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January-February 1966 LY REVIEW International Monetary Reform • . • . . • page 3 Current Debate on the Term Structure of Interest Rates • . • • . • . • • page 10 FEDERAL RESERVE BANK OF KANSAS CITY Subscriptions to the MONTHLY R EVIEW are available to the public without charge. Additional copies of any issue may be obtained from the Research Department, Federal Reserve Bank of Kansas City , Kansas City, M issouri 64106. Permission is granted to reproduce any material in this publication. Toward an Understanding of the Dialogue on International Monetary Reform By Sheldon W. Stahl T INTERNATIONAL monetary system is a majo r ele m nt in our cv ryday life, operating as it does to enhance the commercial and financial interdependence of the free world's community of nation .. Increasingly, however, this payments mechanism has come under criticism from many quarters. In the United States, and in other major industrial and financial centers of the free world, a great deal of effort has been devoted to formulating proposals for reforming the international payments mechanism so that it will do a better job of meeting the require ment of a growing level of world commerce a nd e xchange. In view of the interest in this topic, the n, this article exami nes the international monetary payments system in an effort to provide the fundamental background necessary for a meaningful understanding of the issues involved in any proposed reform of the system. Probably one of the more familiar functions of the international monetary payment mechan ism is that of enabl ing trade and exchange to take place across national boundaries, in much the same way as our domestic monetary system enables us to conduct trade and exchange freely among ourselves in the United States. While this aspect probably is taken for grant d by most of us, there arc certain other requirements which mu st be satisfied by the international payments mechanism to make it acceptab le to the community of trading nations. In addition to facilitating trade and exchange among nations, an international monetary system must provide for some means of financing temporary imbalances which may arise between international receipts and expenditures. This function may be described as providing international liquidity- a term open to many interpretations. Finally, the international financial mechanism should operate in harmony with the goal of total public policy. That is, the goal of attainment or maintenance of equ ilibrium in a country's international balance of payments ought to be regarded as one of several goals of national policy. Other goals, such as the optimal utilization of a country's economic resources or maintaining its national security, should be afforded priority as well. The task of an acceptable international payments mechanism, therefore, is to enable these goals to be pursued simultaneously without undue strain, or without re orting to an unsatisfactory compromise that sacrifices one or more of these goa ls in order to attain the others. Although the manner of financing international transactions is not as simple in actual operation as the description which follows, nonetheless this will help the reader to grasp January-February 1966 3 IIE FUNCTIONS AND MECHANICS OF INTERNATIONAL PAYMENTS Monthly Review • International Monetary Reform the fundamentals involved in the payments process. The overriding principle rests upon the fact that, where international trade takes place, international payments are required. In the case of domestic trade, th e disch arge of debts between the trader involves only an exchange of domestic currency, or a check drawn on the debtor's bank and given to the creditor. In the case of foreign trade, however, since the debtor and creditor reside in different countries with different units of exchange, the matter of payment is not as sim ple. Doll ars do not ordinarily circulate freely abroad, nor does fo reign exchange generally circulate in the United States. Thus , in th e case of th e purchasl; of a foreign good by an Am e rica n, do llars may not be an accep table means of payment. Conversely, in the case of a foreign purchase of U.S. merchandise, the foreigner's currency may not be acceptable to the U.S. creditor. As a consequence, there must be some device to enable traders to convert their domestic currencies into foreign currencies. It may now be asked how the international monetary payments mechanism operates to convert domestic money into foreign money . As an example, let us suppo e that an American purchases a Briti sh good. This necessitates payment in pounds ste rling to the British exporter. Although there arc various types of credit instruments used in conducting intern:itional trade, it is not necessary to take account of them here. To secure the needed foreign exchange, the American importer pays dollars-writes a check-to his bank. Let us assume that the bank is located in New York, one of the major U.S. financial centers. The New York bank would then pay to the London bank of the British exporter the required amount in either U. S. dollars or United Kingdom pounds sterling. Finally, the pounds sterling are paid to the British exporter by the London bank. It is important to note that the entire process was carried out by the banks in both countries acting as intermediaries with4 out any doll ars or pounds actually crossing the ocea n, yet its effect was to increase the amount of pounds held by England and to reduce the amou nt of dollars held by the United States. Just as smaller city banks or country b anks in the United State have correspondent arrangements with banks in the larger financial cen te rs, th e major banks of the different countries mainta in a correspondent relationship with each other by holding accounts in the banks of the various fin anci al centers. By building up or draw ing down th ese accounts, international fin anci al payments arc transacted. That is, banks may build up their fore ign bal ances by purchasing such cred it inst ruments as com merc ial bills of exc han ge from expo rteL; conve rse ly, th ese foreign balances arc reduced when banks sell c red it instruments to impo rters. Thus, imports create a demand for foreign exchange, while exports create a supply of foreign exchange . Although the major part of foreign exchange transactions stems from the import and export of goods or merchandise, there are many other kinds of international transactions involving the payments mechanism. In the U. S. b alance of payments, which records th e total amounts of U.S. international transactio ns, mercha ndise imports and exports are referred to as "visibles" and are handled for accounting purposes in a broad gro uping called "current account. " The current account also records transactions involving " invisibles. " These consist of such items as income on investments made abroad, tourist expenditures for services, transportation expenditures on foreign carriers, and certain other miscellaneous services. Another major group of accounts in the balance of payments is "unilate ral transfers,'' which record the flow of gifts. These transfers arc furth er classified as e ither private remittances or Government grants. The "capital account' ' involves another major category of international financial transactions. This major account records the vast lending and borrowing activities which take place be- International Monetary Reform tween the United States and the rest of the world and may be classified as either "private" or " G overnment" in term s of origin, as well as either "short-term" or "long-term" in terms of maturity. The final major account in the balance of payments is the "gold" account which records the purchase or sale of gold. The reason for tre ati ng gold separately should become clearer when the question of international reserves is discussed. Thus, it can be seen that the payments mechanism plays a larger role than merely facilitating the movement of real goods between nations . Turning to a closer consideration of th e liquidity function of the payments mechani sm , it shoulJ be noted that primary concern in thi s article is directed at th e liquidity po ition of central banks or governments , rather than the "private'' liquidity position of parties or firms engaged in international commerce. Consequently, "official" liquidity may be broadly defined as all the resources which the monetary authorities of a country may have at their disposal for settling its international accounts. Liquidity so defined includes a country's international reserves of foreig n exchange and gold, as wcl I as its ability to borrow reserves when the need arises. It should be recogn ized th at it would be very difficult to define, unambiguously, what "sufficient'' li4uidity really is, since, as the current debate on the subject has revealed, the matter of just how much is sufficie nt is subject to a wide range of interpretations, depending upon whether a country is either a net debtor or a net creditor on its international financial accounts. Nonetheless, o ne generaliza tion may be advanced. Just as our domestic monetary system regulate s the supply of money and credit in an attempt to avoid ei th er inflationary or deflationary di slocations, the international monetary sys tem must function in such a way as to allow the world community to operate at the most optimal levels of resource utilization without erratic gyrations. Similarly, in proMonthly Review • January-February 1966 viding this desired level of liquidity to the world community , the payments mechanism should operate so as to: offset increases and decreases in the des ire of people to hoard liquid assets at given levels of inte rest rates and should be able to prevent shifts in the form in which liquid assets are held from altering the total amount of the assets .1 That is, th e level of international liquidity should be independent of the form in which international reserves a re held by different co untries: Just as a domestic monetary syste m shou ld be able to offset th e effects on domestic mon ey supply of conversions between currency a nd bank deposits, the international system should b e able to offset the effects on international reserves of conversions between gold and foreign exchange reserves and among foreign exchange reserves denominated in different currencies. 2 Having generally spelled out the functions and mech anics of the internation al monetary payme nts system, we m ay now turn to a closer look a t the actua l unde rlying arrangements of the present system. Only by understanding th ese basic arrangements as they have evolved since World W a r lI can one grasp the key role played by the doll ar in the free world's monetary system, a nd the issues involved in the continuing di alogue on monetary reform. THE PRESENT ARRANGEMENTS The present international monetary system generally is referred to as a "gold-exchange" standard. In contrast with the "pure-gold" sta ndard, which fell into di suse following 1 Wa lt er S. Salant, "Does the International Moneta ry System Need Reform?" (The Brookings Institution, Reprint 82 [Washington , D. C., 1964]), pp. 5-6. "Ibid . 5 International Monetary Reform World War I, the international reserves of central banks or national monetary authorities now include liquid claims against certain reserve currency countries as well as holdings of gold by the monetary authorities. As this system has evolved since World War II, it has been aided by the growth of such international financial institutions as the International Monetary Fund (IMF), along with the development of imaginative innovations and increased cooperation by the leaders of the free world's financial community. Tracing these developments in more detail, one should recall that, at the close of World War If, the United States, almost alone, eme rged relatively unscathed in terms of physical damage to its eco nomy. This contra ted with the war-torn eco nomies of Continental Europe, England, and the major powers of the Far East, notably Japan. The immediate task at hand was to restore these nations to a state where their material survival could be assured. Only the United States possessed adequate physical and financial resources to markedly accelerate restoration of these economies. During the postwar period, U.S. dollars and goods flowed abroad to help accompl i h the task, and , by the mid-I 950's, an observable change had taken place. The productive capacity of these countrie had been largely reestablished; the normalization of former trade patterns was well underway; and their increased competitive viability was reflected in their improved balanceof-payments positio n with respect to the United States. By the end of 1958, currency convertibility had been reestablished in Western Europe. The IMF, which had come into being as a result of th e Bretton Woods Conference in 1944, had bee n· firmly established as an international lender of short-term reserves to cope with temporary imbalances which might crop up between trading nations. In short, by the end of the 1950's, the world community had been visibly strengthened and largely was able to stand on its own. 6 Beginning with 1958, the recovery clearly had entered a new phase. The b alance-of-payments deficits of the U nited States ass umed greater magnitudes than in earlier years, with the result that dollars began to accumulate in central banks abroad in the form of increased reserve balances. The deficits which the United States had incurred almost continuously since 1950 were beg inning to be regarded with increasing concern-a concern which was manifested by a stepped-up conversion of dollars into go ld by foreign central banks. The resulting large U.S. go ld ou tfl ows served to raise se ri ous questio ns abo ut the sta bility of, and confide nce in , th e dollar. Beca use of the crucial position of th e U.S. dollar in world monetary affairs, these development. have resulted in a critical reexamination of th e international payments mechanism whose recent performance has, in the view of many observers. become un satisfactory in terms of its ability to carry out its va ried functions in a substantially changed wo rld economic climate. Under the present system, the United States is committed to buy gold at $3 5 per ounce and, upon request, to sell it to central banks of fore ign nations at that price, plus a small transportation and handling charge. The dollar, th en, is firmly committed internationally to gold and the Government is obli ged to honor all requests for gold from foreign central banks at the fi xed rate of $3 5 per ounce. For the most part, the exchange values of other major currencies are linked to the dolla r by fixing their values in term s of dollar equivalents. To support these excha nge rates-which are fixed within a ve ry narrow range of fluctu ationthe respective countries either sell or purchase their own c urrencies, as the case m ay b e, if and when th e demand for th e ir own currencies, in terms of so me foreign currency, becomes excessive , o r, conversely, if the demand for foreign currencies, in term s of their own currency , beco mes excessive. For example, if the demand by U.S. importers for British pounds International Monetary Reform sterling were to rise as a result of increased British exports to the United States, this would act to bid up the dollar price of pounds . In this instance, the British monetary authorities - in order to prevent the exchange rate from rising outside its fixed upper limit-would sell pounds sterling on the exchange market and thereby would increase the supply of pounds. This would serve to lower its price. In the case of an increase in the demand for U.S. dollars by United Kingdom importers as a result of increased U.S. exports to Great Britain, the procedure on the part of British monetary authorities would be reversed. However, in order to purchase their own currency for support purposes, countries mu t offer in exchang some highly acceptable international liquid resource; and, whe n selling their currency, they will expect payment in this same medium . The resources which have found such international acceptance for this purpose include gold and "key" currencies-notably U.S. dollars and, to a lesser extent, British pounds sterling. However, gold and reserve currencies do not provide the sole basis of international liquidity to buttress exchange rates or finance a payments imbalance. As mentioned earlier another significant element in the international liquidity spectrum-though quantitatively less important than owned reserves--consists of "borrowed" reserves and includes the borrowing rights of the 102 members of the IMF. In addition to the subscribed quotas of the Fund, the potential resources of the Fund were expanded in 1961 by a General Borrowing Arrangement executed between the Fund and 10 major industrial 3 countries. Under this arrangement, these countries agreed to lend their currencies to the Fund for its use in advancing loans to any of them incurring a deficit, if, based upon subscribed quota levels, the Fund was unable 3Thes_e countries are referred to as the "Group of Ten," and include Belgium, Canada, Germany, France, Italy, Netherlands, Sweden, United Kingdom, Japan, and the United States. Monthly Review • January-February 1966 to supply the necessary currency or currencies required by the deficit member. Superimposed on this base is the more recent increase in Fund quotas resulting from the review and adjustment of the members' quotas which takes place at 5-year intervals as provided for in the Fund's Articles of Agreement. Holdings of convertible currencies have been increa ed further in the past 4 to 5 years, as a result of the creation of a network of bilateral currency exchange agreements between the Federal Reserve System and the central banks of a number of the more highly industrialized countric of the world. These are the so-called "swap" agreements which serve to provide short-term credit up to agreed amounts to the wap partners for periods of from 3 to 9 months. Under these arra ngements, the Federal Reserve Bank of New York is authorized to conduct transactions for the System Open Market Account in such foreign currencies and within certain limits as may be specified by the Federal Open Market Committee. Still another element in international liquidity, and a quite recent innovation, is the issuance of special U.S. Government securities which are nonmarketable, and of either hort-term or medium-term maturities. These bonds are, for the most part, denominated in the currency of the holder a nd may be converted on short notice by the holder into cash. The incentive to hold these bonds stems from the fact that not only do they earn interest but, by being denominated in terms of the currency of the holder, they insure the holder against the exchange risk of devaluation. These bonds are commonly known as "Roosa" bonds, since, in his former capacity as Under Secretary of the Treasury for Monetary Affairs, Robert V. Roo sa was credited with their innovation. A of June 30, 1965, the free world's official monetary reserves were reported to equal approximately $69 billion. Of this amount, gold accou nted for $41 billion, while total holdings of foreign exchange ( assets denominated in 7 International Monetary Reform convertible currencies) comprised approximately $21 billion. An additional $5 billion represented the IMF position of various countries. The balance consisted of about $1 billion of Roo a bonds, and about $700 million in foreign currencie obtained under swap arrangements. It should be clear, from these figures, that gold is the single most important reserve asset and the basic source of international liquidity. Equally apparent is the fact that currency holdings account for nearly one third of official monetary reserves, and, therefore , constitute the second mo t important sou rce of international liquidity. Since the major share of official monetary reserves is in the form of either go ld or reserve currenciesprimarily dollars and lesser quantities of pounds terling-and since these asset are the primary source of international liquidity, one may ask what determines the total amount of these official rese rve components as well as the changes which take place in them. Newly mined gold and sales by the Soviet Union to the free world provide the basis for additions to free world official gold stocks. To the extent that gold supplied from these sources exceeds the amount of gold used for industrial purposes or added to private hoard ,4 the monet a ry gold stock will grow. From the end of I 959 through mid-1965, $3.2 billion of gold was added to the official monetary reserves of the free world. This accounted for a little more than one fourth of the total growth of official monetary reserves during that period . The magnitude of the other major components of official monetary reserves-the reserve currencies, i.e. , dollars and sterling-is a function of the amount of these currencies ( or assets denominated in terms of these currencies) held by central banks of countries ' It is unlawful for U. S. citizens to hold gold, although the existence of free m a rkets for the purchase and sale of gold is countenanced by a number of countries, with the result that a considerable portion of the world's gold stocks finds its way into private hoards. 8 other than the respective reserve currency countries. Thus, it can be seen that this element of international liquidity can grow only to the extent that the reserve currency countries incur deficits with the rest of the free world. Conversely, when the re erve currency countries have surpluses in their balance of payments , the volume of international reserves-hence, international liquidity-declines. Of the approximately $ 11.5 billion increase in official monetary reserves which took place between December 31 , 1959, a nd June 30, 1965, $4.5 billion- nearly 40 per cent-of the total expansion was accounted for by increased holdings of foreign exchan ge. The rem a inder of the increase in monetary reserves during thi s period-o ther than the 3.2 billion in gold previously mentioned-was accounted for by reserve positions in the IMF, currency-swap arrangements, and Roosa bonds. The sizable additions to international reserves, in the form of increased holdings of foreign exchange by the nonreserve currency countries, was effected primarily as a consequence of the large and protracted balance-of-payments deficits of the United States . During thi s period, the United States experienced a loss in reserves of more than 25 per cent, a loss which stemmed directly from its persistent bala nce-of-payments deficits and subsequent convers ion of dollars into gold by foreign cent ral ba nks . It should be pointed out, however, that sizable additions to the dollar holdings of foreign central banks during the period served to hold down the actual gold loss of the United States compared with what it might have been. One also might note that the expansive influence of the U. S. deficit is offset when central banks convert dollars to go ld . Thus, international reserves and internation al liquidity are diminished when reserve currency holder reduce their stocks of foreign exchange a sets in favor of gold. A c ritical observation of an international payments system operating largely through vehicle or key currencies is succinctly made by Salant: International Monetary Reform The timing and size of their deficits have no rational relationship to the needed expansion in international reserves. Moreover, expansion in these reserves increases the liquid li abilities of the reserve currency countries in relation to their liquid assets. Such increases in liabilities create growi ng danger-or fear on the part of the holders -that the reserve currency countries will be unable to pay off those who wish to co nvert their holdings into gold or other currencies, and this, in turn , increases the lik elih ood that th e holders will actually want to co nvert. The rese rve currency countries arc in the position of banks in a system wit h no central bank; they face a growth of deposit li abilities payable on demand and have no mean of increasing their reserves correspondingly except by bidding reserve assets away from others . This situation increases the likelihood that depos itors will create a run on the bank. Thus, the holding of re se rves in national currencies not only fails to provide for a rati o nal way of increasing this component of internatio nal reserves, but renders the system increasingly un stable. 6 SOME FINAL OBSERVATIONS The record of the prese nt international financi al payments mechanism through the postwar period is mi xe d. Although the more recent years have revealed certain stresses and strains present in the system, these should be weighed against the high degree of international financial cooperation an d inventiveness demon st rated by the world financial community which permitted the system to function in sp ite of its shortcomings. Viewed from th e wider per pective of th e entire postwar period, rather than the last 6 or 7 yea rs, the achievements of the "Salant. op . cir., pp. 12- 13. Monthl y Revi ew • January-February 1966 international payments mech anism are highly impress ive. The renai sance of Western Europe a nd Jap an, the return to curre ncy convertibility, the tremendou s increase in the volume of world trade and exchange, and the provision of adequ a te liquidity to accommod ate these developments all attest to the performance of the paymen ts rnechani m . Thi s impres ive performance, however, must not detract from th e responsibility of looking towa rd th e future. The current dialogue revolving about the reform of the inte rnational payments mecha ni sm is well grounded in tem1 of the implications wh ich mi ght be drawn from th e record of th e past. The grow th in world imports in the past 6 years ha far outpaced the grow th in to tal monetary reserves and the ratio of monetary reserves to imports has fallen sharpl y. Recogni zing th e sub stanti al contribution o f the U. S. balance-of-payments deficits to the over-all increase in fore ign exch ange holdings and, consequently, to the level of international reserves during the past 6 years, it can be seen th a t any future success of the United States in res toring eq uilibrium to its bal ance of pay ments wi11 erve to curtail the primary ource of the increase in total moneta ry reserves. The re olve of the Administration to resto re bala nce in th e . S. international acco unts sho uld provide a continuing and potent stimul ant to th e search for acceptable mon etary reforms . While there is an apparent international consensus a mong th e m ajor industrial nations of the free world th at there is no shortage of liquidity at present, their view is less hopeful a bo ut the adequacy of future liquidity given ex istin g international financi al arrangements. Thu , a continuing e ffort toward reform of th e intern a tional pa yme nts system may be ass ured. In light of thi s, it is important to have some fundamental unde rstanding of the issues involved . 9 CURRENT DEBATE ON THE TERM STRUCTURE Of INTEREST RATES By Frederick M. Strnble TllE MONETARY authorities-the Federal Reserve System and the U.S . Treasury-alter the relationship among maturity yields on Government securities by changing the maturity composition of Government securitie outstanding? For many years, two different theories-the expectations theory and the segmented markets theory-have been used as a basis for answering this question. The expectations theory contends that a change in relative supplies of securities with different maturities will not affect maturity yield relationships unless, in the process, it brings about a change in market expectations of future intere t rates. On the other hand, the segmented markets theory argues that maturity yield differentials are caused by an imbalance between the maturity composition of debt demanded by lenders and supplied by borrowers. From this it follows that a shift in the maturity composition of supply will affect relative yields. The segmented markets theory acknowledges that market expectations of future interest rates may be changed as relative supplies in the various maturity sectors are altered, thus augmenting the change in yield differentials brought about by this operation. In general, however, most discussions of the segmented markets theory have emphasized the direct effects that changes in relative supplies will have on relative yields apart from any possible changes which might occur in expectations of C 10 AN future interest rates. Discussions of the expecwtions theory similarly have played down the possible effects that changes in the maturity composition or debt might have on interest rate expectations. As a result, the theoretical controversy has been clearly defined. Although each of these theoretical positions has a long history, it seems a safe judgment that the segmented markets theory has been and continues to be the theory most generally accepted by market analysts. However, the degree of consensus on this question has been reduced considerably as a result of recent research. Older statements of the expectations theory have been reinterpreted incorporating more plau iblc behavioral assumptions and the more rigorous modern formulations have added clarity to the meaning of the expectations hypothesis. On an empirical plane, several of the more sophisticated tests have provided strong support for the expectations theory. This article reviews the current state of this controversy. To simplify the discussion, references to specific studies have been avoided. The reader interested in pursuing the topic further is referred to the brief bibliography of the major works on this question at the end of this article. THE SEGMENTED MARKETS THEORY Although the term, segmented markets, is used here to identify one theory of the term Current Debate on the Term Structure of Interest Rates tructu re of intere t rate , in other discussions this theory has been identified by several other terms, includ ing institutional, imperfect substitutes, and hedging. Each refers to a type of balance sheet deci ionmaking complicated by legal restrictions and traditional practices such a the matching of the maturity structure of one's a ·sets with the maturity structure of one's liabilitie -pre umably in order to avoid ri k. It is argued that because major groups of borrowers and lenders prefer to match assets and liabilities in thi way, the market for credit in. trument is partly compartmentalized, or segmented. according to the maturity of debt in . truments. As a result, loan with different maturities arc imperfect ub titutes in the .1ggregatc a. well a. for individual inve tor and borrower group in the ense that different rates of return arc required to hold securities with different maturities, and also, the size of the difference in rates of return varies with changes in the maturity composition of as et portfolio . Thi means that maturity yield differentials are determined by an imbalance between the maturity structure of debt demanded by inve tors and the maturity structure of debt supplied by borrower . Since the alternative theoretical position to be di . cussed in the next section of this article :tres. es the importance of interest rate expectations, it i. worthwhile to note that di cus. ions of the segmented markets theory generally have limited the influence of interest rate expectation to possible effects that changes in expectation of future interest rates can have on current interest rate relationships. This is quite different from the primary role as igned to expectations in the expectations theory . For, briefly, the expectation theory a. :crt that current difference in the maturity yields exist because the market expects interest rates to change over future periods of time . Moreover, it contends that it is possible to determine from a given yield relation hip the pattern of future intere t rates predicted by Monthly Review • January - February 1966 the market. Di cussions of the segmented markets theory have either ignored this issue or have asserted that a current yield structure is not affected by interest rate expectations in this manner. Several fact appear to provide strong support for the segmented markets theory. In particular, the behavior of many institutional lenders accord with the a sumption about investor behavior made by this theory. For example, commercial bank portfolios are heavily weighted with as ets of short maturity while as. ets held in the portfolio of in urance companies and . avings and loan in titution are predominantly long term. Many example of borrower behavior al. o may be cited which conform to the a .. umption underlying the egmented market theory. Con umers usually finance purcha es of houses with long-term mortgages and purchases of less durable consumer goods with shorter-term debt agreements. In a . imilar manner, busines firms generally attempt to match the maturity of their liabilities with the durability of their assets -inventories are financed by short-term loans while plant and equipment inve tments are financed by longer-term loan . The e examples clearly arc far from exhaustive. Presumably, it is the perva ivene s of such practices that makes the egmented markets theory o compelling to many analyst , particularly tho e involved in the day-to-day operation of credit markets. Against thi evidence supporting the segmented markets theory, the results of recent empirical studies have been surprising. One study after another designed to measure the effects of the maturity composition of debt on maturity yi Id differentials wa unable to discern a ubstantial relationship between these variable . Con. equently, these findings have cast doubt on the segmented market theory. These empirical studies have not been entirely convincing, however. In attempting to estimate the implications of changing supply 11 Current Debate on the conditions, all but one study ignored the possible consequences of simultaneous shifts in demand. Most studies assumed that the demand for loans with different maturities remains relatively stable over time. If this is the case, then changes in maturity yield differentials can be attributed to changes in relative supply. If, however, conditions of demand change concurrently with changes in relative supplies, this would reduce the correlation between relative supplies and relative yields. The failure of most studies to consider this problem reduces their significance. The fact that the one study which did consider this problem came to essentially the sa me conclu ion s as the others, however, suggests that failure to consider this contingency may not have been an important deficiency. In addition, on an a priori basis, it see ms unlikely that changes in demand would vary inversely with changes in supply so consistently that an actual relationship between relative supplies and relative yields would be entirely obscured. THE EXPECTATIONS THEORY The consistent findings that changes in relative supplies of securities with different maturities have only small effects on maturity yield differentials not only cast doubt on the seg mented markets theory, they also provide indirect support for an alternative theoretical explanation of the term structure of interest rates. Both the pure expectations theory and the version of this theory which contends that liquidity preference is partly responsible for the establishment of maturity yield differentials, agree on one vital point: that the maturity structure of outstanding deb t does not affect the maturity structure of yields. The basic assertion of the pure expectations theo ry is that loans with different maturities , that are similar in all other respects , are perfect substitutes to investors in the aggregate. This means that the relationship among current prices a nd yields on securities with differ12 ing maturities are adjusted so that the rates of return on this debt-calculated to include capital gains and losses where applicable-are expected to be equal for any given period of time ; and that th e maturity composition of outstanding debt does not affect maturity yield differentials. From these assertions it follows that maturity yield differential s exist because the market is expecting interest rates to change over the future-to change in such a way that appa rent differences in return which might be inferred from yield differentials are wiped out in the process- rather than because it expects the rates of return on loan s with different maturities to differ. Moreover, any proccs. which alters the maturity compo. ition of investor portfolios, but docs not change expectation s of future interest rates, will not affect the existing structure of yields on loans with different maturities . It should be emphasized that loans with different maturities may be perfect substitutes in the aggregate even though not every investor views them as such. Credit markets may be dominated by a relatively small but wellfinanced gro up of traders who treat loans of different maturities as perfect substitutes. If this i the case, the investors , whose actions are offset by these traders , would have no influence on security prices and yields. Security prices and yields would be established by traders willing to adjust their holdings of securities with different maturities until they expect the realized rates of return on the securities to be equal over any given period. Still another possibility exists for rationalizing that certain securities in the aggregate are perfect substitutes. The preferences of different investor groups may overlap so that all securities within one maturity range may be perfect substitutes for one investor group, while securities in another maturity range may be perfect substitutes for another investor group. For example, banks may consider debt instruments over a certain range of short-term securi ties to Term Structure of Interest Rates be perfect substitute while savings and loan associations, insurance companies, and other investors m ay view longer maturity dates as perfect substitutes. If the maturity ranges of differe nt investor group overlap sufficiently, the tructure of yield would be adjusted as if each inve tor beli ved all securities to be perfect sub titutes. However one views the process which leads to loans with differing maturities being perfect substitutes in the aggregate, the essential point is that the yields and prices are determined by investors who expec t th e rates of return on these sccurit ie to be th e amc over any given period of time. It is necessa ry to qualify thi statement moderate! , si nce most pre cntations of the expectatio ns th eo ry do r cognizc that such factors as marke t impediments and tran actions costs may r es ult in some inequality in expected rates of return and may cause some distortion between actually established yield structures and tho e which would be established if these factors did not exi t. In general analysis, however, it seems a valid practice to ignore these factors, for yield differentials change rather ubstantially over time, and it is highly unlikely that thi behavior could be attributed in any significa nt way to changes in transaction costs or othe r market impediment . There arc two co mpatible ways to look at the eq uality o f expected rates of return. An existing lon g-term ra te can be considered equal, roughly speaking, to an ave rage of a current shortterm rate and the short-term rates which are expected to be es tabli shed over time until the long-term loan matures. On the other hand, a current long-term rate can be viewed as standing in a specific relation hip to a current shortterm rate such th a t its price is expected to change just sufficie ntl y o that its rate of r turn will equ al the short-term rate over the period req uired for th e sho rt-term loan to mature. In either case, any yield differential represent a market prediction that interest rates will change over th future. For example, conMonthly Review • January - February 1966 ider two loans with 1 and 2 years to maturity that are selling to yield 2 per cent and 3 per cent, respectively . According to the pure expectations theory , this interest rate relationship indicates a m arke t prediction that the price of th e 2-year loan will fall by roughly 1 per cent over the year. Or, it indicates that the market i expecting the yield on a I-year loan to be roughly 4 per cent 1 year in the future. This prediction i implied because the average of the current 1-year yield of 2 per cent and the expected 1-yea r yield of 4 per cent is roughly equ al to the current 2-year maturity yield of 3 per ce nt. In short, the expectati o n theory co ntend s that diffcrenccs in yi Ids o n loa ns with different maturities arc c tabli hcd not beca use the market expects to receive a higher return on one ecurity than on anoth er, but instead, because th e m arket expects the rates of return on the two securities to be the same over an equal period of time. To view this conception from a broader perspective, consider the relationship among a whole range of yields on loans with differing m aturities . This relationship is usually depicted by a yi eld curve, a curve which provide a general picture of the relationship among all maturity yield on a particul ar date. Three prevalent types of y ield curves have been established during thi century. The first i an upslopi ng curve with yields ri sing as maturity lengthens and then generally becoming flat in the range of longe t maturity date . The second is a downsloping curve with yields declining as maturity lengthens and then generally becoming flat in the range of longest maturity dates . The third is a flat yield curve with all maturity yields equ al. According to the expectations theory, the up sloping curve indicates that the market is expecting all yield to rise over future periods of time , with the greatest increases expected among short-term yields. The downsloping curve reflects ma rket expectations that all yields will fall over future periods of time, with the 13 Current Debate on the greatest declines expected in shorter-term yields. The flat curve reflects market expectation s that all yields will remain unchanged. As might be expected, yield curves tend to vary over the business cycle and the types assoc iated with the various phases of the business cycle lend plau sibility to the expectations theory. For exa mple, upsloping yield curves are usually observed during recessions and throughout the early part of a bu siness ex pansio n. It seems quite plausible that borrowers and lender would be expecting intere t rates to increa e at such times. Conversely, downslopi ng yield curves ge nerally have been e tabIi hed at or near th e peak. of bu in css expa nsion. With interest rates ge nera lly hi gh historically, it is at least plausible that investors would be ex pecting to see yields decline in the future. THE LIQUIDITY PREFERENCE VERSION OF THE EXPECTATIONS THEORY Several discussions of the expectations theory have concluded that expected changes in yield relationships provide only part of the explanation for the exi stence of yield differenti als. They have argued th at lenders generally prefer to hold hart-term loans as as et because the price of these a et tends to vary minimally . Thi s preference is reflected in the willingness of investors to forego some expected return in order to hold short-term assets . As a result, longer-term assets generally provide a liquidity premium and their expected rate of return tends to be higher. To put this another way, it is asserted that the level of longer-term yields is always higher than it would be if the structure of yields was _determined solely by market expectations. The fact that yield curves have sloped upward considerably more often than they have sloped downward since World War II often is cited as evidence of the existence of a liquidity premium on longer-term securities. It should be noted, however, that the predominance of upsloping yield curves is not 14 necessarily inconsistent with the pure expectations theory. If the market generally had expected yields to rise over this period-and yields did rise-the larger proportion of yield curves would have had an upward slope. It will be remembered that at the outset of the postwar period interest rates were at historically low levels . Although the liquidity preference variant of the expectations theory contends that rates of return on loans with different maturities are expected to differ, it does not view credit market as being segmented. Instead, the size of the pres umed liquidity premium is held to be unrelated, or c sentiall y unrelated, to th e maturity co mpo ition of out tanding debt. Thus, the position of the liquidity preference approach i the same as th e pure expectation approach on this vital point. In addition, the liquidity preference theory asserts that, in general, changes in yield differentials imply that the market has changed its expectations about the future course of interest rates. Here, again, the liquidity preference approach is in accord with the pure expectations approach and in conflict with the segmented markets approach. For these reasons, it is po ible to consider thi s po ition as a vari ant of the expectations theory. IMPLICATIONS OF EMPIRICAL EVIDENCE The expectations theory has never been widely accepted outside of academic circles . Until recently, one reason was the inability of analysts to develop a test which supported this theory. In fact , early studies which purported to test this theory concluded that it had no empirical validity. This conclusion was based upon the demonstration that yield predictions derived from a structure of yields in accordance with logic of the expectations theory were usually wrong. Recent presentations of thi theory have made it clear, however, that this is not a valid test. A test of the market's ab ility to form accu rate forecas ts of future Term Structure of Interest Rates interest rates does not constitute a test of whether an existing yield structure depends upon market expectations of future interest rates. All that is asserted by the expectations theory i that yield differentials exist because the market expects interest rates to change. It is not claimed that the prediction of the market necc arily will be accurate. In addition to thi clarification, recent tudie have generated new evidence in support of the expectations approach. And, although these findings taken individually are not overwhelmingly compelling, a, a group they do erve to increase the degree of acceptance of the expectations theory. lt is impossible in the short space available to describe these tests in detail, but their general approach may be outlined. First, hypotheses about how intere t rate expectations are formulated at one point in time or how they are altered with the pa sage of time are developed. Maturity yield relationships establi hed at variou point in time and the subsequent changes in these relationships with the pas age of time are then compared with this independent evidence of market expectations. A high degree of correlation has been found between these variable . Another approach has been to draw inference about the validity of the expectation approach by comparing actual interest rates established over a certain period of time with forecasted interest rates as implied by yield structures established in the past. The criterion u ed for judging the results was not whether market predictions always turned out to be correct, however, as it was in earlier tests of this kind. Rather, it was one of determining whether actual rates turned out on the average to be above or below foreca ted rates. The presumption has been that if, on the average, actual rates were equal to forecasted rates, this suggested that the pure expectations theory wa correct. The findings in several studies that forecasted rates generally exceeded actual rates has been the principal source of support for Monthly Review • January - February 1966 the assertion that a liquidity premium on longterm debt mu t be recognized as a factor in determining maturity yield relationships. Although mo t recent empirical studies of the expectations theory have proceeded along the lines de cribed above, it hould be noted that some inve tigations have approached the problem from a different perspective and have found evidence which casts doubt on this theory. One piece of evidence of this kind has been the inability to identify a group of balance sheet units that behave like the hypothetical speculator as urned in ome pre entations of the expectation theory. Moreover, objection have been raised as to the po ibility of the type of speculative activity a cribed to tradeL because of technical defici ncie, in the market with regard to short- elling. Additional evidence, which would appear to be particularly damaging to the overlapping markets version of this theory, was the finding in one recent study that interest rate expectations were not uniform among different market observers. This conflicts with one of the assumptions usually made in pre enting the expectations theory which is that interest rate expectations of all investors tend to be uniform. SUMMARY AND CONCLUSIONS The problem of explaining maturity yield relation hips remains unresolved. The implications of recent empirical findings , although far from being one-sided, have shifted opinion away from the segmented markets theory and toward either the pure expectations theory or this theory modified to include the existence of a liquidity premium on long-term debt. Perhaps the most compelling evidence produced by these tudie wa the consi tent finding that changes in the maturity compo ition of debt have little, if any, effect on the maturity structure of yields. This, of course, constitutes not only a direct challenge to the segmented markets approach but, in addition, provides indirect upport for the alternative theory. Other direct 15 Current Debate on the Term Structure of Interest Rates tests of the expectations hypothesis have added further support for this theory. In fact, on the basis of the results of these two groups of tests, a strong argument ha s been made for rejecting the segmented markets theory and accepting the expectations theory. However, all the evidence does not point in one direction. The generally acknowledged fact that major groups of borrowers and lenders are constrained either by legal res trictions or personal preferences from viewing securities with different maturities as perfect sub titutes, the inability to identify eco nomic units performing as speculators, and th e ev idence of diverse inte res t rate expec tation s all serve to temp r any inclination to di sca rd the segmented market ap proach and acce pt the ex pectations theory . Perhaps the best appraisal at thi time is that, as a result of recent research , the expectations approach has won an important skirmish, but the outcome of the war remains in doubt. BIBLIOGRAPHY CONARD, JOSEPH W . An Introdu ction to the Th eory of Int erest. Berkeley and Los Angeles: University of California Press , 1959. CooTNER, PAUL H . "S peculation in the Government Securities Market," Fiscal and Debt Managem ent Policies, a series of research studies pre- 16 pared for the Commission on Money and Credit. Englewood Cliffs, N. J.: Prentice-Hall, 1963, 267- 310. CULBERTSON, J. M. "The Term Structure of Interest Rates," Quarterly Journal of Economics, LXXI (November 1957) , 485-517. DE LEEUW, FRANK. "A Model of Financial Behavior," The Brookings Quarterly Econometric Model of the United States, ed. J. S. Duesenberry et al. Chicago: Rand McNally & Company, 1965, 465-530. KESSEL, REUBEN A. Th e Cyclical Behavior of the Term Structure of Interest Rates. (Occasional Pa per 91 , National Bureau of Economic Research.) N ew York: olumbia Univ rsily Pres, 1965. MALKI L, BURTON G . "The Term Structure of Interest Rates," American E a nomic R eview, LIV (May 1964) , 532-543 . MEISELMAN, DAVID. The Term Structure of Interest Rates. Englewood Cliffs, N. J.: PrenticeHall , 1962. OKUN, ARTHUR M. "Mo netary Policy, Debt Management and Interest Rates: A Quantitative Appraisal," Stabilization Policies, a series of research studies prepared for the Commission on Money and Credit. Englewood Cliffs, N. J . : Prentice-Hall , 1963, 331-380. SCOTT, ROB ERT H. " Liquidity and the Term Structure of Interest Rates," Quarterly Journal of Economics, LXXIX (February 1965), 135-145.
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