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F E D E R A L RESERVE B A N K O F ATLANTA
J A N U A R Y / E E B R l l A R Y 1991
MORTGAGE-BACKED SECURITIES
Analyzing Risk and Return
U.S. Population Migration
New Farm Bill Provisions
Economic
Review
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V O L U M E 76, N O , 1. J A N U A R Y / F E B R U A R Y 1991. E C O N O M I C R E V I E W
2
Analyzing Risk and Return
for Mortgage-Backed Securities
Stephen D. Smith
12
Population Migration in the
United States: A Survey of Research
William J. Kahley
22
30
FYL
The author provides a nontechnical introduction
to modern methods used in calculating yields on
mortgage-related products.
In this survey of studies on the factors that motivate migration, the author also presents tentative
findings of his empirical work on some unresolved migration issues.
The 1990 Farm Bill
Gene D. Sullivan
Book Review
B. F r a n k K i n g
FEDERAL RESERVE B A N K O F A T L A N T A
Manias, Panics, and Crashes:
A History> of Financial Crises
by Charles P. Kindleberger
Analyzing
Risk and
Return for
MortgageBacked
Securities
Mortgage-backed
securities and their
derivative products have become a major
component of banks' and other financial
firms' investment holdings.
Calculating
risk and return measures for these securities is complicated by the fact that homeowners have an option to prepay their
debt obligation at any time. Because this
prepayment option increases the risk of
lower returns, new methods have been
developed for adjusting
the yields on
mortgage-related instruments. The author
describes one of these techniques—the option adjusted spread
approach—which,
unlike more conventional methods, adjusts for both the timing and level of potential prepayment.
Stephen D. Smith
T
he growth o f an active secondary market
Y i e l d adjustments for mortgage-backed securities,
for h o m e mortgages w a s o n e o f the
or MBSs, are necessary primarily because o f the law
m a n y important innovations in financial
allowing h o m e o w n e r s to prepay the principal bal-
markets over the past decade. Although
a n c e o n their m o r t g a g e s w i t h o u t p e n a l t y . 3 Since
organizations such as the Federal National Mortgage
such prepayments occur primarily w h e n
Association (FNMA or "Fannie Mae") have been buy-
rates fall substantially b e l o w existing c o u p o n rates
ing securities b a c k e d by the Veterans Administration
(that is, contract rates) o n the mortgages, investors
market
a n d the Federal H o u s i n g Administration for decades,
in the mortgages face the risk that, after h a v i n g p a i d
o n l y recently h a v e mortgage-related securities be-
a p r e m i u m for a high c o u p o n security, they will be
c o m e an integral c o m p o n e n t of financial statements
saddled with m o n e y that must b e reinvested at low-
for a n u m b e r o f b a n k s a n d other intermediaries. 1
er (current market) rates. Investment banks a n d oth-
The growth of these securities has led to a dazzling
er f i n a n c i a l f i r m s h a v e d e v e l o p e d
array of derivative a n d hybrid products p r o d u c e d by-
adjusting the yields o n mortgage-related instalments
methods
for
r e p a c k a g i n g t h e basic cash flows f r o m a p o o l o f
to reflect this possibility o f p r e p a y m e n t s a n d the
fixed-rate mortgages. 2 Equally bewildering to poten-
corresponding lower yields.
tial investors in these products is the technology invented to calculate adjusted yields or, equivalently,
adjusted spreads over Treasury yields.
2
Regulators are b e c o m i n g c o g n i z a n t o f these issues as they b u i l d a f r a m e w o r k for a n a l y z i n g the
risk profiles o f an increasingly large p o o l o f securi-
ECONOMIC REVIEW, JANUARY/FEBRUARY 1991
ties w i t h u n c o n v e n t i o n a l cash
flow
characteristics.
I n d e e d , the Comptroller o f the Currency has recent-
cators o f the return to b e expected from h o l d i n g
mortgage-backed securities, as discussed b e l o w .
ly provided s o m e specific guidelines for the holdings o f c o l l a t e r a l i z e d m o r t g a g e o b l i g a t i o n s
(see
W i l l i a m B. H u m m e r 1990).
T h e p u r p o s e o f this article is to p r o v i d e a non-
Shortcomings of Static Yield
technical i n t r o d u c t i o n to the m e t h o d s used to analyze the risks a n d returns associated w i t h investing
in m o r t g a g e - r e l a t e d securities. This
A s s u m i n g that p a y m e n t s are guaranteed against
information
default by a government agency such as the Gov-
s h o u l d h e l p potential investors better c o m p a r e the
e r n m e n t National Mortgage Association ( G N M A or
cash flow a n d yield measures for mortgage-backed
" G i n n i e Mae"), a standard fixed-rate mortgage is, in
securities w i t h those o n alternative investments.
t h e a b s e n c e o f the p r e p a y m e n t c l a u s e ,
nothing
m o r e than an annuity contract. G i v e n a r e m a i n i n g
life, a market price, a n d the promised payments per
period, it is possible to find the contract's yield to
The Prepayment Problem
maturity (YTM), or "static" yield. Static is used to denote the fact that an investor will earn the yield to
The p r o b l e m o f prepayment o n a mortgage (an
maturity per period if all of the p r o m i s e d payments
asset) is in s o m e ways the reverse o f the p r o b l e m o f
are m a d e w h e n d u e a n d are reinvested at the same
early withdrawal o f a fixed-rate certificate o f deposit
rate (that is, rates d o not change over the life o f the
(CD; a liability). I m a g i n e that a banker has issued a
loan). T h e latter c o n d i t i o n is a w e l l - k n o w n short-
fixed-rate C D for s o m e period o f time, a n d s u p p o s e
c o m i n g o f u s i n g the yield-to-maturity m e t h o d to
the depositor has the right to w i t h d r a w his or her
calculate the expected return o n a n y security. It is
funds at any time before maturity, without penalty.
the first c o n d i t i o n that m a k e s the yield-to-maturity
The depositor might w i t h d r a w early for t w o general
a p p r o a c h p a r t i c u l a r l y u n a t t r a c t i v e for a n a l y z i n g
reasons. If market rates o n C D s rose substantially
m o r t g a g e - b a c k e d securities. I n s h o r t , t h e static
a b o v e the current rate o n the C D , the C D h o l d e r
yield treats t h e p a y m e n t s from a mortgage-backed
m i g h t c h o o s e to w i t h d r a w early a n d reinvest the
s e c u r i t y as a s u r e t h i n g o v e r t i m e , w h i c h
funds in a higher-yielding account. W h e t h e r f u n d s
clearly are not.
are actually r e m o v e d or s i m p l y rolled over into a
n e w account at the current b a n k , the banker will be
replacing this relatively low-cost C D with funds that
will cost substantially more than the old deposit. The
second reason for early withdrawal w o u l d fall into a
"catch-all" category that includes noninterest factors
like the depositor's m o v i n g or d e v e l o p i n g an unexpected need for funds. In either case, the b a n k suffers a cost if it imposes n o early withdrawal penalty.
they
The static yield approach will also distort calculations c o m m o n l y u s e d to m e a s u r e the interest-rate
risk o f a security. Duration a n d convexity are t w o
such measures. H o w e v e r defined, the duration o f a
fixed-income security is basically a measure o f the
percentage c h a n g e in a security's price if interest
rates c h a n g e b y a small a m o u n t . 5 Securities with
shorter durations experience smaller price decreases,
i n percentage terms, for a small increase in rates
Prepayment o n a mortgage is analagous to the C D
than d o securities w i t h longer d u r a t i o n . Likewise,
e x a m p l e a n d may occur because rates fall substan-
smaller increases occur for shorter duration securities
tially b e l o w the m o r t g a g e rate the h o m e o w n e r is
w h e n rates decrease.
paying. Prepaying the m o r t g a g e for this reason is
However, duration is itself a function o f the level
called "rational exercise" o f the o p t i o n . Exercising
o f interest rates. In fact, duration declines as interest
the prepayment o p t i o n in other cases (such as mov-
rates rise (and vice versa) for standard fixed-income
ing for a n e w job) is called "irrational exercise" be-
securities. This relationship is simply a result of the
cause such behavior is not tied directly to interest
fact that price changes are not symmetric. The per-
savings. 4
centage c h a n g e in b o n d prices as rates increase is
Rational exercise o f p r e p a y m e n t o p t i o n s forces
smaller than the price changes associated with equal
m o r t g a g e holders t o reinvest their f u n d s at rates
rate decreases. Thus, the risk measure (duration) is
substantially b e l o w those they w o u l d have earned if
p r e p a y m e n t h a d not occurred. Moreover,
m o r t g a g e s typically h a v e maturities m u c h
since
longer
t h a n those o f m o s t o t h e r assets o r liabilities, the
earnings loss is felt over a longer period o f time.
Uncertainty concerning repayment of
principal
m a k e s conventional yield measures unreliable indi-
FEDERAL RESERVE BANK OF ATLANTA
The author is an Associate Professor and the interim Mills Bee
Lane Professor of Banking and Finance, Georgia Institute of
Technology• ¡Ie is currently a visiting scholar in the financial
section of the Atlanta Fed's research department. He would
like to thank Richard Hall and Michelle Trahue for assistance.
3
inversely related to the interest-rate level. Convexity is
Treasury term structure o f interest rates o r y i e l d
the term usually applied to this "drift" in the duration.
curve. Typically, the implied one-period future inter-
H o w e v e r , unlike fixed-income securities, mortgage-
est rates (or forward rates) from the Treasury curve
related securities' p r e p a y m e n t o p t i o n m a k e s cash
are used as the m e a n , or expected value, a r o u n d
flows a function o f interest rates. Risk measures such
w h i c h a d i s t r i b u t i o n o f f u t u r e short-term interest
as duration need to be adjusted to reflect this fact.
rates is constructed. 8 Future mortgage rates are ei-
T o summarize, the standard yield-to-maturity ap-
ther constructed as a m a r k u p over the short-term
proach for calculating risk a n d return is i n a d e q u a t e
rates or, in m o r e c o m p l e x models, a m a r k u p over a
w h e n analyzing mortgage-related securities primari-
long-term Treasury rate that does not m o v e exactly
ly because prepayment risk causes cash flows to b e
in concert with short-term rates. A volatility (or vari-
a f u n c t i o n o f interest rates a n d o t h e r factors. By
ance) estimate is also needed to construct a distribu-
treating the promised cash flows as certain, an in-
tion o f future interest rates. This parameter restricts
vestor is likely to overstate seriously the return from
the degree to w h i c h rates m a y deviate from the cur-
h o l d i n g mortgage-backed securities. The o p t i o n ad-
rent term structure (the m e a n ) . Estimated prepay-
justed spread ( O A S ) a p p r o a c h discussed in the fol-
m e n t s are critically d e p e n d e n t o n t h e v o l a t i l i t y
l o w i n g section is an attempt to adjust the cash flows
estimates, w h i c h m a y c o m e from historical data or
to reflect p r e p a y m e n t risk. 6
more exotic forms, such as implied volatilities from
options contracts.
Prepayments are estimated as a f u n c t i o n o f the
The Logic of the Option Adjusted Spread
Approach
deviation o f current c o u p o n rates in the mortgage
p o o l from estimated market rates a n d other currently available information such as the average age o f
the mortgage p o o l a n d other k n o w n factors (for ex-
The basic premise o f the option adjusted spread
a m p l e , the region o f the country in w h i c h the mort-
a p p r o a c h is that prepayments, a n d therefore cash
gages o r i g i n a t e d ) . Future cash f l o w s are
flows, will be a function o f both the evolution of in-
generated as a function o f the evolution o f interest
then
terest rates a n d other (for e x a m p l e , d e m o g r a p h i c )
rates a n d the d e m o g r a p h i c factors. The fact that fu-
factors that c o u l d cause irrational prepayments o n
ture cash flows are d e p e n d e n t o n the entire interest
pools or portfolios o f mortgages. A distribution o f
rate process is c o m m o n l y referred to as path
future cash flows (or prices) is generated b y assign-
dency.
ing probabilities to plausible alternative future interest-rate scenarios. Finally, in a step a n a l o g o u s to
f i n d i n g t h e d i s c o u n t rate ( t h e static y i e l d )
that
e q u a t e s the p r e s e n t v a l u e o f the p r o m i s e d
cash
flows
to the current price, a yield measure can b e
f o u n d that e q u a t e s the a v e r a g e present v a l u e o f
these o p t i o n a d j u s t e d cash f l o w s to t h e c u r r e n t
price. T h e difference b e t w e e n this adjusted yield
a n d that o n a base security—a c o m p a r a b l e duration
Treasury b o n d , for e x a m p l e — i s considered the option adjusted spread. A l t h o u g h this analogy is not
exactly correct unless the yield curve is flat (see the
a p p e n d i x for general definitions o f o p t i o n adjusted
spread), the general idea is that similar calculations
result in a yield measure for mortgage-backed securities that has b e e n adjusted for the expected level
( a n d t i m i n g ) o f p r e p a y m e n t s over the life o f the
mortgage pool. 7
depen-
Consider the case in w h i c h a d o w n w a r d movement in mortgage rates will p r o m p t a prepayment. If
rates increase next period a n d return to their original level in period two, n o p r e p a y m e n t will occur.
By the same token, if rates s h o u l d fall next period
a n d then increase to their original level, prepayment
will occur. The level o f rates in period t w o is the
same in both scenarios, but the cash flow in period
t w o is not. In this case the period t w o p a y m e n t is
either the promised p a y m e n t or zero a n d is clearly a
function o f earlier interest rates (in this case interest
rates in period one). Therefore, each path of rates
can generate a different cash flow pattern for the
mortgage.
The next step in the process is to find a constant
discount factor w h i c h , w h e n a p p l i e d to every' path
of future short-term Treasury rates, equates the cash
outflow's present v a l u e (the current market price o f
The critical steps to be taken in the option adjust-
the mortgage) to the average present value o f the
ed spread process appear in Chart 1. Although each
cash inflows. This constant discount factor is the op-
practitioner is faced with a n u m b e r o f specific choic-
tion adjusted spread.
es (some of w h i c h are discussed below), the steps
The final step in Chart 1 involves shocking inter-
outlined in C h a n 1 must be followed for almost all of
est rates u p a n d d o w n b y s o m e a m o u n t . C o m b i n e d
the option adjusted spread models currently in use.
Raw input is p r o v i d e d from a n u m b e r o f sources.
Interest rate information is gathered from the current
4
with the current price, the n e w prices provide sufficient information to calculate option adjusted duration a n d convexity measures.
ECONOMIC REVIEW, JANUARY/FEBRUARY 1991
Chart 1
Steps in Option Adjusted Spread Calculation
FEDERAL RESERVE BANK OF ATLANTA
5
Computational Choices
The procedure outlined in Chart 1 has at least two
different versions, depending o n the practitioners'
choice o f techniques for generating interest rates and
discounting the cash flows.
I n t e r e s t Rates. Probably the most widely used
approach for generating a distribution of interest
rates is the simulation method. Using forward rates
embodied in the term structure as the means, the investigator inputs a variance estimate and draws a series of short-term rate paths. Resulting cash flows are
generated and the process is repeated for another
drawing from the distribution of rates. The simulation approach is sometimes ad hoc in the sense that
the method need not be based directly on a rigorous
link to the term structure of interest rates.9 An alternative is given by the binomial, or lattice, approach,
which starts with today's term structure and assigns
probabilities to scenarios wherein rates increase or
decrease (or possibly remain the same). Cash flows
are calculated at each point in the interest rate tree.
(See the next section for an example.) A volatility estimate is needed for this technique as well, because
it determines the amount by which rates are allowed
to vary from point to point.
D i s c o u n t i n g . The most intuitively a p p e a l i n g
method for discounting involves finding the expected
cash flow for each period (over all possible rates)
and discounting back at rates contained in today's
Treasury curve. However, the most popular method
in use today (see, for example, Alan Brazil 1988) involves discounting back each cash flow at the simulated rate (as o p p o s e d to today's term structure
rates). To the extent that rates and cash flows are
correlated—correlation being the whole premise of
rate-sensitive cash flows—the two techniques will
yield different results. An example in the next section
illustrates the difference between these approaches.
Properties o f t h e O p t i o n A d j u s t e d S p r e a d . The
foremost benefit o f the option adjusted spread approach is that it provides a yield measure that more
accurately reflects the timing and level of payments
that an investor might expect to receive from holding a mortgage-backed security. A second advantage
is that risk measures calculated from prepayment
adjusted cash flows provide a better indicator of the
security's true interest-rate risk properties. For example, although the price of a standard fixed-income
security will vary inversely with the level of interest
rates, it is possible for prepayment adjusted prices to
change in the same direction, no matter which way
rates move. The key to this concept is that, should
rates fall, the possibility of mortgage prepayments
may go up, in which case investors may bid down
6
the mortgage-backed security's price. This action is,
of course, the opposite of what would happen with
a truly fixed-income security like a Treasury bond. This
"whipsaw" effect is particularly evident in mortgagebacked securities that are selling at a premium from
par value.
Finally, the option adjusted spread methodology is
often put forth as one method for identifying "rich"
(overpriced) and "cheap" (underpriced) mortgagebacked securities. Typically, the o p t i o n adjusted
spread on securities with similar adjusted durations
and coupons are compared. Matching durations is an
attempt to hold constant the differences in the risks
of the assets. Note, however, that such comparisons
tell the investor nothing to give direction about
whether he or she should purchase either of the securities.
Suppose, for example, that the yield for a stream
of expected cash flows is greater than that for a
comparable duration Treasury security. This situation
is analogous to the case of a positive option adjusted
spread (OAS > 0). A risk neutral investor—one w h o
demands no compensation for the variability of the
cash flows (read "variability o f prepayments")—
would certainly find such an investment attractive.
However, a positive option adjusted spread alone
would not generally provide a risk averse investor
with enough information to determine whether or
not the extra yield would exceed the investor's desired risk premium.
Another (and equivalent) way to view this ambiguity is to recognize that if two mortgage-backed securities have the same expected cash flows but the
variability is greater for, say, the second one, riskaverse investors will bid a lower price for the second
mortgage-backed security. The result will be that the
second mortgage-backed security has a higher option
adjusted spread. The meaning is clearly not that the
second security is a better one, however. In short, establishing that the expected return on a risky security
is greater than the Treasury rate, or even greater than
the expected return on some other security of comparable risk, does not imply that it is a good buy unless you happen to be neutral toward risk (because it
could be the case that neither of the securities has a
high enough premium to cover its risk). Such "risk
neutral" information is exactly the sort the option adjusted spread methodology provides.
Examples of Option Adjusted Spread
Technology
In the following examples, noninterest rate "irrational" factors that might influence prepayments are
ECONOMIC REVIEW, JANUARY/FEBRUARY 1991
ignored for simplicity. Moreover, for simplicity the
examples will deal with a case where the term structure is flat.
Consider a mortgage-backed security for which
the underlying fixed-rate mortgages are identical.
The total principal balance on the pool is $1,000,000,
and the mortgages carry an 11 percent coupon and
have a maturity of four years. The latter assumption,
while unrealistic, allows analysis of the process without changing the qualitative results. Promised payments on this annuity contract amount to $322,326
per year. Shortly after issue, rates decline in such a
fashion that the mortgage pool is now selling for a
current market price of $1,044,246.
It is always possible to find a rate, the static
yield, that will discount back the promised cash
flows to the current market price. In this case the
rate turns out to be 9 percent (see the appendix). If
Treasury rates are 8 percent, the "static spread" is
9% - 8% = 100 basis points. Assume that because of
refinancing costs and other factors prepayment will
not occur unless the spread between the c o u p o n
rate and market rates on mortgages is 300 basis
points (3 percent). In this case prepayment will occur if mortgage rates are less than or equal to 11% 3% = 8%.
Interest Rates. A simple binomial (or two-state)
process is used to model changes in interest rates.10
Rates can move up and down with equal likelihood
from their current levels. The assumed change is
equivalent to a rate volatility estimate. Let this be 50
basis points. In this situation, mortgage rates will be
either 9.5 percent (9% + .5%) or 8.5 percent (9% .5%) next year. In year two rates will be either 9.5
percent ± .5 percent or 8.5 percent + .5 percent. So in
year two there is a 25 percent [(.5)(.5)J chance that
rates will be either 10 percent (go up twice) or 8
percent (go down twice) and a 50 percent chance
the rates will return to 9 percent (that is, a 25 percent chance they will increase and then decline and
a 25 percent chance they will decline and then increase). Chart 2 provides a graphic representation (a
"tree") of all possible rates over the four-year life of
the mortgage pool.
C a s h Flows. In any given year the realized cash
flows will be either ( a ) the p r o m i s e d p a y m e n t
($322,326), (b) the promised payment plus prepayment of the remaining principal ($322,326 + principal
balance) or (c) zero. Case (b) occurs if and when
mortgage rates fall below 8 percent, while case (c) is
the cash flow in subsequent periods should prepayment take place.
Chart 2
Interest Rate Tree
Current Mortgage Rate = 9.0%
Volatility = 50 Basis Points
Year
FEDERAL RESERVE BANK OF ATLANTA
7
Given the volatility estimate of 50 basis points
there is n o chance of prepayment in period one because rates can only fall as low as 8.5 percent. The
cash flow is certain to b e $322,326. However, in period two there is a 25 percent chance that rates will
d r o p to 8 percent a n d p r e p a y m e n t w i l l o c c u r .
Should this happen, the cash flow will b e $322,326 +
$551,992 = 874,318, where $551,992 is the remaining
principal balance on the mortgage. O n c e prepayment has occurred, the cash flow in years three and
four will be zero.
The expected (or average) cash flow from the
pool can also be calculated by multiplying each possible cash flow by the probability that it will occur,
in year one, for example, there is a 0 percent chance
of prepayment because rates will always be above 8
percent. Alternatively, in year two there is a 25 percent chance the mortgage rate will be 8 percent and
the corresponding cash flow $874,318. There remains a 75 percent chance the rates will be above 8
percent and the cash flow will be $322,326. Thus,
the expected cash flow is $874,318 (.25) + $322,326
(.75) = $460,324. Table 1 provides the possible and
expected cash flows by period.
In this special case, the option adjusted yield can
b e c a l c u l a t e d by f i n d i n g a d i s c o u n t factor that
equates the discounted value of the expected cash
flows (see Table 1) to the current price. The rate that
solves this discounting problem is about 8.85 percent, somewhat less than the static yield of 9 percent. Finally, the o p t i o n adjusted spread in this
simple example is given by subtracting the Treasury
rate (8 percent) from the adjusted yield; the option
adjusted spread is 8.85% - 8% = 85 basis points.
This importance of the volatility measure can be
seen by first considering the case in which rates in
Table 1
Possible and Expected
Cash Flows from Mortgage by
Period
Period
Possible Cash F l o w
Expected Cash F l o w
1
$322,326
$322,326
2
$322,326 or $874,318
$460,324
3
$322,326 or $0
$241,745
4
$ 3 2 2 , 3 2 6 or $0
$241,745
8
each period can c h a n g e by only 25 basis points
rather than 50. The mortgage rates n o w have n o
chance of falling to 8 percent before the mortgage
m a t u r e s . T h e r e f o r e , t h e e x p e c t e d cash f l o w is
$322,326 in every period a n d the option adjusted
spread will be the same as the static spread (100 basis points). Alternatively, the option adjusted spread
is actually negative (-12 basis points) if the volatility
estimate is doubled to 100 basis points.
O p t i o n adjusted spread estimates are also extremely sensitive to the discounting method used by
the investigator. The calculation procedure described
above can be viewed as a "discounted average cash
flow" approach. Alternatively, as mentioned earlier,
many investment houses prefer what could be called
an "average discounted cash flow" (or average price)
approach. This method differs from the discounted
average cash flow approach because the cash flows
are discounted back at the realized interest rates in
Chart 1, as opposed to today's rate. In this case, lowcash flows are, o n average, associated with lower
discount rates (the prepayment problem) and vice
versa for higher rates. The net result is that the option adjusted spread will b e different (typically lower). For this particular example the option adjusted
spread is actually a negative 2 percent (-200 basis
points) w h e n using the average price method.
The a p p e n d i x contains equations (2) a n d (3),
w h i c h s h o w the mathematical distinction between
the approaches. 11 This rather large difference in results comes from the fact that the high cash flows
are discounted at higher rates in the average price
approach. 1 2 The benefits are not symmetric, though,
because the zero cash flow after prepayment is still
zero n o matter h o w low the discount rate is.
A final example of the o p t i o n adjusted spread
method involves its use in calculating the risk an investor faces for relatively large interest-rate changes.
A potentially useful exercise is to see h o w mortgage
prices w o u l d c h a n g e if rates are s h o c k e d u p or
d o w n by some amount in the current period. For example, if Treasury and mortgage rates increased immediately by 100 basis points, there would be a zero
chance that the mortgage rate could fall to 8 percent
before year four (that is, 9% + 1% = 10% and the
volatility is 50 basis points a year). It is possible, using the original option adjusted spread, to calculate a
new price.
Consider, for simplicity, the average cash flow
m e t h o d . The o p t i o n adjusted spread is 85 basis
points, while current mortgage and Treasury rates
are 9 percent and 8 percent, respectively. Suppose
rates increase immediately to 10 percent and 9 percent, respectively, and volatility remains constant at
50 basis points. Then, using the average cash flow
method, the new price is $1,025,057, which is less
ECONOMIC REVIEW, JANUARY/FEBRUARY 1991
than $1,044,246 because the present value o f the fu-
average risk. T w o other caveats merit attention. It is
ture cash flows has been reduced.
possible, especially for mortgage securities selling at
Alternatively, if rates s h o u l d immediately fall by
100 basis points, prepayment will occur as s o o n as
p r e m i u m a b o v e par, to encounter
interest-rate
changes that " w h i p s a w " the investor; that is, prices
possible (probably in period one), because the n e w
m a y fall if rates either decline or increase. The ad-
mortgage rate is 8 percent. In this case the n e w price
justed yield measures can b e very sensitive to the in-
is $1,029,208, w h i c h is also lower than the original
puts u s e d — f o r e x a m p l e , the a s s u m e d volatility o f
price. This w h i p s a w effect occurs because the lower
interest rates.
interest rate causes earlier p r e p a y m e n t , m o r e than
The o p t i o n adjusted spread has b e c o m e a favored
offsetting the present v a l u e a d d e d from h a v i n g a
technology for dealing with this p r o b l e m because it
lower rate w i t h w h i c h to d i s c o u n t b a c k the cash
adjusts for b o t h the t i m i n g a n d level o f potential
flows. These examples should m a k e clear that, w h i l e
prepayments. In fact, the a p p r o a c h can b e u s e d in a
it is conceptually an averaging technique, the actual
variety o f settings because m a n y assets a n d liabili-
option adjusted spread is extremely sensitive to a va-
ties have o p t i o n s o f s o m e sort e m b e d d e d in their
riety o f i n p u t a n d methodological decisions practi-
structure. 1 3
tioners make.
W h i l e potentially useful, the o p t i o n
adjusted
spread is not a panacea for investors h o p i n g to find
u n d e r v a l u e d assets o n a risk-adjusted basis. N o form a l m o d e l currently provides a basis for decompos-
Conclusion
ing the o p t i o n adjusted spread into c o m p e n s a t i o n
for risk a n d excess returns. V i e w e d properly as a
The calculation o f yields o n mortgage-backed se-
yield (or yield spread over Treasury), h o w e v e r , the
curities is c o m p l e x primarily because of the difficulty
option
o f v a l u i n g an owner's o p t i o n to p r e p a y the mort-
clearer indicators o f the likely return than conven-
adjusted spread measures are
probably
gage. Despite their computational complexities, cur-
tional static yield calculations. The trade-off here in-
rent approaches to mortgage valuation are still just
volves the o p t i o n a d j u s t e d spread's sensitivity to
averaging techniques. As s h o w n in this article, cash
inputs (such as volatility a n d the p r e p a y m e n t mod-
flows, a n d therefore returns, d e p e n d o n the entire
el) a n d the v a l u a t i o n f r a m e w o r k the investigator
path of interest rates; that is, they are path depen-
employs. Potential purchasers, as well as regulatory
dent. Therefore, the interest-rate history over the life
personnel, s h o u l d b e aware o f these facts. Asking
of a mortgage-backed security is an important piece
potential sellers for information concerning the ac-
o f i n f o r m a t i o n . A n a d d i t i o n a l c o m p l i c a t i n g factor
tual r i s k / r e t u r n p r o f i l e s o f p r e v i o u s l y
arises from the difficulty in determining whether a
mortgage-backed securities w o u l d b e useful in this
mortgage that looks "cheap" is really undervalued or
regard. 1 4
analyzed
whether it is selling at a discount because of above-
Appendix
This appendix contains the general formulas used
for calculations in the text. As noted below, the actual
examples usually involve simplified versions of these
equations (for example, the term structure is flat).
M =
market price of the mortgagebacked security
C = promised payment per period
on a fixed-rate contract
Y = static yield to maturity
N = remaining maturity of the contract
The static yield is the rate that equates the present
value of the promised cash inflows (Cs) to the current
market price. That is, Ysolves
FEDERAL RESERVE BANK OF ATLANTA
C
C
(1 + Y)
(1 + Y)
M
+ ...+
C
a + Yy
(i)
If G is the yield on a comparable maturity (more specifically, duration) Treasury security, the static spread is
just Y - G = S. For the example in the text, C =
$322,126; N= 4; M= $1,044,246, so Y= 9% and 5 = 9 %
- 8 % = 1%.
More notation and calculations are needed to calculate the option adjusted spread. Let/, = one-period forward rate for government securities in period t, ft= (1
+ R, Y/O + Rt_ j ) ' "
where R, is the current spot rate
for a government security that makes one payment in
period t and zero otherwise. Define rt = actual interest
9
rate on one-period government securities in period /.
Note that this number is unknown today if / > 1. With
this notation, J\ = r, = R{. Finally, let Ct = actual cash
flow realized from the mortgage in period t. Notice that
there are two general cases: C t = C (promised payment) if there is no prepayment, or C) = C + remaining
principal balance > C if there is prepayment. In this
case Ct + j = Ct + 2 = • • • = CN = 0. For notational purposes let £ ' ( • ) denote expectation (or expected value)
of the term inside the parenthesis. The expected value
of x, for example, is given by the sum of the possible
outcomes for x multiplied by the probability that each
outcome will occur. There are two approaches to calculating the option adjusted spread.
Expected Cash Flow A p p r o a c h
Search for a discount factor, Oc , such that Oc solves
,v/=
E[CX]
(1+/,+
+. . . +
Oc)+
E[C2)
(l + /i +
oc}(i+/2+oc)
(2)
1-1C.v]
(1 + / , + O c X 1 + f , + O . ) , . . (1 + f
N
+ Oc )
The term E[CtJ, t= 1, . . . 4 is given by the right-hand
column of Table 1. These terms can be calculated bymultiplying the possible cash flows by the probability
that rates will be above or below the cutoff rate for
prepayment. In particular, with equal probabilities (.5)
of an increase or decrease in rates and volatility = 50
basis points, E[C{\ = $322,326(1). Because there is a 25
percent chance [(.5)05) = .25] that the Treasury rate will
fall to 7 percent in year two (mortgage rate = 8%), the
expected cash flow in period two is given by multiplying the possible cash flows in Table 1 by their respective probabilities. This calculation gives the expected
value, or E\C2) = $322,326 (.75) + $874,318025) =
$460,324. Likewise, because the cash flow in period
three is zero if prepayment occurs, the expected cash
flow in this case is E[C}\ = $322,326 (.75) + $0 025).
The expected cash flow in period four will be the
same, so E[C4] = $322,326 075) + $0 025). Solving (2)
for the option adjusted spread yields Oc = 85 basis
points. Notice that when the term structure is flat, the
forward rates will be the same. Thus, solving (2) is the
same, in this case only, as the simpler approach used in
the text—solving for the yield first and then subtracting
the (constant) Treasury rate.
Expected Price A p p r o a c h
Find a discount factor, O p , that solves the following
equation:
M=E
+ . . . +
£
(1 + r, + Op)
+
¿2
(1 + r, + Op)+(1 + r2 + Op)
(3)
c.
(1 + t\ + Op)(1 4- r2 + Op) . . . (1 + rv + Op)
In this case the rs are the realized one-period Treasury
rates from the tree in Chart 2. For this example, the current Treasury rate is 8 percent and the term structure is
flat; therefore, r, = 8%. However, next-period rates will
be either 7.5 percent or 8.5 percent, so r? = 7.5% with
probability 05) and r2 = 8.5% with probability .5. Interest rates for future periods are calculated in a similar
fashion. The possible C's are found in the first column
of Table 1. Using (3), Op can be calculated as Op =
-2.0% or -200 basis points.
Calculating New Prices
The new prices are calculated by fixing 0 ( (or O p ),
adding a constant amount (+ 100 basis points) to each
f t (or r t ), and finding the new cash flows associated
with these rates. The new M is then given by simplyusing the discount formula. For the expected cash flowapproach, a 100-basis-point increase in rates will result
in a zero probability of prepayment, so
E[C\) = E\C+,)=ElCl
1 = EIC\] = $322,326,
where C * is the cash flow for a rate increase. The
discount rates in equation (2) are (1 + /, + .01 + .0085)
for period one, (1 + /J + ,01 + .0085) (1 + / , + .01 +
.0085) for period two, and so forth. The new price can
be calculated using equation (2). The rate decrease is
the same problem except that, if rates should fall by
100 basis points, prepayment occurs immediately, and
E[C\] = $1,110,000 and E[C21 = E[C$ = E[C4] = O.
The discount factors are (1 + / , - .01 + .0085) and so
on. An analogous approach would also be used if one
were applying the expected price methodology.
12 ECONOMIC REVIEW, JANUARY/FEBRUARY 1991
Notes
1. The book value of domestic bank holdings of guaranteed and nonguaranteed mortgage-backed securities
was about $200 billion at the end of 1989. About $35
billion of these assets was held by banks in Alabama,
Florida, Georgia, Louisiana, Mississippi, and Tennessee.
2. See Sullivan and Lowell (1988) for an introduction to
the mechanics of the mortgage securities market and
the major participants.
3. For convenience the terms mortgage and mortgagebacked security will, when there is no ambiguity, oftentimes be used interchangeably.
4. See, for example, Hendershott and Van Order (1987)
for a formal options approach to modeling rational exercise.
used here is based on the original probabilities. In
essence, such a formulation amounts to assuming that
investors are, in some sense, truly indifferent to risk.
See notes 8 and 11 for additional comments on this
point.
8. Such a formulation is equivalent to assuming that investors demand no risk premium for holding longerterm bonds. See Abken (1990) for a review of this
"expectations" hypothesis of the term structure.
5. Interestingly, duration can also be viewed as a weighted average time to maturity, where the weights for each
period / are equal to the present value of period t's
cash flow divided by the total present value (the market value, or price). Shorter-term securities are those
that have relatively large cash flows in earlier periods.
For fixed-rate mortgages, however, the promised cash
flows are a level annuity, so the weights are simply the
present value factor for each period relative to the present value interest factor for an annuity.
9. Schwartz and Torous (1989) provide a good example
of a method for explicitly linking interest rate processes to a theory of the term structure in the context of
valuing mortgage-backed securities.
10. See Abken (1990) for a discussion of binomial processes in the context of the term structure of interest rates.
11. From a somewhat more technical perspective this
choice of assumptions may be v i e w e d as one of
choosing between "global" and "local" risk neutrality
on the part of investors. With local risk neutrality investors expect to earn the same return from all securities over any one period of time. It can be shown byrepeated substitution that this results in the expected
price approach discussed in the text. See Cox, Ingersoll, and Ross (1985) for a mathematical discussion of
the "local" expectations hypothesis.
6. It should be noted that some adjustment for early prepayments is typically incorporated into the static yield
framework. For example, yield quotes provided by investment banks will often incorporate a constant prepayment rate per month for the remaining mortgage
balance.
12. Part of the difference may also come from the fact that
in this example the average realized rate is set equal to
today's rate. This approach is different from the more
mathematically correct one, which would be to make
the average realized one-period bond price equal to
today's one-period bond price.
7. Those familiar with options pricing theory will realize
that this method is only loosely based on conventional
option pricing models. Although it is true, for example,
that an option's value can, under certain circumstances,
be viewed as the expected payoff over a transformed
(or "risk neutral") probability distribution, the approach
13. See, for example, Ayaydin, Richard, and Rigsbee (1989)
for a discussion.
14. For example, Toevs (1990) provides evidence on the
return characteristics o f various mortgage-backed securities when compared to duration-matched Treasury
securities.
References
Abken, Peter. "Innovations in Modeling the Term Structure
of Interest Rates." Federal Reserve Bank of Atlanta Economic Review 75 (July/August 1990): 2-27.
Ayaydin, Sirri, Charles Richard, and Stephen Rigsbee. "Applying an OAS Model Consistently." Financial Managers
Statement 11 (November/December 1989): 65-75.
Brazil, Alan. "Citicorp's Mortgage Valuation Model: Option
Adjusted Spreads and Option Based Durations." Journal
of Real Estate Finance and Economics 1 (June 1988):
151-62.
Cox, John C., Jonathan F. Ingersoll, Jr., and Stephen A.
Ross. "A Theory of the Term Structure of Interest Rates."
Econometrica 53 (March 1985): 385-407.
Hendershott, Patrie, and Robert Van Order. "Pricing Mortgages: An Interpretation of the Models and Results."
FEDERAL RESERVE BANK OF ATLANTA
Journal of Financial
1987): 77-111.
Services Research 1 (September
Hummer, William B. "Say Hello to the CMO." Bankers
Monthly 107 (December 1990): 54.
Schwartz, Eduardo S., and Walter N. Torous. "Prepayment
and the Valuation of Mortgage-Backed Securities." Journal of Finance 44 (June 1989): 375-92.
Sullivan, Kenneth, and Linda Lowell. "Mortgage PassThrough Securities." In The Handbook
of MortgageBacked Securities, edited by Frank J. Fabozzi, 69-114.
Chicago: Probus Publishing, 1988.
Toevs, Alden. "Laser Brains Rejoice: Analytical Methods
Can Help Shape Market Equilibrium Prices." Financial
AnalystsJournal 46 (November/December 1990): 8-10.
11
Population Migration in the
United States: A Survey of Research
William J. Kahley
Migration behavior can strongly influence a region's economic development. Understanding
the motivations for migration is important to
state and local policymakers because in-migrants can fuel job growth
and stimulate construction activity, but they can also overburden
roads, schools, and other infrastructure. This article provides insights into the determinants of migration through an overview of
theories on the subject and a survey of relevant literature. The
author also reports the findings of his own empirical workconcerning the influence of certain economic variables.
eople m o v e from o n e c o m m u n i t y or re-
P
growth a n d differentials in e c o n o m i c performance.
g i o n to another for m a n y reasons. Un-
Because o f the contribution o f w o r k e r a n d retiree
derstanding this m o v e m e n t o f p o p u l a t i o n
migration to Florida's a n d Georgia's above-average
is important because it alters a n area's
e c o n o m i c g r o w t h c o m p a r e d w i t h the nation's, im-
potential for e c o n o m i c growth by directly affecting
p r o v e d u n d e r s t a n d i n g o f t h e c a u s e s a n d conse-
the size a n d c o m p o s i t i o n o f regional labor forces.
q u e n c e s o f m i g r a t i o n is o f s p e c i a l i n t e r e s t
State or local g o v e r n m e n t officials, w h o see in-
southeastern states. At the same time, recessionary
in
migration as fueling job growth a n d the d e m a n d for
e c o n o m i c conditions have caused other southeastern
h o u s i n g a n d other types o f construction, work to at-
states such as Louisiana a n d Mississippi to lose pop-
tract (or keep) high-income earners, skilled workers,
ulation in recent years. As the a m o u n t o f natural in-
or wealthy retirees with g o o d pensions.
crease ( n u m b e r o f births m i n u s n u m b e r o f deaths)
in-
i n the U n i t e d States declines in the years a h e a d ,
migration can also create burdens for state a n d local
Rapid population growth
resulting from
p o p u l a t i o n change via redistribution will b e c o m e an
governments, however. Congestion, p o l l u t i o n , a n d
even more important demographic influence on
increased need for p u b l i c transportation, schools,
state economies.
a n d other infrastructure investment can drain a local
The considerable research in recent decades o n
economy. The goal o f planners a n d policymakers is
the factors motivating migration is reviewed in this
to lure migrants w h o will add less to the social bur-
article along with several important issues that con-
d e n than they return in taxes a n d other receipts,
tinue to d e m a n d attention. Research concerning the
thereby raising the area's quality o f life.
overall qualitative or quantitative impact of migration
A n u m b e r o f studies that deal with the effects o f
is m o r e limited a n d generally b e y o n d the scope o f
m i g r a t i o n s h e d light o n t h e s u b j e c t o f r e g i o n a l
this article. However, this summary includes a report
12
ECONOMIC REVIEW, JANUARY/FEBRUARY 1991
o n s o m e progress in the study o f the impact o f mi-
e c o n o m i c theorizing a n d empirical findings reveal
gration w h e n it is narrowly viewed as a process o f
that m i g r a t i o n decisions are c o m p l e x a n d multidi-
adjustment to regional labor market differences.
m e n s i o n a l , m a d e b y i n d i v i d u a l s w i t h a variety o f
Following an overview o f theoretical perspectives
considerations. I n fact, individuals (or a family unit)
o n the factors that motivate migration, the article in-
can be viewed as m a k i n g not o n e but t w o decisions,
cludes a brief review o f the literature dealing w i t h
in sequence. The first is the basic determination o f
the relationship between migration a n d e m p l o y m e n t
whether or not to relocate, the second, the choice o f
growth. The succeeding section contains important
destination.
survey results concerning specific determinants o f in-
Theorists favoring a h u m a n capital a p p r o a c h to
migration. The final t w o sections consist o f tentative
the question o f whether to m o v e (Larry A. Sjaastad
findings o n s o m e unresolved migration issues based
1962; Gary S. Becker 1964) have argued that individ-
o n the author's empirical w o r k a n d a s u m m a r y o f
uals will "invest" in migration only if it is profitable—
the principal conclusions a n d policy implications of
that is, if the present v a l u e o f perceived benefits
information presented in this survey o f migration re-
from m o v i n g exceeds the present value of costs as-
search.
sociated with m o v i n g (earnings m i n u s
migration
costs). 2 Individuals can b e expected to m o v e to the
place that offers t h e m the highest net a d v a n t a g e ,
more broadly defined than in the definition b y Hicks
Migration Theories
cited earlier. A c c o r d i n g to Sjaastad, migration distance generates several costs b e y o n d the monetary
In early migration studies researchers v i e w e d the
expenses o f m o v i n g , i n c l u d i n g earnings forgone a n d
issue o f labor migration primarily from either the
other costs related to the job search, the psychologi-
neoclassical e c o n o m i c perspective or in light of the
cal cost o f leaving the current environment, a n d un-
m e c h a n i c a l gravity m o d e l . As succinctly stated by
certainty about prospective i n c o m e because o f the
J o h n R. Hicks, neoclassical e c o n o m i c theory assumes
possibility of imperfect information.
that "differences in net e c o n o m i c advantages, chiefly
Subsequent theorizing has a d d e d that the decision
differences in wages, are the m a i n causes o f migra-
to migrate is also m u l t i d i m e n s i o n a l because o f the
tion" (1932, 76). I n this view, migration is seen as
m a n y factors involved in perceived benefits. For ex-
part o f the process whereby workers adjust to differ-
ample, a family or individual's personal characteris-
ences a m o n g regional labor markets. Labor is ex-
tics w i l l affect t h e v a l u e p l a c e d o n w h a t a n e w
pected to flow from low-wage, labor-surplus areas
location has to offer. In addition, characteristics o f
to high-wage, labor-short regions until w a g e levels
the places themselves—the migrant's place o f origin
converge.
and the potential d e s t i n a t i o n — h e l p
The mechanical gravity m o d e l — l i k e Newton's law
determine
whether or not a m o v e will occur.
o f universal gravitation, w h i c h states that the force of
Individual or personal qualities like age, sex, race,
attraction between t w o bodies is directly proportion-
education a n d skills, earnings a n d e m p l o y m e n t sta-
al to their respective masses a n d inversely propor-
tus, a n d health, as well as life-cycle characteristics
tional
such as completion o f schooling a n d entry into the
to t h e s q u a r e o f t h e d i s t a n c e
between
t h e m — h o l d s that migration between t w o regions is
work force, marriage or divorce, birth a n d aging o f
related to links between regional populations a n d in-
children, a n d retirement, influence the individual or
tervening distances. These gravity models originally
family unit m a k i n g the migration decision. Individu-
hypothesized that gross migration interchange w o u l d
als or families with different traits will weight the net
b e directly related to the size of the p o p u l a t i o n in
advantage of o n e place over another differently, de-
the areas p e o p l e were m o v i n g between a n d inverse-
p e n d i n g u p o n b o t h the individual's or family's traits
ly related to distance. 1 Distance is seen as a barrier
a n d the characteristics of the place being evaluated.
a n d larger p o p u l a t i o n masses, a magnet. More recently, the original m e c h a n i c a l v i e w has b e e n exp a n d e d b e y o n d p h y s i c a l q u a l i t i e s . For e x a m p l e ,
p o p u l a t i o n a n d distance might really reflect the econ o m i c influences of market size a n d transportation
costs, respectively.
N u m e r o u s factors figure in w h e n calculating the
net a d v a n t a g e o f o n e place over another.
Among
e c o n o m i c factors, j o b o p p o r t u n i t i e s ( o r the lack
thereof) a n d potential living standards adjusted for
cost differences are obvious considerations. Nonecon o m i c benefits such as topological ( m o u n t a i n , plain.
Recent research has exposed both o f these views
o f w h y migration occurs as oversimplifications. Comprehensive surveys by Michael J. G r e e n w o o d (1975,
1985) a n d Charles M u e l l e r (1982) o f m o r e recent
FEDERAL RESERVE BANK OF ATLANTA
The author is an economist in the regional section of the Atlanta Fed's research department.
13
or seashore), climatological (sunshine a n d temperature), a n d e n v i r o n m e n t a l ( c l e a n air a n d
In response to this view, an alternative theory
water)
emerged that held that migration itself could also in-
amenities m a y also be important. Additionally, the
duce job growth and development or that "jobs fol-
levels of public services provided, along with the rel-
low people." George H. Borts a n d Jerome L. Stein
ative cost of certain items like food, housing, a n d
(1964) explained regional economic growth from this
taxes, m a y be key concerns influencing migration
contrary, supply-side perspective. For them, migra-
decisions.
tion to a higher-wage region was the driving force
Characteristics that lure or attract migrants to a
behind regional population and employment growth.
place are "pull" factors. Surf, sun, and availability of
In Chart 2, the shift in labor supply (Zv —
jobs, for example, invite new residents. For reasons
sents migration from a low-wage region. The impor-
)
repre-
that will become clear in the next section, in-migration
tant assumption underpinning this approach is that
itself is a pull factor. Qualities that repel migrants—
labor demand in area Beta will accommodate work-
such as a high unemployment rate a n d stagnating re-
ers f r o m the l o w - w a g e area w i t h o u t
gional economy—are called "push" factors.
wages. ( D e m a n d for labor is assumed to be perfectly
depressing
elastic, and it is as if "jobs follow people.") Also, inmigration is likely to induce more local investment,
shifting the labor d e m a n d curve u p w a r d and raising
Migration in Regional Growth and
Development Models
wages still higher. Historically, supply-driven growth
may have occurred in the United States with movement of workers out of agriculture and into urban
A key issue in regional growth theory is whether
manufacturing.
or not interregional factor mobility leads to conver-
Push a n d pull influences discussed earlier corre-
gence of regional per capita incomes.^ As noted,
spond to these supply- and demand-driven models
Hicks and the basic neoclassical economic model sug-
of regional e m p l o y m e n t growth. According to the
gest that convergence is likely. Assuming two regions,
supply approach, low wages push workers out of a
one with relatively abundant labor a n d the other with
region. J o b opportunities lure workers, as stated by
capital, the low-wage region with a relative abun-
the d e m a n d theory. Both are equilibrium-type mod-
dance of labor should attract capital. That is, because
els in that the tendency is for wages between re-
capital is relatively scarce in the low-wage region, it
gions to converge. Another potential implication of
will be comparatively productive and profitable to use
the demand-driven model is that job or income op-
more capital there. Equivalently, the higher-wage and
portunities associated with places may better explain
lower-return-to-capital region will attract labor. In
in-migration than out-migration. Economic prosperity
short, factor mobility arbitrages away differences in
will b e a d o m i n a n t factor affecting the choice of
returns to labor or capital geographically.
where to move. O n the other hand, personal charac-
In the 1960S, the basic approach of Cicely Blanco
teristics such as age, stage of education, and beginning
(1963), I.S. Lowry (1966), and Warren F. Mazek (1969)
work or retiring seem more important in explaining
to explain regional economic growth assumed that
out-migration (within the supply-driven theoretical
increases in d e m a n d for goods a region produces
framework).
and exports to other regions leads to an increase in
In the 1970s, two theoretical developments impor-
labor demand locally, inducing in-migration. In this
tant for this review occurred, one by Richard F. Muth
export-based view of growth, where "people follow
a n d the other by Philip E. Graves and Peter Linne-
jobs," in-migration or net migration gain occurs in
man. The demand- a n d supply-driven models briefly
the high-wage region w h e n a disequilibrium is creat-
described above can be viewed as alternative per-
ed via the increase in d e m a n d for goods; the key to
spectives analogous to the "which came first—chick-
change is the increased d e m a n d for products a n d
e n or egg?" debate. In fact, M u t h (1971) m a d e a
the profitability o f a region's industries that serve
major contribution to the migration debate with an
outside markets. In Chart 1, z j represents increased
article titled "Migration: Chicken or Egg?" H e con-
d e m a n d for labor in region Alpha resulting from in-
cluded that attention should be focused o n the inter-
creased d e m a n d for exports produced there. The dif-
d e p e n d e n c e of migration a n d job opportunities in
ference between Z a n d Z' represents in-migration
explaining regional growth and development. While
induced by job opportunities (reflected in the shift in
a c k n o w l e d g i n g that either factor can generate
labor d e m a n d , Ld~•Zj).
growth, Muth maintained that typically both d o so si-
Labor supply is assumed
to be abundantly available from another region to
multaneously. In Chart 3, the labor supply or labor
meet the increased d e m a n d for labor in Alpha. New
d e m a n d curves (or b o t h ) c o u l d shift, triggering em-
jobs that become available both attract migrants and
ployment growth. Additionally, the initial supply or
trigger faster growth.
d e m a n d shifts (L$
14
or Ld — • z j ) cause further
ECONOMIC REVIEW, JANUARY/FEBRUARY 1991
shifts in the curves ( t o L " or L "d ). Unfortunately,
comparative static-type diagrams cannot adequately
capture these dynamic interactions and feedback
effects.
Chart 1
The D e m a n d A p p r o a c h
Graves and Linneman (1979) argued that rising income levels may cause migration by prompting new
demands for amenities that may be location-specific.
Changes in individual or family demands for amenities related to marriage or divorce, birth, death, or
retirement can also trigger migration. Moreover, according to Graves (1983), the mobility of firms as
well as households is an impetus for regional development. It is also the way by which location-specific
factors such as amenities are capitalized, or their values incorporated, into land and labor markets.
Graves and Linneman's argument is that the only
way an individual's or family's demands for nontraded amenities can be satisfied is by relocation. However, migration will also change wages and prices in
resource and product markets to reflect the value of
amenities. A major implication is that regional wage
differences can persist in the long run because of the
capitalization of regional amenities. For example,
employers may be able to pay persistently lower
wages for a given job and still attract workers to a
region because it possesses desired amenities in
abundance. A regional divergence of wages can also
be created when growing incomes permit consumers
to seek n e w amenities (such as a sudden popularity
of snow skiing), with a wage divergence compensating for regional differences in the value of amenities.
In short, labor markets can be in equilibrium in two
regions, yet wages can differ because of disparities
in the availability of amenities. The result is that unadjusted wage differences will not necessarily equalize as migration occurs.
Thus far, the consequences of migration have
been analyzed primarily within the narrow framework of regional economic development as a process of adjustment in regional labor markets. Labor
tends to move from low-wage, labor-surplus regions
to high-wage, labor-scarce regions unless differences
in amenities compensate for wage differences. At a
broader level, though, migration can be viewed as a
process that significantly affects the local economies
migrants leave behind and those into which they
move in ways beyond the direct impact on incomes.
For example, selective out-migration of young, educated people from a low-wage region can have cumulative, adverse effects on labor demand that can
more than offset the positive impact of reduced aggregate labor supply in raising wages. Alternatively,
crowding or other deleterious effects can reduce or
eliminate the presumed benefits to an area from inmigration. The effects of migration are complex,
and any in-depth discussion of them would require
FEDERAL RESERVE BANK O F ATLANTA
Chart 2
Chart 3
Supply and D e m a n d Interactions
review o f a n e n o r m o u s segment o f e c o n o m i c litera-
interregional moves" (1988, 251). Research reviewed
ture that is b e y o n d the scope o f this article's focus
by G r e e n w o o d (1975, 1985) a n d Mueller (1982) also
o n the determinants o f migration.
tends to support the idea that d e m o g r a p h i c determinants have impacts like those discussed here. 5
A l t h o u g h certain p e r s o n a l traits are associated
Personal Characteristics Affecting
Migration
with a greater or lesser probability of migration a n d
can be linked to e c o n o m i c or life-cycle forces in predictable ways (such as c o m p l e t i n g school, getting
married or divorced, taking a job), other personal
Demographers, economists, a n d other researchers
circumstances entail c o m p l e x interactions. For exam-
attracted to the study o f migration have noted sever-
ple, the effect o f race or ethnicity is not self-evident.
al patterns in the demographic, social, a n d e c o n o m i c
Racial differences in the probability o f interstate mi-
characteristics o f migrants. Comparisons o f the pro-
gration based u p o n simple tabulations m a y not h o l d
files o f movers a n d n o n m o v e r s have led to general-
u p w h e n other influences are held constant. Aggre-
izations about the relationship between m o v i n g a n d
gate differences in interstate migration by race may,
the life cycle. Several tendencies regularly reported
for example, b e attributable to differences in educa-
in Geographical
Mobility,
an a n n u a l report from the
tion levels rather than racial propensity to migrate,
Census Bureau, are illuminating, even t h o u g h they
a n d the results are not always clear even in multi-
are based o n simple univariate or bivariate tabula-
variate m o d e l s . Similar a m b i g u i t i e s c o n f o u n d
tions from U.S. p o p u l a t i o n surveys. 4 For instance,
study of the effects o f gender or family status o n in-
m o v i n g rates a p p e a r to b e related directly to age,
terstate migration.
the
with persons in their twenties most likely to m o v e to
another state. A secondary age spike in migration occurs a m o n g the very y o u n g ( w h o tend to be accomp a n y i n g parents in their twenties), a n d there is an
uptick w h e n persons enter retirement. The census
figures also s h o w that m o r e m e n tend to b e interstate migrants than w o m e n , in part because m e n are
more often in the military, a g r o u p with a higher rate
o f m o v i n g than p e o p l e in other occupations.
Place Characteristics and Migration
Labor market conditions such as j o b opportunities
a n d available w a g e s in regions also contribute to
w o r k e r s ' d e c i s i o n s to m i g r a t e . M o r e o v e r ,
local
amenities, costs o f living, a n d fiscal characteristics
Moving rates for civilians also vary by labor force
are likely to influence migration flows, especially o f
status. A m o n g the u n e m p l o y e d , migration is quite a
retirees. 6 Researchers have identified several place
bit higher than it is for persons with jobs. The lowest
characteristics, discussed in this section, that affect
m i g r a t i o n rate is for i n d i v i d u a l s n o t i n t h e l a b o r
worker migration.
force, such as retirees or students. A n o t h e r factor
G r a v i t y E f f e c t s . Researchers w h o use m o d e l s
correlated w i t h migration rates is e d u c a t i o n level.
that include population a n d distance variables typi-
Rates rise with educational attainment, p e a k i n g for
cally find t h e m very robust in explaining migration.
persons with four years o f college. Race is also a
Brian J. Cushing (1986, 1987) f o u n d that population
variable: non-Hispanic whites have higher rates o f
a n d distance (as indicated b y beta coefficients in re-
long-distance m o v i n g than Hispanics a n d blacks.
gression equations) have the largest relative positive
S o m e o f these differences are linked to e c o n o m i c
a n d negative impacts, respectively, o n the d e p e n d e n t
a n d life-cycle influences on migration patterns. For
migration variable w h e n it is measured as the alloca-
example, labor force members are less likely to mi-
tion rate o f migrants from each state o f origin to
grate as t h e y g r o w o l d e r b e c a u s e they e x p e c t a
each o f forty-seven other coterminous states. Peter R.
shorter remaining w o r k i n g life during w h i c h to real-
Mueser (1989b), however, f o u n d that m a n y aspects
ize the benefits o f migration. Similarly, the m o r e ed-
o f the migration structure cannot be tied to geogra-
ucation p e o p l e attain, the m o r e information a b o u t
p h y e v e n t h o u g h m i g r a t i o n flows b e t w e e n states
e m p l o y m e n t a n d job opportunities they are likely to
d u r i n g the periods 1955-60, 1965-70, a n d 1975-80 re-
have so that they are active in a job market more na-
flect g e o g r a p h i c distance. His analysis also s h o w s
tional in scope.
that changes in migration streams, in particular, re-
As Larry F„ Long has pointed out, "A rather parsi-
sult from nongeographic p u s h a n d pull effects.
m o n i o u s set o f categories ( j o b transfer, l o o k for
C o s t o f L i v i n g . Presumably, distance influences
work, take a n e w job, enter or leave a r m e d forces,
migration in part because it serves as a proxy for a
retirement, attend schools, be closer to relatives, or
cost-of-transportation barrier to m o v e m e n t b e t w e e n
to seek a change in climate) usually account for 70
places. 7 Mark C. Berger and Glen C. Blomquist (1989),
or 80 percent o f the 'main' reasons for interstate or
using migration data from the 1 in 1,000 Public
16
Use
E C O N O M I C REVIEW, JANUARY/FEBRUARY 1991
Sample of the 1980 Census, found indirect evidence
that moving costs are important in the decision to
migrate. Their main focus of attention, however, was
the significance of living costs. Their study suggests
that people consider the cost of housing but that its
importance diminishes with age, "presumably because of shorter time horizons" (2). Curiously, they
found that the differences in moving costs grow in
importance with age, "reflecting greater attachments
to an area as one grows older" (2).
State a n d Local Fiscal Structure William F. Fox,
Henry W. Herzog, Jr., and Alan M. Schlottman (1989)
studied the extent to which migration seems related
to variations in local and state government fiscal
policies. Using microdata for individuals, their empirical results indicate that high state or local gove r n m e n t taxes a n d o t h e r o w n - s o u r c e r e v e n u e
enhancements have the expected effect o f discouraging in-migration, as does specific reliance on the
income tax. Also as expected, good police and fire
protection, as well as park and recreation facilities,
are enticements; however, regional education conditions appear not to have a significant effect on
in-migration. These researchers conclude that fiscal
structure does seem to play an important role in
the migration decision.
I n c o m e . A finding c o m m o n to many migration
studies is that income opportunities are an important pull factor. Statistically, this variable often has a
large relative impact on the dependent migration
variable as well as strong statistical significance.
Thus, empirical findings support the theoretical
view that alternative economic opportunities need
to be considered in the analysis of migration.
Simultaneity—Migration and Employment
G r o w t h . Researchers have investigated the relationship between migration and employment growth using simultaneous equations techniques since Muth's
pioneering work in the early 1970s. These models,
estimated to allow employment growth and migration to be determined jointly with two-way causation, generally take the form Mi = f(Ejy X{) and Ej =
g(Mf, Z-), where Mi and Ei are the dependent migration and employment variables and X( and Z / are
vectors of location-specific factors affecting migration
and employment, respectively. "In an average year
two extra jobs attract about one additional net migrant, and one additional net migrant has a direct effect o n area e m p l o y m e n t o f a l m o s t 1.4 j o b s , "
according to Greenwood, Gary L. Hunt, and J o h n M.
McDowell (1986, 231).
These findings mean that migrants d o not fully
substitute for or take jobs from workers where employment is growing and suggest that migration
causes job growth over and above employment of
the migrants themselves. In the example above, only
FEDERAL RESERVE BANK OF ATLANTA
one-half of all newly created jobs are taken by inmigrants, while a newly employed in-migrant causes
nearly one-half of an additional job to be created.
They conclude that their results are very similar to
those Muth obtained in his earlier work. They also
find some evidence for the notion that migration increases during national business-cycle expansions
and falls during downturns.
R e g i o n a l W a g e Arbitrage. Stuart A. Gabriel, Janice Shack-Marquez, and William L. Wascher (1989)
evaluated whether interregional migration arbitrages
regional wage and unemployment differentials. Their
results, based on simulation, suggest that interregional migration reduces regional w a g e differentials.
However, their findings also indicate that the direct
effects of migration are insufficient to narrow unemployment rate differences much within a period of
less than several years.
A s s o c i a t i o n o f In- a n d O u t - M i g r a t i o n Rates.
Migration researchers have long noted the positive
association between rates of in-migration and outmigration. An often-mentioned explanation for the
association is that areas with extensive and sustained
in-migration tend eventually to have populations that
are more migration prone, thus increasing their outmigration rates. Some other explanations include migration's tendency to i n d u c e a counterstream of
return migrants and the probability that residents'
departure creates an environment conducive to inmigrants as jobs are vacated and homes b e c o m e
available to newcomers. Mueser a n d Michael J.
White (1989) explain the dynamic character o f the
migration process. An area with high net migration
gain experiences population gain. This gain increases the number at risk to depart while also raising the
denominator of the in-migration rate.
Unresolved Migration Issues
Numerous factors make it difficult to derive precise estimates of the relationships between migration
flows and the personal and place characteristics behind these flows.
A s y m m e t r i e s . Researchers have noted that some
motivation factors explain in-migration better than
out-migration, while the reverse is true for other factors. For e x a m p l e , G r e e n w o o d (1975, 400) a n d
Mueller (1982, 32) both note that several other researchers found that income and job opportunities
generally provide a better explanation of in-migration
whereas personal characteristics such as age and education seem to have more effect on migrant departures. From a theoretical economic perspective, it is
not clear w h y migrants seem strongly p u l l e d to
17
destinations where employment growth is high but
not pushed to the same extent from origins where
employment growth is low. However, because o f
these and other asymmetries, better empirical results
are obtained from in-migration or out-migration
models than from net migration models. (Another
problem with net migration models is that the effect
o f distance, for example, is neutralized because it
has the same sign in gross in- and out-migration
equations.) Yet, because o f data limitations, researchers often have had only net migration data to
work with, at the cost of substantial loss of information and insight into the migration process.
D a t a L i m i t a t i o n s . A problem with much migration research is that data refer to aggregate migration
flows whereas the migration decision is an individual
decision, often reflecting personal characteristics. As
a consequence, the more readily identifiable place
characteristics such as income or job growth have
more often been cited as explanatory factors, and,
by definition, the effects of personal characteristics
have been underestimated.
Fortunately, new microdata sets increasingly will
allow for needed modeling refinements such as focusing on the decision-making unit and studying the
life-cycle influences on migration decisions (including measurement of the economic return to migration). These data include the Panel Study of Income
Dynamics, the National Longitudinal Survey, and
Census Public Use Microdata Samples. Nevertheless,
explaining aggregate migration will continue to be a
goal because aggregate statistics are relevant for local governments and policymakers concerned with
the consequences of migration.
A n o t h e r data s h o r t c o m i n g has b e e n that researchers too often have had to rely on cross-section
data rather than time-series information. This limitation has prevented study of inherent lags in migration such as the t i m e b e t w e e n an i n d i v i d u a l ' s
recognizing and then acting on new job opportunities (time spent selling the old house a n d making
other arrangements). Moreover, the determinants
and consequences of migration both vary cyclically
and in the long run, but, lacking appropriate timeseries data, researchers have not been able to explain h o w a n d why. Fortunately, new time-series
state-level data from the Internal Revenue Service
are helping to address this issue.
M e t h o d o l o g i e s a n d M o d e l Specification. Several conceptual issues in the study of migration are unresolved. They are often linked to statistical methods
or the specification of particular migration models.
Mueser (1989a) has noted that cross-sectional
studies may be seriously biased because the current
geographic population distribution reflects previous
migrants' choices. Mueser notes that population, of-
18
ten included in migration models to capture social or
economic scale effects, may actually be a proxy for
unmeasured characteristics such as place amenities,
which might be stable and have been effective in attracting migrants earlier. Under these circumstances,
population and the unmeasured variables will be
correlated. If population and other explanatory variables also have a correlation not taken into account,
complex statistical biases result.
Because o f this interrelationship a m o n g several
determinants of migration, researchers have turned
increasingly to simultaneous-equations models of migration's causes. Often, though, data are inadequate
for estimating migration models, for reasons beyond
even those already mentioned. For example, it has
been noted that variables in the gravity model—population and distance—are important factors in explaining migration. However, population and
distance can be interpreted in different ways, depending on the size of the city or town in which one
lives and normal travel distances. Moreover, sorting
out the underlying factors these variables represent
is not a straightforward exercise. For instance, population might be an indicator of economies of scale or
agglomeration, meaning that larger population leads
to lower production cost and thus concentration of
activity. 8 In contrast, as mentioned above, population also could be simply a measure of an area's past
success in attracting migrants. Similarly, although the
fiscal structure of a region or amenities such as climate may cause migration, it is not clear which variables should be used in specific models. Generally,
clear structural and behavioral models of the migration process are lacking in this area of economic research.
At least a few other practical specification issues
cloud statistical and conceptual understanding of migration relationships. Economic factors thought to be
important in explaining migration behavior are often
correlated with each other or with noneconomic migration influences. As a consequence, channels of influences among the factors are blurred statistically, a
problem k n o w n as multicollinearity. Because the
probability of migration is a function of levels of certain variables, such as movement cost, and changes
in the absolute levels of explanatory variables, another practical difficulty is created. When changes in
the absolute levels of variables and their levels at
one place relative to all others are examined as determinants of migration, the issue of multicollinearity
among variables is heightened.
Statistical F i n d i n g s . Differences in methodologies used, model specification, and the functional
fonn imposed on variables in migration models have
resulted in some significant statistical differences of
opinion concerning the direction and strength of in-
ECONOMIC REVIEW, JANUARY/FEBRUARY 1991
fluence of migration determinants. O n e of the most
vexing and perplexing issues for migration scholars is
the erratic finding concerning the regional unemployment rate's influence. W h e n viewed with the individual in m i n d , the notion that the u n e m p l o y e d are
more likely to move than the employed has strong
theoretical appeal and statistical support. However, at
the aggregate level u n e m p l o y m e n t rates have frequently h a d nonsignificant coefficients a n d even
unanticipated signs, suggesting either that this finding
is eroded during the aggregation process or that the
model specification or form of data used is faulty. As
noted below, results from the author's empirical research suggest that model specification is key to the
issue.
Other empirical findings in dispute include the
relative importance of jobs versus amenities in migration. This disagreement may be more a matter of
difference in interpretation than a disagreement of
substance, though. For example, G r e e n w o o d a n d
Hunt (1989) conclude that location-specific amenities d o not appear to have an important direct effect
o n migration w h e n employment growth is taken into account. They say that these results differ considerably from Graves's (1983) findings. G r e e n w o o d
and Hunt agree with Graves that the influence of
amenities is positive, but for them the primary impact of amenities is via the stimulation given to job
growth. State and local government fiscal variables
and climate variables are other influences for which
either ambiguous statistical results have been found
or for which interpretation of meaning or channel of
influence is difficult to make.
Author's Empirical Research
In an effort to help develop insight into some of
the unsettled issues in migration research, the author
is analyzing n e w U.S. Internal Revenue Service estimates of historical state-to-state migration flows that
are based on income tax returns. Preliminary statistical analyses of these data for the 1980-87 period are
revealing. The summary results reported below are
based o n regression equations estimated for each of
the eight years. Altogether, these new data provide
strong evidence concerning the influence of certain
e c o n o m i c variables in determining migration a n d
s h e d n e w light o n s o m e issues that h a v e b e e n
cloudy. For example, this work has led to several
conclusions:
• A state's income growth, lagged o n e year to reduce simultaneity bias, positively influences inmigration.
FEDERAL RESERVE BANK OF ATLANTA
• Expected pay, measured as average state pay
lagged one year and weighted by a state's une m p l o y m e n t rate, has a positive influence on
in-migration.
• The higher the cost of living index for a state,
the less in-migration it will experience.
• The greater the number of annual cooling degree days—the warmer the climate—the greater
in-migration will be.
• The greater the amount of in- and out-migration
the state experienced in the 1975-80 period, the
greater in-migration was in the 1980s.
All of the directions of influence for these determinants are as expected. In addition, these results
are very robust as measured by the stability a n d
significance o f the statistical coefficients relating inmigration to these explanatory variables and the significance of the entire e q u a t i o n e x p l a i n i n g state
in-migration. Altogether these variables explain from
96 percent to 99 percent of the variation in state inmigration for the eight years for w h i c h migration
equations were estimated.
It is encouraging that statistical results using this
new data set conform so well with economic theory
and with the central tendencies found in a review of
the migration literature. For e x a m p l e , there is a
strong t h e o r e t i c a l e x p e c t a t i o n that fast i n c o m e
growth should attract migrants. Also, according to
theory in-migration should tend to be toward regions
that pay higher wages, other factors remaining equal.
Important "other factors" that must be accounted for
include the probability of getting a job (suggesting
that pay should be weighted by the region's unemployment rate) and cost-of-living differentials (indicating that individuals respond to real, not nominal,
wage differences). Additionally, it is obvious that
amenities such as warm and sunny days should lure
m i g r a n t s . Finally, m i g r a n t s are likely to i n f o r m
friends and relatives about the merits and shortcomings of their n e w place of residence and, having experienced migration, are more likely to m o v e again
themselves.
Besides finding support for the factors thought to
motivate migration, a few other noteworthy findings
have surfaced in the author's work. O n e is that the
determinants of in-migration d o not perform well in
explaining state out-migration in the 1980-87 period.
This discovery is consistent with the c o m m o n , yet
somewhat perplexing, finding that economic conditions in destinations e x p l a i n in-migration better
than such variables in origin localities explain outmigration. Another finding supportive of previous
research is that there appears to be a tendency for
migration to slow d o w n in recession and speed u p
during economic expansions. This finding suggests
19
that migration can have countercyclical effects over
is helpful, what is really needed for policy purposes
the course o f the business cycle at the regional a n d
related to r e g i o n a l e c o n o m i c d e v e l o p m e n t is to
even national level. All in all, although the migration
k n o w w h i c h areas individuals will choose.
p u z z l e has yet to b e totally solved, it nevertheless
Based o n the research reviewed in this article, it
seems clear that this research supports important the-
appears that e c o n o m i c d e v e l o p m e n t efforts that spur
ories regarding motivations.
i n c o m e growth in a region increase in-migration. I n
addition, environmental policies a n d others that protect a n area's amenities w o u l d appear to have a payoff. Finally, state a n d local policies that keep d o w n
Policy Implications and Conclusions
the cost of living, including perhaps the p r o m o t i o n
of affordable housing, can b e expected to meet with
Because regional d e v e l o p m e n t is expected to b e
success.
influenced strongly by the mobility behavior of
M u c h research into migration influences remains
firms a n d i n d i v i d u a l s , u n d e r s t a n d i n g the determi-
to b e d o n e . The relative importance of origin a n d
nants o f their migration is important. Benefit to a re-
destination characteristics in e x p l a i n i n g
gion from e x p a n d i n g its export base, or its capacity
still is not adequately k n o w n . Also, the full extent to
to sell products a n d services outside the local econ-
w h i c h migrant-attracting policies w i l l b e effective
o m y , is a n underlying focus o f state a n d local pro-
cannot b e quantified. Nor are the timing a n d extent
grams d e s i g n e d to d r a w firms or jobs to an area.
to w h i c h
The assumption is that migration will follow at the
k n o w n , a n d very little hard evidence exists concern-
migration causes w a g e
migration
convergence
same time that such programs will offer m e m b e r s o f
ing other consequences o f migration. C o n t i n u e d re-
the local w o r k force n e w job opportunities.
search is needed that will increase o u r understanding
Current research findings indicate that personal or
o f migration's d e t e r m i n a n t s a n d its c o n s e q u e n c e s
life-cycle influences strongly motivate individual mi-
a n d lead to development of more effective ways to
gration with or without reference to e c o n o m i c condi-
address critical policy issues.
tions at specific locations. A l t h o u g h this information
Notes
1. See Isard (I960) for a thorough review of the gravity
model. The simple formulation of the model that would
be analogous to Newton's law of universal gravitation
would be My = k(Pt * Pp/Cdy)2, where M{ - is migration
between places i and j, Pi and Pj are the populations of
i and j, dtj is the distance between them, and k. is a constant. Thus, the greater the population mass between
two places, the greater will be gross migration, but the
greater the distance, the less migration there will be. In
modern work, functional rather than geographic measures of distance and population are used so that the
distinction between gravity models and economists'
econometric models incorporating influences such as labor market conditions, amenities, and so forth, has been
blurred.
2. If the present discounted value of the earnings stream in
place j compared to place i is
X (En-Eit)K\
t=1 J
+ r)'
and the comparable present discounted value of costs of
being at these places is
£ (C,-Cit)/(1
t=l J
+ r)',
then movement to j from i will occur when earnings minus costs exceed zero. Individuals move to the place
with the highest net present value(PK.), where
20
_ £
p v
ij
t=i
(E
>~
E
"} _ £
(1 + r)
1
,=i
(C
j'~Ci'} ,
(1 = r)'
and E = earnings, C = costs, r = discount rate, and t =
time period.
3. This issue, generally referred to as "factor-price equalization," has been central to the discussion of the effect of
international trade as well. In the context of trade between nations, complete equalization of the prices of
production factors internationally also requires mobility
of the factors. Free trade of goods will only partially
substitute for factor mobility and only tend to equalize
relative factor prices internationally.
4. Primarily because of data limitations, generalizations
about migration have tended to be drawn from crosssectional and aggregate population data rather than
from information about individuals over time.
5. A recent paper by White and Mueser (1989) specifically
tests for changes in the demographic determinants of
U.S. residential mobility in the 1940-80 period using a
multinominal logit model. Their results also are consistent with the literature. Educational attainment promotes
migration, the influence of education declines with age,
blacks are less migratory than whites, and women are
less migratory than men.
6. As might be expected, the place characteristics that influence retiree migration differ from those that affect
worker migration. Studies conducted by researchers at
ECONOMIC REVIEW, JANUARY/FEBRUARY 1991
Florida State University—Fournier, Rasmussen, and
Serow (1988); Rasmussen, Fournier, and Charity (1989);
and Serow (1987)—support plausible notions concerning differences in what workers and retirees are looking
for in a new place. Labor market conditions such as employment opportunities, for example, are important to
workers but not to retirees, whereas cost-of-living considerations are more important to retirees. Apparently,
regional disparities in cost of living give elderly households on fixed incomes an incentive to move in much
the same way that job opportunities motivate workers to
migrate. Besides being sensitive to cost-of-living variations, the migration decisions of the elderly also seem to
be especially attuned to amenity variables, such as
warm, sunny weather and an absence of crime.
7. The flow of information between places may also lessen
with distance, limiting migration flows.
8. Scale economies are internal economies in a firm's production at a given facility as its scale of operation increases while agglomeration economies are associated
with economies that accrue to all firms in a single industry at a particular location.
References
Becker, Gary S. Human Capital. Princeton, N.J.: NBER,
Princeton University Press, 1964.
Berger, Mark C., and Glenn C. Blomquist. "GeographicMobility and Quality of Life." Paper presented at the annual meeting of the Population Association of America,
Baltimore, Md., March 1989.
Blanco, Cicely. "The Determinants of Interstate Population
Movements." Journal of Regional Science 5 (Summer
1963): 77-84.
Borts, George H., and Jerome L. Stein. Economic Growth in a
Free Market. New York: Columbia University Press, 1964.
Cushing, Brian J. "Accounting for Spatial Relationships in
Models of Interstate Population Migration." Annals of
Regional Science 20 (July 1986): 66-73.
• "A Note on Specification of Climate Variables in
Models of Population Migration." Journal of Regional
Science 27, no. 4 (1987): 641-49.
Fournier, Gary M., David W. Rasmussen, and William J.
Serow. "Elderly Migration: For Sun and Money." Population Research and Policy Review 7 (1988): 189-99.
Fox, William F., Henry W. Herzog, Jr., and Alan M.
Schlottman. "Metropolitan Fiscal Structure and Migration." Journal of Regional Science 29 (November 1989):
523-36.
Gabriel, Stuart A., Janice Shack-Marquez, and William L.
Wascher. "Does Migration Arbitrage Regional Labor
Market Differentials?" Unpublished manuscript, Board
of Governors of the Federal Reserve System, Washington, D.C., May 1989.
Graves, Philip E. "Migration with a Composite Amenity:
The Role of Rents." Journal
of Regional Science 23
(November 1983): 541-46.
Evidence on the Spatial and Temporal Dimensions of
the Linkage." Journal of Regional Science 26, no. 2
(1986): 223-35.
Hicks, John R. The Theory of Wages. London: Macmillan
Press, 1932.
Isard, Walter. Methods of Regional Analysis: An Introduction to Regional Science. Cambridge, Mass.: MIT Press,
1960.
Long, Larry E. Migration and Residential Mobility in the
United States. N e w York: Russell Sage Foundation,
1988.
Lowry, I.S. Migration and Metropolitan Growth: Two Analytical Models. San Francisco: Chandler, 1966.
Mazek, Warren F. "Unemployment and the Efficacy of Migration: The Case of Laborers." Journal of Regional Science 9 (April 1969): 101-7.
Mueller, Charles. The Economics of Labor Migration: A Behavioral Analysis. New York: Academic Press, 1982.
Mueser, Peter R. "Measuring the Impact of Locational
Characteristics o n Migration: I n t e r p r e t i n g CrossSectional Analysis." Demography 26 (August 1989a):
499-513.
• "The Spatial Structure of Migration: An Analysis of
F l o w s b e t w e e n States in the U.S.A. over Three
Decades." Regional Studies 23, no. 3 (1989b): 185-200.
Mueser, Peter R., and Michael J. White. "Explaining the
Association between Rates of In-Migration and OutMigration." Papers of the Regional Science Association
67 (1989): 121-34.
Muth, Richard F. "Migration: Chicken or Egg?" Southern
Economic Journal 37 (January 1971): 295-306.
Graves, Philip E., and Peter Linneman. "Household Migration: Theoretical and Empirical Results." Journal of Urban Economics (April 1979): 383-404.
Rasmussen, David W., Gary M. Fournier, and Douglas A.
Charity. "The Impact of Cost of Living Differentials on
Migration of Elderly People to Florida." The Review of
Regional Studies 19 (Spring 1989): 48-54.
Greenwood, Michael J. "Research on Internal Migration in
the United States: A Survey." Journal of Economic Literature 13 (June 1975): 397-433-
Serow, William J. "Determinants of Interstate Migration:
Differences between Elderly and Nonelderly Movers."
Journal of Gerontology 24, no. 1 (1987): 95-100.
• "Human Migration: Theory, Models, and Empirical
Studies." Journal of Regional Science 25 (November
1985): 521-44.
Greenwood, Michael J., and Gary L. Hunt. "Jobs versus
Amenities in the Analysis of Metropolitan Migration."
Journal of Urban Economics 25 (January 1989): 1-16.
Greenwood, Michael J., Gary L. Hunt, and John M. McDowell. "Migration and Employment Change: Empirical
Sjaastad, Larry A. "The Costs and Returns of Human Migration." Journal of Political Economy 70 (Supplement, October 1962): 80-93.
FEDERAL RESERVE BANK OF ATLANTA
White, Michael J., and Peter R. Mueser. "Changes in the
Demographic Determinants of U.S. Population Mobility,
1940-1980." Paper presented at the annual meeting of
the Population Association of America, Baltimore, Md.,
March 1989.
21
The 1990 Farm
Gene D. Sullivan
ongress r e s p o n d e d to the c h a l l e n g e o f
farmers g r o w i n g supported crops. Each must choose
cutting the cost of federal farm programs
what crop to g r o w o n the newly freed land. Their
C
by building into the 1990 Farm Act an es-
c o m b i n e d adjustments will influence not only their
timated $13.6 billion cut in farm subsidies
support payments received but also total production
over the next five years. Most savings came from the
o f various crops, w h i c h will in turn affect prices a n d
addition o f a provision to the system o f target prices
the actual federal expenditure savings resulting from
continued from the F o o d Security Act of 1985 (also
the n e w bill. These issues will b e more fully consid-
k n o w n as the 1985 Farm Bill). In addition to reduc-
ered later in this article.
-
ing estimated costs, this feature—called the triple-
This article is intended to b e a s u m m a r y o f the
base o p t i o n — h e l p s to improve the farm program's
background a n d development o f the 1990 Farm Bill
m a r k e t o r i e n t a t i o n b y f r e e i n g 15 p e r c e n t o f t h e
a n d the m a i n features that distinguish it from earlier
acreage in subsidized crops for unsupported produc-
legislation. F o l l o w i n g a discussion o f the general
tion o f any crop (except for fruits a n d vegetables).
Other features o f the 1990 a n d 1985 bills are simi-
framework of the bill, its major provisions for specific commodities are outlined. More general provisions
lar. However, in the 1990 bill target prices are frozen
are also discussed. I n the concluding sections impli-
at that year's levels after h a v i n g b e e n reduced in
cations o f the legislation are examined.
stages by the 1985 bill. Generally, price support levels are to b e a d j u s t e d e a c h c r o p m a r k e t i n g year
based o n stocks-to-use ratios.
T h o u g h it enhances market orientation, the triple-
Controlling Government Costs
base o p t i o n presents a c o m p l e x set o f choices to
Under the previous (1985) a n d current legislation,
i n c o m e s u p p o r t p r o g r a m s for farmers h a v e b e e n
The author is a research officer in the regional section of
the Atlanta Fed's research department.
22
geared to a concept of target prices that was based
o n direct payments to support incomes rather than
ECONOMIC REVIEW, JANUARY/FEBRUARY 1991
on supporting prices at levels that frequently required the government to purchase farm commodities at prices well above market clearing levels.
Farmers have the option to sell their commodities at
prevailing market prices or obtain a nonrecourse
loan from the Commodity Credit Corporation (CCC)
at a specified price per unit, usually set below the
expected market price level. Direct government payments to farmers make u p the difference between
the target price and the higher of the CCC loan rate
or the average market price during a specified period. This deficiency payment program encourages the
flow of commodities into the marketplace, thereby
reducing or avoiding government storage costs.
In the past the government sometimes held commodities for many years because they could not be
marketed at or above their acquisition cost. Stored
commodities were eventually disposed of in gifts to
impoverished foreign countries or to needy groups
at home, or they were sometimes bartered to countries that lacked foreign exchange but had products
they could trade. The target price and deficiency
payment program is intended to help avoid such
losses to the government.
G o v e r n m e n t payments to farmers have themselves become an expensive item in the budget of
the U.S. Department of Agriculture largely because
of the wide differences between target and market
prices. Payments reached a peak o f $16.7 billion in
1987, compared with direct outlays to farmers totaling SI.3 billion in 1980. Increases in market prices
reduced direct payments after 1987, but estimates for
1990 indicate farmers again received a relatively high
level o f support—about $12 billion. Without program alterations it is estimated that payments for
1991 would have moved up sharply from 1990's level, largely because of weakening market prices for
wheat and feed grains as stocks are rebuilt from the
shortages 1988's major drought in the Midwest and
Upper Plains engendered.
P o l i c y Pressures. Negotiations for the 1990 Farm
Bill began under the specter of several unusual pressures. O n e was the General Agreement on Tariffs
and Trade (GATT) negotiations in which then U.S.
Secretary of Agriculture Clayton Yeutter had been
campaigning vigorously for the removal o f tradedistorting agricultural subsidies t h r o u g h o u t the
world. The success of this endeavor would have produced revolutionary changes in American farm policy
because policy is heavily based on price and income
support mechanisms that presumably w o u l d have
been revamped or possibly eliminated. Congress decided to proceed with the 1990 Farm Bill under the
assumption that total subsidy cuts were unlikely (an
assumption that proved correct when the GATT negotiations subsequently broke down). Thus, the ini-
FEDERAL RESERVE BANK OF ATLANTA
tial proposals for the 1990 legislation were rather
closely modeled after the expiring 1985 Farm Bill.
An additional pressure on bill writers was the
need to develop legislation in line with the budget
agreement b e i n g crafted by other congressional
committees. In fact, the failure of Congress to accept
the budget summit agreement on October 5, 1990,
left the House-Senate conference (at that time attempting to negotiate a final version of the Farm Bill
from the separate bills passed by the House and
Senate) without specific guidelines or goals for cutting crop subsidies. As it turned out, the estimated
$13 billion cut required by the budget summit agreement remained the requirement of subsequent budget negotiators as well.
S a v i n g s E s t i m a t e s . E x p e n d i t u r e cuts w e r e
achieved largely by reducing the amount of land on
which farmers could collect subsidy payment by 15
percent. The cutbacks were made more palatable to
farmers by giving them broad flexibility in crops
they are permitted to grow on the nonsubsidized
acreage.
It is assumed that farmers, on balance, will not
change acreages and production of crops in such a
way as to increase government outlays. Although
production of individual crops, such as cotton and
soybeans, could expand and depress market prices
so that deficiency payments or CCC outlays would
increase for those commodities, the corresponding
reduction in grain production presumably would lift
market prices and reduce deficiency payments on
grain acreage. The overall effect is expected to keep
net government expenditures at levels that will maintain the estimated reductions o f $13.6 billion over
the five-year period of the legislation.
The savings estimate is also based on assumed
continued strength in domestic and foreign demand
for agricultural commodities. Because target prices
have been frozen, market or support price fluctuations will directly affect costs of government agricultural programs.
Provisions for Major Commodities
The new bill's major provisions for specific commodities are as follows:
W h e a t . The target price for wheat is to be frozen
at $4 per bushel for five years. The old legislation
had allowed the m i n i m u m target price to decline
each year since 1987, moving d o w n from $4.38 to $4
per bushel in 1990. (See Chart 1, which compares
target prices for the five major commodities in the
first production season under the 1985 and 1990
bills.) The rate at which the CCC would lend money
23
Chart 1
Target Prices
1985 and 1990 Farm Bills*
Dollars per Unit
Wheat
* For the first production
Source:
$11.90
Rice
Sorghum
Cotton
U.S. Department of Agriculture, Economic Research Service, The 1990 Farm Act and the 1990 Budget Reconciliation
December 1990, 6.
to farmers on wheat (the price support loan or loan
rate) is set at 85 percent of a five-year moving average of market prices. Previously, the loan rate had
been set in the range of from 75 to 85 percent of the
five-year average. The objective of this provision is
to ensure that in most years the loan rate would be
far enough below the market price at some period
of the year to encourage wheat to flow into the
market rather than remain in storage. If stocks should
build up anyway because of unusual price weakness,
the Secretary of Agriculture is given the authority to
reduce the loan rate as much as 20 percent, as he
was also allowed to do under previous legislation.
Deficiency payments are to be calculated on a
twelve-month average market price rather than the
average of the first five months of the marketing
year, as was the case for previous legislation. This
change will probably have the effect of reducing the
average deficiency p a y m e n t to farmers because
prices are typically lower during the first five months
of the marketing season when the crop is being harvested than is the average price for the whole year,
which w o u l d include prices during periods when
supplies are likely to be drawn down (see Table 1).
Feed G r a i n s . The 1990 target price for corn of
$2.75 per bushel is frozen for a five-year period (see
Chart 1). Like wheat, the loan rate is set at 85 percent of a five-year moving average of market prices
24
Corn
season under each bill.
Act
instead of in the range of from 75 to 85 percent of
the average price. The secretary would also have the
authority to reduce the support price by as much as
20 percent during a year when stocks build to high
levels. Deficiency payments for corn will be calculated on a twelve-month average of market prices for
the 1994 and 1995 crops, rather than a five-month
market season average price. The latter average will
continue to be used until 1994.
Target prices for other feed grains are set at $2.61
per bushel for grain sorghum, $2.36 per bushel for
barley, and $1.45 per bushel for oats. Loan rates for
these commodities are to be held in a fair and reasonable relationship with corn.
C o t t o n . The expiring legislation had reduced the
target prices for cotton in annual increments from 81
cents per pound in 1986 to 72.9 cents in 1990. The
new bill freezes the target price at that amount for
five years. The loan rate for cotton will continue to
be set at 85 percent of a five-year moving average of
market prices. However, cotton producers will continue to have an option of repaying less than the
loan amount to the CCC. A "marketing loan" concept
is in use under which the producer can repay a
commodity loan at the unit price earned at market.
For example, if the prevailing world market price is
below 80 percent of the loan rate, a loan repayment
level may be set not in excess of 80 percent of the
ECONOMIC REVIEW, JANUARY/FEBRUARY 1991
Table 1
Commodity Price Averages*
Cotton
Marketing
Year
Average
Five-Month
Average
1985
2.23
2.41
0.57
1986
1.50
1.69
1987
1.94
1988
1989
Wheat
Marketing
Year
Average
Five-Month
Average
Marketing
Year
Average
Five-Month
Average
0.56
3.08
3.00
6.53
7.74
0.52
0.50
2.42
2.31
3.75
3.87
1.74
0.64
0.65
2.57
2.45
7.27
5.92
2.54
2.34
0.56
0.55
3.72
3.61
6.83
6.96
2.33
2.27
0.63
0.63
3.72
3.77
7.30
7.25
* The "marketing year average"
as follows: corn, September
The "tive-month average"
Marketing
Year
Five-Month
Average
Average
Rice
column shows the weighted average price for the crop sold during the marketing year defined
1 to August 31; cotton, August
1 to July 31; wheat, June 1 to May 31; rice, August
column shows the average price during the first five months of the commodity's
Source: U.S. Department of Agriculture, Agricultural
1 to July 31
marketing
year.
Prices Monthly and Annual Reports.
loan rate. This provision may sometimes bestow substantial financial benefits to growers in addition to
the direct deficiency payments collected.
Rice. The rice program's general provisions are
the same as those for cotton. The target price for rice
will be $10.71 per hundredweight (cwt) for five
years. As with corn, beginning in 1994 and continuing through 1995 deficiency payments for rice are to
be calculated on a twelve-month average market
price rather than a five-month average, which will
continue in use until that time.
O i l s e e d s . Target prices are not p r o v i d e d for
oilseeds because they are not included in the socalled basic program crops. The support price for
soybeans has been set at $5.02 per bushel for the
five-year period of 1991 through 1995, less a 2 percent loan origination fee to be deducted from the
proceeds at the time the loan is granted. Producers
will also be provided a marketing loan that allows
CCC loans to be repaid at the smaller of the loan
rate or the prevailing world market price for soybeans. Other oil seeds, including sunflower seed,
canola, flax, and safflower, will have loan rates set at
levels comparable to soybeans. The Secretary o f
Agriculture may also establish loan programs for additional oilseed crops as he deems necessary.
D a i r y P r o d u c t s . The price support level for milk
will be frozen at $10.10 per cwt of product with 3.67
percent butterfat content. This move interrupts the
trend of declining support prices that had been in
process since 1986, w h e n the support price was
$11.60 per cwt. Previous legislation had specified
that price supports would decline periodically to reduce the incentive for surplus milk production. The
CCC was required to buy manufactured milk products in sufficient volume to keep the price of milk
from dropping below the legislatively specified minim u m level. If surplus production levels should decline sufficiently during the life of the new legislation,
price support levels might increase. To make producers share a portion of the program's cost, the new
legislation requires an assessment of 5 cents per cwt
o f milk produced in 1991 and 11 cents per cwt for
1992 through August 31, 1995. However, a producer
may apply for a refund of this assessment by certifying that his o w n milk production has not increased
from the previous year.
To further defray program costs, the Agriculture
Department may level assessments on farmers to recover the full costs o f purchasing surplus dairy
products in excess of 7 billion pounds a year, provided legislation has not been enacted by January 1,
1992, to limit dairy surpluses. For 1989 and 1990,
net supply removal by CCC purchases is indicated
to have totaled 9.0 billion and 8.5 billion pounds,
respectively, suggesting that surpluses are likely to
FEDERAL RESERVE BANK OF ATLANTA
25
continue to exceed the trigger point for assessments
unless new dairy legislation is enacted.
Sugar. The sugar program has operated basically
to restrict imports to quota levels in order to maintain domestic prices at or above the support price
level. Although previous legislation allowed the support price to rise to reflect increases in the cost of
production, the new bill has frozen the price-support
loan for sugar at 21 cents per pound, and the legislation specifies that the programs continue to operate
at no cost to the government. Duties on imported
sugar have covered the government's cost of operating the p r o g r a m . H o w e v e r , imports have b e e n
shrinking over time, and domestic production has
expanded to supply a larger share of total consumption. In addition, sugar substitutes and fructose (sugar from corn) have been claiming growing shares of
the market.
To preserve a minimum level of imported sugar,
the new legislation requires domestic marketing controls on cane and beet sugar if imports fall below
1.25 million short tons (about 18 percent of total domestic production). The growth of corn sugar marketings is also controlled by the imposition o f a
200,000 ton sugar-equivalent limit on annual marketings. To ensure that sugar producers share the
burden of the mandatory reductions in costs of government programs along with other major crop producers, a 1 percent fee will be assessed on sugar
loans from the CCC.
General Provisions
The new legislation contains a number of other
provisions that are not c o m m o d i t y or producergroup specific.
P a y m e n t l i m i t a t i o n s . A limitation on the amount
of payments that an individual producer can receive is
carried forward from previous legislation with some
changes. The maximum amount a fanner may be paid
from all government programs has been cut in half,
from §500,000 to $250,000. The expiring legislation's
limit of $50,000 per producer on direct deficiency
payments is maintained. However, payments in larger
amounts may be secured from such programs as disaster relief when crops are destroyed by drought or
other calamities and from marketing loan gains. Nevertheless, the total of these payments may not exceed
$250,000 per farmer for the major commodities listed
above. For producers of honey, wool, and mohair,
the n e w legislation specifies a p a y m e n t limit o f
$200,000 in 1991, decreasing to $125,000 by 1994. The
stricter limits for these producers impose a way they
will share in the reductions in program costs.
26
F o o d f o r Peace. The Food for Peace (P.L. 480)
program, the chief instrument for delivering food aid
abroad and helping develop markets for U.S. farm
products, has been extended in the new legislation,
with a few changes. The authority for grant programs, including a new government-to-government
grant program, is specifically assigned to the Agency
for International Development, with the Department
of Agriculture retaining responsibility for concessional sales of products abroad. The 1985 act contained a
provision authorizing commodity donations to support agricultural policy reform in developing countries. The new legislation restricts use of the program
for foreign policy purposes and attempts to direct
commodities to countries with the greatest need and
market potential.
To assist the U.S. maritime industry, previous legislation specified that 80 percent of the gross tonnage of agricultural commodities exported under
the P.L. 480 program must be transported on U.S.flag commercial vessels. The new legislation allows
foreign vessels to reflag as U.S. ships to qualify as
carriers under the existing "cargo preference" requirements for certain ports.
E x p o r t E n h a n c e m e n t . Previous legislation required the Secretary of Agriculture to provide $325
million annually, or the equivalent in CCC commodities, for export assistance to counter adverse effects
of a foreign country's unfair trade practices. The program involved selling export certificates to commercial exporters o n a c o m p e t i t i v e b i d basis. The
certificates could be redeemed for CCC-owned commodities that could be exported at the prices necessary to p e n e t r a t e f o r e i g n m a r k e t s . The n e w
legislation enlarges the Export Enhancement Program subsidies to not less than $500 million per
year. In addition, a Marketing Promotion Program is
funded at not less than $200 million per year to target markets where unfair trade practices are cited.
Legislation viewed these measures as additional
weapons for use against countries that continue to
refuse to reduce agricultural trade impediments.
C o n s e r v a t i o n . Growing environmental concerns
are largely responsible for a number o f new and revised stipulations of the conservation section of the
new legislation. Previous legislation provided penalties intended to discourage the expansion of agricultural production on land defined as highly erodible
or as wetlands, which are important wildlife habitats.
The new legislation enlarges previous programs by
creating an Agricultural Resources Conservation Program to protect these fragile lands as well as land
that in cultivation may contribute to water pollution.
The new program includes three separate components: the existing Conservation Reserve Program,
which assists owners and operators in conserving
E C O N O M I C REVIEW, JANUARY/FEBRUARY 1991
and improving soil and water resources on highly
erodible land; a n e w Wetlands Reserve Program;
and a new Water Quality Incentives Program.
The Conservation Reserve Program specifies that
by 1995 not more than 45 million or less than 40 million acres of environmentally sensitive lands are to be
enrolled in the program. The new Wetlands Reserve
Program authorizes the subsidized enrollment of u p
to one million acres of wetlands into easements of
thirty years or longer, with priority given to wetlands
that enhance wildlife habitat. Landowners may participate in this program on a voluntary basis. The new
Water Quality Incentives Program would pay farmers u p to $3,500 a year to carry out governmentapproved plans to reduce water pollution, and more
if wildlife habitat is also improved. The program
specifies an enrollment goal of 10 million acres.
C r e d i t . During the latter half of the 1980s the
Farmers H o m e Administration experienced severe
problems with loan delinquencies and defaults. For a
period of time the agency was prevented from disposing of this property, and the foreclosed property
inventory ballooned. That development motivated
the authors of the 1990 agricultural legislation to include stipulations to address the Farmers H o m e Administration's property inventory problems. The new
legislation calls for disposing of the land within one
year. Leasers o f property acquired by the Farmers
Home Administration before January 6, 1988, would
have the right o f first refusal on the sale of that property. Purchase preference would also be given to beginning farmers and ranchers.
Write-downs o f both loan principal and interest
have been used to bring a borrower current on his
indebtedness to the Farmers H o m e Administration.
The n e w legislation limits borrowers to a single
write-down for loans made after January 6, 1988. It
also places on individual borrowers a lifetime cap of
$300,000 in principal and interest, a stipulation that
grew out of losses to some unusually large fanning
operations during the late 1970s and early 1980s.
R u r a l D e v e l o p m e n t . In conjunction with the liquidations and consolidations of farming operations
during the period of unusual financial stress on the
farm sector during the 1980s, the economies of rural
communities shrank and, in some cases, virtually disappeared. This development has motivated afflicted
regions to secure government assistance to preserve
and develop rural economies.
The new law contains provisions to create a Rural
Development Administration within the Agriculture
Department. O n e of its specified functions is to establish in as many as five pilot states panels of state
officials w h o will rank state and local applications
for Farmers H o m e Administration funding through
that agency's loans for community development.
FEDERAL RESERVE BANK OF ATLANTA
Implications of the Farm Bill
The major change in the 1990 Farm Bill is the
triple-base option, which calls for the division of a
farmer's acreage base into three categories. As already noted, that provision reduces the acreages of
program crops on which farmers can receive deficiency payments by 15 percent, but it allows farmers
the freedom to plant the crop of their choice (except
fruits and vegetables) on those acres. It also permits
farmers to remove voluntarily an additional 10 percent of the base acreage program crop production
under the same stipulations. Farmers may still be required to remove (idle) some acreage from all crop
production to qualify for program benefits according
to the annually announced Acreage Reduction Program based on stocks-to-use ratios of the specific
crop in question. The portion of the crop base left is
the permitted acreage on which the program crop is
grown. Fach permitted acre o f the crop is eligible
for income deficiency payments as previously described.
The major u n k n o w n impact of the new legislation concerns what farmers will actually d o with the
15 percent of their acreage base the new legislation
has freed. Farmers can be expected to make individual decisions based on the productivity of their land
(expected yields) in various crops and the expected
price once a particular commodity has been produced. Farmers w h o select options different from
the majority o f their counterparts will p r o b a b l y
make the most rewarding choices. For example, if
most corn farmers choose to switch their triple-base
acreage to soybeans, a substantially larger harvest
might well push d o w n the price of soybeans while
reduced production o f corn might drive its price u p
so that farmers w h o continue to produce corn on
their freed acreage could end u p receiving a higher
income than those w h o switch. In that case, deficiency payments to corn producers w o u l d shrink
because of the rise in market prices. In the South,
reduced winter wheat and rice production in favor
o f increased soybean and cotton output could have
the same result. That is, those w h o stay with the
base program crop might receive higher returns after all. O b v i o u s l y , s u c h p o t e n t i a l rewards for
second-guessing competitors make it unusually difficult to forecast what most farmers will d o in 1991
and subsequent years. In addition, the USDA has
not released detailed rules and regulations governing all of the specific commodity programs. These
stipulations could also influence farmers' decisions
in the coming crop year.
Indications thus far are that acreage shifts may
be relatively small for the nation as a whole. The
27
American Farm Bureau has projected that total cotton and wheat acreages are unlikely to change m u c h
as a result of the 1990 Farm Bill, and relatively minimal changes are projected for corn and soybeans. 1
A n n u a l corn acreage may decline by a n average
800,000 acres, a n d a n n u a l s o y b e a n acreage will
probably increase by an average 1.2 million acres
over the five-year life of the program. As a result, the
level of soybean production could rise by 30 million
bushels (1.5 percent) and the amount of corn output
diminish by 90 million bushels (1 percent) during
that time. The reduced output should raise the fiveyear average corn price by 4 cents per bushel (1.8
percent) from what it w o u l d have been under previous legislation. Increased soybean output is expected to lower the five-year average soybean price by
31 cents per bushel (5.1 percent) from the baseline
forecast. The bill should have little impact on cotton
and wheat prices.
The 15 percent reduction in acreage eligible for
government payments will cut producers' program
crop returns. Farmers w h o produce other more marketable crops o n acres n o longer eligible for deficiency payments could recoup at least some of that
loss. However, if market prices of crops decline, the
government's deficiency payments would have to increase to maintain income levels o n program base
acres. For example, if corn production does not decline as anticipated, prices could fall from the approximately $2.25 per bushel level at year's end 1990
to the projected loan rate of $1.90 per bushel, necessitating increased payments o n program acreage. In
addition, CCC outlays could grow as farmers repay
certain commodity loans at market prices that have
dropped rather than at the higher loan rate. If, as expected, a significant amount of triple-base acreage is
shifted to soybean production so that prices drop,
soybean producers would be the ones most likely to
exercise the marketing loan option, but the price
w o u l d have to decline by more than the 31 cents per
bushel projected by the Farm Bureau to drop the
year-end 1990 price of about $5.60 per bushel below
the $5.02 per bushel loan rate.
The likelihood that deficiency payments will increase over the next five-year period is somewhat
reduced by the program's movement to the twelvemonth-marketing-year average as the base for calculating payments. Table 1 shows that for corn in the
1985-89 period, the marketing-year average price
was higher than the five-month average in three out
of the five years. For wheat, the marketing-year average was higher in four out of five years (the exception occurred in 1989, w h e n the five-month average
was slightly higher).
Corn a n d wheat account for the major share of
the government's deficiency payment expenditures.
28
If price relationships during the next five years remain approximately the same as during the last fiveyear period, using the marketing-year average base
could cut deficiency payments an additional 1.5 to
2.5 percent. Because the target price is frozen for the
term of the n e w legislation, however, a plunge in
commodity prices w o u l d require that deficiency payments increase substantially, regardless of the market
price series used. The new program has been designed to keep American grains competitive in world
markets, though, so total d e m a n d for grains is expected to remain strong e n o u g h to prevent major
price declines. The American Farm Bureau projects
modest increases in corn and wheat prices during
the five years of the program.
Whether government costs rise or not, farmers in
s o m e regions fear d a m a g e from potential m a j o r
acreage shifts. For example, southeastern soybean
farmers worry that midwestern corn growers might
plant soybeans instead of corn on their nonsubsid i z e d acreage because the s o y b e a n c r o p may
promise greater marketplace returns in their region.
If prices fall because of extra soybean production,
southeasterners w o u l d fail to cover their relatively
high production costs. For these farmers, few profitable alternatives are available for a good portion of
the poor land n o w devoted to soybeans. Southeastern farm spokesmen point out that the region's farm
failures might well increase in the wake of the newlegislation.
Conclusion
The 1990 Farm Bill has the overriding objective of
cutting the government's costs for agricultural programs, costs that had grown large and threatened to
grow m u c h larger if allowed to continue on their
course. The chief cost-cutting measure is the triplebase feature, which in effect reduces the acreage on
which eligible crop producers can collect income deficiency payments. Such farmers n o w have a third
category of land in addition to the acreage on which
they receive subsidy payments and the acreage the
government can require them to idle as a condition
of receiving these payments. O n land in this third
category, farmers can plant whatever crop offers the
greatest return in the marketplace (except fruits and
vegetables) and still preserve the acreage history for
the basic crop.
If market prices for the crops g r o w n o n triplebase acreage remain high or increase, farmers' incomes m a y not d e c l i n e m u c h as a result o f the
program change. However, market prices could sag
under the weight of additional production and possi-
ECONOMIC REVIEW, JANUARY/FEBRUARY 1991
bly softening d e m a n d abroad as world production o f
crops increases.
If farm incomes d r o p sharply u n d e r the n e w program, Congress will c o m e u n d e r intensifying pres-
A reduction in market prices a n d support prices
sure to raise subsidies again. O n the other h a n d , the
w o u l d lead to increased government expenditures to
l i k e l i h o o d o f c o n t i n u i n g excessive b u d g e t deficits
maintain i n c o m e s o f farmers, w h i c h w o u l d
reduce
the estimated savings projected for the n e w legisla-
will almost certainly stiffen resistance to enlarging
s p e n d i n g programs.
tion. O n the other h a n d , if d e m a n d s h o u l d prove
stronger than expected, g o v e r n m e n t s u p p o r t costs
c o u l d decline a n d a greater budget savings than the
$13-6 billion projected w o u l d be realized.
FEDERAI. RESERVE BANK OF ATLANTA
Note
1. The American Farm Bureau Federation, Economic Review 7 (October 1990): 1-6.
29
Book Review
Manias, Panics, and Crashes:
A History of Financial Crises, revised edition.
by Charles P. Kindleberger.
New York: Basic Books, Inc., 1989.
320 pages. $21.95 (cloth). $12.95 (paper).
A
s the extensive set o f sources cited in
C h a r l e s P. K i n d l e b e r g e r ' s
tests, f i n a n c i a l crises h a v e
The author, w h o s e grasp o f the subtleties of inter-
at-
national e c o n o m i c relations has long been appreciat-
claimed
ed, has m a d e the case for an international lender of
book
e c o n o m i s t s ' a n d historians' intermit-
last resort in m a n y forums. I n Manias,
Panics,
and
of
Crashes, Kindleberger's basic thesis is again that the
well-publicized gyrations in financial markets b o t h
w o r l d needs a central bank, but the large n u m b e r o f
here a n d abroad in the past few years, the expan-
stories he tells to illuminate this idea often serve to
sion phase o f a n e w cycle o f interest seems to b e
mask the message. His arguments are less succinct
occurring. Kindleberger's b o o k , in the revised edi-
a n d m o r e colorful t h a n the straightforward recount-
tent a t t e n t i o n for c e n t u r i e s . I n the a f t e r m a t h
tion reviewed here, is o n e o f several recent systemat-
ing o f t h e m in this review might suggest. D r a w i n g a
ic considerations.
broad descriptive outline o f the process of m a n i a ,
The d e v e l o p m e n t s o f the 1980s have, it seems,
panic, a n d crash from the w o r k o f H y m a n Minsky
a d d e d evidence to support Kindleberger's view o n
(1977, 1982), the A m e r i c a n economist best k n o w n
the progress a n d impacts o f financial crises. His ar-
for explorations o f financial fragility, Kindleberger
g u m e n t has several basic points. Financial crises, he
p u t s m e a t o n the b o n e s o f M i n s k y ' s stylized de-
contends, occur at o d d times. Such events may cause
s c r i p t i o n w i t h e x a m p l e s f r o m a p l e t h o r a o f sec-
real harm in the economies in w h i c h they take place.
o n d a r y sources covering financial panics from the
I n a d d i t i o n , financial crises m o r e a n d m o r e often
S o u t h Sea B u b b l e o f 1720 t o t h e s t o c k
have global dimensions. Kindleberger emphasizes
crashes o f 1987.
market
that central banks can alleviate s o m e of these events'
I n Kindleberger's version o f Minsky's m o d e l , fi-
costs. Furthermore, these crises' global implications
nancial fragility results m a i n l y from high levels of
a n d the absence o f a strong international financial
d e b t b o r r o w e r s h a v e t a k e n o n to b u y assets for
p o w e r call for the establishment o f a n international
short-term profit. Following Minsky, Kindleberger di-
lender o f last resort to maintain the stability o f the
vides the events o f a crisis into several stages. The
world's economies.
first is a "displacement," an event that changes profit
30
ECONOMIC REVIEW, JANUARY/FEBRUARY 1991
opportunities in at least o n e important sector of the
economy. W h e n businesses and investors flock to
these opportunities, the second phase—the b o o m —
gets under way. The b o o m is typically fueled, at
least in part, by expanding bank credit.
A b o o m often progresses into euphoria, a phase
characterized primarily by investors' buying assets
for short-term resale, often o n the basis of overestimations of future profits. This speculation results in
further credit expansion a n d leveraging. Euphoria
draws in people w h o d o not usually enter speculative markets; such investors also have o v e r b l o w n
profit expectations. Kindleberger calls the stage that
ensues from euphoria a mania or a bubble, implying
that the phase's speculative activities are irrational
and precarious.
U n d e r Kindleberger's scenario, a crisis begins
w h e n some investors, emerging from euphoria, begin to cash in o n their speculations and prices resist
further increases. After a period of "financial distress," Kindleberger explains, speculators realize that
prices may not always rise. Then panic selling sets
in, asset prices fall, bankruptcies increase, lenders
fail, credit becomes unavailable, and even projects
with high projected returns find n o lenders. Panicfeeds itself until it burns out or is extinguished by
some policy response. Ultimately, real output and
welfare decline as a result of the crisis.
After delineating the model, Kindleberger embarks
on a series of chapters that flesh out his outline. He
draws stories from a 275-year series of financial
crises. This anecdotal method, the author contends,
is an appropriate technique for conveying a sense of
events that are unpredictable, chaotic, and unique.
Kindleberger's stories, selected and written with wit
and a sense of the bizarre, are a trove of information
o n the varieties o f financial panics' p r o p a g a t i o n ,
spread, and resolution through the years. They show
clearly that events similar enough to fit the term "financial crises" have occurred with some frequency
but have also been quite varied in all their aspects.
As with most models that concentrate o n stages,
Kindleberger's stylized description is somewhat unsatisfactory. H e tends to fit his stories into the
model's stages rather than to probe systematic relat i o n s h i p s that m i g h t e x p l a i n the d y n a m i c s that
drive the e c o n o m y from stage to stage. The m o d e l
is presented as a one-way progression with little explicit consideration of the role of the real (or nonfinancial) e c o n o m y or expectations about the real
economy. For example, Kindleberger clearly considers the initial displacement stage exogenous. Booms
sometimes m o v e to euphoria; sometimes they d o
not. In addition, n o variables in the model account
for transitional phases from one stage o f a financial
crisis to another. Some of the explanations the mod-
FEDERAL RESERVE BANK OF ATLANTA
el does provide, such as a discussion of the timing of
financial distress, are inadequate.
Furthermore, in considering the impacts of financial crises o n the rest of the economy, Kindleberger
fails to apply the insights of recent macroeconomic
thinking, particularly the perspectives of real business cycle and rational expectations theorists. H e assumes without discussion that real costs occurring
after a crisis are the result of irrational behavior during the crisis. He might well have considered the insights o f economists such as Gary Gorton (1984),
Charles Jacklin and Sudipto Bhattacharya (1988), and
Ellis Ta 11 m a n (1988), w h o relate behavior d u r i n g
b a n k i n g panics to the public's expectations about
real p h e n o m e n a in an ensuing recession or depression. Their approach makes the crisis at least partially a function of expected future real losses rather
than a cause of these losses. Such a view undermines Kindleberger's arguments for intervention in
the latter stages (financial distress and panic), calling,
rather, for policies designed to maintain a stable
economy.
The author's failure to provide adequate explanations o f his model and to consider alternative app r o a c h e s ultimately detracts from the b o o k ' s
credibility. Despite the marvelous stories, o n e begins to w o n d e r why, if this broad model of financial
crises' progression is truly systematic, documentation for each phase o f the process is selected from
only a sample of historical crises. Is the selection
criterion only that the tale fits the model? Could o n e
support a different m o d e l with a different set o f
anecdotes from the same universe of crises or, as
Gorton's work implies, from the same set of samples?
Kindleberger a p p e n d s two observations from his
o w n earlier w o r k to the general descriptions o f
Minsky's model. These points are vital to his argument for an international lender of last resort. In
the most important o f these he "opens" Minsky's
o n e - e c o n o m y m o d e l by noting that history gives
many examples of situations in which manias, panics, crashes, and their effects have been transmitted
a m o n g national economies, becoming international
in scope. Interestingly, he points out, the impacts of
internationally transmitted panics have not always
been the same in different countries. For example, a
building b o o m in Germany and Austria, which the
author interprets as mania, removed credit from the
U.S. economy in 1871 and 1872, restraining credit to
American railroad speculators and contributing to a
national panic. Kindleberger also argues that international transmission of crises has expanded in recent
years with the growing integration of the world's
economy, but he admits that, even as long ago as
the 1720 South Sea Bubble, crises had international
implications.
31
T o s u p p o r t his a p p e a l for a lender o f last resort
sively? W o u l d it not b e m o r e effective for n a t i o n a l
the a u t h o r c o m p a r e s panics that have b e e n a l l o w e d
central b a n k s to coordinate u n d e r pressure o f crisis?
to stop w i t h o u t intervention to those that have b e e n
W h a t c o u l d a n international central b a n k d o to han-
arrested w i t h i n t e r v e n t i o n . K i n d l e b e r g e r is clearly-
dle a potentially d a n g e r o u s one-country m a n i a that
c o n v i n c e d that crises in w h i c h n o lender o f last re-
threatened to b e c o m e a n international panic? W h e n
sort intervened have run longer a n d b e e n costlier in
faced w i t h nations in different phases o f the business
real terms. A n a l y z i n g the historical record o f the in-
cycle, h o w w o u l d the international central b a n k de-
ternational p r o p a g a t i o n o f financial crises, the a u t h o r
cide o n its course o f action?
c o n t e n d s that the depression f o l l o w i n g a crisis has
Kindleberger's w i d e array o f stories demonstrates
b e e n shorter w h e n a lender o f last resort has inter-
that m a r k e t e c o n o m i e s are n o t , a n d for centuries
vened. To accept this p o i n t fully, o n e must b e con-
have not been, i m m u n e to manias, panics, a n d crash-
vinced b y the author's a r g u m e n t that a g o v e r n m e n t ,
es. His cautionary tales shake a n y c o m p l a c e n c y that
b a n k , or private organization has stepped in to per-
m a y still exist a b o u t the stability o f today's w o r l d
f o r m c e n t r a l b a n k f u n c t i o n s in a m a j o r i t y o f t h e
e c o n o m y ; in fact, K i n d l e b e r g e r clearly s h o w s that
crises he discusses. In international crises s u c h a n or-
i n t e r n a t i o n a l transmission o f e c o n o m i c crises is at
ganization has, often w i t h cooperation from similar
least frequent a n d p r o b a b l y b e c o m i n g m o r e so. For
institutions from other countries, b e c o m e a n interna-
this reason his b o o k is w o r t h the attention o f those
tional lender. O n l y in infrequent crises, Kindleberger
interested in e c o n o m i c policy for financial
avers, has there b e e n n o strong organization to inter-
a n d the real e c o n o m y . T h e reader c o u l d w i s h , how-
vene, a n d such events h a v e resulted in greater wel-
ever, that this b o o k ' s m a s s o f e v i d e n c e
fare losses.
m o r e e n l i g h t e n m e n t o n the e n g i n e operating in the
These discussions lead to the key p o r t i o n
of
markets
provided
c h o s e n m o d e l a n d at least sortie c o n s i d e r a t i o n
of
Kindleberger's b o o k — t h e a r g u m e n t for establishing
the role o f real shocks a n d expectations in alterna-
a n i n t e r n a t i o n a l l e n d e r o f last resort. T h e current
tive m o d e l s .
global e c o n o m y , h e maintains, lacks a strong, active
T h e increasing integration o f the w o r l d ' s econo-
lender o f last resort able to act in the international
mies m a y s o m e d a y b r i n g m o r e c o o r d i n a t i o n o f na-
sphere: the U.S. federal deficit w e a k e n s
tional e c o n o m i c conditions a n d demonstrate that a n
American
ability; n e i t h e r J a p a n n o r G e r m a n y are yet strong
international institution designed to respond to finan-
e n o u g h , a n d each is h a m p e r e d b y internal d e m a n d s ;
cial crises is vital to e c o n o m i c well-being.
the International Monetary F u n d does not have suffi-
berger breaks s o m e g r o u n d t o w a r d p e r s u a d i n g his
cient resources or s c o p e o f powers. Consequently, in
readers that s u c h a n o u t c o m e is desirable a n d in-
t h e face o f increased threat o f i n t e r n a t i o n a l crisis
evitable, b u t h e falls short o f his ultimate goal.
Kindle-
transmission, K i n d l e b e r g e r p r o m o t e s the establishm e n t o f a n institution c a p a b l e o f s u p p l y i n g financial
resources n e e d e d to stop international panics or mit-
B. F r a n k K i n g
igate their results.
This c o n c l u s i o n p r o m p t s several q u e s t i o n s that
the a u t h o r answers o n l y briefly, if at all. W o u l d a n
international central b a n k increase m o r a l hazard in a
w o r l d in w h i c h risk taking is often subsidized exces-
The reviewer is vice president and associate director of research at the Federal Reserve Bank of Atlanta.
References
Gorton, Gary. "Banking Panics and Business Cycles." Federal Reserve Bank of Philadelphia Working Paper, 1984.
Jacklin, Charles J., and Sudipto Bhattacharya. "Distinguishing Panics and Information-Based Bank Runs: Welfare
and Policy Implications." Journal of Political Economy
96 (June 1988): 568-92.
Minsky, Hyman P. "A Theory of Systematic Fragility." In
Financial Crises: Institutions and Markets in a Fragile
Environment, edited by E.I. Altman and A.W. Sametz.
New York: Wiley International, 1977.
32
. "The Financial Instability Hypothesis: Capitalistic
Processes and the Behavior of the Economy." In Financial Crises: Theory, History, and Policy, edited by
C.P. Kindleberger and J.P. Laffargue, 13-29- Cambridge:
Cambridge University Press, 1982.
Tallman, Ellis. "Some Unanswered Questions about Bank
Panics." Federal Reserve Bank of Atlanta Economic Review 73 (November/December 1988): 2-21.
E C O N O M I C REVIEW, JANUARY/FEBRUARY 1991
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