The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
Opinions expressed in the Economic Review do not necessarily reflect the views of the
management of the Federal Reserve Bank of San Francisco, or of the Board of Governors of
the Federal Reserve System.
The Federal Reserve Bank of San Francisco's Economic Review is published quarterly by the Bank's
Research and Public Information Department under the supervision of John L. Scadding, Senior Vice
President and Director of Research. The publication is edited by Gregory 1. Tong, with the assistance of
Karen Rusk (editorial) and William Rosenthal (graphics).
For free copies of this and other Federal Reserve publications, write or phone the Public Information
Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco, California 94120.
Phone (415) 974-3234.
2
I.
Chain Banks and Competition: The Effectiveness of
Federal Reserve Policy Since 1977................................ ..................... 5
Anthony W. Cyrnak
II.
Monetary Control Without a Central Bank:
The Case of Hong K ong.......................................................................17
Ramon Moreno
III.
Predicting the Money Stock: A comparison of
Alternative Approaches.........................................................................38
Brian Motley and Robert H. Rasche
IV.
Bank Regulation and the Public Interest............................................. 55
Michael C. Keeley and Frederick T. Furlong
Editorial Committee:
Carl E. Walsh, John Judd, Randall Pozdena, Bharat Trehan,
Gary Zimmerman and Tom Sargent.
3
4
Anthony W. Cyrnak*
One-bank holding companies offer numerous financial and organizational advantages to bank owners. To achieve holding company status,
however, the owners must satisJY Federal Reserve standards that involve
financial, managerial, legal, and antitrust considerations. This paper
examines the Federal Reserve's efforts to foster more competitive local
banking markets through the application of a particular antitrust policy.
It is concluded that the Federal Reserve's efforts have been largely
successful.
acquired banks in different locations. Because these
acquisitions were made by individuals rather than
corporations, they were largely immune to formal
antitrust review until the passage of the Change in
Bank Control Act of 1978. As a result, many
bankers acquired more than one bank within individual banking markets and frequently induced
important anticompetitive effects.
The Federal Reserve Board began to examine the
antitrust implications of some chain banking ownership patterns when owners of chain banks sought to
place their banks into one-bank holding companies
during the 1970s. The Board's analysis of these
formations has typically been conducted in two
stages. The first is an assessment of any competitive
effects that could arise from placing the target bank
into a one-bank holding company (this portion of
the competitive assessment has almost always been
a pro forma matter since the formation usually is
merely a corporate reorganization). The second
phase of the analysis consists of examining the
competitive effects of any affiliation that the target
bank may have formed with other banks in the same
geographic banking market in the past. For example, assume that bank A, which has been in operation more than five years, applied to form a onebank holding company in year t. Assume further
The one-bank holding company has been a popular form of bank ownership for the past 15 years.
From 1970 through 1985 nearly 7,000 applications
to form such companies were filed with the Federal
Reserve System. Approximately 98 percent of these
applications have been approved. Those few
applications, however, which were denied by the
Federal Reserve were most often disapproved for
financial, managerial, or legal reasons. In a small
number of cases since 1977, however, disapproval
has stemmed from competitive factors.
These competition-related cases were disapproved as part of what has been referred to as the
Board's "chain bank" policy. Chain banking is a
form of bank ownership in which control of at least
two banks is vested in a single individual or a group
of individuals. Occurring for the first time in the late
nineteenth century, chain banking was a response to
the restrictive branching laws of certain northwestern and southern agricultural states. Unable to
establish branches throughout counties or across
county lines, bankers who sought to expand the
geographic scope of their operations simply
* Economist, Board of Governors of the Federal
Reserve System, and Visiting Economist, Federal
Reserve Bank of San Francisco.
5
that bank A's owner had in some earlier year, say t-5,
acquired bank B
a bank located in the same
geographic market. Since bank A and bank B had
been competitors before the acquisition, common
ownership in year t-5 would have eliminated the
competition that had existed. If this anticompetitive
effect is judged to have been substantially adverse
with no outweighing benefits of fulfillment of community convenience and needs, the Board would
normally deny the holding company application in
year t even though this corporate reorganization
generated no further anticompetitive effects.
The Board's rationale for denying such cases is
twofold and is clearly stated in a number of Board
orders. One, the chain bank policy is intended to
prevent the use of the holding company mechanism
to further what already is an anticompetitive
arrangement. Two, it is believed that denying such
applications will encourage the eventual disaffiliation of the chain banks and thereby promote a more
competitive market structure.
The study in this article examines the Board's
chain bank policy as it has been implemented since
the first chain bank case was denied in 1977. Such
an investigation is of interest despite the small
I.
number of cases involved because it provides an
avenue for investigating the effectiveness of a specific policy in an area in which the Federal Reserve
has a regulatory responsibility.
Part one of the study examines the level of bank
holding company formation activity during recent
years and discusses some of the advantages and
disadvantages of this type of bank ownership. Part
two defines the chain bank issue as delineated by the
Board and presents an analysis of those cases that
have been denied under this policy. Part three presents evidence with respect to the incidence of subsequent chain bank divestitures and thus "tests" the
effectiveness of the Board's policy.
An important conclusion developed in part three
of this study is that the advantages of the holding
company - especially certain tax advantages provide a strong incentive to form such companies.
This conclusion is supported by evidence that demonstrates that bank owners are willing to go to
considerable lengths to achieve holding company
status for their banks. Some observations on the
Board's more recent implementation of the chain
bank policy are also presented. The final section
summarizes the study.
One-Bank Holding Companies:
Advantages and Disadvantages
The popularity of the bank holding company
(BHC) as a form of bank ownership has increased
steadily since 1970. Table 1 demonstrates that the
number of approved formations has increased in
each of most of the years between 1970 and 1985,
with formation activity reaching a peak in 1982.
Overall, from 1970 through 1985, the number of
BHC formation applications filed with the Federal
Reserve System amounted to 6,899. 1
The large number of BHC applications suggests
that the advantages of the BHC form of bank ownership outweigh any disadvantages. These advantages, moreover, are broad-based and relate to an
organization's ability to engage in nonbanking
activities, its ability to expand geographically, the
degree of control it can exercise over its own corporate ownership, and the firm's financial flexibility.
Since 1970, when amendments to the Bank Holding Company Act of 1956 were enacted, BHCs have
engaged in a growing number of nonbanking
activities. These include, but are not limited to, such
activities as mortgage banking, consumer finance,
leasing, data processing, courier services, certain
management consulting activities, and merchant of
futures commissions. BHC entry into many of these
product markets has been extensive and has afforded
many BHCs an important opportunity for diversification.
BHCs can also provide a convenient vehicle for
geographic expansion in states that have restrictive
branching laws. States that permit BHC expansion
generally allow BHC acquisitions on anunrestricted, statewide basis. Thus, BHe acquisitions
can produce nearly the same degree of geographic
6
diversity as branching operations while preserving a
high degree of local autonomy (through the retention of local officers and directors in the acquired
bank).
Another advantage of the .BHC form of· bank
ownership is the ability to exercise considerable
control over corporate ownership. For example, the
formation of a BHC provides the majority owners of
the proposed bank subsidiarywith an opportunity to
eliminate minority shareholders within the bank and
thus consolidate their control of the banking organization. This can be accomplished by forcing minority shareholders to accept cash (rather than shares of
the forming BHC) for their bank shares. Certain
regulations also give BHCs more flexibility than
banks in incorporating anti-takeover measures into
their corporate structure. BHCs, for example, have
the ability to repurchase their own stock.
The BHC form of bank ownership also provides
important financial flexibility. This flexibility
derives from several sources. BHCs, for example,
may enjoy an advantage in raising new capital and in
structuring existing capital. Under present Federal
Reserve standards, rules for including certain items
as capital (such as equity commitment notes and
intangible assets) are more liberal for BHCs than
they are for banks. Also, certain BHCs (generally
those with less than $150 million of assets) can
engage in "double leveraging," in which funds
borrowed by the parent company (debt) are "pushed
down" to the subsidiary bank as equity capital.
Another very important financial benefit associated with the BHC form relates to the tax treatment
of certain income and expenses. 2 One area in which
these considerations are particularly important is
the retirement of bank acquisition debt. Typically,
personal debt is employed when an individual purchases a bank. The bank's owner usually retires this
debt with bank dividend payments that accrue to
him as owner of the bank. Dividend payments to the
owner, however, are taxable as ordinary income.
Thus, some portion of the dividend payments to the
owner are "lost" to taxes and cannot be fully
applied to debt retirement. All other things being
equal, the amount of bank dividends that must be
paid to service the acquisition debt will be greater in
the case of individual ownership - in which "aftertax" dollars are being used to retire debt - than if
all bank dividends went directly to debt retirement.
The creation of a one-bank holding company,
however, enables all bank dividends to go toward
debt retirement and thus effectively reduces the
amount of dividend payments a bank must make in
order to retire a given amount of acquisition debt.
7
Typically, when the newly formed holding company
"buys" the owner's bank, the BHC also agrees to
assume the owner's acquisition debt as part of the
purchase price of the bank. The source of funds to
retire this debt remains, as in the case of the individual owner, bank dividends. A critical difference
now, however, is that bank dividend payments to the
BHC are (by IRS regulations) tax-free income to the
BHC. Thus, the BHC can use the entire stream of
bank dividends to retire acquisition debt. That is, no
bank dividend payments are "lost" to tax payments.
The amount of bank dividends that must be paid
in order to retire a given amount of debt, therefore, is
less when the debt is retired by a BHC than when it
is retired by an individual. Because the holding
company can retire the acquisition debt with essentially tax-free dollars, the debt servicing burden on
the bank is significantly less than if an individual
retired debt with dollars on which he must pay
income taxes.
A second important tax advantage of the BHC
form is related to the ability of a BHC to file a
consolidated tax return (combined parent company
and bank subsidiary), and is known as the "taxexpense" benefit. Typically, bank subsidiary dividend payments to the parent company BHC (for
small, undiversified holding companies) comprise
the sole source of income to the parent holding
company. These dividend payments, as noted earlier, are tax-free income to the parent holding company. Thus, the parent company has actual cash
income but no taxable income (that is, it has a
taxable income base of zero). The parent holding
company, however, usually has tax-deductible
II.
expenses in the form of interest payments on
acquisition debt assumed upon the purchase of its
subsidiary bank. This combination of zero taxable
income but positive deductible interest expenses
generates a negative income tax liability for many
small parent companies.
Without positive taxable income, however, the
parent company cannot take advantage of its negative tax liability. By filing a consolidated tax return
with a subsidiary bank that has a positive income tax
liability, the parent company can effectively reduce
the income tax liability of the overall organization
by an amount equal to the subsidiary bank's marginal tax rate times the parent company's interest
expense.
Typically, the subsidiary bank pays the parent
company the value of this benefit. In the end,
however, the subsidiary bank will not have incurred
any greater total cash outlay than if the bank were
owned individually. However, the holding company
has additional cash which it may use to retire debt.
Compared to these substantial advantages, the
disadvantages of the BHC form of bank ownership
seem minor. Among the disadvantages are start-up
and organizational costs which entail professional
fees, franchise taxes, and staffing costs. In addition,
the regulatory process itself imposes some costs
upon the principals of proposed BHCs in the form of
reporting requirements and greater regulatory scrutiny. These disadvantages notwithstanding, it is
clear from Table 1 that the BHC is a form of bank
ownership that many bank owners have chosen to
adopt.
The Chain Bank Issue
The formation of a BHC requires the prior
approval of the Federal Reserve System pursuant to
Section 3(a)(l) of the Bank Holding Company
Act. 3 Table 1 shows that all but 132 (two percent) of
the 6,899 applications filed from 1970 through 1985
were approved. An examination of the formations
that were denied reveals that most were disapproved
for financial, managerial, or legal reasons. Twelve
of the proposed formations, however, were denied
for competitive reasons as part ofthe Board's "chain
bank" policy, discussed earlier. (See Table 2). 4
To reiterate, the Board's rationale for scrutinizing
the competitive effects of one-bank holding company formations among commonly owned banks is
that the BHC vehicle should not be used to further
an anticompetitive arrangement, and that denial of
such cases might lead to a procompetitive restructuring of the affected banking markets by precipitating
a dissolution of common ownership. This rationale
was clearly stated in the Mahaska decision, the first
of the chain bank denials:
8
While denial of the proposal may not immediately result in.a complete termination of the
present situation . . . it would preserve the
distinct possibility that [the target bank] could
again become an independent organization in
the future. Approval, on the other hand would
almost certainly foreclose that possibility
since, as a result of the flexibility afforded by
the holding company structure, Applicant
would appear capable of servicing its acquisition debt, and, in addition, a mutuality of
interest between the affiliate and [the target
bank] would likely be established. s
Section 3(c) of the Bank Holding Company
Act requires the Board to consider whether
any proposed acquisition by a bank holding
company (1) would further the monopolization .or attempted monopolization of a banking market, or (2) may substantially lessen
competition or tend to create a monopoly in
any banking market. Where, as here, a proposed acquisition involves the use of a holding company by a group of individuals to
acquire control of a bank that is a competitor
of another bank under the control of essentially the same individuals, the Board believes
it must apply these standards. In the Board's
view, the subject proposal presents a compelling case where the holding company is being
used to further an anticompetitive arrangement.
When implemented in 1977, this method of analyzing the competitive effects of one-bank holding
company formations clearly constituted a new
approach to the Board's scrutiny of one-bank hold-
9
Any uncertainty regarding whether chain bank
cases could be legally denied did not exist for long.
In 1978, the U. S. Supreme Court upheld the
Board's authority to deny one-bank holding company formations even though the fonnations did not
exacerbate pre-existing financial factors. 8 This 1978
decision clearly established the Board's authority to
deny one-bank fonnations for adverse financial and
managerial factors. It was also seen as confinnation
of the Board's authority to deny formations on the
basis of competitive factors as well. Any remaining
doubt on this point was removed in 1980 when the
only legal challenge to a Board competitive chain
bank denial was rejected in court. 9
ing company fonnations. 6 It was not clear, however,
that the Board's approach to these cases would be
beyond legal challenge, particularly in view of a
related legal decision rendered in 1977. In that
decision the Board's denial of a one-bank holding
company formation on the basis of financial factors
(First Lincolnwood) was overturned in district court
on the argument that". . . in order to be grounds for
disapproval, the condition or tendency deemed not
to be in the public interest must be caused or
enhanced by the proposed transaction."7
In a second competitive chain bank denial which
quickly followed Mahaska, however, the Board
argued that the First Lincolnwood decision did not
apply because (l) First Lincolnwood related to
aspects other than competitive factors; (2) consummation of the current holding company fonnation
proposal is related to competitive (not financial)
factors and would enhance and further an anticompetitive arrangement; and (3) evasion of the Bank
Holding Company Act would be facilitated and
encouraged.
Characteristics of Chain Bank Denials
From 1977 to 1981, the Board denied twelve
proposed fonnations for reasons relating to the
competitive effects of past affiliations. These twelve
cases, listed in Table 2, are examined more closely
below to review the competitive factors in question.
Some of the data relating to the cases are presented
in Table 3.
10
ratios higher than 75 percent and a HerfindahlHirschmann Index in excess of 1800. 10 Only one
case (Lake Jackson) involved a market of moderate
concentration.
The profile, then, that emerges of the banks and
markets in these cases is one of small banks operating in small, highly concentrated markets. Within
such markets, it is not difficult to imagine that past
multiple acquisitions of banks could have resulted in
significant anticompetitive effects.
Several important observations can be made from
this information. First, virtually all of the target
banks involved in the twelve denials were small
banks located in small, primarily rural banking
markets. The smallest of the target banks (Caneyville) had deposits of only $7.1 million at the time
of application. Even the largest (Lake Jackson) had
only $36.2 million of deposits. For the entire group
of twelve banking organizations, the average bank
size amounted to $16.0 million.
The markets in which these banks operated were
likewise small and contained few banking competitors. Five of the cases, for example, involved markets with five or fewer banking organizations. Six
other markets had between six and ten banking
organizations, and only one application involved a
market with more than ten banking organizations.
Similarly, the total deposits of the twelve markets
averaged only $144 million.
The markets in which these twelve organizations
operated also were, in all but one case, highly
c()ncentrated at the time of application. Eleven of
the twelve markets had four-firm concentration
An Analysis of the Denials
Data related to the anticompetitive effects of the
twelve denials are presented in Table 4. Among the
most obvious and most important aspects of these
cases is that the target bank and its affiliate(s)
accounted for a relatively large market share of
deposits at the time the common ownership of
shares (anticompetitive affiliation) occurred. Eleven
of the twelve applications, for example, involved
affiliations in which the combined market share was
greater than 24 percent. Only one proposal (Eicher)
involved a market share combination of lesser mag-
11
might result in severance of this relatllJmmrp.
nitude. Denial of this application resulted from
unfavorable financial as well as competitive factors.
The average combined market share for all twelve
applications was 44 percent, ranging from a low of
13.0 percent (Eicher) to a high of 100 percent
(Childress).
Eight of the twelve proposals involved affiliations
of four years or less (Table 5). In two cases (Welch
and Serno), however, common ownership had been
in effect for more than 20 years prior to the application to form a BHC.
The duration of the anticompetitive affiliations in
these cases was of considerable interest to the
Board. In particular, it was believed by some Board
members that there was little likelihood of disaffiliation in those cases where the period of common
ownership was lengthy. Thus, it was argued, denial
would have little chance of precipitating a subsequent procompetitive divestiture. Chairman Paul
Volcker and Governor Lyle Gramley voiced this
concern in the Welch application:
The duration of this relationship is significantly longer than in any application previously denied by the Board
on competitive grounds, however, and thus it appears
unlikely that denial would have any meaningful effect.
Similarly, Governor Lyle Gramley stated in the First
Southeast proposal:
The affiliation between Kenosha, West Kenosha, and Silver Lake Banks has spanned
nearly a decade. Denial in any of these cases
would not increase significantly the probability that common control of the three banks
will be terminated . . . so that the prospects
for disaffiliation seem small.
The issue of the likelihood of divestiture in these
applications raises the question of whether the
Board's chain bank policy in general has been
effective in promoting subsequent divestitures.
Also, how soon following denial did the divestitures, if any, take place; and was divestiture related
to the length of the affiliation? Answers to these
questions are presented in the next section. They
provide some evidence as to the overall effectiveness of the Board's chain bank policy.
We do not believe that denial of this application at this time will increase the probability
that common control of the two banks will be
terminated. The combined market share of the
two banks is certainly substantial, and we
would join the majority of the Board if there
was some reasonable possibility that denial
12
III.
Divestitures
availability of purchasers, and the presence of regulatory barriers. However, the most likely explanation fpr such a broadly based result ~a92p¢tc¢nt
rate of divestiture (II of 12) - is that the laqk of
holding company status prevented the owners of
these banks from realizing the important benefits of
BHC status discussed earlier.
In particular, a lack of BHC status would have
prevented the realization of important debt-servicing tax benefits -.a fact of some importance given
that, in all Cases that were denied, the proposed
purchase of the bank involved the immediate or
planned assumption of debt. 11 Since the Board's
denial prevented the parties from realizing tax benefits, the principals of the banks appear to have
decided that continued common ownership of the
affiliated banks was a less favorable proposition
than BHC status.
For evidence on the incidence of divestitures, this
study examined Federal Reserve records and interviewed individuals associated with the twelve
denied applications.• The results of these inquiries
are presented in Table 6. Thedatareveal that divestitures subsequently occurred in eleven of the twelve
The only application· in. which no
divestiture wasrecorded was First Southeast,and,
in that instance, the commonly owned banks later
merged. In several instances (for example, Citizens,
Mahaska, and Mid-Nebraska), subsequentapplications by the resulting nonaffiliated banks to form
BHCs were refiled and approved by the Board
following divestiture.
relatively short time after denial. In three of the
twelve cases (Citizens, Caneyville, and Childress), a
divestiture was made within six months or less. In
four others (Eicher, First State, Lake Jackson, and
Welch), the time to divestiture was less than 24
months. In only four applications (Midwest, MidNebraska, Mahaska, and Serno) was the divestiture
period significantly longer (45 months to 60
months). The average time from denial to divestiture
was 27 months, or just overZ years.
It is not P?SsibletoaccountfuIIy for the motivations behill<lthe divestitures that occurred. A bank
owner's willingness to sell a bank depends upon any
number of factors including the terms of pun;hase,
Recent Board Policy on Chain Cases
Since the First Southeast case in 1981, the Board
has not denied a chain bank case. There are several
possible explanations for this absence of denials.
One is that banking antitrust standards have e~sed as
the result of important banking legislation. Specifically, both the Depository Institutions Deregulation
and Monetary Control Act of 1980 and the Garn-St
Germain Depository Institutions Act of 1982 have
13
antitrust laws or the BHC Act. Common
control was effected in 1959, before the Celler-Kefauver Antimerger Act of 1950 was
believed to apply to bank mergers; before the
enactment of the Bank Merger Act of 1960,
which required regulatory agencies to take
competitive factors into account in approving
mergers; and before the enactment of the
Bank Merger Act of 1966, which clarified the
applicability of the antitrust laws to bank
mergers. 13
strengthened the argument that thrift institutions
should be regarded as partial or full competitors of
commercial banks. Counting thrift institutions as
competitors increases the total number of "banking" competitors and thereby lowers concentration
within markets. Thus, the competitive effects of any
horizontal affiliation are likely to be less severe.
Two other developments have also served to limit
denials under the Board's chain bank policy in
recent years. The first arose in a 1983 chain bank
application involving an affiliation of more than 40
years. In that case, the Board suggested that bank
affiliations established before the passage of the
Bank Merger Act of 1960 might appropriately be
exempted from antitrust review. 12 Reviewing the
effects of affiliations established before that year, it
was argued, would unfairly apply antitrust standards that were created subsequent to the affiliation.
This proposition was reiterated and expanded somewhat in a second approval decision made by the
Board in 1983:
A final contribution to the approval of chain bank
cases in recent years has been the Change in Bank
Control Act of 1978. This law, which embodies a
competitive standard equivalent to that of the BHC
Act, requires that changes in the effective ownership or control of a bank receive prior approval from
one of the three federal bank regulatory agencies.
Thus, seriously anticompetitive affiliations of the
type which raise a chain bank issue presumably
have not occurred since the passage of this law. As a
result, the pool of potential chain bank cases has
shrunk since 1978. 14
The duration of the affiliation here is 24 years
and did not represent an attempt to evade the
IV.
Summary and Conclusion
Beginning in 1977, the Board forged a rather
well-defined policy with respect to the formation of
bank holding companies from chain banks. This
policy requires an assessment of the competitive
effects of any prior affiliations between the target
bank and other banks located in the same banking
market. If the original affiliation had substantially
adverse effects on competition within the relevant
geographic market, the Board will normally deny
the formation application based upon the requirements of the Bank Holding Company Act. The
Board's purpose in applying the standards of the
Ban.I<. Holding Company Act to these chain bank
cases is twofold: to prevent the use of the holding
company vehicle to further an anticompetitive
arrangement and to promote conditions under
which the anticompetitive chain affiliation might be
dissolved in the future.
From 1977 to 1981, the Board denied 12 chain
bank applications. The target banks involved in
these applications were nearly all small institutions
located in rural, concentrated markets. An exam-
ination of these 12 cases revealed that the Board's
chain bank policy was highly effective. Procompetitive divestitures occurred in eleven of the twelve
cases.
The Board has not denied any chain bank cases
since 1981 for several reasons, including a general
easing of banking antitrust standards, a determination that pre-1960 affiliations should be exempted
from antitrust review, and the effects of the Change
in Bank Control Act. However, the experience of
1977-81 and the subsequent divestitures to gain
BHC status suggest strongly that the BHC form of
ownership enjoys decided advantages. Among the
most important of these is the ability to service debt
more advantageously than an individual. Other
important advantages of the holding company
include the ability to engage in certain nonbanking
activities and, in some cases, to expand geographically in ways not available through normal bank
branching. Greater flexibility in structuring capital,
ownership and control, and anti-takeover provisions
also derive from the holding company form and
provide important additional benefits.
14
FOOTNOTES
7. First Lincolnwood Corp. vs. Board of Governors of the
Federal Reserve System 560 F.2d 258 (7th Cir. 1977)
1. Table 1 includes one-bank and multibank holding company formations. Available aggregate data did not permit
the segregation of the two types of formations by number,
although experience indicates that except for the early
1970s nearly all of the formations recorded in this table
consist of one-bank holding companies.
8. U.S. Supreme Court in First Lincolnwood Corp. vs.
Board of Governors, 439 U.S. 234 (1978).
9. Mid-Nebraska Bancshares, Inc. vs. Board of Governors, 627 F.2d 266 (D.C. Cir. 1980)
2. IRS regulations stipulate that a BHC must acquire at
least 80 percent of the target bank to qualify for the tax
treatment herein described.
10. The Herfindahl-Hirschmann Index is obtained by summing the squared market shares of deposits (or some other
measure, such as assets or loans) of each banking organization in a market. The Department of Justice presently
considers an index of 1800 or higher to comprise a high
degree of concentration.
3. More or less routine formations involving no serious
financial, managerial, or competitive issues are normally
approved by the 12 Reserve Banks under delegated
authority procedures. More complicated cases are
approved or denied by actions of the Board of Governors
of the Federal Reserve System.
11. Ten of the twelve acquisitions were to be made by an
exchange of shares and the assumption of acquisition
debt ranging from $297 thousand to $2.9 million. In two
other applications, no acquisition debt was involved, but
the newly formed holding companies planned to borrow
funds that were to be used as capital injections into the
respective banks.
4. Few studies have been conducted on the importance of
chain banking within individual states. One such study
involving five midwestern states, however, identified 86
chain organizations controlling a total of 332 banks. Within
these states, the various chain organizations controlled as
little as 4.2 percent of state bank deposits and as much as
16.9 percent of bank deposits (see Joseph T. Keating,
"Chain Banking in the District," Economic Perspectives,
Federal Reserve Bank of Chicago, Sept.lOct. 1977, pp.
15-20).
12. First Monco Bancshares, Inc., Federal Reserve Bulletin, Vol. 69 (1983), p. 293.
13. Texas East BanCorp, Inc., Federal Reserve Bulletin,
Vol. 69 (1983), p. 636
14. This law actually became effective in early 1979. The
date of effectiveness explains why two of the affiliations
(Caneyville and Childress) that occurred in 1978 and 1979
were, nonetheless, reviewed by the Board under the chain
bank policy.
5. Mahaska Investment Co., Federal Reserve Bulletin, Vol.
63 (1977), p. 579.
6. In the early 1970s the Board routinely considered preexisting relationships as part of its analysis of proposed
multibank holding company formations. The Board generally did not regard these pre-existing relationships as
raising any competitive issues because in most instances
the affiliated banks had been started de novo by principals
of the applicant's lead bank.
15
16
Ramon Moreno·
The traditional critique of the "real bills" doctrine argues that the
price level may be unstable in a monetary regime without a central bank
and a market-determined money supply. Hong Kong's experience suggests this problem may not arise in a small open economy.
proposed that the money supply and inflation could
successfully be controlled by the market, without
central bank control ofthe monetary base, as long as
banks limited their credit to "satisfy the needs of
trade".
The real bills doctrine was severely criticized on
the belief that it could lead to instability in the price
level. However, a number of leading economists
such as Fama (1980) and Sargent and Wallace
(1982, 1983) have recently argued in favor of regimes where the money supply is market-determined.
In this respect, Hong Kong provides an interesting example of an economy where there is no central
bank, and where, to the extent possible, central
banking functions are minimized. Thus, it provides
a unique opportunity for ascertaining whether a
market-determined money supply is consistent with
overall macroeconomic stability, particularly stability in the price level.
Section I reviews the real bills doctrine and discusses how it may be feasible in a small open
economy even if it may lead to price instability in a
closed economy. The discussion identifies certain
testable features that distinguish a stable monetary
regime from an unstable one. These features form
the basis for an empirical test on the stability of
Hong Kong's monetary system in a later section.
Section II discusses three key features of Hong
Kong's monetary sector typically believed to influence money creation and monetary control: (I) the
note issuance mechanism under fixed and floating
In our century, it is generally assumed that monetary control exerted by central banks is necessary to
prevent excessive money creation and to achieve
price stability. More recently, in the 1970s, this
assumption is evident in policymakers' concern that
financial innovations have eroded monetary controls. In particular, the proliferation of marketcreated substitutes for money not directly under the
control of monetary authorities has led Phillip
Cagan (1979) to argue for regulatory reform:
New financial developments may make the
past degree of monetary control increasingly
more difficult to maintain. Yet pursuit of
national policies to restrain inflation and stabilize economic activity appears impossible
without effective monetary controls. The
creation of a regulatory environment in which
the erosion of monetary controls is kept to a
minimum is particularly important in the
present period of rampant inflation.
While this statement reflects the mainstream view
today, it has not always been obvious that the
government, rather than the market, should determine the money supply. A market-determined
money supply is traditionally associated with the
long discredited "real bills" doctrine. This doctrine
* Economist,
Federal Reserve Bank of San Francisco. Thanks to Mark Thomas for excellent
research assistance.
17
exchange rates, (2) the interest-setting agreement of
the Hong Kong Association of Banks, and (3) liquidity ratios. Section HI reviews Hong Kong's
macroeconomic performance and includes an
empirical test of the stability of Hong Kong's monetary system under floating exchange rates as well as
a discussion of exchange rate sta15ility.
The paper concludes that allowing the market to
determine the money supply in a small open econ-
I.
Q!tiy may be consistent with price level stability
tlnder either fixed or floating exchange rates, and
that monetary authorities under such conditions
may relax their control over monetary aggregates.
Furthermore, such a prescription may be most
appropriate under a fixed exchange rate regime
since,underfloating rates, Hong Kong was unable
to counteract destabilizing speculation against the
value of its currency.
The Real Bills Doctrine and the Price Level
The Closed Economy
For over two centuries, there was a widespread
belief that price stability could be achieved as long
as banks extended only short-term self-liquidating
loans for business needs. Known as the "real bills
doctrine" , this viewpoint was once so influential it
was a premise underlying the creation of the Federal
Reserve System l .
While John Law first proposed the real bills
doctrine in 1705, the classic statement on this
subject was provided by Adam Smith (1776). Smith
suggested that an appropriate rule for money creation is for each bank to "discount(s) to a merchant a
real bill of exchange drawn by a real creditor upon a
real debtor, and which as soon as it is due, is really
paid by that debtor." In other words, Smith advocated that banks only finance short-term commercial paper arising from real transactions in goods
and services.
The original version of the real bills doctrine
appears to have emphasized short-term commercial
paper linked to real economic activity to ensure that
banks indeed financed only those loans that would
be repaid. By so doing, the doctrine also limited the
quantity of those loans. However, it may not be
necessary to restrict loans to certain types of
activities 2 and to short maturities to guarantee
repayment. Instead, banks may be allowed to
finance any type of activity as long as they can
correctly assess credit risk. This last criterion will
still •satisfy the essential requirements of the real
bills doctrine: that loans respond to the requirements
ofthe market, that they be selected in such a manner
that they will be repaid, and that the volume of loans
be limited. Thus, modem interpretations of the real
bills doctrine, as well as the presentation adopted
here, do not restrict loan supply to short-term commercial paper.
The previous discussion also suggests two possible models of the real bills doctrine. In one model,
the real loan demand is defined in such a manner
that borrowers are assumed always to repay their
loans. In such a case, lenders could seek to accommodate any real loan demand by borrowers3 , and
the real money supply thus passively accommodates
real money demand. Most presentations of the real
bills doctrine4 implicitly make this assumption,
which is equivalent to a monetary regime where a
central bank targets interest rates.
The real bills doctrine may also be modelled by
assuming that banks limit loan supply according to
their perception of default risk. Real loan supply at
any given interest rate therefore will not necessarily
coincide with real loan demand because banks may
ration credit rather than passively accommodate real
credit demand. The result would be a loan and
money supply function that is upward sloping (over
a certain range) in relation to the rate of interest. A
money supply function that is upward sloping in
relation to interest rates also results if one assumes
that .bank operations are characterized by rising
marginal costs. This is the supply function postulated by Patinkin (1965). As shown in the appendix,
the macroeconomic equilibrium of a real bills regime depends significantly on the loan and money
supply process assumed.
Most of its early proponents believed that the real
bills doctrine would suffice to prevent an overissuanceof notes and to maintain a stable price level
because, under the doctrine, real loan supply would
18
rates ,banks may determine the volume of loans and
deposits created on the condition that their liabilities
be fully convertible to gold at a fixed rate. This
condition is sufficient to guarantee that banks will
have to limit the amount of money they create
according to the availability of gold in the domestic
economy. 9
In an open economy, convertibility to gold
implies that the external sector will regulate the
supply of money and the price level. The adjustment
process in such cases is traditionally described by
the classical price specie flow mechanism. An
excess supply of money would tend to raise domestic prices and reduce international competitiveness.
This, in tum, would tend to produce a gold outflow
that would eliminate the excess supply of money
and lower domestic prices until a trade balance is
restored.
In a modem economy, a system analogous to a
gold standard would be one that requires convertibility with some internationally traded asset at a
fixed exchange rate (such as sterling or the U.S.
dollar) and one in which capital mobility, as well as
trade flows, govern the adjustment process. An
excess supply of money in this case would tend to
lower domestic interest rates and thereby create an
incipient capital outflow. In the process ofaccommodating this capital outflow, the banking sector
would supply foreign assets in exchange for its
monetary liabilities at a fixed exchange rate. 10 This
would preserve the fixed exchange rate while eliminating the excess money supply and preventing any
instability in the price level.
Under both the classical gold standard and a
modem economy with fixed exchange rates, a market-determined money supply is well-defined and
self-limiting. Variations in the supply of the internationally traded asset would, however, induce fluctuations in the domestic price level of a modem
economy such as Hong Kong's because the domestic rate of inflation depends on the rate of growth of
the internationally traded asset.
As shown in the appendix, the money supply may
also be self-limiting under flexible exchange rates if
two key assumptions hold: domestic output is not
fully insulated from the external sector, and the real
loan supply - and therefore the real quantity of
money supplied by profit-maximizing banks - is
be limited by real loan demand in the economy. 5
(Alternatively, loan supply may be limited by the
perceived capacity to repay). Loan supply would in
tum limit money creation, since banks concerned
about the valueoftheir monetary liabilities would
seek to ensure that these are not excessive in relation
to the loan assets backing them. The flaw in this
reasoning is that if the nominal value of bank assets
rises with inflation, then banks may also increase
the nominal value of their liabilities, and. create
more money, without penalty.
Critics of the real bills doctrine have emphasized
that while the market limits real loan supply and
real money creation, this does not mean that the
market will successfully limit nominal money supply or the price level. The mistake of the original
exponents of the real bills doctrine was to confuse an
equilibrium in real terms with an equilibrium in
nominal terms. The appendix shows that in a closed
economy, an endogenous or market-determined
money supply may be inconsistent with price level
stability. 6
Another fault of the real bills doctrine, first found
by Henry Thornton (1802), is the possibility of
accelerating inflation under a real bills regime.
Anticipating Wicksell by almost 100 years, Thornton argued that if interest rates were pegged below
the equilibrium there would be a persistent excess
demand for loans. Under the first model of the real
bills doctrine described above, the nominal increase
in loan supply to accommodate this excess demand
would result in an increase in money supply and
prices. The increase in priceswould reduce real loan
and money supply below equilibrium, and lead, in
tum, to a further increase in nominal loan demand
and nominal money. This would set off a process of
continued expansion of loans, money and prices. 7
Notwithstanding these shortcomings, economists in
recent years seeking to address the implications of
unregulated banking have attempted to rehabilitate
the real bills doctrine. 8
The Open Economy
Smith's analysis avoided traditional objections to
the real bills doctrine as the regime he described was
a small open economy following a. gold standard.
Under this system, which closely resembles Hong
Kong's monetary regime under fixed exchange
19
A market-determined money supply under floating rates may lead to price level instability if either
ofthe two key assumptions made above do not hold.
If flexible exchange rates fully insulate the domestic
econorny, the external sector will not stabilize the
domestic price level. Price instability is also possible if banks passively accommodate money demand
rather than limit money supply at any given interest
rate.
Aside from stability in money and prices, policymakers may be concerned with other implications of
an exchange rate regime. For example, in a small
open economy with a high degree of capital mobility, there may be sudden shifts in the demand for
domestic assets. Under fixed exchange rates, these
financial sector shocks can be offset by appropriate
variations in domestic money supply. Under flexible
exchange rates, these shocks are reflected in variations in the value of the currency. For a small
economy where trade represents a large proportion
of gross national product, informational advantages
may favor a fixed exchange rate regime. Furthermore, persistent fluctuations in the value of the
currency may lead to destabilizing speculation. As
we shall see, the last consideration, in particular,
appears to have influenced the choice of an
exchange rate regime in Hong Kong.
positively related to interest rates. Capital mobility
pegs the domestic interest rate to the world rate. This
determines the real money supply. At the same time,
interaction with the external sector determines an
exchange rate and a price level consistent with
money market and goods market equilibrium. Since
the price level is stabilized by the external sector,
bank decisions affecting real loan supply in effect
determine nominal loan supply and nominal money
balances. The reason this prescription does not work
in a closed economy is that a closed economy has no
external sector to regulate the price level.
Comparative statics exercises show that, at the
exchange rate and price level consistent with equilibrium, an excess supply of money would result in
an equilibrating reduction in loans and money
because banks would find that real loan supply
exceeds real loan demand at the prevailing rate of
interest. In contrast, when prices are above equilibrium, the contractionary effects on the trade
balance and aggregate demand would result in equilibrating price reductions. This contrasts sharply
with the unstable Thornton/Wicksell scenario where
money creation leads to price increases, and price
increases lead to further money creation. The distinction is the basis for later empirical tests on the
stability of Hong Kong's monetary regime.
II.
Money and Monetary Control
Note Issuance and Currency Backing
A first step towards understanding the process of
money creation in Hong Kong is to recognize that
government intervention in Hong Kong is generally
believed to be ineffective and harmful to growth. II
This non-interventionist philosophy manifests itself
in a conservative fiscal posture that is justified as a
means of controlling money creation. Hong Kong's
government believes that "the public sector's
impact on the growth of the money supply should,
on the average, be neutral". 12
This philosophy is also apparent in the government's reliance on the market to determine the
money supply. The market works within a framework of three institutional restrictions thought to
influence money creation: the mechanics of note
issuance, the interest rate setting agreement of the
Hong Kong Association of Banks, and required
liquidity ratios. In this section, we review the
implications of these restrictions for price stability.
In a typical central banking regime, the monetary
authorities control the creation of base money,
defined as currency and reserves l 3, by limiting its
availability to private banks. Given the supply of
base money, a money multiplier (a function of the
banks' desired holdings of reserves in relation to
totald~posits and the public's desired ratio of currency to d~posit holdings) will then determine the
total money supply. In a real bills regime, each bank
can either issue its own currency or, on its own
initiative, present some asset it holds to the government in exchange for currency. In contrast to a
regime with a central bank, where the availability of
currency is controlled by the monetary authority, the
amount of currency in a real bills regime is determined by the market, as is the total money supply. 14
Hong Kong's monetary system operates exactly
20
like a real bills regime. Two note-issuing banks
credit the account of a government Exchange Fund
and receive the equivalent amount in Hong Kong
dollar certificates of indebtedness against which
HongKongdoHarnotesm<lY be issued.• The currency issue by the note-issuing banks is thus backed
by the certificates of, indebtedness (CIs) of the
Exchange Fund. Under Hong Kong's monetary system, there are no government monetary liabilities
other than the CIs, so the dornestic monetary base
consists only of currency.
It is worth emphasizing that note issuance occurs
on the initiative of the private note-issuing banks. In
implementing its mandate to "regulate the
exchange value of the Hong Kong dollar," the
Exchange Fund has not resorted to direct manipulation of the monetary base (through such familiar
instruments as open market operations, reserve
requirements, or the discount rate). Instead, it has
allowed the market to determine the money supply
while regulating the terms on which two noteissuing banks issue currency. The basis for note
issuance has varied with the exchange rate regime,
with potential implications for price level stability.
foreign currency deposits for domestic currency
notes and the ratio of vault cash and currency to
deposits. This multiplier is illustrated in the box.
The fixed.exchange rate regime implemented in
Hong Kong is •consistenf\viththeconditions' for
price stability under the real bills regime proposed
by Adam Smith. Domestic notes arefullyconvertible into an internationally traded foreign asset dlle to
100 percent backing. And banks have to lirnit
deposit and money creation to ensure that their
liabilities can be fully converted into foreign currency.
An important difference between Hong K()ng's
Exchange Fund and a typical central bank is that the
former does not actively intervene to achieve .fixed
exchange rates but relies instead on market arbitrage
to do so. If the currency tends to depreciate (as when
there is an excess supply of money), banks would
have an incentive to redeem notes in exchange for
foreign currency at the higher rate offered by the
Exchange Fund, and then sell the foreign currency
at a profit in the market. This process would lead to a
monetary contraction that would preserve the fixed
exchange rate (see example provided in box). Furthermore, this fixed exchange rate mechanism guarantees passive control of the monetary base and
therefore of total money supply. Note issuance is
limited by requiring domestic banks to deposit
foreign assets at a fixed price to back currency
creation.
Fixed Exchange Rates
In Hong Kong's system of money creation, the
Hong Kong dollar has been pegged to the U.S.
dollar since October 1983 and the two note-issuing
banks are required to hold government-issued certificates of indebtedness as backing for their note
issuance. The two banks pay the Exchange Fund in
foreign exchange when they desire to issue new
bank notes at the fixed rate of HK$7.80 per U.S.
dollar for the certificates required as backing for any
increase in note issuance. When bank notes are
withdrawn from circulation and the two banks surrender certificates of indebtedness, the Exchange
Fund pays the banks the equivalent foreign
exchange at the same fixed rate. The sterling standard in force prior to JulY1972 operated in a similar
fashion.
Un,der fixed exchange rates, the total money
supply depends on total foreign currency deposits in
Hong Kong banks - which, in tum, determines the
monetary base - and a money multiplier that is a
function of the extent to which banks convert their
Flexible Exchange Rates
Under the regime in force between July 1972 and
October 1983 - a period largely corresponding to
that of a floating Hong Kong dollar - note-issuing
banks were allowed to issue currency by crediting
the Exchange Fund with the equivalent in Hong
Kong dollar deposits. The Exchange Fund would
then seek to achieve full foreign currency backing of
the currency issue by purchasing foreign assets with
these deposits; it did not require banks to provide the
backing themselves. As a result, during this period,
foreign exchange availability no longer constrained
the ability of the note-issuing banks to expand loan
or money creation. Currency could be created on
dernand by creating a deposit liability in Hong Kong
dollars with the Exchange Fund.
21
22
23
An immediate effect of the 1972 revision was that
domestic monetary issuance by banks need not have
any relationship to the exchange rate set by the
government. When a government pegs the exchange
rate,it will find itself unable to enforce the pegged
rate unless that rate was consistent with the market
equilibrium rate. Independent money creation by
banks could neutralize any effort by the government
to fix the exchange rates. This was the sequence of
events in Hong Kong between July 1972 and
November 1974. The government attempted to peg
the currency to the U.S. dollar only to abandon the
effort because of the limited impact of its intervention. In effect, Hong Kong went into a floating rate
regime by default because it had adopted an institutional arrangement inconsistent with a fixed
exchange rate. As we shall show later, this institutional arrangement would have implications for the
feasibility of stabilizing exchange rates in response
to shocks.
Abandoning the requirement that currency issuance be backed by foreign assets also removed the
self-regulating mechanism that limits the monetary
base under fixed exchange rates. As discussed earlier (and shown formally in the appendix), in a small
open economy such as Hong Kong's, where flexible
exchange rates do not fully insulate the domestic
economy, interaction with the external sector may
nevertheless guarantee price level stability as long
as banks limit the loan and money supply at any
given interest rate.
If these conditions do not hold, money, prices,
and exchange rates in Hong Kong could be indeterminate or unstable. This view is held by a number of
observers of the Hong Kong scene. For example, in
the December 1983 issue of the Asian Monetary
Monitor, John Greenwood remarked:
... Hong Kong's monetary arrangements
(under floating exchange rates) constituted an
indeterminate, metastable equilibrium system. This meant that for any given level of
money supply and prices in Hong Kong, the
exchange rate would adjust to that price level;
alternatively, given any level of the exchange
rate, money supply and domestic prices would
adjust to that exchange rate. IS
omy may guarantee that real money demand equals
real money supply even as the nominal money
supply, prices and exchange rates are indeterminate
or unstable.
Interest-Setting in Hong Kong
Since 1964, banks in Hong Kong have restricted
the interest rates they pay on deposits with maturitiesof less than twelve months to a level determined by the Hong Kong Association of Banks
(HKAB) or its predecessor, the Exchange Banks'
Association. This restriction was designed to prevent the destabilizing interest rate competition
experienced during banking crises in the early
1960s, and was formalized in legislation in 1981
that established the HKAB and empowered it to
require banks to observe the interest rates it established. While this agreement was originally established for prudential reasons, subsequent discussions of its function have focused on the
implications for price stability and monetary control.
Jao (1984) and Fry (1985) assert that the HKAB
set interest rates consistently below the equilibrium
determined by the world market. Given our earlier
discussion of Wicksell and Thornton, it would seem
that such a policy could create the potential for
hyperinflation on the assumption that banks would
set the loan rate as well as the deposit rate below the
market equilibrium. Competition in the loan market
could prevent this from happening. FurthernlOre,
given that the loan rate was in fact set below the
market equilibrium, the Thornton/Wicksell view
also assumes that banks continually seek to accommodate an excess demand for loans. This may not
occur if profit-maximizing banks respond to an
ex<;ess demand for loans by rationing credit rather
than continually raising the nominal loan and
money supply.
There are also indications that the ability of the
HKAB to influence interest rates was limited, particularly as the 1970s progressed, and that it probably had to adjust its interest rates to reflect market
conditions. One reason it may have been forced to
raise rates is that the profitability of Hong Kong's
financial system depends on attracting depositors
who have access to the Euromarket. Hong Kong
banks must therefore pay internationally competitive rates. By affecting the cost of funds in a
Greenwood's reasoning is analogous to the traditional criticism of the real bills doctrine. The econ24
competitive lending environment, the external sector would tend to bring overall Hong Kong interest
rates into line with the world market. equilibrium,
and thereby limit the ability of the HKAB to set
deposit rates that were excessively out ofequilibrium.
Another factor that may have limited the ability of
the HKAB to determine interest rates was the rapid
growth of Deposit Taking Companies (DTCs) in the
1970s. DTCs were financial intermediaries that, up
to 1976, had avo.ided banking restrictions by limiting their business to deposits with maturities in
excess ofthree months. As DTCs were not subject to
the interest rate agreement, they undoubtedly made
it increasingly difficult for the Hong Kong Association of Banks to fix the interest rate. The frequency
with which interest rates were revised suggests that
the DTCs were influential. The HKAB revised its
deposit rates only once, in 1976 when the Deposit
Taking Ordinance was passed. This ordinance
allowed DTC deposits of any maturity but imposed
other restrictions on their operation. In 1980,
however, just before major additional restrictions
were imposed on DTCs, the HKAB revised its
deposit rates 13 times. Thus, while concern about
their inflationary impact was typically associated
with DTCs, DTCs probably helped ensure that
market considerations prevailed in determining
interest rates in Hong Kong. The impact of the
HKAB interest-setting agreement may therefore
have been limited to some distortion of the term
structure of interest rates, and, as in other countries
where restrictions of this kind are imposed, may
have reduced the availability of savings.
The government could use the interest-setting
powers of the HKAB as an instrument for monetary
control to the extent that the HKAB was not limited
by competition to adjusting interest rates passively
in response to market conditions. Variations in the
interest rate could induce desired changes in real
money demand or supply, and affect prices and
exchange rates. However, this approach would not
always work, as the criteria used by the HKAB in
setting interest rates need not be based on macroeconomic considerations.
Furthermore, the government appears to have
been unable to use the interest rate agreement to
achieve certain macroeconomic objectives on certain critical occasions. For example, during the
1982-83 episode in which uncertainty about the
future government of Hong Kong caused the value
ofits currency to plummet, a rise in the rate paid on
Hong Kong dollar deposits could have dampened
th~drop in. the value of the currency. Instead, the
HKAB was reportedly reluctant to raise interest
rates, .and the government was reluctant to insist. 16
Liquidity Ratios
Aside. from the mechanics of note issuance and
the int~rest rate. agreement, the liquid assets ratio
requirement is typically cited as a potential means
for limiting the money supply in Hong Kong. Also
established for prudential, rather than macroeconomic, reasons, this institutional restriction
requires that the ratio of liquid asset holdings
(mostly vault cash and foreign assets, given the
limited amount of marketable government
securities) of banks to deposits exceed twenty-five
percent.
In Hong Kong, this requirement is often believed
to restrict money creation in a manner analogous to
reserve requirements. However, the analogy is
invalid since the market, and not the government,
determines the creation of liquid assets by the
acquisition of foreign currency deposits or the
mechanism of note issuance described previously.
Thus, the liquid assets ratio has not functioned as a
reserve requirement in the sense of requiring banks
to hold liabilities of the government monetary
authority, the supply of which is determined by
policymakers. In particular, base money creation by
banks could nuIIi:ry any effects of liquid assets ratio
requirements. In any case, the government has
altered the liquid assets requirements very infrequently.
It may also be noted that the liquid assets ratio
was not binding on banks, which typically held
liquid assets significantly above the required level.
For example, between 1972 and 1984, the year-end
liquidity ratio of banks averaged well in excess of 40
percent. Up to the early 1980s, deposit-taking companies, which were close competitors of banks,
were not subject to liquid ass~ts ratio requirements.
The weakness of liquidity ratios as instruments
for monetary policy under floating rates is illustrated by the effort of the government to use them to
control money creation at the end of the 1970s. In
February 1979, the government imposed a 100
25
money and price level depends on the process governing note issuance, including the pegged
exchaJ1ge rate arrangement, and that other institutional r~strictions, such as the interest-setting agreementof theHKABor liquid assets ratio requirements, are of limited importance.
Unlike most modern economies, base money
creation in Hong Kong results from the initiative of
two private note-issuing banks whose decisions are
based. on market considerations. The institutional
restrictions on note issuance guarantee that money
creation is self-limiting under fixed exchange rates.
The stability of Hong Kong's monetary system
under floating exchange rates is less obvious. Leading observers believe that the monetary process may
have been unstable, and theory is ambiguous on this
point. A closer look at the empirical evidence is
therefore indicated.
percent liquid assets requirement on deposits of the
Exchange Fund. As a result, note-issuing banks had
to hold either currency or foreign exchange assets
against these deposits.
If the constraint were binding, it would tend to
contract the money multiplier, as the banks' vault
cash to deposit ratio would have to rise. However, it
would not necessarily limit the creation of base
money. As the Hong Kong dollar depreciated, a
fixed amount of foreign assets used to serve the
liquidity requirement could support an increasing
amount of domestic currency creation. That is, the
effectiveness of this policy as a means for controlling the money supply was diluted because the government did not set a price for the Hong Kong dollar
in relation to its foreign currency liquid assets
cover. 17
Our brief review of Hong Kong's monetary regime suggests that the stability of Hong Kong's
m.
Hong Kong's Macroeconomic Performance
Macroeconomic Indicators
One feature of a regime where the money supply
is market-determined is that movements in the
money supply tend to be procyclical. For example,
Ml dropped 5 percent in 1974 and may have contributed to the rise in the unemployment rate to 9.1
percent in 1975. However, the cost of a procyclical
monetary adjustment was offset by a drop in the
inflation rate from 16 percent in 1974 to 1.6 percent
the year after.
Furthermore, flexible real wages have undoubtedly been a major stabilizing influence and reduced
the need for countercyclical monetary policy. For
example, although annual real GDP growth slowed
during the world recessions of 1975 and 1982 (to
2.2 and 2.9 percent, respectively), Hong Kong has
not experienced a GDP decline in at least twenty
years. While the costs to the real sector of Hong
Kong's market-determined monetary regime are not
evident, it is also necessary to investigate whether
the stability of prices and exchange rates was
affected.
As shown in Table 2, Hong Kong's inflation rate
averaged 4.7 percent in the period 1966-1972 when
fixed exchange rates applied. During the period
when Hong Kong's currency floated, the average
inflation rate almost doubled to 9.3 percent, but it
If Hong Kong's monetary system had adverse
effects on its economy, it is not apparent in the
performance of the real sector. Real gross domestic
product (GDP) growth averaged 8.0 percent
between 1966-1972 when exchange rates were
fixed, and 8.5 percent between 1974-1983 when the
Hong Kong dollar was floating. In fact, as shown in
Table I, Hong Kong's economic growth has been
among the highest in the world since the early
1960s.
This remarkable growth is partly attributable to a
competitive labor market that has resulted in a high
degree of real wage flexibility. Between 1974 and
1982, real wage growth averaged only 1.9 percent,
and it fell sharply during certain years. For example,
real wages fell 12 percent following the first international oil price shock in 1974, and 11 percent during
the severe world recession of 1975.
Unemployment data, available on a yearly basis
only since 1975, suggest a satisfactory economic
performance. The unemployment rate averaged 4.4
percent between 1975 and 1983 notwithstanding
periodic surges in the labor force caused by immigration, such as the Y2 million immigrants from the
Chinese mainland between 1978 and 1981.
26
27
remained below that of five of the other six developing countries in the table. Furthermore, it was not
much higher than the inflation rate of the U. S. (8.5
percent) or Japan (7.8 percent).
Aghevli and Khan (1980) surveyed some of the
countries included in Table 2 (Brazil, Colombia,
Dominican Republic and Thailand) and found that
fiscal deficits in those countries lead to destabilizing
monetary accommodation and inflation. Given the
inflationary experience of countries such as Brazil
and Colombia, it would seem that fiscal deficits
represent a greater problem for monetary policy
than does a market-determined money supply.
While Hong Kong's inflationary performance was
clearly satisfactory when compared to other economies during the floating exchange rate period, such
casual observation does not rule out the possibility
that the regime was unstable. After all, the rate of
inflation was much higher during the period of
floating rates, and other factors, such as Hong
Kong's rapid growth, may have disguised the effects
of an unstable monetary regime. A more formal test
is therefore desirable.
national product or inflation. In Hong Kong, the
problem is complicated by two additional considerations. First, until 1981, money supply data did
not distinguish between the Hong Kong dollar and
foreign currency. Second, Hong Kong does not
separate Eurocurrency operations from domestic
financial transactions. As a result, there may be
large movements in the reported money supply that
are unrelated to domestic economic activity and that
would have no inflationary implications.
The measurement error in Hong Kong's monetary
statistics implies that reliable estimates of the effect
money may have on prices are not possible. IS Thus,
while preliminary tests suggest that money has a
very weak influence on prices in Hong Kong - a
result that is consistent with our description of a
stable monetary regime in an open economy - this
result is still open to question.
The measurement error in Hong Kong's monetary
statistics do not preclude estimates of the impact of
prices on money cr~ation. Inflation leading to
money creation is a necessary condition for monetary instability when the money supply is marketdetermined, and we will focus on it here. Furthermore, as the share of Eurocurrency transactions is
much larger for Hong Kong's M2 and M3, tests will
be limited to the effect of prices on MI. One
technique for ascertaining whether prices "cause"
money creation is the test of Granger causality.
Prices are said to "Granger cause" money if past
values of prices improve the forecast of the current
money supply.
There are a number of ways to implement the
Granger test l9 , and two different methods were
attempted here. The first method involved filtering
the monthly series of money and prices for the
period of floating exchange rates to remove trend
and seasonality and to approximate white noise.
Then the cross-correlation of de-trended and deseasonalized money with prices was estimated for
prices lagged backwards and forwards 30 months. A
positive cross-correlation between past prices and
current money supply would indicate that "innovations" in prices lead to "innovations" in money, and
would be consistent with the view that prices
"Granger-cause" money. This procedure is discussed in Pierce and Haugh (1977).
An Empirical Test
Earlier, we noted that in stable monetary regimes,
disturbances to money and prices tend to correct
themselves. In unstable monetary regimes,
however, they do not, so an increase in the money
supply leads to an increase in the price level, and an
increase in the price level leads to a further increase
in the money supply.
If the hypothesis that Hong Kong's monetary
regime under floating rates was unstable were correct, money creation should induce inflation and
price increases should have led to further money
creation after 1972. The Hong Kong government's
conservative fiscal stance permits us to rule out
government deficits as the source of any monetary
accommodation that may be found, and allows us to
focus exclusively on whether the operation of the
private market leads to instability.
Before proceeding with an empirical test, it is
appropriate to remark on certain peculiarities of
Hong Kong's statistics. In modem economies, it has
become increasingly difficult to determine which
monetary aggregate is most related to nominal gross
28
Table 3 reports the results of th!efirst t!eSt. For the
p!eriod January 1973-0ctober 1983, the data failed
to .reject •at .a 10. percent significance kvel·. th!e
hypothesis that the cross-correlation •at 29. lags is
zero. .The • hypothesis of. zero cross-correlation
would be rejected at 17.lags because tbe crosscorrelation betw!een Past prices and current money
exceeds two standard !errors for prices lagged eleven
montbs (witbiacorrelation.coefficientofO.21) and
thirteen months (coefficient - 0.23). As the filtering proceduredidnotJldly su.cceed in "whitening"
the series, these· coefficients probably reflect an
annual seasonal factor. "Causality" of prices to
money therefore cannot be inferred, and even if it
could be, the alternating signs of the coefficients are
ambiguous.
One difficulty with the above procedure is that the
pre-whitening process may remove any evidence of
a relationship between prices and money. As a
result, an alternative test of Granger causality is
reported below. Furthermore, although it was earlier
argued that the imposition of a 100 percent liquid
assets ratio requirement on Exchange Fund deposits
in February 1979 had certain flaws, it may nevertheless have affected the link between prices and
money. Subsequent estimation does not extend
beyond this date.
The second test of Granger causality involved
regressing the logarithm of money supply on its own
past values as wen as past prices lagged 1 to 12
months:
12
Mt
A
+ .2:
J=1
12
Bt-jMt - j
+ .2: Ct - j Pt - j
J=1
If past prices have significant coefficients, then
they .canbesaid to "Granger callse" money. Evidence of GrangercausaIity is a necessaryblltnot
sufficient condition for. instability. in money •afid
prices. Two starting periods were chosen in the
second test: (1) January 1973 was some six months
after domestic currency assets were permitted as a
basis for note issuance. We have argued that tbis is
inconsistent with fixed exchange rates and could
lead to monetary instability. (2) November 1974 was
when Hong Kong abandoned the effort to peg its
currency to the U.S. dollar. After that month, we
can be certain that any systematic effort to back
domestic currency issuance with foreign assets at a
fixed price was abandoned.
The results are shown in Table 4. As can be seen,
no significant relationship, in the Granger sense,
could be established between past prices and current
money supply. The results therefore suggest that
Hong Kong's monetary regime was stable even
during the period of floating rates.
29
Exchange Rate Stability
While Hong Kong's monetary regime under floating exchange rates appeared to be stable (in prices),
the inability of the government to enforce a currency
peg under floating exchange rates could prove
costly.
This is illustrated by the 1982-83 fall in the value
of the Hong Kong dollar caused by uncertainty
about the future of Hong Kong. This uncertainty
provoked a general shift out of Hong Kong dollardenominated assets into foreign currency assets,
and resulted in a drop in the trade-weighted value of
the Hong Kong dollar of 27 percent over 15 months.
Furthermore, it is quite possible that the crisis put
the exchange market on a speculative path, on
which expectations about further declines in the
Hong Kong dollar created further pressure on the
currency and thus tended to be self-fulfilling. In July
1982, when the Hong Kong dollar began its sharp
decline, the annualized rate of depreciation was 7.7
percent. By September 1983 - the last month of
the crisis - the Hong Kong dollar was depreciating
at a 65 percent annual rate. The government was
therefore compelled to take steps to break this
accelerating erosion in the value of the currency. 20
While the Exchange Fund could (and possibly
did) intervene during the 1982-83 crisis by selling
its foreign assets in exchange for Hong Kong dollar
notes, note-issuing banks could fully offset this
intervention by simply printing more notes to
acquire foreign currency assets. 21 As pointed out
previously, the ability of the government to influence interest rates through the interest-setting agree-
ment of the HKAB also appears to have been quite
limited.
Neither the market mechanism nor the weak
instruments available to the government was sufficient to' control the speculation against the Hong
Kong dollar, so the government halted the Hong
Kong dollar's precipitous drop by reforming the
terms of note issuance. On October IS, 1983, it
announced that it would peg the value of the Hong
Kong dollar at 7.8 Hong Kong dollars per U.S.
dollar and once more require the note-issuing banks
to deposit foreign currency assets with the
Exchange Fund to back note issuance.
The immediate result of this policy was that any
further efforts to shift away from the Hong Kong
dollar would contract the domestic money supply to
the point where the supply of Hong Kong money
was brought down to the level demanded. Furthermore, it would restore confidence in the Hong Kong
currency, which now had foreign asset backing at a
fixed price. The peg to a strengthening U.S. dollar
was immediately effective and' has been successfully maintained, with the result that the Hong
Kong dollar has appreciated significantly on a tradeweighted basis since 1983 - reversing the trend of
the preceding five years.
This last episode highlights the risk of a marketdetermined money supply under floating rates. In
the absence of discretionary instruments for monetary control, the requirement that note issuance be
backed by an internationally traded asset at a fixed
price appears to be necessary to offset shocks that
prompt speculative attacks against the currency.
30
IV. Conclusion
Our inability to find results consistent with monetary instability in Hong.Kollg is somewhat surprising given the traditional critique of the real bills
doctrine. The result expected from a real bills regime did not occur for one of two reasons. First,
Hong Kong's monetary regime. may actually not
have satisfied the real bills doctrine. This would be
the case if note-issuing banks did not base theirIoan
decisions only on lllarket considerations but cared
about the price level and behaved as if they were a
modern central bank. Second, proponents of the
real bills doctrine may have been correct in arguing
it would . not result in price indeterminacy or
instability.
The idea that the private note-issuing banks,
particularly Hongkong and Shanghai Bank, acted
like a central bank is appealing. As the major bank
in Hong Kong, Hongkong and Shanghai Bank presumably could be affected by macroeconomic considerations such as price stability. However, decisions based consistently on public policy
considerations could pose insurmountable problems for a bank accountable to its stockholders.
There is no evidence, for example, that the
Hongkong and Shanghai Bank voluntarily con·
tracted note issuance, or that the HKAB sought to
raise interest rates to stabilize exchange rates in
1982-83 .. Instead, the government had to impose a
fixed exchange rate regime that would accomplish
the necessary results.
Our· findings are therefore consistent with the
view that a market-determined money supply in a
Small open economY need not .be associated with
price level instability or indeterminacy. Theysuggest that monetary authorities under circumstances
similar to those in .Hong Kong could successfully
relax their direct control over monetary aggregates.
Casual observation suggests that certain features of
Hong Kong's economy, such as a conservative fiscal
posture and real wage flexibility, may help this
monetary regime work.
However, the exchange rate regime and the
institutional arrangements underlying it also are
important to Hong Kong's monetary regime. Under
the monetary system in force during the period of
floating exchange rates, Hong Kong had essentially
no instruments to prevent destabilizing speculation
against the Hong Kong dollar. It did not control
interest rates or the monetary base, and could not
rely on the market to stabilize the value of the
currency. Only through the current pegged regime
do these problems appear to have been solved. 22
31
ApPENDIX
Formal Treatment of Regimes with An Er'ldogenous Money Supply
where the signs under the arguments correspond to
those of the partial derivatives and
In the case of a classical closed economy, a
regime with an endogenous money supply may be
charllcterized as follows (see Plltinkin 1965, Sargent
1979):
G(y,r) = 0
(M/P)
=
m (r,y)
Goods market
(A. 1.1)
Money market
(A.l.2)
Given output (y), equation A.I.l can determine
the interest rate (r). Equation A.l.2 can determine
combinations of money (M) and prices (P) that
satisfy money market equilibrium. HQwever, since
money supply is endogenous, both nominal money
and the absolute price level are indeterminate.
Loosely speaking, the number of equations is not
sufficient to determine the number of unknowns.
Somewhat less familiar is the applicability of
these conclusions to an open economy with flexible
prices. This may be illustrated in the simplest possible manner by modifying equations A.l.l - A.l.2
to incorporate the effects of the external sector in a
small open economy.
The price level in an open economy depends on
both domestic and foreign prices adjusted for the
exchange rate, that is,
Aggregate Supply
(A. 1.3)
G[y, A(y, rF), B(y, YF' PH/E)] = 0 Goods Market
+ - +
+ - +
(A. 1.4)
(M/P)
=
m(rF' y)
-
+
world rate of interest
y, YF
domestic and foreign output, respectively
A
domestic absorption
B
net exports
Equation A.I.3 applies because exchange rates
affect aggregate supply in an open economy. A
depreciation will raise consumer prices and reduce
labor supply while not affecting labor demand.
Under fixed exchange rates, equation A.l.4 can
determine the combinations of output and home
prices consistent with equilibrium in the goods
market. Equation A.I.3 determines y with fixed
exchange rates, and, given the foreign interest rate
and the home price, it is possible to determine
nominal money supply in equation A.l .5 .
While loan supply is still determined by loan
demand, as was the case in the closed economy
described by equations A.I.I - A.I.2, the problem
of price level indeterminacy does not arise here. The
reason is that an increase in loans, and therefore of
M, will result in an offsetting money supply contraction to maintain the fixed exchange rate. The
fixed exchange rate guarantees a determinate quantity of money. Adam Smith was aware of this result
and, while he subscribed to the real bills doctrine
and a market-determined money supply, he also
would have required banks to ensure that their
monetary liabilities were fully convertible with gold
at a fixed price.
Consider now the case of flexible exchange rates
with an endogenous money supply. The reader may
verify that equations A.I.3 to A.I.5 cannot determine the nominal levels ofM, P or E. This problem
is compounded by the fact that even output is now
indeterminate. Once more, we may loosely say that
there are too many unknowns given the number of
equations. Reducing one plausible unknown does
where PH represents the price of goods produced at
home, E is the domestic currency price of foreign
exchange, and the foreign price is set equal to one.
We may begin by assuming perfect capital mobility as such a case is the easiest to illustrate. Under
fixed exchange rates, the domestic interest rate
equals the foreign rate of interest, and equilibrium is
given by
y = y(E)
rF
Money Market
(A.I.5)
32
Except for Patinkin(1965), most of the literature
uses A.I.5 rather than A.I.6 to model the real bills
doctrine. However, A.I.5 is not necessarily consistent with profit-maximization, and more appropriately describes the behavior of a central bank pegging the interest rate rather than the behavior of
private banks.
A well-defined level of money, prices, and
exchange rates occurs because we have assumed in
equation A.I.3 that the domestic economy is not
fully insulated from the external sector even under
floating rates. If we assumed instead that exchange
rates did not influence the level of output at all, and
that output is fixed, we would once more have a
situation where equation A. 1.4 determines the ratio
PHfE, and equation A.I.6, the ratio MfP. However,
neither the level of M nor P can be determined.
Another problem is that if interest rates were
determined abroad, there would be no reason to
suppose that the money supply given by equation
A.I.6 is consistent with the money demand of
equation A.I.5.
However, it is implausible to assume that the
external sector does not influence domestic activity
in a small open economy like Hong Kong's. Thus, it
is likely that Hong Kong's nominal money and price
level were well-defined even under floating rates.
We may now examine how similar results can be
obtained if we relax the strong assumption that
domestic and foreign assets are perfect substitutes.
A more elaborate framework will also permit us to
analyze the implications of the interest-setting
agreement of the Hong Kong Association of Banks.
Following Tobin and de Macedo (1980), we used
a modified IS-LM approach in which all asset markets satisfy flow as well as stock equilibrium. If we
assume that the government maintains fiscal balance, there are four markets: the market for private
domestic bonds or commercial paper, the market for
foreign bonds, the money market, and the goods
market. By Walras's law, equilibrium in the first
three guarantees equilibrium in the fourth. Thus, we
may characterize the overall equilibrium by:
not solve the problem. For simplicity, assume initially that domestic output is fixed, and insulated
from the external sector so equation A.I.3 does not
apply. Then the reader may verify that equations
A.1.4 and A. L5 can determine the optimal real
money balances but not the nominal quantities M
and P, orE.
The above provides a formal interpretation of a
prevalent view that Hong Kong's monetary regime
under flexible exchange rates was indeterminate. It
also appears to be the rationale for the view of the
Asian Monetary Monitor, quoted in the text.
Equation A.I.5, and equation A.I.2, assume that
real money supply passively adjusts to accommodate real money demand. This is the standard way of
modeling how a real bills regime operates in an
economy with a central bank. It is also an appropriate way of modeling a market-determined money
supply under fixed exchange rates, as it is consistent
with the view that banks exploit any arbitrage
opportunities arising from deviations from the fixed
rate set by the Exchange Fund.
Hong Kong, however, has no central bank to take
the initiative in adjusting money supply, and equation A.I.5 does not appear to portray accurately the
behavior of profit-maximizing banks under a closed
economy or in an open economy with flexible
exchange rates. In particular, under flexible
exchange rates, A.I.5 suggests that the real money
supply always will be set by banks to equal the real
money demand. At any given interest rate, however,
it is more likely that private banks will only be
willing to supply a limited amount ofcredit based on
considerations of cost or default risk. Thus, they
would follow the rule:
MlP = S(r)
(A. 1.6)
+
Substituting S(r) for MfP into A.I.5, it can be seen
that, under floating rates, the behavior of profitmaximizing banks ensures an equilibrium. In particular, A.I.5 and A.I.6 determine the level of
output and, through A.I.3, the exchange rate that
would be consistent with equilibrium. Equation
A.I.4 then determines the prices of home goods and
therefore the price level. This will suffice to determine the nominal money supply.
y
33
= y(E)
Aggregate supply
(A.I.3)
AH(r H, rp, E, y, a)
+
+ +
±
I(rh, y)
1
=
Domestic Bond Market
AF(rH' rp, E, y, a)
+
qH(rH)K
EF -
I
to determine the absolute price level P, and the
nominal money supply M in equation A.l.6. Thus,
ina small open economy with flexible exchange
rates and imperfect capital mobility, the price level,
nominal money supply, and exchange rates are
determinate.
(A.I.7)
=
+
±
HE/PH' y)
Foreign bond market
(A.l.8)
+
m(rH' rp,
y) = M/P
±
Money market
(A.I.9)
+
ImpUc:ations of the Interest-Setting
Agreement
where
rH
domestic interest rate
a
asset preference shift parameter involving the relative desirability of
domestic and foreign bonds
qh
the market valuation of a domestic
bond
K_ 1
the pre-existing capital (or private
domestick bond) stock of foreign
bonds
F_ 1
the pre-existing stock of foreign bonds
A(.)
asset demand
1(.)
investment
TO
trade balance
m(.)
money demand
The HKAB sets the interest rates it pays on
deposits, and this rate-setting may affect the corresponding loan rate. If we assume that the interestsetting agreement of the HKAB were effective in
determining domestic interest rates, there would be
no indeterminacy if banks passively supplied money
according to this interest rate (that is, we could
ignore equation A.l.6). This arrangement is equivalent to a central bank with an interest rate target.
In fact, given such a money supply rule, a fixed
interest rate would be required to obtain a welldefined nominal equilibrium in money, prices, and
exchange rates. Furthermore, this money supply
rule would permit the use of interest rates as a policy
tool.
Consider the 1982-1983 attack on the Hong Kong
dollar which may be described as an effort to shift
from domestic to foreign bonds (a persistent decline
in thea parameter in equations A.I.7 and A.I.8).
Comparative statics analysis reveals that the shift
would lead to an exchange rate depreciation.
Although not explicitly modeled here, if the
depreciation in tum leads to further efforts to shift
away from the Hong Kong dollar, we would have an
unstable process. In contrast, an increase in interest
rates by the HKAB would create an offsetting tendency towards exchange rate appreciation that may
restore stability.
If we more realistically assume that the money
supply function of profit-maximizing banks is
upward sloping with respect to interest rates (equation A.l.6) when exchange rates are floating, the
money market equilibrium could not be guaranteed
unless the Hong Kong Association of Banks sets rH
in such a way as to ensure that money supply equals
money demand. This is not a trivial calculation, and
The arguments of the demand functions and their
signs are generally familiar. The exchange rates
enter to represent capital gains or losses from holding assets denominated in different currencies. If
Hong Kong were a net creditor, the net holding of
foreign assets would be positive and capital gains
obtained from holding assets during a depreciation
would be reflected in a rise in a demand for all
assets. The reverse applies if Hong Kong were a net
debtor.
The domestic interest rate, rH' and output can be
determined by substituting S(r) from A.l.6 into
equation A.!. 9 and using equation A.!. 7. The
corresponding nominal exchange rate follows from
A.l.3, while equation A.l.8 can then determine the
price of home goods. This is sufficient information
34
approaches - do not fully capture the role and
motivation of banks in creating money in an open
economy. For example, it would be desirable to
reconcile A.1.5, which we assumed applies under
fixed exchange rates, with A.l.6, assumed to determine money creation under floating rates. Both
reflect efforts to exploit profit opportunities under
different exchange rate regimes.
Furthennore, in light of the discussion of the
money multiplier in the text, it would be desirable to
spell out explicitly what detennines the proportion
of foreign currency deposits banks will convert for
note issuance under fixed exchange rates. Such
exercises would clarify the process by which a
market-determined money supply in an open economy achieves stability, given the profit-maximizing
behavior of banks. In the meantime, the examples
used serve to illustrate the feasibility of stable,
market-detennined monetary regimes.
the HKAB may set interest rates to create a persistent excess demand for or excess supply of
money.
In the text of this article, we have noted that price
instability may then result in line with Thornton and
Wicksell's reasoning. Thornton and Wick sell ,
however, appear to have been describing a regime
consistent with A.I.5 rather than A.I.6. If equation
A.l.6 applies, banks may ration credit rather than
create money given an excess demand for loans, and
it is not obvious that price instability will necessarily follow. Furthennore, the relative weakness of
the HKAB in a small open economy would favor
price stability. Note, however, that the inability of
the HKAB to detennine interest rates in this regime
would mean that there are no policy instruments
available to offset an attack on the value of the Hong
Kong dollar, as occurred in 1982-83.
One limitation of the discussion in this Appendix
is that the models used - modifications of standard
FOOTNOTES
loosely to refer to either indeterminacy or instability. Patinkin (1965) observed that indeterminacy arises because a
change in prices does not affect the excess demand for
goods in the economy. In particular, because the money
supply is market-determined under a real bills regime, the
equilibrium in the money market applies independently of
the equilibrium in the goods market. This would not be the
case if the money supply were determined by a central
bank that sought to limit the nominal quantity of money.
1. Oneofthe purposes olthe Federal Reserve Act of 1913,
according to its introduction, is "to furnish an elastic currency, (and) to afford means of rediscounting commercial
paper". In line with this, Section 13 of the Act states that
Federal Reserve Banks "may discount notes, drafts and
bills of exchange arising out of actual commercial transactions; that is, notes, drafts and bills of exchange issued or
drawn for agricultural, industrial or commercial purposes ... " Note the similarity of this concept to Adam
Smith's definition of the real bills doctrine, quoted in the
next paragraph of the text of this article.
7. The dynamic instability of a real bills regime has been
succinctly described in a recent paper by Thomas
Humphrey (1982), who showed that it may be associated
with hyperinflation, hyperdeflation or an indeterminate
price level.
2. For example, the Federal Reserve Act sought to enforce
application of the real bills doctrine according to this
narrow concept by forbidding the discount of "notes,
drafts or bills covering merely investments or issued or
drawn for the purpose of carrying or trading in stocks
bonds or other investment securities, except bonds and
notes of the government of the United States".
8. For example, Fama (1980) solves the problem of price
stability by suggesting that the chosen numeraire be one
with a value that does not depend on the volume of
deposits outstanding in the financial sector. Sargent and
Wallace (1982) suggest that a real bills regime has certain
welfare properties that make it in some sense superior to a
regime with "quantity theory" restrictions consistent with
price level stability. While not endorsing the real bills
doctrine, McCallum (1984) shows conditions under which
it may be consistent with price level stability.
3. Whether banks would succeed in accommodating real
loan demand would depend on the real savings resources
available in the economy. If at a given interest rate, the real
savings resources are less than the demand for loans, the
effort to accommodate loans may lead to the price
instability described by Thornton and Wicksell, and discussed later in the text.
9. The description of the operation of the gold standard in
an open economy is attributed to Hume. However, Laidler
(1981) observes that Hume had little to say about the
operation of the financial sector under a gold standard. It
was Adam Smith who first pointed out that full convertibility
of the monetary liabilities of banks with gold was required
to prevent note overissuance. He also recognized that any
excess supply of money would" spill over" into the external
sector.
4. Sargent (1979) and McCallum (1984).
5. This view was not necessarily shared by Adam Smith,
however. See Laidler (1981) and the discussion of the
open economy under fixed exchange rates which follows.
6. As shown in the Appendix, the problem is that the level
of nominal money balances and the price level become
indeterminate. As this concept is less familiar than that of
instability, in the text the term "instability" will be used
35
10. The equilibrium of this system is described in the
simplest terms in the Appendix, using the flexible price
version of the Mundell-Fleming model.
18. Technically, the measurement error in the money
series implies that when used as an explanatory variable
for prices, it is correlated with the error term. This "errors in
variables" problem implies that the estimated coefficient
on money would be inconsistent.
11. This is a traditional government viewpoint, according
to a former Financial Secretary. See Philip Haddon-Cave
(1984).
19. Sims (1972) and Haugh and Pierce (1977).
20. The exchange rate drop was precipitated by a crash in
the real estate market that reduced the loan collateral of
banks and consequently their net worth. Beers, Sargent
and Wallace (1983) present the intriguing hypothesis that
the government may have allowed the exchange rate to
depreciate to reduce the Hong Kong dollar deposit liabilities of banks and thus to improve their balance sheets.
12. Philip Haddon-Cave (1984). As a result of this fiscal
conservatism, Hong Kong had no marketable government
debt outstanding in 1982.
13. Wallace (1983) argues that reserve requirements
would also be necessary to ensure that banks hold the
currency liabilities of the government. However, if hand-tohand currency were legal tender and the circulation of
foreign notes forbidden, as it is in Hong Kong, these
conditions may suffice to create a demand for the legal
tender. For a related discussion, see Keeley and Furlong's
paper in this issue of the Economic Review, and Fama
(1983).
Ketkar and Sweet (1984) discuss the balance sheet structure under which a depreciation will actually benefit banks,
and suggest there is an optimal rate of depreciation (or
appreciation) depending on the particular balance sheet
structure of banks. As a general point, it should also be
noted that, to benefit from a depreciation, the foreign
assets of banks should exceed their foreign liabilities. In
this way, their wealth increases from capital gains induced
by a depreciation (see discussion of the Tobin-de Macedo
model in the Appendix).
14. This of course does not preclude a central bank from
following a policy that accommodates the market demand
for money by targetting exchange rates or interest rates.
However, it is still the central bank rather than the private
sector that retains the initiative for money creation in this
case.
Although it is not clear that the balance sheet structure of
banks in Hong Kong would have benefited from a
depreciation in 1982-1983, the Beers, Sargent and Wallace argument highlights the potential use of exchange
rate policy to satisfy certain objectives in the financial
sector. This novel point raises many interesting questions
for policy, but our discussion suggests that during the
period of floating rates, the Hong Kong government simply
did not have the instruments to conduct a deliberate
exchange rate policy of the sort described by Beers,
Sargent and Wallace.
15. Using a different framework, Beers, Sargent and Wallace have argued that the exchange rate was indeterminate in Hong Kong during the period of floating rates.
Exchange rates could also be indeterminate under floating
rates if Hong Kong money and foreign money were perfect
substitutes, as shown by Kareken and Wallace (1981) in
the context of an overlapping generations model. Maxwell
Fry (1985) has also arqued that Hong Kong's monetary
regime in the floating rate period was unstable. Our general description of Hong Kong's monetary system under
fixed and floating rates is closer to that of the Asian
Monetary Monitor.
21. In fact, note-issuing banks could speculate against
the value of the currency by increasing the rate of note
issuance to purchase foreign assets. The data on currency
creation during 1982-1983 suggest that this did not happen at the time of the attack on the Hong Kong dollar, but in
principle, this could be a destabilizing sour~e of note
issuance.
16. Asian Monetary Monitor, Vol. 7, NO.6.
17. A similar problem applied to the objective of the
Exchange Fund of maintaining full foreign asset backing of
note issuance. Under floating exchange rates, it is not
clear what "full backing" means, since a fixed amount of
foreign assets may "back" an increasing quantity of note
issuance as the currency depreciates. Thus, the "backing"
would not limit note issuance under floating rates, and, as
argued in the text, would not be effective in pegging the
exchange rate because note issuance would not be limited
by the availability of foreign exchange assets.
22. This is nollo say that a fixed exchange rate regime has
no disadvantages. It is not obvious that pegging to a
strongly appreciating currency such as the U.S. dollar was
the best course. Furthermore, Hong Kong's money creation and domestic inflation rate are particularly vulnerable
to external disturbances under this regime.
In contrast, under fixed exchange rates, the Hong Kong
dollar is fully backed in the sense that at the rate set by the
government, the Exchange Fund always has enough foreign currency assets to redeem on demand any quantity of
Hong Kong dollar notes in circulation. The fact that Hong
Kong dollar note issuance is limited by foreign asset
availability at the fixed rate ensures that the currency peg is
enforceable.
36
REFERENCES
Aghevli, B.B. and Khan M.S. "Government Deficits and the
Inflationary Process in Developing Countries" in Warren L. Coats and Deena R. Khatkhate, eds. Money and
Monetary Policy in Less Developed Countries. Pergamon Press, 1980.
Asian Monetary Monitor. Various issues. Hong Kong.
Beers, David T., Thomas J. Sargent and Neil Wallace.
"Speculations about Speculation Against the Hong
Kongpollar." Federal Reserve Bank of Minneapolis.
Quarterly Review, 1983.
Cagan, Philiip in William Fellner, ed. Contemporary Economic Problems. Washington, D.C.: American Enterprise Institute for Public Policy Research, 1979.
Chen, Edward K.Y. "The Economic Setting" in Lethbridge,
D. The Business Environment in Hong Kong. Hong
Kong: Oxford University Press, 2nd ed., 1984.
Dale, Richard. "Regulating the Euromarkets." The Regulation of International Banking. Cambridge: WoodheadFaulkner, 1984.
Fama, Eugene F. "Banking in the Theory of Finance."
Journal of Monetary Economics 6, January, 1980.
Fama, Eugene F. "Financial Intermediation and Price Level
Control," Journal of Monetary Economics 12, 1983.
Fry, Maxwell J. "Financial Structure, Monetary Policy and
Economic Growth in Hong Kong, Singapore, Taiwan
and South Korea. 1960-1983" in A. Krueger, V. Corbo,
and F. Orso, eds. Export Oriented Development Strategies. Colorado: Westview Press, 1985.
Haddon-Cave, Sir Philip. "Introduction" in Lethbridge, D.
The Business Environment in Hong Kong. Hong Kong:
Oxford University Press, 2nd ed., 1984.
Haugh, Larry D. and David A. Pierce. "Causality in Temporal Systems: Characterizations and a Survey." Journal of Econometrics 5, 1977.
Humphrey, Thomas M. "The Real Bills Doctrine." Economic Review, Federal Reserve Bank of Richmond,
September/October 1982.
Hong Kong Monthly Digest of Statistics. Various issues.
Hong Kong: Census and Statistics Department.
Jao, Y.C. "I;-. Libertarian Approach to Monetary Theory and
Policy," Hong Kong Economic Papers No. 15, Hong
Kong Economic Association, 1984.
Jao, Y.C. Banking and Currency in Hong Kong. London:
The MacMillan Press, 1974.
Jao, Y.C. and Lee, S.Y. Financial Structures and Monetary
Policies in Southeast Asia. New York: St. Martin's
Press, 1982.
Jao, Y.C. "The Financial Structure" in Lethbridge, D. The
Business Environment in Hong Kong. Hong Kong:
Oxford University Press, 2nd ed., 1984.
Kareken, John and Neil Wallace. "On the Indeterminacy of
Equilibrium Exchange Rates," Quarterly Journal of
Economics, Vol. 96, No.2, May, 1981.
Ketkar, Suhas and Lawrence M. Sweet. "Speculations
Aboul$peculation Against the Hong Kong Dollar - A
Comment." Manuscript, 1984.
Laidler, David. "Adam Smith as a Monetary Economist,"
The Canadian Journal of Economics. Vol. XIV, No.2,
May, 1981.
Lethbridge, David G. The Business Environment in Hong
Kong. Hong Kong: Oxford University Press, 2nd ed.,
1984.
McCallum, Bennett T. "Some Issues Concerning Interest
Rate Pegging, Price Level Determinacy, and the Real
Bills Doctrine." Working Paper No. 1294. Massachusetts: National Bureau of Economic Research, Inc.,
1984.
McCarthy, Ian S. "Financial System of Hong Kong" in
Robert C. Effros, ed., Financial Centers, Legal and
Institutional Framework, International Monetary Fund,
1982.
Patinkin, Don. "Money, Interest and Prices," An Integration
of Monetary and Value Theory. New York: Harper and
Row, 2nd ed., 1965.
Sargent, Thomas J. Macroeconomic Theory. New York:
Academic Press. 1979.
Sargent, Thomas J. and Neil Wallace. "Rational Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule," Journal of Political Economy
Vol. 83, 1975.
Sargent, Thomas J. and Neil Wallace. "The Real-Bills
Doctrine versus the Quantity Theory: A Reconsideration," Journal of Political Economy Vol. 90, No.6, 1982.
Sims, Christopher. "Money, Income and Causality," American Economic ReView, Vol. 62, No.4, 1972.
Smith, Adam. An Inquiry into the Nature and Causes of the
Wealth of Nations, London 1776. Reprinted. New
York: Random House, 1937.
Thornton, Henry. An Enquiry into the Nature and Effects of
Paper Credit of Great Britain. Reprinted in 1939.
London: London School of Economics.
Tobin, J. and J. Braga de Macedo. "The Short-Run Macroeconomics of Floating Exchange Rates: An Exposition" in John Chipman and C. Kindleberger, Flexible
Exchange Rates and the Balance of Payments. North
Holland, 1980.
Wallace, Neil. "A Legal Restriction Theory of the Demand
for 'Money' and the Role of Monetary Policy," Quarterly Review. Federal Reserve Bank of Minneapolis,
Winter, 1983.
37
Brian Motley and Robert H. Rasche'"
This paper develops two alternative procedures for making short-term
predictions of the M 1 money stock and compares their forecasting
peiformance over the periodfrom 1981 to 1984. Theftrst procedure is the
Rasche-Johannes money multiplier approach while the second involves
the simulation ofa structural model ofthe money market developed at the
Federal Reserve Bank of San Francisco. Although the money market
model provided better forecasts in 1983 and 1984, neither model is
clearly dominant over the other. However, the relatively large forecast
errors of both models suggest that the Federal Reserve's ability to "ftnetune" the money stock in the short run is very limited.
outstanding. The central bank can, however, affect
the money stock indirectly, through its influence
over both the public's demand to hold money and
the private banking system's ability and willingness
to supply checking accounts.
Depository institutions are required to hold
reserves equal to specified proportions of certain of
their deposit liabilities, and the supply of these
reserves is controlled by the Federal Reserve. When
the Federal Reserve's Trading Desk buys securities
in the open market, it increases the quantity of bank
reserves because the transaction is settled by crediting the reserve account the seller's bank maintains at
its Federal Reserve Bank. Similarly, when the central bank lowers the discount rate it charges for
short-term borrowing by private depository institutions, the lower rate will tend, everything else being
equal, to lead to a greater volume of such borrowing
and thus, to a larger stock of bank reserves. Both
ways of increasing the supply of reserves not only
add to the quantity of deposit liabilities that the
private banking system is able to supply but also,
because they cause short-term interest rates to fall,
increase the amount of M I that the public demands
to hold.
During the last ten years, and especially in the
period from October 1979 to October 1982, the
Federal Reserve System has stated its policy objectives in terms of the growth rates of monetary
aggregates. During most of this time, the principal
emphasis has been on M 1, which consists of the
public's holdings of currency and checking
accounts, and thus represents a measure of the stock
of "transactions money" outstanding. Since variations in the growth of M 1 have been found historically to be closely related to variations in the
growth of nominal GNP, the Federal Reserve has
sought to affect the course of output and prices by
influencing the growth of this aggregate.
Since the bulk of MI consists of checking
accounts, which are the liabilities of private depository institutions, the Federal Reserve cannot
directly control the stock of t~ansactions money
* The authors are Senior Economist, Federal
Reserve Bank of San Francisco and Professor of
Economics, Michigan State University, respectively. Kenneth Khang and David Taylor provided
able research assistance.
38
The effects on Ml growth of changes in interest
rates and the supply of bank reserves do not occur
instantaneously. Instead, theytlmd to be spread over
a period of several months in a pattern that cannot be
predicted precisely. As a result, close short-run
control of the stock of M 1, such as was attempted in
the 1979-82 period, requires the Federal Reserve
continually to forecast the likely course of Ml
growth in the weeks and months ahead. When the
forecast indicates that Ml is likely to deviate from
the target set by the Federal Open Market Committee (FOMC), the Trading Desk must adjust the
supply of reserves with a view to bringing the
aggregate back toward target. Thus, the success of
policymakers in controlling Ml growth depends
heavily on their ability to make accurate short-run
forecasts.
Closer short-run control of the money stock after
October 1979 was generally expected to make interest rates more variable (because the central bank
would no longer accommodate short-run shocks to
financial markets), and M 1 growth less variable. In
fact, although the Federal Reserve was "controlling" Ml, the aggregate remained volatile, and
unanticipated month-to-month fluctuations in its
growth rate continued.
The fact that control of M1 is necessarily indirect
and requires the use of forecasts suggests one reason) for this (at the time) surprising outcome. If the
Federal Reserve cannot forecast M 1 well enough to
choose the correct settings of the discount rate and
the stock of reserves needed to keep Ml close to its
short-run targets, the central bank may destabilize
the aggregate as it tries to control it.
It must be recognized, however, that while the
ability to make good forecasts of M 1 is necessary to
the successful short-run control of the aggregate, it
is not sufficient. Successful short-run control also
depends on the operating instrument the Federal
Reserve chooses to use. For an exhaustive discussion of various instruments, see David Lindsey and
others (1981).
This paper seeks to throw light on the relationship
between forecasts of M 1 and short-run control of the
monetary aggregate. It studies two methods for
forecasting and compares their respective 3months-ahead forecasting performance over the
period from 1981 to 1984.2 One model is a reduced
form, money multiplier model; the other is a struc-
tural model of the supply of and demand for bank
reserves and the principal monetary aggregates.
Both models have been used in the past for
predicting MI. 3 The first is a variant of the moneymUltiplier component model that was developed by
Johannes and Rasche (1979, 1981). That model is
employed regularly by Rasche to develop forecasts
ofMl as background for deliberations of the
"Sha.dow" Open Market Committee - a group of
private economists who meet periodically to discuss
th~ Federal Reserve's monetary policy. The second
model is the San Francisco Money Market Model,
developed by Judd and Scadding (1981, 1982,
1984), that is used regularly by the staff ofthe San
Francisco Federal Reserve Bank to make short-run
forecasts ofthe monetary aggregates and to examine
the likely effect of alternative policy actions.
For each of the four years 1981 to 1984, we
estimated each model using data extending through
December of the preceding year. In the case of the
monetary aggregates and reserves series, we used
the data actually available at the time. 4 For income
and prices, we used the data available now (September 1985) since complete historical series were not
easily accessible. Data on interest rates are never
revised. Each estimated model for each of the four
sample periods was then used to make four separate
three-months-ahead forecasts of Ml in the year
following the end of the sample period with information through December, March, June, and September, respectively. Thus, for each model, sixteen
separate 3-months-ahead forecasts ofMl were constructed.
For each 3-months-ahead forecast, we used the
reserves and monetary aggregates data actually
available at the beginning of the period to which the
forecast refers. For example, in projecting Ml
growth over the three months from June to September 1983, we assumed that the forecaster was able to
use the revised money stock data through December
1982 published in February 1983 and the preliminary data for January-June 1983 published monthly
over that period. The former set of data was used to
estimate the parameters of the two models, whereas
the latter was used as the base for simulating the
models.
The resulting forecasts were compared both with
the preliminary actual data published immediately
after each 3-month forecast period and with the
39
discussed in the second last section. Our calculations show that the money market model would have
provided more accurate M1 forecasts over the
1981-84 period, but that the errors from both models were sufficiently large to make close short-run
control of Ml growth by the central bank quite
difficult. The final section of the paper summarizes
our results and offers some concluding comments.
revised data issued at the beginning of the succeeding year. Their accuracy was measured by examining the forecast errors both over each year and over
the four years as a whole.
The next section of the paper outlines the principal features of the two models used in our forecasting experiments. Sections II and III describe the
estimation and simulation of each model in detail.
The simulation results are set out in Tables 3-5 and
I.
The Models
In the multiplier component approach of
Johannes and Rasche, the stock ofMl is modeled as
the product of a money multiplier and a reserve
aggregate:
Ml = m· R
tl
According to this decomposition, all changes in Ml
reflect changes either in the reserve aggregate assumed to be under actual or potential Federal
Reserve control - or in the money multiplier. In a
1981 contribution, Johannes and Rasche argued that
the multiplier may be forecasted with sufficient
accuracy to make it possible for the Federal Reserve
to control the growth of Ml quite closely over
periods of six months to a year.
In this paper's version of the model, the reserve
aggregate employed is the stock of nonborrowed
reserves, adjusted for changes in reserve requirements, plus the quantity of extended-credit borrowings from Federal Reserve Banks. This is the reserve
aggregate used by the Federal Reserve as its shortrun operating instrument in the period from October
1979 to October 1982. Using this reserve aggregate,
the money multiplier is defined as
t2
m
= __l_+_k-'.(_l_+_t.:.;:.c,,-)__
rb(l + t l + t2 + g + z)
g
z
An ARIMA model was estimated for each of
these component ratios for each of four overlapping
sample periods ending in December 1980 to
December 1983. That is, each component was modeled a<; a linear function of its own past values.
These estimated models then were used to generate
3-months ahead forecasts of the components and
thus of the complete multiplier. The stock of nonborrowed reserves plus extended credit was treated as
exogenously determined by the Federal Reserve.
Although the components of the money multiplier are influenced by the behavior of the non-bank
public (which largely determines k, t l , t2 and tc), the
"spirit" of the multiplier approach is that changes in
the stock ofMl are caused mainly by changes in the
quantity of reserves available to the banking system
to support transactions deposits, and thus, that the
stock ofMl is determined primarily from the supply
side.
The second model used in the forecasting experiment, the San Francisco Money Market Model, is a
structural model that describes the behavior of the
(2)
where
k
tc
rb
ments) plus extended credit borrowings
to total deposits (M3 + government
deposits + foreign deposits - currency
- nonbank travelers checks).
the ratio of the difference between M2
and Ml to transactions deposits
the ratio of the difference between M3
and M2 to transactions deposits
the ratio of U.S. government deposits at
commercial banks to transactions
deposits
the ratio of fdreign deposits at commercial banks to transactions deposits
the ratio of the currency component of
M1 to the transactions deposit component
the ratio of nonbank travelers checks to
the currency component of Ml (for
1982-84 only).
the ratio of nonborrowed reserves
(adjusted for changes in reserve require-
40
public, the banking system and the Federal Reserve
in the markets for money, reserves and bank credit.
A unique feature of this model is that M I is viewed
as serving a "buffer-stock" function in the public's
asset portfolio. In the short-run, the public is
assumed passively to accept at least part of any
changes in the supply of money brought about by
variations in the quantity of bank credit outstanding.
Suppose, for example, there were an increase in the
public's demand for loans which the banking system
accommodates. The model posits that the public
will hold a portion of the resulting rise in the supply
of money temporarily without a change in interest
rates (see Judd 1984), even though there has been no
permanent increase in its demand to hold money
balances. The public's willingness to hold "extra"
money is due to the transactions costs associated
with adjusting money balances quickly to desired
levels. Also, although individual transactors can
alter their money holdings by varying their rate of
spending on goods and services, the nonbank public
as a group cannot do so.
The San Francisco model may be used to generate
forecasts of M1 growth under a variety of alternative
assumptions about the Federal Reserve's short-run
operating procedure. In most recent years, the
Federal Reserve's short-run policy - although
seeking to keep M 1 growth within an annual target
range - has generally been concerned with influencing money market conditions rather than closely
controlling bank reserves or money on a month-tomonth basis. This certainly was true prior to October 1979, when the Federal Open Market Committee (FOMC) directed the Trading Desk to keep the
federal funds rate within a very narrow range
through manipulating the supply of reserves. It also
has been largely true since October 1982, when the
II.
operating instrument has been the level of borrowed
reserves. (The current operating procedure is
described in Wallich, 1984.) As Motley and Bisignano noted recently (1985), the use of discount
window borrowing as the System's short-run operating objective is similar to a funds rate control
procedure because it requires short-run variations in
the banking system's demand for reserves to be
accommodated by variations in the supply of nonborrowed reserves. This means that shocks to the
reserves market are not permitted to affect the funds
rate.
Between October 6, 1979 and the fall of 1982, the
Federal Reserve's operating instrument was the supply of nonborrowed reserves rather than the federal
funds rate. However, given its short-run money
stock objectives, the Federal Reserve did not choose
its target for nonborrowed reserves by projecting the
money multiplier from its own past values as the
Rasche-Johannes procedure would have recommended (see Rasche-Johannes, 1981). Instead, the
Federal Reserve believed that changes in the supply
of nonborrowed reserves affected the money stock
through changing interest rates, and thus altering
the underlying demand to hold transactions money.
The nonborrowed reserves procedure therefore was
similar in many ways to one in which the Federal
Reserve varied the funds rate to attain its money
stock objectives.
These considerations led us to treat the federal
funds rate as exogenous in all the forecasting experiments with the San Francisco model. In effect, the
federal funds rate that emerged in any given month
was assumed to be the rate which the Federal
Reserve believed at the time was required to attain
its short-run Ml targets
Estimating and Forecasting with the Multiplier Model
To forecast M 1 with the money multiplier
approach requires the use of separate forecasts of
each of the component ratios that make up the
multiplier expression in equation 2. These forecasts
were provided by dynamic simulations of an estimated ARIMA model for each component ratio.
Each of the estimation sample periods for these
models started in January 1971 and extended
through the December of the year prior to that being
forecast. We used the same specifications of the
ARIMA models for all of the estimation periods.
Results from various subsequent diagnostic tests of
the estimated equations supported this procedure by
indicating that the structure of the models did not
change. The parameter estimates for each of the
samples are given in Table 1.
In addition to the parameter estimates indicated
in Table 1, dummy variables were included in the
41
42
estimating equations for k, t j , tb g and z for the
sample periods ending in December 1981 through
December 1983. These dummy variables allowed
for the introduction of nationwide NOW accounts in
1981. At the time, that institutional change
was judged to have induced many holders of passbook savings accounts and other small time
deposits, which are included in M2 but not in Ml, to
consolidate their transactions
into
a single NOW account. This consolidation would
have raised the level of transaction deposits permanently and the growth rate of those deposits temporarily as the process was proceeding. These
changes would, in turn, have affected the levels and
growth rate of k, t l , t2 , g and z. During 1981, the
Federal Reserve published estimates of "shiftadjusted MIB"6 that excluded that portion of the
NOW account total judged at the time to represent
funds transferred from savings accounts. A detailed
discussion of this adjustment of the data is given in
Bennett (1982). These estimates suggest that the
consolidation of funds was largely complete by
mid-1981.
The coefficients on the dummy variables in the
fitted equations for k, t j , t2 , g and z were not
estimated jointly with the other parameters. They
were chosen to approximate the effect on the component ratios of a shift into NOW accounts from
deposits outside M1 of the magnitude represented
by the difference between total and shift-adjusted
Ml as published at the time. Although the coefficients on the dummy variables do not capture the
exact month-to-month behavior of the difference
between actual and shift-adjusted Ml, they do
represent the general trend in that difference. In
particular, they include the assumption that the shift
of funds into NOW accounts (and thus its effect on
the ratios) was
mid-1981. The same
adjustment was imposed on each of the various
component models. The experience here, as with
earlier adjustments of this form, is that the ARIMA
coefficients remain stable once this adjustment is
made. Our use of the dummy variable approach
causes no problems for ex ante forecasts for 1982-84
since the coefficients on these variables were constructed with data publicly available in 1981.
Ex ante forecasts for 1981 raise other difficulties.
At the end of 1980, there was no finn infonnation
available to measure the effect of nationwide NOW
accounts on the various monetary aggregates. Our
approach here was to regard the multiplier models
estimated through the end of 1980 as appropriate for
forecasting the levels of shift-adjusted MIB during
1981. Shift-adjusted M 1B was the aggregate the
Federal Reserve used to guide its policy decisions
during most of that year. However, since the portfolio shift that necessitated the adjustment in the
essentially completed by the middle
of 1981, the growth rate of unadjusted M1B in the
second half of that year was close to the growth rate
of shift-adjusted MlB. Thus, as far as growth rates
are concerned, the forecasts for the second half of
1981 may be viewed as predictions either of
adjusted or of unadjusted MlB.
In examining the errors in the forecasts for 1981 ,
we compared the forecasted values with the published estimates of shift-adjusted MIB. It must be
recognized, however, that any evaluation of model
forecasts for 1981 is problematic. 7 The shift-adjustments to the data were made on the basis of estimates by the Board of Governors staff of the extent
to which the introduction of NOW accounts would
cause the public to consolidate their savings and
transactions. Hence, the accuracy of the Board
staff's estimates, and thus the shift adjustments
applied to the data, affected the model forecasting
errors in 1981. Yet even with the benefit of
hindsight, it is impossible to measure the extent of
portfolio shifts precisely since the composition of a
NOW account between transactions and savings
funds is known only to the accountholder.
One other modification was made to the multiplier model before using it to forecast Ml growth in
1981. Preliminary simulations of the ARIMA equations produced particularly large prediction errors in
the first half of that year. In an earlier paper,
Johannes and Rasche (1981, p. 305) found that the
forecasting accuracy of their multiplier model deteriorated sharply in 1980 and that this deterioration
was largely attributable to errors associated with the
imposition of credit controls in March of that year.
Examination of the "within-sample" residuals from
the estimated ARIMA models in Table 1 revealed
that the equation describing the ratio of non-borrowed reserves to total deposits (rb) significantly
(relative to the standard error) underestimated this
ratio in April and May of 1980.
Although the earliest forecasting experiment in
43
this study was for 1981 , the structure of the ARIMA
model for the rb ratio implies that errors in AprilM;ly 1980 wouJd h;lve significantly affected the M 1forecasts for those same months of 1981 if, as seems
possible,the 1980el'rors were the result Ofa uriique
event associated with the imposition and later
removal ofcredit controls and thus not repeated in
1981.A detailed discussion of this issue has been
placed in an Apperidix.Toprevent the fOrecasts of
Ml in 1981 from being contaminated by the 1980
experiencew.ithcredit controls, the ARIMA equation reported in Table 1 for the rb ratio in the sample
period ending in December 1980 was modified to
include dummy variables for March-May 1980. The
result was a significant reduction of the money
multiplier model's errors in the first half of 1981.
The effect of changes in legal reserve requirements on the time series of adjusted nonborrowed
reserves posed a further problem. Each time there is
a change in legal reserve requirements (about twice
a year under the phase-in of the new requirements
mandated by the Monetary Control Act of 1980),
the procedure used in constructing adjusted nonborrowed reserves requires the entire history of the
series to be reconstructed. This is a problem in
principle for the forecasting of the rb ratio since it
means that the historical data used to estimate the
ARIMA model for rb through the end of the preceding year may be different from those available at the
time of the forecast. In practice, the problem is not
serious since the rb model in Table 1 (along with all
other component models) is a model of the rate of
change of rb rather than of its level. Adjustments to
the history of the nonborrowed reserves series when
reserve requirements change are fundamentally
adjustments to the level of the series that preserve
rates of change. The component model therefore
should remain valid even if the data are adjusted for
a change in reserve requirements between the end of
the estimation period and the beginning of the
forecasting period.
For each of the four sets of estimated coefficients
in Table 1, four sets of three-month ahead forecasts
of the component ratios were constructed for the
year following the end of the estimation period.
These • foursetsofforecastswere fotDecemberMarch, March-June, June-September,and September-December. The forecasts of the component
ratios can be· combined to produce forecasts of the
not-seasofldlly-adjustedrioribOrrOwed reserves multiplierusing the formula in equation 2. However,
since the . desired output of the iorecastingexperiment is seasonally adjusted M 1, equation 2 must be
modified to yield a forecast of the multiplier .connecting seasonally adjusted Ml and nonborrowed
reserves not seasonally adjusted. This modification
was made using the seasonal factors that were published at the beginning of each year for the components of the monetary aggregates. If Sd, Sk and Stc are
the seasonal factors for transactions deposits, currency and travelers checks, respectively, the forecast
of the multiplier connecting seasonally adjusted Ml
and not-seasonally-adjusted nonborrowed reserves
is:
_l_+l+ktc
(3)
m = _Sd=:---,_-:S..:;k_ _S...;.tc=-_
rbO HI +tz + g+ z)
where m represents the forecasted value of the
seasonally adjusted multiplier, and R, t l , tz, g, z; rb
and tc represent the forecasted values of the multiplier components from the individual ARIMA models. s
Finally, the forecasts of seasonally adjusted MI
are constructed by multiplying the computed values
of the multiplier, m, from equation 3 by the notseasonally-adjusted values of nonborrowed reserves
plus extended credit in the forecast period. 9
44
III.
Estimation and Forecasting with the Money Market MOdel
The San Francisco money market model is a
structural model of the supply of and demand for the
monetary aggreg;ates. A full description of the versionof the model used in this paper is provided in
Judd (1984). Given projections of personal income,
prices, the discount rate and the federal funds rate,
dynamic simulation of this model yields forecasts of
M1, M2, various other short-term interest rates, and
the stocks of bank loans and of borrowed and
nonborrowed reserves. 1O
As with the multiplier model, the money market
model was estimated over four overlapping sample
periods. In the case of this model, the sample
periods began in August 1976 and ended in December 1980 to December 1983. The choice of August
1976 as the starting date for all four samples was
dictated by the widely acknowledged fact that the
demand for money shifted in 1974-75. This shift
made model estimates over those years produce
unreliable coefficient values.
Because of the pivotal roles played in the model
by the M 1 demand function and the equation
explaining bank loans, the coefficients of these
equations in the four sample periods are reported in
Table 2. As indicated earlier, the income, price and
interest rate data used in this estimation were those
available in September 1985, while the monetary
and reserve aggregates were those available shortly
after the end of each sample period.
For the three sample periods ending in December
1981, 1982, and 1983, each of which included
1981, a set of dummy variables also is included to
allow the intercepts of the Ml and transactions
deposits demand equations to shift upward in 1981
and thereby capture the effect of the nationwide
introduction of NOW accounts. As discussed in the
previous section, this institutional change apparently led some holders of passbook savings and
small time accounts to consolidate their savings and
transactions deposit holdings in a single NOW
account. The result was an upward shift in the
demand for MI. Coefficients on the dummY variables represent this demand shift. In contrast to our
procedure with the multiplier component models,
these coefficients were estimated directly from the
non-shift-adjusted data. As in the multiplier model,
the size of the upward shift in Ml demand during
1981 was estimated with data available at the end of
that year, thus eliminating any problem in using the
shift-adjusteddata to make forecasts for 1982 alld
subsequent years.
The forecasts of M1 made for December 1980March 1981 and for March-June 1981 on the basis
ofthe mod~lestimated through December 1980
were treated as forecasts of "shift-adjusted MlB" as
published by the Federal Reserve at that time. As we
pointed out earlier, this adjustment to the data was
made on the basis of staff estimates of the extent to
which savings funds would flow into new NOW
accounts and thus cause an upward shift in Ml
demand. In forecasting the growth of shift-adjusted
Ml from March to June 1981, however, an "add
factor" was introduced into the Ml demand equation to put the model "on track" at the beginning of
that period. This add factor was structured so that
any error in the staffs judgment of the demand shift
from December to March, does not affect the model
forecast of the M1 growth rate from March to June.
Since the shift of funds into NOW accounts
seemed largely completed by mid-1981, and therefore affected the growth rate ofMl only temporarily,
the model simulations for the third and fourth quarters of 1981 were regarded as forecasts of the growth
rate of non-shift-adjusted MI. For these two quarters, add-factors were again introduced to put the
model on track at the beginning of each forecast
period and thereby ensure that shifts in the level of
Ml did not affect the forecasted growth rate. Since a
shift in money demand of unknown proportions was
anticipated in 1981, an actual forecaster most likely
would have used this add-factor procedure (or something like it) to take advantage of the information
about the size of the shift that became available as
th~ year advanced. (In forecasting the growth rate of
MI· at the time, the staffof the San Francisco Federal
Reserve Bank largely ignored the level of the aggregate because it Was known to be distorted by. the
demand shift).
{jnlikethe multiplier model,. in which forecasted
values depend only on past values of the multiplier
components, the money market model is a structural model in which forecasts of M 1growth depend
also on the expected course of income and prices.
45
This aspect has two implications for the forecasting
experiments. First, because the money market
model uses more information, one would expect,
ceteris paribus, its forecasts of Ml growth to be
subject to smaller errors than those using the multiplier approach. Second, because the model requires
more information, the quality of its forecasts
depends on the accuracy of that information. If
income and price predictions are wide of the mark,
the Ml-forecasts generated by the model are likely
also to be poor. Thus, comparing the usefulness of
the structural approach to that of the multiplier
model requires striking a balance between these two
conflicting considerations.
We attempted to deal with this dilemma by making two sets of M1 forecasts using the money market
model. In the first set, we used the actual (presently-
available) values of income and prices during each
forecasting period. The resulting Ml forecasts were
those that would have been possible with the model
had the policymaker been able to predict income
and prices perfectly. Clearly, in practice, this would
not be possible, so actual Ml-forecasting errors
would be expected to be somewhat larger.
The second set of M I forecasts used predictions
of the growth rates of income and prices made by a
well-known economic consulting firm and published close to the beginning of each forecasting
period. ll These forecasts, which may be more
representative of those that an actual policymaker
would have been able to achieve, would be expected
a priori to exhibit greater errors than those generated under the assumption that future income and
prices are known perfectly. A priori, the forecasting
errors of an actual policymaker using the money
46
market model would be expected to lie Qetween
those of the two sets of forecasts generllted in this
article, As it hllppened, the differences between the
two sets of forecasts were small in most cases.
Forellch ofthesixtee.n forecllSting experiments,
the forecasted MJ growth rate was constructed by
performing a three-month-ahead dynamic simulation of the model with the actual values of the
monetary <:lJJdcreditaggregates in the immediately
preceding month presumed to be .l<:nown. Thus., the
forecast of the level of MI in September 1983, for
example, used the model coefficients estimated
using revised data for the sample period which
ended in December 1982, and took as•• given. the
actual value of Ml.for June 1983 published early in
July. The simulated level of Ml in September llnd
theaCtl~allevel inJune then \vereusedtoconstruct
the forecast of the growth rate of MI. over the threemonth span. 12 These simulated growth rates then
were compared with the realizedgro\\Tth r~t:sboth
from the preliminary data published during the year
be;ng forecast (1983 in the above example) and from
the revised data published early in the succeeding
year (1984 in the example).
47
IV.
The Results of the Forecasting Experiments
The results of the forecasting experiments are set
out in Tables 3, 4, and 5. Both the preliminary and
revised actual growth rates of Ml are shown. Since
the multiplier model in the first instance predicts the
level of M1 and the size of the portfolio shift into
NOW accounts in 1981 was not known when the
year began, the forecast and actual growth rates for
the multiplier model in that year are for shiftadjusted MIB. For the money market model, the
forecasts for the first half of 1981 also were regarded
as predictions of the shift-adjusted aggregate.
However, since the demand shift was completed by
mid-year and the presence of a lagged, dependent
variable in the Ml demand equation adjusts the
forecasts for upward-shifts in the level of Ml (that
is, the model in the first instance predicts the growth
rate of Ml rather than its level), the projections of
growth in the second half of the year are regarded as
48
projections of actual (not-shift-adjusted) MI.
Over the four year period as a whole, the mean
error· in forecasting the annualized growth rate of
Ml compared to the preliminary actual data publisiled immediately after each forecasting period
was 0.46 percent using the multiplier model and
3.06 percent using the money market model
(assuming income and prices were known 13). The
corresponding mean absolute errors (that is, .the
average errors without regard to their signs) were
5.07 percent and 4.31 percent respectively.
Examination of Tables 3 and 4 shows that the
different ranking of the two models according to
these alternative criteria largely reflects the fact that
in 1981, the forecast errors from the money market
model were not only large but all in the same
direction making the mean error the same as the
mean absolute error in that year. Bycontrast,the
multiplier model's errOrs in 1981, which also were
large in the absolute sense, were both positive and
negative, making the mean error smaller. Again,
however, we should point out that the measured
growth of shift-adjustedMlin 1981 was based on
estimates of the amount of funds shifted into NOW
accounts from outsideMl. Thus the size of both
models' forecast errors in 1981 depends· on the
correctness of those judgments.
The tendency of the money market· model to
overestimate the growth of shift-adjusted Ml in
1981 was recognized at the time. The explanation
for this over-estimate then suggested (see Bennett
1982) was that Ml growth was slowed in 1981 by
49
the massive surge in ownership of money market
mutual funds. These funds provided high yields and
allowed some limited check-writing. As a result,
they were strong competitors to the checkable
accounts provided by commercial banks, the yields
on which remained regulated. Thus, at the same
time the nationwide introduction of NOW accounts
was boosting the growth of M1, the spread of money
funds was reducing it. The shift-adjustment of the
data in 1981, which had the effect of reducing
measured Ml growth, was designed to account for
the first of these institutional developments, but no
adjustment was made for the second. As a result, the
model over-predicted shift-adjusted M1 growth.
In fact, in the first half of 1981 , the money market
model provided better forecasts of non-shiftadjusted MlB growth. This suggests that the effects
of the two institutional developments on Ml
demand tended to offset one another. Non-shiftadjusted M1 grew at an average rate of 6.4 percent
in the December 1980-June 1981 period; the money
market model forecast 9.5 percent and the multiplier model, 0.7 percent growth. Thus, if the comparison is made in terms of the unadjusted data, the
money market model outperforms the multiplier
model by a significant margin. In the second half of
1981, the shift of funds into NOW accounts was
largely complete but that from M1 into money
market funds actually accelerated. As a result, both
models overpredicted the growth in both measures
ofMl.
In 1982, the mean absolute error was about the
same for both models. But in 1983 and 1984, the
money market model performed significantly better.
Since October 1982, the Federal Reserve's operating instrument has been the level of borrowed
reserves. This change to a new operating instrument
has resulted in a reduction of the short-run volatility
of short-term interest rates compared to the prior
period in which the stock of nonborrowed reserves
was the central bank's policy instrument. As the
short-run volatility of interest rates was reduced,
however, their longer run swings increased. Thus,
one would expect a model using information about
movements in interest rates as well as their impact
on income and prices to have performed better in
this period. By contrast, the components of the
money multiplier may have become more difficult to
forecast as financial deregulation increased the
amount of shifting of funds among different classes
of deposits.
The summary error statistics reported in Table 5
also were computed using the revised actual M1
data published early in the year following that being
forecast. The results did not alter our conclusions
regarding the relative forecasting efficiency of the
two models, but they did reveal one noteworthy
point. The revised forecast errors from the money
multiplier model tended to be larger than those
computed from the preliminary data, whereas errors
from the money market model tended to be a little
smaller. Over the four years as a whole (sixteen
separate forecasts), the mean absolute error of the
money market model was 4.3 percent with respect
50
the process of revising the seasonals for an economic time series tends to yield a "smoother"
series, one expects the forecasting errors from the
revised series to be smaller than those from the
original published series. Our results confirm this
expectation.
However, the fact that the money market model
yielded better forecasts of the revised than. of the
preliminary data may provide little comfort to. the
real world policymaker who frequently is forced by
the pressure of events to make decisions on the basis
of preliminary data. Nonetheless,· sharp dep<mures
of model forecasts from the preliminary published
data may alert the policymaker to the possibility that
preliminary data will be significantly revised later
and thus should be treated with caution in making
policy decisions. On occasion, the staff of the San
Francisco Reserve Bank has found that model forecast errors are predictors of subsequent data revisions.
to the preliminary data and 4.0 percent with respect
to the revised data. The corresponding error statistiGs for the multiplier model were 5.. 1 percent and
5.8 percent.
We believe thatthe most likely explanation ofthis
result is that the process of revising the data at the
end of each year included revisions to the seasonal
adjl!stment factors. As we described earlier, the
jections of not-seasonally-adjusted MI. It was used
to generate seasonally-adjustedMl forecasts by
using the seasonal adjustment factors published ex
ante to modifY the expression which defines the
multiplier in terms of its components (compare
equations 2 and 3). Clearly, if these seasonal adjustment factors were laterrevised, the forecasts derived
from the preliminary factors would tend to exhibit
larger errors.
The forecasts generated by simulating the money
market model are of seasonally-adjusted MI. Since
V.
Conclusion
In summarizing the results of our calculations,
two features stand out as important to policymakers.
First, although the money market model provided
better forecasts in 1983 and 1984, neither model is
clearly better than the other. This conclusion suggests that both the supply conditions emphasized in
the multiplier approach and the demand factors
considered by the money market model play roles in
determining monetary growth. Second, the relatively large errors in forecasting suggest that the
central bank's ability to "fine tune" the money stock
in the short-run is very limited. In sixteen separate
forecasts, the multiplier model missed even the
direction ofchange of the Ml growth rate five times;
the
missed it three times.
Given that the central bank's control over the
monetary aggregates is necessarily indirect, our
results make the Federal Reserve's apparent inability
to control MI closely in the short run easy to
understand. The empirical findings of this <micle
strongly suggest that both the Federal Reserve itself
and the small army of "Fed-watchers" who keep
tabs on its activities from the sidelines should focus
their attention on longer run movements in money
growth.
Given the apparent difficulty of forecasting shortrun movements in money growth, even when either
the federal funds rate or the stock of nonborrowed
reserves is assumed to be fully under the Federal
Reserve's control, it seems unlikely that the central
bank will be able successfully to counter unforeseen
developments in the real economy by quickly varying the rate of money growth. This suggests to us
that an operating procedure that automatically
reverses short-run variations in the rate of money
growth - and therefore does not require Federal
Reserve officials to make judgements on the basis of
forecasts - would tend to produce better long-run
results.
51
ApPENDIX
The Effect of the 1980 Credit Controls
on Estimates of the Money MUltiplier
As pointed out in the text of this article, the
ARIMA model for the rb ratio exhibited large
residuals in April and May of 1980. Although our
forecasts began in 1981, one-time errors in 1980
would have had a significant effect on the M1
forecasts for 1981. This can be seen by rewriting the
estimated ARIMA model for rb in Table 1 as:
(AI)
preliminary forecasts for March and June 1981.
There is no way to estimate accurately the monthto-Illonth effects. of credit controls in the spring of
1980 since we only had the single experience. One
technique involves re-estimating the ARIMA model
for rb with the addition of individual dummy variables for March-May, 1980. This model would take
the form:
Inrb t = Inrbt _ 1 + (1nrbt - 12
Inrb t _ 13 ) + .1273a t _ 1
(A3)
.6522a t _ 12 - .0830a t _13
(l - B)(l - B12)[lnrbt - (XoCRl t
- (XICR2 t - (X3CR3t] =
(l - 6 IB)(1 - 6 12B12)a t
where Inrb t is the predicted value of Inrb t and a t - l'
at - 12 and at _ 13 are the estimated residuals from
those previous periods. This equation in tum can be
rewritten in terms of the previous predictions of rb
and the associated prediction errors as:
(A2)
Inrbt
=
where CR1, CR2 and CR3 are dummy variables that
take the value one in March, April and May of 1980,
respectively, and zero in all other months. The
estimate of equation A3 for the sample ending in
December 1980 is:
Inrb t _ 1 + (1nrb t - 12
Inrb t - 13) + 1.1273a t - 1
(A4)
(1 - B)(1 - BI2)[lnrbt
+ .0364 CRl t + .0195CR2t
+ .3478a t _12 - 1.0830a t _13
(.0100)
Now consider the implication of a situation in which
the model accurately forecasts rb t _ 1 and rb t - 13 , but
predicts a small change in rb from date (t - 13) to
date (t -12) when a large increase actually occurs.
That is, there is a large one-time innovation in the
data at date (t - 12) that is not modeled explicitly.
Under these circumstances, the large positive prediction error at date (t - 12) (a t - 12 > 0) would be
carried forward to generate a large positive predicted change between dates (t - 1) and t through
the .3478at _12 term.
By assumption, this change would not occur in
the actual data series since the experience at date
(t-12) was a one-time occurrence. Consequently,
rb t would be overpredicted by a considerable
amount. Since the elasticity of the multiplier with
respect to rb is - 1.0, the error in rb would appear as
a large underprediction of the multiplier and the
money stock at t. This phenomenon appears to be at
least partially responsible for the large errors in the
(.0115)
- .0165CR3 t]
(.0099)
=
(1
+ .0320B) (l - .5869BI2)a t
(.1020)
(.0928)
The first order moving average factor is no longer
significant in this specification, and the credit control dummy variables have signs that are consistent
with an increase in excess reserve holdings (ora
reduction in borrowed reserves) at the initiation of
the credit controls. This effect in March and April
1980 is subsequently, although only partially, offset
as indicated by the negative coefficient on the May
1980 dummy variable. * The effect of the inclusion
of these credit control dummies is substantial as they
reduce the estimated error of the rb equation by
approximately 9 percent.
In principle, the effect of the credit controls
experience on other component ratios of the multiplier also should be investigated. We did not pursue
52
September 1981. Over the year as a whole, the
credit control dummies reduced the mean absolute
error in the forecasted annual growth rate of shiftadjusted Ml from 9.20 percent to 6.78 percent.
this investigation here both because no systematic
pattern in the residuals of the other component
ratios was observed during spring 1980 and
because, except in the case of the t} ratio, the
elasticity of the multiplier to the remaining component ratios is quite low. Therefore, even if the effects
of the credit controls filter through to produce forecast errors in these other component ratios, they
should exert only a minor influence on the multiplier
forecasts.
The forecasts of MI for 1981 shown in Table 3 are
those computed using Equation A4 to simulate rb
and the other component models in Table 1 to
simulate the other components. Adding the credit
control dummies improved the forecasting performance in March and June 1981 dramatically, While
slightly hurting the already bad performance in
* If the effect of the credit controls on the reserve
ratio is strictly temporary, then the sum of the
coefficients on the variables should be zero. The
sum of the three coefficients in equation A4 is
.0394, which suggests, on the surface, that the
impact may not have been fully reversed by the end
of May 1980. However, the sum is not significantly
different from zero (s.e. = .0259), so the case for
introducing additional dummies for subsequent
months is weak. Equation A3 could be re-estimated
with the sum of the three coefficients on the credit
control dummies restricted to zero, but that has not
been done for these forecasting exercises.
FOOTNOTES
1. Other reasons for the volatility of M1 growth during the
1979-82 period have been suggested. For example, the
credit control program imposed in 1980 was associated
with very large changes in M1. Some economists have
argued that even in the 1979-82 period, the Federal
Reserve in practice did not attempt to control M1 closely in
the short-run.
8. In February 1984, the Federal Reserve moved to a
system of contemporaneous reserve requirements (CRR)
from its previous system of lagged reserve requirements.
This institutional change might have altered the statistical
properties of the time-series of the rb ratio and thus
affected our forecasts of the multiplier in 1984. In practice,
tests conducted by Rasche subsequent to the completion
of this article indicate that the effect of CRR on the monthly
behavior of the multiplier has been small.
2. Our forecasts assume that the settings of the Federal
Reserve's policy instruments over the forecast period are
fully known. However, the Federal Reserve itself also
makes M1 forecasts using both econometric and "judgmental" methods. If it changed policy in response to these
forecasts, the actual values of the policy instruments in our
models may be different from those that an outsider would
have assumed at the beginning of any forecast period.
9. In cases where there were revisions to the nonborrowed
reserves series between the end of the estimation period
and the forecast period, the monthly growth rates of the
revised series for nonborrowed reserves were used to
extrapolate the unrevised series from the last available
observation. The resulting constructed values of unrevised
nonborrowed reserves were multiplied by the forecasted
multiplier to generate a forecast for M1.
3. An earlier study examining the forecasting performance of both the Johannes-Rasche and San Francisco
models
together with several other approaches to forecasting M1
is reported in David Lindsey and others,
1981
10. If either nonborrowed or borrowed reserves were
regarded as the exogenous policy instrument. the model
may be used to derive a forecast of the federal funds rate
as well as the other endogenous variables. This procedure
was not followed in the experiments reported here.
4. The Federal Reserve typically issues revised historical
data for the monetary aggregates in February of each year.
We used these revised data in our estimations.
11. Unfortunately, it was not possible to obtain income
and price predictions made precisely at the beginning of
each forecast period.
5. Occasionally during the October 1979-0ctober 1982
period, the Trading Desk permitted nonborrowed reserves
to diverge from target in order to avoid temporary short-run
interest rate fluctuations that were expected to disrupt
financial markets but have little effect on M1 growth.
12. The procedure was more complicated in 1981. The
firstthree-month forecast (December 1980 to March 1981)
was treated as a prediction of "shift-adjusted M1 B" taking
the level of actual M1B in December 1980 as given.
The second forecast (March-June 1981) took the level of
shift-adjusted M1 B in March as given and forecast its level
in June after adjusting for the error made by the model in
March. Since the portfolio shift into NOW accounts was
complete by mid-year, the June-September and September-December forecasts were regarded as predictions of
6. Prior to January 1982, the monetary aggregate that
consisted of currency, demand deposits and NOW
accounts was described as M1 B. Since January 1982, this
aggregate has been termed Mi.
7. This comment applies equally to forecasts from the
multiplier model and the money market model.
53
REFERENCES
non shift-adjusted M1B, taking the level of that aggrf;lgate
at the beginning of each period as given but again adjusting for the errors made in the model forecasts for June and
September.
13, Table 5 shows that the forecasting errors using the
predicted values of personal income and prices rather
than the actual values were almost identical. This reflects
partly the fact that the income and price forecasts we used
were quite good and partly the fact that the short-run
impact of income and price changes on money demand is
quite small.
Bennett, Barbara A. " 'Shift Adjustments' to the Monetary
Aggregates," Economic Review, Federal Reserve
Bank of San Francisco, Spring 1982,
Johannes, .J,M, and R.H, Rasche "Predicting the Money
Multiplier," Journal of Monetary Economics, July
1979,
----------, "Can the Reserves Approach to Monetary Control
Really Work," Journal of Money, Credit and Banking,
August 1981
Judd, John P, and John L Scadding, "Liability Management, Bank Loans and Deposit 'Market' Disequilibrium," Economic Review, Federal Reserve Bank of
San Francisco, Summer 1981,
----------, "What Do Money Market Models Tell Us About
How to Conduct Monetary Policy?
Reply," Journal
of Money, Credit and Banking, November 1982, Part
2,
Judd, John P, "A Monthly Model of the Money and Bank
Loan Markets, Unpublished Working Paper, Federal
Reserve Bank of San Francisco, 1984,
Lindsey, David and others, "Monetary Control Experience
under the New Operating Procedures," New Monetary Control Procedures, Staff Study, Vol, II. Washington, D,C,: Board of Governors of the Federal
Reserve System, 1981,
Motley, Brian and Joseph Bisignano, "Rules vs, Discretion
in Controlling Money," FRBSF Weekly Letter, Federal
Reserve Bank of San Francisco, March 8, 1985,
Henry C. Wallich, "Recent Techniques of Monetary Policy," Economic Review, Federal Reserve Bank of
Kansas City, May 1984,
54
Michael C. Keeley
and
Frederick T. Furlong*
Bank regulation often is argued to be in the public interest. The
rationale for this position is that an unregulated banking system would be
characterized by market failures and reduced economic efficiency. This
view is widely held despite the lack ofsystematic analysis of why market
failures might arise in banking. This paper examines whether there are
aspects ofbanking that could be expected to lead to marketfailures in the
absence of regulation. Our analysis suggests that, to be viable, a fiat
monetary system likely requires some degree ofbank regulation. We also
find that bank runs result from a market failure related to poorly defined
property rights for depositors whenever the par value ofdeposits exceeds
the market value ofbank assets. We conclude that public policy measures
that help define and enforce depositor property rights could have a
positive effect on social welfare by eliminating runs and enhancing bank
stability.
Much has been made of the "deregulation" of
depository institutions. However, banking regulations regarding entry, capital requirements, location
of offices, reserve requirements, and asset portfolio
composition are still in force. The public policy
debate concerning depository institutions centers on
whether deregulation should proceed or whether
there is a need to retain and perhaps even strengthen
some aspects of bank regulation.
Arguments on both sides of this debate have
referred to "public interest" considerations. Proponents of further deregulation point to the public
benefit from increased competition and gains in
economic efficiency. Their detractors appear to support continued regulation of depository institutions
at least in part because they believe that unrestricted
banking would not lead to the socially optimal
behavior as defined in a microeconomic model of
perfect competition. Key to the latter position is the
presence of market failures associated with banking. Specifically, government intervention in the
form of "correcting" market failures is presumed to
have the potential to enhance the public interest.
As central as market failures are to linking the
public interest to bank regulation, public policy
toward banking generally has been formulated without a clear articulation of what those failures may
be, why they may exist, or how regulation would
correct them. In part, this is due to lack of much
systematic analysis of possible market failures associated with banking. l
In this paper, we attempt to fill the gap by
examining how bank regulation, in principle at
least, might be related to the public interest because
of market failures in banking. By focusing on the
link between regulation and the public interest, we
do not mean to suggest that the structure of bank
regulation is shaped entirely or even primarily by
public interest considerations. The implementation
as well as the removal of regulatory constraints can
* Senior Economists, Federal Reserve B~ of San
Francisco. This article draws on an earlier paper by
the authors (see Furlong and Keeley, 1985).
55
result in a redistribution of wealth among various
interest groups. Given the redistributive effects of
regulations, many analysts argue that it is the relative effectiveness of the affected groups in promoting their own interests that ultimately shapes public
policy. However, even within this "private interest"
view of regulation, public interest considerations
can play a role. This is because the dead weight
losses from economic inefficiencies, whether due to
market failures or regulation, will affect the degree
of support for and opposition to regulations.
Since considerations of both public and private
interests can have a bearing on regulation, a complete analysis of banking regulation would identify
the groups benefiting from and those harmed by
various regulations as well as the nature of market
failures, if any, that characterize banking. Such an
approach would be able to explain why certain
regulations exist, how regulations would change as
market forces change, how regulations affect the
redistribution of income, and how they might rectify
I.
market failures.
The purpose of our paper is not to explain the
incidence of regulation or to differentiate among
theories of regulation. Our approach is to examine
the conditions under which there could be market
failures in the operations of the banking industry
and to assess the types of public policy measures
that might address those failures.
The organization of our paper is as follows. In
Section I, we discuss the link between regulation
and the public interest. We also discuss, in general,
the sorts of market failures that are typically considered to justify regulation. Section II then investigates specific sources of market failures that might
lead to regulation in banking. The focus there is on
the connection between banks and the monetary
system and on the credit intermediation services of
banks. We also examine how market failures might
be related to instability in banking. Finally the
summary and conclusions are presented in Section
III.
Regulation and the Public Interest
Economic theories of government regulation
have been developed under two distinct lines of
thought - the public and private interest theories.
Within the public interest framework, the presence
of market failures sometimes makes it possible for
regulation to enhance economic efficiency. Microeconomic theory focuses on three major types of
market failures - inadequate competition, externalities, and public goods - that lead an unregulated private market to an equilibrium not necessarily socially optimal.
Inadequate competition could arise in a market
because of cartels or because of economies of scale
in production in the relevant range of demand (that
is, "natural monopolies"). Government intervention in terms of legal prohibitions and penalties for
anticompetitive behavior (antitrust laws and regulations) and the regulation or control of natural
monopolies have been rationalized as public interest
responses to this type of market failure.
The main reason a competitive market would fail
to achieve an efficient allocation and production of
resources is the existence of nonpecuniary externalities. In such cases, the consumption or production of goods imposes costs or bestows benefits on
parties not directly involved through some nonmarket channel. As Coase (1960) has shown, externalities arise whenever property rights are nonexistent or poorly defined.
An extreme case of a good characterized by
positive externalities is a pure public good- that is,
a good whose quantity does not diminish as the
number of persons consuming it increases. Pure
public goods are characterized by the quality of
nonexcludability, which makes it impossible (or too
costly) for a competitive private market to charge a
positive price for them. As a result, the private
market cannot provide them.
Pigou's solution to externalities was the imposition of taxes or subsidies. But in some cases, the
legal assignment of property rights, regulation, or
the governmental provision of public goods may
internalize the externalities.
In contrast to the public interest framework for
regulation, the private interest approach, perhaps
most often associated with the pioneering work of
George Stigler (1971, 1975), sees regulation as
being sought by an industry (through political
activities) to further its own well-being. Often, the
industry desires regulation to shield itself from the
56
rigors of competition. In a sense, the private interest
theory views regulation as analogous to a system of
taxes and subsidies in which the regulated group
receives subsidies at the expense of some other
"taxed" group, or vice versa. The implicit taxes of
regulation, however, are often hidden or indirect,
like entry restrictions, price controls, exemptions
from antitrust laws, or prohibitions on certain types
of activities. Similarly, the subsidies are not direct
payments by government but are the higher-thannormal profits that result from regulations. 2
Nevertheless, even within a private interest theory approach to regulation, market failures and the
impact of regulation on economic efficiency can be
important. This is shown in a recent work by Becker
(1983) that attempts to bridge the public and private
interest theories of regulation. Becker develops a
model of competition among political pressure
groups in which, in keeping with a private interest
framework, the groups compete to secure legislation beneficial to their own interests. This model
departs from the more traditional private interest
theory of regulation by considering the effects of the
deadweight costs of taxes and subsidies on political
pressure.
In the context of this paper, an important implica-
II.
tion of Becker's integrated theory is that there are
pressures to adopt public policies (regulations) that
overcome market failures, and hence raise efficiency. Regulations that enhance efficiency to the
benefit of all groups will be widely supported and
unopposed. Even efficiency-enhancing regulations
that harm some groups may be adopted if the gains
to society sufficiently outweigh the harm imposed. 3
Economic inefficiencies related to market
failures are thus relevant to both the public and
private interest theories of regulation. As a result, an
important first step in analyzing bank regulation
would be to determine the nature of market failures,
if any, in banking. In the next section, we examine
the arguments for why market failures might exist in
banking. We focus on market failures related to
externalities (including public goods) rather than
inadequate competition. In doing so, we recognize
that some components of the payment system in
which banks have a role, such as check clearing and
funds transfers, are probably characterized by economies of scale. In fact, the Federal Reserve is a
major provider of both services. Also, various government agencies regulate bank mergers. These are
not, however, practices subject to much controversy
that stems from the special features of banks.
Why Regulate Banks?
As indicated earlier, the presence of externalities
gives rise at least to the potential for regulation to
improve efficiency in production. Banks' (the term
is used here to represent all depository institutions)
provision of monetary and credit services usually is
cited as the main reason banking should be the focus
of public policy concern. It is often argued that
government oversight of money creation, the operation of a monetary payment system, and credit
intermediation is necessary. In addition, some argue
that unregulated competitive banking would be
unstable and susceptible to runs with widespread
adverse effects.
special role and the fact that they do in most current
monetary systems is a result of regulation - not a
reason for regulation.
Much of this debate turns on what is meant by
"money" and whether banks create money. Some
economists have argued·that, because banks have
the power to create money, an unregulated banking
system would lead either to an infinite or indeterminate price level (see Johnson, 1968; Pesek and
Saving, 1967; and Gurley and Shaw, 1960); while
others (most notably Tobin, 1963, and Fama, 1983)
have argued that banks do not create "money" and
that regulation is not needed to make the price level
determinant.
In sorting through these positions, it is useful to
keep in mind that money has two essential, highly
related, but sometimes separate economic functions. It is the numeraire or unit of account in which
The Monetary System
Some economists have argued that banks should
be regulated because of their key role in the monetary system. Others argue that banks need not have a
57
(or other financial assets) is used to facilitate
exchange.
Thus, the quantity of debt, or other financial
assets that serves as a medium of exchange and is
used for payment purposes, does not directly affect
the price level. In a commodity system, the price
level is determined by the supply of and demand for
the nmneraire commodity (not debt7 ), banks do not
create money in the sense of creating the numeraire
(even though they might issue their own banknotes),
and no restrictions are needed for price level determinacy.
With a commodity monetary standard, there
remains the issue of price stability. Unanticipated
changes in the supply of the commodity (for example, gold discoveries) or changes in the nonmonetary demand (for example, the invention of printed
circuit boards that require gold connectors) would
affect the price level. However, changes in relative
prices caused by changes in real demand or supply
conditions are not nonpecuniary externalities.
Moreover, since this type of instability has nothing
to do with the banking system it seems unlikely that
any sort of banking regulation could eliminate it.
This is not to say that a commodity with stable
nonmonetary supply and demand conditions, and
therefore a stable price, would not be preferable to
one with a fluctuating price. Both lower computation costs involved in current exchange and a
reduced degree of risk in future exchange may favor
such a commodity.
Changes in the monetary demand for the commodity also would cause the price level to change.
Even though a decline in the banking sector might
increase the demand for the numeraire commodity
as a medium of exchange (and thus lead to a decline
in the price level), such an effect does not constitute
a nonpecuniary externality if the decline in banks'
ability to produce media of exchange is caused by an
increase in their real costs of production.
An increased monetary demand for the commodity might, however, be caused by a "banking
panic." And if banking panics themselves result
from a market failure, some form of banking regulation that eliminated panics might enhance efficiency
by reducing the waste involved in actually using a
commodity as a medium of exchange (that is, by
reducing the amount of financial intermediation).
prices are quoted, and it is a medium of exchange
that facilitates trade by eliminating the double coincidence of wants needed for barter.
The arguments for why banks mayor may not
have a "special" role in the current monetary system can be best understood by considering the roles
of banks in alternative, simpler systems. Below, we
discuss banks' role in several types of monetary
systems to determine whether there is something
inherent in banks' monetary role that results in
market failures.
COmmodity Money
Perhaps the simplest monetary system is a commodity system in which a commodity such as gold
serves as the numeraire and circulates as the sole
medium of exchange. In such a system, the price
level is determined by the supply and demand
conditions for the numeraire commodity (for both
monetary and nonmonetary purposes) relative to
supply and demand conditions for other goods.
Although such a monetary system (without banks
as providers of payment services) is more efficient
than a barter system, it is likely that it would be less
efficient than a system with bank-provided payment
services. 4 Indeed, even in systems with a commodity numeraire, bank debt, either in the form of
privately issued banknotes or deposit liabilities such
as checks, has served a role as a medium of
exchange. 5
One economic function of banks in such a system
is to economize on the real resource costs of holding
and transferring the numeraire and thereby facilitate
trade by providing a financial medium of exchange.
The question is whether there is some private market failure that characterizes the private provision of
a medium of exchange. In particular, will an unregulated banking system lead to an infinite price level
and return to barter or a pure commodity system?
Based on Fama's (1980) research, the answer
appears to be no. Fama pointed out that in such a
commodity-based monetary system with privately
produced media of exchange, the price level is still
determined by the supply and demand conditions
for the numeraire commodity relative to other
goods. 6 In other words, the Walrasian determination of equilibrium relative prices (in terms of the
numeraire) holds even in an economy in which debt
58
The equilibrium private market solution would be a
fiat money of zero value. A fiat money with no value,
of course, cannot serve as a numeraire or a medium
of exchange. Since the public could be expected to
anticipate this equilibrium solution, there would be
no initial demand for a competitively produced fiat
currency.
The common solution to this problem is for the
government to sanction or to be itself a monopoly
supplier of fiat currency, and to use various regulatory techniques to create and enhance the demand
for it. Although a monopoly supplier does not face
any inherent technical problems .in limiting the
supply of fiat currency, it may face political problems in doing so. A number of countries, apparently
unable to raise tax revenues from other sources,
have increased their rates of monetary expansion
with the result of hyperinflation. Under such circumstances, governments are often unsuccessful in
maintaining a demand for their currency and their
fiat systems have collapsed. Commodities or foreign currencies often do begin to circulate in economies with rampant inflation. Nevertheless, the relative success of fiat systems in many developed
countries suggests that governments in general can
maintain a demand for their currency as long as they
also limit its supply.
In practice, there have been two common
methods of creating or enhancing the demand for
fiat currency: reserve requirements and the prohibition of the private issuance of hand-to-hand circulating media of exchange (for example, private banknotes). Reserve requirements create a demand
directly, by requiring banks to hold fiat money, as
well as indirectly, by taxing a substitute financial
medium of exchange. Prohibiting the private issuance of banknotes prevents them from competing
with government currency as a medium of
exchange, and thus is equivalent to a 100 percent tax
on a substitute medium of exchange.
Reserve requirements increase the demand for fiat
currency, but there probably would be some demand
for fiat currency even in their absence. Fama (1983)
has argued that there probably is an inherent
demand for a zero-interest circulating medium of
exchange because of its convenience in facilitating
small transactions. However, absent reserve requirements, there still might be a need for regulations to
prevent the issuance of private banknotes. Even
Such panics might also impose costs by disrupting a
competitive payments system. We discuss these
possibilities in more detail later in this section.
Thus, aside from the possibility of banking panics
or runs, no private market failures appear to· be
associated with the workings of a commodity-based
monetary system in which payment services are
competitively provided by banks. The only sort of
regulation that might be warranted would be regulation that defined which commodity would be the
numeraire, although private market forces historically appear to have been able to make that determination.
Fiat Money
Since virtually all modern economies have
moved away from commodity standards to pure fiat
money, we now discuss whether banks' behavior
may be of greater public policy concern in a pure fiat
system. In a pure fiat system, pieces of paper that
(I) have no intrinsic value, (2) are not redeemable
from the issuer for real goods, and (3) do not pay
interest typically serve as both the numeraire and
circulate as a medium of exchange. Compared to a
commodity-based system in which the commodity
circulates as the medium of exchange, a fiat system
may be more efficient because it does not divert a
real resource from nonmonetary uses to be used as a
medium of exchange. However, it may be possible
to have a commodity-based system in which the
commodity itself does not circulate. In that case, it is
unclear whether a fiat system would be more effident. Nevertheless, a fiat system does differ importantly from a commodity based system in that it
makes the social control of money, prices and credit
possible, and it provides a source of tax revenue.
A workable fiat money system, however, cannot
be provided by a competitive private market.
Assuming there initially would be a demand for
privately produced fiat moneyS, and that all fiat
money had the same unit of account (for example,
dollars), each private producer would have an incentive to expand the quantity of money it issued as
long as the money's marginal value exceeded its
marginal cost (assumed to be zero). Each producer,
however, would not take into account the negative
externalities of its fiat money issuance, namely, a
reduction of the real value of the money stocks of
other private producers and holders of fiat money.
59
though privately issued banknotes are not a type of
fiat money (or numeraire) they would likely be a
close substitute for government currency for use as a
hand-to-hand circulating medium of exchange
because they would have convenience features similar to government currency. This substitutability,
however, could make the demand for governmentissued currency unstable and therefore make it difficult to maintain a stable price level.
Finally, it seems possible that if technology continues to lower-the cost of bank-provided payment
mechanisms, such as electronic payments and
checks, the demand for currency as a medium of
exchange would decline. Monetary authorities
would then have to offset the decline to stabilize the
price level. It is even conceivable that in the future if
rapid technological change occurs, the demand for
currency (for domestic legal monetary purposes at
least) could approach zero and lead to a collapse of a
reserve-free fiat system.
For whatever reason, reserve requirements are a
feature of virtually all fiat systems. To enforce
reserve requirements, it is necessary to restrict the
sorts of financial assets that can be used in transactions as media of exchange to those that are reservable. As Black (1970, 1975) and Fama (1980) have
pointed out, in an unregulated banking system, as
long as there is a well-defined numeraire, virtually
all assets (in principle at least) could be used as
media of exchange. 9 Thus, nonreservable financial
assets could be used as media of exchange to circumvent, at least partially, reserve requirements.
Without regulations limiting which assets could be
used as media of exchange, the degree of circumvention would depend only on the substitutability of
nonreservable assets in exchange.
In sum, a fiat money system may require some
degree of banking regulation. However, it is not
certain whether a fiat system, in which the numeraire is socially controlled and the media of exchange
are regulated, is superior on microeconomic efficiency grounds to a commodity-based system in
which a privately supplied commodity serves as the
numeraire and the media of exchange also are
supplied privately without government intervention. lO
Even if a fiat system were not more efficient than
a commodity-based system from a microeconomic
standpoint, it has several distinguishing characteristics that may account for its almost universal adoption. First, the supplier of fiat money ("base
money" in the U.S.) can raise revenue directly by
issuing more money. Second, by varying the quantity of base or fiat money or by varying reserve
requirements, the supplier can influence the price
level. And third, in a fiat system with reserve
requirements, the degree of financial intermediation
(and possibly, real interest rates) can be influenced
by· varying reserve requirements or the quantity of
reserves.
Regarding this third point, an increase in reserve
requirements lowers the amount of financial intermediation, and this, in tum, may increase real
interest rates by reducing the supply of credit. It is
not possible, however, to increase the degree of
financial intermediation beyond what would occur
in an unregulated market. Although reserve requirements enable the social control of the degree of
financial intermediation, they do so by increasing
the cost of financial intermediation and are therefore
a source of economic inefficiency from a microeconomic standpoint.
It seems likely that these characteristics of a fiat
system are more important than any potential
advantages in efficiency such a system might have
over a commodity-based monetary system. If so,
from a social welfare perspective, support for a fiat
system with reserve requirements over, say, a commodity-based monetary system would seem to be
based on the assumption that there are social benefits to government control of money and credit
intermediation. The market failure implied by this
perspective is that the macroeconomy, in the
absence of government intervention regarding the
money supply, would not have the desired stability
in prices, credit intermediation, and economic
activity. In pointing this out, we do not contribute to
the debate about whether (discretionary) macroeconomic stabilization by the monetary
authorities is either possible or a socially legitimate
role of government. We merely note that if it were a
goal, then some form of regulation would be necessary. The degree of regulation needed for these
purposes is quite limited, however. It consists of
restrictions on the private issuance of base money,
limitations on the private issuance of assets that can
60
be used as media of exchange, and reserve requirements on assets that are used as media of exchange.
Furthermore, it might have been more costly for
banks to evaluate the riskiness of new loans with a
given level of confidence when the economic
environment was changing so drastically.
To the extent that higher intermediation costs
result from increased difficulty in evaluating borrowers, it is unlikely that public policy (greater
regulatory or supervisory intervention) could help.
Regulatory agencies could not be expected to hold
any particular advantage over commercial banks in
evaluating borrowers. Therefore, even federal
deposit insurance might not be sufficient to affect
banks' investment decisions. That is, even if the
administration of deposit insurance accounted for
the riskiness of a bank's assets as perceived by the
insurance agency (which presumably would not
have an advantage over banks in estimating risk),
banks would not necessarily be less likely to shift
into "safe" a<;sets. In an environment that induces
flight to quality, it might be true that some "good"
borrowers would not be able to obtain credit - a
problem in the 1930s cited by Bernanke. These
would be good borrowers to the extent that, if the
banks and depositors could obtain information costlessly about the true risk, credit would be extended.
But, information is not costless and it is unclear
whether public-policy measures (regulation) could
reduce its cost in this case.
Alternatively, the banking industry may be disrupted not by an economic shock that changes the
quality of bank assets or the ability of banks to judge
the riskiness of borrowers but by a change in the
public's perception of banks. In this case, the
"inside" information possessed by banks is not
transferred to depositors. This may be the situation
to which Bernanke referred. Banks are aware of
profitable loan alternatives but are unable to convince depositors, or, with the same result, unwilling
to compensate depositors for the risk that they
misperceive. This could be interpreted as there
being "good" borrowers that were unable to obtain
credit because of the public's misperceptions.
Why would the relevant information not be produced by the market? One answer, suggested by
Leland and Pyle (1977), is that moral hazard hinders
the transfer of information between market participants. That is, banks have an incentive to overstate
the quality of their portfolios. This is especially true
Banks as Credit Intermediaries
Aside from their roles in the monetary system,
banks are involved in providing credit intermediation services. As credit intermediaries, banks generally hold a large volume of nontraded assets (loans).
One reason these assets are not traded is that banks
have specialized information about them that other
market participants do not.
One study that attempted to establish that this
aspect of credit intermediation by banks makes
them special is Bernanke (1983). Because banks
have specialized information, Bernanke argues that
a disruption of the credit intermediation services of
banks is possible and that such a disruption can be
very costly to the economy. II
Bernanke's specific thesis is that the loss of bank
internlediation services in the 1930s contributed
significantly to the length and severity of the
Depression. One obvious reason for the loss of
credit intermediation services was the large number
of bank failures .12 But Bernanke argues that, even
without failures, intermediation costs could rise if
banks adjust their allocation of funds to head off
depositor runs. That is, depositories could shift to
"safe" assets such as Treasuries, that can be evaluated easily by the market. Such a "flight to quality"
by banks could result in a reduction of the extension
of new credit to the private sector and adversely
affect the economy by contributing to a contraction
in production.
Consistent with the framework of our analysis,
such an increase in intermediation costs should be of
public policy concern only if it constitutes an externality. However, higher intermediation costs could
come about without external effects. One possibility is that the disruption of the banking system
and the resulting higher intermediation costs come
about because of an actual change in the economic
environment that reduces or even eliminates the
value of the information depositories have concerning borrowers. The Great Depression is a case in
point. Information on the past behavior of borrowers
would not have been extremely valuable to depositories in distinguishing the risks associated with
lending to different customers during the 1930s.
61
sy~tem
if verifying· banks' claims (information) is very
costly. One solution to the moral hazard problem,
suggested by Leland and Pyle, is for firms' managers to use their willingness to invest in a project as
a signal to the market of the true quality of that
project. This strategy would seem most useful for
owner-managed firms. However, when ownership
and control are separate, bank managers with specialized information may face a similar problem
convincing potential shareholders.
The moral hazard problem could be circumvented if the relevant information were collected
(and if necessary transferred) by disinterested parties - those that would not benefit from making
biased evaluations of banks. Depositors constitute
one set of candidates, but the usual assumption is
that it is too costly for individual depositors to
collect the information. A third party could acquire
information on banks and sen it to depositors (or
even bank shareholders). However, given the nature
of information as a public good and the inability to
prevent information from being resold, a private
information agency might not be able to "force" all
users to pay. In contrast, government regulatory
agencies should not encounter this problem.
Alternatively, depositors might be willing to
accept an arrangement whereby banks paid a third
party directly for providing information on, say,
loan quality. It might be noted that private rating
agencies do currently collect and disseminate information on the debt quality of a wide variety of
issuers, although it is not certain how well this
would work for banks. Therefore some government
role might be consistent with public policy that
addresses the moral hazard problem in the generation of information on banks.
In practice, U.S. regulatory agencies currently
gather information but do not provide it to depositors. 13 They also enforce regulations that control
bank behavior instead of leaving the task to liability
holders. This dual role does not follow directly from
the information-deficiency argument, and would
have to be rationalized on some other basis, such as
the provision of federal deposit insurance which is
discussed later.
and credit market may be a basis for some
puhlicpolicy measures such as reserve requirements, prohibitions against the private issuance of a
hand-to-hand circulating medium of exchange, and
government provision of information on banks. The
susceptibility of banks to runs, which themselves
may be related to market failures, also may be a
source of public policy concern.
As S1Jggested earlier, banks' roles in the monetary
system may justify concern over the stability of the
banking system. One reason is that disruptions to
the banking system might impair the ability of a
central bank ina fiat system to conduct monetary
policy. 14 For. example, a loss of public confidence
(and the resulting instability) in the institutions
whose liabilities are reservable could make the
demand for base money (the numeraire) unstable. It
likely could make it difficult, if not impossible, for
the monetary authorities to take offsetting actions
involving reserves to stabilize the price level and
economic activity. IS Also, a central bank would be
unable to control shifts into currency and out of
deposit accounts completely. Such shifts might
cause large economic losses because currency and
deposits are not good substitutes. In addition, Diamondand Dybvig (1981), as well as Bernanke,
argue that bank runs impose real costs by disrupting
credit intermediation and reducing production.
Assessing Banks Runs
A number of studies present models that explain
why banks are vulnerable to runs. A useful example
is Diamond and Dybvig. In their model, banks add
value by transforming illiquid assets into liquid
assets. They provide a kind of "insurance" for
consumers, who are uncertain as to the timing of
their consumption and, therefore, when they will
need to tap their illiquid resources. An important
characteristic of the transformation banks provide is
that banks fund their illiquid assets with par-value
liquid deposits. 16
The. uncertain timing of consumption makes the
volume of withdrawals uncertain for banks. As a
result, banks may not hold enough reserves to cover
deposit outflows, and may have to undertake what is
ass.umed to be a costly liquidation of assets. Depositors trying to avoid sharing in the resulting losses
run on banks in such situations. In the Diamond and
Bank Stability
The discussion above raises the possibility that
market failures in the workings of the monetary
62
Dybvig world, bank runs impose real costs on the
economy because they disrupt credit intermediation
and· output. And depositors making withdrawals
beyond the volume expected by banks· (beyond the
amount of reserves held by banks) •impose social
costs on other depositors.
In identifying the source of the market failures
associated with bank rullS, we note that externalities
can arise when there are poorly· defined property
rights. This is what occurs with liquid par-valued
deposits when banks incur losses that exceed net
worth. The situation is analogous to the problem of a
communal good. Inthat case, resources are used up
"too" quickly as individuals attempt to convert the
communal good to a private good. Similarly, with
par-valued deposits, depositors have a fixed claim
on a pool of assets. When depositors believe that the
value of the assets is less than the par value of the
fixed claims and the bank remains open, depositors'
property rights are not protected. Accordingly,
depositors act on their incentives to convert the
communal pool of assets to private assets by withdrawing funds: they run on the bank.
The par-value feature of deposit contracts results
in poorly defined (or poorly protected) property
rights which can lead to externalities and expose
individual institutions to runs. With par-value
deposits, therefore, even a run on an individual bank
can involve a market failure.
The more traditional concern with bank runs has
been whether the banking system as a whole is
vulnerable to panics. The Diamond and Dybvig
model can provide little guidance on that question.
Their model includes elements that make a run on
one bank possible, but a systemwide run unlikely.
Runs in their model are possible because the volume
of withdrawals is uncertain. However, with a very
large number of depositors, the withdrawals from
the banking system should be predictable with a
small error. If there were a number of banks, instead
of one as in the Diamond and Dybvig model,the
prediction errors for individual institutions would be
larger. Even this complication should not be important since the free trading of bank assets, which are
not risky (no default risk) in the Diamond and
Dybvig model, would effectively pool systemwide
reserves.
The problem of bank runs, however, involves
more than bank liquidity and the predictability of
deposit withdrawals. Bank portfoliOS are risky, and
a bank can sustain sufficiently large losses as a result
of credit and interest rate risk to generate a run.
With individual institutions susceptible to runs
because>of risky portfolios,the system as a whole
also could be unstable if the value of bank assets is
frequently reduced by common exogenous factors.
Kindleberger (l985) makes exactly this point. He
indicatesthatexogenousmacroshocks were the
predominant causes of bank failures in the 1920s
and 1930s. Exogenous macro shocks such as the
strength of the dollar, the unexpected drop in inflation and relative price changes (such as declines in
oil prices) are again at the core of the problems of
many failed and weakened banks in the 1980s. To
the extent that such macro shocks stem from unexpected changes in fiscal and monetary policy, they
represent the external effects of government activity
on the private economy.
Another reason that the banking system generally
is depicted as being susceptible to instability is that
the failure of one bank increases the probability of
runs at other banks. Such "contagion" effects, if
they exist, would represent a classic example of
externalities. The existence of contagion effects in
banking, however, has not been substantiated by
post-Depression empirical work. This lack of
empirical support may be due to the presence of
deposit insurance, but other evidence indicates that
depositors are able to distinguish, to some degree,
safe institutions from unsafe ones. Beebe (1985), for
example, argues that the behavior of large bank
holding companies' stock prices indicates that the
market is able to make distinctions amollg holding
companies on the basis of factors affecting the
quality of their individual portfolios. In addition,
Rolnick and Weber (1983) raise doubts that the
evidence from the free-banking era supports the
presence of contagion effects in banking.
Policy Responses
Whether contagion effects or macro shocks determine the .potential for systemwide instability· in
banking, the vulnerability of banks to runs remains
a problem. of property rights. That problem isa
function of three factors - par-value accounts, risk
in banking, and the liquidity ofdeposits. The incentive to run on banks can be removed by muting the
63
adv~rse
would . not be allowed to hold commercial and
industriaUoans,consumer loans, mortgage loans,
etc; but banks might still be able to originate loans
and then sell them. Such stringent regulation would
s~Ytet~lynarrow th~ ~conomic function of banks. A
policy, for example, that made banks hold only
liquid and riskless assets would make it impossible
for banks •to perform what Diamond and Dybvig
argu.eis ak~y function - transformation of illiquid
assets to liquid assets.
Public policy toward banks as currently structuredcan be viewed as a compromise between
eliminating the riskiness of banks and maintaining
their economic functions. Yet much present bank
regulation has been justified as necessa~y to control
risk in banking, and thereby to enhance stability.
These so-called safety-and-soundness regulations
include restrictions on activities, capital requirements and anticompetitive measures, such as limits
on entry. l3elow, we discuss these regulations.
side effects of anyone of the three compo-
nents.
Par~Value Accounts
Thepar-valuefeature of deposits could be elimidepositors to equity holders, as
are money market mutual fund shareholders. In a
world of complet~ markets and no unc~rtainty, this
change would not pose problems since banks, as
well as other firms, would be indifferent to the mix
of~quity and debt financing. But that is not the state
ofth~world; ifit were, there probably would be no
role for banks as intermediaries.
It seems likely that the economic contribution of
banks as integrated providers of transaction and
intermediation services would be affected adversely
by a complete regulatory abolishment of par-value
deposit accounts. Even before the Glass-Steagal
Act, banks offered par-value deposit contracts. In
part, this practice likely is due to the problem of
d~termining the market value of many bank assets.
In addition, the public may have a preference for
par-value bank accounts for transactions needs since
there may be some advantage to having a predictable account balance when planning purchases.
It is difficult to evaluate the importance of parvalue liquid deposits to banking. The shift of many
money market mutual funds from marked-to-market to amortized cost accounting, which results in
quasi-par value accounts, suggests that there may be
a demand for predictable balances for certain types
Of accounts. Nev~rtheless, the use of nonpar-value
accounts for liquid deposits by banks would eliminate the incentives for bank runs. To the extent that
bank runs are a public policy concern, regulation, at
a minimum, should not prevent the development of
nonpar-value accounts by banks.
nat~d.by converting
Restrictions on Activities
From a safety-and-soundness perspective, the
usual arguments for limiting the economic activities
of banks is that some activities, such as insurance
und~rwriting and direct real estate investment, are
considered highly risky. Furthermore, gains from
diversification are viewed as unable to offset the
risks these activities present. Limiting banks'
activities, it is argued, would lower the institutions'
risk-return positions.
There is considerable debate, however, over
whether regulation can lower the risk-return position, and even whether regulation is counte~roduc
tive. To increase their return on equity, institutions
might simply raise their risk exposure in permitted
activities. Alternatively, banks, if allowed, might
increase their leverage to re-establish a desired riskretumposition. Moreover, regulations that limit the
ability ofinstitutions to diversify may exacerbate the
problem of instability, by reducing returns without
lowering risk. 17
Risk in Banking
Aside from par-value accounts, another condition
for bank runs is that banks be exposed to risk. One
way of preventing bank runs would to be eliminate
risk in banks' portfolios - credit risk as well as
interest rate risk. This would mean that bank assets
would have to be free of default risk, and asset and
liability durations would have to be matched.
To eliminate risk in banking, the structure of
banking would have to be radically altered. Banks
Capital Requirements
Capital requirements also have been justified on
safety-and-soundness grounds. In the absence of
regulation, banks could be expected to hold some
level of capital, if only to increase the probability
64
that they could make good on noncontingent deposit
claims held against them. The question facing policy makers is whether market-detennined·capital
"requirements" for banks would be adequate.
Tothe extent that public PQlicy regatding banks is
based on the existence of market failures, the
amount of capital demanded by the market would
not be adequate. Moreover, in the present environment, the subsidized rateonfedetal· insllraricedistorts the equity-deposit mix thatwould be demanded
by the market by reducing the need for equity. We
discuss the issue of federal deposit insurance more
fully in the next section.
practice that would eliminate most of the economic
functions of banks, there remains the question of
whether regulation can ensure sufficient stability in
financial markets to avoid disruptions to monetary
c()IltrOl,.thepayment system, .and· creditlllarkets.
Depository institutions have incentives to circumvent regulatory constraints to improve their riskreturn positions. But perhaps moreiInportarltly,
much· of the instability in banking appears· to have
stemmed from macroeconomic shocks.· As long as
banks •maintain risky portfolios, .it is doubtful that
supervision and regulation can insulate banks from
such shocks.
Anticompetition Regulations
In addition to portfolio constraints, the riskreturn position of banks might be affected by anticompetition regulations such as entry restrictions.
Entry restrictions are widespread in banking and
include prohibitions on de novo entry through chartering regulations, as well as restrictions on branching, chain banking and interstate banking, although
many of these appear to be breaking down (Keeley,
1985).
The primary effect of limiting entry is to create
rents by restricting competition. The direct effect of
entry restrictions (or any other anticompetitive regulation for that matter), then, would be to create a
market failure - not to rectify one. By limiting
competition, however, bank charters (the right to do
business) have a capital value that would not exist in
the absence of regulation. Moreover, this capital,
unlike most assets, cannot be separated from the
bank. It would appear, therefore, from a marketfailure point of view, that the only justification for
entry restrictions would be their usefulness as an
indirect way of enforcing minimum capital requirements. I8 However, while this capital may provide
some cushion, particularly for the deposit insurance
agencies in the event of a failure,direct capital
regulation could achieve the same result without the
distorting influence of restricted competition.
To the extent that public policy concerning banks
is based on the presence of certain market failures,
capital requirements, linked with monitoring of
risk-taking might be appropriate in principle.
However, absent easily enforced restrictions that
allow banks to invest only in riskless assets - a
DepOsit Liquidity
The third component in the bank run problem is
deposit liquidity. Without ready access to their
funds, depositors would not be able to act on their
desire to avoid losses. One innovation that often is
argued to neutralize the problems associated with
liquid deposits is the existence of a lender-of-Iastresort. A central bank, acting as lender-of-Iastresort, is said to be able to prevent runs without
limiting the liquidity of deposits by providing a
market for bank assets.
By acting as a source of liquidity, a lender-of-Iastresort could indeed prevent runs if the only source of
losses for banks were unexpected asset liquidations,
and if the lender-of-Iast-resort could significantly
reduce the cost of such liquidations. As suggested
earlier, however, banks are exposed to losses from a
variety of sources, not all of which can be controlled
by a lender-of-Iast-resort. If the lender-of-Iast-resort
is required to mark bank assets to market, as is the
case for the Federal Reserve, then losses related to,
say, credit risk could be sufficient to prompt a run.
That is, a lender-of-Iast-resort that marks-to- Illarket
does not fully address the property rights problem of
liquid par-value accounts.
Diamond and Dybvig offer another approach for
maintaining property rights when deposits are liquid. Their solution suggests that it is not necessary
to deny depositors access to their funds to prevent
runs. Instead, it is only necessary to prevent depositors from avoiding any liability when they do withdraw their funds. Runs are prevented in their model
through the threat of an ex post levy on all depositors. This levy would meet deposit obligations at a
65
resultfromthe bank's risk-taking. There is no riskpooling, only the enforcement of property rights.
l)epositors. would consider risk-exposure in. determining their expected rate of return on deposits, so
the cost of deposits to the bank would be positively
related to the risk of its portfolio. Asa result, the
cost ofbank risk-taking would be internalized.
A system for preventing runs more in keeping
withthes()lution suggested by Diamond and Dybvig would enforce property rights without government-provided insurance.. With many banks in the
system, oneway to accomplish this would be to hold
depositors, both past and present, liable for the
losses of a failed bank and not the insurance funds
and the general public. For past depositors to remain
at risk, depositor liability would have to extend
beyond the time when funds are withdrawn.
As a practical matter, a working definition of
what constitutes a "past depositor" would be necessary and probably only the government could
enforce an ex post levy on such depositors. Nevertheless, such an alternative to the current deposit
insurance would have the effect of making depositors sensitive to bank risk. This is similar to the goal
of deposit insurance reforms that stress increasing
market discipline, but unlike them, it would still
prevent bank runs. 21
Such a system would take the government out of
the deposit insurance business but keep it in the
property rights enforcement business. At the same
time, depositors would have an added incentive to
optimally diversify their portfolios. Moreover, the
program suggested to prevent runs would not preclude, and could even facilitate, the provision of
private deposit insurance that took advantage of
pooling nonsystemic risk in banking. If private
insurance were not available, it would even be
possible to have some nominal federal coverage for
small depositors considered unable to take advantage of diversification. Such protection would not
distort bank behavior.
ban.1e in the event of greater-than-expected withdrawals .. Depositors do not have an incentive to
withdraw their funds prematurely since, with the
threatofan ex post levy, they would be no betteroff
iHherewerearun, an.dthey wouldbe.worse.off if
thereivvere no run (for example, depositors making
withdrawals might forgo interest income and incur
other transactions costs).
I)nderc1.]J'tentpolicy measures related to banking, depositors' . claims are. secured through the
systeluoffed.eral deposit insurance. The administration of federal deposit insurance parallels the
approach suggested by Diamond and Dybvig to
some degree. While the insurance agencies maintain funds, the effectiveness offederaldeposit insurance lies in the understanding that the full faith and
credit of the federal government stands behind the
insurance funds. That is, the viability of the insurance funds rests on the taxing authority of the
government. The ability to levy taxes to meet
deposit withdrawals is similar to the ex post fees on
depo~itorsin the Diamond and Dybvig model.
Despite this similarity, the current deposit insuranCe system is quite different from the solution
suggested by Diamond and Dybvig. While federal
deposit insurance maintains well-defined property
rights for insured depositors, it also involves poolinguonsystematic risk in banking. 19 This second
aspect of federal deposit insurance raises the concern that the current insurance system generates
distortions in the economy by creating incentives
for depository institutions to take on nondiversifiable or systemic risk. 20 These incentives for risktaking arise because the value of the insurance is not
reflected in the cost of funds to individual banks.
The ex post levy in the Diamond and Dybvig
mo(lel does. not distort incentives for risk-taking
even ifbank assets are risky. In their model, there is
only one bank and depositors know they must
ultim<itely bear a pro rata share of losses .that might
66
UI. Summary and >Conclusion
The debate over the role of government in regulating depository institutionsundollbtedly will continue. Although the debate in the political arena is
partly about the distributive effects ofregulation,
regulation's social benefits and costs also can be
important considerations from even a purely private
interest. perspective. We have ther~fore examined
how banking regulation might be related to social
welfare. This would seem to be a necessary first step
in a more complete study that would also look at
regulation from the viewpoint of private interests.
Examining the distributive effects of banking regulation is, however, left for future research.
Our approach has been to determine whether
there is a potential for market failures in banking as
it relates to the monetary and credit systems. With
regard to the monetary system, an unrestricted,
competitive, private fiat system is not viable. A fiat
monetary system requires control over the supply of
money (the numeraire) and a demand for the fiat
money. One way to ensure a demand is by imposing
reserve requirements, although, if there were a
stable demand for a fiat currency for transaction
purposes, reserve requirements would not be necessary. Reserve requirements, however, make possible
the social control of the degree of financial intermediation, but at a cost of restricting it to be less
than it would be under a reserve-free system. In a
monetary system where reserve requirements are
used, it may be necessary to limit the types of
privately issued assets used as media of exchange to
enforce reserve requirements.
In providing credit, banks hold a large volume of
nontraded assets (loans). The asymmetry in information of banks and the public concerning the
quality of bank assets could inhibit the intennediation process. This situation, however, is not unique
to depositories, but is shared by other private
placers of credit, such as finance companies and life
insurers. The problem of deficient information
would seem to imply, at most, a need to collect and
disseminate information
services the market
might not be able to supply.
Where there may be a public policy concern
regarding the credit system is the stability of banking. The stability question is also important to
banks' role in the. monetary system. For example, to
the extent that the demand for fiat money is derived
from. reserve. requirements, •the stability . ofthe
institutions on which the requirements are imposed
becomes important. Moreover, even in a system
without reserve requirements, the stability (predictability) of the. demand for money (del11and for the
numeraire) is related to the stability of the demand
for bank-produced payment services.. For banks (all
depository institutions), the issue of stability is
particularly important given their vulnerability to
macroeconomic shocks and runs.
The problem of runs can be traced to banks'
reliance on par-valued liquid liabilities which they
use to fund risky assets. When the market value of a
bank's assets are thought to be less than its liabilities, the poorly defined, or at least unenforceable, property rights of the deposit holders to the
pool of assetS can cause depositors to run. Property
rights can be maintained through the use of nonparvalue or marked-to-market contracts. The full economic implications of "forcing" the use of non-parvalue liquid accounts are not clear, but public policy
should at least not inhibit their development.
Other public policy measures to ensure bank
stability, such as safety-and-soundness regulation
and lender-of-Iast-resort, Can play roles in reducing
the probability of a bank run, but they do not fully
address the problem of property rights in deposit
contracts. Deposit insurance, in contrast, can in
principle protect property rights.
To prevent runs, a deposit insurance system does
not rely solely on a reserve fund; it also relies on its
ability to impose ex post levies. The effectiveness of
a deposit insurance system depends on depositors'
confidence in the ability and willingness of the
system to impose such fees. In this regard, a government agency might be viewed as more effective than
a private finn. Some government responsibility in
the provision of deposit insurance might also have
the effect of internalizing within the government
sector the cost of macro shocks related to fiscal and
monetary policy
The benefits of federal deposit insurance have not
come without a price. As it is currently admin-
67
istered, the system raises a number of regulatory
issues regarding the incentives it provides for risktaking. Indeed, much of the current debate over
traditional safety-and-soundness issues is cast in
tefllls Of theseincentives and the risk exposure of the
insurance funds. At best, safety-and-soundness regulation and risk-related deposit insurance premia
will be only partially successful in checking bank
risk-taking 'and limiting the inefficiency due to
deposit insurance. The insurance itself likely will
continue to distort bank behavior because the losses
of an individual bank remain liabilities of the insur-
ancefundsand the general taxpaying public and not
the liabilities of ,the shareholders and depositors of
individual banks.
The question of how government intervention in
banking relates to the public interest will continue to
be a controversial one. Our contribution has been to
focus the debate, on market failures, partly because
economists generally believe that market failures
arethe Only "appropriate" reason for regulation and
partly because understanding the nature of these
failures is anecessary first step in understanding the
possible distributive aspects of regulation.
FOOTNOTES
1. In fact, many analyses of the effects of regulations on
the banking industry (see Dothan and Williams, 1980, and
Kareken and Wallace, 1978) have used models of banks in
which there are no market failures. The conclusion from
such models is that no regulation is best. These analyses
would seem to be of little practical use, however, because
their conclusions follow directly from their assumptions. In
contrast, our approach tries to determine first whether
there might be market failures associated with banking
activities.
Moreover, physical transfers of the commodity needed to
carry out trade may be very costly compared to the use of
financial assets to effect trade through an accounting
system of exchange or through the use of banknotes. It
might be noted that a banking system with 100 percent
required reserves thus could be very costly. Such a system
could be more efficient than a commodity system since it
might reduce the costs of physically transporting the commodity during exchange, but it would be less efficient than
a system in which the commodity was relatively freed from
monetary uses.
2. There is now a literature in economics that at least
partially validates this private interest view. A large number
of regulations in the airline, automotive, steel, financial,
trucking, agricultural, and communication industries have
beehshown to be primarily attempts to restrict competition. Although these sorts of anticompetitive regulations
did not serve any discernible public interest goal in terms
of rectifying market failures, they probably did redistribute
income.
5. We do not use the term "medium of exchange" necessarily to denote an actual physical circulating medium
such as currency or banknotes. Instead, we use it to refer
to all bank-provided payment services including checks,
wire transfers, credit cards as well as private banknotes.
6. Although the economics of a commodity-based monetary system with bank debt as one medium of exchange
were discussed by Adam Smith (1776), this part of the
monetary economics literature seems to have been
neglected until recently as exemplified in the work of Fama
(1980, 1983), Laidler (1981), Sargent and Wallace (1982),
Hall (1983), and White (1984).
3. 8ecker's model also relates to the impact of deadweight losses stemming from regulations that are primarily
intended to redistribute wealth. He shows that an increase
in the deadweight cost of a subsidy reduces political
pressure from the subsidized group because a given
expenditure results in a smaller net benefit to them. Similarly, an increase in the deadweight cost of a tax leads to
greater pressure by taxpayers to reduce taxes because a
given reduction in their tax rates has a smaller effect on the
revenues produced.
7. However, there still might be a question of whether
regulation would be required to limit the private issuance of
media of exchange to ensure their continued usefulness.
One would expect that in such a commodity-based system, competitive private market forces would require that
bank debt be redeemable in the numeraire commodity to
prevent banks from issuing too much debt. Without
redeemability, banks might be tempted to engage in Ponzi
schemes, redeeming old debt in terms of new debt. Creditors of banks (for example, depositors) might not be able to
ascertain the actual financial condition of such banks
because of high information costs and incentives of banks
to overstate their true financial conditions. Currently, to our
knowledge, all debt is redeemable for the numeraire,
although not necessarily on demand.
4. One reason is that in a pure commodity system the
monetary demand for the commodity (to effect trade) will
lead to mere production of the numeraire commodity compared to a system in which the commodity is not held for
purposes of monetary exchange. Even if the commodity is
in fixed supply, so that production of the commodity money
is. not affected, the monetary demand for the commodity
will lead to its diversion from productive nonmonetary uses
for monetary uses. Thus, a commodity system in which the
commodity itself serves as the sole medium of exchange
wastes real resources compared to a system in which the
costs of holding the commodity for a monetary purpose are
reduced by using other less costly mechanisms to effect
exchange.
Competition also would force banks to charge the marginal
costs of operating such a system and to pay a market rate
of interest on debt, points often neglected by writers on this
subject. The payment of interest on and redeemability of
68
targeting, that rate could be affected by concerns over the
stability of the banking system,
bank debt would limit its issuance just as the payment of
interest on and redeemability of other forms of debt limit its
issuance.
Finally, the traditional concern over stability in banking and
monetary control is that shifts from deposits to currency
could lead to a multiple contraction in the measured money
supply, such as Mi., becquseof.the systemoffra.ctional
reserves. Given the lessons that have been learned from
the past, it is likely that the Federal Reserve would be able
to maintain the level (or growth rate) of a predefined
aggregate such as M1, However, a constant growth rate of
M1 might not ensure financial stability, and the. Federal
Reserve may be unable to predict accurately just how
much money (M1) it should supply to ensure stability.
8, Note that privately issued banknotes under a commodity system are not fiat money because they are not the
numeraire, In fact, unlike fiat money, privately issued banknotes are redeemable for the numeraire commodity and
are financial assets (that is, bank liabilities),
9. This is not to say that some assets would not be used
more often than others to effect transactions. For example,
the transaction costs of trading with assets whose prices
are uncertain might be very high and thus limit their use in
most trades.
16, In the Diamond and Dybvig model, banks are mutual
organizations in the sense that in the last time period any
residual above the guaranteed rate of return is shared by
surviving depositors.
10. A Hat system may eliminate the holding of commodities for monetary purposes and thus free real
resources for other uses, Even with a fiat system, however,
persons may hold commodities for monetary purposes.
Today, large quantities of gold appear to be held for such
purposes,
17. Given these problems, controlling risk through supervision (monitoring and controlling risks) rather than restricting particular activities is an alternative, That is, to limit risk
it is more important to monitor and control how institutions
carry out various activities than it is to regulate which
activities they may pursue. One caveat is that the ability of
regulators to monitor a bank's riskiness may be affected by
the variety of activities in which the institution is involved. In
addition some risky activities may be more difficult to
monitor than others even though they are not inherently
more risky. But it is not clear, a priori, which activities would
involve higher monitoring costs.
Moreover, a fiat system implicitly taxes the holders of fiat
money in proportion to their holdings. (The tax is the
foregone nominal interest associated with holding fiat
money.) This tax distorts behavior and leads persons to
hold less fiat money than is socially optimal. To achieve a
socially optimal quantity of fiat money holdings (see Friedman, 1969), interest must be paid on fiat (base) money
either directly or indirectly through deflation, and these
interest payments must be financed by a nondistorting tax
such as a head tax. Since private entities do not have the
power to tax, this is another reason the private sector
cannot produce a socially optimal fiat money system.
18, A similar argument could be made about interest rate
ceilings. That is, if they could be enforced by eliminating
non price competition and disintermediation, they also
would represent a restriction on competition that would not
appear to address any market failure but instead would
create one. Moreover, with nonprice competition, such
ceilings have the effect of increasing the marginal cost of
deposits while lowering the marginal return compared to
the competitive situation, thus creating a further distortion,
Furthermore, a private monopoly supplier would have no
incentive to provide the socially optimal quantity of fiat
money and would be likely to maximize the real revenue
from printing money instead, Thus, government regulation
of such a supplier could enhance efficiency,
11. This argument could apply to all private placers of
credit such as insurance companies and finance companies.
A traditional rationale for deposit rate ceilings is that unfettered competition would drive up deposit rates and cause
banks to take on riskier portfolios, This view now seems
largely discredited because if banks could benefit from
riskier portfolios without deposit ceilings, why would they
not benefit from such activities with them?
12. Another reason for a decline in the level of financial
intermediation in the second half of the 1930s would be the
increase in reserve requirements that occurred in 1936
and 1937.
13. Information may not be made public because it is
believed that, with deposit insurance, which has effectively
covered all depositors, the public would not use the information to monitor banks, Most recently, with the FDIC
looking for an increased role for market discipline, consideration has been given to greater public disclosure of
information on banks.
Smith (1984) has argued that because depositors are
heterogeneous in terms of withdrawal probabilities and,
because the information is private, that bank runs and
instability might occur essentially because of adverse
selection. That is, while deposit ceilings do not affect the
risk of banks' asset portfolios, they can reduce the risk of
bank runs. However, his analysis, which views banks as
providers of insurance, is far from persuasive and raises
more issues than it settles, In particular, his conclusions
seem at odds with the wide variety of financial instruments
with different liquidities and maturities that are provided by
banks and other financial intermediaries, Moreover, it
seems possible that ceilings might lead to large deadweight losses for some types of depositors and even a
breakdown in intermediation altogether.
14. As mentioned earlier, in a commodity-based monetary
system, a bank panic might also be a concern since it
could affect indirectly the demand for the numeraire and
thus, prices,
15, Even under an interest rate targeting procedure, a loss
of confidence in the banking system and a "flight to
quality" can pose problems for monetary policy, In the
1930s, for example, low rates on safe assets do not appear
to have sent the proper signal regarding whether the
Federal Reserve was providing sufficient liquidity
(reserves) to the economy, Also, with federal funds rate
19, In the case of systemic risk, the current deposit insurance system still serves to maintain depositors' property
rights and, as SUCh, is more in keeping with the Diamond
69
and Dybvig prototype. One difference between the two
systems is that there would be some redistribution of
wealth with the current system since taxes would not likely
be based on individuals' deposit holdings.
evaluation of what it might recover from the liquidation of
assets. Such measures for reforming deposit insurance
are consistent with the small depositor protection rule of
insurance. However,. they are not necessarily. in keeping
with the view that deposit insurance is needed to insure
stability because otmarket failures(see F\.lrlong.,J~84)
Approaches to reforming deposit insurance through regulation include risk-related deposit insurance premia and
portfolio-adjustedcapital guidelines. The usual criticism of
the regulatory approach is that it is doubtful that insurance
qgencieS\'ilould besuccess!u\inq$sess.ingriskex. ante.
Proposals for risk-related premia and capital requirements
also have been criticized because they continue the practice of defining regulatory and supervisory guidelinesin
terms of book value rather than market value. One way of
looking at the degree of subsidy provided through deposit
insurance is the extent to which it allows the marketvalue of
an institution's net worth to go below zero. If all institutions
were closed when the market value of their capital reaches
zero, there would be no insurance subsidy.
20. See Darby (1986).
21. There are a number ofproposals forIncreasing market
discipline in banking to reduce the distortions associated
with deposit insurance. These include lowering the statutory maximum insurance limit as well as permitting coinsurance, which would mean that only a fraction of the
depositors' balances would be covered.
The modified payout plan is another example of how the
deposit insurance agencies mightseek to increase market
discipline. The modified payout plan introduced by the
FDIC for a short period in 1984 was intended to change
formally the practice of paying off all depositors in the
event of failure. With the modified payout plan, depositors
with balances above the statutory maximum received only
a fraction of their deposit balances based on the FDIC
70
REFERENCES
Becker, Gary S. "A Theory of Competition Among Pressure
Groups for Political Influence", Quarterly Journal of
Economics, No.3, Vol. XCVIII, August 1983.
Beebe, Jack. "Bank Stock Performance Since the 1970s,"
Economic Review, Federal Reserve Bank of San Francisco, Winter 1985.
Bernanke, Ben S. "Nonmonetary Effects of the Financial
Crises in the Propagation of the Great Depression",
American Economic Review, Vol. 73, June 1983.
Black, Fischer. "Banking and Interest Rates in a World
Without Money", Journal of Bank Research, Vol. 1,
Autumn, 1970.
_ _. "Bank Funds Management in an Efficient Market",
Journal of Financial Economics, Vol. 2, 1975.
Coase, Ronald H. "The Problem of Social Cost", The
Journal of Law and Economics, October 1960.
Darby, Michael R., "The Internationalization of American
Banking and Finance: Structure, Risk, and world Interest Rates", UCLA Working Paper #385, May 1986.
Diamond, Douglas W. and Philip H. Dybvig. "Bank Runs,
Deposit Insurance, and Liquidity", Journal of Political
Economy, June 1983.
Dothan, Uri and Joseph Williams. "Banks, Bankruptcy, and
Public Regulation", Journal of Banking and Finance,
Vol. 4,1980.
Fama, Eugene F. "Banking in the Theory of Finance",
Journal of Monetary Economics, Vol. 6, 1980.
_ _. "Financial Intermediation and Price Level Control,"
Journal of Monetary Economics, Vol. 12, 1983.
Friedman, Milton. "The Optimum Quantity of Money", in
The Optimum Quantity of Money and Other Essays, by
Milton Friedman, Chicago: Aldine Publishing Co.,
1969
Furlong, Frederick T. "A View on Deposit Insurance
Coverage", Economic Review, Federal Reserve Bank,
San Francisco, Spring 1984.
Furlong, Frederick T. and Michael C. Keeley. "Search for
Financial Stability", in The Search for Financial Stability: The Past 50 Years, Federal Reserve Bank of San
Francisco.
Gurley, John G. and Edward S. Shaw. Money in a Theory of
Finance, Washington, D.C.: The Brookings Institution,
1960
Hall, Robert E. "Optimal Fiduciary Monetary Systems",
Journal of Monetary Economics, Vol. 12, 1983.
Johnson, Harry G. "Problems of Efficiency in Monetary
Management", Journal of Political Economy, Vol. 76,
Sept/Oct 1968.
Kareken, John H. and Neil Wallace. "Deposit Insurance
and Bank Regulation: A Partial Equilibrium Exposi-
tion", Journal of Business, Vol. 5, No.3, 1978.
Keeley, Michael C. "The Regulation of Bank Entry", Economic Review, The Federal Reserve Bank of San
Francisco, Summer 1985.
Kindleberger, Charles P. "Bank Failures: The 1930's and
1980's," in The Search for Financial Stability: The Past
50 Years, Federal Reserve Bank of San Francisco,
1985.
Leland, Hayne E. and David H. Pyle. "Information
Asymetrics, Financial Structure, and Financial Intermediation", Journal of Finance, May 1977.
Laidler, David. "Adam Smith as a Monetary Economist,"
Canadian Journal of Economics, Vol. XIV, No.2, May
1981.
Modigliani, Franco and Merton H. Miller. "The Cost of
Capital, Corporation Finance and the Theory of Investment", The American Economic Review, Vol. XLVIII,
No.3, June 1958.
Patinkin, Don. "Financial Structure of Intermediaries and
the Logical Structure of Monetary Theory," American
Economic Review, Vol. 51, March 1961.
Pesek, Boris and Thomas R. Saving. Money, Wealth and
Economic Theory, New York: MacMillan, 1967.
Rolnick, Arthur J. and Warren E. Weber. "New Evidence on
the Free Banking Era," American Economic Review,
Vol. 73, No.5, December 1983
Sargent, Thomas J. and Neil Wallace. "The Real Bills
Doctrine Versus the Quantity Theory: A Reconsideration", Journal of Political Economy, Vol. 90, No.6,
December, 1982.
Smith, Adam. An Inquiry into the Nature of Causes of the
Wealth of Nations. 1776, New York: Modern Library,
1937.
Smith, Bruce D. "Private Information, Deposit Interest
Rates and the Stability of the Banking System," Journal of Monetary Economics, Vol. 14, 1984.
Stigler, George J. "The Theory of Economic Regulation",
The Bell Journal of Economics and Management Science, Spring 1971.
_ _. The Citizen and the State: Essays on Regulation,
Chicago: University of Chicago Press, 1975.
Tobin, James. "Commercial Banks as Creators of Money,"
in: Dean Carson, ed., Banking and Monetary Studies,
Homewood, Illinois: Irwin, 1963.
Wallace, Neil. "A Legal Restrictions Theory of the Demand
for 'Money' and the Role of Monetary Policy", Federal
Reserve Bank of Minneapolis Quarterly Review, Winter 1983.
White, Lawrence H. "Competitive Payments Systems and
the Unit of Account," The American Economic Review,
Vol. 74, No.4, September 1984.
71
@FedFRASER