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Fisherian and Wicksellian
Price-Stabilization

Models in the

History of Monetary Thought

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of
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. . . 72e moneymanagementwouki thus ctit
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thrzuotened rise above that par.
to
-In&g F&k f3, p. si7J

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wbhb wouki norm@ be gwemed by t&ereal rate m&g at t& time /isJ a cimmtame
wbkb, so hng as it hsts, must cause a pmgmsive he or fall in prim . . . JTZusJ thm
s/w&i be a commm policy, a raising or hmihg of bank ram . . . jwn time to time in
order to akpms tire commodityprice hel wkn it showeda &znaknqto r& and to raise it
-Knuc Wiu&dZ/17, pp. 225, 223J

Introduction
Central bankers charged with the responsibility for
stabilizing the general level of prices need to know
at least two things. First, what causes prices to deviate
from their desired fixed target level? Secondly, what
policy rule or response most effectively corrects those
deviations and restores prices to target?
Historically, proponents
of price stability developed two basic reduced-form models to answer
these questions. One model, associated with Irving
Fisher, attributes price movements
to shocks
operating through excess money supply and demand.
It calls for money-stock adjustments to keep prices
at their target level. The other model, associated with
Knut Wicksell, ascribes price movements to discrepancies between market and natural (equilibrium)
rates of interest. It prescribes interest-rate adjustments to restore prices to target. Although both
models are fairly well known, their historical
significance has not always been fully appreciated;
Until the Keynesian revolution of the 1930s and

1940s they constituted the dominant policy models
in nineteenth and twentieth century central banking
tradition. In fact, many celebrated
economists
before Fisher and Wicksell contributed to their
development.
Given the importance of price stability as a policy
goal, it is useful to reexamine these historical models.
As simple, stripped-down prototypes of the more
elaborate macroeconomic models employed today,
they reveal in sharp focus much about the mechanics
of price-level stabilization. In particular, they provide
information on the relative price-stabilizing powers
of alternative policy feedback rules-e.g.,
money
stock rules versus interest rate rules. Accordingly,
the threefold purpose of this article is (1) to describe
the structure and logic of the two reduced-form
models, (2) to sketch their evolution in the history
of monetary thought, and (3) to analyze each to see
if they yield dynamic stability such that prices return
to target equilibrium following economic shocks. The
central message is that both models, if properly
formulated, still provide reliable guides to policy.

FEDERAL RESERVE BANK OF RICHMOND

3

The Models Outlined

‘
,

’

Before tracing the historical development of the
models, it is necessary to sketch their essential
features so as to identify what particular contributors
had to say about each. As presented here, both
reduced-form models consist ,of (1) a price-change
equation relating price movements to the variables
that cause them and (2) a policy-response function
specifying the feedback rule the central bank follows
to keep prices on target.
Fisherian Model
The Fisherian model says that prices rise or fall
when the existing quantity of money exceeds.or falls
short of the amount people wish to hold at prevailing prices and real ‘
incomes. It also says that
policymakers can correct deviations of prices from
target by expanding or contracting the money stock
(or at least its high-powered base component) as
prices are below or above their target level. In
symbols:
(1)

dP/dt

= &(M -kPy)

(2)

dM/dt

= @(Pr -P)

where dP/dt denotes price change;P actual prices,
Pr their fixed target level, M the money stock, dM/dt
its change, k the inverse of money’ turnover velocity
s
or the fraction of nominal income people wish to hold
in money, y real income, and o and fl positive
constants.
Thus suppose a money-control error or decrease
in money demand .produces an excess supply of
money. The resulting attempts by cashholders to get
rid of the excess cash through spending puts upward
pressure on prices according to equation 1. As prices
begin to rise above target, the central bank responds
by conuacting the money stock according to the feedback-policy rule represented by equation 2. In this
way the central bank eventually contracts the money
stock sufficiently to restore prices to target. Such is
the underlying logic of the Fisherian model.
Wicksellian Model
The alternative Wicksellian model attributes price
movements to the differential between the natural
(equilibrium) and market rates of interest. Prices rise
when the market rate is below the unobservable
natural rate, fall when the market rate exceeds the
natural rate, and remain unchanged at .a stationary
level when the two rates coincide. When prices start
4

to rise or fall the central ,bank acts to restore them
to target by raising or lowering the market rate in
proportion to prices’ deviation from target. Stated
mathematically: : 1 ,.
~ ..
‘
:,
_‘
..a.
(3)

dP/dt

= o(r -i)

(4)

di/dt = @(P APT)

’’

where r denotes the natural rate, i the market rate,
di/dt its adjustment, and the other symbols are as
defined above.
These reduced-form equations, are derived from
a larger model that explains how the interest rate
differential affects, (1). real investment and saving,
(2) loan supply and demand, (3) money supply and
demand, and (4) ‘
aggregate supply and demand.
Through these factors the rate differential moves the
price level.
Thus when the loan rate lies below the natural rate
(the rate that equilibrates saving and investment) investors demand more funds from banks than savers
deposit there. Assuming banks accommodate these
extra loan demands by issuing notes .a$ creating
checking deposits, a monetary expansion occurs.
Since neither real income nor prices have changed
in cashholders’ money demand functions, the additional money constitutes an excess supply of cash
that spills over into the product market in the form
of an excess demand for goods. This excess demand
.
puts upward pressure on prices which contrnue to
rise until the rate differential vanishes. Since the
model in its pure credit or inside money version contains no automatic
self-equilibrating
market
mechanism to eliminate the rate differential, the central bank must do the job. To arrest and reverse the
price rise the bank must raise the market rate until
prices return to target.
Of course if the central bank knew the level of the
natural rate it could always keep the market rate there
and no price movements would occur. But the
essence of the Wicksellian model is that the natural
rate is an unobservable variabie. that moves around
under the impact of productivity shocks, technological progress, factor endowment changes, and
other real disturbances that cause it to deviate from
the market rate. In such circumstances the central
bank does not know what the natural rate is. It knows
only that the resulting price level movements indicate
that the market rate is not at its natural level and must
be changed. That is, the bank must adjust the market

ECONOMIC REVIEW, MAY/JUNE 1990

rate in the same direction that prices are deviating
from target, ceasing only when they finally stabilii
there.
Historical Evolution of the Models
Having outlined the essential features of the two
price-stabilization models, one can readily uace their
evolution in the history of monetary thought. At least
four classical and neoclassical economists conuibuted
to the development of the Fisherian model: David
Hume (1711-1776), David Ricardo (177%1823),
Irving Fisher (1867-1947),
and Lloyd Mints
(1888-1989).
Likewise at least four monetary
economists helped advance the Wicksellian model:
Henry Thornton
( 1760- 18 1S), Thomas Joplin
(c.1790-1847),
Knut Wicksell (1851-1926), and
Gustav Cassel (1866-1945).
David Hume
The Fisherian model is much older than Irving
Fisher. The origins of the model date back at least
to David Hume’ 1752 essay “Of the Balance of
s
Trade.” There Hume stated the gist of the model’
s
equations, albeit in words rather than algebraic
symbols (see Waterman 115, pp. 86-71). True, as
noted below, he substituted the world gold price of
goods Pw for target prices Pr in the model’ feeds
back policy rule or money adjustment equation. He
also assumed that corrective money stock adjustments were achieved through international specie
flows rather than through central bank action. But
these are superficial differences only. Basically his
equations were those of the Fisherian model.
Hume applied the model to a small open economy
operating under a metallic (gold standard) regime with
fmed exchange rates and a currency convertible
into gold at a fixed price on demand. He showed how
inflows and outflows of gold through the balance of
payments would operate to correct monetary disequilibria and bring domestic prices in line with given
world prices. In his famous exposition of the international price-specie-flow mechanism he assumed a
sudden conuaction of the domestic money stock and
argued that three results would ensue.
First, the money stock conuaction would, by
reducing the existing quantity of money below the
amount people desired to hold, produce domestic
price deflation. Prices would fall in proportion to the
monetary shortage or excess demand for cash:
(5)

dP/dt

= cr(M-kPy).

Second, the fall in domestic prices P relative to given
foreign (world) prices PW would generate a uade
balance surplus B as cheaper domestic goods outsold dearer foreign ones at home and abroad:
(6)

B = /3(Pw-P).

Third, the trade surplus would be paid for by a compensating inflow of monetary gold from abroad:
(7)

B = dM/dt.

Substituting
(8)

dM/dt

equation

7 into equation 6 yields

= B(Pw -P)

which implies that the domestic money stock adjusts
through specie flows until domestic prices stabilize
at the fured level of world prices as required for
balance-of-payments and monetary equilibria. Here
is the Fisherian model with (1) world prices replacing target prices and (2) the balance of payments
replacing the central bank as adjuster of the money
stock.
David Ricardo
Hume applied the model to a metallic or convertible currency regime. Ricardo, writing almost sixty
years later, extended Hume’ model to an incons
vertible paper currency regime with floating exchange
rates and a variable price of gold.
Ricardo wrote during the Bank Resuiction period
(1797-l 82 1) of the Napoleonic Wars when the Bank
of England had suspended the convertibility of the
pound into gold at a f=ed price upon demand. The
suspension of specie payments and the resulting
move to inconvertible paper was followed by a rise
in the paper pound price of commodities,
gold
bullion, and foreign currencies. A debate then arose
over the question: Was there inflation in England and
if so what was its cause?
Ricardo’ answer was definitive. In various
s
newspaper articles and pamphlets, most notably his
18 10 High Price of Bullion, A Proof of the DqbrecMtion
of Bank Notes, he argued that inflation did exist, that
overissue of banknotes by the Bank of England was
the cause, and that the premium on gold (the difference between the market and official mint price of
gold in terms of paper money) together with the
pound’ depreciation on the foreign exchanges cons
stituted the proof. He reproached the Bank’ direcs
tors for having taken advantage of the suspension

FEDERAL RESERVE BANK OF RICHMOND

5

of convertibility to overissue the currency. And he
admonished them to contract the note issue until the
preexisting
noninflationary
price situation was
restored. Here is the model’ core postulate: that
s
rising prices spell a redundancy of money requiring
immediate corrective contraction.
In employing the model, Ricardo dropped Hume’
s
assumption of an observable general level of prices
since few reliable general price indexes existed at the
time. He argued that given inconvertibility, gold’
s
price and the exchange rate constituted
good
proxies for the unobservable general price level whose
movements they matched almost one-for-one. This
tight linkage derived from the notion that the pound
price of goods was by definition equal to the pound
price of gold times the world (and English) gold price
of goods. Likewise it derived from the corresponding idea that the pound price of goods equalled the
pound price of foreign currency times the foreign
currency price of goods. With the price of goods in
terms of gold and foreign currency given and normalized at unity, it followed that the paper pound
price of goods moved one-for-one with the pound
price of gold and foreign exchange.
Accordingly, in the model’ equations he made
s
three small changes. He substituted gold’ price and
s
the exchange rate for general prices P. He likewise
used gold’ premium over the official mint price and
s
the depreciation of the exchange rate to represent
price rises dP/dt. Finally, he used gold’ mint price
s
and the preexisting exchange rate to stand for target
prices PT.
He then condensed the equations into his famous
Rzizrdian &&him of eJcGt?TT
according to which if gold
commands a premium and the exchange rate is depreciated then the currency is by definition excessive
and must be contracted. His definition states that
rising prices, or rather their empirical proxies, the
gold premium and depreciated exchanges, sign@ an
excess supply of money according to the expression
His definition also directs
dP/dt = cr(M -kPy).
the central bank to reduce the money supply when
gold’ price exceeds its old mint price and when the
s
exchange rate is depreciated relative to its pre:
existing level. As these two differentials represent
the corresponding gap between actual and target
prices, one obtains the expression
dM/dt
=
fi(P-r - P). Hence the Ricardian definition of monetary
excess embodies both equations of the model.
hying Fisher
The two main twentieth century proponents of the
monetary model were the American quantity theorists
6

and price stabilizationists Irving Fisher and Lloyd
Mints. Fisher employed the model in developing his
famous “compensated dollar” rule for stabilizing the
purchasing power of the dollar. His rule called for
adjusting the gold content of the dollar or its inverse,
the official buying and selling price of gold,
equiproportionally
with changes in the preceding
month’ general price index. In essence his proposal
s
was based on the relationship: dollar price of goods
equals dollar price of gold times gold price of goods.
It required adjusting the dollar price of gold to offset
movements in the gold price of goods (as proxied
by last month’ general price index) so as to stabilize
s
the dollar price of goods.
Thus if excess supplies of monetary gold were
elevating the price of goods (both in terms of gold
and dollars) in the equation dP/dt = cu(M -kPy) the
monetary authorities would respond with compensating reductions in the dollar price of gold. The fall
in gold’ price would have a twofold stabilizing
s
effect. It would neutralize the inflationary impact of
the rise in the gold price of goods such that dollar
prices would remain unchanged. It would also, by
rendering gold cheaper to industry and the arts, divert
existing stocks from .monetary to nonmonetary uses.
The result would be to reduce the excess supply of
monetary gold that put upward pressure on prices.
Money (and prices) would move in the direction
dictated by the expression dM/dt = @(PT-P).
Fisher also used the monetary model in developing his alternative proposal to stabilize prices through
open market operations. He stated the essentials of
the model most clearly in his 1935 book 200% Mongr.
There he argued (1) that price level movements stem
from excess money supplies and demands, (2) that
prices can be restored to target via corrective adjustments in the money stock, and (3) that such
corrective adjustments can be achieved through open
market operations. As he put it:
If money became scarce, as shown by a tendency of the
price level to fall, more could be supplied instantly; and if
suderabundant,
some could be withdrawn with equal
promptness.
. . . The money management would thus
consist, ordinarily, of buying [securities] whenever the
price level threatened to fall below the stipulated par and
selling.whenever
it threatened to rise about that par. @.
97).

Via such operations, the monetary authority could,
he claimed, precisely adjust the quantity of money,
so as to “stabilize the price level at the prescribed
point.” (p. 90).

ECONOMIC REVIEW, MAY/JUNE 1990

Lloyd Mints
Fisher emphasized the efficacy of open market
operations. Lloyd Mints’ innovation was to note
s
that corrective money stock adjustments could be
achieved through government budget deficits and
surpluses as well as through open market operations.
In his 1946 article “Monetary Policy” and his 1950
book Monemy Pohy J% a Competitive society, he
pointed out that since deficits had to be financed
either by new money creation or by expansion of the
public debt, one could choose the former route and
use those deficits to augment the money stock.
Likewise, budget surpluses could be used to conuact
the money stock rather than to retire the public debt.
As to how those deficits and surpluses were to be
obtained, he favored variations in tax collections with
expenditures held constant. In any case, he argued
that the purpose of budget deficits and surpluses is
to increase or decrease the money stock M so as to
bring prices to target in the equation dM/dt =
P(Pr -P). Here is his contribution to the Fisherian
model.
Historical Development of the
Wicksellian Model: Thornton and Joplin
Like the Fisherian
model,
the alternative
Wicksellian interest rate model has its roots in
the writings of English classical economists (see
Humphrey [6]). Rudiments of the model’ prices
change equation dP/dt = cr(r -i) uace back to Henry
Thornton’ classic 1802 volume An &Gy
s
into the
Natm and Efem of th Paper Cm&t of &at Britain.
There he defined the two interest rates that enter
the equation and described the underlying inflationary
transmission mechanism through which they operate
to raise prices.
He argued that business loan demands depend on
a comparison of the loan rate of interest (i) with
the expected rate of return (r) on the use of the borrowed funds as proxied by the prevailing rate of profit
on mercantile capital. He further argued (1) that a
positive profit rate-loan rate differential induces an
expansion of loan demands, (2) that banks accommodate these demands by issuing notes and creating
checking deposits, and (3) that the resulting monetary
expansion, by stimulating aggregate expenditure in
an economy already operating close to full employment, puts upward pressure on prices which continue
to rise as long as the rate differential persists. Taken
together, these arguments imply that rising prices and
the money growth that supports them stem from
discrepancies between natural (equilibrium) and
market (loan) rates of interest as indicated by the
expression dP/dt = o(r -i).

Thornton did not state the model’ interest-rate
s
adjustment equation di/dt = @(P - Pr). But he did
note that the Bank of England could have forestalled price rises by setting its loan rate equal to the
going rate of profit on capital had statutory usury ceilings not prevented it from doing so. On this point
he differed from Wicksell and Cassel both of whom
viewed the natural rate as an empirically unobservable variable impossible to target.
Following Thornton, Thomas Joplin in the 1820s
and early 1830s added saving and investment schedules to the theoretical inflationary mechanism that
leads to the price-change equation dP/dt = cr(r -3.
He did so in his &&!im of a System PoktimZhnomy
of
(1823), KimsonthCu~(1828),
andhlawlystj
and Hktmy of the Curnmy &don (1832). In those
works Joplin pointed out that desired investment expenditure constitutes the demand for loanable funds.
He noted that saving constitutes part of the supply
of such funds. Finally, he stated that an excess of
investment over saving caused by a positive natural
rate-loan rate differential must be financed by net
money creation that puts upward pressure on prices.
Wicksell’ Contribution
s
The pioneering efforts of Thornton and Joplin notwithstanding, economists today chiefly associate the
interest rate model with the Swedish economist Knut
Wicksell. It was Wicksell who, in the late 1890s and
early 19OOs, derived the model’ reduced-form prices
change equation from a full structural model of the
inflationary process and who supplied the interestrate adjustment equation that closed the model. Containing the most complete account of the logic and
assumptions underlying the price-change equation,
his structural model merits examination in some
detail.
Following Wicksell, define the natural rate as the
rate that equilibrates saving and investment and that
corresponds to the marginal productivity of capital.
Likewise define the market rate as the rate banks
charge on loans and pay on deposits. Assume that
all saving is deposited in banks, that all investment
is bank financed, and that banks lend only to finance
investment. Let saving and investment be increasing and decreasing functions of the market rate on
the grounds that a rise in the rate encourages thrift
but discourages capital formation. Assume absolute
full employment such that shifts in aggregate demand
affect prices and not real output. These definitions
and assumptions yield the following equations linking the variables planned real investment I, planned
real saving S, market (loan) rate i, natural rate r, loan

FEDERAL RESERVE BANK OF RICHMOND

7

demand LD, loan supply Ls, excess. money. supply
X, excess aggregate demand E, money-stock .change
dM/dt, price-level change -dP/dt, and market rate
change di/dt.
Fist, natural rate-market rate! diff&entials produce
corresponding gaps between investment and saving:
(9)

I-S

= a(r-i)

where the coefficient a relates the rate differential
to the I-S gap.
Second, investment-savings gaps are matched by
new money created to finance them:
.
(10)

I-S

=:dM/dt.

In other words, since banks create money by
lending, moneta& expansion occurs when they lend
more to investors than they receive in deposits from
savers. To see this, denote the’
investment demand
for loans as LD = l(i). Similarly, denote loan supply
as the sum of saving plus new money created by
banks in accommodating
loan demands; in short
Ls = S(i) + dM/dt. Equating loan demand and
supply (LD = Ls) yields equation 10.
Third,. since the demand for money to hold at
existing prices and real incomes remains unchanged,
the new money created in accommodating
loan
demands constitutes an excess supply of money X:
(11)

dM/dt

= X.

Fourth, cash-holders attempt to get rid of this
excess money by spending it. As a result, the excess supply of money spills over into the commodity market in the form of an excess demand for
goods as aggregate expenditure at full employment
outruns real supply:
(12)

X = E.

Fifth, this excess demand bids up prices, which
rise in proportion to the excess demand:
(13)

dP/dt

= kE.

Substituting
equations (9) through (12) into
(13) yields the model’ reduced-form price-change
s
equation:
(14)

dP/dt

= c&-i)

where 01 = ka

which says that price-level changes stem from the
discrepancy between the natural and market rates
of interest.
8

As for the interest-rate adjustment equation that
closes the model and brings price movements, to an
end, Wicksell suggested, two. The first:

(1Sj
diidt

= ‘
b(dP/dt)

directs the central bank to adjust market rates in the
same direction ihat prices are moving, stopping
only when price movements cease. In Wicksell’ own
s
words:
So long as prices remain unaltered the banks’rate of
interest is to remain,unaltered. If prices, rise,. the rate of
inrer&.st,is be raised; and if prices fall, the rate of interest
io
is to be lowered; and the rate of interest is hencefdrth to
be maintained at its ‘
new level until a further movement
of prices calls for a further change in one d&Con or the
other., 118, p. 1891
The foregoing rule has one shortcomifig: it brings
prices to a standstillbut leaves them higher or low&r
than before: Because it fails to restore prices to their
preexisting target level Wicksell replaced it with his
second rule which he thought would stabilize prices.
That rule:
(16)

di/dt = ,B(P-PT)

directs the bank to adjust market rates to correct
price-level deviations from target.
That Wicksell proposed such a rule to roll back
prices to their original level after they had risen or
fallen is clearly evident in his writings. It appears in
his statement that bank rates should be raised or
lowered “to depress the commodity price level when
it showed a tendency to rise and to raise it when it
showed a tendency to fall.” [ 17, p. 2231. Stronger
still is his 1919 proposal to reverse inflation by
deflating Swedish prices to their 19 14 level.
In my opinion, we should try to return to the prewar
price level. It is difficult to present any valid argument for
stopping half way. The means to do this is to maintain a
high discount rate . . . in order co reduce the stock of
notes to the 1914 level. Ir is a very painful process, but
it is probably better to do it now rather than to wait.
119, p. 27, quoted in 7, p. 465)
He repeated his advice again in 192 1 when he argued
for
a withdrawalby the Riksbank of the cotal stock of notes in
circulation. Half this stock should be destroyed and the
rest returned to the holders of notes . . . , our prices
would fall to a level slightly below half the present level
of prices. Then it should be the duty of the R&bank to
hold A% level constant. [20, p. 86, quoted in 7, p. 4651

ECONOMIC REVIEW, MAY/JUNE 1990

In short, he advocated raising the discount rate so
as to contract the money stock and thus lower prices
to their pre-existing level. Here is the essence of
Wicksell’ feedback rule di/dt = /3(P - Pr). Whether
s
that rule does in fact possess the price-stabilizing
powers he sought is discussed below. Before doing
so, however, it is necessary to identify Gustav
Cassel’ contribution to the model.
s

matrix form and then examining the signs-positive,
negative, or zero-of the determinant and trace of
the coefficient matrix (see Chiang [Z, pp. 638-6431).
Expressed in matrix form, the model’ equations are:
s

Camel’ Contribution
s

Stability is ensured in this. second-order case if the
determinant &Y of the coefficient matrix is positive
and the trace -arky is negative. Since both conditions
are met, the model is stable. In other words, the roots
of the system’ characteristic equation are either real
s
and negative, implying monotonic movement to
equilibrium, or they are imaginary with negative real
parts, implying convergent cycles. In either case the
policy authorities, provided they adhere to the rule
of adjusting the money stock to counter price-level
deviations from target, can always bring prices back
to target. Indeed the model’ phase diagram displays
s
this result; prices and the money stock invariably
return to equilibrium directly or via convergent
counterclockwise paths (see Figure 1).

Wicksell’ policy rule can be criticized as being
s
inferior to the alternative rule of maintaining equality between market and natural rates such that price
changes never occur. Gustav Cassel’ contribution
s
was to rebut this criticism. In his famous 1928
article “The Rate of Interest, the Bank Rate, and the
Stabilization of Prices” he argued that any rule requiring knowledge of the unobservable natural rate
was completely non-operational
and therefore of
little use to central bankers. Policymakers could never
know what the natural rate is. But they could observe
the price signals generated by departures from the
natural rate. And these very signals constitute the
arguments of the feedback policy rule di/dt =
/3(P - Pr), thereby rendering that rule operational. On
this ground Cassel contended that Wicksell’ feeds
back rule dominated the alternative natural rate
rule.
.
Dynamic Stability of Equilibrium
Without exception all the economists discussed
above saw their models as offering reliable guides to
policy. None questioned the ability of those models
to deliver price stability. It never occurred to them
that the models might be dynamically unstable such
that policy attempts to stabilize prices would
destabilize them instead. They simply assumed that
the models’ feedback policy rules would always be
sufficient to restore prices to target.
It is now time to test the validity of that assumption by formal stability analysis. And it is extremely
important to do so. For if the models indeed are
dynamically unstable such that attempts to stabilize
prices destabilize them instead then those models
are useless as policy guides and should have been
discarded long ago. It turns out that both models are
stable provided one adds a price-change variable to
the Wicksellian model’ policy response function.
s
Stability of the Fisherian Model
Demonstrating
the dynamic stability of the
Fisherian model requires expressing its equations in

Oscillatory Behavior of the
Wicksellian Model
The same techniques of dynamic stability analysis can be applied to the Wicksellian model. One
simply expresses the model in matrix form and
examines the signs of the determinant and trace of
the coefficient matrix. As shown below, the model
generates perpetual oscillations of prices and interest
rates about equilibrium until a price-change variable
is added to the policy response function. Then the
model converges to equilibrium.
To demonstrate the validity of these assertions
write the model dP/dt = o(r -i) and di/dt =
fl(P - PT) in matrix form:

Examination reveals that the determinant c~/3of the
coefficient matrix is positive and the trace is zero.
This in turn means that the characteristic roots
of the system are imaginary with zero real parts,
implying cycles of constant amplitude without convergence or divergence. Thus the best the policymakers can do when adhering to the feedback policy
rule of adjusting interest rates to counter price deviations from target is to keep prices cycling forever

FEDERAL RESERVE BANK OF RICHMOND

9

Figure 1

Figure 2

Fisherian Model’ Phase Diagram
s

Wicksellian Model’ Phase Diagram
s
P

P

dP
5’
0

r

L

PT

PT

di
=o
dt

-I
-M

0

This diagram depicts the dynamical behavior of the
two-equation monetary model dP/dt = cr(M- kPy)
and dM/dt = /3(Pr- P). The positively sloped line
shows all P-M combinations that yield zero excess
money supply such that prices do not change. It is
the graph of the expression P = (1lky)M obtained _
by setting dP/dt equal to zero in the model’ first
s
equation. Points above the line represent situations
of excess demand for money putting downward
pressure on prices (see vertical arrows). Points below
the line represent situations of excess supply of money
putting upward pressure on prices (see vertical
arrows).The horizontal line graphs the expression
P, = P obtained by setting dM/dt equal to zero in the
model’ second equation. The line shows that when
s
prices are on target no corrective money stock
changes are required. Points above the line represent
positive price deviations from target requiring contractions of the money stock (see horizontal arrows).
Points below the line represent negative price deviations from target requiring expansions of the money
stock (see horizontal arrows).Starting from any disequilibrium point B prices and money will converge
to equilibrium A either directly or via the counterclockwise path shown.

around target. Indeed the model’ phase diagram
s
displays this result: the path of prices and interest
rates orbits ceaselessly around equilibrium without
approaching it (see Figure 2). True, prices conform
to target on avenage over the whole cycle. But they
also are forever rising and falling. Clearly this is not
the sort of absolute price stability Wicksell or Cassel
sought. Their model represented by matrix equation
18 cannot deliver such stability.
Response Function Fully Specified
The foregoing result stems from the particular
policy response function embedded in the Wickselhan
model. -That response
function derives, from
10 -

0

1
+i

r

This diagram depicts the dynamical behavior of
the Wicksellian two-equation interest rate model
dP/dt = a(r- i) and dildt = @(l?- Pr). The vertical
line graphs the expression i = r obtarned by setting
dP/dt equal to zero in the model’ first equation. The
s
!ine shows that when the market rate equals the natural
rate no price changes occur. Points to the left of the
line represent situations in which the market rate is
below the natural rate causing- prices to rise (see
vertical arrows). Points to the right of the line represent situations in which the market rate is above the
natural rate causing prices to fall (see vertical arrows).
The horizontal line graphs the expression P = P,
obtained by setting dildt equal to zero in the model’
s
second equation. The line shows that when prices are
on target no corrective interest rate changes are
required. Points above the line represent positive
price deviations from target requiring corrective rises
in the market rate (see horizontal arrows). Points below
the line represent negative price deviations from target
requiring corrective fails in the market rate (see
horizontal arrows). Formal stability analysis reveals that
the coefficient matrix of this system has a zero trace
and a positive determinant. This means that the
characteristic roots are imaginary with real parts zero,
implying cycles of constant amplitude without convergence. The system ceaselessly orbits equilibrium
without approaching it.

Wicksell’ advice to the policymakers to adjust ins
terest rates to counter price deviations from target.
Consistent with that recommendation response function di/dt = /3(P -Pr) contains but one argument,
namely the gap P -PT between actual and target
prices. As noted above, however, Wicksell also
postulated an alternative response function coma&
ing price changes dP/dt as the independent variable.
Incorporating that variable into equation 4 yields the
augmented or fully specified function:
(19)

di/dt = P(P -Pi).

ECONOMIC REVIEW. MAY/JUNE 1990

4 b(dPldt)

”

that directs the authorities to adjust the market rate
in response to two variables, namely price changes
and the gap between actual and target price levels.
In other words, the equation’ last term b(dP/dt) halts
s
inflation or deflation in’ tracks while the fust term
its
/3(P- PT) seeks to undo the damage already done by
bringing prices back to target. This rule seems
eminently sensible. Certainly the Federal Reserve,
if charged with the duty to stabilize prices, would
respond to emerging inflation and deflation as well
as to price gaps.

Figure 3

Fully Specified Wickseliian Model’
s
Phase Diagram

Stability of Equilibrium
Incorporation of the price-change variable into the
policy response function renders the Wicksellian
model. dynamically stable. To show this, first
substitute equation 3 into equation 19 to obtain di/dt
= p(P - PT) + bcr(r -i). Then express this equation
together with equation 3 in matrix form:

Stability requires that the coefficient matrix possess
a negative trace and a positive determinant. The
model passes both tests. The trace -bar is negative
and the determinant /3a is positive as required, This
means one of two things: Either the roots of the
system’ characteristic equation are real and negative,
s
implying monotonic movement to equilibrium, or
they are imaginary with negative real parts, implying convergent cycles. In either case the policy
authorities, provided they adhere to the rule of
adjusting interest rates to counter price movements
and price-level deviations from target, can always
bring prices back to target. Indeed, the model’
s
phase diagram displays this result. Instead of orbiting
continuously around equilibrium, prices and interest
rates invariably return to equilibrium via a convergent clockwise path (see Figure 3). In short, the
fully specified Wicksellian model yields dynamic
stability after all. It follows that central banks conducting monetary policy through Wicksellian interestrate adjustment rules have not been seriously
misadvised.
Conclusion
The main conclusions of this paper can be stated
succinctly. Two models-monetary
and interest-rate
-historically have dominated analytical discussions
of the policy problem of price-level stabilization. Of
these, the Fisherian monetary model unambigously
yields price stability. By contrast, the Wicksellian

r

”

This diagram depicts the dynamical behavior of the
two-equation interest rate model dP/dt = a(r - i) and
dildt = B(P- P,) + b(dP/dt) = B(P- PJ + ba(r-i)
obtained by adding a price change variable to the
policy response function.The vertical line graphs the
expression r = i obtained by setting dP/dt equal to zero
in the model’ first equation. The line shows that when
s
the market rate equals the natural rate no price
changes occur. Points to the left of the line indicate
that the market rate is below the natural rate causina
prices to risa (see vertical arrows). Points to the right
of the line indicate that the market rate is above the
natural rate causing prices to fail (see vertical arrows).
The upward-sloping line graphs the expression
P = [P,-(bc@)r] + (Wg) i obtained by setting dildt
equal to zero in the model’ second equation. Points
s
above the line represent situations in which prices are
too high requiring corrective rises in the interest rate
(see horizontal arrows). Points below the line repre
sent situations in which prices are too low requiring
corrective falls in the interest rate (see horizontal
arrows). Formal stability analysis reveals that the
system is dynamically stable. Starting from any disequilibrium point B prices and interest rates will converge to equilibrium A either directly or via the
clockwise path shown.

interest rate model in which policymakers adjust
market rates in response to gaps between actual and
target prices does not deliver the absolute price
stability its authors sought. Instead it yields perpetual
oscillations of prices about their target level. Such
an outcome can be avoided by adding a price-change
variable to the model’ policy response function.
s
Doing so renders the model dynamically stable such
that the policymakers can always restore prices to
target. Policymakers can rest assured that neither the
Fisherian model nor the augmented or fully specified
version of the Wicksellian model will lead them
astray.

FEDERAL RESERVE BANK OF RICHMOND

11

REFERENCES
1. Cassel, Gustav. “The Rate of Interest, the Bank Rate,
and the Stabilization of Prices."
Quamdy Joumal of
&mo&s
42 (1927-28): 5 1 l-29. Reprinted in &a&s
in
Monew
T+.,
Edited by F. Lutz and L. Mints.
Homewood, Illinois: R.D. Irwin, 1951, pp. 319-33.
2. Chiang, Alpha C. Futukental Metho& of MazhnatkaI
&mornz&. Third edition. New York: McGraw-Hill, 1984.
3. Fisher, Irving. 200% Money. New York: Adelphi,
4.

1935.

. .!QaMting the lh’
&zr. New York: Macmillan,
1920.

5. Hume. David. “Of the Balance of Trade” (1752).
Reprinted in Wtitr& on Enmmnic. Edited by Eugene
Rotwein. Madison: University of Wisconsin Press, 1955.
6. Humphrey, Thomas M. “Cumulative Process Models from
on the Hl’
storyof
Thornton to Wicksell.” In P-e&m
Economic Thmght Volume IV: Selected Papers from the
History of Economics Society Conference 1988. Edited
by Donald E. Moggridge. Aldershot: Edward Elgar, 1990,
pp. 40-52.

11. Mints, Lloyd W. Monctory PO&Y@ a cmnpeririue So&y.
New York: McGraw-Hill. 1950.
12.
S&Z&,

“Monetary Policy.” Rev&r of Emnomics and
28 (May 1946): 60-69.

13. Ricardo, David. i?e H&h ?%e of B&on, a Rvoj of the
Depreciaon of Bunknom (18 IO). Reprinted in Tk WbrRr
of Davki Rkamb. Edited by P. Sraffa
and Chnqmhze
and M. Dobb. Vol. III. Cambridge: Cambridge University
Press, 1951.
14. Thornton, Henry. 14n &q+
into rh Notur and I$&
of
th Paper Cr&t of Grruf B&in (1802). Edited with an
introduction by F.A. von Hayek. New York: Rinehart and
Co., Inc., 1939.
15. Waterman, A.C.M. “Hume, Malthus, and the Stability of
Equilibrium.” Historyof Po/iticol&moqy 20 (Spring 1988):
85-94.
16. Wicksell, Knut. “The Influence of the Rate of Interest on
Prices.” Economit JounrO, 17 (1907), 2 13-20. As reprinted
in Economy Thgk
A H&on&l h&&y.
Edited by J.
Gherity. New York: Random House, 1965, pp. 547-54.

7. Jonung, Lam. “Knut Wicksell’ Norm of Price Stabilization
s
and Swedish Monetary Policy in the 1930’
s.” JoumaI of
Monetary Economics 5 (October 1979): 459-96.

17.

Lectures on PoktkaolGonomy. Vol. II Monq
(1906). Translated by E. Classen. Edited by L. Robbins.
London: Routledge and Kegan Paul, 1956.
.

8. Joplin, Thomas. Out&z of a Sysm of Poiikal Economy,
London: Baldwin, Craddock &Jay, 1823. Reprint. Kelley,
New York, 1970.

18.

. Intemrt and ptice (1898). Translated by
R.F; Kahn. London: Macmillan, 1936. Reprint. New York:
A.M. Kelley, 1965.

9.

19.

. Comments to a talk by G. Cassel. NotionaekonomkkaFlnzningm &thznaXngar, ( 19 19)) 2 5-28.

10.

12

. &vs on th Cutnx.y,
and Baldwin & Craddock, 1828.

London: J. Ridgway

An Analpi and Historyof the Cm-enq Question, London:’ J. Ridgway, 1832.

20.
Natbmakhn&

ECONOMIC REVIEW. MAY/JUNE 1990

Comments
lhninp

to a talk by G. Silverstolpe.
l%rfra&hgar, (192 l), 85-86.

Free Enterprise and Central Banking
in Formerly Communist

Countries

Robert L. Head

I.
I~VTR~DUC~UON
The economic difficulties manifest in communist
countries have encouraged a desire in many of them
to move toward a market economy. This paper
surveys specific reasons for the breakdown of centrally planned economies and discusses the difficulties
of making the transition to a market economy. A
general theme is that a market economy requires the
limitation
of government
intervention
in the
marketplace. This theme is illustrated by a discussion of the central bank. The final part of the paper
advances the proposal that formerly communist countries eliminate their central banks by adopting the
currency of a large western country with a stable currency. This proposal is discussed in the context of
the German monetary union, which will eliminate
the East German central bank.

B-OWN

OFTHE

II.
SOCIALISTECONOMIES

Market Pricing
The economies of communist countries collapsed
in part because external forces overwhelmed their
pricing system. In a market economy, prices equate
the value consumers attach to consuming more of
a good to the costs of producing more of it. This
equality between the (marginal) cost of consuming
and producing a good derives from the incentives in
the price system to eliminate discrepancies between
the marginal benefit of consuming and marginal cost
of producing a good. In contrast, central planners set
prices as part of an implicit tax-and-transfer policy
designed to subsidize some goods by taxing others.
On first pass, central planners set the price of a firms
output at whatever level is necessary to cover its
average labor costs. They then adjust price differentials among firms in order to tax some kinds of output and subsidize others.
I received useful criticism from John Caskey, Norman Fieleke,
Anne Krueger. ho Maes, Mark Swinbume, Steven Webb and
colleagues at the Richmond Fed.
l

Typically, basic foodstuffs and commodities are
subsidized, while goods considered
luxuries are
taxed. For example, the N&V Y& 25~~ (l/7/90, p.
E3) reports that every pound of butter sold in
Czechoslovakia
costs the government
more than
$1.70 in subsidies. The nm (4/3/90, p. A16) also
reports that in the Soviet Union, “the government
is forced to spend about $160 billion in subsidies on
food and some consumer goods annually, while the
cost of many industrial goods is far higher than in
the West.” The banking system extends credit to
cover the deficits of firms whose prices are set below
average cost.
Because central planners did not change prices in
line with changes on world markets, over time, the
subsidies required by their price system became
intolerably expensive. For example, in the Soviet
Union, energy prices were not raised with the rise
in world prices. The resulting increased subsidy to
energy-intensive activities and to Comecon countries
receiving oil and natural gas exports removed the
incentive to economize on the use of energy and
forced the Soviet Union to make large investments
in energy production that strained its economy. The
lack of a free-market price system to coordinate
economic activity in communist economies meant
that these economies could not adjust to changes in
the world economy.
Communist countries promisedequality
and individual security to their citizens in return for their
acceptance of authoritarian control. As the standard
of living in communist countries fell behind that of
capitalist countries, the need to deliver on this
promise became more pressing. In practice, in communist counuies, equality meant subsidizing basic
commodities
and foodstuffs.
Individual security
meant keeping open inefficient enterprises in order
to prevent unemployment.
The required system of
taxes and transfers became too costly and collapsed. The rationale for communism then collapsed.
In countries like Poland and the Soviet Union, the
pressure to provide subsidies overcame the ability

FEDERAL RESERVE BANK OF RICHMOND

13

of the government to tax. From that point on, credit
extension to enterprises running a deficit had to be
financed by printing money. The resulting inflation
interacted with unchanged, centrally set prices to produce shortages and lines. The time spent waiting in
line raises the effective price paid for goods and limits
demand. Workers waiting in line, however, cannot
produce. As production fell, the tax base also fell and
exacerbated the lack of revenue needed to finance
subsidies. In a letter to the N&v York ir;,, (12111189,
p. AlS), a visitor to Poland wrote:
I can testify to the harshness of everyday life, where there
were lines for every kind of food, for appliances and
clothing, etc. There were lines of people waiting in the
morning when we went to work, and they were still there
in the evening. There were lines forming on Sundays,
awaiting the stores’ opening on Monday if some home
appliances such as refrigerators, TVs or kitchen stoves
were promised. The average housewife had to run out
before 6 a.m. to get some breakfast, and after work orschool each member of the family had an assigned task to
stand in line for foodstuffs or other essentials.

By reducing the real value of fixed prices, inflation lowered the return to producers, who then
decreased supplies. An article in the Nm Yo& Z%zr
(lo/3 l/89, p. A4) reported that:
. . . in the last three years stocks of hogs, Poland’s principal livestock, fell from 22 million to fewer than 14
million. . . . In a reversal that would be bizarre in the
West, but is common enough here, the supply of pork has
diminished precisely as the demand has grown. What has
happened is that the farmers have killed off their own
herds rather than prolong their own agony of paying the
high prices fned for fed grain available only from a state
monopoly and at the same time selling their butchered hogs
for prices fared low enough to appease consumers.

state employees accept bribes and when individuals
who sell in black markets acquire goods from stateowned enterprises at controlled prices. As a result,
the public believes that market-determined
prices
favor the few.
Piecemeal decontrol of prices exacerbates the
public’ distrust of market pricing because groups sells
ing goods at prices that are high relative to statecontrolled prices become a target of popular resentment. For example, in the Soviet Union, the private
cooperatives, which initially could sell at unregulated
prices, b.ecame natural scapegoats for politicians in
crises. The NW Yorff2h.s (1 l/20/89, p. Al) reports,
“Mr. Gorbachev told the Soviet parliament this fall
that the soap shortage was the fault of the fledgling
private sector cooperative movement, something that
he began as part of peresuoika but which has become
so unpopular with the people-because
of allegations
of profiteering-that
even Mr. Gorbachev himself
often finds it an easy target.”
Free Trade
In a market economy, resource allocation is
based on the value placed on private property by
In market
economies,
pricemarket
prices.
coordinated voluntary exchange among individuals
solves the related problems of how to assign value
to scarce resources and of how to allocate them.
Integration into the world economy requires that a
country make its pricing system compatible with that
of the world economy by adopting market pricing.

Market pricing requires an end to price controls.
Price reform, however, is difficult because it
redistributes income. The queueing produced by the
use of price controls to suppress inflation redistributes
income to people whose time has little market value,
such as the elderly and unskilled. The price rises
necessary to eliminate suppressed inflation eliminate
queues, but they also raise relative prices to groups
with a comparative advantage in queueing.

The practice in communist counuies of using the
price system to provide subsidies collapsed when they
lost their ability to limit foreign uade. With free trade,
market economies export goods for which they
possess a comparative advantage in production. By
contrast, with free uade, communist economies export goods they subsidize, thus creating bargain
bazaars for foreigners until the communist governments run out of funds to finance exports. As explained to the Nm Yoli4 7Zm (1 l/30/89, p. Al) by
Gerhard Stauch, Chief Inspector for East German
customs:

The bribery and black markets that inflation and
price conuols create also render price reform difficult
politically. Because price rationing through bribery
and the “high” price of black markets is illegal, these
rationing mechanisms create a class of criminals. The
popular impression is that this class enriches itself
at the expense of the ordinary person by charging
exorbitant prices. This impression
is correct
when

The smuggling-speculation
spree has been stimulated by
the relative abundance here of consumer goods that are
inexpensive because they are subsidized up to 45 percent
.by the East German Government.
. . . Last Friday the
East German government initiated measures to curb the
smuggliig and speculation by declaring it illegal for foreigners, including American soldiers, to purchase a variety
of goods. This placed an additional burden on the.customs
service, Mr. Stauch said, because many of his offricers had
to be posted in . . . department stores.

14

ECONOMIC REVIEW. MAY/JUNE 1990

Local governments in the Soviet Union are even
attempting to keep Soviet citizens from other areas
from purchasing subsidized goods available locally.
According to the Financial Gms~(3/9/90, p. 19),
In Leningrad . . . the City Council has just introduced a
measure which forbids non-residents from buying a wide
range of basic consumer goods: fresh fruit and vegetables,
cheese, meat, sausage, knit-wear, china, watches, and so
on. This act of self-defense against marauders from neighboring towns is certain to provoke counter-measures
and
could, if unchecked, lead to fragmentation of large parts of
the Soviet economy.

Private Property
In the Soviet Union, Hungary and Yugoslavia,
decentralization of decision-making without allowing free-market pricing and without creating private
property rights has exacerbated poor economic performance. In communist counuies, coordination
among enterprises is effected through commands
issued by a central committee to ministries that in
turn issue commands to enterprises. Committees of
party members in enterprises enforce the centrally
issued commands. Party members exercise conuol
through the nomenklatura system, under which they
appoint key officials in enterprises. In the Soviet
Union, for example, this system gives the party direct
conuol over as many as three million key jobs (F&nc&d 7hws, 10/l 7189,. p. 2). In the Soviet Union,
perestroika abandoned this system of coordination
without replacing it with coordination by the price
system.
Under communism,
capital is controlled
by
members of the Communist Party. Authoritarian control of party members places controlof the capital
stock in the hands of the central committee. The
breakdown in the authority exercised by the Communist Party with perestroika
and with the
discrediting of the party has meant that effective conuol of the capital stock has passed into the hands
of the managers of enterprises. Pricing decisions then
are based on the ability of managers to exploit the
relative monopoly power of their enterprises. The
returns to monopoly power are divided between
managers and workers. This system, despite its
decentralized decision-making, has proven to be even
more inefficient than the centrally planned system
it replaced. The Finuncziz~
i%ts(3/12/90,
p. XIII)
reports, “A large part of the Soviet economy is like
a quasi-medieval economy, based on exchange of
goods in kind in an inefficient market, which operates
without publicised prices. It is run by powerful indusuial fiefdoms, rather than central planners.”

III.

Transferring State-Owned Property
In attempting to make the transition to a market
economy, the most difficult problem formerly communist countries face is how to transfer the stateowned capital stock to private ownership. In countries like the Soviet Union, there is a lack of popular
support for private ownership. Historically, ownership of resources has been determined through the
coercive power of the state. In the Soviet Union,
when the system of serfdom broke down and was
replaced by the system of industrial labor relations
in which workers are employed by capital owners,
it was natural to view the capital owners as simply
replacing the old landowners. Conuol of capital, like
conuol of land formerly, was viewed as the basis for
exploitation of workers. The belief that the ownership of resources is arbitrarily determined to benefit
a few undermines the respect for property rights
necessary to maintain a market economy.
The sale and pricing of state-owned assets will be
socially divisive. Consider houses, which are owned
by the government and rented at uniform rates.
Viktor Gerascenko, President of the State Bank of
the USSR, noted, “. . . housing is supplied by the
state at a ridiculously low price which fails to differentiate between an apartment in the center of
Moscow and one in the suburbs that is more than
an hour’ bus ride away.” ((%+e?x &L&J Sera,
s
1 l/22/89). In East Germany, the monthly rent for
a two-bedroom house in the center of East Berlin
is less than a meal for one person in a medium-priced
restaurant in West Berlin (Nm Yorff Z%zr, l/7/90,
p. E3). The sale of houses at market prices established through auction would upset ownership patterns completely. The people who lost their houses
would be dissatisfied. The sale of houses at belowmarket, uniform prices to current occupants,
however, would preserve a status quo in property
rights that was established arbitrarily or established
through political influence.
Transferring state assets to private owners gradually
will be difficult. The existence of private firms along
with state firms creates incentives to loot the state
firms by secretly transferring assets to the private

FEDERAL RESERVE BANK OF RICHMOND

15

firm~.~ There may be no procedures for selling off
state assets that will engender widespread public support for the resulting distribution of property. Govemments may simply have to hold open auctions of all
state-owned enterprises and accept that there will be
winners and losers.2

allow the marketplace to do so. Government must
maintain the rules of the competition over ownership of property and must provide an independent
judiciary to adjudicate disputes over property rights,
rather than decide the outcome of the competition
for ownership of property.

Committing to Private Property Rights

A primary difficulty in maintaining private property rights in a market economy is the inherent ambiguity between private and public property. In particular, taxes appropriate part of the return on private
property for the state and effectively force the individual to share ownership of property with the state.
Although private ownership of property is not
established in an absolute sense, market economies
have been able to use the rule of law and public support for private property to reserve a large part of
the return (and risk) of ownership of property to individuals. Just as important, these economies have
been able to provide a significant degree of consistency in the rules that determine the share of
the return to private property appropriated by the
state through taxes. This consistency is essential
in providing an incentive to accumulate productive
property.

In a market economy, individual producers and
consumers are the planners, and their plans are coordinated by the price system. Each individual (each
planner) needs to know only the prices immediately
relevant to his activity. In this way, the price system
economizes on the knowledge that each individual
(each planner) must possess. As a consequence, plans
can be made by those who possess detailed information about particular productive activities. In contrast, a central planner needs in principle to know
everything about an economy. The flaw in central
planning is that no planner can organize such a vast
amount of information-the
infinite complexity and
rapid change of modern economies simply overwhelm him.
The planners of a market economy, that is, the
individual producers and consumers, follow the price
system’ signals out of a desire to find the most
s
remunerative
use for their physical and, human
resources. Private ownership provides the incentive
to use resources productively. Governments of countries desiring to make the transition to a market
economy must protect private property rights. Instead of assigning property rights directly, they must
* In western countries, when a fum becomes insolvent, it is
immediately placed in court receivership to prevent looting by
the management. In the United States, the exception to this
practice was the insolvent S&Ls in the early 1980s that were
allowed to remain open through deposit insurance that relieved
their creditors of default risk. The S&L experience is analogous,
say, to what has happened in Poland, where the managers of
insolvent state-owned enterprises have transferred resources of
these enterprises to their own private firms.
2 In the absence of market prices that can be used to value firms
for sale, governments must simply release as much information
as possible about these fums through independent audits. By
offering large numbers of shares in these fms to the public,
individual shares will be available in small denominations that
can be purchased by individuals with only small savings. The
auction of shares could be modelled after the U. S. Treasury
bill auction. That is, investors would submit a tender in two
forms. With a competitive tender, an investor specifies a price
and the number of shares desired. With a noncompetitive tender,
an investor specifies the number of shares desired (up to some
maximum amount determined by the government) and agrees
to buy that number of shares at the average of the competitive
bids that are accepted. (A minimum payment is required when
tenders are submitted.) The government then accepts competitive bids up to a given fraction of the total shares and assigns
the remaining shares to the noncompetitive
bidders.
16

Communist countries have had difficulty in providing individual incentives because of their inability to commit to this fiscal consistency.
As
described above, in centrally planned economies,
prices are maintained through a tax-and-transfer
policy that subsidizes some activities by taxing others.
Under pressure to provide subsidies, communist
governments were unable to commit to allowing productive enterprises to retain some of their surpluses.
Litwack (1989) describes how, in the Soviet Union,
ministries under pressure to fund enterprises running a deficit impose taxes at their discretion at
whatever rates are necessary to appropriate the
surpluses of the remaining firms. Firms then have
no incentive to operate efficiently and generate
surpluses. On the contrary, discretionary taxation
creates incentives to run a deficit. Establishment of
private property rights requires a fiscal system that
is operated without discretion and that ensures consistency in the share of income appropriated through
taxes.
Countries desiring to make the transition to a
market economy must find ways of committing their
governments to a nondiscretionary
fiscal system.
More generally, they must find ways of limiting
discretionary
government
intervention
in the
marketplace. It is, however, difficult to devise the
institutional
safeguards that provide for this kind of

ECONOMIC REVIEW, MAY/JUNE 1990

commitment. Incumbent politicians possess an incentive to build the coalitions that keep them in
power by assigning property rights and-control over
markets to groups that support them politically.
Communist countries represent an extreme of this
phenomenon. No competition is allowed over ownership of resources. Conuol over resources is assigned to party members in return for their support
of the communist dictatorship.
There is a relationship between democracy and a
market economy in that each requires a resuiction
of the government’
s ability to limit competition.
Democracy is unusual historically because of the
difficulty of devising ways to keep the coercive power
of the state from being used to limit competition for
political power. The self-interest of individuals in
government works over time to erode the safeguards
placed on the ability of others to compete openly for
political power. Success in achieving democracy and
a market economy will depend on the success of
formerly communist countries in solving the related
problems of how to put into place institutional arrangements that safeguard free competition in the
political arena and in the economic marketplace.
Iv.

CENTRAL BANKS AND THE
TRANSITION

TO A MARKET

ECONOMY

Monetary Stability
Countries desiring to establish relative prices that
measure the interaction between resource scarcity
and consumer preferences need price level stability.
Determining
equilibrium relative prices is complicated by a constantly changing, unpredictable
average price level. Price stability requires an end
to rapid money creation which, in turn, requires fiscal
discipline. Governments too weak politically to levy
explicit taxes resort to an inflation tax, which does
not require legislation. Eliminating inflation therefore
requires that a government possess enough popular
support to enforce payment of taxes.
Another difficulty in making the transition to
market prices and price stability is the need to end
price conuols and allow a one-time rise in the price
level to eliminate past, suppressed inflation. This onetime price rise will cause a perception of loss of wealth
to the extent that persons were valuing their nominal
assets with a shadow price level lower than the
equilibrium price level. In counuies like the Soviet
Union, where the government has always maintained that inflation is confined to capitalist countries,

it seems likely that an open price rise will be seen
by the public as destructive of its health.
Eliminating the ability of the central bank to create
surprise inflation is an important part of limiting the
ability of government to interfere arbitrarily in the
economy. Surprise inflation appropriates part of the
value of existing money holdings and fixed income
securities. It is inconsistent with a fiscal system providing consistent rules to determine the share of
private property appropriated for public use. Price
stability also prevents the government from raising
revenue through the interaction of a nonindexed tax
code and inflation. In raising revenue, government
must respect the democratic safeguards provided by
requiring that taxes be enacted through explicit
legislation. Finally, price stability prevents governments from creating a shadow fiscal system that
redistributes income to politically influential constituencies through the combination of inflation and
price controls. [The ideas of this paragraph are
developed in Hetzel (1990).]
Market Allocation of Capital
In communist countries, banks are the only
creditors of enterprises. In the transition to a market
economy, banks will be r/re arbiters of which enterprises meet the market test of viability. Banks must
be required to make the hard choice not to continue
lending to an insolvent institution through having
their own capital and their own depositors’ money
at stake. Bank failures must impose losses on holders
of bank liabilities.
In general, in a market economy, the government
must allow firms to disappear if the marketplace
determines
they are nonviable. Firm closings,
however, produce concenuated
pressures that
governments find hard to resist. Separation of the
central bank from commercial banks is necessary to
prevent the government from using the central bank
to lend to commercial banks in return for their
lending to insolvent but politically influential enterprises. The base money creation of the central bank
must be resuicted to controlling commercial bank
deposit creation and the price level, rather than subsidizing particular uses of credit. In particular, either
the central bank should not lend at all to commercial banks or, if it does, it should lend only for shortterm liquidity needs. Cutting commercial banks off
from central bank credit ensures that commercial
banks risk their own capital when they lend.
From a wider perspective, it is essential that legal
arrangements strike a balance between requiring

FEDERAL RESERVE BANK OF RICHMOND

17

lenders to be at risk and providing them with an
incentive to lend. An incentive to lend rests on welldefined property rights and on an independent
judiciary that adjudicates disputes over property
rights. Legal arrangements
must include bankruptcy laws that allow borrowers to post collateral
that can be seized in case of default and, more
generally, determine how the assets of bankrupt firms
will be distributed among creditors. Private property rights also require elimination of government
price controls. Banks cannot assess solvency without
a price system that measures market-determined scarcity and demand. Price controls render problematic
bank decisions about solvency. Nonviable enterprises
can appear profitable because they obtain inputs at
artifically low prices, while viable enterprises can
appear unprofitable because they are forced to sell
at artificially low prices.
A Free Market in Foreign Exchange
A market economy requires a private market in
foreign exchange with no capital controls. Communist
countries have used their monopoly on trading in
foreign exchange and capital controls to enforce an
artificially high value for their currencies for two
reasons. First, as discussed above, these countries
subsidize basic commodities and food. If there were
a free market in foreign exchange, these items would
be exported. An overvalued exchange rate makes
subsidized goods expensive to foreigners while allowing the state to sell them cheaply to domestic
residents. Second, an overvalued exchange rate
means that the free market price of the foreign exchange turned over to the government by exporters
exceeds the price that the government charges importers. This excess is the economic equivalent of
an excise tax on foreign exchange uansactions. Lie
a regular tax, it can be disuibuted by the government.
For a weak government, it is an easy tax to collect
and distribute to politically potent state enterprises.
The price paid for an overvalued exchange rate is
isolation from the world economy.3 Market pricing
and a market-determined
exchange rate would produce efficient allocation of resources by encouraging a more open, export-oriented economy, which
would bring the benefit of exports into line with their
domestic resource cost. International trade has produced rising prosperity for countries integrated into
3 Through Comecon, communist countries entered into a large
number of barter arrangements with each other. These centrally
imposed trades, however, do not indicate the existence of an
open economy that produces according to its international comparative advantage.

18

ECONOMIC RNIEW,

the world economy through an efficient allocation of
production and through the encouragement to innovation from worldwide competition.

V.
GERMAN MONETARY UNION
Governments
desiring to establish a market
economy can limit government intervention in the
economy by limiting the ability of their central banks
to produce unpredictable changes in the price level,
to allocate capital, and to allocate foreign exchange.
The most direct way to limit intervention of the central bank in the economy is to eliminate the central
bank. Countries making the transition to a market
economy should consider simply adopting the currency of a large western neighbor with whom they
trade to a significant degree and which possesses a
stable currency. The experience of East Germany
with monetary union is interesting because it will
demonsuate one practical way of limiting government
intervention in the marketplace-elimination
of a central bank.
This proposal was made earlier by Milton Friedman (1973, p. 59) in the context of LDCs:
For most such [developingj countries, I believe the best
policy would be to eschew the revenue from money creation, to unify its currency with the currency of a large,.
relatively stable developed country with which it has close
economic relations, and to impose no barriers to the movement of money or prices, wages, or interest rates. Such a
policy requires not having a central bank.

The proposal is also similar in spirit to Wayne Angers
(1989) proposal that the Soviet Union adopt a gold
standard.
Monetary unioneliminates
the East German central bank. East Germany, like states in the United
States, will have surrendered its ability to run its own
monetary policy. For example, without a central
bank, Texas could not postpone the difficult adjustments required by the fall in the oil price in’
the
mid-1980s. First, because Texas cannot exercise
discretion over its money stock, it had no recourse
to an inflation tax. It could not print money to finance
the deficit in the state budget caused by,the oil-related
fall in revenues.
Second, the state of Texas could not use a central bank to keep alive thrifts rendered insolvent by
the fall in the price of real estate. It could not lend
to insolvent thrifts through use of the money-creating
powers of a central bank. When the price of oil fell,
Texas could not keep its terms of trade with the rest
MAY/JUNE 1990

of the United States from deteriorating by maintaining an overvalued exchange rate. Texas had no choice
but to let its price level fall to reflect a deterioration
in its terms of trade. Also, no one suggested that
Texas impose capital controls to prevent capital
outflows from reducing the value of its currency.

money creation with wealth creation. The resulting
inflation then leads to myriad interventions in the
economy in the form of wage, price, interest rate,
exchange market, and capital controls. Eliminating
the central bank is one way of committing to a limited
role for the state.4

German monetary union can serve as a model for
other East European countries. A country desiring
to eliminate its central bank and adopt a deutschemark standard would first allow its currency to float
freely to determine its equilibrium value relative to
the mark. The central bank would borrow marks,
perhaps through the new European Development
Bank. On a preannounced day, it wduld exchange
domestic currency turned in to banks for marks at
the prevailing free market exchange rate. It would
also exchange bank reserves for marks. The central
bank would then go out of business. The country
would maintain no restrictions ori trade in foreign
exchange and no capital controls. Henceforth, the
marketplace would determine the quantity of money
through the balance of payments. If the Treasury
wanted to affect the domestic quantity of money, it
would have to draw on mark accounts held with West
German banks.

A few years ago, this proposal would have been
radical. Today, it is quite conventional. It simply
telescopes the likely evolution of monetary arrangements in Eastern Europe into a one-time reform. The
countries of Eastern Europe want to integrate their
economies with the economies of western Europe.
Western Europe is itself moving toward monetary
union. By adopting a mark standard, the countries
of Eastern Europe simply accelerate the process of
economic and monetary integration with Europe.
They also eliminate the inflation, credit allocation,
foreign exchange controls, overvalued exchange rate,
and other mistaken policies that political systems
under stress require of their central banks.

There are, of course, problems in eliminating a central bank. One problem is that if countries in Eastern
Europe establish a mark standard, West Germany
receives the seigniorage from money creation.
Overall, however, governments can determine the
net wealth transfer between Western and Eastern
Europe. For example, partial forgiveness of the debts
owed by Eastern European countries could offset the
wealth transfer necessary to finance their imports of
marks. The new European Development Bank could
also finance the initial import of marks through
interest-free loans. Another problem is that countries
that suffered under Nazi occupation may be unwilling to use the mark as a currency. These countries
could adopt the dollar as a currency ..An example is
Poland, whose residents already save partly through
dollars received from workers in the United States.
Conversion to a mark standard requires a period
during which countries stabilize the foreign exchange
value of their currency in a freely operated foreign
exchange market. After doing so, they may see no
need then to abolish their own currency. A market
economy, however, isnot established by a one-time
reform. It requires a lasting commitment to limiting
the role of the government in economic activity. The
existence of a central bank provides a continuing
incentive for politicians under pressure to confuse

4 Creation of a currency board would be a close substitute for
the proposal to eliminate the central bank. [See Hanke and
Wakers (1990).] With a currency board, base money is created
only when someone turns in to the board a specified foreign currency, say, marks. Similarly, base money is extinguished when
someone presents domestic currency to the board and asks for
the foreign currency. A currency board would have the political
advantage that a domestic currency would circulate, rather than
a foreign currency. Also, the foreign currency held by the board
could be kept in the government securities of the foreign country, so that the seigniorage from money creation would not go
to the foreign country. The ,disadvantage of a currency board
is that there is no absolutelybiding way to keep the government from forcing it to devalue for domestic political reasons.

REFEREN~I~S
AngelI, Wayne D. “Monetary Policy in a Centrally Planned
Economy.” Paper presented at The Institute of the U.S.A.
and Canada, Moscow, U.S.S.R., September 4, 1989.
Friedman, Milton. Mommy and Economi Lhe&mmt.
The
Horowitz Lectures of 1972, New York: Praeger Publishers,
1973.
Hanke, Steve and Alan Walters. “Reform Begins with a
Currency Board.” Fina&
T&s, February 21, 1990,
p. 17.
“East German Currency Board.” Finankzf &es,
March 7; 1990, p. 19.
Hetzel, Robert L. “A Mandate for Price Stability.” Federal
Reserve Bank of Richmond Economic R&ew, March/April
1990.
Litwack, John M. “Discretionary Behavior and Soviet Economic
Reform.” Stanford University, December 1989.

FEDERAL RESERVE BANK OF RICHMOND

19

Is Saving Too, Low in the United States?
lTUh.z E. Cul/son

A high America savkzgsrate wouhi enhance our mmomk indepenrlkr reduce in$ationary
przssum, incmzseprvdtitivity, inzpme living star&m& and enabk us to reduce w/ratare
still obscenelykg/l interestrates after ckxe to a &cad? of disb$Won. Wliat zi nee&d sj a
national, nonpahan ej%rt to imm
he&an
savings, incZud..ngbetkpr incenk~ @r
priwate tz?h~mm??zt and a jim rkn on taxRF
plans
gmmaLiy.
-Louis

Rukeyser

America’ saviq-s c&k is a chknera. Lhifferentaccounting rnethoa3nzake it. szm as if the
s
U.S. zk dangervusb behind Japan in QZV&IS
and investment. But wtkn the nectx~ry
ad+tmentx &e ma& the gap d-kappeaar
-Paul Craig Roberts

The foregoing statement by Louis Rukeyser, host
of the public television program “Wall Street Week,”
was published in his nationally syndicated newspaper
column-run
August 19, 1989 in the local Richmond
newspaper
[ 171. Rukeyser also stated that the
Japanese save at a rate three times the U.S. rate,
which “. . . enables such foreigners
to amass
the
means to both finance our deficits . . . and to buy
American property.”
Martin Feldstein, former Chairman of the President’ Council of Economic Advisers, has also
s
lamented the low rate of saving in the U.S. economy,
stating:
The United States has long had one of the lowest saving
rates in the world. . . . The low race of saving means that
the United States has a lower rate of income and possibly
a substantially lower level of income growth than would
otherwise be possible. The already low rate of saving fell
precipitously in the 1980s. [7, p.41.

Observers in other countries are also concerned
about declining savings rates. The British Economist,
for example, has recently published an article concerning the worldwide reduction in the savings rate,
stating:
. . . Over the past three decades saving has fallen sharply
in almost every rich country. The industrial countries as a
group have saved less than 10% of their income in the
198Os, compared with 15% or so in the 1960s. This
decline has come at an awkward time. In the 1990s and
beyond, demands on the world’ pool of savings are likely
s
to be huge. (21, p.131
20

ECONOMIC RMEW.

Feldstein, Rukeyser, and the Economtit summarize
fairly well the conventional wisdom about saving in
the U.S. and world economies. But other observers
contend that the conventional wisdom may be wrong.
For example, in addition to Paul Craig Roberts
(quoted above), Robert Eisner (51 and Robert J.
Samuelson [ 181 have also written columns critical of
the conventional wisdom. Eisner’ piece is titled
s
“Low U.S. Savings Rate: A Myth,” while Samuelson’
s
is titled “The Great Savings Debate: A Smoke
Screen.”
This article examines the concept of saving and
evaluates the contentions that the growth rate of U.S.
saving in the 1980s has been slow relative to its own
past and slow relative to the rates of saving and
investment registered in’
other countries. The paper
is organized as follows:
I.

Saving and Investment Defined: these
definitions are necessary for evaluating
savings statistics

II.

National Income and Product
(NIPA): definitions

III.

The Current Condition of U.S. Saving and
Investment, NIPA basis

IV.

Alternatives or Complements to the NIPA:
including United Nations System of National
Accounts (UNSNA), Flow-of-Funds,
Hendershott-Peek,
Total Incomes System of
Accounts (TISA), and Jorgenson-Fraumeni

MAY/JUNE 1990

Accounts

V.

Comparison of Systems of National Accounts:
The Historical Record: current and past U.S.
savings compared under different
methodologies

VI.

Interim Conclusions

VII.

U.S. Saving Relative to Saving in Other
Industrial Countries

VIII. Conclusions

and Observations

,

.

I.
SAWNGAND INVESTMENTDEFINED
What is saving? Children are encouraged to save
by putting their loose change into a “piggy” bank.
The concept of saving that parents attempt to teach
their children is that if they refrain from spending
now, they can get something better in the future.
Thus, saving takes place when consumption is
foregone.

The logic of the somewhat counterintuitive equality
between saving and investment can be illustrated by
the following simplification. A certain quantity of real
goods and services will be produced in the economy
this year. Those who buy the goods and services will
either consume them or use them to produce other
goods. Thus, national product (X) is equal to consumption (C) plus investment (I). By the same token,
incomes (wages, rents, interest, and profits) are
generated when the national product is produced.
The sum of these incomes, known as the national
income (Y), goes to firms and individuals, who
either use it for consumption (C) or savings (S). Since
national product is equal to national income, saving
is equal to investment. Thus, in this simplified
example,
X=C+I
and
Y=C+S,

The definition of saving from an economist’ point
s
of view is analogous to the view of saving that parents
teach to children; namely, saving is refraining from
consuming. Can one spend his income and still be
saving? Yes. Suppose an entrepreneurial child who
has a lemonade stand uses his earnings to buy additional lemons and sugar instead of putting them in
the piggy bank. The parent would undoubtedly commend the child for using money wisely, but probably
would not think that the child had saved the money.
Economists, on the other hand, would consider the
young entrepreneur’ action as saving (and investing
s
in inventory). The key is that goods purchased for
investment are not consumed.
The Equality of Saving and Investment
In the case of the young entrepreneur, all of the
money saved was invested. This concept-what
is
saved is invested-is
important. Saving and investment are usually different acts by different people.
Nonetheless, from an economist’ viewpoint, the
s
amount of total saving in an economy is always equal
to the amount of total investment.
Thus, to an economist, a statement that the U.S.
savings rate is too low is equivalent to a statement
that the U.S. is consuming too much and investing
too little of its national output. The debate about the
adequacy of the savings rate, therefore, is essentially a debate about the future growth of the U.S.
economy and whether there is sufficient plant and
equipment spending to sustain adequate future
economic growth.

so, because X = Y,
s = I.

II.
THE NATIONAL INCOME AND
PRODUCT ACCOUNTS
The U.S. National Income and Product Accounts
(NIPA) are compiled and reported quarterly by the
Bureau of Economic Analysis (BEA) of the U.S.
Department of Commerce. Virtually all of the debate
about the existence or extent of a saving and investment shortage in the Unites States has to do with
definitions used in the NIPA, mainly those relating
to decisions about what goods and services to include
in national production.and, of those included, which
to count as being “used up” or “consumed.” A review
of the NIPA is thus in order.
The NIPA defines National Income as the sum
of wages, rents, interest, and profits, and Net National Product as the measure of national product that
is conceptually equal to the National Income.1 The
Net National Product (NNP) thus is the NIPA account that corresponds to “X” in the conceptual example above. Gross National Product (GNP), which
is the most widely publicized NIPA measure, is equal
to NNP plus depreciation.
* Net National Product is not quite equal to National Income.
It differs because of indirect business taxes, business transfer.
payments, statistical discrepancy, and subsidies.

FEDERAL RESERVE BANK OF RICHMOND

21

NNP and GNP are measures of final goods and
services produced in the country in a year, and they
are divided into subaccounts by type of purchaser
of the good or service. For example, NNP is broken
down into Personal Cqnsumption Expenditures (purchases by consumers), Net Private Domestic Investment (net purchases of investment goods and additions to inventory by businesses), Government
Purchases of Goods and Services, and Net Exports.
GNP has the same breakdown except that the investment account is Gross Private Domestic Investment, which is net investment plus depreciation.
The NIPA adopts the concept of saving discussed in the section above, namely, that saving is
refraining from consuming. Thus, the NIPA defines
personal saving as that part of personal income that
is neither paid out in taxes nor spent for personal
outlays.* Consistently, business saving is defined as
that part of profits that is neither paid out in taxes
nor distributed to shareholders, and government saving (or dissaving) is the combined budget surplus (or
deficit) of federal, state, and local governments. The
sum of personal, business, and governmental saving
equals the sum of net private domestic investment
and net foreign investment.3
The reader may have noticed that NNP differs
from “X” in the simplified example of the preceding
section in that it has separate government and foreign
accounts. This segregation of the government and
the foreign sectors results from special treatment accorded government and foreign investment spending.
Government capital formation (or investment) is not
recognized in the NIPA; government purchases of
investment-type
goods and services are not considered investment. Also, the funds used to purchase
such goods are not considered to be saving. This
treatment of government purchases is not followed
by most countries.4
2 Mainly purchases of goods and services for current consumption, but outlays also include interest payments to businesses
and net personal transfer payments to foreigners.
3 Personal saving in the NIPA is derived by deducting personal
taxes and personal consumption expenditures from personal
income. Business saving is found by summing undistributed
corporate profits (plus the inventory valuation and capital consumption adjustments), corporate and noncorporate capital consumption allowances, and net wage accruals. Government
saving is the sum of the Federal and state and local budget
surpluses (or deficits, which are counted as negative saving). Net
foreign investment is defmed as exports of goods and services
less imports, transfer payments to foreigners, and government
interest payments to foreigners.
4 See the discussion of the United Nations System of National
Accounts, below.

22

The NIPA also segregate the foreign sector and
include net exports (exports minus imports) as an
element of national product. The rationale for this
treatment is that when individuals (firms) purchase
imported goods for consumption (investment) purposes, those goods are included in the personal
consumption expenditure (domestic investment) account, but they are not produced in the United
States, so they should not be included in the U.S.
national product. On the other hand, when foreigners
abroad buy U.S. goods, the value of the goods is not
included in U.S. consumption or investment accounts, but the goods are produced in the U.S., so
they should be included in the U.S. national product.
This method works welI for determining the market
value of final goods and services produced in the
U.S., which is the definition of national .product,
but because net exports are defined as part of investment, it can produce anomalies in the investment
account.5
Critique of NIPA Investment
The NIPA definition of investment has been
criticized for its treatment of net exports as foreign
investment and because it excludes from investment:
(1) all types of government spending, (2) alI consumer
durables purchases, (3) “human capital” spending,
and (4) most research and development spending.
Discussion of these criticisms follows.
Net foreign investment is defined as net exports
less transfer payments to foreigners and government
interest payments to foreigners. This definition
means that a consumer in Japan who buys and eats
an American-made frozen pizza adds to U.S. investment, while a police department in Maryland that
buys a Japanese-made truck reduces U.S. investment.
5 Some economists have been concerned with the relation between saving rates and capital flows across countries. Their argument goes that since X - M = S - I, where X - M is net
exports, S is saving, and I is private domestic investment, any
excess of investment over saving must be offset by a deficit in
the balance of payments current account. This deficit in the
balance of payments account is interpreted to mean that foreign
capital flows into the deficit country to supplement domestic
saving.
This seemingly simple argument is actually incredibly complex, involving real exchange rates, real interest rates, marginal
propensities to consume and import, and potential investment
opportunities. It is too complex to investigate here in any depth.
Interested readers are invited to read Roger S. Smith’ coms
prehensive review article 1191. Smith concludes that much of
the economists’ concern about the relatiori between savings rates
and capital flows is misplaced.

ECONOMIC REVIEW. MAY/JUNE 1990

Of these two examples, only the second transaction,
which reduces measured investment, actually adds
to the real capital stock in the U.S.
Although consumer purchases of new housing are
defined as investment, the NIPA do not consider
consumer purchases of durable goods to be investment. Thus, consumer purchases of automobiles are
considered as current consumption even though
automobiles, like houses and other capital goods,
yield a stream of services over a period of many years.
Business purchases of automobiles, on the other
hand, are defined as investment.
A number of economists have criticized the treatment of government expenditures and consumer purchases of durables in the U.S. nationai income and
product accounts. As Robert Eisner puts it:
If Hera, Avis, or any other private company buys an
automobile, that constitutes investment. If a police car or
any other automobile is purchased by any branch of government, that shows up merely in “government purchases
of goods and services.” And automobiles purchased by
households are part of personal consumption expenditures.
Yet, in terms of economic theory and analysis, the automobile in each case, like any other durable good, is investment in that it will provide future services. . . . Is a nation
really investing less if it builds highways and produces
automobiles than if it invests in trains and busses? (6,
PP. 6-71

The NIPA definition of investment excludes
expenditures for human capital (such as education,
job training, health, etc.). These expenditures are
classified as current consumption, as are other expenditures designed to maintain or improve one’
s
ability to work. Business spending for research
and development is also excluded from business
investment.

The implications of the exclusions of government
and consumer purchases of investment-type goods,
R&D spending, and human capital expenditures from
the NIPA definition of investment have been analyzed extensively in the economics literature. Before
discussing these analyses, this article examines the
current condition of U.S. saving and investment as
depicted by the NIPA.
III.

THE CURRENT CONDITIONOF U.S. SAVING
ANDINVESTMENT, NIPA BASIS

Chart 1 displays gross saving as a percent of the
Gross National Product and net saving as a percent
of Net National Product. As the chart indicates, gross
saving as a percent of GNP has declined in recent
years. It averaged 16.5 percent from 1960 to 1981,
14.3 percent in 1982-1984, and 12.9 percent in
1985-1989.
A better measure of the potential effects of saving
and investment on the economy, however, is given
by net saving and investment,
which exclude
depreciation. It is important to know, for example,
whether a firm’ purchase of five new machines is
s
made to add to its capacity or whether the five
machines simply replace five old worn-out machines.
Chart 1 also illustrates that net saving has declined relatively more than gross saving in recent
years. Net saving as a percent of NNP averaged 8.0
percent from 1960-1981, 3.0 percent from 19821984, and 2.4 percent from 1985-1989. This reduction in saving is consistent with the FeldsteinRukeyser statements mentioned at the outset.

Chart 1

Eisner has also criticized these exclusions:

GROSS AND NET SAVINGS
National Income and Product Accounts (NIPA)

Research and development efforts by business are treated
as intermediate products, . . . research and development
expenditures by nonprofit institutions turn up as consumption, . . . and government expenditures for research
are buried in . . . government purchases of goods and
services. Yet, research and development expenditures may
well prove more of an economic investment in future output
than much of what is currently treated as “gross investment.” And what are we to make of the vast amounts of
expenditures . . . for education, training, and health, let
alone the raising of our children, which create the human
capital on which our future depends? Can we confidently
say that’ the United States is lagging far behind other
nations in investment without counting R&D, education,
government capital, and expenditures for household dur-,
ablesin ways that are comprehensive as well as comparable across countries? [6, pp. 6-71

Percent
20 L

I

Gross Savings + GNP

I
i950

55

FEDERAL RESERVE BANK OF RICHMOND

60

I
65

I

L

I

I

70

75

60

65

23

Iv.

Chart 2 shows net personal, business, and government saving as percentages of NNP. Net business
savings averaged 3.1 percent of NNP in 1960- 198 1,
1.9 percent in 1982-1984, and 2.0 percent in
1985-1989. Net personal saving averaged 5.6 percent of NNP in 1960-1981, 4.9 percent in 198284, and 3.4 percent in 1985-89. Net government
saving (dissaving actually), on the other hand, fell
from -0.7 percent of NNP in 1960-81 to -3.8
percent in 1982-84, recovering to -2.9 percent in
1985-89.

United Nations System of National Accounts
KJNSNA)

Federal, state, and local governments ran combined deficits that averaged 2.2 percentage points
more of NNP in 1985-89 than in 1960-8 1. The
culprit in government saving was the Federal government, however, because state and local governments
ran larger surpluses in 1982-89 than in 1960-81. The
Federal government deficit, by contrast, averaged 1.2
percent of NNP over 1960-81, 5.4 percent over
1982-84, and 4.3 percent in 1985-89.

This system of accounts is used for cross-country
comparisons in ah United Nations and OECD
publications. It is fairly similar to the NIPA except
in its treatment of government investment, where
the UNSNA defines nonmihtary government construction and equipment purchases as investment
while the NIPA does not. The U.S. provides national
economic data to the UN and the OECD in UNSNA
form, so the information is readily available to interested parties.

Are saving and investment in the national accounts
measured correctly, and if not, is mismeasurement
or misinterpretation
responsible for the U.S. “savings crisis?’ Several economists have constructed
alternative measures of national investment and
saving. Many of these alternative systems of national
accounts, particularly those that include nonmarket
activities and/or human capital investment, yield
estimates of saving and investment that are strikingly
different from the NIPA estimates. The paragraphs
below review these reconstructions
and the
arguments put forward by their proponents.

Chart 2

DISAGGREGATED NET SAVING
(as Percent of

NNP)

ALTE~KFMXS

0R COMPLEMENTS

TO THE

NIPA

A number of attempts are being made to provide
measures of economic welfare that are legitimate
alternatives to the BEA’ National Income and
s
Product Accounts. This article discusses five of these.

The Flow-of-Funds Accounts (FFA)
Flow-of-funds estimates are published quarterly
by the Federal Reserve Board. The FFA measure
saving differently from the way it is calculated for the
NIPA, thus providing a readily available alternative
source of estimates of national saving. The FFA
system also differs from the NIPA in that net purchases of consumer durables are considered to be
investment and the funds used to purchase them to
be saving.
Saving in the FFA is figured in the following way.
Individuals’ saving is defined as the sum of individuals’
increases in financial assets6 and tangible assets’ less
their net increase in debt,* both terms excluding
the effects of asset revaluation. Saving so measured differs in concept from NIPA personal saving
mainly because it includes: (1) Government insurance

Percent

6

6 Fiicial
assexs in this context inchrde checkable deposits, time
and savings deposits, money market fund shares, U.S. Treasury
securities, U.S. Government
agency securities, tax-exempt
obligations, corporate and foreign bonds, open-market paper,
mutual fund shares, other corporate equities, private life insurance
reserves, private insured pension reserves, private noninsured
pension reserves, Government insurance and pension reserves,
and miscellaneous financial assets.
7 Tangible

assets include owner-occupied

homes,

other fixed

assefs (indutling corporate farms), consumer iiurables, and
inventories

(also includes corporate

farms).

* Indiiiduals’ debt includes mortgage debt on nonfarm houses,
other mortgage debt (mcludes corporate farm), CollsUmer Credit,
security credit, policy loans, and other debt (includes corporate
farms).
24

ECONOMIC REVIEW. MAY/JUNE 1990

and pension reserves, (2) net investment in consumer
durables; (3) capital gains dividends from mutual
funds, and (4) net saving by farm corporations. In
addition, the two measures of saving differ because
of measurement differences, by an amount that is
called the “household discrepancy.“9
Hendershott-Peek Adjustments
Panic Hendershott and Joe Peek [lo] adjusted the
NIPA accounts to move the measurement of U.S.
private saving closer to the concept of saving as a
change in real wealth. Such a concept viewed saving as the difference between end- and beginningof-period net worth (revalued to current prices). So
defined, saving is equal to the change in real resources
available for future consumption.
The Hendershott-Peek concept of saving is similar
to that used in the FFA accounts. Indeed, Hendershott and Peek utilize FFA accounts quite liberally
in making their adjustments to NIPA savings and
investment. Beginning with the NIPA estimates of
personal saving and investment, Hendershott and
Peek, consistent with the FFA accounts, added net
purchases of durable goods by consumers, sole
proprietorships, and partnerships as well as net purchases of government life insurance and pension
reserves.rO They also added OASI contributions,
which are not defined as saving in the FFA.11
Defining social security contributions as part of
personal saving is controversial. The debate centers
on whether social security “contributions” differ from
ordinary taxes.12 The answer depends upon whether
the expectation of receiving future social security
benefits affects current consumption spending. If, for
example, individuals discount future social security
benefits as illusory and therefore continue to save
whatever amount they would have saved anyway,
9 See Wilson, Freund, Yohn, and Lederer
analysis of the “household discrepancy.”

[Z?] for a detailed

r” A dollar of income put into a private retirement plan is considered to be a dollar of income saved, and a dollar of interest
earned on those private retirement funds and not consumed is
also considered to be a dollar saved.
I* Hendershott and Peek froze. the amount of the social security contribution to be added in 1981-85 at the 1980 real level.
They argued that the promised rate of return on social security
began to fall short of the market rate in the early eighties, so
individuals would not have increased their contributions voluntarily after that time.
r2 They are treated as ordinary taxes in the NIPA.

social ‘
security payments
saving. l3

should not be defined as

Hendershott and Peek also adjust saving to remove
the inflation premium from interest income. This
adjustment also makes sense theoretically; from the
change-in-net-worth
approach to saving, it is clear
that a portion of interest payments in inflationary
periods merely compensate for a decline in the real
value of dollar-denominated assets. The mechanics
of HP’ actual adjustment procedure was criticized
s
severely by de Leeuw, l4 however, and it needs
rethinking.
In any event, despite de Leeuw’ criticisms, the
s
Hendershott-Peek
adjustments deserve serious consideration both as criticisms of the conventional accounts and as proposals for future change in the
NIPA.
The Total Incomes System of Accounts
CTISA)
Robert Eisner [6] has developed an extended
system of accounts that he calls the Total Incomes
System of Accounts (TISA). His system is based
upon the assumption that there is a need for “. . .
better measures of economic activity contributing to
social welfare, more inclusive and relevant measures
of capital formation and other factors of economic
growth, and better and/or additional data to fit concepts of consumption, investment and production.”
(6, p.21 Eisner’ system retains,the NIPA’ central
s
s
focus on the measurement of final product, but TISA
defines final product differently than the NIPA.
The TISA system is designed to “. . . include the
income corresponding to alI consumption and capital
1s The specific HP adjustments for social security have been
criticized. Frank de Leeuw, in a commentary, argued as follows:
“It would seem . . . that adjusting the present [NIPA] estimates
to a change-in-wealth approach would require adding contributions to personal saving and subtracting benefit payments.
. . . HP’ adjustments do add contributions . . . but they do
s
not subtract benefit payments. . . . This procedure has the
peculiar consequence that, if contributions and benefits rise by
identical amounts . . . personal saving rises.” [lo, pp. 224-251
The de Leeuw criticism of the HP social security adjustment
seems appropriate. One can, however, accept the argument that
social security contributions are saving and easily make the
straightforward adjustment suggested by de Leeuw of including
social security contributions in personal saving and excluding
benefits. This adjustment may be made to NIPA personal saving simply by adding the social security surplus, because NIPA
personal saving already includes social security benefit payments.
r4 Particularly their assumption that the average real interest rate
was constant (equal to the nominal rate in 1950) from 1950
through 1980.

FEDERAL RESERVE BANK OF RICHMOND

25

accumulation, market or nonmarket, in all sectors
of the economy.” [6, p. 211 Eisner’ TISA accounts
s
thus include items of nonmarket product such as
“
. . . the services of government, household capital,
unpaid household labor, and the opportunity costs
of students’ time.” [6, p. 211
Eisner classifies national defense, roads, and police
services as intermediate product, while redefining a
portion of commercial television, radio, newspaper,
and magazine services as final product. He. also subtracts expenses related to work from income and
product and adds the value of employee training
and human capital formation to income and product.
Also, business product is reduced by the amount of
intermediate product deemed to be received by
government.
The Total Incomes System of Accounts also includes as output the value of government subsides,
the deficits of government enterprises, the services
of volunteer labor, and the “. . . differences between
opportunity costs of military conscripts and jurors and
what they are paid.” 16, p.211
The TISA measure of capital accumulation includes NIPA’ gross private domestic investment,
s
plus (1) governmental acquisitions of structures and
equipment and additions to inventory ($125 billion
in 1981), (2) household acquisitions of durable goods
and additions to inventory ($351 billion in 1981),
and (3) investment in intangible capital in the form
of research and development, education and training, and health ($850 billion in 1981). As a result
of these changes, the TISA gross national product
was estimated to have been 54.4 percent larger than
NIPA GNP in 198 1, while TISA saving and investment measures were over three times larger than the
NIPA measures.
TISA also provides estimates, as a supplement to
conventional capital accumulation, of net revaluations
of tangible asset@ ($- 153.7 billion in 1981). TISA
thus equates current dollar net investment to the current dollar value of the real change in net worth,
whether due to acquisition of newly produced capital
or to changes in the value of existing capital.
Jorgenson-Fraumeni, Full National Product
Dale Jorgenson and Barbara Fraumeni [l 11 have
developed a system of national accounting that in15 Net revaluations measure the changes in the nominal values
of tangible assets less changes attributable to general price
movements.
26

eludes investment
in human and nonhuman
capital,and consumption of market and nonmarket
goods a&services.
According to Jorgenson and
Fraumeni (IF), the NIPA understates the amount of
economic activity in the U.S. by a very substantial
amount, primarily because nonmarket activities are
excluded.
The JF measure of capital formation puts investment in human capital at least four times the
magnitude of investment
in nonhuman capital.
Thus, the JF national accounts assign a much larger
relative importance to investment than the NIPA.
“FulI” investment in the JF system, where both
human and nonhuman capital are included, constitutes around half of “full” product. “Full” consumption makes up the-other half. The value of full
product equals the value of outlays on the services
of human and nonhuman capital, which take the form
of both market and nonmarket labor and property
compensation.
Labor compensation is about 90 percent of the
total factor outlay, and nonmarket labor compensation, which includes investment
in education,
household production, and leisure time, accounts for
more than 80 percent of labor compensation. The
JF system assumes that both labor and property compensation are measured after taxes are deducted and
subsidies accruing to individuals are added.
Consistent with the inclusion of gross human
capital in the JF accounts, JF estimate the depreciation of human capital. Depreciation of human capital
is defined as the sum of changes in lifetime labor
incomes that occur with age for all individuals who
remain in the population, and lifetime labor incomes
of all individuals who die or emigrate. Depreciation
of nonhuman capital is the sum of changes, in the
current year, of asset values for all investment goods
remaining in the capital stock and the asset values
of all investment goods that are retired from the
capital stock.
As a result of all of these adjustments, JF’ “full”
s
investment is substantially larger than Gross Private
Domestic Investment as reported in the NIPA. In
1984, for example, JF estimated “full” investment
to be $6.15 trillion, of which $5.12 trillion was human
investment and $1.03 trillion was nonhuman investment. NIPA gross private domestic investment was
estimated to be $0.66 trillion. As in the NIPA,
Jorgenson-Fraumeni full investment equals JF full saving, except for statistical discrepancy. Also, full
human capital equals full human saving.

ECONOMIC REVIEW. MAY/JUNE 1990

V.
COMPARISONOF SYSTEMS
OF
NATIONAL ACCOUNTS:
THE
HISTORICAL RECORD
UNSNA

Chart 4

PERSONAL AND INDIVIDUAL S/iVlNGS ACCOUNTS
NIPA vs. Flow of Funds (as Percent of NNP)
Percent

i
t

Versus NJPA

Chart 3 shows UNSNA gross and net savings
ratesI in comparison to NIPA gross and net saving
rates. As the chart shows, UNSNA savings rates were
consistently larger than NIPA rates, which is to be
expected because saving in the UNSNA system includes funds to be used for government capital
spending. UNSNA net saving does show a downward
trend after 1973, but its downward movement is considerably more moderate than the trend in ‘
NIPA net
’ saving. UNSNA net saving averaged 7.9 percent of
net domestic product in the 1970-83 period and 6.6
percent of NDP in 1984-88. NIPA net saving, in contrast, averaged 8.0 percent of net national product
in 1970-83 and 2.6 percent of NNP in 1984-88.
Flow-of-Feds

Versus NIPA

Chart 4 shows individuals’ saving from the flowof-funds accounts (FFA) and the reconcilement of
the FFA and NIPA personal saving rates over the
1952-89 time period. All three are plotted as percentagesof NNP. The comparison shows, first, rhat
FFA personal savings rates, even after reconciliation,
I6 As percentages of gross damestic product (GDP) and net
domestic product (NDP). GDP is the market value of output
produced by factors pf production Win
a country, while GNP
is the market value of output produced by factors of production
owned by citizens of a country.

Chart 3
NIPA vs. UNSNA
Percent

Gross t GNP (NIPA)

I

I
60:65

I

i
70

I
75’
60

may(Flow

of Funds) /.\&

.,... -..
x.'
.

--., ,-.-.j
. h.
.
\
I x.

d
1.
i
-.. .. !
*.&.-

Persona; (NIPA)
r-

L
01’ l...,l,,..1,,,,l....I.,..I..~~I~~~
;955

60

65

70

75

60

65

remain generally higher than NIPA personal savings
rates, and second, that FFA individuals’ savings rates
have shown no downward trend in recent years.
The differences between individuals’ savings rates
and personal savings rates17 are quite striking.
Thus, although the point is valid that U.S. savings
rates as measured by the National Income and Product Accounts have declined in recent .years, ‘
individuals’ savings rates, as derived from the flow-offunds accounts, do not show similar declines.
The -Hendershott-Peek Adjustments
Versus NIPA

I7 The major differences between individuals’ saving and personal saving are that the former includes net investment in
consumer durables and government insurance and pension
reserves. MPA Personal Income and FFA Personal Income differ
by the amount of the household discrepancy. See discussion
above, Section IV.

Net + NDP IUNSNA)

1953

(Flow of Funds)

The estimates of net private saving rates as
adjusted by Hendershott
and Peek (with minor
modificationsl*) are shown in Chart 5 in comparison to NIPA net private savings. Both rates are
percentages of ,Net National Product. As the chart
shows, the HP saving rate is almost twice as large
as the NIPA rate. In the 1960-81 period; for example, the HP rate averaged‘
142 percent of .NNP,
while the NIPA rate averaged only 8.7 percent.

GROSS AND NET SAVING

of

Individual

I

I

I

65

66

** Because of de L.eeuw’ criticism, HPs adjustment for the
s
inflation premium in interest income was not made. Also because
of de Leeuw, the actual HP adjustment ,for social security
contributions was modified. Following his suggestion (see footnote 13), the social security modification was’
made by adding
the social security surplus to personal saving.

FEDERAL RESERVE BANK OF RICHMOND

27

-Chart 5

Chart 6

NET PRIVATE SAVINGS
(as Percent of NNP)
Percent

DOMESTIC INVESTMENT
(Percent of TISA GNP or NNP)
(Excludes Net Revaluations)

NIPA vs. Hendershott-Peek Adjustments

Percent

Gross Saving t GNP (TISA)
40

/

Net Saving i

20

.

.

.

NNP (TISA)
-.... ..-“-..
.J=*...

.--WC
\

...
% /-“‘
-..*..
.-.*
5.’

-se. ‘ .-.
,/
.
T
‘
xs 2”S.-f
v’
-Net investment in Intangible
f

Net Saving + NNP (NIPA)
i950

55

60

65

70

75

60

65

of:,,,[.,,.I,,~~,l,,,.!
1950

During the 1982-85 period, the HP rate averaged
13.5 percent while the NIPA rate averaged 6.7
percent.
The decline of private saving in recent years is
considerably less severe when saving is measured
with the HP adjustments. While the average NIPA
saving rate fell 2.0 percentage points between the
1960-81 and the 1982-85 periods, the average HP
saving rate fell only 0.7 percentage points. The
major reason for the more moderate decline in the
HP savings rate is that HP personal saving includes
the social security surplus.

55

,.,I
60

65

I l,,,

70

75

II
60

.sponding estimates of full private GNP and NNP.
Net human capital investment is also plotted as a
percentage of full private NNP. The chart shows that
full gross investment declined only about five percentage points from its 1970 peak to 1984. Full net
investment, on the other hand, fell almost ten percentage points. The difference, which is depreciation, is mainly in the depreciation of human capital,
as is shown in Chart 8.

TISA Versus NIPA
Chart 6 shows TISA gross and net saving as
percents of TISA GNP and NNP as well as net
investment & intangible capital as a percent of TISA
net national product over the 1950-1980 period.
NIPA net saving as a percent of NNP is, shown for
comparison. As the chart illustrates, TISA savings
rates substantially exceed NIPA savings rates. In fact,
in 198 1, TISA net investment in intangible ,capital
alone (as a percent of TISA NNP) was more than
twice as large as NIPA net investment (as a percent
of NIPA NNP). Moreover, TISA saving over the
1950-80 period shows no obvious overall downward
trend. Net investment in intangibles seems to have
peaked in 1972 and has since moved downward, but
its 1981 level was well above the levels of the
fifties.

PRIVATE DOMESTIC INVESTMENT
JORGENSON-FRAUMENI SYSTEM
(as Percent of Full Private GNP and NNP)

Net Human Capital + FP NNP

0

Jorgenson-Fraumeni Versus NIPA

,,,,1,,,,1,.,.1...,I,...I~~~~i~~~

1950

Chart 7 shows Jorgenson and Fraumeni’ full gross
s
and net investment as percentages of the corre28

Chart 7

55

60

65

70

75

60

Source: Jorgenson and Fraumeni. “Lifetime Income and Human Capital,”
unpublished preliminary manuscript, August 1966.

ECONOMIC REVIEW. MAY/JUNE 1990

Chart a

Chart 9

ESTIMATED DEPR~ClAilOi
JORGENSON-FRAUMENI SYSTEM

NET SAVINGS

(as Percent of Gross lnvestmentj
Percent

RATES

COMPARED

(selected pars)
(as Percent of Relevant NNP Edmate)
:

TEA
29.6\

/

,9.5/24-5-

4

Human Capii

Depreciation

2’
-6-,g

5

Hendershott-Peek

I
,~~~~15.3~15.~~‘
5.~

‘
12.8
9.9
9.4-

1

-9.4

10.9

-9.9-10.2-g.*
\7.1\

Flow of Funds Accounts

I
I

0
1950

I

I

I

55

60

65

70

I

I’

‘
75

-5.5
NIPA 5’
4

I

I

I

I

1966

1971

1976

1961

Bo

I

1956

Source: @e Chart 6.

All Systems Compared
Chart 9 shows a comparison of net savings rates
calculated from the NIPA, Jorgenson and Fraumeni,
TISA, and Hendershott
and Peek. As the chart
shows clearly, the JF savings rates tower over the
other rates. The TISA rates are next largest, followed
by the Hendershott-Peek
and flow-of-funds
estimates. Lowest, and substantially below the flowof-funds estimates, comes the NIPA.
VI.
INTERIM CONCLUSIONS

AND OBSERVATIONS

Which system is best? Strong cases can be made
for all of them. It seems especially clear, however,
that if one is using the rate of saving as an indicator
of the future rate of national economic growth (as
do Feldstein and Rukeyser), it is not appropriate to
exclude from saving funds used to finance investments in human capital, research and development, and the public infrastructure.
Moses
structure
plaining
growth.

Abramovitz believes investments in infraand human capital to be key factors in excross-country
differences in economic
As he puts it:

Social capability is what separates less developed from
advanced countries today and which, in the past, separated the lare-comers among the countries that are now
industrialized from the early entrants into what Kuznets
called ‘
modern economic growth.’ . . . [S]ocial capability
. . . refers to a country’ political institutions, its political
s

integration and the effective consensus in favor of development. These [attributes affect] . . . (1) the ranking of
economic activity and of material welfare in the scale of
social values, (2) the social sanctions that protect earnings,
propertj and honest trade, and (3) the willingness and
capacity of governments to create the physical infrastructure
for private activity. Next, there is a country’ technical
s
competence for which, af least among Western countries,
years of schooling may be a good proxy. 11, p.31

Of the five alternative systems of national accounts,
the saving and investment
estimates from the
UNSNA,
flow-of-funds
accounts,
and the
Hendershott-Peek
system depart the least from the
U.S. national income and product accounts. Do they
indicate a savings slowdown?
The UNSNA-based
saving rate had only a
moderate decline between 1970-83 and 1984-88.
Individuals’ saving as measured by the flow-of-funds
accounts showed no observable trend toward lower
savings rates. Consistently, the HPadjusted accounts
indicated considerably higher saving and considerably
less of a decline in the savings rate since the midseventies than did the NIPA. The least controversial systems, therefore, provide no evidence that the
U.S. is in a “saving crisis.”
Only the Jorgenson-Fraumeni
estimates of net
investment seem to be consistent with the existence
of some sort of a U.S. saving crisis. But the post-1971
decline in the JF net investment rate is attributable
to a declining rate of /unman capital spending, and that
in turn is attributable to a rapid rise in human
depreciation since 197 1. If the JF data describe the

FEDERAL RESERVE BANK OF RICHMOND

29

long-lamented U.S. saving crisis,19 the crisis is quite
different in character from that envisioned by
Rukeyser and Feldstein, et af.
VII.
U.S. SAVING RELATNETo
SAVJNGIN
t?WJ3R INDUSTilIAL cOUNTRiES20
This section of the article will review five different
analyses of U.S. savings rates compared to savings
rates in other advanced countries. Robert Lipsey and
Irving Kravis [ 12, 131 have argued persuasively that
although the United States currently is not a leader
in saving among the major industrialized countries,
much of the concern that the country is improvident
is based upon a misinterpretation of the data. Mincer
and H&hi’
s
study of on-the-job training in the
United States and Japan [ 151, however, raises questions about Lipsey and Kravis’ favorable conclusions,
s
at least those relating to the relative levels of human
capital investment in the United States and Japan.
Fumio Hayashi [8, 91, on the other hand, reaches
the conclusion that the difference between the U.S.
and the Japanese savings rate is substantially
overstated because of noncomparabilities
in the
definition of the national income and product accounts in the two countries.

a set of adjustments to incorporate spending for consumer dun&es, education, and research and develop
ment into the investment accounts. The effects of
these adjustments on cross-country savings rates are
given in Table I. As is shown in the table, when all
of the adjustments are made, the difference between
the U.S. rate of capital formation and that of the
average of the rest of the Group of Seven countries
is reduced from 4.7 percentage points to 3.3 percentage points.z2
Lipsey and Kravis discussed further adjustments
that would be desirable if they were not precluded
by data unavailability. One particularly important
additional adjustment would have been to include in
saving and investment the foregone earnings of
students. As Lipsey and Kravis state, “As the proportion of working-age students attending institutions
of higher education is higher in the United States than
in all or most of the other countries, the inclusion
of their foregone earnings in the form of investment
would raise the U.S. investment rate and bring it
closer to the average.” [13, p. 73)
ra Lipsey and Kravis also make an adjustment for differences
in military capital formation, which further reduces the differential
to about 3.1 percentage points.

Robert McCauley
and Steven Zimmer [ 141
examine differences in investment spending in the
United States, Britain, Japan, and Germany. They
conclude that the cost of capital in Japan and Germany was lower than in the United States and the
United Kingdom, and then argue that this higher cost
of capital may explain the consistently lagging investment spending in the latter two countries.

Table I

Gross Fixed Capital Formation
as a percent of Gross Domestic Product
average of individual year ratios, 1970-1984
Conventional Measure
+ Education

David Aschauer [Z] argues that a relatively low rate
of public (governmental) investment spending in the
United States can also explain some of its lagging
investment and slower productivity growth.

+ Research &
Development
+ Consumer
Durables
I

Is the U.S. a Spendthrift Nation?

United

Lipsey and Kravis discuss the items that should
be included in saving and investmenP
and develop

Canada

*a Particularly the “Group of Seven” countries, which include
Canada, France, West Germany, Italy, Japan, the United
Kingdom, and the United States.
z1 Lipsey and Kravis use gross saving and investment throughout
because they are skeptical of cross-country comparisons of capitai
consumption measures.
30

24.2

26.2

30.1

22.0

30.9

31.9

37.2

Japan

31.9

36.1

38.0”

39.9”

France
19As the rise in human depreciation after 1971 stemmed from
the use of the life-cycle approach to estimating depreciation combined with the baby boom’ effects on the age distribution of
s
the population, the decline in JF net investmenr may be more
of a measurement anomaly than a piece of reliable evidence of
a saving crisis.

18.1

22.2

25.9

27.5

32.4

Germany

22.1

26.0”

27.9”

NA

Italy

19.8

24.gb

25.7b

29.0b

18.5

23.0

24.9”

28.4”

22.8

27.8

29.3

33.4

United

States

Kingdom

Average-US

excluded

a 1970-1983
b 1970-1982
Source: Lipsey and Kravis, 112, pp. 47-501
United Nations System of National Accounts

ECONOMIC REVIEW, MAY/JUNE 1990

Lipsey and Kravis also argued that capital goods
are cheaper relative to other goods in the U.S. than
they are in many other countries. As a result, even
with higher savings rates, investors in those other
countries can not purchase as many investment goods
as can investors in the United States.
Finally, Lipsey and Kravis consider a criticism that
the U.S. funnels excessively large shares of its
saving into residential construction and consumer
durables, while other countries channel their saving
into more productive forms of investment, such as
machinery and equipment.
They conclude that
“
. . . the share of capital formation going into residential building has not been exceptionally high in
the United States.23 . . . [Also], the share of producer durables . . . in conventional capital formation
was above average in the U.S.” [13, pp. 41-Z] This
view is shared by Tatom [‘
ZO),who has argued that
U.S. investment in equipment in the eighties was
quite strong, especially in the first half of the decade.
Can On-the-Job Training be Ignored?
Lipsey and Kravis’ conclusion about the narrows
ing of the differential between the U.S. and the
Japanese savings rates after adjustment for human
capital investment might well have been reversed if
their study had included on-the-job training. Jacob
Mincer and Yoshio Higuchi [ 151 recently reported
the results of a massive study of differences in training in Japan and the United States that used
microdata from the Panel Studies of Income
Dynamics for the United States, and microdata from
the “Employment Structure Survey” for Japan.
The Mincer and Higuchi study began with two
observations: (1) that workers in Japanese firms have
lower turnover rates than workers in U.S. firms and
(2) that wages of workers in Japanese firms ‘
tended
to rise more rapidly with years of tenure than did
wages of workers in U.S. firms. They then showed
that lower worker turnover rates were not cultural
traits peculiar to Japanese workers, noting that the
very low turnover rates in Japan are postwar
phenomena, and that turnover rates and wage profiles for American workers in Japanese plants located
in the United States were similar to those of Japanese
workers in Japan. Both the lower turnover rates and
the higher wage profiles, they argued, stemmed from
Japanese firms’ on-the-job training programs.
Seven of fourteen countries studied (Belgium, Denmark,
Finland, France, Germany, and Italy) had higher shares over
1960-1984.
23

Mincer and Higuchi then argued persuasively that
the more intensive formation of human capital on the
job in Japanese firms resulted from those firms
being forced to cope with rapid technological change
in the post-World War II period. They reached that
conclusion for the following reasons:
(i) There were strong reductions in turnover during the
1950s. when economic growth accelerated. . . . (ii) There
was a lack of deceleration in the wage profde of mature
workers relative to younger workers in Japan-suggesting
continuous training and retraining processes characteristic
of rapid technological change. (ii) There were larger
declines in wages of workers inJapanwhointerrupted
their
labor force participation for several year periods than in
the wages of comparable U.S. workers. [15, p. 1241

Finally, they observed that research using U.S. data
also suggested that the more rapid the productivity
growth in an industry, the greater the demand for
education and training.
The Mincer-Higuchi study, therefore, has rather
disturbing implications about the future prospects of
the U.S. economy relative to those of the Japanese
economy. Even if Lipsey and Kravis are correct in
arguing that the U.S. invests more of its GNP in
education than does Japan, the Mincer-Higuchi study
implies that the U.S. expenditures may not be as
efficient in forming usable human capital and promoting productivity growth.
!s Japan’ Savings Rate High?
s
Fumio Hayashi shows that the Japanese national
accounts value depreciation at historical cost, while
it is valued at replacement cost in the U.S. national
accounts. Relative to the U.S., therefore, Japanese
saving is overstated by the amount of the difference
between depreciation at historical cost and depreciation at replacement cost. He also notes that the U.S.
national income accounts fail to recognize government capital formation, while the Japanese accounts,
following the UNSNA, do.
Hayashi reconciles the U.S. and Japanese accounts
by changing the Japanese depreciation data to a
replacement cost basis and by making Japanese
government saving correspond to the NIPA definition of U.S. government saving. These adjustments
make a very large difference in the Japanese saving
rate.
Chart 10, which is taken directly from Hayashi’
s
article, illustrates the difference in the unadjusted

and adjusted savings rates for Japan. It shows that,
adjusted for -accounting differences, the national
saving rate in Japan rose substantially from 1955 to

FEDERAL RESERVE RANK OF RICHMOND

31

Lawrence Christian0 [4] examined the analysis
underlying the Hayashi “reconstruction” hypothesis
in an article immediately following Hayashi’ in the
s
Federal Reserve Bank qf Minneapolis’ QNZ~,Q&~
s
R&.
He concluded that the Hayashi hypothesis,
with its implications about the future convergence
of savings rates in the U.S. and Japan, was not implausible, but he argued that further verification would
be required before it could be accepted.

Chart 10

NATIONAL SAVING RATES
(as Percent of Net National Product)
Percent
.Btz,

“I

30-

Japan,

unadjusted

Costs of Capital as Determinants of
Investment Spending

0 ~~,,f,,.,l,,,,l
1955

60

III,
65

70

l,,*.l
75

.I,,
so

I.
85

Note: Reprinted from NBER Working Paper No. 3205, p. 27. Fumio Hayashi.

1970 but after that time it began to decline, fmally
converging with the U.S. rate by the late 1970s. As
Hayashi states:
To people unaware of the differences in national income
accounting, the discrepancy between Japan’ unadjusted
s
saving rate and the U.S. rate appears quite substantialeven ominous. But by now it should be clear that most of
the apparent discrepancy is due to accounting differences
between the two countries. [S, p. 51

Hayashi concluded that “the phenomenon of high
Japanese saving rate is limited to the period of
1965-1975” (9, p. 71. Japan’ relatively high savings
s
rates in that ten-year period presumably came about
in response to Japan’ efforts to reconstruct its capital
s
stock, which had been severely damaged in World
war II.
As the chart shows clearly, however, after 1980
the adjusted savings rate for Japan began to rise again
while the U.S. saving rate continued to fall. Hayashi
discounts the divergence in the rates since 1980,
however, arguing that since Japan’ reconstruction
s
was completed in the early 198Os, the Japanese and
U.S. savings rates should converge in the future.24
This prediction is debatable.
z4 To explain the diver&nce in savings rates since 1983, Hayashi
offers two competing explanations. The first is that, owing to
the U.S. dollar’ post-1983 depreciation against the Yen, the
s
Japanese have been saving more to offset capital losses and
diminished rates of return on their holdings of U.S. bonds. This
explanation assumes that the Japanese kish ,to maintain a constant wealth-to-income ratio. The second explanation is that the
divergence stems from differences in the two countries’ budget
policies.
32

McCauley and Zmmer, as noted earlier, found that
the cost of capital was lower in Japan and Germany
than it was in the United States and the United
Kingdom. They investigated, and subsdquently rejetted, differences in income tax structures as important determinants of the relatively low cost of
capital in Japan and Germany. Rather, they attributed
the “cost of capital gap” to two basic factors: (1)
Japanese and German households are thriftier; and
(2) the Japanese and German economies face lower
risk from economic instability. These two factors will
be examined in turn.
Chart 11 demonstrates the differences in thriftiness. Household saving amounted to about 17 percent of disposable income in Japan and 13 percent
in Germany in 1988, but only about 4 percent of
disposable income in the U.S. McCauley and Zimmer attribute much of the cross-country difference
in thriftiness to cross-country differences in the
availability of consumer credit.
Chart 12 demonstrates the differences in household
debt as a share of disposable income across the four
countries. This chart shows a much higher (though
narrowing) use of credit in the U.S. and U.K. than
in Japan and Germany. McCauley and Zimmer cite
a report by the President’ Commission on Industrial
s
Competitiveness
that “. . . juxtaposed ‘
low interest
rates on business debt’ in Japan with a two-tier,
regulated rate structure in which interest rates are
far higher on consumer loans than on business loans.”
[ 14, p. 18) They conclude that “. . . the Japanese
and German financial systems formerly did not pump
much credit to consumers but now circulate credit
more evenly, though American and British consumers
may still enjoy a stronger flow.” (14, p. 181
McCauley and Zimmer also attribute the lower cost
of capital in Japan and Germany to more stable rates
of GNP growth (particularly
in Japan) and lower rates
of inflation.
They argue that as a result of this

ECONOMIC REVIEW. MAY/JUNE 1990

:

Chart11

economic stability, and relatively close relations between nonfinancial corporations and banks, Japanese
and German firms are ,able to use less expensive
shorter-term floating-rate debt, while U.S. firms must
regularly issue long-term fixed-rate debt to insure
against inflation-caused rises in short rates.

.’

HOUSEHOLD SAVING RATES COMPARED
(as Percent of Disposable Income)
:
Percent

LI)

I

I

Public Investment &ending in the
Group of Seven.
David Aschauer [Z] points out that while private
savings and investment levels are. important determinants of economic growth, another determinant
exists-the
share of government spending devoted
to public investment.

0.‘
.
19778

.

I,_ 1980

1

I

i

I

.

.

I

1985

1968

Source: Organization for Economic Cooperation and Deveiopment.
Explaining
Note: Reprinted from Robert N. McCauley and Steven A. Zimmer.“
International Differences.in the Cost of Capital.” Federal Reserve Bank
uf New York Wafter/y Review/Summer lgS9. p. 17.

Chart 12

HOUSEHOLD

DEBT

(as Percent of Disposable Income)
Percent
100
United Kingdom I
90

!

,

80

Aschauer follows the U.N. System of National Accounts in ‘
distinguishing between public investment
and public consumption. He therefore treats public
purchases of nonmilitary investment-type goods as
public investment. Public investment thus defined
includes such things as roads, highways, dams, water
and sewer’
systems, mass transit, airport facilities, port
facilities, etc. Aschauer argues persuasively that these
hinds of expenditures have “positive direct and indirect effects on private. sector output and productivity growth.” [Z, p.171
Aschauer finds that the United States used a far
smaller percentage of its gross domestic product for
public net (of depreciation)25 investment in the
1967-85 period than .any other of the Group of Seven
industrialized countries. The differential between
Japan and the U.S. is especially striking. Japan used
5.1 percent of its GDP for public net investment over
the 1967-85 time period, while the U.S. used less
than one percent.
VIII.

CONCLUSIONS
Abramovitz argues that the slower rate of productivity growth in the U.S. is an understandable implication “. . . of a process of international productivity
catch-up and convergence that is, in certain conditions, natural and foreseeable and, in the long-run
sense, desirable. Desirable not only for the countries
that are catching up, . . . but also desirable for the
. . . United States.” [ 1, p. 1]
In the same vein, Lipsey and Kravis argue that the
U.S. savings rate, while not stellar, is not too bad,
and they conclude that “. . . Americans are not
1970

72

74

76

76

60

82

64

06

Source: Organizetion for Economic Cooperation and Development.
Note: Reprinted from McCauley and Zimmer. (see Chart 10). p. 18.

88
a Aschaker does not adjust for cross-country differences in dehitions of depreciation.

FEDERAL RESERVE BANK OF RICHMOND

33

significantly less forward-looking than people in other
countries.” Hayashi also concludes that after adjustment, net savings rates in Japan and the U.S. are not
too different.

there is probably an element of truth in some of the
lamentations about the outlook for future economic
growth in the U.S.’ relative to that of its stronger
rivals.

Mincer and Higuchi, on the other hand, show that
Japanese firms use managerial policies that promote
better human development and more rapid worker
acceptance of technological advances. They argue,
furthermore, that the Japanese firms adopted these
policies out of necessity after World War II, and that
U.S. firms are not likely to change their policies
toward human investment unless they are forced to
do so for one reason or another.

On the other hand, as was shown in the first part
of this paper, virtually all of the debate about the
existence or extent of a saving shortage in the United
States is based upon NIPA data, and the so-called
shortage does not show up in savings rates derived
from alternative national accounting systems. Eisner ,
Roberts, and Samuelson are thus also correct in
pointing out that the concern about the savings crisis
is overblown.

McCauley and Zimmer and Aschauer also reach
gloomy conclusions. McCauley and Zimmer conclude that “. . . a considerable gap in the cost of
capital between the United States and Great
Britain, on the one hand, and Japan and Germany,
on the other, is likely to remain open.” [14, p. 25)
Aschauer concludes that too much of U.S. governmental spending goes into public consumption. He
expects the United States to continue to have
relatively slow growth unless the government increases its public investment expenditures.

In any event, the remedy for slow economic growth
in the United States is clearly not as simple as raising the conventionally measured savings rate. In fact,
a number of endeavors that would increase future
economic growth, such as directing more government
spending toward infrastructure items and toward
human capital (improving the education and training system and promoting public health and safety),
actually would her
the conventionally measured
savings rate.

Abramoviu and others have pointed out that investment in human capital and expenditures for
research and development may well be the key to
the future economic growth of the U.S. relative to
that of other countries. Investment in human capital
is difficult to measure, however, even within one
country over time.
Many economists
(including Abramovitz
and
Lipsey and Kravis) use either years of education or
educational expenditures as proxies for investment
in human capital, but real monetary expenditures for
education or years of schooling may not capture the
quality of education provided. For example, countries that have relatively minor problems with drugs
and violence in the schools may provide the same
levels of education more efficiently than countries
with major drug and violence problems. Also, as
Mincer and Higuchi show, on-the-job training may
do more than traditional forms of educational expenditure to increase human capital in times of rapid
technological change.
Given these alternative interpretations, what can
one conclude about the U.S. rate of saving and investment? Is the savings crisis a “chimera,” as Paul
Craig Roberts writes in R~.~~%x.ss
WeeR, or is it real,
calling for a national nonpartisan effort, as Louis
Rukeyser argues? No categorical answer emerges, but
34

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35


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