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Marx& Goodfiend and Robert G. King*

EDITOR'SNOTE: Among their
members of th Federa/ Reserve Bank of Richonds
research department engage in exploratoryresearch on
hader issuesof interestto the Bank and the Federal
Reserve System. The nsa/ts of such research are pubhiked in the Economic Review J?V~ time to time in
-orderto stinzul’atediscussionand debate. This article
swnmarixes the ?zxtzltsof such research. It must be
emphasi~d strong&that the viewsdo notrepresentin any
way an o&iaL position of the FederaLResewe Bank of
Richmond OTthe Federal ReserweSystem.
Financial deregulation is widely understood to have
important economic benefits for microeconomic
reasons. Since Adam Smith, economists have provided arguments and evidence that unfettered private
markets yield outcomes that are superior to public
sector alternatives. But financial regulations-specific
rules and overall structures-are
sometimes justified
on macroeconomic grounds. This paper analyzes the
need for financial regulations in the implementation
of central bank policy. Dividing the actions of the
Federal Reserve into monetary and banking policy,
we find that financial regulations cannot readily be
rationalized on the basis of macroeconomic benefits.
’ This paper was written while the first author was Visiting
Professor of Economics at the Universitv of Rochester. on leave
from the Federal Reserve Bank of Richmond where he is Vice
President in the Research Department. The second author is
Professor of Economics (College of Arts and Sciences) and
Professor of Business (Simon School of Business) at the
University of Rochester. ‘He is also Research Advisor; Federal
Reserve Bank of Richmond. We would like to thank. A. Broaddus, M. Flannery, B. McCallum, W. Poole, A. Stockman, and
seminar participants at the Federal Reserve Bank of Richmond
for valuable comments.
Research support from the American Enterprise Institute and
National Science Foundation is acknowledged.
The paper
presents the results of research conducted as part of the American
Enterprise Institute’s project on financial services regulation. It
is a revision of a paper that will appear in a forthcoming volume
providing a comprehensive review of financial regulatory policy
entitled, Res~fwing Banking and Fhanckd L&-rvkes
in Amekca.
However, the views are solely those of the authors and should
not be attributed to any of the preceding institutions.

There is a consensus among professional economists that monetary policy can be executed without
supporting financial regulations. This consensus
reflects an understanding of the central role of open
market operations. There is, of course, substantial
among economists concerning the
nature and magnitude of monetary policy’s influence
on the price level and real activity, but this should
not mask the broad agreement on the central role
of open market operations in the management of
high-powered money. Nor should it obscure the
general agreement that there is an important,
unique role for the public sector in the management
of money.
Banking policy, as we define it, involves regular
lending and emergency financial assistance to individual banks and other institutions. Many aspects
of Fed lending resemble credit market relationships
in the private sector. In particular, there is a useful
analogy between private lines of credit and Fed discount window lending. Fed regulation and supervision support banking policy in much the same way
as loan covenants and monitoring support private
lending. The value of Fed regulation and supervision, then, depends on the need for banking policy.
The Federal Reserve is only one of many competing
entities in the credit market, however, and any
rationale for Fed intervention in this market must
involve evidence of a relative advantage for the public
sector or a market failure deriving from inappropriate
private incentives. Moreover, banking policy may influence outcomes in banking and financial markets
by subsidizing certain economic activities, prompting
the erosion of private arrangements for liquidity and
encouraging risktaking. On the basis of such considerations we conclude that it is difficult to make
a case for central bank lending policy and the supporting public financial regulation.
The paper is organized as follows. Section 1 provides definitions of monetary and banking policy. In
Section 2, we consider financial deregulation and
monetary policy. We begin by considering monetary
policy in a deregulated environment and illustrate how
a prominent feature of Fed monetary policy, interest



rate smoothing, is undertaken in such an environment. We conclude by pointing out the irrelevance
for monetary policy of a well-known financial regulation, reserve
given the Fed’s
preference for an interest rate as its monetary policy
Section 3 discusses deregulation and banking
policy. Again, we begin by considering a deregulated
We first describe the character of
private borrowing and lending transactions, and then
discuss the provision of line of credit services through
the Fed discount window. We conclude by developing the distinction between illiquidity and insolvency as a means of judging the appropriateness of
public line of credit services.
In Section 4, we discuss how monetary and banking policy could react to systemwide banking crises.
We conclude that monetary policy can effectively and
desirably limit crises arising from a widespread demand to convert deposits into currency. In this connection, we interpret Walter Bagehot’s “lender of last
resort” rule as an irregular interest rate smoothing
policy. Banking policy in contrast can do little to influence such events. Banking policy may have other
roles to play in dealing with systemwide disturbances, however, and we explore these at the end of
the section.



Our investigation requires that we distinguish between central bank monetary policy and what we
have referred to as banking policy. By monetary
policy we mean changes in the total volume of highpowered money (currency plus bank reserves). Banking policy, in contrast, involves (1) changes in the
composition of the asset side of the central bank’s
balance sheet, holding the total fured, or (2) regulatory
and supervisory actions of the central bank.’ These
latter actions might be described as commercial
policies. In the United States, however, central bank
commercial policies focus largely on the banking
sector, so we term them banking policy.2
r One can easily imagine central bank actions that combine both
monetary and banking policy. An increase in bank reserve requirements, coupled with an increase in high-powered money
sufficient for banks to finance it, is one important example.
The possibility of combination policies in no way diminishes the
usefulness of our distinction.
* Hodgman (1976) is a good survey of commercial policies
executed by foreign central banks. In the United States, commercial policies executed through the credit market are extensive. See, for example, Bennett and DiLorenzo (1983) bment CditAflocation: W/rereDo We Go From Here?(1975), U.S.

When the Federal Reserve was established, its
principal goals, according to the Federal Reserve Act,
were “to furnish an elastic currency, to afford a means
of rediscounting commercial paper, and to establish
a more effective supervision of banking in the United
States.” These primary objectives involve a mix of
monetary and banking policy. The provision of an
elastic currency is a monetary policy of sorts, since
it involves varying the stock of currency in response
to economic conditions. The -other two objectives
fall into the category of banking policy. For example, by allowing its inventory of government securities
to vary, a central bank can accommodate variations
in discounting without any change in the stock. of
high-powered money.




Monetary policy entails the control of high-powered
money by the central bank to manage nominal
variables like the price level, the inflation rate, and
the nominal interest rate, and possibly to influence
temporarily real variables such as employment and
output. This section explains why financial regulations are not needed to conduct monetary policy
effectively, although their effects must be taken
into account where they exist. Section 2.1 provides
an overview of the argument. Section 2.2 discusses
interest rate smoothing, which is an important feature
of monetary policy in the United States, and shows
that such smoothing does not require regulations. Indeed, the practice of smoothing interest rates essentially eliminates the need for reserve requirements.
Finally, Section 2.3 explains that, once in place,
financial deregulation would have only minor effects
on the use of monetary policy for purposes of broad

2.1 Why Regulations Aren’t Necessary
There is a concensus among mainstream economists that monetary policy can be conducted without
supporting financial regulations, in spite of the fact
that there is not a consensus on the efficacy of
monetary policy or on desirable patterns of behavior
for the monetary authority. In this context most
Congress, Fed’al Credit Activities(1984), and “The Federally
Sponsored Credit Agencies,” in Cook and Rowe (1986). Federal
deposit insurance, farm credit programs, and pension guarantees
also fall into this category. In contrast to these activities Federal Reserve banking policy emphasizes availability on very short
notice, through line of credit services at the discount window
and through daylight overdrafts and float extended in the
payments system.


economists think of a deregulated environment as
being one in which the central bank has a monopoly on the issue of high-powered money, but in
which private markets are otherwise unregulated.
This view is based on the fact that currency and
bank deposits are not perfect substitutes in making
transactions. For example, when payments are executed through bank deposits, costs are incurred in
determining that the payor has sufficient wealth to
cover the transaction. Also, costs are incurred when
securities are sold and purchased to complete the
desired wealth transfer. Bankers specialize in providing these transaction services. In a deregulated,
competitive system they have incentives to provide
payment services at cost, and to pay interest on
deposits that reflects the net return on their earning
In contrast, when payments are executed with currency, costs are lower because the value of currency
is more easily verified than the value of a check
written against a deposit. Also, the privacy provided by currency is an advantage for some transactions, since currency doesn’t leave a paper trail. There
is presumably a substantial set of payments for which
the cost saving and other benefits from using currency rather than deposits more than offsets the inconvenience and interest foregone.
The fact that deposits are imperfect substitutes for
currency is important for two reasons. First, it implies that the public has a determinate real stock
demand for currency (C/P), where C is the aggregate
nominal stock of currency supplied by the central
bank and P is the currency price of goods (the price
level).3 It follows that controlling the nominal stock
of currency (C) and its growth rate is sufficient to
control the price level (P), the inflation rate, and the
level of the nominal interest rate (expected inflation
plus the ex ante real rate).4 This, in turn, implies that
3 A brief survey of money demand
McCallum and Goodfriend (1987).

theory may be found in

4 This argument is due to Patinkin (196 1). It was later emphasized by Fama (1980, 1983).
Patinkin pointed out that a central bank must fix both a
nominal interest rate and a nominal quantity to make the price
level determinate. These conditions are met if a central bank
pays no interest on currency and controls its aggregate nominal
quantitv. The mice level is determined as follows. Because currency earns zero nominal interest, the opportunity cost of holding
it is the nominal interest rate on securities. It is efficient for people
to hold a real stock of currencv for which the mareinal service
yield just equals the interest rate. For a diminishLg marginal
service vield on currency with a suffrcientlv hiah initial threshold.
there is a determinate real stock demand for currency and a determinate price level for any given nominal interest rate on
securities. The nominal interest rate on securities is the sum
of expected inflation plus a real interest rate component. The

the banking system can be completely deregulated
without interfering with the ability of a central bank
to control nominal magnitudes via monetary policy.
Open market operations are sufficient to accomplish
monetary objectives. 5 To illustrate that banking
regulations are not essential for monetary policy, consider how a central bank prevents a temporary increase in the real demand for currency from decreasing the price level. It simply acquires securities
temporarily in the open market, providing sufficient
nominal currency to satisfy the higher real demand
without a price level fall. Alternatively, suppose a central bank wants to restore a lower price level after
an inflationary period. It does so by selling securities
in the open market to reduce the stock of currency.
Regulations influence the magnitude and timing
of open market operations necessary to achieve
specific objectives because they affect both the supply
and the demand for currency.6 For instance, reserve
requirements on bank deposits absorb high-powered
money made available through open market operations, thereby influencing the effective quantity of
currency supplied. Alternatively, by affecting the
incentive to substitute between currency and bank
deposits, a prohibition of interest on demand deposits
influences the magnitude of open market operations
necessary to minimize price level effects of changes
in market interest rates.’
2.2 Interest Rate Smoothing
In the preceding section we emphasized that open
market operations are sufficient for a central bank
to manage the price level, inflation, and nominal
interest rates. In practice the Federal Reserve has
employed monetary policy throughout its history to
smooth nominal interest rates against routine seasonal
and cyclical variations in the demand for money and
central bank can control inflation and thereby expected inflation by choosing a desired rate of currency growth. For example, it can choose zero currency growth and zero inflation,
so that the nominal interest rate is simply the real rate, and the
price level is constant.
5 This point was emphasized by Friedman (1960). Related
discussions may be found in Fama (1980, 1983) and McCallum
6 See, for example, the textbooks of Barro (1986) Darby (1976),
Dornbusch and Fischer (1984) Gordon (1987), Hall and Taylor
(1985) and Sargent (1979, 1987). A notable exception is the
view emnhasized bv Wallace (1983) and Sareent and Smith
(1987). I%Callum (1983), who emphasizes Fhe medium-ofexchange services of money, and King and Plosser (1986), who
emphasize verification costs, may be read as responses to the
arguments of Wallace, Sargent, and Smith.
7 See Mehra (1986), for an analysis of how recent financial
deregulation has influenced the demand for money.



credit. This section begins by describing briefly the
effect the Fed has had on nominal rates. Next, we
discuss the mechanism by which the Fed has managed them, pointing out among other things that
interest rate smoothing may be interpreted as the
means by which the Fed has satisfied its mandate
to provide liquidity to the economy. We also note
that reserve requirements have not played a substantive role under this procedure, although there are
other procedures under which they could play a role.
We thereby suggest reserve requirements as a candidate for additional deregulation.
Z.2. I Evidence
The purpose of this section is to describe briefly
the extent to which the Federal Reserve has succeeded historically in changing the character of
nominal interest rate movements.
Consider one
measure of the short-term interest rate, the monthly
average call money rate on short-term broker loans
in New York.8 Prior to the creation of the Federal
Reserve in 1914, this rate rose suddenly and
sharply from time to time. For example, in October
of 1867, after remaining between 4.3 and 7.2 percent for the prior three years, the call money rate
rose suddenly from 5.6 to 10.8 percent. Although
this change seems large by post-war U.S. standards,
similar episodes of at least this magnitude occurred
26 times during the period between the end of the
Civil War and the establishment of the Fed. Moreover, sudden changes of over 10 percentage points
occurred with surprising frequency, on 8 occasions
during the same 49-year period. In September 1873,
the call money rate jumped from 4.6 percent in
August to 61.2 percent before falling back to 14.9
percent in October and 5.5 percent in January 1874.
Accompanying these sudden upward jumps in call
money rates were similar-though
much less
in 60- to 90-day commercial
paper rates. These episodes were distinctly temporary, ranging from one to four months, with many
lasting for no more than one month. Needless to say,
such extreme temporary spikes are absent from interest rate behavior since the creation of the Fed.
Another distinctive feature of the period before the
Federal Reserve was the large seasonal movement
in short-term interest rates. For example, the average
seasonal variation of the call money rate from 1890
to 1908 ranged from a peak of +4.6 percent in
January to a trough of - 1.39 percent in June.9
s This series is reported

in Macaulay (1938).

These numbers come from Miron (1986). See Clark (1986)
and Kemmerer (1910) for particularly useful related material.

Generally speaking, rates were at their annual mean
in the spring, below it in summer, and above it in
the fall and winter. By the 1920s the prominent interest rate seasonal had virtually disappeared.

As just discussed, broadly speaking the Federal
Reserve may be said to have smoothed nominal
interest rates in two senses. First, it insulated rates
from regular seasonal movements in money and credit
markets. Second, it removed temporary spikes that
were prompted by recurrent irregular tightness in
money and credit markets. For purposes of this
discussion, we may define interest rate smoothing
as a deliberate effort by the Fed to reduce or eliminate
temporary nominal interest rate fluctuations.*0 We
shall find the distinction between regular and irregular
interest rate smoothing useful when we characterize
Bagehot’s lender of last resort rule in Section 4.2
There has been considerable controversy about
whether central bank interest rate smoothing is feasible in principle when the public understands policy,
i.e., when the public has rational expectations. We
can see that it is possible by drawing on the simplest
possible model. 11The model has three basic equations: (1) a money demand function, (2) a money
supply function, and (3) an expression equating the
expected real return on nominal securities, i.e., the
nominal interest rate minus expected inflation, to the
expected real rate that clears the credit market..
The model embodies two principles that are essential to understanding nominal interest rate smoothing.
First, the price level is determined by a money supply
rule, which provides a nominal anchor for the system.
Second, the nominal rate is affected by expected inflation, which allows a central bank to translate price
level and inflation policy into interest rate policy.
Nominal interest rate smoothing works as follows.
The money supply rule pins down the expected
future nominal stock of money, which together with
the expected future real demand for money determines the expected future price level. In practice,
central banks, including the Fed, have employed
10 There are actually a number of ways that one can define a
nominal interest rate smoothing policy. It can mean eliminating
deterministic seasonals, as emphasized by the authors listed in
note 9 above. It can mean minimizing interest rate surprises,
as studied bv Goodfriend (1987a). Or it can mean using monetary
policy to maintain expected constancy in interest ratesas studied
bv Barro (1987). Reeardless of what nominal interest rate policy
is’ followed, however, the theoretical mechanism by which it
works is basically as described in the text.



I1 See Goodfriend




interest rate instmnzentsto smooth interest rates,
which amounts to running an adjustable nominal interest rate peg. ia To illustrate the process, we
describe the response to the following two disturbances. In each case we first ask what happens when
the stock of high-powered money remains constant,
and then we ask how high-powered money must
change to be consistent with a nominal rate peg.
A temporaryrise in real moneydemand. With highpowered money initially unchanged, the current price
level would fall, raising both expected inflation and
the nominal interest rate. By assumption,
expected real yield on nominal securities is unchanged. Therefore, under a nominal rate peg expected inflation must remain unchanged, which
means the current price level must remain equal to
the expected future price level. Hence, the Fed
would merely provide enough high-powered money,
through open market purchases, to satisfy the initial
rise in money demand.
A temporarytie in the Hairate. With high-powered
money constant, the nominal rate would rise, real
money demand would fall, and the current price level
would rise. Under a nominal rate peg the necessary
increase in the expected real rate on nominal
securities would be achieved by a matching expected
deflation due to a temporarily high price level. The
Fed would merely provide enough nominal highpowered money to satisfy the unchanged demand for
real money balances at the higher price level.‘3

r* The method by which the Federal Reserve smooths interest
rates has varied over the years. In the 1920s the Fed forced the
banking system to be “in the window” for a portion of highpowered money demanded. Since there was relatively little nonprice rationing, the discount rate tended to provide a ceiling for
interest rates. The discount rate was raised or lowered to adjust
the level of interest rates, with appropriate adjustments to nonborrowed reserves to keep banks marginally borrowing reserves.
In the 1930s nominal rates were near their floor at-zero, and
in the 1940s thev were oeeeed. In the 1950s and ’60s the Fed
used proceduressimilar
to those it used in the ’20s. See Brunner and Meltzer (1964). Explicit Federal funds rate targeting
was used in the 1970s. Similarly, the nonborrowed reserve
operating procedure emploved from October 1979 to the fall
of 1982 was in effect a noisy week-by-week funds rate peg. See
Goodfriend (1987b), pp.40-41. Since then the Fed has employed
a mixture of borrowed reserve and Federal funds rate targeting.
Goodfriend (1987b) contains theoretical, institutional, and
historical discussion of the Federal Reserve’s use of an interest
rate policy instrument. For an analysis under rational expectations, see McCallum (198 1) and “A Weekly Rational Expectations Model of the Nonborrowed Reserve Operating Procedure,”
in Goodfriend (1987b).

I3 Empirical evidence on the high-powered money and inflation
response associated with the elimination of nominal interest rate
seasonals around 1914 may be found in Barro (1987) and Barsky et al. (1987).

A number of important practical points emerge
from this theoretical discussion. First, nominal interest rate smoothing is monetary policy because the
Fed’s power to create or destroy high-powered
money through open market operations is necessary
and sufficient for it to smooth nominal interest rates.
In particular, no financial or banking regulations are
Second, interest rate smoothing is
clearly feasible when the public understands policy,
i.e., has rational expectations. Third, the mechanics
of interest rate smoothing are the same regardless
of whether the disturbances are seasonal or irregular
in nature. Fourth, since the nominal interest rate is
the private opportunity cost of holding high-powered
money (as currency for hand-to-hand transactions or
as bank reserves), the change in the seasonal and
irregular pattern of nominal interest rates produces
a corresponding change in the pattern of real money
balances held by individuals and banks. Thus, interest rate smoothing is the means by which the
Federal Reserve satisfied its statutory mandate to provide liquidity to the U.S. economy.
Finally, Federal Reserve interest rate smoothing
has in practice made bank reserve requirements
unnecessary for conducting monetary policy. The
conventional view, of course, is that reserve requirements help the Federal Reserve control the
stock of money. This is the view implicit in the 1980
Monetary Control Act, which extended reserve requirements beyond member banks to all depository
institutions. If the Fed were operating with a total
reserve instrument, reserve requirements would help
determine how a change in high-powered money
would influence the price level and the nominal interest rate. However, the Fed has chosen to operate
with an interest rate instrument, i.e., to run an adjustable rate peg. As should be clear from the examples discussed above, under even a temporary peg
the current price level is determined by the chosen
level of the nominal interest rate, the creditmarket-clearing real rate, and the expected future
price level. The Fed simply uses open market operations to satisfy current money demand at the current price level. In such circumstances,
requirements merely help determine the volume of
open market operations that the Fed must do to
provide the accommodation. Reserve requirements
do not help determine the money stock or the price
level. I4
14 This was true even under the Fed’s post-October 1979 nonborrowed reserve operating procedure. See “A Historical Assessment of the Rationales and Functions of Reserve Requirements,”
in Goodfriend (1987b), pages 40-41.




2.3 Financial Deregulation and
Stabilization Policy
Since the Employment Act of 1946, the Federal
Reserve has had a mandate to use monetary policy
to stabilize real economic activity. Thus, a major
question about ongoing and prospective financial
deregulation concerns its influence on stabilization
policy. While macroeconomic textbooks show broad
agreement on issues concerning the nature of the demand for money, there is little or no agreement on
a number of central issues concerning monetary
Traditional monetarist arguments originating with
Milton Friedman and Karl Brunner hold that
monetary policy has a powerful but frequently
destabilizing impact on economic activity.i5 From
this perspective, monetary policy exacerbates cyclical
volatility because (1) its effects are subject to long
and variable lags, which makes the timing of monetary policy actions difficult, (2) it is difficult for
policymakers to assess promptly the state of economic activity due to problems of inference about
the dominant forces that drive the economy in a given
period, and (3) the policymaker’s focus on smoothing
nominal interest rates against cyclical changes in real
rates generally leads monetary aggregates to be
developed by Robert Lucas, Thomas Sargent and
Robert Barro, stress the distinction between unpredictable policy actions (shocks), which exert a powerful influence on real economic activity, and predict!
able policy responses, which do not.i6 This group
argues that systematic monetary policy cannot influence real activity, such as employment, real gross
national product, and real interest rates, because
private agents rationally anticipate the systematic
component of monetary policy and take actions that
neutralize its potential effects, leaving it to influence
nominal variables only.
Real business cycle analysts using a perspective
initiated by Edward Prescott, John Long, and Charles
Plosser deny any major influence of money, anticipated or unanticipated, on real economic activity.i7
From the perspective of real business cycle analysis,
variations in real activity arising,for example, from
I5 See Darby (1976), Friedman and Schwartz (1963), and Poole
I6 See Lucas and Sargent (1980).
17 See King and Plosser
(1986) for a discussion of the relationship between money, credit, and real activity in a real business
cycle model.


changes in technology, sectoral reallocations, energy
shocks, or taxes and government spending drive the
monetary sector, reversing the traditional macroeconomic view.
Modern Keynesian analysts led by Stanley Fischer,
Edmund Phelps, and John Taylor see a powerful role
for monetary policy, even with rational private
anticipations, because the Federal Reserve can act
after private agents have entered into wage and price
agreements. From this perspective, monetary policy
is a powerful stabilization tool that can offset potentially inefficient economic fluctuations arising from
variations in the demand for money, autonomous
changes in private spending, and supply shocks.
The disagreement
about the feasibility and
desirability of stabilization policy, however, should
not obscure the consensus that is apparent among
leading macroeconomists regarding the operation of
monetary policy. Whether monetary policy influences
real activity or only nominal variables, all agree that
it involves manipulations of the stock of high-powered
money. The major ongoing professional debates concerning monetary policy accept as common ground
the perspective that open market operations are a
necessary and sufficient policy instrument. Financial
market regulations are not necessary for the conduct
of stabilization policy irrespective of how it influences
the cyclical
of economic
only is this the view of academic economists, it is
also the view that the Fed itself takes in practice.
In its early years the Fed relied extensively on the
discount window as a means of managing the highpowered money stock, but it rapidly came to regard
the method by which it did so as a tactical consideration of little fundamental importance. In the early
1920s the Fed substituted open market security purchases for discount window loans as the primary
means of adjusting high-powered money.





Banking policy, as defined above, has three dimensions. It involves changing the composition of central bank assets holding their total fixed, it involves
financial regulation, and it involves bank supervision.
When executing banking policy, a central bank functions like a private financial intermediary in that its
actions neither create nor destroy high-powered
money. Banking policy involves making loans to individual banks with funds acquired by selling off other
assets, usually government securities. In effect, the


primary dimension of banking policy is central bank
provision of line of credit services to private banks.
Regulatory and supervisory dimensions of banking
policy may be understood in this regard. Private
credit extension is accompanied by restrictions on
the borrower to limit his ability to take risks and to
protect the value of loan collateral. Private credit lines
are accompanied by ongoing monitoring of borrowers
by lenders. Efficient central bank line of credit provision likewise requires regulation and supervision
of potential credit recipients.
The focus of this paper is deregulation. In Section 2 we argued that banking and financial regulations were not essential for the execution of monetary
policy. Here we ask whether banking policy needs
supporting regulation and supervision. The analogy
between private and central bank credit extension
drawn above, however, suggests that our inquiry
into banking policy should be somewhat different.
If a central bank provides line of credit services, the
analogy suggests that it must follow up with supervision and regulation to safeguard its funds and make
sure its commitment is not abused. Ultimately we
must ask, therefore, whether central bank line of
credit services to banks are really necessary and
desirable in the first place.
Our analysis follows the strategy employed in
discussing monetary policy in Section 2 by first considering a deregulated environment. We begin in Section 3.1 by motivating and describing restrictions
voluntarily agreed to by borrowers in private credit
markets. Section 3.2 explains the demand for line
of credit services in general, and emphasizes that by
their very nature credit lines must be accompanied
by ongoing monitoring of potential borrowers. Section 3.3 takes up central bank lending and the particular issues that arise for public lenders such as the
Federal Reserve. To keep things concrete, we
discuss these issues in terms of Federal Reserve discount window lending practices. We emphasize how
regulatory and supervisory actions taken by the Fed
to safeguard its funds parallel those taken in private
credit markets.
The Federal Reserve discount window functions
most importantly as a source of emergency credit
assistance. It is a temporary source of funds, available
on short notice, for financially troubled individual
banks. No one argues that the discount window
should be used to prevent insolvent banks from failing, only that the window be used to aid solvent
banks. The distinction between illiquidity and insolvency is therefore crucial to the management of
the discount window. First of all, the feasibility of
such selective lending depends on the Federal

Reserve’s having an operational and timely means
of distinguishing insolvent from illiquid banks.
Moreover, understanding the economic distinction
between illiquidity and insolvency is necessary to
decide whether discount window lending is desirable
policy at all. We address these fundamental issues
in Section 3.4.
Our treatment of banking policy here in Section
3 is confined to routine credit assistance. We take
up the feasibility and desirability of monetary and
banking policy responses to systemwide banking and
financial market crises in Section 4.

Private Lending and Private Regulation

Lenders face many potential problems because
borrowers can take actions that affect the risk that
loans will not be repaid. Thus, borrowers and lenders
agree on sets of rules and restrictions to accompany
loans. Consider for example, a car loan. The lender
provides the borrower an initial amount of funds to
purchase a car. The borrower agrees to a regular pattern of loan repayments. But the car loan involves
more than these financial flows. Typically, the car
is collateral against the borrower’s ability to repay the
loan, i.e., as part of the contract the borrower gives
up the right to sell the car for the duration of the
loan. Additional agreements may restrict other
aspects of the borrower’s behavior. For example, insurance against damage to the car is usually required,
and the borrower may be prohibited from renting the
car to others. These additional restrictions further
protect the lender against damage to the loan
It is important to note that restrictions on the borrower’s range of actions are ultimately in the borrower’s interest, since they lower the cost of the loan.
For example, suppose that one wanted to borrow
funds for a vacation, and owned a car without any
encumbering car loan. It would generally be cheaper
to offer the car as security for the vacation loan,
although to do so would require acceptance of a set
of restrictions on use or transfer of the car.
Issues concerning incentives for borrowers become
far more important and sophisticated when corporate
lending is considered. For this reason, corporate loans
typically involve complex covenants (restrictive
that limit the borrower’s range of
actions.‘* Covenants that limit risktaking are particularly important. For example, consider the naive
policy of lending to a corporation that is engaged in
a specific riskless line of business, at an appropriate
I8 See Smith and Warner (1979).



rate of return for riskless loans, without any restrictions on how the funds are to be spent. Ultimately,
the loan is a claim to the minimum of the stream of
loan payments or the liquidation value of the corporation’s assets. From the standpoint of the firm’s
shareholders the risky project would thus be a good
idea: if it is a success, they will get the rewards; if
it is a failure, the losses will be the lender’s, i.e., the
bondholder’s. Thus, with managers of the corporation responsive to shareholders, the firm has an
incentive to use the borrowed funds to take on risky
projects. This difficulty could be circumvented with
a covenant restricting the types of projects that the
company could initiate.

Private Lines of Credit

Efficient lending involves the costly accumulation
of detailed information about borrowers, both to sort
borrowers into risk classes and for the purpose of
designing covenants. Like many other economjc activities, information production is highly costly when
undertaken quickly without development of systems
and experience. For this reason, lending is typically
undertaken in the context of long-term relationships,
in which information production can be undertaken
in a less expensive mariner....
One form of long-term lending arrangement is commonly known as a line of credit. The demand for
line of credit services arises because firms often need
funds suddenly, as a result of unpredictable events.
For example, a firm may discover a potentially
lucrative investment opportunity which must be
seized quickly. The firm may not have a sufficient
inventory of readily tradable assets such as U.S.
Treasury bills from which to raise the necessary
funds. Furthermore, the delay involved may make
a public security offering ineffective. In contrast, a
line of credit arrangement is designed to make funds
available on very short notice, possibly as a bridge
loan until other arrangements can be made.
Alternatively, a firm might develop a sudden need
for funds after suffering a bad shock such as a decline
in sales or the unexpected failure of a project. Credit
lines, of course, are specifically designed to make
funds immediately available in such circumstances
too. The extension of credit in response to bad outcomes, however, is more troublesome for lenders.
Bad outcomes might provide information that a firm
should be dissolved, in which case the credit should
19 Haubrich (1986) provides a recent formal description of one
set of gains from long-term relationships in financial intermediation. Benston and Smith (1976) discuss why bundling of financial products can be efficient in a world of costly information.

not be extended. But credit lines are valuable precisely because they make funds immediately
available. Therefore, lenders must protect themselves
against such contingencies.
For this reason, continuous monitoring of potential borrowers is a particularly important feature of the provision of line of
credit services.zO
Lines of credit typically require the payment of a
facility fee either on the full amount of the line or
on the unused portion to cover the ongoing cost of
monitoring incurred by the bank.21 Often the fee: is
paid by holding a compensating
balance at t.he
lending bank, i.e., a bank deposit that pays a below
market rate of interest. Because the compensating
balance allows the lender to observe the borrower’s
financial transactions, it helps reduce monitoring
costs. In return for the fee, the line of credit recipient acquires an option to borrow funds, up to the
amount of the line, at a predetermined interest rate
spread above a market reference rate. The size of
the fee and the rate spread are lowest for top borrowers and higher for worse credit risks. For the
reasons outlined above, credit lines usually involve
restrictions and covenants, as well as the specification of allowable collateral, if any is required, should
a loan actually be taken down. Since such restrictions affect the riskiness of the credit, they influence
the fee and spread: acceptance of more restrictions
by the borrower generally reduces the cost of the line.
Finally, monitoring costs vary. Monitoring a mom
and pop grocery store is less costly than monitoring
a firm with many employees, offices, and product
lines. Higher monitoring costs would also be reflected
in a higher fee and/or spread.22
Individual banks position themselves to fund their
credit lines in several ways. Most importantly, they
maintain good credit ratings themselves so they can
attract funds in the certificate of deposit market in
a timely fashion and at relatively low cost.23 To a
lesser extent they hold inventories
of readily
*O A number of authors in recent years have emphasized monitoring as a key function of banks. See, for example, Diamond
(1984), Fama (198.5), Gorton and Haubrich (1987), and
Haubrich (1986).
21 Berlin (1986), Crane (1973), Hanweck (1982), and Summers
(1975) provide descriptions of various aspects of the market for
lines of credit. Berlin documents substantial growth in the use
of bank loan commitments since 1977.
22 Hawkins (1982), and Melnik and Plaut (1986a, 1986b) contain theoretical
analyses of the economics
of bank loan
23 See the chapter on certificates of deposit in Cook and Rowe
(1986), as well as the chapter on repurchase agreements, a related
bank funding source.


marketable securities such as U.S. Treasury bills,
which they can sell to acquire funds on short notice.z4
If the need is expected
to be particularly
short-lived, a credit line may be most economically
funded by borrowing Federal funds.z5

Discount Window Lendingz6

Discount window lending is essentially the provision of line of credit services by central banks. As
such there are important similarities between discount
window operations and private lines of credit. There
is, however, a potentially important difference
because a central bank’s liabilities are high-powered
money. We develop these points below by describing discount window procedures actually followed by
the Federal Reserve. In particular, we explain that
while the discount window is unnecessary
monetary policy, it plays an essential role in the
execution of banking policy. We also indicate by
analogy to private credit lines, why Federal Reserve
regulation and supervision of eligible borrowers must
be tied to discounting. We save our inquiry into the
desirability of banking policy, executed through discount window lending, until Section 3.4.
Discount window lending is the extension of credit,
virtually always secured by collateral, from a central
bank to a private institution. In the United States,
it is lending by Federal Reserve Banks through their
discount windows to individual banks or other
depository institutions in their respective districts.
Reserve banks can finance discount window credit
with high-powered money or with funds obtained
from securities sold in the open market. We define discount window lending that is deliberately
allowed to create high-powered money as unsterilized. Under our definition, unsterilized discount
window operations are, in part, monetary policy. We
say that discount window lending is sterilized when
z4 In recent years loan sales have apparently become more common. See Gorton and Haubrich (1987). Pave1 (1986). and Pennacchi (1986). Though it is not clear ‘whether they’are being
used as a funding source on short notice.
2s See the chapter on Federal funds in Cook and Rowe (1986).
r6 The term “discount window” arose from the following
historical circumstances. In the eighteenth and nineteenth centuries, much of international and interregional trade was financed with bills of exchange, which were short-term securities
that did not pay explicit interest. When sold or used as collateral,
a security was discounted-or
valued at less than its face valueto provide a return to its holder. The discount window was sonamed because much of the Fed’s lending in its early years was
done by discounting. Hackley (1973) con&s a thorough discussion of the legal historv of Federal Reserve lendine. For manv
years virtually all Federal Reserve lending has tak;n the form
of advances rather than discounts. Hackley describes the shift,
as well as the evolution of other aspects of Fed lending.

it is accompanied by an open market sale of equal
value. Sterilized discount window operations are thus
pure banking policy, with no monetary policy implications, since they leave high-powered money unchanged. In this case a loan to an individual bank
is merely substituted for government paper on the
books of the central bank, with no change in total
central bank liabilities, i.e., high-powered money.
As we explained in Section 2, open market operations are sufficient for the execution of monetary
policy. It follows that unsterilized discount window
lending is redundant as a monetary policy tool.Z7 In
contrast, sterilized discount window lending plays a
distinctive policy role apart from monetary policy.
It allows a central bank to lend selectively to individual banks without affecting aggregate monetary
conditions. In other words, it enables a central bank
to offer line of credit services to individual banks in
much the same way as private banks provide credit
lines to their customers.
The 1984 report of the Bush commission on financial regulation put the rationale for Federal Reserve
provision of discount window services as follows:
Operation of the FRB’s discount window is a vital element
in the public “safety net” supporting stability of the banking
system. Particularly in the event of difficulties affecting a
large financial institution, the FRB must remain available
to provide potentially extremely large amounts of liquidity
on extremely short notice, and it is the only government
agency that is in a position to provide this type of support
to the financial system. (Bluepritfor Reform: Th Report of
the Task &up on Regdation of Financial Services, p. 49.)

Earlier a 1971 Federal Reserve report reappraising
the discount window stated:
Under present conditions, sophisticated open market operations enable the System to head off general liquidity crises,
but such operations are less appropriate when the System is
confronted with serious financial strains among individual
firms or specialized groups of institutions. At times such
pressures may be inherent in the nature of monetary restraint, . . . [which often has] excessively harsh impacts on
particular sectors of the economy. At other times underlying economic conditions may change in unforeseen ways,
to the detriment of a particular financial substructure. And,
of course, the possibility of local calamities or management
failure affecting individual institutions or small groups of
*’ Nevertheless,
over the years the Federal Reserve has
employed unsterilized discount window lending extensively,
together with discount rate adjustments, in the execution of
monetary policy. See note 12. Though it remains puzzling, use
of the discount window this way seems to be connected with
the use of secrecy or ambiguity in monetary policy. See Cukierman and Meltzer (1986) and Goodfriend (1986). In a similar
vein, Cook and Hahn (1986) provide extensive evidence that
the discount rate has served as a monetary policy signal:
specifically, a signal of permanent changes in the Federal funds



institutions is ever-present. It is in connection with these
limited crises that the discount window can play an effective role. . . . (Reappraidof theFeakrajReserveLkcount Mechanism, volume 1, p. 19.)

The Federal Reserve discount window is understood
and valued as a line of credit facility. Open market
operations are seen as capable of handling aggregate
monetary conditions; sterilized discount window
lending is valued for its ability to direct potentially
large quantities of funds to individually troubled firms
on very short notice. Based on our discussion of
private lending above, we would expect the Fed in
its role as public provider of line of credit services
to impose restrictions on potential borrowers and
engage in monitoring as well. It does. In the public
sector, however, these activities are known as regulation and supervision.
Like private lenders, the Fed too is concerned
about pricing its loans according to risk.Z8 In Regulation A, the Fed classifies discount window loans
into short-term adjustment credit, seasonal credit,
and extended or emergency credit assistance. Adjustment credit is temporarily employed by banks in
good financial condition.29
Seasonal credit is
employed primarily by banks in agricultural areas.
Its use is also rather routine. In contrast, emergency credit is longer-term borrowing by troubled
banks.sO The discount rates on adjustment and seasonal








because the riskiness of a loan is generally lower on
the former than the latter.
The riskiness of a discount window loan depends
critically on the collateral. The Fed has considerable
latitude as to what it will accept and the haircut it

2s Notably, although the Monetary Control Act of 1980 directed
the Federal Reserve to price many of its services, the discount
window was exempted. There are some superficial similarities
between Federal Reserve practices and private line of credit
pricing. For instance, the noninterest earning required reserves
at the Federal Reserve are like compensating balances. But there
is little evidence that the Federal Reserve prices line of credit
services according to each bank’s circumstances with respect to
supervision cost, risk of insolvency, or collateral.
Since the early 196Os, the Federal Reserve has allowed the
Federal funds rate to move above the discount rate for long
periods of time. To limit borrowing the Federal Reserve has
imposed a noninterest cost, which rises with the level and the
duration of borrowing. In practice, higher and longer duration
borrowine increases the likelihood of costly Federal Reserve consultationgwith bank officials. See Goodfriend (1983, 1987b) for
discussions of how this means of administering the window has
been employed in executing monetary policy.

30 For example, Continental Illinois Bank borrowed extensively at the Federal Reserve discount window from May 1984
to February 1985. It was in the window for over 4 billion dollars
during much of that period. See Benston et al., pp. 120-24.

will take.31 Fully collateralizing a loan with prime
paper such as U.S. Treasury bills would make the
value of a central bank’s line of credit minimal, since
a bank could acquire the funds by simply selling the
bills in the private market. A central bank could still
make its credit line attractive, however, by charging
below market rates or taking less than a market haircut. Whatever a central bank might do in practice,
the point of the current discussion is to analyze how
a central bank providing line of credit services
based on imperfect collateral would operate.
In addition to setting the terms on which a loan
can be taken down, our discussion of private lines
of credit emphasized the need for ongoing monit.oring of potential borrowers by the lender. This is no
less necessary for public provision of line of credit
services by the Fed. A 1983 Federal Reserve position paper on financial regulation stated:
Central banking responsibilities for financial stability are
supported by discount window facilities-historically
a key
function of a central bank-through
which the banking
system, and in a crisis, the economy more generally, can
be supported. But effective use of that critically important
tool of crisis management is itself dependent on intimate
familiarity with the operations of banks, and to a degree
other financial institutions, of the kind that can only be
derived from continuing the operational supervisory responsibilities . . . . (“Federal Reserve Position on Restructuring of Financial Regulation Responsibilities,”
in U.S.
Congress. House. Committee on Government Operations,
House of Representatives,
99th Congress, 1985, p. 235.)

We interpret the term “effective use” in the above
quotation to mean that the Fed must be able on short
notice to discern the financial position of a bank requesting funds. Especially with respect to emergency credit assistance such information is necessary
to price loans appropriately, and even more importantly, to determine that the borrower is still viable.
If the Fed were too lax-in the sense of lending to
excessively weak borrowers-it
would risk supporting banks that should be dissolved. If it were too
cautious, it would risk not supporting temporarily
troubled but fundamentally sound banks, possibly
allowing them to fail unnecessarily. Only by continually supervising banks to which it has credit com3r Hackley (1973) documents the history of legal collateral
requirements in discount window lending. Although the Federal
Reserve has wide discretion in what it can take, it has generally required very good collateral on its loans.
A “haircut” is a margin that is subtracted from the market or
face value of a security for purposes of calculating its value as
collateral in a loan transaction. For example, a 10 percent haircut off face value of a $100 securitv would value it as $90 for
purposes of collateral.


mitments can the Fed hope to lend funds efficiently
on short notice.3a
Beyond setting lending terms and associated supervisory requirements, the Fed needs to set eligibility
rules. Unlike a private firm, the Fed cannot simply
choose its customers. The logic of the quotations
presented above suggests that the Fed ought to provide line of credit services to the entire economy as
well as to banks. To do so, however, would obviously
require an enormous allocation of resources for regulation and supervision. Hence, the Fed and Congress
have to limit that commitment rather arbitrarily. Currently, only Federal Reserve member banks, or
depository institutions holding transaction accounts
or nonpersonal time deposits, are entitled to basic
discount window borrowing privileges. This group
closely to the institutions holding
reserves at Federal Reserve banks.
If this logic is carried one step further, we can better
understand the concerns of some policymakers for
maintaining a separation between banking on one
hand, and finance and commerce on the other, and
for limiting access to the payments system.33 We
interpret the argument as recognizing the need to
limit the Fed’s line of credit commitments, and the
regulation and supervision that must accompany
them, to a manageable subset of the economy,
namely, depository institutions. Blurring the line, for
example, between banking and commerce would
make it difficult for the Fed to do so. Without a clear
delineation, the Fed would tend to be drawn into
additional implicit commitments that it could not
keep. Further, without the regulatory and supervisory
resources to safeguard its funds, the Fed might have
to withdraw from providing line of credit services
The argument for limiting access to the payments
system is similar. In the process of making payments
over its electronic funds transfer network, the Federal
Reserve grants intraday credit to depository institutions in the form of daylight overdrafts on their

3a In fact, though Fed regulations apply to all banks, it directly
supervises and examines only state-chartered Fed member banks
and bank holding companies. The Comptroller of the Currency, for example, supervises and examines nationally chartered
banks. The Federal Deoosit Insurance Cornoration does so for
insured state-chartered non-Fed-member banks. Other agencies,
however, make information available to the Fed. Continental
Minti NationaLBank: Report of An Inquiry into its FederrolSupervisionand&tame,
contains a good discussion of government
supervision of banks.

33 See Corrigan (1987).

reserve accounts .34 Because they are imperfectly
collateralized, daylight overdrafts create potential
problems analogous to those associated with discount
window lending. Though quantitatively much less
significant, Federal Reserve float generated in the
process of clearing checks creates similar problems.35
Because the Fed does not elimnate or perfectly collateralize daylight overdrafts or float, it needs to limit
access to the payments system to protect its funds.
In summary, efficient lending, whether by private
firms or public institutions, necessarily involves
restrictions. If banking policy in the form of discount
window lending and the provision of payments
system credit is desirable, then it must be accompanied by central bank regulation and supervision just
as private line of credit services require restrictions
and continual monitoring.

Illiquidity and Emergency
Credit Assistance

The preceding discussion indicated that the
Federal Reserve discount window is most important
as a source of immediately available short-term credit
to individaai banks. As noted above, no one argues
that the discount window should be used to rescue
insolvent banks, only that it be used to aid temporarily illiquid banks. The familiar rule of thumblend only to illiquid but solvent banks-both protects
public funds and safeguards the freedom to fail, which
is vital to the efficiency of the economy.36 The
purpose of this section is twofold. First, it is to
evaluate whether the rule of thumb can be feasibly
implemented. Second, it is to see whether the public
34 See Mengle, Humphrey, and Summers (1987) for a discussion of daylight overdrafts. They report total funds transfer
- overdrafts of 76 billion dollars per day. This is an enormous number when one considers that total reserve balances
with Reserve Banks are around 3.5 billion dollars. Davliaht overdrafts are currently not priced. They are interest ‘f&e loans.
depository institutions have little incentive to
economize on their use. To limit somewhat the use of intraday
credit the Fed monitors depository institutions according to
“caps” and relatively informal guidelines, resorting to consultations with bank officials when necessarv. This is reminiscent
of administration of the discount windo’w. See note 29.
35 The Monetary Control Act of 1980 mandated that the Federal
Reserve charge fees to recover the cost of providing check clearing and other services. In particular, the Federal Reserve was
directed to charge for Federal Reserve float at the Federal funds
rate. Consequemly, check float has fallen from 7.4 billion dollars
in the first half of 1979 to under 1 billion dollars todav. See “The
Tug-of-War Over Float,” (1983), U.S. Congress, Th Role of the
Federal Reseme in CkeckClearingand tke Nation’sPaymentsSystem
(1983), and Young’(1986).
36 Todd (1987) documents in detail the establishment of the
principle that the central bank should lend only to illiquid but
not to insolvent institutions.



provision of line of credit services through the discount window can be rationalized as necessary to aid
temporarily illiquid banks. The value of central bank
regulation and supervision hinges critically on the
answer to these questions.
To carry out the analysis we require an operational
means of distinguishing between illiquid and insolvent banks. This distinction appears meaningful only
in the presence of incomplete and costly information about the value of bank assets. If information
were freely available about such assets, then private
markets would stand ready to lend any bank the
present value of the expected income streams from
its assets, discounted at a rate appropriate for the risk.
Thus, any bank would always be fully liquid, able
to pay all claimants, as long as it was also solvent.
If information is incomplete and costly to obtain,
then it becomes possible to imagine the following
situation, which could be described as involving an
illiquid but solvent bank. 37 Suppose that a disturbance arises which adversely affects the returns to
some existing bank loans. If the private market cannot distinguish between strong and weak banks, then
it will only lend to any individual bank at a rate
appropriate for the entire pool of borrowing banks.
For any strong bank needing to borrow funds, then,
the private market will charge a higher rate under
incomplete information than under complete information because the rate takes into account a probability that the bank is bad, even though it may not
be. Faced with a need for funds, a strong bank may
find itself in a dilemma: its loans maybe able to support the borrowing rate under full information, but
not the higher rate prevailing under incomplete information. More precisely, at the full information borrowing rate, the bank might have positive economic
net worth, but at the higher rate under incomplete
information its net worth may be negative. We would
describe such a bank as potentially illiquid though
The higher rate that prevails in the market is an
outcome of costly information. It is a result of
pooling diverse risk groups, as discussed above, made
necessary by the costliness of auditing the underlying assets of the bank. Timely auditing over very
short periods can be so costly that individual banks
might not find it feasible to engage in “last minute”
auditing as part of a program for raising funds.
37 The analysis here relies on the substantial work on private
information economies stimulated by Rothschild and Stiglitz
(1976). However, since we consider costly evaluation, our treatment of private information economies is closer to Boyd and
Prescott (1986).

Credit lines exist to deal with precisely this situation. As described above, these involve an ongoing relationship with periodic credit evaluation so
that the lender can distinguish illiquidity from insolvency in the event of a request for funds. The
ongoing relationship develops because evaluation
costs are lower, as with many other economic activities, when they are distributed over time.
In operating a discount window, the government
faces the same problem as a private lender when there
is incomplete and costly information. It has the same
range of choices. It can lend to a pool of undifferentiated risks. If it were to pursue such a strategy, then
to break even it would have to lend at a penalty rate
equal to the private market pooled rate. However,
if the discount window had to compete with private
lines of credit, such a pricing policy would only attract insolvent banks. Hence, indiscriminate lending
would be undesirable.
Alternatively, a central bank could supervise, i.e.,
evaluate, banks and selectively lend based on the
information that supervision actually generates.
Distinguishing among banks on this basis, a central
bank selectively aids illiquid banks, but it incurs
supervision costs to discriminate between types of
banks. From this perspective, it is not an accident
that discount window lending and bank supervision
are jointly included in the primary rationales for the
Federal Reserve. If these supervision costs are taken
into account and they are at least as great as those
of the private sector, then banking policy breaks even
or subsidizes illiquid banks. It could not penalize
illiquid banks which have the option of using competitive private credit lines.
As with many other areas of government intervention, then, the efficacy of discount window lending
turns on the relative efficiency of the government and
the private sector in undertaking a productive activity.
We know of no analysis that establishes the relative
advantage of central banks in this area, though more
research is needed before any definitive conclusions
.can be reached. Indeed, in view of political pressure
to support large banks, it is possible that the private
market is inherently superior because it may be
difficult for a government agency to lend only to illiquid but not to insolvent banks.38 From this perspective, selective discount window lending and
38 Sprague (1986) and Todd (1987) report numerous instances
of government support for insolvent institutions. The Federal
Reserve minimizes the risk of supporting insolvent banks by
making discount window loans only on the best collateral.
However, by doing so it greatly reduces the value of its line of
credit services too. For example, it took the best collateral when
lending to Continental Illinois Bank in 1984-85. See note 30.


necessary supervision of banks fulfill the second
objective of the framers of the Federal Reserve Act.
But, in contrast to the provision of an elastic currency, it is less clear that this is an appropriate government intervention.39
We are now in a position to consider more fully
whether regulation and supervision are essential for
central banking. We emphasized in Section 2 that
regulations were not essential for the execution of
monetary policy. In sharp contrast, we have argued
here that banking policy needs supporting regulation
and supervision. 4o The reason for the difference is
that monetary policy can be carried out with open
market operations in government securities. But by
its very nature, banking policy involves a swap of
government securities for claims on individual banks.
Just as private lenders must restrict and monitor
individual borrowers, so must a central bank. As
indicated above, however, we know of no compelling rationale for public provision of line of credit
services to individual banks through a central bank
discount window. The fiat monetary system we currently have requires central bank management of
high-powered money. But today’s financial markets
provide a highly efficient means of allocating credit
privately. On the basis of such considerations, we

find that it is difficult to make a case for central bank
lending and the regulatory and supervisory activities
that support it.
This conclusion must, however, be qualified in two
ways. First, it is beyond the scope of this paper to
analyze the benefits of Federal Reserve credit
generated by the payments system. Provision of imperfectly collateralized daylight overdrafts and float
also requires regulation and supervision. Second,
we have so far only discussed banking policy with
39 There is an additional reason why government emergency
credit assistance might be necessary. Private markets would only
make arrangements
to protect themselves against liquidity
problems if they believed that the government would not offer
such services. Yet it mightbe impossible
for thegovernment
to make credible its intention not to intervene in future crises.
To do so, the government would have to precommit itself not
to prbvide emergency credit assistance. The worst possible case
would be one where the government announced its intention
not to provide emergency credit assistance in the future, but
the banks believed that in fact it would. Then if a liauiditv
problem arose, banks would not have prepared for it by hblding
sufficient capital and by arranging lines of credit. If the government remained true to its policy, widespread insolvency could
prevail. Bulow and Rogoff (1986) provide an interesting analysis
of this sort of problem with respect to international debt.
4o If the Federal Reserve always perfectly collateralized its
banking policy loans, then in principle it could need very little
supporting regulation and supervision. However, if it lent at below
market rates, it would still need regulation and supervision to
see that its policy was not abused.

respect to individually troubled banks. We must also
ask whether banking policy has a useful role to
play in response to aggregate, i.e., systemwide,



Distinguishing between monetary and banking
policy, the previous two sections of the paper have
analyzed central bank policy in routine circumstances.
Policy was analyzed as it might be undertaken in
response to normal macroeconomic disturbances and
in response to individual bank problems. Here we
address questions concerning central bank policy with
respect to systemwide banking and financial crises.
We begin the discussion in Section 4.1 by describing the nature of banking crises in the United
States before the establishment
of the Federal
Reserve, with particular attention to the measures
taken privately by clearinghouses to protect the banking system. This discussion is then used in Section
4.2 to develop the idea that monetary policy (provision of high-powered money) and not banking
policy (provision of sterilized discount window loans)
is both necessary and sufficient for a central bank
to protect the banking system against such crises.
We proceed to characterize Walter Bagehot’s famous
lender of last resort policy prescription as an irregular
nominal interest rate smoothing policy. We show how
Bagehot’s rule would automatically trigger highpowered money responses to protect against the sort
of banking system crises experienced before the
establishment of the Federal Reserve. Finally, we
compare Bagehot’s propostd rule to regular interest
rate smoothing procedures practiced by the Fed.
Having pointed out that monetary policy has an important role to play in response to systemwide
banking or financial crises, in Section 4.3 we ask
whether banking policy has a useful role to play in
such circumstances.

Banking Crises Before the
Federal Reserve

In his Historyof Crises undo the Nationai Banking
System, 0. M. W. Sprague identified five banking
crises between the end of the Civil War and the creation of the Federal Reserve.41 Sprague’s crises
occurred in 1873, 1884,1890, 1893, and 1907. Each
41 Kemmerer (1910), pp. 222-23, contains a more extensive
classification of financial panics including more moderate



of these crises was accompanied by interest rate
spikes of the sort described earlier, although not all
interest rate spikes were associated with banking
All of these banking crises involved an incipient,
widespread desire on the part of the public to convert bank liabilities into currency. They were also
accompanied by a defensive effort on the part of
banks to build up their reserve-deposit
Under the fractional reserve system without a central bank, this widespread demand for currency could
not be satisfied. Organized around clearinghouses,
the banking system responded in two ways.43 First,
clearinghouses coordinated general restrictions of
convertibility of deposits into currency while maintaining banks’ ability to settle deposit accounts among
themselves and to undertake lending. Second, clearinghouses issued temporary substitutes for cash,
known as clearinghouse loan certificates. These notes
were issued against acceptable collateral as clearinghouse liabilities rather than individual bank
liabilities. In this way, clearinghouse certificates
facilitated the settlement of accounts among banks
that were mutually suspicious of each other. The
clearinghouse certificates were issued in each of the
crises discussed by Sprague and remained outstanding for as little as four months in 1890 and as
long as six months in 1907. Convertibility restrictions, however, accompanied the issue of clearinghouse certificates only in 1873, 1893, and 1907.
Because convertibility
satisfaction of the increased demand to convert
deposits into currency, they involved temporary
periods in which currency sold at a premium relative
to deposits. For example, during the restriction
in 1907, the premium on currency over deposits
ranged as high as 4 percent. Taken together, the actions of the clearinghouses allowed member banks
both to accommodate a higher private demand for
using certificates in place of currency
for clearing purposes-and
frustrated it-by temporarily increasing the relative price of currency to
How well did these measures contain the harmful
effects of banking crises? As calculated from data
4* See Cagan (1965).
Clearinghouses were associations of commercial banks initially
established to clear checks and settle accounts among member
banks. Given their central position in the clearing process, they
subsequently assumed responsibility for overseeing individual
banks and protecting the banking system as a whole. In addition to 0. M. W. Sprague (19 lo), see Cannon (1908) Gorton
and Mullineaux (1987), Timberlake
(1978, 1984) on the
behavior of clearinghouses.


reported in HistoricaLStatisticsof th UnitedStatesthe
mean annual bank failure rate was less than 1 percent during the period 1875 to 1914. Moreover, this
rate was comparable to a nonbank business failure
rate which was only slightly higher. The annual bank
failure rate exceeded 2 percent in only three years,
1877, 1878, and 1893. It exceeded 4 percent only
in 1893, when it was 5.8 percent. Notably, the failure
rate was 1.7 in the 1884 crisis year and only .5
and .4 percent in the 1890 and 1907 crisis years,
The 1940 Annual Repoti of the Federal Deposit
Insurance Corporation reports data on losses to bank
depositors over the period 1868 to 1940. Tbe
estimated average rate of loss on assets borne by
depositors in closed banks was $.06 per year per
$100 of deposits from 1865 to 1920, $. 19 from 1865
to 1880, $.12 from 1881 to 1900, and $.04 from
1901 to 1920.
The relatively small losses borne by depositors
reflected, in part, the high capital-asset ratios of
banks, which cushioned depositors against loss in the
event of a bank failure. Lindow (1963, p. 2) reports
ratios of total bank capital to risk assets from 1863
to 1963. The ratio falls from a high of 60 percent
in 1880 to approximately 20 percent at the turn of
the century, then rises to about 30 percent in the
1930s and ’40s and falls to under 10 percent by the
This discussion is not meant to suggest that bank
failures before the creation of the Fed were not potentially very harmful to those involved. It does suggest,
however, that even at their worst they were roughly
of the same order of magnitude as nonbank business
failures. Their aggregate effects appear to have been
reasonably well contained by the private provision
of bank capital and by the collective protective
behavior of the banking system by clearinghouses.

Banking Crises, Monetary Policy, and
the Lender of Last Resort

Our review of the banking crises prior to the Fed,
and the clearinghouses’ response to them, contains
these important lessons. From a systemwide point
of view, banking crises were dangerous because they
were accompanied by a widespread demand to convert deposits into currency that could not be satisfied
under the fractional reserve system without a cen44 Lindow defines total capital to include total equity, reserves
for losses on loans and securities, and subordinated notes and
debentures. Risk assets are defined as total assets, less cash,
less government
securities issued by the U.S. Treasury


tral bank. The clearinghouses responded in two
ways. First, they made more currency available to
the nonbank public by using certificates in place of
currency for clearing purposes. Second, they organized restrictions on cash payments which reduced
the quantity of currency demanded by temporarily
raising its price relative to deposits. These measures
were clearly monetary in the sense that they responded to temporarily high real demands for currency with actions that changed the terms under
which currency was supplied to the nonbank public.
The evidence that the aggregate effects of banking
crises appear to have been relatively small supports
the view that the aggregate difficulties were monetary
in nature, since policies focusing on currency
supply seem to have been sufficient to contain
The preceding remarks lead us to conclude that
central bank monetary policy would have been both
necessary and sufficient to prevent the pre-Fed banking crises. Banking policy, on the other hand, would
have been neither necessary nor sufficient, because
the policy problem was to satisfy a temporary increase
in currency demand, and only monetary policy could
do that. Importantly, the effectiveness of monetary
policy in this regard does not depend on whether the
Fed makes high-powered money available by accepting bank assets as collateral at the discount window
or by purchasing securities in the open market. By
extension, it seems clear that the Fed’s power to
create currency remains sufficient today to contain
any aggregate disturbances due to sudden sharp increases in currency demand, whether they result from
banking problems or other difficulties.
We can make this point more concrete by using
it to interpret Walter Bagehot’s famous recommendation that a central bank should behave as a
lender of last resort.45 Bagehot’s (1873) policy prescription-summarized
as lend freely at a high ratewas to fix the discount rate at a level suitably above
the normal range of market rates. The discount rate
would then provide an interest rate ceiling, and
therefore an asset price floor, which would allow
banks, in the event of crises, to liquidate their assets
while remaining solvent. The proposal amounts to
providing a completely elastic supply of currency at
the fured ceiling rate. Put still another way, it amounts
to a suggestion for smoothing nominal interest rates
when market rates reach a certain height.
An important point about “lender of last resort”
policy in banking crises is that in our nomenclature
45 Humphrey and Keleher (1984) provide a historical perspective on the concept of the lender of last resort.

it is not banking policy at all. It is monetary policy
because it works by providing an elastic supply of
high-powered money to accommodate precautionary
demands to convert deposits into currency. Further,
central bank lending, in the sense of advancing funds
to particular institutions, is not essential to the policy
since it can be executed by buying government
securities outright.
One aspect of Bagehot’s rule deserves additional
comment. He argued that the last resort lending rate
should be kept fixed above normal market rates,
making central bank borrowing generally unprofitable, and minimizing any government subsidies that
might accrue to individual banks. He counted on
nominal interest rate spikes accompanying banking
crises to hit the ceiling rate and thereby automatically trigger the injection of currency into the
Bagehot’s advice in this regard, has not been followed by the Fed. Rather, as discussed in Section
2.2 above, the Fed has chosen to regularly smooth
interest rates. It has done so either by using a Federal
funds rate policy instrument directly, or by using
objectives for unsterilized borrowed reserves together
with discount rate adjustments to achieve a desired
Federal funds rate path. 46 In principle, regular interest rate smoothing could satisfy Bagehot’s concerns. First, it could be free of subsidies to individual
banks if carried out by purchases and sales of
securities in the open market. Second, it provides
lender of last resort services which are automatically triggered at the current central bank interest
rate. Of course, routine seasonal and cyclical increases
in currency demand are also accommodated at the
same rate.
Thus, Federal Reserve lender of last resort policy
and the routine provision of an elastic currency are
functionally equivalent. Both are directed at insulating
the nominal interest rate from disturbances to the
demand for currency. Both can be executed by
using open market operations to create and destroy
high-powered money. Since both are monetary policy
we may extend our conclusion from Section 2.1 to
make the point that banking and financial regulations
are neither necessary or sufficient for a central bank
to pursue effective last resort lending.
4.3 Banking Policy and
Credit Market Crises
In Section 3.4 we described how banking policy
could provide line of credit services to enable illiquid
46 See notes 12 and 27.



but solvent banks to continue operating. Implicitly,
we assumed that the source of the trouble was
limited. At worst only a few banks were insolvent,
so when line of credit services sorted the strong banks
from the weak, there was a negligible effect on interest rates. We now ask whether banking policy has
a role in general credit market crises when interest
rates rise. If banking policy is to have a role it will
be in response to real interest rate increases, since
banking policy is clearly an inappropriate response
to nominal interest rate increases caused by monetary
The real rate is determined by macroeconomic
conditions, including anticipated changes in the state
of the economy and uncertainty in future prospects.
It adjusts to equate aggregate supply and demand for
output, or what is the same thing, to equate the
aggregate supply and demand for credit. For example, an increase in future prospects which raises
current consumption demand causes a rise in the real
rate to induce consumers both to save more out of
current income and to produce more, thereby restoring goods market equilibrium. Likewise, an increase
in investment demand resulting from a perceived increased profit opportunity induces a real rate rise to
maintain goods market equilibrium.
To investigate whether there is a role for banking
policy in general credit market crises, we consider
an unexpected rise in the real interest rate. Even a
temporarily high real rate could cause previously profitable investment projects to become unprofitable.47
This, in turn, would generate a rise in nonperforming bank loans, which could create insolvencies. The
role for banking market intervention in such circumstances is usually formulated as “lend only to
illiquid but solvent banks,” as discussed in Section
3.4 above. But it was argued there that illiquidity
arises only when financial markets cannot readily
determine the status of a particular financial institution. However, unlike firm or bank-specific shocks
a general increase in interest rates would be observable in financial markets. If all firms were alike on
the one hand and all banks were alike on the other,
the distinction between illiquidity and insolvency
would surely be irrelevant for real interest rate shocks.
A real interest rate spike per se could not make banks

47 Many investment projects involve the purchase of inputsfuel, intermediate goods, and labor-today,
but only yield
output in the future. Production is profitable if the current value
of future output discounted back to the present at the real
interest rate is greater than the current cost of inputs. By pushing
the present discounted value of output below its cost of production, even a temporarily high real interest rate could cause
a project to be shut down temporarily.

illiquid unless it also made them insolvent. In so far
as its effects were distributed unevenly across firms
and banks, of course, a real rate rise could cause some
individual banks to be illiquid but solvent. Thus
aggregate disturbances can affect individual bank
liquidity in addition to factors specific to a bank. But
the fact that an aggregate disturbance is the source
of the trouble does not alter the relative advantages
of the central bank and private markets in providing
liquidity. Central banks and private markets continue
to face problems of screening strong from weak banks
that we discussed in Section 3.4. Practically, the rule
of thumb-lend
only to illiquid but solvent bankscould rule out the use of banking policy entirely. But
if banking policy did not respect this rule, then it
could well have important negative effects by subsidizing risktaking.
We are somewhat uneasy about the implications
of our result. While we think the familiar rule of
thumb makes sense, we wonder whether discount
window lending could be rationalized under a different criterion: to prevent the disruption costs of
widespread insolvencies associated with temporary
real interest rate spikes. If such aggregate disruption
costs were large enough, temporary transfers to the
banking system that could avoid such costs might
be in society’s interest. It should be pointed out,
however, that a similar argument could be made for
avoiding disruption costs of temporary insolvencies
anywhere in the economy. Therefore, acceptance of
the criterion for banking policy alone would need to
be based on a demonstration that disruption costs
are much larger in the banking sector than elsewhere.
In any case, because it would have no effect on
goods supply or demand, banking policy could not
reverse a real rate rise. Of course, a central bank’s
interest income could change as a result of banking
policy, i.e., exchanging government securities for
claims on private banks. But that fiscal effect, per
se, would have no implications for the real interest
What banking policy could do is support otherwise
insolvent banks by temporarily swapping government
securities for nonperforming bank loans. If the disturbance were temporary, and the loans earned
nothing for the central bank, then the size of the subsidy would be the lost interest on government
securities that has been diverted to bank depositors.
Alternatively, if the loans defaulted, the subsidy
48 If a central bank’s remittances to the Treasury changed as
well, and the Treasury adjusted its goods purchases accordingly, then there could be a goods market effect. But this would
involve more than banking policy.


would be the entire face value of the loans purchased by the central bank. The Treasury, in turn,
would have to finance the loss by cutting back goods
purchases, raising current taxes, or borrowing, i.e.,
raising future taxes. Banking policy of this sort is
clearly redistributive in nature, a contingent tax and
transfer fiscal policy. It need not, however, represent a subsidy to the banking system as a whole if
banks are taxed during normal times to finance any
transfers during periods of high real rates. Importantly, to be effective at reducing insolvency risk, the
tax and transfer policy would need supporting regulations. Otherwise banks might simply restore the risk
of insolvency to its initially optimal level by reducing capital accordingly, or by restructuring contingent
liabilities to offset the transfers.49 Thus we have
another example of how banking policy needs supporting regulation and supervision to be effective.
It must be emphasized that we are by no means
advocating the use of banking policy to rescue insolvent banks or, more generally, the use of tax and
transfer policies to rescue insolvent firms in other
industries. In fact, we think there are serious problems with such a policy. It requires costly regulation
and supervision. It opens the door to bank rescues,
which might be extremely difficult to limit in practice. It would be difficult to choose when to intervene.
And there would be political pressure to abuse the
policy. Moreover, it is far from clear that disruption
costs associated with widespread temporary insolvencies are large. Last, the potentially perverse incentive effects of systematic banking policies are a
matter of concern. Designed to promote financial
market stability, they encourage risktaking and lead
to the deterioration of private liquidity provision.
Thus, they are likely to lead to more severe financial market crises, particularly if political conditions
arise where the anticipated public provision of financial support does not materialize.
49 This argument is analagous to those that arise in consideration of the “Ricardian Eauivalence Pronosition.” which states
that under certain conditibns a substitution of public debt for
taxation will have no effects on prices or quantities. Robert
Barro’s Macmeconomics(1986) provides an accessible introduction to Ricardian analysis. Chan (1983) provides a proof of
Ricardian neutrality under conditions of uncertainty, stressing
the analogy to Modigliani-Miller
propositions in finance.
The ineffectiveness of credit policy, of which banking policy
is an example, is well-illustrated by the student loan program.
Student loans need not result in increased expenditure on education. A loan may reduce the extent to which families draw
down their own financial saving or sacrifice expenditure on other
goods and services to pay for a student’s education. Because loan
funds are fungible, they cannot assure a net increase in expenditure in the targeted area. The targeted effect would require
provisions in the program to prevent substitution for private
outlays and to restrict access to other credit sources.

This paper has analyzed the need for financial
regulations in the implementation of central bank
policy. To do so, it has emphasized that a central
bank serves two very different functions. First, central banks function as monetary authorities, managing high-powered money to influence the price level
and real activity. Second, central banks engage in
regular and emergency lending to private banks and
other financial institutions. We have termed these
functions monetary and banking policies. Our
analytical procedure
was to investigate how a
minimally regulated system would operate and then
to consider the consequences of various forms of
The analysis drew on conpublic intervention.
temporary economic knowledge in the areas of
finance, monetary economics, and macroeconomics.
Our conclusions regarding the need for supporting
financial regulation were radically different for
monetary and banking policy, respectively. We emphasized that regulations were not essential for the
execution of monetary policy. The reason is that highpowered money can be managed with open market
operations in government bonds. By its very nature,
however, banking policy involves a swap of government securities for claims on individual banks. Just
as private lenders must restrict and monitor individual
borrowers, a central bank must regulate and supervise the institutions that borrow from it.
Virtually all economists agree that there is an
important role for public authority in managing the
nation’s high-powered money. In contrast, there is
little evidence that public lending to particular institutions is either necessary or appropriate. Banking
policy has been rationalized as a source of funds for
temporarily illiquid but solvent banks. To assess that
rationale we developed the distinction between illiquidity and insolvency in some detail, showing the
distinction to be meaningful precisely because information about the value of bank assets is incomplete
and costly to obtain. Nevertheless, we saw that the
costliness of information per se could not rationalize
the public provision of line of credit services. Even
if central bank lending served a useful purpose earlier
in the century, today’s financial markets provide a
highly efficient means of allocating credit privately.
On the basis of such considerations, we find it difficult to make a case for central bank lending, either
through the discount window or the payments
system, and the regulatory and supervisory activities
that support it.
Consideration of the use of monetary and banking policy in response to systemwide crises led us



to modify our conclusion only slightly. We saw that
monetary policy could play an important role in banking crises by managing the stock of high-powered
money to smooth nominal interest rates. Moreover,
it could do so without costly regulation and supervision. Banking policy, on the other hand, directly
influences neither high-powered money nor the
aggregate supply and demand for goods. So banking policy could not influence either nominal or real
interest rates. We recognized, however, that a role
for banking policy in preventing banking crises might
arise in response to real interest rate spikes, which

could cause widespread insolvencies against which
monetary policy would be ineffective. Such banking
policy actions could have social value if the temporary
disruption costs associated with widespread insolvencies were large. But central bank transfers to troubled financial institutions redistribute wealth between
different classes of citizens at best. And inappropriate
incentives for risktaking and liquidity management
might lead to more severe and frequent financial
crises at worst. Hence, it is by no means clear that
there is a beneficial role for banking policy even in
this case.

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States. Washington, DC, 1975.

Sprague, Irvine H. Bailout: An Insider’sAccountof Bank Failures
and Rexws. New York: Basic Books, 1986.

Wallace, Neil. “A Legal Restrictions Theory of the Demand
for ‘Money’ and the Role of Monetary Policy.” Federal
Reserve Bank of Minneapolis &afz+&y R&eu 7 (Winter
1983): l-7.

Sprague, 0. M. W. H.tosy of Cti
Under tke National Bankhg
System.Washington, DC: National Monetary Commission,

Young, John E. “The Rise and Fall of Federal Reserve Float.”
Federal Reserve Bank of Kansas City Economic Review
(February 1986): 28-38.




Dan M. Becher, ChtistineChnzura. and Richard K. Ko

The absence of timely data on regional manufacturing output makes it difficult to determine what is
happening in the manufacturing sector in a particular
area. Data comparable to the monthly indexes of U.S.
manufacturing output are not generally available for
individual states or for specific regions of the country. Although annual surveys of manufacturers provide measures of output by state and industry, these
data are published after a lag of more than a year.
For example, data on state manufacturing output in
1986 are not yet available. Analysts of regional
business conditions therefore need an indicator of current manufacturing output.
Here we present this Reserve Bank’s new
monthly indexes of manufacturing output for the
Fifth Federal Reserve District, its individual states,
and three of its major industries-textiles,
and electric equipment. To introduce these new
indexes, we use charts that track regional manufacturing output over the period 1979-1987. Of special
historical interest is the 1978 1982 period when two
recessions occurred but the Bureau of the Census
did not conduct its annual survey of manufacturers.
Of current interest is the recent performance of the
region’s manufacturers.


During the recessions of the early 198Os, manufacturing output did not decline as much in the Fifth
District as in the nation. Manufacturing in some
District states, however, fared better than in others
during this period. Manufacturing output in West
Virginia declined sharply in both the recessions of
1980 and 1981-1982. Among the District states, output declined the least in North Carolina during the
1980 recession and actually rose in Virginia during
the 1981-1982 national recession.
Because of the District’s stronger performance in
the early part of this decade, its manufacturing output grew by a larger percentage than the nation’s over
the entire 8-year period of the 1980s. However,
District and U.S. manufacturing output grew by



over the course

of the cur-

rent economic expansion from late 1982 through
1987. The District’s growth was slower than the
nation’s during the first half of this expansion, but
faster than the nation’s during the second half. Within
the District from early 1985 through the end of 1987,
output grew the fastest in the

Output in the District’s manufacturing sector rose
5.7 percent in 1987. North Carolina posted the
largest gain, followed by South Carolina, Virginia,
and Maryland, in that order. Manufacturing output
in West Virginia declined in 1987. Among the
District industries, output in the tobacco industry
grew the fastest in 1987. (See Appendix Table A-l .)
Other industries posting strong increases in output
in the District in 1987 included printing and
publishing, electric and electronic equipment, and
transportation equipment.


Dan M. Bechter is a Vice President in the Research Depart-

ment, Christine Chmura is an Associate Economist, and Richard
K. Ko is an Assistant


We calculated regional monthly indexes of manufacturing output by using monthly data on employment and electricity consumption to interpolate
between annual measures of output.’ Employment
data alone do not provide adequate information to
measure changes in manufacturing output. For example, from the end of 1982 to the end of 1987,
manufacturing employment
in the District rose
only a few percentage points, while manufacturing
output rose over 30 percent. Chart 1 compares the
paths of manufacturing output and employment in
the District.

r A companion Research Working Paper, available on request,
gives details of the methodology used in calculating monthly indexes of regional manufacturing output.



Table I



(Millions of



Fifth District

During the past eight years, U.S. industries grew
at different rates for several reasons, including their
exposure to import competition, their sensitivity to
the business cycle, and their pace of technological
change. Thus, the pattern of growth in the combined output of all manufacturing industries in any
particular geographic area was closely related to the
mix, or structure, of industries in that area, to the
ways that mix was changing, and to other factors
favorable or unfavorable to growth in manufacturing
In this section, we examine the patterns of growth
in manufacturing output in the District and the
District states,2 comparing these patterns to the
national one. The analysis focuses on differences in
industrial structures which we believe explain much
of the variations in the regional growth rates of
manufacturing output. Of course, differences in
growth patterns could have been due to other factors, including (1) more narrowly defined differences
in industrial structure, (2) locational advantages or
disadvantages associated with manufacturing activity in particular regions, (3) intraindustry differences in management, labor, etc., that are coincidentally captured by regional boundaries, and (4)
differences in regional and national index construction and measurement.3 We do not here explore
the possible influences of these other factors on differences in regional output growth.
2 Data limitations required combining the manufacturing
puts of Maryland and the District of Columbia.






North Carolina




South Carolina











FZJ%D&&Y. Output indexes are useful measures
for comparing patterns and rates of growth, but they
do not permit comparisons of amounts of output. In
1985, the latest year for which comprehensive data
are available, manufacturers located in the Fifth
Federal Reserve District produced 9.4 percent of
U.S. manufacturing output (Table I). Among the
states in the Fifth District, North Carolina accounted
for the largest amount of this production.4
Over the period reviewed here, manufacturing output in the Fifth District grew along a path similar
to that traced by manufacturing output in the nation
(Chart 2). However, the District experienced proportionately smaller declines in output during the two
recessions early in the current decade (Table II).
Moreover, manufacturing output in the District grew
slower than in the nation during the first two years
of the expansion and has grown faster than its national counterpart since the beginning of 1985.
4 Data on industry output by state are published by the U.S.
Department of Commerce, Annual Sumq of U. S. Manufactum.




3 The U.S. Index of Manufacturing Output is based on calculations somewhat different from those we used to construct these
regional indexes. For an explanation of the construction of the
U.S. Manufacturing Output Index, see Board of Governors of
the Federal Reserve System (1986).

Percent of Percent of


West Virginia

Indexes of Total Manufacturing Output:
Fifth District and Fifth District States







Output: Growth Over Selected Periods


Expansion Periods*

Recession Periods
Jul. 1981Nov. 1982

Nov. 1982Feb. 1985

- 12.7













North Carolina





South Carolina











Fifth District


*The uninterrupted
reached its peak.


was divided

at the month when the foreign

The marginally smaller contractions in manufacturing output in the District as compared to the nation in the early 1980s probably stemmed from the
smaller proportion of industries producing durable
goods in the District. In 1980, for example, producers
of durable goods accounted for only 43 percent of
District manufacturing output, as compared with 59
percent of U.S. manufacturing output. In the two
recessions early in this decade as in other recessions,
the output of durable goods declined more than the
output of nondurable goods (Table III).
Also evident from Chart 2 are differences between
the District and the nation in the timing of the recessions and recoveries. In the months preceding the
national recession which began in January of 1980,
manufacturing output in the nation was declining but
manufacturing output in the District was still rising.
There were only negligible differences in the timing


Total Manufacturing




value of the dollar

of the troughs of regional and national manufacturing output in 1980 and subsequent peaks in 1981 .s
However, following its decline from mid-1981 to
mid-1982, District output began expanding before
U.S. output. The District’s earlier rise in manufacturing output was, again, probably due to its less
cyclically sensitive mix of industries.
The relative stability of District manufacturing output also seems to explain the differences in the trends
of output over the current expansion. From 1982 to
1985, output in the nation increased faster than in
the District, perhaps because durable goods production tends to increase faster than nondurable goods
production at the onset of a recovery. Over the course
of the two years ending with December
manufacturing output accelerated somewhat from its
1984-1985 pace, although its growth was still slower
than early in the expansion. In these two recent years,
District output outpaced national growth.6

5 Small differences in timing may be due to the use of a 3-month
moving average of electricity data in the District but not in the
U.S. index.




- 12.7


- 15.0





Marykmd/D.C. Manufacturing output in Maryland
and the District of Columbia declined less than that


Declines in U.S. Manufacturing
in Two Recessions



- 16.8

West Virginia


Feb. 1985Dec. 1987

Jan. 1980Jul. 1980


6 The difference in the District and national growth patterns
in manufacturing output over the current expansion may also
reflect a greater sensitivity in the District to the foreign exchange
value of the dollar. Textile and electric equipment manufacturing have relatively high concentrations in the District, and
both of these industries have experienced large swings in net



of the nation in percentage terms during the 1980 and
1982 recessions,
but increased less during the
1982-1987 period of expansion (Table II and Chart
3). That difference is largely due to different types
of industries in Maryland versus the nation. The proportions of durable and nondurable industries in
Maryland and in the nation were similar over the
period under study, but the more narrowly defined
kinds of industries within these categories and their
shifts in relative importance over time were different.
(See Appendix Table A-Z.) Growth in the electric
equipment industry figured importantly in these
period differentials. From 1979 through 1982 the output of Maryland’s electric equipment industry grew
at an annual average rate of 19.5 percent, compared
to the nation’s average annual gain in that industry
of 10.3 percent. During the years 1983 through
1985, however, when the nation’s manufacturing output grew faster than Maryland’s, the output of electric equipment grew faster in the United States.
Estimates of Maryland manufacturing output for
the period July 1985 through November 1987 suggest that Maryland producers did not benefit at first
from the decline in the foreign exchange value of the
dollar that began in February 1985. From the autumn
of 1986 through the end of 1987, however, manufacturing output in Maryland has kept pace with that
of the nation.

North Carolina manufacturing industries are much
more concentrated in nondurable goods production,
where output growth was more rapid nationwide
since mid-1984. Also, the North Carolina manufacturing sector includes a large proportion of industry
groups that posted increases that exceeded national
averages in output from 1985 through 1987. Specifically, about one-fourth
of North Carolina’s
manufacturing output over this period was produced by two industries, textiles and chemicals,
whose annual gains in output of 5.2 percent and 7.1
percent, respectively, outpaced the 3.9 percent increase for all manufacturing.
Soz& Cardha. The pattern of change in manufacturing output in South Carolina was similar to that
of the nation during the early 198Os, but differed
sharply from the national pattern after mid-1984
(Chart 5). Manufacturing
output in the state
throughout this period was strongly influenced by its
concentration of textile mills, which produced over

Nort/l Camhka. Manufacturing output in North
Carolina suffered smaller declines than in the nation
during the 1980 and 1982 recessions (Table II and
Chart 4), and outpaced the rate of growth of manufacturing output in the nation over the five years
ending with 1987. The industrial structure of North
Carolina appears to have been responsible for that
state’s relative stability and stronger growth in
manufacturing output.


20 percent of the state’s total manufacturing output
in 1985. The textile industry has been as cyclical as
many durable goods industries. Moreover, it has
proven to be vulnerable to foreign competition.
When the dollar was high and rising in 1984 and
1985, the domestic producers of textiles suffered
from an increase in imported textiles. Consequently, the output of textile mills in South Carolina
dropped sharply between August of 1984 and August
of 1985, pulling down total manufacturing output.
Then, when the foreign exchange value of the dollar
began to fall, the textile industry rebounded and
total manufacturing output in South Carolina turned
The attractiveness of the state to new manufacturers in many other industries also helped boost
South Carolina’s manufacturing output in the past two
years. In 1987, for example, the South Carolina
Development Board reported that capital investment
announced by new and expanding companies in the
state recorded the largest increase in 22 years. More
than half of the capital investment was in the
manufacturing sector.
F’irginia. Manufacturing output in Virginia held
up fairly well during the last nine years (Chart 6).
In fact, during the recession of 1982, manufacturing
output in Virginia rose 1.6 percent, in contrast to the
decline in manufacturing output in the country. The
relative stability of Virginia manufacturing output
during this period was probably because almost threefifths of the state’s output was composed of the less
cyclically sensitive nondurable goods. Also, Virginia
economic activity, including manufacturing, was
strongly influenced by federal government spending,
which added stability to the state’s growth rate.
The relative stability of Virginia output has also
been apparent during the current expansion. Dur-

ing the first two years of the expansion, manufacturing output in Virginia rose more slowly than it did
in the nation-at
an annual rate of 5.3 percent in
Virginia, compared to 10.9 percent in the nation. In
the last two years, however, Virginia’s growth in
manufacturing output was greater than the nations.
The behavior of Virginia’s manufacturing output
since 1982 might also suggest that the state’s industrial structure is somewhat more sensitive than the
nation’s industrial structure to changes in the foreign
exchange rate. From 1982 to 1985 when the foreign
exchange value of the dollar was rising, manufacturing output in Virginia rose more slowly than it did
in the nation. And during the more recent period
when the foreign exchange value of the dollar was
falling, manufacturing output in Virginia grew faster
than in the nation.
Ukt lh’rginia. The West -Virginia pattern of
growth in manufacturing output contrasts more
sharply than other District states’ to the national
pattern (Chart 7). Manufacturing output in West
Virginia declined steadily and dramatically from 1979
through 1982, when the state experienced severe
drops in manufacturing activity during the two recessions. The sensitivity of West Virginia to economic
contractions was largely due to its dependence on
three highly cyclical industries: the chemical industry;
the primary metals industry; and the stone, clay, and
glass industry. These three industries were responsible for over half of the manufacturing output in West
Virginia, and all three suffered sharp downturns nationally in the recessions of 1980 and 1982.
West Virginia’s manufacturing output did recover
somewhat during the early part of the expansion that
began in late 1982. Most of the gains in 1983 and
early 1984 were in the durable goods sector.
However, plant closings and layoffs in 1984 ended



the short-lived recovery in West Virginia manufacturing. Output leveled off late that year, then
weakened further through 1986.
West Virginia’s close ties to coal mining help explain the decline in manufacturing output in the
early 1980s and its subsequent poor recovery.
Employment in coal mining declined sharply during
the period covered by this study. Largely because
of out-migration attributable to high unemployment
rates in the coal fields, and the lack of alternative
employment elsewhere in the state, West Virginia’s
population fell. Over the first five years of the 198Os,
the population in West Virginia declined almost one
percent, while it rose 6.3 percent in the nation.
During the eight years ending with the fourth quarter
of 1987, real income in West Virginia declined 3.4
percent. The state’s shrinking population and real
income might have contributed to the decline in
output by reducing demand for
manufactured goods, such as food items, targeted for
local markets.
The manufacturing outlook for West Virginia may
be improving. The state’s producers finished 1987
with output on the rise.



This section reviews the 1980’s production patterns of the textile, chemical, and electric equipment
industries. Each of these three industries produced
over 10 percent of total manufacturing output in the
District, and the three industries combined accounted
for an estimated 35 percent of the region’s manufacturing output in 1987.
The U.S. textile industry is more heavily concentrated in the Fifth District than in any other Federal
Reserve District. In 1986, for example, five out of
every 10 textile workers in the nation were employed
at mills located within the District.
The textile industry produced more than 10 percent of total District manufacturing output during the
1980s and even larger shares of the manufacturing
output of the Carolinas. In 1985, for example, the
textile industry in North Carolina accounted for about
14 percent of that state’s manufacturing output, and
in South Carolina, about 20 percent. In that year,
the two Carolinas were responsible for 88 percent
of total District textile output, and Virginia accounted
for almost all of the rest (Table IV).
The U.S. textile industry went through some
radical adjustments in the past 10 years. During the



Textile Production in Fifth District States

of District






North Carolina



South Carolina









West Virginia

late 1970s and up to mid-1982, both employment and
output in the industry declined. After about a year
of recovery in 1983, the textile industry suffered
another decline in 1984. During these periods of contraction, the textile industry experienced a wringingout process as hundreds of inefficient mills were
closed for good. Many of the surviving textile
manufacturers invested in highly productive machinery and manufacturing processes. Despite pla.nt
closings, total productive capacity in the industry has
been fairly constant since 1980. For the most part,
therefore, changes in production over the period
under review reflect changes in capacity utilization.
At the end of 1987, textile mills were operating at
close to their maximum capacities.

Chart 8 shows that output for the textile indust.ry
in the Fifth District generally followed a path similar
to that of textile output in the nation. However, the
District’s output of textiles declined proportionally
less than the nation’s during the two recessions
early in this decade, and proportionately more during the industry slump of 1984. From late 1984 to
the end of 1987, District textile output grew less


rapidly than U.S. textile output. At the end of 1987
District textile output was 11.0 percent above its July
1982 level, but still 2.2 percent below its March 1984
peak. In contrast, U.S. textile output was 34.4 percent above its July 1982 level, and 9.3 percent above
its level of March 1984.
In addition to differences in growth rates, differences in the timing of national and District swings
in textile output are apparent from Chart 8. The most
obvious is the earlier upturn in national textile production in 1985. Somewhat less obvious from the
chart are the “delayed”,District downturns, as compared to the nation’s, in 1980, 1981, and 1984.
The differences between the United States and
District patterns of textile output over the period
probably were due partly to the difference in the types
of textiles produced. For example, over the period
under review only about 2 percent of the textiles
manufactured in the District were carpets and rugs,
compared to 9 percent in the nation. The demand
for carpets and rugs is closely tied to the demands
for new homes and new cars. These demands usually
shrink in economic contractions and expand during
periods of economic growth.
Also important was the District concentration in
synthetic fiber products. Over the period reviewed,
about 25 percent of District textile output came from
synthetic fiber weaving mills versus about 15 percent in the rest of the nation. This relative District
emphasis on manmade fibers worked to the advantage of the region’s textile manufacturers in the
early 1980s when demand for synthetic textile products rose sharply, but to their relative disadvantage
in more recent years when demand shifted back to
natural fibers.’

Table V

Chemical Production in Fifth District States

of District






North Carolina



South Carolina






West Virginia




however, declined proportionately less than in the
country as a whole in 1979-80, and then declined
more in 1981-82. Following the
trough of the recession in late 1982, District chemical
output rose rapidly through most of 1983, outpacing growth in U.S. chemical output. From
October 1983 through December 1987, however,
District growth in chemical output was slower than
that of the nation.
Differences in the timing of District and U.S.
declines and recoveries in chemical industry output
are also apparent from Chart 9. The nation’s chemical
producers began reducing production much earlier
than the District’s in 1979-80, but the District producers reduced output earlier than in the nation in
1981. Also, it appears that in the recession of 1982,
the chemical industry in the country as a whole
started to recover earlier than in the District.
The differences between the District and the
nation in their growth patterns for chemical industry
output reflect their different types of products. Consider three chemical groups: drugs; cleaning preparations and cosmetics; and synthetic and plastic

The Fifth District produced an estimated 13 percent of the nation’s chemical and allied products in
1985. North Carolina accounted for the highest
percentage of the District’s total (Table V). The
chemical industry’s proportion of all manufacturing
output in the District and in the nation increased only
slightly from 1979 to 1985, but in West Virginia the
chemical industry’s share of that state’s manufacturing output rose from 9.4 percent in 1979 to 38.7 percent in 1985.
The output of chemical products in the Fifth
District generally followed the same pattern as in the
nation (Chart 9). District chemical production,
? Kent M. Barker, “Textiles,” in 1987 U.S. Industrial Output,
U.S. Department of Commerce/International
Trade Administration, pp: 41-43.


Table VI

Table VII

Percentages of Output Within the Chemical and
Allied Products Industrial Category, 1982

Electric Equipment Production
in Fifth District States

Fifth District

United States




Cleaning Preparations
and Cosmetics



Synthetic and Plastic








North Carolina



South Carolina






Electric and electronic equipment manufacturers
in the Fifth District produced nearly 10 percent of
the nation’s output for that industry in 1985. North
Carolina was the largest District producer (Table
s Leo McIntyre, “Cleaning Preparations, and Cosmetics,” in I985
IndustrialOttput, U.S. Department of Commerce, Bureau of Industrial Economics, p. 16-5.




The electric equipment industry grew rapidly in
both the District and the nation over the 1979 to
1987 review period (Chart 10). Output in the industry rose at an average annual rate of 7.7 percent
in the District and 4.0 percent in the nation in those
eight years. From 1979 to 1985, the electric equipment industry’s share of total manufacturing output
in the District rose from about 7.5 percent to 12.5
percent. The electric equipment industry comprised 19.0 percent of manufacturing in Maryland in
1985 and nearly 12.0 percent each in North Carolina
and Virginia.
The national and District growth patterns in the
output of the electric equipment industry were quite
similar until the middle of 1984. District output grew
somewhat faster than national output from 1979
through 1982, but experienced much the same in
the way of contractions in growth during the recessions of 1980 and 1981-82. The divergence in
District and national growth rates in the electric
equipment industry began in the autumn of 1984,
when the industry’s output growth in the nation fell
while that of the District continued
to rise.

Electric Equipment

9 Philip Lewis, “Chemicals and Allied Products,”
dust&l Output, U.S. Department
of Commerce,
Industrial Economics, pp. 97-102.



West Virginia

materials (Table VI). The trends and cycles in output of these three groups over the review period have
diverged and affected comparisons of the District
with the nation.
The relatively greater concentrations in the nation
versus the District in drugs and in cleaning preparations and cosmetics helped stabilize total chemical
industry output nationally during the early 1980s and
helped industry output to grow nationally thereafter.
Output in the drug industry grew over the entire
period under review. To a somewhat lesser extent,
output in the cleaning preparations and cosmetics
group also contributed to greater stability and growth
The wider fluctuations in the District chemical
industry from 1981 through 1983 were at least
partly due to the District’s higher concentration in
the production of synthetic and plastic materials.
During 1981-82, exports of petrochemicals, of which
synthetic and plastic materials are a part, fell
sharply for several reasons, including shrinking world
demand and the imposition of antidumping duties.9
In 1983, exports of these products rose rapidly until
leveling off in 1984-85 because of the high foreign
exchange value of the dollar. In 1986-87, a falling
dollar and lower oil prices helped stimulate world
demand for synthetic and plastic materials.

of District

in 2982 ZnBureau of



The explanation for the more rapid District growth
in the output of electric equipment lies in its lesser
concentration in the production of electronic components and its greater concentration in communications equipment. The national decline in electronic
equipment output from mid-1984 to mid-1986 was
due largely to a decrease in the output of electronic
components. A consolidation of U.S. producers of
electronic components occurred in 1985 because
of intense foreign competition. The District felt the
effects of this competition somewhat less than the
nation because manufacturers of electronic components comprised only 19 percent of the District’s
output for the electrical equipment industry as compared with the nation’s 25 percent.
The relatively faster growth in electric equipment
output in the District compared to the nation was
also due to the District’s relatively greater concentration in the production of communications equipment. About 40 percent of the District’s electric
equipment production over this period was communications equipment, compared to about 33 percent in the nation. Demand for products in this group
grew rapidly in the 1980s for two major reasons. First,
a large proportion of output was associated with the
growth in federal government defense expenditures.
Second, the continued introduction of new products
stimulated demand.
What is true for the electric equipment industry
seems to replicate the general patterns discussed in
the rest of the article; namely, there appear to be
differences in the patterns of production in specific
states and industries. The information presented in
this article does not exhaust the findings that one can
acquire from these indexes. We hope that researchers
will be encouraged to extract more insights from our

Board of Governors of the Federal Reserve System. Fifth
Federal Reserve District electric-use data, unpublished.


I986 Edition, Washington, D.C.

Bryan, M. F. and R. L. Day. “Views from the Ohio Manufacturing Index.” Federal Reserve Bank of Cleveland
EconomicRewiew(Quarter 1, 1987): 20-30.
Zoltan. “Annual Output Indexes for Federal
Reserve Districts 19634986.” Presented at the meeting of
the System’s Committee on Regional Analysis held at the
Federal Reserve Bank of St. Louis, October l-2, 1987.
Pyun, C. S. Sixth District ManufacturingIndex, TechnicaLNote
and Statistical Suppkment. Federal Reserve Bank of
Atlanta, 1970.
Schnorbus, Robert H. and Philip R. Israilevich. “The Midwest
Manufacturing Index: The Chicago Fed’s new regional
economic indicator.” Federal Reserve Bank of Chicago
EconomicPenpectiwes11 (September/October
1987): 3-7.
Sullivan, B. P. Methodoologv
of the Texar Industrial Production
Index. Federal Reserve Bank of Dallas, 1975.
U.S. Department of Commerce, Bureau of Census.
Survq of Manufacturwx,various issues.


U.S. Department of Commerce, International Trade Administration. U.S. Indum’ai Outiook,various issues.
U.S. Department
U.S. Department


of Energy.

Electric Power Monthby,various

of Labor, Bureau of Labor Statistics. Tape


Table A-l





Recession Periods
Jan. 1980Jul. 1981Jul. 1980
Nov. 1982







- 7.5



Wood Products
Paper Products

& Publishing


Clay & Glass











Nov. 1982Dec. 1987

Entire Period
Jan. 1979Dec. 1987















- 5.4





- 16.4

- 10.8











- 7.4















- 15.7

- 25.9

- 18.5















- 12.4


















Table A-2






















Food & Kindred
































Paper Products









Printing &









Chemical &
Allied Products


















All Durable





































































they are withheld

All Nondurable



Clay, & Glass


NA -



data were not available.


by the Bureau

of Census to avoid disclosing



figures for individual

* The proportion of nondurable goods is probably understated and the proportion
industry were not released in 1978 but were released in 1985.
U.S. Department
of Commerce,
and 1985.

Bureau of Census, Annual

of durable

Survey of Manufacturers,


goods overstated


for Industry

data for the rubber

Groups and Industries,