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STABILIZATION

POLICY:

TIME FOR A REAPPRAISAL?
Audrey N. Suellirlgs

The combination
of rampant
tressingly
high unemployment
years

represents

the worst

inflation and disover the last few

conjuncture

of eco-

nomic events since the Great Depression
of the
1930’s. These events have brought severe distress
to many
individuals
and
organizations
and
shaken the foundations
of some economic and financial institutions
that were thought to be invulnerable.
They have also shaken the confidence
of the economics
profession
and caused many
economists to question some of the basic premises
of economic
stabilization
theory.
One of the
long-time
practitioners
of the “dismal science”
recently summed up the feelings of many of his
professional
colleagues
when he woefully
commented that “The old rules no longer apply.”
Reflecting
this attitude,
some economists
are
calling
for a re-examination
of stabilization
theory and for new approaches
to economic stabilization
policy.
This widespread
confusion
and self-doubt
are
of rather recent origin. Only a little more than a
de;ade ago economists
seemed supremely
confident of their ability to control the level of economic activity
and to achieve
a nice balance
among the objectives
of economic growth, highlevel employment,
and price stability.
With an
extraordinary
degree of confidence,
practitioners
of what became known as the “New Economics”
spoke of their ability to “fine tune” the economy.
The Econo~nic Report of the President transmitted
to the Congress
in January
1965, for example,
noted that in the effort
to achieve
balanced
growth in the year ahead “Fiscal and monetary
policies must be continuously
adjusted
to keep
the aggregate
demand for goods and services in
line with the economy’s growing capacity to produce them.”
One can picture a group of economists, seated before a huge console,
feverishly
twisting
dials in order to achieve just the right
mix of policies that will produce the optimum
combination
of economic results.

It should
questioning

be noted at this point that while the
of basic premises
is rather
wide-

spread, it is by no means unanimous.
Indeed a
number of economists
would question the proposition that there has been any change in the economic fundamentals,
and they would deny that
there is anything approaching
a crisis in stabilization policy.
The old rules have not changed,
they say, and all we have to do is return to the
old-time religion.
On the other hand, there are a
few economists
who contend that the entire body
of contemporary
economic theory is without substance and largely irrelevant.
But there are a
great many economists
who have been sorely
troubled by the events of recent years and who
fear that important institutional
changes over the
last several decades have altered the way the economy responds to traditional
stabilization
actions.
More importantly,
perhaps, the unfortunate
combination of strong inflation and high unemployment has caused an important
segment
of the
American
public to question the efficacy of our
economic
system and even our form of government.
The purpose of this article is to review, briefly
and in a nontechnical
fashion, the historical
development
of stabilization
theories
and to describe the recent developments
that have caused
some economists
to begin to reevaluate
these
theories.
The Classical Period
Prior to the Great Depression of the 1930’s, the majority
of economists
were not much concerned
with what we would
call stabilization
theory and policy. The so-called
classical
and neoclassical
school
of economic
thought
was dominant
throughout
the century
and a half between
the publication
of Adam
Smith’s Wealth of Nations and the economic collapse of the early 1930’s.
There was a gradual
growth and refinement
of the basic body of economic thought over this period, and, of course, at

FEDERAL RESERVE BANK OF RICHMOND

3

any given time significant
differences
found in the thinking of the individuals

might be
compris-

ing the classical
school.
Thus, it is difficult to
summarize in a few brief paragraphs
the thinking
of this large and impartant
group of economists
without doing injustice
to individual members of
the group.
Nevertheless,
most of the members
of the classical
school adhered to certain basic
principles,
and it may be possible
to describe
those aspects of the classical
system that were
relevant to the question of economic stabilization.
The classical
and neoclassical
economists
believed the economy
was inherently
self-stabilizing.
A basic feature
of their system was the
concept of long-run full-employment
equilibrium
toward which the economy tended to move. From
time to time exogenous
shocks would disturb the
basic equilibrium
of the system, but there were
powerful
forces, operating
through
the market
system, to return it to a new equilibrium.
Prices.
wages, and interest rates were generally assumed
to be highly flexible
in response
to changes in
supply or demand, although some of these economists recognized
the possibility
of problems arising from sticky prices or xvages.
In

a system

unemploymelit
sitional

possessing

these

of resources

phenomenon,

characteristics.

would be only a tran-

at worst.

Flexible

interest

rates

would

tend

to equate

savings

and invest-

ment

at the

full-employment

level,

and flexible

prices

and wages

goods

and labor

would
would

insure

that

be cleared.

markets
Beyond

for
tem-

porary transitional
periods, changes in aggregate
demand for goods and services would not affect
the level of output and employment;
they only
changed the general price level.
An increase in
aggregate
demand
at a pace faster
than the
growth in procluctive capacity would simply raise
A fall in aggregate
demand
the levels of prices.
would not cause unemployment
; it would merely
reduce prices and wages.
Even the most orthodox of the classical economists recognized the obvious fact that in the real
world depressions
and inflation
did occur, and
that from time to time aggregate
demand might
be inadequate
to insure full employment.
These
rather frequent
periods of depression
were usually considered
to be the result of temporary
disturbances
of markets caused by such things as
speculative
escesses,
a general loss of confidence,
an abnormal
contraction
of credit, or a sharp
decline in the money stock.
In the longer run,
4

ECONOMIC

REVIEW,

the classicists
believed, powerful forces were at
work to restore full-employment
equilibrium.
The
unemployment
that accompanied
depressions was
considered
to be one of two types: It might ‘be
frictional unemployment
caused by people changing jobs, ignorance
of job opportunities
on the
part of workers, or some other temporary
imperfection in the labor market.
Or it could be caused
by collusion
on the part of labor in a stubborn
refusal to accept employment
at a wage equal to
their

marginal

productivity.

Unemployment

the latter

type was considered

orthodox

economists

unemployment

“voluntary.”

even described

of
Some

the massive

of the 1930’s in these

terms.

It is clear from the foregoing that government
stabilization
policies played no role in the classical scheme of things.
Indeed, the doctrine
of
Z&see-faire,
one that called for a minimum of government intervention
in the economic
affairs of
the nation, was the dominant philosophy
during
this period.
The classical
writers
would have
considered
government
intervention
not only a
threat to individual
freedom, but also a destabilizing- force in the economy.
The strength of the
laissez-faire philosophy is indicated by the fact t:hat
Herbert
Hoover was the first American
President to attempt to use the powers of the central
government
to alleviate the harmful effects of a
depression.
It would be a serious
ever,

that

the classical

went unchalleng-ed
to the Great
the period.
great

abounded
Some

mainstream

thought.

Others

from without.
lhe other
suing
analysis,
mons,

Mitchell,

working

attacked
continental

and

Smith

contrib-

the classical
Wicksell

to

States
other

As time event on, the orthodox

of

doctrine

and some of

economists

all economic

the

of this school

approaches
the

days of

within

thought,

and evolution

and in the United

\Yere questioning

doctrine

from the earliest

of these,

different

how-

of the 1930’s. As a matter

In addition,

great

quite

and neoclassical

of classical

uted to the growth

to conclude,

from the days of Adam

Depression

of fact, critics

mistake

were pureconomic

Veblen,

Com-

institutionalists
theory.
economic

theory

seemed to conform
less and less to economic
reality, and efforts to construct
an alternative
increased.
As Hansen notes, this activity became
especially
strong following the turn of the present century,
particularly
among the economists
1~110 began their professional
lives in the period
MARCH/APRIL

1976

around World War 1.l Much of this work was
related to the problem of economic
fluctuations,
and there were many attempts to refute the central tenet of neoclassical
analysis,
the premise
that there is a basic tendency for the economy to
move automatically
toward full employment.
But
the problem faced by these economists
was that
“You can’t beat something with nothing.”
Critics
of the classical
system had no generally
acceptable body of theory to take its place. Even some
of the more effective
dissenters,
such as J. M.
Clark, continued
to use the classical
analysis.
The Keynesian
Revolution
An alternative
theoretical approach
was provided in 1936 with the
publication
of a book by the English
economist,
His General Theory of
John Maynard Keynes.
Employnzent, Interest and &foney is a rather poorly
written and sometimes confusing book, but with the
exception of Marx’s Das Kapital it was perhaps the
most influential
book on economics
since Adam
Smith.
Keynes
attacked
head-on the central tenet of
the classical theory, i.e., the tendency of the economy to move constantly
toward a condition
of
full-employment
equilibrium.
As expounded by a
leading classicist
of that day, A. C. Pigou, this
tendency toward full employment
rested on two
conditions:
(1) flexible
interest
rates would insure full use of resources by equating saving and
investment,
and (2) flexible
wage rates would
ensure full employment,
regardless
of the level of
total demand.
Keynes contended that both of these principles
were fallacious.
Saving and investment
are two
entirely separate processes and are not mutually
determined
by any single variable,
such as the
Saving, he said, is determined
by
interest rate.
the level of income;
the level of investment
depends on the relationship
between
the rate of
interest and the return on investment.
If planned
investment
fell short of the level of saving at full
realized
saving
and investment
employment,
would be equalized through a fall in income (and
saving).
It is possible, therefore,
for equilibrium
to be attained at a level of income below full employment.
Flexible
wages, even if they existed,
A fall in
would not ensure full employment.
money wages would reduce consumption
outlays
and thus reduce total demand for goods and ser-

1 Alvin H. Hansen, A Guide to Keynes
Book Company, Inc., 1953). PP. 4-11.

(New

York:

McGraw-Hill

vices.
The lower level of demand for goods and
services
would lower the derived
demand for
labor and therefore
would not eliminate
unemployment.
It is not our purpose here to discuss the details
of the Keynesian
system.
This has been done
many times over the last forty years, and in the
process many features of the system have been
changed and some that Keynes
considered
important have been ignored.
But the importance
of the General Theory is that it focused attention on
the level of aggregate
demand as the determinant
of the level of output and employment.
Moreover, it provided theoretical
justification
for the
use of governmental
actions to influence employment and prices by manipulating
total demand.
Fiscal policy was justified
on the grounds that
government
spending
is an important
element
of aggregate
demand,
while changes
in taxes
affect the private components
of demand.
Monetary policy could affect the investment
component of demand by changing the level of interest
rates.
If one accepts the idea that the economy does
not move automatically
toward full-employment
equilibrium
(indeed that equilibrium
at less than
full employment
is quite possible)
and that the
government
possesses the power to determine the
level of employment
and prices, then the exercise
of that power becomes inevitable.
And this is
what happened in the years following the publication of the General Theory.
the
boost
War

use

of fiscal

when

policy

government

spending

II wiped out the heavy

had persisted

throughout

ernment

commitment

officially

recognized

Keynes’s

received

emphasis on

an

important

during

World

unemployment

that

the 1930’s and the gov-

to stabilization

policy

in the Employment

Act

was
of

1946.
The Phillips
Curve
Many
early Keynesians
seemed to think of the “full-employment”
level of
aggregate
demand as a relatively
narrow range.
At most points below full employment,
a change
in the level of aggregate
demand would change
employment
with little or no effect on prices. At
points above the full employment
level, a change
in aggregate
demand would change prices with
little or no effect on employment.
As time passed,
however, economists
generally
came to perceive
the “stabilization
band” as comprising
a rather
wide range, and this view received
theoretical

FEDERAL RESERVE BANK OF RICHMOND

5

Chart

THE ORIGINAL

“optimum”
combination
of
inflation
given the Phillips

1

him.
The actual choice, of course, would
reflection
of the values of the policymaker

PHILLIPS CURVE

perhaps,

‘ii
02

I
0

I
2

I

I
4

I

I
6

I

I
8

I

1

,

10’

Unemployment.
Source:

12
(%)

A. W. Phillips. “The Relation Between Unemployment and the Rote of Change of Money
Wage
Rates in the United KinGdom, 18611957,”
Economica,
25, No.
100 (November
1958) 285.

support with the publication
of a paper in 19%
by the British
economist
A. W. Phillips.’
Applying statistical
analysis
to wage and unemployment
data for the years between
1861 and
1913, Phillips
discovered
an inverse relationship
between these two variables.
That is, there was
a tendency for the rate of increase in wages to be
high in periods
when unemployment
was low,
and vice versa.
These
somewhat
unsurprising
findings
became
embodied
in what was called
the “Phillips
curve.”
Although
expressing
an unspectacular
and
rather commonsense
idea, the Phillips curve was
of considerable
importance
in the evolution
of
stabilization
policy.
Since the rate of change of
prices is closely related to the rate of change of
wages, the Phillips
curve provided
intellectual
underpinning
for the concept of a trade off between inflation
and unemployment.
The policymaker was given a choice over a wide range of
combinations
of unemployment
and inflation. Because of the shape of the curve (see Chart l), the
higher
the rate of unemployment,
the lower
would be the cost in terms of additional inflation
of reducing the unemployment
rate; conversely,
the higher the rate of inflation, the less would be
the cost in terms of additional
unemployment
of
policies designed to restrain inflation.
The role
of the policymaker,
therefore,
was to choose the

?A. W. Phillips, “The Relation Between Unemployment and the
Rate of Change of Money Wage Rates in the United Kinadorn.
1861-1957,” Economica. Vol. 25. No. 100 (November 1958). 285.

6

political

considerations.

transmitted
to Congress in January
1962, a 4 percent unemployment
rate was adopted as a “tem-

.

-4

important

be a
and,

Something
similar to the Phillips curve analysis has probably been the basis of economic stabilization policy since World War II, but it was
not until the early 1960’s that it received its most
explicit
statement
as a guide to stabilization
policy,
In the Econonzic Report of the President

1861-1913

t
al

unemployment
and
curve confronting

ECONOMIC

REVIEW,

porary” target.
In a later discussion of this goal,
a member of the President’s
Council of Economic
Advisers
in 1961 stated,
“Four
percent
w:as
chosen with an eye on the Phillips
curve, specifically the 4 percent inflation that accompanied
4 percent unemployment
in the mid-1950’s.“3
Recent Developments
The concept of some sort
of trade off between inflation and unemployment
continues
to play an important
role in economic
stabilization
policy, but in recent years this idea
has come increasingly
into question.
First of all,
Phillips’
work has been subjected
to searching
criticism
with respect to theoretical
and methodological considerations.4
But more importantly
from the viewpoint of practical policy, it has become more and more difficult
to reconcile
the
recent behavior of prices and unemployment
with
the idea of a smooth trade off between the two.
As one economist
notes “. . . there is as yet no
convincing
way of fitting
the phenomenon
of
stagflation
into the framework of post-Keynesian
economics.“6
A number of explanations
have been advan’ced
as to why the postulated
trade off between inflation

and

unemployment

valid.

One

school

terms
ing

of the formation

to this

behavior
experience.
bility,

theory,

are formed

no

longer

explains

of expectations.

expectations

expands

be

this

in

Accord-

of future

price

of past

price

on the basis

If, following

the economy

may

of thought

a period
rapidly,

of price

sta-

wages

may

3 James Tobin, The New Economics One Decade Later
Princeton University Press, 1972), pp. 16-17.

(Princeton:

4 See, for example. M. Desai, “The Phillips Curve: A Revisionist
Economica. Vol. 42. No. 165 (February X975).
Igpretatlon,”
j Hendrik S. Houthakker, “Incomes Policies as a Supplementary
Tool,” in Answers to lnflatim and Recession: Economic Policies
for a Modern Society. ed. by Albert T. Sommers (New York: The
Conference Board. 1975). p. 73.

MARCH/APRlt

1976

be bid up and unemployment
fall below some
“natural” rate. Prices will begin to rise, and the
price expectations
of workers
and businessmen
will be disappointed.
As the inflation continues,
people’s expectations
will be revised;
and this
results in an upward shift in the Phillips curve, so
that each rate of unemployment
is now associated
with a higher rate of inflation.
For any given
rate of inflation,
unemployment
will gradually
rise back to the natural level, and the temporary
stimulative
effect of inflation will vanish.
In the
long run, unemployment
will return to its equilibrium level, and the inflation rate will stabilize.
An attempt
to halt the inflation
by reducing
aggregate
demand will initially
cause a rise in
unemployment.
But persistent
expectations
of
inflation
may cause the Phillips
curve to continue to shift to the right, and the response of
inflation

to a reduction

be excruciatingly
Another
flation”

in aggregate

approach

in terms

of product

demand

and

explains

the

of institutional
labor

ample,

distinguishes

tomer”

product

markets

other.6

in traditional
In customer

not equate

supply

Okun,

what

for

economic

labor marmarkets

analysis

markets,

and demand.

ex-

he calls “cus-

and “career”

product

“stag-

characteristics

markets.

between

recent

kets, on the one hand, and the “auction”
postulated

ma)

slow.

For

on the

prices

do

most prod-

ucts, the price is set by the seller and the quantity
sold is determined
market,

but

expectation
shopping
relationship
customer

by demand

the -price
of

is not

clearing

is costly

the

conditions
market.

and bothersome,

is usually

established

and the supplier.

long-term

employer-employee

established

in labor markets.

in the

established

in the
Because

a continuing
between

In a similar

labor

markets

cause of the stickiness
inflation

is slow

gather

demand

started

a lag.
it tends
and

to increase,

on employment,

Be-

and prices,

but

as it progresses,

may continue

impact

with

of many wages

getting

momentum

and prices
verse

only

to

wages

with an ad-

long

after

excess

is removed.

These
two explanations
of the recent
instability of the Phillips curve are not mutually
exclusive, of course, and there is little doubt that
both help to explain the recent failure of prices
and unemployment
to conform
to the expected
Phillips curve configuration.
One of the weaknesses of the expectations
approach, perhaps, is
that it puts too little emphasis
on the institutional aspects of the problem.
The fact is, most
prices and wages in our economy are not determined in the manner
described
in many economics textbooks.
Producers
of a great many
products
do not think of themselves
as facing
some market-determined
price, and indeed they
are not. They set their own prices, and the most
important
determinant
of any price is the producer’s estimate of current unit costs and anticipated future changes in costs.
Wages of a great
many workers are the result of a collective
bargaining process where the most important factors
are the relative bargaining
powers of the particiAs Okun notes, however, wages in other
pants.
firms and industries,
the firm’s profit picture,
and changes in the workers’ costs of living are
important
considerations.
Moreover,
prices of
most products are not changed very often, while
wage contracts
often cover a period of several
years.

the

fashion,

relationships
A firm’s

and career

are

wage rates

(and number of employees)
may be influenced
very little by short-run
changes in demand, and
Okun emphasizes the concept of “fairness” in the
determination
of long-run wage levels.
Fairness
in this case is defined in terms of the relationship
of the firm’s wage structure to other wages, or to
the price of the firm’s product, or to the workers’
cost of living.
According
to this approach, the
appearance
of excess demand will first be reflected in a rise in prices in the “auction” markets
and will then spread to customer product markets

Implications

for Policy

implications
policy,

for

but just

on the basic

that

that

to expectations
is needed

to

many

expectations,

inflation

there

and the most

Those
that

stability

all

is to

and gradually

to

economists

is always

is
in

believe

price
back

also

of policy

today.

expectations

of the

agreement

of the Phillips

of inflation

unemployment

For

prevails

to achieve

inflationary

move

stabilization

direction

all of the instability

eliminate
rate.

of

is no general

of the problem,

the kind of situation
who attribute
curve

conduct

on the proper

tary phenomenon,
“Arthur M. Okun. “Inflation: Its Mechanics and Welfare Costs,”
Bmokings Papen on Economic Activity. No. 2 (1975), pp. 351-90.

the

as there

cause

no agreement

All of this has important

the

“natural”

emphasizing

and only a moneimportant

factor

in the control of inflation
is the proper use of
tnonetary
policy
to prevent
it from
getting

FEDERAL RESERVE BANK OF RICHMOND

7

started.

Once

tionary
minds

it is started,

expectations

however,

are firmly

of businessmen

and inffa-

embedded

and consumers,

the

way to deal with it is to hold aggregate
below

the full-employment

pectations
manner

are eliminated.
in which

in the

level

until

And

because

expectations

are

only

demand
these

ex-

of the

formed,

this

much
the

more

result

eign

lands

that

early

chovies
valuation

expectations
fears

of creating

caution

against

an

to the inflation

recovery

because

of

These
boost

in energy

cartel,

Many economists
acknowledge
the importance
of expectations
in prolonging
and strengthening
the inflationary
process, but they argue that institutional
factors also play a role. They believe
that fundamental
changes
in our society,
our
economy,
and in the role of government
have
seriously
weakened
the traditional
stabilization
techniques
insofar as the control of inflation
is
concerned.’
Some of these changes have helped
to create an inflationary
bias in our economy,
while others have reduced the effectiveness
of
monetary
and fiscal policy in controlling
inflation.
Foremost
among these changes would be
the decline in price competition
in both product
and labor markets.
This, of course, has weakened
the link between monetary and fiscal actions, on
the one hand, and prices and wages, on the other.
In addition, welfare programs
and income maingovernment
and private intenance policies
of
dustry have reduced the incentive
for workers to
search diligently
for employment
or to accept
At the same
employment
at a reduced wage.
time, minimum wage laws contribute
to the inexorable
rise in wage rates and, some believe,
they may price many unskilled
workers
out of
the labor market, thereby aggravating
the unemRegulatory
policies of govployment
problem.
ernmental agencies sometimes make price competition in the regulated
industry
impossible
and
contribute
significantly
to the downward inflexibility of prices.
Finally,
subject
own

our economy
to

influences
The

borders.

international

trade

last two decades

has become
originating

outside

elimination
and financial

has served

of

barriers

flows

over

on foreign

our
to
the

to tie our economy

s

ECONOMIC

REVIEW,

of the an-

and the sharp

de-

greatl)States.

imposed

by the sharp
by

the

of our growing

OPEC

dependence

of fuel and raw materials.

Some, but by no means all, of those economists
who emphasize
institutional
factors and market
imperfections
advocate
some kind of incomes
policy.
These proposals
range from guideposts
and jawboning,
to control of certain basic materials prices, to full-scale
wage, price, and profit
controls.
Some advocate temporary
use of these
powers during periods of inflation on the ground
that their use would speed the adjustment
Iof
price expectations.
Others advocate a permanent
system of controls on the ground that it is needed
to offset the market power of large corporations
and labor unions. A great many economists question the efficacy
of permanent,
full-scale
wage
Such controls,
they argue,
and price controls.
would seriously
distort
the functioning
of the
economy and lead to the inefficient
allocation
of
resources.
Some are skeptical of temporary
controls on the ground that they are ineffective.
Economists
of all persuasions
favor some type
of “structural”
reform that would eliminate many
of the institutional
features
that contribute
to
the inflationary
bias in the economy or tend to
reduce

the response

of wages

ditional

stabilization

policies.

ingly,

there

is little

many

of the
interests,

significant

we have
ditional
MARCH/APRIL

reforms

affect

experience

stabilization
recognize

stabilization

list

A great
powerful

obstacles

clearly

reappraisal

had do not call

1976

reforms.

to any

in this area are formidable.

Recent

should

to tra-

not surpris-

on the specific

and the political

the need for a serious
to economic

But

in these

proposed

action

Conclusion

and prices

agreement

of items to be included

praisal
‘See, for example, an address by Arthur F. Burns. “The Real
Issues of Inflation and Unem~b~ment,”
delivered at the University
of Georgia, September 19. 1975.

oi

failure:5

contributed

were followed

prices

boom

crop

in the United

experienced

sources

vested

increasingly

economic
with

disappearance

an illustration

expectations.

for

of Peru,

developments

inflationary

01)

believe,

of the U. S. dollar,

would

new

impact

Some

coupled

a rapid

factor

to achieve

with
in for

important

worldwide

off the coast

period of time.
who stress

attempt

the

1970’s,

abroad,

developments

an

the temporary

In a period like the present,

the

economies

economy.

abroad,

can be done only over an extended
those

have

in our

example,

to

economic

may

conditions
the

closely
that

tools.

policy.
first

indicates

of our approach
that

Such

for a scrapping
Indeed,

a reap-

the problems
some

of trawould

say that most of our recent problems
resulted
from ineptitude
in the use of these traditional
tools. But demand management
is still necessary
because inadequate
demand can cause unemployment and excess demand can create or exacerbate
inflation.
At the same time, the limitations
of
these tools should be recognized.
They are primarily effective
in dealing with economic instability arising
from an excess
or deficiency
of
aggregate
in dealing

demand.
They- are not very effective
with price increases arising from crop

failure, the actions of an oil cartel, or against the
cost-push
price pressures
so prevalent
in our
economy today.
If used to combat this type oi
inflation
they can be very costly, not only in
terms of unemployment
and lost output, but also
in terms of a weakening
fabric of our society.

of the social

and political

Efforts
to control inflation and achieve an acceptable level of employment
have not been very
successful
in recent years.
This has been partly
because of the extraordinary
nature of some of
the disturbances
that have rocked the econom>
and partly because of the stubborn persistence
of

inflationary
espectations.
In the absence of other
approaches to economic stabilization,
perhaps too
much has been expected of the traditional
techniques. This seems to have been particularly
true
Some of the more ardent
of monetary
policy.
champions of monetary policy have claimed more
for that policy than it can deliver, with the result
that the central bank has been subjected
to a
great deal of criticism.
Such exaggerated
claims
may seriously
impair the ability of the Federal
Reserve
System to perform its traditional
functions.
It may be that the recent problems of economic
stabilization
are a passing
phenomenon,
but if
they are not, new policy approaches
may have to
be developed.
The most obvious first step would
appear to be the elimination
of artificial
barriers
to competition
in labor and product markets and
the alteration
of structural
features that reduce
the flexibility
of the economy.
But in order to
achieve a reasonable
degree of economic stability
in the years ahead it may be necessary to develop
new policy tools to supplement
those presently
in use.

FEDERAL RESERVE BANK OF RICHMOND

A REVIEW OF THE
MUNICIPAL BOND MARKET
Richard H. Rosenbloom

Recent

developments

in the

municipal

bond

market have increased
public awareness
of the
problems state and local governments
face in obOf speciai concern to
taining debt financing.r
many interested observers is the recent steep rise
in the yields on municipal bonds relative to those
on corporate
bonds with the same credit rating.
This article undertakes
to assess the significance
of this development
through an evaluation
of recent trends affecting
both the supply of and demand for municipal
bonds and the resulting
effects on the borrowing
costs of state and local
governments.
The discussion focuses on the primary (new issue) market for municipal
bonds
with emphasis
on market participants,
market
trends over the past fifteen years, recent market
developments,
and the probable future course of
the market.
Measurement
of Municipal
Bond Market Conditions
Municipal
bonds have generally
the same
investment
characteristics
and attributes
as corporate bonds with one fundamental
exception.
The interest
income
from municipal
bonds is
exempt from Federal income taxation.2
This taxexempt
feature
makes
municipals
sufficiently
different from corporates
that it is uncommon to
find the two types of bonds together in the same
portfolio.
The purpose of the tax-exempt
feature
is to lower the borrowing costs of state and local
governments
by enabling them to offer investors
a lower yield that is competitive
with the aftertax yield available on corporate bonds.
The relationship
between the yields on equal
credit-rated
municipal and corporate bonds differs
for investors
in different
income brackets
since
the value of the tax-exempt
feature, given a progressive
income tax structure,
increases
as taxable income moves into brackets
for which the
1 Municipal bonds are any tax-exempt debt security of a state or
loyal government. agency. or special authority.
*In many cases. the interest income is also exempt from state and
local taxation in the issuing state and/or locality.

10

ECONOMIC

REVIEW,

tax rate is higher. The investor in tax bracket “t”
would be indifferent
between investment
in corporates
(1)

and in municipals
Rm =

when:

Rc(l-t)

where Rm = the yield on municipal bonds, Rc =
the yield on corporate
bonds, and t = the marginal tax rate at which the after-tax
yields on
municipal and corporate bonds are equal.
Given
t and Rc, equation
(1) determines
the minimum
municipal yield necessary
to induce investors in
tax bracket t to buy municipal
rather than corporate bonds.
When
transposed,
the equation
can be solved for t as follows:
(la)

t =

1-

Rm/Rc.

This equation
says simply that given the relationship between yields on municipals
(Rm) and
yields on corporates
(Rc), the marginal tax rate
at which investors
are indifferent
between
the
two types of bonds is automatically
determined.
The relationship
between
Rm and Rc can be
affected, of course, by factors other than the value
of the tax exemption to investors.
Relative risks
and call protection,
for example, could be major
factors.
However, the risk factor has been minimized in the discussion
by using both Aa-rated
corporate
and Aa-rated
municipal bonds and by
assuming the risk relationship
between them has
remained stable.
The call protection
factor has
been minimized by the use of corporate and municipal bonds with approximately
the same call
protection.
The relationship
Rm/Rc
is a widely
used
measure
of conditions
in the municipal
bond
market relative to other capital markets and specifically
to the corporate
bond market.
High
levels of Rm/Rc are taken to indicate relatively
tight credit conditions
in the municipal
bond
market, while low levels of Rm/Rc indicate comparatively
easier credit conditions
for municipal
borrowers.
MARCH/APRIL

1976

The course of Rm/Rc
over the past fifteen
years is shown in Chart 1. As can be seen, the
movements
are quite erratic with no long-term
trends. There are, however, a number of conspicuous short-term
movements
that merit examination along with the general volatility of the series.
The Supply of Municipal Bonds Municipal bonds
are issued by state and local governments
and
their special governmental
agencies and authorities primarily
to finance capital outlays that are
too large to be financed out of current revenue.
In many cases a new agency or authority, such as
a transportation
authority,
is created solely to
issue bonds for a specific project and, perhaps, to
administer
the project upon completion.3
There are two general types of municipal bonds
--general
obligation
bonds and revenue bonds.
General
obligation
bonds are “full faith and
credit” obligations
of the issuing body. As such,
they are secured by the taxing
power of the
issuer.
These
long-term
debt obligations
are
usually issued as serial bonds” with maturities
from 1 to 30 years.
Revenue
bonds are issued
primarily
by governmental
authorities
that have
no taxing power. They are secured solely by the
revenue collected from the users of the particular
capital project funded by the debt issue.
Thus,
the credit quality of a revenue bond is directl)
related to the ability of the issuer to collect revenues from the project involved.
In the case of a
well established
sewer authority this credit qunlity is likely to be high, whereas the bonds of a
new mass transit authority in a low-density
city,
for example, might be more speculative.
These
obligations
consist largely of one or two longterm issues with a smaller amount of serial bonds
with shorter
maturities.
One type of revenue
bond worth
noting
is the “moral
obligation
bond.”
This type of bond is secured by earmarked revenue and by a promise from the issuing government
to appropriate
funds from general revenues
to cover debt service if revenues
prove insufficient.
The credit quality of these
bonds is as good as the promise or moral obligation to redeem them.
Occasionally,
state and local governments
will
issue short-term
debt in the form of tax, revenue,
or bond anticipation
notes, which generally
have
” In many cases special authorities are established to provide services
“off-budget,” thereby bypassing state constitutional requirements for
balanced budgets.
4 Serial bonds are single bond issues comprised of many different
maturities, as opposed to a term bond issue in which all the bonds
have the same date of maturity.

FEDERAL RESERVE BANK

a maturity
of less than one year.
As the name
implies, tax and revenue anticipation
notes are
issued to aid cash flow while waiting for taxes
and revenues to come in, at which time the debt
is retired.
Bond anticipation
notes are generally
issued to finance a project during periods of tight
credit conditions to prevent getting locked into a
high rate, long-term debt obligation.
When more
favorable
credit conditions
develop,
the shortterm debt is refinanced
by a bond issue.”
The growth in the dollar amount of total state
and local debt outstanding
is shown in Chart 2.
Examination
of this time series reveals a remarkable stability
in the growth of outstanding
municipal debt. The quantity outstanding
increased
in every quarter from 1960 through 1975. From
early 1960 to the middle of 1968, the growth was
nearly
constant
at an average
annual rate of
approximately
6.S percent.
In the middle of 1968
a significant
shift in the growth path occurred.
The average growth rate accelerated
from 6.8 to
approximately
S.4 percent per year. Late in 1970
the growth rate again accelerated,
in this instance
from 8.4 to 10.4 percent per year.
These
sharp increases
in the growth of the
supply
of municipal
bonds offered
each year
might be explained
by the acceleration
in the
pace of inflation
in 1968 and again in late 1970.
particularly
the acceleration
of construction
costs.
This development
had two effects.
First,
as

3 See J. E. Petersen, “Response of State and Local Governments to
Varying Credit Conditions,” FedewE Reserve Bulletin, March 1971,
p. 209.

I

Chart 1

,;;;’

,

;RATIO OF MUNICIPAL BOND +
: CORPORATE .BOND YIELDS,

,’ ; ;~o

Percent

I

1974 I’
1970
1972
1968
.1964 .i 1966
.,.1960,,G, .1962
,.
_,
,
. .
‘i.“‘,:, ‘Note: Rat& computed from the ‘municipkl yield’ o,n. new,’
,: i : issue redffering of Aa bonds compjled by.Secuiities
_‘,, *
c’ _,
’ lnd,itstry ,Association and the corpomte yield”,on
.,“‘.
L,.
ney issue; reoffaring of’ deferred toll ..Aa ‘bonds
T <>“,
‘compiled by Solomon Brothers:
I
-*
sourcei~ U..: S. Treasury Department,
Treasury &II&;
,xq .’
_
So!bmon ‘8rothers, ~Andytical
Record of ‘Yiis
1
‘and Yield Spreads.

OF RICHMOND

11

to the yield on municipal
are stable, little short-term
yields

rise,

short-term

bonds.
When yields
financing is used. As

bond

anticipation

notes

are increasingly
used while finance officers await
lower rates, which sometimes
fail to materialize.
As yields turn lower, the short-term
debt is retired by the issuance of bonds.
Another
interesting
development
concerning
the supply of municipal bonds is the increasing
use of revenue bonds as opposed to general obligation bonds.
In 1960 revenue bonds accounted
for approximately
27 percent of total bonds issued. By 1975 this percentage
increased to nearly
40 percent.
This

shown in Chart 2, it increased
the cost of construction,
thus requiring
a Iarger bond issue to
finance any given project.
Second, to the extent
inflation
impacts
on expenditures
more rapidly
than on revenues,
it increased
the costs of providing government
services,
which are payable
out of current receipts.
This reduced the availability
of funds from current
receipts
to help
finance
capital
projects.
Consequently,
more
bonds were issued to help fill this gap.
The
growth in state and local debt may also have been
affected by the entry of New York City into the
long-term
market to finance operating
expenditures and by sharp increases
in short-term
debt
issuance by New York City and New York State.
The stable and continued
growth of the total
supply of outstanding
municipal securities
masks
some changes
in the composition
of the tota
supply that warrant
examination.
As shown in
Chart 3, the percentage
of total municipal
debt
outstanding
accounted
for by short-term
debt is
small but increasing.
It is a highly volatile function but seems closely related, with a small lag,
12

ECONOMIC

REVIEW,

increasing

use of revenue

bond financing

reflects
two influences.
The first is the apparently growing
reluctance
of taxpayers
to pa.y
higher taxes for debt service and, thus, their disinclination
to approve
new general
obligation
bond issues. Accordingly,
state and local governments
have increasingly
resorted
to revenue
bonds, which do not require voter approval.
The
second influence is the enlarged concept of what
constitutes
a proper government
service and the
growing
feeling that, as much as possible,
t’he
users of particular
government
services
should
pay for them.
This enlarged concept of government services is particularly
evident in the gro’wing use of tax-exempt
financing
to obtain funds
for pollution control and industrial
development
projects, which are then leased or sold to private
businesses.
The governmental
unit is, in effect,
an agent
of industrial
tax-exempt
borrowing.
Ostensibly
the government
service is the attraction of business
enterprises
to provide employment.
More frequently,
therefore,
governmentsponsored corporations
or authorities
are created
to issue bonds, provide services,
and collect the
revenues to retire the bonds. Revenue bonds are
likely to continue to be of growing importance
in
the municipal bond market.
To sum up, the supply of municipal bonds has
grown at a steady pace with no apparent relationship to the business cycle. While there have been
some structural changes in the component
mix of
the supply of municipal bonds, there seems to be
no reason to believe that supply phenomena
in
the municipal
market
are responsible
for the
movements in the ratio of the yields on like-rated
municipal and corporate bonds.

The Demand for Municipal Bonds
tas-exempt
MARCH/APRIL

nature
1976

of municipal

Due to the
bonds, investors

vestors in recent
instructive.

years

may,

accordingly,

prove

Com~~tercial banks Of fundamental importance to
the understanding
of developments
in the municipal bond market is the fact that the demand
for municipal
bonds by commercial
banks is a
residual demand, i.e., banks purchase municipals
with any funds remaining
after commitments
to
The primary
other borrowers
have been met.6
investment
and much

outlet for commercial
banks is loans,
of the variation
in commercial
bank

participation
be explained

in the municipal
bond market
by variation
in loan demand.7

can

Chart 4 shows an index of loan demand pressure expressed as the ratio of commercial
loans
to time deposits. 8 This ratio is intended to mea-

are generally
those persons and institutions
subject to high marginal
income tax rates.
Chief
among these are commercial
banks, individuals
and individual trusts, fire and casualty insurance
companies,
and to a lesser extent, nonfinancial
corporations
and life insurance
companies.
Although

not immediately

municipal
more

so since

mentioned
vidual

demand

centage

While

In

holdings

all

for 67 percent
; by the third

the

previously
indi-

bank demand

1960
of

individual
municipal

are
and

bonds

of the total amount
quarter

for

and has become

in the market,

and commercial

bank

the market

narrow

participate

importance.

commercial
standing

1960.

groups

of prime
accounted

apparent,

bonds is rather

of 1975 this

outper-

had risen to 78 percent.

The nature of the demand for municipal bonds
may offer a reasonable
explanation
for the erratic
movements
in municipal bond market conditions
relative to other capital markets shown in Chart
1. An examination
of the patterns of investment
behavior by various types of municipal bond in-

sure the extent
to which banks have residual
The relationship
between
the
funds available.
loan demand pressure and commercial
bank participation in the municipal market is quite clear,
particularly
during the tight credit conditions
of
3968-69. Generally as loan demand pressure falls,
demand for municipal bonds by banks rises.
As
loan demand pressure rises, due to either a rise
in loans or a runoff of time deposits, municipal
bond demand by banks stabilizes
or falls.
A
notable excepTion to this tendency, however, has
developed since the third quarter of 1974. During
that period boTh loan demand pressure and bank
demand for municipals
have declined.
This recent experience
suggests
the presence
of a new
influence tending to reduce bank demand for municipal bonds, a development
which will be discussed later.
Commercial
banks are presently
the primary
holders of municipal bonds, although this was not
always true.
To maintain
liquidity, banks tend
to prefer
shortor intermediate-term
bonds.
Chart 4 shows the municipal
bond investment
record of commercial
banks, both absolutely
and
relative to the entire market.
The dollar amount
of bank holdings has trended generally
upward,
but not without interruption.
Prior to 1961 the
‘: For a discussion of commercial bank demand for municipal bonds
as a residual demand see Donald R. Hodgman, Comma-oial Bank
Loan and Investmeat Policy, (University of Illinois: Bureau of
Economic and Business Research, 1963). pp. 38-45; and Stephen 1.
Goldfeld, ConmnemiaZ Bank Behevim and Economic Activity, (Amsterdam: North-Holland Publishing Company. 1966).
: See Hodgman.
SThis measure w-as chosen because it is used as a portfolio balance
variable in explaining municipal bond demand in many econometric
models. In the FMP model (a large econometric model used by the
Federal Reserve Srstem), for example, the commercial loans/time
daposits ratio is used in the equation determining the municipal
Lund yield.

FEDERAL RESERVE BANK

OF RICHMOND

13

creased from 25 percent in early 1960 to over 50
percent in 1972. Tight credit conditions
in 1966
and in 1968-69 temporarily
interrupted
this rising

‘SlATi AND LOCAL DEBT HELD BY _.i,’
. COMMERCIAL BANKS COMPARED TO4NDEX,
‘) ,OF;LqAN DEMAND PRESSURE

trend, especially
in the latter period.
More recently,
the percentage
has declined
since the
middle of 19i2, with the decline accelerating
since
the spring of 1974.
Individwls and individual trusts
For individual
investors the principal investment
alternatives
to
the municipal bond market are the stock and corporate bond markets.
The reasons for this are

Index of
w

that capital
.
,yJ;”

Percent
of Debt Held

gains

are taxed

at a lower

rate than

regular income and corporate
bonds can provide
an income-producing
alternative
to municipals,

r’
,’
A’,A

depending,
of course,
on the individual’s
tax
bracket.
While there is probably a hard core of
high income, risk-averse
individuals
who seldom
seek investment
alternatives
to municipal bonds,
changes
in stock prices and the corresponding
changes
in opportunities
for capital gains may
cause other, less risk-averse
individuals
to alternate between stocks and municipals.
The variation in individual participation
in the
municipal
bond market
can be explained
to a

I‘:y(ji1

1

.394&l’
i)
%A
,.,. Notes:
,;

.il

I

1

I

193396%

I

L

1966

I

I

‘1966

I

I

,

1970.

I

I

1972

I

,

.;1974’
..,

,’

indei,of
loan demond pressure computed from
‘the FMP model .doto base. Percent of debt held
:
,, ~~cotiputed from Flow of Funds data.

Sources:

Board of Governors of the Federal Reserve
System, Flow of Funds and FMP model data
base.

participation
of commercial
banks in the market
was limited and erratic.
From mid-1961 to late
1968 holdings grew steadily with the exception
of one quarter
of liquidation
during the tight
credit conditions
of 1966.
In the latter part of
1968, due to increasing
loan demand pressure,
banks sharply curtailed new purchases of municipal bonds and did not resume them until early
1970. As will be seen, their departure from the
market at this point was responsible
for a rise in
Rm/Rc
much like that experienced
from the
second quarter of 1974 through the first quarter
of 1975. The growth in holdings then continued
from early 1970 until early 1974, when banks
again essentially
pulled out of the new issue
They have yet to return in any signifimarket.
cant way.
As shown in Chart 4, the percentage
of total
municipal
debt outstanding
held by banks
in14

ECONOMIC

REVIEW,

1960,

J962‘

1966

Percent of debt
Funds data.

Note:
) Sources:

MARCH/APRIL

1964

196R

1970%: 1972

heid computed
._.
,,

zi974’:
??
,,
”
from $0~
‘of’
”
‘_
,.

Board of Governors, of .;he^ Federal ;.Reierve;‘-.”
System, Flow of Funds, cind Federal :Rescrvo
.,
Bulletin.

1976

large degree by variations
in stock prices and in
the level of municipal
bond yields relative
to
yields on other bonds (Rm/Rc).
The data in
Chart 5 indicate a pronounced
inverse relationship between stock prices and individual holdings
of municipals.
As stock prices rise, bond holdings are increased
at a slower rate or are liquidated ; the reverse
seems to be the case when
stock prices fall.
This reverse
relationship
is
particularly
evident during the periods of generally declining stock market prices from the fourth
quarter
of 1968 through
the second quarter
of
1970 and from the first quarter of 1973 through
the third quarter of 1974.
The relative level of bond yields (Rm/Rc)
is
important
to individual
demand for municipals,
because as the yield ratio increases the number of
potential
individual
investors
rises.
Unlike the
institutional
investors,
most of whom face approximately
the same income tax rate, individual
investors
face different
tax rates.
As Rm/Rc
rises, t (the tax rate of indifference)
falls, lowering the marginal
tax bracket
at which investment in municipals
becomes
attractive
to individuals.
For this reason when banks or other
institutional
investors
leave the market,
yields
rise until t falls sufficiently
to encourage enough
individuals
to fill the gap in the demand for municipal bonds and thereby clear the market.
Individuals
and individual
trusts are now the
second most important source of demand for municipal bonds, having fallen from the dominant
position that they held during the first half of
the 1960’s.
These
investors
tend to hold the
longer maturities
of an issue.
Chart 5 shows the
municipal
bond demand by individuals
in absolute and relative
terms.
Although
there is a
general
upward trend in the dollar volume of
total bonds held by households,
its movement
is
much more erratic than that displayed by bank
holdings and shows many periods of liquidation.
In relative terms, household
demand for municipal bonds has exhibited
a general downward
trend since 1960.
Individual
holdings
declined
from 43 percent of total outstandings
in 1960 to a
low of 26 percent in 1972-73.
Recently,
however,
this fraction has increased to 30 percent, largely
as a result of the decline in the market share of
commercial
banks and the introduction
of municipal bond funds that facilitate
investment
by
individuals.
Generally
speaking,
the high
in recent years may be expected

rate of inflation
to have reduced

the attractiveness
of fixed income securities.
But,
combined with a progressive
tax structure a high
inflation rate raises the marginal tax bracket of
many individuals,
thereby
increasing
the value
of the tax-exempt
feature
of municipal
bonds
through
a reduction
in the effective
after-tax
yield on taxable
securities.
Chart 5 suggests
strong demand for municipals
by individuals
in
recent months.
This demand may be associated
with high municipal
yields relative
to taxable
bond yields and to uncertainty
about the extent
of the stock market recovery.g
The present high
level of demand by individuals
for municipal
bonds is easily understood
when it is realized
that investors in marginal tax brackets as low as
30 percent
(i.e., t I
30) receive
a return on
municipal bonds greater than the after-tax
yield
available
on corporate bonds.
Fire and casualty insurance companies
Fire and
casualty insurance companies are ranked third in
importance
in the municipal bond market.
These
companies,
like commercial
banks, are subject to
the standard corporate income tax rate and thus
desire the tax-exempt
income municipal
bonds
can provide.
Unlike
life insurance
companies,
fire and casualty insurance companies cannot accurately predict their probable losses; thus their
net taxable income, as well as their cash needs,
are highly variable.
For these reasons, the demand for municipals
of any fire and casualty
insurance
company is unstable.
However, while
any particular
company may be highly erratic in
its purchases,
fire and casualty
insurance
companies as a group are the most stable source of
demand in the market.
Chart 6 shows a steady
upward trend in holdings
of this group since
1960, with no periods of liquidation.
In the first.
quarter of 1971, fire and casualty insurance companies
markedly
increased
their rate of purchases, and their percentage
of the market also
began to rise.
Their
market
share stabilized
again in the third quarter of 1973, however.
The percentage
of total municipal outstandings
held by fire and casualty
insurance
companies
was remarkably
stable from 1960 through 1970 at
approximately
12 percent.
By 1973, this market
share had increased
to its present
level of 15
percent.
Recent reductions
in purchases
appear
to be due to lower industry profits and should
prove temporary.
BMunicipal bond funds, a primary bond investment instrument of
individuals. set an all-time sales record of $1.05 billion in the first
half of 1975 compared to $1.26 billion in all of 1974.

FEDERAL RESERVE BANK

OF RICHMOND

15

Experience in the Municipal Bond Market

Past

Due to the residual nature of the demand for municipal bonds by the commercial
banks, the overall composition
of demand is highly sensitive to
developments
in other capital markets and in the
The participation
of various
economy generally.
investor

groups

changes

greatly

ods as well as over the longer
ation in the composition
bonds

seems

movements
Figure

to

be

of demand

a major

1 illustrates
in

the

changes

Rm/Rc

and the municipal
in the
among

marginal

tax rates

cial bank

Nonfinancial
panies

corporations

Both individually

cial corporations
relatively
cause

they

the tax
rate

exemption,

on these

corporations
ing

buyers

companies

of municipal

to take

market

institutions

demand

for

causes

to

high

in commer-

by a decline
municipal

An

municipal

subject

an increase

triggered

pressure)

affect

in general.

of demand

(e.g.,

through

composition

in loan

bond

prices

In

held roughly
life

1972
: ‘:<

1974
;

be-

1960,

3 percent
insurance

of
tax

nonfinancial
of outstandcompanies

The market share of each fell to
held 5 percent.
roughly 2 percent by the first quarter of 1975.
The participation
of these investors
is the most
erratic of any in the market.
Nonfinancial
corporations primarily
buy short-term
obligations
to
meet cash management
needs.
For most of the
1960’s, life insurance
companies
were a supply
factor in the secondary
market rather than a demand factor in the new issue market,
although
their purchases
of new issues have recently
inIn general, these two investor
groups
creased.
have little impact on the municipal bond market.
16

explaining

are

full advantage

due to the low effective

while

factor

bonds.

buy few municipals

companies.

municipals,

for municipal

and as a group, nonfinan-

companies

are unable

vari-

and 1$e inszdrance com-

and life insurance

insignificant

Life insurance

peri-

This

mechanism

demand

level

securities

demand

short

in Rm/Rc.

which
increase

over
term.

ECONOMIC

REVIEW,

,,-#-----------

Fire and Casualty insurance Cor.
-*----

Life Insurance Cos.
s
1 *
0.’
1960
1962:
,. ( .‘,

:

i

‘~Sources:
>’
L
‘,,
’
‘..

MARCH/APRIL

1976

*
(.
1964
a

,’

*.
1966

*
1968

a
1970
‘,

,,

Board of Governors of the Federal R&e
Sys- j
tern, .Fkw of Funds; U.: S. Treasury ~Dq&tment~
Treasury Bulletin; Solomon .Brot@s,
+nni$jL$
8,
Record of ,Yields’and Yield. Spreads’ L ;’ ;: ,_ ‘,
.’ ,>‘,> .’ .,
(,

Total Demand

for Municipals

Inflation

General

Economic Activity

to rise, resulting
in lower levels of Rm/Rc and
thus higher levels of t. At the higher levels of t,
the relative attractiveness
of municipal bonds declines along with the value of the tax exemption.
Individual
demand for municipals
falls as many
individual investors
forego purchases of municipal bonds in favor of alternative
investments
in
stocks and corporate bonds. Under these circumstances
most investors
are in the same tax
bracket as the marginal investors, and all receive
a yield very near the after-tax
yield available on
corporate bonds.
When demand for municipal
bonds declines
among
tax-exposed
institutional
investors,
as
when loan demand pressure rises, the situation is
Municipal
prices fall, causing Rm/Rc
reversed.
to rise and t to fall.
This falling level of t increases the value of the tax exemption
and the
demand for municipal bonds among investors
in
lower tax brackets,
thereby inducing individuals
and tax-sheltered
institutions
to enter the market.
Due to progressive
taxation,
a larger number of
individual investors will be in tax brackets above
the marginal tax bracket
(t) of the marginal investors.
Thus, in this situation,
many more investors receive a tax-exempt
yield considerably
greater than the after-tax
yield available on corporate bonds.
Chart
municipal
to

7 shows
bonds

corporate

generally

the composition

of demand

and the ratio of municipal

bond

yields

since

fell from 1961 through

1960.

for
bond

Rm/Rc
the second quar-

Rate

ter of 1968. This fall was due to the rising market participation
of commercial banks (caused by
generally falling or stable loan demand pressure),
which also reduced the participation
of individual
investors.
In the second quarter of 1968 Rm/Rc
started a steep rise (steeper than the recent one)
that lasted, with one interruption,
through the
second quarter of 1970. This period was one of
high loan demand pressure
on banks.
To accommodate
Ioan customers,
commercial
banks
halted new purchases
of municipal bonds.
The
departure
of banks from the municipal
market
reduced
institutional
demand
for municipals,
causing Rm/Rc to rise and t to fall until individual demand for municipals, spurred both by rising
Rm/Rc and falling stock prices, rose sufficiently
to clear the market.
The

rising

Rm/Rc
generally

and

decline

to the second
loan
for

participation
the

demand

of institutions

participation

from the second

quarter

of 1974.

pressure

municipal s resumed

1970 and rose through

conditions,
in the
the first

caused

of individuals
quarter
Owing

of 1970
to easier

bank
first

to

demand

quarter

quarter

of

of 1972.

At that time a period of relative stability in bank
demand for municipals
began that lasted until
the second quarter of 1974. lMunicipa1 bond demand by institutions
was aided by the growth in
municipal
market
participation
of fire and casualty insurance
companies
from 1971 to 1973.
This institutional
demand supplanted
a portion
of the participation
of individuals,
whose market

FEDERAL RESERVE BANK

OF RICHMOND

17

share declined from the first quarter of 1970 to
the third quarter
of 1972, due both to falling
Rm/Rc and rising stock prices, and then stabilized

until

the second

quarter

of 1974.

Recent
quarter
of the

Developments
and Problems
The second
of 1974 brought an increased
awareness
importance
of commercial
banks to the
While
the financial
municipal
bond market.
problems of many cities have been widely publicized as the main reason for the recent steep rise
in Rm/Rc,
it would appear that the decline in
commercial
bank participation
in the market,
from the second quarter of 1974 to the present, is
The rise in Rm/Rc has been
the .primary cause.
further aggravated
by a decline in the demand for
municipals
by fire and casualty
insurance
companies in the first quarter of 1975, because of a
low level of industry profits.
The significant
fact about the recent developments is that bank demand for municipals
has
fallen during a period of slack loan demand pressure, as is shown in Chart 4. This unprecedented
situation
indicates
that a departure
from traditional patterns of demand for municipal bonds by
commercial
banks may be occurring.1°
Banks
have found other profitable
methods of tax-sheltering their income through
leasing and foreign
operations.
Leasing
operations
enable banks to
realize tax savings from the investment
tax credit
and deductions
for depreciation.
Foreign
operations
provide
banks
with deductions
or tax
credits
for taxes paid to foreign
governments.
Recent additions to loan loss reserves and losses
on security holdings have further reduced banks’
taxable income.
Since 1961 the effective
Federal
tax burden on commercial
banks has fallen about
60 percent, with much of the decline occurring in
recent years.ll
Banks have accumulated
a significant amount of municipal
debt and may have
Finally,
banks are
reached a saturation
point.
increasingly
concerned
with their liquidity position.
These
developments
suggest
that banks
have a reduced need and desire for the tax-exempt
income from municipal
bonds and thus may not
buy the volume of municipals
in the future that
they have in the past.

10This development will have an adverse impact on the validity of
municipal bond demand and yield forecasts made hy many
econcmetric models that incorporate loan demand as an explanatory
variable.
“Margaret
E. Bedford, ” Income Taxation of Commercial Banks,”
Monthly Review, Federal Reserve Bank of Kansas City. July-August
1976, p. 10.

18

ECONOMIC

REVIEW,

It does not appear that the New York City
financial crisis can be held primarily
responsible
for the recent rise in Rm/Rc.
The rise in Rm/Rc
of New
began, prior to the general recognition
York City’s problems, under the same conditions
that initiated
and maintained
a similar rise in
Rm/Rc in 1968-69, i.e., a reduction
in commercial. bank demand for municipal
bonds.
These
conditions
experience.

have persisted
throughout
the recent
This is not to imply that the recent
chaos and uncertainty
in the market have had no
impact.
It is probable that the lack of information concerning
state and local finances combined
with the recent
financial
disclosures
of some
cities and states have resulted in some additional
risk premium being demanded, i.e., investor discounting
of credit ratings
may have started or
increased.
However, this should be a short-term
phenomenon
until fuller financial
disclosures
are
made by state and local government
borrowers to
allay any investor
fears of municipal
financial
collapses
occurring.
The fuller disclosure
and
credit reexamination
by municipal
credit rating
agencies may result in the downgrading
of some
municipal securities,
as New York State’s recent
experience indicates, and the upgrading of others.
Thus, in the long run the major impact of the
New York City financial crisis on the municipal
bond market will be the reexamination
of state
and local creditworthiness,
and the possible
regrading of some municipal
securities,
not a general rise in Rm/Rc for equal risk securities.
However, the outcome
of litigation
concerning
the
New York City debt moratorium
may have a
substantial
impact on the value of guarantees
associated
with general
obligation
bonds
and
hence the evaluation
of their risk..
The immediate
future dose not appear to offer
any substantial
relief for municipal
borrowers.
For the time being banks will probably remain on
the sidelines, especially
as loan demand quickens
with the economic recovery.
Therefore,
individuals will be the primary
source of demand for
new bond issues in the immediate
future, aided
by the recent entrance of thrift institutions
into
the market.
As the stock market improves, individuals will demand higher yields to remain in
the market.
Thus state and local borrowing costs
will likely remain relatively
high, assuming
the
outstanding
supply continues
to grow at its historical pace.
One solution that has been suggested
problem of high municipal
rates relative
MARCH/APRIL

1976

to the
to cor-

porate rates is a Federally-subsidized
taxable muThe reasoning
behind
this
nicipal
security.13
plan is that the tax-exempt
status of municipal
securities
was originally intended as a subsidy to
However, as Rm/Rc rises,
municipal borrowers.
more and more of the subsidy
tors.

If the bonds

were

goes to the inves-

taxable,

they

would

be

competitive
with corporate
bonds of like rating
and would be attractive to the growing number of
tax-sheltered
institutions.
The subsidy could be
returned to state and local governments
through
direct payments by the Federal Government.
The
funds would come primarily
from the increased
tax revenues
resulting
from the bonds’ taxable
income.
Another suggested solution is to reduce
the supply of municipal
bonds by limiting
the
amount of, or disallowing
the tax exemption
on,
industrial
revenue and pollution
control bonds.
If Rm/Rc remains at its present high level, there
will be an increasing call for one or both of these
remedies.
Summary
and Conclusion
The ratio of municipal bond to corporate bond yields exhibits
considerable variability,
part of which takes the form
of explainable
short-term cyclical movements.
An
analysis of the municipal bond market indicates
that while supply is steadily rising at a stable
rate, demand is continually
changing in composition.
These changing demand patterns
are primarily due to the influence of other capital markets on municipal
bond investors,
residual nature of commercial
bank

i.e., to
demand

the
for

z See Peter Fortune, “Tax-Exemption of State and Lo4
Inter&t
Payments: An Economic Analysis of the Issues and an Alternative,”
New England Economic Review, Federal Reserve Bank of Boston.
May/June
1973, pp. 3-20.

municipal bonds and to individuals’
changing demand for municipals versus stocks and corporate
bonds.
The continual
change in demand is responsible
for the short-term
volatility
in the
movement
of Rm/Rc as well as its longer-term
movements.
Commercial
banks are of primary importance
to the municipal bond market, as their non-participation from the fourth quarter of 1968 through
the first quarter
of 1970 and since the second
quarter of 1974 has made clear.
There are indiwith
cations (e.g., low bond demand concurrent
slack loan demand pressure,
additions
to loan
loss reserves, and the use of other methods to taxshelter
income)
that the present
low level of
demand
for municipal
bonds
by commercial
banks may be longer lasting than similar situIf these indications
are corations in the past.
rect, new buyers of municipal bonds will have to
Steps in this direction
are currently
be found.
under way. The marketing
efforts of municipal
bond funds seem to have increased individual investor demand for state and local securities,
as
evidenced by the record sales figures municipal
bond funds posted in the first half of 1975. The
recent
entrance
of thrift
institutions
into the
market is another positive development.
Other
possible solutions involve limiting the supply of
some types of tax-exempt
securities
and the development of a Federally-subsidized
taxable muNonetheless,
one fact is clear.
If
nicipal bond.
state and local governments
are to achieve any
stability in their borrowing costs relative to their
corporate counterparts,
they must structure
their
bond offerings around a stable group of investors
that will hold municipal bonds as a primary investment.

FEDERAL RESERVE BANK

OF RICHMOND

19

THE $2 BILL RETURNS
Suzanne J. Stone

On April 13, 1976, the $2 bill will be issued for
the first time in ten years.
This move will help
fill the need for a currency denomination
between
The last $2 series was disthe $1 and $5 bills.
continued
in 1966 after low production
and the
concomitant
unpopularity
of the bill resulted in
insufficient
use.
This time, however, an ample
number (400 million) of bills will be printed annually to permit widespread use of the $2 denomination.
The New Design
The Secretary
of the Treasury
is authorized
by the Federal Reserve Act to determine the denomination
and design of all currency.
The front of the new $2 bill features an
engraving
from a portrait
of Thomas
Jefferson
painted in the early 1800’s by the American artist
Gilbert Stuart.
Also on the front, as required by
law, appear signatures
of the Secretary
of the
Treasury
and Treasurer
of the United
States,
William
E. Simon and Francine
I. Neff, respecUnlike
the last $2 bill, which was a
tively.
United States
Note, the new bill is a Federal
Therefore
a Federal
Reserve
Reserve
N0te.l
Bank seal replaces the number 2 to the left of
the portrait,
and the corresponding
Federal
Reserve Bank identification
number
is added on
both the left and right sides.
Date of the series
is 1976.
The design of the back of the bill is completely
new. The picture of Monticello,
Jefferson’s
home
in Virginia,
that was on the earlier $2 bill has
been replaced by an engraving
based on John
Trumbull’s
post-Revolutionary
painting “Signing
of the Declaration
of Independence.“?
Six figures
1 A chief difference between these notes is that the Federal Government must “make good” on United States Notes, while Federal
Reserve Banks are liable for all Federal Reserve Notes, In addition,
U. S. Notes are backed by gold held by the Treasury; both gold and
U. S. Government securities back Federal Reserve Notes.
2 The original painting is in the Trumbull Gallery, Yale University.
In 1817. Congress commissioned Trumbull to reproduce his painting
in a mural for the Capitol Rotunda. The only
noticeable difference
between the painting and the mural is that the foreground figures
in the painting appear to be seated on a wooden platform, while a
rug covers the platform in the mural.

20

ECONOMIC

REVIEW,

in the painting,
four seated on the extreme left
and two on the extreme right, have been omitted
in the engraving
for aesthetic
and security reasons.3
Once it was decided that the $2 bill would be
reissued,
widespread
support was voiced for a
bicentennial
theme for the bill. Despite the 1976
issue date, however, the reissue of the bill is not
intended as simply a commemorative
act for this
year, but rather it signifies the permanent
addition of another U. S. denomination.
Printing
of
this bill will continue
in subsequent
years, and
there will be no “collector’s”
or other special
issues of it.

Earlier $2 Bills

History

in U. S. currency
to this country’s
the Continental
of $2

independence.
Congress

denominations

$2 bills

were

11,

1562,

issued.

of credit

Almost

a century

acted

of the

Silver

Certificates,

National

Currency.

included

those

Jefferson;

and Harrison;

was issued

McPherson,

U. S.
and
have

Thomas

Winfield
William

S.
Win-

under Presidents

and George

more familiar,

with Jefferson’s

$2

Notes,

Hamilton;

of the Treasury

In 192s the smaller,

the

tender.

as oversized

both Civil War generals;

dom, Secretary
Garfield

B.

on

on the front

of Alexander

James

Hancock,

49,000

later,

legal

Treasury

Portraits

for the

to make

nation’s

Since that time, it has appeared
Notes,

the issuance

this power,

Congress
part

prior

On June 25, 1776,

authorized
Under

of America.“4

denomination

just

in “bills

defense
July

of the $2 denomination

goes back 200 years,

picture

Washington.
$2 U. S. Note
on the front.

3 Omitted on the left were: George Wythe. Virginia, lawyer; William
Whipple, New Hampshire, merchant and judge: Josiah Bartlett,
New Hampshire, physician and judge; Thomas Lynch, Jr., South
Carolina, lawyer.
Omitted on the right were Thomas MeKean.
Delaware, lawyer; and Philip Livingston, New York, merchant.
Omission of these figures allowed greater detail in the engraving,
thereby reducing the risk of counterfeiting.
‘U. S., Department of the Treasury. “Historical Narrative on the
$2 Bill,” (Washington. D. C., November 3. 1975).

MARCH/APRIL

1976

His

picture

then,

has

appeared

as illustrated

Prior
recent

to the April
$2 series

officially
ment

accounted
percent

was the

for

of total

1963

by the

1966.

At that

approximately
currency-

reissue,
series,

years;

when

are worn
“unfit”

Banks

these

one-third

of

banks

to

Upon

one

The aver-

of a $5 bill is
the aver-

When

out, commercial

for destruction.

from commercial

the $2 note

outstanding.

notes

was

Depart-

it was discontinued,

of currency

most

which

time

age life of the $2 bill was six years.
turn

since

the

Treasury

age life of a $1 bill is 1s months,
three

series

I.

13, 1976,

discontinued

in August

on each

in Table

pieces

banks

re-

Federal

Reserve

receiving

requests

for additional

money,

Reserve
Banks ship them new, as well
(good used) money.
Federal
statutes

the

as “fit”
require

about $320 million U. S. Sotes to be outstanding
at all times, and the 1963 issue of the $2 note was

partly to meet the legal requirements.;
the limited quantity
printed
made
extreme no\-elty, thereby
superstitions
about it.

contributing

However,
the bill an
to public

Reissuing
the $2 Biil
-4s early as 1969, the Bureau of Engraving
and Printing,
a division of the
Treasury
Department,
became
interested
in
bringing back a $2 denomination.
Various other
groups including Congress,
the Federal Reserve
System, and the bicentennial
commission,
as well
as many individuals,
have expressed
support for
its reissue. Great emphasis has been placed, however, on a sufficient quantity of such notes being
available
in order to help insure
widespread
public use of the bill. Accordingly,
225 million $2
notes will be printed and some of these shipped
to commercial
banks for public distribution
beginning April 13, the anniversary
of Jefferson’s
j This requiremen: is non- met entirely by $100 U. S. Notes.

FEDERAL RESERVE BANK

OF RICHMOND

21

Table

The Federal
Reserve
Bank of
quate supply.
Richmond
estimates
that its share of this year’s

I

HISTORY OF EACH PRIOR $2 BILL RELEASED
UNITED

STATES NOTES-LARGE

Not

1862

Description
Alexander

Available
14.4Q8,OOO

Thomas Jefferson

1874

11.632,QQO

Thomas

Jefferson

1875

11,518,000

Thomas

Jefferson

4,676,OOO
28,212,OOO

Thomas

1917

317,416,OOO

Thomas

Jefferson

24,904,OOO

21,000,000

Winfield

1891

20,988.ooo

William

1896

20,652,OOO

Allegorical

1899

538,734,OOO

Vignette

Washington

CURRENCY)
Thomas

Jefferson

CURRENCY
Allegorical
2/25/1863

Vignette
8 6/3/1864

1,381,205

Allegorical

Vignette

1875
UNITED

S. Hancock
Windom

Not Available

First Charter
Period
(No Series)

-

George

(NATIONAL

68,116,OOO

BANK

STATES NOTES-SMALL

SIZE

430,760,OOQ

Thomas

Jefferson

1953- 1953c

79,920,OOQ

Thomas

Jefferson

1963-l 963A

18,560,OOO

Thomas

Jefferson

1928-l 928G

Source:

U. S., Department
on the $2 Bill.”

of the Treasury,

“Historical

Narrative

birth.
By July 4, 1976, an additional
150 million
bills will be printed.
This total is about 60 times
greater than the average number of the last $2
It is anticipated
that about 400
note printed.
million $2 bills will be printed
in subsequent
fiscal years, further helping to provide an ade-

l’hc

E:CoNo~~lc KEVIEW

Richmond.

Szlbscriptions

is produced 6y

Articles

nmy be reproduced

and Printing,

continue

to

of the $2 bill
of other debe

printed

the Keseurch Depart~rrrefztof the l~edcrul Reserve Bank of

Bank of Richmond,

REVIEW,

in

Success of the $2 bills depends on the public’s
reception of and demand for the new note.
The
bill should become
more acceptable
once the
public realizes that the Treasury
has made it a
permanent
component of U. S. currency.
Its use
can save the Government,
and therefore
all taxpayers, money and increase
the convenience
of
cash transactions.

if source is given.

ECONOMIC

which

tween 1976 and 1981. Similarly,
individuals
will
need to carry fewer “ones”, thereby
facilitating
small cash transactions
and reducing the number
of pieces of currency
retailers
and banks must
handle.
Decreased
handling, in turn, will help to
lower business operating
costs.

charge.

P. 0. Box

Address

inquiries

to Bank

27622, Richmond,

Virginia

Please provide the Bank’s Research Depart-

ment with a copy of any publication in -which an article is sued.

22

This

About $75 million worth of bills of varying
denominations
are printed each day. The printing cost of any bill is 1.525 cents.
“Ones” now
account for 55 to 60 percent
of the number of
pieces of currency
in circulation.
By replacing
about half the “ones” with an equivalent
dollar
volume of “twos”, thus decreasing
the number of
bills in circulation,
the Federal Government
will
save about $27 million (in 1976 dollars) in printing, handling,
storage,
and shipping
costs be-

are available to the public without

nnd Public Relations, Federal Reserve
23261.

of Engraving

nominations,
which
their usual volume.

1886

1918

The Bureau

being printed each day. Production
does not interfere
with the printing

SILVER CERTIFICATES

NATIONAL

million.

James B. McPherson

TREASURY NOTES

NOTE

$92

proximately
seventeen weeks later, in December,
the first bills rolled off the presses.
To satisfy
the initial requirement,
11 million $2 bills are

Jefferson

FEDERAL RESERVE BANK

about

prints all U. S. currency, began work on the new
Federal Reserve Note in late summer 1975. Ap-

Thomas Jefferson

1878
1880

1891

total

branches.

Hamilton

1869

18908

will

sum will be released through the Richmond
Reserve Bank
and its Baltimore
and Charlotte

SIZE (LEGAL TENDER ISSUE)

Total

Series Date

production

MARCH/APRIL

1976