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CHANGING YIEL
RKET’

U. S. GOVER
FLOWER

BONDS BLOOM, THEN

Timothy

The differentials, or spreads, among the yields of
individual U. S. government bond issues vary significantly over time.
This variability was particularly
noticeable in the last two months of 1976 and the
first month of 1977. The rapidly changing configuration of U. S. bond yields over this period is largely
attributable to changes in the tax code implemented
by the Tax Reform Act of 1976. This article specifies
the determinants of U. S. bond yield spreads.
In
particular, these spreads are explained by two factors,
referred to in the article as the “capital gains effect”
and the “flower bond effect.” The first effect occurs

WILT

Q. Cook

of 89-94, and the Gg’s of 93.
(The first number
refers to the coupon
of the bond and the second refers
to the call elate, if there is one, and maturity date.)
Chart 1 shows the movement in the market yields of
these three bonds since January
1973, when the
6%‘~ of 93 were first issued.
Kot only are there
significant differences among the yield levels, but the
spreads between them vary substantially.
Intuitively, it appears paradosical
that investors
would allow yield differentials to persist on bonds of
equal quality and roughly equal maturity, such as
those shown in Chart 1. The explanation, however,

because some U. S. bonds carry coupons well below
market yields, while the second effect occurs because
some TJ. S. bonds have a special feature enabling
them to be used at par value for estate tax purposes.
The article proceeds as follows. First: it provides
a framework for analyzing how the capital gains and
flower bond effects contribute to U. S. bond yield
spreads. Then it reviews the impact of these effects
on U. S. yield spreads from the mid-1960’s to tile
passage of the Tax Reform Act, attempting for the
latter part of this period to decompose selected
spreads into parts attributable
to the two effects.
Lastly, it discusses the impact of the 1976 Tas Keform ..4ct on U. S. bond yield spreads.
Factors Contributing
to IJ. S. Bond Yield Spreads
As of the beginning of this year, there were 15 outstanding U. S. bond issues maturing or callable in
10 years or more. Six of these issues were sold prior
to June 1963 and have coupons ranging from 3 to 4%
percent.
The other nine were issued after January
1973 and have coupons ranging from 6% to 8%
This article focuses on a representative
percent.
sample of these issues, namely the 3’s of 95, the 4ys’s

1 This article

is adapted

from

a section

of

[21.

FEDERAL RESERVE BANK OF RICHMOND

3

is straightforward.
Virtually all calculated yield
series are before-tax
yield series generally computed
under the assumption that the bond is held to maturity.2 In this framework the yield is the discount
rate r that equates the bond’s price P to the present
value of the future cash flows associated with holding
it. If a bond with a par value of $100 pays a constant
return C each year and matures in N years, then the
yield is determined by the formula

PI

c
n=l

Second, a larger part of the tax is deferred to a later
period.
For given marginal and capital gains ta!x
rates, any number of combinations of coupons and
before-tax
yields as calculated by formula 1 w:ill
provide the same after-tax
yield as calculated by
formula 2.
The second aspect of formula

s
(1)

new issue bond for two reasons.
First, the tax rate
applied to the long-term capital gain at maturity of
the discount bond is below the marginal tax rate.

c
(l+r)”

1 that contributes

spreads among U. S. government

- 100
(l+r)”

bond yields is the

formula

has two aspects

assumption

that contribute

spreads between U. S. bond yields.

First,

to

it calcu-

lates a before-tax yield when in fact the relevant
yield to an investor is, abstracting from risk considerations, the after-tax yield that equates the price
of a bond to the present value of the future after-tax
returns.
Income accruing to long-term bonds is
alternatively subject to the relevant marginal income
tax rate, to the capital gains tax rate, or in some
cases, to no tax rate. Consequently, a wide range of
before-tax yields can provide the same after-tax yield.
The price of a bond that is “seasoned” (i.e., old or
outstanding) will deviate from its par value in order
to keep the yield in line with current market yields.
In particular, a bond with a coupon below current
market yields will sell at a discount (price below
par) in order to raise the yield to a level equivalent
to that of comparable newly-issued bonds. For such
a discount bond, the after-tax yield r* is determined
by the formula

(loo-P)(l-cg)
(l+rr)x

+

P
(1$-r*)”

where t is the marginal income tax bracket of the
investor, and cg is the tax rate on long-term capital
gains.3 The interest income C is taxed at the relevant
personal income or corporate income tax rate, while
the capital gain at maturity ($100--P)
is taxed at
the lower capital gains tax rate.
A low coupon seasoned U. S. bond selling at a
discount will require a lower before-tax yield than a

2 The effects on observed yield differentials of call provisions, default
risk, and tax treatment are discussed in the context of the Yield-tomaturity formula in Cl].
3The formula is more complicated
for a bond selling at a price
greater than its par value because the investor has the option of
accepting a capital loss at maturity or annually taking part of the
premium paid for the bond as a deduction against current interest
income.

4

ECONOMIC

REVIEW,

that the bond is held to maturity.

assumption
The

+

may not hold for an important

bonds, namely those that are redeemable
for estate
value.

tax purposes

These

expectation
maturity.
the

that

they

will

yield

declines,

rises

because

as

the

class of

of their

be retired

market
with the

well

before

at a discount,

expected

the capital

This

at par valzle

purchased

If such a bond is purchased

expected

period

regardless

bonds are often

to

ho1din.g

gain when the

bond is retired is spread over a shorter period of time.
U. S. bonds redeemable at par for estate tax purposes are widely and irreverently
called “flower”
bonds because of the association between flowers and
funerals.
In addition to their par value redeemability, these bonds had a second notable feature
prior to the 1976 Tax Reform Act.
Under thenexisting tax law, beneficiaries computed the gain or
loss on inherited property on the basis of the fai.r
market value of the property on the date of the
decedent’s death.
In the case of flower bonds,
this value was the par value of the bond.
Consequently, no capital gains tax had to be paid on the
difference between the purchase price and the par
value of the bond. (The capital gain was not com.pletely tax free, however, since it became part of the
decedent’s estate and was, therefore, subject to estate
taxation.)
In summary, prior to the recent changes
in the tax code, flower bonds used for estate tax
purposes had two features that lowered their before:tax yield-to-maturity
as calculated by formula 1.
First, they provided relatively tax-free capital gains.
And second, because they were discount bonds, their
relatively short expected holding period raised their
expected yield.
For completeness, it should be noted that a third
factor, length of time to maturity, can also contribut,e
to differentials
between U. S. government
bond
yields.
This factor is relatively unimportant, however, for bonds that have a maturity of 15 years or
longer, such as those considered
in this article;
therefore it is ignored.
MARCH/APRIL

1977

U. S. Bond Yield Relationships
Prior to 1973 In
the latter half of the 1960’s and the early 1970’s, virtually all long-term U. S. government bonds had two
characteristics
that affected their relative yields.
First, they carried coupons below current market
yields and, as a result, sold at prices below their par
values. This occurred because as yields in the mid1960’s rose above the Congressionally-legislated
4%
percent interest rate ceiling on new Treasury bonds,
the Treasury was unable to sell new issues. When
market yields continued to rise in the late 1960’s,
the discount on outstanding U. S. bonds became
progressively larger.
Because they were selling at a discount, the beforetax yields on these low coupon U. S. bonds were
depressed relative to the yields on new issues of
An approximate
taxable bonds in other sectors.
measure of the impact of a low coupon on a bond’s
before-tax
yield can be derived
by using its
before-tax
yield series to construct a “new issue
equivalent” yield series that, given marginal and
capital gains tax rate assumptions, would provide
Specifically, the after-tax
the same after-tax yield.

since the higher the interest rate level, the greater
the discount ior a bond with a fixed low coupon and,
hence, the grezer the capital gain at maturity.
The
spread reached a peak of 100 basis points in May of
1970. Consequently , given the tax rate assumptions,
the capital g&s
tax
effect was responsible for 100
basis points of the rise in the spread between the
observed yields on newly-issued bonds and the yield
on the 45
percent coupon U. S. bond over this
period.*

yield-to-maturity
for any discount bond can be calculated from formula 2 after making marginal and
capital gains tas rate assumptions and using the
The after-tax
appropriate coupon and maturity.yield can then be converted into its corresponding
new issue equivalent by the formula

The effect of the low coupon on the observed yield
series is then calculated as the spread between the
reconstructed new issue equivalent and the original
yield series for the low coupon bond. This spread
is a measure of the capital gains effect on the low
coupon bond yield.*
Chart 2 shows the spread between the new issue
equivalent and original yield series for the 4ys’s of
S9-91.
Corporate marginal and capital gains tax
rates applicable in each period were used to construct
the new issue equivalent yield series.”
The spread
between the new issue equivalent and original yield
series rises and falls with the level of interest rates

*It should be emphasized that this procedure is valid only over a
period when the low coupon bond’s rieid is unaffected by the fkwer
If the flower bond provision is pulling down the
bond provision.
low coupon bond’s yield, thereby decreasing the differential between
its yield and coupon, the estimate of the capital e;ains effect calculated in the manner described here will be biased downward.

The second characteristic
of U. S. bonds affecting
their before-tax yields over this period was that virtually all of them could be used for estate tax purposes.
Of these, the ones actually purchased because of this feature tended to be the lowest coupon
bonds, such as the 3’s of 95 and the 3%‘~ of 98,
which were setig
at the largest discounts. Evidence
of this is seen in the table, which shows the amount
of six flower bond issues outstanding at the end of
each year from 1965 through 1976. The net decline
from year to year is a measure of the amount used
The amount outstanding of
for estate tax pcrposes.
the 3’s of 95 declined steadily throughout the period,
and the amonE: outstanding of the 3%‘~ of 98 declined steadily beginning in the late 1960’s.
There
was no decline In the amount outstanding of the 4jd’s
of 87-92, the IT/s’s of 89-94, and the 4’s of 88-93
until 1971, ho\\-ever, and the decline was extremely
small until 19%

“It is armed in [Z] that the corporate tax rates are appropriate
rates to use to calculate new issue equivalent yields for low coupon
E. S. bonds and that other reasonable assumptions
result in Ned
issue equivalent yield series that are not very different from those
derived using corporate tax rates.
L31 concludes that the best tax
rate assumptions
to use in adjusxinr: the yields on low coupon
discount bonds are slightly lower than the corporate tax rates.

FEDERAL RESERVE BANK

B In actualitu, the -s?read between new issue prime corporate rates
and the market rielti of the 4+$‘s of 89-94 rose by more than 200
basis pains throu&
mid-1970.
It is argued in [Zl. however, that
other factors such as differential
call risk and default risk can
explain the additional rise in the spread.

OF RICHMOND

5

of 89-94 (and similar coupon bonds) related to their
flower bond provision through the early 1970’s. Second, when new high coupon bonds (6vh percent or
higher) were issued again in the 1970’s, the differentials between their yields and the yield of the 476’s
of 89-94 could initially be fairly well explained by
the capital gains effect alone.
U. S. Bond

Yield

Spreads

From 1973 Through

Late 1976 In the early 1970’s two developments
occurred that were to affect significantly the spreads
among U. S. government bond yields. First, the 4%

I

isI
1965
Sohe:

I
‘15’66

1967

I
19ks

I
1970
1

_1

See Chart 1.

I

I

1969

percent ceiling on new U. S. bond issues was lifted
to permit the issue of some high coupon bonds at
current yields. Second, effective March 1971, Congress eliminated the extension of flower bond privi-

1971

1972‘

I

leges on new U. S. bond issues, thereby insuring a
steadily declining stock as outstanding issues purchased for estate tax purposes were retired over time.
The table shows the decline in the stock of flower
bonds in recent years.

Chart 3 shows the spread between the market
yields of the 4%‘~ of 89-94 and the 3’s of 9.5. The
spread widened considerably in the latter half of the
1960’s.
Part of the rise can be attributed to the
greater capital gains effect on the yield of the lower
coupon 3’s of 95. Most of the rise, however, occurred
because the flower bond provision had a much greater
depressing influence on the yield of the 3’s of 95
than on the yield of the 4%‘~ of 89-94.
In fact, the
argument can reasonably be made on two grounds
that the yield of the 4%‘~ of 89-94 (and similar
coupon bonds) was affected very little by the flower
bond provision over this period. First, the evidence
on outstanding flower bonds in the table indicates
that there was relatively little demand for the 4%‘~

AMOUNT

The presence of newly-issued high coupon U. S.
bonds in the 1970’s makes it possible to get a more
precise measure of the impact of the flower bond
provision on low coupon U. S. bond yields by decornposing the spread between the yields of a high coupon
bond and a seasoned low coupon bond into the part
attributable to the capital gains effect and the part
attributable to the flower bond provision of the low
coupon bond. The capital gains effect can be calculated as follows. First, the after-tax yield of a high
coupon bond is calculated using formula 2. Second,
using formulas 1 and 2, the before-tax yield for a
specific low coupon bond is constructed that provides
the Same after-tax yield as the high coupon bond.

BONDS

OF FLOWER

OUTSTANDING

($ millions)
1965
3’h’s

of 90

4%‘~ of 87-92
4’s of

88-93

4%‘~ of 89-94

1966

1967

1968

1969
--

1970

1971
--

1972

1973
---

1974

1975

1976
--

4900

4894

4885

4873

4819

4727

4537

4262

4018

3750

3545

3086

3818

3817

3817

3816

3814

3809

3794

3765

3695

3605

3490

30:!8

250

250

249

249

249

248

245

240

230

224

220

1560

1560

1559

1559

1558

1554

1543

1514

1470

1384

1312

3’s of 95

2207

2006

1801

1610

1408

1253

1108

959

851

757

692

3H’s of 98

4413

4395

4367

4307

4207

3999

3706

3365

3132

2901

2652

TOTAL

17148

16922

16678

16414

16055

15590

14933

14105

13396

12621

11911

Note:
SOWCe:

6

End-of-year

data

for

Treasury

all flower

bonds with

a maturity

Bulletin.

ECONOMIC

of

1990 or later.

REVIEW,

MARCH/APRIL

1977

15’1
1146
6i!6
226 1
1033,8

Third,

the differential

between the high coupon bond

before-tax
yield and the constructed
low coupon
bond before-tax yield is calculated.
This differential
is the capital gains effect on the spread between the
high and low coupon bond yields; it is solely attributable to the difference in coupons of the two bonds.
If the low coupon bond’s flower bond provision is
causing additional downward pressure on the low
coupon bond’s yield, this yield will fall below the
constructed yield that provides
yield as the high coupon bond.

the same after-tax
The difference be-

tween the constructed yield and the actual low coupon
bond yield can, therefore, be attributed to the flower
bond provision

and used as a measure

of the flower

bond effect on the low coupon bond’s yield.
Using the 6%‘~ of 93 as the high coupon bond,
Chart 4 shows the flower bond effect on the yields
of the 3’s of 9; and the 478’s of 89-94.
The chart
shows an increase in the flower bond effect that begins in 1973 and subsequently rises sharply. This
trend is similar both for the bonds whose yields had
,already been substantially
affected by the flower
bond effect, such as the 3’s of 95 and the 3%‘~ of
98, but also for those, such as the 4%‘~ of 89-94
and the 4%‘~ of 87-92, whose yields had previously
been affected only slightly.
According to the estimates in the chart, the flower bond effect on the
observed yield of the 3’s of 95 rose from 100 basis
points in mid-1973 to 250 basis points in September
1976. Over the same period the flower bond effect
on the yield of the 4%‘~ of 89-94 went from nil to
160 basis points.
Two factors account for the sharp increase in the
impact of the flower bond effect on low-coupon, deepdiscount bond yields over this period.
First, the
stock of flower bonds was steadily declining, and it
was widely and correctly expected that there would
be no additions to the supply in the future.
This
circumstance
alone would be expected to lead to
ever-higher premiums on flower bonds. It was reinforced, however, by rapid rates of inflation, which
drove up the value of estates.
Since tax laws were
not changed to adjust for the impact of inflation on
the level of estate taxes, the demand for flower bonds
naturally increased.
The combination of decreasing
supply and increasing demand resulted in a continually increasing flower bond effect on the yields of
low coupon U. S. bonds through the third quarter of
1976.

U. S. Bond Yield Spreads Since Passage of the
1976 Tax Reform Act The Tax Reform Act of
1976, passed in October,

has had a significant

effect

on U. S. government bond yield spreads through its
impact on the demand for flower bonds.
The Tax
Reform Act did not explicitly deal with flower bonds.
Thus, bonds that were redeemable at par for estate
tax purposes retain that feature.
Nevertheless, the
Act contained a provision that diminished the appeal
of flower bonds. As indicated earlier, prior to the
1976 Act flower bonds, like other investments providing capital gains, were valued as inherited property at their fair market value on the date of the
decedent’s death; for flower bonds this value was
the par value of the bond. Consequently, under the
old tax law not only was there the potential of a very
rapid capital gain, but it was free from capital gains
tax.
The 1976 Tax Act changed the tax basis for inherited property to its cost to the decedent.
For
certain property, such as flower bonds, beneficiaries
may increase the cost basis to the fair market value
of the property on December 31, 1976.
Consequently, under the new law the difference between the
par value of the flower bond used for estate tax
purposes and the original cost or market value at the
end of 1976, whichever is greater, is subject to
capital gains tasation. The extent of the capital gains
tax is a complicated matter depending on the individual’s estate tax.
A second provision of the Tax Act that has possibly decreased the attractiveness of flower bonds is

FEDERAL RESERVE BANK

OF RICHMOND

7

the extension from six months to one year (by 1978)
of the holding period necessary to apply the long-term
capital gains tax rate.
will affect “deathbed”

It is not yet clear how this
purchases of flower bonds

which were a common

but somewhat

controversial

matter even under the old tax law.
The flower bond effect on U. S. bond yield spreads
diminished greatly following passage of the 1976 Tax
Reform Act. As Chart 4 indicates, the flower bond
effect on the low coupon yields began to decline
around the time of the passage of the Act.
The
decline in the flower bond effect on the low coupon
U. S. yields became more rapid in November and
December and accelerated further in January.
Interestingly, the changing flower bond effect prior to
January was not widely recognized because market
yields were falling.
Thus, yields on low coupon
flower bonds were relatively stable over this period
while yields on high coupon U. S. bonds were falling
sharply.
It was only in January, when increases in
the yields on high coupon U. S. bonds were far outpaced by increases in the yields on low coupon bonds,
that the impact of the 1976 Tax Reform Act on
flower bond yields was widely recognized.
From October 1976 through January
1977 the
typical decline in the flower bond effect on low
coupon bond yields was about 150 basis points. For
the 4%‘~ of 89-94 (and similar coupon bonds such as
the 4%‘~ of S7-9.2 and the 4’s of 88-93) the flower
bond effect was almost wiped out. That is, as of the
end of January the spreads between the original
before-tax yields of these issues and the yields of high
coupon U. S. bonds could be almost completely explained by the capital gains effect.
For the lowest

ECONOMIC

coupon bonds, such as the 3’s of 95 and the 3@‘.s of
98, the flower bond effect as of the end of January
still accounted for about 100 basis points of the differential between the before-tax yields on these bonds
and the yield on high coupon bonds.
It should be noted in conclusion that the capital
gains effect and the flower bond effect on before-tax
U. S. bond yields are of interest not only to investors
but also to researchers
who use before-tax U. S.
bond yield series in studies of risk, studies of interest
rate expectations, and studies of the impact of relative
supplies of debt on yield differentials.
These yield
series are frequently used with the implicit assumption that investors respond to before-tax, rather than
after-tax, yields.
Their use, without proper reg.ard
for the impact of the capital gains and flower bond
effects on before-tax yield relationships, can be highly
nlisleading.T
: I21 discusses several studies that have used U. S. government bond
yield series without regard for the possible impact of the capital
gains and flower bond effects on the movement of the series.

References
Lo:ngCook, Timothy Q. “Some Factors Affecting
Term Yield Spreads in Recent Years.”
Monthly
Review, Federal Reserve Bank of Richmond, (September 1973).
Cook, Timothy Q. and Hendershott, Patric H. “The
Impact of Taxes, Risk, and Relative Security Supplies on the Spread Between the Yields of Corporate
and U. S. Bonds.”
Paper presented at the Conference of the American Institute for Decision Sciences,
(November 1976).
Robichek, Alexander
A. and Niebuhr, W. David.
“Tax-Induced
Bias in Reported Treasury Yields.”
JournaZ of Finance, (December 1970), pp. 1081-90.

REVIEW, MARCH/APRIL

1977

PRIVATE DOMESTIC INVESTMENT

IN THE

CURRENT BUSINESS CYCLE
Thomas

A. Lawler

Few business statistics are as important as those
that measure private investment.
Private investment decisions are often crucial in determining
whether a recovery will speed up or falter. Furthermore, over the long run current private investment
determines the future productivity of the economy.
Analysts have been concerned about the weak behavior of investment in the current recovery.
This
weakness may just be a reflection of the general
sluggishness of the economy. However, if this weakness cannot be explained by cyclical factors alone,
then there must be other special factors inhibiting
investment.
In order to determine the amount of
weakness to be attributed to cyclical causes, this
article compares the relative behavior of investment
and consumption in the current cycle with that of
past cyc1es.l It then discusses some possible explanations for any weakness found in the investment
sector that cannot be attributed solely to cyclical
factors.
Cyclical
Comparison
Method
In order to compare the behavior of the consumption and investment
series in the current cycle with their behavior in past
cycles, charts similar to the Cyclical Comparison

...

each quarter of a given cycle according

to how many

quarters it is before (-)
or after (+)
the trough
date. An average of the percentage deviations from
the reference peak level for each quarter (dated as
above) of all the cycles is then calculated to obtain a
profile of average postwar cyclical behavior.
The
maximum and minimum deviations for each quarter
are plotted along with this average composite deviation from the reference peak level to indicate the
range of variability in past cyclical behavior.
The
percentage deviations from the reference peak level
for the currem cycle are plotted along with the average composite deviation series in order that recent
cyclical behavior can be compared with past cyclical
behavior.
Examination
of the Data
Chart 1 compares the
cyclical behavior of constant dollar GNP in the current cycle witL? its behavior in past cycles. It shows

Chart
1

1

’

”

”

‘I

:

i

1 GROSS ‘NATIONAL

PRODUCT’

‘, .:‘, :
.’ _, ,,

Charts used in the Commerce Department’s Bz&ess
Conditions
Digest are constructed.”
Business cycles
are defined using the reference peak and trough dates
designated by the National Bureau of Economic Research.3 For each series percentage deviations from
the reference peak level are calculated for the past
five postwar cycles. For each cycle, these deviations
are then superimposed on a chart in order to facilitate
comparison among cycles.
This is done by dating
* The Department
of Commerce’s
Personal Consumption
Expenditures and Gross Private Domestic Investment series are used to
measure the performance
of consumption
and investment
in the
Gross private domestic investment is composed of
different cycles.
residential fixed investment. nonresidential
fixed investment,
and
the change in business inventories.
? See U. S. Department
October 1976, p. 117.
3The peaks and
1948 IV, 1953 II,
II. 1958 II. 1961
current cycle are

of

Commerce,

Business

Conditions

Digest,

troughs for the past 5 postwar cycles are: peaks:
1957 III, 1960 II. 1969 IV: troughs: 1949 IV, 1954
I, 1970 IV.
The peak and trough dates for the
1973 IV and 1975 I, respectively.

FEDERAL RESERVE BANK

OF RICHMOND

9

that the decline in real GNP is much sharper in the
current cycle than in past cycles and that the rate of
recovery has been slower. For example, six quarters
after the trough date, real GNP is only 2.3 percent
higher than the reference peak level for the current
cycle, while for the average of past cycles it is 8.96
percent higher. This suggests that both consumption
and investment may be recovering more slowly than
usual.
Comparison

of

Consumption

and

Investment

Chart 2a shows the cyclical behavior of constant
dollar personal consumption
expenditures
in the
present cycle and in the average of past cycles. The
chart indicates that on average the recovery of real
personal consumption from the initial peak to six
months after the trough has been somewhat slower
in the current cycle than in past cycles.
Chart 2b compares the recent cyclical behavior of
real gross private domestic investment with its past
cyclical behavior.
Again, the chart indicates the recovery of real gross private domestic investment has
been slower in the present cycle than it has been in
past cycles. However, comparison of Chart 2b with
Chart 2a seems to indicate that the recovery oE
investment relative to the recovery of consumption
has been much weaker in the 1973-76 cycle than in
past cycles.
Chart 2c measures the difference between the percentage change from the reference peak level of real
gross private domestic investment and the corresponding percentage change for real personal consumption for both the average of past cycles and for
the current cycle. This difference measures the relative performance of investment and consumption in
the present cycle and in past cycles. The chart shows
that the weakness in the current recovery has been
much more pronounced in the investment series than
in the consumption series.
For the average of past
postwar cycles, the percentage change from the initial
peak to six quarters after the trough for real gross
private domestic investment exceeds the corresponding percentage change for real personal consumption
by 7.92 percentage points; for the current cycle, the
percentage change from the initial peak to six quarters after the trough for real gross private domestic
investment is 23.8 percentage points less than the
corresponding
percentage change for real personai
consumption.
Reasons
for the Weakness in Investment
A.
number of different hypotheses have been put forward to explain this weakness in the investment
sector. Three of these are presented below.

10

ECONOMIC

REVIEW,

MARCH/APRIL

1977

Chart

FEDERAL SURPLUS

( + ) OR DEFICIT ( - )

AS A PERCENTAGE

-

Avg.

out private investment.

OF GNP

A second explanation is that the severity of the
recent recession has created an abnormal amount of
excess capacity in the economy, which has acted as a
brake on investment spending.
According to this

CurrentCycle

A---

ponents of the crowding out hypothesis believe that
the deficit in the current cycle has been crowding

3

of Post PortwDr
I
of Post Cycle,

Cyclsr

view, investment is determined by the difference between the desired capital stock and the actual capital
stock.
The desired capital stock decreases during
recessions and increases during expansions.
If, dur-

I

-4

-2

0
2
Qvartm from Trough

I

4

I

ing a severe recession, the desired capital stock decreases substantially
more than the actual capital
stock, then during the initial part of the recovery
increases in the desired capital stock will lead to
increased utilization of capacity and not to increased
Since the recent recession has been
investment.
more severe than the past postwar recessions, adherhypothesis believe
ents of this “underutilization”
that it is a cause of the weakness in investment
in the current recovery.

I

6

Source: BwinwsCnnditlowDigad.

The first is that the large Federal deficit in the
current cycle has been “crowding out” private investment. Proponents of this view argue that the effect
of Government spending financed by borrowing from
the private sector is to reduce the amount of savings
available for private investment.
According to this

Chart 4 depicts the cyclical behavior of the Federal
Reserve’s
Capacity Utilization
in Manufacturing
Index, which measures the ratio of actual output to a
measure of total output capacity, for the current cycle
and for the average of past cycles. The chart indicates that for the current cycle the index is lower on
average than past cycles throughout the entire period,
and that the recovery of the index to pre-recession
utilization rates has been a little slower than usual in

hypothesis, the total supply of bonds in the capital
market increases as Government debt increases. This
greater bond supply causes bond prices to fall and
interest rates to rise, thereby crowding out private
borrowers.
Moreover, so the argument goes, since
the deficit in the current cycle has mainly financed
income transfer programs such as unemployment
insurance, that deficit (assuming
it crowded out
private investment) would tend to increase consumption relative to investment in the recovery.
Chart 3 shows the Federal
surplus
(positive
values) or deficit (negative values) as a percentage
of GNP for both the current cycle and the average of
past cycles.

The chart indicates

share of GNP

is substantially

cycle than in past cycles.

that the deficit as a
larger

in the recent

Since it has been financed

chiefly by sales of bonds to the public as opposed to
indirect

bond sales

to the Federal

Reserve,4

pro-

’ From December 31. 19’73 to September 30. 1976. total holdings of
Government
securities
by private
investors
increased
by $123.9
billion. while total holdings by the Federal Reserve went up by
only $17.9 billion.

FEDERAL RESERVE BANK OF RICHMOND

11

the current cycle. However, it is difficult to determine to what extent this low level of capacity explains the recent weakness in investment.”
third

explanation

is that recently

proposed

“antibusiness”

The

legislation,

such as stricter

antipollu-

tion requirements
behavior

and price controls, plus the erratic

of recent

scared

businessmen

ments.

According

monetary
away

and fiscal
from

to this “scare”

threat of these antibusiness

policy, has

long-term

invest-

hypothesis,

the

proposals becoming law,

as well as the unpredictability

of future

monetary

and fiscal policy, has increased the risk associated
with private investment, which is similar to reducing
the rate of return on investment. If the current mood
of legislators is more antibusiness than it has been in
previous cycles, or if current monetary and fiscal
policy has been less predictable than past policy, then
one would expect consumption to outperform investment in the current cycle. While this hypothesis is
difficult to support empirically, adherents point to
statements by both business leaders and financial
analysts that support it.
5 Also, the degree to which this capacity utilization index actually
measures the utilization rate of the economy is open to question.
It is particularly
difficult
to measure how much of the existing
This is especially true in recent
capital stock is actually usable.
years. since the rapid rise in energy costs has made many older
plants obsolescent.

12

ECONOMIC

REVIEW,

Obviously,

the policy implications

of each of these

explanations differ. For esample~ an increased deficit
financed by borrowing from the public will have little
or no effect on total spending if the crowding out
effect is strong.
The underutilization
hypothesis
suggests that if the recovery is going along smoothly,
then investment will eventually pick up as pre-recession utilization rates are reached.
And if the scare
hypothesis has validity, then more cautious and predictable economic policies are needed to restore confidence and induce investment.
It is possible that the weakness in the recovery of
investment spendin, m has been the result of a combination of all three of the above explanations.
For
example, it is possible to have some crowding out
occur and at the same time have a low utilization rate
inhibiting investment, with an unpredictable Gover:nment simultaneously
scaring
businesses
with its
policy threats.
It is also possible that the weakness
in investment has been caused by factors not menWhatever
the causes, the subject of the
tioned.”
determinants of private investment merits continued,
careful study.
6 Some other possible
the adverse effect of
of corporate
balance
longer time it takes
in economic activity

MARCH/APRIL

1977

causes of the weakness in investment include:
inflaion
on corporate profits: the restructurinx
sheets weakened by the recession:
and the
for investment spending w respond to changes
than for consumption
spending to respond.

Focusing on . . .

FARM FINANCIAL AND CREDIT CONDITIONS
Sada

Weather

and the cost-price

top billing in the Fifth

District’s

nancial and credit conditions
important

parts,

squeeze competed for
story of farm fi-

in 1976.

although

geography

which factor got the leading role.

Both

played

determined

In localities where

spring freezes, summer drought, or too much rainfall
at harvesttime

cut deeply

weather

the

normal,

took

into the year’s

spotlight;

the cost-price

where

harvest,

weather

was

squeeze was the prime

per-

caused

. . .

former.
Weather’s

fickleness

output

to vary

Where weather played the starring role, it often
at times exerting strongly favor“played favorites”able, at others, unfavorable, influences on local farm
production, income, and credit conditions.
Weather’s favorable role in crop output in 1976
was accomplished without too much fanfare.
Adequate rainfall and a good growing season in many
areas aided in producing better yields per acre. The
improved yields plus larger acreages combined to
produce favorable results for some crops.
Cotton
output jumped 49 percent. The corn crop increased
25 percent, and peanut production rose 12 percent.
Tobacco yields averaged slightly higher, but drought
conditions in some areas and cuts in acreage held
total poundage down some 6 percent below 1975.
But weather’s part in causing sharp declines in
production was of unusual scope and severity. With
the hard spring freezes, fruit crops suffered severe
frost-freeze
damage in large areas of the District.
The apple crop, a telling case in point, was 29 percent
Soybeans were especially
below year-earlier levels.
hard hit, both by extremely dry growing conditions
and by a wet harvesting season, and yields per acre
fell sharply.
The lower yields in combination with
smaller acreage cut soybean production 28 percent.
Hay tonnage dropped 18 percent.
And because of
the shortage of hay and poor pasture conditions,

Note:
This article is based on summary reports of this Bank’s
QuarterI~ Survey of Agricultural
Credit Conditions in 19’76 and on
the latest statistical
information
from the U. S. Department
of
Agriculture,
the Farm
Credit Administration.
and the Federal
Reserve Bank of Richmond.

L. Clarke

some farmers were forced to sell their cattle early at
low prices.
. . . and the cost-price

squeeze

tightened.

The squeeze between costs and prices continued to
be a major factor in farmers’ financial conditions in
1976. But the intensity of the squeeze varied with the
type of farming. Costs of materials used in farm production, interest, taxes, and wage rates averaged
around 7 percent above a year earlier. Even so, the
rise in farm production expenses was slower than in
other recent years, reflecting lower prices for fertilizer and seed and relatively small gains for feed and
chemicals.
No doubt the role of the cost-price squeeze was
not readily recognized by some farmers.
For those
producing tobacco, cotton, soybeans, peanuts, eggs,
and milk, higher prices overshadowed cost pressures.
But the lower prices for cattle, hogs, poultry-especially turkeys-and
both feed and food grains made
the pinch of the cost-price squeeze not only apparent
to, but painful for, their producers.
Costs

rose faster

than

income.

Whether the District’s farmers remember 1976 as
a poor year or as a good one will depend on what
combination of crops and/or livestock they produced.
Some will almost surely count it a good year. Others
will not be so fortunate.
But when the cash income
from all crop and livestock marketings is added up,
total cash receipts may run slightly higher than in
1975.
Livesto&
production has provided the basis
for a high and improved level of income from livestock and livestock products.
But crop marketings
may not be large enough to bring crop income up to
the 1975 level. Much will depend on the volume of
crops stored for sale later in hopes of a recovery in
prices.
All in all, the situation points to only a slight
increase in gross farm income in 1976. And with the
modest gain in gross income likely to be offset by
the rise in production expenses, realized net farm
income seems almost certain to fall short of the 1975
figure.

FEDERAL RESERVE BANK OF RICHMOND

13

Demand
Farmers’

for farm

loans

was strong

. . .

. . . but fund availability

demand for short- and intermediate-term

loans was generally strong throughout the year, both
at commercial banks and at production credit associations.
This general increase in demand for loans
stemmed in part from the continued rise in the costs
of production and the sharply higher prices of farm
machinery and equipment.
Strength in loan demand
also came from the expansion in poultry and hog
operations and from new and expanding dairy operations. Moreover, there was a big demand for loans
to build on-farm storage facilities, especially in the
Carolinas.
Weather-induced
problems also strengthened the
demand for loans.
After experiencing
widespread
dry weather conditions in the early fall, some livestock producers borrowed funds to buy feed.
By
late fall, however, wet weather delayed harvest of
some fall crops and increased the demand for loan
renewals.
Statistical evidence supports these findings. Shortand intermediate-term
farm debt held by member
banks at midyear was 14 percent above a year earlier,
while the loan volume held by PCAs was up 10
percent.
But farmers stepped up their borrowing
from PC4s
sharply during the third and fourth
quarters, particularly so in the third.
As a result,
the volume of loans made by PCAs for the year as a
whole was 18 percent larger than in 1975.
And
the year-to-year
gain in PCA loans outstanding
amounted to 14 percent.
Unlike non-real-estate
farm loans,, demand for
farm-mortgage
loans in 1976 was comparatively
weak. While farm real estate loans held by member
banks in mid-1976 were down fractionally from the
year-earlier
level, outstanding
loans held by the
Federal land banks showed a gain of 12 percent. But
the volume of new money loaned by the Federal
lancl banks during the entire year was 10 percent
below that in 1975. Most of the decrease came in the
first half of the year and followed on the heels of even
larger declines during the second half of 1975. By
year-end 1976, loans outstanding at the Federal land
banks were 11 percent above the level a year earlier.
Could these changes represent a return to a more
normal lending pattern when annual loan increases
were not so high as they have been in recent years?
Reportedly, farmers were less optimistic over farm
income prospects in 1976 and hence were hesitant to
make large long-term capital investments.
Then, too.
other lenders-especially
life insurance companiesincreased their share of the volume of credit-financed
farmland transfers during the year.
14

ECONOMK

REVIEW,

was ample

. . .

Bank funds available for making short- and intermediate-term loans to farmers were generally ample
throughout the year even though farm loan demand
was strong. (By contrast, fund availability for longterm real estate lending was reported to be a continuing problem for some banks.)
While loan fund
availability varied considerably from bank to bank
and state to state, banks with the greatest availability
of funds were most often located in the Carolinas.
The general availability of loan funds at commercial
banks has stemmed both from strong inflows of time
deposits and from a continued weak, but improving,
business loan demand.
Rarely

did one of the surveyed banks report that

it had been forced to refuse or reduce a farm 1oa.n
because of a shortage of funds-further
evidence of
the availability of ample funds for lending to qualifie:d
farm borrowers.
Moreover, bankers reporting that
they were actively seekin, (+ new farm loan accounts
usually ranged from 60 to 70 percent of all respondents.
Since bank loan funds were ample, loan referral
activity remained fairly weak. Generally, the number
of bankers making referrals to correspondent banks
was small, probably because many of the sampled
banks are either large branch banks or bank holding
Nore banks as a rule reported referrals
companies.
to nonbank credit agencies,
referrals was not unusual.

but the volume of these

Banker respondents in this five-state area do not
appear to be too enthusiastic about the Farmers
Home Administration’s guaranteed loan program nor
with the provisions whereby commercial banks and
production credit associations can jointly participate
Some bankers indicate that
in making farm loans.
too much red tape is involved : others say they would
much prefer to have the opportunity to participate
with the Federal land banks.
Merchants
and dealers, especially those selling
farm machinery and equipment, provided a higher
volume of loan funds in 1976 by strengthening their
lending activity over that in other recent years.
Increased selling competition seems to have provided
the impetus for this change in lending policy.
, . . and interest

rates

showed

mixed

trends.

On the average, bank interest rates on farm loans
eased slightly during the first three quarters of 1976.
with the most noticeable lowering of rates occurring
Rates on short- and interin the third quarter.
mediate-term loans softened much more than those
MARCH/APRIL

1977

on farm real estate mortgages.
bank interest rates was in line

This

lowering

with

the general

of

farmland continuing to advance during the year,
most farm owners are i~i an improved equity position.

movement of interest rates during 1976 at PC4s
and other major institutional farm lenders and was a
boon to farm financing.

But the cash income position of farmers varies
Uetter incomes enabled a good many
substantially.
farm producers to meet their loan obligations on
time. On the other hand, where cash returns were
unfavorable, delinquencies were high-especially
in
certain sections of Virginia,
Maryland, and South
Carolina.
Ifany of these farmers. unable to make
their loan repayments as scheduled, found it neces-

But average interest rates charged by banks on
short-term farm loans edged upward again during
Rates charged on
the fourth quarter of the year.
both feeder cattle and other farm operating loans
averaged 8.89 percent, about the same as a year
Rates reported for intermediate-term
loans
earlier.

sary to renew or extend their loan obligations.
Some
no doubt began 1977 with larger debts or less cash,
or both, than they had at the beginning of 1976.

averaged 9.29 percent, down from the 9.48 percent
charged 1’2 months before, while the average charge
of 9.28 percent on farm real estate loans was up
fractionally from the average reported for the fourth
quarter of 1975. Bank interest charges on farm loans
in 1976 generally varied widely, both among banks
and by type of loan, with “typical” rates reported by
banks ranging from a low of 7 percent to a high of
12 percent.

Most of the District’s farm lenders, however, will
probably remember 1976 as a comparatively
good
year.
Demand for non-real-estate
farm loans was
strong throughout the year. But bank funds available
for making short- and intermediate-term
loans to
farmers were generally ample, and loan referral acBank interest rates
tivity remained fairly lveak.
charged on farm loans showed mixed trends, easing
slightly earlier in the year and edging upward again
in the fourth quarter.
By and large, most bankers
had little trouble with repayment rates, renewals, and
extensions until the fourth quarter when the rate of
loan repayments slowed noticeably and requests for
renewals or extensions rose significantly.

Farmers’ financial conditions vary.
Despite the further tightening of the cost-price
shortages in cash
squeeze, some weather-induced
farm income, and the continued upturn in farm debt,
a majority of the District’s farmers remain in generally good financial condition. With market values of

THE RELEVANCE

OF ADAM

SMITH

The Federal Reserve Bank of Richmond is pleased to announce the publication of
The Relevance
of Adam Smith, a reprint of the 1976 Annual Report’s
feature article.
This booklet discusses how Smith’s ideas, as revealed in The Wealth of Nations, appear
in contemporary public policy debates regarding, e.g., monopoly and government subsidies and centralized economic planning.
It may be obtained free of charge by writing
to Bank and Public Relations, Federal Reserve Bank of Richmond, P. 0. Box 27622,

Richmond, Virginia 23261.

FEDERAL RESERVE BANK

OF RICHMOND

15


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102