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I C Q , :<eO,M, i 6c.

FEDERAL

RESERVE
CLEVELAND

BANK

OF

E C O N O M I C
1 9 8 6

2

Exchange-Market Intervention:
The Channels of Influence.

Can the United States lower and stabilize dol­
lar exchange rates by buying and selling for­
eign currencies? Economist Owen Humpage
discusses recent theoretical and empirical
results which indicate that the effects of
intervention, which is not accompanied by a
change in monetary policy, are quite limited.

R E V I E W

Q U A R T E R

Economic Review

3

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Editor: William G. Murmann.
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Comparing Inflation Expectations
of Households and Economists: Is a
Little Knowledge a Dangerous Thing? Why

M

are the inflation forecasts of economists so
inaccurate? Can households do better? Econ­
omist Michael F. Bryan and Economic Advisor
W illiam T. Gavin use survey results to show
that households have been more accurate than
economists in predicting the annual increase
in the consumer price index. They suggest
some reasons for this surprising result.

Opinions stated in

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Reserve System .

Material m ay be reprinted provided
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IS S N 0013-0281

O A
Ld U

Aggressive Uses of Chapter 11 of the
Federal Bankruptcy Code. Chapter

11 petitions have recently been put to some
unusual nondefensive uses by a num ber of
firms. Author Walker F. Todd examines the ag­
gressive uses of bankruptcy from an economic
and historical perspective, and discusses
some implications for the free-market system.

Economic Review

are those of the authors and not

Exchange-Market
Intervention:
The Channels
of Influence
by Owen F. Humpage
Ow en F. Flumpage is an economist
at the Federal Reserve Bank of
Cleveland.
The author would like to thank
Gerhard Rosegger, David Bowers,
Asim Erdilek, Nicholas Karamouzis,
Ralph W . Sm ith, J r ., Alan Stock­
m an, Jam es G. Hoehn and William
T . Gavin for helpful comments.

Introduction
The major developed countries abandoned the
Bretton Woods system of fixed exchange rates in
March 1973 in favor of a system of more general­
ized floating rates. Over the 13 years since the
adoption of floating exchange rates, however,
governments generally have refused to allow the
private market free rein in determining the
foreign-exchange values of their currencies. They
frequently have intervened in the foreignexchange market to influence outcomes. The fre­
quency and intensity of intervention has varied
greatly over the years and among the countries.
Most noticeable has been a sharp reduction in
the intervention activity of the United States since
early 1981. This reduction reflected a growing
realization that exchange-market intervention,
conducted independently of monetary policy,
had only a limited effect on exchange rates.
Economic theory suggests three
possible channels through which exchangemarket intervention could alter exchange rates:
the monetary channel, the portfolio-balance
channel, and the expectations channel. The
monetary channel allows intervention to influ­
ence exchange rates by altering the relative
growth rates of nations’ money stocks. There is
little disagreement about the potency of such
intervention; in fact, central banks can maintain
fixed exchange rates through relative changes in
their money stocks.
Central banks, however, have
sought a means to influence exchange rates
independent of their monetary policy. Portfoliobalance models of exchange-rate determination

offer such a channel. According to this approach,
intervention that alters the relative stock of
domestic and foreign currency denominated gov­
ernment debt could influence exchange rates in a
manner consistent with the objectives of the inter­
vening monetary authority. The portfolio model
seemed to offer support for frequent intervention
as conducted during the 1970s by the United
States. Although not conclusive, subsequent
empirical work has cast doubt on the ability of
central banks to influence exchange rates through
the portfolio-balance channel. This research,
however, has left open the possibility that inter­
vention can influence exchange rates by provid­
ing new information to the exchange market. In a
highly efficient market, however, the instances
when the monetary authority has better informa­
tion than the market are few. The belief that
intervention operates largely through the expecta­
tions channel forms the basis for the limited use
of intervention by the United States in the 1980s.
Recent attempts to encourage an
orderly depreciation of the dollar from its record
levels in exchange markets have renewed interest
in the feasibility of frequent exchange-market
intervention. Consequently, this article surveys
the literature on intervention for readers who are
not necessarily specialists in international finance.
After providing a definition of intervention and a
discussion of why countries intervene, we focus
on the theoretical channels through which inter­
vention might alter exchange rates. Box 1 pro­
vides a bibliographic guide to many of the empir­
ical studies on intervention.

I. A Definition
Exchange-market intervention refers to official
purchases and sales of foreign exchange, which
nations undertake to influence the exchange value
of their currencies. This definition describes inter­
vention in terms of two criteria: the types of trans­
actions and the motives guiding those transactions.
The distinction among various
types of transactions is important because coun­
tries have many policy levers with which to affect
the exchange value of their currencies. They can
alter monetary and fiscal policies, institute broad

Some Empirical Studies
of Intervention
Argy (1982) investigates the profita­
bility of intervention by Japan, West
Germany, and the United Kingdom,
emphasizing the need to adjust for
the accumulation or dim inution of
foreign-exchange inventories. He
finds mixed results, depending on
the time period chosen and on the
specific country.
Bagshaw and Humpage (1986) find
that the decision to cease systematic
intervention from April 1981 to
March 1982 generally had no effect
on the volatility of exchange rates,
as measured by the parameters of a
stable Paretian distribution.
Danker, Haas, Henderson, et
al.(1983) investigate intervention by
Germany, Japan, and Canada using
monthly and quarterly data in a
portfolio-balance model that differ­
entiates between bank and nonbank
demands for bonds, and which
incorporates rational and static
expectations.
Greene ( 1984a) argues that inter­
vention from January to March 1975
successfully broke a string of almost
continuous declines in the dollar.
The studies seems to illustrate the
importance of coordinated
intervention.
Greene (1984b) suggests that inter­
vention, although effective on cer­
tain occasions, could not over­

or selective capital controls, or resort to various
trade barriers. Almost any government policy can
have exchange-rate repercussions in a floating
exchange-rate regime with a high degree of inte­
gration among nations’ capital and goods
markets. The purchase and sale of foreign
exchange, however, is the most direct and most
flexible lever through which to affect exchange
rates. It is, therefore, the most frequently used
intervention device.
Usually a nation’s central bank or
exchange-stabilization fund conducts its interven-

whelm the influence of market
fundamentals and sentiments
promoting a rapid dollar deprecia­
tion from September 1977 to
December 1979.
Greene (1984c) investigates inter­
vention from October 1980 to Sep­
tember 1981. She does not find
strong evidence of an increase in
exchange-rate volatility after the Unit­
ed States ceased intervention in Feb­
ruary 1981.
Humpage (1985) constructs a daily
time-series model of U.S. interven­
tion (November 1,1978 to October
31, 1979) suggesting the United
States attempted to smooth unantic­
ipated exchange-rate movements
but found no evidence of the
expected exchange-rate response.
Hutchison (1984) develops a
portfolio-balance model of Japanese
intervention and concludes that Jap­
anese intervention would need to
be massive to affect the yen-dollar
exchange rates appreciably.
Jacobson (1983) calculates the prof­
itability of U.S. intervention, show­
ing the problems of evaluating
inventories of foreign exchange. The
results are mixed.
Loopesko (1983) tests for a system­
atic relationship between interven­
tion and unexploited interest arbi­
trage profits, using daily data on six
major currencies against the dollar.
About half the cases do not support
a portfolio-balance channel.

Mayer and Taguchi (1983) investi­
gate the profitability of German, Jap­
anese and British intervention,
emphasizing the need to adjust for
interest earnings on foreign
exchange reserves. They develop a
rule for assessing a leaning-againstthe-wind intervention strategy.
Pippenger and Phillips (1973) find
that Canadian intervention during
the Canadian float (1952 to I960)
reduced day-to-day fluctuations in
exchange rates; the study uses daily
data and spectral analysis.
Rogoff (1984) investigates Canadian
intervention within a portfoliobalance framework with weekly
data, but finds no evidence that
intervention operates through this
channel.
Taylor (1982a, 1982b) calculates the
profitability of intervention by the
major developed nations under
floating rates and finds that nearly
all countries experienced losses
over the period. For many countries,
and for the group as a whole, the
probability of experiencing similar
large losses through random inter­
vention was very small.
Tryon (1983) provides a review of
empirical models of intervention
that utilize the portfolio-balance
framework.
Wilson (1982) discusses the empiri­
cal difficulty of making profit
comparisons.

3

4

tion. Some governments occasionally have
directed banks and public or private corporations
to carry out exchange-market transactions and
have subsidized such transactions (see Jurgensen
[1983] )• Although difficult to identify, these trans­
actions constitute intervention.
Central banks can intervene in
either the spot-or forward-exchange market.
Because covered interest arbitrage links the spot
and forward markets, intervention in either
market could affect both exchange rates. Most
central banks, however, show a preference for
spot-market intervention.1
An understanding o f the motives
for buying or selling foreign exchange is a neces­
sary component o f the definition o f intervention.
While all official purchases and sales o f foreign
exchange place pressure on exchange rates, this
is not always the purpose o f such transactions.
Central banks often buy or sell foreign exchange
for customers, usually the home-country govern­
ment, which otherwise would undertake the trans­
actions through normal commercial channels.
The home-country government might use the
funds to repay official foreign-currency debts or
to purchase military equipment. Central banks
also buy foreign currency to build up or to
replenish foreign-currency reserves. Sometimes
central banks enter the exchange markets to con ­
vert interest payments on foreign reserves (which
are paid in foreign currency) into domestic cur­
rency. Such transactions would not seem to con ­
stitute intervention according to a strict interpreta­
tion o f our definition.
Unfortunately, the distinction is
not always very clear. Adams and Henderson
(1983) discuss this issue and note that such trans­
actions often constitute a type o f “passive inter­
vention.” Central banks can conduct commercial
transactions in a manner consistent with the over­
all aims o f their intervention policy. Adams and
Henderson favor a broader definition o f interven­
tion and would characterize a transaction as inter­
vention if it altered the currency composition o f
assets in the hands o f the public from that which
otherwise would have resulted had all transactions
occurred through normal commercial channels.

II. Sterilized and Nonsterilized Intervention
Central-bank intervention in foreign-exchange
markets can be sterilized or nonsterilized? Steril­
ized intervention refers to purchases and sales o f

I

foreign exchange whose impact on the home
country’s money stock is offset through domestic
open-market operations. Nonsterilized interven­
tion refers to purchases and sales o f foreign
exchange whose effects on the money stock are
not offset by the home country’s monetary
authorities. If sterilized intervention is effective, it
gives the intervening country a policy tool, inde­
pendent o f monetary or fiscal policy, with which
to alter the exchange rate; hence, the interest in
sterilized intervention.
The important distinction between
sterilized and nonsterilized intervention is illus­
trated in table 1, which presents a consolidated
balance sheet for a hypothetical central bank. On
the asset side o f the ledger are net foreign assets
(NFA), which consists o f foreign reserves less lia­
bilities to foreign official holders, and domestic
assets (DA), which consists primarily o f loans to
depository agencies and government securities.
On the liability side is the monetary base (MB),
which consists o f currency in the hands o f the
public and reserves in the banking system. Both
sides o f the ledger must balance. Consequently,
the balance-sheet identity is:
NFA + DA = MB.
When a central bank intervenes in the exchange
market, buying or selling foreign assets (NFA),
two things happen: First, the composition o f its
assets changes; that is, NFA/DA rises or falls.
Second, the monetary base changes by an
amount equal to the change in net foreign assets;
that is, A MB = A NFA The change in the m one­
tary base results from the balance-sheet identity
and leads to a multiple change in the domestic
money stock.
If the change in the money stock
resulting from intervention is not consistent with
the central bank’s domestic monetary-growth
objectives, the central bank could offset (steril­
ize) the effect on its money stock o f a change in
its net foreign assets. The intervention authority
can sterilize intervention by buying or selling
domestic assets through open-market operations,
or by making loans to depository institutions
through discount-window operations until:
AAK4 = — A DA
Sterilized intervention involves only an assetcomposition effect. It is a stronger assetcomposition effect than nonsterilized interven­
tion, because it involves changes both in net
foreign assets and in domestic assets. Nonsteril­
ized intervention involves both an assetcomposition effect and a money-supply effect.
Consequently, nonsterilized intervention is ana-

The reluctance to intervene forward might reflect a fear that, if
the situation necessitating intervention persists at the time the
forward contracts mature, a central bank could find that the volume of

intervention necessary to defend its currency has increased greatly.
Essentially, it must offset past pressures, as well as any new pressures.
See Tsiang (1959).

2

A dam s and Henderson (1983), Batten and Ott (1984), Genburg
(19 8 1), and Jurgensen (1983) also discuss the distinction between

sterilized and nonsterilized intervention.

lytically indistinguishable from sterilized interven­
tion, plus a change in monetary policy.
Sterilized intervention can be com ­
plete or partial. Even when the home country
sterilizes the impact of intervention on its currency
unit for unit, the transaction can alter the money
stock o f the foreign country whose currency was
purchased or sold. The foreign country also can
sterilize the impact of home country intervention
on its money stock through the instruments o f its
domestic monetary policy. In addition, either the
home or the foreign government can elect not to
offset intervention unit for unit.

Monetary Authority’s Balance Sheet
Assets

Liabilities

Net Foreign Assets (NFA)

Monetary Base (M B)

Gold
Foreign currency
SDR
Net position in IMF

Currency in hands o f public
Reserves

Domestic Assets (D A )

Government securities
Loans to depository institutions
Other
TABLE

1

Many foreign countries lack money
markets with sufficient breadth to offset interven
tion on a continual basis. Some sterilize through
changes in their discount rate or their reserve
requirements. Some, like Switzerland, use
foreign-currency purchases and sales to execute
domestic monetary policy. As long as countries
attain their monetary objectives in the face o f
intervention, we can conclude that they have neu­
tralized the monetary effects o f intervention (see
Jurgensen [1983])Completely sterilized intervention
is analytically equivalent to a trade o f public
securities denominated in home-country currency
for securities denominated in foreign-country
securities. It results in a change in the currency
composition o f securities held by the public, the
mirror image o f which is a change in the cur­
rency composition o f assets held by the central
banks. When the United States and Germany
conduct completely sterilized intervention to
support the dollar vis-a-vis the mark, for example,
they reduce (increase) the amounts o f U.S.
government obligations held by the public (Fed­
eral Reserve System) and increase (decrease) the
amount o f German government bonds held by
the public (Bundesbank).

III. Why Do Central Banks Intervene?
According to official publications, governments
intervene to “calm disorderly exchange markets.”
Yet, no clear definition o f what constitutes a dis­
orderly exchange market exists, and the official
perception o f disorder seems to vary among cen­
tral banks and over time. The experience with
floating exchange rates, however, suggests two
broad reasons for exchange-market intervention:
First, exchange-rate movements can have impor­
tant macroeconomic implications; nations have
viewed intervention as a means o f influencing
these movements independently o f monetary and
fiscal policies. Second, governments view
exchange markets as periodically inefficient, justi­
fying market intervention.
Exchange rates are the price o f
one nation’s monetary unit in terms o f another
nation’s monetary unit. They are endogenous var­
iables; that is, exchange rates respond to changes
in other econom ic variables such as monetary
and fiscal policies at home or abroad. Because
exchange rates are endogenous variables, one
cannot easily ascribe causality to exchange-rate
movements. The record appreciation o f the dollar
from 1980 to 1985, for example, seemed to
reflect the huge increase in federal borrowing
associated with the budget deficit. Was it then the
dollar or the budget deficits that contributed to
the deterioration in the trade balance since 1982?
Nevertheless, policymakers often
seem to view exchange-rate movements as exo­
genous events. One possible explanation for this
view is that developments in foreign countries,
beyond the control o f the home-country govern­
ment, can produce exchange-rate movements.
From this perspective, exchange-rate movements
appear responsible for altering the relative prices
o f goods, services, and financial assets in one
country vis-a-vis other countries. These relative
price changes can have important influences on
real econom ic growth, employment, and prices
in the aggregate national econom y or in specific
sectors. Consequently, despite the adoption o f
floating rates, nations have continued to regard
exchange rates as important policy targets and, in
varying degrees, have attempted to manage their
exchange rates. From this perspective, central
banks found intervention, especially sterilized
intervention, interesting. It seemed to offer
nations an “additional” policy variable with which
to influence exchange rates, while leaving mone­
tary and fiscal policy free to pursue domestic
economic objectives.
Monetary authorities have not
taken this view to the extreme; that is, they have
not attempted to peg an exchange rate with steril­
ized intervention.3 Nor did they regard monetary
policy as irrelevant in determining exchange
rates. Nevertheless, policymakers appeared to

5

believe that through sterilized intervention they
could influence the speed at which exchange
rates adjusted. This view is evident in the fact that
many central banks have intervened frequently,
often following a strategy o f leaning against the
wind (see Jurgensen [1983]).
Since the early 1980s and the find­
ings o f the Jurgensen Report, the proposition that
sterilized intervention offers an independent pol­
icy lever with which to affect exchange rates has
not found wide acceptance. As the next section
discusses more fully, the preponderance o f
research suggests that intervention probably has a
very limited, if any, independent influence on
exchange rates. Nevertheless, many policymakers
believe that intervention, when undertaken in
conjunction with other (monetary) policies,
affords a market impact substantially greater than
one would expect from the sum o f the two poli­
cies taken independently. That is, intervention
can augment monetary and fiscal policies. As the
Jurgensen Report noted:
... most members felt that the impact o f the
simultaneous application o f the two instru­
ments exceeded their individual effects. In
other words, these members argued that
exchange market intervention and m one­
tary policy changes reinforced each other
and thus enhanced the size and duration
o f their respective effects (pp. 20-21).
Extending this view, many argue that coordinating
international monetary, fiscal, and intervention pol­
icies also augments their individual effectiveness.
The preceding discussion assumes
that policymakers want to change the exchange
rate in order to achieve some macroeconomic o b ­
jective; it also assumes that exchange markets are
efficient. However, the second general reason for
intervention is that policymakers regard exchange
markets as not always efficient. Because o f ineffi­
ciencies, exchange rates can becom e “mis­
aligned” or exhibit excessive volatility or both.
Exchange-rate misalignments and volatility can
impose real resource cost on all nations, affecting
econom ic growth, employment, and prices.4 As
the Jurgensen Report illustrates, monetary author­
ities often have intervened to “dampen erratic
fluctuation,” to “calm disorderly markets,” or to
“keep exchange rates in line with fundamentals.”
All these suggest that something is wrong with
the market and that the monetary authority is
capable o f correcting the deficiencies.

3

The European M onetary System comes the closest to using inter­
vention to peg an exchange rate. How ever, it is not clear that

E M S intervention is routinely sterilized and therefore independent of

IV. The Channels of Influence
Economic theory offers three possible channels
through which foreign-exchange-market interven­
tion could influence exchange rates. First, non­
sterilized intervention and, to a lesser extent, par­
tially sterilized intervention alter the relative
supplies o f domestic and foreign money. These
monetary shifts could affect relative interest rates,
relative price levels, and exchange rates. Second,
sterilized intervention alters the relative supplies
o f government interest-bearing debt held by
international investors. Any resulting portfolio
adjustments could affect exchange rates. Third,
both sterilized and nonsterilized intervention
could alter expectations in the foreign-exchange
market. Exchange rates, like all asset prices, are
very sensitive to changes in market participants’
expectations. This section discusses each o f these
possible channels o f influence.

A.

The Monetary Channel

Economists have recognized a relationship be­
tween changes in countries’ monetary-growth rates
and changes in their exchange rates (or balance
o f payments under fixed exchange rates) at least
since Hume’s price-specie-flow doctrine.5 Al­
though international economists might disagree
about the relevant time frame and relative impor­
tance o f money in exchange-rate models, few
would object on theoretical grounds to the inclu­
sion o f money among the determinants o f ex­
change rates. Most recent models o f exchangerate determination either include relative money
growth rates among their arguments, or represent
the reduced form o f models whose structural
forms include money.6
Under classical assumptions o f the
neutrality o f m oney and o f the constancy o f veloc­
ity in the long run, a given percentage increase in
a nation’s money stock will result in a similar per­
centage increase in that nation’s price level. Given
purchasing-power parity, that nation also will ex­
perience a depreciation o f its nominal exchange
rate equal to the percentage rise in its price level.
The real exchange rate remains unaffected.
While economists have challenged
the strict versions o f classical assumptions and
have observed that purchasing power parity need
not hold strictly even in the long run, the tenet
that relative rates o f money growth are important
determinants o f nominal exchange rates continues.
In fact, one current approach to exchange-rate

3

Keynesian economics did not emphasize the role of m oney in
balance-of-payments adjustment problems; rather it focused on

the elasticities approach and later the absorption approach. One can

m onetary policy.

trace the recent re-emphasis on m oney, at least, to Johnson (1968).

4

6

For a discussion of the effects of exchange-rate volatility, see
International M onetary Fund (1984).

For a recent survey of approaches to exchange-rate determination,
see Schafer and Loopesko (1983).

determination, the monetary approach, views rel­
ative patterns in the supply o f and demand for
nations’ money as the key determinant o f
exchange rates.7
Modern approaches differ from his­
toric treatments in that they allow for instanta­
neous adjustment in asset markets through a
rational-expectations framework, and they allow
for sticky prices in goods markets. One important
consequence o f these assumptions is that the chan­
nel o f influence between monetary changes and
exchange-rate movements does not necessarily run
through relative prices and trade flows, as in the
classical models. Modem approaches to monetary
theory allow, at least in the short run, for influ­
ences o f money on interest rates, and exchange
rates through an interest-rate parity mechanism.
Contemporary models suggest that a change in
relative monetary growth rates will produce both
nominal and real exchange-rate changes in the
short run, but not in the long run. Another impor­
tant implication o f modem models is that, follow­
ing a monetary expansion, nominal exchange
rates initially can overshoot their long-term equil­
ibrium value (given by purchasing power parity)
because o f the slow adjustment in goods prices.
The extent o f the overshoot will depend on all
the interest elasticities and price elasticities
em bodied in the model. However, if goods prices
adjust instantaneously, no exchange rate over­
shooting will result.8
Nonsterilized intervention, which
changes nations’ relative money supplies, has the
potential to alter exchange rates rapidly and last­
ingly. International economists rarely disagree
with this proposition. Sterilized intervention, as
typically conducted by the United States, also
could have an effect on exchange rates if foreign
monetary authorities did not completely sterilize
the transactions.
As indicated earlier, U.S. interven­
tion to alter the dollar’s exchange rate can change
the money stocks o f the nations whose curren­
cies the Federal Reserve buys or sells, unless
those nations take appropriate offsetting actions.
The major developed countries, such as Germany
and Japan, can sterilize the effect o f foreign or
domestic intervention on their money stocks.
Smaller developed and developing countries
often lack credit markets with sufficient depth to
undertake such sterilization activities on a routine
basis through open-market operations. They can
undertake reserve-ratio changes or discount-rate

changes, but these have a fairly dramatic impact
on monetary growth and are not well-suited for
routine adjustments to sterilized intervention.
They do, however, provide a mechanism where­
by the foreign central bank could offset the
impacts o f intervention over a longer period.

B. The Portfolio-Adjustment Channel
Economists have extended the closed-economy,
portfolio-balance models o f asset demand,
initially developed by Tobin (1958, 1969), to the
open-econom y case. In a portfolio model o f asset
demand, risk-averse wealth holders, facing uncer­
tain rates o f return on an array o f assets, diversify
their portfolios across assets instead o f holding
only the single asset currently yielding the high­
est rate o f return. When exchange risk and politi­
cal risk are introduced into the model, a strong
incentive exists for wealth holders to diversify
their portfolios across currencies.9 The resulting
demands for assets denominated in foreign cur­
rencies affect exchange rates. The open-econom y
portfolio model illustrates an important channel
through which completely sterilized intervention
might affect exchange rates and the conditions
that must hold for sterilized intervention to work.
In a world with no transaction cost
and no restraints on capital flows, arbitrage will
equate returns on assets denominated in dollars
with returns on assets denominated in other
currencies:
(1)
r = r* + / - s
In equation 1, ris the log o f the interest return
on U.S. bonds and r* is the log o f the interest
return on foreign bonds. (We assume that the
bonds mature in one year.) The forward exchange
rate, / is the log o f the current dollar price o f for­
eign currency for delivery in one year. The spot
price o f foreign currency is s.w Assuming that
domestic and foreign assets are perfect substi­
tutes, so that the forward exchange rate equals
the expected future spot exchange rate, arbitrage
ensures that the return on domestic bonds, equals
r*, the return on foreign bonds, plus any capital
gains associated with holding foreign-currencydenominated assets as exchange rates change.
When wealth holders do not view
domestic and foreign bonds as perfect substi­
tutes, the forward exchange rate will differ from

9

Initial applications of portfolio models to the study of capital m ove­
ments under fixed exchange rates are Branson (19 70 ), and Kouri

and Porter (19 74 ). Early applications to floating exchange rates include
Girton and Henderson (19 77) and Kouri (1980). Discussions of sterilized
intervention within the context of portfolio models are found in Tryon

7

For examples of fhe monetary approach to exchange-rate deter­

(1983), Genburg (19 8 1), Henderson (1984), and Hutchison (1984).

mination see Frenkel (1976) and Bilson (19 78 ).
Equation 1 is the log form of the covered interest-rate parity
condition:

8

The overshooting model is attributable to Dombusch (1976).

(1 + r) - f/ (1 * /-*)
s

7

the expected future exchange rate ( s e) by a pre­
mium, 0, that reflects the risks associated with
holding an open position in dollars. That is:

(2)

f - s e =6.

Substituting yields:
(3 )
r - / + (se -s) + 6.
As can be seen from equation 3, wealth holders
demand an extra return for holding the risky dol­
lar asset above the interest return and expected
appreciation from holding the foreign bond. (One
could specify the problem with the foreign asset
as the risky asset without affecting the analysis.)
Rearranging equation 3 provides
an expression for the risk premium:
(4)
d = r - r* + s - se.
With interest rates and the expected future value
o f the dollar held constant, an increase
(decrease) in the risk premium on dollar assets is
associated with a depreciation (appreciation) o f
the dollar relative to the foreign currency. This
depreciation o f the dollar in the spot market is
necessary to give wealth holders a capital gain
over the holding period sufficient to compensate
them for the additional risks o f holding dollardenominated assets.
Before explaining intervention
within the context o f this model, we should spec­
ify the determinants o f the risk premium. Under­
lying the risk premium is the preference o f indi­
viduals to hold assets in their home currency, an
aversion to risk, and a desire to hold assets which
maximize a return from a portfolio, given the
risks. These risks include exchange risk (the
uncertainty associated with unanticipated move­
ments in exchange rates) and political risk (the
probability that governments will impose future
capital controls). In the case o f major developed
countries, most analysts attach greatest impor­
tance to exchange risk (see Dooley and Isard
[1980] and Frankel [1979]). In specifying a func­
tion to explain the risk premium, most research
includes, among other terms, the ratio o f domes­
tic bonds to total wealth (see Frankel [ 1984,
1979] and Hutchison [1984]).
The assets relevant to the portfolio
balance model are government bonds. Individu­
als generally do not hold large balances o f for­
eign currency, since they would earn no interest.
In addition, bondholders must view the bonds as
additions to their net wealth. Private bonds are
assets to lenders and liabilities to borrowers;
therefore, they do not represent net additions to
wealth. Government bonds will equal net addi­
tions to wealth if bondholders do not associate
with an increase in government debt a future tax
liability sufficient to retire the debt and all inter­
est accrued on the debt (see Barro [1974]).

The portfolio balance model pro­
vides a channel through which sterilized inter­
vention can alter exchange rates perm anently
since, as demonstrated earlier, sterilized interven­
tion alters the relative supplies o f domestic and
foreign government bonds in the hands o f the
public and, when the bonds are imperfect substi­
tutes, alters the risk premium. Assume, for exam­
ple, that the United States intervenes in the for­
eign exchange market to support the dollar
relative to the German mark. The Federal Reserve
buys dollars in the foreign exchange markets with
German marks and sterilizes the intervention by
buying Treasury bonds at the open-market desk.
Assume that Germany also sterilizes by selling
mark-denominated bonds. The Federal Reserve’s
purchase o f Treasury securities initially creates an
excess demand for Treasury securities that tends
to lower U.S. interest rates, while the German sale
o f mark-denominated bonds creates an excess
supply and tends to raise German interest rates.
Because U.S. and German bonds are not perfect
substitutes, U.S. bondholders are not willing to
hold all o f the excess supply o f German bonds.
The interest-rate movements tend to increase U.S.
money demand and to lower German money de­
mand. Yet, the money supplies in both countries
have remained unchanged. With the expected
future spot rate constant, the dollar will appre­
ciate relative to the German mark.1 The
1
exchange-rate change, which occurs as moneydemand shifts alter the terms o f trade, is neces­
sary to restore balance in both the money and
bond markets. The appreciation o f the dollar rela­
tive to the German mark reduces the attractive­
ness o f domestic bonds relative to mark bonds by
increasing (decreasing) the expected future
depreciation (appreciation) o f the dollar relative
to the mark, hence, it also reduces expected capi­
tal gains on dollar assets.
In terms o f equation 4, therefore,
intervention has produced movements in interest
rates and the spot exchange rate associated with a
reduction in the risk premium on dollar assets.
The movement in the exchange rate, moreover, is
compatible with the designs o f the intervening
monetary authorities.
If assets are perfect substitutes,
wealth holders expect the same return from each
bond. Under these assumptions, sterilized inter­
vention will not affect the exchange rate, because
individuals have no incentive to alter portfolios
given a change in the relative stocks o f bonds.
Asset holders are perfectly willing to hold more
mark-denominated bonds in place o f dollar-

n

Analysts usually assume that long-term determinants, such
as purchasing power parity, or a sustainable current account
deficit, maintain the level of

se.

denominated bonds in their portfolios. When the
bonds are perfect substitutes, intervention also
w ill leave interest rates unaffected because the
intervention transactions, although altering the
currency composition of bonds, have not changed
the total value of bonds relative to money in port­
folios. Wealth holders, therefore, have no incen­
tive to diversify out of bonds and into money.
Given the other assumptions men­
tioned previously, the extent to which interven­
tion alters exchange rates depends on the degree
of substitutability between dollar-denominated
and mark-denominated securities. Other things
equal, if dollar and mark bonds are close substi­
tutes, the change in the exchange rate will be
small. If the assets are not close substitutes, a
larger change in the exchange rate will be
required to compensate for the risks. This implies
that completely sterilized intervention might be
feasible in some markets where assets are imper­
fect substitutes, but infeasible in other markets,
where assets are perfect substitutes.1 Therefore,
2
the United States might intervene successfully
against lira but not against marks. Clearly, one
must evaluate the portfolio effects of completely
sterilized intervention on a case-by-case basis.
Empirical investigations to date
generally do not find strong support for the con­
tention that intervention affects exchange rates
through a portfolio-adjustment mechanism (see
box 1). Although the issue remains unresolved,
the evidence of the existence of a risk premium
between similar assets denominated in currencies
of different major developed countries is mixed.1
3
These investigations involve simultaneously test­
ing the joint hypothesis that markets are efficient
and that bonds are perfect substitutes. Conse­
quently, a finding that the yield on domestic and
foreign securities differs significantly from zero is
subject to two interpretations. First, this result
could indicate that assets are imperfect substitutes
in an efficient market. Hence, intervention would
work through the portfolio-balance mechanism.
Second, and equally plausible, the finding could
result if assets are perfect substitutes, but if
markets are not perfectly efficient. This second
finding suggests that intervention does not oper­
ate through a portfolio-balance channel.1
4
Loopesko (1983), Hutchison (1984) and Danker,

Haas, Henderson et al. (1985) offer three investi­
gations of intervention within the portfolioadjustment framework. None finds strong support
for the existence of a portfolio-adjustment chan­
nel for intervention.
Even if the relevant bonds are im ­
perfect substitutes, it appears that the response to
small changes in the risk premium is quite low.
Hutchison (1984) notes that changes in the
cumulative total publicly held government debt is
the relevant variable for the portfolio-adjustment
model. Total government debt responds to inter­
vention, to the surplus or deficit in the govern­
ment budget, and to monetary policy. In his study
of Japanese intervention, Hutchison (1984) sug­
gests that intervention is usually too small, rela­
tive to the total volume of outstanding debt, to
have a significant impact on portfolio choices.
With the publicly held federal debt in excess of
$1.5 trillion, U.S. intervention probably would
need to be massive before the cumulative volume
had significant impact on portfolio decisions.1
5
C. The Expectations Channel
Exchange-market intervention also could alter
exchange rates if it changed expectations in the
foreign-exchange markets. Most economists regard
foreign-exchange markets as highly efficient. An
efficient market is one that “fully reflects” all
relevant, available information about today’s
events as well as about all predictable future
events, including policy decisions (see Fama,
[1970] ).1 An implication of this is that exchange
6
rates respond to unanticipated events or “news.”
When the exchange market and other markets are
efficient, transactions based on observed exchange
rates ensure the optimal allocation of resources.
W hile exchange markets are highly
efficient, they probably are not perfectly efficient.
Tests of market efficiency generally search for
unusual profits from arbitrage or trading rules. In
an efficient market, unusual profits should not
exist; their existence would imply that certain
transactors consistently have better information
than others. Although these tests generally are

-1

^

Batten and Ott (1984) make a similar argument, which does

_L J /

not result from a portfolio model, noting that the average

daily volume of funds flowing through the exchange market is quite large
1

^

See Fukao (1985) for an interesting discussion of similar

1

Ld

relative to the typical volume of intervention.

problems with coordinated intervention within the context of

For a survey, see Levich (1983). See also references to port­
folio models in box 1.

1 /T

Levich (1983) writes the spot rate, S , as:

JLO

a portfolio-balance model.

S, = Z , + p [ E ( S , . , ) - S, ] ,

where Z f is a collection of contemporaneous variables that explain S (.
Collecting terms and substituting repeatedly for lagged values:

S, =

(1 +/?r1|

03/1-/?)*

E ( Z h k ).

This does not preclude the possibility that sterilized interven­
tion could influence the exchange rate by improving market
efficiency.

Hence, the spot exchange rate depends on current expectations of the
relevant “fundamentals" in Z from the present to the indefinite future.

10

inconclusive, they have raised serious doubts
about perfect exchange-market efficiency.1
7
In addition, casual observations
have raised questions about whether the market
consistently uses all available information when
setting exchange rates (see Dornbusch [1983] )•
Many exchange-market analysts contend that the
exchange market often focuses on one piece of in­
formation to the exclusion of other important
information and sometimes trades on false infor­
mation or the wrong model. Trades on false in­
formation can be self-fulfilling . If, for example,
traders believe that a full moon causes dollar
depreciation and sell during full moons, their
expectations w ill be met. Such activity can lead to
abrupt, potentially disruptive adjustments in
exchange rates as the market changes its focus to
a different set, or eventually to the correct set, of
fundamentals. Exchange-market analysts also
have argued that exchange rates periodically are
subject to speculative runs or bubbles. When
information is incomplete, traders might rely on
recent exchange-rate movements to indicate
market sentiment and future movements in the
rate. Traders may buy an appreciating currency or
sell a depreciating currency, thereby reinforcing
exchange rate movements. It is important to
emphasize that most economists regard the inef­
ficiencies in the exchange market as minor and
as generally not contributing much to exchangerate volatility. Nevertheless, to the extent that inef­
ficiencies exist, intervention could alter exchange
rates by altering expectations in the market.
Most monetary authorities attempt
to conduct intervention policy in such a way as to
improve the information flow through the
market; according to the Jurgensen (1983) report:
The authorities in each of the Summit
countries at times undertook large-scale in­
tervention when they judged that market
participants had not taken full account of
fundamental factors, [or] had only reacted
slowly to changes in fundamentals... (p.21).
There are a number of difficulties
in implementing intervention designed to influ­
ence market expectations. Such intervention
involves a judgment on the part of the monetary
authorities that first, the current volatility in the
market reflects inefficiencies and not adjustments
(or expectations of adjustments) in fundamental
determinants; and second, that the monetary
authorities possess better information than the
market about market developments. In the pro­
cessing of normal information flow about real
economic developments, prices, interest rates, or
routine policy, there is little reason to suspect that

17

See Levich (1983) for a survey.

policymakers are any better informed than market
participants. At times, however, the Federal
Reserve and the U.S. Treasury could have better
information than the market. This might occur,
for example, when policymakers are considering
a change in monetary or fiscal policy that differs
from past policy reactions. The market already
will incorporate a policy reaction function into
the exchange-rate quotations. The need to pro­
vide new information to the market limits the
instances when sterilized intervention is feasible.
A highly efficient market will inter­
pret intervention activity quickly. Hakkio and
Pearce (1985) found that unanticipated moneysupply announcements had a significant effect on
exchange rates, but that the adjustment usually oc­
curred within twenty minutes of the announce­
ment. One would expect the exchange-rate change
in response to new information to be permanent.
The decision of the Group of Five
countries to intervene in late September of 1985
(the Plaza decision) seems to represent a recent
example of successful intervention that altered
expectations in the foreign exchange markets. At
the time, the dollar was depreciating in the
foreign-exchange market, but the market seemed
uncertain about the future course of monetary
and fiscal policies. The money stock, narrowly
defined, was growing in excess of its target range,
suggesting that the Federal Reserve might take
steps to reduce money growth. O n the other
hand, economic activity seemed weak at the
time; many complained that the dollar was over­
valued, and banks continued to experience diffi­
culties with agricultural and international loans.
These events suggested that the Federal Reserve
might not tighten. At the same time, there was
increasing talk in Congress about the need to
reduce the federal budget deficit, but little con­
crete action. Under these circumstances, the
market seemed to view the decision to intervene
as a signal that U.S. policy would not move in a
direction that might strengthen the dollar in
exchange markets. The United States intervened
forcefully, but did not continue to intervene
beyond the quarter.
A second important question con­
cerns the appropriateness of using intervention to
alter expectations. Given that monetary authorities
can provide new information to the exchange mar­
ket about future monetary policy and alter expec­
tations in the market, is intervention the approp­
riate vehicle for providing this information?
Could the central bank provide the same informa­
tion through the announcement of monetary pol­
icy intentions or by providing an interpretation of
recent events? This issue has not received much at­
tention in the literature on central-bank interven­
tion. Perhaps actual currency purchases or sales
are necessary to convince the market about cen­

tral bank intentions because it represents a bet by
the central bank on its own information. Profita­
ble intervention tends to stabilize the exchange
rate. Moreover, as Henderson (1984) notes:
...losses on foreign exchange positions can
lead to significant political problems for the
authorities. Thus, if the authorities under­
take an intervention policy which would
generate foreign exchange losses if their
pronouncements about future monetary
policy were not put into effect, there might
be more reason for private agents to take
these pronouncements seriously, (p. 391)
We also should question the
extent to which one truly can regard intervention
that alters expectations about future monetary
policy as being sterilized. W hile such intervention
might intensify the effects of the change in mone­
tary policy, as suggested in Jurgensen (1983, pp.
20-21), it is clearly dependent on fulfillment of
the expectations.
W hile the expectations channel
offers the most promise as a means of accom­
plishing sterilized intervention, it probably is the
most difficult channel for a central bank to navi­
gate. It is important to emphasize that the pur
chase or sale of foreign exchange
is not
affecting the exchange rate; the critical factor is the
information these transactions might provide.
Such intervention must be unanticipated and
convey new, convincing information to the
market. Because it is difficult to determine how
expectations are forged and how strongly they are
carried, attempts to alter expectations through
intervention could be very expensive.

per se

policy. Such intervention would allow them the
opportunity to influence exchange rates without
interfering with domestic monetary objectives.
Our second conclusion is that sterilized interven­
tion has a limited, but not necessarily insignifi­
cant, impact on exchange rates. The portfoliobalance approach to exchange-rate determination
suggests that sterilized intervention could influ­
ence exchange rates permanently by altering the
relative supplies of government bonds in the
hands of the public. If wealth holders perceive
these bonds as net wealth and as imperfect sub­
stitutes, sterilized intervention could alter the
exchange rate in the desired direction by chang­
ing the risk premium on these bonds. Unfortu­
nately, empirical investigations to date have not
demonstrated unequivocally that a risk premium
exists on government bonds issued by the major
developed countries. Nor have they shown that
intervention in the magnitudes typically under­
taken by the major central banks is sufficiently
large to influence the risk premiums. The expec­
tations channel suggests that sterilized interven­
tion can influence exchange rates by altering the
flow of information in the exchange market.
However, this requires that the intervening cen­
tral bank be able to identify periods of market
inefficiency and that it have information, for
example, about future monetary policy, which the
market lacks. The exchange market seems highly
efficient, so that opportunities for the central
bank to exploit this channel probably are not
great. Nevertheless, under the proper conditions,
such intervention can have an immediate and
permanent impact on exchange rates.

V. Conclusion
This article has discussed three channels through
which central bank intervention could alter
exchange rates. These are the monetary channel,
the portfolio-balance channel, and the expecta­
tions channel. Two broad conclusions emerge
from our review of these channels. First, changes
in a nation’s money growth relative to money
growth abroad can have a profound effect on that
nation’s nominal exchange rates. This holds true
whether the money stock change is engineered
through conventional methods of monetary policy
— open-market operations, discount-rate changes
or reserve-ratio changes— or whether the money
stock change is engineered through nonsterilized
intervention in foreign exchange markets.
Changes in a nation’s monetary growth, however,
may have only temporary effects on that nation’s
real exchange rates, especially if goods prices
adjust slowly to changes in money growth rates.
However, nations have been most
interested in conducting sterilized intervention,
that is, intervention independent of monetary

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Comparing Inflation
Expectations of Households
and Economists: Is a
Little Knowledge a
Dangerous Thing?
by Michael F. Bryan
and William T. Gavin
Michael F . Bryan is an economist
and William T. Gavin is an economic

The authors gratefully acknowl­
edge the research assistance of

advisor at the Federal Reserve Bank

Michael Pakko, and helpful com­

of Cleveland.

ments from Ja m es G. Hoehn, Ow en
F. Flumpage, and Donald Mullineaux.

1 4

Many economic decisions depend on the infla­
tion expectations of market participants. For
example, households consider future inflation
when making intertemporal decisions about con­
sumption, savings, and leisure, and investors
allow for potential inflation when estimating the
real returns on investments.
For a number of reasons, empirical
researchers are paying increasing attention to sur­
vey measures of inflation expectations. While
reduced-form forecasts are readily available as
proxies for inflation expectations, their use gen­
erally assumes a long period of policy and struc­
tural stability. In the presence of policy and other
structural shifts in the economy, direct measures
of expectations may adapt to changing conditions
fester than model-based ones.
Survey measures of inflation expec­
tations are important to research economists
because they provide data on an otherwise unob­
servable variable. Wallis (1980) and Pesaran
(1981) derived the conditions required to iden­
tify behavioral parameters in simultaneous
rational expectation models. They showed that
the assumptions needed to identify behavioral
parameters in rational expectation models are
arbitrary; these assumptions generally are not
im plied by economic theory and cannot be
tested. Kaufman and Woglom (1983) have sug­
gested using observable survey-based measures
of expectations to estimate otherwise unidentifi­
able, policy-invariant parameters in rational
expectation models.

Measures of inflation expectations
are important to the Federal Reserve because it
has the responsibility for managing the money
supply in a way that fosters price stability. Expec­
tations of inflation can influence the linkage
between money, interest rates, and prices. Infla­
tion expectations have become especially impor­
tant in recent years due to the Federal Reserve’s
disinflationary strategy.
In this paper, we examine the
inflation forecasts from two surveys: one taken
from households, and the other taken from pro­
fessional economists.1 W hile the state of the art
in economic forecasting is still primitive, econo­
mists would probably like to believe that they are
able to make better inflation forecasts than lay­
men. In order to determine whether this is so, we
compare these two survey forecasts to each other
and to a time-series forecast. Pearce (1979)
showed that, for the period from 1959 to 1976, a
simple univariate ARIMA model produced more
accurate out-of-sample inflation forecasts than did
a survey of professional economists. We have
included a similar model to test whether the
Pearce results are valid for recent years and to see
how the time series model fares against the

I

Gramlich (1983) presents statistics suggesting that both the
economist and the household survey measures of inflation expec­
tations are biased and inefficient. Bryan and Gavin (1986) show that his

main results are derived from a mis-specified model. When the specification
error is corrected, the Michigan survey of household inflation expectations
passes the standard tests for unbiasedness. However, there remains doubt
about the properties of the inflation expectation series derived from the Liv­
ingston survey of professional economists.

households’ inflation forecast. Embarrassingly
enough, our results suggest that the knowledge
which economists bring to the forecasting exer­
cise may have made their inflation forecasts less
accurate than both the more naive forecast of
households and the forecasts generated from a
simple, atheoretical, time-series model.

+@ n

Pp

2

Pf),

P\,

Other surveys not examined in this paper include the N B E R A S A quarterly survey of inflation expectations and the M oney

Market Services monthly survey of inflation expectations. Both represent
surveys of economists. Victor Zarnow itz examines the N B E R - A S A in a
number of papers. See Zarnow itz (1984) for a recent paper and references
to earlier work. Pearce (1985) provides an analysis of the M oney Market
Services survey of inflation expectations.

3

The form of the Michigan survey has changed substantially
over the years. For example, prior to 1966, panel participants

were merely asked for qualitative responses. Between the second quar­
ter of 1966 and the second quarter of 19 77 respondents had categories
of price increases suggested to them , and those who expected prices to

- P fi t +
1

u v

E (u

P,=

where:

E (utut') = o 2I,
u

a +0 !

t _xP\t -

t _xP f,+

02

t lPet + ut
2
t

the forecast of inflation for year
from the Livingston Survey made
in year M , and

t . jP f, = the forecast of inflation for year
from the Michigan Survey made
in year M .

Philadelphia Inquirer,

PI

t

ft

where
t) = 0 and
then, a = 0, 0i = 1, and 0 ,= 0 for / > 1.
Specifically, we estimated the fol­
lowing equation over the 1949-84 period:
(2)

I. Conditional Efficiency of the Survey Forecasts
This section presents results comparing the fore­
casts of inflation.2 The household survey of infla­
tion, compiled by the University of Michigan’s
Survey of Consumer Finances, records 12-month
consumer price forecasts for approximately 1,000
randomly selected households. The economists’
survey measure is constructed by Joseph Living­
ston of the
where yearahead inflation forecasts of approximately 50
economists are summarized semi-annually.3
A simple procedure for evaluating
the relative efficiency of competing forecasts is
discussed by Granger and Newbold (1977). Since
it is only in special cases that we know the m in­
im um attainable forecast variance, they suggest
using a criterion of “conditional efficiency” to
evaluate forecast accuracy. A forecast is said to be
conditionally efficient with respect to another if
the variance of that forecast’s error is not signifi­
cantly greater than the variance of the forecast
error from a combined forecast. In the case of
multiple, linearly independent forecasts (
...
the “conditionally efficient” forecast,
say
is defined such that in the ordinary least
squares (OLS) regression:

/>,= a + f t

(1)

The results of this estimation are reproduced at
the top of table 1. F-tests were conducted on the
joint hypothesis that a=0, /3/= 1, and 0 „ #<=O for
1,2. The University of Michigan survey of
households was found to be conditionally effi­
cient for both the June and the December infla­
tion forecasts (that is, the hypothesis 0 2 = 1 and
0i=O could not be rejected at the 5 percent level
of confidence). This means that the year-ahead
forecast of inflation for the survey of households
could not be significantly improved using addi­
tional information from the Livingston survey of
economists. However, the economists’ survey
could have been improved given information
contained in the household forecast. That is, the
hypothesis that 0 i= l and 0 2 = 0 could be rejected
at the 5 percent level of confidence
= 9.17 for
the June inflation forecasts and 4.35 for the
December inflation forecasts).
Because the Michigan survey
results are derived from qualitative survey data
before 1966, it is not clear what influence knowl­
edge of past experience may have had on devel­
oping the procedures used to generate the
numerical data and, consequently, on the survey’s
accuracy. We separated the sample at 1966
to examine the period for which the Michigan
survey data included only quantitative estimates
of inflation.
We also included the one yearahead univariate time-series forecast of inflation

i-

(F

ex post

(/ i^ 3 /) in
con d ition al efficiency tests for
the post-1966 period to com pare the perfor­
m ance o f the tw o surveys against a relatively
sim ple, atheoretical m odel o f in flatio n .4

fall were not asked to quantify their response. Only since the third quar­
ter of 19 77 did Michigan survey panelists actually forecast the rate of
inflation. See Juster and Comment (1980) for a description of the proce­
dures used to derive the household inflation expectations from the Mich­
igan survey data; a summary of this paper is published as an appendix
in Noble and Fields (1982). Livingston Survey responses are compiled by
the research staff of the Federal Reserve Bank of Philadelphia. The
mean expected inflation rate derived from the Livingston survey uses the
methodology proposed by Carlson (19 77).

t

4

The time-series model w as not included in the full-sample tests
for conditional efficiency because the early observations were

needed to generate the out-of-sample forecasts.

15

The time-series forecast is sim ­
ilar to the one used by Pearce (1979). Specif­
ically, the m odel used to generate the timeseries forecasts is:

P™ x ~ 9at l+at-, E (at) = 0,
E (ata t')= o 2I.
a
where P m is the monthly inflation rate (approx­
(3 )

imated by the first difference in logarithms of the
Consumer Price Index) and is the error. Notice
that the n-step-ahead forecast of a first-order mov­
ing average model is equal to the one-step-ahead
forecast. Three F tests were conducted on the
separate hypotheses that each of the forecasts was
“conditionally efficient,” as defined in (1). The

a

model were conditionally efficient, relative to the
survey of economists.

II. An Analysis of Survey Forecast Errors

table 2,

In
we show the mean absolute error
(MAE), the root mean square error (RMSE) and
the Theil decomposition of the forecast error for
the two survey measures of inflation expectations.5
The Theil decomposition evaluates the portion of
the error due to bias (
the portion due to
the difference of the regression coefficient from
unity
and the portion due to residual varia­
tion (
In an optimal forecast, we expect to
find
and
approximately equal to zero and
close to one.

UM),

UD

(UR),
UD).
UM UR

Conditional Efficiency of Alternative Forecasts
Entire Sample
1949-1985
June forecasts

16

P2

R
2

0.71
(1.27)

0.12
(0.46)
9.17**

0.89
(3.27)
1.19

0.69

DW
1.57

SEE
2.10

1.13
(1.90)

0.69
(1.98)
4.35*

0.28
(0.81)
2.02

0.67

1.25

2.15

a

t-statistics
F-statistics

Pi

1949-1984
December forecasts
t-statistics
F-statistics

Post-1965 Years
1965-1985
June forecasts

P*

Ps

R
2

DW

0.157
(0.12)

-0.196
(-0.54)
6.41**

0.792
(1.97)
1.11

0.433
(1.23)
1.87

0.73

1.63

SEE
1.81

2.743
(1.74)

0.142
(0.28)
3.57*

-0.690
(-1.02)

1.167
(2.55)
0.79

0.59

1.18

2.28

a

t-statistics
F-statistics

Pi

1966-1984
December forecasts
t-statistics
F-statistics

NOTES: t-ratios for a and (3 around 0 are in parentheses.
F-statistics are calculated for each

/3 under the joint
(

hypothesis that

2.09

a =0, f}(= 1, and ft n^ t = 0

for

i = 1 to 3, respectively.

** = significant at 1 percent.
* = significant at 5 percent.

results of these tests are presented at the bottom
of
For both the June and December
inflation forecasts, only the survey of professional
economists could have been improved given
information from the other forecasts. Hence, we
could not reject the hypothesis that the house­
hold survey and the atheoretical time-series

table 1.

Over the full period, the Michigan
survey has the lowest mean absolute error and
the highest value for
while the Livingston
forecast does relatively poorly. Only about 70 per­
cent of the Livingston forecast error was residual

UD,

For a description of this procedure, see Theil (1966) pp. 33-36.

variation. That is, about 30 percent of the econo­
mists’ inflation error appears to be nonrandom.
In the post-1966 period, which
includes the simple time-series model, the timeseries model has the lowest mean absolute error,
the lowest mean square error, and the lowest
residual bias. The Michigan survey of households
has the highest portion of the forecast error
attributed to residual variation (96 percent). The
Livingston survey of professional forecasts is the
least accurate inflation guess of the three, and the
errors in this survey have a proportionately large
nonrandom component.

was 2.335 percent in the post-1966 period, and
that the difference between the Michigan and Liv­
ingston forecast errors was only 0.5 percent.
Anecdotal evidence for this argu
ment is provided by the generally thin trading in
the CPI futures market. Since June 21, 1985, the
Coffee, Sugar, and Cocoa Exchange in New York
City has made a market in CPI futures contracts. If
there were a significant amount of risk uniquely
associated with uncertainty about movements in
consumer prices (apart from uncertainty about
the behavior of interest rates which have very
active futures markets), then we would expect

Alternative Forecast Accuracy
MAE

RMSE

uM

Livingston
Michigan

1.902
1.607

2.715
2.264

0.240
0.074

0.022
0.010

0.738
0.916

Livingston
Michigan
Time-series

Tim e Period

2.257
1.904
1.870

2.900
2.377
2.335

0.194

0.013
0.000
0.107

0.794
0.957
0.876

M odel

uR

uD

June 1949 -June 1984

HP = 4.37
sp = 356
June 1966 -June 1984
Hp

= 6.64

sp = 3.22

NOTE: np is the average actual inflation rate,

0.043
0.018

sp is the standard deviation o f actual inflation. The time-series forecasts are in-sample fore­

casts for the period 1949 through 1965. After 1965, the forecasts are 12 m onths ahead. The m odel was re-estimated every six months. The
first-order MA parameter ranged from a high o f 0.729 in 1973 to a low o f 0.684 in 1983.

TABLE

2

III. Is a Little Knowledge a Dangerous Thing?
Why is the Michigan survey of households a more
accurate and less “biased” inflation forecast than
the Livingston survey? We suggest several possi­
bilities. One may be that the large sample of
households is relatively more representative of
the participants in the market for the basket of
goods covered by the Consumer Price Index. No
individual actually buys the representative basket
of goods; the basket will vary with demographics
and income class. It may be that any small, hom ­
ogeneous group of consumers would misforecast
the inflation rate as badly as do economists. It
seems likely that the 50 or so economists in the
Livingston survey are as homogenous a group as
one might put together from a subset of the
Michigan sample. Furthermore, they are highly
unlikely to be a representative sample, since they
are almost all male and well-paid in comparison
to the average consumer.
Another reason for the Livingston
economists’ relatively poor forecasts may simply
be that they have little incentive to do better. The
average size of the error from the best forecast is
large relative to the difference between the alter­
native forecast errors. In
we saw that the
root mean square error of the time-series forecast

table 2

active trading in this financial vehicle. However,
such active trading has not occurred.
Empirical support for this incentive
argument is given by Hafer and Resler (1982),
who identified each of the Livingston respond­
ents with one of six professional affiliations. Hafer
and Resler argued that only economists employed
by nonfinancial businesses had direct and strong
incentives to produce accurate inflation forecasts.
They show that this group produced better fore­
casts than did economists from academia, com
mercial banks, investment banks, the Federal
Reserve System, and others. This argument is
based on the notion that economists with more
incentive to produce a better forecast will spend
more resources gathering better information.
This line of reasoning is consistent
with the supposition that the mean of the Michi­
gan survey would be a better forecast than any
individual economist’s forecast. The survey of
1,000 households combines information about
inflation in a way that would be very expensive
for an individual economist to replicate.
Furthermore, there is a high
degree of communication among economists
about their forecasts, so that the already small
number of respondents in the Livingston survey

17

18

may not represent much independent information. This is in strong contrast with the survey in
which Michigan respondents are asked to forecast
the rate of inflation in the things they buy. This
latter survey was designed by specialists to get
independent information from a representative
sample of consumers. Our results may simply re­
flect the superior design of the Michigan survey.
Another potential reason for the in­
feriority of the economists’ forecasts is that they
may have been relying on econometric models to
forecast inflation. Econometric models used dur­
ing this period typically estimated inflation as an
adaptive process, that is, as a weighted average of
past inflation rates. Figlewski and Wachtel (1981)
show that the poor forecasts in the Livingston sur­
vey appear to have been formed in this way. Vanderhoff (1984) presents further evidence that econ­
omists’ forecasts went astray in much the same
way as did econometric forecasts that were based
on linear models assumed to have constant
parameters.
The naive forecasts of households
and the ARIMA model appear to be have captured
the essentially nonstationary aspects of the process generating inflation in a way that economists
using econometric models did not. We note that
there has been a growing tendency for econo­
mists to incorporate time-series methods in their
econometric models; in particular, economists
have been more conscious of the possibility that
the variables they study may be generated by
nonstationary processes.

IV. Conclusion
We may draw several conclusions from this study.
First, none of the forecasts perform well in an
absolute sense. The differences among the fore­
casts are small relative to the size of the mean
error of even the best forecast.
Second, we would clearly choose
the Michigan survey over the Livingston survey of
economists on the basis of historical accuracy.
The mean forecast from the Livingston survey has
been shown to perform relatively poorly; it does
worse than a simple time-series model and worse
than a forecast derived from a survey of house­
holds. However, the Livingston survey may be
useful if one accepts the notion that it is an accu­
rate historical representation of economists’
beliefs. For instance, since policymakers rely on
economists’ forecasts, the Livingston survey may
help us understand policymakers’ past errors.
Finally, the relatively simple timeseries model has performed about as well as the
Michigan survey. Thus, for those who seek timely
forecasts of the CPI, we recommend this ARIMA
model. For those researchers who need an
observable measure of expectations, the Michigan

survey is more likely to represent the expecta­
tions of rational, maximizing agents, than is the
extensively-used Livingston survey of economists,

References
Bryan, Michael F. and W illiam T. Gavin. “Models
of Inflation Expectations Formation: A Compar­
ison of Household and Economist Forecasts. A
Comment,” Journal of Money, Credit and
Banking (Forthcoming, November 1986).

Theil, Henri. Applied Economic Forecasting Am­
sterdam: North Holland, 1966.
Vanderhoff, James. “A ‘Rational’ Explanation for
‘Irrational’ Forecasts of Inflation,” Journal oj
Monetary Economics, vol. 13, no. 3 (May
1984), pp. 387-92.

Carlson, John A “A Study of Price Forecasts,”

Annals of Economic and Social Measurement,
vol. 6, no. 1 (Winter 1977), pp. 27-56.
Figlewski, Stephen and Paul Wachtel. “The For­
mation of Inflationary Expectations,” The
Review of Economics and Statistics, vol. 63, no.
1 (February 1981), pp. 1-10.

Wallis, Kenneth F. “Econometric Implications of
the Rational Expectations Hypothesis,” Econometrica, vol. 48, no. 1 (January71980), pp. 49-73.
Zamowitz, Victor. “The Accuracy of Individual
and Group Forecasts from Business Outlook
Surveys "Journal oj Forecasting vol. 3, no. 1
(January/March 1984), pp. 11-26.

Granger, Clive W. J., and Paul Newbold. Forecast­
ing Economic Time Series. New York: Aca­
demic Press, Inc., 1977.
Gramlich, Edward M. “Models of Inflation Expec­
tations Formation: A Comparison of House­
hold and Economist Forecasts,” Journal of
Money, Credit and Banking vol. 15, no. 2
(May 1983), pp. 155-731 9

Hafer, R.W., and David H. Resler. “O n the Ration­
ality of Inflation Forecasts: A New Look at the
Livingston Data,” Southern EconomicJournal,
vol. 48, no. 4 (April 1982), pp. 1049-56.
Kaufman, Roger T., and Geoffrey Woglom. “Esti­
mating Models with Rational Expectations,”
Journal oj Money, Credit and Banking vol.
15, no. 3 (August 1983), pp. 275-85.
Juster, F. Thomas, and Robert Comment. “A Note
on the Measurement of Price Expectations,”

Institute jor Social Research Working Paper,
The University of Michigan, 1980.
Noble, Nicholas R, and T. Windsor Fields. “Test­
ing the Rationality of Inflation Expectations
Derived from Survey Data: A Structure-Based
Approach,” Southern EconomicJournal, vol.
49, no. 2 (October 1982), pp. 361-73.
Pearce, Douglas K. “Short-run Inflation Expecta­
tions: Evidence from a Monthly Survey,”
Research Working Paper
Federal
Reserve Bank of Kansas City, 1985.

85-03,

________ “Comparing Survey and Rational Mea­
sures of Expected Inflation,” Journal oj
Money, Credit and Banking vol. 11, no. 4
(November 1979), pp. 447-56.
Pesaran, M.H. “Identification of Rational Expecta­
tions Models,” Journal oj Econometrics, vol.
16, no. 3 (August 1981), pp. 375-98.

Aggressive Uses of Chapter
11 of the Federal
Bankruptcy Code
by Walker F. Todd
Walker F. Todd is an assistant gener­
al counsel and research officer at the
Federal Reserve Bank of Cleveland.
Substantial contributions to and
useful comments on this article
were provided by John M . Davis,
Mark Sniderman, and Erica Groshen
of the Federal Reserve Bank of
Cleveland, and by Andrea Berger
Kalodner, member, New York Bar.

20

Introduction
The filing of a voluntary bankruptcy petition
under Chapter 11 of the Bankruptcy Code of 1978
by the LTV Corporation on July 17, 1986 focused
renewed attention on the recent evolution of
corporate reorganizations under the Bankruptcy
Code. This article reviews that evolution and
offers alternative explanations for the kinds of
uses noted in recent Chapter 11 petitions. To
some observers, a Chapter 11 petition is becom­
ing one of the standard financial strategies of
large corporations. In a period of disinflation, the
filing of a Chapter 11 petition is not a completely
unexpected or unnatural response to the need to
reduce corporate obligations.
Alternative legal mechanisms do
exist for the orderly downsizing of corporate
assets and liabilities in the face of a generally fal
ling price level or a significantly reduced demand
in specific markets. Those alternatives include
assignments for the benefit of creditors, corporate
liquidations, and corporate dissolutions and reor­
ganizations under state law, as well as contractual
agreements for nonbankruptcy lending ( “work­
outs”)- However, those alternatives often are
unsatisfactory because they do not provide a con­
venient method for debtors to stay all creditors’
claims automatically or to reject burdensome
contingent liabilities. Thus, corporate reorganiza­
tion under Chapter 11 typically is the debtor’s
preferred alternative. Creditors also may prefer
the orderly process of negotiation with a debtor
through creditors’ committees under the supervi­
sion of a federal bankruptcy court, instead of
attempts to reorganize the debtor without the

court’s protection and assistance.
A more restrained, and probably
more accurate, view of bankruptcy petitions such
as that filed by LTV is that a Chapter 11 filing may
be helpful in restructuring large claims of secured
creditors and of creditors with the priority claims
described in section 507 of the Bankruptcy Code
(11 U.S.C. section 507). Nevertheless, the use of
Chapter 11 filings as a sword rather than a shield
was not traditionally contemplated under the
1978 Bankruptcy Code or the prior United States
bankruptcy acts.

I. An Economic Perspective
Basic economics textbooks pay little, if any, atten­
tion to bankruptcy proceedings as a mechanism
for allocating resources. When an uncompetitive
firm becomes insolvent, economics texts gener­
ally assume that its assets will be liquidated to
satisfy creditors and that the firm no longer will
exist. Economists call this process “exit from the
market.” Shareholders may suffer large losses,
including the complete loss of their investments.
At times, new investors purchase some of the liqui­
dated assets on favorable terms, putting up fresh
capital, and a new firm “enters the market.” Some
former assets are scrapped, some former employ­
ees are not re-employed, and some former credi­
tors are not paid fully. The new firm generally has
a better chance of succeeding than the old firm be­
cause it has some combination of lower costs,
greater productivity, and better management.
Economists describe this market-driven process
as being efficient because investors purchase

assets or new stock in the firm at market prices.
Those investors could have used their capital for
other purposes.
In practice, corporate reorganiza­
tions under the Bankruptcy Code allocate re­
sources in a manner that may differ significantly
from an economist’s description of corporate
reorganizations. Under Chapter 11, troubled firms
essentially bargain with creditors’ committees
and, occasionally, with their own employees
regarding the conditions under which they can
remain “going concerns.” Negotiations with
employees typically would cover the restructuring
of executives’ compensation contracts and
unions’ collective bargaining agreements.
The bankruptcy judge acts as a
mediator/arbitrator, following the Bankrupcty
Rules. However, the real power to affect the dayto-day operations of a debtor is in the hands of
the creditors’ committees. Usually, management
of the bankrupt firm attempts to remain in con­
trol of the ongoing operations of the enterprise.
In such cases, management is referred to as the
“debtor in possession.” Often, as was the case
with the LTV filing, bank creditors already have a
functioning committee that has been negotiating
with management before a bankruptcy petition is
filed. Thus, it is not at all inaccurate to describe
the bankruptcy judge as a detached mediator or
referee. Usually, the judge plays only a small role
in preparing a reorganization plan. That plan
ordinarily is drafted by the debtor and must be
ratified by the creditors’ committees. The com­
mittees may serve as active, involved co-managers
of the bankrupt firm, and it is not unusual for
counsel for the creditors’ committees to meet at
least weekly with management.
If no agreement between the bank­
rupt firm and its creditors can be reached volun
tarily, the court, usually acting through a trustee,
can impose a solution. One possible solution is a
complete liquidation of the firm, but such a solu
tion is used in Chapter 11 cases only after a judge
determines that no viable alternative exists. It
would be mere coincidence if a firm reorganized
in a Chapter 11 proceeding had the same assets,
liabilities, capitalization, labor force, wage rates,
and productivity as a market-organized firm.
Indeed, a Chapter 11 proceeding may support, at
least temporarily, the continued existence of a
firm that otherwise would have been liquidated.
Corporate reorganization arguably
is always a smoother process for all concerned
rather than a straight liquidation under Chapter 7
of the Bankruptcy Code. That is why the threat of
filing a Chapter 7 petition serves management as
a strong bargaining tactic in dealing with credi­
tors’ committees. Regardless of the outcome of a
Chapter 11 proceeding, all parties theoretically
have a sense of participation and partial control

in a corporate reorganization. If reorganization
produces a new firm that proves to be uncompet­
itive, and if further restructuring is required, at
least the affected parties w ill have time to adjust
to the changed circumstances.
Yet, to the extent that a Chapter 11
petition thwarts the discipline of the market­
place, the ultimate costs of corporate reorganiza­
tion to society may be greater than those of cor­
porate liquidation. This can occur because the
court’s judgment as to the viability of the reorgan­
ized firm and any arrangement reflecting the
vested interests of the creditors may be wrong.
O n the other hand, lawyers seem to believe that
creditors’ lawyers, bankruptcy judges, and trustees
usually assess the possibilities of corporate reor­
ganizations accurately because of their repeated
experiences with working out the consequences
of Chapter 11 petitions. Also, the continued pres­
ence of corporate management in debtor-inpossession arrangements under most Chapter 11
plans guarantees that the role of business judg­
ment will be significant. Thus, in the end, the
normal result of a corporate reorganization tradi­
tionally has not been completely at odds with the
overall lessons of human experience.

II. Priorities Among Creditors
Section 507 of the Bankruptcy Code prescribes a
schedule of the priorities of distribution for
claims of classes of creditors in a bankruptcy pro­
ceeding. A simplified listing of the priorities
under Section 507 is as follows:
• Administrative expenses of the
bankrupt’s estate.
• Postpetition unsecured claims
arising prior to the appointment of a bankruptcy
trustee.
• Up to $2,000 per claimant for
unsecured claims for accrued but unpaid wages,
salaries, commissions, vacation, and sick leave
pay.
• After deducting the $2,000 per
employee above, unsecured claims for up to
$2,000 per claimant for contributions to
employee benefits.
• Unsecured claims of farmers
against grain elevators or of fishermen against fish
processing plants.
• Up to $900 per unsecured claim­
ant for security deposits and down payments for
services not rendered or goods not provided.
• Unsecured claims of govern­
mental units for taxes, customs duties, and penal­
ties accrued but unpaid.
Claims for employees’ wages and
benefits have third and fourth priority in the
schedule. General, unsecured, unsubordinated

21

claims, including the balance of claims for wages
and benefits, are given no priority and, thus,
effectively have eighth priority — behind all
other classes of prior claims.
claims are
subject to
the schedule of priorities, but bankruptcy trustees
may restrain secured creditors from realizing upon
their liens in return for providing “adequate pro­
tection” to the secured creditors while their claims
are stayed. Unfortunately, one man’s “adequate
protection” may be another man’s outrageous in­
fringement of rights. In practice, secured creditors
often are forced to renew their extensions of cred­
it to bankrupt enterprises in order to allow those
enterprises to continue operating for the benefit
of all creditors, both secured and unsecured.
Holders of investment securities
have no priority of claim and generally are paid, if
at all, only after all prior classes of creditors are
paid in full. A normal ranking of security holders
is as follows:
• Subordinated debt holders,
including bond and note holders.
• Preferred shareholders.
• Common equity shareholders.
Holders of investment securities
are referred to the terms of the relevant legal
documents to determine the relative priority of
different types of investment securities within the
classes of investment security holders.

Secured

2 2

not

III. Evolution of the Bankruptcy Code
The power to establish uniform laws on bank­
ruptcies was given to Congress under Article I,
section 8, clause 4, of the United States Constitu­
tion. Bankruptcy was bound up with controver­
sies regarding debtors’ prison under the common
law and, for the first century of its existence, the
United States had no permanent bankruptcy law.1
Congress managed to keep bankruptcy laws on
the books only briefly, during the years 18001803, 1841-1843, and 1867-1878. Disputes regard­
ing the availability and liberality of discharges
from debts in bankruptcy proceedings created the
political pressures that caused the repeal of those
early bankruptcy acts. Generally, Jeffersonians,
Jacksonians, and Southern and Western Demo­
crats favored liberal bankruptcy laws as a means
of discharging prior debts and granting debtors
fresh starts in life. Naturally, Tories, High Federal­
ists, Whigs, and Republicans (that is, the creditor
class) opposed the liberal discharges available to
nonmerchant debtors under bankruptcy laws.2 In

the aftermath of the depression following the
Panic of 1893, the first permanent bankruptcy law
was passed in 1898. That legislation provided
principally for straight liquidations. Then, in fits
and starts between 1932 and 1938, in the throes
of resolving the problems of a time when “so
many were debtors, and so few were solvent,”
the forerunners of the reorganization provisions
of the present Bankruptcy Code were enacted in
1938. Provisions for corporate reorganizations
(Chapter 10) and corporate arrangements (Chap­
ter 11) appeared for the first time as part of the
Chandler Amendments of 1938. Still, bankruptcy
was a defensive measure for corporate debtors,
and the requirement of corporate good faith in
filing bankruptcy petitions, not difficult to estab­
lish during the Great Depression, routinely was
enforced by the courts.
The present Bankruptcy Code was
enacted in 1978. Chapters 10 and 11 of the 1938
bankruptcy act were combined in the new Chap­
ter 11. Under the new Chapter 11, the stay of
creditors’ claims became automatic upon the fil­
ing of the petition. The automatic stay was seen
as a procedural improvement from the debtors’
perspective because, previously, the stay had to
be requested separately, and creditors could re­
sist the application for a stay, even after the Chap
ter 11 petition was filed. Also, the requirement of
actual insolvency at the time of filing under the
1938 act was eliminated in the new Chapter 11.
The Bankruptcy Code was
amended in 1984, following a June 1982 United
States Supreme Court decision striking down cru­
cial parts of the 1978 Code.3 The 1984 amend­
ments primarily were procedural, covering the
jurisdiction and tenure of bankruptcy judges.
However, the 1984 amendments also restricted
the extent of discharges in consumer bankrupt­
cies, established standards for judging the reaso­
nableness of employers’ rejections of collective
bargaining agreements, reordered the priority of
distributions of stored grain to farmers, and
exempted certain repurchase agreements cover­
ing financial instruments from the automatic stay
provisions of the Code.

2

See Countryman

(id)

at 229-230. Of course Jeffersonians object­

ed when the first bankruptcy act (1800) made discharges availa­

ble only to merchants. On the other hand, Hamiltonians found the act
useful. Robert Morris, once the financier of the American Revolution, and
by then “the most daring real estate plunger in the United States,"
financed speculative housing development in the District of Columbia,
beginning in 1796. Unfortunately, in 1 79 7, a financial panic arose from
the outbreak of the wars between England and revolutionary France.
Morris w as ruined and spent more than three years in the Philadelphia

I

A good overview of the comparative histories of the evolution of
bankruptcy acts in the United States and the United Kingdom is
Vem Countryman,

A History of American Bankruptcy Law,

81 Commer­

cial La w Journal 226 (19 76 ), from which much of the historical informa­
tion in this commentary is taken.

debtors' prison. His discharge in 1801 under the 1800 bankruptcy act
probably w as the most famous bankruptcy discharge in the nineteenth
century. See John C. Miller,

3

The Federalist Era: 1780-1801,

252 (1960).

Northern Pipeline Construction Co. v. Marathon Pipe Line Co., 458
U .S . 50 (1982).

Throughout the evolution of the
present Bankruptcy Code, the statutes enacted
have been reasonably clear expressions of the
Congressional view that bankruptcy should be a
defensive, nonroutine measure and should not
be used to advance the financial interests of cor­
porate debtors beyond the point that would have
been achieved by competition in a free market
among solvent corporations.

IV. Aggressive Uses o f Bankruptcy
A potentially disturbing trend of filings under the
Bankruptcy Code began with the classic “surprise
filing” by the
in 1982.
Johns-Manville, facing an unpredictable amount
of claims for damage thought to be caused by
asbestos, proposed a Chapter 11 reorganization
under which all present and future asbestos claim­
ants would be reimbursed from a separate fund
created by Johns-Manville. Meanwhile, the normal
business operations of the corporation continued,
comparatively unimpeded by the claims of asbes­
tos victims. The victims’ fund is to receive up to
$2.5 billion over 25 years, including the contribu­
tion of at least 50 percent of the common voting
equity shares of the corporation. The
case has been questioned in some of
the bankruptcy literature as lacking the elements
of a good-faith filing, but at this writing it appears
that the settlement will stand.4
Other potentially disturbing bank­
ruptcy decisions soon followed in the wake of
the
case. In February 1984, the
United States Supreme Court decided, 5-4, in

Johns-Manville Corporation

Johns-

Manville

Johns-Manville

National Labor Relations Board v. Bildisco & Bildisco, Inc., that employers undergoing Chapter 11

reorganizations unilaterally may abrogate or m od­
ify collective bargaining agreements that are
seriously burdensome to the employer when, on
balance, the equities of the case favor modifica­
tion of burdensome terms.5

Bankruptcy and Mass Tort, 84 Columbia
The Manville Corporation bank­
ruptcy; an abuse of the judicial process? 11 Pepperdine La w Review 151
(1983); Note, Manville: good faith reorganization or "insulated" bank­
ruptcy? 12 Hofstra La w Review 121 (1983); Note, Manville corporation
and the "good faith” standard for reorganization under the Bankruptcy
Code, 14 University of Toledo La w Review 1467 (1983); Note, Manville
bankruptcy: treating mass tort claims in Chapter 11 proceedings, 96 Har­

4

See,

e.g.,

Mark J , Roe,

La w Review 846 (1984); Note,

vard La w Review 112 1 (1983).
A thorough account of the

Bildisco

decision, 465 U .S . 513 (1984),

and the enactment of the collective bargaining provisions of the

The Con­
tinuing Conflict Between Bankruptcy and Labor Law -The Issues that
Bildisco and the 1984 Bankruptcy Amendments Did Not Resolve, 1986
Bankruptcy Code Am endm ents of 1984 is Thomas R. Haggard,

Bildisco

The
case illustrates the way
that bankruptcy courts usually resolve fundamen­
tal conflicts between provisions of the Bankruptcy
Code and other provisions of federal law: Bankrupcty provisions prevail. It is only natural for
bankruptcy courts to consider the creation of viably reorganized entities as their paramount duty
in Chapter 11 cases. The remedy for those dis­
tressed by such tendencies on the part of the
bankruptcy courts is to petition Congress for
amendments to the Bankruptcy Code that would
specifically address such conflicts. However, as is
noted below, the bankruptcy courts have modified
somewhat their tendency to elevate bankruptcy
procedures above other considerations of federal
or state law only in environmental pollution cases.
Labor leaders lobbied Congress to
overturn the effect of the
decision, and
Congress did so in the July 1984 amendments to
the Bankruptcy Code (11 U.S.C. section 1113,
“Rejection of collective bargaining agreements”).
Although they still allow employers to reject col­
lective bargaining agreements, these amendments
establish standards for judging the reasonable­
ness of the rejection in light of good-faith efforts
to negotiate modification of the agreements. In
the first court test of the 1984 amendments, In
(W.D. Pa. 1985),
the district court sustained an employer’s rejec­
tion of wage provisions of a union contract under
section 1113, even though it was arguable that
the employer had not bargained in good faith on
the wage concessions. The union was holding
out for further bank lenders’ concessions before
agreeing to the wage concessions. Upon appeal
(May 1986), the Third Circuit Court of Appeals re­
manded the case to the district court, finding that
the standards for rejection established by section
1113 of the Bankruptcy Code had not been met.6
In the Daikon Shield (intrauterine
device) litigation, a Chapter 11 filing by the AH.
Robins Company (March 1986) was intended to
forestall future product liability claims against the
company. At the date of filing, Robins had settled
9,300 claims for $517 m illion, with 5,000 more
claims still pending. As in the
case,
the
filing was intended to cut off future
product liability claims and to enable the rest of
the company to continue operating without the
burden of those claims. However, enough allega­
tions of high-level corporate malfeasance emerged
in the
case that the court appointed a spe­
cial monitor to review the ongoing operations of
senior management. Management remains in
control of the company at this writing.7

Bildisco

Wheeling-Pittsburgh Steel Corp.

Robins

Johns-Manville

Robins

Brigham Young University La w Review 1. See also, Benjamin Weintraub

Problems with Labor
Unions: Rejecting Collective Bargaining Agreements, paragraph 8 .11 (9)
(1986). See In re Bildisco, 682 F.2 d 72 (3d Cir. 1982).

and Alan N . Resnick, Bankruptcy La w M anual,

Wheeling Pittsburgh Steel Corp. v. United Steelworkers of
America, 791 F.2d 1074 (3d Cir. 1986).

re

23

In other aggresive filing develop­
ments under the Bankruptcy Code, a new line of
cases is evolving that might lim it corporations’
capacity to cut off liability for toxic waste pollu­
tion of the environment by filing Chapter 11 peti­
tions. In January 1986, the United States Supreme
Court decided, 5-4, that bankruptcy trustees may
not abandon corporate property under 11 U.S.C.
section 554 (a) that is burdensome to the bank­
ruptcy estate if the abandonment causes envir­
onmental damage that contravenes state laws or
health and safety regulations. The case decided in
January 1986 was
which
was an appeal of two 1984 Third Circuit cases
involving Quanta Resources Corporation.8 It is
noteworthy that, in the
case, Justice
Rehnquist wrote the dissenting opinion which
stated, in relevant part:
The Bankruptcy Court may
not, in the exercise of its equitable powers,
enforce its views of sound public policy at
the expense of the interests the Code is
designed to protect. In these cases, it is
undisputed that the properties in question
were burdensome and of inconsequential
value to the estate. Forcing the trustee to
expend estate assets to clean up the sites
would plainly be contrary to the purposes
of the Code.
The
case involved a
liquidation, but comparable concerns would arise
in Chapter 11 cases if abandonment of contami­
nated property seemed essential to achieving a
financially successful corporate reorganization. In
the future, it is not inconceivable that corpora­
tions would attempt to cut off toxic waste liability
by filing Chapter 11 petitions with the intent to
abandon contaminated property. At present, the
weight of court decisions appears to be against
such aggressive use of Chapter 11 petitions.9
The original bankruptcy court order
in the
ase was issued in 1981. Since
then,
has had two progeny worthy of
note:
and
In

Midlantic Bank v. New Jersey
Department of Environmental Protection,
Midlantic

24

Midlantic

Bildiscoc
Bildisco
Wilson Foods

7

See

Continental Air Lines.

A.H. Robins Co. v. Piccinin,

788 F.2d 994 (4th Cir. 1986). The

Fourth Circuit upheld a preliminary injunction staying all claims

April 1983, Wilson, then the fifth-largest meat
packer in the United States, filed a Chapter 11 pe­
tition in Oklahoma. Wilson then unilaterally re­
jected collective bargaining agreements covering
two-thirds of its employees and reduced wages
by 40 to 50 percent. W ilson’s petition showed an
estimated positive net worth of more than $67
m illion. After reducing wages, Wilson was re­
ported to have obtained a new line of credit for
$80 m illion from a New York City bank.1
0
In September 1983, Continental,
then the eighth-largest airline in the United States,
filed a Chapter 11 petition in Texas. Continental
had been bargaining with its employees for wage
concessions as part of a corporate strategy for be­
coming an efficient, low-cost carrier in a deregu­
lated environment. After the filing, Continental
unilaterally rejected contracts with several unions,
including the pilots’ union. All employees tempo­
rarily were laid off. A few days later, one-third of
the employees were recalled, but new wages were
reduced from former levels by more than half in
some instances. Although Continental had a
heavy debt burden at the time of filing, net worth
still was positive. The reorganized Continental,
together with low-cost affiliates such as New York
Air, is a strong competitor over major airline
routes in the United States and on certain interna­
tional routes; furthermore, it is usually mentioned
as a potential acquirer of other, troubled airlines.
During the spring and summer of 1986, Conti­
nental’s parent company, Texas Air, was involved
in negotiations to acquire Eastern Airlines and
People Express. At this writing, it appears that
those acquisitions will be consummated.
Taking the Chapter 11 baton from
Continental is
a unionized carrier
serving the western United States that was
acquired in 1985 by the ultimate low-cost air car­
rier, People Express. Facing a heavy debt burden
and expanded price competition over most of its
domestic routes, People Express offered Frontier
for sale in the late spring of 1986. One potential
acquirer, United Airlines, was close to completing
the purchase of Frontier but, as of this writing,
has not done so.
One of the obstacles to United’s ac­
quisition of Frontier was its inability to negotiate

Frontier Airlines,

arising from Daikon Shield litigation against personally named co­
defendants (typically, officers and directors of Robins) once the

Robins

Chapter 11 petition w as filed. This decision is viewed as an affirmation
of the broad injunctive powers of a bankruptcy court to stay all claims
involving a debtor reorganizing under Chapter 11.

8

vacs,

Midlantic,

474 U .S ___________ 88 L.E d .2 d 859 (1986). The

Ohio v. KoKovacs, the

469 U .S __________ , 83 L.E d .2 d 6 49 (1985). In

Supreme Court held that a discharge in bankruptcy w as allowed for a
debtor whose property w as seized by a state receivership which began
to clean up a toxic w aste site and then ordered the debtor to pay for the

(Midlantic)

the reso­

lution of the issue of allowing bankruptcy trustees to abandon contami­
nated property.

United States v. Maryland Bank & Trust Co.,______ F.S up p.

tion laws were extended to enable the Environmental Protection Agency

Supreme Court made a similar finding in the case of

clean-up. The Supreme Court left for another ruling

9

In

______ (D . M d „) slip op. Apr. 9, 1986), the environmental protec­

to maintain lawsuits against innocent parties foreclosing on contami­
nated property and to require them to pay for the costs of cleaning up
the property. It is believed that such precedents will complicate Chapter
11 proceedings in the future by raising the spectre of unscheduled liabili­
ties in amounts that, if not stayed or discharged, would disrupt the
orderly reorganization of companies operating under Chapter 11 in cases
involving infringement of environmental protection laws.
1

Graeme Browning,
U

Using Bankruptcy to Reject Labor Con-

tracts, 70 American Bar Association Journal 60 (Feb. 1984).

a mutually satisfactory transitional salary scale for
Frontier’s pilots, who generally earned less than
United’s pilots. Other potential acquirers of Fron
tier apparently were w illing to purchase it only if
the collective bargaining agreements with the
principal Frontier unions were rejected. People
Express apparently threatened to file a Chapter 11
petition for Frontier in order to induce Frontier’s
unions to be more forthcoming. Thus, the Fron­
tier case illustrates another variation of the
aggressive use of Chapter 11 filings: The threat to
file becomes a bargaining chip in labor negotia­
tions. United’s negotiations regarding Frontier
were interrupted by the filing of a Chapter 11
petition for Frontier on August 28, 1986.1
1
One debtor that has shown real
initiative following a bankruptcy reorganization is
a California-based building
supply company that filed its Chapter 11 petition
in April 1982, shortly before the upturn from the
1981-82 recession began. Reorganized under
strong management, Wickes reduced operating
expenses, closed unprofitable stores, and renego­
tiated or rejected a number of building leases for
its stores. Wickes emerged from Chapter 11 in
early 1985. A year later, in April 1986, Wickes
attempted to acquire the National Gypsum Cor­
poration for approximately $1.2 billion. After that
takeover attempt failed, during August 1986,
Wickes mounted a new hostile tender offer for
Owens-Coming Fiberglas Corporation, Toledo,
Ohio. Wickes apparently intended to finance the
tender offer with an issue of so-called “junk
bonds” and with the planned post-acquisition
sale of Owens-Coming operations not closely
related to the core operations of Wickes. The
tender offer was valued at $2.1 billion. O n August
29, 1986, Wickes terminated the offer, but analysts
estimated that Wickes had a net gain of at least
$30 m illion from the increased value of OwensComing shares acquired during the takeover
attempt. It is significant that a company that not
long ago filed a Chapter 11 petition, apparently in
good faith, has been able to mount hostile tender
offers for multi-billion-dollar corporations within
little more than a year after ceasing to operate
under the supervision of a bankruptcy court.

Wickes Corporation,

V. Implications for the Bankruptcy System
The sequence of all the cases cited above is a
signal that something might be wrong in the
bankruptcy system. For bankruptcy specialists,
and for economists generally, those cases are like,

n

in the words of Thomas Jefferson, a “fire-bell in
the night... [W] e have the w olf by the ears, and
we can neither hold him, nor safely let him go.
Justice is in one scale, and self-preservation in the
other.”1 Jefferson was writing about the perni­
2
cious effects of slavery on the preservation of the
Union and about the controversies raised by the
Missouri Compromise. The message of those
words, however, for defenders of the notions of a
free market and of market discipline in American
enterprise, is that actions currently taken under
Chapter 11, while perfectly legal under the pres­
ent Bankruptcy Code, may be moving inexorably
in the direction of a race to the courthouse to
enable solvent, albeit troubled, corporations to
gain positive advantages over competitors. Such a
race for competitive advantage through the legal
process eventually undermines the free-market
system, as well as the other laws overridden by
the Bankrutpcy Code, such as environmental pro­
tection or labor laws.
Yet, competitors in any line of bus­
iness “have the w olf by the ears” in that they
cannot safely renounce the use of Chapter 11 fil­
ings as a means of reducing operating costs
significant competitors in that line of
unless
business refrain from filing as long as they are
solvent. Thus, justice (fair play) demands that all
solvent competitors refrain from filing, but selfpreservation demands that all competitors retain
the capacity to file as long as any significant com­
petitor has that capacity.
If efficiency in the market is
achieved most easily by becoming a low-cost
producer under the protective umbrella of a
Chapter 11 filing, why should any corporation
exert itself to achieve efficiency by bargaining
and by open competition in a free market? Before
1978, a showing of insolvency was a prerequisite
of a Chapter 11 filing, but that requirement was
dropped in the present Bankruptcy Code.1 The
3
question now presented is whether the benefits
that were supposed to flow from the removal of
the requirement of insolvency have been out­
weighed by the deficiencies — if they are, in fact,
deficiencies — of the present statute. After all, in
the words of one bankruptcy expert,
Chapter 11 is supposed to be
rehabilitative,... a device “which can be
used to cure a company that’s ill or hemor­
rhaging.” It is better to apply the cure while
a company “has strength and vitality left —
before letting it die.”1
4

Press reports in early September 1986 indicated that Arm co,
a major producer of steel, also allegedly w as using the threat
of a Chapter 11 filing to induce its employees’ union to make wage con­

cessions. In fact, the union agreed to the concessions and no Chapter 11
petition w as filed.

all

"I

^

Letter from Thom as Jefferson to John Holm es, April 2 2 ,1 8 2 0 ,

Ld

in The Portable Thomas Jefferson 567, Merrill D . Peterson

ed. (19 75 , reprinted 1980).

13

Browning,

supra

note 10.

25

Thus, it is important to remember
that not all observers believe that the present
uses of Chapter 11 are all bad. The issue of good
faith in filing could be addressed satisfactorily by
scrutinizing Chapter 11 filings in light of the
question: “Is this company financially troubled
enough to justify the filing?” By that standard,
some of the recent Chapter 11 filings (for exam­
ple,
and
) might not be par­
ticularly troublesome.

Wickes, LTV,

2 6

Frontier

VI. Summary
The law of bankruptcy has been intended since
1898 to grant debtors relief from claims of unse­
cured trade creditors, bank lenders, and the like,
but not to affect substantially the claims of em­
ployees for accrued, but unpaid, wages and bene­
fits, or the claims of governmental units for taxes.
Such claims were, and still are, given priority in
the distribution of assets of bankruptcy estates.
Since 1982, a new trend has emerged in which
aggressive bankruptcy filings are used to achieve
the greater financial objectives of the corporations
filing Chapter 11 petitions. The 1984 amendments to the Bankruptcy Code were intended to
rein in perceived abuses of the corporate capacity
to disavow employment contracts. Some may
argue that the July 17, 1986 filing by LTV Corpora­
tion was yet another corporate effort in the direc­
tion that was opposed by the 1984 amendments.
It is possible to contend that the filing was
designed to enable LTV to modify its collective
bargaining agreements substantially or to reject
future liability for employee benefits, including
pension or insurance liabilities. O n the other
hand, LTV clearly was having financial troubles,
and issues regarding the good faith of its failing
still have to be resolved by the bankruptcy court.
The cases described above fall into
three broad categories:
1. Contingent products liability or environ­
mental protection

Johns-Manville (1982)
AH. Robins (1986)
Midlantic (1986) (Chapter 7)
2. Executory collective bargaining agreements

Bildisco (1981-1984).
Wilson Foods (1983)
Continental Air Lines (1983)
Frontier Airlines (1986)

"I

/

Roy Carlin, Esq ., bankruptcy counsel for Wilson Foods,

JL

I

quoted in Browning,

supra

note 10.

3. Restructuring and downsizing corporate
liabilities

Wickes

(1982)
Z7V(1986).
The Supreme Court thus far seems to be sustain­
ing the primacy of bankruptcy considerations in
the second and third categories of cases, while
continuing to sustain the primacy of environmen­
tal protection laws in cases that do not involve
mass tort litigation.
In any case, it is clear that compan­
ies with the benefit of the protection afforded by
Chapter 11 filings have advantages in corporate
financial structure that are not available to sim­
ilarly situated, but presumably solvent, competi­
tors who do not file. Thus, it is reasonable to
predict that, in a disinflationary environment, an
increased number of aggressive Chapter 11 filings
will occur in any industry in which a significant
competitor alters its costs of production by filing
a Chapter 11 petition. In the absence of a more
orderly, formal procedure for downsizing corpo­
rate assets and liabilities in the United States, such
a use of Chapter 11 is neither illogical nor com­
pletely unforeseeable. The remedy for aggressive
uses of Chapter 11, if a remedy becomes desira­
ble as a matter of public policy, is to be found by
following the traditional path of Congressional
enactment of corrective amendments of the
Bankruptcy Code.
At the same time, the purpose of
the 1978 revisions of Chapter 11 should be kept
in mind: The rehabilitation of ailing companies
should be effected before they become termi­
nally ill. If nothing concentrates the m ind like the
prospect of being hanged, then the opportunity
for a debtor to file a Chapter 11 petition before its
case is terminal ought to serve a constructive
purpose: It should encourage lenders,
employees, and the company’s other constituent
groups to cooperate in attempting to improve the
chances for restoring the company’s competitive
viability in order to avoid the filing. The same
spirit of cooperation should prevail if a filing
occurs despite everyone’s best efforts.

Economic Commentary

Monetary Policy Debates Reflect
Theoretical Issues
by James G. Hoehn
May 1, 1986
How Good Are Corporate Earnings?
by Paul R. Watro
May 15, 1986
The Thrift Industry: Reconstruction
in Progress
by Thomas M. Buynak
June 1, 1986
The Emerging Service Economy
by Patricia E. Beeson and Michael F. Bryan
June 15, 1986
Domestic Nonfinancial Debt: After
Three Years of M onitoring
by John B. Carlson
July 1, 1986
Equity, Efficiency, and
Mispriced Deposit Guarantees
by James B. Thomson
July 15, 1986

A Correct Value for the Dollar?
by Owen F. Humpage and
Nicholas V. Karamouzis
January 1, 1986

Target Zones for Exchange Rates?
by Owen F. Humpage and
Nicholas V. Karamouzis
August 1, 1986

Bank H olding Company Voluntary
Nonbanking Asset Divestitures
by Gary W halen
January 15, 1986

W ill the D ollar’s Decline Help
O hio Manufacturers?
by Amy Durrell, Philip Israilevich,
and KJ. Kowalewski
August 15, 1986

Junk Bonds and Public Policy
by Jerome S. Fons
February 1, 1986
Can W e Count on Private Pensions?
by James F. Siekmeier
February 15, 1986
American Autom obile Manufacturing:
It’s Turning Japanese
by Michael F. Bryan and Michael W. Dvorak
March 1, 1986
Should W e Be Concerned About the
Speed of the Depreciation?
by Owen F. Humpage
March 15, 1986
The Government Securities Market
and Proposed Regulation
by James J. Balazsy,Jr.
April 1, 1986
A Revised Picture: Has O ur View
of the Economy Changed?
by Theodore G. Bernard
April 15, 1986

Im plications of a Tariff on O il Im ports
by Gerald H. Anderson and KJ. Kowalewski
September 1, 1986
Alternative Methods for Assessing Risk-Based
Deposit-Insurance Premiums
by James B. Thomson
September 15, 1986

27

Economic Review

Quarter I 1985
Beauty and the Bulls: The Investment Character­
istics of Paintings
by Michael F. Bryan

by Edward Montgomery

The Reserve Market and the Information Con­
tent of Ml Announcements

28

Quarter I 1986
The Impact of Regional Difference in Unionism
on Employment
The Changing Nature of Regional Wage Differ­
entials from 1975 to 1983

by W illiam T. Gavin and Nicholas V. Karamouzis

by Lorie Jackson

Quarter II 1985
Vector Autoregressive Forecasts of Recession
and Recovery: Is Less More?
by Gordon Schlegel

Revenue Sharing and Local Public Expenditure:
Old Questions, New Answers

Labor Market Conditions in Ohio Versus the
Rest of the United States: 1973-1984
by James L. Medoff

Quarter II 1986
Metropolitan Wage Differentials:
Can Cleveland Still Compete?

by Paul Gary Wyckoff

by Randall W. Eberts
and Joe A Stone

Quarter III 1985
The Impact of Bank Holding Company Consoli­
dation: Evidence from Shareholder Returns

The Effects of Supplemental Income
and Labor Productivity on Metropolitan
Labor Cost Differentials

by Gary Whalen

by Thomas F. Luce

The National Debt: A Secular Perspective

Reducing Risk in Wire Transfer Systems

by John B. Carlson and E. J. Stevens

by E.J. Stevens

The Ohio Economy: A Time Series Analysis
by James G. Hoehn and James J. Balazsy, Jr.

Quarter IV 1985
Stochastic Interest Rates in the Aggregate LifeCycle/Permanent Income Cum Rational Expec­
tations Model
by Kim J. Kowalewski

New Classical and New Keynesian Models of
Business Cycles
by Eric Kades