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Vol. 2 6 , N o . 1

ECONOMIC REVIEW
19 9 0 Quarter 1

A Hitchhiker’ s Guide
to international

2

Macroeconomic Policy
Coordination

j

by Owen F. Humpage

Public Infrastructure and
Regional Economic
Development

15

by Randall W. Eberts

Using Market Incentives
to Reform Bank Regulation
and Federal Deposit
Insurance

by James B. Thomson




FEDERAL RESERVE BANK
OF CLEVELAND

28




— «BIT

MI C

R E V I E W

1 9 9 0 Quarter 1
V ol. 2 6 , N o . 1

A Hitchhiker’s Guide
to International

2

Macroeconomic Policy
Coordination
by Owen F. Humpage
A wealth of studies about international macroeconomic policy coor­
dination have surfaced in the past decade, offering important insights
that unfortunately have remained inaccessible to many economists

Economic Review is published
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and policymakers because of the sophisticated mathematics inherent
in the literature. This paper lifts the analytical veil from these stud­
Coordinating Economist:
Randall W. Eberts

ies, presenting their findings in a less-technical fashion.

Public Infrastructure and
Regional Economic

15

Development
by Randall W. Eberts
What are the various channels through which public capital can
influence regional economic activity? A review of recent empirical
studies reveals that, among other findings, 1) public capital stock
positively affects regional growth, primarily as an unpaid input into
the production process; 2) public capital and private capital are com ­
plements in manufacturing; and 3) public capital stock has a positive

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those of the Federal Reserve
Bank of Cleveland or of the
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influence on the start-up of firms.

Using Market Incentives

2 8

to Reform Bank Regulation
and Federal Deposit
Insurance
by Jam es B. Thomson
The current system of bank regulation and federal deposit insurance
is not working and requires a massive overhaul. This paper looks at
the issues involved in reforming the regulatory structure of the finan­
cial services industry, including the financial safety net, and presents
the case for adopting market-oriented reforms.




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ISSN 0013-0281

A H itch h ike r’s Guide
to International
M acroeconom ic Policy
Coordination
by Owen F. Humpage

Owen F. Humpage is an economic
advisor at the Federal Reserve Bank
of Cleveland. The author gratefully
acknowledges helpful suggestions
from Fadi Alameddine, Brian Cody,
Randall Eberts, Norman Fieleke, Wil­
liam Gavin, and Dale Henderson.

Introduction

The last 10 years have witnessed a virtual explo­
sion of articles about international macroeco­
nomic policy coordination. In part, advances in
econometric modeling, particularly in tech­
niques for understanding strategic interactions
among countries, have encouraged studies in
this area. A further, more recent incentive for
these studies is a renewed interest among policy­
makers in world institutions and in mechanisms
that require a greater coordination of economic
policies. Examples include target zones for
exchange rates and a European central bank.
This article offers a hitchhiker’s guide to the
literature: a fairly nontechnical survey for those
who want to follow along, but are not inclined
to take the wheel.1 We focus on the empirical
literature that attempts to measure possible gains
from macroeconomic policy coordination, offer­
ing notes on those assumptions and methodolo­
gies that circumscribe their interpretations. In
the conclusion, we try to synthesize the overall
policy implications of this important literature.

 ■ 1 In deference to Douglas Adams, The Hitchhiker's Guide to the Galaxy.
New York: Pocket Books, 1979.


To begin, however, we ask the most basic
question: Why do many economists believe
international policy7coordination is an important
objective?

I. Cooperation and
Coordination

Two terms continually reappear in our discussion:
international cooperation and international
coordination. Following the economics literature
on this subject: International cooperation refers
to the sharing of information. The term implies
that each country establishes its macroeconomic
objectives and sets its economic policies inde­
pendently of all other countries, but that all share
information about the world economy. This infor­
mation includes observations on the nature of
economic interactions, on the sources and extent
of economic disturbances, on intended policy
responses, and on the economic outlook in light
of these disturbances and intended responses.
International coordination, in contrast,
refers to the joint determination of countries’
macroeconomic policies toward a collective set

3

of goals. Through policy coordination, countries
attempt to maximize joint welfare, rather than
their individual welfare. Policy coordination pre­
supposes cooperation, but not vice versa.2
The major industrialized countries maintain
many forums to encourage macroeconomic
cooperation. Economic summits among the
industrial countries, and meetings of the Interna­
tional Monetary Fund (IMF) or the Organisation
for Economic Co-operation and Development
(OECD), are the most formal of these forums.
Similarly, one finds many examples of interna­
tional macroeconomic policy coordination. The
Plaza Accord in September 1985 represented an
agreement, especially among West Germany,
Japan, and the United States, to undertake spe­
cific macroeconomic policies to eliminate huge
imbalances in their international accounts and to
promote a dollar depreciation. Similarly, at the
Bonn Summit in 1978, the major industrial coun­
tries agreed to policies that would encourage
world economic expansion.
Besides these ad hoc arrangements, the world
has also seen some more formal attempts at
international policy coordination. Fixedexchange-rate regimes, for example, operate
within certain “rules of the game,” methods of
resolving international interdependencies, which
ultimately require a coordination of macroeco­
nomic policies. As is well known, rigidly fixed
exchange rates prevent member countries, except
the reserve-currency country, from pursuing
independent monetary policies.
History shows that countries are eager to
cooperate with their allies, but that these same
countries are more reserved about their willing­
ness to coordinate macroeconomic objectives.
Tliis observation provides a basis against which
to consider the result of the following studies.
Why do countries cooperate, but do not coordi­
nate except occasionally on an ad hoc basis?

■ 2

Although the distinction between international cooperation and interna­

tional coordination seems simple and straightforward, confusion easily can

II. International
Interdependence

The belief that international cooperation and
coordination can make all countries better off in
terms of their macroeconomic performance rests
on the view that international interdependence
among nations creates a type of policy external­
ity, or spillover effect. The policies of one coun­
try affect economic developments in others,
sometimes positively, sometimes negatively.
Countries understand these external effects,
but evaluate them lopsidedly. They consider the
implications of foreign policies on their own
economic well-being and adjust their own poli­
cies accordingly. Nevertheless, acting individu­
ally, sovereign nations do not fully consider the
implications of their own policies for the eco­
nomic welfare of other countries. In the worst
case, each country might engage in beggar-thyneighbor policies; that is, enhance its individual
welfare at the expense of other countries. The
competitive depreciations of the 1930s are a clas­
sic example. More generally, however, when
countries ignore the consequences of their
actions for world welfare, these policies often
prove to be suboptimal in the sense that some
alternative set of policies, which account for the
spillover effects, could make at least one country
better off without making any other country
worse off.
As an example, consider an argument that
seemed to underlie discussions for coordination
at the Group of Five meeting in September
1985.3 Acting unilaterally, as if isolated from the
other nations, the United States could eliminate
its current-account deficit by tightening monetary'
and fiscal policies. The cost, however, would be
a substantial slowing in real economic activity
and perhaps a recession. Similarly, West Ger­
many and Japan could unilaterally eliminate their
current-account surpluses through a monetary
and fiscal expansion. The cost would be a more
rapid inflation rate in both countries.
But these countries are not isolated. The coor­
dination problem results because the individual
actions of each country tend to benefit the others.
The contraction in the United States would help
eliminate the West German and Japanese currentaccount surpluses by lowering their exports. Sim­
ilarly, the expansion in West Germany and Japan
would help eliminate the U.S. current-account
deficit by encouraging U.S. exports. Realizing this

result. Most empirical studies of international interdependence use techniques
of game theory, which describes the strategic interactions of individuals.
Game-theoretic literature often uses the term cooperation to imply the joint
determination of policy, or what the economics literature coins as coordination.

 See Canzoneri and Edison (1989), Horne and Masson (1988), and Cooper
(1985).


■ 3

The Group of Five (G5) refers to France, Japan, the United Kingdom,

the United States, and West Germany. The Group of Seven (G7) refers to
these five countries plus Canada and Italy.

interdependence creates an incentive for each
country to attempt to avoid the costs associated
with the corrective policy by “free riding” on the
policies of the others. This positive policy spill­
over results in too little overall corrective policy.
The external imbalances might persist.
Cooperation could eliminate the attempt to free
ride on the policies of the other countries in this
case. Countries would provide more corrective
policies and world welfare might be enhanced.
As this example suggests, interdependencies
among countries arise because the structures of
their economies are intertwined through trade
and financial flows.4 Trade and capital flows
among nations create what Cooper (1985) has
termed structural interdependencies. U.S. real
GNP, for example, depends in part on real net
exports. Net exports, in turn, depend on foreign
income, on the foreign marginal propensity to
import, and on the terms of trade between
exporters and importers. U.S. price levels sim­
ilarly depend on foreign prices as translated
through exchange rates. U.S. interest rates are
linked to foreign interest rates and to expected
exchange-rate movements through arbitrage.
These and other similar linkages among coun­
tries transmit shocks between the U.S. economy
and the rest of the world.
Structural interdependencies among nations’
economies have always existed. Cooper (1985,
1986) suggests that largely because of advances
in technology and communications, structural
interdependencies among countries have
increased over the last 40 years, making these
linkages all the more important in policy con­
siderations. This consensus view suggests that
the potential benefits from international policy
coordination are greater now than at any time
since World War II.
Fieleke (1988), however, investigates an array
of empirical data bearing on the extent to which
markets are integrated. His data do not reject the
consensus view that the world is becoming more
closely integrated, but they do not depict the
world as a single market. Similarly, Wyplosz
( 1988) presents evidence suggesting that the
trade linkages between the United States and the
European Economic Community are small. He
argues that the main linkages are from financial
flows. In short, although interdependencies are
increasing, one must be careful not to overstate
their importance.

■4

One also could envision a world in which a set of independent coun­

tries faced a common external economic shock, such as an oil-price shock.

 These countries might benefit more from a joint response than from a unilat­
eral response.


Beyond these structural interdependencies,
mutual economic objectives can create policy
conflicts. The United States and West Germany
might both desire stable currencies or a bal­
anced current account. These objectives do not
conflict, and cooperation to achieve them is pos­
sible. If, however, each county wants its cur­
rency to appreciate relative to the other, or if
each country desires a bilateral current-account
surplus against the other, the desired values for
these mutual objectives are inconsistent. The
closer one country comes to achieving its objec­
tive, the further the other country moves from its
goals. Coordination might not be possible.
The existence of interdependencies and con­
sistent mutual objectives is not, in itself, suffi­
cient to require cooperation among countries. As
Oudiz and Sachs ( 1984) suggest, if countries can
adjust their domestic policy variables in a
manner that fully compensates for the foreign
influence, then those countries need not coop­
erate to attain their national policy targets.5 The
crucial ingredient is that the spillover alters the
relationship between domestic policies and their
ultimate targets, or that it changes the relation­
ship among the targets in a manner for which no
domestic offset is feasible. Moreover, it implicitly
assumes that countries do not have enough
independent policy instruments to maintain all
of the desired policy goals.
Assume, as is typical of most models used to
study macroeconomic policy coordination, that
goods prices are sticky7and that a short-run trade­
off exists between inflation and output. If a for­
eign country expands its money supply, a tem­
porary7real depreciation of its currency could
worsen the current account and real growth in
the home country. In response, the home country
might attempt to expand its money supply to
offset the real depreciation of the foreign cur­
rency and the slower real growth. The negative
externalities associated with these policies result
in too much overall expansionary7policy; world­
wide inflation would be higher. Thus, the faster
foreign money growth alters the relationship
among exchange rates, current-account balances,
and inflation rates in a manner that the home
country cannot offset with a limited number of
policy instruments. A coordinated policy
response might have produced a better outcome.

■ 5

"... the inefficiency of uncoordinated policymaking arises not from the

mere fact of interdependence; but because one country’s policies affect
another's targets in a way that is (linearly) distinct from that country's ability
to affect its own targets." Oudiz and Sachs (1984), p. 28.

F I

G

U

R

E

A Simple Policy 6ame

Each of the countries also has a vector of pol­
icy instruments, C ‘ = ( C 1 , C 2 , ■
■
■Cn), which it
manipulates in an effort to attain its policy
targets. These policy instruments would include
money growth, taxes, and government spending.
In an interdependent world, the policy choices
of any one country affect the target variables, and
hence the welfare, of the other. Equation (2) is a
shorthand notation of an econometric model,
incorporating such policy spillovers:
(2)

r 1 = F l {C\ C 2, X ) and
T2 = F 2 (C\ C 2, X ).

III. Policy Coordination

T o understand the nature of the gains from macroeconomic policy coordination, consider the follow­
ing simple example of a one-time policy game.6
Assume that the world consists of two countries
designated with superscripts, / = 1, 2, respec­
tively.7 Each country seeks to maximize its own
welfare, U '( T which it defines in terms of a
vector of m policy targets, T' = ( Tx , T2 , ... Tm):
(1)

¿71 = ¿71 ( r 0 and U 2 - U 2 ( T 2).

These policy targets might include a desired
inflation rate, a real economic growth objective,
and a current-account goal. Different countries
attach different welfare weights, and sometimes
no weight, to specific policy objectives. West
Germany, for example, seems to attach more
importance than most countries to maintaining a
low inflation rate.

■

6 This example follows Oudiz and Sachs (1984), who provide useful detail.

■7

Superscripts refer to countries 1 and 2, respectively. Subscripts refer to


policy targets or instruments, as the case may be.


Notice that the policy instruments of both coun­
tries appear in each equation.
Absent coordination, each country chooses a
monetary and fiscal policy to attain the combina­
tion of growth, inflation, and current-account
targets that maximizes its individual welfare. In
so doing, each country considers the other’s pol­
icy choice, but ignores the impact of its own pol­
icy choice on the foreign country’s welfare. We
can manipulate equations ( 1 ) and ( 2) to express
the optimal value of C \that is, the value that
maximizes equation (1), as a function of C 2 and
vice versa. One set of optimal values for C 1 and
C 2 will satisfy both of the functions that we have
derived simultaneously. This is called the no­
coordination equilibrium.
In a one-shot policy game, where players
make choices only once, to reach the no­
coordination equilibrium, one assumes that each
country has perfect knowledge of the model and
makes all calculations instantly. Figure 1 depicts
such an outcome, where each country’s indiffer­
ence curve cuts through the equilibrium point,
N, such that its tangent at N is perpendicular to
the tangent of the other country’s indifference
curve. As this requirement ensures, without pol­
icy coordination, this is the best each country
can do, given the behavior of the other. Country
1, knowing that country>2 will choose C 2N, will
itself choose C 1v , since any other policy7choice
would put it on a lower indifference curve. In a
similar way, country 2 chooses C 2N.
Because the indifference curves are not tangent
to each other at point N, a different combination
of policies could make at least one country bet­
ter off without making the other worse off. The
lens-shaped area, which the indifference curves
outline, gives the mixes of policies that would
provide a more efficient outcome.
Within the context of a standard one-shot pol­
icy game, countries can reach a superior outcome
through cooperation. When countries cooperate,

instead of maximizing welfare as given in equa­
tion ( 1 ), they maximize a joint utility function,
(3)

W7 = b U l + (1 - b ) U 2,

with respect to the policy instruments. For each
value of h (the weight attached to the home
country’s welfare function), this maximization
will yield a unique value of the policy instru­
ments. Line hh' in figure 1 depicts these values.
A subset of these points will fall in the
indifference-curve lens, described above, and
will make both countries better off. Participating
countries, of course, must negotiate the utility
weights; point E in figure 1 represents one such
negotiated solution.
Although this one-shot policy game helps illus­
trate the basic idea that policy coordination can
improve welfare, and although it underpins much
of the empirical estimation to date, it is, neverthe­
less, hopelessly artificial. The strategic behavior
of nations more closely resembles a sequence of
games or a dynamic game where the state of the
world changes in response to repeated economic
shocks and policies, where strategies change in
response to states of the world and build on past
strategies, and where the economic model
changes as the players learn about the economy.8
As discussed in subsequent sections of this
paper, much of the more recent literature adopts
dynamic techniques, which have produced some
important considerations and results that contrast
markedly with the one-shot policy experiments.

IV. Econometric Models
and Policy Coordination

The measurement of gains from policy coordina­
tion and the policy7 implications that one derives
from a policy game as described in the previous
section depend crucially on the economic model
that was used to generate them. This literature
presents a wide variety of econometric models,
reflecting different schools of economic thought
and opinions about the optimal degree of abstrac­
tion. Holtham (1986) provides a useful survey.
Most, but not all, of the analysts rely on large
econometric models. Nearly all of the models
embody some form of lagged adjustment in
wages and prices, a feature that allows monetary
policy to affect real output and real exchange
rates. Many include forward-looking expectations,
at least in asset markets. Substantial differences
among the models also result from the approach

 ■ 8 For a review of game theory, see Friedman (1986).


for assigning parameter values. Some parameters
are purely statistical estimates, specific to the
time period of their estimation. Others take
assigned values, consistent with an economic
theory and with generally expected magnitudes.
This variety allows findings to be compared
across many different techniques and should
serve to distinguish between those findings that
are artifacts of a specific model and those that
are more general.
Nevertheless, certain caveats apply to nearly all
of these models and should restrict one’s will­
ingness to accept their policy implications. For
example, in the one-shot game, the results refer
to a specific time horizon and could change sub­
stantially if the time horizon was altered. One
would expect, for example, that in a model with
sticky prices, a monetary expansion might
initially result in a real depreciation. Later, how­
ever, as prices adjust, the real exchange rate
would revert to its long-term value.
Similar comments apply to any trade-off
between inflation and real output. A model simu­
lated over a short time frame could produce a set
of welfare implications entirely different from
those of a similar model estimated over a longer
time frame. Policy coordination might prove em­
pirically beneficial in the short run, but not in the
long run. This is also the case in the specification
of the governments’ welfare functions. Ultimately,
governments might seek to maximize the stan­
dard of living (output per capita), but what are
the choices for the short term? The welfare im pli­
cations depend crucially cm this specification.9
A second problem is that models of the type
used in policy-coordination experiments are
vulnerable to the Lucas critique. Lucas (1976)
argues that the parameters estimated in econo­
metric models reflect past relationships among
economic agents and policymakers. If these rela­
tionships changed, historically estimated parame­
ters would no longer provide accurate forecasts,
nor would policy simulations provide credible
results. A shift from autarky to coordination can
profoundly alter governments’ reaction functions
and interactions between the government and
the private sector. The parameters estimated over
the no-coordination regime will not accurately
reflect outcomes after coordination, and the wel­
fare results of such experiments remain suspect.

■9

See Holtham and Hughes Hallett (1987).

V. National Sovereignty,
Coordination, and
Reputation

Macroeconomic policy coordination, by its very
nature, compromises national sovereignty. Issues
of national sovereignty appear throughout the
literature under three distinct guises. The first,
monetary policy sovereignty, arises because the
objective of policy coordination often is
exchange-rate stabilization. As already noted,
fixed exchange rates require a convergence of
monetary growth (and inflation) rates, constrain­
ing domestic policy discretion. The second sov­
ereignty issue refers to the traditional domestic
ordering of policy7preferences. Policy coordina­
tion might require a set of policies not in keeping
with traditional preferences; for example, higher
rates of inflation in West Germany.
These aspects of sovereignty represent the
counterweights against which the benefits of
international cooperation are measured. They do
not preclude international policy coordination,
but countries that engage in international policy
coordination expect gains that exceed the per­
ceived losses associated with these sovereignty
issues. The fact that nations highly value these
aspects of national sovereignty might help to
explain why countries prefer to coordinate on an
ad hoc basis.
A third sovereignty issue deals with the incen­
tive to cheat. In the one-shot policy game, which
figure 1 illustrates, coordination is not feasible
without some supranational agency to guarantee
compliance. As one can easily see in figure 1,
each country has an incentive to revert back to
an uncoordinated form of policy setting, once it
believes the other country has adopted the coor­
dinated policy option. Because disparate coun­
tries like the United States, West Germany, and
Japan are not likely to relinquish such broad
authority as setting monetary and fiscal policy to
organizations like the IMF or the OECD, many
argue that international policy coordination is
infeasible.
This result stems from analysis in a one-shot
policy game. In games that repeat, countries
establish reputations, and it is possible to attain
solutions that resemble coordinated solutions,
but that do not require a loss of sovereignty.10
Canzoneri and Henderson (1988) and Oudiz
and Sachs (1985) discuss a class of game-theory
models in which countries will independently
adopt what seems to be a coordinated policy,
but maintain the option of reverting back to an
uncoordinated equilibrium. These models, unlike

■ 10 See Friedman (1986).


the one-shot models, assume that governments
act to maximize present utility and the expected
discounted value of future utility, and that the
shocks to the economy repeat. Consequently, at
any point in time, policymakers weigh each pos­
sible policy option, including that of reneging on
a coordinated-like policy, in light of the reper­
cussions each option has for the future.
Basically, these models suggest that countries
will independently adopt coordinated-like poli­
cies as long as any expected gains from reneging
are small relative to the expected losses of shift­
ing away from the coordinated-like policy to an
uncoordinated policy for all future periods. One
problem with this class of models, however, is
that many different solutions resembling coordi­
nation might exist (see Friedman [1986]). As
noted in Canzoneri and Henderson (1988),
nations would need to consult in forums such as
the IMF or OECD to focus on a particular
coordinated-like solution.

VI. Benefits of
Macroeconomic
Policy Coordination

Theory offers a strong case for possible gains
from macroeconomic coordination, but the exist­
ing empirical literature suggests that the benefits
from policy coordination are small and asymmet­
rically distributed. In a pioneering study, Oudiz
and Sachs (1984) investigate the gains to the
United States, West Germany, and Japan from the
coordination of their macroeconomic policies.
The exercise relies on simulations of the Federal
Reserve Board’s Multi-Country Model (MCM) and
the Japanese Economic Planning Agency (EPA)
model over the period 1984 through 1986, and
assumes that governments target real output,
inflation, and the current account. The results
suggest very small overall welfare gains from pol­
icy coordination: no more than 1 percent of GNP,
even in the case of a common oil-price shock.
Japan benefited most from policy coordination;
the United States generally benefited least.
Subsequent studies tend to confirm the main
result of Oudiz and Sachs; the overall gains from
coordination seem small. Nevertheless, these
other studies have suggested some factors that
might determine the size of the benefits from
coordinated macroeconomic policies. Oudiz and
Sachs, for example, believe that the welfare gains
would increase with the number of countries
that were willing to coordinate their policies.11
■ 11 It would also seem that the difficulties and costs of achieving and
maintaining a coalition would increase with the number of countries.

McKibbin and Sachs (1988) construct a fivesector model with forward-looking asset markets
and sticky prices in goods markets. They assign
parameter values to the model, and they simu­
late various types of exchange-rate regimes, each
of which implies different institutional arrange­
ments for the coordination of policies. These
exchange-rate regimes include a free float, one
in which governments do not coordinate poli
cies; a float with policy coordination among
governments; and two types of fixed exchangerate regimes, differing with respect to the rules
governing total world money growth. McKibbin
and Sachs find that the welfare gains from a float
with policy coordination generally exceed those
of an uncoordinated float, but beyond this, the
results elude a simple generalization. The wel­
fare ranking of these various monetary regimes
differs from country to country (or region), and
overall welfare is rather insensitive to the regime
choice. McKibbin and Sachs do offer some evi­
dence that the choice of exchange regime might
depend on the type of economic shock that the
country (or region) experiences.
Canzoneri and Minford (1988) focus on the
reasons for the small gains from policy coordina­
tion. Their analysis with the Liverpool World
Model is particularly interesting, because it com­
pares countries of similar magnitude in a model
with large spillover effects from monetary7policy7.
They test to see if the gains from policy coordi­
nation are sizable in a model with large spillover
effects. Canzoneri and Minford find that the dif­
ference between the two solutions, although
showing gains from monetary policy coordination,
are not very different in terms of their policy
implications: “...probably infeasible in an opera­
tional sense...” [p. 1149]. Canzoneri and Minford
go on to investigate the importance of other fac­
tors. Spillovers, the weights on arguments in the
preference function, and the size of the shocks all
matter, of course, but what seems to be especially
important to secure sizable gains from coordina­
tion is the simultaneous inheritance of conflicting
problems, such as high inflation and recession.
Taylor (1985), using a model that embodies
forward-looking wage setting and sticky prices,
finds that coordination enhances overall world
welfare, particularly when the countries that
coordinate their policies exhibit dissimilar pref­
erences for price and output stability. He finds,
however, that the gains from policy coordination
are not always evenly distributed, and policy
coordination makes at least one country (West
Germany) worse off. Hence, coordination would
require side payments to West Germany. Taylor
also
suggests that the source of the shocks might



be important; demand shocks do not provide
benefits from coordination, but supply shocks,
under some circumstances, could.
The existence of mutual policy objectives
between countries also seems important for the
assessment of gains. Holtham and Hughes Hallett (1987) find large gains for policy coordina­
tion across a wide range of econometric models
when they introduce an exchange rate as a pol­
icy objective. Not only is the exchange rate a
shared policy objective, but its introduction
results in more policy objectives than policy
instruments, which increases the potential gains
from policy coordination.
Taken together, these studies suggest that pol­
icy spillovers among the major industrialized
countries, at least as captured by standard large
econometric models, are small on average.
Nevertheless, these studies do suggest that coun­
tries might benefit from macroeconomic policy
coordination on an ad hoc basis, especially
when confronted with conflicting shocks, when
the shocks are large, when countries share
common objectives, and when the participants
have dissimilar national priorities.
Canzoneri and Henderson (1988) argue, how­
ever, that these results do not close the case
against macroeconomic policy coordination. The
small gains from coordination might result
because most studies consider only one-shot
games.12 The disturbance that starts the game is
a one-time disturbance. Canzoneri and Hender­
son argue that if conflicts between countries are
continual, and if the affected target variables
receive large weights in countries’ social welfare
functions, then coordination can render much
larger gains. Ongoing conflicts arise when the
gains of one country come at the expense of the
other, such as when both countries attempt to
achieve a bilateral current-account surplus.
Similarly, Currie, Levine, and Vidalis (1987),
using dynamic techniques, find large gains from
international policy coordination when govern­
ments have established credibility with the private
sector and when economic shocks are perma­
nent. According to these economists, studies that
do not find large gains from macroeconomic
coordination do so because they fail to consider
the important interplay between international
cooperation and domestic policy credibility.

■ 12

Many of the one-shot games seem to embody an inherent contradic­

tion in that they adopt models with some degree of forward-looking behavior,
and yet they specify a government that attempts to maximize only a currentperiod utility function.

VII. Model Uncertainty

The standard approach to international policy
coordination assumes that the participants have
complete knowledge about the workings of the
world economy and about its present state (see
also Cody [1989]). It assumes that governments
understand the nature of economic disturbances
and know about the appropriate policy responses
to these shocks. Moreover, the models assume
that governments have well-established prefer­
ence functions, defined over relatively few target
variables, and that these preferences truly reflect
those of society in general.
Much of the recent literature questions these
assumptions. Not only could such uncertainties
prevent nations from coordinating their eco­
nomic policies, but coordination under model
uncertainty could leave nations worse off in
terms of their economic welfare than under no
coordination.
Frankel and Rockett (1988) investigate macroeconomic policy coordination when policymak­
ers disagree about the true model.13 Their
experiments include coordinating monetary' pol
icy to achieve real growth and current-account
objectives, and coordinating both monetary and
fiscal policies to achieve real growth, currentaccount, and inflation objectives. Frankel and
Rockett consider combinations of 10 large econ­
ometric models.14 They allow one to represent
the true model of the world economy and allow
each of the participating governments to adopt a
model. Repeating the selection process allows
for 1,000 possible combinations. Frankel and
Rockett find, however, that policy coordination
reduces the economic welfare of the United
States and the non-U.S. OECD sectors in roughly
half of the cases relative to the true model. The
results are virtually unchanged in experiments
where policymakers, realizing their ignorance
about the true model, follow a weighted average
of 10 econometric models.
These losses result from assuming the wrong
model. Frankel and Rockett find that the gains to
any single country' from discovering the true
model and moving to it are often greater than
any gains from coordination.
Domestic policymaking undoubtedly suffers
from many of the same types of uncertainty as
does international policy7coordination. With
autarkic policymaking, however, differences in
the policy multipliers of various models are gen­
erally more a matter of degree than of direction.
■ 13 See also Frankel (1988).


■ 14 See Holtham (1986).


When the models allow for global interdepen­
dencies, however, the policy multipliers often
disagree in terms of sign as well as magnitude.
For example, all but three of the models pre­
sented by Frankel and Rockett show the conven­
tional result on the domestic economy from a
change in domestic monetary policy. The magni­
tude of the nominal income multipliers ranges
from 0.1 percent to 3 0 percent for the United
States and from slightly positive ( less than 0.05
percent) to 1.5 percent for the rest of the OECD.
The degree of consistency with respect to the
direction and the magnitude of domestic fiscal
policy multipliers is about the same.
The models, however, show a wide variance
in the size and direction of the effects on foreign
economies from domestic monetary policy.15
The different results among these models stem
largely from how each links monetary policy
with the current account. The monetary expan­
sion in models that have sticky prices can cause
a real depreciation, which tends to improve the
current account. At the same time, however, the
increase in money growth also could cause an
expansion in real income, which would tend to
worsen the current account. The net impact on
the current account, then, will depend on the
relative weights that a specific model attaches to
each of these effects. A worsening in the domes­
tic country’s current account will tend to benefit
real economic activity in the foreign sector,
while an improvement in the home country’s
current account will tend to worsen the eco­
nomic outcome abroad.
With a closed economy, a policy decision
made with the wrong model probably will err in
terms of degree and not in terms of direction.
With an open economy, however, the wrong
model can advise governments to expand when
they should contract. The welfare losses that
Frankel and Rockett observed resulted when the
governments chose models that differed in the
sign of their international policy multipliers from
that of the true model [p. 330].
Holtham and Hughes Hallett (1987) find
results that tend to confirm those of Frankel and
Rockett. They generate 200 cases, roughly half of
which produce worse outcomes. This result is
not dependent on the assumption about how the
gains are split between the countries. Holtham
and Hughes Hallett also observe that the models

■

15 The models remained fairly consistent in the sign of the foreign

response to domestic fiscal policy, but the magnitude of this response seemed
to vary substantially among the models.

Ea
in their study offer a wide variance in policy
prescriptions, but that this variance is greater
under no cooperation than under cooperation.
Ghosh and Masson (1988) criticize Frankel
and Rockett because their procedure implicitly
assumes that policymakers do not take model
uncertainty into account. Frankel and Rockett’s
policymakers simply choose a model that may or
may not be the correct one. Brainard (1967)
shows that the optimal policy setting in a model
with uncertain parameters differs from the
optimal setting for policy in the same model
with known parameters. Extending this work,
Ghosh and Masson argue that rational policy­
makers attach probabilities to their model
parameters and that model uncertainty, meas­
ured by the variance of the parameters, can
increase incentives for coordination.16
To illustrate this, they first present a model,
with no uncertainty, in which policy7coordination
is not necessary because each player can adjust
for the policy spillovers of the other; the coordi­
nated and noncoordinated solutions are then the
same. With model uncertainty, an additional pol­
icy7spillover enters the problem because the pol­
icy choices of one country7affect the uncertainty7
experienced by the other in a manner that can­
not be offset. Each country7 "... incorrectly esti­
mates the efficiency7of [or the variance asso­
ciated with its] instrument and chooses an
inappropriate degree of intervention.” [p. 235]
The coordinated and noncoordinated outcomes
then differ. In simulations of their econometric
model, Ghosh and Masson find that uncertainty7
increases the gains from coordination, but that
the gains are modest.
A key aspect is that all policymakers share the
same probabilities about alternative models and
that these probabilities are equal to the actual
probabilities. It is not clear that coordination
would be possible or optimal if this were not the
case.17 These probabilities could likely change
with the economic state of the world and might
not be the same for different policymakers, since
policymakers do have different views of the world.

■ 16

When model uncertainty stems from the international transmission of

the effects of countries' economic policies, an incentive exists for coordination;
when uncertainty stems from the impact of domestic policies on domestic var­
iables, the implications for coordination are ambiguous. As already noted, most
uncertainty among economic models seems to center on the international
transmission of policy responses.


■ 17 On this point, see Frankel (1988), pp. 32-33.


VIII. Consistency

Thus far we have discussed international macroeconomic policy coordination in a context that
assumes no interaction between the government
and the private sector. Some recent studies take
issue with this assumption and suggest that
when governments coordinate macroeconomic
policies, private-sector behavior can change in
such a way that the country is worse off than in
the absence of coordination.
This line of criticism extends ideas concerning
the time-consistency aspect of government pol­
icy, which Kydland and Prescott (1977) originally
presented. At its heart is the idea that coordina­
tion might create incentives for governments to
engage in activities detrimental to the best inter­
ests of the private sector. Private agents predicate
their activities on expectations about govern­
ment actions. Consumers, for example, base
decisions about work and savings, in part, on tax
rates, and they negotiate nominal wages on an
assumed inflation rate. Before we can establish
that coordination unequivocally improves wel­
fare, we must consider how coordination might
alter private expectations about the likelihood of
governments to achieve inflation goals, to raise
taxes, or to alter other implied agreements with
the private sector.
Rogoff (1985) considers the effect of policy
coordination on nominal wage demands. In his
model, he allows that money is not neutral with
respect to employment and to real exchange
rates. Individual governments desire higher
employment levels than private markets, but the
inflation consequences of seeking higher employ­
ment constrain them. In the absence of interna­
tional policy coordination, part of the inflation
constraint results from a real exchange-rate
depreciation. When countries coordinate their
policies— that is, both nations expand money
growth to increase employment— a real depreci­
ation does not follow. Coordination eliminates
one of the constraints on government and raises
the inflation associated with a given reduction in
unemployment. Wage-setters realize this, how­
ever, and raise their nominal wage demands to
compensate themselves for the higher expected
inflation rate under international policy coordi­
nation. International policy coordination then
imparts an inflationary bias to policy and exacer­
bates central banks’ credibility problems with the
private sector. Rogoff concludes that, because
time-consistent nominal wages are higher, coop­
eration might not increase nations’ welfare.

Kehoe (1986) also questions whether policy
coordination necessarily will improve social wel­
fare. He argues that, in the absence of policy
coordination, governments might face incentives
that effectively commit them to certain behavior.
For example, competition to attract capital might
force governments to impose very low taxes on
capital. The private sector can make decisions,
affecting its present and future well-being, know­
ing that the mobility of capital restricts the ability
of individual governments to impose high taxes
on capital. Under policy coordination, however,
governments need no longer compete and could
have an incentive to raise taxes on capital. With
policy coordination, then, the private sector will
not adopt the same set of decisions with respect
to savings and investment.
The conclusion that macroeconomic policy
coordination necessarily will affect government
incentives and private expectations in a manner
detrimental to social welfare might not be valid.
Oudiz and Sachs (1985) offer an example in
which policy coordination actually enhances
welfare. In their example, in the absence of pol­
icy7coordination, governments engage in com­
petitive currency depreciations, which the
forward-looking currency market anticipates. Pol­
icy coordination removes these incentives and
improves welfare in their model.
As Canzoneri and Henderson (1988) note,
these articles do reach a common conclusion
despite their dissimilar results: macroeconomic
policy coordination can affect government credi­
bility relative to the private sector, with impor­
tant implications for social welfare. This is not an
indictment of policy coordination, since the
same problem exists in autarky, but it highlights
the need for an institutional framework that m in­
imizes time-inconsistency problems.
One can find some work along these lines in
the literature on the European Monetary System
(EMS). Giavazzi and Pagano (1988) consider the
interplay between central-bank credibility and
international arrangements. They show how
high-inflation countries can derive welfare gains
from pegging their nominal exchange rate with a
low-inflation country. Inflation then results in a
real exchange-rate appreciation that constrains
the tendency of the high-inflation country7to
inflate. Especially interesting for the question at
hand, Giavazzi and Pagano then consider institu­
tional arrangements, compatible with the EMS, to
deal with the current-account problems such a
peg might impose on the high-inflation country.
These arrangements include periodic real depre­
ciation and temporary membership. Collins
(1988) considers alternative models of the EMS

and shows that the form in which participants


resolve their international interdependencies,
the “rules of the game,” affects the average rate
of inflation and the divergence among
participants.
Woven through these time-consistency discus­
sions is the thread of an argument pulled from
the fabric of public choice. That thread questions
more generally if governments act to maximize a
utility function that accurately reflects the prefer­
ences of the private sector or, instead, if govern­
ments seek to foster a different set of objectives.
If governments do seek to maximize utility func­
tions different from those of the private sector,
one cannot conclude that macroeconomic policy
coordination is welfare-enhancing, since the
resulting government coalition could push poli­
cies further from the social optimum.18

IX . Cooperation Instead
of Coordination

Although the issues remain unresolved, for the
most part, the literature casts doubt on the case
for macroeconomic policy coordination. Never­
theless, we do witness governments voluntarily
participating in international forums to their
mutual benefit. Have the models and arguments
missed something?
Countries might not be able to achieve a high
degree of policy coordination with respect to
specific policies and a wide range of targets, but
they may be able to coordinate in terms of lessdemanding criteria. Frenkel, Goldstein, and Mas­
son ( 1988), in an analysis that seems particularly
relevant to recent policy discussions, consider
two such criteria: smoothing monetary and fiscal
policies, and adopting target zones. Both policy
options seek to avoid sharp swings in the real
exchange rates.
They simulate these policies in an IMF multi­
country7model, MULTIMOD, which includes
equations for the United States, West Germany,
and Japan; for the other G7 countries; and for
the other (non-G7) industrial countries. Their
model allows for perfect foresight in capital
markets and for sticky prices in goods markets. A
monetary7expansion also improves the currentaccount balance in the short term as the relative
price effects dominate the income effects.
The results of the simulations, though prelim­
inary7, do not support policies aimed at smooth­
ing monetary or fiscal policies. Smoothing policy
does not generally tend to smooth fluctuations

■

18 See Vaubel (1986).

in economic variables, and seems to increase the
volatility of interest rates in the model. Frenkel,
Goldstein, and Masson argue that economic
shocks, other than those associated with abrupt
policy changes, seem most responsible for
exchange-rate variations. Unsmoothed policy
changes might offset such shocks, but smoothed
policies could not.
Their simulations also do not lend support to
proposals for exchange-rate target zones. Indeed,
their results suggest that target zones could
prove counterproductive because monetary7pol­
icy might then face conflicting objectives. If, for
example, the real exchange rate appreciated
because of a shift in asset preferences away from
the dollar, the United States might temporarily
offset the appreciation through a monetary7
expansion. As the U.S. inflation rate accelerated
following the monetary7expansion, however, the
real exchange rate would appreciate again. This
finding suggests that target zones, relying only
on monetary policy, may not be feasible.19
Apparently aware of such criticisms, some pro­
ponents of target zones suggest that countries
direct fiscal policy toward maintaining targetzone arrangements and direct monetary7policy
toward promoting real growth. Frenkel, Gold­
stein, and Masson find that this policy7fares only
slightly better than the purely monetary scheme.
They also note that the more elaborate targeting
proposal assumes a higher degree of fiscal-policy
flexibility than seems feasible given the exis­
tence of large budget deficits in the United States
and abroad.
Canzoneri and Edison (1989), noting that pol­
icy coordination might be infeasible, allow coun­
tries to share information about the shocks and
about policy instruments. In their simulation,
policy choices are either monetary7targets or
interest-rate targets, and the shocks stem from
the size of U.S. budget deficits. Their results sug­
gest that countries can derive large gains, relative
to the gains from policy coordination, simply
from sharing information about shocks and pol­
icy instruments. Unfortunately, their models sug­
gest, at least in the case of sharing information,
that the benefits of cooperation might accrue
only to a single player.


http://fraser.stlouisfed.org/
■ 19 Feldstein (1989) makes a similar argument.
Federal Reserve Bank of St. Louis

X . Conclusion

When we compare these individual, often
abstract, and technical studies of international
policy coordination, they begin to reveal an
image that we can reconcile with the observed
behavior of nations. Nations seem to cooperate
regularly and freely, but they coordinate policies
infrequently, only when all participants clearly
see the ends, and understand the means, of such
efforts. This literature does not seem to offer
much support for formal, international institu­
tions that require continual policy coordination,
such as fixed exchange rates or a narrowly
defined target zone.
A recurring empirical finding of this literature
is that the benefits from policy coordination are
small. This finding suggests that, although inter­
national interdependencies are increasing, policy
spillovers do not seem critical to the economic
well-being of the largest industrial countries
today. The types of economic shocks that could
enhance the returns from macroeconomic policy
coordination do not occur with sufficient fre­
quency to justify any ongoing commitment that
might sacrifice national policy independence.
Moreover, economists do not agree on the mag­
nitude, or even the direction, of some key inter­
national policy7repercussions. Model uncertainty
makes coordination difficult, and coordination
with the wrong model could lower world welfare.
The literature suggests that nations can secure
most of the gains associated with international
coordination— small though these gains might
be— through the sharing of information about
world conditions, shocks, and policies. Interna­
tional cooperation is relatively costless in terms
of national sovereignty. Perhaps this explains the
willingness of countries to meet often in forums
that allow for the exchange of information.
The literature also suggests that policy coordi­
nation on an ad hoc basis is feasible and could
be beneficial. Indeed, we do observe nations
coordinating their macroeconomic policies from
time to time. The literature suggests that the
benefits of coordination seem to increase when
countries face problems that pose policy dilem­
mas, such as simultaneous inflation and unem­
ployment, and when the gains of one nation
come at the expense of others. The benefits
from this type of coordination could be large,
particularly if the form of the coordination tends
to enhance the credibility of governments rela­
tive to the private sector. Coordination that
adversely affects the private sector’s perceptions
of government will affect expectations and could
reduce welfare.

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Public Infrastructure
and Regional Econom ic
Developm ent
by Randall W. Eberts

Randall W. Eberts is an assistant
vice president and economist at the
Federal Reserve Bank of Cleveland.
The author is grateful to Michael
Bell, Douglas Dalenberg, Kevin
Duffy-Deno, Michael Fogarty, Wil­
liam Fox, and Chul Soo Park for dis­
cussions that were helpful in formu­
lating some of the ideas presented in
this paper.

Introduction

Recent attention given to the serious deterioration
of the nation’s public infrastructure raises the
question of whether public capital significantly
affects economic development. Local policy­
makers and researchers concerned with regional
issues have claimed for years that public infra­
structure investment is one of the primary7 means
to implement a strategy of regional growth. In
fact, one of the ways local governments compete
for new firms is through investing in various
types of public facilities.
Yet, very little is known about even the most
basic relationships between public and private
investment, such as the propensity to substitute
between public and private capital, the relative
timing of public and private investment, and the
effect of public investment on firm and house­
hold decisions, to mention a few. Recent research
byAschauer (1989) and Munnell (1990) reports
a positive correlation between public infrastruc­
ture and productivity aggregated to the national
level. However, this research has not identified
empirically the linkages by which public infra­
structure affects productivity by addressing ques­
tions such as the ones posed above. From a

research standpoint, one of the benefits of exam­


ining the effect of infrastructure at the regional
level as opposed to the national level is that the
linkages between physical infrastructure and
those that use it are more direct when the analy­
sis focuses on smaller geographical areas.
The purpose of this paper is to summarize
previous work that has examined the effect of
public infrastructure on various types of eco­
nomic activity7at the state and local levels. Sec­
tion I defines public infrastructure and discusses
various ways to measure it that are useful for
analytical purposes. Section II examines the
effects of public infrastructure on regional
growth by first reviewing regional growth theory
and then presenting empirical evidence of this
relationship. Section III raises the issue of
whether the observed effect of public infrastruc­
ture on regional growth results from its effect on
productivity or from its effect on factors of pro­
duction. The subsequent discussion focuses on
public infrastructure as an input into the firm’s
production process. Section IV briefly examines
the effect of public infrastructure on household
location decisions. Finally, the “causation” of
public and private investment is discussed in
section V. The paper concludes with an overall
assessment of the relationship between public
infrastructure and regional growth.

I. Definition and
Measurement of Public
Infrastructure
Definition

This paper focuses on the public works compo­
nent of public infrastructure. This category
includes roads, streets, bridges, water treatment
and distribution systems, irrigation, waterways,
airports, and mass transit— installations and facil­
ities that are basic to the growth and functioning
of an economy. The term public infrastructure
includes a range of investments broader than
public works investment. To distinguish between
the various functions of different types of infra­
structure, several definitions and classifications
are used throughout the literature.
For example, Hansen (1965), in looking at the
role of public investment in economic develop­
ment, divides public infrastructure into two cate­
gories: economic overhead capital (EOC) and
social overhead capital (SOC). EOC is oriented
primarily toward the direct support of productive
activities or toward the movement of economic
goods and includes most of the public works
projects listed above. SOC is designed to enhance
human capital and consists of social services
such as education, public health facilities, fire
and police protection, and homes for the aged.
Other classifications of public infrastructure
include investments by the priv ate sector. Mera
(1973), examining the economic effects of public
infrastructure in Japan, extends Hansen’s defini­
tion of EOC to include communication systems,
railroads, and pollution-abatement equipment.
Mera also expands the SOC list of investments to
include administrative systems. In some studies,
the term infrastructure also includes the spatial
concentration of specific sets of economic activi­
ties, similar to what urban and regional econo­
mists refer to as agglomeration economies.
Common to all of these classifications of public
infrastructure are two characteristics that distin­
guish them from other types of investment. First,
public infrastructure provides the basic founda­
tion for economic activity. Second, it generates
positive spillovers; that is, its social benefits far
exceed what any individual would be willing to
pay for its services. These positive spillovers
occur for at least three reasons. First, some com­
ponents of public infrastructure, such as roads
and waterways, are nonexcludable services.
Users can share these facilities up to a point
without decreasing the benefits received by
other users. Second, some infrastructure invest­
 ments, exemplified by water treatment facilities
and pollution-abatement equipment, reduce


negative externalities (for example, pollution)
generated by the private sector. Third, many
infrastructure projects, such as power-generating
facilities, communication networks, sewer sys­
tems, and highways, exhibit economies of scale.
Because the large costs of these investments can
be spread among many users, the unit cost of
production continually falls as more users gain
access to the system.
For the purposes of this paper, the scope of
public infrastructure is limited to public works
investment. Public works projects, in addition to
exhibiting many of the public infrastructure
characteristics listed above, are also under direct
government control and thus can be effective
public policy instruments in promoting eco­
nomic development.

Measurement

One reason for the lack of empirical work on the
effect of public infrastructure on economic
development is the paucity of consistent and
accurate measures of infrastructure that are suit­
able for empirical analysis. Unlike measures of
private input usage in manufacturing, there are
no reliable and consistent government sources
of information on public infrastructure, particu­
larly for individual states and metropolitan areas.
Two basic approaches have been suggested
for measuring public infrastructure. One method
is to measure physical capital in monetary terms
by adding up past investment. An alternative
approach is to use physical measures by taking
inventory of the quantity and quality of all perti­
nent structures and facilities. Each approach has
its advantages and disadvantages.
The standard method of measuring private
capital stcx:k is to use the monetary approach,
often referred to as the perpetual inventory' tech­
nique. The measure of capital under this method
is the sum of the value of past capital purchases
adjusted for depreciation and discard. Two
assumptions are essential in using this scheme.
First, the purchase price of a unit of capital,
which is used to weight each unit of capital,
reflects the discounted value of its present and
future marginal products. Second, a constant
proportion of investment in each period is used
to replace old capital (depreciation). The first
assumption is met if a perfectly competitive capi­
tal market exists. The second assumption is ful­
filled if accurate estimates of the asset’s average
service life, discard rate, and depreciation func­
tion are available.

T A B L E
Levais of Public Capital Stock per
Capita and Rankings by Total Public
Capital Stock for 40 Selected SM SAs
in 19 85

SMSA
New York City
Buffalo
San Francisco
Seattle
Memphis
Milwaukee
Cleveland
Los Angeles
Baltimore
Detroit
Pittsburgh
Minneapolis
Rochester
Chicago
Kansas City
Cincinnati
Jersey City
New Orleans
Philadelphia
Portland
Atlanta
Akron
Louisville
Newark
Dayton
Toledo
Grand Rapids
Denver
Indianapolis
Richmond
Columbus
Youngstown
Houston
Dallas
Birmingham
St. Louis
San Diego
Reading
Canton
Erie

Capital Stock
per Capita
$1,216.0
871.7
871.5
8587
842.4
823.9
762.8
753.0
716.6
714.6
713.7
687.1
663.8
661.7
649-6
613.4
610.1
592.3
584.0
563.1
561.9
552.6
546.4
529.4
517.2
500.9
493-5
492.7
485.1
484.1
475.4
467.4
467.0
446.3
443.2
443.O
406.4
376.1
330.2
322.7

Ranking by
Total Capital
Stock
1
18
4
12
23
15
13
3
7
5
10
11
26
4
20
22
34
24
6
20
14
33
29
17
30
31
36
19
27
35
28
37
9
8
32
16
21
39
38
40

NOTE: Size and rankings of total public capital stcx'k are measured in 1967
dollars.
SOURCE: Author’s calculations.




A frequent criticism of the perpetual inventory
approach for public capital stock is that the
government is not subject to competitive
markets, and public goods are not allocated
through a price mechanism. In some cases, user
charges such as gasoline taxes finance local pub­
lic infrastructure investment, but this reflects
average costs more than marginal costs.
A considerable portion of the analysis related
to economic dev elopment is based on a neoclas­
sical production function in which inputs are
used up to the point where the value of their
marginal product is equal to their cost of use. In
such a context, current input capital should be
measured as the maximum potential flow of serv­
ices available from the measured stock. Such a
measure of capital can be constructed with the
perpetual inventory technique by using a depre­
ciation function that reflects the decline in the
asset’s ability' to produce as much output as
when it was originally purchased. This approach
is used by the Bureau of Economic Analysis
(BEA) for national-level estimates of both private
and government assets and in many national and
regional studies of total factor productivity.
This approach has been used recently by
Eberts, Fogarty, and Garofalo (see Eberts, Dalenberg, and Park [1986] for details) to construct
estimates of five functional types of public infra­
structure for 40 metropolitan areas from 1958 to
1985. Public outlays for each city since 1904
were obtained from City Finances and other U.S.
Bureau of the Census publications, and were
aggregated using average asset lives, deprecia­
tion, and discard functions used by the BEA and
other sources to obtain capital stock measures.
The size and rankings of total public capital
stock for each standard metropolitan statistical
area (SMSA) in 1985 (measured in 1967 dollars)
are presented in table 1 as an illustration of the
estimates such a method would yield. The per
capita estimates of public capital stock reveal a
wide variation across SMSAs in the amount of
capital invested and presumably in the amount
of infrastructure services offered within these
areas. In addition, the growth rates of public and
private capital stock for the 40 SMSAs are shown
in table 2. These estimates illustrate the general
slowdown in public capital stock accumulation.
The notable exceptions to this trend are in the
faster-growing regions of the country.
Capital stock estimates have also been con­
structed for other levels of aggregation. Costa,
Ellson, and Martin (1987) use similar techniques
to construct public capital stock for states,
although with a much shorter time period. Boskin, Robinson, and Huber (1987) estimate capital

T A B L E

2

Percentage Change in Publie Capital for
Selected S M S A s . 19 55 -19 8 5

SMSA

1955-1965

1965-1975

1975-1985

22.5
31.1
22.3
34.7
14.8
12.9
19.7
10.2
51.4
-2.0
33.5
10.4

13-0
15.9
8.5
29.5
13.6
11.4
25.0
35.9
40.6
-3.9
35.3
22.1
7.5
59.3
16.9
5.5
2.1
9.8
37.1
21.9
31.7
9.2
35.9
15.5
20.4
18.8
24.6
25.2
23.4
20.8
8.8
25.0
15.7
-9.9
24.5
23.5
-2.8
7.2
7.7
1.9

-4.4
1.6
5.1
8.8
1.0
0.5
17.6
46.7
63.9
-1.8
22.2
8.7
0.8
68.0
4.9
1.5
-3.4

New York City
Los Angeles
Chicago
San Francisco
Detroit
Philadelphia
Baltimore
Dallas
Houston
Pittsburgh
Minneapolis
Seattle
Cleveland
Atlanta
Milwaukee
St. Louis
Newark
Buffalo
Denver
Kansas City
San Diego
Cincinnati
Memphis
New Orleans
Portland
Rochester
Indianapolis
Columbus
Louisville
Dayton
Toledo
Birmingham
Akron
Jersey City
Richmond
Grand Rapids
Youngstown
Canton
Reading
Erie

10.3
44.7
31.8
9.7
11.9
21.1
27.5
10.3
89.2
5.9
54.2
44.3
9.0
10.3
26.4
17.9
33.2
27.6
4.8
11.1
15.6
14.9
9.8
3.0
28.8
2.2
-5.1
0.5

10.3
47.0
13.1
27.3
2.6
9.0
6.4
21.0
2.7
14.0
15.2
2.9
10.0
4.9
10.8
8.2
-10.2
15.1
28.9
-7.4
8.2
6.8
-8.9

NOTE: SMSAs are listed from largest to smallest public capital stock.
SOURCE: Author’s calculations.




stock series aggregated across all state and local
governments, to critique the BEA’s methodology
in constructing its state and local public capital
stock series aggregated to the national level.
Leven, Legler, and Shapiro (1970) advocate
using physical measures of public infrastructure
to avoid problems related to the use of prices in
the monetary approach. In order to account for
differences in capacity and quality, as the price
and depreciation measures do to some extent in
the first method, they propose to collect informa­
tion on the physical characteristics of these assets
that reflect capacity and quality. In the case of
highways, for example, they cite a study that
converts physical characteristics of highways to
estimates of the traffic flow capacity.
Although their approach avoids the issue of
asset prices, there are problems with this
approach as well. One issue is the monumental
task of collecting adequate measures of the phys­
ical size and quality of each type of public infra­
structure. For the private sector, it would be vir­
tually impossible because of the diverse types of
capital in use. For the public sector, the task is
somewhat less formidable because public capi­
tal, as Leven, Legler, and Shapiro suggest, can be
classified into a few dozen basic types.
Another issue is how to enter these various
measures into a regression analysis that relates
public infrastructure to economic activity. Enter­
ing more than a half dozen public infrastructure
measures simultaneously into a regression equa­
tion would introduce a number of estimation
problems, including multicollinearity. Further­
more, how would one interpret the separate
effects of miles of roads versus cargo capacity of
ports, for example? In addition, it may prove use­
ful at some point to construct broader classifica­
tions of infrastructure, for example combining
roads, highways, and bridges into a transporta­
tion network, which would be difficult to do
under this approach. Also, it would be more
convenient in regression analysis to have quality
differences incorporated within a single meas­
ure. Both requests would require some type of
aggregation scheme, perhaps more arbitrary than
using prices or user costs.
One alternative is to develop a hybrid approach.
The monetary estimates of public capital could
be benchmarked by using the physical quantity
and quality measures of public infrastructure.
This approach would improve the accuracy of
comparisons across metropolitan areas and over
time by essentially adjusting the price of capital
for differences in quality and quantity.

II. Public Infrastructure
and Regional Economic
Development

Economic development depends primarily on
locational advantage, whether it is between cit­
ies, states, or countries. Firms seek areas that
offer greater opportunities for economic profit.
Public infrastructure can enhance these oppor­
tunities either by increasing productivity or by
reducing factor costs; that is, by augmenting the
efficiency of private inputs employed by firms or
by providing an attractive environment within
which households are willing to accept lower
wages in order to reside.

Regional Models

Regional and national economic growth
depends on processes that are more complex
than simply the aggregation of independent
decisions of firms and households. The deci­
sions of economic agents are inextricably inter­
twined, and this interdependency must be taken
into account in order to explain the process of
development. The traditional, neoclassical view
of regional development ignores this interde­
pendence and relies heavily on the notion that
capital is perfectly mobile between regions. As
described by Romans (1965), capital tends to
flow toward those regions offering the highest
price and away from regions offering the lowest
price, maintaining at all times an equilibrium of
price equality after subtracting transport costs.
The price of capital is determined by supply and
demand. The supply in a region continually
adjusts via imports and exports to changes in
regional demand so as to maintain interregional
price equality.
Richardson (1973) and other regional econo­
mists dismiss this framework as too simplistic.
Instead, they maintain that regional investment
decisions are characterized by the durability of
capital, the sequential and interdependent nature
of spatial investment decisions, the importance
of indivisibilities in the regional economy, spa­
tial frictions on interregional capital flows, and
the distinction between private-sector capital and
public infrastructure. The interdependence
between public-sector investment and privatesector investment is paramount to understanding
the regional development process and for pre­
scribing regional economic development policy.
Leven, Legler, and Shapiro (1970) provide a
simple picture of the feedback relationships
between public and private investment decisions.




Their model recognizes that an important share
of the regional capital stock consists of social
and public capital and that the scale and spatial
distribution of public capital may have a signifi­
cant impact on subsequent private investment
decisions and on the location decisions made by
firms and households. Since the initial size and
distribution of the public capital stock is at least
partly predetermined by the prior spatial distri­
bution of households and economic activities in
the region, an interdependent system emerges.
Once growth in such a system is under way,
the process can easily become self-sustaining
and cumulative. However, if the initial popula­
tion and level of activity are small, and their spa­
tial distribution costly and inefficient, a region
may remain in a low-level equilibrium trap
(Murphy, Shleifer, and Vishny [1989]). In such a
case, attempts to promote regional growth may
need the exogenous injection of public and
social capital expenditures to generate an expan­
sion rather than merely as a response to changes
in the level and spatial distribution of population
and economic activity. The difficulty with this
approach, as Richardson points out, is that we
know very little about the generative impact of
various types of public infrastructure on private
investment decisions. Furthermore, we know lit­
tle about the effect of a region’s economic con­
ditions on infrastructure’s contribution to output.
Hansen (1965) theorizes that the potential
effectiveness of economic overhead capital will
vary across three broad categories of regions:
congested, intermediate, and lagging. Congested
regions are characterized by very high concentra­
tions of population, industrial and commercial
activities, and public infrastructure. Any marginal
social benefits that might accrue from further
investment would be outweighed by the margin­
al social costs of pollution and congestion result­
ing from increased economic activity. Interme­
diate regions are characterized by an environment
conducive to further activity— an abundance of
well-trained labor, cheap power, and raw mate­
rials. Here, increased economic activity resulting
from infrastructure investment would lead to
marginal social benefits exceeding marginal
social costs. Lagging regions are characterized by
a low standard of living due to small-scale agri­
culture or stagnant or declining industries. The
economic situation offers little attraction to firms,
and public infrastructure investment would have
little impact.
A number of policy implications emerge from
this regional growth theory. The most obvious
policy conclusion is that subsidies for infrastruc­
ture investment are more likely to pay off in the
long run than investment incentives to firms and

other subsidies to private capital. Furthermore,
following Hansen (1965) and Hirschman (1958),
the main task of infrastructure subsidies for
underdeveloped areas is to generate the minimum
critical size of urbanization that can serve as a
core for economic development. For these lag­
ging regions, however, infrastructure may not be
enough to attract firms; additional means such as
wage subsidies may be necessary. Finally, a
major outcome of a spatial approach to regional
growth analysis is the need for more coordina­
tion between government agencies at all levels
and for the integration of all infrastructure deci­
sions in an overall regional development strategy7.
Before the wisdom of such policies can be
assessed, a number of questions must be an­
swered. For example, how7do w7e identify the
mechanisms by which infrastructure investment
generates regional growth? What types of infra­
structure investment are crucial for promoting
regional growth? Partial answers are found in the
literature.

Empirical Findings
A direct test of Hansen’s hypotheses about the

effects of public infrastructure on regional
development is prov ided by Looney and Frederiksen (1981). Unfortunately from the perspective
of U.S. policy, they examine economic develop­
ment in Mexico. Their findings support Hansen’s
intuition, however: economic overhead capital
has a significant effect on gross domestic product
for intermediate regions but not for lagging
regions; social overhead capital exhibits the
opposite effect, as Hansen predicted.
Costa et al. (1987) support Hansen’s hypothesis
of differential impacts of infrastructure on regional
growth using U.S. data. They find that the larger
the stock of public capital relative to private capi­
tal within a state, and the larger the stock of pub­
lic capital per capita, the smaller the impact of
public capital stock on manufacturing production.
Eberts (1986) also finds regional differentials in
the effectiveness of public capital on manufactur­
ing output. He reports that public capital was
more effective in SMSAs in the South than in the
North and in SMSAs with a lower amount of pub­
lic capital relative to private capital and labor.
Duffy-Deno and Eberts (1989), examining 28
metropolitan areas from 1980 through 1984, find
that public capital stock has positive and statisti­
cally significant effects on per capita personal
income. The effects come through tw7o channels:
first, through the actual construction of the public
capital stock; and second, through public capital




stock as an unpaid factor in the production proc­
ess and a consumption good of households. This
second effect is twice as large as the first effect
using ordinary least squares (OLS) estimation,
but the relative magnitudes of the tw7o effects are
roughly reversed using two-stage least squares
(2SLS).
Other evidence of the differential effects of
public infrastructure among regions comes from
analysis of the operation of U.S. federal regional
development programs on the growth rates of per­
sonal income for different categories of distressed
areas. Martin (1979) finds that investment in pub­
lic capital yields few gains for low-income areas,
but that business development and planning/
technical assistance are more effective in highunemployment areas.
Mera (1975) provides one of the most compre­
hensive analyses of the effect of public infrastruc­
ture on regional economic growth for the United
States. He hypothesizes that the growth of regional
economic activity is determined primarily by the
growth of public infrastructure and technical
progress in the region. The growth of labor and
private capital, w7hich are allocated through price
differentials, responds to growth differentials in
social capital and technical progress. He exam­
ines the growth characteristics of the nine U.S.
census regions from 1947 to 1963. Mera con­
cludes that more-developed regions are growing
because of the growth of public infrastructure,
w7hile less-developed regions are growing pri­
marily because of the growth of technology.
Garcia-Mila and McGuire (1987) estimate the
contribution of state educational and highway
expenditures to gross state product. Using
pooled cross-section time-series data from 1970
to 1983, they estimate a Cobb-Douglas produc­
tion function with these two public inputs along
with manufacturing capital stock and production
employees as the private inputs. They find that
highway capital stock and educational expendi­
tures have a positive and significant effect on
gross state product, with educational expendi­
tures having the larger impact.
Other studies support these findings. For
example, Helms (1985) shows that government
expenditures on highways, local schools, and
higher education positively and significantly
affect state personal income. A study of the
effects of public investment in rural areas by the
CONSAD Research Corporation (1969) attempts
to assess the effect of public works investment
on the growth of real income in 195 small Mis­
souri municipalities. This study finds that public
works infrastructure accounted for 30 percent of
the gain in real income between 1963 and 1966.

O f the major investment projects considered,
federal highways, barge docks, vocational
schools, and recreational facilities contributed
the most to income growth.

III. Public Infrastructure
and Firms

Is the effect of public infrastructure on regional
growth a result of an overall increase in firmlevel productivity or an increase in the region’s
attractiveness to labor and capital? Hulten and
Schwab’s (1984) research on regional productivity
differentials lends some insight into this distinc­
tion. They test the hypothesis that the economic
decline of the Snowbelt was due to differences
in economic efficiency relative to the Sunbelt, by
calculating regional differences in total factor
productivity (TFP). They find little support for
this hypothesis, determining instead that these
interregional differences are largely a result of
differences in the growth rate of capital and labor.
Thus, the implication from these findings is that
regional differences in the quality and quantity
of public infrastructure may have a greater effect
on the migration decisions of factors of produc­
tion than on productivity differentials.
There is another reason to look at factors of
production rather than at Hicks-neutral produc­
tivity changes in analyzing the effect of public
infrastructure. If public infrastructure is indeed
an input (as will be discussed later in this sec­
tion), then relating public infrastructure to a
measure of TFP, which includes only labor and
private capital as inputs, may be a misspecification of the relationship. Munnell (1990) raises
this issue for explaining TFP at the national level.
When public capital is entered into the TFP cal­
culations as a third input, she finds that the varia­
tion in TFP over time reflects more a change in
public infrastructure than a change in technolog­
ical innovation.
Very little attention has been given to the
technological relationships between public
infrastructure and other inputs in a firm’s pro­
duction process. The extant literature addresses
this issue primarily from a theoretical stand­
point. Three basic questions are considered:
1) Howr does public infrastructure enter the pro­
duction process: as a factor-augmenting
atmosphere-type input or as an unpaid input?
2) What implications do these two types of pub­
lic inputs have on the efficient allocation of
resources?
3) What effect do public inputs have on a firm’s
profits, and thus on an area’s locational

http://fraser.stlouisfed.org/ advantage?
Federal Reserve Bank of St. Louis

Infrastructure
as a Public Input

The basic premise of the theoretical literature is
that public infrastructure may increase firm pro­
ductivity either through increasing the efficiency
of private inputs employed by firms or through
its own direct contribution to production as an
input into the production process. Economists
have taken both approaches. Meade’s (1952)
classification of external economies distin­
guishes between these two approaches. Meade
refers to the first type of public input as the crea­
tion of atmosphere. It is analogous to Samuel
son’s pure public good and is exemplified by
free information or technology. In this case, an
increase in the level of public inputs results in
increased output for all firms through neutral
increases in the efficiency with which the private
inputs are used. Any firm entering a region
immediately benefits from the existing level of
public input without affecting the benefits from
the public input received by other firms.
In more formal terms, public inputs are consid­
ered to enter the production function as factors
that augment the productivity of each of the pri­
vate inputs. If a firm is assumed to operate in a
perfectly competitive environment, then each
private factor of production receives a payment
equal to the value of its contribution to output.
Factors, whose productivity has been enhanced
by public inputs, receive compensation higher
than they would receive in the absence of public
inputs. For example, suppose that governmentsupported research and worker training pro­
grams targeted at the electronics industry
increase the productivity of labor and capital
employed by an electronics firm. Workers and
owners of capital receive higher compensation
because of increased productivity. However,
since the firm’s entire revenue has been distrib­
uted among the private factors of production, no
revenue is left to pay for public inputs. Thus,
public inputs will not be supplied without
government intervention.
Meade refers to the second type of public input
as an unpaid factor. An example is free access
roads. This input has private-good characteristics,
except that it is not provided through a market
process and thus is not paid for on a per-unit
basis and does not have a market-determined
price. Its private-good characteristics generally
result from congestion. In the case of highways,
as the number of firms in a region expands,
increased use of the highways results in conges­
tion, which effectively reduces the total amount
of highway services available to each firm. Thus,

from the firm’s perspective, the level of public
input is fixed, unless the facility is continually
underutilized.
Having many characteristics of a private input,
the unpaid-factor type of public input is entered
into the production process in the same way as
private inputs. Unlike the first case, the public
input does not augment the productivity of the
private inputs. Rather, it contributes independ­
ently to the firm’s output. Because firms, by defi­
nition, do not pay directly for the public input,
they initially earn profits or rents according to
the value of the marginal product of the public
input. It is usually assumed that the rent accrues
to some ownership factor such as capital or entre­
preneurship. As with a private unpriced input,
these profits from the public good will attract
other firms into the industry (or area). As addi­
tional firms enter the industry, the per-firm usage
of the public input declines relative to other
inputs. Before and after entry into an industry,
capital or the factor collecting the accrued rent is
paid the value of its marginal product plus the
rent to the unpriced factor. The influx of firms
increases the ratio of private inputs to public
inputs, causing the marginal product of public
inputs to rise relative to private inputs. Local
governments, acting as agents for these firms,
increase the allocation of public investment rela­
tive to the private inputs because of its high
marginal productivity. Additional firms move into
the region until the rents are dissipated and capi­
tal earns a competitive rate of return.

profit of industries. The firm’s ability to deter­
mine the allocation of public investments is
defended by Downs (1957), who argues that a
firm’s lobbying activities sufficiently influence
government decisions. However, when household
preferences for public expenditures are repre­
sented by majority rule voting, public goods are
in general not optimally supplied. Pestieau
(1976) shows that only under very restrictive
assumptions will majority voting lead to an
optimal supply of the public input. In most
cases, it will oversupply public inputs.
The same optimality conditions hold for the
case of an unpaid factor of production, but the
level of provision is different. Negishi shows that
for an unpaid factor, the public good most likely
will be oversupplied when the government tries
to maximize the joint net profit of firms in the
long run. He offers the following explanation.
Since returns to public goods are imputed to
capital in the case of the unpaid factor, capital
tends to concentrate excessively in industries
that can enjoy more gains from public expendi­
tures than other industries. Unless public goods
and capital are perfect substitutes, the capital
intensity of the industry raises the productivity of
public goods, which implies that more of the
public good is required to maximize the indus­
try’s profits. Thus, allocation is inefficient even
without the additional complication of house­
hold preferences and majority rule voting.

Financing Public
Infrastructure
Optimal Allocation
of Public Inputs

The two types of public inputs have different
implications concerning the efficient allocation
of resources, the level of provision of the public
inputs, and the appropriate financing arrange­
ments. For the first case, Samuelson’s conditions
for the allocation of pure public goods apply.
Kaizuka (1965) and Sandmo (1972) show that
resources are allocated efficiently when the total
savings of all firms brought about by substituting
a public input for a single private input are equal
to the resource cost of using that private input to
produce the public input. However, because of
the free-rider problem, government must supply
the intermediate input. The revenue necessary7
for government to provide the service must be
raised by some form of taxation or user charges.
Negishi (1973) demonstrates that for a pure
public input, an optimal level of public good will
be produced if the government supplies a level

of public inputs that maximizes the joint net


These theoretical results highlight the impor­
tance of the total fiscal package, not simply taxes
or public investment, in firm location decisions.
As previously mentioned, firms with access to
public infrastructure earn rents according to the
value of the contribution of public infrastructure
to production. In the unpaid factor case, a por­
tion of these rents (if not all rents) may be taxed
or paid out as user charges in order to finance
public infrastructure. The amount of rents
remaining with the firm as a result of public
unpaid factors depends on the taxing scheme
adopted and on properties of the production
process or utilization of public inputs.
For any given level of public investment, the
amount of rents accruing to firms depends on
the sharing arrangements between taxpayers
inside and outside a local jurisdiction. For
example, if public infrastructure is financed
entirely by individuals outside the area (through
federal grants, for example), then a firm receives

the entire rent, which in turn creates a greater
incentive for that firm and others to locate in the
area. O n the other hand, if the entire burden of
financing the public infrastructure investment
falls on individuals within the local area, then
profits would be much smaller, creating less of
an incentive for firms to locate or remain there.
Another arrangement is for households to
assume a larger proportion of the financing costs
of public investment than warranted by the
direct benefits they receive. Some communities
pursue this approach through tax moratoriums
and lower tax rates for firms, with the idea that
the benefits to the community from creating new
jobs outweigh the increased burden of financing
the investment.
An additional feature of the fiscal package is
that taxes need not equal the total rents accruing
to firms (and even to households). Benefits from
public investment projects characterized by econ­
omies of scale and sharing properties will exceed
the cost of the project. Since many components
of public infrastructure, such as highways and
water distribution and treatment facilities, exhibit
these properties, it is reasonable to assume that
public investment may have a net positive effect
on firm productivity and thus on firm location.

Empirical Findings
A number of basic questions emerge from the

theoretical foundations of the relationship
between infrastructure and firm-level behavior:
1) How does public capital enter into the pro­
duction process?
2) What effect does public infrastructure have on
a firm’s productivity? How does this vary with
the type of firm and type of infrastructure?
3) Are private and public capital related as sub­
stitutes or complements?
4) What effect does public infrastructure have on
firm location decisions?
Only recently have researchers estimated the
technical relationships between public infrastruc­
ture and other production inputs. Previously, the
literature looked primarily at peripheral issues
such as the effects of federal programs on eco­
nomic growth in distressed areas or the effects of
various government expenditures on firm loca­
tion. These are undoubtedly important questions,
but their particular focus does not provide much
insight into the technical relationships outlined
above. Another problem with the earlier studies
is that, with the exception of Mera (1973, 1975),
they use public expenditures or the number of
 government employees as proxies for public
infrastructure.


More recent studies have tried to address these
issues directly by estimating production functions
with public capital-stock estimates included as
inputs. Eberts (1986) estimates the direct effect
of public capital stock on manufacturing output
and the technical relationships between public
capital and the other production inputs. Public
capital stock is estimated using the perpetual
inventory technique, described in section I, for
each of 38 U.S. metropolitan areas between 1958
and 1978. With this method, capital is measured
as the sum of the value of past investments
adjusted for depreciation and discard. Public cap­
ital stock includes highways, sewage treatment
facilities, and water distribution facilities within
the SMSA He estimates a translog production
function with value added as output, hours of
production and nonproduction workers as the
labor input, and a value measure of private
manufacturing capital stock as private capital.
Eberts finds that public capital stock makes a
positive and statistically significant contribution
to manufacturing output, supporting the concept
of public capital stock as an unpaid factor of
production. Its output elasticity of .03 is small
relative to the magnitudes of the other inputs:
0.7 for labor and 0.3 for private capital. It follows
that the magnitude of the marginal product of
public capital is also relatively small.
The small estimated contribution of public
capital may be viewed in two ways. If one con­
siders public capital stock to be a pure public
good, then the marginal product of public capi­
tal stock reveals the manufacturing sector’s valua­
tion of the total stock of public investment in
place in the SMSA. If local governments allocate
public funds in response to the preferences of
the local voters, then the marginal valuation
should be equal to their tax share. Thus, it is not
unreasonable that a typical firm pays 4 percent of
its total value added to local taxes— a value close
to the marginal product of public capital.
Another way to interpret the results is to
assume that the manufacturing sector uses only a
specific portion of the stock. For instance, firms
may be spatially concentrated in one area of the
metropolitan area and thus intensively use only
the roads and sewer systems in that part of the
region. If one assumes that the per-unit cost of
constructing one unit of private capital is the
same as the per-unit cost of constructing one unit
of public capital, then the marginal products of
the two capital inputs should be equal. Estimates
show, however, that the marginal product of pri­
vate capital is seven times that of the marginal
product of public capital. This difference may

result from assuming that the manufacturing sec­
tor uses the total capital stock instead of some
portion of it. If one assumes that the use of the
total public capital stock by manufacturing firms
is approximately proportional to manufacturing
employment’s share of the total population, then
the use of the public capital stock is overesti­
mated by roughly seven times. Multiplying the
marginal product of public capital stock by seven
brings it in line with the marginal product of pri­
vate capital.
With respect to technical relationships, Eberts
finds that public capital and private capital are
complements, while the private capital/labor
pair and the public capital/labor pair are substi­
tutes. Public and private capital are interpreted to
be complements when an increase in the level
of public capital reduces the price of priv ate cap­
ital by increasing its relative abundance. Dalenberg (1987), using the same data as Eberts but
estimating a cost function, also finds public capi­
tal and private capital to be complements.
Deno (1986) also estimates technical relation­
ships, but uses investment data instead of capital
stock data. Using pooled data for U.S. metropoli­
tan areas from 1972 to 1978, he estimates labor
and private investment demand equations
derived from a Cobb-Douglas production func­
tion. He finds that local public investment and
private capital are complements. In addition, he
finds that a 1 percent increase in public invest­
ment is associated with a 0.01 percent increase
in net private investment in the short run and a
0.2 percent increase in the long run. Further­
more, he concludes that public investment has a
significantly greater positive effect on net private
capital formation in distressed cities than in
growth cities. In subsequent work, Deno (1988)
finds the output elasticities of water, sewer, and
highway infrastructure for the full sample of 36
SMSAs are 0.08, 0.30, and 0.31, respectively.
These estimates were obtained using a profit
function approach for the period 1970 to 1978.
At the state level, Costa et al. (1987) estimate
the contribution of public capital stock to manu­
facturing output by estimating a translog produc­
tion function. Their analysis differs from that of
Eberts in two key ways, in addition to the unit of
analysis. First, Costa et al. estimate the produc­
tion function using cross-sectional data for 1972,
while Eberts combines cross-sectional and time
series data in his estimation. Second, Costa et al.
distribute the BEA estimate of capital among
states in proportion to the gross book value of
fixed assets at year-end 1971. The private capital
stock used by Eberts, on the other hand, is based
 on the same perpetual inventory7technique used
http://fraser.stlouisfed.org/
to construct the public capital stock.
Federal Reserve Bank of St. Louis

Costa et al. also find that public capital stock
makes a statistically significant contribution to
manufacturing output. However, the magnitudes
of their public capital elasticities are higher than
what Eberts found, which may be partly explained
by their inclusion of more categories of public
investment. Another difference between the
results of these studies is that Costa et al. find
private and public capital to be substitutes and
public capital and labor to be complements,
while Eberts and Deno find the opposite. One
explanation for the difference may be in the cal­
culation of these relationships. Costa et al. use
the log form of the production function to derive
the cross-partial derivative, while Eberts converts
back to the original production relationship to
compute the technical relationships.
Mera ( 1973) estimates the technical relation­
ships between various types of infrastructure and
other inputs for Japan. Using pooled data of nine
regions in 10 years from 1954 to 1963, he esti­
mates a Cobb-Douglas production function for
each of three major economic sectors and four
types of infrastructure. He reports the following
findings: ( 1) when the infrastructure variable is
entered as a separate factor of production, its
production elasticity ranges from 0.1 to 0.5, most
frequently around 0.2; (2) the transportation and
communication infrastructure appears to have a
sizable effect on mining, manufacturing, and
construction; (3) in most cases, the rates of
return from infrastructure are similar to those of
private capital; but (4) the elasticity7of substitu­
tion between private capital and infrastructure is
undetermined in this study.
Studies of the determinants of firm location
usually concentrate more on the effect of taxes
than on the effect of expenditures on location
decisions. However, those studies that have
included various measures of public infrastruc­
ture have found that certain forms of infrastruc­
ture are attractive to firms. Some of the strongest
results were reported by Fox and Murray ( 1988),
who found that the presence of interstate high­
way systems had a positive and highly significant
effect on the location of individual establish­
ments in the state of Tennessee. Bartik (1985),
using a national sample, also found that the
number of new7branch plants was higher within
states with more miles of roads. Eberts ( 1990)
offers evidence that public infrastructure posi­
tively affects the number of firm openings in
metropolitan areas.

25

IV. Public Infrastructure
and Households

Public infrastructure may also affect the migra­
tion decisions of households by enhancing the
area’s amenities. However, the existing literature
related to household location decisions does not
focus much on public infrastructure. Labor migra­
tion studies tend to concentrate primarily on
demographic characteristics and wage differentials
to explain migration flows. Urban quality-of-life
comparisons, which deal with the same underly­
ing decision process, come closer to addressing
this issue, but their major focus is on attributes
such as air quality, climate, and so forth.
One exception is the migration study by Fox,
Herzog, and Schlottmann (1989). They estimate
the effect of local fiscal expenditures and revenue
on household decisions to migrate across met­
ropolitan areas. Using Public Use Microdata
Samples, which record a household’s place of
residence in 1975 and 1980, they determine that
fiscal variables are more important factors in
pushing people from an area than in attracting
them toward one. They explain this result in
terms of information. Information on fiscal struc­
ture is more readily available in an area where a
person has been living than for areas under con­
sideration as migration destinations.

V. “ Causal” Relationships
Between Public and
Private Investment

Most of the studies that address the stimulative
effect of public investment presume that public
investment “causes” or precedes private capital.
Yet, scant attention has been given to testing this
relationship. Eberts and Fogarty (1987) explore
the causal relationship between public and pri­
vate investment. Their premise, following the
cumulative model of regional growth, is that the
timing of investment indicates the role of public
investment in promoting local economic devel­
opment. If public investment precedes private
investment, then it would appear that local areas
actively use public outlays as instruments to
direct local development. On the other hand, if
the sequence of events occurs in the opposite
direction, it would appear that local officials
merely respond to private investment decisions.
Using data on public capital outlays and manu­
facturing investment from 1904 to 1978 for 40
U.S. cities, Eberts and Fogarty' find a significant
causal relationship between public outlays and
 private investment in 33 of the 40 metropolitan


areas examined. The direction of causation goes
both ways. Private investment is more likely to
influence public outlays in cities located in the
South and in cities that have experienced tre­
mendous growth after 1950. Public outlays are
more likely to influence private investment in
cities that experienced much of their growth
before 1950.
Looney and Frederiksen (1981), in their study
of Mexico, support the findings of Eberts and
Fogarty' for older U.S. cities— that public invest­
ment appears to be the initiating factor in the
development process, rather than a passive or
accommodating factor. They do not attempt to
determine whether causal directions differ across
types of regions, however.

VI. Overall Assessment

The importance of public infrastructure in pro­
moting economic development has been widely
recognized among policymakers. Economists
have only recently begun to assess the effects of
infrastructure on regional economic develop­
ment beyrond simply a stimulus of construction
activity. The consensus among economists is that
public infrastructure stimulates economic activ­
ity, either by augmenting the productivity of pri­
vate inputs or through its direct contribution to
output. Furthermore, byr enhancing a region’s
amenities, public infrastructure may also attract
households and firms, which further contributes
to an area’s growth.
Results show that public capital stock signifi­
cantly affects economic activity. The magnitudes
of the effects for public capital are much less
than for private capital, however. Results also
show7, w'ith some exception, that public capital
and private capital are complements, not substi­
tutes. This relationship may be interpreted to
mean that the existence of public infrastructure
is a necessary' precondition for economic growth.
Evidence suggests that the effect of public
infrastructure on regional development depends
on the type of investment and on the economic
conditions of the region. Studies of Japan and
Mexico, in particular, show that investment in
communications and transportation appears to
have the most significant impact on regional
growth. In the United States, public investment
appears to have a greater effect on economic
activity in distressed cities than in growth cities,
in Sunbelt cities than in Northern cities, and in
those areas with less public capital stock relative
to private capital and population.

26

The critical question is at what point, if any,
does an additional increase in public infrastruc­
ture cease to have any effect on economic
development? Alder (1965) sums up the effect of
transportation on economic development: “It is
frequently assumed that all transport improve­
ments stimulate economic growth. The sad truth
is that some do, and some do not....” In a
broader context, it can be concluded that some
types of infrastructure investment will have sig­
nificant effects, while others will not.
Many local and state governments in the United
States are faced with the monumental task of
replacing and upgrading their present public
capital stock. But the challenge is more than
simply maintaining existing structures. The chal­
lenge facing these governments is to meet the
future infrastructure needs of a U.S. economy
that is undergoing dramatic changes with the
restructuring of both manufacturing and service
industries and the spatial redistribution of these
activities. Innovations in areas such as telecom­
munications and computer automation, to men­
tion only two, are changing the w7ay businesses
operate, and infrastructure investment must
adapt to this changing technology7. Results from
studies reported in this paper underline the
importance of maintaining, improving, and
expanding public capital stock in order to sup­
port future economic growth.




References

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port Projects,” in Gary Fromm, ed., Transport
Investment a n d Economic Development.
Washington, D.C.: Brookings Institution, 1965,
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vol. 23, no. 2 (March 1989), pp. 177-200.
Bartik, Timothy J. “Business Location Decisions
in the United States: Estimates of the Effects of
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14-22.
Boskin, Michael J., Marc S. Robinson, and Alan
M. Huber. “New Estimates of State and Local
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Cambridge, Mass., January 1987.
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Costa, Jose da Silva, Richard Ellson, and Ran­
dolph C. Martin. “Public Capital, Regional
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Evidence,” Journal o f Regional Science, vol.
27, no. 3 (August 1987), pp. 419-37.
Dalenberg, Douglas. “Estimates of Elasticities of
Substitution Between Public and Private
Inputs in the Manufacturing Sector of Metro­
politan Areas,” Ph.D. dissertation, Eugene,
Ore.: University7of Oregon, 1987.
Deno, Kevin T. “The Short Run Relationship
Between Investment in Public Infrastructure
and the Formation of Private Capital,” Ph.D.
dissertation, Eugene, Ore.: University of
Oregon, 1986.
------ - “The Effect of Public Capital on U.S.
Manufacturing Activity: 1970 to 1978,” Southern
Economic Journal, vol. 55, no. 2 (October
1988), pp. 400-11.
Downs, Anthony. An Economic Theory of
Democracy. New York: Harper and Row, 1957.
Duffy-Deno, Kevin T., and Randall W. Eberts.
“Public Infrastructure and Regional Economic
Development: A Simultaneous Equations
Approach,” Working Paper 8909, Federal
Reserve Bank of Cleveland, August 1989.

Eberts, Randall W. "Estimating the Contribution
of Urban Public Infrastructure to Regional
Growth,” Working Paper 8610, Federal
Reserve Bank of Cleveland, December 1986.

Leven, Charles, John Legler, and Perry Shapiro.
An Analytical Framework fo r Regional Devel­
opment Policy. Cambridge, Mass.: The MIT
Press, 1970.

_________“Some Empirical Evidence on the Link­
age between Public Infrastructure and Local
Economic Development,” in Henry7W. Herzog,
Jr. and Alan Schlottmann, eds., Industry’ Loca­
tion a n d Public Policy. Knoxville, Tenn.: Uni­
versity of Tennessee Press, forthcoming 1990.

Looney, Robert, and Peter Frederiksen. “The
Regional Impact of Infrastructure in Mexico,”
Regional Studies, vol. 15, no. 4 (1981), pp.
285-96.

________, Douglas Dalenberg, and Chul Soo
Park. “Public Infrastructure Data Development
for NSF,” mimeo, Eugene, Ore.: University of
Oregon, May 1986.
Eberts, Randall W., and Michael S. Fogarty.
“Estimating the Relationship Between Local
Public and Private Investment,” Working
Paper 8703, Federal Reserve Bank of Cleve­
land, May 1987.

Martin, Randolph C. “Federal Regional Devel­
opment Programs and U.S. Problem Areas,”
Jo u rn al o f Regional Science, vol. 19, no. 2
(May 1979), pp. 157-70.
Meade, J.E. “External Economies and Disecon­
omies in a Competitive Situation,” Economic
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Mera, Koichi. “Regional Production Functions
and Social Overhead Capital: An Analysis of
the Japanese Case,” Regional a n d Urban Eco­
nomics, vol. 3, no. 2 (May 1973), pp. 157-85.

Fox, William F., and Matthew N. Murray. “Local
Public Policies and Interregional Business
Development,” mimeo, Knoxville, Tenn.:
University of Tennessee, June 1988.

_________ Income Distribution a n d Regional
Development. Tokyo: University of Tokyo
Press, 1975.

Fox, William F., Henry W. Herzog, Jr., and Alan
M. Schlottmann. “Metropolitan Fiscal Structure
and Migration,” Jo urnal of Regional Science,
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Munnell, Alicia. “Why Has Productivity Growth
Declined? Productivity7and Public Investment,”
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1990, pp. 3-22.

Garcia-Mila, Teresa, and Therese J. McGuire.
“The Contribution of Publicly Provided Inputs
to States’ Economies,” Research Paper No.
292, State University7of New York at Stony
Brook, April 1987.

Murphy, Kevin M., Andrei Shleifer, and Robert
W. Vishny. “Industrialization and the Big
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1985), pp. 574-82.

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“Regional Productivity Growth in U.S. Manu­
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a n d Statistics, vol. 47 (1965), pp. 118-20.




Using M a rk e t Incentives
to Reform Bank
Regulation and
Federal Deposit
Insurance
by James B. Thomson

James B. Thomson is an assistant
vice president and economist at the
Federal Reserve Bank of Cleveland.
The author thanks Edward Kane,
George Kaufman, and Walker Todd
for helpful comments and
suggestions.

Introduction

Reform of the financial services industry7became
a hotly debated issue in the 1980s, and this
debate continues to rage in the 1990s. Much of
the debate has been generated by a growing
recognition that fundamental reforms are
needed in our bank and thrift regulatory7systems
to respond to market-driven changes in the
financial services industry7. Deposit-insurance
reform has taken center stage in the political
arena, as the Financial Institutions Reform, Re­
covery and Enforcement Act (FIRREA) of 1989
formally commits $159 billion of taxpayer money
to resolve the thrift crisis and mandates that a
study of federal deposit insurance be undertaken.
The overall objective of reform in the financial
services industry should be to maximize the effi­
ciency and stability7of the banking and thrift sys­
tems while minimizing the exposure of the fed
eral safety7net, and hence the taxpayer, to losses
generated by insured banks and thrifts. A plethora
of reform proposals have been advanced by the
banking industry7, bank regulators, and the aca­
demic community. These reform proposals typi­
cally can be divided into proposals that rely on
 increased regulation and less discretion for bank


management,1 and proposals that rely on marketoriented solutions and increased management
discretion within supervisory guidelines.2
The purpose of this paper is twofold. First, it
presents the case for adopting market-oriented
reforms to the regulatory system and to the
financial safety net.3 Second, it summarizes the
literature from one perspective and presents a
cohesive view on the topic. Section I reexamines
the issue of whether banks are special and the
■ 1 Reform proposals that rely on increased government regulation include
Corrigan (1987) and Keehn (1989). These authors propose the use of regula­
tion as a substitute for market discipline, and hence reforms to the federal
safety net. In their separate proposals, Corrigan and Keehn would allow bank
holding companies to engage in virtually any financial activity so long as there
is legal separation between the nonbanking activities and the insured banks in
the holding company. In principle, this would capture some of the efficiencies
of an integrated financial services industry without increasing the size and
scope of the safety net. However, Kane's (1989b) application of principal-agent
theory to regulatory agencies calls into question the substitutability of regula­
tion and market discipline.

■2

Proposals that rely on increased market discipline include Cates (1989),

Ely (1985, 1989), Kane (1983, 1985, 1986), Benston et al. (1986, ch. 9), Benston et al. (1989), Benston and Kaufman (1988), the Federal Resen/e Bank of
Minneapolis (1988), Hoskins (1989), Thomson and Todd (1990), and Wall
(1989).

■3

For an opposing view, see Campbell and Minsky (1987), Guttentag and

Herring (1986, 1988) and Randall (1989).

29

issue of stability in banking markets, both regu­
lated and unregulated. In addition, section I
looks at principal-agent problems associated
with bank regulation (Kane [1988b] ). Section II
proposes reforms to our system of regulatory
taxes and subsidies. Conclusions are presented
in section III.

I. Stability in
Banking Markets

Those who propose reforms that rely on an
increased role for regulation in determining lim­
its on bank powers and activities— and hence a
reduced role for management discretion, share­
holders’ control, and market discipline— assume
that financial markets are inherently unstable or
that banks are “special” in the sense that the
social costs of bank failures significantly exceed
the private costs (Corrigan [1987] and Tallman
[1988]). Therefore, proponents of increased
regulation are willing to trade efficiency for sta­
bility. Moreover, in principle, increased regula­
tion protects the public purse from losses by re­
stricting the participation of insured depository'
institutions in activities that are deemed to be
excessively' risky'.
The reforms outlined in this paper assume
that the opposite is true; that, left to their own
devices, financial markets are stable in the sense
that in the long run they exhibit an orderly pro­
cess of change, and that, if there is a trade-off
between efficiency and stability, it exists only in
the short run.4 Moreover, it is the system of reg­
ulatory taxes and subsidies, in our view, that
makes banks “special,” and not any intrinsic
characteristic of banking.5

Are Banks Special?

The banks-are-special argument typically is based
on one of two notions: either that bank failures
have a high social cost or that all runs on indi­
vidual banks are contagious and, therefore, the
banking system is unstable. Since the issue of
banking-system stability is dealt with in the fol-

■4

The trade-off between efficiency and stability in the short run can occur

only when there are no principal-agent problems associated with bank regula­
tion or, in other words, when bank regulators are “faithful agents" as defined
by Kane (1989b), Otherwise, the trade-off between efficiency and stability
would not hold even in the short run. The author thanks Edward Kane for this
analysis.

■5

For a comprehensive look at the arguments and evidence as to why

 banks are not special, and a list of articles on the subject, see Saunders and
http://fraser.stlouisfed.org/
Walter (1987).
Federal Reserve Bank of St. Louis

lowing section, we will concentrate on the social
cost of bank failures here. To argue that banks
are special because there are high social costs
associated with their failures, one must demon­
strate two things: first, the social costs of bank
failures are significantly greater than the private
costs of bank failures (that is, there is an eco­
nomically significant externality associated with
the failure of a bank); and second, the social
costs of bank failures are significantly higher
than the social costs of failures of other firms.
What has been the cost of bank failures? Benston et al. (1986, ch. 2) show that for the entire
period from 1865 to 1933 (the time period
between the National Banking Act and the crea­
tion of the FDIC), total losses were $12.3 billion,
or about 1 percent of total commercial bank
assets. Losses to depositors were only about $2.4
billion, or about 0.21 percent of commercial bank
deposits. Even in the Great Depression (19301933), the losses to depositors were only about
0.81 percent of total commercial bank deposits.
So, in an environment of no federal deposit
insurance and lighter regulation, the private costs
of bank failures appear to have been small.
The issue of the “specialness” of banks rests
on social costs, however, and not on private
ones. Unfortunately, the social costs of bank fail­
ures are difficult to quantify, because measures
of the size of the externalities associated with
bank failures are highly subjective or do not exist.
The first of these externalities is the loss of
banking services in the community or the dis­
ruption of special banking relationships. Banking
relationships are considered valuable because
one service performed by banks is information
intermediation. In the first case, rarely does a
community lose all of its banking services when
an individual bank fails. Kaufman (1988) argues
that in those few cases where the only bank in
the area fails, it is often replaced by another bank
or financial institution, often in the same loca­
tion. Furthermore, liberal chartering of new
banks and the relaxation of intrastate and inter­
state branching restrictions should take care of
this problem when it does arise.
Second, most firms have relationships with
more than one financial institution, and many of
the lending officers of the failed institution find
jobs with other banks in the area, often with the
bank that replaces the failed institution (Benston
and Kaufman [1986]). Moreover, as Schwartz
(1987) argues, it is difficult to believe that finan­
cial institutions interested in acquiring the liabili­
ties of failed banks would not also be interested
in capturing their creditworthy customers, espe­
cially if banking relationships have value.

The second externality may be the disruption
of the payments system.6 Because banks are the
conduit for payments in this country, the failure
of a major depository institution could cause the
failures of other banks on the payments system,
topple the payments system itself, or at least shut
it down for an unacceptable period of time.
However, there is no reason that the failure of
any institution, let alone a large one, should
result in the collapse of the payments system.
Even today, the loss on assets associated with
large bank failures is typically small, certainly not
approaching 100 percent.7 Therefore, banks with
payments-related exposure to the failed institu­
tion should realize only a small loss, and the
threat of loss from payments-system defaults
should cause banks to limit their exposure to
other banks that are considered to be excessively
risky. After all, banks routinely do this today in
the federal funds market. In addition, the lender
of last resort can immunize the rest of the pay­
ments system from the failure of a single bank
by lending (with a “haircut”) to banks against
their claims on the failed institution until those
claims are realized.8 The Federal Reserve’s role
in providing liquidity to financial markets during
the October 1987 stock market crash illustrates
how a properly functioning lender of last resort
can prevent spillover effects from bank failures
or from crises in individual financial markets.
The third component of social costs is the
causal relationship between declines in the
banking industry and in the level of general
economic activity. Do declines in the banking
sector cause declines in economic activity, or is
the opposite true? A review of the historical evi­
dence by Benston et al. (1986, ch. 2) and
Schwartz (1987) suggests that bank failures are
caused by the declines in general economic
activity, whether the declines are national or
regional.
Therefore, although there are economic and
social costs associated with individual bank fail­
ures, these costs do not appear to be significantly
larger than those for other firms. As Saunders and

■

6 Payments-system concerns are the motivation for the safe-bank pro­

posals of Litan (1987) and others.

■7

Walter (1987) point out, the costs of individual
bank failures are much different from the costs
to the economy from a collapse of the banking
system, and those who argue that bank failures
have high social costs often fail to recognize that
difference. Thus, the argument that banks are
special because of social externalities associated
with their failures does not appear to be valid.

Bank Runs and Stability

Opponents of market-based banking reforms
argue that the very nature of bank and thrift
deposit liabilities (that is, they are redeemable at
par on demand) makes free-market banking sys­
tems inherently unstable.9 They argue that,
without federal deposit guarantees, the banking
system is subject to contagious bank runs. As the
argument goes, deposit insurance removes or
reduces the incentives for bank runs and thus
stabilizes the banking system. Regulation, in
turn, is needed to protect the federal deposit
insurance agency, and ultimately the taxpayer,
from the moral hazard embedded in federal
deposit guarantees.10
To analyze this claim of instability, one needs
to distinguish between rational and irrational
bank runs. Kaufman (1988) argues that a rational
bank run is one that occurs because depositors
have good information that their depository insti­
tution has (or may) become insolvent. This type
of run should not be contagious and, in fact, is
the method the market uses to weed out weak
institutions. Because rational bank runs are essen­
tially a market-driven closure rule, they act as a
form of market discipline on bank management
and shareholders (Benston and Kaufman [1986]).
Kaufman (1988) describes an irrational bank
run as one that occurs because poorly informed
depositors mistakenly believe that their deposi­
tory7institution has (or may) become insolvent.
Institutions that are truly solvent can stop an ir­
rational run by demonstrating their solvency.
Although these runs theoretically could be conta­
gious, it is unlikely that they would be (except,

■9

The theoretical foundation for this viewpoint is found in Diamond and

Dybvig (1983). In their model of a simple economy, Diamond and Dybvig find
that government deposit insurance improves social welfare by removing the

Although loss rates have ranged as much as 50 percent of assets in

small-bank failures, the failure of these banks is not a threat to the payments
system.

possibility of systemic bank runs. However, McCulloch and Yu (1989) show
that private contracts could perform the same function as deposit insurance in
the Diamond and Dybvig world. Furthermore, McCulloch and Yu find that
neither the private contracts nor government deposit insurance can improve

■

8 Lending with a haircut refers to the practice of making short-term col­

lateralized loans for less than the estimated market value of the collateral.
That is, the lender estimates the value of the collateral and then "takes a little

 off the top." This is usually done when the market value of the collateral is
http://fraser.stlouisfed.org/
measured with uncertainty.
Federal Reserve Bank of St. Louis

social welfare in the Diamond and Dybvig world if private capital markets exist
outside the official banking sector.

■ 10

For a detailed discussion of bank runs and their positive implications

for economic stability, see Kaufman (1988).

possibly, to other insolvent institutions) because
other banks and thrifts have incentives to provide
liquidity to solvent institutions experiencing runs.
In fact, private bank clearinghouses performed
this function prior to the creation of the Federal
Reserve System (Gorton and Mullineaux [1987] ).
Moreover, a properly functioning lender of last
resort can prevent irrational bank runs from
becoming systemic bank runs by providing liq­
uidity7to solvent institutions experiencing runs.
In so doing, the central bank further relieves
pressures on solvent institutions, while removing
any potentially destabilizing effects of irrational
bank runs, yet without precluding rational bank
runs on insolvent institutions (Meltzer [1986]
and Schwartz [1987, 1988] ). One should note
that bank runs were historically a statewide or
systemic problem primarily in unit banking sys­
tems, where regional and therefore industry7
diversification of assets was artificially restricted
by regulations. Thus, irrational bank runs may
simply be an unintended side effect of branch­
ing restrictions, rather than a natural source of
instability in free-market banking systems.
By suppressing or overriding market closure
mechanisms, federal deposit insurance has
reduced or removed one of the self-correcting
forces that ensures the efficiency and long-run
stability of banking markets. Kane (1985, ch. 3)
and Thomson ( 1986, 1989) argue that the way
federal deposit insurance is priced and adminis­
tered results in government subsidization of the
risks undertaken by insured banks and thrifts.
This, in turn, leads to perverse incentives for risktaking by insured institutions and decreases the
stability of the financial system.

Moral Hazard
and Regulation

To mitigate the moral hazard (that is, the incen­
tives for the insured to increase their risk in
order to maximize the combined value of their
equity and deposit guarantees) intrinsic in
deposit-insurance guarantees, strict regulations
were adopted that limited the scope of activities
in which banks could participate and the types
of products (both asset and liability) they could
offer. In other words, regulations were used as a
tax to offset the perverse effects of the subsidy
inherent in federal deposit insurance (Buser et
al. [1981] ). These regulations sought to alleviate
the moral hazard problem by removing a large
degree of management and shareholder discre­
tion in the operation of depository7institutions.



An unintended side effect has been that these
regulations have made managers and share­
holders less responsive to market incentives and
have reduced the flow of capital from poorly
managed institutions to well-managed ones
(because all institutions are equally insured).
This system most assuredly resulted in fewer
bank failures from the mid-1930s through the
late 1970s, but did so at the expense of the longrun stability7of the financial system, as evidenced
by the escalation of problems in the banking and
thrift industries in the 1980s.11 The movement of
capital from marginal firms in an industry to the
strongest and best-managed firms is another of
the self-corrective forces that would ensure the
long-run stability of our banking system.
While regulation may reduce the moral hazard
associated with deposit guarantees, Kane (1988b,
1989b) shows that principal-agent problems cause
other forms of moral hazard to arise.12 In the
principal-agent framework, bank and thrift reg­
ulatory agencies are viewed as self-maximizing
bureaucracies whose primary task is to act as the
agent for taxpayers to ensure a safe and sound
banking system and to minimize the taxpayer’s ex­
posure to loss. In addition, regulators must cater
to a political clientele who are intermediate or
competing principals. Furthermore, regulators are
sometimes motivated by their own self-interest.13
In Kane’s (1989e) principal-agent framework,
political pressures and self-interest considerations
create perverse incentives for regulators that may
cause them to “paper over” emerging problems
in an industry7instead of dealing with them early
and forcefully with the hope that, by buying time
to deal with each crisis, the ultimate cost of
resolving it will be smaller. Policies such as “too
big to let fail,” capital forbearance programs, and
the adoption of regulatory7accounting principles
(RAP) for thrifts are some of the more visible
manifestations of the problem (Kane [1989b]).

■

11 Schwartz (1987, 1988) argues that the 60 years of relative stability in

our financial system were due to price stability and not to either deposit insur­
ance or bank regulation. She argues that one cost of price-level instability is
troubled depository institutions, regardless of whether they are regulated.

■ 12

For a general discussion of agency costs and pricipal-agent problems

and their applications in corporate finance, see Jensen and Meckling (1976)
and Jensen and Smith (1985).

■ 13

Of course, throughout this paper, it is assumed that all politicians and

bureaucrats firmly believe that their actions are motivated exclusively by the
public interest. The analysis provided here emphatically does not accuse public
servants of intentionally acting in bad faith but, rather, assumes that they do
not always articulate or understand their real motives.

32

Regulation and Stability

Government-regulated systems, such as those
operative in our banking and thrift industries,
attempt to achieve stability by setting up a deli­
cate and complex web of regulatory taxes and
subsidies. In the case of banks, regulation has
attempted to achieve stability by limiting compe­
tition between banks and nonbank financial
institutions, both through prohibitions on activi­
ties banks can engage in (Glass-Steagall restric­
tions) and by subsidizing bank funding (through
federal deposit insurance). Regulators are
charged with the task of stabilizing the banking
system by delivering an optimal mix of regula­
tory subsidies and taxes.
As Kane (1985, ch. 5) points out, the ability of
regulators to deliver an optimal mix of regulatory
taxes and subsidies becomes increasingly difficult
over time as competitive forces in financial mar­
kets gradually erode existing regulations and
alter the size and mix of regulatory taxes and
subsidies.14 Existing regulations often are weak­
ened, or are made completely inappropriate, or
become counterproductive. In addition, subsi­
dies inherent in fixed-rate deposit insurance,
access to discount-window credit, and free final­
ity of payments over the Federal Reserve’s wire
transfer system increase in size. This effect is
accentuated by exogenous shocks to the finan­
cial system, such as surges of inflation or techno­
logical changes.
These market-driven changes in our system of
regulatory7taxes and subsidies are the beginning
of the ongoing process of regulation, market
avoidance, and reregulation: a process that Kane
(1977, 1988a) calls the “regulatory7dialectic.’’
The response of government-regulated systems
to market-driven changes in the size and mix of
regulatory7taxes and subsidies is to accommo­
date the shocks. Changes to the regulatory7struc­
ture tend to lag developments in the market­
place and are typically piecemeal, usually with
the purpose of either validating market innova­
tions or reregulating areas where market forces
have made existing regulations obsolete.15 This

■ 14

Regulatory subsidies arise because banks and thrifts are not charged

the fair value of the risk-bearing services provided to them by the federal
safety net. Regulatory taxes represent the reduction in the value of a bank or
thrift due to constraints placed on its profit-maximization function through
regulation.
■

15 The difference between the market and regulatory adjustment process

is equivalent to the difference in exchange-rate adjustments under floating and
fixed exchange rates. Under a floating-exchange-rate regime, supply and
demand factors in markets cause nearly continual adjustment of the exchange

 rate. Under a fixed-exchange-rate regime, the official exchange rate is main­
http://fraser.stlouisfed.org/
tained for long periods of time, with large adjustments made periodically.
Federal Reserve Bank of St. Louis

may include regulations designed to limit or
prohibit new activities that are deemed too risky
(for example, thrifts’ investments in high-yield
bonds), the removal of regulations that are
unenforceable or politically costly to continue
(for example, deposit-rate ceilings), or the modi­
fication of existing regulations ( for example,
risk-based capital standards for banks and RAP
accounting standards for thrifts).
Essentially, the regulatory response is to deal
with the symptoms of a shock without making the
basic structural adjustments necessary to allow the
banking system to adjust fully. This often results
in policies aimed at protecting the regulator’s
weakest client firms at the expense of the effi­
cient firms in the industry and, hence, the stabil­
ity of the banking system. An example is the cap­
ital forbearance policies adopted by both the
bank and thrift regulators during the 1980s
(Barth and Bradley [1989, table 3], Caliguire and
Thomson [1987], and Thomson [1987a]). More­
over, regulatory interventions in the banking sys­
tem tend to thwart market-oriented forces often
enough that normal market outcomes are difficult
to achieve within the limited scope of activities
that the regulators are willing to permit. Conse­
quently, increased subsidies from the public
purse become necessary7to permit regulated
entities to achieve the returns on equity that
enable them to remain competitive. This system
minimizes the number of failures of individual,
regulated firms in the short term, but increases
the efficiency loss and the aggregate public
exposure to loss in the long term. Kane ( 1989b)
points to the current thrift debacle as a vivid
example of this type of regulatory7behavior.
The result is a set of financial institutions that
are special or unique only in terms of the regula­
tory taxes and subsidies to w7hich they are sub­
ject. In other words, it is the restrictions on
organizational form, where they can do business,
and what businesses they can be in, coupled
with access to federal deposit guarantees, to the
Federal Reserve’s discount window, and to the
Federal Reserve-operated payments system that
make depository institutions special. Addition­
ally, banks and thrifts are less efficient and less
able to adapt to changes in the economy than
they would be if they were more subject to
market incentives, and the resulting banking
system is less stable in the long run than one
governed by market principles.

H g

II. Market-Oriented
Reforms

The alternative to increased regulation is a sys­
tem of reforms that relies more heavily on
market forces to shape the structure of the finan­
cial services industry.16 Market-oriented reforms,
such as a reduction in the scale and scope of the
federal safety net, improved information systems
( including the adoption of market-value account­
ing and early dissemination of information), and
the adoption of a timely, solvency-based closure
rule for banks and thrifts, would increase the
efficiency and long-run stability of the banking
system. Rather than blocking or attempting to
circumvent market forces, these reforms would
rely on market forces to reestablish the trade-off
between risk and return in financial services, so
that those who benefit from the gains of risky
strategies would also bear the losses when these
strategies did not pan out. Therefore, there
would be less of a need for regulations, as dis­
tinct from reliance on market forces, to protect
the public purse from losses.
In its most extreme form, market-oriented
reforms would establish a free-market banking
system with no remaining vestiges of the federal
safety net (discount-window access, deposit
insurance, and direct access to the Federal
Reserve payments system). The market would
determine the structure and scope of financial
intermediaries’ activities, and market-determined
closure rules would prevail. The role of the
government would be limited to collecting and
disseminating information and to enforcing
property rights by resolving contractual disputes.
However, reforms to the federal safety net neces­
sary for a free-market banking system are
unlikely to be implemented. Kane (1987), echo­
ing Downs (1957), argues that subsidies, like
those embodied in the financial safety net, tend
to become viewed as entitlements by the subsi­
dized industry. Industry trade associations and
other special interest groups lobby Congress
vigorously to protect their narrow interests, while
society’s interests are sufficiently diffuse that they
cannot defeat special interest lobbies.
One caveat to note is that the following pro­
posed reforms have transitional or “switching”
costs that must be dealt with. This is especially
true of deposit-insurance reforms. These transi­
tional costs would be less of a problem if the
reforms were applied to an industry that is already
healthy. Obviously, this is not the case for either
our banking industry or the thrift industry.
 ■ 16 This section draws heavily on Benston et al. (1986), Benston and
http://fraser.stlouisfed.org/
Kaufman (1988), and Kane (1985, 1986, 1987, 1989a, 1989b, 1989c, 1989d).
Federal Reserve Bank of St. Louis

It must be recognized that the transitional
costs, which include the cost of recapitalizing,
reorganizing, or closing insolvent and unsound
institutions, cannot be avoided forever regardless
of whether reforms are adopted. Moreover, as
demonstrated so vividly by the thrift crisis, the
sooner these costs are dealt with, the smaller
they are likely to be (Kane [1989b, ch. 3] and
Barth and Bradley [1989] )■Therefore, the reali­
zation of the switching costs should not be seen
as an impediment to reform, but rather as an
important first step in implementing any set of
reforms. FIRREA represents a partial realization
of these switching costs; however, considerably
more needs to be done before a comprehensive
package of deposit insurance and regulatory
reforms can be implemented.

Deposlt-lnsurance Reform

Restoring market discipline as an effective con­
straint on bank and thrift activities is the main
purpose of deposit-insurance reform. The cover­
age and pricing of federal deposit guarantees
must be changed so that federal bank and thrift
insurance funds do not subsidize risk in the
financial system.
To restore market discipline to banking, fed­
eral deposit insurance coverages must be
limited, and remaining coverage must be cor­
rectly priced.17 At the very least, deposit insur­
ance should be cut back to strict observance of
the current statutory limit of $100,000. Further­
more, this limit should be applied per depositor,
rather than to each insured deposit account.
Coverage should not be extended in any circum­
stance to explicitly uninsured depositors, unse­
cured creditors, or stockholders of banks and
their parent holding companies. In other words,
the failures of all insured institutions should be
handled in a manner that reduces the regulators’
and insurers’ incentives to minimize insured
deposit payouts while maximizing long-term
exposures to uninsured claims.
Kane (1985, ch. 6) proposes that strict enforce­
ment of the current limit would require some
changes to the failure-resolution policies of the
FDIC and might require statutory constraints on

■ 17

Merton (1977, 1978) shows how option pricing can be used to model

and value deposit guarantees. Using Merton's results, Thomson (1987b) shows
how information regarding the market prices of uninsured and partially insured
deposits can be used to construct risk-based deposit-insurance premiums for
insured deposit balances. Ronn and Verma (1986) show how option pricing can
be used to derive estimates of the value of deposit insurance using stockmarket data and different closure assumptions.

34

the authority of the FDIC to rescue large insol­
vent financial institutions.18 These constraints
would preclude the use of failure-resolution
techniques such as open-bank assistance and
purchase-and-assumption transactions, which
provide de facto coverage to de jure uninsured
claimants.19 Such changes would give the “too
big to let fail” doctrine the decent burial it
deserves and would restore some measure of
market discipline to banking.
However, to truly reap the benefits of depositinsurance reform, the statutory limits on cover­
age should be reduced to levels significantly
below the current $100,000 ceiling. Kane (1986)
and Thomson and Todd (1990) suggest that a
reduction in the limit from $100,000 to $10,000
(indexed to the Consumer Price Index) would
be consistent with a social desire to provide a
safe haven for the savings and transactions bal­
ances of small savers while reestablishing large
depositors as a source of discipline on banks'
risk-taking. Thomson and Todd (1990) point out
that a $10,000 ceiling exceeds the average
(arithmetic mean) insured deposit account in
both banks and thrifts (about $8,000) and that
depositors with balances in excess of $10,000
already have access to U.S. Treasury bills, which
are close substitutes for federally guaranteed
bank deposits.
In addition to lowering the insured deposit
ceiling, several authors have suggested that a
coinsurance feature could be added for additional
deposit balances above the full-insurance level.20
For example, if the deposit insurance ceiling
were set at $10,000, the FDIC could provide 90
percent coverage for balances between $10,000
and $50,000 and 70 percent coverage for balances
in excess of $50,000. Other, apparently more
drastic, variations on this theme are possible; the
original (1933) interim deposit insurance scheme
provided for only 50 percent coverage for bal­
ances in excess of $50,000, for example. Presum­
ably, if mandatory closure rules were adopted,

■ 18

For expressions of skepticism that regulators would allow big banks

to fail, even if explicit deposit-insurance coverage were reduced or, in advance,
said to be strictly enforced, see Tngaux (1989) and Passell (1989).

■ 19

The failure-resolution policies of the FDIC are the process through

which implicit guarantees are issued to uninsured depositors, general creditors,
subordinated creditors, and even stockholders. For a discussion of FDIC failureresolution policies, see Benston et al. (1986, ch. 4), Caliguire and Thomson
(1987), Kane (1985, ch. 2), and Todd (1988b).

■ 20

Coinsurance was a feature in the original FDIC Act (see Todd

[1988a]). Kane (1983) suggested coinsurance as part of a six-point depositinsurance reform proposal. Baer (1985) suggested it as part of a proposal for
mixed private and public coverage of deposits. More recently, Cates (1989),
the Federal Reserve Bank of Minneapolis (1988), and the Federal Reserve

 Bank of Cleveland (Hoskins [1989]) have embraced the concept of
http://fraser.stlouisfed.org/
coinsurance.
Federal Reserve Bank of St. Louis

private insurance markets would develop to pro­
vide coverage for the coinsurance deductible
portion of the deposit for those depositors who
desired full protection.
An important feature of coinsurance is that it
would establish minimum recoveries on deposit
balances in excess of the fully insured limit. This
would remove an important constraint on the
FDIC’s ability to resolve bank failures quickly
without extending forbearances to uninsured
depositors. With coinsurance, the federal deposit
guarantor would not need to estimate in advance
the losses to the uninsured depositors. It would
simply apply the coinsurance haircut to deposi­
tors’ balances. If the institution’s total losses did
not exceed the haircut amount, the receiver
would rebate to the uninsured depositors their
share of the difference. Thus, coinsurance would
alleviate financial hardship for uninsured deposi­
tors by paying them a predetermined portion of
their deposits up front.

The Role of the
Discount Window

For deposit-insurance reform to be truly effec­
tive, the Federal Reserve should avoid using its
discount window to support the solvency (capital
replacement) of, or to delay the closing of, an
insolvent bank or thrift (Kane [1987]). Benston
et al. (1986, ch. 5) maintain that solvency support
or capital replacement lending by Federal Reserve
Banks is simply another way for regulators to
extend de facto guarantees to uninsured deposi­
tors and other creditors of depository institutions:
it provides an opportunity for these claimants to
liquidate their claims at par, thereby increasing
the ultimate cost (loss upon liquidation) to either
the lender of last resort, the deposit insurance
fund, or the receiver.
This loss arises because, if good assets are
pledged to the lender of last resort to fund early
redemption at par of some (usually the largest)
uninsured claims, then the pool of good assets
remaining to cover eventual payments to insured
depositors and other uninsured claimants is
reduced. The effect of this practice is analogous
to the effect of a leveraged buyout (LBO)
announcement on outstanding corporate bonds
of the LBO target: the pool of assets available to
cover outstanding bonded debt service is
reduced to cover LBO debt service. Rating agen­
cies have no choice but to downgrade outstand­
ing bond issues, and those bonds decline in
secondary market value.

To prevent the use of the discount window for
purposes other than liquidity support for solvent
institutions (the originally intended and the only
theoretically sound purpose, according to Todd
[1988a] ), the following guidelines should be fol­
lowed. First, the discount window should be
available only to demonstrably solvent institu­
tions, with the loans fully secured by sound and
fairly evaluated collateral. Heavy and frequent
borrowers at the window should be required to
demonstrate their solvency, and loans should
not be extended or renewed once an institution
is determined to be insolvent.
Second, discount-window advances should be
made at unsubsidized rates with a penalty for
loans made to heavy or frequent borrowers.
Finally, the discount window should not be seen
as a substitute for the maintenance of a reasona­
ble amount of liquidity by even solvent financial
institutions, except in extraordinary circumstances.

Information and MarketValue Accounting

Kane (1989b, ch. 6) asserts that better informa­
tion systems are needed to increase the effec­
tiveness of both government regulation and
market-oriented regulation of depository institu­
tions. Currently, our regulatory system sup­
presses information about depository institu­
tions, which results in information flows to
market participants that are both noisy and
“lumpy.”21 Noisy and lumpy information flows
do not allow markets to make several small cor­
rective adjustments as new information comes
in; instead, they cause the market to make larger
and more dramatic adjustments as market partic­
ipants attempt to process new information. This,
in turn, leads to the appearance that markets
overreact to new information as it arrives.
To improve the informational efficiency of
markets, several authors have advocated the use
of market-value accounting (Kane [1985, chs. 5
and 6; 1987, 1988a], Benston et al. [1986, ch. 8],
Benston et al. [1989], and Benston and Kaufman
[1988] ). Traditional accounting systems like
GAAP (generally accepted accounting principles)
and RAP result in unnecessary noise in the
information system because they allow firms to
carry assets and liabilities at their par value (usu­
ally, historical cost) and do not reflect the sub­
sequent changes in their market value. There­
fore, Thomson ( 1987a) argues that GAAP and

RAP may not be good measures of the true sol­
vency of a bank or thrift, that both GAAP and RAP
tend to be high-biased measures of solvency for
banks and thrifts experiencing solvency prob­
lems, and that the degree of error in GAAP and
RAP measures increases as solvency deteriorates.
Berger et al. (1989) correctly point out that
market-value accounting systems themselves are
not perfect, as there are many assets and liabili­
ties on the balance sheets of banks and thrifts for
which estimates of market value are not readily
available. However, Benston and Kaufman ( 1988)
and Mengle ( 1989) argue that it is possible to
adjust asset and liability values for changes in
interest rates and that, as markets develop for
securitized bank assets, the ability to make rea­
sonable, market-based adjustments to the value
of similar assets in bank portfolios increases.
Market-value accounting is not a panacea and
still results in noisy information streams. None­
theless, it is a less-noisy information stream than
the one that flows from both GAAP and RAP.
Over time, market-value accounting should
become less noisy as financial markets evolve.
In addition to the use of market-value
accounting, Benston et al. (1986, ch. 7) suggest
that the regulatory community move from sup­
pression to timely dissemination of information.
FIRREA takes an important step in this direction
as it mandates that cease-and-desist orders,
supervisory agreements, and other regulatory
actions are to be published by the appropriate
supervisory agency. Hoskins ( 1989) goes even
further in advocating that banks and thrifts
should have the right to release their examina­
tion ratings and reports to the public.22 Finally,
annual audits by independent accounting firms
should be required for all financial institutions.
For small, well-capitalized institutions for whom
this rule could prove to be a financial hardship
(for example, consolidated entities with less
than $100 million in assets), outside audits could
be required only every second or third year.
Both of these changes in the current informa­
tion system would increase the effectiveness and
efficiency of market-based oversight of deposi­
tory institutions and would increase the stability
of the financial system. Markets would be better
able to discriminate among financial institutions
and to force corrective action much sooner than

■ 22

Mandatory release of examination ratings and reports by the regula­

tors is a sufficient, but not necessary, condition for the timely dissemination of
information about the condition of insured institutions. If banks and thrifts are

■ 21

The information flows are lumpy in the sense that large amounts of

 information are arriving at discrete intervals, as opposed to smaller amounts of
http://fraser.stlouisfed.org/
information arriving nearly continuously.
Federal Reserve Bank of St. Louis

allowed to release their examination ratings and reports to the public, then
institutions with high ratings would have incentives to signal their condition to
the market.

is currently possible, thereby reducing the prob­
ability of bank runs (Pennacchi [1987] ). Conse­
quently, systemic stability would be improved, as
the size and the volatility of the market correc­
tion would be smaller. Better information sys­
tems also would reduce the ability of regulators
to conceal problems in the financial services
industry as they emerged.

Deregulation and Timely
Closure of Insolvent
Institutions

Under a market-based incentive system, the role
for supervision and regulation would be radically
different. Regulators would be assigned the task
of enforcing a few basic rules ( for example, m in­
imum capital requirements, periodic reporting
and public disclosure requirements, outside aud­
its, and market-value accounting), and monitor­
ing efforts would be directed at ensuring that
those rules were observ ed. Any individual or
financial institution able to meet these minimum
guidelines would be granted a bank charter.
Institutions that failed to meet these guidelines
would be required either to close or to adjust
their operations to comply.23
This approach, proposed by Benston and Kauf­
man ( 1988) and Benston et al. ( 1989), recognizes
that a bank’s management has the skills, informa­
tion, and incentives to make optimal use of its
resources, while bank regulators do not. As long
as supervisors tolerated failure (either through
market closure or a solvency-based closure rule),
any financial service or activity could be per­
formed by any financial institution, as long as it
could do so within the minimum operating
guidelines.
Unlike the current approach toward bank reg­
ulation, which often seeks to suppress market
forces, this approach attempts to complement
and enhance market discipline. Allowing man­
agers and stockholders to make the decisions
governing the operation of their institution,
including scope of activity and institutional struc­
ture, would make them more responsive to
market incentives. The perverse incentives cur­
rently facing managers and owners of weak and
barely solvent institutions would be neutralized

■ 23

Prior to 1933, the solvency test applied in bank closing cases was

by supervisory interference as the condition of
the institution deteriorated.24 The most extreme
case of supervisory interference would be the
closure or forced sale of institutions that deterio­
rated to the point where they violated the m in­
imum operating standards.
This approach would lead to a more efficient
and stable financial system than pure regulation.
Fewer resources would be expended in the
enforcement and evasion of outdated rules by
regulators and regulatees, respectively, and those
who took the risks would bear the consequences
of those decisions. Organizational form and
activities would be dictated by markets.
Since market forces would be allowed to
operate unfettered, efficiency and stability would
be enhanced: private capital would be reallo­
cated by market forces to the best-managed insti­
tutions and away from the weak and poorly
managed ones, which would be allowed to fail.
Timely release of information to markets under
the supervisory approach would allow financial
distress in an institution to be detected more
quickly, constraining the growth of marginally
solvent and insolvent institutions. Market recog­
nition of financial distress would lead to an
orderly outflow of funds and an increase in the
cost of funds for troubled institutions, which, in
turn, would lead to more orderly and timely clo­
sure of insolvent institutions and a reduction in
their ultimate failure-resolution costs.

III. Conclusion

At the August 9, 1989 signing ceremony for
FIRREA, President Bush proclaimed, “We will
keep the federal deposit insurance system solvent
and help serve those millions of small savers who
make America great...” while “...ensuring the
taxpayers’ interests will always come first ....”25
Accomplishing both of these objectives will
require great effort in any case, but might be
impossible without market-oriented reforms of
the financial structure such as those described
here.
Moreover, as Kane (1989c, 1989e) argues, the
Bush plan from which FIRREA evolved was not
based on a comprehensive theory of how the

■ 24

The Benston and Kaufman (1988) and Benston et al. (1989) proposals

either incapacity to pay obligations as they matured or balance-sheet insol­

set up several different trigger points for increasing supervisory interference as

vency. Since then, the Office of the Comptroller of the Currency has tended to

the institution slides toward insolvency and allows regulators to close the insti­

use only the former “ maturing obligations" test, although the statutory basis

tution before it becomes insolvent.

for the latter-"balance-sheet” test remains intact. Compare 12 U.S.C. Section

 191 (balance-sheet or maturing obligations) with Section 91 (usually inter­
preted as “ maturing obligations" only).


■ 25

See “ Bush Remarks: 'First Critical Test’ Has Been Passed," American

Banker August 10, 1989, p. 4.

37

losses in the thrift industry occurred and were
allowed to grow so large. Consequently, because
the Bush plan (and, by inference, FIRREA) fails
to correct the incentive-incompatibility problems
in the current deposit-insurance contract that
caused the current thrift crisis, there is a high
probability that taxpayers will be faced with
another deposit-insurance crisis in the near future.
It is hoped that the study of federal deposit
insurance mandated by FIRREA, and currently
under way at the U.S. Treasury Department, will
address the fundamental structural flaws in the
federal safety net and, in particular, in federal
deposit insurance. The purpose of any reforms
to the federal safety net and to our system of
bank regulation should be to increase the effi­
ciency and long-run stability of the banking sys­
tem while protecting the public from financial
loss. The market-oriented reforms put forth in
this paper would go a long way toward achieving
these goals.26

■ 26

The reforms set forth in this paper are aimed at increasing market

discipline primarily through increased depositor and stockholder discipline on
insured banks and thrifts. Another way to increase market discipline on banks
is through the use of subordinated debt (see Baer [1985], Benston et al.
[1986, ch. 7], and Wall [1989]) and surety bonds (see Kane [1987]). For con­
flicting evidence of the ability of subordinated-debt holders to discipline bank
risk-taking, see Avery et al. (1988) and Gorton and Santomero (1990). Ely

 (1985, 1989) would use banks to discipline each other through a system of
http://fraser.stlouisfed.org/
cross-guarantees for their liabilities.
Federal Reserve Bank of St. Louis

w

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41

Ec o n o m ic R e vie w

■ 1989 Quarter 1
The Determinants of Direct
Air Fares to Cleveland:
How Competitive?
by Paul W. Bauer and
Thomas J. Zlatoper
Bank Capital Requirements
and the Riskiness of Banks:
A Review
by William P. Osterberg and
James B. Thomson
Turnover, Wages, and
Adverse Selection
by Charles T. Carlstrom

■ 1989 Quarter 2
Removing the Hazard of
Fedwire Daylight Overdrafts
by EJ. Stevens
Capital Subsidies and
the Infrastructure Crisis:
Evidence from the Local
Mass-Transit Industry7
by Brian A. Cromwell
Employment Distortions
Under Sticky Wages
and Monetary Policies
to Minimize Them
by James G. Hoehn




■ 1989 Quarter 3
The Stability of Money
Demand, Its Interest
Sensitivity, and Some
Implications for Money
as a Policy Guide
by John B. Carlson
Accounting for the Recent
Divergence in Regional Wage
Differentials
by Randall W. Eberts
Why We Don’t Know Whether
Money Causes Output
by Charles T. Carlstrom and
Edward N. Gamber
■ 1989 Quarter 4
Deposit-Institution Failures: A
Review of Empirical Literature
by Ash Demirgiic-Kunt
Settlement Delays and
Stock Prices
by Ramon P. DeGennaro
The Effect of Bank Structure
and Profitability on
Firm Openings
byTPaul W. Bauer and
Brian A. Cromwell

42

W orking Papers

■ 8901
The Effects
of Disinflationary
Policies on
Monetary Velocity
by William T. Gavin

■ 8907
The Structure
of Supervision and
Pay in Hospitals
by Erica L. Groshen
and Alan B. Krueger

and William G. Dewald

■ 8902
A Two-Sector Implicit
Contracting Model With
Procyclical Quits and
Involuntary Layoffs

■ 8908
Intervention and the
Risk Premium in
Foreign Exchange
Rates
by William P. Osterberg

by Charles T. Carlstrom

■ 8903
Predicting De Novo
Branch Entry Into
Rural Markets
by Gary Whalen

■ 8904
Dedicated Taxes
and Rent Capture
by Public Employees
by Brian A. Cromwell

■ 8905
Modeling Large
Commercial-Bank
Failures: A
Simultaneous-Equation
Analysis
by Asli Demirguc-Kunt

■ 8906
Do Wage Differences
Among Employers Last?
by Erica L. Groshen




■ 8913
Portfolio Risks and
Bank Asset Choice
by Katherine A. Samolyk

■ 8914
The Role of Banks in
Influencing Regional
Flows of Funds
by Katherine A. Samolyk

■ 8915
Regime Changes in
Stock Returns

■ 8909
Public Infrastructure
and Regional Economic
Development:
A Simultaneous
Equations Approach

by Nan-Ting Chou
and Ramon P. DeGennaro

by Kevin T. Duffy-Deno

by James B. Thomson

■ 8916
An Analysis of Bank
Failures: 1984-1989

and Randall W. Eberts

■ 8910
Structure, Conduct, and
Performance in the
Local Public Sector

■ 8917
The Timing of
Intergenerational
Transfers, Tax Policy,
and Aggregate Savings

by Randall W. Eberts
and Timothy J. Gronberg

by David Altig
and Steve J. Davis

■ 8911
Factor-Adjustment
Costs at the Industry
Level

■ 8918
Altruism, Borrowing
Constraints, and Social
Security

by Mary E. Deily
and Dennis W. Jansen

and Steve J. Davis

■ 8912
Enforcement of
Pollution Regulations in
a Declining Industry
by Mary E. Deily
and Wayne B. Gray

by David Altig

43

F irs t Q u a rte r
W orking P ap e rs

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■ 9002
On the Choice of the
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lomic Com m entary

International Policy
Coordination: Can We
Afford It?
by W. Lee Hoskins
January 1, 1989
Money and Velocity
in the 1980s
by John B. Carlson
and John N. McElravey
January' 15, 1989
Monetary Policy,
Information, and Price
Stability
by W. Lee Hoskins
February7 1, 1989
Bank Lending to LBOs:
Risks and Supervisory7
Response
by'James B. Thomson
February7 15, 1989
The Costs of Default and
International Lending
by Chien Nan Wang
March 1, 1989
Is There a Message in
the Yield Curve?
by EJ. Stevens
March 15, 1989
A Market-Based View of
European Monetary Union
by W. Lee Hoskins
April 1, 1989
Communication and the
Humphrey-Hawkins Process
by John N. McElravey
April 15, 1989




Airline Deregulation:
Boon or Bust?
by' Paul W. Bauer
May 1, 1989
Economic Principles and
Deposit-Insurance Reform
by James B. Thomson
May 15, 1989
Rethinking the Regulatory
Response to Risk-Taking
in Banking
by W. Lee Hoskins
June 1, 1989
Payment System Risk Issues
by EJ. Stevens
June 15, 1989
Inflation and Soft Landing
Prospects
by John J. Erceg
July 1, 1989
Setting the Discount Rate
by E.J. Stev ens
July 15, 1989
Mergers, Acquisitions, and
Evolution of the Region’s
Corporations
by Erica L. Groshen and
Barbara Grothe
August 1, 1989
LBOs and Conflicts of Interest
by William P. Osterberg
August 15, 1989

Have the Characteristics of
High-Earning Banks Changed?
Evidence from Ohio
by Paul R. Watro
September 1, 1989
The Indicator P-Star: Just
What Does it Indicate?
by John B. Carlson
September 15, 1989
Forecasting Turning Points
with Leading Indicators
by Gerald H. Anderson and
JohnJ. Erceg
October 1, 1989
Breaking the InflationRecession Cycle
by W. Lee Hoskins
October 15, 1989
Foreign Capital Inflows:
Another Trojan Horse?
by Gerald H. Anderson and
Michael F. Bry7an
November 1, 1989
How Soft a Landing?
by Paul J. Nickels and
John J. Erceg
November 15, 1989
Monetary Policy and
the M2 Target
by Susan A. Black and
William T. Gavin
December 1, 1989
Making Judgments About
Mortgage Lending Patterns
by Robert B. Avery7
December 15, 1989