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Federal
Reserve Bank of
New York
Quarterly Review




Winter 1991-92

Volume 16 Number 4

1

Rebuilding the Economic and Financial
Fundamentals: The Case for Vision and
Patience

6

Changes in the Government Securities
Market

12

Determinants of Long-Term Interest Rates:
An Empirical Study of Several Industrial
Countries

29

Explaining the Persistence of the U.S. Trade
Deficit in the Late 1980s

47

Evolution of U.S. Trade with China

55
61

Treasury and Federal Reserve
Foreign Exchange Operations
November 1991-January 1992
August-October 1991




Federal Reserve Bank of New York
Quarterly Review
W in te r 1991-92 V olum e 16 N um ber 4

Table of Contents




1

Rebuilding the Economic and Financial Fundam entals: The Case for
Vision and Patience
E. Gerald Corrigan
Remarks before the 64th Annual Mid-Winter Meeting of the New York State
Bankers’ Association at the Waldorf-Astoria, New York City, January 30,
1992.

6

Changes in the Government Securities Market
E. Gerald Corrigan
Statement before the Committee on Banking, Finance, and Urban Affairs
and the Subcommittee on Domestic Monetary Policy of the House of
Representatives, February 6, 1992.

12

Determinants of Long-Term Interest Rates: An Em pirical Study of
Several Industrial C ountries
Howard Howe and Charles Pigott
Real interest rates on long-term financial assets play a central role in
linking financial markets to the economy at large. Over the last fifteen
years, these rates have risen steadily in the United States and some key
foreign countries. The authors consider long-term forces contributing to
this rise— the rate of return to capital, risk factors, and changes in financial
structure— along with macroeconomic policies leading to short- and
medium-term fluctuations in the rates.

Table of Contents




29

Explaining the Persistence of the U.S. Trade D eficit in the Late 1980s
Susan Hickok and Juann Hung
The U.S. trade deficit was twice as large a percentage of U.S. GDP in 1989
as in 1979 although the value of the dollar and the level of U.S. demand
relative to foreign demand were roughly comparable in both years. This
article investigates the reasons for the deficit’s magnitude in the late 1980s.
Particular attention is given to two prominent theories about the per­
sistence of the deficit, one focusing on the relationship between exchange
rate movements and capital stock developments and the other on shifts in
the structure of U.S. trade flows.

47

Evolution of U.S. Trade w ith China
James Orr
Despite the improvements in the overall U.S. trade balance in the latter half
of the 1980s, the U.S. trade deficit with China has widened significantly.
This article investigates the factors underlying this growing deficit and
analyzes how growth in imports from China has affected the pattern of U.S.
imports from other Asian economies, notably Hong Kong.

Treasury and Federal Reserve Foreign Exchange O perations
55

A report for the period November 1991-January 1992.

61

A report for the period August-October 1991.

67

Recent FRBNY Unpublished Research Papers

Rebuilding the Economic and
Financial Fundamentals: The
Case for Vision and Patience
Once again it is a great pleasure to have the opportunity
to address the mid-winter meeting of the New York
State Bankers Association. The past year has not been
an easy one for the economy or for banks and bankers,
not just here in New York but around the nation and
around much of the world. My main message today,
however, is that despite the current problems, a strong
case can be made that many of the painful but neces­
sary adjustments occurring today are laying the founda­
tion for a stronger, a more efficient, and a more compet­
itive national banking system and national economy.

Many of the painful but necessary adjustm ents
o ccurring today are laying the foundation fo r a
stronger, a more efficient, and a more com petitive
national banking system and national economy.

However, if we are to reap the full measure of those
potential gains, we will need vision and patience. We
must also learn from our past mistakes, since it is now
all too clear that many of the hardships of today reflect
excesses of an earlier day.
Nowhere is that more apparent than in the very diffi­
cult process of unwinding the explosion of debt built up
by governments, businesses, and households over
much of the decade of the 1980s. In one sense, the fact
Remarks by E. Gerald Corrigan, President of the Federal Reserve
Bank of New York, before the 64th Annual Mid-Winter Meeting of
the New York State Bankers Association at the Waldorf-Astoria, New
York City, January 30, 1992.




that the economy and the financial system are impaired
by debt and debt service burdens should not surprise
us since the problem could be seen in the making. For
example, in a September 1985 address I asked rhetori­
cally whether it was reasonab le— even th e n — to
assume that so much more good-quality debt could be
supported by a given GNP than had been the case
earlier.
We now know the answer was that such an assump­
tion was not reasonable. A massive amount of the debt
accumulated in the 1980s was bad debt. Indeed, if we
were to add up all of the losses that have been incurred
by banks, thrifts, nonbank financial institutions, bond­
holders, credit card issuers, and others, it is clear that
the bad debts of the 1980s ran well into the hundreds of
billions of dollars. For example, if we look at just the fifty
largest commercial banking institutions, actual charge-

I am not surprised th a t we have a “ credit crunch,”
but in a way, I am surprised that it did not come
sooner, and I am thankful th a t it has not inflicted
even more serious damage on the econom y than we
have seen.

offs between year-end 1985 and the third quarter of
1991 aggregate to the astonishing total of almost $90
billion. And even with these charge-offs, nonperforming
and other problem assets are still at postwar record
levels.
In these circumstances, I am not surprised that we

FRBNY Quarterly Review/Winter 1991-92

1

have a “ credit crunch,” but in a way, I am surprised that
it did not come sooner, and I am thankful that it has not
inflicted even more serious damage on the economy
than we have seen. I also believe that the term “ credit
crunch” as it is widely used and interpreted often
misses the point as to the dynamics of the current
situation. Allow me to elaborate.
To be sure, all measures of credit growth have slowed
dramatically, even when adjusted for the slower pace of
economic activity. To be equally sure, lending and
underwriting standards have been tightened up across
the board. And there are, no doubt, some cases in
which creditworthy borrowers find it difficult to obtain
credit. Finally, it is certainly the case that there are
individual financial institutions that have been forced to
curtail lending or otherwise shrink their balance sheets.
All of these developments inflict hardship, but they also
are symptomatic of a delayed, inevitable, and ultimately
healthy response to the excesses of the past.

What we are seeing is the desire of individuals,
co rporation s, and financial in s titu tio n s to
strengthen and rebuild th e ir balance sheets after
the debt binge of the 1980s.

To put it more concretely, what we are seeing is the
desire of individuals, corporations, and financial institu­
tions to strengthen and rebuild their balance sheets
after the debt binge of the 1980s. Looked at in that light,
there is an understandable debate as to how much of
the credit crunch is due to the desire of debtors to
shrink the rate of debt accumulation and how much of
the credit crunch is due to the unwillingness or inability
of creditors to lend. For my part, I would put more
weight on the former but, in a sense, that debate is
meaningless. What is meaningful is that balance sheets

A case can be made tha t we are fu rth e r along in that
healing process than may be w idely appreciated.

had to be strengthened, capital positions had to be
improved, and lending and underwriting standards had
to be firmed.
Having said that, I hasten to add that a case can be
made that we are further along in that healing process
than may be widely appreciated. Let me cite several
examples that lead me to that view.
First, it is now clear that the origins of the adjustment

2 FRBNY Quarterly Review/Winter 1991-92


process, as measured, for example, by various mea­
sures of inflation-adjusted debt accumulation by corpo­
rations and h o useh olds, predated the m id-1990
business cycle peak by about a year. Given that per­
spective, the adjustment process has been under way
for the better part of two and one half years.
Second, there are now straws in the wind to suggest
that the buildup in nonperforming loans in the banking
system as a whole may have peaked, even if the level of
problem assets remains very high. Needless to say,
however, the future course of problem assets in the
banking system is not independent of the future course
of economic activity.
Third, the combination of the buildup in capital and
reserves, as well as rigorous cost containment efforts at
major banking institutions, should pay off handsomely
over time. For example, the overall capital and reserves
at the seven (now six) major New York banking compa­
nies is now well in excess of $60 billion, and the mean
tier I and overall risk-based capital ratios for those
institutions are now about 5.5 and 9.5 percent, respec-

The overall capital and reserves at the seven (now
six) m ajor New York banking com panies is now well
in excess of $60 b illio n , and the mean tie r I and
overall risk-based capital ratios fo r those
in s titu tio n s are now about 5.5 and 9.5 percent,
respectively.

tively. At the same time, operating expenses, which in
the second half of the 1980s were growing by almost 15
percent per annum, rose by only 5.9 percent over the
four quarters ending in September 1991. Indeed, over
that four-quarter period, a number of these institutions
experienced actual declines in operating expenses.
Broadly similar patterns are taking hold in bank and
nonbank financial institutions across the country.
Fourth, nonbank corporate restructuring and cost
containment efforts— as painful as they are— are pav­
ing the way for a leaner and more competitive corporate
America, which will be better able to produce truly
world-class goods and services, with commensurate
returns to shareholders and other investors.
Finally, with nominal interest rates at low levels, debt
servicing burdens have been reduced appreciably. In
saying that, however, I ask you to keep in mind that
nominal interest rates will remain relatively low only so
long as inflationary forces in the economy remain in
check and recede even further. To put it differently,
lenders or borrowers who made the bet during the
1980s that inflation would bail them out were wrong, and

they would be dead wrong to press that bet today.
While I can speak only as one member of the Open
Market Committee, I believe I can say with confidence
that the U.S. monetary authorities simply will not toler­
ate a return to the self-destructive process of inflation.
Indeed, what we seek are further gradual reductions in
the core inflation rate, even as the economy returns to a
pattern of moderate growth in the period ahead.

Lenders or borrow ers who made the bet during the
1980s that inflation w ould bail them out were wrong,
and they would be dead wrong to press that bet
today__ I believe I can say w ith confidence that the
U.S. m onetary auth oritie s sim ply w ill not tolerate a
return to the self-destructive process of inflation.

While I cite these positive developments, don’t get me
wrong. I am under no illusion. Problems, real problems,
remain. The near-term economic outlook is very uncer­
tain. Elements of the financial system are still under
considerable strain. It will take a number of years to
work off the inventory of excess commercial real estate.
Confidence is badly shaken as major corporate restruc­
turings and dire fiscal problems in state and local gov­
ernments across the nation threaten what were once
regarded as the safest and most stable sources of jobs
and income.
While we are all mindful of these and other problems
and threats, it is important that we not lose sight of the
progress that is being made in rebuilding the fundamen­
tals that are capable of ushering in a new age of

We are at one of those p oints when fru stra tio n w ith
imm ediate problem s can all too easily give rise to a
pell-m ell rush to find sh o rtc u ts and quick fixes that
w ill serve only to make th in g s worse in the longer
term.

prosperity and global leadership for the U.S. economy
and for the U.S. banking system. To gain the full mea­
sure of that potential will require vision and it will require
patience. Indeed, we are at one of those points when
frustration with immediate problems can all too easily
give rise to a pell-mell rush to find shortcuts and quick
fixes that will serve only to make things worse in the
longer term.
Perhaps nowhere is that temptation to find shortcuts
more dangerous than in regard to fiscal policy, espe­



cially in an election year.
constructive steps on the
our national reach. But it
discipline will have to be

That is not to say that some
fiscal side are wholly beyond
is to say that great care and
exercised in evaluating fiscal

A careful and disciplin ed approach to the evaluation
of fiscal options should give im p o rta n t w eight to the
follow ing considera tions: (1) any changes should
be su rgically neat and clean, (2) any changes
should give p a rticu la r em phasis to the alm ost
desperate need to rebuild the stock of productive
plant and equipm ent in th is country, and (3) above
all, any changes m ust not do fu rth e r damage to the
d e ficit o u tlook fo r the interm ediate term.

options. For my part, a careful and disciplined approach
to the evaluation of fiscal options should give important
weight to the following considerations: (1) any changes
should be surgically neat and clean, (2) any changes
should give particular emphasis to the almost desper­
ate need to rebuild the stock of productive plant and
equipment in this country, and (3) above all, any
changes must not do further damage to the deficit
outlook for the intermediate term. Indeed, even under
current law, the outlook for the budget deficit by mid­
decade is not encouraging, especially since the outyear budget estimates already imply very substantial
cuts in defense spending. Perhaps the outcome will be
aided somewhat by a rise in the savings rate, but I, for
one, would not bet the ranch on that possibility.
Beyond that, it is important to keep in mind that a rise
jn the savings rate necessarily implies a drop in the
consumption rate— an outcome we should welcome if it
occurs in a gradual and orderly fashion. We should also
keep in mind that even a modest rise in the personal
savings rate can be offset by a fall in the savings rate
for state and local governments or for the corporate

The only failsafe way to increase the national
savings rate by nearly the am ounts that are needed
is to reduce sharply the dissaving s rate associated
w ith federal budget deficits.

sector. To put it differently, the only failsafe way to
increase the national savings rate by nearly the
amounts that are needed is to reduce sharply the dis­
savings rate associated with federal budget deficits.
Surely, that will require vision and patience.

FRBNY Quarterly Review/Winter 1991-92

3

The full restoration of the financial muscle of the U.S.
banking system also will require vision and patience.
The call for vision and patience in this specific context
might seem so obvious as to be unnecessary. However,
experience suggests that it is not. For example, whether
it was LDC lending, highly leveraged transactions lend­
ing, or real estate lending, there was a point in the cycle
when a few bankers or a few regulators said “ enough is
enough.” But when the amber light flashed, it was
ignored by most, in part because the loans then on the
books looked fine and in part because new and enticing
deals kept rolling in. With the passage of time, however,
it became clear that enough was enough, but by then it
was too late.
Regulation— even the most sophisticated system of
so-called early intervention— cannot solve this problem.
Indeed, experience tells us in a convincing manner that
the only solution is to be found in a system of discipline
and prior restraint that is created and maintained by the
directors and top management of individual financial
institutions.

Perhaps the progress we are now seeking in the
strengthening of the banking system suggests that
some hard lessons have been learned. But even if
that is true, we s till have a very long way to go.

Perhaps the progress we are now seeing in the
strengthening of the banking system suggests that
some hard lessons have been learned. But even if that
is true, we still have a very long way to go. It is also true
that some of the necessary ingredients of that rebuild­
ing process are not directly controllable by banking
institutions or, for that matter, by banking regulators.
The legislative framework within which banks must
operate is a case in point. Here, I know most of you
share the sense of deep disappointment that I have for
the outcome of the banking legislation debate of last
year. That is, while there are some distinctly positive
aspects to the new legislation, the failure of the Con­
gress to enact any of the badly needed structural
reforms, such as the effective repeal of McFadden,
Douglas, and Glass-Steagall, must be viewed as a
major setback. Let us hope that the Congress will return
promptly to these issues this year.
W hile progre ssive banking le g isla tio n and an
improved economic environment will assist the banking
industry in restoring the full measure of its strength, the
fact remains that the lion’s share of the burden for this
adjustment lies with banks and bankers themselves.
In some ways the challenges facing individual banks
O

http://fraser.stlouisfed.org/
4 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

and the banking system are quite straightforward:
namely, individual institutions and the industry as a
whole will have to generate the capital and the returns
on that capital that are needed to restore the full mea­
sure of confidence of the marketplace and to satisfy the

While progressive banking le gislation and an
improved econom ic environm ent w ill a ssist the
banking in d u stry in restoring the fu ll measure of its
strength, the fact rem ains th a t the lio n ’s share of
the burden fo r th is adjustm ent lies w ith banks and
bankers them selves.

demands of increasingly selective investors and depos­
itors. For virtually all banking institutions, that challenge
will require strong and continuing efforts along several
lines, including the following:
First, the large— and in some cases, the truly enor­
mous— drag on income and profits arising from non­
performing and underperforming loans will have to be
worked down over time. Among other things, this will
require still more effort at structuring workouts and
the willingness perhaps to better recognize that fresh
credits can be a constructive part of workout strat­
egies for some troubled borrowers. It also is impor­
tant that all members of loan syndicates— even the
smaller participants— behave in a reasonable and
responsible fashion in evaluating workout strategies.
Second, operating expenses must be reduced fur­
ther. That process can be aided and facilitated by
mergers and other steps that promote needed consol­
idation in banking and finance. But even absent such
steps, recent experience suggests that further cuts in
operating costs— with their powerful implications for
the bottom line— are within reach.

The h isto ric dictates of (1) know ing your custom er,
(2) knowing how and when to say no, and (3) seek­
ing strength through d ive rsifica tio n m ust assum e a
s till larger role in the banking m arketplace.

Third, the emphasis on growth, current earnings,
and market share must be further tempered in favor of
an even greater premium on capital strength and
asset quality. This means that the historic dictates of
(1) knowing your customer, (2) knowing how and
when to say no, and (3) seeking strength through

diversification must assume a still larger role in the
banking marketplace. Part of this may require some
fresh and very aggressive thinking about concentra­
tions of credit exposures that takes greater account of
the bigger picture. For example, we can all readily
think of cases in which an individual real estate pro­
ject looked fine on a stand-alone basis but proved
disastrous when a particular market was later satu­
rated with multiple projects of a similar nature.
Fourth, where it is relevant, you had all better take
a very, very hard look at off-balance sheet activities,
including the payments, clearance, and settlement
risks associated with many of those activities. The
growth and complexity of off-balance sheet activities
and the nature of the credit, price, and settlement risk
they entail should give us all cause for concern,
especially when it seems so easy to accept the view
that what counts is net, not gross, exposures. That
distinction between gross and net may be relevant in
some cases, and it may be fine when all else is well,
but in the event of a major market disruption, I assure
you that it will be the gross, not the net, that will really
matter in most segments of the financial marketplace
both nationally and internationally.
High-tech banking and finance has its place, but it is
not all that it is cracked up to be. For example, the
interest rate swap market now totals several trillion
dollars. Given the sheer size of the market, I have to
ask myself how it is possible that so many holders of
fixed or variable rate obligations want to shift those
obligations from one form to the other. Since I have a
great deal of difficulty in answering that question, I then

Off-balance-sheet a c tiv itie s have a role, but they
m ust be managed and co ntrolled carefully, and they
m ust be understood by top management as well as
by traders and rocket scie ntists.

have to ask myself whether some of the specific pur­
poses for which swaps are now being used may be
quite at odds with an appropriately conservative view of
the purpose of a swap, thereby introducing new ele­
ments of risk or distortion into the marketplace— includ­
ing possible distortions to the balance sheets and
income statements of financial and nonfinancial institu­
tions alike.
I hope this sounds like a warning, because it is. Offbalance-sheet activities have a role, but they must be
managed and controlled carefully, and they must be
understood by top management as well as by traders



and rocket scientists. They also must be understood by
supervisors. In that regard, I can assure you that at both
the national and the international level we are redoub­
ling our efforts to ensure that supervisory policies for these
activities are sensitive to the full range of risks they pre­
sent to individual institutions and to markets generally.

What makes banks tru ly special is that public
confidence in th e ir strength and in te g rity is th e ir
only stock in trade. When th a t confidence has been
shaken— as it clearly has— the banks suffer, but
when the banks suffer, the so ciety also suffers.

If these are some of the things that strike me as
important in coming full circle in the restoration of the
strength of the U.S. banking system, allow me to close
on a note as to why achieving that goal is so very
important. In recent weeks and months we have seen
numerous examples— some good but most bad— of
how vitally important the confidence factor is to our
economic well-being. I point to this in a context in which
I have long maintained that banks are special. But I also
point to it in a context in which it is all too easy to forget

Nothing w ould please me more than to see the U.S.
banking system reemerge from these recent painful
years as a true w orld-class leader in cre a tivity and
innovation, yes, but especially as the bedrock of
confidence fo r the national econom y and the
international banking system .

that what makes banks truly special is that public confi­
dence in their strength and integrity is their only stock in
trade. When that confidence has been shaken— as it
clearly has— the banks suffer, but when the banks suf­
fer, the society also suffers.
As I said earlier, there are some very positive devel­
opments taking hold in the economy at large and in the
banking system in particular that can be an enormous
source of strength to our country and to the world over
the intermediate term. As a part of that process, nothing
would please me more than to see the U.S. banking
system reemerge from these recent painful years as a
true world-class leader in creativity and innovation, yes,
but especially as the bedrock of confidence for the
national economy and the international banking system.
That will not be easy, and there surely will be some
bumps along the road, but with vision and patience I
believe it can be done.

FRBNY Quarterly Review/Winter 1991-92

5

Changes in the Government
Securities Market
by E. Gerald Corrigan

I am pleased to have this opportunity to appear before
you this morning to share with you my observations on
the Joint Report on the Government Securities Market,
with particular emphasis on those aspects of the report
that relate directly to the activities or responsibilities of
the Federal Reserve Bank of New York.
Let me say at the outset that I strongly support the
overall thrust of the joint report. Taken as a whole, the
changes and legislative recommendations outlined in
the report represent a comprehensive yet well-balanced
approach to the problems that surfaced in the govern­
ment securities market last year. Let me quickly add
that the changes are at or near the outer threshold of
what I believe the market can reasonably absorb in the
near term without running undue risks to market effi­
ciency, Treasury debt management practices, or the
flexibility of Fed open market operations.
With those general observations in mind, let me turn
to the specific aspects of the report that relate directly
to the responsibilities of the Federal Reserve Bank of
New York. There are three such major areas: first, the
changes in the Bank’s administration of relationships
with primary dealers; second, the Bank’s role in the
development, testing, and implementation of new auto­
mated systems for Treasury auctions and Fed open
market operations; and third, the Bank’s expanded role
with regard to day-to-day surveillance of the govern­
ment securities market. The statement concludes with a

Statement before the Committee on Banking, Finance, and Urban
Affairs and the Subcommittee on Domestic Monetary Policy of the
House of Representatives, February 6, 1992.


6 FRBNY Quarterly Review/Winter 1991-92


brief status report from the Fed’s standpoint on the
Salomon Brothers situation, as requested by the
Committee.
A dm inistratio n of re la tionsh ips w ith prim ary
dealers
Attached to this statement is a paper issued late last
month by the Federal Reserve Bank of New York outlin­
ing revised procedures for the administration of the
Bank’s relationships with primary dealers (see appen­
dix). While that document itself represents a careful
balancing of many considerations and viewpoints, it is
based on a number of key and interrelated considera­
tions, including the following.
First, while change was needed, the complete dis­
mantling of the primary dealer system— including the
responsibility of dealers to make markets for Fed open
market operations and to participate meaningfully in
Treasury auctions— would not have been a prudent
step.
Second, in part because the existing approach has
been viewed as conferring special status on dealer
firms that carries with it elements of “franchise” value,
and in part because of fairness and equity considera­
tions, it was important to provide for a more “ open”
system of primary dealers. This has been accomplished
by the elimination of the so-called 1 percent market
share requirement and the use of straightforward and
objective capital standards for eligibility as a primary
dealer. Taken together, these changes will substantially
increase the potential number of firms that can become
primary dealers.
Third, in part because of “ moral hazard” considera­

tions and in part because of legal and regulatory real­
ities, it was important that the Federal Reserve Bank of
New York make absolutely clear to the marketplace that
the New York Fed does not regulate the primary dealer
firms. For this reason we are disbanding the Bank’s
dealer surveillance unit.
Fourth, for obvious reasons, it was necessary to clar­
ify the reasons and the conditions under which the New
York Fed would alter its relationship with a primary
dealer firm. Under the new administrative procedures,
there are three independent sets of circumstances
under which that might occur:
• A dealer firm’s status will be altered if the firm fails
to meet its responsibilities to make reasonable mar­
kets for Fed open market operations or it fails to
participate meaningfully in Treasury auctions or it
fails to meet its responsibilities to provide the Fed
with meaningful market intelligence over time. To
the extent a firm’s dealer status is altered for any or
all of the above reasons, that action by the Fed will
reflect considerations relating to the business rela­
tionship alone and will carry no implication as to
the creditworthiness, financial strength, or manage­
rial competence of the firm.
• A dealer firm’s status will be altered if its capital
falls below the relevant capital standards and it
does not, in the eyes of its primary federal reg­
ulator, have a credible plan to restore such capital
in a reasonable period of time.
• A dealer firm’s status will be altered if the firm is
convicted of a felony under U.S. law or pleads
guilty or nolo contendere to a felony under U.S. law
for activities directly or indirectly related to its busi­
ness relationship with the Federal Reserve. This
should create powerful incentives for a firm— when
faced with wrongdoing by individual employees— to
take immediate and strong actions to root out the
source of the problem so as to minimize the risk to
that firm.
While major elements of the changes in the adminis­
tration of the relationships with primary dealers will
begin to take place immediately, the full benefits of
these changes will occur only as the automation of
Treasury auctions and Fed open market operations
takes place and as the other changes contemplated by
the joint report take hold. Over time, however, the auto­
mation efforts may prove particularly important. These
initiatives are described below.
Federal Reserve Bank of New York autom ation
e ffo rts
The design work for the automation of the competitive
bidding portion of Treasury auctions based on existing



auction techniques has been under way for some time
and should be completed late this year. The software for
the automation of the auctions is not particularly difficult
to develop. The difficult aspects of this task relate more
to its communications system— particularly as the num­
ber and nature of prospective direct participants in the
auctions change. But what makes this automation effort
especially difficult is the need to build into the computer
systems and the communications system a very high
level of operational integrity, as well as multiple levels of
backup for various contingencies.
If the Treasury were to decide to move to a different
auction technique, the strategy would be to enhance
the system presently being developed to accommodate
both types of auctions. While important elements of the
work being done for the current auction procedures can
be used with a new auction technique, the enhance­
ment of the system being developed to accommodate
the new procedures will take some time after the
requirements have been defined. This will not, however,
delay the planned implementation of automated proce­
dures for the current auction by the end of this year.
In order that the Committee might gain a more useful
insight as to exactly how the automated Treasury auc­
tion system will work in practice, and at the risk of a
great oversimplification, the major characteristics of the
system can be thought of in the following terms.
First, each institution that is “ eligible” to submit com­
petitive bids in Treasury auctions would have a terminalbased telecommunications link to the Federal Reserve
Bank of New York, either directly or through another
Federal Reserve Bank. The basic “ hardware” used for
this purpose will be the FedLine terminal that is pres­
ently in use in over 9,000 depository institutions nation­
wide. The communications network will be the proven
and highly reliable Fedwire telecommunications system.
Finally, the new auction system will utilize the same
security and encryption devices that are currently used
for Fedwire operations.
Second, for each such “ e lig ib le ” bidder, certain
data— including any affiliations with other “ eligible” bid­
ders— would have to be housed in our data base, as
would acceptable methods for making payment for
securities and for receiving delivery of securities
awarded in the auctions. Since payment and delivery
must be made in electronic form, nonbanks would have
to have suitable “ auto-charge” agreements in place with
banks for this purpose.
Third, following electronic announcements of notices
of auctions, bidders would be able to submit bids elec­
tronically up until the auction cutoff time, which cur­
rently is 1:00 p.m. eastern standard time. In order to
provide adequate backup for contingencies, however,
the system must be designed such that all bids can be

FRBNY Quarterly Review/Winter 1991-92

7

routed to both the Federal Reserve Bank of New York’s
main data processing center in lower Manhattan and its
remote backup processing center.
Fourth, the computers would then sort through the
bids on the basis of the highest prices (lowest yields)
received in much the same fashion as today’s manual
procedures do. As a part of this process, a number of
internal audit and control procedures are planned to
ensure compliance with Treasury auction rules and to
flag outlier bids, including those resulting from clerical
errors in message preparation.
Fifth, once the proper audits have been performed,
the information has been sent to the Treasury, and the
“ awards” have been made, the payment for and delivery
of the securities must be initiated and completed. This
will be achieved through the Fed’s money and securities
transfer systems (Fedwire).
Finally, and in the normal course, after the initial
delivery and payment for the securities in question are
completed, end-of-day verifications and reconcilements
must be made as a part of the overall controls on
operating systems that often handle more than $1 tril­
lion of transactions per day.
The full automation of Fed open market operations is
an even more complex and time-consuming task, espe­
cially since it is impossible to prejudge with any preci­
sion the number, location, and other characteristics of
potential counterparties for such operations. Moreover,
the operating systems and communications systems
associated with this effort must be integrated with a
number of other highly complex automated systems,
including the Fed’s existing money and securities trans­
fer systems. Because of this, an extraordinarily high
level of reliability and integrity will be needed. To appre­
ciate the concerns I have in mind, just imagine for a
moment what might have occurred on the morning of
October 20, 1987, had the Fed been unable— due to
technical problems with such a system— to furnish sub­
stantial liquidity through open market operations as a
part of the effort to stabilize financial markets in the
wake of the stock market crash.
The role of the Federal Reserve Bank of New York
in the m arket surveillan ce process
There is little that needs to be added to what is con­
tained in the joint report as it pertains to the expanded
role of the Federal Reserve Bank of New York— in
cooperation with the other agencies— with regard to
day-to-day surveillance of the government securities
market except (1) to emphasize that market surveillance
is quite distinct from dealer surveillance, which we are


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8 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

discontinuing; and (2) to emphasize that it will take
some time to put in place the new or altered statistical
reporting arrangements that might be agreed upon by
the interagency surveillance working group over the
period immediately ahead.
As a first step in the overall process of gearing up for
this effort, the Federal Reserve Bank of New York
expects to have the initial redeployment of key person­
nel necessary for this effort in place later this month.
Final decisions as to the number and mix of personnel
needed for this effort will have to await agreement
among the agencies as to the precise scope and nature
of the statistical reporting and other aspects of the
market surveillance effort, which should be essentially
completed in a month or two.
The Salomon Brothers situation
Since the official investigation into the Salomon Broth­
ers wrongdoings is still under way, there is very little
that can be said at this time regarding the particulars of
that situation. The firm, in response to inquiries by the
Federal Reserve Bank of New York, has provided the
Bank with several reports over the period from Septem­
ber through December 1991. In general, these reports
cover (1) the sweeping changes in management and
management structure that were put in place following
the disclosures made by the firm last August, (2) the
major changes in internal control procedures and com­
pliance systems that have been put in place over the
period in question, (3) various estimates of the profits
associated with the auctions in which irregularities have
been acknowledged by the firm, and (4) further details
regarding the firm’s financing activities in certain of the
Treasury issues. Where relevant, all such materials
have been made available to the Securities and
Exchange Commission and the U.S. Attorney.
It is contem plated that any decision regarding
Salomon Brothers’ status as a primary dealer by the
Federal Reserve Bank of New York will be made in the
context of the findings reached by the Securities and
Exchange Commission as a result of its ongoing investi­
gation of the matter. This approach, which has the
support of the other agencies, is being followed in
deference to fairness and due process considerations
and in order to minimize uncertainties that might follow
from multiple and uncoordinated announcements of this
nature. The timing of the Salomon Brothers episode is
such that certain Federal Reserve Bank of New York
sanctions might apply even if the firm is not convicted
of, or pleads guilty or nolo contendere to, a felony under
U.S. law.

Appendix: Administration of Relationships with Primary Dealers
The Federal Reserve Bank of New York (FRBNY) is
adopting certain changes in the administration of its
relationship with primary dealers in U.S. Government
securities. The primary dealer system has been devel­
oped for the purpose of selecting trading counterparties
for the Federal Reserve in its execution of market opera­
tions to carry out U.S. monetary policy. The designation
of primary dealers has also involved the selection of
firms for statistical reporting purposes in compiling data
on activity in the U.S. Government securities market.
These changes in the administration of these relation­
ships have been developed after consultation with the
Federal Reserve Board, the Federal Open Market Com­
mittee, the Treasury and the Securities and Exchange
Commission.
The changes announced today have been prompted by
two related factors:
First, decisions have been made to accelerate the
automation of Treasury auctions and Federal Reserve
open market operations with a view toward increasing
the efficiency of the auction process and open market
operations, and providing the potential for further broad­
ening the base of direct participation in these operations.
These automation initiatives are major undertakings, as
they must be planned and executed with extreme care to
ensure operating and communications systems of the
highest level of reliability and integrity. They will require
back-up systems comparable to those now in place for
the Fed’s funds and securities transfer systems. Plan­
ning for automation of the existing Treasury auction for­
mat is well under way and automation is scheduled for
completion by the end of this year. Automation planning
for Federal Reserve open market operations is just get­
ting started, and completion of this automation will prob­
ably take about two years.
Second, and more important, while the system of des­
ignating primary dealers on the whole has served the
Federal Reserve, the Treasury, and the nation well for
many years, there also have been some drawbacks to
the existing arrangements. Prominent among these is
the public impression that, because of the Federal
Reserve Bank's standards for selecting and maintaining
these relationships, the Fed is in effect the regulator of
the primary dealer firms. Moreover the primary dealer
designation has been viewed as conferring a special
status on these firms that carries with it elements of
“franchise value” for the dealer operation and possibly
for other aspects of the firm ’s standing in the
marketplace.
The net result of these interrelated factors is that the
Federal Reserve is amending its dealer selection criteria
to begin providing for a more open system of trading
relationships, while still exercising the discretion that any




responsible market participant would demand to assure
itself of creditworthy counterparties who are prepared to
serve its needs.
For the most part, the changes in the administration of
the primary dealer relationships will have no immediate
effect on existing prim ary dealers— recognizing, of
course, that they will, over time, be subject to the
requirements noted below for maintaining a counterparty
relationship with the Fed. However, existing as well as
any new primary dealers will no longer be required to
maintain a one percent share of the total customer activ­
ity reported by all primary dealers in the aggregate; this
requirement is no longer deemed necessary given the
active and liquid state of development now achieved in
the U.S. Government securities market, and its retention
could be an obstacle to achieving more open trading
desk relationships. In addition, while continuing to seek
creditworthy counterparties, and while continuing to
exercise market surveillance, the FRBNY will discon­
tinue its own dealer surveillance activities relating to
primary dealer firms’ financial characteristics.
New firms will be added on the basis of criteria listed
below. As in the past, all prim ary dealers will be
expected to (1) make reasonably good markets in their
trading relationships with the Fed’s trading desk; (2)
participate meaningfully in Treasury auctions; and (3)
provide the trading desk with market information and
analysis that may be useful to the Federal Reserve in the
formulation and implementation of monetary policy. Pri­
mary dealers that fail to meet these standards in a
meaningful way over time will have their designation as a
primary dealer discontinued by the FRBNY. It is contem­
plated that each dealer firm’s performance relative to
these requirements will be reviewed on an ongoing basis
and evaluated annually beginning in June 1993. If a firm’s
relationship with the FRBNY is discontinued because of
shortfalls in meeting these standards, the action by the
FRBNY will be made strictly on a business relationship
basis. As such, any decision by the FRBNY will carry no
implication as to the creditworthiness, financial strength
or managerial competence of the firm.
In evaluating a firm’s market-making performance with
the trading desk, the FRBNY will look to the amount of
business of various types actually transacted and the
quality of the firm’s market-making and market commen­
tary. Dealers that do little business with the Fed over a
period of time, that repeatedly provide propositions that
are not reasonably competitive, and that fail to provide
useful market information and commentary add little to
the Fed’s ability to operate effectively and will be
dropped as counterparties for at least six months.
In evaluating participation in Treasury auctions, the
Fed will expect a dealer to bid in reasonable relationship

FRBNY Quarterly Review/Winter 1991-92

9

Appendix: Administration of Relationships with Primary Dealers (continued)
to that dealer’s scale of operations relative to the market,
and in reasonable price relationship to the range of
bidding by other auction participants. Any decision to
suspend a primary dealer designation because of inade­
quate auction bidding will be taken in close consultation
with the Treasury.
Finally, consistent with the Omnibus Trade & Competi­
tiveness Act of 1988, a foreign-owned primary dealer
may not be newly designated, or continue to be desig­
nated, in cases where the Federal Reserve concludes
that the country in which a foreign parent is domiciled
does not provide the same competitive opportunities to
U.S. companies as it does to domestic firms in the
underwriting and distribution of Government debt.

Criteria for accepting new dealers
New prim ary dealers must be commercial banking
organizations that are subject to official supervision by
U.S. Federal bank supervisors or broker/dealers regis­
tered with the Securities and Exchange Commission.
The dealer firms or the entities controlling the dealer
firms must meet certain capital standards as follows:
• Com m ercial banking in stitu tio n s m ust— taking
account of relevant transition rules— meet the mini­
mum Tier I and Tier II capital standards under the
Basle Capital Accord. In addition, commercial banks
must have at least $100 million of Tier I capital as
defined in the Basle Capital Accord.
• Registered broker/dealers must have capital in
excess of the SEC’s or Treasury’s regulatory “ warn­
ing levels” and have at least $50 million in regulatory
capital. Where such capital standards do not apply
to a consolidated entity controlling a primary
dealer— consistent with the treatment of banks
under the Basle Accord— the FRBNY will also look
to the capital adequacy of the parent organization.
The minimum absolute levels of capital specified
above (i.e., $100 million for commercial banks and $50
million for broker/dealers) are designed to help insure
that primary dealers are able to enter into transactions
with the Fed in sufficient size to maintain the efficiency of
trading desk operations.
A bank or a broker/dealer wishing to become a primary
dealer must inform the FRBNY in writing. As a part of
that notification a prospective dealer must also provide
appropriate financial data demonstrating that it meets the
capital standards outlined above. The FRBNY will con­
sult with the applicable supervisory body to ensure that
the firm in question is in compliance with the appropriate
capital standards. When new firms are accepted as pri­
mary dealers, the nature and extent of the Bank’s trading
relationship with the firm will, as under current practices,
evolve over time. As a result of this change and the


http://fraser.stlouisfed.org/
FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

elimination of the one percent market share criterion,
there will no longer be any need for individual firms to be
considered by the market as “aspiring dealers.”
Of necessity, at least for the time being, the number of
additional primary dealers will be relatively limited
because of resource constraints on trading desk opera­
tions. The selection of this limited number will be depen­
dent on how many can be added without adverse impact
on the efficiency of Federal Reserve trading desk opera­
tions. Applications received by March 31, 1992, will be
evaluated in relation to the foregoing capital standards. If
it is not feasible to add all of the qualifying firms as
primary dealers, a selection will be made among those
firms in a manner that gives primary consideration to
their relative capital positions. Following the implementa­
tion of automated communications for trading purposes,
further expansion in the number of primary dealers will
be feasible, and further changes in the criteria for selec­
tion also could be considered, although there is no pre­
conception at this time as to what, if any, further changes
would be made.

Maintenance of capital standards
As a result of the adoption of the capital standards for
accepting primary dealers, all primary dealers will be
expected to maintain capital positions that meet the
standards described above on an ongoing basis. Should
a firm’s capital position fall below these minimum stan­
dards, the FRBNY may suspend its trading relationship
until the firm’s capital position is restored to levels corre­
sponding to these minimum standards. In making such
determinations, the FRBNY will look to the firm’s primary
Federal regulator for guidance as to whether the firm has
in place an acceptable plan to restore its capital position
in a reasonable period of time. However, in no circum­
stances will the Bank maintain a trading relationship with
a primary dealer that is unable to restore its capital
position to the stipulated minimum level within a year.
Over time, the maximum grace period of one year may
be shortened and would not apply in any event if a firm’s
capital position were seriously impaired.

Elimination of dealer surveillance
While the Federal Reserve Bank of New York will con­
tinue to seek creditw orthy coun te rp a rtie s— and w ill
continue, or enhance, its market surveillance— it is plan­
ning to discontinue the “dealer surveillance” now exer­
cised over primary dealers through the monitoring of
specific Federal Reserve standards and through regular
on-site inspection visits by Federal Reserve dealer sur­
veillance staff. Rather, the FRBNY will seek to act as any
reasonably well-informed and responsible firm might
behave in evaluating the creditworthiness of its counter-

Appendix: Administration of Relationships with Primary Dealers (continued)
behave in evaluating the creditworthiness of its counter­
parties. Accordingly, the Federal Reserve will expect to
receive periodic reports on the capital adequacy of pri­
mary dealers, just as any other responsible market par­
ticipant should expect to receive such reports.
The elimination of the Bank’s dealer surveillance activ­
ities should be viewed merely as confirmation of the
long-standing reality that the Bank does not have— nor
has it ever had— formal regulatory authority over the
Government securities market or authority over the pri­
mary dealers in their capacity as such. The Bank is
satisfied that the existing regulatory apparatus over the
market and the regulatory apparatus as it applies to
dealer firms are adequate— especially in light of changes
outlined in the joint Treasury-SEC-Federal Reserve
study— and it is satisfied that it can protect itself against
fin a n c ia l loss w ith o u t re lia n ce on form al dealer
surveillance.
Sanctions of primary dealers for wrongdoing
The Federal Reserve Bank of New York does not have
civil or criminal enforcement authority over primary deal­
ers in their capacity as primary dealers. This considera­
tion and the dictates of fairness and due process require
that the disposition of allegations of wrongdoing lies with
the Government bodies having such authority— including
the U.S. Treasury, the Federal bank supervisor, the
Securities and Exchange Commission and the U.S.
Department of Justice.
In the future, if a primary dealer firm itself is convicted
of a felony under U.S. law or pleads guilty or nolo
contendere to felony charges under U.S law for activities
that relate directly or indirectly to its business relation­
ship with the Federal Reserve, the firm will be subject to




punitive action, possibly including suspension as a pri­
mary dealer for six months. Depending on the nature of
the wrongdoing the penalty could be more severe,
including permanent revocation of a trading relationship.
Statistical reports on government securities
activities
The current statistical reporting program is expected to
continue unchanged for the time being, but a review is
being undertaken to determine how best to adapt this
program to an environment in which market surveillance
is receiving greater emphasis and a statistical reporting
relationship is not necessarily tied to a trading relation­
ship with the Federal Reserve. This review will take into
account the needs of the Federal Reserve, the Treasury
and the SEC as well as the burden of statistical reporting
on dealer firms.
Summary
Taken as a whole, these changes are designed to facili­
tate an orderly and gradual move to a more open system
of primary dealer relationships with the FRBNY while at
the same time preserving certain key characteristics of
the current system that have been beneficial to the Fed­
eral Reserve and the Treasury over the years. Over time,
the successful implementation of highly automated sys­
tems for Treasury auctions and Federal Reserve open
market operations will provide the room and the opportu­
nity for still further changes. However, the desirability of
further changes will have to be evaluated against the
experience with these modest changes and the need to
preserve both the efficiency and flexibility of Federal
Reserve monetary policy operations, and the liquidity and
efficiency of the market for U.S. Government securities.

FRBNY Quarterly Review/Winter 1991-92

11

Determinants of Long-Term
Interest Rates: An
Empirical Study of Several
Industrial Countries
by Howard Howe and Charles Pigott

Real interest rates on long-term financial assets play a
central role in linking financial markets to the economy
at large. Long-term real interest rates are a key determi­
nant of business and housing investment as well as
household spending on automobiles and other dura­
bles. As such, the rates are an important influence on
the business cycle and on capital formation and a key
link in the transmission of macroeconomic policies. The
extensive debate over the reasons for and implications
of the apparently high level of real long-term rates
worldwide during much of the 1980s attests to their
practical economic significance— and the importance of
trying to improve understanding of their behavior.
This article examines the principal influences on
long-term real interest rates over the last fifteen years in
the United States and four major foreign countries:
Japan, Germany, the United Kingdom, and France. Our
goal is to identify the macroeconomic and other factors
that have shaped the broader movements of the real
rates over the period as well as their shorter term
fluctuations.1
We begin by examining several important features of
the behavior of long-term real interest rates since the
mid-1970s. This analysis yields two key findings: first,
'O ur approach complements that of most studies on long-term
interest rates over the last decade, which have focused on more
specific and technical issues such as the degree to which long­
term rates are determined by expectations of future short rates.
Our analysis is similar in spirit to two earlier studies of real interest
rates that attempted to explain the evolution of real rates over time:
Robert J. Barro and Xavier Sala i Martin, "World Real Interest
Rates," National Bureau of Economic Research, Working Paper
no. 3317, April 1990; and Olivier J. Blanchard and Lawrence H.
Summers, "Perspectives on High World Real Interest Rates,”
Brookings Papers on Economic Activity, 2: 1984.


12 FRBNY Quarterly Review/Winter 1991-92


the countries’ real rates have shown a persistent rise
since the mid-1970s, reaching levels in the 1980s that
seem unusually high by historical standards; second,
the movements in the real rates appear to reflect, at
least in part, shifts in their long-run, or “equilibrium,”
levels. This second finding suggests that any adequate
explanation of the evolution of the real rates must allow
for determinants with relatively lasting effects as well as
factors leading mainly to short- and medium-term fluc­
tuations in those rates. We apply such a framework in
evaluating the empirical importance of several potential
influences, including macroeconomic policies, the rate
of return to capital, and the effects of risk and other
factors arising in part from changes in financial struc­
ture and regulation.
Overall, the evidence developed here suggests two
important if very tentative conclusions. The first, and
probably firmer, is that much, perhaps the dominant
portion, of the observed movement in long-term real
interest rates reflects relatively permanent changes in
their long-run equilibria. In particular, the increase in
real rates from the 1970s to the 1980s, which occurred
to some degree in all the countries (and for short-term
rates as well), appears to stem largely from such a
change in equilibria. There is also some evidence,
although mixed and highly tentative, that rising debt
levels relative to GNP along with increases in the return
to physical capital are at least partly responsible for the
increase in real rates.
Our second conclusion is that macroeconomic pol­
icies have been an important, but clearly not exclusive,
influence on the evolution of the long real rates over the
last fifteen years. In particular, monetary policy appears

to have contributed significantly to the rise in real rates
abroad at the end of 1970s and to the increase in U.S.
real rates in the early 1980s. On the whole, however,
monetary policy was not responsible for persistently
high real rates during the last decade. Likewise,
changes in government budget deficits appear to have
affected real rate movements in certain periods, but to a
degree (apart from their effect on debt levels) that is
fairly modest compared with the overall trend in the real
rates. On balance, the two conclusions suggest that
macro policies have affected real long-term interest
rates but, given the importance of other influences,
have not exercised a high degree of “control” over those
rates in any economically meaningful sense.
The evolution of long-term real interest rates
Conceptually, the real interest rate on a financial asset

Chart 1

Real Long-Term Interest Rates
Nominal Yields less Inflation of Past Three Years
Percent
United Stat 3S

A
/ A V

a /L i

Germany

••

A

'M

r\
i
i
\
l»

r\ j United
W
\/
rfxMi VA
,6
V / \,i

n

2There are, of course, other significant measurement problems— for
example, the accounting for taxation of bond returns,

\

b
3Maturities on the instruments considered are ten years for all
countries except Germany, where the term is four years or longer
Government bonds are generally the most widely held and actively
traded long-term fixed income instruments in all the countries.

Kincjdom

4That is, in some long-run or average sense, the proxy used here
should equal the actual real rate, since investor expectations of
future inflation should (at least if they are "rational") ultimately
coincide with its actual trend.

!i
V

'
j France
'
i
!
1 " .... ...

A
/]
/ft
~ f\
hJ
m 11111 M111111111111

f

1975

\ J

o Japan

7

l!
96 1

VfIT-

J d

VJ fP\ JN\r Jl4\

i 7j

/£
!%'

A

77

79

is equal to its nominal yield minus the inflation that a
typical investor expects to prevail over the holding
period. Because the anticipated inflation rate cannot be
directly measured, any empirical measure of real inter­
est rates inevitably is only a rough proxy.2 In this study,
we approximate the long-term real interest rate as the
nominal rate minus the average of consumer price infla­
tion over the past three years. (For the nominal rates we
use the yields to maturity on government bonds, since
these bonds are the primary fixed income instruments
in the countries we are considering.3) Our real rate
measure is very rough and not necessarily the best that
might be constructed. But given the considerable evi­
dence that inflation expectations tend to be strongly
influenced by past trends, the measure should reasona­
bly reflect the broad movements in actual real rates over
time that are our main concern here.4
Chart 1 shows the movements in the real long-term
interest rate proxies since the mid-1970s, and Table 1
presents the corresponding averages. Movements in
nominal long-term rates appear in Chart 2. Three fea­
tures of these movements are noteworthy. First, long­
term real rates have varied considerably over time,
indeed, by nearly as much as their nominal counter­
parts. This observation implies that nominal rates have
not varied just to offset movements in inflation, as a
simplified Fisherian model of interest rate determination

Table 1
lllllllllllllllilll

81

83

85

11111111111111111II
87

89

ml

91

Average Real Long-Term Interest Rates
Nominal Yields less Past Three Years’ Inflation
Japan

Sources: Board of Governors of the Federal Reserve System
(U.S. data); Bank for International Settlements (data for all other
countries).
Notes: Nominal yields are for ten-year government bonds except
in the case of Germany, where the term is four years or longer.
Inflation is measured by the consumer price index. Quarterly
figures are averages of monthly data.




1975-90
1975-82
1983-90
Memo:
1963-69

1.8

- 0 .5
4.2
2 .0 +

United
Kingdom

United
States

5.1

1.7
- 1 .7
5.1

3.1
0.9
5.4

2.8

3.2

2.7

Germany

France

4.1
3.2
5.0

3.2

4.1

1.2

*1965-69.

FRBNY Quarterly Review/Winter 1991-92

13

would suggest. Moreover, the behavior of the real rates
has often been quite different from that of their nominal
counterparts; in particular, real rates have tended to
rise over time, while the nominal rates, reflecting the
general decline in inflation rates from the 1970s to the
1980s, have fallen over the period as a whole.
Second, although the average levels of the real rate
have differed significantly across countries, both the
overall trend in real rates and their behavior from the
late 1970s to the early 1980s and again at the end of the
1980s have been remarkably similar across countries.
The coincidence of the broad movements in the coun­
tries’ real rates suggests that their underlying determi­
nants may have behaved in very similar ways.
The third and perhaps most striking feature of the real
rate movements is their general rise after 1975 to levels
in the 1980s that appear unusually high in comparison
with the past.5 Admittedly, the first portion of this rise, in
the latter 1970s, represents the recovery of real rates
sThe persistently high level of both short- and long-term real interest
rates during the 1980s has been widely noted and discussed. (See
in particular Paul Atkinson and Jean-Claude Chouraqui, "The
Origins of High Real Interest Rates," Organization for Economic
Cooperation and Development, OECD Economic Studies, no. 5,

from the exceptionally low, indeed generally negative,
levels to which they had fallen during the first half of the
decade (in all the countries but Germany). (Because
much of the rapid rise in inflation during the mid-1970s
was probably unanticipated by markets, our measure
may significantly understate the true level of real inter­
est rates during this period.) The surge in real rates
over 1979-81, to levels somewhat above past averages
(except in the United Kingdom), is similar to that seen in
several of the countries in 1973-74. The sustained
increase in real rates after 1982, however, marks a clear
departure from past historical patterns. Although real
rates abroad, at least during 1982-85, did not rise
nearly as much as in the United States, the average
level of the rates in all five countries after 1982 was
noticeably higher than during the 1960s or the first half
of the 1970s. Thus, by postwar standards, real long­
term interest rates have been quite high internationally
during the last decade.
The persistent rise in real long-term interest rates6
Footnote 5 continued
Autumn 1985, pp. 7-55.) Commentators have attributed it to a wide
range of factors, including government budget deficits and, more
recently, a worldwide “ shortage of capital.”
6This rise is also displayed by several alternative definitions based
on other inflation indexes and measures of expected long-term
inflation. In particular, real rate proxies based on a “ forwardlooking" measure of anticipated inflation, calculated as the average
of inflation rates one year in the future and two years in the past,

Chart 2

Nominal Long-Term Interest Rates
Percent
18
\ France
! \

Table 2

16
A
!\

14 / • /
'
12

i

A
/

*.
I

\

/'

\ i
, / ' v \

10
8

V

V'

1

\J / q q C
3°oqo
'

j

r

v

M
I

*
A

Tests fo r Varying E quilibrium of Long Rates

United St ates

United United
Japan Germany France Kingdom States

x
V

/

j K I
I v

\

f\
L\

u
■

*
A
/ Vn

United Kingdc)m
! \
\ r.
/ •]
\ \ ' ■ ' k- ■ S ' '
\ i A A. /

W
U W
*r k '

o •• Germany

9f t i
11 L i
l;P*“

VJ

j

h
D

6

4

^ Japan

2 llll m l i i i l m l m l i i i
1975
77
79

111111111111HI l l l l J l i l t l 11111111l l l l I . I I I
81
83
85
87
89
91

Sources: See sources in Chart 1.
Note: See yield definitions in Chart 1.


http://fraser.stlouisfed.org/
14 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

Real long rate
-1 .7 7
(1973-111 to 1990-IV)
Long-short spread -4 .0 0 *
(1973-111 to 1990-IV)

-1 .0 6
— 3.21 *

- .4 9

-1 .7 9

-1 .7 5

-3 .9 2 *

— 2.09t

-2 .4 5

Notes: Figures are augmented Dickey-Fuller test statistics on
the coefficient b in the equation
4
x(t) = b x (t- 1 ) + X c,A x(t-i) + ex,
i= 1
where four lagged autocorrelation terms are used. A significant
value indicates that the hypothesis that the equilibrium (long-term or
unconditional mean) is changing can be rejected. None of the
values for tests of constant equilibrium real long rates are
statistically significant. Tests of constant long-short spread are
statistically significant at the 5 percent (*) level for Japan, Germany,
and France. Critical values for the Dickey-Fuller statistic are
obtained from W.A. Fuller, Introduction to Statistical Time Series,
1976, p. 373.
^The United Kingdom spread appears to have a negative time
trend but to be otherwise stable (that is, around the trend):
when a time trend is included, the critical value of the test
statistic for significance at the 5 percent level is -3.4 1 .

strongly suggests that their long-run (conditional) mean
values have changed over time. We will refer to such
changes as shifts in the “ equilibria” of the real interest
rates since the means represent the levels to which the
real rates will eventually converge in the absence of any
further disturbance to their values.7 The supposition
that the equilibria have changed periodically is sup­
ported by formal statistical tests, reported in Table 2,
Footnote 6 continued
also display a considerable rise between the mid-1970s and the
1980s, although somewhat more modest than that shown in Chart 1.
The same is true of proxies calculated by discounting considerably
(for example, by smoothing over a longer period) the sharp surge
in our inflation measure in the mid-1970s and of proxies based on
the GNP deflator or the consumer price index excluding food and
energy. Comparisons of the 1980s with the 1960s are also fairly
robust to alternative measures.

which evaluate whether the long-term real rate is “ sta­
tionary” in the sense of having a constant mean value
toward which it tends to return. As the table indicates,
the hypothesis that the long-run mean values of the real
rates have varied over time cannot be rejected at any
reasonable confidence interval.8
The most plausible interpretation of these statistical
results is that the equilibrium values of the long-run
rates have changed significantly over time rather than
that the real rates are simply “ unstable” in the sense of
having no true equilibrium. The implication is that the
observed evolution of real long-term rates reflects not
only fluctuations about a given equilibrium but also
changes in the equilibria themselves. Note too that the
average level of real interest rates on short-term finan­
cial assets has also increased noticeably (Chart 3).

7Thus, "equilibrium ” as defined here is inherently subject to change

over time, in contrast to the very long-run "steady-state" equilibria
referred to in classical growth theories and much other literature.
The economic meaning of the real rate equilibrium is discussed
below.

Chart 3

Real Short-Term Interest Rates
Nominal Yields less Inflation of Past Three Years
Percent

8Tests over a longer period (beginning in the mid-1960s, or late
1960s for Japan) support this conclusion even more decisively than
the tests reported in the table Furthermore, a more general
regression relating the long-term nominal rate to inflation (allowing
the real rate to vary systematically with inflation) also appears to
have an "unstable" mean. It is, of course, possible that the shifts
in the mean real long rate have occurred at a few discrete points
during the period, rather than more or less continuously, as a literal
reading of the statistical results underlying Table 2 would imply.
Nevertheless, the hypothesis that a single mean shift occurred after
1981, or at mid-sample, is effectively rejected by the test statistics
(at the 5 percent, and generally the 10 percent level) for all
countries but the United States.

Chart 4

Spread between Real Long-Term and
Real Short-Term Interest Rates
Percent

A ft\ \ \ |! iI ^ Fran
ce n
A / \l ifffV - M f/ •' K / ^
/
i

A /"'x
^ \
f

m

fr \
y/V7 \_\
j
9 \
/
/Ufl \ y r R

J

6

i\ s j
J
m
\•
' Vf
\/
•/

f

b
>an

\

Va
r

T

i

\

‘‘ Germany
\ i
U lited Kingdom V

III m lm lm ui
1975
77
79

in m l ml m il ul in in iiilm lm liii ill
81

83

85

87

89

91

Sources: See sources in Chart 1.
Notes: Nominal yields are for three-month obligations in the
money markets. Inflation is measured by the consumer price
index. Quarterly figures are averages of monthly data.




Sources: See sources in Chart 1.
Note: Real interest rates are those presented and defined in
Charts 1 and 3.

FRBNY Quarterly Review/Winter 1991-92

15

However, the relation between long- and short-term
rates, as measured by the difference in their values,
appears to have remained fairly stable over time (Chart
4). This latter observation is supported by statistical
tests analogous to those applied to the real long rates;
here the tests suggest that the long-short spread does
have a constant mean in most cases (Table 2, bottom
row).9 Thus we may also conclude, if equally tentatively,
that the rise in equilibrium long-term real rates appears
to reflect forces affecting financial instruments gener­
ally, not simply forces specific to long-term instruments.
The finding that equilibrium real rates have varied
does not itself, of course, cast light on the specific
economic factors responsible. Nevertheless, the finding
does help us to determine the factors we will consider
and the approach we will take in our empirical analysis
of the behavior of long-term real rates— the analysis to
which we now turn.
Fundamental determ inants of long-term real
interest rates
In this section we attempt to identify and quantify the
importance of the fundamental economic forces behind
the evolution of the real long-term interest rates exam­
ined above. The evidence presented in the first section
implies that any adequate framework for this analysis
must consider forces leading to persistent changes in
the equilibria of the real rates as well as forces produc­
ing fluctuations about those equilibria. Such a frame­
work is provided by the approach to interest rate
determination formulated by the Swedish economist
Knut Wicksell in the late 19th century.10 The “Wicksellian” approach is the prototype for much modern
theoretical analysis of interest rate determination.
The Wicksellian framework
Fundamental to Wicksellian frameworks is the distinc­
tion between the “ natural” real rate of interest and the
market rate. The first corresponds to what we have
called the long-run equilibrium real interest rate: it is the
rate toward which actual real rates will eventually tend
over time in the absence of any further disturbances.
Fundamentally, the equilibrium real rate represents the
9The spread for the United States is just below the 10 percent
critical value that would indicate "acceptance" of the hypothesis of
a constant mean. But evidence from earlier work using a longer
sample period (for example, Robert F. Engle and C.W. Granger,
“ Cointegration and Error Correction: Representation, Estimation, and
Testing," Econometrica, vol. 55, no. 2 [March 1987], pp. 251-76)
indicates that the U.S. spread is in fact stationary, and we will so
regard it in our statistical analysis.

1°Wicksell's approach was developed in his treatise, Interest and
Prices (1898).


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16 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

future return in forgoing current consumption.11 This
equilibrium real rate can, and generally will, change
over time as its underlying determinants vary; these
changes will be reflected in the broader, longer term
movements in actual real rates.
The framework recognizes, however, that actual inter­
est rates generally adjust only gradually to shifts in
their underlying equilibria. Asset supplies and demands
may respond slowly to altered conditions, and certain
forces may temporarily push interest rates away from
equilibrium without altering the equilibrium itself.
Accordingly, the actual market rate of interest at any
given time (which Wicksell called the “financial” rate)
will generally differ from its equilibrium. Virtually any of
the factors affecting supplies of or demand for financial
assets could lead to such deviations, but two are widely
believed to be of special importance: monetary policy
and fiscal policy.
From this perspective, the evolution of long-term real
interest rates over any substantial period reflects both
changes in their long-run equilibria and fluctuations
about those equilibria. In practice, however, forecasting
and other empirical models of real interest rates have
tended to focus mainly on the latter, with little or no
explicit consideration of changes in real-rate equilibria.
The models most often view long-term real interest rates
as reflecting actual and expected movements in short­
term nominal interest rates and inflation, movements that
are largely determined by macroeconomic policies.12
In such models, monetary policy induces fluctuations
in short- and therefore long-term real interest rates
through its effects on the supply and demand for liqui­
dity but does not (to a first approximation) affect the
long-run equilibrium real rate.13 Real interest rate vari11The natural rate was originally identified with the real rate level
compatible with a constant (nonaccelerating or decelerating)
inflation rate. As originally formulated, the Wicksellian framework
was meant to apply to the general level of interest rates within a
given country, rather than to individual assets or even classes of
assets. Risks affecting the general level of rates are most likely to
arise from fundamental technological factors, business cycle
fluctuations, or other forces affecting all assets. The framework can
be applied to particular types of assets, as here, but then it must
allow for their individual risks.
12Fairly typical in this respect are the interest rate relations
embedded in the MPS, DRI, and other large econometric models.
These models generally relate long-term nominal interest rates to a
distributed lag on past short-term rates; in some cases, the models
also relate the long-term rates to inflation and other variables.
Short-term (nominal) rates are then usually modeled as a function
of some measure of the money stock, the level of prices, and real
activity. However, in a reduced-form model, macroeconomic policies
tend to be the main explicit driving forces of prices and income. In
any case, the determination of real interest rates is largely implicit
in such models.
13For example, expansionary monetary policy initially tends to lower
short-term nominal and real interest rates by increasing liquidity.

ations about equilibrium can also arise from cyclical
fluctuations in real growth caused by fiscal stimulus or
contraction. In principle, fiscal policy may alter the real
rate equilibrium through its effect on government debt
levels (see below) or other channels, but such effects
are normally not considered, at least not explicitly, in
standard models.
Models focusing on changes in interest rates around
some equilibrium have proved useful in analyzing inter­
est rate movements over moderate intervals such as the
business cycle. But they can be expected to provide
only a very incomplete explanation of the movements
over longer periods. Here we consider extended inter­
vals for the reason emphasized previously: long-term
real interest rate movements appear to be too per­
sistent to be attributed simply to business cycle fluctuaFootnote 13 continued
Long-term rates are thus likely to fall at first, both in nominal terms
and relative to prevailing inflation trends (that is, in real terms
according to our measure). Over time, however, as the policy
increases inflation and stimulates real growth, interest rates will
tend to rise, with real rates returning to their original equilibrium.
Nominal rates, of course, are likely to end up higher than they were
originally because of the increased inflation.

Chart 5

Money Market Intervention Rates
Percent
A
/' \ / | i
/ '•4
/ \
i
/A
l/ |\
/ \
!
il\
\ \ v
l/l
i l/ T
U
~ t f

LA

■
r\
\ J
• •Hi
•/ i
1/ v / /
T
i
I
S

T
\P

1
h
2

V

United Kingd<am
r \
/

K

v \ j \

\ a
' \ : \
v\

Y

\ w \

J 1
/

\

\

/
t

A

\
Germany

j
Franc 3
j
f \.
I / y

/ > y

V

In it e r i
/
States f /
r y
/ /
Japa n

in l l l l l l l l l l l l l l l l l l ! l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l III
1975
77
79
81
83
85
87
89
91
Sources: See sources in Chart 1.
Note: Money market intervention rates differ among countries: for
the United States, we use the federal funds rate; for Japan, the call
money rate; for Germany, the repurchase rate on short-term
Treasury bills; for the United Kingdom, the base rate on sales of
commercial and eligible bank bills; and for France, the repurchase
rate on short-term private paper.




tions caused by macroeconomic policies. Examination
of the pattern of monetary and fiscal policies over the
last fifteen years further supports this conclusion.
No single measure can fully capture the stance of
monetary policy. Chart 5 provides one measure of the
stance of the five countries’ monetary policies, namely,
central bank money market intervention rates or inter­
bank rates. The movements in short-term real interest
rates and in the spread between long and short rates in
Charts 3 and 4 provide additional indicators of the
policy stance. Collectively, these measures suggest that
monetary policy was relatively expansionary during
1975-78, the years following the first oil shock (note
especially the sharp declines in the central bank rates),
but then tightened fairly markedly beginning around
1979-80, partly in response to the second oil shock.
Policy next seems to have relaxed— as early as 1980 in
Japan, about 1982 in Germany and the United King­
dom, and somewhat later in the United States— and
showed only moderate changes through much of the
decade until about 1988, when it began to tighten in
most countries. As judged by money market interven­
tion rates, monetary policy eased after 1989 in the
United States, relaxed in the United Kingdom a bit later,
and in the other three countries either tightened or
showed no significant change.
These patterns suggest that monetary policies influ­
enced the relatively low level of real long-term interest
rates over 1975-79 and contributed significantly to the
surge in real rates in the early 1980s.14 It seems quite
unlikely, however, that monetary policy could have been
responsible for the persistence of relatively high long­
term interest rates after 1982. These rates remained
nearly as high as in 1980-81 despite a considerable
easing of monetary policy.
Fiscal deficits are widely believed to have been a
major contributor to high real interest rates during the
1980s. In the United States, the persistence of a high
deficit throughout the decade (Chart 6) seems at least
consistent with this view. In the foreign countries, how­
ever, the deficits were highest in the 1970s and early
1980s, and fell substantially thereafter; foreign deficitto-GNP ratios after 1983 were noticeably lower on aver­
age than in the latter half of the 1970s. Hence fiscal
deficit movements, which appear to have reinforced the
effects of monetary easing after 1982, would seem
unable to explain the high level of real rates abroad
during that period.
These observations do not mean, of course, that
14Comparison of individual country experiences also supports the
conclusion that monetary policy was substantially responsible for
the sharp rise in foreign real long-term rates at the beginning of
the 1980s. The rate increases were greatest in Britain, and most
sustained there and in Germany, the two countries that appear to
have undergone the most severe and prolonged tightening.

FRBNY Quarterly Review/Winter 1991-92

17

macroeconomic policies have had little or no impact on
the long-term real interest rates. The observations do
confirm, however, that analysis of the real rates must
account for shifts in equilibria and consider fundamen­
tal factors in addition to standard macroeconomic
policies.
Determinants of the equilibrium real long-term interest
rate
The equilibrium level of a country’s real interest rates
can be viewed as the product of three factors. The first
is the rate of return to physical capital, which represents
the rate at which current savings are transformed into
future output. Chart 7 shows one very crude summary
measure of this return, namely the gross profit rate
(including depreciation) on business capital as esti­
mated by the Organization for Economic Cooperation
and Development. Because this measure reflects only
the current earnings of capital, it can only indirectly
indicate the prospective return to new investment.
Nonetheless, it is interesting that the gross profit rates
have increased over time and were on average 1 to 2
percentage points greater over 1983-89 than during the
preceding economic expansion of the latter 1970s
(although not generally higher than in the 1960s).15 To
15Of course, the return to capital may be measured in several ways,
but all have serious defects. For alternative measures and

the extent that this increase reflects a fundamental shift
in capital productivity or capital’s share of output, it may
have contributed to the rise in real interest rates on
financial assets.16
A second factor determining the equilibrium real bond
rates is their risk. Conceptually, the interest rate on an
asset includes a “ risk premium” to compensate for the
uncertainty about the future value of wealth entailed in
Footnote 15 continued
discussion of the issues raised, see James Chen-Lee and Helen
Sutch, "Profits and Rates of Return in OECD Countries,” OECD
Working Paper no. 20, 1985. One alternative measure is the market
return to equities, which was also relatively high during the 1980s;
the Barro and Sala i Martin study (“ World Real Interest Rates") in
fact attributes much of the rise in short-term real rates during the
1980s to this factor.
16The reasons for the increasing return to capital are unclear,
although a general rise in profit shares was apparently one proxi­
mate contributor. Note, however, that investment was very robust
abroad during the latter half of the 1980s and in the United States
in the middle portion of the decade. This pattern at least suggests
that returns to capital improved significantly. Blanchard and
Summers (“ Perspectives” ) make a similar argument and provide
evidence that the shifts may have been manifest by the early 1980s.

Chart 7

Gross Rate of Return to Capital
Percent

Chart 6

Government Balances as a Share of GNP

France

1975

1975

77

79

81

83

85

87

89

91

Source: Organization for Economic Cooperation and Development.
Note: Quarterly figures are interpolated from semiannual data.


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18 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

89 90

Source: Organization for Economic Cooperation and Development.
Notes: The rate of return to capital is defined as the gross
operating surplus of enterprises divided by the nonresidential gross
fixed capital stock. Quarterly figures are interpolated from
semiannual data.

holding that asset. Like the return to capital, risk has a
number of possible proxies, all of which are imperfect.
Chart 8 shows a common measure based on the histor­
ical contribution, “ beta,” of government bonds to the
volatility of the overall market portfolio— a portfolio that
consists of domestic bonds plus domestic equities.
Generally, these measures reached their peaks in the
early to mid-1980s; they have fallen considerably since
then. Abroad, the risk proxies appear about equal to or
lower than those of the latter 1970s, although in the
United States they seem to have remained somewhat
higher.
An alternative proxy that may better reflect prospec­
tive risks than measures based on past performance is
the ratio of government debt to GNP. One rationale is
that high and rising government debt burdens could
undermine the credibility of the government’s commit­
ment to contain inflation or could create other economic
problems that depress the future value of government

debt. As the upper panel of Chart 9 indicates, the public
debt ratio in the United States rose throughout the last
decade; by contrast, the debt ratio has fallen or leveled
off since 1985 in Japan, Germany, and France, and
declined continuously in the United Kingdom since the
mid-1970s.

Chart 9

Debt as a Share of Nominal GNP
Percent

Chart 8

Contribution of Bonds to the Volatility of the
Domestic Portfolio
Percent
1.25

1.00

0.75

0.50

0.25

0
-0.25

-0.50

1975

77

79

81

83

85

87

89 90

Source: Authors’ calculations.
Notes: The risk contribution, or beta ((J), of bonds is defined as
the covariance between the ex post real bond yield and the real
return on the domestic portfolio (bonds plus equities weighted
by their respective shares of the total value of domestic bonds
and equities) divided by the variance of the ex post real return
on the domestic portfolio. The data plotted here and used in
the estimation of the model (equation A.1 of the appendix) are
three-year moving averages. Since the average maturity of the
bonds is not Known, the computation assumes an average
effective duration of six years in calculating capital gains.




Sources: Organization for Economic Cooperation and
Development (OECD), Bank for International Settlements,
U.K. Central Statistical Office, and Board of Governors of the
Federal Reserve System.
Notes: Net public debt for all countries and gross public debt for
all countries except the United States are interpolated from
semiannual data of the OECD. Gross public debt and private
nonfinancial sector debt for the United States are available
quarterly. Private nonfinancial sector debt (private nonbank debt
for the United Kingdom) is interpolated from annual data.

FRBNY Quarterly Review/Winter 1991-92

19

Deregulation and other extensive changes in financial
structure represent a third factor thought to have perma­
nently affected real interest rates.These changes, which
have occurred to varying degrees in all major industrial
countries over the last decade, have spurred the excep­
tionally rapid growth of private sector debt in the 1980s.
It is widely believed that this debt growth, along with the
great increase in the number and complexity of avail­
able financial instruments associated with it, has added
to aggregate financial risks by increasing the vulnerabil­
ity of lenders and borrowers to adverse economic devel­
opments.17 Moreover, the factors leading to increased
credit availability may well have affected interest rates
in other ways— for example, by substantially curtailing
credit rationing and other mechanisms that tended to
depress rates below market clearing levels.18 These
considerations suggest that the trend in overall debt,
private as well as public, better reflects the impact of
changes affecting equilibrium returns on financial
assets than do historical risk measures or government
debt alone. As shown in the lower panel of Chart 9, the
overall debt ratios have grown substantially and contin­
uously over the last decade in all the countries except
Germany.
17Bank for International Settlements, Recent Innovations in
International Banking, Chap. 10, April 1986.

18For an extensive discussion of these financial changes and their
effects, see M. A. Akhtar, “ Recent Changes in the Financial
System: A Perspective on Benefits versus Costs,” in D.F. Fair, ed.,
Shifting Frontiers in Financial Markets (1986)

Estimates of the equilibrium rate
To apply the Wicksellian approach to the analysis of the
real rate movements, we have estimated empirical mod­
els of interest rate determination for the five countries.
Each of the country models consists of two basic rela­
tions, estimated on quarterly data beginning in 1975.
The first describes the determination of the equilibrium
real long-term interest rate in terms of the fundamental
factors described below. The second relation depicts
the fluctuations in real rates around those equilibria as
the rates adjust to changes in the equilibrium determi­
nants and shifts in macroeconomic policies.19 Details of
the models, their estimation, and key properties are
given in the appendix. Beginning with the equilibrium
relation and then proceeding to the overall “ explana­
tion” of the real rate movements provided by the full
models, we will focus on the models’ main economic
implications.
Empirical relations between the equilibrium long-term
interest rates and the return, risk, and financial change
measures are summarized in Tables 3 and 4. We focus
19The dynamic model has a fairly traditional form in that movements
in long-term real interest rates are effectively related to movements
in real short-rates and, in part through the latter, to changes in
macroeconomic policies. However, following the “ error correction”
methodology (see, for example, Engle and Granger,
"Cointegration” ), we include the real rate equilibrium in the
dynamic relations, so that long-term real interest rates approach
their equilibrium in the absence of further disturbances. An
equilibrium relation between long and short rates is also included
in the model. The dynamic relations should be regarded as partial
reduced forms, with variables such as real income and oil price
shocks essentially reflected in the estimated coefficients on the
policy variables.

Table 3

Determ inants of the E quilibrium Long-Term Interest Rate
Dependent variable is the bond yield less average inflation over the past three years as measured by the consumer price index
Germany

Japan
Constant
Return to capital
Beta
Ratio of debt to GNP
Adjusted R-squared
Cointegration test:
ADF

-2 0 .3

—

3.19
0.08

(- 8 .4 )
(2.3)
(9.3)

- 12.8
0.57
—
0.06
.62

.57
- 3 .5 1 ”

- 3 03

France

United Kingdom

( -7 .0 )
(4.7)

-7 .5 5
0.47

( - 6 .1 )
(4.8)

-3 8 .4
0.76
8.53

( 8 .8 )

0.30

(12.5)

0.22

—

.71
-3 .4 5 **

.71
-3.0 1

(-9 .3 )
(1.9)
( 6 .6 )
(11.3)

United States
- 1 1 .3
0.44
7.04
0.026

( - 5 .0 )
(1.9)
(7.1)
(1.3)

.64
-3 .7 5 *

Notes: The bond yield is the yield to maturity on ten-year government bonds, except in the case of Germany, where the term is four years or
longer. Return to capital is the ratio of profits (including depreciation) to gross capital stock; The source for these figures is the Organization
for Economic Cooperation and Development. Beta is the contribution of the government bond to the risk of the overall (bonds and equities)
domestic portfolio. The ratio of debt to GNP is the total nonfinancial debt ratio; it is calculated as the nominal value of gross government
debt plus nonfinancial private debt, divided by nominal GNP (except in France). In France, the public debt ratio is used; it is calculated as
the nominal value of net government debt divided by nominal GNP. T-statistics are in parentheses. ADF is the augmented Dickey-Fuller test.
Critical values for the Dickey-Fuller statistic are obtained from P.C.B. Phillips and S. Ouliaris, “Asymptotic Properties of Residual-Based Tests
for Cointegration," Econometrics, vol. 58, no. 1 (January 1990), pp. 165-93.
’ Significant at the 12.5 percent level,
•’ Significant at the 10 percent level.


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20 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

on the relations using the overall debt measure (except
for France) since these appear somewhat superior to
those using government debt only.20 In any case, the
empirical relations are intended, first, to provide an
estimate of the movements in the equilibrium real rate
itself. These movements are important for interpreting
the evolution of actual rates and, in particular, for
assessing the influence of monetary policy and other
primarily cyclical influences. Second, the relations pro­
vide some indication of the factors at least associated
with, and perhaps even proximately responsible for,
changes in the real rate equilibria. We caution, however,
that the relations, along with the interpretations given
below, cannot be viewed as causal in any meaningful
sense. As the discussion above indicates, the return
and risk measures may well be related to more funda­
mental determinants of the real rates, but they probably
are in large part proxies for their effects.
As Table 3 shows, the equilibrium long-term real inter­
est rate appears positively and significantly related to
20ln general, the equations using total debt come closest to
accepting the hypothesis that the residuals have a constant mean
(in other words, that the real rate and other variables are
"cointegrated")— a key criterion if the relations are to be used to
estimate the real rate equilibrium. The augmented Dickey-Fuller
(ADF) tests reported in the table support this hypothesis most
strongly for Japan, France, and the United States, and at best
marginally for Germany and the United Kingdom. The alternative
equations using the government debt ratio give quite similar
estimates of the equilibrium real rate, although what they imply
about its determinants differs importantly in certain respects. In
any case, data limitations and other factors seriously constrain the
ability to choose among alternative variables, underscoring the
need to interpret our results cautiously.

the debt ratio21 in all cases except Japan.22 The beta
risk measure appears to contribute to the real rates of
Japan, the United Kingdom, and the United States,
although (at least in this particular relation) not to those
of Germany or France. The return to capital exerts the
most uniform influence across countries. In particular, a
rise of 1 percentage point in the return to capital is
associated with an increase in the equilibrium rate of
roughly one-half of 1 percentage point for Germany,
France, and the United States, and about three-quar­
ters of 1 percentage point for the United Kingdom.
These magnitudes are consistent with the view that
bonds and real capital assets are close but imperfect
substitutes. The effects of a change in the debt ratio
vary more considerably among countries. A rise in the
debt ratio of 1 percentage point is associated with
increases of 20 and 30 basis points in the U.K. and
French real rates, respectively, but with much smaller
increases for Japan and Germany, and a negligible
21The equilibrium relation was tested with total debt and with (net)
government debt. Arguably, total debt is a preferable measure
because it provides a more comprehensive notion of risk and
captures more fully the pace of financial innovation and deregula­
tion over time. Total debt as a share of GNP provides better results
than does government debt for all countries but France Financial
markets in France remained regulated longer than those of other
industrial economies, with reforms coming in much later. So, for
France, the total debt ratio is not associated with an increasing real
rate through much of the sample.

22The presence of private debt causes the return to capital to drop
out of the equilibrium relation for Japan. When only public debt is
used, the return to capital enters significantly with a positive sign.

Table 4

C ontrib u tio n s to Change in the E quilibrium Long-Term Interest Rate
In Percentage Points
Japan
Return to capital
Beta
Ratio of debt to GNP
Total change in
equilibrium real
long-term interest
rate
Actual change in real
long-term interest
rate
Unexplained change

_

Germany

France

0.46

0.65

United Kingdom

United States

3.13

- 1.11
6.46

0.87
2.18
0.79

2.06

3.78

5.99

3.84

1.86

3.81
0.03

6.87
0.88

4.47
0.63

-0 .7 3
5.16

—

—

1.60

4.33

4.61
0.28

- 0.20

0 64

Notes: The entries in the first three lines of the table combine the coefficients of Table 3 with the differences in subsample means of the
arguments between the first (1975-1 to 1982-IV) and second (1983-1 to 199G-IV) halves of the sample period. For example, the mean value of
the real long-term interest rate in Japan for the second half was 4.61 percentage points higher than it was for the first half. The average
"equilibrium” value of the real long rate increased 4.33 percentage points over the two periods; 5.16 percentage points of this change was
attributable to the shift in the mean value of the total debt-to-GNP ratio. The relative riskiness of bonds in the Japanese portfolio declined
over the two periods, thereby reducing the equilibrium value of the real long rate by 0.73 percentage points.




FRBNY Quarterly Review/Winter 1991-92

21

change for the United States.23
Of course, the overall influence of each factor on the
evolution of long-term rates over the sample period
depends on the amount by which the determinant varies
as well as the size of its respective coefficient. Table 4
presents a simple accounting of the sources of shift in
the equilibrium interest rate between the first and sec­
ond halves of the sample period.
The pattern of relative contributions in the United
States differs from that of the other countries. Here, the
rise in the relative risk of bonds accounts for about half
the increase in the real rate; the increase in the rate of
return to capital and the rise in the debt ratio account
nearly equally for the remainder of the explained shift in
the equilibrium real rate. The shift in the debt ratio
contributes less to the rise in the equilibrium long-term
interest rate in the United States than it does in the
other countries. One reason could be that the greatest
increase in the debt-to-GNP ratio occurred somewhat
later than the steepest rise in the real interest rate. The
increase in private and public debt contributes slightly
more than three times as much to the rise in the Ger­
man real long-term rate as does the rise in the return to
capital. In France, the rise in the public debt ratio
accounts for about three-quarters of the shift in the
equilibrium rate over the two halves of the sample.
To sum up, the equilibrium component of a Wicksellian model explains between 60 and 70 percent of
the variation in real long-term interest rates in the major
industrial economies over the period 1975-90. Charts 10
through 14 illustrate how well the equilibrium relation
alone explains the major movements of the real long
rate in each of the five countries over time. These
results are consistent with the case made above for the
factors influencing the equilibrium rate. But we caution
against too strict a structural interpretation of the equi­
librium equations. Debt and the other variables could be
picking up the influence of a host of other factors
related to real interest rates. All we can claim is that the
variables are related in a way that helps to explain the
equilibrium shift in the real rate.24
23The U.S. and U.K. debt data for the private nonfinancial sector are
consolidated (U.S. data are from Board of Governors of the Federal
Reserve System, Money, Stock, Liquid Assets, and Debt Measures-,
U.K. data are from Central Statistics Office, Financial Statistics,
various issues, Table 14.1). By contrast, private debt data for
Japan, Germany and France are summed from sector balance
sheets and could contain double counting of cross-sectoral
holdings (source of data is OECD, Financial Statistics, Part 2,
Financial Accounts of OECD Countries, various issues, Table 33 B.)
Where identified, liabilities in the form of equity shares are
subtracted. Comparisons across countries regarding the influence
of private debt would require further data refinement to ensure
comparable coverage of the debt aggregate.
24Because we cannot measure inflation expectations at all precisely,
and because a significant portion of the surge in inflation during


http://fraser.stlouisfed.org/
22 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

Some 30 to 40 percent of the variation in real long
rates remains to be explained by other influences.
Fiscal policy, apart from its link to the debt ratio, and
monetary policy could drive short-term fluctuations in
the real rate. The dynamic equations discussed below
will allow monetary and fiscal policy to play a role in the
adjustment of the real rate to shifts in the determinants
of the equilibrium rate.
Estimates of the short-run fluctuations in real long
rates
The second key relationship in the country model
explains the fluctuations of the real long rate around its
equilibrium value. The dynamic equation explains the
change in the real long rate in terms of the difference
between the previous period’s actual rate and equi­
librium rate, current and past changes in interest rates,
and shifts in macroeconomic policy. Fiscal policy
changes are introduced in the form of current and past
changes in government deficits or surpluses. Current
and past changes in the real central bank intervention
Footnote 24 continued
the mid-1970s was very likely unanticipated, our estimates probably
overstate the true increase in equilibrium real rates from the 1970s
to the 1980s. This overstatement is probably greatest for Japan and
the United Kingdom. These two countries underwent the largest
surge in inflation during the 1970s, and their equilibrium long-term
real rates appear by our measure to have increased the most.

Chart 10

Real Long-Term Interest Rate: Japan
Percent

Actual
!
/

/
A
■" x y

/

/•

/J

V

A

/ "

r/ \
A ^ /

V v

Equilibrium

J //
J

j

Ln.i ljja.Liiil-nih.LL l l l l l l l l l l l l l l l l l l l
1976
78
80
82
84

i i i Ii i i Ii m

86

Note: The equilibrium path charts the solved values of
equation A.1 of the appendix.

88

I m i I iii
90

rate represent shifts in monetary policy.25 The model
imposes the condition that the real long rate, if unper­
turbed by macroeconomic policy changes or random
shocks, will converge over time to the equilibrium rela­
tion estimated above.
Incorporating the information on monetary and fiscal
policies improves the explanation of rate movements
over history. Relative to the movements captured by the
equilibrium relation, the dynamic model reproduces his­
tory with approximately 5 percent (United Kingdom) to
45 percent (France) less error.26 However, the dynamic
model’s main application is to assess the relative contri­
butions of the equilibrium long rate and changes in
macroeconomic policies to movements in the actual real
rate.
We apply this assessment to episodes of unusual
movement in the real rate. For example, between 1978
and 1979 the Bank of Japan raised the intervention rate
nearly 6 percentage points. The equilibrium real rate

Chart 12

Real Long-Term Interest Rate: France
Percent
Actual.

>

r

y

Equilibrium

. i i 11 i.i 111111 u 11111 m i l 11111,1.1111 i LLL in
1976
78
80
82
84
86

2STests on earlier versions of the dynamic model (using the ratio of
government debt to GNP in the equilibrium relation) indicated that
changes in the return to capital and changes in beta did not
contribute to the explanatory power of the dynamic relations.
Although we did not repeat the tests for the models using total
debt in the equilibrium equation, the earlier findings led us to
exclude changes in these arguments from the dynamic equations.

mi

in
88

i i i I iii

90

Note: The equilibrium path charts the solved values of
equation A.1 of the appendix.

“ The appendix table assesses the ability of the equilibrium relation
and the dynamic model to track history across countries and
measures the degree to which each country's dynamic model
improves on the explanatory power of the equilibrium relation alone.

Chart 13

Real Long-Term Interest Rate: United Kingdom
Percent
10

Chart 11

Real Long-Term Interest Rate: Germany
Percent

8
6
4

f\

iAI
z A A
/

/

Equilibrium ^

VJ

V

/

/

2

j

0
-2
-4

Actual
-6
Lu-ii-LI I i l l i l l li_i.l.LL 11 1 1 m 111111ii 11n i i i i i i i i i i i i n i i i i i i
1976
78
80
82
84
86
88
90
Note: The equilibrium path charts the solved values of
equation A.1 of the appendix.




-8

Note: The equilibrium path charts the solved values of
equation A.1 of the appendix.

FRBNY Quarterly Review/Winter 1991-92

23

also moved up in 1987 and 1979, but with a two-quarter
lag and by 2 percentage points less than the real long
rate (Chart 10). The dynamic equation, incorporating
policy changes, explains almost the full run-up in the
real rate, with at most a one-quarter lag. How much of
the difference between the actual rate and the equi­
librium rate is attributable to monetary policy, how much
to fiscal policy, and how much to the adjustment proper­
ties of the model?
Two additional sets of calculations, one assuming an
alternative history of unchanged monetary policies and
the other an alternative history of unchanged fiscal
policies, shed light on such a decomposition.27 Table 5
attributes the changes in four countries’ real long rate
during selected intervals to shifts in the equilibrium
relation, changes in monetary policy, and changes in
fiscal policy.28
In Japan during 1978-80, the real long rate rose some
51/4 percentage points, and the equilibrium rate rose
about 5 percentage points. The decomposition of this
27Such alternative histories might not represent realistic policy
choices, but they can help us to assess the importance of the
changes in policy relative to other changes affecting the economic
environment. These model simulations are described further in the
appendix.

28The intervals are uniform for all countries except Germany, where
the real long-term rate reached a trough at the end of 1982. Note
that France is omitted from the table.

A ttrib u tio n of Real Long Rate Changes in
Selected Episodes
In Percentage Points
1978-80

1981-84

Equilibrium
Monetary policy
Fiscal policy

5
23/4
'A

'/>
- 3/4
0

23/4
- 2'A
</4

Total*
Actual change
in real long­
term rate
Memo:
Initial gap

73/4

- 1/4

%

%

5'/4

V /2

-3/4

Va

'A

V /2

Japan

Germany

Percent
Actual

/
"A
/
/ 1
I a /
/ x
//

A
j \
f i \ A
'/ /
v

\
\ /

111 ! 11 i 1 1 : 11111 i i m

78

80

/\
' M

\J V \ J \

aA 7
/

rLa v i

w

^

A/

Equilibrium

1 1 1 1 1 1 1 1 111 1 1 ii 1 1 11 i 1 l1_l 1.1.I 1 1 1 11 1 1 1 iu J

82

84

86

88

Note: The equilibrium path charts the solved values of
equation A.1 of the appendix.


http://fraser.stlouisfed.org/
24 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

90

1
1978-80

Equilibrium
Monetary policy
Fiscal policy

0

Total*
Actual change
in real long­
term rate
Memo:
Initial gap

1

Equilibrium
Monetary policy
Fiscal policy

Real Long-Term Interest Rate: United States

1976

Table 5

United Kingdom

Chart 14

- -

change suggests that the rise in the central bank rate
would have added about 23A percentage points to the
real long rate, while the increase in the government
deficit would have influenced the real rate by much less,
an increase of 1/4 percentage point. This accounting
indicates that with changes in the determinants of the
equilibrium, a rise in the real central bank rate, and a

1981-82*
3/4

%
V*

1985-88

V2
0

-2
1989-90

V/2
V/2

'A
— V2
1

- 1’/4
— Vi

0

-y 4

3

1

2’/2

-2 '/4

V2

- 1 ’/4

1%

-1 %

V2

1978-80

1981-84

1985-88

1989-90
3
- 1 V2

3 'A

VS>
'A

1V2
'A

-V A
-1
-2'/4

23/4

9’/2

-4V2

23/4

43/4

5V4

_,/2

-3/4

3/4

8

-2

United States

1978-80

1981-84

1985-88

V*
- V/2
VA

4>A
1%

-1
- Vz
0

Total*
Actual change
in real long­
term rate
Memo:
Initial gap

0

1983-88

Total*
Actual change
in real long­
term rate
Memo:
Initial gap

Equilibrium
Monetary policy
Fiscal policy

1989-90

1%

0

1

-1

1/4

1

5

— V/2

6 V2

-2

0

11/4

2

1989-90
PA
-2
3/4

V2

-2>/4
1%

^Columns may not sum to totals because of rounding,
in te rva ls are uniform for all countries except Germany, where
the real long-term rate reached a trough at the end of 1982.

widening government deficit in these years, the real
long rate in Japan would have risen some 73/t
percentage points. Thus it appears that unexplained
factors along with the adjustment process itself held the
rise to 51/4 points.
During 1978-80, monetary policies in all five countries
tightened (Chart 5) and real long rates rose by 7>h to 5
percentage points in all countries except the United
States. In Japan, Germany, and the United Kingdom
monetary policy had a positive influence on the real
rate, but in the United States it did not. The reason for
this anomaly might be that during 1980, the real central
bank intervention rate (the argument of the dynamic
equations) in the United States declined sharply.29 The
attributions suggest that during this episode, fiscal pol­
icy generated upward pressure on rates of about 1A to
VA percentage points in all countries.
The 1981-84 period, if judged by movements in the
nominal central bank intervention rates, appears to be a
period of monetary easing. But on net, the real central
bank rates declined between the beginning and end of
the period only for Germany and the United States. In
Germany (between 1981 and 1982) and Japan, mone­
tary policy negatively influenced the real long rate. But
the United Kingdom, perhaps owing to the rise in the
real central bank rate, experienced tighter monetary
policy than the movement in the nominal central bank
rate would suggest. Germany showed a negative contri­
bution from fiscal policy, consistent with a declining
deficit ratio over this interval.
In all countries but the United Kingdom, nominal
central bank rates continued to decline between 1985
and 1988 (1983 to 1988 for Germany). In Japan, the real
central bank rate also tended to decline; here the effect
of monetary policy on the real long rate was negative. In
Germany, however, the real central bank rate increased
despite the decline in the nominal rate; our calculations
attribute V/2 percentage points of the rise in the real
long rate over the period to monetary policy. The final
episode, 1988-90, might also be characterized as a
period of tight monetary policies because all four coun­
tries experienced increases in their nominal central
bank rate (although the rate hikes were comparatively

^The dynamic model seems to work less well for the United States
than for the other countries. For some intervals, the results
presented in Table 5— suggesting, for example, that fiscal policy
had a net negative effect on the real rate over the early 1980s and
monetary policy a net negative impact on the rate in the 1985-88
interval— are counterintuitive. There are two possible explanations
for these anomalies: 1) as Chart 15 in the appendix demonstrates,
the directions of fiscal and monetary policy effects in the United
States are initially correct but short-lived and lead to reversals over
subsequent quarters, and 2) these intervals might not be the best
for analyzing U.S. policy shifts because the real central bank rate
and the deficit-to-GNP ratio fluctuate inordinately within the interval.




mild in the United States). In addition, real central bank
rates rose and fell, but ended higher in the episode.
Nevertheless, only in Japan did monetary policy appear
to raise the real long rate.
Of the three forces— equilibrium shifts, monetary pol­
icy, and fiscal policy— equilibrium shifts tended to pre­
dominate in explaining real long rates over the three- to
five-year intervals. In slightly under half the episodes
reported in Table 5 (seven of sixteen), the changes in
the real long rate attributable to shifts in the equilibrium
rate were as large or larger than the changes attribut­
able to either monetary or fiscal policy. Germany poses
an interesting exception: here, the equilibrium shifts
were no larger than the influences of monetary or fiscal
policy in any of the four intervals. Recall that in Ger­
many, the real long rate (and therefore the equilibrium
rate) varied over a narrower range than in the other
countries. Equilibrium shifts showed a strong upward
drift over the four intervals; in twelve of the sixteen
episodes, the equilibrium factor influenced real rates
positively. By contrast, the influences of monetary and
fiscal policy did not show clear upward tendencies. In
only six of the sixteen episodes were the contributions
of monetary policy to the change in the real long rate
positive; in nine episodes, fiscal policy contributions
were positive. In all but two cases, the magnitude of
fiscal policy influences on the real long rate was smaller
than that of monetary policy influences.
Conclusions
We have attempted to identify the broad macroeconomic forces shaping the evolution of long-term
interest rates in several major industrial countries. Our
basic contention is that the movements in these rates
reflect persistent and sizable changes in what we have
called their “ equilibria,” as well as fluctuations around
those equilibria. More specifically, we argue that the
dominant portion of the overall rise in the real long-term
rates of the United States and major foreign economies
over the last fifteen years is attributable to increases in
the rates’ equilibrium levels. This large shift in the
equilibrium also accounts for the apparent similarity of
the broad movements in the countries’ real rates over
the period as a whole. Macroeconomic policy as it
normally influences rates over the business cycle can­
not fully explain the increases in real long-term rates.
Our analysis yields more tentative evidence that the
shifts in long-run equilibrium real rates reflect changes
in the returns to capital and perceptions of the risks to
these returns. In particular, the general rise in the return
to capital during the 1980s seems to have been a
significant, although not the principal, contributor to the
rise in equilibrium real long-term rates of the countries
studied. Most strongly associated with the rise in equi­

FRBNY Quarterly Review/Winter 1991-92

25

librium real rates in the four foreign countries are
increasing debt ratios, which appear to reflect higher
aggregate financial risk. Somewhat surprisingly, the
debt ratio seems only weakly associated with the
increase in U.S. real long-term rates.
Finally, our evidence suggests that at certain times,
macroeconomic policies did significantly influence the
movements in long-term real interest. For example,
monetary policies and changes in budget deficits were
important factors behind the movements in real interest

rates in the early 1980s. Nonetheless, it appears that
the broader upward movement in the real rate equilibria
over the last fifteen years has dominated the business
cycle fluctuations induced by the policies. Overall, our
analysis suggests that the high levels of real long-term
interest rates experienced during the 1980s cannot be
explained adequately w ithout taking into account
changes in both macroeconomic policies and other eco­
nomic fundamentals such as rates of return to capital
and financial sector risks.

Appendix: An Empirical Model of Real Long-Term Interest Rates
This appendix describes the major features of the model
used to analyze movements in real long-term interest
rates. The model combines the equilibrium long-term
rate with two dynamic equations to describe the adjust­
ment paths of the real interest rates toward their equi­
libria. The model was estimated for each country on
quarterly data beginning in 1975.
The equilibrium long-term rate, RL, is related to the
return to capital, RK; risk, (3; and the total debt-to-GNP
ratio, DB. In the case of France, however, the ratio of
government debt to GNP replaces the total debt-to-GNP
ratio.+

(A.2) ARL(t) = b, eRL(t-1) + b2 eSP(t-1)
+ 2

ba ARL(t-i) + 2

i « 1 ,2 ,4

+ 2 ba ADF(t-i) + X b6i ACB(t-i) + eARL,
V - 0 ,1 .2.4

The dynamic model is based on the well-accepted
proposition that long-term interest rates in part reflect
movements in short-term rates. For each country,
changes in short- and long-term real interest rates are
jointly explained in terms of deviations from the real rate
equilibrium, changes in monetary policy and in govern­
ment budget deficits, and the rates’ own past changes.
The equations have the following form:*

tOur estimation procedure initially used the return to capital,
beta, and one of two debt-to-GNP ratios as the explanatory
variables of the real rate in each country. Those arguments
with a positive sign were retained, even if only marginally
significant. In general, the equations using total debt fit
better and came closer to a cointegrating relationship than
did those using the ratio of net government debt to GNP. In
the case of Japan, the fit with total debt is poorer than with
government debt, but the augmented Dickey-Fuller statistic is
larger. The final estimation results are summarized in text
Table 3.
*Note that contemporaneous causation is assumed to run
from the short-term interest rate and the policy variables to
the long rate. (For this reason, current values of these
variables are included in equation A.2 but not in equation
A.3.) In the case of Germany, however, lagged values of the
change in the central bank rate are statistically insignificant
and therefore omitted.


http://fraser.stlouisfed.org/
26 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

t « 0 , 1.2.4

and
(A.3) ARS{t) = c, eHL(t-1) + c2 eSP(t-1)
+ X Ca ARL(t-i) + 2
i = 1,2,4

(A.1) RL = a0 + a ^ K + a23 + a3DB + eRL-

b4i ARS(t-i)

i — 0,1.2,4

c4j ARS(t-i)

< =1 ,2 ,4

+ X c5i ADF(t-i) + X ce ACB(t-i) + eARS,
i

0 ,1.2.4

i

0.1,2.4

where RL and RS are the long-term and short-term real
rates, respectively, eRL is the residual from the long-term
equilibrium equation A.1, eSP is the long-short spread
less its mean, DF is the ratio of the government deficit to
GNP, and CB is the real central bank intervention rate
(nominal rate less the past three years’ inflation).
The model incorporates the equilibrium real rate rela­
tion. The equations imply that the actual long (and short)
real rates will converge to the equilibrium in the absence
of further disturbances; likewise, a constant equilibrium
for the spread between long and short rates is imposed.8
We use the real central bank intervention rate to mea­
sure the stance of monetary policy, since movements in
the nominal rate relative to underlying inflation are the
primary influence on the real economy.B

§Recall that the evidence in text Table 2 generally supports
the proposition that the spread is stationary. The United
Kingdom is, however, an exception: in the model estimation
for this country, we allow the equilibrium spread to follow an
estimated time trend.

I In effect, the model (that is, its “reduced form") ultimately
attributes movements in long-term real rates to a) past

Appendix: An Empirical Model of Real Long-Term Interest Rates (continued)

Summary Statistics for Interest Rate Models
United
Kingdom

United
States

1.31
0.76

2.20

1.55
0.97

0 32
0.89

0.59
0.57

Japan

Germany

Franceft

2.06
0.55

0.87
0 52

0.56

0.61
0.43

Root mean squared
error (percentage points)
Equilibrium relation
Dynamic model

1.65

Goodness of fit of
_
dynamic equations (R2)
Real long rate
Real short rate

0.88

0.70
0.88

ttThe model for France uses net government debt as a share of GNP.

The table above compares the abilities of the equi­
librium relationship alone and the dynamic model to
explain the actual path of the real long-term rate in the
five countries. Statistics on goodness of fit for the
dynamic equations are also provided.
We introduce hypothetical changes in macroeconomic
policy to illustrate how the initial interest rate responses
and the rate changes over time differ for monetary and
fiscal policy. The initial responses to a 1 percentage point
sustained increase in the central bank rate range from 80
basis points in Japan to 40 to 50 basis points in the other
countries (Chart 15, upper panel). Since monetary policy
has no permanent effect in the model, the rises in the
real long-term rate decay at various rates, although the
effects do persist for some time, particularly in Japan
and France.
A onetime increase of 1 percentage point in the ratio of
the government deficit to GNP generates shorter lived
interest rate responses than does a monetary policy
shock.** The deficit surge in the United States, United

Chart 15

Real Long-Term Rate Responses to Shocks
Percent

Footnote 11 continued
changes in the equilibrium real rate; b) past changes in the
macroeconomic policy variables; and c) "unexplained”
disturbances, in particular to short-term rates, as well as
factors such as oil shocks. The impact of macroeconomic
policies includes not only direct effects, but also indirect
effects on interest rates by way of real income and other
variables.
ttThis experiment is somewhat artificial in assuming that the
equilibrium remains unaffected. Since the debt-to-GNP ratio
is a component of the total debt ratio (an argument of the
equilibrium real rate), a shock to the change in the deficit
would have a permanent effect on the long rate. However,
because the purpose of this shock is to illustrate the real
income effects over the business cycle, the link to the debt
ratio is not completed and consequently the equilibrium does
not shift. And since the presence of debt in the equilibrium
relation acts as a proxy, the link to debt need not be
implemented literally. This shock could also be interpreted as




One Percentage Point Increase in Debt/GNP Ratio

Germany
**■*.*».

United Kingdom

United States

- L L 1 1 1 1 1 1 1 i 11 I 11 I i 11 I 11 I i I i 1 1 1 l l 1 1 1 1 1 1 1 1 1 1 1 1 1 i I 1 1 1 1 I 11 i I i i

0

4

8

12 16 20 24 28 32 36 40 44 48 52 56
Quarters

FRBNY Quarterly Review/Winter 1991-92

27

as

"l l l l l
Appendix: An Empirical Model of Real Long-Term Interest Rates (continued)
Kingdom, and France increases the real long rate by
some 40 to 60 basis points in the first year (Chart 15,
lower panel). The deficit shock causes the real long rate
to oscillate,§§ but the adjustment is heavily damped in
most countries, with the possible exception of Japan and
France. The most durable effect occurs in the United
Kingdom, where a 20 basis point increase in the real long
rate persists as long as four years after the shock.
Finally, to identify the contributions of policy changes
to movements in the real long rates (text Table 5), the
Footnote ** continued
an assumption that a decrease in private debt offsets the
effects of increased public debt on the equilibrium.
§§This response stems from sign shifts on the lagged deficit
terms in the dynamic equations


28 FRBNY Quarterly Review/Winter 1991-92


models are simulated assuming unchanged monetary
and fiscal policies. For example, real long-term rates
have trended upward over the past fifteen years and real
central bank rates are now higher than they were in the
high-inflation environment of the mid-1970s. How would
real long rates have moved had the real central bank
rates not risen? Comparison of these results with the
actual paths over history provides a measure of the
contribution of tightened monetary policies to changes in
real rates. Analogously, the contributions of fiscal pol­
icies to the actual movements in real rates are derived
from the real rates that would have prevailed had govern­
ment deficits remained unchanged. •*
Again, the effects of alternative fiscal policies on debt are
ignored.

Explaining the Persistence of
the U.S. Trade Deficit in the
Late 1980s
by Susan Hickok and Juann Hung

The United States ran a larger, more persistent trade
deficit during the 1980s than many trade analysts had
anticipated. To be sure, the dollar’s rise in the early
1980s led most observers to predict a sharp increase in
the trade deficit in the middle of the decade. However,
the return of the dollar to its 1979-80 level (measured in
real terms) by 1987, coupled with strong growth in
foreign demand, raised expectations that before the
decade’s end, the U.S. merchandise trade deficit would
also return to roughly the level registered at the begin­
ning of the 1980s— about $25 billion, or 1 percent of
U.S. GNP. Instead, the deficit remained above $100
billion, or more than 2 percent of U.S. GDP, through
1990. Only in 1991 did the deficit slide below the $100
billion level, reflecting to some extent the effects of the
U.S. recession.
Several hypotheses were advanced in the second half
of the 1980s to explain the trade gap’s persistence, but
to date no attempt has been made to assess the relative
merits of these theories. This article returns to the
puzzle of the enduring deficit and evaluates some
efforts by earlier researchers to solve it. As a first step,
we investigate whether macroeconomic factors and the
debt problems of developing countries played a role in
keeping the deficit high. We then turn to a detailed
analysis of two prominent interrelated hypotheses put
forward to explain the deficit’s surprising magnitude in
the late 1980s. Our analysis includes a careful review of
the statistical evidence bearing on the hypotheses. In
addition, it presents an expanded trade model specifi­
cally geared to test each theory.
The first hypothesis we investigate argues that the



rise in the dollar in the early 1980s depressed U.S.
capital stock investment relative to investment abroad,
hurting U.S. supply capability and hence the U.S. trade
balance. The dollar’s fall in the mid-1980s began revers­
ing this process, but the reversal was not yet complete
by the decade’s end. With time, further improvement in
the trade balance is expected as this reversal plays
itself out. The second hypothesis argues that shifts in
the structure of U.S. trade flows, affecting both the
commodities traded and the participants in trade, signif­
icantly weakened the ability of the United States to
adjust its trade balance in response to the mid-1980s
dollar depreciation. This hypothesis predicts that the
U.S. trade balance will not return to its level of the late
1970s or early 1980s over time, despite the return of the
dollar to its beginning 1980 level and the ultimate com­
parability of demand growth in the United States and
abroad.
These two hypotheses are not totally independent of
each other. Changes in relative capital stock levels
could be one determinant of structural shifts in trade.
Structural shifts in trade could also be one factor lead­
ing to shifts in relative capital stock levels. Although we
recognize this interrelationship, we have chosen to
focus on narrowly defined versions of each hypothesis.
This approach underscores the two theories’ very differ­
ent assessments of the future course of the U.S. trade
deficit.
The recent fall in the U.S. trade deficit highlights the
importance of evaluating the different outlooks implied
by the two narrowly defined hypotheses. The U.S.
recession has clearly played a significant role in reduc­

FRBNY Quarterly Review/Winter 1991-92

29

ing the trade deficit in 1991. However, if this decline in
the deficit also partially reflects a readjustment of world
capital stocks, a significant part of the recent trade
balance improvement may be sustained after the reces­
sion ends. But if capital stock developments have not
played a prominent role in the deficit’s tenacity in the
late 1980s or in its more recent decline, the recent trade
balance improvement is less likely to be sustained to
any substantial degree as the U.S. recovery takes hold.
Our analysis suggests that both the dollar’s fall in the
mid-1980s and the resurgence of foreign demand in the
late 1980s have led to substantial adjustment in the
U.S. trade balance. We find, however, that in 1989 the
U.S. trade deficit still remained well above the level that
exchange rate and demand conditions would have war­
ranted in the past. We further find that the trade deficit’s
tenacity cannot be simply explained by shifts in world
capital stocks in response to exchange rate move­
ments, as the narrowly defined capital stock hypothesis
would suggest. Shifts in the relative size of world capital
stocks have been dominated by factors other than
changes in the value of the dollar. Thus, there is little
evidence that relative capital stock developments were
moving in step with exchange rate developments in the
1980s or that the U.S. trade balance is currently chang­
ing in favor of the United States because of capital
stock adjustments to the dollar’s depreciation in the
second half of the decade.
This article finds that the factor most directly respon­
sible for the relatively weak U.S. trade position in the
late 1980s is structural change in world trade. Struc­
tural change appears to have substantially hurt both
U.S. export and import-competing capabilities in the
1980s. In fact, it is estimated to have worsened the 1989
U.S. trade balance by roughly $65 billion. As a conse­
quence of structural shifts, the United States may now
be expected to be in a significantly weaker trade bal­
ance position for any given set of exchange rates and
demand conditions than would have been the case in
the past.
The next section examines the evolution of the U.S.
trade balance deficit in the 1980s, underscoring the
limited role played by exchange rate and demand devel­
opments in its net deterioration. Following this, we
briefly discuss the influence of the developing countries’
debt repayment problems on U.S. export sales and the
trade deficit. We then analyze the interrelated hypoth­
eses concerning the trade balance impact of shifts in
relative capital stocks and structural changes in trade
relationships. Our conclusions are compared with those
of other recent studies examining the persistence of the
U.S. trade deficit— notably the studies of Lawrence and
Cline. A final section considers the implications of our
findings for future U.S. trade balance adjustment.

30 FRBNY Quarterly Review/Winter 1991-92


U.S. trade balance adjustm ent in the late 1980s
In 1989, the U.S. merchandise trade deficit rose to $116
billion, four times its level in 1979 (Chart 1). Although
the 1989 deficit had come down $43 billion from a peak
level of $159 billion in 1987, it was still much larger than
many analysts had expected. To be sure, the trade
deficit has declined substantially further over the last
two years, falling to roughly $75 billion in 1991. How­
ever, trade elasticities from a variety of models suggest
that this recent improvement has been due to the U.S.
recession as well as the net fall in the dollar since
1989.1 More difficult for economists to explain than the
recent fall in the deficit is the failure of the trade deficit
in the late 1980s to show significantly more improve-

’ Calculations based on the income and price elasticities of six
macroeconomic models suggest that relative price developments
and, more important, relative demand growth developments during
1990 and 1991 basically "explain” all of the improvement in the U.S.
non-oil, nonagricultural trade volume balance over these two years.
Elasticities are reported in Ralph Bryant, Gerald Holtham, Peter
Hooper, eds., External Deficits and the Dollar (Washington, D C.:
Brookings Institution, 1988).

Chart 1

U.S. Trade Balance
Billions of dollars
50Nominal Merchandise Trade Balance

u

u

□

-50-

-100-150-2 0 0 1

Billions of 1982 dollars
5 0 --------------------------Real Merchandise Trade Balance

LJ □
-50-

U

-100-150-2001
1979

80

81

82

83

84

85

86

Source: National Income and Product Accounts.

87

88

89

ment in response to exchange rate and demand devel­
opments. For instance, Hooper and Mann comment that
“ while the initial widening of the deficit [in the early
1980s] can be adequately explained by macroeconomic
factors, the deficit has adjusted substantially more
slowly (particularly in real terms) to the fall in the dollar
since early 1985 than conventional macro trade equa­
tions would predict,” while Krugman and Baldwin refer
to “the puzzling persistence of the trade deficit.”2
The gap between the deficit’s size in 1979 and 1989 is
particularly perplexing because the economic funda­
mentals that typically determine the size of the trade
balance— the real effective value of the dollar and the
level of U.S. real demand relative to the level of real
2Peter Hooper and Catherine Mann, "The U.S. External Deficit: Its
Causes and Persistence,” Board of Governors of the Federal
Reserve System, International Finance Discussion Papers, no. 316,
1987, abstract; Paul R. Krugman and Richard E. Baldwin, "The
Persistence of the U.S. Trade Deficit,” Brookings Papers on
Economic Activity, 1:1987, p. 1.

Chart 2

Exchange Rates and Growth Developments
Index
1980 = 100
160---------------------------------------------------Nominal and Real Dollar Exchange Rates

1979

80

81

82

83

84

85

86

87

88

89

Notes: In the top panel, rates are computed using International
Monetary Fund MERM weights. Real effective rates are
calculated from the nominal exchange rates (foreign currency/
dollar) adjusted for relative movements in wholesale prices. In
the bottom panel, foreign domestic demand is a GNP-weighted
geometric average. The foreign countries are Germany, Italy,
France, the United Kingdom, Canada, and Japan.




demand in industrial countries abroad— were roughly
equivalent in 1979 and 1989 (Chart 2). Of course,
exchange rates and relative demand levels had shifted
dramatically in the years between 1979 and 1989. The
dollar rose 46 percent in the early 1980s before falling
back in the mid-1980s. U.S. demand grew much more
rapidly than foreign demand in 1983 and 1984, while
foreign demand grew more rapidly than U.S. demand in
the 1987-89 period. Nevertheless, measured in real
terms, the dollar had returned to its 1979 level by 1987
and it remained there for the rest of the decade.3 More­
over, by 1989 the level of foreign demand had regained
its 1979 position relative to the level of U.S. demand.
The similarity in exchange rate and relative demand
conditions in 1979 and 1989 suggests that other factors
largely explain why the U.S. trade deficit was so high in
the late 1980s. To be sure, the change in the dollar in
the early 1980s and the rapid U.S. growth rate relative
to growth abroad did lead to a much sharper increase in
U.S. imports than in U.S. exports in the first half of the
decade. It is possible that lingering adjustment to these
early 1980s developments, along with differences in
U.S. and foreign trade responses to income growth,
explains some of the difference between the 1979 and
1989 U.S. trade balance levels. Nevertheless, a variety
of estimates of trade volume elasticities indicate that
these two macroeconomic factors do not account to any
significant extent for the net deterioration in the U.S.
trade volume balance between 1979 and 1989.4 In fact,
since exchange rate levels and demand conditions do
not appear to be an important factor behind the differ­
ence in the trade balance in these two years, 1979 and
1989 are particularly useful reference years in which to
examine other hypothesized causes.
Before considering the two most prominent hypoth­
eses, it is important to note that the dramatic diver­
gence between the 1979 and 1989 trade balances
consisted prim arily of a sharp difference in trade
volume balances, measured in constant 1982 prices, for
the two years (Chart 1). More particularly, the difference
reflected a sharp change in the volume of non-oil
imports relative to the volume of nonagricultural exports
3The dollar exchange rate index on which this calculation is based
includes only the currencies of major industrialized countries.
However, a nominal trade-weighted dollar index based on the
currencies of eighteen industrialized and newly industrializing
economies in Asia also shows that the dollar was back at its 1979
level in 1988 and 1989. See Federal Reserve Bank of Atlanta,
Economic Review, June-July 1986, Summer 1987, and SeptemberOctober 1990 issues.
C alculations based on the income and price elasticities of six
macroeconomic models suggest that relative price and income
movements caused no net deterioration in the U.S. trade volume
balance between 1979 and 1989. Of course, these calculations are
by nature imprecise. Elasticities are reported in Bryant, Holtham,
Hooper, eds., External Deficits.

FRBNY Quarterly Review/Winter 1991-92

31

(Chart 3). In 1979 the U.S. non-oil, nonagricultural trade
volume balance registered a positive $9 billion. In 1989
this balance was in deficit by $54 billion, a swing of $63
billion from its 1979 position. This difference in the non­
oil, nonagricultural trade volume balance will be useful
in evaluating the two competing hypotheses: the
hypothesis that best explains these trade volume devel­
opments is the more plausible. But first we consider
another factor often cited in discussions of the tenacity
of the trade deficit.
Developing co un try problem s
In the mid-1980s, the deterioration in the U.S. trade
balance position was often linked to the debt crisis in
the developing countries. Recognizing the attention this
argument received in the past, we briefly reconsider it
here. The debt crisis broke out in 1982 when Mexico
announced that it was unable to meet its contractual
loan obligations. Although many developing countries
experienced severe debt repayment problems in the
1980s, the most pronounced regional debt problem was
in Latin America. Some analysts felt that this regional

Chart 3

U.S. Trade Volume Developments
Billions of 1982 dollars
450

5The share of U.S. exports going to developing countries was
unusually low in 1979 and unusually high in 1980. Consequently,
shares given for the beginning of the 1980s refer to the average of
1979 and 1980 shares.

Non-Oil Imports and Nonagricultural Exports

400
350
300
250
200
150
Non-Oil, Nonagricultural Trade Balance

50

0
-50
100

J_ _ I_ _ I_ _ I_ _ I_ _ I_ _ I_ _ I
1979

80

81

82

83

84

85

86

concentration had a particularly sharp impact on U.S.
trade because Latin America was a major market for
U.S. exports. In this view, a drop in demand in Latin
America could have significantly weakened the U.S.
trade performance. These analysts further argued that
U.S. trade forecasts would not have captured the effect
of declining demand in Latin America because the
econometric models behind many of the forecasts were
driven by perceived growth prospects in industrialized,
rather than developing, countries.
In assessing this argument, we note that Latin Amer­
ica’s imports did drop sharply in response to financing
problems in the 1980s. In 1982 Latin America took 151/2
percent of total U.S. exports, already less than the
share it had taken at the beginning of the 1980s (Chart
4).5 In 1983 Latin America’s share of U.S. exports fell to
121/2 percent and then hovered between 13 and 14
percent for the rest of the decade. This fall in Latin
America’s share of U.S. exports represented a signifi­
cant loss of potential U.S. export sales. If U.S. exports
to Latin America had grown at the same pace as U.S.
exports to the rest of the world during the 1980s (that is,
if Latin America had maintained a constant share of
U.S. exports), U.S. export volume would have been $11
billion higher in 1989.
The analysis of the role played by developing coun­
tries in shaping U.S. trade performance would not be

87

88

Source: National Income and Product Accounts.


http://fraser.stlouisfed.org/
32 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

89

complete, however, without considering other regions.
U.S. exports to Asian developing countries soared in
the 1980s. Asian countries purchased 13 percent of
U.S. exports at the beginning of the 1980s; by the end
of the decade, Asia’s share had risen to 19 percent. By
contrast, the Middle East’s share of U.S. exports
declined substantially— from 7 percent to 4 percent—
during the course of the 1980s as the Middle East
adjusted to a sharp decline in the price of petroleum.
When these developments are taken into account, the
overall share of U.S. exports going to developing coun­
tries in 1989 was about the same, roughly 38 percent,
as it had been at the beginning of the 1980s. Weakened
developing country demand, consequently, does not
appear to have been a significant factor explaining the
large U.S. trade deficit of the late 1980s.6
The role of capital stock developm ents and
stru ctu ra l s h ifts in trade
The first of the two prominent hypotheses explaining the
persistence of the U.S. trade deficit centers on capital
stock developments. It argues that the rise in the dollar
in the early 1980s discouraged U.S. investment and
hence reduced the supply of U.S. goods relative to the
demand for U.S. goods, hurting the U.S. trade balance.
This capital stock hypothesis, which fits in with the
increased attention economic analysis has devoted over
the last decade to “ supply side” factors, further argues
that the fall in the dollar starting in 1985 should now be
encouraging U.S. investment and improving the U.S.
trade position.7
The second hypothesis has several variants, but all
contend that changes in the structure of world trade in
«Developments in traditional macroeconomic factors— relative price
developments and income growth— are consistent with the
observation that developing countries did not grow in U.S. export
share. Growth in real GNP was only slightly faster in developing
countries (registering 3.2 percent per year) than in foreign
industrial countries (registering 2.8 percent per year) during the
1979-89 period. The impetus from this small growth differential was
likely to have been more than offset by the loss of purchasing
power experienced by the developing countries as their terms of
trade declined, notably in the oil sector. Moreover, U.S. exports to
developing countries generally compete more with exports from
other industrialized countries than with goods produced in the
developing countries themselves. As noted, there was no net shift
in the value of the dollar relative to the currencies of other
industrial countries between 1979 and 1989. It might be argued
that developing countries should have increased their share of U.S.
exports to reflect a growing integration in world trade. It is difficult,
however, to choose a benchmark period in the past upon which to
base expected share growth. Although developing countries
increased the share of U.S. exports they purchased by 6
percentage points between 1969 and 1975, the share they
purchased fell by 1 percentage point between 1975 and 1979.
7Ramon Moreno describes, but does not specifically endorse, this
widely discussed capital stock hypothesis in "The Baffling Dollar,”
Federal Reserve Bank of San Francisco Weekly Letter, December 2,
1988.




the 1980s have affected the U.S. trade response to
changes in exchange rates and income levels. Specifi­
cally, this structural shift hypothesis argues that at any
given exchange rate level and level of U.S. demand
relative to foreign demand, the United States will now
export less and import more than it did in earlier years
because of structural changes in trade relationships.
As noted earlier, the capital stock and structural shift
hypotheses are clearly interrelated. According to stan­
dard international trade theory, a change in the size of a
country’s capital stock relative to the size of the capital
stock in the rest of the world is likely to affect that
country’s trade composition. A change in trade com­
position would be one important example of a structural
shift in trade that would affect a country’s response to
exchange rate changes. Conversely, a structural shift in
trade such as a change in purchaser sentiment toward a
given country’s products could alter investment plans
and hence relative capital stock levels.
The cross effects of capital stock changes and struc­
tural shifts in trade are very difficult to separate econometrically; therefore, any separate empirical analysis of
the two hypotheses must be conducted with care. How­
ever, by defining the two hypotheses narrowly and con­
sidering only the direct impact of each, we can obtain
some interesting findings. Narrowly defined, the capital
stock hypothesis would focus on changes in the relative
size of capital stocks due solely to exchange rate
changes, thereby excluding capital stock developments
resulting from structural shifts in trade. The structural
shift hypothesis would focus on the impact that struc­
tural shifts have had on trade adjustment beyond any
direct supply considerations arising from a change in
capital stock size. The remainder of this section pre­
sents fuller descriptions of these narrowly defined
hypotheses and econometric evidence of the validity of
each one.
Capital stock developments

The narrowly defined capital stock hypothesis, which
we will call the exchange rate/capital stock hypothesis,
may be divided into two arguments. The first argument
considers relative capital stock levels in the United
States and abroad without regard to ownership ques­
tions. This argument starts with the premise that a
country’s export supply and, more generally, its total
supply of goods (sold dom estically and exported)
depend on its production capacity— specifically, the
size of its capital stock. The size of a country’s capital
stock, in turn, depends in part on the level of the
country’s exchange rate. That is, as a country’s cur­
rency appreciates, its goods become less competitive,
discouraging investment. At the same time, investment
is encouraged abroad as foreign goods gain in competi­

FRBNY Quarterly Review/Winter 1991-92

33

tiveness. Domestic production capacity, output, and
exports fall relative to foreign production capacity, out­
put, and exports. Consequently, the trade balance of
the appreciating country deteriorates.8
Applying this argument to U.S. trade, proponents of
the exchange rate/capital stock hypothesis contend that
the large rise in the dollar in the early 1980s adversely
affected U.S. investment and hence depressed U.S.
exports relative to U.S. imports. Indeed, in the early to
mid-1980s the claim was often made that the strength of
the dollar was causing U.S. companies to move produc­
tion offshore. Moreover, certain U.S. industries, most
notably machine tools, sought protection by arguing
that U.S. production of their goods was about to cease,
making the United States totally dependent on imports
to meet its needs. According to the exchange rate/
capital stock hypothesis, the fall in the dollar starting in
1985 should have led to a reversal of this U.S. disinvest­
ment process. However, this reversal would not have
been completed by 1989 because investors were ini­
tially uncertain whether the lower dollar would persist.
Even after investors became convinced that the dollar
would not rebound, it would take time for investment to
be set in place.
The second argument of the exchange rate/capital
stock hypothesis focuses on additional trade considera­
tions arising from foreign direct investment. Specifically,
foreign direct investment is postulated to have a shortrun positive influence on the host country’s imports
because foreign subsidiaries initially import a dispropor­
tionate amount of capital equipment and components
from their parent firms. But in the longer run, because
the subsidiaries often produce goods identical with
those of their parent firms, production in the host coun­
try may actually directly displace imports of these
goods (as opposed to competing with both imports and
other domestically produced goods for domestic sales).
Such a development would reduce host country imports
even more than would the creation of new domestically
owned enterprises. Mindful of these relationships, and
assuming that exchange rate developments have signifi­
cantly influenced foreign direct investment flows, some
adherents of the exchange rate/capital stock hypothesis
have argued that the rise in the dollar increased U.S.
investment abroad in the early 1980s, causing a tempo­
rary positive boost to U.S. exports that turned to a
depressant on U.S. exports in the late 1980s. Similarly,
they have argued that the fall in the dollar starting in
•Investment only responds to what is perceived to be a sustained
change in exchange rates; moreover, it takes a fairly long time to
be put in place. Consequently, proponents of the exchange rate/
capital stock hypothesis argue that these capital stock
developments are not captured in normal trade price elasticities,
which typically assume that all trade adjustment to exchange rate
changes is completed by the end of two years.


34 FRBNY Quarterly Review/Winter 1991-92


1985 increased foreign investment in the United States,
temporarily boosting U.S. imports over the last few
years.
Developments in relative capital stocks
Two observations from the 1980s have focused analysts’
attention on the premise that a country’s export level is
correlated with the size of its capital stock. First, the
economies with the strongest capital stock growth,
those of the Asian newly industrialized countries
(NICs),9 showed the strongest export growth over the
last decade. Second, anecdotal evidence in a few U.S.
industries, notably chemicals and paper, suggests that
export growth was slowed by capacity constraints in the
1987-88 period.10
On a more rigorous econometric level, proponents of
the exchange rate/capita l stock hypothesis have
pointed to work by Helkie and Hooper that estimates a
statistically significant relationship between the U.S.
trade performance and the size of the U.S. capital stock
relative to the size of the aggregate capital stock
abroad.11 (Helkie and Hooper’s estimation focused on
the direct effects of capital stock changes on trade
through changes in supply capabilities; it did not
include any indirect effects arising from capital stock
developments that cause structural shifts in trade rela­
tionships.) These researchers found that U.S. nonagricultura l export volume increased roughly 1Vb
percent for every 1 percent increase in the ratio of the
U.S. capital stock to the aggregate capital stock of
major foreign industrial countries. Their results also
showed that U.S. nonpetroleum import volume fell
about four-fifths of 1 percent for every 1 percent
increase in the ratio of the U.S. capital stock to the
capital stock abroad.
Helkie and Hooper’s findings are corroborated by the
econometric trade volume model described in the
appendix. This model, which specifically incorporates
capital stock developments as well as other special
trade factors discussed in this article, finds a statis­
tically strong positive relationship between U.S. capital
9The group comprises Hong Kong, Singapore, South Korea, and
Taiwan.
10Whether capacity constraints significantly impeded overall U.S.
export growth was frequently discussed during this period.
However, only selected industrial supplies industries actually
reached their peak capacity levels during 1987-88, and capacity
constraints had a minimal impact on overall export growth.
"W illiam L. Helkie and Peter Hooper, "The U.S. External Deficit in
the 1980s: An Empirical Analysis,” Brookings Institution, Brookings
Discussion Papers, no. 56, March 1987; Peter Hooper, “ Exchange
Rates and U.S. External Adjustment in the Short Run and the Long
Run," Board of Governors of the Federal Reserve System,
International Finance Discussion Papers, no. 346, March 1989.

stock growth and U.S. export growth. A 1 percent
increase in the level of the real gross U.S. nonresidential capital stock is associated with a 3 percent increase
in U.S. export volume growth. On the import side, the
model finds a weaker but still statistically significant
positive relationship between foreign capital stock
growth and U.S. import growth. A 1 percent increase in
the level of the real gross foreign capital stock12 is
associated with an increase of two-fifths of 1 percent in
U.S. import volume. (Our estimated capital stock elas­
ticities are not directly comparable with those of Helkie
and Hooper because of differences in capital measure­
ments and model specifications. Nevertheless, both
models indicate that capital stock developments in the
industrialized countries had a very limited impact on the
evolution of the U.S. trade balance in the 1980s.13) The
weaker import response to foreign capital stock growth
may be due to problems in measuring the aggregate
foreign capital stock. A second possibility is that foreign
producers, viewing the United States as an integral part
of their global market, consistently seek to meet
demand regardless of the strain it puts on supply, while
U.S. producers view foreign countries more as a
peripheral market to enter when supply conditions war­
rant. Differences in the composition of U.S. and foreign
exports may also explain the divergence in response to
capital stock changes.
These statistically significant relationships between
capital stock growth and export and import growth
explain one link of the exchange rate/capital stock
hypothesis, that between capital stock developments
and trade performance. The other link is the relation­
ship between exchange rate movements and capital
stock developments. This second link did appear to
hold in the late 1960s and 1970s (Chart 5). As the dollar
became increasingly overvalued at the end of the
1960s, the real net U.S. manufacturing capital stock fell
sharply relative to the real net capital stock in major
U.S. trading partners.14 The relative decline in the U.S.
12This stock unfortunately includes residential construction because
data excluding residential construction were not available for all of
the countries covered. See the appendix for a description of this
aggregate.
13A major difference in model specification is that Helkie and Hooper
use the ratio of the U.S. capital stock to the foreign capital stock
as a variable in their regressions whereas our model uses the
actual levels of the capital stocks. Our model is built from
structural supply and demand relationships, in which capital stock
levels set the basic amount of available supply.
14Our comparisons are based on changes in the ratio of the real net
U.S. nonresidential capital stock to the real net aggregate capital
stock in ten major foreign industrial countries, although the
comparisons also hold true for the ratio of the real net total U.S.
capital stock to the real net aggregate capital stock in these
countries. Timely, comprehensive data excluding the residential
capital stock abroad were not available. However, data on real net




capital stock subsequently abated in the 1970s after the
dollar depreciated following the demise of the Smithso­
nian Agreement.
A close examination of capital stock developments in
both the early and late 1980s suggests that this
straightforward mapping between exchange rate move­
ments and relative capital stock developments broke
down in the last decade. As the dollar rose in the early
1980s, the U.S. capital stock declined at only a slightly
increased pace relative to the capital stock abroad.
Relative capital stock changes then leveled off between
1983 and 1985 despite the continued rise in the dollar.
Moreover, the U.S. capital stock began declining in
relative terms at its early 1980s pace in the second half
of the 1980s, well after the dollar had fallen. The U.S.
capital stock continued declining relative to the foreign
capital stock through 1989, four years after the dollar
began its fall and after what most analysts would have
considered sufficient time for the dollar’s decline to have
exerted its effect on capital stock growth. In fact, on an
annual average basis the U.S. capital stock fell more
relative to the foreign capital stock during the 1986-89
period than it did during the 1980-85 period. Moreover, it
fell at an even greater rate in 1989 than it did on
average in 1986-88, a pattern strongly contradicting the
expected relationship between exchange rate changes
and relative capital stock movements.
These relative capital stock developments clearly
show that factors other than exchange rate changes
dominated U.S. and foreign investment decisions in the
1980s. Of course, income growth has traditionally been
found to dominate all other considerations in investment
planning. Beyond this, however, a very low U.S. savings
rate during the past decade was a prime factor behind
weak U.S. investment.15 Strong European investment in
the late 1980s was in part tied to preparation for the
Europe 1992 program. Strong Japanese investment was
associated with a surge in the Japanese stock market in
the mid-1980s, which substantially reduced the cost of
capital in Japan.16 The overriding influence of these
factors helps to explain some elementary empirical find­
ings: in a very simple regression equation for the log of
the real gross U.S. capital stock, the estimated sum of
the coefficients on twelve lags of the nominal exchange
Footnote 14 continued
capital stocks in manufacturing for four major foreign countries and
the United States through 1987 suggest a movement relatively
similar to that of these broader capital stock measures.
15Ethan S. Harris and Charles Steindel, “ The Decline in U.S. Savings
and Its Implications for Economic Growth,” this Quarterly Review,
Winter 1991, pp. 1-19.
’ •Robert N. McCauley and Stephen Zimmer, “ Explaining International
Differences in the Cost of Capital," this Quarterly Review, Summer
1989, pp. 7-28.

FRBNY Quarterly Review/Winter 1991-92

35

rate is statistically insignificant (t-statistic: -0 .6 9 ); in a
second regression for the U.S. capital stock, the sum of
the coefficients on twelve lags of the real exchange rate
is also statistically insignificant (t-statistic: 0.12) and of
the wrong (unexpected) sign. Similarly, in comparable
simple regressions for the real gross capital stock
abroad, the sums of the coefficients of twelve lags of
both the nominal and real exchange rates are also
insignificant (t-statistics: -0 .8 4 and -0 .2 7 , respec­
tively) and of the wrong sign.17
17AII regressions reported in this paragraph impose an Almon lag
distribution on the impact of the lagged exchange rate terms. The

Of course, these regression sp e cifica tio n s are
extremely simple, and a more comprehensive regres­
sion exercise could give different results. Nevertheless,
both the regression results and the observed U.S. and
foreign capital stock growth rates in the 1980s do raise
serious questions about one of the two key tenets of the
exchange rate/capital stock hypothesis— that while the

Footnote 17 continued
regressions also include a constant term and the contemporaneous
level of real U.S. or foreign GNP. All variables are entered in natural
log form. The exchange rate terms are computed as explained in
the model description in the appendix.

Chart 5

Capital Stock Developments
Index 1980 = 100
160

Ratio of U.S. to Foreign Capital Stock

140

120

100
80
60
40

20

0

__111.. i l l __ urn 111__L l __ I iLJil_111__Li__ML_111_111..JiI__Lu__111__uJ__111..i l l__ill__w__u
1969

70

71

72

73

74

75

76

77

78

79

80

81

82

83

84

85

86

87

88

89

Percent

0
-2
-4

-6
-8
-10

Sources: National Income and Product Accounts; Organization for Economic Cooperation and Development, Flows and Stocks of Fixed Capital.
Notes: U.S. capital stock excludes the residential sector. Foreign capital stock is an import-weighted index of the real net fixed capital stock for the
ten major industrial countries.


http://fraser.stlouisfed.org/
36 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

rise in the dollar in the early 1980s hurt U.S. relative
capital stock developments, the fall in the dollar since
1985 is reversing the U.S. relative capital stock deterio­
ration and will eventually lead to a substantial U.S.
trade balance improvement in the beginning of the
1990s. Although the dollar’s fall in the second half of the
1980s may have prevented even less favorable U.S.
capital stock developments, one cannot easily point to
any evidence of a significant exchange-rate-induced
improvement in the U.S. capital stock in recent years
that would signal a sustained improvement in the U.S.
trade balance in the medium term. Other factors appear
to have simply overwhelmed any exchange rate effects.
The second major tenet of the exchange rate/capital
stock hypothesis— that a fall in the U.S. capital stock
relative to the foreign capital stock will necessarily
worsen the U.S. trade balance— is also called into
question by the results of the model discussed in the
appendix. The model’s elasticities indicate that, in gen­
eral, capital stock growth in the United States has had
an impact on U.S. exports substantially exceeding that
of capital stock growth abroad on U.S. imports. For the
1980s in particular, the model suggests that moderate
U.S. capital stock growth raised U.S. exports much
more than considerably stronger foreign capital stock
growth raised U.S. imports, a finding that sharply rebuts
the capital stock hypothesis. A more realistic appraisal
of the role of capital stock developments in the 1980s
would scale capital stock growth in each area by GNP
growth because most investment typically goes to sat­
isfy domestic rather than foreign demand. During the
1980s, the U.S. capital stock grew 2 percent faster than
U.S. GNP. The foreign capital stock grew 15 percent
faster than foreign GNP. The model’s elasticities sug­
gest that a growth rate for U.S. capital stock 2 percent
beyond that necessary to maintain a constant U.S.
capital/output ratio increased U.S. exports by about $23
billion, while a growth rate for foreign capital stock 15
percent beyond that necessary to maintain a constant
foreign capital/output ratio increased U.S. imports by
about $25 billion. In other words, the model suggests
that even conservatively scaled by GNP growth, capital
stock developments in the 1980s did not significantly
contribute to the net increase in the U.S. trade balance
deficit between 1979 and 1989.
Note that Helkie and Hooper’s capital stock data and
model generate essentially the same conclusion— that
capital stock developments explain little of the differ­
ence between the 1979 and 1989 U.S. trade volume
balances— despite the very different capital stock spec­
ifications employed by these authors. Helkie and
Hooper’s model specification based on the ratio of the
U.S. manufacturing sector capital stock to the manufac­
turing sector capital stock of five major foreign industrial



countries does show that capital stock developments
can significantly affect U.S. trade. According to Helkie
and Hooper’s data, however, this capital stock ratio
remained virtually constant during the 1979-89 period
after having fallen substantially in earlier years. Conse­
quently, capital stock developments as measured by
this ratio would not explain any of the changes in the
net U.S. trade balance over the 1980s. In fact, Hooper
notes that relative capital stock developments in the
United States and in major industrialized countries have
been dominated by factors other than exchange rate
changes in the 1980s.18
In another model specification, Helkie and Hooper
add the capital stock of ten developing countries to their
foreign capital stock aggregate. The U.S. capital stock
did fall about 10 percent relative to the more compre­
hensive measure of foreign capital stock between 1979
and 1989. Hooper feels that this fall was a major factor
behind the persistence of the U.S. trade deficit in the
late 1980s. Most of the fall, however, is attributable to
trend growth in the developing countries’ production
capacity rather than to an investm ent reaction to
exchange rate changes, as the exchange rate/capital
stock hypothesis would require. Trend growth in devel­
oping countries’ production capacity, in fact, could be
considered as one element in the structural shifts
hypothesis.
Overall, it is difficult to conclude that relative capital
stock movements driven by exchange rate changes
directly explain much of the difference in the U.S. trade
volume deficit between 1979 and 1989. It appears
unlikely that the U.S. capital stock will soon rebound
relative to the foreign capital stock in direct response to
the mid-1980s dollar depreciation and thus lead to a
substantial, sustained reduction in the U.S. trade defi­
cit. In sum, the narrowly defined capital stock hypoth­
esis finds little empirical support.
Developments in foreign direct investment
The second argument of the exchange rate/capital
stock hypothesis concerns the additional effect capital
stock increases financed by foreign direct investment
are expected to have on a country’s trade. As noted
earlier, some economists have suggested that factories
established through foreign direct investment are likely
to increase a country’s import level initially because
these factories tend to purchase a disproportionate
share of their capital equipment and components from
their parent firms. In the longer run, these factories are
expected to reduce imports as their production dispro­
portionately displaces parent firm final sales. Studies of
18Peter Hooper, “ Comment," in C. Fred Bergsten, International
Adjustment and Financing: the Lessons of 1985-91 (Washington,
D.C.: Institute for International Economics, 1991), pp. 103-12.

FRBNY Quarterly Review/Winter 1991-92

37

recent Japanese direct investment in the United States
by Orr and Suzuki show that for some industries these
additional foreign direct investment effects can be sig­
nificant in size.19 However, an examination of total direct
investment flows and their impact on U.S. trade in the
1980s suggests that the distinctive effects of foreign
direct investment, beyond those implicit in overall cap­
ital stock developments, account for little of the U.S.
trade balance deterioration during the 1980s.
The model described in the appendix estimates that
U.S. direct investment abroad does have a statistically
significant long-run impact lowering U.S. export growth,
as this hypothesis would predict. But the contention that
foreign direct investment, spurred by changes in the
dollar in the 1980s, partly explains the large U.S. trade
deficit in the late 1980s requires a positive correlation
between the level of the real stock of U.S. investment
abroad and the exchange rate value of the dollar. Dur­
ing the last decade, such a correlation did not exist. The
real stock of U.S. direct investment abroad grew on
average 2 percent a year in the early 1980s when the
dollar was rising. However, the stock of U.S. investment
abroad grew at an average annual rate of 71/2 percent
during the 1970s and 31/2 percent during the late 1980s,
periods when the dollar on net fell. In fact, simple
regressions of the real stock of U.S. investment abroad
against twelve lags of the nominal and real exchange
rates of the dollar show no statistically significant
correlations.20
An examination of direct investment flows into the
United States and their impact on U.S. imports also
raises questions about the foreign direct investment
argument. Consistent with this argument, the real stock
of foreign investment in the United States did grow at a
dramatically rapid pace in the late 1980s, when the
dollar was falling, relative to the early 1980s, when the
dollar was rising (average annual growth rates of 144
percent and 16 percent, respectively). But our regres­
sions and those reported by Orr show no statistically
significant relationship during the last two decades
between growth in the stock of foreign direct investment
in the United States and U.S. import growth. Given the
varying ages of foreign subsidiary operations in the
United States, this lack of relationship may reflect a
mixing of the positive initial import effects and the
negative long-run import effects of foreign direct invest­
ment. According to Orr, it may also reflect the fact that
19James Orr, “ The Trade Balance Effects of Foreign Direct Invest­
ment in U.S. Manufacturing," this Quarterly Review, Summer 1991,
pp. 63-76; Tsuyoshi Suzuki, "External Balance of Japan," Nomura
Research Institute Quarterly Economic Review, May 1990,
pp. 26-28.
“ The regressions reported here follow the same format as the
exchange rate/capital stock regressions described in the previous
subsection.


38 FRBNY Quarterly Review/Winter 1991-92


foreign investment in the United States during much of
the 1970s and 1980s was in industries subject to U.S.
import restrictions, limiting any long-run trade displace­
ment impact such as that found in our model for the
export side. Orr does estimate, through a detailed anal­
ysis of industry data rather than regression techniques,
that the surge in foreign direct investment (primarily the
establishment of Japanese automobile subsidiaries) in
the United States in the second half of the 1980s may
have increased U.S. imports by about $5 billion in
recent years because of capital equipment and compo­
nents shipments.21 This relatively small increase sug­
gests that foreign direct investment in the United States
did not make a substantial contribution to the net deteri­
oration in the U.S. trade balance over the 1979-89
period.
Overall, the capital stock hypothesis, viewed narrowly
as asserting that changes in the dollar’s value deter­
mine relative capital stock levels, foreign direct invest­
ment flows, and ultimately trade balance levels, does
not hold up very well as an explanation of the large and
persistent U.S. trade deficit in the late 1980s or as a
reason to expect a sustained improvement in the U.S.
trade balance in the near future. Of course, capital
stock developments have a number of indirect effects
on trade dynamics. For instance, relative capital stock
changes can affect the composition of trade and, con­
sequently, trade elasticities. Moreover, capital stock
changes may reflect or elicit changes in a producer’s
commitment to exporting or importing from a given
country, an effect much discussed under the term
“trade hysteresis.” The impact of these and other struc­
tural shifts in trade is discussed below.
Structural changes in trade

The structural shift hypothesis focuses on all trade
shifts affecting the level of U.S. exports or imports at
any given exchange rate and relative demand level.
These shifts include changes in trade composition
across industry categories or across products within a
given industry. Also included is a change in the per­
ceived desirability of purchasing products from different
regions (owing, perhaps, to the purchasers’ increased
familiarity with new products) or of supplying products
for sale to different regions (a response to changes in
producers’ fixed cost considerations). The hypothesized
result of all of these changes is that at any given
exchange rate level and level of U.S. demand relative to
foreign demand, the United States will now export less
and import more than it did in earlier years.
Perhaps the best known variant of the structural shift
hypothesis is the “ beachhead” hysteresis model pro21Orr, "Trade Balance Effects."

posed by Baldwin.22 This model deals with the last of
the changes just mentioned, that of new fixed cost
considerations. Baldwin proposes that when the dollar
rose in the early 1980s, a group of new foreign pro­
ducers started to sell goods in the U.S. market. Once
some of these producers had met the fixed costs of
setting up distribution networks (a development related
to the previous capital stock hypothesis), gaining brand
name recognition, and so forth, they were unwilling to
stop exporting to the U.S. market when exchange rates
returned to their initial levels.
A permanent change in the composition of market
participants could have had several effects on the rela­
tionship between U.S. import level and relative prices.
First, import supply would probably have been greater
at any given exchange rate level than in the past. The
sensitivity of both import supply and import demand to
changes in exchange rates would also have been likely
to change, because the new foreign producers probably
sold a different type of product than did the traditional
suppliers of U.S. imports. The increase in imports at
any given exchange rate level would have helped to
sustain the U.S. trade deficit in the late 1980s. Depend­
ing on how they shifted, changes in the sensitivity of
import supply and demand to exchange rate shifts
could also have contributed to the deficit by limiting the
import reaction to the dollar’s fall in the second half of
the decade.
Counterpart hysteresis effects may have occurred on
the U.S. export side. The sharp rise in the dollar in the
early 1980s may have driven some U.S. exporters out of
foreign markets while inducing foreign firms, perhaps
from other exporting countries, to enter those same
markets. As the dollar fell, the change in market partici­
pants abroad as well as the fixed cost considerations of,
say, reestablishing distribution networks may have kept
some U.S. firms from reentering foreign markets. U.S.
export supply and demand relationships may have been
altered by this change in U.S. export market partici­
pants, particularly if the change entailed a significant
shift in U.S. export composition.
More generally, any substantial change in U.S. import
and export composition during the 1980s, whether or
not induced by changes in the value of the dollar, could
have affected the level of U.S. im ports and U.S.
exports. Since the sensitivity of demand and supply to
price changes differs significantly across products, a
change in product composition may explain why U.S.
imports and exports did not return to their previous
levels (relative to each other) when the dollar moved
back to its 1980 level. Moreover, if either U.S. or foreign
“ Richard Baldwin, "Hysteresis in Import Prices: The Beachhead
Effect," American Economic Review, vol. 78, no. 4 (September
1988), pp. 773-85.




trade compositions changed, the level of competition
facing any product may have also changed, affecting
the demand or supply of exports or imports at any given
price. Consequently, substantial composition change
could have bedn an important determinant of the differ­
ence in the 1979 and 1989 U.S. trade balances despite
the similarity of exchange rate and relative aggregate
demand levels in those two years.
The composition of U.S. trade did, in fact, change
substantially between 1979 and 1989. Perhaps the most
notable changes were an 8 percentage point rise in
capital goods as a share of U.S. nonagricultural export
volume and a much sharper 19 percentage point rise in
capital goods as a share of U.S. nonpetroleum import
volume (Chart 6). That capital goods rose more as a
share of U.S. imports than as a share of U.S. exports
was symptomatic of the growing convergence between
the composition of U.S. exports, traditionally more ori­
ented towards capital goods, and the composition of
other countries’ exports, traditiona lly less oriented
toward capital goods. This convergence was in part the
result of the capital stock developments highlighted in
the previous section.23 It may also reflect the inroads
foreign capital goods producers made in the 1983-84
period when the dollar was high and U.S. demand
buoyant, inroads that these producers retained in the
late 1980s for the hysteresis reasons just discussed.
Products across the spectrum of capital goods
showed a greater rise in import share than export share.
Disaggregated by product type, data at the three-digit
Standard Industrial Classification (SIC) level indicate
that for thirteen out of sixteen industries, import share
gain exceeded export share gain.24 That this pattern
held for such diverse capital goods categories as farm
machinery and communications equipment suggests a
fundamental shift in U.S. trade structure in the capital
goods sector: the United States appears to have suf­
fered a decline in competitiveness in many capital
goods products.
Note that some of the rise in capital goods as a share
of both U.S. exports and U.S. imports resulted from
tremendous growth in the volume of world computer
trade. Much of this recorded growth reflects technologi­
cal progress; computer volume is measured in units of
“ Hickok argues that changes in the relative size of capital-to-labor
ratios in the 1970s and 1980s were a major factor behind shifts in
the composition of U.S. manufactured goods exports and imports
over the course of the 1980s ("The Shifting Composition of U.S.
Manufactured Goods Trade,” this Quarterly Review, Spring 1991,
pp. 27-37).
24Radio and television receivers, electronic components, and
miscellaneous electric machinery are the exceptions. Computed
share gains are based on nominal data adjusted for a revision to
the SIC classificiations starting with the 1983 data and the impact
of the 1989 Boeing strike.

FRBNY Quarterly Review/Winter 1991-92

39

computing power, and computers in 1989 were much
more powerful than computers in 1979. Because the
United States has been relatively competitive in the field
of computers, rapid recorded growth in computer trade
actually helped the U.S. trade volume balance in 1989.

If in the 1979-89 period the recorded volume of com­
puter exports and imports had grown at the same rate
as the volume of other U.S. manufactured goods
exports and imports rather than growing many times as
fast, the U.S. trade volume deficit would have been

Chart 6

U.S. Trade Composition Developments

Nonagricultural Export Volume

Capital goods

Noncapital goods

1979

1989
Computer

t

2%
Computer
22%

Noncomputer
39%
Noncomputer
28%

Other
33%

Other
36%
Consumer
goods
8%

Consumer
goods
9%

Nonpetroleum Import Volume

Noncapital goods
Computer

1%
Noncomputer

Computer

15%

17%

Noncomputer
Consumer
goods

18%

19%
Consumer
goods
20%

Source: National Income and Product Accounts.
Note: Import and export volumes are measured in constant 1982 dollars.


40 FRBNY Quarterly Review/Winter 1991-92


Other
29%

$5 billion higher in 1989.
That capital goods grew much faster as a share of
U.S. imports than as a share of U.S. exports may be
expected to have had an adverse effect on the U.S.
trade balance, abstracting from computer trade. On the
U.S. import side, the increased share of capital goods
probably lowered the responsiveness of U.S. import
demand to the fall in the dollar in the second half of the
1980s because capital goods purchases are generally
less responsive to changes in relative price than are
purchases of other products. On the U.S. export side,
in cre a se d fo re ig n c o m p e titio n in the ty p ic a lly
oligopolistic capital goods area probably reduced the
extent of foreign demand for U.S. capital goods exports,
the United States’ strongest export category, at any
given exchange rate level. As a secondary effect,
increased foreign competition also likely increased the
foreign price sensitivity of demand for U.S. products.25
Results from the model in the appendix suggest that
there have indeed been structural changes in U.S. trade
conditions adversely affecting the U.S. trade balance
during the 1980s. Specifically, the constant and price
elasticity terms in the model show statistically signifi­
cant shifts in the mid 1980s, shifts that taken together
result in a substantial deterioration in the predicted U.S.
trade balance. Quantitatively, the shifts (excluding the
effect of increased computer trade) translate into a $67
billion deterioration in the net U.S. trade volume bal­
ance relative to what it would have been had these
shifts not occurred. The model estimates that export
volume has declined $22 billion and import volume has
increased $45 billion as a result of these shifts.
Our estimate of $67 billion for the trade deterioration
due to structural shifts should be viewed as suggestive
rather than precise, given the econometric difficulties
involved. Although the figure is based on a hypoth­
esized long-run change in structural trade relationships,
this shift has only been estimated over a short period of
four and a half years. Nevertheless, the large size of
the estimated impact, coupled with t-statistics indicating
that statistically significant shifts did occur, does imply
that these shifts probably had a very great impact on
the U.S. trade balance. In fact, the magnitude of the
estimated $67 billion deterioration due to structural
shifts strongly suggests that the shifts were the primary
factor behind the difference in the 1979 and 1989 U.S.
trade balance levels. Importantly, the impact of these
25This export price elasticity argument differs from the argument on
the import side, which posits a decrease in the price sensitivity of
demand due to an increased share of capital goods imports. Two
factors account for the difference. First, capital goods increased
significantly less in share on the export side than on the import
side. Second, a rise in price sensitivity due to increased
competition was less relevant on the U.S. import side because the
U.S. market for capital goods was already very competitive.




shifts is estimated to be long lasting; that is, it will not
be reversed in the near to medium term without some
specific change in U.S. trade conditions.
Given the large, albeit imprecise, magnitude of this
estimated effect, it would be reassuring to have further
evidence supporting the model’s results. One observa­
tion substantiating the model’s conclusions is that the
noncomputer capital goods sector— the sector most
clearly identified as showing a structural shift— does
appear to account for the bulk of the deterioration in the
U.S. trade volume balance between 1979 and 1989. If
noncomputer capital goods imports and exports had
grown at the same rate as other imports and exports,
respectively, during those ten years, the U.S. trade
volume deficit would have been $46 billion less in 1989.
In other words, the poor trade performance of the non­
computer capital goods sector relative to that of other
sectors accounts for about three-quarters of the net
deterioration in the U.S. trade balance over the last
decade.
Two other observations help to corroborate the
model’s results. First, the model estimates a rise in the
foreign price sensitivity of demand for U.S. exports and
a decline in the U.S. price sensitivity of demand for U.S.
imports, developments that the observed change in
U.S. export and import composition would lead one to
expect. Second, other analysts have also found signifi­
cant signs of structural shifts in trade: Baldwin presents
a model showing indications of hysteresis,26 and some
recent studies provide implicit evidence of structural
shifts. These studies will be discussed in the next
section.
Overall, it appears that the hypothesis concerning
structural shifts in U.S. trade best explains why the U.S.
trade deficit remained so high in the late 1980s. This
hypothesis is strongly supported by the observed shift
in the composition of U.S. trade, which would seem to
mandate a change in estimated trade relationships.
Moreover, that capital goods increased much more
sharply as a share of U.S. imports than of U.S. exports
strongly suggests a secular decline in U.S. competi­
tiveness. Consequently, it is not surprising to find that
structural shifts seem to account for much of the tenac­
ity of the U.S. trade deficit.
These structural shifts have several implications for
future trade adjustment. First, U.S. exports now appear
to face a much more competitive, price-sensitive foreign
market, while U.S. imports are better able to maintain
their competitive position in the face of a change in the
value of the dollar. Structural shifts, therefore, imply that
the United States trade balance is not likely to regain its

^Baldwin, “ Hysteresis.

FRBNY Quarterly Review/Winter 1991-92

41

position of the late 1970s or early 1980s unless the
dollar moves substantially below its value at the start of
the past decade or the ratio of U.S. demand to foreign
demand falls permanently below its 1980 level. Second,
the shifts suggest that further changes in the U.S. trade
balance are likely to arise more from export develop­
ments and less from import developments than has
been the case in the past. In other words, if the United
States wants further trade balance adjustment, it must
compete more vigorously in world trade rather than
expect foreign producers to shoulder their traditionally
higher share of trade realignment.
Com parison w ith other adjustm ent analyses
Several recent studies have examined the U.S. trade
imbalance in the late 1980s. These studies have
reached differing conclusions, most notably regarding
the role they assign to exchange rate changes in the
U.S. trade balance evolution. The studies, however, all
implicitly support the conclusion that structural shifts in
U.S. trade relations in the 1980s have led to a deteriora­
tion in the U.S. trade balance position.
A small group of economists have contended that the
U.S. trade deficit remained large even after the dollar
fell in the mid-1980s because exchange rate changes
no longer had any significant impact on trade flows.
This group has offered little empirical evidence to sup­
port its contention. Rather, the group has advanced
several arguments to explain why exchange rate move­
ments are no longer important: 1) foreign producers
have cut prices to offset the fall in the dollar, 2) an
increasing share of U.S. trade has been with developing
countries whose currencies have not appreciated
against the dollar, and 3) an increased number of
imported products, such as VCRs, are not produced in
the United States.27 Most economists, while conceding
that these arguments may have some validity, firmly
reject the group’s assertion that exchange rate changes
no longer have a significant impact on trade flows. Note,
however, that these arguments, even if only partially
true, do suggest that a structural shift has occurred in
U.S. trade relationships.
Recent studies by Cline and Lawrence represent
more mainstream analyses of factors behind the tenac­
ity of the U.S. trade deficit in the late 1980s.28 Both
studies argue that traditional trade models, which incor­
porate a substantial trade response to exchange rate
27Robert Kuttner, The End of Laissez-Faire (New York: Knopf, 1991),
pp. 82-112.
“ William Cline, “ United States External Adjustment: Progress,
Prognosis, and Interpretation,” Institute for International Economics,
1990, mimeo; Robert Z. Lawrence, “ U.S. Current Account
Adjustment: An Appraisal,” Brookings Papers on Economic Activity,
2:1990, pp. 343-92.


42 FRBNY Quarterly Review/Winter 1991-92


developments, work reasonably well once data pecu­
liarities are resolved. Lawrence, whose study has been
endorsed by Krugman,29 emphasizes that U.S. trade
volume equations estimated for the period from 1976
through the first half of 1984 forecast U.S. trade vol­
umes in 1989 fairly well after adjustment for computer
trade: the sharp deterioration in the U.S. trade balance
between 1979 and 1989, according to Lawrence, is
attributable to a much higher U.S. income elasticity of
demand for imports relative to the foreign income elas­
ticity of demand for U.S. exports. Cline also finds that a
conventional set of equations accounts quite well for the
U.S. trade deficit in the late 1980s. In contrast to Law­
rence, however, Cline estimates roughly similar U.S.
and foreign income elasticities. Cline attributes the
large U.S. trade deficit in the late 1980s to the fact that
the real level of the dollar, deflated by U.S. and foreign
export unit values, was 15 percent higher in 1989 than it
had been, on average, during 1978-80. He argues that if
the real dollar had fully returned to its 1978-80 level
based on the export unit value criterion, the U.S. trade
deficit would have been largely eliminated in 1989.
This article shares the view of both Lawrence and
Cline that exchange rate changes continue to have a
significant impact on U.S. trade flows. It argues, how­
ever, that structural shifts in U.S. trade relations have
weakened the U.S. trade response to the d o lla r’s
decline in the second half of the 1980s. Closer exam­
ination of the Lawrence and Cline studies suggests that
they, too, imply significant structural shifts in U.S. trade
relationships in the 1980s.
Two elements of Lawrence’s results indicate that
structural shifts have occurred in U.S. trade. Lawrence
estimates a much higher income elasticity of demand
for U.S. imports than for U.S. exports compared with
the elasticities in models estimated over earlier periods.
In addition, when data are added to the Lawrence equa­
tions for the 1985-89 period, certain coefficient shifts
imply structural breaks.30 Cline’s finding that the real
“ Paul Krugman, "Has the Adjustment Process Worked?” Institute for
International Economics, Policy Analysis in International Economics
no. 34, 1991.
“ The Lawrence equations are difficult to compare with other trade
models because Lawrence excludes computers but includes
services trade. The gap between import and export income
elasticities in the Lawrence equations is 1.0, about twice the size of
the income elasticities found in regressions estimated in earlier
periods. See Morris Goldstein and Mohsin S. Khan, "Income and
Price Effects in Foreign Trade," in R.W. Jones and P.B. Kenen, eds.,
Handbook of International Economics, vol. 2 (Elsevier Science
Publishers, 1985); and Bryant, ed., External Deficits.
These earlier regressions do have different specifications and
activity variables. Consequently, a comparison of their elasticities
with those estimated by Lawrence offers suggestive rather than
definitive evidence of structural changes. As to coefficient shifts in
Lawrence’s regressions, when data are added for 1985-89, the
Durbin-Watson statistic in the import equation drops from 2.2 to

value of the dollar, deflated by U.S. and foreign export
unit values, was still 15 percent higher in 1989 than in
1978-80 also indicates a structural shift. By most other
price measures, including unit labor costs in manufac­
turing or producer price indexes, the real dollar had
returned to its 1978-80 level by 1989. This difference in
behavior between the real dollar based on export unit
values and the real dollar based on other price indexes
was not present in the 1970s. The emergence of a
substantial difference between these real dollar series
in the 1980s suggests pronounced structural shift in
export composition or pricing behavior on the part of
U.S. or foreign producers over the past decade. This
shift in turn indicates a pronounced change in trade
relationships during these years.
Although a finding of structural shifts in trade relation­
ships is implicit in all the recent studies, the studies
disagree significantly on the outlook for the U.S. trade
balance. The asymmetry of U.S. and foreign income
elasticities leads Lawrence to a very pessimistic conclu­
sion: “ Rates of growth in the United States that are
about 60 percent of those abroad [in countries belong­
ing to the Organization for Economic Cooperation and
Development] are required to keep exports and imports
growing at similar rates.”31 For different reasons, the
small group of analysts who contend that exchange rate
changes no longer affect the U.S. trade balance have a
sim ila rly pessim istic view of the relative income
changes necessary to achieve a sustained improve­
ment in the U.S. trade balance. Cline is much more
optimistic. He argues that only a 15 percent further
depreciation of the dollar would have balanced U.S.
trade in 1989 and that because of roughly similar U.S.
and foreign income elasticities, the balance would have
Footnote 30 continued
1.4. Lagged import price terms also become much more significant.
Moreover, when domestic demand is used as the activity variable,
the long-run price elasticity shifts significantly in the 1985-89
period. The constant term shifts in both the import and the export
equations when the more recent data are included.
31Lawrence, "U.S. Current Account Adjustment," p. 366.




been relatively easy to maintain. This article agrees
with Cline that U.S. and foreign income elasticities are
roughly equal, but our model indicates that the dollar
would have had to fall about double the amount sug­
gested by Cline to have balanced trade in 1989. In other
words, we find that the effort required to achieve a
sustained U.S. trade balance improvement is consider­
ably greater than Cline’s analysis would indicate, but
considerably less than Lawrence’s analysis would
suggest.
Conclusion
This article investigates the persistence of the U.S.
trade deficit in the late 1980s. It finds that changes in
the composition of U.S. trade, affecting both commodity
categories and foreign producers participating in trade,
are primarily responsible for impeding U.S. trade bal­
ance adjustment in the late 1980s. These changes have
made U.S. imports less responsive to the fall in the
dollar since the beginning of 1985 while increasing the
foreign competition facing U.S. exports. Exchange rate
effects on the size of U.S. capital stock relative to the
capital stock abroad do not appear to play a significant
direct role in explaining the tenacity of the U.S. trade
deficit, although they have undoubtedly contributed to
the structural changes behind the deficit’s endurance.
Several important implications may be drawn from
these findings. First, the U.S. trade balance is not likely
to regain its late 1970s position on a sustained basis
without substantial further exchange rate movements or
significantly slower U.S. growth relative to growth
abroad. Second, with the growing similarity between
U.S. import and U.S. export composition (a key element
of the structural shifts), U.S. products are likely to face
greater competition at any given exchange rate level.
Finally, given the estimated rise in the foreign price
sensitivity of demand for U.S. exports and the decrease
in the U.S. price sensitivity of demand for imports, U.S.
exports are likely to be more responsive, and imports
less responsive, to exchange rate changes than they
have been in the past.

FRBNY Quarterly Review/Winter 1991-92

43

■m m m

Appendix: An Expanded, Cointegrated Model of U.S. Trade
Standard trade models do not capture any direct impact
of capital stock or foreign direct investment develop­
ments on trade flows.f Nor do they allow structural shifts
in trade relationships to have any effect on trade flows.
To test the significance of these factors, we estimate an
expanded trade volume model. This expanded trade
model includes the U.S. capital stock and the stock of
U.S. direct investment abroad as explanatory variables in
the export volume equation. To assess the impact of
structural changes that may have occurred around 1984,
the model also allows the price elasticities of supply and
demand for U.S. exports and the export constant term to
shift. Comparable adjustments are made to the import
volume equation.
Using ordinary least squares, we estim ate the
expanded export and import volume equations without
any lagged terms. The residuals of the regressions are
tested to ensure that both equations are cointegrated.
Since the equations pass the cointegration test, their
estimated coefficients may be viewed as expressing
long-run "elasticities” linking changes in export and
import volume with changes in the explanatory variables.
The long-run regressions, estimated over the period
from the first quarter of 1967 to the fourth quarter of
1988, are:

where all variables are in natural log form, t-statistics are
in parentheses, and

(1)

px°

X
M
C
DC
Trend
V
Y*
P
P*

e

FDI
FDI*
K
K*

X, = -15.19 + 0.26 DC - 0.022 Trend + 1.90 Y‘
(-2.80)
(0.82)
(-3.95)
(4.20)
+ 3.34 K,
(3.26)

- 1.19 FDI, - 0.45 P,*0
(-3.44)
(-2.94)

- 0.38 DP,™
(-2.20)

Hr 0.65 P,xs + 2.57 DP*S + 8,x
(4.97)
(4.07)
adj. R2 = 0.98

A.D.F.= -5.15

(2 )

0.41 K,* - 0.32 FDI,* - 1.28 P«D
(2.98)
(-1.95)
(-6.43)

+ 1.17 DPf*>
(2.89)

- 0.17 P,M5 + 0.03 DPf*s + 6 “
(-0.74)
(0.10)
adj. R2= 0.99

DPXS
pMD

DpMo
pMS

M, = -10.77 + 0.05 DC + 0.01 Trend + 2.15 Y,
(-3.19)
(1.84)
(1.02)
(7.46)
+

DPxd
pxs

A.D.F.= -5.56

tStandard trade models are typically of the form:
Xd = Xd (C, Trend, Y\ P *-e P ‘)
Ma = Md (C, Trend, Y, P">-P),
where the variables are in natural log terms and Xd is
demand for U.S. export volume, C is a constant, Trend is a
time trend, Y' is real foreign income, P* is the price level for
U.S. exports, e is the nominal exchange rate (dollar/foreign


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44 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

DPms

= the U.S. nonagricultural export volume
= the U.S. non-oil import volume
- a constant term
= a dummy constant
= a time trend
= real U.S. income
*= real foreign income (an aggregate income index
of twenty-five major U.S. trading partners)
= the U.S. producer price index excluding capital
goods
= the foreign price level (trade-weighted whole­
sale price index for the countries included in
the International Monetary Fund’s multilateral
exchange rate model [MERM])
= the effective nominal exchange rate (dollar/for­
eign currency) between the U.S. dollar and
MERM countries’ currencies
= the real stock of U.S. direct investment abroad
= the real stock of foreign direct investment in the
United States
= the real U.S. net nonresidential capital stock
= the real aggregate net capital stock of the
major OECD countries
_ (p x -e p * ^ the relative export price affecting
demand, where Px is the U.S. nonagricultural
export price
= a slope dummy for Pxo
= (P *-P ), the relative export price affecting sup­
ply, where P* is the U.S. nonagricultural export
price excluding capital goods
= a slope dummy for Pxs
_ (pm P), the relative im port price affecting
demand, where Pm is the U.S. non-oil import
price excluding capital goods
_ a S|0pe dummy for PMD
=■? (p m -e p *^ the relative import price affecting
supply, where Pm is the U.S. non-oil import
price
= a slope dummy for PMS,

The export and import specifications in this two-equation
model are basically symmetrical. Each includes a con­
stant, a time trend, and the relevant trade partner’s level
of GNP. Unlike standard models, this model bases Y* on
an expanded list of twenty-five countries, including
Footnote + continued
currency), P' is the foreign price level, Md is demand for U.S.
import volume, Y is real U.S. income, Pm is the price level
for U.S. imports, and P is the domestic price level in the
United States.

Appendix: An Expanded, Cointegrated Model of U.S. Trade (continued)
developing countries.* The export and import equations
also include separate relative price terms to reflect both
demand and supply considerations^ The relative price
ratios affecting export demand (PXD) and import demand
(pM°) capture the traded goods’ price relative to the
competing goods' price.11 The relative price ratios affect­
ing export supply (Pxs) and import supply (PMS) measure
the traded goods’ price relative to the price those goods
command in their home market. Relative price slope
dummies (DPXD, DPXS, DPMD, DPMS) and constant
dummies (DC) are allowed to be operational in the third
quarter of 1984 to capture any structural shifts. (Krugman and Baldwin suggest that this quarter is likely to be
the earliest period in which measured hysteresis effects
in response to the dollar’s rise might have occurred.™) A
final set of factors included in the export and import
equations deals with investment. The export equation
has variables measuring the U.S.-owned capital stock
located at home and abroad. The import equation has
analogous measures for capital owned by foreigners.
Short-run error-correction models (ECM), or dynamic
adjustment regressions, of export and import volume are
also estimated. For exports, AXt (the first difference in
exports) is regressed against lagged residuals from the
long-run equilibrium export regression, along with lagged
changes in the dependent and independent variables in
the long-run regression. A comparable regression is esti­
mated on the import side. After eliminating insignificant
lag terms, we obtain a parsimonious ECM representation
*The countries are Australia, Belgium, Brazil, Canada,
People’s Republic of China, Denmark. France, Germany,
Hong Kong, Israel. Italy, Japan, Korea, Luxembourg, Mexico,
Netherlands, Norway, Saudi Arabia, Singapore, Spain,
Sweden, Switzerland, Taiwan, the United Kingdom, and
Venezuela.
§The simultaneous bias problem that would normally occur
when traded goods’ prices are included as independent
variables in trade volume equations disappears in a
cointegrated model when the sample size is sufficiently
large.
i Computer prices have moved very differently from other

prices in recent years. Unfortunately, computer prices have a
much higher weight in Px and P™ than in P and eP\
distorting relative price comparisons. For this reason, capital
goods prices are removed from the indexes used to
construct P *-P and Pm- P for the actual model estimation.
(It is impossible to remove only computer prices from these
indexes.) Since capital goods prices cannot be removed
from eP\ they are not removed from any of the indexes used
to construct Px-e P ' or F ^ -e P '.
ttKrugman and Baldwin, “ The Persistence."




for AX, and AM, as follows:
(3)
AX, = -0.37 RX,_, + 1.66 AK,.., - 0.36 APXDt_3 + jJL*
(-3.36)
(3.32)
(-2.40)
adj. R2= 0.22
(4)
AM,= -0.61 ARM,
(-5.55)

+ 1.37 A V ,
(3.91)

-H

adj R2 = 0.34

Overall, the above four-equation model “fits” the trade
data very well. In the long-run regressions, the adjusted
R2’s are high and the coefficients on all variables are of
the expected sign and are almost all statistically signifi­
cant. In the short-run dynamic regressions, the adjusted
R2's are at acceptable levels and the coefficient esti­
mates appear plausible.
Reestimation of the model under five variations also
suggests that the expanded model is reasonably robust.
That is, these five variations in explanatory variables or
estimation period do not result in large changes in the
estimated coefficients (see table below). Significantly,
the major findings of the benchmark model hold true for
all five variations: (1) there are large changes in the
import and export price elasticities, strongly indicating a
significant structural shift in trade; (2) capital stock
developments have a much stronger impact on exports
than on imports; and (3) the U.S. and foreign income
elasticities of demand estimated for each variation are
generally fairly close to each other.
In the text, we use the coefficients on the benchmark
m odel’s dummy variables to estimate the effect of
changes in structural trade relationships. The impact of
these dummy variables is to raise predicted U.S. export
sales $24 billion, and predicted U.S. import purchases
$84 billion, over what the model would have predicted in
1989 if the dummy terms had been suppressed. In other
words, the statistically significant dummies suggest that
structural shifts in world trade resulted in a substantial
($24 billion) rise in U.S. exports and a huge ($84 billion)
rise in U.S. imports. On net, the dummies suggest that
structural shifts led to a $63 billion deterioration in the
U.S. trade balance.
The dummy variables result in a large rise in both
export and import volume because they coincide with,
and thus partly reflect, the sharp increase in the volume
of world computer trade during the 1980s. The impact of
the surging computer trade volume on the dummies may
be estimated by calculating what the average annual

FRBNY Quarterly Review/Winter 1991-92

45

Appendix: An Expanded, Cointegrated Model of U.S. Trade (continued)
levels for computer export and import volumes would
have been in the period from the third quarter of 1984 to
the fourth quarter of 1989 if these volumes had grown at
the same rate as the volumes of other nonagricultural
U.S. exports and nonpetroleum U.S. imports. These cal­
culated computer volumes would be $46 billion less than
the actual average annual computer export volume and
$39 billion less than the actual average annual computer
import volume during the period. The differences, $46
billion on the export side and $39 billion on the import
side, may be assumed to be the increase in the dummies
attributable to the effect of rapidly rising world computer
trade on U.S. export and import flows.
According to these calculations, the dummy variables
suggest that structural shifts in world trade, excluding
the rapid growth in computer trade volume, have led to a

$22 billion fall in U.S. export volume (the difference
between the $24 billion estimated overall dummy vari­
able rise and the $46 billion rise attributed to computers)
from what it would have been had these structural shifts
not occurred. On the import side, the dummy variables
suggest that structural shifts in world trade, again
excluding the rapid growth in computer trade volume,
have caused U.S. import volume to increase $45 billion
(the difference between the $84 billion estimated overall
dummy variable rise and the $39 billion rise attributed to
computers) over what it would have been had these
shifts not occurred. On net, structural shifts, excluding
the rise in computer trade, are estimated to have caused
a $67 billion deterioration in the U.S. trade volume
balance.

Coefficient Estim ates of the Expanded Trade Model under Five Variations
Export Equation

Benchmark
Model

No. 1

No. 2

Constant
DC
Trend
Y*
K
FDI
pxo
DPX0
pxs
DPXS

-1 5 .1 9
0.26+
-0 .0 2 2
1.9
3.34
-1 .1 9
-0 .4 5
-0 .3 8
0.65
2.57

-3 6 .5
0.014+
-0 .0 3
1.60
5.87
- 1.26
- 0.20+
-0 .4 8
0.47
2.54

-11.0+
0.007+
-0 .0 2
2.2
2.38
- 1 .0
-0.16+
-0 .9 4
0.84
2.54

Constant
DC
Trend
Y
K*
FDI*

-1 0 .7 7
0.05*
0.01 +
2.15
0.41
-0 .3 2 *
-1 .2 8
117
-0 .1 7 *
0.03t

-1 0 .8
0.05+
0.01 +
2.15
0.41
-0.32+
-1 .2 8
1.17
-0.17+
003+

Variations
No. 3
- 15.02+
0.26+
-0 .0 2 3
2.12
3.09
- 1 09
-0.37+
- 0 45
0.66
2.47

No. 4

No. 5

-2 7 .3
0.007+
-0 .0 3
3.03
4.35
— 1.19
-0.04+
-0 .4 0
0.44
2.12

-7.29+
-0.02+
-0 .0 2
2.76
2.37+
-1 .5 6
-0.37+
-0 .4 4
0.75
1.82

- 12.0
0.01 +
0.00+
2.16
-0 .0 1 +
-0.03+
-1 .0 7
0.91
-0.37+
0.41 +

-1 1 .2
0.05+
0.00+
2.17
0 42
-0 .3 0
-1 .2 9
1.16
-0.18+
0.03+

Im port Equation

pMO

:

D pMD
pMS
QpMS

Notes:
Variation
Variation
Variation
Variation

no.
no.
no.
no.

1:
2:
3:
4:

-1 2 .3
0.04+
0.00+
2.24
0.44
-0.24+
-1 .2 8
1.12
-0.25+
0.011 +

-6.44+
0.03+
0.21 +
2.00
-0.26+
-0 .4 3
-1 .0 9
1.02
-0 .3 1 +
0.29+

the model is estimated using total U.S. capital stock.
the model is estimated using the real value of the dollar measured against the currencies of six major foreign countries.
the model is estimated using data from 1970-1 to 1988-IV.
the model is estimated from 1970-1 to 1988-IV using the trade-weighted domestic demand levels of the United States and
six major foreign countries.
Variation no. 5: the model is estimated using data from 1967-1 to 1989-111. Data of 1989-IV are excluded because the Boeing strike tainted
fourth-quarter export numbers.
♦Indicates insignificant estimates.


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46 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

Evolution of U.S. Trade
with China
by James Orr

Over the course of the past decade U.S. trade flows
with China have contrasted sharply with overall U.S.
trade patterns. While the U.S. trade balance as a whole
deteriorated during the first half of the 1980s, our trade
with China remained roughly in balance. After 1987,
when the overall U.S. trade balance began to improve,
a surge in imports from China led to a substantial
worsening in the U.S. bilateral balance with China. At
present, our trade deficit with China has risen to roughly
$12 billion, a sum exceeded only by our deficit with
Japan.
This article analyzes developments in U.S. trade with
China since 1980. It attributes the surge in U.S man­
ufactured goods imports from China in the second half
of the decade to significant changes in China’s foreign
economic policies. The country has sought both to
improve price competitiveness by devaluing its currency
and to acquire capital and technology by encouraging
foreign investment. These policy changes have enabled
China to take advantage of its vast supply of inexpen­
sive labor and to develop an internationally competitive
export sector. Between 1985 and 1990, China raised its
share of U.S. imports of manufactured goods and
became a significant source of relatively low-cost con­
sumer goods.
One corollary of the growth in U.S. imports from
China has been the shift in the pattern of U.S. imports
from Asia. In particular, Hong Kong’s share of U.S.
manufactured imports has declined as Hong Kong pro­
ducers have increasingly moved processing and assem­
bly operations to China.



Trends in U.S.-China trade
The pattern of U.S.-China trade during the past decade
differs remarkably from that of U.S. trade with the rest
of the world. The overall U.S. merchandise trade bal­
ance steadily worsened during the first half of the
1980s, but U.S. bilateral trade with China remained
roughly in balance (Chart 1). Since 1985, however, our
bilateral trade balance with China has steadily deterio­
rated at the same time that the U.S. trade balance with
nearly all other major trading partners has substantially
improved.

The deterioration in our trade position with China is
largely explained by the rapid growth in U.S. imports.
After having grown by only $3.5 billion between 1978
and 1985, U.S. imports from China increased by nearly
$15 billion from 1985 to 1991 (Chart 2). Since 1987, U.S.
imports from China have grown at an annual rate of 35
percent, about five times as fast as overall U.S. import
growth. In contrast, U.S. exports to China have
expanded by about 11 percent annually since 1987, a
rate roughly in line with the growth of overall U.S.
exports over the same period.1
Accompanying the rapid growth in U.S. imports from
China has been a significant shift in the composition of
these imports. During the first half of the 1980s, food
and industrial supplies made up about one-half of U.S.

1Overall U.S. exports grew at an annual rate of 16 percent since
1987. The 11 percent annual growth in U.S. exports to China since
1987, however, is low compared with the 21 percent annual growth
in U.S. exports to the Asian newly industrialized countries (NICs).

FRBNY Quarterly Review/Winter 1991-92

47

imports from China (Table 1). By contrast, consumer
goods imports have dominated the recent growth in
trade, expanding to more than three-fourths of U.S.
imports from China by 1990. The share of food and
industrial supplies by 1990 had fallen to around 15
percent. Consumer goods imports have generally been
in relatively unsophisticated product categories, partic­
ularly toys, textiles and apparel, and telephones and
radios.
Our growing trade imbalance with China not only
contrasts with overall trade patterns but also runs coun­
ter to the substantial progress the United States has
made in reducing its trade deficit with other Asian econ­
omies.2 Between 1980 and 1987, the U.S. trade deficit
with all Asian economies rose from $15 billion to $98
billion (Table 2). Japan and the Asian newly indus2Japan, China, the four Asian NICs (Hong Kong, South Korea,
Singapore, and Taiwan), Indonesia, Malaysia, the Philippines, and
Thailand.

Chart 1

U.S. Merchandise Trade Balance
Billions of dollars

0---------------------------------------

10

-

trialized countries (NICs) were the major sources of that
deficit. Since 1987 the overall deficit with the Asian
economies excluding China decreased by about $33
billion, an improvement led by the declining deficits with
Japan and the Asian NICs. The $10 billion increase in
the deficit with China, however, offset almost one-third
of this improvement, and in 1991, the U.S. deficit with
China accounted for one-sixth of the U.S. trade deficit
with Asia.
Sources of China’s im proved international
com petitiveness
In analyzing the growth of U.S. trade with China, one
must recognize that until the late 1970s China was
effectively a closed economy. Annual levels of exports
and imports were predetermined in five-year economic
plans, and trade patterns did not reflect China’s relative
competitiveness in different products. Moreover, the
exchange rate was fixed and Chinese firms were insu­
lated from world price movements. China’s adoption of
an “open door” policy in 1978 signaled the beginning of
an overhaul of its foreign trade system. The country
sought to expand the role of market forces in trade and
investment decisions and, in particular, to promote
manufactured exports.
One major change in China’s foreign trade system
has involved the exchange rate of its currency, the
yuan.3 Since the early 1980s China has actively pur­
sued a policy of improving the price competitiveness of
Chinese goods by devaluing the yuan. The effects of
this policy on China’s price competitiveness are seen in
Chart 3, which plots the real value of the yuan against
the dollar. Between 1980 and 1985, the real value of the
3The Chinese currency is called the renminbi (RMB). It is
denominated in yuan.

Chart 2

U.S. Merchandise Trade with China
Billions of dollars
2 0 ------------------------------------------------------------

Source: U.S. Department of Commerce.
*The developing Asian economies are Hong Kong, South Korea,
Singapore, Taiwan, Indonesia, Malaysia, the Philippines, and
Thailand.

t Based on data from three quarters.


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48 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

Source: U.S. Department of Commerce.

of low-skilled labor. Comparing China's labor costs with
those of other countries underscores the Chinese
advantage (Table 3). Earnings of workers in the man­
ufacturing sector averaged a mere $.20 per hour in
1989. Earnings of workers in firms primarily producing
manufactured goods for export are estimated to be
about twice that level. Even at this higher level, how­
ever, Chinese earnings are only about one-fifth as much
as the earnings of workers in the manufacturing sectors
of the Asian newly industrialized economies and onetwentieth of the wage of comparable U.S. workers.
However dramatic the differences in labor costs, the
devaluation of the yuan cannot alone explain the sharp
expansion of U.S. imports from China over the past six
years. Indeed, as Table 3 suggests, production costs in
China were quite low throughout the 1980s, although
the gap widened over time. More likely, China’s strong
export performance in the second half of the 1980s
resulted from the combined effects of improved price
competitiveness and a series of policy changes in the
foreign trade sector designed to expand exports. These
changes gave individual firm s greater freedom to
engage in trade, improved the allocation of foreign
exchange by allowing firms to retain and ultimately to
trade their foreign exchange earnings, and liberalized

yuan depreciated by roughly 50 percent against the
dollar. Industrial countries and developing Asian econo­
mies other than China also recorded large real
depreciations against the dollar during this period. Nev­
ertheless, the dollar’s sharp fall over 1985-88 reversed
earlier trends with most countries, so that at present the
real value of both industrial world and other Asian cur­
rencies exceeds their 1980 values against the dollar. In
contrast, Chinese authorities have acted to maintain the
competitive gains made in the first half of the decade. In
particular, they undertook large devaluations in 1990
and 1991 that have kept the yuan still roughly 50 per­
cent below its 1980 level relative to the dollar.4
This large currency devaluation against the dollar
during the 1980s has significantly enhanced the cost
advantage enjoyed by Chinese producers. In particular,
the devaluation of the yuan has enabled Chinese sup­
pliers to avail themselves of the vast supply of inexpen­
sive (when measured in dollars) labor and to expand the
production and export of goods requiring large amounts
4The nominal value of the yuan was set at roughly 1.5 per U.S.
dollar in the early 1980s. By mid-1991, the yuan was fixed at
roughly 5.2 per U.S. dollar, about 10 percent above the rate at
which the yuan was trading in the rather limited foreign exchange
market in China.

Table 1

C om m odity C om position of Trade between the United States and China
U.S. Imports from China
(Share of Total)

Food and industrial
supplies
Capital goods
Consumer goods
Other

U.S. Exports to China
(Share of Total)

1980

1985

1990

1980

1985

1990

47.8
1.0
51.0
0.2

42.7
1.7
54.1
1.5

15.6
7.1
75.9
1.4

87.8
11.4
0.0
0.8

39 2
52.6
Q.1
2.3

39.9
43.1
1.5
15.5

Table 2

U.S. Trade w ith Asia
Billions of Dollars

U.S. trade balance with Asia
Total
China
Asian economies excluding China
Japan
Asian newly industrialized countries
Other Asian economies

1980

1985

1987

1990

1991f

-1 5 .0
2.7
- 17.7
-10.1
- 3 .0
- 4 .6

-7 4 .5
00
-7 4 .5
-4 6 .2
-2 2 .2
-6 .1

-9 8 .4
- 2 .8
-9 5 .5
-5 6 .3
-34 .1
-5 .1

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

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

^Estimates are based on data through October.




FRBNY Quarterly Review/Winter 1991-92

49

the rules governing foreign direct investment (see box).
Improved price competitiveness, therefore, did not by
itself boost trade; rather, it reinforced the effects on
trade of the overall reform of the foreign trade system.
China’s relaxation of restrictions on foreign direct
investment was one of the most important reforms that
spurred the development of a thriving export sector. The
infusion of foreign capital and technology has enabled
China’s manufacturing sector to expand current export
production and to develop production expertise. Liber­
alizing foreign direct investment promoted this export
expansion in two ways. First, Chinese firm s were
allowed to assemble and export goods made from
imported parts and components. These same firms
were freed from many of the trade restrictions imposed
on other domestic Chinese firms. Second, “ special eco­
nomic zones,” created in 1979, offered foreign multina­
tionals specific incentives to establish plants in China
for the manufacture and production of goods for export.
China initially set aside four geographical areas as
special economic zones— three in Guangdong province
adjacent to Hong Kong and one in Fujian province
directly across the Formosa Strait from Taiwan— and
added a fifth, Hainan Island off the coast of southern
China, in 1984. Foreign investment was further pro­

Chart 3

Real Exchange Rates versus the U.S. Dollar
Index 1980=100
120
110

Developing Asian economies
excluding China*

100

Table 3

/

Labor Cost C om parisons: China and Selected
Asian Economies

/

90
80
70

/

/

50

\
S
^

China1

/
's - . y

'

\
\

v

i
i
i
i
i
i
i
i
i
i
i
i
1978 79 80 81 82 83 84 85 86 87 88 89 90
Note: A rise signifies dollar depreciation.

*

Hourly Wage in
Manufacturing
(U.S. Dollars)

*nclustrial economies

China'*'
60

moted in 1984 with the designation of fourteen coastal
cities as “ open areas” offering foreign firms advantages
similar to those in the special economic zones.
Although information on individual sources of invest­
ment in the zones and open coastal areas is not avail­
able, data on overall trends show a rapid increase in
foreign direct investment since the mid-1980s. Between
1979 and 1990 China attracted over $20 billion of for­
eign direct investment. The majority of that investment
followed the significant liberalization of rules governing
foreign investment in 1984 (Chart 4). Foreign investment
has accounted for more than 2 percent of total plant and
equipment spending in China since 1984, and its impor­
tance in domestic capital formation has risen steadily
since the early 1980s. In addition, foreign investment
has also increased as a share of exports since 1984,
exceeding 6 percent of exports in 1990.
The Asian economies accounted for three-quarters of
foreign direct investment in China between 1985 and
1990. Of these economies, Hong Kong has been by far
the single most important source of foreign investment
in China. The flow of investment from Hong Kong into
China reflects the large-scale restructuring of Hong
Kong’s manufacturing sector in the face of rising labor
costs. Although Hong Kong firms have invested in facto­
ries throughout Asia, China has been the most favored
location. Industrial countries have also invested in
China, though to a lesser extent. Between 1985 and
1990, investment by the United States, Japan, and the
European Community accounted for about one-third of
total direct investment in China.

Weighted average using 1985 shares of U.S. imports.

t Computed using China’s retail price index and the U.S.
wholesale price index.


50 FRBNY Quarterly Review/Winter 1991-92


Hong Kong§
South Korea§
Taiwan§
Thailand*
Malaysia #
United States5

1980

1985

1989

.26

.20

1.53
.65
.70
n.a.
n.a.
5.61

1.77
.88
1.17
n.a.
n.a.
7.27

.22
(0.40*)
2.69
2.19
2.68
0.47
0.58
8.05

Sources: Statistical Yearbook of China; U.S. Department of
Labor; Hang Seng Bank, Economic Monthly, March 1990.
t Average industry wages, excluding compensation, converted
to U.S. dollars at the official exchange rate.
* Hourly wage in firms producing primarily for export.
§ Hourly wage of production workers in the apparel sector.
11 Average wage of unskilled workers in manufacturing.

Foreign-owned firms in the special economic zones
and the other designated areas are either joint ventures
or wholly owned companies. The firms typically engage
in manufacturing or assembly operations, which often
utilize imported parts and components. Foreign inves­
tors are attracted to these areas by the relatively low
cost of labor and by the preferential treatment accorded
them in the areas of import controls, taxes, foreign

exchange dealings, and profit repatriation.5
Data on foreign-owned firms show the importance of
foreign investment in the overall expansion of Chinese
5At the end of 1990, over 25,000 foreign-owned firms had contracted
to invest in operations in China and roughly 12,000 were in
operation. These included foreign-owned firms and Chinese firms
engaged in the assembly of imported parts and components for
export.

Box: China’s Changing Foreign Trade System
In 1978 China adopted an "open door” policy toward
foreign trade and investment as the first step in an
ambitious program of trade reform. Before 1978, Chinese
firms were effectively insulated from the world economy.
The Chinese government had set required levels of
exports and imports in its five-year economic plans.
Foreign direct investment was restricted, and only twelve
national foreign trade corporations were permitted to
have contact with foreign businesses and to carry out the
purchase and sale of goods.
Since 1978, these policies have been gradually trans­
formed. The government has been working to expand the
role of market forces in trade and investment decisions
and, in particular, to expand and improve the efficiency of
China’s manufactured exports. Although China’s foreign
trade system is significantly more market-oriented today
than in the late 1970s, the transition is by no means
complete.
A chronology of the principal reforms since 1978
follows.
1979/1980

The government enacts the “ Law of the People’s
Republic of China on Joint Ventures Using Chinese and
Foreign Investment,” which encourages the growth of
joint ventures between Chinese firms and foreign part­
ners and establishes four special economic zones offer­
ing incentives for firms to locate there and produce
goods for export. Over time, the law is interpreted as
allowing the establishment of wholly foreign-owned firms.
The government decentralizes the control over exports
and imports; the twelve national trade corporations share
this authority with provincial and other local-level govern­
mental authorities.
The government introduces a system of import licens­
ing; licenses and tariffs become means of controlling
imports. The ease of obtaining a license and the number
of goods requiring a license have varied with economic
circumstances over time.
1984

Local area authorities are given expanded power to




export and import, and large private firms are allowed to
engage in trade directly. Over 4000 such entities now
engage in trade.
Local foreign trade corporations and private firms
engaging in exporting are allowed to retain the rights to
25 percent of their foreign exchange earnings. Retention
rights are increased beyond the 25 percent level for
“key” export industries, exports in excess of planned
targets, and provinces in which the special economic
zones are located.
Foreign-owned firms are allowed to trade foreign
exchange in a newly established foreign currency
market.
The Chinese currency is devalued by 40 percent.
Hainan Island is designated as the fifth special eco­
nomic zone, and similar foreign investment incentives
are extended to fourteen coastal cities.
1985/1986

The authority to export and import extended to various
local authorities and enterprises in 1984 is curtailed in
the face of balance of payments problems; some central
government control over trading is reimposed.
The Chinese currency is devalued by 14 percent.
1988

The government establishes local foreign exchange
swap centers where firms can trade foreign exchange at
market prices.
The Chinese currency is devalued by 40 percent, a
measure that mitigates the adverse effects of high
domestic inflation on competitiveness.
1990

Incentives for foreign investment in relatively high-tech
industries, similar to the incentives in special economic
zones, are extended to a municipality of Shanghai.
1991

The Chinese currency is devalued by 10 percent. All
residents of China are permitted to trade in the foreign
exchange swap centers.

FRBNY Quarterly Review/Winter 1991-92

51

exports. The firms’ first exports, reported in 1985,
accounted for only about 1 percent of total Chinese
exports in that year (Table 4). By 1990, exports of
foreign-owned firms accounted for almost 17 percent of
total Chinese exports. Moreover, in 1990 alone, these
exports accounted for nearly three-quarters of the
growth in China’s exports.
The available data on the performance of foreignowned firms in China cannot track the firms’ exports to
specific final destinations. But two observations, taken
together, suggest that foreign-owned firms have contrib­

Chart 4

Foreign Direct Investment in China
Percent

Percent
------- 10

Direct Investment Flows

Share of exports
S c a le ----- ►

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

s

Share of investment

y

-*------- Scale

11982

J_____I
____
L 85
83
84

86

87

88

J____J_____lo
89

90

Billions of dollars
18Cumulative Investment by Country: 1985-90
16
1412108

-

6

-

4 2

-

Total

Asia

Hong Kong

Japan

United
States

jJZL

European
Community^

Source: Ministry of Foreign Economic Relations and Trade,
China.
Includes the following European Community countries: Belgium,
the Netherlands, Luxembourg, Germany, France, Italy, and the
United Kingdom.


http://fraser.stlouisfed.org/
52 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

uted significantly to the growth of China’s exports to the
United States. First, foreign investm ent has been
largely concentrated in the manufactured goods sector.
Second, virtually all of the growth in China’s exports to
the United States since 1984 has consisted of manufac­
tured goods. Foreign-owned firms are thus likely to have
accounted for a substantial share of the growth of these
manufactured exports to the United States.
Note, however, that the United States has not been
the only destination for China’s manufactured exports:
in 1990, 30 percent of China’s manufactured exports
were to the United States, while about 25 percent were
to Japan and the European Community. Nevertheless,
since 1984, China’s manufactured exports to the United
States have grown faster than exports to these other
industrial countries.6 The increasing importance of the
United States as a destination for China’s manufactured
exports between 1984 and 1990 further suggests that a
significant part of China’s export growth to the United
States since the mid-1980s has been due to the growth
in exports of foreign-owned firms.
The changing pattern of U.S. trade w ith Asia
The growth of foreign investment in China and, in par­
ticular, the importance of Asian countries as a source of
that investment have significantly altered the trade links
between the United States and the region. An examina­
tion of Asian market shares in U.S. manufactured goods
imports indicates that Chinese inroads in U.S. markets
for several categories of low-tech consumer goods have
often been made at the expense of other countries in
Asia.
China’s share of U.S. manufactured goods imports
has grown substantially over the past decade, reaching
3.8 percent in 1990 (Table 5). Dramatic market share
gains have been made in three categories: telecom­
munications equipment: textiles and apparel; and toys,
games, and sporting goods. In each of these areas
China’s market shares rose by more than 5 percentage
points during the 1980s, with the most rapid gains
recorded between 1985 and 1990.
The market share of other Asian economies (exclud­
ing Japan) in these categories declined over the course
of the 1980s. In particular, the large increase in China’s
market share in textiles and apparel contrasts sharply
with the declines recorded by other Asian countries.
Note, however, that the overall market share of U.S.
manufactured goods imports from other Asian countries
increased over the course of the 1980s. This evidence
suggests that losses in market share incurred by these
6The U.S. share of China's manufactured exports rose from 20 to 30
percent between 1984 and 1990, while the combined shares of
Japan and the European Community rose from 20 to about 23
percent.

countries in low-tech goods were offset by gains in
other areas.7
One country whose U.S. market share in manufac­
tured goods has declined is Hong Kong. Hong Kong’s
share of U.S. manufactured goods imports fell by a
percentage point during the 1980s. Considerably larger
declines were observed in each of the categories in
which Chinese imports expanded rapidly. Given the
importance of Hong Kong as an investor in China, these
shifts in market shares are not surprising. As noted
earlier, more than one-half of all foreign investment in
China since 1985 has been from Hong Kong. Further­
more, roughly 75 percent of that investment has been in
the manufacturing sector, primarily in relatively lowwage industries.8 Within China, Hong Kong investors
have tended to establish manufacturing plants in
Guangdong province, a location that is linked to Hong
7The gains were recorded mainly in capital goods, especially
electronic components and equipment.
8Data are not available to determine how much of the investment
recorded as coming from Hong Kong is actually from other Asian
countries that for a variety of reasons list their Hong Kong
subsidiaries as the source of their investment.

Kong by efficient transportation and communications
networks and that contains three of the five special
economic zones.9
Data on trade links between China, Hong Kong, and
the United States suggest how the growth of foreignowned firms in China has altered trade patterns.
Although Hong Kong’s share of total imports has fallen,
total shipments from Hong Kong to the United States
have increased substantially over the course of the
1980s (Table 6). Underlying this increase, however, is
the expansion of Hong Kong’s re-exports from China.10
These re-exports, which are measured as Chinese
9Recent trends suggest that Taiwan, and to a lesser extent, South
Korea, are rapidly becoming important sources of foreign
investment in China as their manufacturing sectors face growing
competitive pressure. Reports indicate that Taiwan's investments
have been concentrated in Fujian province; over 90 percent of this
investment has been in manufacturing industries. The investment
includes relocating the production facilities for Taiwan's shoe,
umbrella, textiles, and toy industries to China.
10Hong Kong’s re-exports consist of goods produced in China and
shipped through Hong Kong to other destinations. They can include
goods produced in both foreign-owned firms in China and Chineseowned firms.

Table 4

The Role of Foreign-Owned Enterprises in China’s E xports: 1984-90
Total Merchandise Exports
(Billions of Dollars)

Total exports
Exports of foreign-owned
enterprises
Foreign-owned enterprises’
share of total (in percent)

1984

1985

1986

1987

1988

1989

1990

26.1

27.4

30.9

39.4

47.5

52.5

62.1

0

.3

.9

1.3

2.3

3.9

10.5

0

1.1

2.9

3.3

4.8

7.4

16 9

Sources: China's Customs Statistics; Hong Kong Bank, China Briefing, March 1991.

Table 5

Shares of U.S. Im ports: China and Selected Asian Economies
Share of U.S. Imports
(Percent)
Developing Asian
Economies Excluding China

China
Product
All Manufactures
Telecommunications1
Textiles and apparel
Toys, games, and
sporting goods

Hong Kong

1980

1985

1990

1980

1985

1990

1980

1985

1990

0.6
0.0
4.5

1.0
0.1
6.9

3.8
5.3
13.0

16.5
32.8
54.7

18.1
31.2
47.8

19.2
31.2
41.8

3.5
3.9
19.9

3.3
3.1
17.7

2.5
2.2
13.1

1.2

3.2

10.6

46.5

45.7

44,5

11.5

9.3

6.1

+ Primarily radios, televisions, and telephones.




FRBNY Quarterly Review/Winter 1991-92

53

Table 6

Trade between China, Hong Kong, and the United States: 1984*90
Billions of U.S. Dollars
1984

1988

1990

Hong Kong's shipments to the United States
Total'
Exports
Re-exports from China

9.4
7.8
1.1

15.6
9.3
5.5

19.8
8.5
10.5

Trade of China’s licensed processing and assembly firms with Hong Kong
Imports of parts/components from Hong Kong
Share of total imports from Hong Kong (percent)
Exports of assembled goods to Hong Kong*
Share of total manufactured exports to Hong Kong (percent)

n.r
n.r.
n.r.
n.r.

6.0
50.0
5.9
32.4

7.5
53.2
9.1
34.2

Sources: China’s Customs Statistics and Hong Kong Review of Overseas Trade.
t These data are not comparable to U.S. trade data because they treat re-exports differently. Total shipments includes a small amount of re­
exports from other countries.
* Finished products assembled in licensed processing firms in China using imported parts, components, and materials,
n.r. = not reported.

exports in U.S. trade data, rose from $1.1 billion in 1984
to $10.5 billion in 1990. In contrast, direct exports from
Hong Kong to the United States have actually declined
over the past three years. Shipments of Chinese
exports through Hong Kong to the United States now
make up almost one-half of the combined exports of
Hong Kong and China to the United States.
As investment from Hong Kong spurs China’s export
trade and encourages the growth in shipments of Chi­
nese goods through Hong Kong, a new pattern of trade
is evolving between China, Hong Kong, and the United
States. Although precise data on the operations of
Hong Kong firms in China are not available, evidence
suggests that a sizable number of these firms are
engaged in the processing and assembly of goods from
parts and components imported from Hong Kong. In
fact, the economic reforms that encouraged foreign
investment also encouraged firms, both foreign-owned
and wholly Chinese firms, to engage in these opera­
tions. The one advantage to firms performing these
operations in China is the low cost of labor; the actual
value added to the good in China may be relatively
small.
Data on the activities of these licensed processing
firms in China show that the firms play an important role
in trade between Hong Kong and China. In 1990, the
firms imported parts and components from Hong Kong
totaling $7.5 billion, or more than 50 percent of all of
China’s imports from Hong Kong. At the same time,
China exported over $9 billion of assembled goods to
Hong Kong, a quantity that represents almost 35 per­
cent of its total exports to Hong Kong. Although these


http://fraser.stlouisfed.org/
54 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

data neither fully describe the activities of Hong Kong
firms in China nor indicate the final destination of the
goods, they suggest that these firms are increasingly
using China as a base for the final processing and
assembly of exports.
Conclusion
The growth of manufactured exports from China to the
United States since the mid-1980s reflects both China’s
e ffo rt to im prove price co m p e titive n e ss through
exchange rate devaluation and the acquisition of capital
and technology through foreign investment. These
developments have enabled China to take advantage of
its vast supply of inexpensive labor and to increase
significantly the ability of its manufacturing sector to
compete in world markets. In the latter half of the
1980s, China raised its share of U.S. imports of man­
ufactured goods and became a significant supplier of
several categories of relatively low-cost manufactured
goods.
The growth of foreign investment in China has shifted
the pattern of U.S. imports from the region. In the
categories where China has significantly increased its
share of U.S. im ports— telecommunications; textiles
and apparel; and toys, games, and sporting goods— the
shares of other Asian economies have declined. Hong
Kong, in particular, has seen substantial declines in its
shares of U.S. manufactured imports. Shipments of
goods from Hong Kong to the United States are increas­
ingly goods produced in China. Nevertheless, the
amount of actual value added to the product by firms in
China may be relatively limited.

Treasury and Federal Reserve
Foreign Exchange Operations
November 1991-January 1992

The dollar declined through the end of the calendar
year, approaching historical lows against both the Ger­
man mark and the Japanese yen as sentiment toward
the prospects for U.S. economic recovery turned
increasingly negative and large short-dollar positions
were built up. Early in the new year, however, the dollar
recovered somewhat as expectations about the econ­
omy tended to stabilize and short positions were signifi­
cantly reduced. The dollar’s decline was consequently
pared back at the end of the period to a net 31/2 percent
against the mark and 4 percent against the yen. On a
trade-weighted basis, the dollar declined 23A percent,
on balance, over the period.1 On January 17, the U.S.
authorities sold $50 million against yen in their only
intervention operation of the period.
November and December
As the period opened, skepticism was deepening about
the prospects for a U.S. economic recovery. During the
fall, it had become increasingly apparent that the tenta­
tive pickup in consumer spending following the Persian
Gulf War had served merely to work off inventories and
would not lead to a sustained pattern of growth. Then,
just prior to the period, any remaining hopes of recovery
suffered a severe blow when the Conference Board’s
A report presented by William J. McDonough, 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. Robert Ennis was primarily
responsible for preparation of the report.
’ The trade-weighted value of the dollar is measured by the Federal
Reserve Board staff’s index.




index of consumer confidence took an unexpected
plunge. Thus, by early November, market participants
were beginning to question what mechanism might still
be able to spark recovery, noting that up to that point
monetary policy had been about the only instrument
available to support the economy.
Under these c ircu m sta n ce s, the N ovem ber 6
announcement that the Federal Reserve had cut its
discount rate Vz percentage point to 41/2 percent was
widely anticipated. But market observers noted thett the
Federal Reserve had now cut the discount rate five
times in eleven months, producing a cumulative drop of
21/2 percentage points, and they were beginning to
doubt whether monetary policy could do much more to
facilitate recovery. At the same time, they were sensitive
to the political pressures generated by disappointment
about the economy and concerned about what alter­
native measures might be proposed. Operators in the
exchange markets, who were mindful that interest rate
differentials were already widely unfavorable to the dol­
lar, especially in relation to the German mark, felt a
strong incentive to sell the dollar short.
The dollar declined as events in November and early
December tended to confirm pessimism about U.S. eco­
nomic prospects. In mid-November, when financial mar­
kets grew nervous about a congressional proposal to
spur consumer spending by capping credit card interest
rates, a sharp drop in U.S. equity prices dragged the
dollar down for a few days. In late November and early
December, release of data showing a further drop in
consum er confidence and a much sharper than
expected drop in payroll employment prompted another
sell-off. Meanwhile, statistics for consumer price infla­

FRBNY Quarterly Review/Winter 1991-92

55

tion suggested to financial markets that the Federal
Reserve had further leeway to ease monetary policy. In
addition, speculation mounted that an excessively
expansionist fiscal package might be forthcoming.

Chart 1

During the first two months of the period, the
dollar declined steadily amid evidence of weakness
in the U.S. economy. After the new year, the dollar
reversed course as market participants bought
dollars to cover short positions.
Percentage change
15
Dollar Exchange Rates
Swiss franc

British
P°.und
Canadian dollar
r vr T

..

fS -

Japanese yen

i l I i I
M

l I

m

J

I I I

J

I

I

l I
A

I i i i I i ll
S
0
1991
I

Germany
mark \ — r * I ! I I I I I 1
i 11 i
N
D
J
1992

During November and December, German interest
rates firmed while U.S. and Japanese interest rates
declined.
Percentage points
Three-Month Euro Interest Rates
Germany

Japan
V
-------- ^ - 1
\
^= y —

United otcitss

» » * il
11111111111111111111111111
A
S
1991

1 LJ.xl.Ll. L L 1 1 L.
J
1992

Notes: The top panel shows the percentage change of weekly
average rates for the dollar against designated currencies from
May 3, 1991. The bottom panel shows weekly average U.S.,
German, and Japanese three-month Euromarket interest rates
from May 3, 1991.


http://fraser.stlouisfed.org/
56 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

The dollar declined more against the German mark
during this period than against other currencies. This
was in part because interest rates in Germany were at,
and were expected to stay near, historically high levels.
The German economy was still going through the transi­
tion associated with unification. Although the full force
of the unity-related boom had dissipated earlier in the
year, credit demands were still significant enough to
keep monetary aggregate growth stronger than desired,
and inflationary pressures were being kept alive by high
wage demands. Accordingly, market p a rticip a n ts
believed that the German Bundesbank would seek to
maintain a tight monetary policy stance. They inter­
preted the Bundesbank’s money market operations as
clear evidence of its intention to resist domestic and
international pressures to ease. They saw this policy
stance as implying that the large interest rate differen­
tials against the dollar would be maintained for the
foreseeable future. Market participants also suspected
that there might be tension between the monetary pol­
icy objectives of Germany and those of other European
countries where econom ic a ctivity was generally
decelerating more rapidly. And they were wary of the
possibility that these tensions might be reflected sooner
or later in pressures within the exchange rate relation­
ships of the European Monetary System (EMS), pres­
sures that might spill over into the exchange markets
more broadly— especially because final negotiations
over eventual monetary union in Europe were sched­
uled for early December in Maastricht, the Netherlands.
In this environment, two announcements by the Fin­
nish authorities in mid-November, first, that the Fin­
nish markka would float and, later, that it would be
effectively devalued by about 12 percent, heightened
the sense of exchange rate risk and boosted the Ger­
man mark. This episode served as a reminder that
market pressures could at tim es force unwanted
changes in exchange rate policy. In response, market
participants rushed to reduce their holdings of assets
denominated in those European currencies that had
previously appeared attractive because of their high
yields but that no longer carried a yield sufficient to
compensate for their perceived exchange risk. The
Swedish krona, for example, came under significant
pressure, forcing the Swedish Riksbank to raise its
marginal lending rate by a total of 7 percentage points
by early December.
As market participants sought to shift funds from
higher yielding currencies into the mark, the Exchange
Rate Mechanism (ERM) of the EMS became strained.
Market participants questioned whether an ERM real­
ignment at the upcoming Maastricht summit could be
avoided, raising further uncertainty about the effects
such developments might have on the dollar. Support

for the mark was partly offset, from time to time, by
concerns about the rapidly moving political situation in
the Soviet Union and its possible negative effects on
European countries, including Germany.
In the event, the Maastricht summit proceeded with­
out incident and tensions among European currencies
abated somewhat by mid-December. But the growing
disparity in economic conditions between the United
States and Germany persisted. As wage negotiations in
Germany became more tense, the Bundesbank moved
to increase interest rates both sooner and by a larger
amount than the market had expected, announcing
1/2 percentage point rises for both its discount and Lom­
bard rates on December 19. To avoid renewed exchange
rate pressures, all other EMS central banks except the
Bank of England followed this interest rate move, at
least in part, over the next several days. By contrast, on
December 20, the Federal Reserve reduced its discount
rate by more than had been expected. The 1 percentage
point cut brought the discount rate to 31/2 percent, its
lowest level since 1964. The Federal Reserve also
appeared to signal that it had relaxed reserve pressures
to an extent consistent with about a Vz percentage point
decline in the federal funds rate.
As the foreign exchange market responded to these
divergent moves in interest rates, the dollar continued
its decline against the German mark. After moving
irregularly lower in November and early December, the
dollar moved down a further 31/2 percent after Decem­
ber 19, hitting its low of the period of DM 1.5025 on
December 27. At this level, the dollar had depreciated
10 percent from DM 1.6713 at the period’s start and
181/2 percent from its 1991 high.
The dollar’s decline against the yen during November
and December was more tempered than its decline
against the mark. Evidence was accumulating that the
pace of expansion in Japan was clearly decelerating.
Japan’s monetary growth was slowing, business confi­
dence and investment intentions were weakening, and
flagging domestic demand was being reflected in a
widening of Japan’s trade surplus. Market participants
had therefore come to expect that the Japanese mone­
tary authorities, who had eased official interest rates
the previous July, would continue moving to a some­
what more accommodative monetary policy stance, so
that U.S.-Japanese interest differentials would remain
relatively stable. Indeed, official Japanese interest rates
declined during these two months. The Bank of Japan
trimmed its official discount rate once in mid-November
and again at the end of December. At the same time,
persistent weakness in Japan’s equity market and politi­
cal uncertainty caused by recent scandals also weighed
on the yen at a time when the dollar was declining
generally.



As a result, the dollar eased only moderately against
the yen during November. Although the pace of decline
quickened during December, the dollar rebounded at
the end of the year to close December at ¥124.80,
down on balance 43A percent from ¥130.75 at the
beginning of the period.
January
By early January, the dissolution of the Soviet Union
was introducing a new level of uncertainty, especially
regarding the outlook for Europe. Although recurring
rumors about the Soviet Union’s financial condition had
been a concern during the earlier months, market par­
ticipants were now faced with the prospects of greater
disarray stemming from changing political structures
and moves to liberalize prices in January. Accordingly,
the German mark was increasingly susceptible to sell­
ing pressures whenever new financial or political diffi­
culties in the former Soviet Union became evident.
Meanwhile, market participants’ assessment of the
German mark and the German economy weakened con­
siderably after the new year. Press commentary at that
time increasingly focused on the sustained slowdown in
Germany’s expansion. Not only was the pace of domes­
tic demand moderating, but export orders were also
sagging under the weight of slowing economies in other
industrialized countries. Market participants did not
believe that this evidence would lead to any near-term
moderation of the Bundesbank’s tight monetary pol­
icies; indeed, the Bundesbank appeared still to be con­
cerned about wage inflation and credit demands. But
the evidence did suggest that the scope for further
policy tightening was more limited and the prospects for
growth in the coming year more clouded than previously
perceived. Under these circumstances, market partici­
pants began to question whether interest differentials
so unfavorable to the dollar would continue to widen.
Moreover, the financial markets appeared to react
positively to the Federal Reserve’s policy move of midDecember. The capital markets in the United States had
responded favorably, with long-term interest rates
easing and the stock m arket showing sustained
strength. Also, the move appeared to have broken the
pattern of market expectations concerning U.S. interest
rates. Market participants were less certain that a
weaker than expected U.S. economic statistic would
immediately trigger another monetary policy action, and
they were more likely than before to attribute weakness
in the data to temporary factors. Moreover, they became
mindful once again of the possibility that some statistics
might show greater than expected strength.
The dollar’s decline against the European currencies
therefore lost momentum early in January. Market par­
ticipants were aware that the dollar had been under

FRBNY Quarterly Review/Winter 1991-92

57

virtually continuous selling pressure for almost six
months. Many investors as well as foreign exchange
market operators had portfolios that were heavily
weighted in assets denominated in European curren­
cies. The developments of November and December
had led to an even greater concentration in these port­
folios of assets denominated in German marks. Under
the circumstances, there was a perception of a large
risk of loss if market sentiment should switch in favor of

Chart 2

Data released early in the period reinforced the
negative outlook for U.S. economic recovery.
Consumer confidence fell for a second consecutive
month in November. Employment remained
depressed, failing to show the rebound typical of
previous recoveries.
Index
90-

Consumer Confidence Index

80-

706 0 ------- = =
50

the dollar and a perception of diminishing chance of
gain if sentiment should remain negative to the dollar.
For a short while, however, the focus of market atten­
tion was the Japanese yen, a currency against which
the dollar continued to decline in early January. Talk
had already begun to circulate before the turn of the
year that the United States and Japan would agree on
some official action to support yen appreciation. Com­
mentary about President Bush’s trip to Japan to meet
with Prime Minister Miyazawa suggested that the deteri­
orating condition of the U.S. economy would prompt the
President to seek ways to reduce the U.S. trade deficit.
There was also speculation that the Japanese govern­
ment was looking for ways to counter weakness in
Japan’s stock market. In this context, an upward move
in the yen’s exchange rate was thought to be acceptable
to both governments.
In response to these expectations, the dollar received
only a temporary boost from the year-end cut in the
Bank of Japan’s discount rate. During the first five
business days of January, the dollar resumed its down­
ward trend against the yen, declining 11/2 percent to a
low of ¥122.80 on January 7, the day President Bush
arrived in Tokyo. At this level, the dollar was down
6 percent from the start of the period and 131/2 percent
from its 1991 high.
Thereafter, expectations of official action to support
the Japanese yen gradually faded. Market participants
became less convinced during President Bush’s stay in

40

M
Index
102.0

J
J
1991

O

N

D

J
1992

Table 1

Federal Reserve
Reciprocal Currency Agreements

Nonfarm Payroll Employment

In Millions of Dollars
101.5 — Dec. 1974 - Nov. 1975
Aug. 1982 - Jul. 1983

\

101.0-\

Ann

1 0 7 0 . . 11

1Q71

100

Jan. 1991 - Dec. 1991

J___I__ l___L
2

3
4
5
6
Months after trough

Notes: The top panel shows the Conference Board’s consumer
confidence index; the shaded portion highlights data released
during the period. The bottom panel shows nonfarm payroll
employment data during each of the past four recessionary
periods. The data are indexed with the trough month set at 100.
Data for months six, seven, and eight of the current period were
released on November 1 and December 6, 1991, and
January 10, 1992, respectively.


58 FRBNY Quarterly Review/Winter 1991-92


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

Amount of Facility
January 31, 1992
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

Table 2

Drawings and Repayments by Foreign Central Banks under Special Swap Arrangem ents
w ith the U.S. Treasury
In Millions of Dollars; Drawings ( + ) or Repayments ( - )
Central Bank Drawing
on the U.S. Treasury
National Bank of Panama

Amount
of Facility

Outstanding as of
October 31, 1991

November

December

143.01

January

Outstanding as of
January 31. 1992

+ 143.0

143.0

Note: Data are on a vaiue-date basis. Components may not add to totals because of rounding.
^Represents a bilateral credit facility with the National Bank of Panama that was established on January 28.

Japan that the two countries would take immediate
steps to strengthen the yen against the dollar. In keep­
ing with these diminished expectations, the President
and the Prime Minister agreed “that recent exchange
rate movements were consistent with current economic
developments.” Nonetheless, market participants con­
tinued to focus on the possibility that a more gener­
alized Group of Seven (G-7) policy towards the yen
might be considered at an upcoming G-7 meeting on
January 25. This possibility seemed credible to market
participants because the yen had lagged behind rising
European currencies during previous months and
because this gap appeared to be generating economic
and political concerns in a number of countries other
than the United States. But in time, even this proposi­
tion lost standing in the marketplace.
When the G-7 meeting occurred in New York, the
finance ministers and central bank governors issued a
communique in which they agreed to intensify their
cooperative efforts to strengthen world economic
growth. With reference to exchange markets, the G-7
“ agreed to continue to monitor market developments
and reaffirmed their commitment to cooperate closely in
exchange markets, thus contributing to favorable condi­
tions for stable exchange markets and economic recov­
ery.” Market participants, however, were somewhat
disappointed by the absence of any specific mention of
the yen exchange rate.
As expectations of a yen appreciation subsided, mar­
ket participants began to worry that there was an over­
hang of short-dollar positions against the yen as well as
against the European currencies. Concerns about the
technical position of the market came to the surface
when the dollar did not fall off sharply on news that
President Bush had become ill and had had to leave a
state dinner during his Tokyo trip. The dollar’s unusual
lack of sensitivity to potentially disturbing news about



Table 3

Net Profits ( + ) or Losses ( - ) on
United States Treasury and Federal Reserve
Foreign Exchange O perations
In Millions of Dollars

Valuation profits and losses on
outstanding assets and
liabilities as of October 31, 1991
Realized November 1, 1991January 31, 1992
Valuation profits and losses on
outstanding assets and
liabilities as of January 31, 1992

Federal
Reserve

U.S. Treasury
Exchange
Stabilization
Fund

+ 2,764.8

+ 1,132.6

+ 75.0

+ 3.9

+ 3,615.2

+ 1.941 6

Note: Data are on a value-date basis.

an American president’s health was interpreted as indi­
cating how unwilling market professionals were to
extend their short-dollar positions further and how great
the risks were that the dollar might rise abruptly if a
general effort to cover some of these short-dollar posi­
tions were to develop.
Under these circumstances, the dollar drifted higher
and staged an uneven recovery during most of January.
In some instances, particular events triggered dollar
buying: the announcement in January of a stronger
than expected report for U.S. employment, testimony by
Chairman Greenspan that further dampened expecta­
tions of an early easing of Federal Reserve monetary
policy, and rumors out of the former Soviet Union of
violence and political upheaval. In other instances, how­
ever, the dollar’s rise was precipitated by the bidding of
market professionals and their customers that reflected
pent-up demand from previous months.

FRBNY Quarterly Review/Winter 1991-92

59

These pressures were particularly intense around
mid-month. The dollar rose sharply to trade at levels
that had not been expected just weeks before and that
therefore threatened to unleash yet further rounds of
bidding as market participants continued to cover their
short positions. Under these circumstances, the U.S.
monetary authorities entered the market on January 17,
in an operation coordinated with the Japanese mone­
tary authorities, selling $50 million against yen. The
intervention sale was shared equally by the Federal
Reserve and the Treasury’s Exchange Stabilization
Fund (ESF). After this operation, the dollar declined
sharply. W hile sub se q u e n tly fin din g s u pp o rt, it
remained below the highs of DM 1.6355 and ¥129.37
reached on January 15. The dollar closed the period at
DM 1.6125 and ¥125.75, down on balance over the
three months by nearly 4 percent against the two cur­
rencies. At these levels, the dollar was about 12 percent
below its 1991 highs against both the mark and the yen.

In other operations, a total of $1,301 million in offmarket spot and forward foreign currency sales, exe­
cuted by the U.S. monetary authorities with foreign
monetary authorities, settled during the period.
• The tw o re m a in in g fo rw a rd p u rc h a s e s of
$551.1 million and $549.9 million against marks
settled on November 27 and December 27, respec­
tively, completing the $5,548.5 million of spot and
forward dollar purchases from the Bundesbank. As
previously reported, the operation was initiated in
June 1991 to adjust the foreign currency reserves of
the Federal Reserve and the ESF. For each trans­
action, 60 percent was executed for the account of
the Federal Reserve and 40 percent for the ESF
account.


http://fraser.stlouisfed.org/
60 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

• On November 22, the Federal Reserve agreed to
purchase $200 million against German marks from a
foreign monetary authority.
The ESF continued to purchase SDRs against marks
in transactions by agreement with the International
Monetary Fund (IMF). During the period, a total of
$341.7 million equivalent of such SDR purchases set­
tled, of which $41 million equivalent was transacted in
the previous report period. The ESF also purchased a
total of $443.4 million against sales of SDRs in transac­
tions by agreement with foreign monetary authorities
needing SDRs to pay IMF charges or for repurchases.
An additional $50.6 million, which was transacted in
October, settled in the period.
The Treasury agreed to participate in a special financ­
ing facility for the first time since March 1991. On Janu­
ary 28, the Treasury, through the ESF, established a
$143 million bilateral credit facility to assist Panama in
repaying its arrears to international creditors. Panama
drew the full amount on January 31. The facility is
scheduled to expire on March 20, 1992.
During the November-January period, the Federal
Reserve and the ESF realized profits of $75 million and
$3.9 million, respectively, from the sales of foreign cur­
rencies. As of the end of January, cumulative bookkeep­
ing or valuation gains on outstanding foreign currency
balances were $3,615.2 million for the Federal Reserve
and $1,941.6 million for the ESF. The Federal Reserve
and the ESF regularly invest their foreign currency bal­
ances in a variety of instruments that yield marketrelated 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, the Federal Reserve holdings
in these securities amounted to $8,938.8 million equiv­
a le n t and the T reasury h o ld in g s am ounted to
$9,203.5 million equivalent, valued at end-of-period
exchange rates.

Treasury and Federal Reserve
Foreign Exchange Operations
August-October 1991

The dollar, having already come down from its post-Gulf
war highs before the beginning of August, moved irreg­
ularly and moderately lower during the August-October
period under review. This development occurred as the
recovery of the U.S. economy appeared both slower to
emerge and less vigorous than had been anticipated in
earlier months. The dollar eased during the three-month
period by over 4 percent against the mark, close to 5
percent against the yen, and about 33A percent on a
trade-weighted basis.1 The U.S. monetary authorities
did not intervene in the foreign exchange markets dur­
ing the period.
A ugust
As the period opened, the dollar was generally trading
with a negative bias, weighed down by widening interest
rate differentials adverse to the dollar. Previously, mar­
ket participants had expected that the United States
would emerge quickly out of recession at a time when
some other economies might be slowing, and that the
large interest rate differentials providing a disincentive
to investment in dollar-denom inated assets would
thereby be eliminated. But U.S. data released around
the beginning of August caused a reappraisal of this
view, raising questions about the vigor of the U.S.
economy and renewing talk of further declines in U.S.
interest rates. At the same time, the Japanese authoriA report presented by Margaret L. Greene, Senior Vice President of
Foreign Exchange at the Federal Reserve Bank of New York. Roger
M. Scher was primarily responsible for preparation of the report.
1The trade-weighted value of the dollar is measured by the Federal
Reserve Board staff's index.




ties were trying to dampen expectations that a reduction
of the Bank of Japan’s official discount rate in early July
would quickly be followed by another such move. In
Germany, new data revealing rising inflation encour­
aged expectations that the Bundesbank would raise
official interest rates to contain inflationary pressures
before the start of important labor negotiations for the
coming year.
Against this background, the dollar showed some
vulnerability to selling pressure in early August, particu­
larly against the mark. Publication of a weak July non­
farm payroll employment report, following a succession
of other worse than expected U.S. statistics, prompted
a 2 percent drop in the dollar from its high of DM 1.7675
on August 2. Evidence that the Federal Reserve had
eased the federal funds rate 25 basis points on August
6 triggered a new round of selling of the dollar against
the mark that took the exchange rate briefly below
DM 1.70 on August 8. But around mid-August when the
Bundesbank announced that it was raising its official
Lombard rate by less than the market had expected, the
dollar almost completely reversed its decline of the
previous weeks. Against the yen, the dollar followed a
similar pattern, easing from a high of ¥138 on August 2
to almost ¥135 about a week later before retracing
some of this decline. But these movements were some­
what more subdued since revelations surrounding scan­
dals in Japan’s financial markets were weighing on the
Japanese currency.
News early Monday, August 19, that Soviet President
Gorbachev had been removed from office sparked a
sudden scramble for dollars. The prospect that the
Soviet leader would be replaced by a reactionary gov­

FRBNY Quarterly Review/Winter 1991-92

61

ernment seeking to roll back the reforms that permitted
liberalization in eastern Europe and the unification of
Germany inflamed the markets’ deepest anxieties about
the outlook for Europe in general, and Germany in
particular. Market participants, seeking currency safe
havens, moved funds out of marks and into other cur­
rencies, including the U.S. and Canadian dollars and
the Swiss franc— currencies thought to be geographi­
cally insulated from whatever potential political disrup­
tion and social unrest might ensue. In a matter of hours,
the dollar rose 7 pfennigs, or about 4 percent, to touch
DM 1.8350 amid fears that the coup attempt would lead
immediately to widespread violence. By the time New
York trading began that day, the dollar had come well off
its highs after reports circulated that a number of cen­
tral banks had been intervening and as the likelihood of
violence in the Soviet Union appeared to diminish. In
these circumstances, no intervention was undertaken
by the U.S. authorities. By Wednesday, August 21,
reports circulated that the putsch had failed and that
Gorbachev would return to office. Market participants
were impressed by the strength of public support for a
more democratic government in the Soviet Union and at
the same time surmised that the threat to continued
liberalization might induce western nations to offer sub­
stantial assistance to eastern Europe. Thus, the outlook
for Germ any and the mark appeared somewhat
improved on balance. In response, the dollar quickly fell
back below its pre-coup levels. By the end of August,
the dollar was trading near levels that prevailed at the
beginning of the month, closing at DM 1.7465 and
¥136.80.
The very sharp swings in exchange rates that
occurred around the time of the events in the Soviet
Union, following the volatility that had been evident
beforehand, had an unnerving effect on many market
participants. There were numerous reports that sub­
stantial losses arising from the Soviet episode had
induced many market participants subsequently to
reduce their position-taking activities. The dollar’s sharp
rise also served as a reminder of the risk of holding
short-dollar positions.
The movement of the dollar against the yen, though
broadly in the same direction, had been less sharp
because the developments in the Soviet Union were
perceived to have a less immediate impact on Japan
than on Germany. As a result, market participants
became persuaded of the merits of using the Japanese
yen as a vehicle for taking positions either in favor of or
against the German mark since the yen might not entail
as much price risk as the dollar.
Early September
In early September, the release of a new round of

http://fraser.stlouisfed.org/
62 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

monthly U.S. data reinforced doubts about the strength
of the U.S. recovery and, in a context of renewed calls
by U.S. officials for lower U.S. interest rates, revived the
negative market sentiment toward the dollar. A steep
downward revision in U.S. nonfarm payroll data was
reported on September 6, following a downward revi-

Chart 1

The dollar declined moderately and irregularly during
the period as doubts arose over the vigor of the U.S.
economic recovery.
Percentage change
3 0 -----------------------------------------------------------------------------------------Exchange Rates
Swiss franc

I I 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 I I I I I I I I I I 1

During the August-October period German interest
rates firmed while U.S. and Japanese interest rates
declined.
Percentage points

10 --------------------------------------------------------------------Three-Month Euro Interest Rates

Germany

— *v

k
--

Vs__

United States
— ♦♦♦<

--

i i i I i i 11 I i i 1 1 1 1 1 , i l l i i I i i 1 1 1 1 i 11 i 11 I T l l J
M

M

J
1991

J

O

Notes: The top panel shows the percentage change of weekly
average rates for the dollar from February 6, 1991. The bottom
panel shows weekly average U.S., German, and Japanese
three-month Euromarket interest rates from February 6, 1991.

sion in late August of U.S. second-quarter GNP growth.
The following week, the Bureau of Labor Statistics
released price data that appeared to suggest that the
risks of reigniting inflation were low. These data, along
with reports of anemic growth in monetary aggregates,

further intensified expectations that more aggressive
easing by the Federal Reserve lay ahead. On Septem­
ber 13, the Federal Reserve announced a 50 basis point
cut in the discount rate to 5 percent.
At the same time, developments in Germany and

Chart 2

Data released during the period reinforced perceptions that the U.S. economic recovery was failing to live up
to expectations.
Percent
0.6

Index
85-

Second-Quarter GNP Growth

Consumer Confidence Index

-----

JRi
:I
- 0.2

■

:

-0.4

I

- 0 .6 '

July 26

August 28
1991
Release dates

September 26

Thousands of persons
109,600--------------------

109,400-

Thousands of persons
--------------------- 18,800
Total nonfarm
payroll employment
------Scale

Nonfarm manufacturing
employment
S c a le ------►

18,700

109,200-

18,600

109,000-

18,500

108,800-

18,400

108,600-

-18 ,3 0 0

1991
Notes: The top left panel shows the seasonally adjusted annual rate of growth in U.S. second-quarter real GNP. The advance,
preliminary, and final releases of the GNP data occurred on July 26, August 28, and September 26, respectively. The top right panel
shows the Conference Board’s consumer confidence index. The shaded portion in the bottom panel represents payroll reports released
during the August-October period and revised on November 1, 1991.




FRBNY Quarterly Review/Winter 1991-92

63

Japan served to improve sentiment for the currencies of
those countries. Market participants felt that because
the Bundesbank’s official interest rate hike in August
was at the lower end of the range of expectations,
another tightening of German monetary policy could not
be ruled out. The contrast in monetary policy orienta­
tion in the United States and Germany weighed on the
dollar relative to the mark. With respect to the yen, the
prospects for interest rates were not so divergent from
those in the United States. Indeed, the Japanese
authorities were seen as exerting downward pressure
on Japanese short-term interest rates to shore up confi­
dence in Japanese financial markets and to respond to
evidence suggesting that the Japanese economy was
losing steam. At times there was even talk in the market
that the authorities in Japan and the United States
might act jointly to lower interest rates. Nevertheless,
the yen tended to firm relative to the dollar as the
outflow of portfolio capital from Japan appeared to be
slowing. Many market participants believed that Jap­
anese firms were anxious to improve the yen liquidity of
their balance sheets, particularly ahead of the fiscal
half-year reporting date at the end of September. It
appeared as well that domestic and foreign investors
were becoming more confident that the time had come
to take advantage of attractive buying opportunities in
the Japanese stock market.
Under these circum stances, market participants
became more willing to sell dollars, and those who
needed to buy felt content to postpone their dollar
purchases. During the first two weeks of September, the
dollar eased more than 3 percent against the mark to
just under DM 1.69 as well as 2 percent against the yen
to just under ¥134.

participants temporarily to question their negative view
of U.S. economic prospects. Furthermore, proposals
then circulating in the U.S. administration and Congress
to encourage bank lending and to cut taxes led market
participants to consider that instruments other than
monetary policy might be employed in efforts to spur
the economy. As a result, earlier expectations that U.S.
interest rates would continue to decline until economic
activity picked up more decisively in the United States
diminished.
This change in expectations roughly coincided with a
revision of expectations concerning German interest
rates. Market participants were becoming increasingly
impressed with evidence of decelerating economic
activity in many of Germany’s neighbors. They were
also aware of the intensifying pace of negotiations
within the European Community over European mone­
tary union. As time passed and the Bundesbank did not
move to raise interest rates again in September, many
market participants began to consider the possibility
that a combination of domestic and international con­
siderations might make another increase in official Ger­
man rates unlikely.
Under these circumstances, the pace of the dollar’s
decline against the mark slowed during the second half
of September, even as the exchange rate eased to its
low for the period under review of DM 1.6577 on Sep­
tember 30. Then in October, the dollar actually firmed a

Table 1

Federal Reserve
Reciprocal Currency Arrangem ents
In Millions of Dollars
Amount of Facility

Mid-September to late October
Starting in mid-September, the dollar drew support
against the mark from developments in eastern Europe.
The economic and political situation there appeared
vulnerable to the kind of sudden political or military
crisis that could cause the dollar to appreciate substan­
tially, as it had during the Soviet putsch. The military
and social disintegration taking place in Yugoslavia was
both a disturbing development in itself and an example
of the risks facing countries trying to make the adjust­
ment to democratic governance and market economies.
Moreover, talk began to circulate that the Soviet Union
might not be able to remain current in its international
obligations, and these financial pressures were seen as
posing severe strains on the Soviet economy ahead of
the difficult winter season.
In early October, economic factors also came to lend
more support to the dollar. Unexpectedly positive data
on U.S. employment and new home sales led market

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64 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

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

October 31, 1991
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

little against the mark and subsequently fluctuated with­
out clear direction, trading as high as DM 1.7218 on
October 28.
Against the yen, by contrast, the dollar showed a
more pronounced tendency to weaken, especially in
early October. As market participants considered the
implications of a deflation of Japan’s asset-price bubble
and consumer boom, the prospect loomed that Japan
might once again develop a troublesome current
account surplus. In fact, Japan’s surplus with Europe
had grown, attracting political attention in at least some
European countries. With the approach of the G-7
meetings in mid-October, talk developed that the major
industrialized nations would agree to seek an apprecia­
tion of the yen as a means of containing Japan’s grow­
ing surpluses with Europe and the United States.
Statements by Japanese government officials suggest­
ing that the yen might appreciate, in addition to a
meeting between U.S. Treasury Secretary Brady and
Japanese Finance Minister Hashimoto before the G-7
talks, encouraged these expectations. When the G-7
communique of October 12 was interpreted as suggest­
ing that the yen’s recent appreciation had been appro­
priate, the yen advanced further against the dollar,
reaching an eight-month high close to ¥128.50. But
thereafter market participants focused anew on the
prospects for a cut in Japan’s official discount rate.
Expectations of continued easing of Japanese mone­
tary policy were reinforced in late October by several
factors, including data releases showing both a further
slowing of growth in Japan’s money supply and a mod­
eration of inflation, official comments promoting lower
interest rates, and the accession to the prime minister’s
office of former Finance Minister Miyazawa— who was
viewed as supporting an easier monetary policy. As a

Table 2

Net Profits ( + ) or Losses ( - ) on
United States Treasury and Federal Reserve
Foreign Exchange O perations
In Millions of Dollars
U.S. Exchange
Federal
Treasury
Reserve Stabilization Fund
Valuation profits and losses on
outstanding assets and
liabilities as of July 31,1991
Realized
August 1, 1991-October 31,1991
Valuation profits and losses on
outstanding assets and
liabilities as of October 31. 1991

+ 1,919.9

+ 321.4

+105.1

+ 9.4

+2,764.8

+ 1,132.6

Note: Data are on a value-date basis.




result, outflows of portfolio capital resumed, the yen
gave up some of its gains, and the dollar was again
trading as high as ¥132.50 on October 28.
Last days of October
During the last days of October, sentiment toward the
dollar turned decidedly negative, and the dollar eased
across the board. Market participants began to forecast
an even feebler U.S. recovery than had been antici­
pated and to expect further easing of U.S. interest
rates. A much worse than expected U.S. consumer
confidence report, coupled with what were viewed as
pessimistic comments about the economy by Federal
Reserve Chairman Greenspan, revived expectations
that the Federal Reserve would move soon to ease
monetary policy. Meanwhile, in Germany, a combination
of rising money supply growth, double-digit wage
demands, and reports from the Bundesbank and Ger­
man economic institutes warning of inflationary pres­
sures appeared to market participants to give the
Bundesbank reason to tighten monetary policy if it so
desired.
Therefore, at the close of the period, market attention
was again focused on the contrasting demands on mon­
etary policy in the major countries. With the existing
interest rate differentials also remaining adverse to the
dollar, the U.S. currency moved lower. The dollar’s
decline against the yen was somewhat constrained in
light of clear evidence that Japanese monetary policy
was also on an easing trend. Yet, the dollar closed the
August-October period at DM 1.6713 and ¥130.75, so
that the decline that had started in midsummer con­
tinued well into fall. At these closing levels, the dollar
was 9 percent below its high against the mark reached
in July but still 16 percent above the all-time low
reached in mid-February during the Gulf war. Against
the yen, the dollar had come down more than 8 percent
from its high in June to trade only 3 percent above its
mid-February lows.
The U.S. monetary authorities did not intervene dur­
ing the period. However, the settlement of a large por­
tion of the U.S. monetary authorities’ forward dollar
purchases against foreign currencies— which, as pre­
viously reported, were initiated in June and July to
adjust the foreign currency reserves of the Federal
Reserve and Exchange Stabilization Fund (ESF)— took
place during the period.
• Three of the forward transactions, entered into with
the Bundesbank on June 25, settled during the
period: $554.9 million on August 27, $553.6 million
on September 27, and $552.3 million on October 28.
For each transaction, 60 percent was executed for the
account of the Federal Reserve and 40 percent for
the account of the ESF. Of the original $5,548.5

FRBNY Quarterly Review/Winter 1991-92

65

million of forward dollars purchased at that time, a
remaining $1,101 million will be settled by the end of
the calendar year.
• The two remaining forward transactions of $1,000
million each against another foreign currency set­
tled, one on August 19 and the other on September
18. The do lla rs purchased were sp lit evenly
between the Federal Reserve and the ESF.
In other operations, the ESF continued to execute
transactions as agreed with the International Monetary
Fund (IMF) to facilitate transactions in Special Drawing
Rights (SDRs). During the period, it sold German marks
against SDRs equivalent to $227.4 million, of which
$186.4 million was settled during the period. The ESF
also purchased a total of $324.1 million against sales of
SDRs with foreign monetary authorities in need of
SDRs for payment of IMF charges or for repurchases, of
which $273.6 million was settled during the period.
As previously reported, the ESF repurchased a total
of $2,500 million of foreign currency warehoused by the
Federal Reserve in August. These repurchases reduced
the amount of ESF foreign currency balances ware­
housed with the Federal Reserve from $4,500 million
equivalent to $2,000 million equivalent.


http://fraser.stlouisfed.org/
66 FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis

During the A ugust-O ctober period, the Federal
Reserve realized profits of $105.1 million and the Trea­
sury realized profits of $9.4 million from the currency
exchanges described above conducted directly with for­
eign monetary authorities. Cumulative bookkeeping or
valuation gains on outstanding foreign currency bal­
ances at the end of October were $2,764.8 million for
the Federal Reserve and $1,132.6 million for the ESF
(the latter figure includes valuation gains on ware­
housed funds). These valuation gains represent the
increase in the dollar value of outstanding currency
assets valued at end-of-period exchange rates, com­
pared with rates prevailing at the time the foreign cur­
rencies 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 October, holdings of such
securities by the Federal Reserve am ounted to
$7,583.4 million equivalent, and holdings by the Trea­
sury amounted to $8,684.9 million equivalent, both val­
ued at the end-of-period exchange rates.

mm
RECENT FRBNY UNPUBLISHED RESEARCH PAPERSf
9128.

Wizman, Thierry A. “ Returns on Capital Assets and Variations in Economic
Growth and Volatility: A Model of Bayesian Learning.” November 1991. With
Connel R. Fullenkamp.

9129.

Akhtar, M.A., and Ethan S. Harris. “ The Supply-Side Consequences of U.S.
Fiscal Policy in the 1980s.” November 1991,

9130.

Park, Sangkyun. “ The Behavior of Uninsured Deposits: Market Discipline or
‘Too Big to Fail’?” December 1991.

9131.

Hardouvelis, Gikas A. “ Margin Requirements, Price Fluctuations, and Mar­
ket Participation in Metal and Stock Index Futures.” December 1991. With
Dongcheol Kim.

9132.

Korobow, Leon, and David P. Stuhr. “ Using Cluster Analysis as a Tool for
Economic and Financial Analysis.” December 1991.

9201.

Wizman, Thierry A. “ What Moves Investment? Cash Flows in a Forwardlooking Model of Capital Expenditures.” January 1992.

9202.

Steindel, Charles. “ Industry Productivity and High-Tech Investment.” Janu­
ary 1992.

9203.

Wizman, Thierry A. “ Evidence from Tests of the Relation between InterestRate Spreads and Economic Activity.” February 1992.

9204.

Johnson, Ronald. “ Price-Adjustment Delays in the Secondary Market for
Developing Country Debt and the Estimation of Asset Pricing. Models.” With
Umran Demirors. February 1992.

9205.

Park, Sangkyun. “ Loan Contraction within a Framework of Moral Hazard.”
March 1992.

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fS ingle 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.




FRBNY Quarterly Review/Winter 1991-92

67

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FRBNY Quarterly Review/Winter 1991-92
Federal Reserve Bank of St. Louis







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