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Economic •
Review B
FEDERAL RESERVE BANK OF ATLANTA
BANK CAPITAL
MONEY SUPPLY
NOVEMBER 1985
Regulation
Lagged Response
TEXTILE INDUSTRY A Clouded
Future?
President
Robert P. Forrestal
Sr. Vice President and
Director of Research
Sheila L Tschinkel
Vice President and
Associate Director of Research
B Frank King
Financial Institutions and Payments
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Larry D. Wall
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Macropolicy
Robert E Keleher, Researcf
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Regional E c o n o m i c s
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ISSN 0 7 3 2 - 1 8 1 3
Regulation of Banks'
Equity Capital
The pros a n d c o n s of prescribing levels
of equity capital are detailed in this
assessment.
20
Lags in the Effect of
Monetary Policy
Debate over the issue of lags enters its
fourth d e c a d e
34
Changing Patterns:
Reshaping the Southeastern
Textile-Apparel Complex
A host of troubles, i n c l u d i n g the dollar's
rise against foreign currencies, dims
the textile industry's prospects.
46
Statistical S u m m a r y
Finance, Construction, General,
Employment
FEDERAL RESERVE B A N K O F ATLANTA 3
"<r
Regulation
of Banks'
Equity Capital
Larry D. Wall
Capital requirements appear to augment the buffer protecting the banking
system and the FDIC. However, regulating levels of bank capital also may
increase banks' risk-taking and hamper
t h e i r a b i l i t y to c o m p e t e w i t h nonbanking organizations
The Depression of the 1930s is often attributed to
t h e failure of t h e b a n k i n g system, a n d many
economists believe that another such failure
c o u l d have equally serious consequences. 1 Bey o n d its obvious concern over such a b a n k i n g
debacle, t h e g o v e r n m e n t also worries a b o u t t h e
failure of individual banks, because a large institution's collapse could endanger the entire system.
Furthermore, t h e failure of individual banks imposes losses o n t h e Federal Deposit Insurance
C o r p o r a t i o n (FDIC), whose u l t i m a t e guarantor is
t h e U n i t e d States government.
A m o n g other means, t h e g o v e r n m e n t tries t o
limit t h e risk of bank failures a n d t h e m a g n i t u d e
of t h e FDIC's losses b y r e g u l a t i n g b a n k i n g organizations' equity capital. Equity capital, w h i c h
includes b o t h t h e owners' investment and t h e
bank's retained earnings, assists a bank in several
i m p o r t a n t ways: d u r i n g lean times it provides a
cushion to absorb losses and ward off insolvency; it
protects against illiquidity resulting f r o m deposit
runs by h e l p i n g t o maintain depositor confidence; 2 and, should a bank fail, e q u i t y capital
also reduces t h e losses t h e FDIC must bear.
In spite of g o v e r n m e n t regulation, bank capital
ratios have fallen dramatically in this century.
The author
is an economist
in the bank's
Research
Depart-
ment
N O V E M B E R 1985, E C O N O M I C R E V I E W
-V*
The ratio of bank e q u i t y capital t o total assets
d r o p p e d f r o m 20 percent in 1 9 0 0 t o approximately 7 percent in 1983. Equity to risk assets
have fallen even m o r e sharply, from a peak of
over 25 percent in t h e m i d - 1 9 4 0 s to u n d e r 10
percent in recent years. 3 In D e c e m b e r 1 9 8 1
federal regulators r e n e w e d their emphasis on
bank capital ratios by issuing numerical capital
adequacy guidelines that r e q u i r e d many institutions to increase their e q u i t y capital significantly. Congress d e m o n s t r a t e d its support for
t h e regulatory actions by specifying in t h e International Lending a n d Supervision Act of 1983
that each " a p p r o p r i a t e Federal Banking Agency
shall cause b a n k i n g institutions to achieve a n d
maintain a d e q u a t e capital by establishing minim u m levels of capital." T w o years later regulators
revised t h e capital guidelines, i m p o s i n g a single
standard o n all banks regardless of size and
primary regulator.
The purpose of this study is t o review t h e
arguments for and against regulating t h e e q u i t y
capital of i n d e p e n d e n t banks and bank h o l d i n g
companies. 4 The current regulatory standards
use t w o definitions of capital: primary capital
(the sum of p e r m a n e n t e q u i t y capital plus an
allowance for possible loan losses and mandatory
convertible securities, minus certain intangible
assets), and total capital (primary capital plus
limited life preferred stock and s u b o r d i n a t e d
debt)- 5 Each of t h e n o n - e q u i t y elements of
primary and total capital raises a u n i q u e set of
issues. For example, equity capital holders (stockholders) can be forced t o share in losses w i t h o u t
a bank's failing, b u t s u b o r d i n a t e d d e b t holders
d o n o t have t o share in losses unless t h e firm is
bankrupt. 6
This study begins w i t h discussion of h o w
capital may protect t h e b a n k i n g system a n d the
FDIC. It proceeds t o review four arguments
against capital regulation: such regulation historically has proven ineffective; it will not significantly
reduce t h e riskiness of t h e banking system;
capital regulation carries considerable disadvantages; and other alternatives exist.
W h y Regulate Capital?
In a market e c o n o m y like that of t h e U n i t e d
States, t h e p r e s u m p t i o n is that free-market comp e t i t i o n should control individual private sector
FEDERAL RESERVE BANK O F ATLANTA
decisions, except w h e r e t h e market fails t o
consider i m p o r t a n t social costs, social benefits,
or both. The case for g o v e r n m e n t regulation of
capital rests o n t w o such failures: t h e market
does not properly price t h e effect of bank failure
on t h e stability of t h e b a n k i n g system, nor t h e
costs of bank failure to t h e FDIC.
In t h e absence of b i n d i n g g o v e r n m e n t regulation, banks w o u l d base capital decisions solely
on their c o m p e t i t i o n for customers, investors (in
d e b t a n d equity), and suppliers (including labor
and management). To succeed in this arena,
banks must offer potential customers, investors,
and suppliers a better deal than other organizations. Banks' capital policies can a f f e c t t h e i r
c o m p e t i t i v e position; for example, their ability t o
attract credit and superior m a n a g e m e n t may be
e n h a n c e d by higher capital ratios, for t h e additional capital may reduce t h e riskof failure. The
institutions' attraction for equity investors may be
r e d u c e d by higher capital ratios, however, because m o r e capital can i m p l y a lower return o n
equity. In theoretical studies of capital ratios, the
most simplistic models maintain that t h e competing d e m a n d s of c r e d i t o r s a n d s t o c k h o l d e r s
exactly offset each other, and banks (like other
firms) have no o p t i m a l capital ratio. 7 A bank's
capital ratio is important, however, in m o r e
general models that include taxes, t h e costs of
financial distress, and agency costs. 8
An additional influence on bank capital ratios
is t h e short maturity structure of liabilities. The
b a n k i n g industry differs f r o m almost all other
industries in that it issues liabilities that are
r e d e e m a b l e on d e m a n d , w h i c h makes banks
more vulnerable to a sudden loss of their creditors'
confidence. If creditors of a n o n b a n k i n g f i r m lose
c o n f i d e n c e in its stability, t h e y can d o n o t h i n g
until their d e b t matures. If depositors begin to
d o u b t the financial c o n d i t i o n of their bank,
however, they can w i t h d r a w d e m a n d deposits
5
WHEN LARGE BANKS FAIL
i m m e d i a t e l y , w i t h o u t e v e n t a k i n g t i m e t o det e r m i n e the institution's actual condition. S u d d e n
d e p o s i t runs can b e deadly, e v e n t o financially
strong banks, because m o s t i n s t i t u t i o n s invest
part of t h e i r d e m a n d d e p o s i t s in i l l i q u i d loans.
Few banks can l i q u i d a t e their loan p o r t f o l i o s o n
short n o t i c e w i t h o u t s u f f e r i n g substantial losses. 9
Capital can r e d u c e t h e risk of a run o n a b a n k by
s t r e n g t h e n i n g c u s t o m e r c o n f i d e n c e in t h e instit u t i o n ' s viability. 1 0
W i t h o u t regulation, banks w o u l d increase their
capital t o r e d u c e e x p o s u r e t o d e p o s i t runs. T h e
increase w o u l d b e less t h a n is socially desirable,
h o w e v e r , because t h e b e n e f i t s t o s o c i e t y f r o m a
safer b a n k i n g system play n o role in banks'
capital decisions. C o m p e t i t i v e pressures reflect
o n l y private gains t o investors a n d suppliers.
T h e failure t o c o n s i d e r benefits t o society is
especially i m p o r t a n t given t h a t t h e d e m i s e of
o n e b a n k can u n d e r m i n e t h e c o n f i d e n c e of
d e p o s i t o r s at o t h e r banks. This is particularly
t r o u b l i n g w h e n a large b a n k fails (see box). O n c e
a run starts s p r e a d i n g f r o m b a n k t o bank, t h e
suspicion of instability can b e c o m e a self-fulfilling
p r o p h e c y w i t h t h e p o t e n t i a l t o rock t h e b a n k i n g
system. Thus, o n e reason for regulating capital is
t o i m p r o v e t h e b a n k i n g system's stability by
r e d u c i n g t h e risk of i n d i v i d u a l b a n k failures.
A s e c o n d a r g u m e n t for regulating capital is t h a t
g o v e r n m e n t actions d e s i g n e d t o p r o t e c t banks
already i n t e r f e r e w i t h t h e c o m p e t i t i v e process
t h a t o t h e r w i s e w o u l d d e t e r m i n e b a n k capital.
The g o v e r n m e n t lessens t h e risk of b a n k runs
t h r o u g h d e p o s i t insurance f r o m t h e F D I C a n d
access t o t h e Federal Reseive's discount w i n d o w .
A n u n i n t e n d e d side e f f e c t of l o w e r i n g d e p o s i t o r
risk is t h a t i n s u r a n c e also reduces depositors'
insistence o n a d e q u a t e b a n k capital. According*
t o several studies, banks r e s p o n d by l o w e r i n g
t h e i r capital ratios, w h i c h in t u r n exposes t h e
F D I C t o greater p o t e n t i a l losses. 11
6
Capital regulation seeks to prevent a collapse of the
banking system by reducing the risk of failure of individual
banks One policy question in developing capital guidelines is whether the failure of individual banks is undesirable for the banking system. If individual bankfailures
are unimportant, then capital guidelines need only
prevent the banking system from foundering. If the
failure of a small number of banks can cause a systemic
problem, however, perhaps the guidelines should be
sufficiently stringent to prevent individual banks from
failing.
Individual failures become especially significant in
the case of large banks. Thomas Mayer(1975) cites four
reasons why the demise of a large institution could
create runs on the banking system. First, large bank
failures receive considerable media attention, while
small bank failures may go virtually unnoticed by depositors at other banks 31 Second, the failure of a large
bank probably provides an indication of the asset
quality at sizable institutions Because many small bank
failures are due to dishonest or incompetent management or local economic conditions depositors at other
banks may justly conclude that their bank does not
suffer from these burdens Large banks that fail, however, probably have major problems in their loan portfolios Other depositors may reason that if one large
bank failed because of problem loans their bank also
could experience difficulties since most large banks
invest in the same types of loans 32 Third, large banks
have substantially more nondeposit liabilities (many
with relatively short maturities) which are not guaranteed
protection by the FDIC. Fourth, large banks have more
deposits that exceed the coverage guaranteed by the
FDIC.
Additional reasons for concern are given by Arnold A
Heggestad and B. Frank King (1982) and Bevis Longstreth (1983). Heggestad and King note that the failure
of a large bank could significantly erode the insurance
fund, reducing depositors' confidence in its stability.
Longstreth points out that most large banks have
substantial liabilities due to other banks and so the
demise of one bank could cause many others to fail.
George G. Kaufman (1985) disputes the theory that
large bank problems have posed a significant threat to
the economy or the banking system since the introduction
of the FDIC. Even if a large bank experiences a run,
Kaufman contends funds are unlikely to be withdrawn
in the form of currency, which could cause the money
supply to contract Instead, he maintains they are likely
to be re-deposited in banks perceived to be less risky. If
institutions that face a run are solvent, the banking
system perhaps with the support of the Federal Reserve
can provide them with liquidity. Admittedly, banks in
these straits will have to pay a premium for the recycled
money, but this recourse is less serious than a sudden
contraction of the money supply If the bank is insolvent
Kaufman suggests that the FDIC should assume control
and write down uninsured liabilities by the excess of
losses over the bank's capital.
N O V E M B E R 1985, E C O N O M I C R E V I E W
These t w o reasons for regulating bank capital
partly offset each other. Increased g o v e r n m e n t
p r o t e c t i o n of banks implies a reduced danger of
bank runs. For example, 100 percent insurance
w o u l d virtually e l i m i n a t e t h e risk of runs b u t
w o u l d saddle t h e g o v e r n m e n t w i t h m o r e of t h e
risk of failure. The current insurance system
contains e l e m e n t s of risk for t h e g o v e r n m e n t and
depositors alike. The g o v e r n m e n t bears risk because it guarantees insurance up t o t h e first
$ 1 0 0 , 0 0 0 per d e p o s i t o r a n d generally absorbs
additional losses. Yet some depositors also are
vulnerable because the FDIC guarantees deposit
insurance only on t h e first $100,000 per depositor per bank. The agency has p r o v i d e d prot e c t i o n t o larger deposits, but o n l y on a case-bycase basis. U n d e r t h e current system, large depositors w h o d o not remove their funds f r o m a
failing bank quickly e n o u g h risk losing part of
their deposits.
Influencing Bank Capital
For capital regulations t o r e d u c e . t h e risk of
bank failure a n d FDIC losses, t h e regulations
must have some influence over bank behavior.
An i m p o r t a n t question is w h e t h e r t h e regulators
or the markets are d o m i n a n t in d e t e r m i n i n g
capital ratios. Indications that market influence is
strong a n d regulatory influence weak have been
f o u n d by studies in three separate areas: market
willingness to supply capital, market control of
bank risk-taking, and regulatory effectiveness in
enforcing capital adequacy controls.
Ronald D. W a t s o n (1975) and James C. Ehlen,
J r. (1983) emphasize the markets role in allocating
capital. W a t s o n argues t h a t banks' p r o b l e m s in
raising capital are not d u e t o " a shortage of
c a p i t a l b u t a n unwillingness
or inability
to pay the
'going rate'" (emphasis in original). Ehlen notes
that large banks' profitability b e t w e e n 1 9 6 4 and
1974 was t o o low to support asset growth, and so
their e q u i t y capital ratios d r o p p e d . Gerald P.
Dwyer, Jr. (1981) a n d Adrian W. T h r o o p (1975)
b o t h claim empirical support for t h e market's
primacy in allocating capital. They hypothesize
that capital inflows into an industry are directly
related t o its profitability and that investors are
w i l l i n g t o invest m o r e in industries w i t h high
earnings. Both studies f i n d that changes in bank
capital are closely related to earnings. Dwyer's
and Throop's studies may overstate t h e market's
FEDERAL R E S E R V E BANK O F ATLANTA
role, however, since most increases in bank
capital result from retained earnings. 12 Thus,
their results may s h o w o n l y that banks retain
more i n c o m e w h e n t h e y have m o r e t o retain.
The evidence on the market's role in controlling
bank risk, i n c l u d i n g capital adequacy, is mixed.
O n t h e basis of his personal experience as a
consultant in this a r e a David C. Cates (1985a)
claims that creditors are m o n i t o r i n g and disciplining high-risk banking organizations. In surveying t h e literature on market discipline, Robert A.
Eisenbeis and Gary G. Gilbert (1985) find evidence
that the markets react to differential risk exposure
in t h e pricing of d e b t and e q u i t y issues. O n e
limitation of that b o d y of literature is that it looks
only at t h e market's evaluation of banks w i t h
assets in excessof $1 billion. A n o t h e r limitation is
that relatively little research has focused on
w h e t h e r market forces are strong e n o u g h t o
influence bank behavior. That is, even if the
market charges higher p r e m i u m s t o riskier banks,
those p r e m i u m s may be t o o small t o affect bank
operations.
Evidence prior t o i m p o s i t i o n of t h e D e c e m b e r
1981 regulatory guidelines suggests that t h e
regulators w e r e ineffective b u t later e v i d e n c e
implies t h e guidelines are i n f l u e n c i n g b a n k i n g
organizations. Sam Peltzman (1970), John H.
M i n g o (1975), and J. Kimball Dietrich a n d Christo p h e r James (1983) use similar models t o test
t h e regulators' effectiveness in controlling bank
capital during the 1960s a n d early 1970s. Using
aggregate bank data from 1963 to 1965, Peltzman
suggests that regulators have been ineffective;
Mingo, using a sample of 323 banks in 1970,
concludes that regulators influence capital. Dietrich
and James c o n t e n d that M i n g o confuses supervisory influence w i t h market influences. Their
results, based o n t h e actions of m o r e than 10,000
banks d u r i n g t h e 1971 t o 1974 period, s u p p o r t
their argument t h a t no supervisory influence
exists. Alan J. Marcus (1983), w h o examines a
sample of large bank h o l d i n g c o m p a n i e s over a
20-year period e n d i n g in 1977, c o n t e n d s that
the supervisors evaluated a bank's capital relative
t o capital levels of its peers and that no absolute
standards existed.
The regulators w i e l d e d considerable i n f l u e n c e
over large bank h o l d i n g companies (over $1
billion in assets) after the capital adequacy guidelines w e r e a n n o u n c e d in 1981, according to
7
1
Larry D. Wall and David R. Peterson (1985). Their
study develops t w o separate m o d e l s of t h e
d e t e r m i n a t i o n of bank h o l d i n g c o m p a n y capital:
o n e is relevant if t h e process is d o m i n a t e d by t h e
regulatory guidelines, and t h e other if d o m i n a t e d
by t h e financial markets. They estimate b o t h
models using a p r o c e d u r e that assigns each bank
a probability of corning from t h e regulatory
regime. From their f i n d i n g that a p p r o x i m a t e l y 90
percent of t h e institutions are classified in t h e
regulatory regime, t h e authors c o n c l u d e that t h e
regulatory guidelines dominate bank capital planning.
Thus, w h i l e available e v i d e n c e suggests that
t h e market may have significantly affected bank
capital ratios at o n e time, o n e empirical study
c o n d u c t e d since t h e guidelines w e r e a d o p t e d
indicates that t h e regulators are currently t h e
d o m i n a n t influence.
Capital Regulations and Bank Risk
Banks are subject to t h e risks of insolvency
( w h i c h occurs w h e n the value of liabilities exceeds t h e value of assets) a n d illiquidity (an
inability to repay creditors o n a t i m e l y basis).
Increased capital can protect banks f r o m insolvency by p r o v i d i n g a cushion to absorb losses;
it can shield banks from illiquidity by reinforcing
depositors' c o n f i d e n c e in their institutions. Indeed, if a bank's capital equals the sum of its risky
assets plus its contingent liabilities, only fraud
can cause it t o fail. However, since banks must
c o m p e t e w i t h other firms for capital, there are
limits on t h e a m o u n t of n e w capital t h e y can
raise. M o s t proposals for increasing banks' equity
capital focus o n raising t h e e q u i t y capital to
assets ratios s o m e w h e r e b e t w e e n a fraction of a
percentage p o i n t a n d a f e w percentage points.'
W o u l d an increase of a f e w percentage points or
less significantly reduce banks' risks of insolvency
and illiquidity?
8
Capital's Effect on Insolvency Risk. Some argue
against capital regulation o n t h e grounds that
m a n a g e m e n t is far more i m p o r t a n t t o bank
solvency than is capital. They maintain that no
a m o u n t of capital can prevent t h e failure of a
mismanaged bank, and that a strong, well-managed
bank can operate w i t h little capital.
Empirical e v i d e n c e that increased bank capital
will not significantly reduce banks' risk of failure
comes from A n t h o n y M . Santomero a n d Joseph
D. Vinso (1977). Using historical data on t h e
volatility of changes in banks' capital, t h e y estimate t h e risk that a sample of banks w o u l d
exhaust their capital base. The e v i d e n c e from
their 1965 t o 1974 sample period suggests that
t h e p r o b a b i l i t y of bank failure was small and that
reasonable variations in t h e capital level w o u l d
not have an e c o n o m i c a l l y significant effect on
t h e risk of failure. 1 3
A d d i t i o n a l s u p p o r t for this hypothesis can be
found in some reviews of bank failures. Cates Consuiting Analysts, Inc. (1985), e x a m i n i n g bank
failures in 1984, concludes that capital risk was n o t a
"significant factor in failure." The study notes that
failed banks typically had lower capital ratios
than their peers b u t points o u t that 70 percent of
t h e failed banks had b o o k capital ratios in 1982
that exceed t h e 1985 guidelines by 35 basis
points or more. George Vojta (1973) concludes:
" T h e weight of scholarly research is overwhelming
to the effect that t h e level of bank capital has not
been a material factor in p r e v e n t i n g bank insolvency, and that ratio tests for capital adequacy
have not b e e n useful in assessing or p r e d i c t i n g
the capability of a bank t o remain solvent."
O n t h e other hand, James G. Ehlen, Jr. (1983)
suggests that capital " p l a y s a critical, although
passive role, in maintaining the financial strength
and credibility of a financial institution in t h e
marketplace, a vital role for any institution that
must rely on c o n t i n u i n g access to funds from a
w i d e variety of sources." W h i l e a c k n o w l e d g i n g
that earnings are m o r e i m p o r t a n t than capital, he
remarks that a relatively high return o n assets is
usually associated w i t h a relatively well-capitalized
bank. He also points o u t that adversity suggests
some sort of earnings problems, and that, t o t h e
extent earning p o w e r is reduced, t h e focus
necessarily shifts t o capital.
A study by Leon K o r o b o w a n d David P. Stuhr
(1983), w h i c h finds that regulators' evaluations
of banks are significantly influenced* by capital
N O V E M B E R 1985, E C O N O M I C R E V I E W
>-.;
*
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A^.
r
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„,
>
*
ratios, lends empirical support t o t h e role of
capital in maintaining bank safety. Furthermore,
the conclusions Vojta drew in 1973 about scholarly
research on bank failures must be reconsidered
in the light of recent work. Studies by John F.
Bovenzi, James A Marino, and Frank E. McFadden
(1983), Robert B. Avery and Gerald A. H a n w e c k
(1984), and Eugenie D. Short, Gerald P. O'Driscoll,
Jr., and Franklin D. Berger (1985) all show a
statistically significant relationship b e t w e e n a
bank's capital ratio a n d its p r o b a b i l i t y of failure.
Recent studies thus indicate that higher levels
of capital are associated w i t h a bank's chance of
e l u d i n g failure. If a bank's losses are sufficiently
great, t h e n n o t h i n g short of 100 percent capital
can prevent failure. But in many cases, greater
capital can provide t h e t i m e necessary f o r a bank
to solve its problems. Empirical evidence suggests
that observed variations in existing bank capital
structures can have a statistically significant effect
on institutions' p r o b a b i l i t y of failure.
Responding to Capital Regulation. The f i n d i n g
that increased capital reduces a bank's risk of
failure does not necessarily i m p l y that regulatory
m a n d a t e d increases w i l l reduce this risk. Augm e n t i n g capital reduces t h e risk of failure o n l y if
other factors, such as t h e riskiness of bank assets,
are held constant. The same market forces that
led banks t o shrink their capital ratios prior t o
regulatory pressure c o u l d lead banks t o assume
other types of risk in response t o capital regulation.
Banks can raise their capital ratios b u t leave
their operations otherwise unchanged, accepting a
r e d u c e d return as t h e cost of lower risk. The risk
aversion of some closely held banks w i t h undiversified portfolios may be such that the difference
b e t w e e n t h e original risk/return relationship and
that after capital standards are i m p o s e d barely
affects management.
Some banks may be forced t o innovate in
response to capital regulation, however, if their
stockholders are u n w i l l i n g t o accept t h e lower
returns accompanying reduced risk. For instance, a
bank can try to raise returns by passing t h e
capital regulation costs on t o customers. This
maneuver will slow a bank's g r o w t h t o t h e extent
that consumer d e m a n d for its products responds
to price: the more responsive t h e d e m a n d , the
greater t h e loss. D e m a n d is likely to be most
responsive w h e r e banks face significant comp e t i t i o n from other banks and f r o m n o n b a n k
providers. Spared t h e banks' increased costs,
FEDERAL R E S E R V E BANK O F ATLANTA
n o n b a n k providers may decline t o go along w i t h
a price increase. Banks may have more success
raising prices o n services w h e n c o n t e n d i n g o n l y
w i t h other banks, w h i c h also have been forced
by regulation t o increase their capital. In this
case, all banks may choose t o raise their prices.
Banks also c o u l d increase their i n c o m e by
finding n e w sources that will not trigger regulatory
d e m a n d s for increased capital. Edward J. Kane
(1977) suggests this possibility in h i s " r e g u l a t o r y
dialectic theory," w h i c h states that i m p o s i n g
regulation limits banks' ability t o serve their
customers, a n d creates o p p o r t u n i t i e s for profitable innovations that circumvent the regulation
w h i l e m e e t i n g its formal requirements. 1 4 Regulators o f t e n respond t o such innovations, b u t
generally not until t h e y identify t h e innovations'
various effects. Following this delay, banks resume
the process of i d e n t i f y i n g and e x p l o i t i n g loopholes.
A c c e p t i n g m o r e risks is an i n n o v a t i o n that can
raise bank earnings w i t h o u t requiring a d d i t i o n a l
capital u n d e r t h e current guidelines. Increased
risk can involve substituting assets w i t h high risk
and return for low-risk, low-return assets. 15 Additionally, increased risk can take t h e f o r m of
receiving fee i n c o m e for risks that are assumed
b u t not placed o n t h e balance sheet, such as
w r i t i n g stand-by letters of credit. Banks that
enhance their i n c o m e in this fashion can maintain their prior return on e q u i t y and restore t h e
value of t h e FDIC subsidy t o its original value.
Koehn and Santomero (1980) note that t h e
banks w i t h t h e weakest capital a d e q u a c y (in t h e
sense of capital per unit of risk) are those most
likely to respond t o higher capital standards by
investing in m o r e risky assets. This suggests that
i m p o s i n g b i n d i n g regulations on all banks w o u l d
increase rather than decrease t h e dispersion of
bank risk exposure. A further implication is that
capital regulations targeted at high-risk banks
may be ineffective in r e d u c i n g t h e i r riskof failure.
All t h e studies suggesting that banks will take
m o r e risks in t h e face of capital regulation are
limited in t w o ways. First, t h e y assume t h e capital
standards are set i n d e p e n d e n t l y of t h e particular
bank's risk exposure. Risk-based capital standards
(discussed in t h e a c c o m p a n y i n g box) may discourage banks f r o m offsetting greater capital
w i t h riskier assets. Second, the empirical underp i n n i n g for t h e hypothesis is meager. A n e c d o t a l
evidence suggests banks are reducing their lower
9
ALTERNATIVE METHODS OF CAPITAL REGULATION
Studies showing that regulatory mandated increases
in equity capital can lead banks to higher risk assume
that the standards are risk-independent; that is, that
regulators require both risky and safe banks to meet the
same capital standards Perhaps the standards would
be more effective if they called for risky banks to
maintain higher capital levels Such variable capital
guidelines could be based on preannounced standards
or on the discretion of each bank's supervisor.
Measures Incorporating Risk
Regulators can impose variable capital guidelines
based on ex ante, or forward-looking, measures of
banks' risk exposure. Such measures would examine
the risk that a bank could suffer significant losses in the
future and would require institutions subject to greater
risk to hold more capital. Ex ante measures could be
based on the regulators' evaluation of the riskiness of a
bank's balance sheet (and possibly its off-balance activities) or they could be derived from financial market
pricing of bank securities By contrast if ex post measures
were used, the regulators would base their current
capital requirements for individual banks on the results
of recent operations Banks with a history of greater
losses and weaker earnings would be required to hold
more capital.
Measures Distinct from Financial Market Measures. U.S. bank regulators have used variable capital
guidelines based on ex ante risk measure before.
Shortly after World War II, regulators gauged capital
adequacy on the basis of capital to risk assets, with risk
assets defined as total assets less cash and U.S.
government securities In the 1950s the New York
Federal Reserve Bank developed a risk-based system
that divided assets into six categories, each assigned a
specific percentage of required capital. Later in that
decade the staff of the Federal Reserve Board of
Governors developed a"Form for Analyzing Bank Capital"
(ABC formula) that was used to help identify undercapitalized banks The Board's formula was based on both
the liquidation values that could be obtained for a
bank's assets and on its liquidity.33
An advantage of using ex ante risk measures is that
they provide for a larger capital cushion before a bank
begins to experience problems Thus some high-risk
banks that might otherwise be forced to close during
difficult times would have the extra capital needed to
survive. A further advantage is that such guidelines limit
banks' ability to offset the effects of capital regulation
by increasing their risk exposure. Under an ideal system,
any benefit a bank obtained by raising its risks would be
balanced fully by higher capital requirements.
A potential disadvantage of ex ante measures is that
weighing risk can be subject to significant error. Banks
could find themselves with artificial incentives to engage
in some activities and artificial disincentives to engage
in others—a similar drawback to risk-independent capital
10
guidelines The major difference is that capital guidelines based on ex ante risk may encourage banks to
seek out new ventures that have not been properly
rated under the guidelines In ferreting out opportunities
whose dangers are underestimated by the regulators,
banks may shoulder more risks than they intended.
Ex ante risk measures have been developed through
"early warning studies" research whose purpose was
to provide regulators with a system to signal future bank
failures 34 The relationship between capital adequacy
and bank failure is more rigorously examined by Sherman J. Maisel (1981), who reviews capital adequacy
and the risks that can cause insolvency.35 Eli Talmoi's
(1980) work provides a complete theoretical model for
determining the optimal capital standard. Using an ex
ante risk measure Talmor's model allows banks to fail
due to insolvency or illiquidity.
Market Data. Bank regulators could rely on the
financial markets for estimates of bank risk rather than
attempting to calculate it themselves The financial
markets already evaluate the riskiness of bank certificates of deposit, subordinated debt stock and stock
options If the markets' risk premiums could be determined, these would provide an independent evaluation
of a bank's risk
Use of market risk premiums would necessarily be
limited to banking organizations with publicly traded
securities The number of such organizations is relatively
small, but they control a majority of the banking system's
assets
Perhaps the most significant objection to relying on
market-based rather than regulator-determined measures is that the regulators possess better—or at least
different—information than the markets The regulators
can examine individual bank assets and internal documents Yet this advantage is countered by two advantages
of the market First the market can make use of all the
information it has available, while the regulators face
political constraints.
Second, the number of market participants far exceeds the number of regulators If an investor errs, he
can at most have only a minuscule effect on the price of
a bank security. If a regulator makes a mistake, it can be
corrected by a bank only through a costly appeal to
Congress or the courts Furthermore, Jack Guttentag
and Richard Herring (1984) point out that market
participants who make systematic mistakes in evaluating
what they call "project-specific" risk eventually will be
driven out of business 36
A variant of the ex ante risk measure that relies on the
market for bank stocks comes from George E. Morgan
(1984). Morgan states that a bank's risk should be
measured by its stock's Beta coefficient from the capital
asset pricing model (CAPM). His results suggest that
optimal regulation could lead to the regulators' requiring
all banking organizations to have the same Beta
(continued
on next
page)
N O V E M B E R 1985, E C O N O M I C R E V I E W
A potentially significant problem with Morgan's approach to capital regulation is the weakness in available
models of stock returns The CAPM has been questioned
on several points including its assertion that all stock
market returns can be explained by a single factor. An
alternative model of stock returns that incorporates
multiple factors is the arbitrage pricing model. Morgan
notes that the capital regulation model also could be
applied if the arbitrage pricing theory (APT) model of
stock returns is used. Unfortunately, while APT does not
suffer the same problems as the CAPM, the use of APT
by the regulators is not feasible until some general
agreement can be reached as to which factors belong
in the model.37
Even if the CAPM and APT models had no theoretical
and empirical flaws in explaining stock returns, both
measures capture only part of a banking organization's
risk exposure. Morgan notes that since Beta measures
only the systematic risk of a stock banks could try to
increase their non-systematic risk One way to capture
systematic and non-systematic risk would be to use the
implied standard deviations from stock options Alan J.
Marcus and Israel Shaked (1984) and J. Huston McCulloch (1985) recently used this approach to estimate
the value of FDIC deposit insurance Regrettably, the
number of stocks with publicly traded options is far
fewer than the number of publicly traded stocks and
some unresolved empirical issues cloud the estimation
of implied standard deviations 38 Another way is to use
the risk premium on bank deposits as James B Thomson
(1985) has done, to estimate the value of deposit
insurance. A minor difficulty in using Beta implied
standard deviations and deposit risk premiums to
establish risk based capital standards is that the financial
markets should recognize that short-run increases in
bank risk eventually will be offset by regulatory actions
Thus market measures of risk may be biased toward
the regulatory standards
Ex Post Risk Measures Ex post risk measures entail
less measurement error than ex ante measures as the
results of a bank's past risk-taking are evident in its
income statement. One disadvantage is that ex post
measures lag behind changes in actual risk exposure.
This lag could permit one-time gains to banks that
increase their holdings of high-risk high-return assets
in that they would gain the additional income for a
period without having to increase their capital ratios
immediately. Similarly, banks that decrease their risk
exposure would pay a one-time penalty because they
would have to maintain the higher capital ratios until
their income stream reflected the decrease. Another
possible drawback is that ex post capital requirements
force banks to raise capital at a time when it is likely to
be most difficult. Furthermore, an ex post request for
additional capital may come too late to prevent some
troubled banks from failing.
An example of an ex post measure of risk is volatility of
a bank's capital account, used by Santomero and Vinso
(1977). Santomero (1983) points out that the empirical
application of this method could be limited by the
frequency with which the economic environment changes
FEDERAL R E S E R V E BANK O F ATLANTA
However, he claims this approach has better theoretical
justification than many of the early warning studies of
bank failure. Another recent study, by Terrence M.
Belton (1985), demonstrates how capital standards
could be tied to one aspect of bank risk: the risk of loan
losses He finds that such a risk-related standard could
have reduced substantially the number of banks for
which loan losses exceeded capital in 1983 and 1984.
Supervision without Numerical Guidelines
Capital supervision without preannounced standards
was attempted in the period immediately preceding
adoption of the current system of capital regulation.
This approach theoretically allows regulators to evaluate
a variety of factors in determining what constitutes
adequate capital for individual banks Under numerical
guidelines regulators are more likely to focus only on
those factors that appear in their formula For example,
the riskiness of a bank loan depends not only on the
type of loan (for instance, commercial versus consumer)
but also on how the process is managed. Loans that are
relatively safe when made by banks with prudent
competent management and sound procedures may
be excessively risky when extended by banks with
imprudent or incompetent management and weak procedures 39 The regulators may have more difficulty
incorporating their information about a bank's management under numerical guidelines than under an informal
system of capital supervision.
The obvious disadvantage of supervision without
numerical guidelines is that it has proven ineffective.
During the 1970s the regulators supervised bank capital
without announcing quantitative standards that individual banks were expected to meet The result of this
type of regulation, according to Marcus (1983), was that
regulators could prevent any bank from operating with
much less capital than its peers but they were unable to
prevent capital ratios from declining throughout the
industry.
An inherent reason for this ineffectiveness is the
difficulty regulators have defending their judgment in
Congress and the courts without some objective standard. An additional reason for guidelines based on a
preannounced formula is that the guidelines aid banks
in planning for the future.
Summary
Various methods exist for setting regulatory standards
for individual banks' capital. The standard may or may
not depend on the specific banks' risk. When it does the
risk measure can be calculated from current accounting
information, recent market information, or historical
accounting results Furthermore, regulators may choose
to announce publicly their formula for determining
optimal capital or they may elect to disclose the guidelines only to bank management The appropriate method
for regulating capital depends on such issues as the
goals of capital regulation and the workability and
enforceability of the various approaches
11
Iglflf
M
risk, more liquid assets in response to t h e regulation. 1 6 G. D. Koppenhaver (1985) e x a m i n e d
t h e off-balance sheet activities of banks in t h e
Seventh Federal Reserve District for S e p t e m b e r
1984. (These bank c o m m i t m e n t s may entail
some risk b u t d o not require i m m e d i a t e creation
of an asset, and thus they are not recorded o n
b a n k b a l a n c e sheets. 1 7 ) K o p p e n h a v e r f o u n d
that loan commitments, stand-by letters of c r e d i t
and c o m m e r c i a l letters of credit all are inversely
r e l a t e d t o t h e b a n k ' s e q u i t y capital t o assets
ratio. Fredricka P. Santos (1985) f o u n d that
changes in multinational banks' primary capital
t o assets ratio had a statistically significant effect
on their off-balance sheet activities (as reported on
Schedule L of t h e Reports of C o n d i t i o n that
banks file w i t h federal regulators).
Capital's Effect on llliquidity Risk. If capital
regulation reduces t h e risk of bank failure d u e to
insolvency, it may in t u r n strengthen depositors'
c o n f i d e n c e in an institution, hence decreasing
their incentive t o participate in a bank run.
However, an increase in capital of only a f e w
percentage points can d o no m o r e t h a n reduce
t h e likelihood of deposit runs—it w i l l not eliminate t h e risk 1 8 Deposit runs are always possible
so long as any group of depositors is at risk should
a bank fail. The only way t o e l i m i n a t e this risk
w o u l d be for banks t o maintain capital equal t o
100 percent of risky assets plus contingent liabilities,
or for t h e FDIC t o insure all deposits.
M i n g o (1985) argues that capital regulation
will increase rather than reduce t h e risk of bank
illiquidity. If an institution falls b e l o w t h e regulatory capital guidelines because of a o n e - t i m e
loss, t h e n t h e p u b l i c may believe t h e bank is
undercapitalized and will be subject to regulatory
action or perhaps even failure. The result c o u l d
be a run o n t h e bank by uninsured depositors.
M i n g o further points o u t that this risk is indep e n d e n t of t h e capital standard set by t h e
regulators; it could as easily happen if the standard
12
w e r e 8.5 percent of assets as if it w e r e 5.5
percent.
Mingo's concern should be addressed in the
d e v e l o p m e n t of capital adequacy standards but
it does not necessarily p r e c l u d e establishment of
numerical capital guidelines. The guidelines are
i n t e n d e d to create a buffer for losses w i t h o u t
resulting in bank failure. To u n d e r c u t t h e risk of
illiquidity occasioned by a bank run, t h e agencies
could a n n o u n c e that u n a n t i c i p a t e d losses occasionally will push some banks b e l o w t h e guidelines. In such cases, banks w h o s e capital remains
above some other target (for example, w h o s e
capital is equal t o zero percent of assets) will be
subject t o special regulatory a t t e n t i o n b u t will
not be closed. 1 9
Drawbacks to Regulating Capital
Capital regulation can impose a variety of
costs o n society. For example, w h i l e increased
capital may protect t h e b a n k i n g system by
reducing t h e risk of bank failure, it also shields
mismanaged firms. As A. Dale Tussing (1967)
points out, banks are disproportionately important t o the development of their communities
because t h e y c o n t r o l t h e allocation of credit.
Therefore, p r o t e c t i n g banks f r o m failure can
i m p o s e costs as w e l l as p r o v i d e benefits.
Another potential disadvantage of regulating
capital is that it may render banks less competitive by raising their cost of funds. The FDIC
deposit insurance guarantee lowers t h e price
banks must pay t o attract deposits. Furthermore, t h e cost of uninsured d e b t is generally
less than that of equity, j u d g i n g f r o m at least
some theoretical m o d e l s of capital structure. 2 0
T w o dangers of reducing banks' competitive
position are that it c o u l d lessen t h e efficiency
of t h e financial system as w e l l as t h e p r o p o r t i o n
of t h e m o n e y supply deposited at banks. A
w e a k e n e d competitive position implies that
banks will forgo some share of t h e market for
various financial services. Such a loss may be
desirable t o t h e extent that banks' current
share is attributable t o a deposit insurance
subsidy. But w h e r e banks' market share owes to
their greater efficiency, the loss they suffer ultimately may exact a toll from socrety, w h i c h
may be d e p r i v e d of t h e efficient c o m p e t i t o r .
N O V E M B E R 1985, E C O N O M I C R E V I E W
The market for transaction accounts, w h e r e
most of t h e m o n e y supply resides, are of
special concern because of society's strong
interest in p r o t e c t i n g t h e m o n e y supply. Currently t h e safety of transaction accounts at
most depositories is assured b o t h by deposit
insurance and the institutions' ability to borrow
through the Federal Reserve discount window. 2 1
If insured institutions w e r e t o lose a substantial
share of t h e transactions account market, then
t h e government's ability t o protect the money
supply c o u l d be u n d e r m i n e d . Thus, capital
regulation designed t o protect the safety of
banks a n d other insured depositories w o u l d be
c o u n t e r p r o d u c t i v e if it substantially reduced
t h e depositories' share of t h e market for transactions accounts.
T w o additional disadvantages c o u l d arise if
banks offset capital regulation by u n d e r t a k i n g
additional risks. First, the FDIC's losses actually
could grow if banks increase their risks by more
than t h e y e x p a n d their capital. Furthermore,
even if banks seek to offset the increased c a p i t a l
only partly, t h e y may inadvertently take o n
more risks than they intended. The second
p r o b l e m is that as banks a t t e m p t t o raise their
return on equity, t h e y may invest in risky
projects that could not otherwise receive funding
Society might f i n d it less costly t o allow banks
to exploit deposit insurance through inadequate capital than through high-risk investments.
Alternatives to Capital Regulation
Neither of the principal potential advantages—
t h e reduced risk of a banking system collapse
and increased p r o t e c t i o n of t h e FDIC—is necessarily u n i q u e to higher e q u i t y capital ratios.
Thus, before w e a d o p t capital regulation as a
solution to these problems, w e should examine
t h e alternatives.
Protecting the Banking System. The banking
system is vulnerable t o collapse because of its
d e p e n d e n c e o n d e p o s i t o r c o n f i d e n c e . Increased equity capital can enhance depositors'
c o n f i d e n c e in the long-run stability of their
banks, thus reducing t h e risk of deposit runs.
However, increasing e q u i t y capital is not sufficient t o maintain d e p o s i t o r confidence, for
depositors remain exposed t o some risk. Nor is
FEDERAL R E S E R V E BANK O F ATLANTA
capital regulation necessary for p r o m o t i n g depositor confidence. The g o v e r n m e n t can lower
t h e risk of deposit runs through deposit insurance, w h i c h serves as a substitute for e q u i t y
capital by curtailing the risk borne by depositors.
The FDIC has effectively p r e v e n t e d bank runs
from spreading since its creation in 1933.
Benjamin M . Friedman a n d Peter Formuzis
(1975) suggest that insurance is such a p o t e n t
substitute that it virtually eliminates depositors'
incentive to d e m a n d higher capital ratios.
An alternative t o e x t e n d i n g FDIC insurance is
t o rely o n t h e Federal Reserve as t h e protective
" l e n d e r of last resort." In this role t h e Federal
Reserve can ensure that t h e b a n k i n g system
does not collapse by p r o v i d i n g liquidity so that
banks can m e e t d e p o s i t o r d e m a n d s for withdrawals. Eventually, as depositors see that their
banks are not going to fail due to illiquidity, t h e y
stop w i t h d r a w i n g deposits. 2 2 O n e p r o b l e m is
that relying on t h e Federal Reserve may p e r m i t
occasional bank runs w h e n depositors temporarily
lose c o n f i d e n c e in some institutions.
Protecting the F D I C In a d d i t i o n t o p r o t e c t i n g
society, increased e q u i t y capital c o u l d r e d u c e
t h e losses t o uninsured creditors and t h e FDIC
w h e n banks d o fail. Capital regulation may n o t
be appropriate protection for uninsured creditors,
w h o should be able t o d e m a n d a d e q u a t e compensation for t h e risks t h e y take w i t h o u t governm e n t help. Capital regulation may be desirable,
however, if it reduces losses e x p e r i e n c e d by t h e
FDIC.
The FDIC generally requires that a t r o u b l e d
bank's losses be borne first by its stockholders
and subordinated debtholders before the agency
contributes t o p r o t e c t depositors. Losses should e r e d by t h e FDIC should be paid o u t of banks'
a c c u m u l a t e d insurance premiums, b u t if losses
exceed t h e insurance f u n d t h e agency w o u l d
turn t o Congress a n d t h e Treasury for support. 2 3
The FDIC must insist that banks maintain
positive e c o n o m i c net w o r t h (the market value
of assets less market value of liabilities) if it
wishes t o prevent banks from operating w i t h
negative net w o r t h . As t h e experience of many
savings and loans demonstrates, t h e market will
not necessarily close federally insured depositories
even if their economic net worth turns negative. 24
A d d i t i o n a l e q u i t y capital may be required t o give
t h e FDIC t i m e t o identify p r o b l e m banks and t o
absorb substantial losses should an institution
13
fail. However, if t h e FDIC c o u l d close banks
before their e c o n o m i c net w o r t h turns negative
or if it required banks t o issue a substantial
a m o u n t of uninsured, s u b o r d i n a t e d debt, t h e
agency w o u l d have less need for equity capital
regulation. The FDIC c o u l d even choose t o
absorb the greater losses that might result from
weaker capital standards, b u t require t h a t banks
pay sufficiently higher p r e m i u m s t o cover t h e
e x p e c t e d rise in losses.
Closing Banks. The FDIC w o u l d face several
problems if it relied solely on closing banks
before their economic net worth turned negative.
First, failure currently is d e f i n e d in terms of
a c c o u n t i n g net w o r t h rather than e c o n o m i c net
worth. Banks can show positive b o o k value even
w h e n their e c o n o m i c net w o r t h is negative,
because t h e y are not required t o recognize
changes in t h e market values of their assets a n d
liabilities in their a c c o u n t i n g records. 25 Thus,
under present procedures t h e FDIC w o u l d be
exposed t o substantial losses even if it held
complete control over the timing of bank closings.
Moreover, managements of banks w i t h positive
b o o k value b u t negative net e c o n o m i c w o r t h
realize that unless they can increase their earnings
by m o r e than their deficit, t h e y face future
closure as t h e e c o n o m i c losses are recognized in
t h e a c c o u n t i n g records. This provides a strong
incentive t o take on assets w i t h high returns even
if t h e y also carry high risks. If t h e assets are good,
t h e bank may c o n t i n u e in operation; if not, t h e
bank m a n a g e m e n t sacrifices n o t h i n g since it was
headed for failure anyway. The real loser w h e n a
bank invests in high risk/high return assets is t h e
FDIC, w h i c h must absorb significantly greater
losses if t h e assets prove t o be bad.
A possible solution t o t h e net w o r t h p r o b l e m is
t o use market values rather t h a n values based on
t h e current generally a c c e p t e d a c c o u n t i n g principles. 26 O n e difficulty, though, is t h a t t h e market
14
value of a bank's assets d e p e n d s partly o n
w h e t h e r t h e y are assessed at l i q u i d a t i o n value or
at their value t o t h e bank if it is a going concern.
In the latter case, t h e assets' value generally
exceeds their l i q u i d a t i o n value. Recognizingthis
problem, George G. Kaufman (1985) suggests
that large failed banks be run by t h e FDIC rather
than liquidated.
A n o t h e r obstacle to this a p p r o a c h is that t h e
market value of an asset or liability sometimes is
hard t o determine. W h i l e t h e effect of interest
rate changes can be measured using d i s c o u n t e d
cash f l o w techniques, establishing t h e change in
value due t o changes in credit risk is m u c h more
difficult. 2 7 Edward J. Kane (1985) r e c o m m e n d s
that the F D l C s liquidation division arrange periodic
auctions of assets as a w a y of p r o v i d i n g some
measure of value for assets hard t o estimate.
Such auctions w o u l d n o t e l i m i n a t e t h e p r o b l e m
of valuing assets but might help set reasonable
parameters for t h e process. A further drawback
of market value a c c o u n t i n g is that t h e FDIC may
find it politically difficult t o force b a n k s t o reduce
t h e value of some assets even t h o u g h t h e agency
and t h e banks k n o w t h e y are overvalued.
Problems w i t h o b t a i n i n g t h e market value of
many assets a n d liabilities almost guarantee that
their estimated value will differ f r o m their true
e c o n o m i c value. Estimated values n e e d not be
perfect, however, t o represent an i m p r o v e m e n t
over current practice. To t h e e x t e n t that market
value a c c o u n t i n g yields better estimates of econ o m i c net w o r t h than does current a c c o u n t i n g
practices, this approach may help t h e FDIC t o
protect itself better.
A second reason t h e FDIC might be unable t o
shield itself f r o m losses is that a bank's value may
be subject t o discontinuous drops. 2 8 In theory,
t h e FDIC need not suffer losses if a bank's value
drops at a c o n t i n u o u s rate. Suppose, however,
that a bank loses a substantial p o r t i o n of its asset
value because of m a n a g e m e n t fraud or a s u d d e n
change in t h e market value of its assets. T h e
FDIC w o u l d not have a m p l e t i m e t o d e f e n d itself
against such a s u d d e n d r o p even if it closed
banks as soon as it k n e w their e c o n o m i c net
w o r t h had p l u n g e d t o zero.
The q u e s t i o n a b l e cost-effectiveness of monitoring all banks closely enough t o recognize
those w h o s e net w o r t h is t u r n i n g negative is a
related p r o b l e m . Bank examinations are costly t o
N O V E M B E R 1985, E C O N O M I C R E V I E W
b o t h t h e g o v e r n m e n t a n d the banks. The costs of
capital regulation must be w e i g h e d against those
of bank e x a m i n a t i o n t o d e t e r m i n e t h e m i n i m u m
a m o u n t of capital r e q u i r e d t o protect t h e FDIC.
If t h e FDIC c o u l d close banks before their
e c o n o m i c net w o r t h t u r n e d negative, t h e n t h e
agency might p r o t e c t itself f r o m losses even
w h e n banks held virtually no e q u i t y capital. To
justify capital regulation on t h e grounds of safeguarding t h e FDIC implies that t h e agency o f t e n
is unable t o close banks before their e c o n o m i c
value turns negative. T h e p r o b l e m s in using
a c c o u n t i n g values rather than e c o n o m i c values
and in measuring t h e latter accurately, the risk of
discontinuous drops in asset values, and t h e
costs of bank e x a m i n a t i o n all make it difficult for
t h e FDIC t o avoid losses. These i m p e d i m e n t s
suggest that some m i n i m a l level of capital regulation might be a p p r o p r i a t e t o give t h e FDIC
t i m e t o identify p r o b l e m banks.
Subordinated D e b t Aside f r o m its role in
affording t h e FDIC t i m e t o recognize problems,
capital also might be required t o absorb substantial losses should a bank fail. If capital guidelines are t o be set sufficiently high to protect t h e
FDIC, should t h e regulations a p p l y t o equity
capital alone or t o t h e sum of e q u i t y capital and
s u b o r d i n a t e d debt? Since s u b o r d i n a t e d debtholders absorb losses o n l y w h e n a firm is bankrupt, t h e principal advantage of regulating o n l y
e q u i t y capital is that banks can charge losses t o
their capital account w i t h o u t failing. The effectiveness of e q u i t y capital in preventing bank failures
may be i m p o r t a n t in reducing FDIC losses if, as
Stanley C. Silverberg (1985) suggests, t h e value
of a big institution drops w h e n t h e market
believes it is going to fail.
An advantage t o regulating t h e sum of e q u i t y
capital plus s u b o r d i n a t e d d e b t is that it may
reduce regulatory costs by allowing banks to
issue s u b o r d i n a t e d d e b t rather than e q u i t y if
d e b t is less expensive. Furthermore, buyers of
s u b o r d i n a t e d d e b t wish t o invest in low-risk
institutions w h i l e equity buyers may prefer to
invest in riskier banks if e x p e c t e d returns also are
higher. Thus, banks that issue s u b o r d i n a t e d d e b t
are less likely t o try t o w o r k around capital
regulation by taking higher risks.
Insurance Premiums. The argument that t h e
FDIC might reduce its losses t h r o u g h capital
regulation does not necessarily i m p l y that such
FEDERAL RESERVE B A N K O F ATLANTA
regulation is the best w a y t o protect t h e fund. An
alternative w o u l d be for t h e agency to substitute
higher insurance p r e m i u m s in return f o r a l l o w i n g
lower capital standards. A potential advantage is
that banks might f i n d higher p r e m i u m s less
costly t h a n higher capital standards. The current
fixed-rate deposit insurance structure c o u l d acc o m m o d a t e such premiums, or t h e y c o u l d be
part of a risk-rated p r e m i u m system. 29
Summary
The theoretical case against relying o n t h e
market t o c o n t r o l bank equity capital positions is
strong. M a r k e t d e t e r m i n e d capital ratios t e n d t o
ignore t h e i m p a c t of o n e bank's failure o n o t h e r
banks. Additionally, it seems clear that banks will
exploit the protection offered by deposit insurance
t o reduce their capital ratios. The i m p o r t a n c e of
b o t h these effects is less clear. Since its creation
in the 1930s, FDIC deposit insurance has acted as
a potent substitute for bank capital in maintaining
depositor confidence: not o n e bank failure has
sparked runs at other banks. Evidence t o indicate
that t h e risk of deposit runs w o u l d be r e d u c e d
substantially by capital regulation is sparse Furthermore, t h e quantitative effect of insurance o n
bank capital ratios has yet t o be established. 3 0
The theoretical case against using equity capital
regulation t o correct for market failure is strong
as well, b u t i t too, lacks crucial empirical evidence.
The primary arguments against such regulation
are that t h e market—rather than t h e r e g u l a t o r s controls bank capital ratios; that regulation w o u l d
be ineffective in reducing bank risk exposure;
that regulation has significant disadvantages; a n d
that better alternatives exist.
The c o n t e n t i o n that the market controls bank
capital ratios is the least persuasive. Some studies
from the period prior to capital guidelines indeed
suggest that t h e market c o n t r o l l e d banking organizations' capital; however, evidence from the
current policy regime points t o t h e regulators' effectiveness in requiring specified capital levels.
W h i l e e q u i t y capital has a statistically significant effect on a bank's risk of failure, t h e benefits
of increased capital may be offset by an increase
in t h e riskiness of bank assets and off-balance
sheet activities. The theoretical e v i d e n c e is clear
that some banks will respond t o capital regulation
15
2
by assuming additional risk, yet the empirical
support for this hypothesis is weak.
The empirical e v i d e n c e on capital regulation's
effect o n bank competitiveness and on resource
allocation is also weak. However, theoretical
e v i d e n c e implies that capital regulation reduces
banks' ability t o c o m p e t e w i t h n o n b a n k i n g organizations a n d that it might result in a misallocation of society's resources.
If increased equity capital reduces banks' risk
of insolvency, it also could reduce their risk of
illiquidity by increasing depositor confidence.
However, increased equity capital is neither
necessary nor sufficient for p r e v e n t i n g bank
failures due t o illiquidity. The FDIC has effectively
shrunk the risk of deposit runs a n d the danger
c o u l d be e l i m i n a t e d if t h e agency p r o v i d e d 100
percent d e p o s i t insurance. Alternatively, the
Federal Reserve c o u l d prevent banks f r o m failing
d u e t o illiquidity by acting as a lender of last
resort.
Capital regulation c o u l d lessen FDIC losses by
p r o v i d i n g a cushion t o absorb losses. Potential
substitutes for shielding the FDIC include closing
banks before t h e y exhaust their e c o n o m i c net
worth, requiring banks to issue additional subo r d i n a t e d debt, and raising FDIC premiums.
However, these measures may be inadequate t o
p r o t e c t t h e FDIC fully. The experience of economically failed savings and loans shows the
market will not necessarily close b a n k r u p t institutions that are federally insured. This suggests
that some m i n i m a l e q u i t y capital standards may
help reduce FDIC losses.
NOTES
1
Ben S. Bernake (1983) argues that the collapse of the banking system
led to a sharp reduction in bank loans to small business and that this
caused a sharper drop in economic activity. Milton Friedman and Anna
Schwartz (1963) suggest that the collapse of the banking system led to a
steep decline in the money supply, which both deepened and prolonged
the Depression.
16
Banks must maintain depositor confidence if they are to remain liquid
since a large portion of bank deposits can be withdrawn with little or no
notice should depositors lose faith. A significant portion of bank assets
are invested in longer term loans which cannot be liquidated on short
notice.
3
See Karlyn Mitchell (1984) for a discussion of why capital ratios have
fallen.
4
The issues in regulating the capital of banks owned by holding companies
are reviewed by Larry D. Wall (1985).
5
The current regulatory guidelines and some of their effects on banks are
discussed by R. Alton Gilbert Courtenay C. Stone, and Michael E Trebing
(1985).
6
See David C. Cates (1985a) for a discussion of some of the issues in
determining the adequacy of the loan loss allowance John J. Mingo
(1985) argues against reducing primary capital by intangibles The case
for increasing required levels of subordinated debt is given by Paul M.
Horvitz (1984) and Larry D. Wall (1984). Stanley C. Silverberg (1985)
discusses the issues involved in requiring banks to meet a nine percent
capital to assets ratio where capital is defined to include subordinated
debt
'The proposition that there is no optimal capital ratio was first developed
for corporations in general by Franco Modigliani and Merton H. Miller
(1958).
"See Stewart C. Myers (1984) for a survey of the literature on factors
influencing corporate capital ratios Yair E Orgler and Robert A Taggart
Jr. (1983) provide a recent discussion of the factors influencing bank
capital positions.
9
See G e o r g e J. Benston (1983) for a further discussion of banks'
vulnerability
'°See also John J. Pringle (1974) for a discussion of the influence of
maturity structure of liabilities on bank capital.
11
Among the theoretical studies that have examined this issue are Orgler
and Taggart (1983), Stephen A Buser, Andrew H. Chen, and Edward J.
Kane (1981), John H. Kareken and Neil Wallace(1978), William F. Sharpe
(1978), and Robert A Taggart, Jr. and Stuart I. Greenbaum (1978).
" R e l i a n c e on retained earnings for increased capital is one element of the
pecking order theory of capital structure discussed by Myers (1984).
13
Santomero (1983) points out that the reliability of their estimates
depends on the nature of the process generating changes in bank
capital. If the stochastic processchanges over time, then the estimates of
risk or failure must also change.
"•See also Robert A Eisenbeis (1980).
15
See Yehuda Kahane (1977), Michael Koehn and Anthony M. Santomero
(1980), and Chun H. Lam and Andrew H. Chen (1985) for theoretical
models of the effect of capital regulation on a bank's asset portfolio
allocation.
,6
For example, see Eamonn Fingleton (1985).
" N o t all off-balance sheet activities increase bank risk; some activities can
be risk reducing. For example, interest rate options can be used to hedge
mismatches in the maturity structure of bank assets and liabilities
'"Benjamin M. Friedman and Peter Formuzis(1975) suggest that increased
bank capital will provide little additional protection to depositors.
' 9 The agencies may choose to close banks with inadequate but non-zero
capital if they place a higher priority on protecting the FDIC than on
preventing bank failures See the discussion below on the use of capital
standards t o protect the FDIC fund.
" S e e Myers (1984).
' ' A m o n g the uninsured alternatives to bank transactions accounts are
accounts offered by money market mutual f u n d s Most money market
funds already allow check withdrawals (although they often require that
checks at least equal some minimum amount) and the potential exists for
them to expand their share of transactions accounts if banks become
sufficiently uncompetitive.
" S e e Thomas M. Humphrey and Robert E. Keleher(1984) for a historical
perspective on the role of a lender of last resort
"Generally, though, the resources of the FDIC would not be expected to
suffice for loss coverage from extraordinarily adverse economic conditions caused by bad macroeconomic policies or unanticipated exogenous shocks to the economy.
" S e e Edward J. Kane (1982) for a discussion of the role of deposit
insurance in maintaining failed thrifts
" K a n e (1982) discusses the ability of savings and loans to remain in
business in spite of very substantial declines in the market value of their
mortgage portfolio due to increases in interest rates He points out that
savings and loans like b a n k s need not recognize declines in market
values and that public confidence in the institutions is maintained by
FSLIC insurance.
26
Both Kane (1985) and George G. Kaufman (1985) have recently advocated
this
" O n e of the biggest problems in applying discounted cash flow techniques
would be determining the effective maturity of some types of assets and
deposits or valuing the options with which they are associated
N O V E M B E R 1985, E C O N O M I C
REVIEW
28
The effect of a discontinuous change in bank operations is developed by
Thomas Ho and Anthony Saunders (1981) for the case of depositors'
reactions to bank risk taking.
29
For example, Robert B Avery, Gerald A Hanweck and Myron L. Kwast
(1985) develop a variable-rate insurance scheme based on historic FDIC
costs. The scheme includes a factor for a bank's equity capital to assets
ratio.
3
°Estimation of the effect of insurance on bank capital ratios by comparing
insured and uninsured banks is impossible because virtually all banks are
insured.
31
Horvitz (1975) points out that reports of large bank problems do not
appear to be causing runs at other banks
32
Mayer perhaps anticipated the future in 1975 when he used loans to
foreign countries as an example of the type of problem loans that could
lead to a systemic problem.
" S e e Sandra L Ryon for a history of bank capital adequacy standards in
the United States
" R e c e n t examples include John E Bovenzi, James A Marino, and Frank E
McFadden (1983), Robert B Avery and Gerald Hanweck (1984), and
Eugene D. Short, Gerald O'DriscoH and Franklin D. Berger (1985).
" S e e Chapters 2 (prepared by Laurie Goodman), 3 and 4 of Sherman J.
Maisefs Risk and Capital Adequacy in Commercial Banks.
36
Guttentag and Herring (1984) also point out that the market will
systematically underestimate the risk of economy-wide shocks This
could provide a rationale allowing the regulators to evaluate bank risk if it
could be shown that they have better estimates of the risk of major
macroeconomic shocks
" R i c h a r d Roll and Stephen A Ross (1984) describe the arbitrage pricing
model and give the four factors they believe influence stock returns Not
all analysts agree with their factor choices
38
See Richard Schmalensee and Robert R. Trippi (1 978) f o r a discussion of
some of the empirical questions surrounding the use of the standard
deviation implied by stock options.
39
For example, most banks that made major loans to energy firms did not
suffer Penn Square's fate.
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N O V E M B E R 1985, E C O N O M I C
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;
>
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19
Lags in the Effect of
Monetary Policy
Mary Susan Rosenbaum
Despite intensive study of how the economy responds
to changes in the money supply, the timing of
such consequences remains elusive.
Policymakers must be alert to
this uncertainty when
considering prospects
for stabilizing the economy
M o s t observers agree that
changes in t h e rate of monetary growth can have potent
short-term effects on real econ o m i c activity. 1 This i m p a c t is
felt even t h o u g h m o n e y is neutral w i t h respect t o real activity
in t h e long run. That is, over a
p r o l o n g e d p e r i o d m o n e t a r y actions affect t h e price level a n d not
real e c o n o m i c activity in an econo m y e x p a n d i n g at its long-term potential.
>
C o n t r o l of t h e m o n e y supply is
i m p o r t a n t t o policymakers, not as an e n d
in itself, but because changes in the m o n e y
supply are associated w i t h subsequent changes
in spending and real economic activity. Theory
suggests that fluctuations in o u t p u t and e m p l o y ment (the business cycle) can be counterbalanced
by t i m e l y changes in t h e g r o w t h rate of t h e m o n e y supply. W h e n t h e
m o n e y supply is m a n i p u l a t e d in this way, it is an i n t e r m e d i a t e target
of monetary policy. M i l t o n Friedman acknowledges "persuasive
theoretical grounds for desiring t o vary t h e rate of g r o w t h of t h e
m o n e y stock t o offset other factors." 2
The stabilizing potential of m o n e y supply changes makes a case
for discretionary monetary policy. As a result, t h e length and
variability of t h e lag, or t h e t i m e that elapses before t h e e c o n o m y responds t o monetary policy, has e m e r g e d as an i m p o r t a n t question
for economists and policymakers alike. W e will e x a m i n e the
evidence relating t o t h e lag b e t w e e n o n e i n t e r m e d i a t e target M l
The author
is an economist
on the Research
Department's
macropolicy
team.
20 N O V E M B E R 1985, E C O N O M I C R E V I E W
<
(coin, currency, a n d checkable deposits), and
e c o n o m i c activity.
The lag before an economic stabilization policy
takes effect has been d e b a t e d intensely for t h e
last 30 years. A l t h o u g h t h e issue pertains b o t h t o
monetary a n d fiscal policy, m o n e t a r y policy's
lagged effect has received most of t h e a t t e n t i o n
since M i l t o n Friedman addressed t h e p r o b l e m
(1953, 1960, 1961 and Friedman and Schwartz,
1963, a,b). Research and d e b a t e focus not o n l y
on t h e exact length of t h e delay b e t w e e n introd u c t i o n of a change in t h e rate of m o n e t a r y
g r o w t h and its initial i m p a c t on n o m i n a l gross
national p r o d u c t (GNP), b u t also on t h e t i m e required for a monetary impulse to attain its maximum
effect and eventually, to be dissipated completely.
Extensive research over t h e last three decades
offers various, and o f t e n conflicting, estimates of
this lag's duration, ranging from o n e quarter t o
several years. The variability of t h e lag is an o b j e c t
of study, as well. This entire b o d y of research has
failed t o p r o d u c e u n a m b i g u o u s conclusions regarding t h e length of these lags and their stability
over time. T h e lack of consensus is i m p o r t a n t
because it is associated w i t h related disagreements over the p r o p e r scope of m o n e t a r y policy.
Variability a n d excessive length of lags complicate p o l i c y m a k i n g in d i f f e r e n t ways. If t h e goal is
t o achieve a given level of G N P growth, t h e n lag
variability c o u l d c o m p l i c a t e t h e p r o p e r t i m i n g of
monetary actions, even if t h e policy response is
appropriate in every other way. A desirable
action may be " w r o n g " if it affects t h e e c o n o m y
at a d i f f e r e n t t i m e than anticipated. Thus, an
accurate forecast of t h e e c o n o m y ' s c o n d i t i o n at
the t i m e t h e policy effects will occur is crucial for
gauging the p r o p e r policy action, particularly
w h e n long lags are involved. T h e further i n t o t h e
future a forecast is made, the greater its uncertainty;
consequently, errors are m o r e likely.
Assumptions and Lag Classifications
For this discussion, w e will assume that t h e
Federal Reserve as monetary authority, has effective control of t h e m o n e y supply, w h i c h w e
use to represent monetary policy. W h e r e possible,
w e will e m p l o y t h e narrowly d e f i n e d m o n e t a r y
aggregate, M l ; w h e n t h e e v i d e n c e uses M 2 ( M 1
plus t i m e deposits, M M D A s , M M M F s , a n d overnight Eurodollar balances) or reserves, this is
noted. 3
FEDERAL RESERVE BANK O F ATLANTA
A lag may occur b e t w e e n the t i m e a policy
action is taken and t h e m o n e y supply responds.
This is part of t h e " i n s i d e " lag, typically d e f i n e d as
t h e t i m e r e q u i r e d to recognize and respond t o
e c o n o m i c conditions requiring policy action,
plus t h e t i m e required t o affect t h e chosen
g r o w t h rate of t h e i n t e r m e d i a t e target. The " o u t side" lag measures t h e t i m e b e t w e e n t h e change
in that target and the response of t h e u l t i m a t e
objectives: o u t p u t , e m p l o y m e n t , and prices. 4
The outside lag concerns us here. 5
Also i m p o r t a n t in t h e study of policy lags is t h e
distinction b e t w e e n initial a n d c u m u l a t i v e lags.
The initial, (or impact) lag is t h e t i m e b e t w e e n
the policy change and its first measurable i m p a c t
on n o m i n a l GNP. The c u m u l a t i v e lag is t h e t i m e
between a policy change and the final measurable
response in GNP.
The Timing of Monetary Influence:
Reviewing the Evidence
A huge b o d y of research addresses t h e channels of m o n e t a r y i n f l u e n c e a n d m a y p r o v i d e
some insight i n t o t h e t i m i n g of lagged policy
impacts. The research w e surveyed a t t e m p t s to
answer such questions as t h e following: H o w
many m o n t h s or quarters after t h e initial change
in monetary growth will w e first observe a response in GNP? H o w long before w e observe t h e
m a x i m u m effect? W h a t is t h e t i m e pattern?
Before Friedman's w o r k focused a t t e n t i o n o n
lag length and variability, f e w formal empirical
studies had analyzed this question. The many
estimates made since then fall into several groups.
First is work based on the reference cycle m e t h o d
that Friedman used. Second is r e d u c e d - f o r m
(often single equation), e c o n o m e t r i c m o d e l s
that concentrate o n t h e relationship b e t w e e n
overall e c o n o m i c activity (GNP) and policy variables. The third group is based o n structural
models. These are large e c o n o m e t r i c models,
c o m p o s e d of many equations, s o m e t i m e s hundreds, specifying t h e relationship a m o n g GNP,
financial market variables (primarily interest rates,
but also m o n e t a r y aggregates), nonfinancial markets, and international trade.
Reference-Cycle Turning Point Analysis. Emp l o y i n g reference-cycle analysis, M i l t o n Friedman's w o r k revived interest in t h e p o t e n c y of
m o n e t a r y policy a n d s t i m u l a t e d m u c h subseq u e n t research i n t o policy lags.
21
Hypothetical Lag Pattern
and Policy I
The economy's adjustment to changes in monetary
growth is not a discrete, all-at-once event but takes
place as a distributed lag. The effects of a monetary
policy action tend to begin gradually, build to a peak,
and then subside Thus past monetary growth continues
to influence GNP long after the monetary growth actually
occurs An increase in the rate of monetary growth
temporarily stimulates real economic activity. Once
such resources as labor and capital are fully employed,
or once inflation becomes generally anticipated, monetary growth produces a permanent increase in the price
level. While this description of the transmission mechanism is extremely simplified it suffices for an examination
of timing issues
To understand what lags in the effect of monetary
policy imply, let us look at a hypothetical lag structure. To
simplify the example, we will assume that the pattern of
monetary influence can be represented by a single,
nonstochastic equation.6 Let us also assume that GNP
is growing along a trend path, and that the only dislocations from the path are caused by monetary policy.
Consider an expression for percentage changes in
GNP away from trend as a function of past growth in the
money supply.7 This does not represent any of the
specific lag structures we will survey later, although its
shape conforms to the classic response profile found in
many studies of monetary policy lags 8
% A G N P { =0.3%AMT.-, +0.5%AMT_2 + 0 . 4 % A M T . 3
0.2%AMT.4
+
This equation reads that the percentage change (% A) in
real GNP in the current period, (t) is determined by the
percentage change in monetary growth in the previous
four periods (t-1, t-2, t-3, t-4). The contribution of each
period's monetary growth to current GNP growth is
determined by the lag weights (0.3, 0.5,0.4,0.2), which
are the coefficients of the %A M t variables According to
our model, a one period increase in monetary growth of,
say, 1 percent, will produce an increase in GNP growth
of .3 percent the following period, .5 percent two periods
later, .4 percent three periods later, and .2 percent four
periods later.
This example, an extreme simplification of even the
most basic lag structures shows that monetary policy's
influence on real GNP exhausts itself afterfour periods
Many studies point to much longer lags a different
pattern of lags (lag weights that decline monotonically,
Friedman ( 1 9 5 3 , 1 9 6 0 , a n d Friedman a n d
Schwartz, 1963a,b) c o m p a r e d t h e t i m e b e t w e e n
business cycle t u r n i n g p o i n t s a n d t h e p r e c e d i n g
t u r n i n g p o i n t in m o n e t a r y g r o w t h f r o m 1 8 6 7
t h r o u g h 1 9 6 0 . T h a t span c o v e r e d 18 c o m p l e t e
business cycles. O m i t t i n g w a r years, he d e m o n :
strated t h a t t h e peaks in m o n e y s u p p l y l e d
( r e f e r e n c e cycle) peaks in G N P by an average of
16 m o n t h s . For troughs, t h e average lead t i m e
was 12 m o n t h s . T h e p e a k - t o - p e a k lag varied
22
for instance), or lag weights that turn negative. (In the
long run the lag weights must turn negative and sum to
zero if money is neutral.) Also, our example does not
specify the length of a "period;" the f s could represent
quarters or years
To set the stage for studying the impact of a change in
monetary growth, assume that monetary growth (% AM)
has held steady at 5 percent for a long time. This level of
growth implies that nominal GNP has been growing at7
percent The economy, fully adjusted to the 5 percent
monetary growth, is said to be in equilibrium. Assume
now that monetary growth is raised to 10 percent (%A
M t = 10). Despite this doubling of monetary growth,
GNP growth will remain at 7 percent during period t
That is it will not appear to respond to the doubling of
monetary growth. This follows from the fact that the
impact on GNP is "in the pipeline" but not immediately
evident Not until the next period, when the quickened
monetary growth "comes on line" does GNP growth
begin to rise above 5 percent If the 10 percent monetary growth is sustained, GNP growth will continue to
increase until it stabilizes at 14 percent in the fourth
period after the initial acceleration of monetary growth.
Now consider the consequences of a decrease in
monetary growth to the original 5 percent level. How
long will it take to bring GNP growth back to 7 percent?
In the period when monetary growth is reduced, GNP
does not reponsed visibly to the decline. In the next
period, t+1, monetary growth decreases and in the
subsequent periods GNP growth approaches the original 7 percent level consistent with long-run monetary
growth of 5 percent Only after four full periods following
the decrease in monetary growth does GNP growth
return to its original pace.
The simplified example used here assumes away
many of the problems that complicate real-life monetary
policy decisions First the example treats only one
influence on GNP, monetary growth, when in reality a
multitude of influences—some predictable; others random—impinge upon it Second we assume the monetary
authority can achieve the desired growth rate for money
immediately, when we know that actual money growth
also depends on consumers' and businesses' choices
about currency holding and the banking system's
choices about deposit expansion. Third, the lags are
assumed to be known as well as stable. Together, these
f r o m six t o 29 m o n t h s . It was these findings t h a t
s u p p o r t e d Friedman's w i d e l y p u b l i c i z e d assertion
t h a t t h e lags are l o n g a n d variable.
Friedman c o n t e n d e d t h a t t h e lag b e t w e e n a
t u r n i n g p o i n t in t h e rate of m o n e t a r y g r o w t h a n d
t h e e c o n o m y ' s response was so l o n g a n d variable
t h a t t h e i n t e n d e d c o u n t e r c y c l i c a l effects of discretionary monetary policy often occurred w h e n
t h e y w e r e n e i t h e r i n t e n d e d nor a p p r o p r i a t e . " I n
terms of past experience," Friedman wrote, " a c t i o n
N O V E M B E R 1985, E C O N O M I C R E V I E W
Table 1. Path of GNP Following Change in Monetary Growth
(in percent)
When AMf Raised to 10 Percent from 5 Percent
Mt
M
t-1
t-2
M
t-3
M
t-4
M
AGNP
When ¿M t Lowered to 5 Percent from 10 Percent
t
t+ 1
t+ 2
t+ 3
t + 4
t
t+ 1
t+ 2
t +3
t +4
10
5
5
5
5
7.0
10
10
5
5
5
8.5
10
10
10
5
5
11.0
10
10
10
10
5
13.0
10
10
10
10
10
14.0
5
10
10
10
10
14.0
5
5
10
10
10
12.5
5
5
5
10
10
100
5
5
5
5
10
8.0
5
5
5
5
5
7.0
Source: Federal Reserve Bank of Atlanta.
assumptions create optimal conditions for carrying out
monetary policy; yet even this best case implies severe
constraints on achieving desired GNP growth quickly.
Consider another experiment Suppose monetary
growth were reduced to 1 percent long enough to trim
GNP growth to 1.4 percent Four full periods are required
after monetary growth is increased to 5 percent to
return to the original 7 percent path of GNP growth. This
lengthy delay suggests another tactic
The monetary authority could return GNP growth to
the 7 percent path rapidly if it "played" the lags by
initially increasing monetary growth above 5 percent. If
the authorities raised monetary growth to 19.6 percent
GNP growth would return to 7 percent in one period.
However, if the authorities wanted to maintain this 7
percent GNP growth they would need to offset the
higher, 19.6 percent level of monetary growth by mandating decreases in the next period. In fact keeping
GNP on the 7 percent track would entail considerable
oscillation in period-to-period monetary growth. The
length and weight of the lag values determines the exact
pattern of oscillation. This relationship helps illustrate
another point: if the monetary authority cannot predict
t a k e n n o w t o offset t h e c u r r e n t recession m a y
affect e c o n o m i c a c t i v i t y in six m o n t h s or n o t for a
year a n d six m o n t h s . " 9 Earlier h e had c o n c l u d e d :
" T h e d i f f i c u l t y is that, in practice, w e d o n o t k n o w
w h e n t o vary t h e g r o w t h rate of t h e m o n e y s t o c k
a n d by h o w much.... t h e r e f o r e , d e v i a t i o n s f r o m
t h e s i m p l e m o n e y g r o w t h rule have b e e n destabilizing rather t h a n t h e reverse." 1 0
Friedman's research was criticized o n a n u m b e r
of points. For example, cycle turning p o i n t analysis
F E D E R A L R E S E R V E B A N K O F ATLANTA
the variability in lag impacts, oscillation is almost a
certainty.
The preceding example demonstrates that lags in the
impact of monetary policy make it impossible to achieve
GNP goals immediately without variability in monetary
growth. At any given time, observed GNP growth exhibits
evidence of earlier changes in money growth. Knowledge of the lag structure is necessary for judging the
probable short-run reponse of GNP to current policy.
When forecasting GNP, policymakers must consider
the pattern of monetary growth over as many previous
periods as it takes for monetary influence to be dissipated completely. For example, a four-period history
must be considered in the instance above. Estimates of
monetary lags suggest that actual lags may be quite a
bit longer, and so a more protracted, more complicated
history must always be kept in mind.
Our example illustrates some of the policy complications that attend even a very simple lag structure. The
survey of the evidence makes it clear that even such
considerations are minor in comparison to the complex
patterns of policy effects
d o e s n o t distinguish a m o n g d i f f e r e n t rates ol
m o n e t a r y e x p a n s i o n nor b e t w e e n s h o r t - l i v e d
a n d sustained changes in t h e rate of m o n e t a r y
growth. 1 1 M o r e o v e r , early criticisms e m p h a s i z e d
t h a t t h e level of e c o n o m i c a c t i v i t y (GNP) was
i n a p p r o p r i a t e l y l i n k e d t o t h e rate of c h a n g e of
t h e m o n e y supply. 1 2 T h e m o s t f r e q u e n t criticism
was t h a t t h e lag s h o u l d n o t b e m e a s u r e d by t h e
t i m e b e t w e e n t h e c h a n g e in m o n e y g r o w t h a n d
t h e c y c l e t u r n i n g point, b u t b e t w e e n t h e change
23
in m o n e y a n d t h e initial response of i n c o m e —
that is, w h e n t h e m o n e t a r y influence displaced
i n c o m e f r o m w h a t it w o u l d have been.
O n e of t h e first p u b l i s h e d responses t o Friedman's findings came from J. M. Culbertson (1960,
1961), w h o not only t o o k issue w i t h t h e " l o n g
and variable" f i n d i n g (he argued that"substantial
effects" occur w i t h i n six m o n t h s or less) b u t
disagreed w i t h its policy implications as well. 1 3
Even t h o u g h Friedman's w o r k was criticized
widely, his f i n d i n g t h a t lags are long and variable
and his conclusion t h a t t h i s implies l i m i t e d scope
for countercyclical m o n e t a r y policy have shown
considerable staying p o w e r for several reasons.
w i t h t h e average lag for recoveries being 8.6
m o n t h s a n d for recessions 19.9 months, w i t h a
variability of up t o 29 months. T h e " l o n g and
variable" conclusion was reinforced.
<*
Clark W a r b u r t o n (1971), reporting results of a
case-by-case cycle history over t h e period 19191965 f o u n d great variability in lag lengths. He
a t t r i b u t e d this t o a steadily changing e c o n o m y ,
t o t h e d i f f e r e n t stages in t h e business cycle at
w h i c h policy was applied, a n d especially to t h e
e c o n o m y ' s continual a d j u s t m e n t t o past monetary disturbances. N o statistical m e t h o d of controlling for these influences was suggested. Warburton's analysis of cyclical history as a whole was
not optimistic about t h e possibility of developing
such methods. Thus, his findings suggest that
variability is t h e n o r m a n d that any conclusions
based on summaries and averaging offer scant
m e a n i n g for t h e study of policy lags.
In a study of monetary g r o w t h a r o u n d cyclical
peaks, W i l l i a m Poole (1975) measured t h e magn i t u d e of m o n e t a r y decelerations by t h e g r o w t h
of t h e m o n e y stock relative to an established
trend. H e was considering t h e necessary a n d
sufficient conditions for a cyclical peak, using
cyclical peaks f r o m 1908 t o 1972, a n d 2 4 - m o n t h
t r e n d monetary growth. The results s h o w that
monetary g r o w t h decelerations typically lead
cycle peaks by a b o u t six months.
,
Generally, t h e application of reference cycle
m e t h o d s t o t h e study of monetary policy lags
yields estimates that suggest t h e lags are i n d e e d
long a n d variable. Consequently, such analysis is
understandably pessimistic a b o u t t h e p r o b a b l e
success of countercyclical m o n e t a r y policy.
First, o n c e researchers addressed t h e major criticisms of Friedman's work, some still f o u n d long
and variable lags. M o r e importantly, t h e lack of
consensus o n t h e length and variability of monetary policy lags as well as the lack of standardization
h a m p e r i n g i n t e r m o d e l comparisons have lent
passive s u p p o r t t o Friedman's assertions.
Using a reference cycle m e t h o d o l o g y similar
t o Friedman's, Beryl Sprinkel (1959) c o m p a r e d
changes in t h e g r o w t h rate of t h e m o n e y stock
w i t h business cycle peaks and troughs for 19091959. The m o n e y supply data w e r e measured in
a variety of ways, t o yield statistical series that
w e r e b o t h sensitive t o recent changes in monetary g r o w t h and s m o o t h e n o u g h t o reflect t u r n i n g
points. Sprinkel's results r e s e m b l e d Friedman's,
24
Other (Non-Model) Based Methods. Using a
nonparametric approach, Gene C. Uselton (1974)
d e m o n s t r a t e d that in t h e ten-year p e r i o d f r o m
1952 t o 1961 t h e average lag in t h e effect of
changes in m o n e t a r y g r o w t h on changes in
industrial p r o d u c t i o n was seven m o n t h s or less.
T h e lag p r o v e d t o be t h e same for contractionary
a n d expansionary policies. The effect was s h o w n
to peak at seven months, after which the additional
stimulus f r o m policy d e c l i n e d rapidly. Uselton
f o u n d t h e l a g t o be highly reliable b u t d i s t r i b u t e d
over several periods of up to 10 months. 1 4
M. Ray Perryman (1980) e m p l o y e d noncyclical
monetary indicators, such as Federal O p e n Market Committee (FOMC) directives and discussions,
t o measure t h e lag in monetary policy's impact.
His measures of t h e o u t s i d e lag show an average
N O V E M B E R 1985, E C O N O M I C R E V I E W
_
,
slightly over t h r e e quarters for t h e period 19531975, w i t h variability averaging a little over o n e
quarter.
In a direct response t o t h e reference cycle
approach, specifically t o Friedman (1953), John
Kareken and Robert M . Solow (1963) analyzed
t h e t i m i n g of t h e o u t s i d e lags by e c o n o m i c
sector, concentrating on investment The authors
p r o v i d e d no estimate of t h e total lag i m p l i e d by
t h e various sectoral lags. W h i l e Kareken a n d
Solow asserted that considerable stabilizing power
occurs after six months, their results also i m p l y a
substantially longer total lag.
Other researchers continued to use the sectoral
approach t o lag estimation. Thomas Mayer's
(1966) attempt t o correct and complete Kareken
and SoloWs estimates of component lags identified
eight sectors of t h e e c o n o m y w h i c h a c c o u n t e d
for almost three-quarters of all d o m e s t i c investment, plus c o n s u m e r c r e d i t M a y e r t h e n comb i n e d t h e eight sectors t o yield a w e i g h t e d lag he
treated as an estimate of t h e c o m p l e t e lag
b e t w e e n a change in credit availability and its
effect o n national income. His findings i m p l y t h a t
t h e o u t s i d e lag is q u i t e long—on t h e order of 1 7
m o n t h s — a n d critically d e p e n d e n t o n the degree
t o w h i c h t h e e c o n o m y had adjusted t o previous
monetary policy changes. After adjusting several
of M a y e r s response estimates, W i l l i a m H. W h i t e
(1961) f o u n d that t h e policy lags w e r e m u c h
shorter, a p p r o x i m a t e l y 12 m o n t h s or less.
In contrast to t h e reference cycle research, t h e
nonparametric approaches of Uselton a n d Perryman indicate shorter a n d m o r e reliable lags.
( N o t e that t h e sample periods t h e y consider
cover a m u c h shorter history than does t h e
reference cycle work. 15 ) A l t h o u g h t h e sectoral
approach initially claimed to disprove Friedman's
" l o n g and variable" finding, t h e lag suggested by
these findings is in fact q u i t e long.
Economic Models. C o m p l e t e structural models
of t h e e c o n o m y can track t h e path by w h i c h
changes in m o n e t a r y policy influence t h e economy. Still, t h e y are not designed specifically t o
e x a m i n e t h e money-lag sequence.
in contrast t o structural models " r e d u c e d f o r m " m o d e l s express key e c o n o m i c variables,
such as GNP or inflation, as direct functions of
policy a n d other o u t s i d e (exogenous) variables.
Supporters of the r e d u c e d - f o r m a p p r o a c h cont e n d that, if users of statistical m o d e l s are concerned principally w i t h explaining and forecasting
t h e behavior of only a f e w primary e c o n o m i c
FEDERAL R E S E R V E BANK O F ATLANTA
variables, it is unnecessary to derive estimates for
all t h e variables of a structural model. Besides,
t h e y argue, our e c o n o m y ' s c o m p l e x i t y eludes
even t h e most a m b i t i o u s structural model. 1 6
Accordingly, t h e y c o n t e n d that it may be preferable t o isolate a n d e x a m i n e o n l y t h e relationship b e t w e e n t h e " d r i v i n g " variables, representing m o n e t a r y a n d fiscal policy, and t h e policies
and t h e variables ultimately affected by t h e m ,
such as o u t p u t or inflation. In general, reducedf o r m models look for a net effect rather than t h e
process of e c o n o m i c adjustment.
R e d u c e d - f o r m models, such as t h e St. Louis
model, are m o r e likely t o s h o w an i m m e d i a t e
i m p a c t of m o n e y on o u t p u t (and extensive lags
in t h e c u m u l a t i v e effect). For this reason, economists w h o believe in a strong causal response of
GNP t o m o n e t a r y g r o w t h favor r e d u c e d - f o r m
models. Structural m o d e l s used t o assess t h e
impact t e n d to s h o w a weaker causal relationship.
Most research conducted explicitly to examine
lags in m o n e t a r y policy's effect has i n v o l v e d
designing and testing reduced-form models. Consequently, considerably m o r e e v i d e n c e can be
culled from such models.
Reduced-Form Models. Leonall C Anderson and
Jerry L Jordan (1968), in a seminal e x p o s i t i o n of
t h e St. Louis model, constructed a r e d u c e d f o r m
m o d e l to measure GNP's response to t w o measures of m o n e t a r y policy ( t h e m o n e y stock and
t h e m o n e t a r y base) and t o several measures of
fiscal policy b e t w e e n 1952 and 1968. O n e goal
was t o gauge the speed w i t h w h i c h m o n e t a r y
policy affects GNP. They f o u n d relatively short
lags and strong effects attributable t o m o n e t a r y
actions. 1 7 Their w o r k s h o w e d t h a t t h e i m p a c t
effect (the marginal c o n t r i b u t i o n of m o n e y to
n o m i n a l G N P in each period) reached its maxim u m in t w o quarters, and that the total effect
(the c u m u l a t i v e i m p a c t of policy up t o a given
point) peaked w i t h i n o n e y e a r — e v i d e n c e at
o d d s w i t h t h e " l o n g a n d variable" finding.
A n o t h e r response t o Friedman's w o r k s h o w e d
that even if t h e e c o n o m y ' s actual response t o
monetary policy was quick and highly predictable,
t h e reference cycle t u r n i n g p o i n t t e c h n i q u e
w o u l d yield estimated lags that w e r e i n d e e d long
and variable. D o n a l d P. Tucker (1966), J. Ernest
Tanner (1969), a n d Paul E. Smith (1972) w e r e
less c o n c e r n e d w i t h actually measuring the lags
than w i t h constructing plausible r e d u c e d - f o r m
models of t h e e c o n o m y ' s response t o m o n e t a r y
25
policy, models consistent w i t h specific channels
of monetary influence. T h e y d e m o n s t r a t e d that
t h e t i m i n g of t h e response is e x t r e m e l y sensitive
t o t h e m a g n i t u d e a n d d u r a t i o n of a monetary
expansion or contraction. This research d i d not
disprove t h a t t h e lag was long a n d variable. It
s h o w e d that reference cycle analysis c o u l d p o i n t
to long and variable lags even if, in fact, t h e lags
w e r e neither.
A n u m b e r of empirical studies have s h o w n that
aggregate i n v e s t m e n t responds only gradually,
over a long period, t o changes in interest rates. 18
Some have inferred that m o n e t a r y policy may be
constrained by these interest rate lags a n d thus
may w o r k t o o slowly t o be useful for stabilization
purposes. According t o Tucker (1966), the investm e n t responds t o interest rate changes w i t h a
long d i s t r i b u t e d lag, b u t other c o m p o n e n t s of
aggregate d e m a n d ( n a m e l y c o n s u m p t i o n ) respond more quickly. The model Tucker developed
is theoretical. H o w e v e r , simulations using some
" r e a s o n a b l e " U.S. e c o n o m i c data y i e l d e d estimates of an e x t r e m e l y short initial lag: o n e
quarter. W h i l e t h e c u m u l a t i v e lag is q u i t e ext e n d e d , t h e simulations suggested that i n c o m e
c o u l d adjust t o w i t h i n 10 percent of its equil i b r i u m level w i t h i n t w o quarters.
TuckeKs w o r k was e x t e n d e d by Tanner (1969)
and Smith (1972) w h o c o n s i d e r e d t h e interest
rate responses i m p l i e d by Tucket's results t o be
26
unrealistically rapid b u t f o u n d other features of
t h e m o d e l valuable. Tanner, using data f r o m
1947 t o 1967, estimated a two-sector m o d e l that
explicitly a c c o u n t e d for t h e interrelation bet w e e n goods markets a n d financial markets. The
effect of m o n e t a r y policy o n C N P was estimated
t o peak in three t o six months. C o m b i n e d w i t h
t h e assumption that accurate e c o n o m i c forecasts can predict further t h a n six m o n t h s into t h e
future, b o t h TanneKs and Smith's w o r k suggests
that discretionary m o n e t a r y policy can be used
for e c o n o m i c stabilization. 1 9
In a paper u p d a t i n g t h e original St. Louis
model, Leonall C. A n d e r s o n and Denis Karnosky
(1972) f o u n d " s h a r p and substantial positive
response of real o u t p u t g r o w t h for five quarters
f o l l o w i n g a p e r m a n e n t change in t h e rate of
increase of money" from 1955 t o 1 9 7 1 , 2 0 " G r o w t h
of o u t p u t t h e n ceases t o accelerate and falls
rapidly w h i l e t h e rate of price increase rises
moderately." 2 1 T h e y also n o t e d that " t h e adjustm e n t of o u t p u t , w h i l e zero in t h e long run, is
e x t r e m e l y volatile c o m p a r e d t o t h e a d j u s t m e n t
pattern of prices.... The length of t h e a d j u s t m e n t
period for b o t h prices and o u t p u t t o a m o n e t a r y
shock was f o u n d t o be almost 24 quarters." 2 2
These specific findings conflict w i t h t h e long a n d
variable results of some other researchers. Yet
Anderson and Karnosky showed that in simulations
using various types of money shocks and different
stages of a d j u s t m e n t t o prior shocks (using equations that indicate a consistent a n d precise
response of o u t p u t and prices), variable lags
c o u l d result. Thus, t h e y suggested that variability
is t o be expected.
Similar results r e p o r t e d by J. R. M o r o n e y and J.
M . Mason (1971) revealed consumption spending
responding t o policy adjustments long before
investment. They s h o w e d t h a t c o n s u m p t i o n is
affected initially d u r i n g t h e quarter w h e n monetary policy (as p r o x i e d by t h e m o n e t a r y base) is
changed, w h i l e i n v e s t m e n t s p e n d i n g does n o t
begin t o respond until t w o quarters later. Overall,
t h e y c o n c l u d e d , t h e influence of a change in
monetary growth peaks in roughly three quarters,
and t h e total i m p a c t appears t o last 15 quarters.
W i t h asmall m o d e l using u n a n t i c i p a t e d monetary growth as the policy variable, Rose McElhatton
(1981) studied h o w o u t p u t and inflation respond
t o m o n e t a r y policy. 2 3 She c o n c l u d e d that output's initial response is small in t h e first quarter
and rises steadily for seven quarters t o a peak;
t h e total effect is c o m p l e t e in a b o u t 10 years.
N O V E M B E R 1985, E C O N O M I C R E V I E W
W h i l e these results are not unusual, t h e implications for countercyclical policy are discouraging
because of t h e severe constraints associated
w i t h designing policy around unanticipated monetary growth. 2 4
Clearly, some divergence exists in estimates of
policy lags. N o n e of t h e estimates is particularly
robust w i t h respect to different estimation periods
and estimation techniques. However, only Tanner
(1979) and Thomas F. Cargill a n d Robert A
Meyer (1978) have explicitly examined systematic
variability of t h e lag. T h e y q u e s t i o n e d w h e t h e r
past estimates that implicitly or explicitly assumed
that t h e lags d i d not change over t i m e may have
been biased. They also asked w h e t h e r a n d w h y
t h e lags m i g h t change systematically through t h e
years.
Cargill a n d M e y e r e x a m i n e d t h e stability of
income's response t o changes in monetary policy
by e m p l o y i n g t w o small e c o n o m e t r i c models of
t h e U.S. e c o n o m y . Each of these m o d e l s embodies fairly d i f f e r e n t ideas of policy effectiveness a n d channels of monetary influence. Using
data f r o m t h e p e r i o d 1 9 5 3 - 1 9 7 3 , t h e authors
f o u n d that t h e e c o n o m y ' s structure and hence
t h e response t i m e t o policy changes is m o r e
appropriately m o d e l e d by using t i m e varying
t e c h n i q u e s — t h a t is, t e c h n i q u e s that yield not
one unchanging estimate representing response,
b u t an estimate for each period. Both models
w e r e estimated using t h e constant coefficient as
well as t i m e varying coefficient techniques. The
results indicate t h a t w h i l e t h e classic response
profile of a fairly short initial lag and long c u m u lative lag is typical for t h e constant coefficient
estimations and t h e t i m e varying estimations of
b o t h m o d e l s , t h e r e s p o n s e has v a r i e d c o n siderably over t h e years. Additionally, t h e t i m i n g
of income's response t o changes in m o n e t a r y
g r o w t h (that is, lag pattern and lag length) is
i n f l u e n c e d p r o f o u n d l y by stage of t h e business
cycle at w h i c h t h e policy change occurred.
Unfortunately, the results can not be generalized
easily because Cargill and Meyer report estimates
only for four selected t i m e p o i n t s — t w o each of
tight and easy m o n e t a r y policy. However, t h e
results provide several insights and w h e t our
a p p e t i t e for a closer e x a m i n a t i o n of t h e cyclical
history of t h e selected t i m e points. First, t h e
empirical findings s h o w that t h e c u m u l a t i v e
response of i n c o m e t o a unit change in m o n e t a r y
g r o w t h d e c l i n e d u n e v e n l y b e t w e e n 1960. and
1972, b u t t h e i m p a c t lag was shorter and t h e
FEDERAL RESERVE B A N K O F ATLANTA
initial response c o n s t i t u t e d a greater p r o p o r t i o n
of t h e total response in those later years.
A b o u t t h e same t i m e Cargill a n d MeyeKs
research was published, Tanner (1979) examined
t h e variability issue w h i l e also considering causes
for possible systematic change in t h e lags f r o m
1953 t o 1974. This approach allowed for variation
d u e t o d i f f e r e n t stages of t h e business cycle, t h e
posture of m o n e t a r y policy (relative ease or
restraint), a n d t h e t r e n d in t h e d y n a m i c relationship b e t w e e n policy changes a n d GNP. Initially,
t h e estimates w e r e m a d e w i t h o u t separately
specifying all three influences. These first results
indicated that over t h e entire period t h e initial
i m p a c t lag is a b o u t o n e quarter, w h i l e t h e t i m e
required for i n c o m e t o e x h i b i t its m a x i m u m
response t o m o n e t a r y change is b e t w e e n three
and four quarters. There is considerable variation
through t h e years however, as revealed by analysis of several separate periods. In contrast t o
t h e Cargill a n d M e y e r results, Tanner 7 s estimates
s h o w e d a substantial l e n g t h e n i n g of t h e lag f r o m
t h e 1950s t o t h e 1960s. W h e n Tanner a c c o u n t e d
for t h e array of varying e c o n o m i c conditions,
though, rather d i f f e r e n t results emerged. First,
t h e c u m u l a t i v e lag appears t o grow longer over
time. Tanner explains that this result illustrates
t h e d o m i n a n c e of t h e trend t o w a r d s o m e w h a t
tighter monetary policy o v e r t h e entire period. At
t h e same time, however, this lengthening t e n d s
to obscure his finding that loose policy is associated
w i t h a shortening of t h e lag, a result interesting t o
those studying m o r e recent m o n e t a r y history.
T a n n e r s overall findings are pessimistic for t h e
scope of countercyclical m o n e t a r y policy: t h e lag
is f o u n d t o vary in a systematic w a y d e p e n d i n g
on t h e stance of m o n e t a r y policy over time, b u t
does not appear t o be p r e d i c t a b l e f r o m e p i s o d e
t o episode, over t h e business cycle.
The general profile of lags that emerges f r o m
r e d u c e d - f o r m models is that of fairly short ( t w o
quarters or less) i m p a c t lags, and fairly long
c u m u l a t i v e lags. M o n e t a r y policy appears t o
have its greatest total i m p a c t o n n o m i n a l G N P
w i t h i n t h e first t w o years after i m p l e m e n t a t i o n ;
its influence dissipates precipitously thereafter.
W h i l e this generalization is q u i t e broad, it is
robust across a variety of models a n d t i m e
periods.
Structural Models. Even t h o u g h most structural
models have not been designed explicitly t o
e x a m i n e t h e t i m i n g question, policy simulations
o n t h e m o d e l s can extract some i n f o r m a t i o n
27
a b o u t timing. Because structural models ordinarily use nonborrowed reserves as the exogenous
monetary policy variable and reduced-form
models use t h e m o n e y supply, c o m p a r a b i l i t y
problems i m m e d i a t e l y emerge. N o n b o r r o w e d
reserves often are considered " m o r e " exogenous
than money; that is, t h e y are better c o n t r o l l e d by
t h e m o n e t a r y authority. Thus, t h e p r o b l e m of
possible t w o - w a y causation b e t w e e n m o n e y and
e c o n o m i c activity may be addressed m o r e effectively in structural models using nonborrowed
reserves. H o w e v e r , t h e difficulty in isolating an
appropriately exogenous m o n e t a r y variable t o
study lags is c o m p o u n d e d by t h e fact that t h e
controversy is n o t over the reserves-moneyi n c o m e sequence b u t t h e m o n e y - i n c o m e t i m i n g
pattern. A n y conclusions a b o u t t h e latter based
on t h e f o r m e r must assert a reliable t i m i n g
relationship b e t w e e n m o n e y and reserves.
Early explorations of policy effects in structural
models (for example, Ta-Chung Lui [1963]) were
d o n e by exogenizing interest rates, w h i c h m a d e
it impossible t o e x a m i n e t h e m o n e y - C N P t i m i n g
issue. Later, however, results of e x p e r i m e n t s
using reserves or m o n e y were published. Michael
K. Evans (1966) described a quarterly m o d e l of
t h e U. S. e c o n o m y that p o i n t e d t o an impact lag
of a b o u t t h r e e quarters; policy evokes no i n c o m e
response for six months. T h e marginal impact
peaks at the e n d of year o n e and virtually,
28
disappears by t h e e n d of t h e sixth year. Evans'
w o r k is notable for explaining h o w t h e uniqueness of multipliers, and thus lag patterns, varies
inversely w i t h t h e degree of nonlinearity in t h e
models being compared. This characteristic should
be r e m e m b e r e d w h e n c o m p a r i n g all m o d e l
results.
In response t o A n d e r s o n a n d Jordan, R. C.
Davis ( 1 9 6 9 ) e x a m i n e d t h e MPS m o d e l f o r
sensitivity to monetary policy changes. This structural m o d e l was o n e of t h e first t o specify a highly
d e v e l o p e d financial sector. Davis f o u n d that not
only was there no i m p a c t on G N P in t h e quarter
in w h i c h m o n e t a r y policy (measured by changes
in n o n b o r r o w e d reserves) was changed, b u t that
even after four quarters the effect was small.
A b o u t t h e same time, Frank de Leeuw a n d
Edward M . Gramlich (1969) also r e p o r t e d o n t h e
MPS m o d e l simulations, c o n c e n t r a t i n g o n t h e
channels by w h i c h m o n e t a r y and financial forces
affect n o m i n a l GNP. Their results indicate some
influence in the first quarter after policy is changed.
The effect increases t o reach its m a x i m u m in
a b o u t 2 1/2 years. They c o n c l u d e d that t h e
largest single i m p a c t occurs in t h e t h i r d a n d
fourth quarters, t h e n falls off steeply so that, by
t h e e n d of t h e fourth year, t h e policy change's
effect is virtually l i m i t e d t o higher prices. That
study also d e m o n s t r a t e d that t h e e c o n o m y ' s
initial c o n d i t i o n greatly i n f l u e n c e d t h e t i m i n g of
effects.
George G. Kaufman a n d Robert D. Laurent
(1970) simulated m o n e t a r y policy on a version
of t h e same model. Like de Leeuw a n d Gramlich,
t h e y i m p o s e d an injection of $1 billion of nonb o r r o w e d reserves into t h e m o n e y supply. T h e
response was slower t h a n f o u n d by A n d e r s o n
and Jordan, b u t n o t as slow as other structural
m o d e l results. By t h e e n d of t h e first year, GNP
had reached a b o u t o n e t h i r d of its total response;
by t h e e n d of t h e second year, 72 percent of its
total.
The m a d d e n i n g p r o b l e m s of c o m p a r i n g t h e
various types of m o d e l s was addressed by Gary
Fromm and Lawrence R. Klein (1975). A l t h o u g h
the quarterly response of income t o the monetary
policy variable is n o t available, a s u m m a r y of
results f r o m t h e DRI (1974) version, St. Louis,
MPS, and Wharton Mark III models was provided.
Except for MPS, t h e large structural m o d e l s
typically s h o w e d t h e initial lags t o be t w o t o t h r e e
quarters, w i t h t h e i m p a c t cresting in a b o u t 2 1/2
years. The St. Louis m o d e l e x h i b i t e d lags similar
N O V E M B E R 1985, E C O N O M I C R E V I E W
t o previously r e p o r t e d experiments; however,
those of t h e MPS m o d e l w e r e shorter than lags
reported by de Leeuw and Gramlich. Considering
t h e t i m i n g of m o n e t a r y policy effects, Laurence
H. M e y e r a n d Robert H. Rasche (1980) summarized t h e consensus across models rather
pessimistically. They s u m m a r i z e d policy simulations of five models, b o t h r e d u c e d - f o r m and
structural, a n d used d i f f e r e n t estimations of
several models. A c c o r d i n g t o their results, t h e
i m p a c t lag averages t w o to three quarters, w h i l e
t h e m a x i m u m effect of policy occurs in a b o u t
three years. M e y e r and Rasche report a secular
rise in m o n e t a r y policy multipliers a n d an attendant shortening of t h e i m p a c t lag from t h e 1960s
to the mid-1970s.
Experiments using structural models show a
s o m e w h a t longer i m p a c t lag and m o r e extensive
c u m u l a t i v e lag in t h e effect of m o n e t a r y policy
than d o r e d u c e d - f o r m models. Interestingly, results for structural m o d e l s suggest a t r e n d t o w a r d
shorter lags a n d greater m o n e t a r y policy impacts
f r o m t h e early 1960s t o t h e later 1970s. W h e t h e r
this is attributable to t h e increased detail in
specification of t h e models' financial sectors,
w h i c h w o u l d i m p l y that earlier lag estimates
w e r e biased, or to a secular shortening of t h e lag,
is unclear. O n e result c o m m o n t o b o t h types of
model is the classic response profile: a reasonably
short initial lag, a p e a k i n g o f influence w i t h i n t w o
to five years, and a long tailing off over several
more years.
Little consensus exists on t h e exact profile of
m o n e y lags in structural models. Nonetheless,
t h e extensive research results d o not contradict
an assertion m a d e over 20 years ago: " t h e full
results of m o n e t a r y policy changes on t h e f l o w of
e x p e n d i t u r e s may be a long t i m e c o m i n g . . . but
some (initial) effect comes reasonably q u i c k l y
and builds u p over t i m e so that some substantial
stabilizing p o w e r results and remains after a
lapse of time. . .and t h e n dissipates." 2 5
Rational Expectations. A n e w a p p r o a c h to business cycle analysis, emphasizing t h e i m p o r t a n c e
of expectations, began t o d o m i n a t e t h e study of
m o n e t a r y policy effects in t h e mid-1970s. Since
then f e w studies have directly addressed t h e
issue of monetary policy lags. The controversy
over policy effectiveness and its a p p r o p r i a t e
scope and t i m i n g t o o k a n e w direction w i t h t h e
publication of a series of papers that established
the rational expectations literature. 26 This research
FEDERAL R E S E R V E BANK O F ATLANTA
has p r o f o u n d implications for t h e study of lags in
t h e effect of countercyclical policy.
Rational expectations applies t h e principle of
rational, optimizing behavior—which economists
have always assumed in t h e m i c r o e c o n o m i c
setting—to t h e acquisition and use of information
in the macroeconomic setting where stabilization
policy analysis is c o n d u c t e d . Together with the
a s s u m p t i o n of efficient markets, rational expectations forms t h e core of t h e n e w classical macroeconomics. This approach asserts that any attempt
to stabilize real activity in the short run is ineffective;
that is, it claims for t h e short run a neutrality
previously applied only to the long run. Minimally,
t h e n e w classical m a c r o e c o n o m i c s implies that
even if variations in m o n e t a r y g r o w t h have s o m e
effect on real o u t p u t a systematic policy designed
in such a setting w o u l d be untenable. Additionally,
t h e lag c o e f f i c i e n t s w o u l d c h a n g e , p e r h a p s
unpredictably, w i t h every change in policy. Moreover, if policy is neutral in its effects t h e n t h e
study of lags is pointless, for rather than real
consequences, only price effects w o u l d result from
policy changes. This reasoning d o m i n a t e d t h e
theoretical discussion of policy for several years
and s t i m u l a t e d considerable research into its
likely empirical implications.
In t h e last four or five years critics of t h e
neutrality proposition have s h o w n that, in t h e
presence of " m a r k e t imperfections," short-run
non-neutrality of m o n e y is consistent w i t h an
economy characterized by rational expectations.
These imperfections are formal a n d informal
institutional structures including overlapping
multi-year labor contracts, other arrangements
that limit price flexibility, investment that requires
time to build, and particular inventory strategies.27
Certainly, these studies have dismissed the initial
assertions of policy ineffectiveness. The institutional structures t h e y associate w i t h non-neutrality suggest that countercyclical policy may be
feasible, even in a rational expectations setting.
Consequently, lags c o n t i n u e t o be an i m p o r t a n t
concern for policymakers.
Recent Estimates. Recent estimates of lags are
quite short For example, M i l t o n Friedman (1984)
n o w maintains that m o n e y changes initially affect
o u t p u t after only six months. In other words, t h e
highest correlation of monetary growth and nominal
G N P g r o w t h occurs w h e n t h e latter is lagged t w o
quarters. Friedman also concludes that variability
29
V
1
is c o n s i d e r a b l y less t h a n p r o j e c t e d earlier, o n l y
a b o u t t h r e e t o n i n e m o n t h s . 2 8 H e associates
b o t h t h e s h o r t e n e d l e n g t h of t h e lag a n d t h e
decrease in variability f r o m late 1 9 7 9 t o late
1982 t o t h e unusually large f l u c t u a t i o n s in m o n e tary g r o w t h over t h a t period. " T h e effect," as he
puts it, " w a s to errhance t h e i m p o r t a n c e of t h e
m o n e t a r y changes relative t o t h e n u m e r o u s
other factors affecting nominal i n c o m e a n d thereby s p e e d u p a n d r e n d e r m o r e consistent t h e
reaction." 2 9
Results r e p o r t e d by Robert J. G o r d o n ( 1 9 8 1 ,
1 9 8 3 ) t e n d t o c o r r o b a t e this view. C o m p a r i n g of
cyclical peaks in t h e real m o n e y stock w i t h
p o l i c y actions d e s i g n e d t o stabilize t h e e c o n o m y
may actually e x a c e r b a t e t h e business cycle? A n y
conclusions a b o u t t h e significance of lags for
p o l i c y m u s t c o n f r o n t b o t h t h e d i f f e r e n c e s in
results across t h e literature a n d t h e i m p l i c a t i o n s
of t h e classic response profile, w h i c h is generally
c o m m o n t o nearly all t h e studies surveyed.
Policy Implications
W h a t stands o u t f r o m these results is that
w h i l e s o m e consensus exists o n t h e overall
p a t t e r n of lags in t h e e f f e c t of m o n e t a r y policy,
estimates of t h e lags' exact length a n d variability
f r o m cycle t o cycle d i f f e r considerably. T h e
p u r p o s e of research o n lags is t o d e t e r m i n e h o w
t h e y c o n s t r a i n t h e effectiveness of m o n e t a r y
policy. Can monetary policy stabilize G N P growth,
or is it so h a m s t r u n g by l o n g a n d variable lags that
Even a m o n g m o d e l s of a given type, especially
n o n l i n e a r m o d e l s , estimates of lag structures
vary w i t h t h e initial c o n d i t i o n s of t h e e s t i m a t i o n
period. 3 2 Such c o n d i t i o n s i n c l u d e t h e stage of
t h e business cycle over w h i c h t h e m o d e l is
e s t i m a t e d or forecast. A d d i t i o n a l l y , t h e specification of the policy instrument affects lag estimates.
In nonlinear m o d e l s , t h e m a g n i t u d e of t h e p o l i c y
change influences m e a s u r e d lags as well. Finally,
30
^
Lack of Consensus. T h e lack of consensus
regarding details of the lag pattern can be attributed
in part t o p r o b l e m s of i n t e r m o d e l c o m p a r i s o n s
o r t o possible systematic changes in l a g s o v e r t h e
history surveyed.
Intermodel Comparisons.Clearly,
t h e lack of
standardization hampers intermodel comparisons. 30 I n d e e d , m a n y " e s t a b l i s h e d " e c o n o m i c
relationships d o n o t stand u p u n d e r varying
specifications. 3 1
T h e largely m a t h e m a t i c a l d i f f e r e n c e s b e t w e e n
structural a n d r e d u c e d - f o r m m o d e l s d o n o t necessarily i n v o l v e d i f f e r e n t a s s u m p t i o n s a b o u t t h e
w a y t h e w o r l d works. Nevertheless, a spirited
d e b a t e has d e v e l o p e d o v e r t h e relative merits of
each for p o l i c y evaluation. Because the m o d e l
t y p e s have b e c o m e associated w i t h particular
views of p o l i c y effectiveness, t h e d e b a t e remains
vigorous. At t h e base of d i f f e r e n t assessments of
m o n e t a r y policy's role are disagreements a b o u t
t h e channels t h r o u g h w h i c h m o n e t a r y variables
operate. Thus, m o d e l s usually are specified b y
researchers w i t h strong prior beliefs a b o u t t h e
variety a n d i m p o r t a n c e of the channels of m o n e tary influence.
C o m p a r i s o n s of t h e results of r e d u c e d - f o r m
a n d structural m o d e l s are full of pitfalls. A f u r t h e r
c o m p l i c a t i o n is t h a t s o m e m o d e l s referred t o as
r e d u c e d - f o r m are actually in t h e final form. T h e
final form's e s t i m a t e d parameters are n o t s o l v e d
f r o m a structural m o d e l , as are those of t h e t r u e
r e d u c e d - f o r m m o d e l . By d e f i n i t i o n t h e final f o r m
is n o t m a t h e m a t i c a l l y e q u i v a l e n t t o t h e structural
form, a n d so w e should not e x p e c t their estimated
m u l t i p l i e r s a n d lags t o be c o m p a r a b l e .
s u b s e q u e n t peaks in c o i n c i d e n t e c o n o m i c indicators, C o r d o n reports an average lag of o n l y
t h r e e quarters, w i t h a range over five p o s t - W o r l d
W a r II cycles of six t o 12 quarters.
y.
N O V E M B E R 1985, E C O N O M I C R E V I E W
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t h e study of lags f r e q u e n t l y has b e e n hostage t o
t h e m o n e t a r y versus fiscal policy debate. That
controversy has been waged, t o a great extent,
through discussion of c u m u l a t i v e policy multipliers w h i c h yields little information on timing.
Systematic
Changes
in Lags over Time. T h e l a c k
of consensus on lags may, of course, reflect
changes in t h e lags over time. Some theories
suggest that t h e lags vary systematically w i t h
changes in m o n e y d e m a n d that are associated
w i t h t h e degree t o w h i c h financial markets are
deregulated, t h e interest sensitivity of t h e dem a n d for money, t h e extent t o w h i c h monetary
policy actions are anticipated, a n d t h e a m o u n t of
international currency substitution. 3 3 T h e 1970s
a n d 1980s may provide empirical e v i d e n c e t o
test these theories: these decades have witnessed
accelerated i n n o v a t i o n and deregulation of financial markets, historically high inflation, the
d e v e l o p m e n t of cash m a n a g e m e n t techniques
that help businesses (and households) react t o
actual a n d e x p e c t e d policy changes, and an
increase in international capital integration.
A stable relationship may underlie t h e t i m i n g
of t h e response of e c o n o m i c activity to m o n e t a r y
impulses, yet the relationship's complexity renders
it difficult or impossible t o specify completely.
N o n e of t h e m o d e l s reviewed has a t t e m p t e d t o
account entirely for d i f f e r e n t cycle phases, initial
conditions, policy instruments, and previous
monetary history, let alone deal w i t h p r o b l e m s of
i n t e r m o d e l comparisons. Also, w h i l e some theoretical models suggest a relationship b e t w e e n ,
for example, t h e interest elasticity of m o n e y
d e m a n d a n d the t i m i n g effects of policy, no
empirical studies have explored possible changes
in the lags d u r i n g or b e t w e e n periods of shifting
m o n e y demand. 3 4 In t h e late 1970s a n d 1980s,
economists paid considerable a t t e n t i o n t o respecifying formerly reliable m o n e y d e m a n d
equations ( w h i c h had begun t o break d o w n in
t h e m i d t o late 1970s). Research suggested that
w h e n interest rates reached n e w highs, t h e
interest elasticity of m o n e y d e m a n d increased. 3 5
Theoretical w o r k has shown that h e i g h t e n e d
interest sensitivity is associated w i t h a smaller
initial i m p a c t of m o n e y stock disturbances a n d a
lengthening of t h e e c o n o m y ' s a d j u s t m e n t t o
m o n e y supply changes. 36 In light of interest rate
history, this f i n d i n g suggests that lags should
have l e n g t h e n e d over that period; however, t h e
latest e v i d e n c e shows t h e y d i d not (Friedman,
[ 1 9 8 4 ] and C o r d o n , [1981]). But w i t h o u t a
FEDERAL RESERVE BANK O F ATLANTA
model that specifies the other possible systematic
influences o n lags, it is impossible t o sort o u t
their relative contributions.
The t i m i n g d e b a t e is no closer t o resolution
than before researchers launched t h e many
investigations surveyed here. Even so, w e have
learned several things. First t h e " l o n g " part of
" l o n g and variable" refers to t h e c u m u l a t i v e lag,
not t h e impact lag. Because t h e impact lag is
fairly short, some stabilizing countercyclical policy
effect can occur relatively quickly. Second, t h e
t e r m "variable" does not necessarily i m p l y t h e
p r e d o m i n a n c e of r a n d o m influences on lags.
Now, let us consider t h e m e a n i n g of t h e o n e
f i n d i n g that is fairly consistent w i t h d i f f e r e n t
specifications a n d initial conditions.
Implications of the Classic Response Profile.
The classic response profile of G N P t o changes
in monetary policy imposes some constraints o n
policymakers, and implies that policy actions
always carry some risk. The presence of lags
means that policy-makers must recognize t h e
likely and c o n t i n u i n g effects of past decisions o n
current and future e c o n o m i c conditions as well
as t h e consequences of current initiatives o n
future e c o n o m i c d e v e l o p m e n t s . This is not easy,
as it involves b o t h a m o v i n g target (the everchanging e c o n o m y ) and a tool w i t h d e l a y e d
effects.
At any point, t h e real o u t p u t effects of past
policy can be having an i m p a c t on e m p l o y m e n t ,
w h i l e t h e price-level effects of even earlier policy
may be influencing prices. Unless policy has
been relatively steady over several years, these
effects may be " w h i p s a w i n g " t h e e c o n o m y . For
instance, w e c o u l d experience high inflation at
t h e same t i m e w e see rising u n e m p l o y m e n t if a
strong expansionary policy, a l l o w e d t o b e c o m e
overly stimulative, w e r e f o l l o w e d by a severe
monetary contraction. A t such a juncture, policymakers w o u l d face t h e u n a p p e a l i n g choice of
raising monetary g r o w t h t o fight u n e m p l o y m e n t
d u r i n g a period of inflation or lowering it t o
c o u n t e r inflationary pressures d u r i n g a recession.
W h i l e policy can be changed quickly, t h e chain
of events c o n s e q u e n t t o p o l i c y a c t i o n s cannot be
reversed. Since past policies cannot be neutralized by s u b s e q u e n t countervailing strategies,
policymakers cannot start w i t h a clean slate
every time a decision is necessary. Unfortunately,
t h e p o l i c y m a k e r does not have t h e luxury of
declaring a n e w set of initial conditions each t i m e
31
policy is changed. In this setting, reacting to
current e c o n o m i c c o n d i t i o n s w i t h o u t reference
to past policy can be disastrous.
The response of t h e e c o n o m y t o monetary
expansion or contraction clearly is not random,
b u t t h e t i m i n g of t h e consequences is i n d e e d
p r o b l e m a t i c The research surveyed shows a
d i s a p p o i n t i n g lack of consistency in measuring
t h e t i m e lags f r o m m o n e t a r y impulses t o changes
in real GNP and inflation. These results indicate
substantial differences of o p i n i o n on timing. The
meaningful results are rather imprecise and t h e
precise results are easily challenged. Therefore,
m o n e t a r y authorities need to c o n d u c t policy
w i t h an awareness of t h e lags a n d a skepticism
regarding any specific claims about their duration.
Policymaking always proceeds a risky environment.
NOTES
'The short run refers to a period over one or more complete business
cycles, shorter than the period required for output and prices to adjust
completely to changes in monetary growth. The term is analytic, not
technical, and may refer to different lengths of times in different settings
2
Milton Friedman (1960), p98.
3
There is a separate controversy concerning the appropriate monetary
aggregate for measuring policy actions. This controversy was not
particularly intense before the accelerated financial innovation and
deregulation that began in the late 1 9 7 0 s
"In this paper, output GNP, and income are used interchangeably, to refer
to the level of overall economic activity on a national basis
5
For a taxonomy of the different lags, see Willes (1965) and Kareken and
Solow (1963).
6
Nonstochastic implies no uncertainty about the economic relationship
involved. A stochastic equation includes a term representing influences
that are unforeseen, although there may be some probability of their
occurring
'The following representation and interpretation follows from Mason
(1976).
"See Leonall C. Anderson, Jerry Jordan, and Keith Carlson, "A Monetarist
Model for Economic Stabilization," Review, Federal Reserve Bank of S t
Louis, vol. 5 2 (April 1970), pp. 7-25; Frank de Leeuw and Edward M.
Gramlich. "The Federal Reserve - MIT Econometric Model," Federal
Reserve Bulletin, vol. 54, (January 1968), pp. 11-40; and Moroney and
Mason (1971). More recently, there is Frederic S. Mishkin, "Does
Anticipated Money Matter? An Econometric Investigation," Journal ot
Political Economy, v o l 90 (February 1982), p p 22-51; and Robert J.
Gordon, "Price Inertia and Policy Ineffectiveness in the United States,
1890-1980," Journal of Political Economy, voL 9 0 (December 1982), pp
1087-1117.
' M i l t o n Friedmaa The Optimum Quantity ot Money and Other Essays
(Chicago: Aldine Publishing Co, 1969), p 186.
'"Friedman (1 960), p 95.
" S e e Culbertson (1960), Kareken and Solow (1963).
12
See, for example, Warburton (1971), especially p 121.
' 3 Culbertson (1960), p 621.
4
' Uselton (1974), p. 113.
' 5 Uselton (1974) covers 1952-1961 and Perryman (1980) covers 19531975, while Sprinkel(1959) and Warburton (1971) each consider sample
periods over 40 years long. The Friedman and Friedman and Schwartz
works contain cycle history covering over 90 years
'"This is especially true if structural is defined as invariant with respect to
policy changes
" A n d e r s o n and Jordan (1968), p. 22.
18
See, for example, Kareken and Solow (1963).
' 9 The proposition that the shorter the lags from money to output are, the
greater the scope for countercyclical monetary policy has been challenged by Howrey (1969). Later however, Fischer and Cooper (1978)
confirmed part of Friedman's conclusions In a theoretical work, they
showed how variability in lags could well bring discretionary monetary
policy to grief. On the other hand, long lags were shown to require more
activist monetary policy. Alternatively, Higgins(1982) discusses conditions
under which lags in the effect of policy are not an impediment to attaining
policy objectives.
20
Anderson and Karnosky (1972), p. 160.
32
21
Ibid., p 164.
"Ibid, p 161.
" U n a n t i c i p a t e d money is defined as that part of actual monetary growth
that is generally anticipated, and, thus can be expected to be offset or
neutralized, before any real effects occur. For a fuller explanation of this
concept, see Robert J. Barro "Unanticipated Money Growth and Unemployment in the United States," American Economic Review, vol. 67
(1977), pp. 101-15.
24
For example, see Thomas J. Sargent and Neil Wallace, "'Rational' Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply
Rule," Journal ot Political Economy, vol. 83 (1975), pp 241-54.
25
A Ando and others (1963), p. 2.
26
For a review of the literature and extensive discussions of policy
implications see Steven M. Sheffrin. Rational Expectation and Economic
Policy (Cambridge: Cambridge University Press, 1 983); Stanley Fischer,
ed. Rational Expectations and Economic Policy (Chicago: University of
Chicago Press for the National Bureau of Economic Research, 1980);
and Robert E Lucas and Thomas J. Sargent e d s Rational
Expectations
and Econometric Practice (Minneapolis: University of Minnesota Press,
1981).
" S e e , for example, Stanley Fischer, "Long-Term Contracts, Rational
Expectations, and the Optimal Money Supply Rule," Journal ot Political
Economy, vol. 85 (1977), pp. 191-205; Edmund S. Phelps and John B.
Taylor, "Stabilizing Powers of Monetary Policy Under Rational Expectations," Journal ot Political Economy, vol. 85 (1977), pp. 163-90; and Alan
S Blinderand Stanley S. Fischer, "Inventories Rational Expectations and
the Business Cycle," M.l.T Working Paper no. 220 (1978).
"Ironically, these are the same lags claimed by Culbertson in an early reply
to Friedman's long and variable finding. Friedman criticized Culbertson's
'casual' empiricism. See Friedman (1961), and Culbertson (1960) and
(1961).
" F r i e d m a n (May 1984), p. 399.
30
Fromm and Klein (1975), p. 396.
31
A number of "reliable" economic relationships are subject to the same
problem. The case of money demand has been taken up by Thomas F.
Cooley and Stephen F LeRoy in "Identification and Estimation of Money
Demand," American Economic Review, v o l 71 (December 1981), pp. 82544.
" S e e , for example, Fromm and Klein (1975), Meyer and Rasche(1980), and
Hanna (1975).
" S e e Jack Vernon, " M o n e y Demand Interest Elasticity and Monetary
Policy Effectiveness," Journal of Monetary Economics, vol. 3 (1977), p p
179-90, as well asTucker(1966), Smith(1972), Tanner(1979), Michael D.
Bordo and Ehsan U. Choudhri, "Currency Substitution and the Demand
for Money: Some Evidence for Canada" Journal of Money, Credit and
Banking, v o l 14(1982), pp. 48-57, and Sophocles N. Brissimis and John A
Leventakis, "Specification Tests of the Money Demand Function in an
Open Economy," The Review of Economics and Statistics, v o l 67 (1985),
pp. 482-89.
34
See Vernon, "Money Demand."
" S e e Flint Brayton, Terry Farr and Richard Porter, "Alternative Money
Demand Specifications and Recent Growth in M1," Staff Memorandum,
Board of Governors of the Federal Reserve System, May 23, 1983
" S e e Vernon, " M o n e y Demand."
N O V E M B E R 1985, E C O N O M I C
REVIEW
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Smith, Paul E."Lags in the Effects of Monetary Policy: Comment," American
Economic Review, vol. 6 2 (1972), p p 230-33.
Spencer, Roger W "Channels of Monetary Influence: A Survey," Review,
Federal Reserve Bank of St. Louis vol. 56 (November 1974), p p 8-26
Sprinkel, Beryl "Monetary Growth as a Cyclical Predictor," Journal of
Finance, vol. 14 (September 1959), pp 333-46.
Tanner, J. Ernest "Lags in the Effects of Monetary Policy: A Statistical
Investigation," American Economic Review, vol. 9 (December 1969),
pp. 794-805.
Tanner J. Ernest, " Are the Lags in the Effects of M o n e t a r y Policy
Variable?" Journal of Monetary Economics, vol. 5 (1979), pp 105-21
Tucker, Donald P. "Income Adjustment to Monetary Policy Changes."
American Economic Review, vol. 56 (June 1966), p p 433-50
Uselton, Gene C. Lags in the Effects of Monetary Policy A Nonparametric
Approach. New York: Marcel Dekker, 1974
Warburton, Clark. "Variability of the Lag in the Effect of Monetary Policy,
1919-1965," Western Economic Journal, vol. 9 (June 1971), p p 11533.
W h i t e William H. "The Flexibility of Anticyclical Monetary Policy," The
Review of Economics and Statistics, vol. 43 (May 1 961), p p 142-147
Willes, Mark H. "Lags in Monetary and Fiscal Policy," Business Review.
Federal Reserve Bank of Philadelphia (March 1968) pp. 3-10
33
Changing
Patterns:
Reshaping
the Southeastern
Textile-Apparel
Complex
David Avery and Gene D. Sullivan
Intense economic challenges, both in
the domestic and foreign arenas, are
taxing the U.S. textile industry's adaptability. The resourcefulness and flexibility
of domestic textile firms may determine
whether they will benefit from anticipated
growth in the world textiles markets
Recent e c o n o m i c d e v e l o p m e n t s have affected
t h e U.S. textile a n d apparel industry's workers,
e m p l o y m e n t p r o d u c t i o n location, e q u i p m e n t ,
and markets. O n e w i d e l y p u b l i c i z e d factor in t h e
i n d u s t r / s p r o b l e m s was t h e d o l l a r s rise in value
against foreign currencies, w h i c h l o w e r e d prices
of i m p o r t e d goods a n d raised prices of d o m e s t i c
exports. O t h e r influential forces i n c l u d e d t h e
increase in d o m e s t i c labor costs relative t o those
in most c o m p e t i n g countries; high real interest
rates that increased t h e capital spending needed
t o m o d e r n i z e d o m e s t i c manufacturing plants
and thus r e d u c e labor requirements; an expectation that d o m e s t i c market growth w o u l d remain
sluggish w h i l e w o r l d markets expand; and d u t y
assessments that encouraged U.S. manufacturers
t o transfer labor-intensive operations abroad
a n d e m p l o y low-cost foreign workers. These
e c o n o m i c forces are transforming the U.S. textile
and apparel industry just as earlier forces shifted
Avery is an economic
analyst
Sullivan a research
the Research
Department's
regional
economics
officer
team.
on
34 N O V E M B E R 1985, E C O N O M I C R E V I E W
Table 1. Textile Mill Products Employment
1950
Employment
(thousands)
1970
Employment
(thousands)
Absolute
Change
(thousands)
Percent
Change
North
Pennsylvania
Massachusetts
New York
Rhode Island
New Jersey
Connecticut
Total
135.1
118.0
98.4
62.7
58.2
33.6
506.0
62.5
32.8
53.7
18.4
29.6
13.0
210.0
- 72.6
- 85.2
- 44.7
- 44.3
- 28.6
- 20.6
-296.0
-53.7
-72.2
-45.4
-70.6
-49.1
-61.3
-59.0
South
North Carolina
South Carolina
Georgia
Alabama
Tennessee
Mississippi
Total
230.7
134.4
107.3
52.9
37.2
5.4
567.9
280.7
148.8
115.8
44.6
36.0
6.4
632.3
50.0
14.4
8.5
- 8.3
-1.2
1.0
64.4
21.7
10.7
7.9
-15.7
- 3.2
18.5
11.3
Source: U.S. Department of Labor. Bureau of Labor Statistica
and Earnings, States and Areas, 1939-1982.
Table 2. Textile/Apparel Employment by Major Sector, 1982
Textile
Region
Percent of U.S.
Weaving
Mills
188,454
77.2
Knitting
Mills
114,523
56.6
Yarn,
Thread
Mills
95,446
84.2
Floor
Covering
31,517
72.6
Finishing
Plants
26,831
46.4
Apparel
Region
Percent of U.S.
Men's Boys
Furnishings
146,222
47.8
Women's
Misses'
Outerwear
87,397
21.6
Children's
Outerwear
28,558
43.8
Miscellaneous
Apparel
13,268
25.2
Miscellaneous
Fabricated
Textile Products
45,151
25.9
Source: County Business Patterns, U.S. Department of Commerce, Bureau of the Census, various issues
t h e i n d u s t r y f r o m t h e N o r t h e a s t t o t h e Southeast
d u r i n g t h e past century. 1
In t h e early 1900s, t h e t e x t i l e i n d u s t r y began
m o v i n g s o u t h w a r d in search of r e d u c e d labor
costs a n d less i n t e n s e u n i o n activity. A l t h o u g h by
1 9 5 0 t e x t i l e e m p l o y m e n t was already larger in
t h e s o u t h e r n states t h a n in t h e N o r t h , e m p l o y m e n t t r e n d s f r o m 1 9 5 0 t o 1 9 7 0 clearly illustrate
t h e i n d u s t r / s shift t o t h e Southeast, as nearly 6 0
p e r c e n t of all t e x t i l e j o b s in t h e N o r t h e a s t ' s six
major t e x t i l e - p r o d u c i n g states d i s a p p e a r e d
(see T a b l e 1). Massachusetts was especially
F E D E R A L R E S E R V E B A N K O F ATLANTA
hard-hit, losing o v e r 70 p e r c e n t of its t e x t i l e
e m p l o y m e n t , or 8 5 , 0 0 0 j o b s . In c o n t r a s t N o r t h
Carolina, w h i c h g r e w i n t o t h e l e a d i n g textilep r o d u c i n g state, p i c k e d u p 5 0 , 0 0 0 t e x t i l e j o b s
f r o m 1 9 5 0 t o 1 9 7 0 a n d a c c o u n t e d for t h e b u l k of
t h e increase in t h e Southeast.
Today, t h e s o u t h e a s t e r n region a c c o u n t s f o r
over 70 p e r c e n t of all e m p l o y m e n t in t h e nation's
weaving, yarn a n d thread, a n d carpet mills
(see T a b l e 2). E m p l o y m e n t in s o u t h e a s t e r n
k n i t t i n g mills a n d f i n i s h i n g plants a c c o u n t s for
a b o u t half of t h e n a t i o n a l total. In t h e a p p a r e l
35
contrast, total n o n f a r m e m p l o y m e n t grew by
over 27 percent d u r i n g t h e same 1 5 year period.
T a b l e 3. S o u t h e a s t T e x t i l e / A p p a r e l S h a r e of Total
Nonfarm Employment
Textile
South
Alabama
Florida
Georgia
Mississippi
N o r t h Carolina
S o u t h Carolina
1970
1980
4.5
N/A
7.4
3.2
1985
1970
2.7
0.1
4.1
0.1
8.2
8.6
1.4
4.5
1.1
4.5
6.7
4.2
5.2
Apparel
1980 1985
4.0
3.7
0.8
1.0
0.1
3.3
2.9
5.5
4.9
4.5
0.8
1.0
3.7
3.3
10.3
15.8
3.9
3.8
11.5
17.7
3.7
3.9
2.7
1.5
5.0
Tennessee
2.7
4.4
3.9
3.1
6.8
3.3
Total
Source: Federal Reserve Bank of Atlanta, computed from U.S. Department
of Labor, Bureau of Labor statistics data
sector, t h e region specializes in men's and boys'
furnishings and children's outerwear, each w i t h
a b o u t 45 percent of t h e U n i t e d States' o u t p u t
E m p l o y m e n t in regional firms manufacturing
w o m e n ' s and misses' outerwear, miscellaneous
apparel, and miscellaneous textile products, such
as nonwovens, tire cord, a n d upholstery filling,
makes up a b o u t 25 percent of t h e national total.
Shrinking Employment
But textile e m p l o y m e n t in t h e Southeast has
changed direction again d u r i n g t h e past decade,
in a way that could reshape southeastern e m p l o y
ment. Since 1 9 8 0 more t h a n 60,000 industry
jobs have been lost in N o r t h Carolina and South
Carolina, t h e t w o leading textile states. C o m b i n e d
w i t h t h e apparel industry, textiles firms e m p l o y
m o r e p e o p l e than any other industry in Alabama,
Georgia, Mississippi, a n d t h e Carolinas. Even so,
t h e industry's d o m i n a n c e has been shrinking in
t h e Southeast Since 1970, textile e m p l o y m e n t
as a share of total n o n f a r m e m p l o y m e n t has
s l i p p e d in every major southeastern textile-prod u c i n g state (see Table 3). For t h e region, textile
e m p l o y m e n t ' s share fell by m o r e than half f r o m
1 9 7 0 t o 1985, n o w a c c o u n t i n g for just 3.3
percent of all nonfarm e m p l o y m e n t T h e apparel
sector registered a less severe decline b u t had
shrunk t o 2.7 percent of regional n o n f a r m employment by 1985. In absolute terms, the region's
textile employment contracted by 155,000 workers
or by 25 percent, f r o m 1 9 7 0 t o 1985. AppareJ
e m p l o y m e n t grew by 31,000 workers, or by 8.7
percent, f r o m 1 9 7 0 t o 1985; b u t t h e industry lost
16,200 jobs, o r 4 percent, f r o m 1 9 8 0 t o 1985. By
36
Shifting Employment Sectors
W i t h its 206,000 textile workers, North Carolina
remains t h e industry's largest e m p l o y e r despite
recent cutbacks. For t h e first half of 1 9 8 5 , t h e
state's u n e m p l o y m e n t rates have hovered around
t h e 5 t o 6 percent range, suggesting that t h e
e c o n o m y is rapidly absorbing displaced mill
workers. N o t w i t h s t a n d i n g N o r t h Carolina's loss
of 16,500 textile j o b s a n d 4 , 5 0 0 apparel j o b s
f r o m June, 1984 t o June, 1 9 8 5 , t h e n u m b e r of
u n e m p l o y e d w o r k e r s a c t u a l l y fell b y nearly
21,000 over that period. In South Carolina,
w h e r e u n e m p l o y m e n t rates also rank b e l o w t h e
national average, t h e pattern is similar 10,400
textile jobs and 3,600 apparel j o b s w e r e lost
statewide over t h e year, w h i l e t h e total n u m b e r
of u n e m p l o y e d workers d i p p e d by nearly 7,000.
Over t h e same p e r i o d each of t h e t w o states
posted gains in construction and service e m p l o y m e n t totaling a b o u t 32,000 and a lift in trade
e m p l o y m e n t of above 22,000. The pattern is
similar for the other regional states except Alabama
as b u r g e o n i n g e m p l o y m e n t increases in t h e
trade, construction, and services sectors more
than offset negative figures registered by apparel
a n d textile firms (see Table 4).
The bankers w e c o n t a c t e d in small t o w n s
w h e r e a large mill closed said that many f o r m e r
textile e m p l o y e e s have been o f f e r e d j o b s in
other plants o w n e d by t h e same company. T h e y
a d d e d that other f o r m e r mill workers f o u n d
e m p l o y m e n t near their h o m e t o w n s .
U n l i k e a u t o or steel workers, low-wage textile
workers s e l d o m lose m u c h i n c o m e w h e n t h e y
shift t o another job. Their communities, however,
are likely t o suffer. Textile mills usually are
located in or near small t o w n s w h e r e alternate
employment opportunities are limited. Low-skilled
workers o f t e n must seek n e w j o b s in larger
m e t r o p o l i t a n areas. Since most of t h e displaced
workers have t o m o v e elsewhere t o f i n d work, it
c o m p o u n d s t h e mill c o m m u n i t y ' s e c o n o m i c loss
t h r o u g h a d r o p in business activity. It is little
comfort to a c o m m u n i t y that such an outmigration
o f t e n removes p e o p l e f r o m its p u b l i c assistance
rolls. 2
Former managerial e m p l o y e e s in particular
can have difficulty locating n e w j o b s nearby,
s o m e t i m e s being f o r c e d t o relocate. ProductionN O V E M B E R 1985, E C O N O M I C R E V I E W
Table 4. Employment Change by Sector, Regional States (thousands of employees)
Textile
Apparel
Trade
Construction
Service
Alabama
June 1984
June 1985
Absolute change
Percent change
40.2
36.5
-3.7
-9.2
58.3
49.9
-8.4
-14.4
291.3
294.6
3.3
1.1
66.8
67.1
0.3
0.5
229.6
232.6
3
1.3
Florida
June 1984
June 1985
Absolute Change
Percent Change
N/A
N/A
N/A
N/A
34.1
33.9
-0.2
-0.6
1107.2
11 66.7
59.5
5.4
321.1
331.8
10.7
3.3
1068.3
1144.9
76.6
7.2
Georgia
June 1984
June 1985
Absolute Change
Percent Change
106.8
99.7
-7.1
-6.7
75.8
72.5
-3.3
-4.4
600.4
671
70.6
11.8
133.4
152
18.6
13.9
441.3
485.4
44.1
10.0
Mississippi
June 1984
June 1985
Absolute change
Percent change
6.1
6
-0.1
-1.6
39.8
37.2
2.6
-6.5
176.1
185.6
9.5
5.4
39.7
41.2
1.5
3.8
124.3
127
2.7
2.2
North Carolina
June 1984
June 1985
Absolute change
Percent change
222.2
205.7
-16.5
-7.4
93.4
88.9
-4.5
-4.8
549.4
571.6
22.2
4.0
136.2
149.1
12.9
9.5
399.9
421.8
21.9
5.5
South Carolina
June 1984
June 1985
Absolute change
Percent change
114.2
103.8
-10.4
-9.1
50.2
46.6
-3.6
-7.2
264.8
289
24.2
9.1
84.3
90.1
5.8
6.9
198.6
224.7
26.1
13.1
Tennessee
June 1984
June 1985
Absolute change
Percent change
26.1
23.4
-2.7
-10.3
70.9
65.7
-5.2
-7.3
415.7
446.9
31.2
7.5
82.4
78.7
-3.7
-4.5
348.1
364.4
16.3
4.7
Region
June 1984
June 1985
Absolute change
Percent change
515.6
475.1
-40.5
-7.9
422.5
394.7
-27.8
-6.6
3404.9
3625.4
220.5
6.5
863.9
910
46.1
5.3
2810.1
3000.8
190.7
6.8
Source: Department of Labor for each regional state.
o r i e n t e d firms a p p e a r m o r e likely t o hire l o w e r
level e m p l o y e e s because such w o r k e r s are relat i v e l y l o w - p a i d a n d s e e m t o a d a p t m o r e readily
t o n e w j o b s t h a n d o managers w h o s e d i f f e r e n t
policies can cause conflicts.
F E D E R A L R E S E R V E B A N K O F ATLANTA
Employment
C e r t a i n characteristics of t e x t i l e a n d a p p a r e l
w o r k e r s set t h e m apart f r o m t h e t y p i c a l m a n u f a c t u r i n g e m p l o y e e (see T a b l e 5). W o m e n w h o
37
Table 5. Selected Characteristics of Employees
in the Apparel and Textile Industries
High School
Graduates
(percent)
Female
Male
Median Age
Manufacturing
Textile Mill Products
Apparel and Other
Finished Textile Products
Source: U.S. Department of Commerce, 1980 Census of
O n e favorable trend for onshore manufacturing,
however, has b e e n t h e reduced p r o p o r t i o n of
p r o d u c t i o n workers in t h e textile a n d apparel
industries. In 1975, managers, professionals, a n d
technical workers c o n s t i t u t e d o n l y 11 percent of
t h e textile w o r k force and 8 percent of apparel
workers. In 1985 t h e n u m b e r s rose t o 15 percent
and 12 percent, respectively, reflecting rapid
change in t h e m a k e u p of t h e mills' w o r k force.
C o n c u r r e n t l y w i t h that reshaping of t h e payroll,
automated equipment has been replacing human
operators. A u t o m a t i o n obviously reduces labor
costs, b u t it complicates managerial responsibilities and may increase t h e risk of loss. As
capital investment per employee increases, equipment d o w n t i m e becomes more costly. Operators
must m o n i t o r machines m o r e closely, for an error
Female
37.1
36.8
35.9
37.6
71.6
50.6
66.3
48.3
37.2
38.7
58.1
46.9
Population.
work in textile (and especially apparel) industries
have a somewhat higher median age than w o m e n
w h o work in manufacturing generally. Differences
in educational levels are far greater. W h i l e nearly
70 percent of all manufacturing workers have
earned high school diplomas, o n l y a b o u t half of
textile and apparel workers are high school
graduates. T w e n t y - f i v e percent of t h e total labor
force 25 t o 64 years of age is n o w m a d e up of
college graduates. T h e c o m p a r a b l e p o r t i o n 10
years ago was only 18 p e r c e n t Because of t h e
rapidly rising educational levels, young j o b seekers
p r o b a b l y will n o t be satisfied w i t h typical operatives' wages, traditionally k e p t low by intense
c o m p e t i t i o n . Manufacturers in search of lowcost labor thus are given increased incentive t o
set up offshore operations to exploit lower wages.
38
Male
can shut d o w n an entire production line D e m a n d
for textile school graduates, therefore, increasingly
intensifies as c o m p a n i e s bring more sophisticated e q u i p m e n t i n t o their plants. 3
Changes in the Mill
Diverse technological changes are taking place
in t h e textile/apparel industry. Changes i n c l u d e
t h e installation of faster, more efficient machines,
advanced auxiliary equipment for machine cleaning
or materials handling, and c o m p u t e r s for data
processing a n d finishing. 4 In some cases a n e w
plant must be c o n s t r u c t e d to integrate t h e w h o l e
process, since in o l d e r mills w o r k typically was
passed t h r o u g h several rooms located o n different floors. N e w mills have only o n e floor, w i t h
machines arranged to m i n i m i z e t h e potentially
significant costs of m o v i n g materials f r o m o n e
o p e r a t i o n t o t h e next.
Production m e t h o d s have i m p r o v e d significantly over t h e last d e c a d e w i t h t h e i n t r o d u c t i o n
of high technology, such as robotics and computera i d e d design and manufacturing. Manufacturers
have m a d e large capital e x p e n d i t u r e s in m o d e r n
machinery t o enhance productivity and competitiveness. Textile and apparel industries increased
their capital outlays more t h a n 28 percent last
year t o $1.78 billion, following a small 4.2 percent
rise in 1983. Outlays w e r e constant at a lower
level in 1981 a n d 1982. 5 By t h e e n d of t h e
current decade, according t o some, estimates,
N O V E M B E R 1985, E C O N O M I C
REVIEW
mills m a y r e q u i r e o n e - t h i r d f e w e r w o r k e r s t h a n
t h e y d i d in t h e 1970s. 6
A l t h o u g h i m p r o v e d t e c h n o l o g y has increased
p r o d u c t i v i t y in t h e U.S. a p p a r e l industry, t h e
i m p r o v e m e n t has n o t c l o s e d t h e price gap sufficiently b e t w e e n d o m e s t i c a n d foreign producers.
Apparel manufacturing still involves many manual
operations. T h e s e w i n g r o o m remains highly
labor intensive, w i t h m o s t e m p l o y e e t i m e s p e n t
positioning a n d handling piece goods. The typical
single-needle shirt p r o d u c e d in t h e U n i t e d States
still requires 1 4 t o 16 m i n u t e s of d i r e c t labor. T h e
i n d u s t r / s t r a d i t i o n a l s t r u c t u r e of a large n u m b e r
of small p r o d u c e r s limits t h e use of capitali n t e n s i v e p r o d u c t i o n m e t h o d s because of ina d e q u a t e capital. Limitations have f o r c e d firms
t o r e s p o n d t o i m p o r t c o m p e t i t i o n by t u r n i n g t o
o f f s h o r e facilities w h i l e r e d u c i n g t h e o u t p u t of
d o m e s t i c plants. A high p r o p o r t i o n of a p p a r e l is
n o w p r o d u c e d in l o w - w a g e c o u n t r i e s either by
A m e r i c a n - o w n e d plants or A m e r i c a n - s e l e c t e d
contractors.
U.S. firms also are using o f f s h o r e processing
u n d e r I t e m 8 0 7 of t h e U.S. tariff c o d e t o increase
c o m p e t i t i v e n e s s . This s t i p u l a t i o n p e r m i t s domestically cut m a t e r i a l t o b e s h i p p e d for s e w i n g
t o c o u n t r i e s w i t h l o w e r labor costs, t h e n rei m p o r t e d . D u t y is p a i d o n l y o n t h e v a l u e - a d d e d
p o r t i o n of t h e c o m m o d i t y , a n d t h a t v a l u e is
m o d e s t because of t h e l o w - c o s t foreign labor
used in t h e s e w i n g o p e r a t i o n . S o m e c o m p a n i e s
are c u t t i n g back t h e i r o w n d o m e s t i c p r o d u c t i o n
and are c o n c e n t r a t i n g o n m a r k e t i n g a p p a r e l
p u r c h a s e d f r o m others. Therefore, m a r k e t i n g has
t a k e n o n a d d e d significance in r e c e n t years.
Demise of Domestic Firms
As a w h o l e , t h e t e x t i l e i n d u s t r y is " m a t u r e " in
t h a t its d o m e s t i c g r o w t h p o t e n t i a l is l i m i t e d .
From 1 9 7 2 t o 1 9 8 3 , m i l l s h i p m e n t s a d v a n c e d at
a c o m p o u n d a n n u a l rate of o n l y 0.3 percent,
expressed in 1 9 7 2 dollars. D u r i n g t h a t span,
m a n y mills s t o p p e d serving markets t h a t o f f e r e d
little or no p o t e n t i a l for g r o w t h . A l t h o u g h t h e
d o m e s t i c t e x t i l e i n d u s t r y has b e c o m e highly
e f f i c i e n t a n d p r o d u c t i v e , particularly in labor
p r o d u c t i v i t y , cost factors regarding labor a n d
g o v e r n m e n t regulation a n d o u t s i d e e c o n o m i c
forces are r e q u i r i n g changes. For e x a m p l e , t h e
e x p e c t a t i o n t h a t t h e dollar's v a l u e w i l l r e m a i n
high a n d t h a t foreign labor costs w i l l r e m a i n
l o w e r t h a n U.S. costs has e n c o u r a g e d s o m e
F E D E R A L R E S E R V E B A N K O F ATLANTA
Chart 1. Average Hourly Compensation, 1982
Dollars
10 r
Apparel
Textile
0
U.S.
Hong
K o n
ml
Korea Taiwan Japan United Sweden
9
Italy
Kingdom
Source: Bureau of Labor Statistics U.& Department of Labor, Office of
Productivity and Technology.
d o m e s t i c c o m p a n i e s t o shift p r o d u c t i o n a b r o a d
or t o purchase fabrics f r o m foreign suppliers.
These same forces are discouraging U.S. exporters
f r o m c o m p e t i n g in foreign markets. The relatively
high v a l u e of t h e d o l l a r makes f o r e i g n g o o d s
cheaper, since d u r i n g t h e past five years t h e
dollar has exchanged for an ever-growing v o l u m e
of foreign currency. T h e d o l l a r s strength correlates closely w i t h fabric e x p o r t s a n d imports.
T h e a t t r i t i o n of t h e U.S. a p p a r e l i n d u s t r y is d u e
partly t o its highly c o m p e t i t i v e e n v i r o n m e n t a n d
t h e a b u n d a n c e of small firms. Recent surges in
i m p o r t c o m p e t i t i o n have d e p r e s s e d p r o f i t margins a n d h a s t e n e d t h e d e p a r t u r e of firms w i t h
scant financial reserves a n d l i m i t e d m e a n s t o
a d o p t c o s t - r e d u c i n g or m a r k e t - e n h a n c i n g technology. Changes of season a n d style necessitate
a d j u s t m e n t s in p r o d u c t i o n t h a t can b e especially
risky for small firms. I n a d d i t i o n , just as f i r m s m a y
e n t e r t h e i n d u s t r y easily w h e n c o n d i t i o n s are
good, t h e y m a y e x i t r a p i d l y d u r i n g p e r i o d s of
s t r o n g c o m p e t i t i v e pressure.
Low labor costs have b e e n t h e key t o f o r e i g n
firms' e f f e c t i v e p e n e t r a t i o n of U.S. m a r k e t s . D o m e s t i c retailers f i n d t h e y can c a p t u r e larger p r o f i t
margins by p u r c h a s i n g l o w - c o s t foreign g o o d s
rather t h a n t h e typically m o r e expensive d o m e s t i c
goods. This is especially t r u e in price-sensitive
lines a n d staple items. In r e c e n t years, wages in
major Far East e x p o r t i n g countries have increased
m o r e r a p i d l y t h a n in t h e U n i t e d States, b u t t h e
39
BOX
Although the Southeast has more apparel establishments, the region's textile sector employs about 35
percent more workers and generates about twice the
annual apparel payroll. Georgia, South Carolina and
North Carolina account for over 85 percent of the
region's textile employment (see Chart 3). By contrast
apparel employment is much more dispersed, with each
regional state accounting for no more than 22 percent
of the region's total apparel employment (see Chart 3).
Textile and apparel employment is concentrated in
east-central Alabama northwestern Georgia, northwestern South Carolina and central North Carolina
(see map). Over 80 percent of the counties in each
regional state except Florida produce textiles, apparel,
or both. About half of Florida's counties produce apparel
or textiles
Chart 2. Textile Employment by State, June 1985
Chart 3. Apparel Employment by State, June 1985
(Thousands)
(Thousands)
Georgia
Florida
72.5
North Carolina
33.9
205.7
/
Alabama
/
/
\ ^
4
9
9
Alabama
36.5
Tennessee
North
1
Carolina—1
88.9
1
V
y r
23.4
Florida &
Mississippi
8.2
\
y
Tennessee
657
South Carolina
103.8
S o u t h Carolina
46.6
Mississippi
37.2
Source: Federal Reserve Bank of Atlanta
Source: Federal Reserve Bank of Atlanta
strength of t h e d o l l a r has o f f s e t t h e e f f e c t of w a g e
a d j u s t m e n t s . 7 T h e average h o u r l y c o m p e n s a t i o n
for w o r k e r s in t h e major textile/apparel p r o d u c i n g
c o u n t r i e s clearly illustrates t h e d i s p a r i t y of c o m pensation levels (see Chart 1). W h i l e U.S. apparel
w o r k e r s earn $6.52 per h o u r o n average, their
c o u n t e r p a r t s in T a i w a n a n d Korea earn $1.43
a n d $1.00, respectively. C h i n e s e w o r k e r s earn,
a b o u t 2 6 cents an hour, w h i c h suggests w h y
A m e r i c a n m a n u f a c t u r e r s are so a p p r e h e n s i v e
a b o u t u n r e s t r a i n e d i m p o r t s f r o m t h a t nation. 8
40
Foreign f i r m s e n j o y a d d i t i o n a l c o m p a r a t i v e
strength b e c a u s e t h e a p p a r e l s e g m e n t of t h e
t e x t i l e c o m p l e x is by f a r t h e m o s t labor-intensive,
a n d foreign p r o d u c e r s ' labor cost advantages are
c o n s i d e r a b l y m o r e p r o n o u n c e d . Furthermore,
t h e e n t r y r e q u i r e m e n t s for capital e q u i p m e n t
a n d t e c h n i c a l k n o w l e d g e are significantly less
stringent for apparel than for textile manufacturers.
A n d , because f o r e i g n e f f i c i e n c y has i m p r o v e d as
firms a d v a n c e d a l o n g t h e l e a r n i n g curve, foreign
c o m p e t i t o r s are s h i f t i n g p r o d u c t i o n f r o m lowN O V E M B E R 1985, E C O N O M I C R E V I E W
Textile a n d Apparel E m p l o y m e n t
By C o u n t y - 1 9 8 2
= 5 0 0 or L e s s
|
B
I = 501 - 5,000
l
= Greater than 5,000
Source: County Business Patterns, U.S. Department of Commerce, Bureau of the Census
priced standard apparel t o newer, more sophisticated products. The results have been predictable:
imports d o u b l e d their 15 percent share of t h e
domestic apparel business in 1973 t o 30 percent
in 1983.
Imports of textiles and apparel for 1984 reached
a record level, up 32 percent f r o m t h e previous
high a year earlier. The 1984 textile a n d apparel
trade deficit of $16 billion also hit a n e w high, 52
percent above 1983's previous record of $10.5
billion. Historically, exports have been i m p o r t a n t
F E D E R A L R E S E R V E B A N K O F ATLANTA
for d o m e s t i c textile producers, and t h e r e f o r e
comparative dollar valuations are significant. The
less capital-intensive apparel industry has been
affected more severely by comparative labor
costs. U.S. apparel exports have n o t s h o w n as
great a d o w n t u r n as have textiles, but imports
have surged (see Chart 2).
Textiles and apparel a c c o u n t e d for 13 percent
of t h e nation's overall trade deficit in 1984, as
imports c o n t i n u e d t o erode t h e c o m p e t i t i v e
position of the U.S. industry. Table 6 shows a
41
T a b l e 6 . P e r c e n t C h a n g e in Profits at M a j o r S o u t h e a s t e r n
Textile C o m p a n i e s ,
First Half 1 9 8 4 to First Half 1 9 8 5
Rank
1
2
3
4
5
Company
State
B u r l i n g t o n I n d u s t r i e s N o r t h Carolina
West P o i n t - P e p p e r e l l G e o r g i a
Springs Industries
S o u t h Carolina
Oxford Industries
Georgia
Shaw Industries
Georgia
Percent Change
-81
-58
-73
-91
-3
Source: Business Week, "Corporate Scoreboard"
Imports f r o m these countries c o n t i n u e growing,
along w i t h rising imports from several European
nations such as the U n i t e d K i n g d o m a n d Italy,
and others n o t c o v e r e d by quotas (see Table 7).
In contrast w i t h t h e typically large foreign
firms, domestic firms historically have been small,
f a m i l y - o w n e d businesses w i t h managers more
p r o d u c t i o n - o r i e n t e d t h a n marketing-oriented. 1 0
The dispersion a m o n g i n d e p e n d e n t companies
of separate steps in t h e manufacturing process
has t e n d e d t o k e e p all b u t t h e largest vertically
integrated mills f r o m direct contact w i t h t h e
market. U.S. producers o f t e n focus o n t h e domestic market because of its size and t h e enhanced costs and risks of exporting. This is
especially significant because per capita domestic
c o n s u m p t i o n is e x p e c t e d t o grow only 1 percent
annually. M o s t foreign firms, o n t h e other hand,
must concentrate on exports because of their
small d o m e s t i c markets. Foreign producers freq u e n t l y rely o n t h e expertise of international
trading companies for assistance in establishing
contacts, securing financing, a n d i d e n t i f y i n g market opportunities.
bleak profit picture for major southeastern textile c o m p a n i e s c o m p a r e d w i t h a year ago. Profit
reductions of 58 percent or more for t h e t o p four
c o m p a n i e s indicate t h e pressures imports are
placing o n t h e d o m e s t i c industry. 9
Market Problems
M a j o r foreign suppliers of textiles a n d apparel
t o U.S. markets are Taiwan, South Korea, H o n g
Kong, China, a n d Japan, all of w h i c h have signed
bilateral trade agreements w i t h this country.
42
Typical of t h e m o r e aggressive foreign producers is South Korea's t e x t i l e / a p p a r e l industry,
a w o r l d leader t h a t operates primarily as an
export industry—earning a b o u t o n e - t h i r d of that
country's foreign exchange. 1 1 The industry (in
contrast t o most d o m e s t i c producers) is virtually
self-sufficient, being vertically structured f r o m
petrochemical production through apparel manufacturing. Taiwan and H o n g Kong also o w e a
large share of their foreign exchange earnings t o
the textile industry. C h i n a reportedly unhampered
by e n v i r o n m e n t a l standards for clean air and
water, has a c o m p e t i t i v e advantage in manufacturing cotton textiles and apparel. The country's
cotton complex (from growing cotton to producing
N O V E M B E R 1985, E C O N O M I C R E V I E W
Table 7. Growth of Textile and Apparel Exports to t h e United States
by Leading Exporting Countries
(Value in Millions of Dollars)
Textiles
1982
1983
1984
Percent Change
1982-1984
Japan
China
Taiwan
Italy
United Kingdom
Brazil
528
238
199
235
115
78
582
249
246
251
130
103
641
391
336
419
180
157
21.4
64.3
68.8
78.3
56.5
101.3
Apparel
1982
1983
1984
Percent Change
1982-1984
Hong Kong
Taiwan
Korea
Italy
Mexico
France
1983
1523
1394
207
176
91
2246
1756
1597
268
189
106
2963
2269
2253
552
257
167
49.4
49.0
61.6
166.7
46.0
83.5
Source: U.S. Department of Commerce, " U S General Imports, World Area and Country of Origin by Commodity Groupings," Various Issues
*The Price Actually Paid or Payable for Merchandise When Sold for Exportation to the Unites States Excluding U S Import Duties, Freight, Insurance,
and Other Charges Incurred in Bringing the Merchandise to the United States.
f i n i s h e d garments) e m p l o y s o v e r 2 0 0 m i l l i o n
p e o p l e 1 2 Nations such as China that are attempting to e x p a n d their manufacturing sectors f i n d
t h e y can i n t r o d u c e textile p r o d u c t i o n easily t o a
newly industrialized w o r k force.
The recent g r o w t h in imports of selected
commodities important to the Southeast is dramatized by Table 8. I m p o r t e d products f r o m c o t t o n
w e a v i n g mills increased by over 75 percent from
1983 t o 1984, and i m p o r t e d men's a n d boys'
suits and coats grew by m o r e than o n e - t h i r d over
t h e period.
Slow Growth Ahead
The long-term o u t l o o k for t h e textile/apparel
industry is for slow growth. Textile e m p l o y m e n t
levels may c o n t i n u e t o contract, as a u t o m a t e d
e q u i p m e n t is substituted for low-skilled workers.
W e l l - f i n a n c e d c o m p a n i e s will hurry t o a d o p t
new t e c h n o l o g y t o increase productivity. M o r e
mergers are likely, since c o n c e n t r a t i o n will prov i d e finances t o m o d e r n i z e e q u i p m e n t and f o r m
F E D E R A L R E S E R V E B A N K O F ATLANTA
more innovative m a n a g e m e n t a n d m a r k e t i n g
teams. W o r k e r s necessarily will b e c o m e m o r e
skilled to operate increasingly sophisticated equipment, and, as a result, wages eventually w i l l
c o m p a r e m o r e f a v o r a b l y w i t h o t h e r manuf a c t u r i n g sectors. Professional a n d t e c h n i c a l
workers will c o m p r i s e a greater share of t h e
textile workforce. At t h e same t i m e , larger companies also are likely t o turn to offshore production
f o r a greater share of p r o d u c t mix, c o n t r i b u t i n g to
shrinking d o m e s t i c textile j o b rolls.
Over t h e longer term, if t h e dollar reaches
m o r e favorable exchange rates against foreign
currencies, t h e U n i t e d States may be able t o sell
m o r e of its p r o d u c t s in e x p o r t markets a r o u n d
t h e world. M á n y emerging nations will require
more textiles for their o w n populations; t h e
d o m e s t i c industry's e x p o r t potential c o u l d expand significantly. Yet organizations that lack t h e
resources to i m p r o v e manufacturing productivity
and marketing may f i n d themselves unable t o
c o m p e t e . M a n y small, inflexible firms fit this
category. W i t h o u t major changes t h e y are likely
t o face e x t i n c t i o n over t h e longer term. Thus,
43
Table 8. Value of U.S. Textile Imports: Selected
Leading Items
(millions of dollars)
Percent Change
1982-1983
1983-1984
1982
1983
1984 1
Men's and Boy's Suits
and Coats (SIC 2311)
613
660
888
7.6
34.5
Weaving Mills Cotton (SIC 2211)
475
559
979
17.8
75.1
Weaving Mills Manmade Fibers (SIC 2221
655
733
953
12.0
30.0
estimated
Source: U. S. Department of Commerce: Bureau of Census, Bureau of Economic Analysis, and International Trade Administration.
d e s p i t e g r o w i n g w o r l d markets, t h e o u t l o o k for
the domestic textile and apparel industry appears
t o i n c l u d e a sharp r e d u c t i o n in t h e n u m b e r of
individual companies and low-skilled employees
in an e n v i r o n m e n t of t o u g h e n i n g international
competition.
NOTES
'For this study, the Southeast includes Alabama Florida Georgia
Mississippi, North Carolina South Carolina and Tennessee.
See G. Glenday and G. P Jenkins, "Industrial Dislocation and the
Private Cost of Labor Adjustment" Contemporary Policy Issues, no. 4
(January 1984), p. 23, for further discussion of this issue.
3
S Killman, "To Attract Kids Trade Schools Hype Low-Tech," Wall Street
Journal, February 15, 1985.
"See D. Avery and G. Sullivan, "Textiles Why Some Firms Will Prosper,"
Economic Review. Federal Reserve Bank of Atlanta vo. 68 (December
1983), p p 11 -20.
5
Standard and Poor's Industry Surveys, vol. 2, (April 1985), pp. T76-T84.
6
"The Dependency of the U.S. Economy on the Fiber/Textile/Apparel
Industrial Complex," a study prepared by Economic Consulting Services, Inc, for the American Textile Manufacturing Institute, November
12, 1981, p 2.
'"Where a Strong Dollar Has Cost American Jobs," U S. News and World
Report. January 16, 1 984, p76.
2
44
"The compensation measures were computed in national currency
units and converted into U.S. dollars at commercial market currency
exchange rates
9
See J. Kotkin, " M a d e in the U.S.A. The Case for Manufacturing in
America" Inc.. March 1985, pp. 51-52, and Daniel Webster and others,
"Free Trade: Four American Voices," v o l 7 (January-February 1983),
pp. 39-42, for references on free trade and the case for domestic
manufacturing
,0
B Toyne and o t h e r s The U.S. Textile Mill Industry: Strategies lor the
1980s and Beyond. University of South Carolina Press, 1983. pp. 8-3033-37.
" W . Freeston and J. Arpay, The Competitive Status of the U.S. Fibers
Textile and Apparel Complex, National Academy Press, 1983, pp 19-20
,2
S Hester and D. Hinkle, "Balancing U S Trade Interest The Impact of
Chinese Textile Imports on the Market Share of American Manufacturers" Business Economics, v o l 19 (April 1984), p p 27-34.
N O V E M B E R 1985, E C O N O M I C
REVIEW
Education and
Southeastern
Economic Growth
November
Economic
Review
Special
Issues
Available
Education's Contribution to Productivity
and Economic Growth
Educational Inventory:
Where Does the Southeast Stand?
Financing Education in the Southeast
The Southeast's Occupational
1984
Employment Outlook
Bank Product
Deregulation
1985
May
Risk Considerations in
N e w D i r e c t i o n s in
Interstate Banking
Deregulating Bank Activities
Bank Product Deregulation:
Some Antitrust Tradeoffs
Strategic Choices
Investment Banking:
Strategies for Potential Acquirees
Commercial Banks' Inroads
Large Bank's Strengths and Weaknesses
1
Going Interstate by Franchises or Networks
Prices Paid for Banks
The Economic Issues
and Home Banking: A Survey
A Retailer's Perspective
on ATM and POS Systems
A Banker's View
of the Payments Area
EFT in Florida:
A Banker's Perspective
Interstate Banking's Impact
I
upon Financial System Risk
Repurchase Agreements:
Taking a Closer
July/August
Firms Involved in ATM, POS,
and National Markets
An Overview of Acquirer's
to New Securities Powers
"Off-Bank" Retail Payment Systems:
on Interstate Banking
Concentration in Local
Maximizing a Bank's Value
Business and Bank Reactions
Probability or Reality?
Congressional Update and Outlook
Preparing for Interstate Banking:
Product Deregulation
Interstate Banking:
States' Interstate Banking Initiatives
January
Consumer Demand for
T h e R e v o l u t i o n in
Retail P a y m e n t s
I
Interstate Banking Laws
March
T h e S o u t h e a s t in 1 9 8 5
February
Southeastern Economic Outlook
Florida: Sunny with Few Clouds
Georgia: Strong but Moderating Growth
Tennessee: Slower Growth Ahead
Louisiana: Slow Speed Ahead
Alabama: "Heart of Dixie"
Slackens Beat
Mississippi: Moving Ahead. But Slowly
L o o k at S a f e t y
September
The Government Securities Market:
Playing Field for Repos
State and Local Government's
Use of Repos:
A Southeastern Perspective
Controlling Credit Risk Associated with Repo's:
Know Your Counterparty
Identifying and Controlling Market Risk
Custodial Arrangements and Other
Contractual Considerations
POS is on Its W a y
Chemical Bank's Experience
with Home Banking
The Business Plan for Home Banking
The Revolution in Retail Payments:
A Synthesis
The Heart of the Issue
Banks and Retailers:
Two Views of the Future
FEDERAL RESERVE B A N K O F ATLANTA
45
!••••• f
FINANCE
SEPT
1985
AUG
1985
SEPT
1984
ANN.
%
CHG.
.77.,232
36..727
14.,144
47.,964
82.,437
7.,469
674
6 ,657
177,055
37,766
14,062
47,540
82,132
7,462
710
6,584
159,130
34,851
11,581
40,735
74,960
6,174
537
5,531
+11
+ 5
+22
+18
+10
+21
+26
+20
Commercial Bank Deposits
Demand
NOW
Savings
Time
Credit Union Deposits
Share Drafts
Savings & Time
17,915
3,894
1,394
3,722
9,320
1,153
127
948
17,950
3,984
1,409
3,716
9,409
1,140
129
947
16,560
3,656
1,045
3,280
9,080
966
97
850
+ 8
+ 7
+33
+13
+ 3
+19
+31
+12
Savings & Loans**
Total Deposits
NOW
Savings
Time
Commercial Bank Deposits
Demand
NOW
Savings
Time
Credit Union Deposits
Share Drafts
Savings & Time
63,973
13,079
5,836
22,157
24,380
3,363
332
2,949
64,091
13,528
5,876
22,026
24,169
3,360
354
2,857
55,791
12,302
4,731
19,138
20,693
2,720
266
2,311
+15
+ 6
+23
+16
+27
+24
+25
+28
Savings & Loans**
Total Deposits
NOW
Savings
Time
r h r l r l r l
ANN.
%
CHG.
SEPT
1985
AUG
1985
SEPT
1984
6,455
231
1,103
5,151
JUN
4,484
333
6,,415
232
1.,100
,131
5,
MAY
4.,411
349
5,543
166
870
4,554
JUN
4,165
222
+16
+39
+27
+13
63,233
2,668
16,020
45,401
MAY
46,959
3,206
58,582
2,239
14,271
42,076
JUN
41,759
3,386
+ 8
+19
+22
+ 7
Mortgages Outstanding
Mortgage Commitments
63,114
2,662
17,373
45,181
JUN
47,453
3,276
8,425
429
1,890
6,260
MAY
9,426
410
7,993
276
1,769
6,071
JUN
8,798
489
+ 5
+62
+ 6
+ 3
Mortgages Outstanding
Mortgage Commitments
8,431
446
1,882
6,242
JUN
9,419
416
10,795
320
2,356
8,247
JUN
9,457
354
10,962
328
2,348
8,424
MAY
9,368
337
9,663
236
2,160
7,377
JUN
8,766
724
+12
+36
+ 9
+12
1,929
68
322
1,597
JUN
2,156
285
1.,913
62
321
1 ,589
MAY
2 ,149
263
N.A.
N.A.
N.A.
N.A.
JUN
2,059
223
7,044
257
1,298
5,549
JUN
6,212
208
7,060
256
1,306
5,541
MAY
6,258
226
6,994
200
1,258
5,586
JUN
5,439
380
$ millions
Commercial
Demand
NOW
Savings
Time
Credit Union Deposits
Share Drafts
Savings & Time
Commercia
Demand
NOW
Savings
Time
Credit Union Deposits
Share Drafts
Savings & Time
Mortgages Outstanding
Mortgage Commitments
Mortgages Outstanding
Mortgage Commitments
28,220
5,332
1,745
6,668
14,960
191
17
184
28,202
5,450
1,724
6,568
14,970
192
17
185
26,180
5,446
1,534
5,484
14,180
212
23
239
+ 8
- 2
+14
+22
+ 6
-10
-26
-23
Savings & Loans**
Total Deposits
NOW
Savings
Time
Commercial Bank
Demand
NOW
Savings
Time
Credit Union Deposits
Share Drafts
Savings & Time
.3,206
2,455
976
2,607
7,432
2.,546
958
2.,592
7.,439
12,139
2,255
838
2,310
7,033
+ 9
+ 9
+16
+13
+ 6
Savings & Loans**
Total Deposits
NOW
Savings
Time
Conmercial Bank Deposits
Demand
NOW
Savings
Time
Credit Union Deposits
Share Drafts
Savings & Time
Commercial Bank Deposits
Demand
NOW
Savings
Time
Credit Union Deposits
Share Drafts
Savings & Time
*
*
*
*
»
*
*
*
*
25,613
4,420
2,201
5,256
13,825
1,231
89
1,149
25,533
4,472
2,209
5,203
13,693
1,247
93
1,168
23,538
4,265
1,870
4,790
12,812
973
67
915
Mortgages Outstanding
Mortgage Commitments ,
Mortgages Outstanding
Mortgage Commitments
+ 9
+ 4
+18
+10
+ 8
+27
+33
+26
Savings & Loans**
Total Deposits
NOW
Savings
Time
Mortgages Outstanding
Mortgage Commitments
+ 8
+ 5
+14
- 3
+ 7
-15
+ 8
-51
+ 5
+28
+ 1
+29
+ 3
- 1
+14
-45
Notes: All deposit data are extracted from the Federal Reserve Report of Transaction A c c o u n t s , other Deposits and Vault Cash (FR2900), and
are reported for the average of the week ending the 1st Monday of the month. This d a t a , reported by institutions with over $15 million in
deposits and $2.2 million of reserve requirements as of June 1984, represents 95« of deposits in the six state area. T h e annual rate of
change is based on most recent dataover December 3 1 , 1980 b a s e , annualized. The major differences between this report and the call report
are size, the treatment of interbank deposits, and the treatment of float. The data generated from the Report of Transaction Accounts is for
banks over $15 million in deposits as of December 3 1 , 1979. The total deposit data generated from the Report of Transaction Accounts eliminates
interbank deposits by reporting the net of deposits "due to" and "due from" other depository institutions. The Report of Transaction Accounts
subtracts cash in process of collection from demand deposits, while the call report does n o t . Savings and loan mortgage data are from the FederHome Loan Bank Board Selected BalanceSheet D a t a . The Southeast data represent the total of the six states. Subcategories were chosen on a
selective basis and do not add to total.
* = fewer than four institutions reporting.
** = S&L deposits subject to revisions due to reporting changes.
Digitized N.A.
for FRASER
= not a v a i l a b l e at t h i s
http://fraser.stlouisfed.org/
46
Federal Reserve Bank of St. Louis
time.
NOVEMBER 1985, E C O N O M I C REVIEW
CONSTRUCTION
SEPT
1985
AUG
1985
SEPT
1984
ANN.
% .
CHG.
Nonresidential Building Permits - $ Mil.
Total Nonresidential
67,822
Industrial Bldgs.
8,897
Offices
16,803
Stores
10,671
Hospitals
2,252
Schools
1,210
66,791
8,691
16,736
10,338
2,160
1,138
58,997
7,950
14,231
9,060
1,829
872
+15
+12
+18
+18
+23
+39
Residential Building Permits
Value - $ M i l .
Residential Permits - Thous.
Single-family units
Multifamily units
Total Building Permits
Value - $ M i l .
Nonresidential Building Permits
Total Nonresidential
Industrial Bldgs.
Offices
Stores
Hospitals
Schools
S Mil.
11,317
1,188
2,525
2,207
437
162
11,124
1,093
2,553
2,142
426
158
9 ,033
885
2 ,100
1,,794
406
111
+25
+34
+20
+23
+ 8
+46
Residential Building Permits
Value - $ Mil.
Residential Permits - Thous.
Single-family units
Multifamily units
Total Building Permits
Value - $ M i l .
Nonresidential Building Permits
Total Nonresidential
Industrial Bldgs.
Offices
Stores
Hospitals
Schools
£ Mil.
654
73
131
152
47
13
637
70
120
147
49
13
742
185
97
128
19
5
-12
-61
+35
+19
+147
+160
Residential Building Permits
Value - $ Mil.
Residential Permits - Thous.
Single-family units
Multifamily units
Total Building Permits
Value - $ Mil.
Nonresidential Building
Total Nonresidential
Industrial Bldgs.
Offices
Stores
Hospitals
Schools
1 Mil.
5,817
565
1,123
1,204
236
54
5,814
571
1,133
1,187
223
50
4,451
416
1,000
1,024
175
45
+31
+36
+12
+18
+35
+20
Residential Building Permits
Value - $ Mil.
Residential Permits - Thous.
Single-family units
Multifamily units
Total Building Permits
Value - $ M i l .
Nonresidential Building
Total Nonresidential
Industrial Bldgs.
Offices
Stores
Hospitals
Schools
1,999
296
546
318
26
20
1,966
288
560
311
27
20
1,650
160
521
248
62
13
+21
+85
+ 5
+28
-58
+54
Residential Building Permits
Value - $ M i l .
Residential Permits - Thous.
Single-family units
Multifamily units
Total Building Permits
Value - $ M i l .
1,399
52
410
256
65
56
1,359
51
392
243
68
57
1,114
29
268
210
123
39
+26
+79
+53
+22
-47
+44
Residential Building Permits
Value - $ M i l .
Residential Permits - Thous.
Single-family units
Multifamily units
Total Building Permits
Value - $ M i l .
293
23
50
59
16
8
290
22
49
57
15
7
242
14
29
52
12
2
+21
+64
+72
+13
+33
+300
Residential Building Permits
Value - $ M i l .
Residential Permits - Thous.
Single-family units
Multifamily units
Total Building Permits
Value - $ M i l .
1,155
179
265
218
47
11
1,058
91
299
197
44
11
834
81
185
132
15
7
+38
+121
+43
+65
+213
+57
esidential Building Permits
•Value - $ M i l .
Residential Permits - Thous.
Single-family units
Multifamily units
Total Building Permits
Value - $ M i l .
12-month cumulative rate
f
-
*•
Nonresidential Building Permits Total Nonresidential
Industrial Bldgs.
Offices
Stores
Hospitals
Schools
ANN.
%
CHG.
SEPT
1985
AUG
1985
SEPT
1984
79,881
77,997
74,275
930.5
758.1
920.2
732.5
930.3
756.1
+ 0
+ 0
147,702
144,788
133,272
+11
14,286
13,912
13,991
+ 2
192.9
161.4
191.9
154.8
191.5
178.6
+ 1
-10
25,603
25,036
23,024
+11
523
487
468
+12
9.7
7.4
9.5
6.2
8.2
8.1
+18
- 9
1,176
1,124
1,210
- 3
8,105
7,856
8,112
- 0
101.7
98.1
101.5
93.3
105.4
98.5
- 4
- 0
13,922
13,670
12,563
+11
3,031
2,951
2,789
+ 9
46.5
24.1
46.0
22.5
42.7
29.0
+ 9
-17
5,029
4,917
4,439
+13
805
830
1,118
-28
11.9
7.9
12.3
8.2
15.7
16.0
-24
-51
2,205
2,190
2,232
- 1
+
333
341 -
385
-14
6.0
2.2
6.1
2.6
6.0
6.2
0
-65
627
631
627
0
1,489
1,447
1,119
+33
17.1
21.7
16.5
22.0
13.5
20.8
+27
+ 4
2,644
2,504
1,953
+35
NOTES:
M.n.oc^ant^fHJf511?^
! ' * u r e a u o f t h e C e n s u s - Housing u n 1 t s Authorized By Building Permits and Public Contracts. C - 4 0 .
Nonresidential data excludes the cost of construction for publicly owned buildings. The southeast data represent the total of the six
states.
Digitized
FRASER
F E D Efor
RAL
R E S E R V E B A N K O F ATLANTA
47
Wà
Personal Income
($bil. - SAAR)
Taxable Sales - $ b i l .
Plane P a s s . A r r . (000's)
Petroleum P r o d , (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
Personal Income
($bil. - SAAR)
Taxable Sales - $bil.
Plane P a s s . A r r . (000's)
Petroleum P r o d , (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
Personal Income
($bil. - SAAR)
Taxable Sales - $ b i l .
Plane P a s s . A r r . (000's)
Petroleum P r o d , (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
Personal Income
($bil. - SAAR)
Taxable Sales - $bil.
Plane P a s s . A r r . (000's)
Petroleum P r o d , (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
Personal Income
($bil. - SAAR)
Taxable Sales - $bil.
Plane P a s s . A r r . (000's)
Petroleum P r o d , (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
Personal Income
($bil. - SAAR)
Taxable Sales - $bil.
Plane Pass. A r r . (000's)
Petroleum P r o d , (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
Personal Income
($bi1. - SAAR)
Taxable Sales - $bil.
Plane P a s s . A r r . (000's)
Petroleum P r o d , (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
Personal Income
($bil. - SAAR)
Taxable Sales - $ b i l .
Plane Pass. A r r . (000's)
Petroleum Prod, (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
YEAR
AGO
ANN.
%.
CHG.
vo
CO
IO
to
GENERAL
+ 7
LATEST C U R R .
DATA PERIOD
PREV.
PERIOD
OCT
3,190.7
N.A.
N.A.
8,978.1
3,159.8
N.A.
N.A.
8,961.0
N.A.
N.A.
8.,884.0
+ 1
OCT
JUL
325.5
208.9
324.5
189.2
315.3
202.1
+ 3
+ 3
361.9
N.A.
4,851.6
1,527.5
352.5
N.A.
4.,723.3
1,,506.0
+10
AUG
OCT
388.9
N.A.
4,643.7
1,524.0
JUL
N.A.
35.0
N.A.
32.9
N.A.
34.1
AUG
OCT
42.1
N.A.
147.8
58.0
41.8
N.A.
147.7
58.5
39.5
N.A.
126.7
54.0
+17
+ 7
JUL
N.A.
4.6
N.A.
4.3
N.A.
4.6
0
2Q
OCT
AUG
OCT
149.8
91.4
2,270.6
37.0
147.5
90.6
2,221.4
35.0
138.5
82.1
2,192.9
37.0
+ 8
+11
+ 4
0
173.5
10.4
171.4
9.9
167.9
9.5
+ 3
+ 9
72.3
N.A.
1,980.8
N.A.
71.6
N.A.
1,960.3
N.A.
66.4
N.A.
1,812.7
N.A.
+ 9
OCT
JUL
333.0
5.9
331.4
5.5
317.8
5.5
+ 5
+ 7
2Q
49.5
N.A.
301.7
49.7
N.A.
283.0
47.0
N.A.
369.2
+ 5
2Q
2Q
2Q
SEPT
JUL
2Q
AUG
AUG
OCT
2,
- 2
+12
+ 3
+ 7
+ 9
-18
1,344.0
N.A.
5.7
1,349.0
N.A.
5.4
1,327.0
N.A.
5.8
+ 1
23.8
N.A.
40.5
85.0
22.4
N.A.
34.6
88.0
+ 5
AUG
OCT
23.5
N.A.
41.2
85.0
JUL
N.A.
2.6
N.A.
2.3
N.A.
2.5
51.7
N.A.
203.3
N.A.
51.3
N.A.
198.7
N.A.
48.7
N.A.
177.0
N.A.
N.A.
5.8
N.A.
5.5
N.A.
6.2
JUL
20
2Q
AUG
- 2
+19
- 3
+ 4
+ 6
+15
•
JUL
- 6
ANN.
OCT
%
1984 CHG.
OCT
1985
SEPT (R)
1985
Agriculture
Prices Rec'd by Farmers
Index (1977=100)
Broiler Placements (thous.)
Calf Prices ($ per cwt.)
Broiler Prices (t per lb.)
Soybean Prices ($ per bu.)
Broiler Feed Cost ($ per ton)
123
81,282
59.70
27.70
4.83
181
121
82,243
58.30
31.60
4.99
189
138
78,612
58.40
29.50
6.04
221
-11
+ 3
+ 2
- 6
-20
-18
Agriculture
Prices Rec'd by Farmers
Index (1977=100)
Broiler Placements (thous.)
Calf Prices ($ per cwt.)
Broiler Prices (t per lb.)
Soybean Prices ($ per bu.)
Broiler Feed Cost ($ per ton)
109
31,821
55.54
27.00
4.99
176
113
32,996
55.24
29.82
5.12
183
143
30,204
51.68
27.82
6.16
213
-24
+ 5
+ 7
- 3
-19
-17
Agriculture
Farm Cash Receipts - $ m i l .
1,324
(Dates: S E P T , SEPT)
10,760
Broiler Placements (thous.)
52.40
Calf Prices ($ per cwt.)
Broiler Prices (t per lb.)
25.50
4.97
Soybean Prices ($ per bu.)
176
Broiler Feed Cost ($ per ton)
-
11,268
53.90
29.00
5.16
180
1,197
10,127
50.80
26.50
6.02
195
- 5
+ 6
+ 3
- 4
-17
-10
3,432
1,928
54.50
28.00
6.02
235
-10
+ 4
+12
- 7
-17
- 2
2,407
12,075
47.50
27.50
6.46
250
- 8
+ 6
+10
- 5
-25
-27
798
N.A.
55.00
55.00
6.18
255
+ 5
+ 5
-18
-10
Agriculture
Farm Cash Receipts - $ m i l .
(Dates: S E P T , SEPT)
Broiler Placements (thous.)
Calf Prices ($ per cwt.)
Broiler Prices (t per lb.)
Soybean Prices ($ per bu.)
Broiler Feed Cost ($ per ton)
3,100
2,014
61.00
26.00
4.97
230
1,982
57.10
30.00
5.16
220
Agriculture
Farm Cash Receipts - $ m i l .
2,205
(Dates: S E P T , SEPT)
Broiler Placements (thous.)
12,827
52.10
Calf Prices ($ per cwt.)
26.00
Broiler Prices (t per lb.)
Soybean Prices ($ per bu.)
4.86
Broiler Feed Cost ($ per ton)
182
13,226
51.50
29.50
5.09
187
Agriculture
Farm Cash Receipts - $ m i l .
801
(Dates: S E P T , SEPT)
N.A.
Broiler Placements (thous.)
58.00
Calf Prices ($ per cwt.)
Broiler Prices (i per lb.)
28.50
5.07
Soybean Prices ($ per bu.)
Broiler Feed Cost ($ per ton)
230
57.00
57.00
5.17
240
Agriculture
Farm Cash Receipts - $ m i l .
{Dates: S E P T , SEPT)
Broiler Placements (thous.)
Calf Prices ($ per cwt.)
Broiler Prices (t per lb.)
Soybean Prices ($ per bu.)
Broiler Feed Cost (# per ton)
1,294
62.20
56.90
29.50
4.97
137
65.19
56.70
31.50
5.17
156
1,111
60.78
51.30
30.00
6.18
159
+16
+ 2
+11
- 2
-20
-14
Agriculture
Farm Cash Receipts - $ mil.
(Dates: S E P T , SEPT)
Broiler Placements (thous.)
Calf Prices ($ per cwt.)
Broiler Prices ($ per lb.)
Soybean Prices ($ per bu.)
Broiler Feed Cost ($ per ton)
1,321
N.A.
52.70
25.00
5.04
178
54.80
28.50
5.05
173
1,159
N.A.
51.00
27.50
6.06
191
+14
-
-
-
-
+ 0
+ J
- y
-1/
- /
NOTES:
Personal Income data supplied by U . S . Department of Commerce. Taxable Sales are reported as a 12-month cumulative total. Plane
Passenger Arrivals are collected from 26 airports. Petroleum Production data supplied by U . S . Bureau of M i n e s . Consumer Price Index data
supplied by Bureau of Labor Statistics. Agriculture data supplied by U . S . Department of Agriculture. Farm Cash Receipts data are reported
as cumulative for the calendar year through the month shown. Broiler placements are an average weekly rate. The Southeast data represent
the total of the six states. N . A . = not available. The annual percent change calculation is based on most recent data over prior y e a r .
R = revised.
«,,
Digitized48
for FRASER
N O V E M B E R 1985, E C O N O M I C R E V I E W
EMPLOYMENT
ANN.
% .
CHG
SEPT
1985
AUG
1985
SEPT
1984
civilian Labor Force - thous.
Total Employed - thous
Total Uemployed - thous.
Unemployment Rate - X SA
Insured Unemployment - thous.
Insured Unempl. Rate - %
M f g . A v g . W k l y . Hours
Mfg. Avg. Wkly. Earn. - $
115,850
107,867
7,984
7.1
N.A.
N.A.
40.8
389
116,679
108,628
8,051
7.0
N.A.
N.A.
40.5
384
113,843
105,792
8,051
7.4
N.A.
N.A.
40.7
376
+ 1;
+ 2
- 1
civilian LaDor i-orce - tnous.
Total Employed - thous
Total Uemployed - thous.
Unemployment Rate - % SA
Insured Unemployment - thous.
Insured Unempl. Rate - %
M f g . A v g . W k l y . Hours
Mfg. Avg. Wkly. Earn. - $
lb,jyy
14,218
1,180
8.1
N.A.
N.A.
41.4
349
ib.iU/
14,246
1,192
7.9
N.A.
N.A.
40.9
342
lb.iiy
13,976
1,146
8.0
N.A.
N.A.
41.1
332
+ Z
+ 2
+ 3
Civilian Labor Force - thous.
Total Employed - thous
Total Uemployed - thous.
Unemployment Rate - % SA
Insured Unemployment - thous.
Insured Unempl. Rate - %
Mfg. A v g . Wkly. Hours
Mfg. Avg. Wkly. Earn. - $
17790
1,646
144
8.9
N.A.
N.A.
41.4
353
1,.792
1,643
149
8.7
N.A.
N.A.
41.3
351
1,808
1,610
198
11.8
N.A.
N.A.
41.0
328
Civilian Labor Force - thous.
Total Employed - thous
Total Uemployed - thous.
Unemployment Rate - % SA
Insured Unemployment - thous.
Insured Unempl. Rate - %
M f g . A v g . W k l y . Hours
Mfg. Avg. W k l y . E a r n . - $
5,301
4,959
342
6.4
N.A.
N.A.
41.8
330
5,030
312
5.9
N.A.
N.A.
41.7
327
4,878
320
6.1
N.A.
N.A.
40.9
316
Civilian Labor Force - thous.
Total Employed - thous
Total Uemployed - thous.
Unemployment Rate - % SA
Insured Unemployment - thous.
Insured Unempl. Rate - %
Mfg. A v g . Wkly. Hours
M f g . A v g . W k l y . Earn. - $
2,860
2,664
196
7.2
N.A.
N.A.
41.3
333
2,879
2,679
201
7.2
N.A.
N.A.
41.0
328
2,810
2,648
162
6.1
N.A.
N.A.
41.0
314
Civilian Labor Force - thous.
Total Employed - thous
Total Uemployed - thous.
Unemployment Rate - % SA
Insured Unemployment - thous.
Insured Unempl. Rate - %
Mfg. A v g . Wkly. Hours
Mfg. A v g . W k l y . E a r n . - $
2,016
1,800
216
11.0
N.A.
N.A.
42.0
439
2,006
1,780
226
11.2
N.A.
N.A.
39.9
418
1,964
1,782
182
9.5
N.A.
N.A.
41.9
422
Livi n a n LaDor rorce - tnous.
Total Employed - thous
Total Uemployed - thous.
Unemployment Rate - % SA
Insured Unemployment - thous.
Insured Unempl. Rate - %
M f g . A v g . W k l y . Hours
M f g . A v g . W k l y . Earn. - $
•L.ibU
1,037
113
10.8
N.A.
N.A.
40.7
295
1.1J4
1,015
118
10.6
N.A.
N.A.
40.5
292
i,uyu
980
109
11.1
N.A.
N.A.
40.8
286
+ b
+ 6
+ 4
Civilian Labor Force - thous.
Total Employed - thous
Total Uemployed - thous.
Unemployment Rate - % SA
Insured Unemployment - thous.
Insured Unempl. Rate - %
Mfg. A v g . Wkly. Hours
Mfg. Avg. Wkly. Earn. - $
2,282
2,112
169
8.6
N.A.
N.A.
41.2
341
2,285
2,099
186
8.7
N.A.
N.A.
40.9
338
2,249
2,074
175
9.0
N.A.
N.A.
40:9
327
+ 1
+ 2
- 3
NOTES:
+ 0
+ 3
+ 1
+ 5
+ 2
-27
+ 1
+ 8
+ 2
+ 2
+ 7
+ 2
+ 4
+ 2
+ 1
+21
+ 1
+ 6
+ *
+ 1
+19
+ 0
+ 4
- 0
+ 3
+ 1
+ 4
ANN.
X
CHG
SEPT
1985
AUG
1985
SEPT
1984
Nonfarm Employment - thous.
Manufacturing
Construction
Trade
Government
Services
F i n . , Ins. & Real.. E s t .
Trans. C o m . & Pub.. U t i l .
19,506
5,023
23,509
16,050
22,242
5,993
5,383
97,924
19,500
5,022
23,448
15,438
22,200
6,032
5,305
19,724
4,659
22,508
15,778
21,089
5,725
5,266
+
+
+
+
+
+
+
1
8
4
2
5
5
2
Nontarm tmployment - thous.
Manufacturing
Construction
Trade
Government
Services
F i n . , Ins. & R e a l . E s t .
Trans. C o m . & P u b . U t i l .
12,763
2,294
798
3,162
2,224
2,690
735
732
12,693
2,294
798
3,160
2,168
2,675
737
732
12,405
2,328
785
3,016
2,178
2,545
702
721
+
+
+
+
+
+
+
3
1
2
5
2
6
5
2
Nonfarm Employment - thous.
Manufacturing
Construction
Trade
Government
Services
Fin., Ins. & R e a l . Est.
Trans. Com. & Pub. U t i l .
350
70
295
294
234
67
73
1,396
351
69
295
293
233
67
73
17391 T i
358 - 2
68 + 3
296 - 0
289 + 2
229 + 2
63 + 6
72 + 1
3 ^
Nonfarm Employment - thous.
Manufacturing
Construction
Trade
Government
Services
F i n . , Ins. & R e a l .. E s t .
Trans. Com. & Pub. U t i l .
4T4TT
516
335
1,161
671
1,149
320
250
4,395
514
337
1,163
658
1,144
320
250
4,227
506
332
1,110
657
1,067
302
243
+
+
+
+
+
+
+
+
Nonfarm Employment - thous.
Manufacturing
Construction
Trade
Government
Services
F i n . , Ins. & R e a l . Est.
Trans. C o m . & Pub. Util.
2,617
547
158
677
440
488
137
163
2,612
546
156
677
436
487
138
163
2,508
555
141
627
433
455
132
158
+ 4
- 1
+12
+ 8
+ 2
+ 7
+ 4
+ 3
Nonfarm Employment - thous.
Manufacturing
Construction
Trade
Government
Services
F i n . , Ins. & R e a l . E s t .
Trans. C o m . & P u b . U t i l .
1,593
175
113
382
326
320
84
114
1,578
™,609
177
185
113
123
382
382
315
321
314 315
84
83
114
119
- 1
- 5
- 8
0
+ 2
+ 2
+ 1
- 4
Nontarm tmployment - thous.
Manufacturing
Construction
Trade
Government
Services
F i n . , Ins. & R e a l . E s t .
Trans. C o m . & P u b . U t i l .
852
220
42
186
191
129
35
40
835
220
42
186
177
125
35
40
Nonfarm Employment - thous.
Manufacturing
Construction
Trade
Government
Services
F i n . , Ins. & R e a l . E s t .
Trans. C o m . & P u b . U t i l .
1,891
486
82
461
302
370
92
92
1,877
486
81
457
289
372
93
92
221
40
179
188
126
35
39
ITSST
503
81
422
290
353
87
90
4
2
1
5
2
8
6
3
+
+
+
+
+
2
0
5
4
2
2
0
+ 3
+
+
+
+
+
+
+
3
3
1
9
4
5
6
2
All labor force dara are from Bureau of Labor Statistics reports supplied by state agencies.
Only the unemployment rate data are seasonally adjusted.
The Southeast data represent the total of the six states.
F E D E R A L R E S E R V E B A N K O F ATLANTA
49
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