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Vol. 28, No. 3
ECONOMIC REVIEW
1992 Quarter 3
2
Comparing Central Banks’
Rulebooks
by E.J. Stevens
16
Forbearance, Subordinated
Debt, and the Cost of Capital
for Insured Depository
Institutions
by William P. Osterberg and James B. Thomson
An Introduction to the
International Implications
of U.S. Fiscal Policy
27
by Owen F. Humpage
m
m
FEDERAL RESERVE BANK
OF CLEVELAND
DEE M I C
REVI EW
1992 Quarter 3
Vol. 28, No. 3
Comparing Central
Banks’ Rulebooks
2
by E.J. Stevens
A central bank’s daylight overdraft and reserve requirement rules
influence payments institutions and its own monetary policy
operating practices. This article contrasts Federal Reserve rules
with those of the Deutsche Bundesbank, the Bank of Japan, and
the Bank of England. The fundamental lesson is that no unique set
of regulations is necessary for the effective performance of a
central bank’s monetary and payments system functions. How
ever, adopting a different rulebook (by eliminating Federal Reserve
daylight overdrafts or reserve requirements, for example) would
entail some adaptation of payments institutions and monetary
policy operating practices. Comparisons to the other central banks
indicate what some of these adaptations might be.
Forbearance, Subordinated
Debt, and the Cost of
Capital for Insured
Depository Institutions
16
by William P. Osterberg and James B. Thomson
Requiring banks to issue subordinated debt has been proposed as a
way to reduce the deposit insurance subsidy and to increase market
discipline. Using a modified cost of capital framework, this article
develops an explicit pricing model for subordinated debt that con
siders the possibility of Federal Deposit Insurance Corporation for
bearances. The results reveal that forbearance alters the required rate
of return on subordinated debt while increasing its value to debt
holders. Moreover, the authors show that a policy of forbearance
weakens the effectiveness of such debt in reducing deposit insurance
premiums and as a source of market discipline.
Economic Review is published
quarterly by the Research Depart
ment of the Federal Reserve Bank
of Cleveland. Copies of the Review
are available through our Public
Affairs and Bank Relations Depart
ment, 1-800-543-3489.
Coordinating Economist:
James B. Thomson
Advisory Board:
David Altig
Erica L. Groshen
William P. Osterberg
Editors: Tess Ferg
Robin Ratliff
Design: Michael Galka
Typography: Liz Hanna
Opinions stated in Economic
Review are those of the authors
and not necessarily those of the
Federal Reserve Bank of Cleveland
or of the Board of Governors of the
Federal Reserve System.
Material may be reprinted
provided that the source is
credited. Please send copies of
reprinted material to the editors.
ISSN 0013-0281
An Introduction to the
International
Implications of U.S.
Fiscal Policy
27
by Owen F. Humpage
A commonly held belief is that aggregate U.S. fiscal policy meas
ures— in particular, the federal budget deficit— are directly linked
to U.S. interest rates, exchange rates, and the trade balance.
Through the use of Engle—Granger cointegration tests and the
development of simple two-period, two-country models, the
author illustrates a complex relationship that depends on the distortionary nature of taxes and on relative differences between pub
lic and private propensities to consume and to import. Fiscal
policies can cause trade deficits, but this need not be the case.
Comparing Central
Banks’ Rulebooks
by E.J. Stevens
E.J. Stevens is an assistant vice
president and economist at the
Federal Reserve Bank of Cleveland.
The author thanks Diana Dumitru
for invaluable research assistance
and Jeffrey C. Marquardt and David
Van Hoose for useful comments.
Introduction
Banks’ account relationships with their Federal
Reserve Banks are changing because account
regulations are changing. The Board of Governors
of the Federal Reserve System began a program in
1986 to limit banks’ use of daylight overdrafts,
broadened the program in 1991, and beginning in
1994 will charge a fee for daylight overdrafts that
exceed certain minimum amounts. The Board also
reduced reserve requirements to zero on nontrans
actions deposits in 1990 and cut the highest
reserve requirement on transactions deposits from
12 percent to 10 percent in 1992.
The purpose of this article is to examine how
major changes in our central bank’s rulebook
might affect Federal Reserve operations and U.S.
monetary and payments institutions. To this
end, I contrast Federal Reserve overdraft and
reserve requirement regulations — and the insti
tutional setting in which they are administered
— with analogous rules and institutional settings
at three of the world’s other leading central
banks: the Deutsche Bundesbank, the Bank of
Japan, and the Bank of England.
Do the account regulations in a central bank’s
mlebook
matter? Central banks in industrialized
countries
all
perfonn roughly the same functions,
centered on controlling the issuance of base
money and providing safe, final settlement of
interbank payments. They do so, however, with
apparently quite different regulations governing
the accounts of their customer banks. Some cen
tral banks allow daylight overdrafts while others
do not; some have no reserve requirements;
and some are more ready to lend than others.
O f course, some central banks may perform
better than others, with less inflation or more
safety in their payments systems. Jiirg Niehans has
observed that .. the effects and the effectiveness
of central bank policy depend to a large extent on
technical and institutional details that vary from
one country to another and in the course of time.”
(Niehans [1978], p. 263) Surely, however, major dif
ferences in perfonnance have more to do with a
central bank’s objectives, and with its institutional
and political will to achieve them, than with its
rulebook of account regulations.
A central bank’s mlebook is important, none
theless. In addition to any costs imposed on banks,
account regulations influence the operating tech
niques and involvement of the central bank in the
money market. With unaltered objectives, sub
stantial changes in the Federal Reserve’s mlebook
w ould require associated modifications in both
3
its operating practices and the nation’s pay
ments institutions.
The curse of considering many questions
labeled as “central banking” is the absence of an
agreed-upon frame of reference within which to
conduct the analysis. The grand perspective of
monetary theory is too broad for this purpose; it
says little about the mundane details of central
bank operations. Likewise, marginal analysis of
an individual bank’s decisions under a particu
lar set of central bank rules is too narrow; it fails
to capture systemic implications of the relevant
market institutions.
Comparison with other central banks is used
here as a way to gain perspective on the Federal
Reserve’s rulebook. With or without daylight
overdrafts, and with high, low, or no reserve
requirements, each central bank is able to per
form similar day-to-day monetary and payments
system functions. Differences in rules can be
associated with differences both in market in
stitutions and in the way a central bank interacts
with financial markets and the banking system.
The remainder of the article is divided into
five sections. The first briefly reviews the unique
monetary and payments system functions of any
central bank. The next section compares the role
of each of the four central banks considered
here in financing customer banks’ clearing im
balances during the course of a day.
Two sections then contrast the four central
banks’ techniques for maintaining policy-intended
supplies of customer banks’ balances and the
monetary base. These practices involve central
bank operations that monetize and demonetize
debt (covered in section III). Some central banks
avoid lending directly to individual banks, tending
instead to use open-market operations in securi
ties to adjust the aggregate supply of base money
and relying on markets to allocate funds among
banks. Others are more willing to bypass credit
markets by lending directly to individual banks
when adjusting aggregate supply.
The level and averaging features of reserve
requirements (covered in section IV) influence
the extent to which a central bank must respond
to daily shocks to the aggregate supply of base
money. Some rely more heavily than others on
customer banks to absorb these shocks. The
concluding section summarizes the international
comparisons and extracts some apparent lessons
about changing the Federal Reserve’s rulebook.
I. Monetary and
Payments Functions
of a Central Bank
As the monetary authority, a modern central
bank controls the supply of “outside,” or base,
money. This anchors the price level in the long
run while allowing a central bank to respond to
variations in the economy over the business
cycle and to liquidity needs in the short run.
As the banker for commercial and other banks
operating in its country, a central bank is able to
settle interbank payments because it is the unique
common site of banks’ deposit accounts: A simple
bookkeeping transfer from one account to another
can settle payments involving any two banks.
In the same way, a central bank is able to settle
payments to and from its government or official
foreign institutions that hold deposit accounts
with it. In short, the central banks of most
industrialized countries control the aggregate
supply of base money while transferring owner
ship of banks’ base-money balances to settle
the daily clearing of payments.
Monetary policy deals with the growth rate of
the monetary base. Raising or lowering this rate
has the immediate effect of, or is brought about
by, changing the interest rate at which banks
can acquire very short-run funding of their ac
counts at the central bank. Ignoring completely
any questions about monetary policy, the ques
tion I address here is how a central bank recon
ciles banks’ need for settlement with its own
need to maintain a targeted level of base money.
Rules about the account balances banks hold
at the central bank are necessary if the central
bank is to control the monetary base. Private
banks have no earnings incentive to hold any
substantial balance in their accounts with the
central bank, because such balances typically
earn no interest.1 If a bank foresees ending the
day with a positive balance, it can lend that
amount overnight in markets for funds with
same-day payment. Moreover, banks are no dif
ferent from their own customers: Absent penal
ties, they have every incentive to use overdrafts
as a dependable source of financing, not only
during a day, but overnight. This means that in
the absence of overdraft and reserve require
ment rules, all banks would have an incentive
to create balances at the central bank by over
draft, but no incentive to hold all the balances
being created.
■ 1
For a rare instance of interest-bearing reserve assets, see
Dotsey (1991).
Sources of
Daylight Credit
Enforcing a rule against overnight overdrafts
allows a central bank to limit the supply of base
money each day. Scarce base money is available
only to those who pass a market test (by selling
goods, services, or existing securities or by bor
rowing). This does not, however, limit the intra
day supply of base money created by temporary,
“daylight” extensions of credit. Much of the daily
activity of banks involves daylight credit, which
must be repaid by day’s end to avoid overnight
overdrafts.
In modern industrialized economies, deposi
tors draw checks and other payment orders on
their bank accounts as the immediate quid pro
quo for many market transactions, and banks
use base money (or deposits at other banks) to
settle interbank clearing imbalances. Even pay
ments with same-day settlement can involve
delays that make it possible for banks to “pay
out” more money than they have on hand at the
moment. They rely on daylight credit provided
by those institutions that must wait for settle
ment before being paid in safe base money.
Clearinghouses are a common source of day
light credit. Routine, standardized transactions
within groups of banks, securities dealers, or
members of exchanges can be covered by blan
ket agreements about who can do how much
business on credit from the other members of
the group prior to settlement, and about how to
apportion losses if one of its members is unable
to settle.
A central bank provides daylight credit if it
makes final payments during the day for customer
banks lacking sufficient balances to cover pay
ments as they are made. The amount added to the
supply of balances will be drained, all else equal,
only when a borrowing bank repays the overdraft.
Repaying Daylight
Credit
Repayment of daylight credit from either source
should be routine even if banks hold zero bal
ances at the central bank overnight. If all trans
actions simply involve payments among banks,
zero balances are sufficient: What some banks
lose from adverse clearings during a day, other
banks gain. The losers should be able to bor
row or buy what they need from the gainers to
cover their positions, as long as they have ac
cess to markets with same-day payment.
Difficulties may arise if there is an aggregate
shortage of balances in the banking system as a
whole. If banks normally hold no excess balances
at the central bank, such a shortage will occur on
any day during which banks’ balances at the
central bank are drained into currency, govern
ment or foreign accounts, or other miscellaneous
accounts on the central bank’s balance sheet.
With too few balances to go around, one or more
banks will be unable to repay daylight credit ex
tended by a clearinghouse or the central bank.
Three mechanisms might allow banks to
acquire the funds needed to repay daylight
credit, despite uncontrolled factors draining bal
ances. One is a central bank’s “defensive” mar
ket operations. These are designed specifically
to offset uncontrolled factors draining (or add
ing) base money. Banks’ balances decline
whenever a central bank reduces its assets or
increases its other liabilities or capital, all else
equal. Defensive operations are simply central
bank actions taken to offset an undesired net
change in all of the factors affecting the aggre
gate amount of its constituent banks’ balances.
The central bank supplies or drains balances in
the aggregate, relying on the market to distrib
ute balances to those banks that need them.
Arbitrage associated with reserve require
ments is a second mechanism that allows the
banking system itself to absorb uncontrolled
deviations of the aggregate supply of balances
around a policy-intended level. A binding
reserve requirement for an averaging period
creates an aggregate average demand for cen
tral bank balances on the part of banks. The
average quantity demanded, however, can be
deferred or brought forward on any day in re
sponse to movements in interbank interest rates.
This interday arbitrage both absorbs the “noise”
from uncontrolled supply factors that are offset
ting during a reserve averaging period and
dampens associated variations in interest rates.2
A third mechanism is direct loans from the
central bank, whereby it acts as a pure liquiditymotivated lender of last resort to the banking
system. Direct lending is used primarily as an
■
2 The power of a reserve requirement to produce noise-absorbing
arbitrage has limits, however, at least in the short run. On the low side,
problems can arise if payments are made by direct transfers of central
bank balances, but the central bank limits the availability of daylight over
drafts. Even though banks may be willing to postpone holding overnight
balances, there may be too few balances to allow all banks to meet their
payment needs during a day within the existing institutional environment.
On the high side, some banks might inadvertently accumulate such large
reserve positions early in an averaging period that they could avoid ex
cess reserves for the whole period only by running overnight overdrafts,
which are prohibited (Dumitru and Stevens [1991 ]).
escape valve when defensive operations and
reserve averaging fail to offset factors draining
reserves from the nation’s banks, or when unex
pected factors increase reserve demand. Banks
normally are discouraged from relying on direct
central bank loans, with lending rationed by
administrative decision (Banks of England and
Japan), by banks’ reluctance to borrow (Federal
Reserve), or by a loan rate that generally ex
ceeds market rates (Bundesbank). For these rea
sons, individual banks typically do not plan to
repay daylight credit by borrowing directly from
the central bank. Instead, they try to acquire bal
ances in the market — balances created deliber
ately by the central bank and coaxed out of the
holdings of other banks.
Repayment problems might arise, however,
even with no aggregate shortage of balances at
the central bank. A bank may be unable to repay
daylight credit because either its incipient failure
or an operational problem (such as a computer
breakdown) prevents borrowing from, or selling
assets to, other banks with excess balances at the
central bank. Central bank, commercial bank, and
clearinghouse rules that prevent unlimited use of
daylight credit protect against this problem.
Conceptually, this source of repayment
problems can be reserved for a fuller discussion
of central banks’ lender-of-last-resort and bank
supervision functions.3 As a practical matter,
however, a central bank may have difficulty
maintaining such a clean distinction between
direct lending as a safety valve for aggregate
shortages of reserve balances and the importun
ing of either troubled banks or (in the United
■
3 The daylight credit involved in making payments causes wellknown payments system risk problems for banks, their clearinghouses,
and their central banks. In particular, a central bank needs to manage
credit ris k .
Daylight credit extensions on private net settlement systems can in
volve systemic risk problems. If payment finality is guaranteed by a
clearinghouse (a regulatory requirement advocated by the major central
banks), failure of a bank to cover a negative position at settlement re
quires other participants to make up the difference. Such guarantees are
now explicit in the rules of the Clearing House Interbank Payments Sys
tem (CHIPS) in the United States and the Gaiteme (Foreign Exchange)
Yen System in Japan.
An alternative structure makes payment finality contingent on suc
cessful completion of the settlement process at the end of a day, as in the
Towne Clearing of same-day paper check payments in London. In such
instances, a bank's failure to cover a negative position precludes settle
ment and implies disintegration of the day's payments, leaving their
status subject to negotiation or litigation. Another possibility, explicit in
the rules of some clearinghouses, is to “unwind" the settlement; that is,
to exclude all payments to and from the offending bank and calculate a
new settlement. However, at least in the case of large-value, same-day
networks, the typical perception is that a central bank would prevent disin
tegration, or an unwinding, by lending to ensure successful completion
of the original settlement (Stevens [1989], Bank for International Settle
ments [1990b]).
http://fraser.stlouisfed.org/
Federal Reserve Bank of St. Louis
States) banks attempting to take advantage of a
below-market discount rate.
II. Daylight Credit
Private clearinghouses operate in each of the four
countries considered here, with same-day net set
tlement on the books of the central bank. In addi
tion, the Federal Reserve Banks, the Bundesbank,
and the Bank of Japan operate their own on-line
payment networks that enable banks to make im
mediate payments throughout a day by transferring
central bank balances directly to other banks.4
Central bank daylight overdrafts are pro
vided only in the United States and Germany,
from payments made on the Fedwire electronic
network operated by the regional Federal
Reserve Banks, and on the express electronic
and paper transfer network operated by the
Bundesbank. Both systems include thousands
of participants and are dominated by largevalue payments. Flowever, the incidence of
daylight overdrafts might be expected to be
greater on Fedwire, where they average more
than $100 billion daily, than on the Bundesbank
system. This is because the value of payments
relative to gross domestic product (GDP) made
on Fedwire is more than five times greater than
on the Bundesbank network, and the ratio of
payments to balances is more than 30 times
larger (Bank for International Settlements
[1990a], Board of Governors [1989]).
The Federal Reserve permits daylight over
drafts for most banks within established limits, but
will begin phasing in a fee of 25 basis points (an
nual rate) in 1994? Compliance with limits is
verified on an ex post basis, rather than by pre
venting excess payments (as is now done, for
instance, on the CHIPS large-value transfer sys
tem). The Bundesbank, in contrast, apparently
does not execute payments that would produce a
daylight overdraft exceeding a bank’s preexisting
collateral, and does not impose a fee.
The Bank of Japan’s large-value same-day
payments systems (Bank of Japan Cheque and
Financial Network Systems) are comparable to
those of the Federal Reserve Banks and the
Bundesbank. However, the Bank of Japan will
not execute payments that would result in a
daylight overdraft. To acquire balances in time
■
4 Descriptions of the four nations’ payment mechanisms can be
found in Bank for International Settlements (1 9 8 5 ,1990a).
■
5 A small number of banks with daylight overdrafts in excess of
limits and arising from transfers of Treasury securities in the Federal
Reserve book-entry system must post collateral.
6
T A B L E
1
Combined Balance Sheet of
the Federal Reserve Banks3
Assets
Gold and Special Drawing Rights
Government securities:
Outright
Repurchase agreements
Loans to banksb
Denominated in foreign currencies
All other assets
Total
Liabilities
11,068
241,431
18,354
190
32,633
23,901
327,577
Components of base money:
Currency
Banks’ balances
Government balance
Other deposits
All other liabilities and capital accounts
267,657
38,658
8,960
6 ll
11,691
Total
327,577
a. As o f December 31, 1990. All figures are expressed in millions of dollars.
b. 0.5 percent o f balances.
SOURCE: Board of Governors o f the Federal Reserve System.
to make payments, banks must manage their
balances throughout a day, perhaps by borrow
ing intraday or overnight, or by selling assets
during a day for payment over the network.
Whereas the Bank of Japan prohibits daylight
overdrafts, the Bank of England does not provide
them because it doesn’t operate any payments sys
tems. Interbank payments take place entirely
through private clearinghouse arrangements, not
on the books of the central bank. Each day, only
the net settlement position of a bank vis-à-vis all
other banks in one or more clearinghouses is set
tled using the bank’s account at the central bank.
Even if a bank could settle its clearinghouse posi
tion only with an overnight overdraft or loan from
the Bank of England, the Bank has no formal
responsibility to guarantee settlement.
In the past, Federal Reserve provision of day
light overdrafts clearly was more liberal than at
the other three central banks. Until 1986, no
limits were imposed and no collateral was re
quired for healthy depository institutions. Pro
vision began to move toward comparability in
1986, with the adoption of the potentially more
restrictive current limits, based on a bank’s capi
tal. With the imposition of a fee in 1994, Federal
Reserve provision will become somewhat more
like that of the other central banks.
III. Defensive
Operations
The level of short-term interest rates is the effec
tive policy instrument of each of the four central
banks considered here. Defensive operations are
deliberate actions taken to insulate the supply
of base money, and thereby the level of directly
affected short-term interest rates, from uncon
trolled changes that are inconsistent with policy
intentions. Most defensive operations take place
within the daily market period in which shortestterm interest rates reflect the forces of demand
and supply in the market for banks’ balances —
what Niehans calls “the ultrashort-run liquidity
of the banking system.” (Niehans [1978], chap
ter 12) The length of the ultrashort run — from
a few minutes to as much as a week — may be
related to reserve requirement arrangements,
which are discussed in section IV.
All four central banks use one or both of two
basic techniques in their defensive operations:
1) m anaging flows of banks’ balances to and
from government and official foreign accounts
at the central bank, and 2) using market transac
tions and lending to offset unmanaged factors
affecting the central bank balance sheet or inter
est rates. In what follows, I discuss the use of
these techniques by each of the four banks.
Federal Reserve
The Fed uses both techniques. Monetizing gov
ernment securities through outright purchases in
the secondary market or directly from foreign cus
tomers is the dominant source of base money in
the United States (see table 1). Fluctuations in the
Treasury’s balance at the Reserve Banks, if not
offset, change the supply of banks’ balances at
the Fed. This is avoided, for the most part, by
having the Treasury maintain two sets of deposit
accounts: one with banks, to wrhich its receipts
are paid, and another at the Federal Reserve
D
T A B L E
2
Balance Sheet of the
Deutsche Bundesbank3
Assets
Gold, Special Drawing Rights, and net
claims on the European Monetary
Cooperation Fund
Securities:
Outright
Bills of exchangeb
Other
Repurchase agreements
Lombard loans
Liabilities
Components of base money:
Government balance
61,309
4,262
108,828
150,548
66,874
5,149
Other deposits
54,916
All other liabilities and capital
accounts
31,083
5,187
Denominated in foreign currencies
58,308
All other assets
31,456
Total
Currency
Banks’ balances
39,219
308,570
Total
308,570
a. As o f December 31, 1989- All figures are expressed in millions o f marks.
b. 92 percent o f balances.
SOURCE: Deutsche Bundesbank.
Banks, from which its payments are made. The
Treasury can transfer funds from the receiving
accounts to the paying accounts each morning
to offset the day’s projected payments. This
practice leaves a relatively constant projected
target balance in the paying accounts, prevent
ing Treasury operations from adding or draining
banks’ balances.6
Defensive operations are used to offset shortrun variations in the public’s demand for curren
cy and in banks’ demand for required balances,
as well as in a host of miscellaneous items. The
vehicle for temporary defensive operations is re
purchase agreements (RPs) in the secondary mar
ket for Treasury securities — that is, purchases (to
add balances) with an agreement to resell, or sales
(to drain balances) with an agreement to buy
back, one or a few days later. Transactions are
conducted by inviting bids from designated (pri
mary) dealers and by accepting enough bids to fill
the projected need on a best-bid basis. These fre
quent, temporary adjustments can be used to finetune the supply of balances on a daily basis. When
needed, transactions take place at about 11:30
a.m., based on projections of demand and of
■
6 Banks’ balances at the Federal Reserve Banks could be completely
insulated from the effects of Treasury operations (within projection er
rors), were it not for occasional episodes when 1) paying accounts must
move above the normal target because receipts exceed banks’ limited w ill
ingness to hold Treasury deposits, or 2) receiving accounts are exhausted
and the paying accounts must be drawn down below the normal target be
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cause the Treasury is constrained from issuing new debt.
Federal Reserve Bank of St. Louis
factors affecting supply. The banking system
must accommodate any deviation of actual
from projected balances for the day, although
as noted above, a substantial shortfall could
force banks to borrow at the discount window.
Defensive operations are not always based
on projected quantities. The Fed’s proximate mon
etary policy target is perceived as a level of the
overnight interbank (federal funds) rate. Devia
tions of the funds rate from target can indicate
projection errors or market expectations that are
inconsistent with policy. Operations in the second
ary market, therefore, may be intended to defend
or to correct the market’s perception of the
interest-rate policy target (Meulendyke [19891 ).
Bundesbank
In contrast to the Federal Reserve, the Bundes
bank does not rely on outright purchases of
government securities as its dominant means of
supplying base money (see table 2). A large por
tion of base money is supplied (within estab
lished “refinancing” quotas) through purchases
of domestic and foreign bills of exchange with
maturities of several months. Banks sell these
instruments to the central bank at the official
discount rate, which is typically below market
rates. An even larger source of base money orig
inates from the continuous rollover of RPs of
one- and two-month maturities.
TABLE
3
Balance Sheet of the
Bank of Japan3
Assets
Gold
Liabilities
140
Securities:
Government bonds
Bills and commercial paper
Bills discounted
31,542
6,906
144
Loans5
6,160
Denominated in foreign currencies
2,996
All other assets
1,269
Total
49,157
Components of base money:
Currency
Banks’ balances
Government balance
Other deposits
All other liabilities and capital accounts
Total
39,798
4,881
521
424
3,533
49,157
a. As o f December 31, 1990. All figures are expressed in billions of yen.
b. 126 percent of balances.
SOURCE: Bank o f Japan.
The Bundesbank adjusts the aggregate sup
ply of banks’ balances weekly, typically by regu
lating the volume of RPs accepted. Other means
of adjustment include shifting federal govern
ment deposits to banks, foreign exchange
swaps or RPs, and sales of special short-maturity
Treasury bills. But, for the most part, any re
maining need for short-run adjustments must
come at the initiative of the banks themselves,
by varying their Lombard borrowing from the
Bundesbank (collateralized by eligible securi
ties) at the Bank’s Lombard rate. This rate always
is higher than the discount rate and typically is
higher than market rates (Deutsche Bundesbank
[1985, 1990]).
The Bundesbank also has an opportunity to
indicate when the overnight interbank rate has
been affected by either projection errors (under
supply, for example, would be expected to drive
the rate up toward the Lombard rate) or a market
perception of rates inconsistent with actual policy
intentions. Both the cutoff rate in accepting RPs
and the volume accepted can provide short-run
signals to the market. A more direct signal can be
given by inviting tenders for RPs at a designated
interest rate, rather than by simply accepting the
best rates offered for a desired quantity.
Bank of Japan
Like the Federal Reserve, the Bank of Japan
holds a large portfolio of government securities
whose outright purchase is the dominant source
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of base money (see table 3). The Bank also can
Federal Reserve Bank of St. Louis
operate in a variety of other markets to adjust
the monetary base and to influence conditions
in specific markets. These actions include en
gaging in Treasury bill and commercial paper
RPs, purchases and sales of commercial bills
(including sales of Bank of Japan bills), and
sales of government bills with an RP. In addi
tion, a pivotal group of large banks is continu
ously indebted to the central bank, within
established lines of credit, at the basic discount
rate, which is typically below interbank lending
rates (Tatewaki [1991]).
The Bank of Japan has two daily oppor
tunities to adjust the supply of balances. One is
through operations in the market (typified by
commercial paper RPs) aimed at the market rate
on uncollateralized interbank call loans — the
counterpart to the federal funds rate in the
United States. The second is by a later daily
decision about the quantity of loans the Bank
will extend or collect. This lending decision is
made shortly before 3:00 p.m., when same-day
transactions in the call loan market must end
(because the Bank’s same-day payments net
work closes), but about an hour after same-day
net positions on the Gaiteme foreign-exchange
net settlement network have been calculated.
Thus, Bank of Japan lending decisions can ac
commodate a need for balances, or put upward
or downward pressure on the call loan market,
based on information accumulated during the
day. The Bank assists the market in distinguish
ing defensive operations from those with policy
implications by releasing data, also at 3:00 p.m.,
showing demand and supply of funds and its
9
T A B L E
4
Balance Sheet of the
Bank of England3
Assets
Issue Department
Securities:
Government
Other
Total
Liabilities
Currency
10,021
5,009
Other
15,030
Total
15,021
9
15,030
Banking Department
Securities:
Government
Bills discounted
Loans
1
Banks’ operating balances
175
843
Government balance
454
540
Other deposits:
Cash ratio
Other
651
All other assets
1,302
All other liabilities and capital accounts
Total
4,336
Total
1,491
1,288
928
4,336
a. As of February 28, 1990. All figures are expressed in millions of pounds.
SOURCE: Bank of England.
own market operations for that day, as well as
an estimate for the next day (Nakao and Horii
[199H, Bank for International Settlements [1986,
1990a], and Bank of Japan [1991]).
Bank of England
The Bank of England maintains an accounting
distinction between two departments. The Issue
Department supplies currency, which finances
outright holdings of government and other
securities. The Banking Department supplies the
small amount of banks’ deposit balances (there
are no reserve requirements), largely by dis
counting (purchasing) eligible securities and
through collateralized lending (see table 4).
Weekly government bill tenders normally drain
enough funds from the banking system to the
government’s account to create a persistent
shortage of balances, requiring daily defensive
operations to add balances back into the system.
Procedures for defensive operations are
elaborate, because banks’ small cushion of
desired “target” balances provides little room
for error in draining or adding balances each
day. Banks report their targets to the Bank of
England, and at three times during the day, the
Bank reports its estimate of the day’s shortage
or surplus of balances relative to the aggregate
of these targets. Open-market operations typi
cally are carried out with the discount houses,
which in turn provide banks with daily financ
ing facilities.
Operations might be conducted after publica
tion of the first estimate of the day’s balance
position, if the need is large. More often, the
Bank operates after releasing its noon update of
estimated need. A third round of operations
may come after the Bank’s 2:00 p.m. update. A
further opportunity to adjust comes through
“late assistance” in the form of secured lending
to discount houses and other money brokers,
which may extend later into the afternoon.
Operations at any of these times can do more
than simply adjust the quantity of balances. The
Bank has discretion over the type of operation
(outright, RP, lending), whether it invites transac
tions or responds to requests, and the terms on
which it will engage in transactions (type of secur
ity, maturity, and “stop rate”). Manipulation of these
variables, in conjunction with the Bank’s published
estimates of the day’s position, provides an oppor
tunity for the Bank to clarify its policy intentions
while engaging in defensive operations (Bank for
International Settlements [1986,1990a], Bank of
England [1988]).
Summary
All four central banks engage in defensive oper
ations along the twin dimensions of quantity of
balances and level of interest rates. Where con
trol of the quantity of balances is not effective
or, for some other reason, market expectations
are not consistent with policy intentions, the
central banks can manipulate the types and
terms of their market operations to provide sig
nals — interpreted on the basis of market tradi
tions — about the level of interest rates thought
to be consistent with policy intentions. No
amount of such suasion can be effective, how
ever, if not supported by control of the quantity
of balances.
Clear differences are visible in the degree to
which any of the four central banks might be ex
pected to seek precise control of the daily aggre
gate supply of balances and relevant interest
rates using defensive operations. The Bundes
bank’s reliance on weekly RPs leaves the daily
supply of balances subject to uncontrolled fac
tors that might move interest rates within the
ceiling provided by the Lombard rate. Federal
Reserve reliance on morning open-market
operations, guided only by projections, means
that the actual daily supply of balances is sub
ject to projection errors, although daily signals
may be sufficient to maintain clarity about the
level of interest rates consistent with policy in
tentions. The Bank of Japan, by making
decisions about lending and repayment late in
the day — after one clearinghouse has closed
and immediately before the close of another —
is in a better position to avoid projection errors
in its daily defensive operations. The Bank of
England, relying on successive estimates, opera
tions, and late assistance over the course of a
single day, can minimize projection errors by
using repeated updates of market information
to estimate the need to adjust the aggregate
supply of balances.
IV. Reserve
Requirements
A banking system is in a better position to absorb
day-to-day uncontrolled variations in the supply
of balances when banks must meet reserve re
quirements. The central bank must eliminate any
net excess or deficiency of balances by the end of
the reserve averaging period, but not every day.
A bank calculates its required reserves by
matching various reservable deposits with their
respective reserve ratios. Specifications of both
reservable deposits and reserve ratios differ in
widely inventive ways among the four central
banks. These computational features influence
the net after-reserves marginal cost of bank
lending financed by various types of deposits.
They also might be germane to monetary policy
operations. For example, predictability of de
mand for reservable balances and the accuracy
of projections underlying defensive operations
are affected by shifts among deposit accounts
having different reserve ratios.8 However, these
features will not be considered here because
they are not of foremost importance to the inter
action of central banks’ reserve requirement
rules with their monetary and payments system
operations in the “ultrashort run.” Rather, of in
terest here are 1) the average quantity of noninterest-bearing reserve balances that banks
must hold and 2) the length of the averaging
period over which banks can spread this
artificial demand and over which the central
bank can spread its supply.
Three of the four central banks had reserve
requirement regulations in 1990. The aggregate
quantity of required balances in each country
can be compared directly only by choosing ex
change rates at which to convert to a common
currency. Examining the ratio of required bal
ances to a country’s GDP avoids this complica
tion, while making a rough adjustment for
differences in the scale of national economies.9
Both methods of comparison are shown in table
5, with required and excess balances converted
to U.S. dollars, as well as scaled by each coun
try’s nominal GDP.
■
■
7 "Large” projection errors occurred on 27 days in 1991, according
to the Federal Reserve Bank of New York, but “large” is undefined. The
New York Bank conducts a weekly Thursday press briefing that reviews in
general terms the factors affecting banks’ reserve balances during the
week ending the previous day. Among other items, the briefing indicates
either 1) that there were no large net one-day deviations from projections,
or 2) the days on which there were large deviations, giving their sign and
source but not their dollar values.
8 A convenient comparison of the basis for computing required
reserves in the four countries can be found in Kneeshaw and Van den
Bergh (1989). The irrelevance of methods of computation for monetary
policy implementation is discussed in Stevens (1991).
■
9 An alternative scale adjustment is to take the ratio of required
balances to total deposits (whether subject to requirements or not) of all
institutions that are subject to requirements. The rank order is the same
as for GDP.
D
T A B L E
5
Banks’ Deposit Balances
at Central Banks3
Excess
Required
Millions of
U .S . dollars
Percentage
of GDP
Millions of
U .S . dollars
Percentage
of GDP
Days in
Averaging
Period
Federal Reserve*7
33,843°
0.6lc
933
0.017
I4d
Discount
rate +2%
Bundesbank!
29,782
2.52
189
0.016
30
Lombard
rate +3%
Bank of Japan
33,410
1.14
28
0.001
30
Discount
rate +3-75%
n.a.
n.a.
232
0.024
1
Bank of England8
Penalty
for
Deficiency
n.a.
a. 1990 annual averages. Currency conversions are at the annual average exchange rate.
b. Reserve requirements were cut substantially in December 1990 and April 1992. The average dollar am ount o f required plus clearing bal
ances declined 25 percent between May 1990 and May 1992.
c. Includes (after rounding) 0.59 percent of required balances and 0.03 percent o f clearing balances.
d. Ninety-one days for small banks.
e. 1989 values are used to avoid discontinuity caused by reunification.
f. Holdings of vault cash cannot be deducted from required reserves in calculating required balances.
g. Excludes “cash ratio” deposits.
SOURCES: Bank of England, Board of Governors of the Federal Reserve System, Deutsche Bundesbank, Bank of Japan, and the International
Monetary Fund.
Federal Reserve
In the United States, large banks must meet
reserve requirements within a basic 14-day
averaging period. Each bank can rely on daily
market transactions to manage balances, aided
by a provision for carryover of excesses or
deficiencies into the next 14-day period that
creates a limited 28-day averaging period.10
A bank’s holdings of vault cash, as well as its
deposit balance at a regional Reserve Bank, are
eligible to satisfy the legal reserve requirement.
Even some of the largest institutions satisfy their
entire requirement with vault cash.
In addition to a legal reserve requirement,
many banks contract to hold required clearing
balances during a reserve maintenance period.
These required balances are administered on
the same basis as the legal requirement, but
yield earnings credits at the level of the federal
funds rate with which to pay for Reserve Banks’
■
10 The Federal Reserve appears to be unique in allowing this addi
tional averaging between adjacent periods (see Kneeshaw and Van den
Bergh [1989]). A deficiency or excess of up to 4 percent of required re
serves (increased from 2 percent in 1992) can be carried into the next
averaging period (but not beyond). Because many banks satisfy a large
portion of their reserve requirement with vault cash, eligible carryover can
be much larger than 4 percent of required balances.
priced services. Failure to maintain at least the
required amount of vault cash plus legal and
clearing balances, after carryover, results in a
fee levied on the deficiency at a rate of 2 per
centage points above the discount rate. This
charge, in addition to administrative oppro
brium, makes deficiencies rare.
Bundesbank
Required balances in Germany are of an order
of magnitude roughly comparable in dollar
value to the aggregate quantity held by U.S. and
Japanese banks, but are substantially higher rel
ative to GDP. In addition, a long, 30-day averag
ing period provides the German banking system
with a substantial ability to absorb offsetting
variations in the daily supply of balances. All in
stitutions subject to reserve requirements must
maintain a required deposit balance. Vault cash
is eligible to meet requirements, but only up to
50 percent of the amount of a bank’s required
reserve. Failure to satisfy the reserve require
ment results in a penalty at a rate 3 percentage
points above the Lombard rate (which itself is
typically higher than market rates).
Bank of Japan
Required reserves in Japan, while of the same
order of dollar magnitude as those in Germany
and the United States, stand in an intermediate
position when measured relative to GDP— al
most twice the U.S. ratio, but only half the Ger
man ratio. Like German banks, Japanese banks
maintain required reserves within a 30-day
averaging period, providing the banking system
with a significant ability to absorb offsetting
daily variations in the supply of balances. All re
quired reserves must be held as balances with
the Bank of Japan: Vault cash holdings do not
satisfy reserve requirements. The penalty for a
reserve deficiency is a rate 3.75 percentage
points above the official discount rate.
Bank of England
The United Kingdom is unique among the four
countries in having no reserve requirement
regulation.11 Banks do target, and hold, selfdetermined levels of operating balances as a
buffer against lower-than-expected clearing
house net positions at the end of a day. In the
aggregate, however, this practice has almost
none of the shock-absorbing function asso
ciated with a reserve requirement: It is impos
sible for banks to accommodate daily variations
in the aggregate supply of balances by postpon
ing or accelerating the accumulation of bal
ances. Extra balances today are worthless on
future days, while an unexpected shortage
today can be no greater than target balances.
And target balances are quite small — about
one one-hundredth of required balances in Ger
many, and normally smaller than the size of
daily defensive operations conducted by the
Bank of England.
National Differences
in Required Balances
There is no obvious rationale for the observed
national differences in the level of balances a
banking system is required to maintain on
■
11 Institutions with more than minimum amounts of eligible
liabilities must hold nonoperational, non-interest-bearing “cash ratio”
deposits, fixed for six-month intervals at about one-half of 1 percent of
both demand and term deposits (without averaging) to finance the Bank
ing Department of the Bank of England. This arrangement is more nearly
analogous to the Fed’s requirement that member banks hold stock in a
Federal Reserve Bank than to a reserve requirement.
deposit at its central bank. One striking associa
tion can be detected: Less frequent defensive
operations tend to be related to higher require
ments that allow the banking system itself to ab
sorb daily, offsetting variations in the supply of
balances. The Bundesbank, with the highest
level of required balances, tends to rely on
weekly operations; the Federal Reserve, with an
intermediate level of required balances, tends
to rely on daily operations; the Bank of Eng
land, with no required balances, may take action
as frequently as four times a day.
Association is not explanation, however. Are
reserve requirements lower because a central
bank is more assiduous in controlling the supply
of balances, or does a central bank control the
supply of balances more assiduously because
reserve requirements are lower? Moreover, the
association is not consistent across the four cen
tral banks: The relatively high level of require
ments in Japan would seem to allow the Bank
of Japan to be less attentive than it is in conduct
ing defensive operations.
Other factors that might account for differences
do not explain much, either. Longer averaging
periods could be a substitute for higher require
ments, but that is not the pattern actually observed
(see table 5).12 Provision of daylight overdrafts
could likewise substitute for higher balances, but
no such pattern is evident. For example, while the
Bank of Japan prohibits daylight overdrafts, the
level of required balances relative to GDP is only
half that of the Bundesbank, which does allow
such transactions.
Perhaps another factor is at work. A central
bank might offset the “tax” of a relatively high
reserve requirement with the “subsidy” of loans
to banks at below-market rates. A perfect offset
would leave the marginal cost of lending unaf
fected by reserve requirements, but none of the
four central banks operates this way. More likely
is a partial offset to the total cost of operating
within all the rules of the central bank. The na
tional basis for this offset is indicated in the foot
notes to tables 1-3, as measured by total central
bank assets acquired from the banking system
at subsidy rates, divided by banks’ required
balances held with the central bank.
The ratio of subsidized assets to required
balances varies from about zero at the Federal
Reserve Banks to a high of 126 percent at the
Bank of Japan. These values provide some
evidence that the cost of required balances may
■ 12 Extra days could replace extra balances in deferring and accel
erating the accumulation of required balances while accommodating a
given pattern of variations in supply; supply variations might be more
likely to be offsetting over longer averaging periods.
ES
not be as unequal as their levels, but that the off
set from the subsidy cannot equalize cost. For
example, a simple calculation suggests that the
Bundesbank would have to maintain a negative
discount rate in refinancing bills of exchange if
it were to offset the difference between the
GDP-based measure of its required balances
and that of the Federal Reserve.13 Moreover,
even a plausible association between required
balances and subsidized assets would not ex
plain why nations might choose these different
institutional patterns.
Just as it is impossible to explain why reserve
requirements differ, so, too, it is hard to explain
variations in the average level of excess balances
among the four banking systems (see table 5).
One interpretation of excess balances might be
that they measure the accuracy of a central
bank’s defensive operations. If banks have no
incentive to hold non-interest-bearing idle bal
ances, defensive operations must aim at zero
excess balances to prevent extreme volatility in
interbank interest rates.
Information about excess balances alone is
not sufficient to justify this interpretation, how
ever. Even if a central bank were able to achieve
zero excess balances, normal practice would be
to target a positive level, demanded by banks in
the aggregate. Individual banks have an incen
tive to target small excess balances on the last
day of a reserve averaging period. This reflects
the monetary and nonmonetary penalties for
failing to meet requirements, coupled with each
bank’s inevitable uncertainty about both the in
cidence of unplanned, last-minute transactions
and the accuracy of its record keeping. Observed
excess balances may reflect actual demand, not
inaccurate supply.
A bank operating in the context of a positive
requirement normally will have a cushion of
balances so that it can operate closer to a zero
target for excess balances than a bank with no
balance requirement. With a requirement, the
cushion is lacking only on the last day of a
reserve maintenance period, when the bank
can no longer postpone or accelerate the accu
mulation of required balances; without a re
quirement, the cushion is lacking every day.
This may explain why excess balances are
highest at the Bank of England — assuming, of
13 Let R equal the market rate forgone on reserve balances, and
s equal the subsidy to that rate for central bank loans. In the case of the
■
Bundesbank, for example, from the values in tables 2 and 5,
0.92s =2.52/?-0.61/?.
That is, s = 1.92/?. The level of the subsidy would be almost twice the
level of the market rate, implying a negative loan rate at the central bank.
http://fraser.stlouisfed.org/
Federal Reserve Bank of St. Louis
course, that actual balances are an indication of
banks’ desired balances rather than of errors in
defensive operations.
Lower excess balances at the Bundesbank
may reflect another difference: German banks
may be willing to set targets closer to zero ex
cess balances because they can rely on Lombard
borrowing to round out their reserve position at
the last moment on the last day of an averaging
period, albeit at an above-market price (and not
repeatedly). The Bank of England and the Fed
eral Reserve Banks do not maintain lending
facilities as hospitable to last-minute borrowing
by individual banks. Bank of Japan lending
might account for the minuscule level of excess
balances in that country, either as a means of
achieving precision in supplying balances or,
given such precision, as a reflection of low de
mand on the part of individual banks in antici
pation of precise supply.
V. Conclusion
The central banks of the United States, Germany,
Japan, and the United Kingdom perform the same
basic functions. In the payments system, they pro
vide safe, base money both as currency and as
banks’ deposit balances, as well as a facility for set
tling clearinghouse payments through bookkeep
ing transfers of banks’ balances. In addition, the
Federal Reserve, Bundesbank, and Bank of Japan
all provide a system for making same-day pay
ments by direct transfers of banks’ balances. Each
attempts to provide the quantity of base money
required to maintain short-term interest rates at
policy-desired levels.
To facilitate payments, some central banks (the
Banks of Japan and England) rely entirely on
clearinghouse organizations to supplement the
supply of base money with daylight credit. Others
(the Federal Reserve and Bundesbank) supple
ment the supply of base money themselves during
the day by providing daylight overdrafts.
All four central banks engage in defensive
operations designed to insulate the overnight
supply of banks’ balances and the level of short
term interest rates from the temporary effects of
variations in currency holdings, government
balances, and other uncontrolled factors. The
four differ, however, in the extent to which
reserve requirements enable the banking sys
tem itself to accommodate day-to-day shocks to
the supply of banks’ balances arising from these
factors. The contrast is most apparent between
the Bank of England, with no reserve require
ments and multiple defensive operations each
KB
T A B L E
6
Summary Comparison of Central
Bank Rules and Operations, 1990
Federal Reserve
Bundesbank
Bank of Japan
Bank of England
Yes
Yes
Yes
Yes
Yes, within line of
credit, monitored
ex post (fee begins
in 1994)
Yes, within limit of
Lombard collateral;
no fee
No
No
Overnight overdraft
Penalty
Lombard loan
Prevented
Discretionary
Central bank defensive
operations
Daily if needed;
in morning, from
projections of
demand and
supply
Weekly or more
frequently
Twice daily if
needed, before
and after close of
clearinghouse
Four times daily
if needed, before
and after close of
clearinghouse
Sources of Daylight Credit
Private clearinghouses
Central bank
Sources of Overnight Balances
Reserve Requirement
Level
High, but falling
Highest
Higher
None
Averaging period
14-day, with limited
28-day
30-day
30-day
None
SOURCES: See references in text.
day, and the Bundesbank, with high reserve re
quirements and major reliance on weekly defen
sive operations.
The fundamental lesson of this study is that
there is no unique set of rules a central bank
must impose on the banking system (see table
6). Monetary and payments system functions
can be carried out under a variety of rules and
regulations whose relative costs would be enor
mously difficult to establish.
Applying this lesson to the Federal Reserve
helps to clarify some recent issues. A common
apprehension about limiting banks’ daylight
overdrafts has been the possibility of payments
system “gridlock,” which some fear would re
quire banks either to hold costly excess balances
at the Federal Reserve Banks or to develop a
finely tuned system for trading and transferring
balances on an hourly or partial-day basis. Ex
perience in nations whose central banks do not
provide daylight credit suggests another likely
alternative: Banks will rely more extensively on
private clearinghouses in making payments.
Lowering, or even eliminating, reserve re
quirements has considerable appeal in the
United States, where their apparent burden on
banks’ domestic and global competitiveness
seems unrelated to their statutory monetary
policy rationale. Deregulating the banking sys
tem by removing reserve requirements, how
ever, would have the seemingly paradoxical
effect of increasing, rather than decreasing, the
pivotal role of the central bank in the money
market. As in the case of the Bank of England,
assiduous defensive market intervention could
be necessary each day simply to match the daily
supply of banks’ balances with any residual
precautionary demand. Alternatively, copying
the Bundesbank’s Lombard facility, the Federal
Reserve Banks’ discount w indow lending could
play a larger defensive role if administrative and
market discouragement of borrowing were
abandoned in favor of a penalty discount rate.
□
References
Bank for International Settlements. Paym ent Sys
tems in Eleven Developed Countries. Basle:
BIS, 1985.
______ . Changes in Money-Market Instruments
a n d Procedures: Objectives a n d Im plications.
Basle: BIS, March 1986.
______ . Large-Value Funds Transfer Systems
in the Group o f Ten Countries. Basle: BIS,
1990a.
______ . Report o f the Committee on Interbank
Netting Schemes o f the Central Banks o f the
Group o f Ten Countries. Basle: BIS, Novem
ber 1990b.
Bank of England. “Bank of England Operations
in the Sterling Money Market,” Quarterly B ul
letin, vol. 28, no. 3 (August 1988), pp.
391-409.
Kneeshaw, J.T., and P. Van den Bergh. “Changes
in Central Bank Money Market Operating
Procedures in the 1980s,” Bank for Interna
tional Settlements, Economic Paper No. 23,
January 1989.
Meulendyke, Ann-Marie. U.S. Monetary Policy
a n d F in an cial Markets. Federal Reserve
Bank of New York, 1989.
Nakao, Masaaki, and Akinari Horii. “The Process
of Decision-Making and Implementation of
Monetary Policy in Japan,” Bank of Japan,
Special Paper No. 198, March 1991.
Niehans, Jiirg. The Theory o f Money. Baltimore:
Johns Hopkins University Press, 1978.
Stevens, E.J. “Removing the Hazard of Fedwire
Daylight Overdrafts,” Federal Reserve Bank
of Cleveland, Economic Review, vol. 25, no.
2 (1989 Quarter 2), pp. 2-10.
Bank of Japan. A n n u a l Review. Tokyo: Bank of
Japan, 1991.
______ . “Is There Any Rationale for Reserve Re
quirements?” Federal Reserve Bank of
Cleveland, Economic Review, vol. 27, no. 3
(1991 Quarter 3), pp. 2-17.
Board of Governors of the Federal Reserve Sys
tem. A n n u a l Report 1988. Washington,
D.C.: Board of Governors, 1989.
Tatewaki, Kazuo. B anking a n d Finance in
Japan: A n Introduction to the Tokyo Market.
New York: Routledge, 1991.
Deutsche Bundesbank. “Recent Developments
with Respect to the Bundesbank’s Securities
Repurchase Agreements,” M onthly Report o f
the Deutsche Bundesbank, vol. 37, no. 10
(October 1985), pp. 18-24.
______ . Report o f the Deutsche Bundesbank
fo r the Year 1990. Frankfurt-am-Main:
Deutsche Bundesbank, 1990, pp. 101-02.
Dotsey, Michael. “Monetary Policy and Operat
ing Procedures in New Zealand,” Federal
Reserve Bank of Richmond, Economic
Review, vol. 77, no. 5 (September/October
1991), pp. 13-19.
Dumitru, Diana, and E.J. Stevens. “Federal Funds
Rate Volatility,” Federal Reserve Bank of
Cleveland, Economic Commentary, August
15, 1991.
16
Forbearance, Subordinated
Debt, and the Cost of Capital
for Insured Depository Institutions
by W illiam P. Osterberg
and James B. Thomson
Introduction
Among the proposals intended to prevent the
commercial banking industry from suffering a
fate similar to that of the nation’s savings and
loans (S&Ls) is the requirement that banks issue
subordinated debt. The claims of the holders of
such debt are subordinate to the claims of the
Federal Deposit Insurance Corporation (FDIC),
which reduces the agency’s exposure to loss.
Furthermore, the rates paid on subordinated
debt theoretically reflect a bank's riskiness; thus,
a subordinated debt requirement penalizes rela
tively risky institutions by imposing market dis
cipline. However, as is the case with competing
regulatory proposals, the efficacy of a subordi
nated debt requirement is directly affected by
regulators’ adherence to stated guidelines.
In this article, we emphasize that a subordi
nated debt requirement interacts with other reg
ulatory forces such as deposit insurance. The
role of subordinated debt will also change when
the risk-based capital system for U.S. banks be
comes effective in December. Under the old sys
tem of capital regulation, primary capital had to
be at least 5.5 percent of on-balance-sheet assets
and total capital had to be at least 6 percent of
http://fraser.stlouisfed.org/
assets, with subordinated debt included in total
Federal Reserve Bank of St. Louis
W illiam P. Osterberg is an
economist and James B. Thomson
is an assistant vice president and
economist at the Federal Reserve
Bank of Cleveland. The authors
are grateful to David Altig, Robert
Avery, and Edward Kane for help
ful comments and suggestions.
capital but not in primary capital. Under the new
system, subordinated debt is included in Tier 2
capital, and the total of Tier 1 and Tier 2 capital
must be at least 8 percent of risk-weighted assets.
Although the impact of subordinated debt will
be affected by the process of risk-weighting,
such debt is a relatively small component of
total capital, amounting to only 10 percent of
equity capital (the largest component of total
capital) for FDIC-insured commercial banks in
1992:IQ (see FDIC [1992]).
As background for understanding the issues
surrounding a subordinated debt requirement, it is
worth considering recent experience in the S&L in
dustry. Several of the same factors that contributed
to losses incurred in the bailout may also be
behind the current deficit in the FDIC’s deposit in
surance fund. These include fraud and misman
agement, outdated regulations, and regulatory
laxity. In addition, mispriced deposit insurance has
provided incentives for S&L managers to maintain
relatively risky portfolios. With fixed-rate deposit
insurance, the riskiness of an institution’s portfolio
does not impact the rate it must pay for deposits.
Regulatory capital forbearance, which occurs
when regulators supplement bank capital rather
than adhering to stated guidelines, may have
increased the incentives for insolvent S&Ls to
D
take on more portfolio risk in an attempt to
regain solvency. In fact, these incentives can be
come so perverse that speculative investments
with little chance of paying off may be under
written by insured institutions. The failure of
deposit insurance premiums to correctly reflect
risk and, to a lesser extent, regulatory forbear
ance are unfortunately also present in the com
mercial banking industry.1
Proposals to reform the current system of bank
regulation can be described in terms of their reli
ance on market mechanisms. At one extreme are
calls to replace government deposit insurance
with a private, market-based system. More widely
discussed is the proposal to implement a system
of risk-based government deposit insurance in
which an individual bank’s premium would vary
with the composition of its portfolio. The feasibil
ity of this approach has been studied by Flannery
(1991), Merton (1977,1978), Ronn and Verma
(1986), and Pennacchi (1987b).2 An analogous
system is the risk-based capital standard, which
would reduce the subsidies to risk-taking embed
ded in the current system.
Some proposals are intended to lessen the
exposure of the insurer. These include limiting
coverage (by restricting coverage to one account
per individual or by reducing the total dollar
■
1 Many studies have analyzed the risk-taking incentives embedded in
the current deposit insurance system (see Kane [1985,1989a, 1989b]).
It deposit insurance were “fairly" priced, as discussed by Thomson (1987b),
then the premium would set the value of the insurer’s claim to zero and
would not distort the market incentives for risk-taking. It is not clear, on
average, whether deposit insurance is fairly priced (see Pennacchi [1987b]).
However, since all banks pay the same premium per dollar of deposits, rela
tively risky banks are obviously being subsidized by relatively safe ones.
Analyzing the impact of deposit insurance is also complicated by the
presence of regulations. In fact, Buser, Chen, and Kane (1981) present a ra
tionale for combining underpriced deposit insurance with capital regulation.
■
2 The FDIC Improvement Act of 1991, which mandated that the
agency do a sim ilar study, is to some degree the driving force behind its
recent announcement of a risk-sensitive deposit insurance schedule.
While this proposed premium schedule is a step in the right direction, it
w ill only marginally alter the degree of mispricing and hence w ill have lit
tle effect on adverse incentives. For a critical evaluation of the FDIC’s plan,
see the statement of the Shadow Financial Regulatory Committee (1992).
■ 3 One alternative proposal is to institute depositor preference laws.
Without such laws, uninsured deposits, insured deposits, nondeposit
claims, and the claims of the insurer have equal priority in the event of
bankruptcy. With such laws, depository claims, which are inherited by the
insurer, have priority over nondeposit claims. Hirschhorn and Zervos
(1990) analyze these laws empirically and note that their effectiveness
can be seriously diluted if they lead to an increase in the amount of col
lateralized claims. Another alternative is to require stockholders to post
surety bonds, which would be used to offset creditors’ losses if a bank
failed (see Kane [1987] and Osterberg and Thomson [1991]). This would
effectively reestablish the double call provision that existed prior to the
Banking Act of 1935.
http://fraser.stlouisfed.org/
Federal Reserve Bank of St. Louis
amount insured) or changing banks’ capital
structure through, among other techniques, a
subordinated debt requirement.3 The maturity
of subordinated debt generally exceeds that of
uninsured deposits, so holders of such debt are
less likely to “run.” Consequently, as we point out
later in this paper, forbearance is more likely to be
extended to uninsured depositors than to subordi
nated debt holders, who receive principal and
interest payments only after the claims of senior
creditors are satisfied. Since subordinated debt
claims are junior to those of the FDIC, the agency’s
exposure would be reduced.
In addition, by increasing the risk exposure
of claimants subordinate to the FDIC, this pro
posal would utilize market incentives; that is,
rates on subordinated debt would presumably
reflect a bank’s riskiness. Baer (1985), Benston
et al. (1986, chapter 7), and Wall (1989) favor
such an approach. Osterberg and Thomson
(1991) analyze the theoretical impact of a subor
dinated debt requirement on both the cost of
capital and the value of deposit insurance. Un
fortunately, the empirical evidence on using
subordinated debt to enhance market discipline
is mixed (see box 1).
This article provides a theoretical analysis of
the extent to which subordinated debt prices
apply market discipline to banks. In theory, the
required rate of return will vary positively with the
bank’s riskiness, reducing the subsidy provided
by deposit insurance and ensuring that the bank’s
investment decisions will take risk into account. In
addition, regulators could utilize the information
contained in the secondary market prices of subor
dinated debt. As is the case with other proposals
that rely on market discipline, however, the effec
tiveness of such an approach will depend on
whether the government implicitly insures the
claims of subordinated debt holders or other tech
nically uninsured claims. Several studies (Allen
and Saunders [1990], Osterberg and Thomson
[1990], and Thomson [1987a, 1987b]) show how
forbearance influences the values of deposit insur
ance and insured institutions, as well as the rate of
return on uninsured deposits.
In this paper, we analyze the impact of forbear
ance on the values of and required rates of return
on subordinated debt, uninsured deposits, and
deposit insurance. Our results are consistent with
those of Gorton and Santomero (1990) in that we
find ranges over which subordinated debt acts
like either debt or equity. We also find a nonlinear
relationship between asset risk and the rate of
return required on subordinated debt. The manner
in which we incorporate forbearance into our
analysis is similar to techniques used by Allen
18
B O X I
Empirical Evidence
on Market Discipline
In general, evidence regarding the extent to which mar
ket prices reflect risk is mixed (see Gilbert [1990]). Except
for Randall (1989), studies of bank equity prices show
that they indeed reflect portfolio risk. Valid criticisms of
Randall’s work can be found in Gilbert’s summary of this
literature.
Studies of rates paid on certificates of deposit and on
subordinated debt are more ambiguous. The two most
relevant studies for our purposes are those of Avery, Bel
ton, and Goldberg (1988) and Gorton and Santomero
(1990). Both papers examine the empirical relationship
between risk premia on bank subordinated debt and
balance-sheet measures of bank risk. Each finds weak
evidence that market risk premia on subordinated debt
are related to risk proxies constructed from accounting
data in the current regulatory environment. These results
contrast with those of earlier studies by Baer and Brewer
(1986) and Hannan and Hanweck (1988), who find a sig
nificant relationship between risk premia and risk prox
ies in deposit markets.
Gorton and Santomero develop an explicit pricing
model for subordinated debt showing that sometimes it acts
like equity and other times like debt. Specifically, when the
bank’s asset value is expected to be above (below) the
value of claims against it, subordinated debt acts like debt
(equity). Also crucial in the analysis are assumptions about
the overall regulatory environment. Many studies (see Mar
cus [1984] and Pennacchi [1987a]) have emphasized the
role that assumptions about closure policies play in analyz
ing deposit insurance. Gilbert (1990) points out that the
banks analyzed by Avery, Belton, and Goldberg were
mainly large firms whose subordinated debt holders were
likely to have been insured de facto. This again highlights
the important role that de facto regulation plays in
interpreting the informativeness of market prices and rates
of return?
a. The test for market discipline in Gorton and Santomero and in Avery,
Belton, and Goldberg simultaneously examines the assumptions regard
ing model specification, closure rules, and the accuracy o f accounting
ratios as measures of risk. In addition, the results may be sensitive to the
particular sample period used. Gorton and Santomero’s findings suggest
that the weak relationship between the subordinated-debt risk premium
and risk proxies constructed from accounting data in Avery, Belton,
and Goldberg is not due to either m odel specification or closure rules.
However, since the sample period encompasses the failure of Continen
tal Illinois Bank, where the FDIC fully protected the subordinated debt
holders of the parent holding company, it is not clear that these studies’
results generalize to other sample periods.
and Saunders (1990) and others (see box 1).
Our findings, which point out the need to
specify carefully and correctly the regulatory en
vironment in place when market performance is
measured, are broadly consistent with those of
Gilbert (1990).
The model is presented in section I. Section
II reports the results of an earlier, single-period
analysis of a bank with uninsured deposits, in
sured deposits, and subordinated debt (see
Osterberg and Thomson [1991]). We show that
subordinated debt affects the value of the in
sured bank only through its impact on the size
of the deposit insurance subsidy, and that the
fair value of deposit insurance is a function of
the subordinated debt requirement. In section
III, we extend the analysis to include the possi
bility of FDIC bailouts of uninsured liability
holders. Section IV then investigates the effects
of mispriced deposit insurance and FDIC for
bearances on the values of subordinated debt
capital and deposit insurance. We find that the
usefulness of subordinated debt as an equity
like buffer is reduced by FDIC forbearance pol
icy and that investors’ required rate of return on
subordinated debt is inversely related to forbear
ance. Conclusions and policy implications are
presented in section V.
I. The Model
To determine the effects of subordinated debt and
surety bonds on the cost of banks’ debt and equity
capital, we utilize the single-period capital asset
pricing model (CAPM) as employed by Chen
(1978) and Osterberg and Thomson (1991). The
value of a bank equals the present value of its fu
ture cash flows. Debt and equity values are in turn
equal to the present value of these respective
claims on the firm’s cash flows. Certain cash flows
are discounted at the risk-free rate of return, while
uncertain cash flows are converted to certaintyequivalent flows by deducting a risk premium
from the expected cash flow. The CAPM implies
that the risk premium is simply the market price of
risk multiplied by nondiversifiable risk.
Our primary assumptions are 1) the risk-free
rate of return is constant, 2) capital markets are
perfectly competitive, 3) expectations are homoge
neous with respect to the probability distributions
of risky asset yields, 4) investors are risk averse,
seeking to maximize the utility of terminal wealth,
and 5) there are no taxes or bankruptcy costs.
In section II, we assume that at the end of the
period, perfect “me-first” rules are enforced. That
is, all claimants receive payment according to the
19
m
Variable Definitions
Bl = Total promised payments to insured depositors
Bu = Total promised payments to uninsured depositors
z — Total promised payments to the FDIC (= pB() d
p = Deposit insurance premium per dollar of insured
deposits
S = Total promised payments to subordinated debt
holders
B = Total promised payments when subordinated debt
(= Bi + Bu + z) is absent
K = Total promised payments when subordinated debt
is present (= Bt + Bu + z + 5)
Yfn> Ybu, Ys, Ye, and YFDIC = End-of-period cash flows to
insured depositors, uninsured depositors, subordi
nated debt holders, stockholders, and the FDIC,
respectively
Vhi, Vbu, Vs, Ve, and VFDIC = Values of insured
deposits, uninsured deposits, subordinated debt,
bank equity, and the FDIC’s claim, respectively
E(Rhi), E (Rhtl), E (RS), and E(Re) = Expected rates of
return on insured and uninsured deposits, subordi
nated debt, and equity, respectively
Vj = Value of the bank
r = Risk-free rate of return (/ ? = ! + r)
X = End-of-period gross return on bank assets
F (X ) = Cumulative probability distribution function
for X
CEQ(X) = Certainty equivalent of
X (=£1X1 - X COV[X, R J )
X = Market risk premium
Rm = Return on market portfolio
XCOV iX, Rm) = Nondiversifiable risk
priority of their claim. Realized cash flows are
used to satisfy the claims of senior creditors (de
positors and the FDIC) before junior creditors
(subordinated debt holders) are paid. Equity
holders receive any residual cash flow after all
creditor claims are satisfied. In sections in and
IV, forbearance by the FDIC occurs when the
agency fails to enforce me-first rules and allows
payments to other creditors (senior or junior) or
equity holders at the expense of its own claim.
Sections II through IV utilize the definitions in
box 2. We assume that all debt instruments are dis
count instruments, so that the end-of-period prom
ised payments to depositors and subordinated
debt holders include principal plus interest. We
also assume that the deposit insurance premium is
paid at the end of the period.4
II. No FDIC Bailouts
In this section, we present results from Osterberg
and Thomson (1991) for a bank with insured
deposits, uninsured deposits, and subordinated
debt. The FDIC charges a fixed premium of p on
each dollar of insured deposits. Total liability
claims against the bank, K, equal the sum of the
end-of-period promised payments to uninsured
depositors (Bu), to insured depositors CBf), to sub
ordinated debt holders, S, and to the FDIC (z =
pB;). We assume that on average the FDIC under
prices its deposit guarantees and provides a sub
sidy that reduces the cost of capital for banks as it
increases their value.5
Given these assumptions, the end-of-period
cash flow to insured depositors, Yhi, equals the
promised payments, B(, in every state. Regard
less of capital structure, the value and expected
return of one dollar of insured deposits are
Vhj = R~l Bi and E (R hi) = r, respectively.
The cash flows to uninsured depositors
depend on promised payments as well as on
the total level of promised payments net of the
subordinated debt, K - S:
a. For simplicity, w e express the premium as a function of insured depos
its. However, the results of interest here would not be materially affected
by adopting the more realistic assumption that premiums are levied on the
total of domestic insured and uninsured deposits.
■
4 For simplicity, we view the premium as an end-of-period claim
on the bank. This is equivalent to assuming that the premium is subor
dinate to Bi and that, in effect, the bank receives coverage without neces
sarily paying the full premium. Although this condition influences the
size of the subsidy, it does not qualitatively affect the key results.
■ 5 Buser, Chen, and Kane (1981) introduce regulatory taxes into a
sim ilar framework.
20
if X > K - S= B..+ B.. + z ,
Yb u = B . „
BUX / ( K - S ) if K - S > X > 0,
0
if 0 > X .
Notice that although the total promised pay
ments to debt holders and the FDIC equals K,
the effective bankruptcy threshold equals K less
the claims of subordinated debt holders. Assum
ing that K - S is less than the previous threshold
without subordinated debt, the value of unin
sured deposits would rise with S. However, as
we discuss below, whether or not this occurs
depends on deposit insurance pricing, which in
fluences z and thus K. The value of and the re
quired rate of return on uninsured deposits are
(1 )
Vbu= R~]K
E (R ,J =
1 - F (K - S ) + [1 /(K - S ) ]E$~S(X)
1 - F (K - S ) + [\/(K- S) 1CEQfî- s (X )
- 1.
Equation (2) shows that the cost of uninsured
deposit capital is a function of the bank’s nondiversifiable risk, XCOV(X, Rm), total promised
payments to depositors and the FDIC, K -S, the
probability that losses will exceed the level of sub
ordinated debt, F (K - 5), and the risk-free rate of
return, r. As stated above, the cost of uninsured
deposit capital, E(Rhli), is influenced by deposit
insurance pricing. Specifically, Osterberg and
Thomson (1990,1991) show that underpriced
(overpriced) deposit guarantees lower (raise) both
the effective bankruptcy threshold for senior
claims, F (K - S), and the bankruptcy threshold,
F(K ). Furthermore, underpricing (overpricing) in
creases (reduces) uninsured depositors’ claims rel
ative to both senior claims, Bu / (K - S), and total
claims, B J K. The size of this effect depends on
the FDIC’s pricing error per dollar of insured
deposits and the deposit mix.
The end-of-period expected cash flows accru
ing to the subordinated debt holders are
Ys= S
(3)
v;=i?-1{5[l-JF(/:-5)]-/:[F(^)
- F (K - S ) } + C E Q *_S(X )} and
(4)
E(R s) = {(511 - F (K - S ) ] - K [F (K ) - F (K - S ) ]
+E s
K_s (X )} /{ S [ l - F (K - S )] - K [F(K )
- F (K - S ) ] + C E Q * _ S(X ) 1} - 1.0.
ll- W - S ) ]
+ [Bn / ( K - S ) ] CEQ q ~ s (X ) } and
(2)
The value of the subordinated debt and the
required rate of return on subordinated debt
capital are
if X > K ,
X+ S-K
if K > X > K - S,
0
if K - S> X .
Equations (3) and (4) show that the cost and
value of subordinated debt capital depend on
the probability of bankruptcy, F (K ), the face
value of subordinated debt, S, total promised
payments, K, and the probability that senior
claimants will not be repaid in full, F (K - 5).
Again, since K is influenced by insurance pric
ing, so are Vs and E (R S). Note that the last two
terms in equation (3) represent the claims of
subordinated debt holders in states where they
are the residual claimants.
Our expression for E(RS) is consistent with
Gorton and Santomero’s expression for the risk
premium on subordinated debt. Here, senior
claims, K - S , total claims, K and the variance
of X (which influences F( ■) over the relevant
ranges in equation [4]) have a nonlinear impact
on the risk premium.
The end-of-period cash flows accruing to
stockholders are
Ye —X — K
if X > K ,
0
if K > X .
The value of equity and the expected return
to stockholders are
(5)
(6)
= R-1 { CEQk (X ) - K[ 1 - F {K ) ] } and
Ek { X ) - K [ 1 - F (K )
R CEQk {X ) - K[l - F (K ) ]
- 1 .0 .
21
The value of equity is unaffected by the sub
ordinated debt requirement as long as total
claims, K, remains unchanged. K, of course, is in
fluenced by S and the pricing of the premium, 2".
Equation (7) gives the total value of a bank
with subordinated debt.
(7)
Vf = R ~ '{ c E Q 0 (X )
+ B jF (K - S ) - z[ 1 - F (K - S ) ]
- [(B i + z )/ (K - S )] C E Q « - s ( X ) }.
Subordinated debt affects the bank’s value only
through the last three terms on the right side of
(7). As we show below, these terms equal the net
value of deposit insurance to the bank. However,
the definition of correct pricing of deposit insur
ance implies that its net value is zero, and that a
subordinated debt requirement has no impact on
bank value. Note, however, that pricing deposit
insurance correctly requires the premium to vary
with the size of the subordinated debt require
ment. In this case, the impact of such a require
ment depends on insurance pricing.
The net value of deposit insurance is simply
the value of the FDIC’s claim on the bank. The
end-of-period cash flows to the agency and the
value of its position are
(8)
Yf d i c =
z
if X > K - 5,
(B' + z ) X / ( K - S ) - B i if K - S > X > 0,
—B i
if 0 > X , and
VFDIC = R ~ l i z [ 1 - F ( K ~ S ) ]
+ [ (B i + z ) / ( K - S ) ] C E Q *- S(X )
~ Bj F (K - S ) }
Bu
if X > K - S = B i + B u + z
BUX / ( K - S ) if K - S > X > Gh ,
Bu
if Gb > X > G v
0
A
Bu X / ( K - S ) if
o
Section II explained how subordinated debt
affects a bank’s value through its influence on the
deposit insurance subsidy. Here, we show how
forbearance affects the value of an insured bank
with subordinated debt in its capital structure. Pre
vious empirical analyses of subordinated debt
prices have failed to account for the possibility that
the FDIC conditionally guarantees some uninsured
liabilities, a practice defined here as forbearance.
We consider two types of FDIC forbearances
that differ in their assumed treatment of subordi
nated debt holders versus uninsured depositors.
In case A, the FDIC bails out all uninsured cred
itors when earnings, X, fall between Gh and
Gl and K - S > Gh. In other words, subordinated
debt holders are paid in states where they would
otherwise receive nothing. In the same states,
uninsured depositors receive the balance of
their promised claim from the FDIC.
In case B, the FDIC extends forbearances to
all uninsured creditors when earnings are less
than Gh but greater than 6}, and K > Gh > K - S.
Subordinated debt holders are paid off when they
otherwise would have received partial payment,
as well as when they would have received nothing
without forbearance.
We assume that the income range over
which the FDIC forbears is known to market
participants. For each case, we model only one
set of bounds for FDIC bailouts of uninsured
creditors. The analysis follows that in Osterberg
and Thomson (1990) and also holds for multi
ple and disjoint bailout states.
Case A. For uninsured deposits, the intro
duction of FDIC forbearances into the capital
structure results in the following end-of-period
cash flows:
A
Notice that the FDIC now receives the full
premium z over a wider range, since K - S < K.
Because the effective bankruptcy threshold has
changed, equation (8) can be interpreted as show
ing the impact of the equity-like buffer provided
by subordinated debt. The subordinated debt re
quirement affects the value of the FDIC’s position
by changing the probability that the put options
corresponding to the agency’s guarantee will be
“in the money” at the end of the period. Equation
(8) also makes clear that if deposit insurance is to
be priced fairly ( VhDIC = 0), the premium must be
influenced by the subordinated debt requirement.
III. Banks’ Cost
of Capital and
the Value of the
Insurance Fund:
The Impact of
Forbearance
if 0 > X .
Comparing equations (9) and (10), below, to
(1) and (2) makes apparent the difference be
tween the two scenarios: In some states where
uninsured depositors had previously received
BUX /(K - S), they now receive Bu. Thus, it is
clear that Vhu will increase and E (Rhlt) will fall.
22
The value of and the required rate of return on un
insured deposits are now functions of the size
and probability of the FDIC bailout. The threshold
K - S will be influenced by the impact of forbear
ance on the insurer’s choice of premium, z.
(9)
(10)
and (12) to (3) and (4). Failure to account for
this effect could lead empirical investigators to
conclude that risk premia for certain banks are
too low to be consistent with market discipline.
In Osterberg and Thomson (1990), we show
that the impact of extending forbearance to
uninsured creditors is entirely captured by those
yhll = R~X \.BU\
\-F(K-S) + F(Gh) -F(Gt) ]
creditors and that there is no effect on equity
holders. However, forbearance influences the
+ [BU/ ( K - S ) ) [CEQ£~s (X ) - CEQ g*(X )] }. values of deposit insurance and the bank.
Equations (13) and (14) indicate the value of
the bank and of FDIC guarantees when the
bailout occurs for X between Gh and Gt.
E{Rhl) = /?{{1 -F(K-S) + F{Gh)~ F(Gj)
+ [1/{K-S) ][E*fs(X) -E%>(X) ]}
(13)
Vf = R~' { CEQq (X) - z [1 - F(K-S) ]
+ {l-F(K-S) + F(Gh)-F(G l )
- [(B. + z)/(K -S) ]ICEQq~s (X)
+ 11/(K-S)][CEQ^~s(X)
- C E Q ^ (X )}- C E Q ^(X ) + B tF ^ - S )
-C EQ ^(X ) 11 }
- 1.0.
+ (S+Bu)[F(Gh) -F (G ,)]}.
z
The end-of-period cash flows to the subordi
nated debt holders are
if X > K - S,
( B i + z )X /(K - - S )- B i if K - S> X > Gh,
A
if
A
S
^3
X - B u -Br
X > K,
(Bt+ z) X / ( K - S ) - B t if Gt> X > 0,
X + S - K if
K > X > K-S,
~Bi
0
if
K - S > X > Gh
5
if
Gh > X > Gh
0
if
G ,> X .
Ys = S
if
(14)
if 0
> X, a n d
VFD/C = R-1 {z[l - F(K - S )]
+ [(Bi + z ) / ( K - S )]
The value of the subordinated debt and its
required rate of return are
[CEQ$-S(X )-C EQ g*(X)]
+ CEQGP(X) - B j F (K - S )
(11)
Vs= R~l {5[1 -F(K-S) +F{Gh) -F(G ,)]
- (S + B u )[F(G h ) - F ( G l )]}.
-K[F(K) -F(K-S) ] + CEQK_s (X) } and
(12)
£(;?,) = tf{{S[l -F(K-S) +F(Gh)-F(G l )]
-K[F(K) -F(K-S)] + E k_ s {X) \
-1511 -F(K-S) + F(Gh) -F (G l)}
- K[F(K) -F(K-S)]
+ CE Q K _S{X) 1} - 1.0.
In some states where X falls below K - S ,
S is now received instead of zero. Thus, Vs must
rise and E(RS) must fall. We show this below
through a formal comparison of equations (11)
The crucial role of deposit insurance pricing
in determining the impact of forbearance is
most easily seen by noting that the bank’s value
in equation (13) is simply the sum of the value
of an all-equity firm and the net value of im
plicit and explicit FDIC guarantees (from [14]):
Vj- R~x CEQ q (X ) + Vpoic- O f course, if the
FDIC prices its guarantees fairly, then VFDIC = 0
and Vf —R l CEQ0 ( X ) , the value of the all
equity firm. The impacts of the subordinated
debt requirement, forbearance, and capital struc
ture are reflected in the value of the deposit
insurance subsidy. In this case, the pricing of
both the explicit and implicit guarantees will in
fluence the impact of subordinated debt.
23
Case B. Introducing FDIC forbearances into
the capital structure when X is less than Gh
( G) > K - S > Gh) results in the following endof-period cash flows to uninsured depositors:
(18)
£(/?s) = /?{l5[l -F(Gl )]-K [F(K )-F(G h)]
+ E *_S(X) 1/(511 -F(G,) ]
—K[F(K) - F{G,))
if
Ybu= Bu
X > G,
Bu X / ( K - S ) if
G , > X > 0,
0
0>X.
if
Again, the value of and the required rate of return
on uninsured deposits are functions of the size
and probability of the FDIC bailout. However,
unlike the previous case, when the uninsured de
positors suffered some losses after the subordi
nated debt was exhausted, this policy guarantees
their claims for all values of X above Gl . Thus,
Vhu will rise and E (R hlt) will fall.
+ CEQk _s {X)\}~ 1.0.
Since Gt > K - S> Gh, a comparison with the
no-bailout case shows that Vs rises and E (Rs)
falls. Equations (19) and (20) indicate the value
of the bank and of FDIC guarantees when the
FDIC bailout occurs for X between Gh and Gl .
(19)
Vf = R ^ { c E Q 0{X )- z[l- F (K )]
~[{K-S)/{K)} C E Q ^(X )- C E Q ^(X )
+ Bi F(K) + BU[F(K) -F(G,)] + S[F(Gb)
(15)
Vbu = /?-1 {bu [1 - F{G[) 1
-F{G ,)]-{ (B' + z )/(K - S ) ] CEQ$,(X)}.
+ 1BU/(K-S) 1[CEQfi(X) ]} and
(16)
if X > K,
= z
E (R bu) = R { il- F (G l )
K - S - B t -Bu
if K > X > Gh
X —Bu —Bj —S
if Gh > X > G x
(Bi + z) X / ( K - S ) -Bi if G1 > X > 0 ,
+ 11/(K - S )]E fi(X )}
-Bi
if 0 > X , and
+{l-F {G l ) + [l/(K -S)]
CEQfr(X) I } -1.0.
(20)
VFDic=
{z[l —F(K) ]- (Bu +Bi+ S)
1F(Gh)- F (G l)] - B i F(Gl)
The end-of-period expected cash flows
accruing to the subordinated debt holders are
+ [(Bt+z)/(K -S) ] CEQ$h(X)
+ [BU/(K -S)]C EQ % (X )}.
Y = S
X+S-K
if
X>K,
if
K > X > G.
if
Gh > X > G,
if
G ,> X > 0 .
The value of subordinated debt and its re
quired rate of return are
(17)
V ^^ jsil- F C G - )]
- K[F(K) - F (G h) 1+ C EQ k
g (X ) } and
As in case A, the bank’s value depends on both
the FDIC’s pricing of its explicit guarantees and
the value of its implicit guarantees via forbearance.
IV. The Effects
of Mispriced
Deposit Guarantees
and Forbearance
on the Value of
Subordinated
Debt Capital
In this section, we use the results of sections II
and III to analyze explicitly the impact of mis
priced deposit insurance and FDIC forbearance
policies on the value of, and hence the required
return on, subordinated debt.
Mispricing deposit insurance increases the
value of subordinated debt. To see this, first
24
define D as total promised payments to liability
holders and Ysd as the respective cash flows
accruing to subordinated debt holders per dollar
of promised payment when insurance is mis
priced or fairly priced.6
In order to calculate the impact of mispricing
on the value of subordinated debt, we construct a
replicating portfolio for the one-dollar par-value
subordinated debt claim when deposit guarantees
are mispriced. This portfolio consists of one unit
of a one-dollar par-value subordinated debt claim
when deposit insurance is fairly priced, and a sec
ond security AdYs (= ys- ysd) with the following
cash flows:
share of subordinated debt without FDIC for
bearances and a security AaYs(AbYs) with the
following cash flows:
\
Ys = 0
if X > G h ,
1 if G h > X > G l ,
0
if
G ,> X .
= 0
(K - X ) / S
if X > G h ,
if G b > X > K - S
1
if K - S > X > G , ,
0
if
G ,> X .
In case A, subordinated debt holders receive
payment from the FDIC equal to the par value of
their claim for all values of X between Gh and Gl .
(D - X ) / S
if D > X > K ,
In case B, they receive a partial bailout when X is
K
>
X
>
D
S
,
if
(D - K ) / S
between Gh and K - S and a full bailout when X
l + ( X - K ) / S if D - S > X > K - S
is between K - S and Gt. The difference between
if K - S > X .
0
the cash flows in the two cases reflects the differ
The value of this security is
ence in the assumed bailout policy. In case A, the
FDIC extends forbearances only when losses ex
ceed the value of the subordinated debt. In case
(21) Ad Vs = { R S ) ~ l |dLF(Z)) - F ( D - S ) ]- C E Q ° ( X )
B, forbearances are extended before losses totally
exhaust the subordinated debt.
- K [ F ( K ) - F ( K - S ) ] + C E Q °Z S (X )
Equations (22) and (23) show that the value
of the securities that replicates the value of for
+ 5[F(D-5)-F(/C-5)]},
bearance to subordinated debt holders is posi
tive and that Ah Ys> Aa Ys.7
which is positive if
0
if X > D ,
C E Q ° Z S (X) > (K-S) [F
( D - S ) - F ( K - S ) ].
Equation (21) shows that mispricing deposit
insurance affects the value of subordinated debt
capital by altering the probability that subordi
nated debt holders will be repaid in full. In effect,
deposit insurance subsidies alter the ranges over
which subordinated debt prices behave like equity
and debt prices. Forbearance policies also affect
the value of, and thus the rate of return on, sub
ordinated debt. In either case, however, forbear
ance both increases the value of subordinated
debt and changes pricing.
Following the procedure used above, we
next construct a replicating portfolio for a onedollar par-value subordinated debt claim when
the FDIC bails out liability holders. The replicat
ing portfolio for case A (case B) consists of one
■
6 When there are no FDIC forbearances and deposit insurance is
fairly priced, the end-of-period expected cash flows accruing to the sub
ordinated debt holders are
Ys, d = S
X+S-D
0
if X > D ,
if D > X > D - S ,
if D - S > X .
(22)
AaVs=R~1[F(Gh)- F (G ,)] > 0 .
(23)
A b Vs =
C ^ ) -1 {a'[F(G^) -.F(/:-S)]
- C E Q j£ h_ s ( X ) +
S[F(K-S) - F(Gt) ] } > 0 .
As noted by Gorton and Santomero, subordi
nated debt is a hybrid instrument whose price
and return behave like debt for high values of
X, but like equity for low values of X . The pos
sibility of FDIC bailouts when X is in the range
for which subordinated debt would typically be
have like equity complicates the pricing dynam
ics. Specifically, without forbearance, there is a
range of values for X such that subordinated
debt prices switch from acting like debt to acting
like equity as earnings increase. The introduc
tion of FDIC forbearances may change the
switch point or introduce multiple switch points.
■
7 To see this, note that
F { K - S)
-
F( Gi ) > F ( G h ) - F( Gi )
and ( K / S ) [F ( G b) - F ( K - S) ] > (1 / S ) CEQG
Kb_s ( X ) .
25
Previous empirical studies of the relationship
between subordinated debt prices and balance
sheets by Gorton and Santomero and Avery,
Belton, and Goldberg do not account for the
possible impact of FDIC forbearance policy. The
theory presented above provides one possible
explanation of previous empirical findings that
risk premia on subordinated debt are weakly
related to risk proxies.
V. Conclusion
Using the cash-flow version of the CAPM devel
oped by Chen (1978) and extended by Osterberg and Thomson (1990, 1991), we develop an
explicit pricing model for subordinated debt that
considers the possibility of implicit guarantees
of nominally uninsured debt capital. Similar
guarantees have been present during the sample
periods of recent empirical studies of subordi
nated debt prices. Our findings indicate that
FDIC forbearance increases the value of subor
dinated debt and thus alters investors’ required
rates of return.
Forbearance reduces the usefulness of subor
dinated debt in two ways. First, the possibility
of FDIC bailouts directly increases the deposit
insurance subsidy. However, given the possi
bility of such bailouts, the size of the subsidy is
reduced by a subordinated debt requirement as
long as there is some chance that subordinated
creditors will realize losses.
Second, forbearance reduces the rate of re
turn required on subordinated debt of a given
risk, a policy that may easily impede market dis
cipline of bank risk-taking. This in turn reduces
the amount of information in secondary market
prices of subordinated debt. Forbearance thus
introduces a potential source of specification
error in empirical studies of the risk premium in
subordinated debt markets.
As we have emphasized previously (Osterberg and Thomson [1990,1991]), the impact of
capital structure changes on insured banks de
pends on deposit insurance pricing. If deposit
insurance is fairly priced, neither subordinated
debt requirements nor forbearance will impact
overall bank value. However, in the more realis
tic case of deposit insurance mispricing, the
effects of expected capital structure changes are
altered through their interaction with the overall
regulatory environment.
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Callable Put,” Baruch College, Working
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Avery, Robert B., Terrence Belton, and Michael
Goldberg. “Market Discipline in Regulating
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Baer, Herbert. “Private Prices, Public Insurance:
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______ , and Elijah Brewer. “Uninsured Depos
its as a Source of Market Discipline: Some
New Evidence,” Federal Reserve Bank of
Chicago, Economic Perspectives, vol. 10,
no. 5 (September/October 1986), pp. 23-31.
Benston, George J., Robert A. Eisenbeis, Paul M.
Horvitz, Edward J. Kane, and George G. Kauf
man. Perspectives on Safe a n d Sound B ank
ing: Past, Present, a n d Future. Cambridge,
Mass.: MIT Press, 1986.
Buser, Stephen A., Andrew H. Chen, and Edward
J. Kane. “Federal Deposit Insurance, Regula
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1981), pp. 51-60.
Chen, Andrew H. “Recent Developments in the
Cost of Debt Capital,”Jo u rn a l o f Finance,
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Flannery, M.J. “Pricing Deposit Insurance when
the Insurer Measures Risk with Error,”Jo u r
n al o f B anking a n d Finance, vol. 15, nos.
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(January/February 1990), pp. 3-18.
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Gorton, Gary, and Anthony M. Santomero. “Mar
ket Discipline and Bank Subordinated Debt,”
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22, no. 1 (February 1990), pp. 119-28.
Hannan, Timothy H., and Gerald A. Hanweck.
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Large Certificates of Deposit,”Jo u rn a l o f
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(May 1988), pp. 203-11.
Hirschhom, Eric, and David Zervos. “Policies to
Change the Priority of Claimants: The Case of
Depositor Preference Laws "Jo u rn a l o f F i
n an cial Services Research, vol. 4, no. 2 (July
1990), pp. 111-26.
Kane, Edward J. The Gathering Crisis in Federal
Deposit Insurance. Cambridge, Mass.: MIT
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______ . “No Room for Weak Links in the
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______ . “How Incentive-Incompatible DepositInsurance Funds Fail,” National Bureau of Eco
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______ . The S&L Insurance Mess: How D id It
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stitute, 1989b.
Marcus, Alan J. “Deregulation and Bank Finan
cial Policy "Jo u rn al o f Banking a n d Finance,
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Merton, Robert C. “An Analytic Derivation of
the Cost of Deposit Insurance and Loan
Guarantees: An Application of Modern O p
tion Pricing Theory,” Jo u rn a l o f Banking
a n d Finance, vol. 1 (June 1977), pp. 3-11.
______ . “On the Cost of Deposit Insurance
When There Are Surveillance Costs,”Journal
o f Business, vol. 51 (July 1978), pp. 439-52.
Osterberg, William P., and James B. Thomson.
“Deposit Insurance and the Cost of Capital,” Re
search in Finance, vol. 8 (1990), pp. 255-70.
______ , a n d ______ . “The Effect of Subordi
nated Debt and Surety Bonds on the Cost of
Capital for Banks and the Value of Federal
Deposit Insurance,”Jo u rn a l o f B anking a n d
Finance, vol. 15, nos. 4/5 (September 1991),
pp. 939-53.
Pennacchi, George G. “Alternative Forms of De
posit Insurance: Pricing and Bank Incentive
Issues "Jo u rn a l o f Banking a n d Finance,
vol. 11, no. 2 (June 1987a), pp. 291-312.
______ . “A Reexamination of the Over- (or
Under-) Pricing of Deposit Insurance," Jour
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(August 1987b), pp. 340-60.
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(September 1986), pp. 871-95.
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27
An Introduction to the
International Implications
of U.S. Fiscal Policy
by Owen F. Humpage
Introduction
A predominant characteristic of U.S. macroeco
nomic developments in the 1980s was the simulta
neous emergence of large federal budget deficits
and unprecedented international trade deficits.
Many economists, relying on open-economy vari
ants of the standard income-expenditure model,
have linked these deficits in a causal chain that
also ties them to high U.S. interest rates and to the
dollar’s appreciation earlier in the decade (see
Hutchison and Pigott [1984]). The description
has now become part of popular economic lore,
but as is often the case with legend or myth,
many of the intricacies of and important quali
fications to a fundamentally plausible story have
been lost in its common transmittal. Moreover, a
paucity of hard empirical support for the simple
and direct relationship offered by this popular
view has done little to curtail its telling.1
This paper acknowledges that fiscal policies
can create trade deficits, but argues that this need
not be the case and typically has not been the case
■
Owen F. Humpage is an eco
nomic advisor at the Federal
Reserve Bank of Cleveland. The
author thanks David Altig, Janice
Boucher Breuer, and Joseph
Haubrich for their helpful com
ments and Diana Dumitru for her
research assistance.
in the United States. Section I offers a simplified
version of the two-period, representative-agent
model found in Frenkel and Razin (1987).2 Un
like the standard income-expenditure approach,
this model does not assign a predominantly
causal role to government budget deficits, but it
does allow that, under certain circumstances, fis
cal policies can influence the trade balance, real
interest rates, and real exchange rates. The out
come depends on how the government’s propen
sities to import and to consume out of current
income compare with those of the private sector,
and on the distortionary effects of taxes.
Section II offers an empirical investigation of
U.S. fiscal policy during the floating-exchangerate period, using Engle-Granger (1987) co
integration techniques. The empirical tests
search for common long-mn trends between
economic variables suggested by the theoretical
analysis and aggregate measures of U.S. federal
fiscal policy. The results do not support the
common contention of simple, direct relation
ships among these measures and U.S. trade
balances, interest rates, or exchange rates. As
1 The popular accounts derive from the open-economy version of
the income-expenditure (or Keynesian) model. Frenkel and Razin (1987,
http://fraser.stlouisfed.org/
part II) offer an unabridged account of this model.
Federal Reserve Bank of St. Louis
■ 2
See also Aschauer (198B), Hill (1990), and Koenig (1989).
28
noted in the concluding section, however, such
tests are subject to important qualifications and
do not preclude the possibility of short-term
relationships.
constraint that the present value of private inter
temporal consumption equals the present value
of his two-period after-tax endowments. The
consumer maximizes
1
CD
[ / = £ p 'u,(c,)
t= 0
I. A Simple Model
A nation running a current account deficit absorbs
more real economic resources than it produces. Its
citizens accommodate differences between their
desired consumption and production by purchas
ing additional goods from abroad, and they fi
nance their activity by borrowing in world money
markets. Because government spending and tax
policies affect consumption and production deci
sions, a nation’s fiscal policies can strongly influ
ence its international trade patterns.
Frenkel and Razin (1987) show that the rela
tionship is often similar to that described in in
ternational economics as the transfer problem.
Because fiscal policies typically involve a trans
fer of funds from the private sector to the gov
ernment sector, their international implications
depend on a comparison of both the govern
ment’s and the private sector’s propensities to
save and to import. Moreover, when govern
ment activities are deficit financed, the outcomes
depend more on the existence of tax distortions
than on public borrowing per se. Following
Frenkel and Razin, this section develops a sim
ple model to illustrate these points. To appre
ciate the argument, however, one must first
understand the motives for international trade
and the intertemporal nature of trade deficits.
Two-Period Trade
and the Nature
of a Deficit
Consider a hypothetical economy consisting of
two countries (home and rest-of-w^orld), each
possessing and consuming quantities of two
goods over two time periods. Each country con
sists of a single representative consumer and a
government, which taxes and spends. Assume
that no production takes place, but that both
countries start each time period with a specific
endowment of the two goods.
Let a single consumer with homothetic prefer
ences represent each country.3 Each consumer
maximizes utility over two periods, subject to the
■ 3 Homothetic preferences are such that, for constant relative prices,
any given percentage change in income results in the same percentage
change in the consumption of all goods. Homothetic preferences cause the
http://fraser.stlouisfed.org/
Income expansion curves in figures 1 through 5 to be straight lines.
Federal Reserve Bank of St. Louis
subject to
(2)
C\(1 +
C 0(l + t 0)+ T0 + -— +
Tx
+ (l + rv)
)
Yx
F°+ (l + rv)'
Here, Ct refers to private after-tax consumption
in time t(= 0,1), such that
(3)
Ct = c x t+ p c mt,
where cx t and cm t represent consumption of
goods X and M in specific time periods. The terms
of trade, p, expresses units of M in terms of units of
X, (3'is a subjective discount factor applied to fu
ture utility, and rx Is the real interest rate. I express
each in terms of good X, but the following arbitrage
condition makes measurement arbitrary:
(4)
( l + rv) = P,/Po( l + r j .
With two goods and two time periods, how
ever, unanticipated changes in the terms of
trade within any period can affect intertemporal
decisions.4 The Tt terms represent lump-sum
taxes, whereas the tt terms are tax rates applied
to private consumption.
At the beginning of each period, consumers
receive an endowment, Yt, of the two goods,
such that
(5)
Yt= qxt+pq mt,
where q it( i =x, m ) refers to quantities of the
two goods, X and M. I assume that consumers
seek to smooth consumption over the two
periods by borrowing or lending through inter
national credit markets.
The government uses tax revenue to finance
expenditures, Gt , subject to the constraint that
the present discounted value of government ex
penditures over the two periods equals the
present discounted value of tax revenue:
1 4
For a discussion, see Frenkel and Razin (1987), pp. 168-71.
29
F I G U R E
1
Optimization over Time and
the Trade Deficit
c;
Y,
-c:
over the two periods must equal the present
value of the endowments. The trade account
must balance, and the countries must extinguish
all international debts.
Equation (1) assumes that utility is intertemporally separable. Each consumer desires an optimal
expenditure over the two periods. Within each
period, the consumer chooses an optimal con
sumption bundle of the two goods, one that maxi
mizes Ut . Although this choice is constrained by
the overall level of expenditure within a period
and by relative prices, the choice of a consump
tion bundle in any period is otherwise independ
ent of the choice in any other period.
Intertemporal
Consumption
Assuming no government sector for the moment,
the representative individual allocates his con
sumption over the two time periods until the
following condition holds:
SOURCE: Author.
(6)
Go + (\+ r ) ~ To +to Co
T,
txCx
(1 + rx)
(1 + rx) '
Solvency requires that the government retire
any budget deficit incurred in the first period
during the second period.
For each nation as a whole, the first-period
budget constraint is
(7)
C0 + G0~ Yq + ^ 0 •
Any nation can absorb, through private con
sumption and government spending, more or
less than its current endowment, as equation (5)
shows, but if it absorbs more than its endow
ment, the nation must borrow (B0 > 0 ) , and if it
consumes less, it will lend the excess (B0 < 0 ).
The second-period budget constraint is given by
(8)
q +G ^ - d + r , ) ^ .
Since this model contains only two periods,
each country must retire any first-period debts
in the second period. Therefore, solvency re
quires that over the two periods,
(9)
c\
C0 + G0 + ~
~
0
0 (1 + r )
F° + (1 + r )
Accordingly, the present value of private after
http://fraser.stlouisfed.org/
tax consumption plus government spending
Federal Reserve Bank of St. Louis
m
+
where Ut is the marginal utility derived from
consumption in period t. The first term in equa
tion (10), the consumer’s marginal rate of substi
tution between present and future consumption,
measures his willingness to trade current for fu
ture consumption. The higher his subjective dis
count factor, the more the consumer prefers
present to future consumption. The second
term, one plus the real interest rate, is the inter
temporal terms of trade— the market terms at
which a consumer can trade current for future
consumption. As equation (10) indicates, the
utility-maximizing consumer will allocate his
consumption over the two periods until his will
ingness to substitute between them equals the
terms offered for this exchange in the market. If
at any time this condition is not met, an exchange
of resources can enhance the consumer’s utility.
In figure 1, this maximization process is illus
trated with an Edgeworth-box diagram, which
shows the home country’s origin in the lower left
comer and the foreign country’s origin in the
upper right comer. (An asterisk designates foreign
variables.) The utility curves I and II show, for a
given level of utility, the willingness of the home
country and the rest of the world to trade current
for future consumption.5 The ray extending from
each origin, the income expansion path, shows
■ 5
See also Hill (1990) and Koenig (1989).
30
FI GURE
2
Intratemporal
Consumption
Optimization across Goods
and Trade at Time t
*
qm t
*
^m l
'
/
After allocating consumption across time, each
representative consumer will choose quantities
of the two goods that maximize utility at each
point in time. Consumers will choose among
the two goods X and M until
( 11)
< lx t
...............
cx t
\
^ \
\
\ \
r--
!
SOURCE: Author.
the respective country’s optimal level of con
sumption for changing levels of income and a
fixed real interest rate. The slopes of these two
rays indicate that the home country prefers cur
rent consumption relatively more than does the
foreign country.
Point A, at the center of the diagram, marks
initial endowments and shows that each coun
try receives equal consumption bundles in each
period, Yt = Y* (t= 0,1). At point A, however,
the countries’ subjective temporal preferences
for consumption differ. The home country val
ues present consumption more highly than does
the foreign country. Consequently, both can in
crease their utility by agreeing to trade at some
rate of intertemporal exchange passing within
the ellipse formed by their utility curves. The
line passing through points A and E, whose
slope is - (1 + rx) , is one such rate of exchange.
Given the real interest rate rx, the nations will
trade to point E, at which the conditions for op
timal consumption, given by equation (10),
hold.6 The home country now consumes more
than its initial endowment in the first period,
running a trade deficit, B 0, but it will run a
surplus, (1 + rx) B(), in the second period. At point
E, each country is on a higher utility curve than at
point A In fact, point E is a Pareto optimum; no
country can be made better off without making the
other worse off.
■
6 The home and foreign countries will negotiate the optimal interest
rate.
uX, t
p-
The term on the left side of equation (11) gives
the marginal rate of substitution, the rate at
which each consumer is willing to substitute be
tween goods X and M. The term on the right
side is the market-based relative price of the
two goods, or the temporal terms of trade. If
during any time period the condition depicted
in equation (11) is not fulfilled, an opportunity
exists for welfare-enhancing trade.
I
again illustrate the maximization process by
reproducing the Edgeworth box in figure 2 with
appropriate changes in the axis and in the termsof-trade line. I depict the home country as favor
ing consumption of good M , the importable good.
At the initial endowment point, A, the home coun
try values consumption of this good more than
does the foreign country, and both countries can
gain from exchange along the terms-of-trade line
(with slope -p) to point E, where the condition
given in equation (11) holds. At point E, the home
country consumes the importable good in excess
of its initial endowment, but it consumes less than
its initial endowment of the exportable good.
Nature of Trade and
Trade Deficits
Despite the simplicity of the model, figures 1 and
2 offer important insights into the nature of inter
national trade and the causes of trade imbalances.
Trade takes place in this model because of 1) dif
ferences in nations’ time preference for consump
tion at the initial endowment point, or 2) differ
ences in the relative preferences for the two goods
in any time period given endowments.7
A trade imbalance results when a country
desires a consumption profile that differs from
its endowment profile. A country that consumes
more (less) than its current endowment will run
■
7 I do not include comparative advantage as a motive for trade,
despite its predominance in the literature, because the model does not Inelude production.
31
a trade deficit (surplus) 8 Changes in the real in
terest rate act to clear the intertemporal imbal
ance between endowments and consumption.
This suggests that factors that influence decisions
about intertemporal consumption— including
government policies— also affect the trade balance.
Hill (1989), for example, argues that a country’s
demographic profile influences its trade balance
because younger households tend to save less
than older households.
Moreover, because this model specifies the
interest rate in terms of good X, and as a result
of the arbitrage condition (4), factors that cause
an unexpected change in the terms of trade can
also influence the interest rate, intertemporal
decisions, and the trade balance. The relation
ship between changes in the terms of trade and
the trade balance depends on whether these
changes are permanent or temporary, on the ini
tial position of the trade balance, and on the
parameters of the model (see Frenkel and Razin
[19871, pp. 176-82).
The analysis in figure 1 also helps to dispel
the notion that a trade deficit represents a state
of economic disequilibrium or a deterioration in
the economic well-being of the deficit country.
Instead, the model illustrates that both the sur
plus and the deficit countries improve their
economic welfare by running trade imbalances.
A developing country, for example, might run a
trade deficit in order to acquire capital goods,
with the intention of eventually financing the
acquisition by running a trade surplus. Such
strategies are typically considered welfare en
hancing.
Nevertheless, the figure does illustrate that
the deficit country must eventually finance its
debts though a reduction in future consump
tion. In the comparative static model presented
here, the reduction is absolute. In a dynamic
model, with growing economies, any change in
future consumption is measured relative to where
it would have been in the absence of trade. In
such a model, it is not necessarily the case that a
trade deficit must lower future standards of living.9
■
8 In the National Income and Product Accounts, gross national
product (GNP) equals consumption (C) plus Investment (I) plus govern
ment purchases (G) plus exports (X) minus imports (M): GNP = C + 1+ G
+ X - M. Rearranging this expression, one obtains GNP - C - 1- G =
X - M, which shows the relationship between national savings on the left
side and the trade balance on the right side.
■ 9 See Anderson and Bryan (1989).
Government Fiscal
Policy and the
Trade Deficit
Much of the recent concern about U.S. fiscal
policy centers on the impact of federal budget
deficits on real interest rates, exchange rates,
and the trade balance. The theoretical analysis
of fiscal policy, therefore, begins by considering
the effects of deficit-financed tax reductions, in
cluding 1) a lump-sum tax cut, and 2) a reduc
tion in the tax rate on consumption.
Because many politicians and economists
favor a balanced-budget amendment, I next
consider the effects of balanced-budget fiscal
policies in the form of 1) temporary and per
manent balanced-budget spending, and 2)
balanced-budget spending on the exportable
commodity. As we shall see, different types of
policies can have different combinations of ef
fects on real interest rates, the terms of trade,
and the trade balance.
Deficit-Financed Cut
in Lump-Sum Taxes
With the introduction of taxes into the model,
equation (12) gives the condition for optimal
intertemporal consumption:
( 12)
u'
(i + o
p i/;
(i + o
(1 + r ).
In maximizing welfare, the representative con
sumer now chooses an intertemporal consump
tion pattern that equates his marginal rate of
substitution between current and future con
sumption to intertemporal terms of trade that
include taxes on current and future consump
tion as well as on real interest rates. As is well
known, lump-sum taxes in the consumer’s bud
get constraint (equation [2]) do not affect the
choice of the optimal consumption pattern, and
therefore will have no effect on real interest
rates or on the trade balance.
According to the principle of Ricardian
equivalence, the intertemporal path of private
consumption is invariant with respect to whether
the government finances a given level of expendi
ture via lump-sum taxes or via borrowing. If
consumers understand that the issuance of gov
ernment debt implies a future tax liability to retire
that debt, and if they also desire a smooth inter
temporal consumption path, then a deficitfinanced cut in taxes will not cause them to
increase their present consumption. Instead, they
32
FI GURE
3
Deficit-Financed Reduction
in Consumption Taxes
c^ E
o
SOURCE: Author.
will save the additional purchasing power result
ing from the tax cut in order to meet the future
tax liabilities associated with retiring the govern
ment debt. The method of financing will, there
fore, leave the interest rate unaffected.
The simple two-period model outlined
above incorporates Ricardian equivalence in
that the single representative agent must retire
any government debt in the second period. The
real-world application of Ricardian equivalence,
however, seems more problematic given that
taxes are distortionary, that the present genera
tion might push the burden of retiring the debt
onto future generations, or that the tax cut redis
tributes income to segments of the population
with high marginal propensities to consume,
while leaving the burden of servicing the debt
spread across all citizens.10
Deficit-Financed
Reduction in
Consumption Taxes
When I allow a deficit-financed reduction in
consumption taxes, equation (12) indicates that
it will distort that optimal intertemporal con
sumption choice. This can be seen in figure 3,
which illustrates the effects of a deficit-inducing
reduction in taxes on cunent consumption.
■
10 For an empirical application to the twin deficit issue, see
Enders and Lee (1990).
Point A represents an initial equilibrium, at
which present and future taxes on consumption
are equal at home and abroad. Now consider a
temporary tax reduction on current domestic
consumption in time period 0. The line for taxadjusted intertemporal terms of trade for the
home country shifts from that designated as a
in figure 3 to that designated as (3. (The foreign
country continues to face intertemporal terms of
trade given by line a . )
As the figure shows, the deficit-inducing tax
cut encourages current domestic consumption
and results in an excess demand for current out
put given by (C Q- C0) . The real interest rate
will subsequently rise, causing the world termsof-trade line a to become steeper, until the
markets for current and future consumption
clear at a point such as E. Because at point E the
home country is consuming more than its initial
endowment, it runs a trade deficit amounting to
(C q - C0). At point E, the home country con
sumes less than its endowment of the future
goods, thereby running a trade surplus in
period 1, given by (C x - C f ). Point E is also on
a lower indifference curve because the higher
interest reduces the present value of future in
come. Although not shown, the foreign country
might share part of this effect.
At the new market-clearing point E, the tax
creates a distortion between the market intertem
poral terms of trade, given by line a ', which the
foreigner faces, and the tax-adjusted intertemporal
terms of trade, given by line (3', which the home
country faces. The resulting lens between the two
utility curves, which pass through point E, repre
sents the welfare costs of the tax distortion.11
Figure 3 shows that a deficit-inducing tax
reduction that encourages current consumption
over future consumption will raise the real interest
rate and create a trade deficit in the home country.
Although the model does not include production,
extrapolating from its underlying logic, one would
expect that a deficit-financed tax reduction (for ex
ample, a payroll tax cut or a lower capital gains tax
that stimulated current production relative to cur
rent consumption) could lower real interest rates
and generate a trade surplus.
As the model suggests, no simple relationship
exists among government budget deficits, real in
terest rates, and the trade deficit. In comparing the
results of this section with those of the previous
one, I find that it is the distortionary nature of the
■
11 Although not drawn as such, the slope of line ( 3 'will be
higher than that of line (3 because of the rise in the world Interest rate.
33
F I G U R E
4
Balanced-Budget Spending
on Current Output
SOURCE: Author.
tax that is crucial and not the deficit per se (see
Frenkel and Razin [1987], p. 223).12
Balanced-Budget
Spending
The preceding suggests that the relationships
among fiscal policy, real interest rates, and the
trade deficit depend on the distortionary nature
of taxes rather than on the use of deficit financ
ing. This section extends the investigation by
considering balanced-budget spending meas
ures. If the observed correlations between defi
cits and the trade balance in the early 1980s
stemmed from specific tax and spending poli
cies, then a balanced-budget amendment would
be of little avail in lowering real interest rates or
eliminating the trade deficit.
Assume that the economy is initially in equi
librium with a balanced trade account. Point A
in figure 4, which is similar to figure 1 in its ini
tial construction, depicts such a situation, with
the home country consuming C0 in the current
period and Cx in the future period. In equi
librium at point A, the intertemporal terms of
trade are given by line / with slope - (1 + rx) .
Now allow a temporary rise in home-country
government spending, financed entirely with
a lump-sum tax on the home-country con-
■
12 I do not consider taxes on specific commodities (such as
tariffs); they are a standard topic of trade theory.
sumers.13 The model depicts this as an increase
in government spending on the current good
only. The government’s fiscal action reduces the
amount of current output available for both
domestic and foreign private consumption,
which figure 4 shows as a shortening by G0 in
the horizontal dimensions of the Edgeworth
box. Two other adjustments follow: First, for the
foreign country only, point A shifts to point A*,
where both current and future consumption are
unaffected by the home government’s fiscal
policy. Second, because of the tax, T0, homecountry consumption shifts from point A to
point B. (Notice that the horizontal distance
measured by T0 equals the horizontal distance
G0.) As its after-tax income falls, the homecountiy private sector reduces its consumption
of both C0 and Cx, but because individuals will
attempt to smooth consumption over both
periods, the reduction in current consumption
will not match the increase in the government’s
current consumption.
Taking account of all of these initial effects in
figure 4, we see that balanced-budget government
spending initially creates an excess demand for
current output, designated by (C 0 - C 0 ), and an
excess supply of fuaire output, designated by
(C j - C j ). These imbalances will cause the real
interest rate to rise, increasing the attractiveness of
future private consumption relative to current
private consumption. Graphically, the rise in the
real interest rate will pivot the intertemporal termsof-trade line to a position such as that shown by /'
until a new equilibrium, as defined by equation
(10), obtains. Figure 4 shows such an equilibrium
at point E. Here, the home country records a
current-period trade deficit equal to (C% - C Q ).
The model indicates that a temporary increase
in home-govemment, balanced-budget spending
reduces both domestic and foreign private con
sumption and causes a home-country trade defi
cit. Intertemporal aspects of these resource trans
fers are accommodated through a rise in real
interest rates.
Extending the analysis to consider the effects
of a permanent increase in balanced-budget
spending helps to illustrate more clearly the na
ture of the relationship between government
spending and the trade deficit. One can show
the effects of a permanent increase in govern
ment spending in an Edgeworth-box diagram
by altering both its horizontal and vertical
dimensions. W hen both dimensions change,
■ 13 Assume that the propensity of the government to spend on
goods Xand M exactly matches that of the private sector, so that the
terms of trade do not change. This assumption is discussed below.
34
F I G U R E
5
Balanced-Budget Spending
on Exportables
SOURCE: Author.
however, many different configurations of
results are possible, depending on the propen
sities of the government to spend on current
and future consumption (see Frenkel and Razin
[1987], pp. 195-98). If, for example, the govern
ment’s propensities to consume current and
future output exactly match those of the private
sector, as indicated by the slope of the diagonal
running from 0 to 0* in figure 4, then no trade
imbalance or change in real interest rates would
result from government spending. The equilib
rium point would simply slide down the diago
nal from A toward 0.
Frenkel and Razin argue that international re
percussions of government spending are similar
to those typically discussed in the literature as the
transferproblem. Balanced-budget spending
transfers resources from the home-country private
sector to the government sector. If the homecountry government’s intertemporal preference
for consumption differs from that of the private
sector, the transfer will alter the overall world equi
librium for intertemporal consumption. If the over
all propensity to spend on current output rises, as
depicted in figure 4, real interest rates will increase
and a home-country trade deficit may ensue.
Conversely, if the overall world propensity to con
sume current output falls, real interest rates will
decline and the home country may experience a
trade surplus. According to the model, one must
know more to predict the effects than simply
that government spending increased.
Government
Spending on
Export Goods
The effects of government spending on a par
ticular commodity within a specific time period
are analytically similar. Assume that the private
sector has obtained the optimal pattern of con
sumption over both time periods and across
both goods. Figure 5 depicts the optimal domes
tic and foreign private consumption of the ex
portable and importable goods for a given time
period at point A. I assume that the government
has the same rate of time preference as does the
private sector.
The initial effects of government balancedbudget spending on the export good are
depicted as shifting the initial foreign position
to point A' and as shifting the initial domestic
private-sector position to point B for reasons
paralleling those offered in the explanation of
the similar shift in figure 4. The tax and spend
ing patterns then create an excess demand for
the export good given by (X Q- X Q ) and create
an excess supply for the import good equal to
(M 0 - M 0). The terms of trade will improve (the
relative price of the exportable good will rise)
until an equilibrium such as point E obtains.
The example outlined above is not a general
case. I have assumed that domestic and foreign
propensities to spend on the importable good
are exactly the same and less than one, but I
have set the government’s propensity to spend
on this good at zero. Allowing the government
to spend on both the exportable and the import
able good, additional outcomes are possible
and reasonable. Frenkel and Razin (1987, pp.
202-03) explain this, again following the argu
ments that underlie the transfer problems. In
general, the terms of trade will deteriorate (im
prove) if the government’s propensity to import
exceeds (is less than) the home country’s pro
pensity to import. The terms of trade will be un
changed when the propensities are exactly alike.
As noted earlier, with the interest rate defined
in terms of the exportable good, unanticipated
changes in the terms of trade can affect intertem
poral decisions and, hence, the trade deficit. This
results because of the arbitrage condition depicted
in equation (4).
II. Empirical
Evidence
The simple theoretical model shows that fiscal
policy can be related to trade deficits, real interest
35
rates, and real exchange rates, but that the con
nection need not necessarily hold. Whether, as
is often asserted, a simple, direct relationship be
tween U.S. fiscal policies and the U.S. trade
balance exists seems largely a matter for empiri
cal analysis. Using Engl e-Granger cointegration
techniques, this section tests for a long-term
relationship among various measures of U.S. fis
cal policy, the trade balance, exchange rates,
and interest rates.14 Because cointegration
looks for long-term relationships, one might
view this exercise as testing the effects of the
permanent component of fiscal policies.
Cointegration
Many macroeconomic time series are not sta
tionary; that is, their mean, variance, and co
variance can change over time. Intuitively, this
suggests that, given a random shock, these
series will move off to new time paths instead
of returning to their original ones. The presence
of nonstationarity can invalidate many standard
statistical techniques for hypothesis testing, mak
ing it difficult to determine if two nonstationary
series, such as government spending and inter
est rates, are related. Economists often model
time series as ARIMA (p, d, q) processes, where d
is the number of times the series must be differ
enced to achieve stationarity.15 For most economic
time series, d-\. Economists refer to such series as
containing a unit root or as being integrated of
order 1, and designate such series 1(1).
Engle and Granger (1987) propose a method
by which one can determine whether two 1(1)
times series tend to move in tandem or drift; apart
over time. In the former case, even though the in
dividual series are nonstationary, their joint rela
tionship is stationary. Engle and Granger refer to
such series as being cointegrated.
The Engle-Granger cointegration test is simi
lar to the Dickey-Fuller (1979) test for unit roots.
One must perform the latter tests as a first step
in the cointegration test to see if the relevant
series are each 1(1), because time series that are
integrated of different orders generally are not
cointegrated. The Dickey-Fuller (DF) test in
volves regressing a time-series variable Y on its
■ 14 Boucher (1991) uses similar cointegration tests to study the
relationship between the nominal current account balance and a set of
variables either related by virtue of the savings—investment identity or
commonly held to “cause” the current account. Included among
Boucher’s causal variables is the nominal federal budget deficit.
■ 15 ARIMA (p , d q ) refers to Autoregressive Integrated Moving
http://fraser.stlouisfed.org/
Average (see Box and Jenkins [1970]).
Federal Reserve Bank of St. Louis
past value to see if the resulting coefficient is
equal to 1. As is common, I specify the DF test
with a constant and a time trend
(13)
r ,= p0 + p , / + p 2
+
where ut is the error term.
Failure to reject the null hypothesis that
(3, = 1 indicates that Y is I (1). One calculates the
DF test statistic exactly like a standard t statistic,
but the DF statistic does not have a t distribution.
TSP version 4.20 provides critical values based
on the appropriate distribution. Fuller (1976,
table 8.5.2) also provides critical values.
The presence of serial correlation in the error
terms greatly weakens the power of the DF test,
but one can correct for serial correlation by aug
menting the above specification with lagged
first differences of the dependent variable.16
The augmented Dickey-Fuller (ADF) test is
(14)
J',= P0 + P1/ + P2 J',.1
p
^
+
Yt- i-\+
i- 0
where et is the error term. The null hypothesis
remains the same: (3, = 1.
According to Engle and Granger, two 1(1)
time series, Y and X, are cointegrated if a linear
combination of these two variables is stationary.
Such a combination can be obtained from an or
dinary least squares regression of Y on X ,
called the cointegrating regression. In what fol
lows, I consistently specify the cointegrating
regression to include a constant term ((30):
(15)
r ,= p0 + p2x , + e,.
The error term, e ,, from the cointegrating re
gression is then a linear combination of X and
Y, and one can use the DF procedures to test
for a unit root in the error term. Following con
vention, I specify the test as
p
(16)
E,= P , E , _ , + X P / + 2A e ,-i-l.
1= 0
including lagged first differences of the error
term when necessary to adjust for possible
serial correlation.
The null hypothesis is (3, = 1. Failure to reject
the null hypothesis indicates that the error term is
not stationary and that it tends to drift away from
its expected value, zero, over the sample period.
■
16
DF tests are robust to heteroscedasticity.
36
ï
Data Description
Description (Code)
Source
Trade-weighted dollar (TWD)
Board of Governors of the
Federal Reserve System
10-year Treasury bill (LTR)
DRI/McGraw-Hill, Inc.
Trade balance:
Net exports of goods and
services (NEX)
National Income and
Product Accounts
Government deficit:
Change in publicly held
federal debt (DEF)
Flow of Funds
Government spending:
Federal expenditures (FEXP)
Federal purchases (FPUR)
National Income and
Product Accounts
National Income and
Product Accounts
NOTE: All series are inflation adjusted. I deflated LTR, DEF\
and FEXP using
the Consumer Price Index. Others are published in an inflation-adjusted format.
W m em m m
t a b l e
i
Unit Root Tests
Dickey-Fuller
Statistic
Augmented DickeyFuller Statistic
TWD
LTR
-1.11
-3.06
-2.17
-2.10
NEX
DEF
FEXP
FPUR
-1.31
-6.14
-2.41
-2.74
-2.75
-3.14
-1.66
Variables
Data
Most popular discussions of the international ram
ifications of U.S. fiscal policy focus on the federal
budget deficit and federal spending, so my meas
ures of fiscal policy exclude the state and local sec
tors. I test for cointegration between either the
federal budget deficit (DEF), federal government
spending (FEXP), or federal government pur
chases of goods and services (FPUR), and long
term interest rates (LTR), the trade-weighted dollar
(TWD), and net exports of goods and services
(NEX). Box 1 describes the data sources.
Consistent with the theoretical analysis, all vari
ables are in real, or inflation-adjusted, form. If an
individual series was unavailable in this form, I
deflated the nominal series with the Consumer
Price Index. I initially ran all tests from 1973:IVQ
through 1991 :IIIQ to include 74 observations, but
because augmented versions include four lagged
variables, the tests run from 1974:IVQ to 1991:IIIQ
and include 70 observations.
-2.05
Critical values for:
a = .01, DF = -4.09
a = .05, DF = -3.47
a = .10, DF = -3.16
NOTE: All variables are inflation adjusted. All series start in 1973:IVQ and end
in 1991 :IIIQ. Dickey-Fuller tests include a constant and a time trend. Aug
mented Dickey-Fuller tests include four lagged first-differences o f the depend
ent variables, w hich shorten the estimation period by four quarters.
SOURCE: Author’s calculations on TSP version 4.20.
This, in turn, implies that the two time series Y
and X do not share a common underlying trend;
they tend to drift apart over the sample period.
One can extend the approach to consider
cointegration among three or more time-series
http://fraser.stlouisfed.org/
variables, each of which is 1(1). In such a case,
Federal Reserve Bank of St. Louis
one adds the additional variables to the right
side of the cointegrating regression (equation
[151) and proceeds with the DF tests described
above. The test statistic, however, is sensitive to
the number of right-side variables (exclusive of
the constant) in the cointegrating equation. TSP
version 4.20 provides appropriate critical
values, based on work by MacKinnon (1990).
Causality is not an issue in cointegration
tests. Consequently, the designation of depend
ent and independent variables for both bivariate
and multivariate tests is arbitrary. Often, how
ever, the results are sensitive to the ordering of
the variables in the cointegrating regression.
One should test all possibilities.
Results
Because cointegration presumes that the series
under consideration are 1(1), table 1 shows the
results of applying DF and ADF tests to the indi
vidual time series. All of the series except FEXP
and FPUR were serially correlated, so ADF tests
were appropriate in most cases. None of the re
sults, after any necessary adjustments for serial
correlation, reject the null hypothesis of a unit
root. Cointegration is an appropriate way to pro
ceed with these data.
Table 2 presents the results of bivariate
Engle-Granger cointegration tests. The first col
umn lists the two relevant variables. The second
column shows the ADF test statistics. The first sta-
B
T A B L E
sent only the results for ADF tests. The tests find
no evidence of cointegration.
2
Bivariate Engle-Granger
Cointegration Tests
Variables
Augmented Dickey-Fuller Statistic
(1974:IVQ-1991:IIIQ)
DEF, LTR
DEF, TWD
DEF, NEX
-3.55 -2.46
-3.31 -2.44
-3.19 -2.50
FEXP, LTR
FEXP, TWD
FEXP, NEX
-0.84 -2.11
-0.84 -2.27
-1.35 -2.76
FPUR, LTR
FPUR, TWD
FPUR, NEX
-0.83 -2.36
-0.37 -2.24
-1.14 -2.64
Critical values for:
a = .01, DF = -4.56
a = .05, DF = -3.92
a = .10, DF = -3.60
NOTE: All variables are inflation adjusted. The first statistic in each pair is for
the regression o f the first variable o n the second. The second statistic in each
pair is for the regression of the second variable o n the first. Because serial cor
relation was present in nearly all cases, I conducted ADF tests with four lagged
first-differences o f the dependent variables. In the few cases where serial cor
relation was not present, using ADF tests did not change any conclusions
reached with a simple DF test.
SOURCE: Author’s calculations on TSP version 4.20.
tistic in each set is for the cointegrating regres
sion (equation [1]) of the first variable from
column 1 on the second variable, and the
second statistic is for the cointegrating regres
sion of the second variable on the first variable.
Because serial correlation was a problem in
nearly every case, table 2 presents only the
results of the ADF test. In the few cases where
serial correlation was not present, using the
ADF tests did not alter any conclusions reached
with the DF test.
The bivariate results indicate that neither the
federal deficit (DEF) nor federal expenditures
(FEXP) nor federal purchases (FPUR) is cointe
grated with real long-term interest rates (LTR’),
with the real effective dollar exchange rate (TWD),
or with real net exports (NEX). Moreover, the re
sults are robust to the designation of the depend
ent variable in the cointegrating regression.
Table 3 presents the results of multivariate
cointegration tests. In these cases, I regressed
the first variable listed in the table (to the left of
the semicolon) on a constant and on the remain
ing three variables. Because serial correlation
was again a problem in nearly all cases, I pre
Interpretation of
Empirical Results
The empirical test found no evidence that the
U.S. trade balance, long-term U.S. interest rates,
and the real trade-weighted dollar have shared
a common trend with the U.S. federal budget
deficit or with alternative measures of federal
spending during the floating-exchange-rate
regime. Such results, of course, do not preclude
the existence of a relationship between fiscal
policies and these economic variables.
Cointegration tests search for a stationary
linear combination of hypothetically related vari
ables. The inclusion of other variables could
reveal a linear combination that is stationary. I
did not, for example, include foreign variables,
such as interest rates. Moreover, I did not scale
the deficit relative to GNP, as many researchers
do, nor have I attempted to take direct account
of the level of public debt. Deficit-financed fis
cal policies, when the level of public debt is
very high, could have substantially different ef
fects on real interest rates, exchange rates, and
the trade balance than would similar policies at
a low level of public borrowing. Similarly, the
relationship between fiscal policy measures and
the trade deficit might not be linear, and a linear
approximation of that relationship might fail to
show any connection at all. For these reasons,
cointegration tests of times series may be sensi
tive to the time period investigated.
Although cointegration tests reveal long-term
relationships among the hypothetically related
variables, they may not find a shorter-term re
lationship. I have interpreted the cointegration
tests as measuring the effects of the permanent
components of U.S. fiscal policies. The tempo
rary aspects, as the theoretical model shows,
can have different and profound effects on im
portant economic variables. Boucher (1991), for
example, concludes that nominal U.S. current
accounts and nominal U.S. government budget
deficits are not cointegrated, but using Granger
causality tests, she finds evidence that U.S.
government budget deficits do help to predict
current account deficits. Similarly, Abell (1990)
considers the twin deficit relationship in a VAR
model estimated strictly over the period of the
dollar’s rapid appreciation: February 1979 to
February 1985. Although he does not find that
budget deficits Granger-cause trade deficits
over this period, he does conclude that deficits
m
TABLE
3
III. Conclusion
Mulfivariate Engle-Granger
Cointegration Tests
Augmented Dickey-Fuller
Statistic (1974:IVQ-1991:IIIQ)
Variables
DEF; LTR, TWD, NEX
LTR; TWD, NEX, DEF
TWD; NEX, DEF, LTR
NEX; DEF, LTR, TWD
-3.77
-2.94
-2.17
-2.53
FEXP; LTR, TWD, NEX
LTR; TWD, NEX, FEXP
TWD; NEX, FEXP, LTR
NEX; FEXP, LTR, TWD
-1.22
-3.27
-2.50
-2.16
FPUR; LTR, TWD, NEX
LTR; TWD, NEX, FPUR
TWD; NEX, FPUR, LTR
NEX; FPUR, LTR, TWD
-1.53
-3.77
-2.75
-2.53
Critical values for:
a = .01, DF = -5.29
a = .05, DF = -4.63
a = .10, DF = -4.30
NOTE: All variables are inflation adjusted. Because serial correlation was pres
ent in nearly all cases, I conducted ADF tests with four lagged first-differences
o f the dependent variables. In the few cases where serial correlation was not
present, using ADF tests did not change any conclusions reached with a
simple DF test.
SOURCE: Author’s calculations on TSP version 4.20.
affect interest rates, which then influence ex
change rates, which then alter the trade bal
ances. 17 Hence, one should interpret the results
here as a general conclusion about die relation
ship between federal fiscal policies and the trade
deficit during the period of floating exchange
rates, rather than as a comment on fiscal policy
over a subperiod, such as the early 1980s, or as a
prediction about possible future effects of U.S. fis
cal policies.
■
17 Because of the enormous volume of empirical studies on the
relationships among measures of fiscal policy and interest rates, ex
change rates, and the trade deficit, I do not survey the literature. The over
whelming conclusion from even a cursory review is that the results are
mixed, with no clear pattern as to the source of the differences among the
studies. In addition to articles cited in the text, other avenues for pursuing
the empirical literature are the following: For results from large structural
models, see Hooper and Mann (1987) and Throop (1989a, 1989b). For
articles using VAR techniques, see Darrat (1988) and Rosenswelg and
Tallman (1991). For some cross-country results, see Bernhelm (1988)
and Laney (1984). For a look at deficits and interest rates, see Evans
(1985) and Hoelscher (1986). On deficits and exchange rates, see Evans
(1986) and Hutchison and Throop (1985).
This paper challenges the commonly held belief
that aggregate U.S. fiscal policy measures, notably
the federal budget deficit, bear a simple and direct
causal relationship with U.S. trade deficits in par
ticular, and with U.S. interest rates and exchange
rates. The simple two-period, two-country models
developed here from earlier work by Frenkel and
Razin (1987) illustrate a complex relationship that
is dependent, in terms of both degree and
direction, on the distortionary nature of taxes
and on relative differences between public and
private propensities to consume and to import.
Although fiscal policies and the trade balance
can be related, they need not be.
The Engle-Granger cointegration tests, which
this paper employs, find no evidence of a long
term relationship between common aggregate
measures of U.S. fiscal policy and real long-term
interest rates, real dollar exchange rates, and
real net exports. This does not mean that the
large U.S. federal budget deficits of the 1980s
did not contribute to the sharp deterioration of
U.S. trade in the early 1980s; nor does it imply
that a rising federal deficit in the 1990s will not
prevent further improvements in the U.S. trade
balance. The findings, however, do serve to
strengthen my main proposition, that the com
mon story about the simple and direct relation
ship between federal fiscal policies and the
trade balance is largely economic folklore.
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m
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Generational Accounting:
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Capital Forbearance
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Debt, Collateral, and
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