. 63-82;
and William D. Nordhaus, “Alternative Approaches to the Political
Business C ycle,” Brookings Papers on Economic Activity, 2:1989. In
theory, the government’s objective function could be strictly rising
with output, but this would imply a willingness to trade leisure for
output that would not be consistent with utility maximization by the
public.
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FRASER Quarterly Review/Winter 1991
prise inflation in order to reap output gains from the
surprise. But the public also knows that at sufficiently
high expected inflation levels, policy makers, by their
own choice, will never inflate further, even by surprise,
and might even choose to disinflate because of the
perceived costs of a high level of inflation.
Using this knowledge, the public forms its expecta
tions. It will never expect inflation to be so low that
policy makers will have an incentive to create surprise
inflation. Nor will the public expect the government to
produce an inflation rate that is so high that the govern
ment would subsequently be tempted to engineer a
recession (that is, create surprise disinflation) to reduce
inflation to more acceptable levels. The rational expec
tation is thus for an inflation rate just high enough to
eliminate the incentives for policy makers to surprise
inflate and low enough to remove the incentive to sur
prise deflate. From the viewpoint of policy makers,
losses from additional surprise inflation at this inflation
rate just balance the perceived benefit of the additional
output. The government, facing this expectation, has no
incentive to produce any surprise. This outcome is
characterized by inflation that is positive in equilibrium
and output that is at the natural rate (but below the
government’s desired level). Nothing is gained on the
output side from the additional inflation, but a welfare
loss is incurred because of inflation. Thus, the outcome
that emerges is inferior to the one that could be attained
at zero inflation.
Although the extent of the knowledge attributed to the
public by these models strains credulity, many of the
specific assumptions are analytically convenient without
being essential. What is essential is the public’s
assumption that policy makers are willing to use sur
prise inflation as a tool to generate higher employment.
It is not necessary that the public know the exact form
of the policy makers’ preferences or the exact structure
of the economy.
Underlying assumptions
The basic ingredients creating a conflict between shortand long-term policy making are (i) irreconcilable output
and inflation goals, (ii) forward-looking or rational
expectations on the part of the public (but not the policy
makers), and (iii) a perceived ability on the part of
policy makers to “surprise” the public with unexpected
inflation.
Although these assum ptions seem technical in
nature, assessing their realism will clarify the realism of
the entire analysis. In particular, the sensitivity of the
analysis and the results to changes in the assumptions
will help us to evaluate the claim that the structure of
policy making is the source of persistent inflation in
recent times. Indeed, one of the major contentions of
this article is that the implications of the time consis
tency literature are virtually indistinguishable from
those of a standard backward-looking adaptive expecta
tions framework. The additional theoretical elegance of
the time consistency models is achieved only at the
cost of assumptions whose empirical robustness is
dubious.
Incompatible targets. The assumption of incompatible
goals is essential.15 In particular, policy makers are
assumed to strive for an unemployment rate that is
inconsistent with the natural rate. By assumption, the
natural rate is the only unemployment rate at which
inflation is stabilized; hence, policy makers must bal
ance approaching their targeted unemployment rate
against the extra inflation generated in getting there.
There is no conflict between time consistent and time
inconsistent policies if policy makers have only a single
goal or multiple goals that are mutually supportive. If
policy makers aim only at stabilizing inflation (at zero or
any other value) or at stabilizing the unemployment rate
at the natural rate (that is, the rate consistent with
stable inflation), the time consistent policy path pro
duced by dynamic optimization is fully consistent with
the time inconsistent policy path toward the equilibrium
of zero inflation (or any desired rate). Hence, the struc
ture of policy making is irrelevant if policy makers are
perceived as pursuing only a zero inflation target or a
sustainable output target. It is only when the public
views policy makers as regarding favorably the prospect
of trading additional inflation for additional output that
the inflationary bias emerges.
The reason that time consistency problems do not
emerge when the output target is the natural rate is that
the public has no reason to question the willingness or
ability of policy makers to achieve their inflation and
output goals. Because there is no conflict among goals,
there is no question of commitment or credibility and no
policy trade-off to exploit.16
As to the policy makers’ objective function, the the
oretical elegance of time consistency models appears
greatly oversold. Undesirably high inflation as an equi15This assumption dates back to Kydland and Prescott, in "Rules
Rather Than Discretion.” It is used in Barro and Gordon, “Rules,
Discretion and Reputation”; Barro and Gordon, "A Positive Theory of
Monetary Policy”; Alex Cukierman and Allan H. Meltzer, "A Theory
of Ambiguity, Credibility and Inflation Under Discretion and
Asymmetric Information,” Econometrica, vol. 54, no. 5 (September
1986), pp. 1099-1128; and virtually every other paper on the subject.
16Brian Hillier and James M. Malcomson, in “Dynamic Inconsistency,
Rational Expectations and Optimal Government Policy,”
Econometrica, November 1984, pp. 1437-51, argue that the essence
of the time consistency problem is that policy makers have two
targets, inflation and output, but only one instrument. Surprise
inflation becomes a second instrument that the policy makers are
attempting to utilize.
librium is derived at the cost of assuming that policy
makers pursue targets that they know to be inconsis
tent. Often the pursuit is justified as a necessary conse
quence of the political process or as a way of offsetting
other output-reducing distortions in the economy. In
general, however, scant attention is paid to motivating
the policy makers’ assumed objective function empiri
cally or theoretically.
Rational expectations. The second requirement for time
consistency problems to emerge is rational expecta
tions by the public. That is, the public knows enough
about the preferences of policy makers and the struc
ture of the economy to forecast policy accurately on
average.17 Under rational expectations, policy makers
cannot systematically fool the public and so cannot gain
the extra output that is sought, even temporarily. There
is an asymmetry here in that while both the public and
the policy makers know the structure of the economy
and the policy makers’ preference, only the public
optimizes on the basis of future events. Indeed, in the
earliest models that developed the time consistency
problem, it was explicit that the public reacted to both
past and future policies, while policy makers optimized
only on the basis of past events.18 Such myopia on the
part of policy makers is often attributed to their suscep
tibility to short-term political influences. Policy makers
do not recognize that the public discerns and reacts to
their incentives. If policy makers recognized that the
public cannot be fooled, they would not make the effort
to do so. Furthermore, in many cases, even if policy
makers assumed (incorrectly) that the public had back
ward-looking expectations, they would nevertheless be
deterred from inflating opportunistically as long as their
discount rate was not too high and they viewed the
p u b lic’s exp ectatio n s as responding reaso nab ly
promptly to actual inflation.19 By implication, in those
17Rational expectations are not strictly required. As long as the
public’s behavior responds somewhat to its expectation of future
policy, a time consistency problem can emerge. However, virtually
all of the literature assumes rational expectations.
18For example, see Kydland and Prescott, “Rules Rather Than
Discretion." In equilibrium, expectations are fulfilled, so both the
policy makers’ and the public’s expectations are rational ex post.
19For example, the low-inflation equilibria discussed in Barro and
Gordon, “Rules, Discretion and Reputation,” can be interpreted as
emerging because policy makers recognize that inflation
expectations respond quickly to actual policies. Also see V.V. Chari
and Patrick J. Kehoe, “Sustainable Plans," Federal Reserve Bank of
Minneapolis, Research Department Working Paper no. 377, 1988;
and Herschel I. Grossman, “Inflation and Reputation with Generic
Policy Preferences,” Journal of Money, Credit, and Banking, May
1990, pp. 165-77. In “Credible Disinflation in Closed and Open
Economies,” Queens University Discussion Paper no. 660, 1986,
David Backus and John Driffill find that the response of
expectations even with Fischer-Taylor-type overlapping wage
contracts is sufficiently quick to avoid the bulk of the costs
associated with time inconsistent policies.
FRBNY Quarterly Review/Winter 1991
71
models where high inflation equilibria emerge, policy
makers believe that they can fool most of the people for
a long time.
The assumption that the public holds rational expec
tations can also be challenged on empirical grounds.
Most empirical tests of the rational expectations hypoth
esis reject it. In particular, inflation expectations appear
to be more backward- than forward-looking and inflation
“surprises” can last for a long time.20 If such is the case,
the premise that adherence to a credible policy rule will
produce costless disinflation may prove to be far off the
mark. In practice, policy makers may find it risky to
adopt a policy path whose success depends crucially
on the assumption that the public will both anticipate
correctly and react immediately to the effects of future
policies.
In considering the robustness of policy conclusions to
be drawn from the models under review, it is important
to recognize that backward-looking (for example, adap
tive) expectations on the part of the public can yield
many of the same results produced by rational expecta
tions in these models. Adaptive or backward-looking
expectations in a multiperiod context would not be
strictly “rational,” but in regimes of moderate or low
inflation the results would not diverge greatly from
rational expectations. As long as expectations even
tually catch up to actual inflation, any systematic infla
tion surprise can only be transitory. During this
transition, policy makers could temporarily generate
higher output (a course not open to policy makers if
strictly rational expectations are assumed), but long-run
output growth would be unaffected as long as policy
makers were unwilling to accept ever-increasing infla
tion. Equilibrium inflation would be higher and output
temporarily higher.
With such backward-looking expectations, however, it
makes no difference if policy makers are credible, and
there is no conflict between the time consistent and
time inconsistent solutions. From the policy makers’
point of view, they are obtaining the best solution given
their preferences and the structure of the economy. That
is, they may feel that if inflation is running at very low
levels, the short-run increase in output can justify a
small, but long-run, increase in inflation. In practice,
however, if inflation expectations react quickly to
increases in inflation, the willingness to inflate is likely
to be extremely curtailed.
The key point is that in the absence of rational expec
tations, policy makers, perhaps reflecting the tastes of
the public, have preferences that lead them to exploit
“ See A. Steven Englander and Gary Stone, "Inflation Expectations
Surveys as Predictors of Inflation and Behavior in Financial and
Labor Markets,” Federal Reserve Bank of New York Quarterly
Review, Autumn 1989.
72
FRBNY Quarterly Review/Winter 1991
the inflation/output trade-off and that make them unwill
ing to accept the output losses required for a return to
zero inflation. In this case, it is probably better to
choose better policies or better policy makers than to
impose a structure of rules that may respond inflexibly,
and thus suboptimally, to economic shocks or changes
in priorities.
Surprise inflation as a policy tool. The final critical
assumption of these models is that policy makers can
generate surprise inflation to exploit an inflation/output
trade-off temporarily. While this assumption is com
monplace in the literature, the process by which the
inflation/output trade-off is exploited in practice is not
clearly described. Indeed, it seems to rest on two
assumptions: 1) that anticipated policy moves (such as
an expected easing in monetary policy) should have
little or no effect on output, and 2) that policy makers
can manipulate the surprise component of inflation to
alter the path of output temporarily.
Surprise inflation is not a tool directly at the disposal of
policy makers. Some other instrument— interest rates,
money growth, reserve requirements— must be used to
implement policy. By common consensus, however, long
and variable lags separate movements in these potential
instruments from changes in inflation or output. It is doubt
ful whether the degree of surprise experienced by the
public when inflation rates change is any greater than that
experienced by policy makers or whether economic
behavior is greatly affected because of ignorance of the
price level.21 Hence, it is unlikely that mistaken beliefs
about the level of real wages or relative prices can gener
ate significant output fluctuations.
How surprise inflation affects aggregate output may
appear to be an arcane question. But it can help us to
determine whether the structure of policy making is the
key factor inducing persistently high inflation expecta
tions. If policies that have been previously announced,
or for some other reason are already expected, never
theless can have an effect on real output, the structure
of the problem assumed in the time consistency liter
ature is altered fundamentally.22 The reason is that
policy makers can achieve output gains, at least in the
21As discussed below, Barro and Gordon, “A Positive Theory of
Monetary Policy,” and Finn E. Kydland, “Monetary Policy in Models
with Capital,” in Frederick van der Ploeg and Aart de Zeeuw, eds.,
Dynamic Policy Games in Economics, pp. 267-87 (Amsterdam:
North Holland, 1989), argue that the effects of surprise inflation on
nominal asset values and capital accumulation are of greater
empirical significance than the effects of wage or relative price
surprises on output.
“ See Frederic S. Mishkin, A Rational Expectations Approach to
Macroeconometrics (Chicago: University of Chicago Press, 1983),
for example. Both his original work and his reworking of Robert J.
Barro and M. Rush, “Unanticipated Money and Economic Activity,”
in Stanley Fischer, ed., Rational Expectations and Economic Policy
short run, without resorting to policy moves that fool the
public. Policy makers would optimize subject to their
knowledge that unsustainable expansionary policies
lead to inflation. Depending on the policy makers’ objec
tive function, they might tend to choose inflationary or
noninflationary policies, but the source of the inflation
would be the policy makers’ actions rather than the
structure of policy making or expectations conditioned
on future policies.
The public might revise its inflation expectation
upward when it observed expansionary policy being
implemented, but it would not do so in the absence of
such policy. Again, the conduct of policy making, rather
than its structure, appears to be the underlying determi
nant of inflation.
Recognizing that ignorance of the level of prices or
real wages is unlikely to produce major output effects,
some analysts have argued that the effects of inflation
ary policy moves are seen immediately in asset values
and capital accumulation decisions (but before the infla
tionary effects show up in actual prices). Hence, the
policy surprise operates through wealth rather than
inflatio n . The em pirical consequences of such
redistributions of wealth, however, are difficult to pin
down. Some authors contend that inflation leads to
higher output because the lower real value of govern
ment debt allows the government to engage in further
spending. In contrast, others argue that price inflation
may actually lead to a reduction in output by lowering
the incentives to accumulate capital.23
While the issue appears abstract, the considerable
uncertainty attending the effects of surprise asset infla
tion makes it unlikely that such surprises are the mech
anism by which an inflation/output trade-off is con
sciously exploited by policy makers. Yet the structure of
such models and the policy conclusions that they yield
presuppose that surprise inflation is the only means by
which policy can affect outcomes. If this assumption is
false, it is hard to make the argument that the mere
presence of discretionary policy making yields an infla
tionary bias. Again the time consistency problem seems
less important than systematic policy errors or prefer
ences in generating inflation.
Credibility
If the zero inflation outcome is preferable to the equiFootnote 22 continued
(Chicago: University of Chicago Press, 1980), suggest that, if
anything, anticipated policy moves have more impact on output
than unanticipated policy.
“ In “Rules, Discretion and Reputation," Barro and Gordon emphasize
the revenue-generating function of inflation; in "Monetary Policy in
Models with Capital," Kydland emphasizes the effect of inflation on
capital accumulation decisions.
librium outcome in the eyes of both parties, why do
they not agree to maintain the preferred alternative?
The time consistency literature argues that the answer
to this question involves the credibility issue. The public
recognizes that policy makers have every incentive to
assert that they will maintain low inflation, but it also
recognizes that policy makers have a greater incentive
to renege if the public accepts the assertion at face
value. According to this view, the public in general will
not believe that low inflation will be maintained unless
policy makers are viewed as strong adherents of low
inflation or policy makers can provide evidence that
they are following a policy rule that will yield low
inflation. It is in this latter context that adhering to
an intermediate target path believed consistent with
low inflation, for exam ple, may reduce inflation
expectations.
This is where credibility issues become important. A
commitment can be credible either because policy
makers have a reputation for backing their commitments
or because a way of enforcing the commitment exists.
Among the suggested strategies for achieving commit
ment are
i) requiring commitment through legislation
ii) ensuring that any breaches are obvious
iii) choosing policy makers whose sole objective is
low inflation.
The mechanisms by which these proposals provide
credibility are discussed below. This analysis concludes
that the strategies, while possessing some attractive
features, are extremely difficult to implement and may
carry concomitant disadvantages that could greatly out
weigh their potential benefits. Moreover, if inflation
expectations are essentially backward-looking, such
policies may be redundant and potentially damaging if
they tie policy makers’ hands unnecessarily. The dis
cussion concludes with an analysis of a fourth consid
eration that may encourage commitment:
iv) The adverse consequences of a reputation for
opportunism may encourage policy makers to
adopt low inflation policies even in the absence of
a specific policy rule.
Legislation. By mandating a specific inflation goal or
an intermediate target, legislation has the appearance
of eliminating discretion by policy makers and substitut
ing prescribed behavior.24 In this way, the authorities’
24Legislation can be viewed as imposing a severe penalty on policy
makers for pursuing inflationary policies. Mats Persson, Torsten
Persson, and Lars E.O. Svensson, “Time Consistency of Monetary
and Fiscal Policy," Econometrica, vol. 55, no. 6 (November 1987),
pp. 1249-73; and Mats Persson, Torsten Persson, and Lars E.O.
Svensson, “Time Consistency and Monetary Policy,” Econometrica,
vol. 55, no. 6 (November 1987), pp. 1419-31, suggest an alternative,
FRBNY Quarterly Review/Winter 1991
73
conduct of policy may gain credibility in the eyes of the
public.
One problem with legislated solutions, however, is the
difficulty of ensuring an adequate degree of flexibility.
Legislation can permit deviations from the rule under
certain specified circumstances, such as war or deep
depression, but there may be other circumstances,
more difficult to identify or foresee, that would also
justify a deviation, even at the risk of higher inflation. If
the set of exceptions is made too general, however, the
entire legislation may lose its credibility. Moreover, if the
legislation is predicated on the assumption that disinfla
tion can be achieved costlessly, a conflict between the
explicit inflation goals and implicit output targets may
well emerge. The public may discount legislation that
does not state explicitly whether output losses are an
acceptable cost of disinflation. In much of the time
consistency literature this problem is “eliminated” by
the assumption that a sufficiently “credible” disinflation
will be costless, but the literature offers no set of criteria
by which to predict in advance whether the costs of
disinflation have in fact been lowered.
A second role for legislation might be to reduce or
eliminate the conflict among final goals. A definite state
ment that price stability is the primary goal for monetary
policy and that any output target ought to be consistent
with this goal on average might mitigate the time con
sistency problem because it might reduce any tempta
tion to exploit the inflation/output trade-off.
Making dissonant behavior obvious—intermediate
targets. A second possible way of ensuring adherence
to the announced path is to remove the possibility of
surprise inflation from the hands of policy makers. In
practice this could be achieved by tying policy to a
particular nominal aggregate. Deviations from target
would, at least in theory, be readily visible and viewed
as reneging on the commitment. Policy makers would
be able to comply with the rule and benefit from the low
inflation equilibrium. Once they deviated from the rule,
the public would recognize their lack of commitment,
and expectations would immediately shift upward.
Faced with these two possible outcomes, policy makers
would adhere to the rule.
Obviously this strategy requires that the aggregate in
question be controllable and predictably related to the
final objectives. If the first condition does not hold, it is
impossible to determine whether deviations from target
represent a willful effort by policy makers to create
Footnote 24 continued
but not very practical, way of penalizing inflationary behavior. They
argue that if the government is a net creditor (and bound by some
restrictions on the term structure of its holdings), the reduction in
the real value of its assets from inflation would provide a
disincentive to inflate opportunistically.
74
FRBNY Quarterly Review/Winter 1991
inflation, that is, to renege.25 If the second condition
does not hold, the credibility will be achieved at the cost
of being unable to respond to shifts in the velocity of the
aggregate in question. Unless an intermediate target
satisfying both these criteria can be found, it will be
impossible to have both credibility and control over final
objectives. These trade-offs are crucial to determining
the desirability of an intermediate target rule. The con
trollability criterion points to a narrow aggregate— if
control is limited, then the observation that an inter
mediate target is conforming to, or deviating from, a
desired path brings little information. With a narrow
aggregate, however, the link to final targets may be long
and uncertain, and adherence to the intermediate target
may lead to shocks to the final targ e t26
By and large, there appears to be scant evidence that
strict observance of an intermediate target would yield
better control over final targets.27 This raises an impor
tant practical question about the use of such intermedi
ate targets. Would a poorly selected intermediate target
itself lack credibility because the public would recognize
“ In fact, Torben M. Andersen, “Rules Versus Discretion in Monetary
Policy: The Case of Asymmetric Information," Journal of Economic
Dynamic Control, vol. 10 (1986), pp. 169-74, argues that if policy
makers have better information than the public about the source of
money demand shocks, they would have an incentive to dissemble
even under a constant growth rate rule.
asSee, for example, Bennett T. McCallum, “Targets, Indicators and
Instruments of Monetary Policy,” in William S. Haraf and Philip
Cagan, eds., Monetary Policy in a Changing Financial Environment
(Washington, D.C.: American Enterprise Institute Press, 1990); and,
in the same volume, Benjamin J. Friedman, “Is the Monetary Base
Related to Income in a Robust Way? A Commentary." These authors
come to opposite conclusions about the suitability of the monetary
base, as an intermediate target. David Currie, “Macroeconomic
Policy Design and Control Theory— A Failed Partnership," Economic
Journal, vol. 95 (June 1985), pp. 285-306, provides a discussion of
the ill effects of what he perceives to be a poorly chosen
intermediate targeting strategy in the United Kingdom in the early
1980s. Some analysts argue that strict control of monetary
aggregate growth over long periods would reduce the drift in
velocity of the monetary aggregates; they claim that many of the
velocity changes seen in the last generation were themselves
induced by the high inflation rates of the 1970s and early 1980s.
See Barro, "Recent Developments in the Theory of Rules versus
Discretion"; and John J. Judd and John L. Scadding, "The Search
for a Stable Money Demand Function: A Survey of the Post-1973
Literature," Journal of Economic Literature, September 1982,
pp. 993-1023. The alternative view is that much of the shift in
velocity was exogenous to inflation and caused by improved
technology, which allowed much greater control by firms and
individuals of assets, and by financial deregulation.
^An extensive survey of intermediate targets is found in Federal
Reserve Bank of New York, Intermediate Targets and Indicators. A
summary of the findings appears in Richard G. Davis’ introduction
to the volume and is reprinted in the summer 1990 issue of the
Federal Reserve Bank of New York Quarterly Review under the title
“Intermediate Targets and Indicators for Monetary Policy: An
Introduction to the Issues."
that adherence requires compromising the final targets
for long periods of time? Knowing that the relationships
between intermediate and final targets are by no means
tight and unchanging, the public may well discount
adherence to such targets as being unsustainable, just
as legislation predicated on a costless disinflation is
likely to be discounted.
To get around the problem of achieving credibility
under shifting relationships between intermediate and
final targets, it has been proposed that there be some
feedback from final targets to policy instrument settings
or that final objectives themselves (inflation or nominal
income growth) be targeted.28 Various contingent rules
have been proposed to increase the stability of real
output. As more contingencies are built into the rules,
the performance in historical simulations appears to
improve, but the public may view adherence to a com
plicated rule as being too difficult to monitor and hence
little better than discretion.
A second mechanism that has been proposed to
make reneging obvious is to release the record of policy
deliberations and decisions immediately after they are
made. The argument is that the public could then
promptly recognize the inflationary consequences of
policy changes, rendering surprise inflation unfeasible.
However, such proposals depend critically on the
assumption that the lags between policy deliberations
and their public release are used by policy makers to
generate surprise inflation or disinflation. In fact, lags
between monetary policy decisions and their public
release are currently so short— about six weeks— that it
is hard to believe that such lags could be a source of
inflation surprises. Moreover, a plausible argument
could be made that immediate release would be coun
terproductive. If immediate release of deliberations
made them more subject to political pressures, inflation
expectations might rise rather than fall.29
Choosing conservative policy makers. By choosing
policy makers of impeccably noninflationary tastes, the
“ Implicit in some of these rules is the assumption that inflation
expectations and actual inflation rates will be more responsive to
policy under a rule than under discretion. If factors other than the
structure of policy lead to sluggish adjustment of actual and
expected inflation, this presumption would not be justified. The
inflation and real output growth engendered by such rules might
then not be desired by either the public or the policy makers.
R. Spence Hilton and Vivek Moorthy review a variety of such rules
in “Targeting Nominal GNP," in Federal Reserve Bank of New York,
Intermediate Targets and Indicators.
“ See William Poole, “Central Control of Interest Rates: A
Commentary," in Haraf and Cagan, eds., Monetary Policy in a
Changing Financial Environment. The political business cycle
literature, which treats political influences on economic policy
making, is beyond the scope of this survey. For recent discussions
and further references, see Nordhaus, “Alternative Approaches to
the Political Business C ycle”; and Alesina and Sachs, "Political
Parties and the Business Cycle in the United States.”
public is relieved of the need to monitor policy makers’
decisions. The literature conventionally describes these
policy makers as “conservative.” In other words, the
public can choose policy makers who attach far greater
weight to low inflation than high output and who are
thus more likely to err on the low inflation side.30
Indeed, the assumption is that they are more averse to
inflation than is the public.
In an economy subject to random shocks, this
approach is likely to be inferior to a policy combining
discretion with output targets that are consistent with
low inflation. For example, if there is a supply shock,
policy makers who pursue both output and price targets
will wish to distribute the shock between the two, while
policy makers who focus only on inflation will allow
output to take the complete shock in order to attain
inflation targets. Choosing conservative policy makers
is equivalent to selecting the latter. In doing so, society
forgoes the flexibility embodied in the former. It is not
possible to determine in advance whether the gain in
credibility from choosing conservative policy makers
offsets the resulting loss in flexibility. In general, the
gain from flexibility is higher when policy makers use
their discretion to smooth output and inflation in an
economy subject to large shocks. By contrast, the gains
from discretion could be small in a relatively placid
economy, and strongly noninflationary policy makers
might be preferable to more flexible ones in that setting.
If society prefers stability in both inflation and real
output, it is preferable to allow policy makers discretion
in spreading shocks between prices and output. An
inflation bias would not emerge if policy makers were
aiming on average at consistent inflation and output
targets. Again, a trade-off between discretion and rules
emerges only if the public knows that the ultimate
output target is not feasible without inflation.
Reputation. Although formal rules seem most direct in
constraining inflationary proclivities, the need to main
tain a noninflationary reputation can be almost as effec
tive in constraining opportunistic policy makers. If
policy makers have a long time horizon and do not
discount the future too heavily, they may be reluctant to
exploit an inflation/output trade-off opportunistically
because this will raise inflation expectations in subse
quent periods. A long time horizon is necessary
because it increases the period during which policy
makers would be “punished” by higher inflation expec“ Kenneth Rogoff discusses the implication of selecting policy makers
with an unusually strong aversion to inflation in "Reputational
Constraints”; “The Optimal Degree of Commitment to an
Intermediate Monetary Target," Quarterly Journal of Economics, vol.
100, no. 4 (1985), pp. 1169-90; and "Reputation, Coordination and
Monetary Policy," in Robert Barro, ed., Handbook of Modern
Business Cycle Theory (Cam bridge University Press, forthcoming).
FRBNY Quarterly Review/Winter 1991
75
tations. The moderate time discount rate is necessary
because the policy makers would otherwise put much
more emphasis on short-run optimization, an approach
which might lead to opportunistic behavior. Analysts
have pointed to the long and overlapping terms of cen
tral bankers as a way of promoting an institutional long
horizon.
The precise degree of restraint that reputational fac
tors impose on policy makers depends in large part on
how the public forms its expectations, how fast expecta
tions respond to a change in policy, and whether, once
policy has been opportunistic, expectations revert back
to low inflation without a loss of output. However, the
following general conclusion is robust: unless policy
makers are extremely short-sighted, valuing short-term
output gains very heavily, their own willingness to inflate
may be greatly constrained by the prospect of a long
period of high inflation and inflation expectations. Know
ing that the penalties from a loss of reputation are
severe, policy makers may even choose zero inflation.
Indeed, in the context of these models the public may
lower its inflation expectations because it knows that
policy makers view these penalties as a deterrent.
Hence, even where there is a willingness to behave
o p p o rtu n is tic a lly , d is c re tio n a ry tim e con sisten t
optimization may not produce significantly higher infla
tion than time inconsistent policies aimed at zero
inflation.
Reputation may be important in a different way even
when policy makers do not have full credibility. Much of
the literature compares results when policy makers
have full credibility at zero inflation with results when
there is no credibility at all— that is, when policy makers
are expected to inflate to their maximum tolerable infla
tion level. Under such circumstances, zero inflation is
not a credible result because policy makers have too
much incentive to renege. However, there may be an
inflation level that is above zero but below that of the no
credibility level to which policy makers could make a
credible commitment.31 While the policy makers may
wish to behave opportunistically, they may be deterred
by the possibility that the public’s inflation expectations
would revert as a result to the fully noncredible level.
Hence, policy makers may find it preferable to adopt
policies consistent with this intermediate level of expec
tations rather than try to achieve additional output
gains.
Such considerations may help explain why announce
ments of near-term zero inflation targets often carry
little credibility. The public may feel that policy makers
31Barro and Gordon, “Rules, Discretion and Reputation”; and Barro
and Gordon, “A Positive Theory of Monetary Policy.” See also John
B. Taylor’s comments on Barro and Gordon in “Rules, Discretion
and Reputation in a Model of Monetary Policy: Comments,” Journal
of Monetary Economics, vol. 12, no. 1 (July 1983), pp. 123-25.
76for FRBNY
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FRASER Quarterly Review/Winter 1991
will too readily jettison the zero inflation target if there is
the opportunity to obtain extra output. While this logic
would appear to argue in favor of announcing more
credible gradualist disinflation policies, there does not
appear to be much evidence that such announcements
themselves produce more credible and less painful dis
inflation. The reason may be that the short-run policy
moves are often too small to be convincing. The public
may also doubt the medium-term political sustainability
of the gradualist policy if it could imply persistent
restraint.
Uncertainty
Much of the previous discussion has been deter
ministic. The public knows with precision the aims of
policy makers and the structure of the economy (includ
ing the linkages of intermediate targets to final out
com es). Loosening these assum ptions of precise
knowledge affects the results as intuition would sug
gest: in the short run, the public is less categorical in its
interpretation of apparent policy moves; in the long run,
it will interpret a string of positive inflation results as an
indication that policy makers are willing to exploit an
inflation/output trade-off.
Two types of uncertainty are discussed below. The
emphasis is less on modeling than on exploring intu
itively how uncertainty affects the results discussed
earlier.
Uncertainty about the structure of the economy
When there are structural changes in the economy, rigid
adherence to a policy rule may be less desirable even
than the time consistent (discretionary) outcome. Sim
ply stated, the benefits from allowing policy makers to
offset shocks may well outweigh the losses from higher
inflation exp ectatio n s due to tim e c on sisten cy
problems.32
In some cases the optimal strategy may be mixed:
follow a rule during normal times when shocks are
relatively small, but switch to discretion in the presence
of large shocks.33 The reasoning is that it is expensive
for policy makers to specify behavior under important
but relatively rare events, just as it is difficult for the
public to specify behavior under all possible contingen
cies in its private contracts. In the event of a crisis, such
as a war or major downturn, both the public and the
policy makers are likely to view a rule as inferior to
w ln general, it has to be assumed that only policy makers are able
to recognize the shock. Otherwise the public would be able to
incorporate the shock into its expectations. Buiter, “The Superiority
of Contingent Rules," has a comprehensive discussion of how
informational advantages may tip the scale in favor of discretion.
MSee Robert P. Flood and Peter Isard, "Monetary Policy Strategies,”
IMF Staff Papers, vol. 36 no. 3 (Septem ber 1989), pp. 612-32.
discretion. Rather than adhere to imperfect rules or
attempt to determine rules for all contingencies it may
be preferable to allow discretion but require some ex
post justification for invoking it.34 According to this rea
soning, however, the benefits from adhering to a rule
may outweigh the benefits of discretion during normal
periods, provided that an adequate rule can be
formulated.
When the economy is subject to shocks, however, the
public may be more inclined to expect higher inflation
because it knows that in the short run policy makers
could disguise policy moves by claiming that they are
actually random shocks to the economy. As a conse
quence, policy makers may find it more difficult to
acquire a reputation for noninflationary policies if they
are not adhering to a verifiable rule. Over the medium
term, however, discretion may remain compatible with
noninflationary behavior by policy makers. For example,
while uncertainty may mean that a given positive infla
tion shock cannot be interpreted as opportunistic
behavior, negative and positive shocks should, on aver
age, offset each other over the medium term. By con
sidering whether an observed sequence of inflation
rates is more consistent with stable inflation than with
opportunistic behavior, the public may be able to estab
lish with fair precision the true objectives of the policy
makers. In one such model, policy makers maintain
credibility as long as inflation remains within a certain
range but lose credibility if inflation rates stray out
side.35 Again, the proof of the pudding emerges in the
eating— in the presence of uncertainty, the past record
of inflation performance is more useful than an imper
fect proxy for policy as an indicator of policy makers’
targets.
It has also been suggested that an explicit trade-off
can be made between the loss of flexibility due to strict
intermediate targeting and the risk that policy makers
may turn out to be more opportunistic than expected.
One such model argues that in an economy with weak
ties between intermediate and final targets, the inflation
record of policy makers with a strong noninflationary
^Flood and Isard point to the requirement in many countries that
central bankers testify periodically before elected officials as an
example of a mechanism that will limit abuse of discretion. As part
of this testimony, the bankers are closely questioned about their
policies.
“ See Matthew B. Canzoneri, “Monetary Policy Games and the Role
of Private Information,” American Economic Review, vol. 75 (1985),
pp. 1056-70. The decision rule is analogous to the rule used in
quality sampling. If an unusual number of defectives emerges in a
small sample of a larger lot, the entire lot is rejected. There is a
finite chance that a few atypical defectives will lead to rejection of
a basically good lot; similarly, there exists the chance that random
shocks beyond the policy makers’ control will lead to their acquiring
a reputation as inflation-prone.
record ought to be judged over a longer period than in
an economy where intermediate targets are closely tied
to final goals and the policy makers’ reputations are not
as well established.36 That is, policy makers of good
reputation should be given more medium-term discre
tion when intermediate targets are unreliable indicators
of the stance of policy.
Uncertainty about policy makers’ preferences
A large literature analyzing how the public forms its
expectations when it is uncertain of policy makers’ pref
erences has emerged in recent years. Time consistency
problems are replaced in this literature by the problem
of identifying policy makers who are more (or less)
willing to inflate opportunistically.37 Once policy makers
are found to be weak on inflation, they lose credibility
and inflation expectations move up to the time consis
tent level.
This literature focuses on the incentives prompting
opportunistic policy makers to look like inflation fight
ers. Revealing themselves to be opportunistic carries a
permanent cost of higher expected inflation, so they
have an incentive to look tough on inflation for some
period of time. (If their time horizon is infinite, the effect
may be absolute.) By and large, an incentive for oppor
tunistic policy makers to adopt noninflationary policies
emerges under a wide variety of conditions.
If there is uncertainty about the state and structure of
the economy, as well as about policy makers’ prefer
ences, the advantages accruing to a noninflationary
reputation diminish, however. The reason is that when
the public sees an apparently inflationary outcome, it
may be uncertain whether the outcome results from a
policy action or from a random shock.38 Policy makers
can do little in the short term to convince the public of
their noninflationary intent. Because of this ambiguity,
opportunistic policy makers may inflate early because it
may take some time for the public to catch on. While the
formation of the public’s inflation expectations would
obviously be influenced by such ambiguities, the use of
“ See Michelle R. Garfinkel and Seonghwan Oh, “Strategic Discipline
in Monetary Policy with Private Information: Optimal Targeting
Periods,” Federal Reserve Bank of St. Louis, mimeo.
37The seminal papers are David Backus and John Driffill, "Rational
Expectations and Policy Credibility Following a Change in Regime,”
Review of Economic Studies, vol. 52, no. 2 (April 1985), 211-22; and
Backus and Driffill, “Inflation and Reputation," American Economic
Review, vol. 75, no. 3 (June 1985), pp. 530-38. See also Robert J.
Barro, “Reputation in a Model of Monetary Policy with Incomplete
Information,” Journal of Monetary Economics, vol. 17, no. 1 (January
1986), pp. 3-20; and John Driffill, “Macroeconomic Policy Games
with Incomplete Information: Some Extensions,” in Dynamic Policy
Games in Economics, pp. 289-323 (1989).
MSee Driffill, "Macroeconomic Policy Games”; and Kazuo Mino and
Shunichi Tsutsui, “Reputational Constraints and Signalling Effects in
a Monetary Policy G am e,” New York University, mimeo, 1989.
FRBNY Quarterly Review/Winter 1991
77
a policy rule in this case has the same problem as in the
situations described earlier— that is, where economic
shocks are large, discretion plus noninflationary policy
makers dominates rules.
Empirical evidence and conclusions
There is little firm empirical evidence on many of the
issues discussed in this article. The optimal structure of
monetary policy clearly depends on many factors
whose importance is difficult to measure. These factors
include a) the public’s ability to predict policy makers’
actions, b) the policy makers’ goals, c) the predictability
of linkages between policy tools and final goals, d) the
extent of shocks to the economy, and e) the perceived
credibility of policy makers. Although much of the liter
ature has been written by authors who hold strong
views on the qualitative importance of these factors,
actual measurement is so difficult that theoretical analy
sis has been far more common than empirical work.
As a result, most of the empirical work has focused
on measuring whether the output costs of disinflation
respond to the perceived credibility of policy.39 Credible
disinflationary policies, supported by verifiable rules,
should carry a lower output cost than less credible
discretionary disinflationary policies. Yet efforts to dis
tinguish credible from noncredible disinflations have not
met with great success. Most empirical work has not
found any significant decline in the output costs of
disinflation either in the United States or in the rest of
the OECD through the early 1980s, and, indeed, these
relations appear to have been stable in most OECD
countries since the 1960s.40 This apparent stability has
persisted despite the view of many that anti-inflationary
policies became more “credible” in the early 1980s.
It is difficult to state with any confidence that a partic
ular set of policies will generate a credible disinflation
with low output costs. The countries that disinflated in
conjunction with a “rule”— which took the form of tying
their currencies to stronger currencies in the European
Monetary System— generally experienced high unem
ployment in the process. A possible interpretation of
^William fellner, “The Credibility Effect and Rational Expectations:
Implications of the Gramlich Study," Brookings Papers on Economic
Activity, 1:1979, pp. 167-89, first suggested this approach.
«For the United States, see A. Steven Englander and Cornelis A.
Los, “The Stability of the Phillips Curve and Its Implications for the
1980s," Federal Reserve Bank of New York, Research Paper
no. 8303, 1983; Olivier J. Blanchard, “The Lucas Critique and the
Volcker Deflation,” American Economic Review, vol. 74, no. 2 (May
1984), pp. 211-15; and Robert J. Gordon and Stephen King, “The
Output Cost of Disinflation in Traditional and Vector Autoregressive
Models,” Brookings Papers on Economic Activity, 1:1982,
pp. 205-43. For other OECD countries, see James Chan-Lee, David
T. Coe, and Menahem Prywes, “Microeconomic Changes and
Macroeconomic Wage Disinflation in the 1980s,” OECD Economic
Studies, no. 8 (Spring 1987), pp. 121-57.
78
FRBNY Quarterly Review/Winter 1991
these 1980s disinflations, one that would be in line with
the time consistency literature, is that the policies put in
place were not in fact credible. Thus, the public may
have questioned the commitments of the policy makers
to low inflation and hence may have refrained from
altering behavior and expectations in response to the
announced policies.
A problem with this interpretation is that it is difficult,
if not impossible, to find alternative independent tests of
the presence or absence of credibility. There are few
examples of countries adhering to monetary targeting
rules that might provide a baseline test of whether such
rules produce credibility and lower the cost of disinfla
tion. In the view of many authors, the low-inflation
OECD countries do not appear to follow an explicit
rule.41 To the extent that low inflation is built into expec
tations in these countries, it is because of the countries’
recent success in maintaining low inflation, rather than
their adherence to an explicit rule.
A second possible interpretation of the 1980s experi
ence is that disinflation is expensive because expecta
tions are largely backward-looking and do not readily
incorporate the effects of policy changes. Most studies
have found this characterization to be broadly accu
rate— at least as it applies to labor markets— as long as
inflation is low or moderate 42 If this is so, policy makers
and society have to accept the output costs if they wish
to disinflate to very low inflation rates. With this back
ward-looking, rather than rational, view of expectations
form ation, the kind of time consistency problem
described in the literature under discussion does not
exist in reality.
Although most analyses have not found any empiri
cally significant credibility effects, there are a few
exceptions, primarily in cases of disinflating from hyper
inflation. Disinflations in Central Europe in the 1920s
and in Chile and Denmark more recently appear more
cessful, although economists still debate whether these
disinflations were indeed p ainless.43 W hat char41See, for example, Michael M. Hutchinson, “Japan’s ‘Money
Focussed’ Monetary Policy,” Federal Reserve Bank of San Francisco
Economic Review, Summer 1986, pp. 33-46; and Bharat Trehan,
"The Practice of Monetary Targeting: A Case Study of the West
German Experience,” Federal Reserve Bank of San Francisco
Economic Review, Spring 1988, pp. 30-44.
42See Englander and Stone, "Inflation Expectations Surveys."
^ S ee Thomas J. Sargent, “The Ends of Four Big Inflations," in Robert
E. Hall, ed., Inflation: Causes and Effects (Chicago: University of
Chicago Press, 1982); Michael Christensen, “Disinflation, Credibility
and Price Inertia,” Applied Economics, vol. 19, no. 10 (1987),
pp. 1353-66; Michael Christensen, “On Interest Rate Determination,
Testing for Policy Credibility and the Relevance of the Lucas
Critique," European Journal of Political Economy, vol. 3 (1987),
pp. 369-88; and Marianne Baxter, “The Role of Expectations in
Stabilization Policy," Journal of Monetary Economics, vol. 15, no. 3
(1985), pp. 343-62. Keith Blackburn and Michael Christensen
acterizes these credible disinflations is that monetary,
fiscal, and, in some cases, exchange rate policies were
all subordinated to the disinflationary goal. In particular,
it has been argued that fiscal tightening, which would
make future monetization of government debt less
tempting, was a key factor in convincing the public that
the low-inflation path was sustainable.
Two other characteristics of these disinflations are
noteworthy, however, and cast doubt on the relevance of
these examples to the task of disinflating from moderate
inflation. First, it may be easier to move from high to
moderate inflation rates because both the policy makers
and the public clearly desire to lower inflation. There is
a high real output cost of hyperinflation in terms of time
and energy spent exchanging “money” whose value
drops daily into assets with more stable value. Hence,
the ambiguity whether the policy objectives are in fact
consistent is not as profound as at lower inflation rates.
Also, hyperinflation in many cases greatly reduced the
real value of government debt. As a result, fiscal policy
could start de novo with little or no debt service burden.
Whether disinflation from moderate to low levels of
inflation can occur with so little cost is not clear. Other
instances of disinflation from more moderate inflation
levels have generally resulted in substantial output
costs.44 Indeed, even the cases of successful disinflaFootnote 43 c on tinued
provide a con cise survey of this literature in "M onetary Policy and
Policy C redibility: Theories and E vidence," Journal o f Econom ic
Literature (M arch 1989), pp. 1-45.
^R o b e rt J. G ordon reviews several such instances of disinflation in
the U nited States and abroad in "W hy S topping Inflation May be
Costly: E vidence from Fourteen H istorical Episodes in Inflation," in
Robert E. Hall, ed., Inflation: Causes an d Effects (C hicago:
University of C hicago Press, 1982).
tion from hyperinflation involved some apparent output
cost. What makes them seem painless is the low output
cost per percentage point of inflation reduction.
Second, the key reform in each of these cases was
generally not an explicit attachment to a monetary pol
icy rule but rather the creation of a set of mutually
consistent monetary and fiscal policies. The consis
tency of policies may also have served to convince the
public that lower inflation was the preeminent goal.
Moreover, in several cases of disinflation with relatively
small output costs, a coordinated structure of wage
bargaining may have been important in unwinding a
wage/price spiral.45 Although credibility may have been
important, these considerations suggest that it is not
rules per se that create credibility but policies that will
lead to disinflation irrespective of the underlying eco
nomic model.
A final consideration is that, in practice, policy may be
more credible in one market than another. In the case of
Ireland’s disinflation in the 1980s, it has been argued
that a reduction in long-term interest rates reflected a
policy credibility in financial markets that did not exist in
labor markets, as reflected in the sharp rise in unem
ployment rates.46 As long as labor market expectations
are slow to adjust, it is unlikely that the output cost of
disinflation can be eliminated.
45Robert J. Gordon, “ Why S topping Inflation May be C ostly,” argues
strongly for this interpretation in several OECD d isin fla tio n s in the
1960s and 1970s.
^S e e Jeroen J.M. Kremers, “ G aining Policy C re d ib ility for a
D isinflation," IMF S taff Papers, vol. 37, no. 1 (M arch 1990); and
R udiger Dornbush, “ C redibility, D ebt and U nem ploym ent: Ire la n d ’s
Failed S tabilizatio n,” E conom ic Policy, no. 8 (A pril 1989).
Christensen, “ D isinflation, C re d ib ility and Price In e rtia ," also
provides evidence on the slugg ishne ss of p rice e xp ectatio ns in
labor markets.
FRBNY Quarterly Review/Winter 1991
79
Treasury and Federal Reserve
Foreign Exchange Operations
November 1990—January 1991
The dollar was subjected to conflicting forces during
the November-January period. Sentiment toward dollar
investments continued to deteriorate as the U.S. econ
omy weakened and as interest rate differentials moved
further in favor of foreign currencies. But at times,
political developments abroad— particularly the Persian
Gulf conflict— encouraged greater demand for dollars
and limited the extent to which negative sentiment
toward the currency was reflected in exchange rates.
With these offsetting factors helping to maintain a
sense of two-way risk to dollar exchange rates, the
dollar ended the period mixed against major foreign
currencies, and the U.S. monetary authorities con
ducted no intervention operations in the foreign
exchange market. The dollar closed the period down
slightly against the German mark and up slightly
against the Japanese yen (Chart 1). On a tradeweighted basis as measured by the staff of the Federal
Reserve Board of Governors, the dollar ended the
period 1 percent below its level at the beginning of the
period.
The first part of the period: early to mid-November
In the early part of the period, market attention cen
tered on evidence of diverging growth and interest rate
trends in the major industrial economies. Ever since the
Iraqi invasion of Kuwait in August and the associated
rise in oil prices and decline in consumer confidence,
analysts had been progressively revising downward
A report presented 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. Daniel H. Brotman was primarily responsible for preparation
of the report.
80 forFRBNY
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FRASERQuarterly Review/Winter 1991
their forecasts for U.S. economic growth. The release of
October payroll employment data in the first week of
November revealed an unexpectedly large drop which,
together with subsequent data, reinforced the view that
the U.S. economy was slowing down (Chart 2). At the
same time, preliminary indications suggested inflation
ary pressures were subsiding. Under these circum
stances, market participants widely expected the
Federal Reserve to continue to ease money market
conditions and possibly to reduce its discount rate.
In contrast, market forecasts for the German and
Japanese economies remained relatively upbeat. The
need to rebuild eastern Germany was seen as providing
ongoing stimulus to the German economy. Japanese
economic data provided little evidence that the econ
omy or price pressures were slowing in response to the
central bank’s tight policy stance. Mindful of these eco
nomic trends, market participants expected German
and Japanese interest rates either to rise further or to
remain at existing levels. Indeed, on the first day of the
period, the Bundesbank announced a one-half percent
age point increase in its official Lombard rate, and many
market participants expected further tightening after
German national elections in early December. The Bank
of Japan was considered less likely than the Bun
desbank to tighten monetary policy, but was nonethe
less seen as unwilling to ease monetary conditions
given high oil prices and Japan’s tight labor market
conditions.
The divergent outlook for interest rates weighed on
the dollar in early to mid-November. Short-term interest
rate differentials had been steadily moving against the
dollar since the spring of 1989, when dollar investments
held a 4 to 6 percentage point interest rate advantage
relative to the mark and yen (Chart 3). By late summer
of 1990, the dollar’s short-term interest rate advantage
had been entirely eliminated. Thus, in early November,
expected further declines in dollar interest rates, cou
pled with steady to higher rates abroad, threatened to
push short-term U.S. interest rates well below mark and
yen rates for the first time since 1980. Under these
circumstances, the dollar declined 3'A percent against
the mark from its opening level of DM1.5170 to its
November low of DM1.4660 on November 16. Its decline
against the yen measured 21/2 percent from ¥130.07 at
the opening of the period to ¥126.70 on November 22.
The dollar was not the only currency affected by the
divergent performance of major national economies.
Pressures also developed among the European curren
cies during early November as the pace of German
expansion contrasted with slowing growth or actual
declines in the United Kingdom, Italy, France, and cer
tain other European countries. The market conditions
that had allowed several European central banks to
lower domestic interest rates earlier in the year dissi
pated with the November increase in German interest
rates. As the mark moved up from its relatively low
position in the exchange rate mechanism of the Euro
pean Monetary System (EMS), a number of participat
ing central banks responded to the softening of their
currencies relative to the mark by raising interest rates
at a time when their economies were weakening or by
intervening against marks to support their currencies.
The Italian lira, the French franc, and the British pound
were the currencies to come under the strongest down
ward pressures in November.
Dollar selling in response to the diverging economic
trends was tempered somewhat by developments in the
Persian Gulf. The Gulf conflict, while not the dominant
market force that it later became, served as a back
ground factor supporting the dollar at times during early
and mid-November. Developments in the military and
diplomatic arena at that time suggested that the proba
bility of a war in the near term was rising. Many market
participants interpreted the U.S. Adm inistration’s
Chart 2
Chart 1
Concerns over the Persian Gulf conflict limited the
extent to which negative sentiment toward the
dollar was reflected in exchange rates.
Declines in employment pointed to a weakening
U.S. economy.
Thousands of jobs
500 -------------------------------------------------------------------Changes in U.S. Nonfarm Payroll Employment
Percent change
400
300
200
-
100
-
0
-100
-200
J
F
M
A
M
J
J
A
S
O
N
D
1990
Note: The above chart shows the percentage change of weekly
average rates for the dollar from January 1990 through
January 1991.
Note: The above chart shows changes in monthly U.S. nonfarm
payroll employment from January through December 1990. The
shaded area represents data released during the period. The
December figure is preliminary.
FRBNY Q uarterly Review/W inter 1991
81
came to build in a safe haven premium for the dollar.
Inthat environment, dealers became increasingly reluc
tant to take on large short dollar positions. Thus, not
withstanding negative sentiment about the U.S.
economy and the belief that interest rate differentials
against the dollar would increase, the prospect of a safe
haven effect associated with the outbreak of war helped
announcement on November 8 of a large reinforcement
of U.S. forces in the Gulf as indicating that the United
States was preparing for an outbreak of hostilities. Past
experience had demonstrated a tendency for the U.S.
dollar exchange rate to benefit from “safe haven”
inflows during periods of political instability or military
conflict abroad, and market participants increasingly
Chart 3
U.S. short-term interest rates continued to decline . . .
Percent
11
10
Short-term Interest Rates
-
/s _ S
United States
\
*
\
/
Germany
A
/
-j
'•..A -
/
—-
r
-
J a p a n ^ ***^
l l 1 111 l l 1 1 l l l l l 1 1 1 1 1 1 l 1 1 I I 1 1 1 1 1 ll 1 1 1 111 1 111 1 1 1 111 111 1
S
O
N
D
J
J
F
M
A
M
J
J
A
1989
111 h 111111111111111 il 1111111 h 111 In 111ii 1ii i il ii i m i l
F
M
A
M
J
J
1990
A
S
O
N
D
J
1991
and interest rate differentials moved further against short-term dollar investments.
Percentage points
Interest Rate Differentials
V
' V-N
Japan
Germany
'« ---------- _______________
___ _
_
^
ll
111 ll l 111111111 11111111111111 ll 111l l 111l l 11 1II 11111
J
F
M
A
M
J
J
1989
A
S
O
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D
ii
J
11111111111111 h 1111ii 11ii 1111111111111111n 11111
F
M
A
M
J
J
1990
A
S
O
N
Note: The top chart shows weekly average U.S., German, and Japanese three-month Eurocurrency interest rates from January 1989.
The bottom chart shows the dollar rate less the foreign rate.
82 for FRBNY
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FRASER Q uarterly Review/W inter 1991
D
/
Mi l l
J
1991
to cushion the dollar’s decline.
The middle of the period: late November to midJanuary
Beginning in late November, the dollar came under
several waves of upward pressure that pushed the cur
rency above its opening levels and to its highs of the
period. These pressures primarily reflected heightening
expectations that the Gulf conflict would result in an
early war. But the dollar’s rise was aided by other
factors, including a perceived deterioration of the politi
cal situation in the Soviet Union and two episodes of
acute upward pressure on U.S. money market rates.
From November 29, when the U.N. Security Council
set a deadline for Iraq to withdraw from Kuwait, until
January 16, when Operation Desert Storm began, mar
ket attention focused almost entirely on the Gulf crisis.
As the threat of war hung over the market during this
month and a half, market participants of all types
showed an increased reluctance to take on new risks or
to respond fully to changes in underlying economic
conditions. With interbank dealing in any case about to
wind down as the year-end approached, many dealing
institutions took the opportunity to impose an early halt
to or reduction in their market-making activities. Many
commercial and institutional participants decided to
move to the sidelines and, to the extent possible, to
postpone further transactions until the Persian Gulf
situation was clarified. In this environment, markets
became unusually thin and illiquid, and managers of
interbank trading rooms at many institutions took steps
to reduce the position-taking latitude of their trading staff.
Meanwhile, pressures in the federal funds and other
short-term money markets began to appear in late
November as banks bid aggressively to secure money
to cover year-end accounting statements. These pres
sures, coming earlier and with much greater intensity
than in past years, occurred against a background of
heightened concerns over bank credit quality. At the
same time, the efforts of many institutions to improve
capital ratios, trim balance sheet size, and enhance
internal liquidity reduced the availability of and
increased the demand for short-term interbank funds,
thereby pushing rates upward. Some market partici
pants unable to secure funds in the interbank market
bought dollars in the foreign exchange market to meet
their year-end requirements. In response, the dollar
moved up in late November and early December. When
these pressures temporarily subsided in early Decem
ber, the dollar retraced most of its rise and, in fact,
edged down to touch a new post-World War II low
against the mark of DM1.4625. But year-end pressures
reemerged late in December and again helped support
the dollar at that time.
Another reason for the dollar’s rise starting in
lateNovember was the growing expectation that the
finance ministers and central bank governors of the
Group of Seven (G-7) would soon meet and discuss
exchange rate issues. With strains appearing in the
exchange market involving the dollar and other curren
cies, some market participants believed the G-7 might
take steps to stabilize exchange rates. This notion
gained credence as several G-7 officials indicated that a
meeting would occur in January.
Around mid-December, market unease over the politi
cal situation in the Soviet Union also contributed to the
dollar’s resilience. The December 20 resignation of
Soviet Foreign Minister Shevardnadze raised concerns
about the outlook for the success of the Soviet leader
ship’s policies of political openness and economic
restructuring. Because Germany was viewed as most
vulnerable to the spillover effects of negative develop
ments in the Soviet Union, the mark eased. The mark
moved lower not only against the dollar and the yen but
also against its partner currencies in the EMS. The
mark’s softer tone helped reduce, albeit temporarily,
pressures that had been building throughout December
within the EMS exchange rate mechanism.
In these circumstances, the dollar reacted only mod
estly to a series of actions by the Federal Reserve to
ease monetary conditions. These included three moves
in December and early January which led to declines in
the federal funds rate totaling 75 basis points and one
move to reduce the Federal Reserve’s discount rate by
Table 1
Federal Reserve
Reciprocal Currency Arrangem ents
In Millions of Dollars
Amount of Facility
January 31, 1991
Institution
Austrian National Bank
National Bank of Belgium
Bank of Canada
National Bank of Denmark
Bank of England
Bank of France
Deutsche Bundesbank
Bank of Italy
Bank of Japan
Bank of Mexico
Netherlands Bank
Bank of Norway
Bank of Sweden
Swiss National Bank
Bank for International Settlements:
Dollars against Swiss francs
Dollars against other
authorized European currencies
Total
250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
700
500
250
300
4,000
600
1,250
30,100
FRBNY Q uarterly R eview/W inter 1991
83
Table 2
Drawings and Repayments by Foreign Central Banks under Special Swap Arrangem ents
with the U.S. Treasury
In Millions of Dollars; Drawings ( + ) or Repayments ( - )
Central Bank Drawing
on the U.S. Treasury
Central Bank of H ondurasf
Amount
of Facility
Outstanding as of
November 1, 1990
November
82.3
34.8
-3 4 .8
Decem ber
-
January
O utstanding as of
January 31, 1991
—
Note: Data are on a value-date basis. Components may not add to totals due to rounding.
-(-Represents the ESF portion of a $147.3 million short-term credit facility established on June 28, 1990.
50 basis points on December 18. In addition, the Fed
eral Reserve on December 2 announced plans to elimi
nate reserve requirements on nonpersonal time
deposits and on net Eurocurrency liabilities in two
stages during December.
Trading in the foreign exchange market remained list
less even after the usual year-end holiday lull. During
the early weeks of January, as participants awaited the
January 15 U.N. deadline for Iraq to withdraw from
Kuwait, the dollar tended to move during the day in
response to the latest statements or signals regarding
diplomatic efforts to avert war. Thus, the dollar eased
following announcements that U.S. Secretary of State
Baker would meet his Iraqi counterpart in Geneva and
that the U.N. Secretary General would visit Iraqi leader
Saddam Hussein in Baghdad, only to rebound later
when these approaches proved fruitless. Against this
background, however, the dollar edged up intermittently.
The dollar’s movements around this time were greatest
against the Japanese yen, which was seen as having
the most to lose from any disruption in oil supplies as a
result of war and the most to gain from an expected oil
price decline in the event of a peaceful settlement. But
the dollar also rose against the mark. By mid-January,
the dollar was trading up to levels as high as ¥137
against the yen and DM 1.55 against the mark, or
roughly 5 percent and 2 percent, respectively, above its
early November levels against those two currencies.
The end of the period: mid- to late January
The dollar’s response to the outbreak of war on January 16
took many market participants by surprise. Having
anticipated a wave of sustained dollar buying upon the
outbreak of war, many interbank dealers had quietly
been building up long dollar positions as the January 15
deadline approached. In the event, the dollar did move
up on the first reports of bombing over Baghdad to
highs of DM1.5525 and ¥138.00. However, the currency
quickly gave way to selling pressures as market partici
pants took profits on these long positions. Within a few
84for FRBNY
Digitized
FRASER Q uarterly Review/W inter 1991
Table 3
Net Profits ( + ) or Losses ( - ) on
United States Treasury and Federal Reserve
Foreign Exchange Operations
In Millions of Dollars
U.S. Treasury
Exchange
Federal
Reserve Stabilization Fund
Valuation profits and losses
on outstanding assets and
liabilities as of
O ctober 31, 1990
+ 5,3 63.3
Realized
November 1, 1990-January 31, 1991
0
Valuation profits and losses
on outstanding assets and
liabilities as of
January 31, 1991
+5,6 88.0
+ 2,876.3
0
+ 3,027.2
Note: Data are on a value-date basis.
hours after Operation Desert Storm began, the dollar
had declined from its highs by about 3 to 4 percent. Oil
prices fell back sharply while bond and stock markets
around the world rallied.
Thereafter, the dollar edged lower through the
remainder of January. From time to time, dollar demand
increased in response to concerns over the severity and
scope of the Gulf conflict. This was the case, for
instance, when missile attacks on Israel raised fears
that the war might widen. But the dollar’s tendency to
firm on negative reports out of the Gulf began to wane
as market participants appeared to grow more confident
that the war would be relatively short and that the
United States and its allies would be victorious.
As the exchange market grew accustomed to news
from the Gulf and liquidity returned to more normal
levels, market participants directed more attention to
the economic developments and interest rate changes
that had gone almost unnoticed in December and early
January. Against this background, the dollar began to
decline again. Statements by Federal Reserve Chair
man Greenspan on the potential for further monetary
easing if growth of the monetary aggregates remained
sluggish, and on the risks of a long and deep recession
if the Gulf war were to drag on, were noted. These
comments, coupled with President Bush’s call for lower
interest rates in his State of the Union speech, height
ened expectations of further near-term cuts in dollar
interest rates.
In a statement issued after their January 21 meeting,
G -7 finance ministers and central bank governors
“agreed to strengthen cooperation and to monitor devel
opments in exchange markets” and stated they were
“prepared to respond as appropriate to maintain sta
bility in international financial markets.” Market partici
pants did not conclude at the time, however, that offi
cials were prepared to take immediate and concrete
action to stem further dollar declines.
Some market participants came to interpret the Janu
ary 21 G-7 statement as suggesting that further interest
rate increases abroad might be avoided as U.S. rates
declined. Indeed, the expectation that Germany would
postpone further tightening became so widespread dur
ing the last two weeks in January that pressures within
the EMS eased, and European authorities were report
edly able to scale back their intervention mark sales.
On the last day of the period, however, the Bundesbank
increased its official discount and Lombard rates by 50
basis points, an action whose timing took the market by
surprise. However, the Bundesbank characterized its
move as technical and subsequently took steps to keep
money market rates from rising.
Thus, as the period closed, sentiment toward the
dollar remained negative as market participants, believ
ing that dollar interest rates would decline further,
expected interest rate differentials to continue to move
against the dollar. The dollar closed the period at
DM1.4768 against the mark, down
percent from its
November opening levels and only slightly above its
post-World War II low against that currency. Against the
yen, the dollar closed the period 1 percent above its
opening levels at ¥131.25.
*
*
*
*
As noted in our report for the August-September 1990
period, the U.S. Treasury Exchange Stabilization Fund
(ESF) repurchased $2,500 million of foreign currencies
from the Federal Reserve on November 1 to reverse
certain previous warehousing operations. From that
date through the close of the period, outstanding ware
housing of foreign currencies with the Federal Reserve
remained at $4,500 million, down from the peak of
$9,000 million reached in March 1990.
The Treasury also continued to provide SDRs in
exchange for dollars to foreign monetary authorities
requiring SDRs for the payment of IMF charges and for
repurchases. These exchanges totaled $204.3 million
equivalent of SDRs over the three-month period.
The ESF’s share of a multilateral credit facility estab
lished in June 1990 for Honduras was repaid in full
during the period, with payments of $34.0 million on
November 15 and $0.8 million on November 20. The
ESF portion of this special facility expired at the end of
November, and as of the end of January 1991, the
T re a s u ry had no s p e c ia l sw ap a rra n g e m e n ts
outstanding.
As of the end of January, cumulative bookkeeping or
valuation gains on outstanding foreign currency bal
ances amounted to $5,688.0 million for the Federal
Reserve and $3,027.2 million for the ESF. The latter
figure includes valuation gains on warehoused funds.
These valuation gains represent the increase in dollar
value of outstanding currency assets valued at end-ofperiod exchange rates, compared with rates prevailing
at the time the foreign currencies were acquired.
The Federal Reserve and the ESF regularly invest
their foreign currency balances in a variety of instru
ments that yield market-related rates of return and that
have a high degree of quality and liquidity. A portion of
the balances is invested in securities issued by foreign
governments. As of the end of January, holdings of such
securities by the Federal Reserve amounted to $8,114.8
million equivalent, and holdings by the Treasury
amounted to the equivalent of $8,000.6 million valued at
end-of-period exchange rates.
FRBNY Quarterly Review/Winter 1991
85
Treasury and Federal Reserve
Foreign Exchange Operations
August-October 1990
During the August-October period, sentiment towards
the dollar was generally negative. Exchange market
participants continued to focus on signs of sluggish
economic activity in the United States and on the move
ment of interest rates against the dollar. The growth
prospects of the U.S. economy were widely perceived
as weak, and the adverse trend in interest rate differen
tials, which had narrowed by several hundred basis
points since early 1989, was expected to continue.
The crisis in the Persian Gulf had both positive and
negative effects on the dollar. Immediately following the
Iraqi seizure of Kuwait on August 2, the dollar rose to its
highs of the period amid expectations that the conflict
would trigger heavy flows into the dollar. Thereafter,
although market participants were attracted to U.S.
assets at times when fears of war intensified, the dollar
was undermined by concerns that the U.S. economy
was more vulnerable than other major economies to the
steep rise in oil prices caused by the conflict.
In this environment, the dollar moved generally lower
during the period, declining almost 5 percent on a
trade-weighted basis as measured by the index of the
staff of the Federal Reserve Board of Governors.
Against individual currencies, the dollar declined
between 4 percent and 4V2> percent on balance against
the major European currencies, reaching record lows
against the German mark and Swiss franc. It declined
against the Japanese yen by almost 11 percent to trade
A report presented 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. Thaddeus D. Russell was primarily responsible for
preparation of the report.
86
FRBNY Quarterly Review/Winter 1991
at its lowest levels against that currency since January
1989. The dollar was relatively unchanged against the
Canadian dollar. The U.S. authorities did not intervene
in the foreign exchange market during the period.
* * * *
The outlook for the U.S. economy was a focus of
attention in the exchange market throughout the period
under review as market participants looked to each new
economic statistic for signs of how significantly the U.S.
economy was slowing. A report released just before the
period had shown second-quarter GNP growth to be
less rapid than had been expected at an annual rate of
1.2 percent. In early August, a number of data releases
and reports reinforced impressions of slowing economic
activity, including data on employment, industrial pro
duction, and capacity utilization as well as the Federal
Reserve’s “beige book” survey of economic conditions
around the country.
As the period progressed, subsequent data releases
provided mixed and hard-to-interpret signals about the
U.S. economy. But the view of the economy in the
exchange market and among observers more generally
became increasingly negative, in large part because of
concern over the econom ic impact of the sharp
increases in oil prices resulting from the Persian Gulf
crisis. Market participants believed that the U.S. econ
omy was less able to cope than some of the other
industrial economies with the potential effects of
sharply higher oil prices on business activity and
prices. A September 25 report revising second-quarter
economic growth downwards to a 0.4 percent rate sug
gested to market participants that the U.S. economy
was weakening markedly, even before the economic
effects associated with the Persian Gulf crisis had
begun to affect it. Other economic data released over
the period provided a more mixed impression, including
preliminary U.S. GNP data released on October 30
estimating growth of 1.8 percent at an annual rate for
the third quarter.
Chart 1
The dollar moved generally lower through the
period. The downward movement was particularly
sharp against the Japanese yen,. . .
Percent change
5-------------------------------------------Canadian dollar
J __ I__ I__ I__ I__ I__ I__ I__ I__ I__ I__ I__ I
August
September
October
1990
Spreading perceptions of slowing U.S. economic
activity added to the view that interest rates in the
United States would continue to go down and that
interest rate differentials would move further against the
dollar. Expectations of lower interest rates were rein
forced by the prospect that some form of compromise
would be reached to reduce the U.S. fiscal deficit. After
a major U.S. money center bank announced large staff
cuts and increased provisions for problem loans late in
September, U.S. banks also became a focus of discus
sion in the exchange market, with some market partici
pants believing that the condition of U.S. banks added
to the likelihood that the Federal Reserve would ease.
On September 30, news of a budget accord between
negotiators from the White House and Congress also
increased expectations that the Federal Reserve would
soon allow an easing in the federal funds rate. After that
initial budget package failed to pass Congress on Octo
ber 5, however, the focus of market attention shifted
away from interest rates. As the budget negotiations
became protracted, the market grew preoccupied with
the stalemate itself, which was widely viewed as evi
dence of the unmanageability of the budget process
and of serious disarray within the U.S. government over
economic management generally. Thus, concern over
the impasse continued to weigh on the dollar until the
making the dollar’s decline against the yen over the
course of the year comparable to its decline
against the German mark.
Chart 2
During the past two years, the pace of economic
activity measured on a year-on-year basis has slowed
in the United States while remaining strong in Japan
and Germany.
Percent change
15---------------------------------------------
Percent
8------------------------------------------- -------------------------------United States
7
~ ] Germany
6 -I
| Japan
5
4
3
2
1
1990
Notes: The top chart shows the percent change of weekly
average rates for the dollar from July 31, 1990. The bottom chart
shows the percent change of weekly average rates for the dollar
from December 31, 1989. All rates are calculated from New York
closing quotations.
0
I
II
III
1989
IV
I
II
1990
III
Note: This chart shows quarterly changes in real GNP on a
year-on-year basis.
FRBNY Q uarterly R eview/W inter 1991
87
closing days of the period. Even when a new budget
acceptable to the President was finally approved by
Congress on October 27, it gave little lift to market
sentiment toward the dollar.
The decline in the dollar during the period occurred
principally during three waves of selling pressure.
The first occurred during the first three weeks of
August. Although the dollar initially firmed on news of
Iraq’s invasion of Kuwait, reaching its period highs on
August 2 of DM 1.6215 against the mark and ¥151.60
against the yen, it quickly started to decline against the
European currencies as market participants became
Chart 3
Since early 1989, increases in Japanese and German interest rates, together with declines in U.S. rates,. . .
Percent
11
J
F
M
A
M
J
J
A
S
1989
eliminated the dollar’s interest rate advantage.
Percentage points
7-
Interest Rate Differentials
-1
J
F
M
A
M
J
J
A
1989
S
O
N
D
J
F
M
A
M
J
1990
J
A
S
Notes: The top chart shows weekly average three-month Euro interest rates. The bottom chart shows the dollar rate less the foreign rate.
88
FRBNY Q uarterly Review/W inter 1991
O
more co n cern ed over U .S . econ o m ic prospects. At this
tim e, the dollar show ed little net m ovem ent ag ain st the
J a p a n e s e yen, the currency initially the most negatively
affected by fears of a disruption of oil flow from the
M idd le East.
T h e second wave took place around m id -S ep tem b e r
w hen the dollar declined ag ain st the yen but traded
relatively stead ily ag ain st other m ajor currencies. T he
d o lla r’s d eclin e ag ain st the yen stalled for a tim e around
the S e p te m b e r 2 2 m eeting in W ashington of the Group
of S even F in an ce M inisters and C entral Bank G over
nors. T h e c o m m u n iq u e re le a s e d afte r the m eeting
stated that the officials had noted the ye n ’s appreciation
since th eir last m eeting and that they had “concluded
that exch an g e rates w ere now broadly in line with co n
tinued ad justm ent of external im b alan ce s.”
From late S e p te m b e r through m id-O ctober, the third
wave occurred, with the yen leading a g e n e ra lize d rise
of foreign curren cies ag ain st the dollar. At that tim e,
m a rk et p a rtic ip a n ts b e c a m e in creasin g ly co n ce rn ed
about the im p asse over the U .S . governm ent budget,
and percep tion s d evelop ed in the m arket that officials,
both in the United States and abroad, were not concerned
Chart 4
about the d o lla r’s d eclin e . T h e d ollar traded as low as
¥ 1 2 3 .7 5 ag ain st the yen on O cto b e r 18 and DM 1.4910
ag ain st the m ark the next day, its lows for the period.
Late in O ctober, steps w ere tak en tow ard dispelling
the im pression of a lack of official co n cern . Treasury
officials m ade c le a r in s ta tem en ts to the press th at the
Adm inistration was co n cern ed ab o ut the dollar, and
rejected suggestions that the d eclin e was w elco m e d . At
about the sa m e tim e, m arket rum ors of U .S . in te rv e n
tion served as a rem ind er to m a rk et p articip an ts of the
possibility of official action to support th e dollar. In fact,
the U .S . m o n etary au th orities did not in te rv e n e during
the th ree m onths under review.
T h e extent to which the dollar m oved a g ain st ind i
vidual currencies was fu rth er influenced by d e v e lo p
m ents in their respective co u ntries. W ith th e form al
unification of G e rm a n y on O cto b e r 3, the p ressu res and
an ticipated costs as so ciate d with the integration of the
East G erm an econ o m y into that of W est G e rm a n y w ere
a m atter for reevaluation in the ex ch an g e m arket. T h e
G erm an m ark continued to b en efit from the percep tion
that a large fiscal deficit and the fast p ace of d om estic
econom ic expansion u nderw ay in the w estern p art of
the country, driven in part by d em a n d from th e east,
would keep G erm an interest rates firm or rising. M arke t
p articip an ts noted re p e ate d a s su ra n c es from the B u n
d esb an k that it would ad h e re to a strict, an ti-in flatio n ary
policy stance, as well as the call for a strong m ark to
keep inflation in ch eck and to help attract cap ital to
Oil prices rose sharply during the period.
Dollars per barrel
4 5 -------------------------------------------------------------------------------------------
Table 1
Federal Reserve
Reciprocal Currency Arrangem ents
In Millions of Dollars
Amount of Facility
Institution
10l I I I 1 LL i l I I I 1 111.1.1 I I I
J
F
M
A
M
I 1I I I 1 I 1 I I I I I I 1 I I I 1 I I I I J
J
1990
J
A
S
O
Note: The chart shows weekly average prices per barrel of West
Texas oil.
O ctober 31, 1990
Austrian National Bank
National Bank of Belgium
Bank of Canada
National Bank of Denmark
Bank of England
Bank of France
Deutsche Bundesbank
Bank of Italy
Bank of Japan
Bank of Mexico
Netherlands Bank
Bank of Norway
Bank of Sweden
Swiss National Bank
Bank for International Settlements:
Dollars against Swiss francs
Dollars against other
authorized European currencies
Total
250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
700
500
250
300
4,000
600
1,250
30,100
FRBNY Q uarterly Review/W inter 1991
89
finance economic integration. The mark’s strength was
dampened periodically during the period as large
upward revisions in estimates of the expenses associ
ated with unification suggested that the costs and diffi
culties had been misgauged. Concerns about these
problems and the upward trend in German interest rates
also contributed to the sharp declines in German stock
prices during the period.
Among other European currencies, the pound sterling
moved higher against the dollar during the period. It
thereby moved broadly in line with the rise of the mark,
despite signs of a weakening in economic activity, rising
unemployment, and declining output and retail sales.
The pound gained some support from safe-haven flows
and from the perception that sterling would benefit from
the United Kingdom’s North Sea oil fields. Also, through
much of the period, sterling was buoyed by expectations
that the currency would soon join the Exchange Rate
Mechanism (ERM) of the European Monetary System.
On October 5, these expectations were borne out when
it was announced that the pound was entering the ERM
with a 6 percent margin of fluctuation. During the rest of
October, the pound declined, moving below its ERM
parity rate against the mark of DM 2.95.
Like the mark, the Swiss franc closed the three-month
period almost 41/2 percent higher on balance against the
dollar. Early in the period, the Swiss franc led the rise
against the dollar and strengthened against all major
currencies. At that time, the franc appeared to benefit to
some extent from the nervousness and uncertainties
surrounding the situation in the Middle East. Its strength
was also based on the Swiss National Bank’s tight, antiinflationary policy stance. After moving up to an all-time
high of SF 1.2525 against the dollar on August 23, the
franc fluctuated below this level through the end of
October, while other foreign currencies subsequently
moved higher. The franc’s rise stalled after the Swiss
central bank took advantage of the leeway provided by
the currency’s strength to moderate its tight monetary
policy slightly, a move acknowledged in public com
ments towards the end of August.
The Japanese yen appreciated significantly against
other major currencies during all but the initial days of
the three-month period. The first effect of the invasion
of Kuwait was to push the yen down against other
currencies as the exchange market initially reacted to
Japan’s heavy dependence on imported oil and fears of
a complete disruption of Persian Gulf oil shipments.
Chart 5
The world’s major stock markets declined during August and September.
Percentage change
10--------------------------------------------------------
change
U.K. FT-100
U.S. Dow Jones
Japanese Nikkei \
\/
August
A \ German DAX
\
September
j
/
October
1990
Notes: The panel on left shows the percent change in weekly averages of daily closing levels. Panel on right shows the percent change in the
weekly averages since the beginning of the quarter under review.
90
FRBNY Q uarterly Review/W inter 1991
Table 2
Drawings and Repayments by Foreign Central Banks under Special Swap Arrangem ents
with the U.S. Treasury
In Millions of Dollars; Drawings ( + ) or Repayments ( - )
Central Bank Drawing
on the U.S. Treasury
Bank of G uyanaf
National Bank of Hungary}:
Central Bank of Honduras§
Amount
of Facility
Outstanding as of
July 31, 1990
August
September
31.8
20.0
82.3
13.4
20.0
57.3
0.0
-1 2 .1
-2 2 .6
-1 3 .4
-7 .9
0.0
October
Outstanding as of
O ctober 31, 1990
_
_
_
—
0.0
34.8
Note: Data are on a value-date basis. Components may not add to totals because of rounding.
The ESF’s special facility with the Bank of Mexico, inactive since July 31, 1990, expired on September 14, 1990.
fRepresents the ESF portion of a $178 million short-term credit facility that expired on September 20, 1990.
^Represents the ESF portion of a $280 million short-term credit facility that expired on September 14, 1990.
§Represents the ESF portion of a $147.3 million short-term credit facility established on June 28, 1990.
However, the yen soon began moving higher against
both the dollar and other currencies as these concerns
receded and market participants came to focus more on
the rising cost of oil— a cost which the Japanese econ
omy seemed better able to absorb than other countries.
Furthermore, market participants expected that move
ments in interest rate differentials would continue to
favor the yen. Market participants believed that the
Bank of Japan, already concerned about the fast pace
of Japan’s economic expansion and inflationary pres
sures, would be quick to raise interest rates in response
to the increase in energy costs resulting from the Per
sian Gulf crisis. In fact, the Japanese central bank did
raise its discount rate by 3A percentage point on
August 30.
In response to rising market interest rates that both
preceded and followed the discount rate hike, talk
spread that Japanese investors were finding the returns
they were getting at home to be adequate and would no
longer be investing abroad as much as before, espe
cially in the United States. Meanwhile, the decline in
Japanese equity prices resumed, with the Nikkei index
of the Tokyo Stock Exchange down 48 percent at the
beginning of October from its levels at the start of the
year. Accordingly, a number of Japanese banks, in
response to the sharp falls in values of their domestic
stock investments as well as their bond holdings,
repatriated funds to shore up their domestic capital
positions ahead of the end of the fiscal half year Sep
tember 30. The yen’s rise gained more momentum as
Japanese companies and investors also moved to raise
their hedge ratios on foreign holdings from below-average to above-average levels.
As the yen rose, Japanese officials were increasingly
questioned about their attitudes towards exchange
rates as some small- and medium-sized Japanese firms
Table 3
Net Profits ( + ) or Losses ( - ) on
United States Treasury and Federal Reserve
Foreign Exchange Operations
In Millions of Dollars
Valuation profits and losses on
outstanding assets and
liabilities as of July 31, 1990
Realized
August 1, 1 9 9 0 -0 c to b e r 31, 1990
Valuation profits and losses on
outstanding assets and
liabilities as of O ctober 31, 1990
Federal
Reserve
U.S. Treasury
Exchange
Stabilization
Fund
+ 3,547.5
+ 1,519.5
0
+ 5,363.3
+ 415.6
+ 2,876.3
Note: Data are on a value-date basis.
began to report that they were losing export competi
tiveness. Official comments at first left questions in the
market as to whether either the Japanese or the U.S.
authorities cared if the yen continued to rise. But in late
October a large customer purchase of dollars against
yen carried out by this Bank was seen in the market.
Then, various remarks by U.S., Japanese, and French
officials renewed market participants’ wariness that the
authorities might intervene to support the dollar.
The U.S. dollar rose slightly on balance against the
Canadian dollar during the three months. In the early
part of August, the Canadian currency firmed to its
highest levels in twelve years against the U.S. dollar. At
that time, market concerns over a possible disruption of
Persian Gulf oil shipments helped buoy the currency
FRBNY Q uarterly R eview/W inter 1991
91
because of Canada’s position as a net exporter of oil.
However, the currency subsequently began to move
lower, particularly after Canadian officials confirmed
that the economy had entered a recession and that they
were prepared to lower interest rates.
The Exchange Stabilization Fund (ESF) renewed
warehousing arrangements with the Federal Reserve
that fell due within the period. These transactions
resulted in realized profits of $415.6 million for the ESF,
reflecting the difference between the rates at which the
Treasury had acquired the funds and the rates at which
the warehousing agreements were renewed. As of Octo
ber 31, the last day of the period under review, the
ESF’s outstanding warehousing of foreign currencies
with the Federal Reserve totaled $ 7,000 million,
unchanged for the period under review.
The U.S. Treasury, however, had initiated steps prior
to the end of the period that resulted in the reversal of
$2,500 million of the warehousing of foreign currencies
effective November 1, the day after the period’s close.
The reversal of warehousing of foreign currencies final
ized on November 1 was financed in part by the Treas
ury’s issue on October 31 of an additional $1,500 million
of SDR certificates to Federal Reserve Banks. The
remainder was financed from ESF cash balances. As of
November 1, outstanding warehousing of foreign curren
cies with the Federal Reserve totaled $4,500 million,
half the level outstanding earlier in the year.
The Treasury also continued to exchange SDRs for
dollars with foreign monetary authorities that needed
SDRs for payment of IMF charges and for repurchases,
exchanging a total of $558.4 million equivalent of SDRs
during the period.
Multilateral credit facilities previously established for
Guyana and Hungary, in which the ESF participated,
were repaid in full during this period, while a similar facility
for Honduras was partially repaid. On September 14,
92for FRASER
FRBNY Quarterly Review/Winter 1991
Digitized
a special Mexican short-term credit facility established
in March by the U.S. monetary authorities expired. All
drawings on the facility had been repaid prior to the
period under review.
Guyana. At the beginning of the period, Guyana’s out
standing commitment to the Treasury on its multilateral
financing facility totaled $13.4 million. Guyana made four
payments in September, including final repayment on Sep
tember 20, the facility’s expiration date.
Hungary. The Treasury’s $20 million share of the first two
drawings by Hungary was outstanding at the start of the
period. Hungary reduced the amount outstanding on its
second drawing by $4.8 million on August 1 and the amount
outstanding on its first drawing by $7.3 million on August 20.
The drawings were fully repaid on September 5. Hungary
also completed repayments to the BIS (representing certain
member central banks) before the September 14 expiration
date of the facility.
Honduras. On August 1, Honduras made a partial repay
ment of $22.6 million to the Treasury, leaving an outstanding
balance of $34.8 million on the Treasury’s part of a multi
lateral facility.
As of the end of October, cumulative bookkeeping or
valuation gains on outstanding foreign currency balances
were $5,363.3 million for the Federal Reserve and $2,876.3
million for the ESF (the latter figure includes valuation gains
on warehoused funds). These valuation gains represent the
increase in dollar value of outstanding currency assets val
ued at end-of-period exchange rates, compared with rates
prevailing at the time the foreign currencies were acquired.
The Federal Reserve and the ESF invest their foreign
currency balances in a variety of instruments that yield
market-related rates of return and that have a high degree of
quality and liquidity. A portion of the balances is invested in
securities issued by foreign governments. As of the end of
October, holdings of such securities by the Federal Reserve
amounted to $8,238.7 million equivalent, and holdings by
the Treasury amounted to the equivalent of $8,331.6 million
valued at end-of-period exchange rates.
Recent FRBNY Unpublished Research Papersf
9033.
Steindel, Charles. “Recent Trends in Capital
Formation.” November 1990.
9034.
Radecki, Lawrence J. “A Survey of the Origins
and Purposes of Deposit Protection Pro
grams.” November 1990.
9035.
C h an , Anthony. “ Are the P re lim in a ry
Announcements of Some Macroeconomic Var
iables R a tio n a l?” November 1990. With
Hareesh Dhawale.
9036.
Hickok, Susan. “Factors behind the Shifting
Composition of U.S. Manufactured Goods
Trade.” December 1990.
9037.
Boldin, Michael D. “Characterizing Business
Cycles with a Markov Switching Model: Evi
dence of Multiple Equilibria.” December 1990.
9101.
Seth, Rama, and Alicia M. Quijano. “Growth in
Japanese Lending and Direct Investment in
the United States: Are They Related?” Janu
ary 1991.
9102.
Park, Sangkyun. “A Triggering Mechanism of
Economy-wide Bank Runs.” February 1991.
9103.
Park, Sangkyun. “Bank Failure Contagion in
Historical Perspective.” February 1991.
9104.
Yuengert, Andrew M. “Estimating Immigrant
Assimilation Rates with Synthetic Panel Data.”
February 1991.
9105.
Yuengert, Andrew M. “Self-Employment and
the Earnings of Male Immigrants in the U.S.”
February 1991.
9106.
Uctum, Merih. “Foreign Interest Rate Distur
bance, Financial Flows, and Physical Capital
Accumulation in a Small Open Economy.” Feb
ruary 1991.
9107.
Seth, Rama. “Patterns of Corporate Leverage
in Selected Industrialized Countries.” Febru
ary 1991.
fSingle copies of these papers are available upon
request. Write Research Papers, Room 901, Research
Function, Federal Reserve Bank of New York, 33 Liberty
Street, New York, N.Y. 10045-0001.
FRBNY Q uarterly R eview/W inter 1991
93
NEW FROM THE FEDERAL RESERVE BANK OF NEW YORK
Interm ediate Targets and Indicators for Monetary Policy: A C ritical Survey
The Federal Reserve has relied on a variety of financial variables in formulating and
implementing monetary policy. Interm ediate Targets and Indicators for M onetary Policy:
A C ritica l Survey evaluates the usefulness of various policy guides adopted or proposed
during the last three decades, including a range of financial aggregates, nominal GNP,
and various market measures such as commodity prices and dollar exchange rates. The
volume also contains a historical overview of the Federal Reserve’s targets and operating
guides in the postwar period and an analysis of recent academic literature on the theory
of policy rules that may have implications for the role of intermediate targets. Postpaid
$5.00 U.S., $10.00 foreign.
International Financial Integration and U.S. Monetary Policy
The dramatic increase in the international integration of financial markets over the last
decade has significant implications for monetary policy. In International F inancial In te gra
tion and U.S. M onetary Policy, the proceedings of a colloquium held at the Federal
Reserve Bank of New York in October 1989, leading academic researchers and Bank staff
members examine the conceptual and practical issues confronting monetary authorities
in a financially interdependent world economy. The authors analyze the role of interna
tional factors in the formation of U.S. monetary policy and assess the effects of increased
international financial integration on the transmission of monetary policy actions to
financial markets and aggregate economic activity. Postpaid $5.00 U.S., $10.00 foreign.
U.S. Monetary Policy and Financial Markets
U.S. M onetary Policy and Financial Markets describes the development of monetary
policy by the Federal Open Market Committee and its implementation at the Open Market
trading desk. Author Ann-Marie Meulendyke offers a detailed examination of the tools
and procedures used to achieve policy goals. She takes the reader through a typical day
at the trading desk, explaining how the staff compiles and analyzes information, decides
on a course of action, and executes an open market operation.
The book also places monetary policy in broader historical and operational contexts. It
traces the evolution of Federal Reserve monetary policy procedures from their introduc
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system and financial markets. Finally, it considers the transmission of monetary policy to
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FRBNY Q uarterly R eview /W inter 1991
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