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FEDERAL RESERVE BANK OF DALLAS
THIRD QUARTER 1996

Corporate Finance
In International Perspective:
Legal and Regulatory
Influences on Financial
System Development
Stephen D. Prowse

Capacity Utilization as a
Real·Time Predictor of
Manufacturing Output
Evan F Koenig

Externalities, Markets,
And Government Policy
Roy j. Ruffin

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)

Economic Review
Federal Reserve Bank ofDallas
Roberl D. McTeer, Jr.
I're!illenl atIO Cnll!/ ExawtM! Olffcer

Helen E. Holcomb
1'1r';l V l'T~ard C1lIeI ~1llI Othief

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VICll Pte!ldIlnIlrId E:I:o~lc Adv~or

Stephen P. A. Brown
AssISlilIIt \'lal PJnlllel1l iIld ~'Ilf £l:GoomI,j

Research Offtcers

John Duca
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William C. Gruben
Ertln F Koenig

Economlm
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Keith R. Pllillins
Stephen 0 Prowse
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Contents
Corporate Finance
In International
Perspective: Legal and
Regulatory Influences
On Financial System
Development
Stephen D. Prowse

Page 2

Capacity UtiIization
As a Real-Time
Predictor of
Manufacturing Output
Evan F. Koenig

In the postwar period, systems of corporate finance and
governance have emerged in the United States, Japan, and Germany
that are dramatically different from one another. To date, there has
been little focus on why. Stephen Prowse argues that differences in
three aspects of the legal and regulatory environments in these
countries are responsible. First is the severity of legal and regulatory
restraints on financial institutions being "active" investors in firms.
Second is the degree to which corporate securities markets are
suppressed by regulation. The third aspect is the degree to which
securities markets are "passively" suppressed by the absence of
mandated disclosure requirements.
Prowse compares the merits of each system and argues that
the U.S. system may be more favorable to the growth of hightechnology firms. He discusses the future evolution of each system.
The German and Japanese regulatory environments are changing
rapidly to increase the role of securities markets in corporate
finance. The U.S. environment is also changing to give financial
institutions more latitude to be active investors in firms. Over the
long term, the regulatory environments of all three countries appear
to be converging. The focal point of this convergence is an entirely
new environment in which financial institutions are free to be active
investors and corporate securities markets are unhindered by
regulatory obstacles.

In this article, Evan F. Koenig demonstrates that the Federal
Reserve Board's initial estimate of manufacturing capacity utilization
is helpful in predicting subsequent growth in manufacturing output.
Together with lagged real-time output growth and growth in the
composite index of leading indicators, capacity utilization explains
more than 50 percent of the variation in output growth at a fourquarter horizon. Based on data available at the beginning of the
year, the forecasting equation predicts little or no growth in manufacturing output during 1996.

Page 16

Externalities, Markets,
And Government Policy
Roy J. Ruffin

Page 24

In this article, Roy Ruffin explains Ronald Coase's contribution
to understanding the role of government in the economy. Before

the work of Coase, economists argued that externalities-unpriced
benefits or costs-constituted the main exception to the rule that
Adam Smith's invisible hand will efficiently allocate resources.
Coase showed that externalities mayor may not require a government solution, depending on the institutional setting of the problems and the size of transaction costs. Moreover, even in the
absence of externalities, market transactions require low transaction costs. Firms exist to economize on those costs. In shifting
the terms of the debate, Coase single-handedly moved economics
from presuming specific roles for government action to a more
neutral position requiring detailed analysis in order to justify government intervention.

In the postwar period, dramatically different systems of corporate finance and governance have emerged among the major
industrialized countries. Even the casual observer
notices large differences between the way firms
finance and govern themselves in the United
States on the one hand, and in Japan and
Germany on the other. Why should corporate
finance and governance systems differ so dramatically across countries? The difference poses
a problem for the theory of corporate finance
and governance. Theoretically, there is a single
best way to organize and finance firms. Since we
should expect finance and governance systems
to converge to this optimum, we ought not
to find much difference in these mechanisms
across countries. The large differences we actually observe thus suggest accidents of history or
culture or factors that theory ignores—such as
differences in the laws, rules, and regulations
that govern the financial systems of industrialized countries.
Recently, much has been written in the
scholarly and policy-oriented literature on the
relative merits of the different corporate finance
systems in the developed countries.1 There is,
however, little focus on the reasons we observe
such differences despite the problems these
differences pose for the theory of corporate
finance.2 Many studies appear implicitly to
assume that the outcomes we observe are essentially cultural or historical accidents. And much
of the discussion on the relative superiority of
one system over another ignores the possibility
that these systems are the products of particular
legal and regulatory environments that may be
difficult to create in other countries.
I argue in this article that there are, in fact,
large legal and regulatory differences among the
United States, Japan, and Germany that affect
the corporate financial systems in place. The
differences are essentially of three kinds. First is
the severity of the legal and regulatory restraints
on large investors’ being “active” investors in
firms. U.S. laws are in general much more hostile to investors’ taking large influential stakes in
firms than are the laws of Japan or Germany.
Second is the degree to which sources of nonbank finance are actively suppressed. For much
of the postwar period, the development of securities markets in Japan and Germany has been
impeded by discriminatory taxation, regulatory
fiat, and cumbersome mandated issuance procedures. Third is the degree to which corporate
securities markets have been “passively” suppressed by the absence of any strong mandated,
standardized disclosure requirements by firms

Corporate Finance
In International
Perspective: Legal
And Regulatory
Influences on
Financial System
Development
Stephen D. Prowse
Senior Economist and Policy Advisor
Federal Reserve Bank of Dallas

M

uch of the discussion on

the relative superiority of one system
over another ignores the possibility
that these systems are the products
of particular legal and regulatory
environments that may be difficult
to create in other countries.

2

wishing to issue securities to outside investors.
U.S. disclosure requirements have been much
more severe than those in Japan or Germany.
These differences may have been important in
determining the relative speed of securities markets development if there is a large public good
aspect to the production of information by firms
seeking external finance that only the imposition of government-backed disclosure requirements can solve.
I argue these legal and regulatory differences are largely responsible for the very different systems of corporate finance and governance
in the United States, Japan, and Germany. One
natural question is, Which system is superior in
terms of providing external finance at the lowest
cost? The academic literature on this topic does
not yield a clear conclusion as to the more
efficient system, or whether any efficiency differences are large enough to be of practical
relevance. However, I point out that this literature ignores that changes in technology, the
globalization of financial markets, and the changing structure of the firm may have made the
Japanese and German systems of finance and
governance less attractive systems over time.
There is evidence that the U.S. system of finance, for example, is more favorable to the
growth of new, high-technology companies than
are the German and Japanese systems.
Perhaps in response to the perceived advantages of the U.S. system, the legal and regulatory environments of the German and Japanese
systems are changing rapidly, and securities
markets are being substantially deregulated in
an effort to increase their importance as a source
of firm finance. However, it is important to
realize that the regulatory environment of the
U.S. financial system is changing, too, albeit
much more slowly than the German or Japanese
system, as financial institutions are being given
more latitude to be active investors in firms.
Thus, over the long term, the legal and regulatory environments of all three countries appear
to be converging, and the focal point of this
convergence is not the Japanese/German or U.S.
system as it currently stands but an entirely new
environment where financial institutions are
free to be active investors and where corporate
securities markets are unhindered by regulatory
obstacles.
These issues are fundamental to the theory
of the firm, corporate finance, and corporate
governance that have engaged academic debate
for many years. However, recently they have
taken on a policy relevance not experienced
before. In the United States, there has been an

FEDERAL RESERVE BANK OF DALLAS

intense, ongoing debate about the most preferred methods of financing and governing firms.3
And in the last few years, both Japan and Germany have substantially deregulated their corporate securities markets. In addition, the stark
differences between these systems provide alternative paths of development for policymakers
in a whole host of countries considering revamping their financial systems. These include
developed countries such as France and Italy, as
well as the excommunist countries of Central
Europe and many of the emerging market
countries of Latin America and Asia, which all
face decisions about how to craft the outlines
of their rapidly developing financial markets.
In doing so, they would undoubtedly appreciate
an understanding of the factors behind the differences in the major industrialized countries’
financial systems and their relative costs and
benefits. This article addresses these issues by
describing in detail the important characteristics
of the corporate financing systems in the United
States, Japan, and Germany, examining why
such differences exist, and comparing some of
their strengths and weaknesses.
In the following section, I describe the
corporate finance and governance system in the
United States, Japan, and Germany, highlighting
the major differences. I then focus on the major
legal and regulatory factors I believe are the
main determinant of these differences. Finally, I
look at why the Japanese/German system and
the U.S. system may be converging and explore
some implications of this convergence.

Corporate finance and governance
across countries
All corporate finance markets must address two generic information problems faced
by firms attempting to raise funds from outsiders: sorting problems and incentive problems.
Sorting problems arise in the course of
selecting investments: firm owners and managers typically know much more about their business than do outsiders, and it is in their interests
to accent the positive while downplaying potential difficulties. Sorting problems and their implications for corporate finance were first analyzed
by Leland and Pyle (1977) and Ross (1977), who
emphasized that the choice of capital structure
was important in minimizing such problems.
More generally, potential outside financiers must
conduct extensive information gathering and
verifying activities in order to minimize such
information asymmetries.
Incentive problems arise in the course of
the firm’s operations. Firm managers have many

3

ECONOMIC REVIEW THIRD QUARTER 1996

opportunities to benefit themselves at the expense of outside investors. Jensen and Meckling
(1976) were the first to address these issues.
They stressed that a combination of methods
is usually needed to align the incentives of
managers and investors, including the use of an
appropriate capital structure, collateral, security
covenants, and direct monitoring. Diamond
(1991) highlighted the role of reputation in mitigating incentive problems: managers of firms
that have a stake in maintaining a good reputation with outside investors have strong incentives not to act opportunistically at the investors’
expense.
Information problems vary in severity across
firms. The firm’s age, size, growth rate, and line
of business all influence the degree of information problems it poses to outside investors. For
example, firms with heavy investments in tangible fixed assets pose less severe information
problems to investors because they may be able
to offer some of their fixed assets as collateral to
potential creditors and because monitoring the
sale of fixed assets or their transformation from
one use to another is likely to be easier than it is
for more liquid assets. Conversely, firms that
focus on research and development may have
wide scope for discretionary behavior, since the
risk implicit in a particular research and development program cannot easily be monitored or
controlled by outside investors. Finally, other
things being equal, small firms pose greater
information problems than large firms. Smaller
firms do not produce detailed information about
themselves and are often too young to have a
credible reputation. Larger, public firms make
available detailed information about their activities and have a bigger stake in maintaining a
good reputation among potential financiers.
The following section describes the structure of U.S., Japanese and German corporate
financial markets and how they address these
information problems.

Figure 1

Short-Term Liabilities of Nonfinancial
Business, 1994
Commercial
paper
9%
Other loans
16%
51%

Bank loans

24%
Finance company
loans

Total stock: $1.5 trillion

securities markets permits a greater role for securities financing than in Japan or Germany.
Although banks dominate U.S. short-term
finance markets, they have much competition
from finance companies, savings institutions,
and the commercial paper market, which is an
option for larger, more highly rated firms
(Figure 1).4 While banks are still an extremely
important source of funds for small firms, over
the past fifteen years rapid consolidation of the
banking industry has led to a decrease in small
business lending. Bank lending to large firms
has also shown declines in recent years, possibly owing to increasing competition from other
intermediaries and from securities markets.5
Securities markets play a more important
role in long-term financing than in short-term
financing, and they play a more important overall role in corporate financing than in most other
countries (Figure 2 ). The public bond market is
the largest source of long-term finance because
it caters to the biggest firms that have the largest

Figure 2

Issuance of Long-Term Securities, 1990 – 94
The U.S. system

Private
equity

The U.S. system is developed broadly and
deeply enough to allow a large variety of suppliers of finance to compete with one another in a
number of different finance markets. These markets differ from one another partly in the degree
to which they are designed to mitigate the information problems posed by firms. This differentiation provides a natural selection mechanism
as to which firms use which markets. While
banks play an important financing role, they are
more limited by regulation than in Japan or
Germany. Conversely, more liberal regulation of

6%
Private bonds
22%
54%

Public bonds

18%

Public equity

Total issuance: $1.2 trillion

4

Table 1

Capital Sources for Firms
capital needs. The public equity market is also
an extremely important source of long-term
funds for large firms and small, fast growing
firms that make initial public offerings. Two
private markets — the private bond and private
equity markets — are often the only realistic
sources of long-term finance for small and middle
market companies. These markets involve the
issuance of securities that are exempt from
registration with the Securities and Exchange
Commission and, thus, free from much of the
expense in money and time of the registration
process and the continuing reporting and disclosure requirements. The largest of these private
markets is the private placement, or private
bond, market. It offers long-term debt at fixed
interest rates and is a significant source of funds
for middle-market firms with annual revenues
between $100 million and $500 million that are
generally not large enough to issue public
bonds.6 The private equity market consists of
equity investments in small and medium-sized
firms professionally managed by specialized intermediaries, mostly limited partnerships.7
Just as firms vary in the degree to which
they suffer from sorting and incentive problems,
U.S. corporate finance markets differ in the extent to which they are designed to mitigate these
problems. Thus, as shown in Table 1, small
firms are forced to raise funds in markets that
have developed the greatest safeguards to mitigate information problems, such as the private
equity and bank loan market. Medium-sized
firms may be able to tap the private bond market, while larger or more promising middlemarket firms may be able to issue public equity.
Large firms that suffer least from information
problems gravitate toward the markets with the
fewest such safeguards and where capital is the
cheapest, such as the public bond and commercial paper markets.
Two common features in the bank loan,
private placement, and private equity markets
safeguard against the most severe information
problems that occur in smaller firms. First, investors in these markets have the expertise and
resources to obtain and analyze information
about the firms that solicit them for money,
helping to mitigate the sorting problem. Second,
investors use various control mechanisms to influence the firm after funds are invested to ensure that it makes proper use of their capital,
which helps mitigate the monitoring problem.
For example, tight covenants in bank loans and
private placements help control risk and constrain opportunistic behavior. Private equity investors use a number of mechanisms to give

FEDERAL RESERVE BANK OF DALLAS

Firm size
Small

Medium

Low

More

High

Sorting/incentive
problems:

High

Less

Low

Capital sources

Angel capital
Private equity
Bank loans

Private equity
Bank loans
Private bonds
Public equity

them influence, including board representation
and voting rights. In addition, they will typically
control the firm’s access to subsequent capital.
Fast-growing firms depend crucially on the initial investors to either provide subsequent capital themselves or find other investors to do so.
Finally, management is almost always given a
significant stock ownership, which more closely
aligns management’s incentives with those of
the private equity investors.
Large, public firms share some of small
firms’ information problems, though to a lesser
extent. The public bond and equity markets
have a number of characteristics that help mitigate these problems. First, there are a host of
stock and bond analysts, ratings agencies, and
other advisors that analyze the operations and
reports of large firms and offer opinions about
whether the firm is worthy of new capital. Second, the public equity market is highly liquid,
making the threat of a takeover of a firm that is
performing poorly a credible one in many cases,
helping to discipline management to act in shareholders’ interests.

The German/Japanese systems
Although there are some differences, methods of finance and governance in Japan and
Germany share a number of important characteristics. In particular, they both look very different from those of the United States.
First, there has been a much less diverse
spectrum of finance markets available to firms in
Japan or Germany than in the United States.
Japanese and German firms, regardless of their
size or the severity of their information problems, have traditionally relied more on bank
financing than have U.S. firms, while securities
markets have been much less important. For
example, from 1970 to 1985, intermediated loans
(principally from banks) comprised 85 percent

5

Large

Information availability

ECONOMIC REVIEW THIRD QUARTER 1996

Bank loans
Public equity
Public bonds
Commercial paper

Table 2

Table 3

Stock Market Capitalization, 1985

Composition of Companies’
Credit Market Debt, 1985

(As a Percentage of GNP)

Unadjusted
Adjusted

(As a Percentage of Total Credit Market Debt)

United
States

Japan

Germany

51
48

71
37

29
14

Securities
Intermediated
debt
of which,
from banks

NOTE: Adjusted figures are corrected for the
double-counting of shares associated with
intercorporate share holdings.
SOURCES: Borio (1990) and national data.

(Percentage of Outstanding Shares Owned by the Largest Five Shareholders)
Japan

Germany

33.1
29.7
13.8
10.9
85.0

41.5
37.0
14.5
15.0
89.6

3,505

1,835

3,483

1,287

811

1,497

1
2

6

45

91

94

36

NA

88

these tight relationships is the ownership of
equity of nonfinancial firms by banks. Unlike in
the United States, banks are the most important
large shareholders in firms in both countries. In
Japan, they own over 20 percent of the outstanding common stock of nonfinancial firms. In
Germany, they own 10 percent, but under current law they have great flexibility to vote according to their own wishes the additional 14
percent of common stock owned by individuals
but held by banks in trust for them. In contrast,
U.S. banks own negligible amounts of nonfinancial firms’ equity.
Banks consequently have a potentially
powerful position as active monitors in both
Germany and Japan. First, they have typically
comprised the lion’s share of external finance to
firms and may, therefore, exercise influence
through their control of the firm’s access to
external funds. Second, the loans they make are
often short-term in nature. In normal times, they
would be rolled over on an almost automatic
basis, but should questions arise about management strategy or quality, the bank always has
the option of not renewing the loan at a fairly
frequent interval. Finally, their large shareholder
status means that they have both the incentive
and ability to directly monitor management
through their presence on the board and the
votes they can exercise at the shareholders
meeting.
Unlike U.S. banks, banks in Germany and
Japan have effectively acted as insiders to firms.
They have had great access to information about
the firm’s operations and have had the ability to

Summary Statistics of Ownership
Concentration of Large Nonfinancial Corporations

25.4
20.9
16.0
1.3
87.1

Germany

9

SOURCES: Borio (1990) and national data.

Table 4

United States

Japan

55

NOTE: Credit market debt excludes trade debt.
Intermediated debt refers to loans from
financial intermediaries. Securities includes
commercial paper and other short-term bills
and long-term bonds.

of the total gross external financing of Japanese
nonfinancial firms, with only 15 percent sourced
from bond and equity markets.8 German nonfinancial firms raised 88 percent of their gross
external funds from intermediated loans over
the same period, with only 12 percent from
securities markets.9
Another important characteristic of the financial systems of Germany and Japan is the
closeness of ties between banks and their corporate borrowers, which are much tighter than
the traditional arm’s length relationships observed
in the United States. One important aspect of

Mean
Median
Standard deviation
Minimum
Maximum
Mean firm size1
(millions of US$, 1980)
Mean firm size2
(millions of US$, 1980)

United
States

Measured by total assets.
Measured by market value of equity.

NOTE: The samples were as follows: United States — 457 nonfinancial corporations in 1980;
Japan —143 mining and manufacturing corporations in 1984; and Germany— 41
nonfinancial corporations in 1990.
SOURCES: For the United States and Japan, Prowse (1992); for Germany, Prowse (1993).
Size data converted to US$, using 1980 average exchange rates and deflated
by U.S. consumer prices.

6

Table 5

Average Annual Volume of Completed Domestic Mergers and
Corporate Transactions with Disclosed Values, 1985– 89

engage in monitoring and influencing management. Banks’ dual role as important lenders and
shareholders has given them a primary role in
the financing and governing of firms.

U.S. and German/Japanese
systems compared

Japan

Germany

1,070

61.3

4.2

41.1

3.1

2.3

As a percentage
of total market capitalization

These differences between corporate finance systems show up in a variety of ways.
First, the relative importance of corporate securities markets across industrialized countries differs dramatically. Stock market capitalization (as
a share of gross domestic product) is much
larger in the United States than in Japan and
Germany after adjustment for the double-counting associated with intercorporate shareholding
(Table 2 ).10 Corporate bond markets also differ
dramatically in size across countries. In Japan
and Germany, less than 10 percent of nonfinancial corporations’ credit market debt was in the
form of securities in 1985, compared with more
than 50 percent in the United States (Table 3 ).
These differences also show up in the financing
patterns of individual large firms in the three
countries. For example, in 1994, the two largest
firms in Germany, Daimler-Benz and Siemens,
had long-term debt securities outstanding accounting for 10 percent and 2 percent, respectively, of their total assets. In Japan, the numbers
for Toyota and Nissan were 10 percent and 4
percent, respectively. In contrast, the percentage
of total assets financed by long-term bond securities for two of the largest U.S. firms were 30
percent for Ford and 20 percent for GE.
Corporate ownership structures in the Untied States, Japan, and Germany also differ
markedly. Ownership concentration is significantly higher in Japan and Germany than in the
United States (Table 4 ). The holdings of the
largest five shareholders average over 40 percent in Germany, 33 percent in Japan, and only
25 percent in the United States. Many of the
large shareholders in Japan and Germany are
banks with lending ties to the firm.
Another major difference is the frequency
of corporate takeovers. The market for corporate control is much less active in Japan and
Germany (Table 5 ). Part of the reason for the
much greater merger and acquisition activity in
the United States is, of course, the larger number
of companies listed on the stock market. However, even after normalizing the dollar value of
mergers and acquisitions by stock market capitalization, the U.S. merger market appears fifteen to twenty times more active than those in
Japan or Germany.
Hostile takeovers are also very much less

FEDERAL RESERVE BANK OF DALLAS

United States
Volume
(in billions of US$)

NOTES: Dollar values calculated at current exchange rates for each of the five years covered.
Market capitalization figures are for 1987, converted to dollars at prevailing exchange rate.
SOURCES: For the United States and Germany, Securities Data Corp., Mergers and Corporate
Transactions database; for Japan, Yamaichi Securities Corp., as reported in Beiter
(1991).

frequent in Japan or Germany than in the United
States. Table 6 illustrates the paucity of hostile
offers (whether ultimately successful or not) in
continental Europe compared with those in the
United States (no comparable data for Japan are
available). The differences across countries in
actual, completed hostile takeovers are even
more striking. Since World War II, for example,
there have only been four successful hostile
takeovers in Germany (see Franks and Mayer
1993). Kester (1991) claims that the use of takeovers in large Japanese firms is very infrequent.
Conversely, in the United States, almost 10 percent of the Fortune 500 in 1980 have since been
acquired in a transaction that was hostile or that
started off as hostile.11

Legal and regulatory determinants of
corporate financial systems
Much of the scholarly and policy-oriented
literature is silent on the reasons for the differences in corporate finance and governance systems across countries. Studies that do focus on
differences in the legal and regulatory environment mistakenly focus on only one aspect of it:

Table 6

Hostile Takeovers and Leveraged Buyouts as a
Percentage of All Attempted Transactions, 1985– 89
United States

Rest of Europe

17.8
20.0

9.6
2.7

Hostile takeovers
Leveraged buyouts

NOTES: Hostile offers are defined as those transactions in which the acquiring company proceeds
with its offer against the wishes of the target company’s management. Data include both
completed and withdrawn transactions.
SOURCES: Securities Data Corp.; Mergers and Corporate Transactions database.

7

ECONOMIC REVIEW THIRD QUARTER 1996

Table 7

Legal and Regulatory Constraints on Corporate Control
United States

Japan

Banks

Stock ownership prohibited
or requires prior approval
of Federal Reserve Board
and must be “passive.”
Source: Glass–Steagall
and Bank Holding
Company Act.

Prior to 1987 banks could
hold up to 10 percent of a
firm’s stock. After 1987 can
hold up to 5 percent.
Source: Anti-Monopoly Act.

No restrictions, apart
from some generous
prudential rules.

Life insurance
companies

Can hold up to 2 percent
of assets in a single
company’s securities;
can hold up to 20 percent
of assets in equities.
Source: New York
insurance law.

Can hold up to 10
percent of a firm’s stock.
Source: Anti-Monopoly Act.

Can hold up to 20 percent
of total assets in equities.
Source: Insurance Law.

Other insurers

Control of noninsurance
company prohibited.
Source: New York
insurance law.

Can hold up to 10
percent of a firm’s stock.
Source: Anti-Monopoly Act.

No restrictions.

Mutual funds

Tax penalties and
regulatory restrictions
if ownership exceeds
10 percent of a firm’s stock.
Source: Investment
Company Act, Internal
Revenue Service.

No restrictions.

No restrictions.

Pension funds

Must diversify.
Source: ERISA.

No restrictions.

No restrictions.

General

Securities and Exchange
Commission notification
required for 5-percent
ownership. Antitrust laws
prohibit vertical restraints.
Insider trading laws discouraging active share
holding. Bankruptcy case
law makes creditor in
control of firm liable to
subordination of its loans.

Institution

—

Germany

Regulatory notification
required for 25-percent
ownership.

SOURCES: For the United States, Roe (1990); for Japan and Germany, various national sources.

differences in the degree to which banks are
allowed to be active investors in firms.12
In fact, there are large legal and regulatory
differences among the United States, Japan, and
Germany that affect the corporate financial systems in place. These differences are of three
kinds. First is the aforementioned severity of the
restraints on large investors being active investors in firms. Second is the degree to which
sources of nonbank finance are actively suppressed. Finally, there are differences regarding
disclosure requirements by firms wishing to issue securities. All these differences play a role in
determining the different outcomes observed
across countries. I consider them in turn.
Restraints on ownership of corporate equity.
As Table 7 documents, financial institutions in

Japan and Germany are generally given much
more latitude to own shares in and exert control
over firms than they are in the United States.
In the United States, financial institutions
face significant constraints on their ability to
take large stock positions in firms and use
them for corporate control purposes.13 Banks
are simply prohibited from owning any stock
on their own account. Bank holding companies cannot own more than 5 percent of any
unaffiliated, nonsubsidiary, nonbank firm without Federal Reserve Board approval, and their
holdings must be passive.14 Bank trust departments are allowed to hold equity for the beneficial owners. However, they cannot invest more
than 10 percent of their trust funds in any one
firm, and there are often other trustee laws

8

Table 8

Legal and Regulatory Constraints on Nonfinancial Firms’ Access to Nonbank Finance
that encourage further
Germany
Instrument
Japan
fragmentation of trust
Issuance discouraged until 1992
Commercial paper
Issuance prohibited until November
holdings.
by issue authorization procedure and
1987.
Other financial insecurities transfer taxes.
stitutions also face strict
Issuance discouraged until 1992
Domestic bonds
Stringent criteria for issuance
rules governing their
by issue authorization procedure and
of straight and convertible bonds
equity investments. New
securities transfer taxes.
until 1987.
York insurance law,
Issuance abroad required prior
Eurobonds
One-year approval period for foreign
which currently governs
notification of the authorities
bond issuance until 1982; restrictions
almost 60 percent of total
and was subject to maturity restrictions
on issuance of Euroyen bonds until
until 1989; issuance of foreign currency
1984; withholding tax on interest
life insurance industry
bonds prohibited until 1990.
income of nonresidents until 1985;
assets, places a limit of
Eurobond issuance restrictions eased
20 percent of a life infurther in 1992.
surer’s assets, or one-half
New share issues must be offered to
Equity
Heavy taxes on equity transactions
of its surplus, that can be
existing shareholders first. One-percent
until 1988.
invested in equity, and a
corporation tax on all equity issues until
limit of 2 percent of its
1992. Secondary trading in equities
assets that can be insubject to securities transfer tax until
1992, ranging from 0.1 percent to 0.25
vested in the equity of
percent. Annual net asset tax of 1 perany one firm. Other states
cent on corporate net assets, payable
have similar rules. Propirrespective of net income position.
erty and casualty insurers
are prohibited outright
SOURCES: Döser and Broderson (1990); Takeda and Turner (1992).
from owning a noninsurer. Mutual funds are
subject to tax and regulatory penalties if they own more than 10 percent
Act, which until 1987 limited a bank’s holdings
of the stock of any one firm. Pension fund
of a firm’s shares to 10 percent (the limit has
investments are governed by the Employment
since been lowered to 5 percent). Insurance
Retirement Income Securities Act of 1974 (ERISA).
companies are similarly restricted to owning at
ERISA requires all pension funds to be diversimost 10 percent of a firm. Antitrust laws and
fied, allowing little room for an influential posiinsider trading legislation on paper look similar
tion in a company.
to those of the United States. However, there is
U.S. securities laws discourage concenwidespread recognition that they are not entrated, active shareholding by investors in genforced by the authorities.
eral. First, all entities acquiring 5 percent or
The institutional structure of the German
more of a company must file with the SEC,
financial system is based on the universal bankoutlining the group’s plans and revealing its
ing principle. Universal banks can hold whatownership and sources of finance. Second, any
ever share of equity they like in any nonfinancial
stockholder who exercises control over a firm
firm, limited only by a number of prudential
may be liable for the acts of the firm. Third,
rules that do not appear to be particularly bindinsider trading rules restrict large active shareing.15 Antitrust laws have not been used to disholders from short-term trading of stock they
courage intercorporate shareholdings as they have
own. Thus, Bhide (1993) reports that pension
in the United States. And for much of the postfund managers are reluctant to own more than
war period, there was no explicit legislation
10 percent of a firm because this would restrict
against insider trading: Germany has only rethe liquidity of their stake, which by law they
cently adopted the European Community stanhave a responsibility to protect. Finally, the legal
dards regarding the establishment of minimum
doctrine of equitable subordination discourages
levels of shareholder protection.
all creditors from taking equity positions in the
Suppression of sources of nonbank finance
firm, since their loans are subject to subordinain Japan and Germany. Table 8 documents some
tion should they exert control.
of the legal and regulatory restraints on access
In Japan, there are far fewer regulations
to external nonbank finance by nonfinancial
constraining particular financial institutions from
firms in Japan and Germany in the postwar
holding corporate stock or from using the stock
period. Unlike in the United States, significant
they own for corporate control purposes. The
obstacles have confronted firms wishing to raise
sole restrictions derive from the Anti-Monopoly
external finance from sources other than banks

FEDERAL RESERVE BANK OF DALLAS

9

ECONOMIC REVIEW THIRD QUARTER 1996

Table 9

Selected Results from a Survey of the Implementation of
OECD Guidelines on the Disclosure of Information by
Multinational Enterprises

secondary market for corporate securities, particularly at its short end. Foreign issuance of
corporate debt has been subject to similar restrictions. Equity issuance and secondary trading
of equities historically have been subject to a
variety of taxes that have generally made equity
uncompetitive with bank loans as a form of
external finance (see Döser and Broderson 1990).
Most important, however, has been the legal
requirement for employee representation on
boards of publicly listed firms, which has discouraged many private firms from going public
(see Borio 1990). Overall, these restrictions have
made securities issuance “not a viable alternative for most German businesses.”17
Fostering nonbank finance in the United
States through disclosure requirements. Quite
apart from the active discrimination against
nonintermediated forms of finance, the lax disclosure requirements in Japan and Germany
may have been an additional (passive) factor in
discouraging the development of securities
markets.
Firms in the United States wishing to issue
securities to the public have been required to
disclose much more information than those in
Japan and Germany. Results from a recent
Organization for Economic Cooperation and
Development survey, which rated the degree
of information disclosure by firms relative to
OECD guidelines, illustrate this pattern.18 Table
9 illustrates the results for two areas of disclosure — operating results and intragroup pricing
policies. Two-thirds of U.S. firms surveyed had
fully implemented the OECD disclosure guidelines for operating results; the rest had partially
implemented them. In Germany none of the
firms surveyed and in Japan less than 10 percent
of those surveyed had fully implemented the
guidelines. The results for disclosure of intragroup pricing policies (and other areas not reported here) reveal a similar pattern.
There is a fairly intense academic debate
as to the effects of mandated corporate disclosure requirements, with no conclusive answer.
One hypothesis is that mandated disclosure rules
help firms make credible commitments to outside investors to provide honest and timely disclosure and protection from market manipulation
or insider trading. In this view, for strategic,
competitive reasons firms may not have sufficient incentives voluntarily to provide the financial information outside investors would require
to consider extending such finance (for example,
they may be afraid that competitors could take
advantage of such information). Thus, absent a
regulatory requirement for adequate disclosure

(Number of Firms)

Country

Implementation of
guidelines on disclosure of
operating results1
Full

United States
Japan
Germany
1
2

34
2
0

Not
implemented

Partial
19
21
19

0
0
0

Implementation of
guidelines on disclosure of
intragroup pricing policies2
Full
29
2
0

Partial
0
0
0

Not
implemented
18
17
15

Includes industrial and financial firms.
Industrial firms only.

SOURCE: OECD, “Disclosure of Information by Multinational Enterprises,” Working Document
by the Working Group on Accounting Standards, no. 6, 1989.

until the mid-1980s in Japan and until very recently in Germany.
Until the early 1980s, Japanese firms had
no direct recourse to capital markets for external finance. The domestic bond market was
open to only a few government-owned firms or
electric utilities. The Bond Issuance Committee
set severe eligibility requirements on issuers of
corporate bonds through a detailed set of accounting criteria that in 1979 only permitted two
firms to issue unsecured bonds domestically.
These requirements were gradually relaxed in
the mid-1980s, so that, by 1989, about 300
firms were eligible to issue unsecured straight
bonds.16 Similar restrictions on access to the
Eurobond market were relaxed in stages from
1982. Commercial paper issuance was prohibited by the authorities until 1987. While not
directly restricted, equity issuance was discouraged by heavy taxes on transactions in equities
until 1988.
Restrictions on nonbank finance in Germany have been significant until even more
recently. Issuance of commercial paper and
longer term bonds was hampered by requirements under the issue authorization procedure
and the securities transfer tax (see Deutsche
Bundesbank 1992). The issue authorization requirements included obtaining prior approval
by the Federal Ministry of Economics. Such approval was granted if the issuer’s credit standing
was satisfactory and if a bank supported the
application. While this procedure was a formality for large German firms, it added to the effective cost of a bond issue because firms could not
generally issue the bonds at a time of their own
choosing but were forced to wait for approval
from the ministry. The securities transfer tax
often imposed a considerable burden on the

10

to outside investors, the development of a liquid
market for corporate securities may be effectively impeded. Proponents of such a view include Dye (1990), Dye and Magee (1991), and
Demski and Feltham (1994).
The alternative hypothesis is that regulation unduly constrains the choices of firms and
investors and prevents efficient contracting. In
this view, firms have sufficient incentives to
provide the optimal amount of disclosure to
obtain external financing and regulations mandating such disclosure are, at best, irrelevant
and, at worst, burdensome and costly on both
firms and investors. Proponents of this view
include Bentson (1973), Leftwich (1980), Watts
and Zimmerman (1986), and Phillips and
Zecher (1981).
Ultimately, the effect of mandated disclosure requirements is an empirical issue. Unfortunately, only a limited amount of research bears
on this topic. Stock price studies of firms before
and after the 1933 Securities Act suggest that
mandated disclosure regulations impose costs
on firms (see Benston 1973 and Chow 1983). On
the other hand, Sylla and Smith (1995) explain
the differing speeds of development of stock
markets in the United States and U.K. since 1800
on differences in mandated disclosure rules. They
attribute the faster development of the stock
market in the U.K. in the nineteenth and early
twentieth centuries to the various companies
acts between 1844 and 1900 that required substantial disclosure by firms wishing to issue equity. Disclosure requirements were significantly
less onerous in the United States until the 1930s,
when the Securities Acts of 1933 and 1934 went
beyond even what the British had put in place.
Sylla and Smith claim these disclosure rules were
responsible for putting the United States ahead
of the U.K. in terms of the size and depth of the
stock market in the immediate postwar period.
While this debate is far from settled, it is
possible that the marked differences in disclosure requirements among countries may, in part,
be responsible for the differences in the relative
speeds of development of corporate securities
markets.

it has not found demonstrably cheaper capital
for firms or obviously superior mechanisms of
corporate control in any one country.
The academic literature to date makes the
following points: first, there are some advantages in fostering tight ties between banks and
firms. Prowse (1990), Hoshi et al. (1990a),
Lichtenberg and Pushner (1993), Cable (1985),
and Elston (1993) all provide evidence suggesting that the concentrated holding of debt and
equity claims by financial institutions in Germany and Japan mitigates the information problems of external finance and governance to a
greater extent than in the United States, where
ties between banks and firms are more arm’s
length.
However, there are also advantages to having large, active corporate securities markets.
Porter (1992) and Sahlman (1990) provide evidence that the U.S. system appears better at
funding emerging companies and new (often
high-technology) business activities than the
German or Japanese system. Franks and Mayer
(1992) argue that such a comparative advantage
is the reason for the predominance of hightechnology firms in the fields of oil exploration,
biotechnology, pharmaceuticals, and computer
software in the United States. Porter also claims
that liquid U.S. capital markets are able to reallocate capital from low- to high-growth sectors
more efficiently than those of Japan and Germany.
The specific advantages of each system do
not appear to translate into overall measurable
differences in either the cost of external financing or the effectiveness of the corporate control
mechanism. There are legions of cost of capital
studies with no clear message as to which
system delivers external finance to firms at the
lowest cost.19 And Kaplan (1993a, 1993b) reports that top management turnover exhibits
similar sensitivities to measures of poor firm
performance in the United States, Japan, and
Germany. Conversely, both systems clearly
have their embarrassing examples of breakdowns in corporate control. The German and
Japanese systems appear particularly susceptible
to potential problems involving “who monitors
the monitor?” 20 The U.S. system appears to
have particular weaknesses when, for one reason or another, hostile takeovers pose no
credible threat to current management.21 Overall, it may well be that neither system clearly
dominates the other. After all, firms from all
three countries have been competing internationally with each other for years, yet no obvious winner has emerged.

Costs and benefits of different systems of
finance and governance
There has been much debate about the
efficiency of the different systems of corporate
finance and governance we observe in the industrialized countries, with no clear consensus.
While the academic and policy-oriented literature often finds specific advantages in a particular country’s financing and governance systems,

FEDERAL RESERVE BANK OF DALLAS

11

ECONOMIC REVIEW THIRD QUARTER 1996

Perhaps the most important consideration
in evaluating the effectiveness of each system is
the system’s long-run stability, a factor many
studies ignore. It appears that the legal and
regulatory environment that sustains the corporate finance system in Japan and Germany is not
stable, but is changing rather rapidly. These
changes may be a result of a conscious decision
by policymakers in these countries to capture
some of the aforementioned advantages of the
U.S. system in financing emerging high-technology ventures. Or they may have resulted from
the fact that legal and regulatory systems have
costs, both economic and political, the bulk of
which may have little to do with the particular
mechanism of corporate finance and governance
they support and which have increased in response to changes in the power of vested interests, financial innovations, and other market
developments.
Japan is the clearest example of this phenomenon. The regulatory and legal structure of
the Japanese financial system has been changing
since the 1970s under both domestic and international pressure for reform. One aspect of Japanese deregulation has been the gradual removal
of restrictions on nonbank finance. Rosenbluth
(1988) argues that the strict regulation of Japanese corporate finance in favor of bank lending
until the early 1980s proved unsustainable in the
face of growing competition from the
Euromarkets and the decline in profitability of
domestic bank lending after the removal of interest rate controls.
Ties between banks and large firms in
Japan that have easy access to the Euromarkets
and the developing domestic bond market are
weakening substantially in response to this
deregulation, as the financing patterns of many
firms are changing (see Hoshi et al. 1993 and
Kester 1991). While Japanese nonfinancial firms
obtained only 15 percent of their total gross
external financing from securities markets between the years 1970 and 1985, from 1986 to
1990 they obtained over 30 percent from bond
and equity markets.22 What these changes mean
for the mechanisms of corporate control employed in Japan is not clear. It may mean that
takeovers start to become more frequently
used to discipline management. However
methods of corporate control evolve, and there
will likely be significant changes from the previous regime.
The German legal and regulatory environment has also shown recent signs of
changing. As part of the attempt to compete
with London as a center of finance, many of

the restrictions on corporate finance have been
relaxed (see Deutsche Bundesbank, March 1992).
In addition, other aspects of the German legal
and regulatory framework will have to change
under planned European Economic Community
reforms. As in Japan, this may increase the role
of securities markets in the financing of German
firms. Again, how methods of corporate control
will change is unclear.
The U.S. financial system has also been
changing, albeit much more slowly than those in
Japan and Germany. Some restrictions, such as
the SEC’s rules on shareholder activism, have
already been loosened and have led to some
institutional investors flexing their muscles
somewhat. However, the wide variety of different laws that support the U.S. system of
corporate control—portfolio regulations on
financial institutions, tax laws, antitrust rules,
and securities laws —means that any changes
are likely to be evolutionary rather than revolutionary.

Implications of changing legal and
regulatory environments
This article has shown that differences in
the legal and regulatory environment pertaining
to corporate ownership by financial institutions
and to corporate securities market development
have been of great importance in determining
differences in the finance and governance systems observed across the industrialized countries. It follows that as these legal and regulatory
environments change, so will methods of finance and governance. As noted above, there is
clearly some long-term convergence going on in
the legal and regulatory environments of the
United States, Japan, and Germany, and the
focal point of this convergence is not the Japanese/German or U.S. system as it currently exists
but an environment in which banks are free to
conduct investment and commercial banking
activities (including active investments in firms)
and corporate securities markets are unhindered
by regulatory and legal obstacles.
What will be the primary mechanisms of
corporate finance and control in such a system?
This is a difficult question because we do not
have models among the developed industrialized countries we can look at that embody such
a legal and regulatory environment. The closest
to this model might arguably be the United
States in the early twentieth century. In the
United States in the 1920s, firms had relatively free access to nonbank finance, securities
markets were relatively active, and there were
few restrictions on the ability of financial insti-

12

tutions to take equity and debt positions of a
size to confer some control.23 In this system,
there might plausibly be some firms that would
solve their financing and governance problems
better by using intermediated finance from intermediaries that also take active equity positions in the firm, while others might better rely
on securities markets for external finance and
an active takeover market for corporate control.
Just how and why this “mix” occurs is a subject
worth further investigation in the form of a more
detailed analysis of this period in U.S. financial
history.
For the United States, the movement toward a more deregulated environment for financial intermediaries should not necessarily be
viewed with trepidation. As pointed out, there
are some clear advantages to be gained from
letting banks and other financial intermediaries
form tighter ties with the firms to which they
lend. Perhaps the biggest concern relates to the
issue of deposit insurance. Allowing commercial
banks to engage in investment banking activities, including the holding of corporate equity,
clearly requires a thorough review of the implications for the deposit insurance fund and possible modifications to the U.S. deposit insurance
system.

12

13

14

15

16
17
18
19
20

Notes
1

2
3

4

5

6
7

8

9
10

11

21

For example, see Jensen (1989), Kester (1991),
Bisignano (1990), Porter (1992), Franks and Mayer
(1992 and 1990), Bhide (1993), Roe (1993), Edwards
and Fischer (1994), and Charkham (1994).
An exception is Roe (1993).
A recent manifestation of this is the Council on Competitiveness’ 1992 report, Capital Choices: Changing
the Way America Invests in Industry. See Porter (1992).
Recent innovations in asset-backed commercial paper
programs and other credit-enhancement techniques
are, however, allowing smaller, less highly rated firms
to access the commercial paper market.
See Berger, Kashyap, and Scalise (1995) for evidence
on these trends in bank lending.
See Carey, Prowse, Rea, and Udell (1993).
Large firms will also use the private equity market on
occasion. See Fenn, Liang, and Prowse (1995).
1985 is chosen as the year for comparison because it
reflects the situation in Japan prior to much of the
corporate securities market deregulation in the second
half of the 1980s.
See Prowse (1995).
Comparing unadjusted stock market capitalization
across countries can be misleading if there is a high
degree of intercorporate shareholding in one country
because these shares are double-counted.
See Morck, Shliefer, and Vishny (1989).

FEDERAL RESERVE BANK OF DALLAS

22
23

Thus, Roe (1993), Allen and Gale (1996), Boot and
Thakor (1996), Gorton and Schmidt (1992), and
Calomiris (1993) distinguish the U.S. and German
financial systems solely on the principle of universal
banking, with no acknowledgement of the severe
restrictions on corporate securities markets in Germany.
For a detailed description of these restrictions, see
Roe (1990) and Prowse (1995 and 1990).
Bank holding companies are regulated by the Federal
Reserve Board under the Bank Holding Company Act
of 1956. In addition, they may purchase up to 24.9
percent of a nonbank firm’s total capital (including
subordinated debt and nonvoting stock); again, the
investment must be passive. See Carey et al. (1993).
The most onerous appears to be the requirement that
total qualifying investments in equity and real estate
should not exceed the bank’s capital. A qualifying
investment is one in which the bank takes a greater
than 10-percent share of the enterprise. See Deutsche
Bundesbank (1991).
See Nomura Securities (1989).
See Döser and Brodersen (1990).
See OECD (1989).
See, for example, Kester and Luehrman (1992).
That is, banks in Japan and Germany are the very
institutions that are themselves diffusely held by shareholders. Thus, there may be a problem in ensuring that
banks in these countries act to maximize value and
conduct the monitoring function in an efficient manner
in the firms in which they have large stakes.
Two examples would be during periods when the
financing for takeovers becomes scarce and when,
in particular industries such as commercial banking,
regulatory constraints effectively preclude hostile
takeovers. See Prowse (1995). Regarding the corporate control mechanism in U.S. commercial banks, see
Prowse (1994).
See Prowse (1995). See also Bank of Japan (1992).
See, for example, De Long (1990).

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Corporate Financial Behavior in the United States and
Japan,” Journal of Financial Economics 27 (1): 43–66.

Kester, W. Carl and T. Luerhman (1992), “Cost of Capital
Comparisons Across Countries,” Harvard Business
Review.

Roe, M. J. (1993), “Some Differences in Corporate
Structure in Germany, Japan, and America,” Yale Law
Journal 102 (8): 1927–2003.

——— (1991), Japanese Takeovers: The Global Quest
for Corporate Control, (Boston: Harvard Business School
Press).

——— (1990), “Political and Legal Restraints on Ownership and Control of Public Companies,” Journal of
Finance Economics 2 (1): 7– 43.

Leftwich, R. (1980), “Market Failure Fallacies and Accounting Information,” Journal of Accounting and Economics
2 (3): 193 – 211.

Rosenbluth, F. (1988), Financial Politics in Contemporary
Japan (Ithaca: Cornell University Press).

Leland, H., and D. Pyle (1977), “Informational Asymmetries, Financial Structure, and Financial Intermediation,”
Journal of Finance 32 (2): 371– 87.

Ross, S. (1977), “The Determination of Financial Structure: The Incentive-Signaling Approach,” Bell Journal of
Economics 8 (1): 23 – 40.

Lichtenberg, F., and G. Pushner (1992), “Ownership
Structure and Corporate Performance in Japan,” NBER
Working Paper, no. 4092.

Sahlman, W., (1990), “The Structure and Governance of
Venture Capital Organizations,” Journal of Financial
Economics 27 (1): 473–521.

Morck, R., A. Shleifer, and R. Vishny (1989), “Alternative
Methods for Corporate Control,” American Economic
Review 79 (4): 842–52.
Nomura Securities (1989), Finance Handbook, Tokyo.

Sylla, R., and G. D. Smith (1995), “Information and Capital
Market Regulation in Anglo-American Finance,” in
Michael Bordo and Richard Sylla (eds.) Anglo –American
Financial Systems (Burr Ridge, Ill.: Irwin).

OECD (1989), Disclosure of Information by Multinational
Enterprises (Paris: Organization for Economic Cooperation and Development).

Takeda, M., and P. Turner (1992), “The Liberalization of
Japan’s Financial Markets: Some Major Themes,” BIS
Economic Papers, no. 34.

Phillips, S., and J. R. Zecher (1981), The SEC and the
Public Interest: An Economic Perspective (Cambridge,
Mass.: MIT Press).

Watts, R., and J. Zimmerman (1986), Positive Accounting
Theory (Englewood Cliffs, N.J.: Prentice Hall).

Porter, M. (1992), Capital Changes: Changing the Ways
America Invests in Industry (Boston: Harvard Business
School Press).

FEDERAL RESERVE BANK OF DALLAS

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ECONOMIC REVIEW THIRD QUARTER 1996

The notion that aggregate output has both
a permanent component and a transitory component is consistent with a wide range of business cycle theories. Insofar as the permanent
component of output is observable in real time,
the gap between current and permanent output
will contain information useful in predicting
future changes in output.
The empirical literature contains several
efforts to predict output in this way. In a bivariate setting, Cochrane (1994) has shown that the
permanent component of U.S. real gross domestic product (GDP) can be closely approximated
by mean-adjusted real household consumption
of nondurable goods and services and that the
gap between current real output and meanadjusted consumption has significant marginal
explanatory power for future output growth.
A procedure for approximating the permanent
component of output using only current and
lagged output observations is suggested by
DeLong and Summers (1988, 459). In a limiting
case, the DeLong and Summers formula reduces to using the historical maximum of output
as a measure of permanent output. The implicit
underlying assumption is that any decline in
output is likely to be transitory. Beaudry and
Koop (1993) report success including the difference between output and its historical maximum in forecasting equations for U.S. real GDP.
Wynne and Balke (1992, 1993) use essentially
the same approach to establish a tendency
for deep recessions to be followed by strong
recoveries.
In this article, I examine whether manufacturing capacity, as estimated by the Federal
Reserve Board, is a useful measure of the permanent component of manufacturing output.
Specifically, I consider whether manufacturing
capacity utilization has marginal explanatory
power for subsequent growth in manufacturing
output. Except for a brief, illustrative aside,
I use only real-time utilization data. The use of
real-time data is critical. The Federal Reserve
indices of capacity and utilization are subject
to extensive revisions, which may extend back
several years. Moreover, revision procedures
are designed, quite consciously, to smooth
capacity and to ensure that utilization is a stationary series. The effect is to incorporate information about future output in the revised
capacity data. Real-time data, obviously, cannot
incorporate information unavailable to analysts
at the time.
The empirical results indicate that the
Federal Reserve’s initial capacity utilization releases do, indeed, contain useful information

Capacity Utilization
As a Real-Time
Predictor of
Manufacturing Output
Evan F. Koenig
Research Officer
Federal Reserve Bank of Dallas

T

he use of real-time data is

critical, for the Federal Reserve
indices of capacity and utilization
are subject to extensive revisions,
which may extend back
several years.

16

Predicting initial estimates of output growth

about future manufacturing output growth. Significant marginal explanatory power remains
even after controlling for real-time estimates of
lagged output growth, a measure of labor force
utilization, and lagged changes in the Commerce Department’s composite leading index.
On the other hand, although the Federal Reserve’s utilization measure appears to contain
more useful information than does the Beaudry–
Koop measure, the difference in information
content is not statistically significant. These results hold regardless of whether one is trying to
predict the Federal Reserve Board’s initial estimate of output growth or a revised estimate.
Using data available through the fourth quarter
of 1995, the forecasting model developed in this
article is predicting essentially no change in the
level of manufacturing output during 1996.

In this section, I look at whether the Federal Reserve’s initial estimates of capacity utilization have real-time predictive power for its initial
estimates of manufacturing output growth. To
shed light on this question, I undertake a series
of regressions of the form
(1)

over a sample period running from 1968 through
1994. Here, ∆yt denotes the change in the logarithm of manufacturing output from the fourth
quarter of year t – 1 to the fourth quarter of year
t, as published in the Federal Reserve Bulletin
early in year t + 1, when data for the fourth
quarter of year t first become available; ∆yt –1
denotes the change in the logarithm of output
from the fourth quarter of year t – 2 to the
fourth quarter of year t – 1, as published early in
year t ; ut –1 denotes the logarithm of capacity
utilization in the fourth quarter of year t – 1, as
published early in year t; and zt –1 is any one of
several lagged explanatory variables.4 Lagged
(real-time) capacity growth and additional lags
of (real-time) output growth are not statistically
significant when included on the right-handside of the estimated equation.
Column 1 of Table 1 presents results for
the case in which α 3 ≡ 0. The coefficient on the
Federal Reserve’s measure of capacity utilization
is statistically significant at better than the 1percent level. Its point estimate indicates that
each 1-percent increase in utilization implies a
nearly 57 basis-point decrease in output growth
over the coming year.
In columns 2 and 3, z is the Beaudry–
Koop measure of utilization that would have
been observed in real time. That is, zt is the
real-time difference between the current log
level of output and the logarithm of the historical maximum level of output. Introduced separately, as in column 2, the impact of the
Beaudry–Koop measure on subsequent output
growth is highly statistically significant. Each 1percentage-point increase in output, relative to
its historical maximum, is associated with a 1.1percentage-point reduction in output growth over
the coming year. In going from column 2 to
column 3, the impact of the Beaudry–Koop
measure drops sharply in magnitude and is
no longer statistically significant. The Federal
Reserve measure is also insignificant, but the
magnitude of its coefficient is affected less and
its t statistic is larger than that of the Beaudry–
Koop measure. The adjusted R 2 s and standard
errors reported at the bottom of columns 1 and 2

The Federal Reserve indices of
capacity and utilization1
For a given industry, the Federal Reserve
Board obtains a series of reference end-of-year
capacity estimates by dividing its output index
for that industry by utilization rates taken from a
biennial Census Bureau survey of manufacturing
plants.2 These reference estimates establish the
long-term trend growth rate of the Board’s published capacity index. Detrended year-to-year
variations in the published capacity index for
a given industry are determined by movements
in the estimated capital stock for that industry
or, less frequently, by movements in direct
physical-unit capacity measures. Estimated capital stocks are calculated from Bureau of Economic Analysis surveys of capital spending
plans using the perpetual inventory method.
The capital stock estimates are subject to substantial revision every fifth year, when Census
investment data become available. Capacity series are aggregated across industries, using the
same value-added weights employed in the
construction of the Board’s aggregate output
indices.
Monthly estimates of capacity are obtained
by interpolating between end-of-year figures. It
follows that within-year variation in capacity
utilization largely reflects month-to-month movements in output (Shapiro 1989). Accordingly,
this article uses only output, capacity, and utilization data reported for the fourth quarter of
each year.
Although capacity and utilization data
extend back to 1948, regular publication did not
begin until 1968. 3 Hence, the analysis that
follows is limited to a sample period that starts
in 1968.

FEDERAL RESERVE BANK OF DALLAS

∆yt = α0 + α1∆yt –1 + α 2ut –1 + α 3zt –1,

17

ECONOMIC REVIEW THIRD QUARTER 1996

Table 1

Predicting the Initial Estimate of Manufacturing Output Growth
Estimated equation: ∆yt = α0 + α1∆yt –1 + α2ut –1 + α3zt –1
Fourth-quarter data: 1967– 94

Z
None

Beaudry–Koop

α0

2.499***
(.771)

–.0128
(.0161)

α1

.523**
(.213)

.680**
(.262)

α2

–.568***
(.177)

—

—

Adj. R 2
SE

α3

Q(6)

Avg. weekly hours
.397
(.896)

1.975**
(.875)

.0231***
(.0082)

1.650**
(.636)

.181
(.256)

.428*
(.224)

.046
(.148)

.326*
(.172)

–.422
(.324)

—

–.686***
(.200)

—

–.373**
(.146)

–1.102***
(.381)

–.365
(.679)

–.0093
(.0222)

.0258
(.0211)

2.427***
(.518)

2.012***
(.495)

.253

.207

.230

.0445

.0458

.0452

2.718

2.379

1.854
(1.432)

Leading index growth

.606**
(.265)

–.061
.0530

2.063

10.138

.268

.441

.0441

.0385

3.715

.546
.0347

6.162

4.337

* Significant at the 10-percent level.
** Significant at the 5-percent level.
*** Significant at the 1-percent level.

tion appears to do a good job of capturing the
qualitative pattern of output growth. Thus, in
six of the seven years in which output was
reported to have fallen, the model would have
predicted either an output decline or zero growth
(more precisely, growth of less than 0.5 percent). Only in 1981 would the model have
stumbled badly, predicting 3.1 percent positive
growth when output subsequently actually fell
by 2.5 percent. Similarly, the model would have
been qualitatively correct in nineteen of twenty
years in which output was reported to have

confirm that the Federal Reserve utilization
measure has greater marginal predictive power
than does the Beaudry–Koop measure.
In columns 4 and 5, z is defined as average weekly hours of manufacturing production
workers —a measure of labor force utilization.5
The estimated coefficient of this variable is not
statistically significant even in a regression with
α1 ≡ 0. With α1 unconstrained, the Federal Reserve capacity utilization measure is both statistically and economically significant, while the
labor force utilization measure is not.
Finally, columns 6 and 7 report results for
the case in which zt –1 is defined as the change
in the logarithm of the Commerce Department’s
composite index of leading economic indicators,
where this change is measured from September
to December of year t – 1.6 The change in the
composite leading index (CLI) clearly has substantial marginal predictive power for future
output growth.7 However, including CLI growth
in the forecasting equation does not eliminate
the influence of capacity utilization as measured
by the Federal Reserve Board.
Figure 1 shows fourth-quarter-overfourth-quarter growth in manufacturing output,
as initially reported by the Federal Reserve
Board, along with predictions obtained from
the forecasting equation of Table 1, column 7.
With isolated exceptions, the forecasting equa-

Figure 1

Real-Time Growth in Manufacturing Output
Percent, fourth quarter-over-fourth quarter
15

10

5

0

–5

Actual
Predicted values

–10
’68

18

’70

’72

’74

’76

’78

’80

’82

’84

’86

’88

’90

’92

’94

Table 2

Predicting the Final Estimate of Manufacturing Output Growth
Estimated equation: ∆yt = α0 + α1∆yt –1 + α2ut –1 + α3zt –1
Fourth-quarter data: 1967– 94

Z
None

Beaudry– Koop

Avg. weekly hours

Leading index growth

α0

2.527***
(.757)

–.0059
(.0161)

2.195
(1.413)

.533
(.884)

2.082**
(.866)

.0285***
(.0079)

1.650**
(.600)

α1

.430*
(.209)

.560**
(.263)

.473*
(.261)

.106
(.252)

.349
(.222)

–.052
(.142)

.227
(.163)

α2

–.573***
(.174)

—

–.498
(.320)

—

–.673***
(.198)

—

–.372**
(.138)

—

–1.056**
(.382)

–.187
(.670)

–.0125
(.0220)

.0219
(.0209)

2.490***
(.496)

2.076***
(.467)

Adj. R 2

.255

.179

.225

SE

.0437

.0459

.0446

α3

Q(6)

1.157

5.963

–.068
.0524

5.038

11.839*

.258

.472

.582

.0436

.0368

.0328

5.828

5.643

5.187

* Significant at the 10-percent level.
** Significant at the 5-percent level.
*** Significant at the 1-percent level.

force utilization nor the Beaudry–Koop utilization measure has marginal predictive power in
the presence of the Federal Reserve utilization
index. While a head-to-head contest between
the Federal Reserve and Beaudry–Koop utilization measures is inconclusive, results tend to
favor the Federal Reserve measure. This tendency is even clearer in Table 2 than in Table 1.
Figure 2 is the revised-data counterpart of
Figure 1. It shows how successfully one can
predict final revised output growth using lagged
CLI growth and initial estimates of lagged output

increased. The glaring exception is 1988, when
the model would have predicted a 0.5-percent
output decline, and actual output growth was
+5.4 percent.

Predicting final estimates of output growth
In Table 1, the dependent variable is manufacturing output growth as first reported by the
Federal Reserve. Table 2 presents corresponding
empirical results for the case in which the dependent variable is output growth as recorded
in final revised data. Presumably, the final revised output data more accurately reflect actual
economic developments. For most purposes, it
is these data that are probably most relevant to
policymakers.8 On the right-hand side of the
forecasting equation, I use exactly the same
variables as before. In particular, on the righthand side I continue to use only output and
utilization data that would have been available
to a forecaster in real time.
Both qualitatively and quantitatively, the
results displayed in Table 2 are very similar to
those reported in Table 1. The Federal Reserve’s
utilization series continues to have significant
marginal predictive power in the presence of
lagged output growth, in the presence of lagged
labor force utilization, and in the presence of
lagged growth in the Commerce Department’s
composite leading index. Neither lagged labor

FEDERAL RESERVE BANK OF DALLAS

Figure 2

Revised Growth in Manufacturing Output
Percent, fourth quarter-over-fourth quarter
15

10

5

0

–5

Actual
Predicted values

–10
’68

19

’70

’72

’74

’76

’78

’80

’82

’84

ECONOMIC REVIEW THIRD QUARTER 1996

’86

’88

’90

’92

’94

growth and capacity utilization. While the model’s
overall ability to predict final revised output
growth—as measured by the model’s adjusted
R 2 or its standard error—is better than its ability
to forecast the initial estimate of output growth,
a comparison of Figures 1 and 2 suggests that
the model does a somewhat poorer job of
catching changes in the sign pattern of revised
growth than it does catching the sign pattern of
real-time output growth. Thus, in the revised
data, eight years show declines in output. In
only four of these eight years is growth predicted to be negative or zero (growth of less
than 0.5 percent). In nineteen years, the final
revised data show an expanding manufacturing
sector. But in three of these nineteen years, the
model predicts an output decline.

growth is smaller than that reported in Table 1
but greater than that reported in Table 2.
Are these differences in coefficient estimates of practical importance? Consider, first, an
effort to forecast output growth as initially reported by the Federal Reserve. For this purpose,
one would, ideally, substitute real-time data into
the equation estimated in the last column of
Table 1. Label the resultant forecasts “model 1.”
The more usual approach is to substitute realtime observations into the right-hand side of an
equation like 2, above, which has been estimated using revised data. Call this approach
“model 2.” Not surprisingly, the standard error
of model 2 forecasts is larger than the standard
error of model 1 forecasts. For example, model
2’s standard error is 0.0373 over the sample
period, as compared with a standard error of
0.0347 for model 1. A formal encompassing test
(see the box titled “Forecast Encompassing”)
indicates that this difference in forecast performance is statistically significant at the 10-percent
level. In other words, the payoff to estimating
the forecasting equation using real-time data is
nontrivial.
Now consider an effort to forecast the
Federal Reserve’s final revised estimates of
manufacturing output growth. In this case, there
are a total of three modeling exercises to consider. First, a naive analyst might expect to be
able to reproduce the performance of equation
2 itself. Call this purely hypothetical forecasting
approach “model A.” Second, the analyst could
regress revised output growth on real-time observations of the right-hand-side variables, as in
Table 2. Label the resultant forecasts “model B.”
More usually, the analyst would obtain forecasts
by substituting real-time data into the right-hand
side of equation 2. Call this approach “model C.”
Generally, one would expect model A to (appear to) outperform model B.10 Invariably, the
forecasts of model B will outperform those of
model C. In the present instance, model A’s
standard error is 0.0321 (see equation 2, above),
as compared with 0.0328 for model B (see Table
2, column 7) and 0.0339 for model C. Formal
encompassing tests indicate that the difference
in forecasting performance between model A
and model C is statistically significant at the 10percent level—meaning that the analyst who
estimates the forecasting equation using revised
data obtains a view of that equation’s forecasting performance that is significantly too optimistic. However, neither the difference in
performance between model A and model B
nor the difference in performance between
model B and model C is statistically significant.

How important is it to use real-time data?
Analysts typically forecast in real time
using equations estimated with revised data.
There are two dangers associated with this practice. First, because revised right-hand-side data
are used in estimation but not in forecasting,
there is a danger that the in-sample predictive
performance of the forecasting equation will
significantly overstate the equation’s actual performance in real time. Second, there is a danger
that the actual forecasting performance of the
equation will fall significantly short of the performance that would have been obtained had
the equation been estimated correctly, using
real-time data for the right-hand-side variables.
This section argues that both of these dangers
are serious when forecasting growth in manufacturing output using data on manufacturing
capacity utilization.
Consider a regression of manufacturing
output growth on lagged output growth, lagged
capacity utilization, and the lagged change in
the composite leading indicators, where all data
are now revised:9
(2) ∆yt = 1.985 + .249∆yt –1 – .447ut –1 + 1.930zt –1.
(.665) (.156)
(.152)
(.478)
Adj. R 2 = .598

SE = .0321

Coefficient estimates are broadly similar to those
obtained when real-time data are used as righthand-side variables. (Compare the estimates
above with those reported in the last column of
Table 1 and the last column of Table 2.) Here,
however, substantially greater weight is placed
on lagged utilization, and somewhat smaller
weight is placed on the lagged change in the
leading index. The coefficient of lagged output

20

Forecast Encompassing
The intuition underlying the Chong and Hendry (1986) forecast encompassing test is simple. Let ∆y
denote the variable being forecasted, and let ∆y 1f and ∆y f2 denote forecasts generated by two competing
models. Consider the regression equation
∆y = α∆y 1f + (1 – α)∆y f2 + ⑀,
where ⑀ is a random-error term. If α ≠ 0, then ∆y 1f contains useful information for forecasting ∆y that is not
contained in ∆y f2 , and model 1 is said to “encompass” model 2. If α ≠ 1, then ∆y f2 contains useful information
for forecasting ∆y that is not contained in ∆y 1f , and model 2 encompasses model 1. If model 1 encompasses
model 2, but model 2 fails to encompass model 1 (that is, if α = 1), then model 1 is clearly superior for forecasting purposes. If model 1 is encompassed but is not encompassing (that is, if α = 0), then it is model 2
that has clear superiority.
Two applications are considered in the main text. In the first application, ∆y is defined as growth in
manufacturing output as initially reported by the Federal Reserve. Model 1 is defined as the regression
equation displayed in the last column of Table 1, which is estimated using real-time data. Model 2 is defined
to be equation 2, estimated using revised data. For both models, real-time data are used on the right-hand
side for forecasting purposes. The estimated value of α is 1.000, with standard error 0.496 and marginal
significance level 0.054. It follows that model 1’s performance is superior to that of model 2 at better than the
10-percent-significance level. That is, the forecasts generated by the equation estimated with real-time data
are significantly superior to the forecasts generated by the equation estimated using revised data.
In the second application, ∆y is defined as growth in manufacturing output as it appeared in August
1995, after numerous revisions. Three alternative forecasting models are considered. Model A is defined to
be equation 2 under the unrealistic assumption that revised right-hand-side data are available for forecasting. Model B is the equation displayed in the last column of Table 2, estimated using real-time data and with
real-time data substituted into the equation’s right-hand side for forecasting purposes. Model C is equation 2
with real-time data substituted into the equation’s right-hand side for forecasting purposes.
In a comparison of models A and C, the estimated value of α is 0.722, with standard error 0.380 and
marginal significance level 0.068. It follows that model A’s forecasting performance is superior to that of
model C at better than the 10-percent-significance level. The proper interpretation of this result is that
models estimated using revised data give a strongly misleading impression of how accurately one can
forecast output growth. In a comparison of models B and C, the estimated value of α is 1.000, with standard
error 0.725, and in a comparison of models A and B, the estimated value of α is 0.627, with standard error
0.490. In neither case does one model clearly dominate the other.

were 6.6 percent and 84.4 percent, respectively.
CLI growth during the final three months of
1994, as reported early in March 1995, was 0.2
percent (not annualized). Combining these numbers with the coefficient estimates reported in
Table 1, column 7, one obtains predicted output
growth of 2.0 percent between the fourth quarter of 1994 and the fourth quarter of 1995—only
0.5 percentage point above the Federal Reserve
Board’s initial estimate of actual growth.
As of January 1996, the Federal Reserve
Board estimated 1995 output growth and 1995:4
capacity utilization to be 1.5 percent and 82.0
percent, respectively. As of early March 1996,
the CLI was reported to have fallen 0.4 percent
in the final three months of 1995. According to
the coefficient estimates recorded in Table 1,
column 7, it follows that manufacturing output
will likely expand by only 0.2 percentage points
between the fourth quarter of 1995 and the
fourth quarter of 1996 —essentially no growth
at all. Recall, however, that in 1974 a similar

(For details, see the box titled “Forecast Encompassing.”)
Thus, it would appear that in predicting
growth in manufacturing output, there is a very
real danger that forecasting equations estimated
with revised utilization data will either (1) perform significantly worse than summary statistics
from the regression would suggest or (2) perform significantly worse than would a forecasting equation estimated with real-time utilization
data.

Forecasts for 1995 and 1996
The estimates reported in Tables 1 and 2
and the predictions displayed in Figures 1 and 2
extend only through 1994. How well did this
simple forecasting model predict 1995 output
growth? What is it predicting for 1996?
The answer to the first question is “very
well, indeed.” The initial Federal Reserve Board
estimates of 1994 manufacturing output growth
and 1994:4 manufacturing capacity utilization

FEDERAL RESERVE BANK OF DALLAS

21

ECONOMIC REVIEW THIRD QUARTER 1996

forecast was followed by a 4.3-percent output
decline, while in 1988 a similar forecast was
followed by a 5.4-percent output increase!11 More
generally, the standard error associated with the
output-growth forecasts of the model is large
enough (roughly 3.5 percentage points) to cover
a fairly wide range of outcomes.

3

Concluding remarks
This article tests whether the Federal Reserve Board’s initial capacity utilization releases
contain information useful in forecasting future
growth in manufacturing output. Results suggest
that initial utilization releases do indeed have
significant predictive power for both initial and
final estimates of output growth. Significant predictive power is evident even after controlling
for the initial estimate of lagged output growth,
lagged labor force utilization, and lagged growth
in the Commerce Department’s composite leading index. However, although the Federal
Reserve’s utilization measure appears to contain
more useful information than does a utilization
measure proposed by Beaudry and Koop, the
difference in information content between the
two measures is not statistically significant.
Together, the leading index, real-time
lagged output growth, and real-time capacity
utilization explain more than half the variation
in the initial and final estimates of fourth quarter-over-fourth quarter manufacturing output
growth. With a few important exceptions, the
forecasting equations have also performed well
in predicting the qualitative pattern of the initial
output growth estimates. Data available early in
the year suggest that the level of manufacturing
output is likely to be essentially flat over 1996.
However, the standard error attached to this
forecast is such that one cannot rule out either a
moderate expansion or a moderate contraction
of manufacturing activity.

4

Notes

8

1

2

5

6

7

Shenghi Guo, Chih-Ping Chang, and Sheila Dolmas
provided research assistance. An earlier version of this
paper was presented at the annual meeting of the
Southern Economic Association. Nathan Balke, Sarah
Culver, Ken Emery, Richard Raddock, and Mark
Wynne offered helpful suggestions.
The following discussion draws upon Raddock (1985,
1990).
The Census Bureau began its survey in 1974. Prior to
then, the Federal Reserve Board relied on end-of-year
utilization surveys conducted by McGraw-Hill/DRI and
the Bureau of Economic Analysis. These surveys were
discontinued in 1988 and 1983, respectively. The
Board adjusts the level of the Census Bureau utilization

9

10

11

22

rates to minimize any historical discontinuities between
them and the McGraw-Hill/DRI rates.
Moreover, pre-1967 data are not fully consistent with
data for subsequent years. In particular, both physicalunit capacity data and Bureau of Economic Analysis
investment estimates receive substantially greater
weight in the post-1966 calculations of capacity and
utilization than in pre-1967 calculations (Shapiro 1989,
193–4; Raddock 1990).
Initial estimates of fourth-quarter manufacturing output
and fourth-quarter capacity utilization are typically released in mid-January of the following year and appear
in the March issue of the Federal Reserve Bulletin.
An alternative measure of labor force utilization—
average weekly overtime hours in manufacturing—
failed stationarity tests.
I use final revised leading index data in the regressions, rather than real-time data. Historically, the Commerce Department’s leading index has been subject to
two kinds of revisions. First, there are routine revisions
to the CLI’s component data series. Second, there are
occasional changes in the structure of the CLI. Arguably, the first type of revision should not be a source of
concern in the present context. The largest routine
data revisions typically occur within the first few months
following the CLI’s initial release. In particular, the bulk
of the routine revisions to fourth-quarter CLI growth are
completed by the end of the first quarter of the following year. A two or three month delay in the availability
of reliable CLI data might be significant if I were forecasting quarterly output growth, but here I am concerned only with output growth over four-quarter
spans. As regards structural revisions, while the historical record of the CLI’s current formulation may
over state the CLI’s future forecasting performance, the
historical record of older formulations of the CLI would
almost certainly under state the current CLI’s future
performance. I have chosen the alternative most likely
to bias my results against finding a significant role for
capacity utilization in the output forecasting equation.
Additional lagged changes in the composite leading
index were not significant.
However, the Federal Reserve’s initial published estimates of output growth may have an important influence on the investment and pricing decisions made by
households and firms. Consequently, predicting the
initial estimate of output growth is an exercise not
without interest.
The data are for the fourth quarter of each year from
1968 through 1994, as published in August 1995.
That is, one would expect it to be easier to predict
revised output growth using revised right-hand-side
variables than using real-time right-hand-side variables.
Both of these estimates were later revised downward—
to a 5.9-percent decline and a 3.5-percent increase,
respectively.

References

——— (1985), “Revised Federal Reserve Rates of Capacity Utilization,” Federal Reserve Bulletin 71 (October):
754 – 66.

Beaudry, Paul, and Gary Koop (1993), “Do Recessions
Permanently Change Output?” Journal of Monetary
Economics 31 (April): 149–63.

Shapiro, Matthew D. (1989), “Assessing the Federal
Reserve’s Measures of Capacity and Utilization,”
Brookings Papers on Economic Activity, no. 1: 181– 225.

Chong, Yock Y., and David F. Hendry (1986), “Econometric Evaluation of Linear Macro-Economic Models,”

Review of Economic Studies 53 (August): 671–90.
Wynne, Mark A., and Nathan S. Balke (1993), “Recessions and Recoveries,” Federal Reserve Bank of Dallas

Cochrane, John H. (1994), “Permanent and Transitory
Components of GNP and Stock Prices,” Quarterly Journal
of Economics 109 (February): 241– 65.

Economic Review, First Quarter, 1–17.
——— (1992), “Are Deep Recessions Followed by Strong
Recoveries?” Economics Letters 39 (June): 183– 89.

De Long, J. Bradford, and Lawrence H. Summers (1988),
“How Does Macroeconomic Policy Affect Output?”
Brookings Papers on Economic Activity, no. 2: 433– 80.
Raddock, Richard D. (1990), “Recent Developments in
Industrial Capacity and Utilization,” Federal Reserve
Bulletin 76 (June): 411–35.

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ECONOMIC REVIEW THIRD QUARTER 1996

In 1991, Ronald H. Coase received the
Nobel prize for his work on the role of transaction costs in economics. His paper on “The
Nature of the Firm” (Coase 1937) introduced
transaction costs as the primary reason for the
existence of firms. Coase pointed out that firms
substitute an internal management structure for
market transactions to eliminate the costs of
negotiating, writing, and enforcing contracts. More
than two decades later, his classic paper, “On
the Problem of Social Costs,” (Coase 1960) revolutionized the way in which economists perceived market and nonmarket solutions to the
problem of externalities. In this paper, Coase
argued that the problem of externalities cannot
be examined without looking at the institutional
setting of the problem and the size of transaction costs. According to the Nobel committee,
the latter paper is the most cited paper in economics in the years since its publication. His
work has stimulated research in the areas of law
and economics, antitrust economics, regulation,
public choice, and the role of government in
economic society. The purpose of this article is
to offer an explanation of Coase’s contribution
to the analysis of the role of government.

Externalities,
Markets, and
Government Policy
Roy J. Ruffin
Research Associate
Federal Reserve Bank of Dallas
and
M. D. Anderson Professor of Economics
University of Houston

W

hile public production or Pigovian

taxes might correct for market failures,
theory cannot solve the problem without
a detailed analysis of the institutional

Externalities
Until the work of Coase (1960), economists had a highly simplified view of the role of
markets. From Adam Smith, they believed that
the basic role of government is to establish the
rules of the game (defend property rights); from
A. C. Pigou (1932), they learned that it is worthwhile for the government to subsidize or tax
private activities whenever the market produces
too little of a good thing (such as education) or
too much of a bad thing (such as pollution).
Such externalities (unpriced benefits or costs)
constituted the main exception to the rule that
Adam Smith’s invisible hand will efficiently allocate resources. Coase basically showed that
externalities may or may not require a governmental solution; the need for a government
solution depends on the circumstances of each
case. In shifting the terms of the debate, Coase
single-handedly moved economics from presuming specific roles for government action to
a more neutral position requiring detailed
analysis.
Let us reconsider a simple situation examined by Pigou and Coase: one agent’s profitmaximizing decisions affect the profits of another
party through a technological external diseconomy. For concreteness, imagine a railroad
engine is the source of fire-starting sparks to a
farmer’s crops. Pigou had argued that the rail-

structure of the problem at hand.

24

Table 1

Railroad Directly Compensates Farmer
road should be held liable for the damage
done to the farmer’s crops because, otherwise,
too many resources would be allocated to the
railroad. Pigou suggested that efficiency could
be brought about by imposing a tax on the
railroad.
Coase began his analysis with a simple
point: if the railroad is made liable to the
farmer, in a world of zero transaction costs, the
railroad and farmer would reach an agreement
themselves. Moreover, even if the railroad were
not liable, an agreement would be reached
with substantially the same allocation of resources. As an example, suppose a railroad
could make $100 running one train per day
and $150 running two trains per day. The farmer
can make $150 planting one field or $160 planting two fields. If the fields are planted next to
the tracks, the railroad destroys $60 worth of
crops per train per field. It is assumed that
there is no problem of assessing damages.1
Tables 1, 2, and 3 describe three situations. Each row describes the consequences of
the railroad running no trains, one train, or two
trains per day. Each column shows the consequences of the farmer’s planting no fields, one
field, or two fields. The lower-left-hand corner
of each cell shows the profits to the railroad;
the upper-right-hand corner of each cell shows
the profits to the farmer; if positive, the lowerright-hand corner shows payments to third parties (Table 3 only). In Table 1, the railroad must
directly compensate the farmer for damages to
his crops. In Table 2, the railroad has the right to
start fires on the farmer’s fields. Table 3 shows
an ideal Pigovian tax: the railroad is taxed by the
amount of the damage and a third party receives
the lump-sum amount of the tax revenues.
In any table, the total benefit to society is
the sum of the payoffs shown (ignoring consumer surplus). In all three tables, the maximum
attainable total benefit is $190 and is reached
when one train is run and one field is planted.
In Table 1, the railroad is liable for damages inflicted and must pay $60 per train per
field to the farmer. When one train is run and
one field is planted, the railroad receives a payoff of $40 (= $100 – $60) and the farmer receives
a total payoff of $150 (the same as if there were
no railroad). While this is the social optimum, if
the railroad is running one train per day, the
farmer has an incentive to plant two fields because, with the payment of damages, the farmer
can make $160, more than can be made by
planting only one field. This would lower the
railroad’s profit to –$20. Clearly, in a world of
zero transaction costs, it would pay the railroad

FEDERAL RESERVE BANK OF DALLAS

Farmer: fields planted
0

1
0

2
150

160

0
0
Railroad
(Trains per day)

0

0

0

150

160

1
100

40

– 20

0

150

Railroad
liable

160

2
150

30

– 90

Table 2

Railroad May Start Fire in Farmer’s Field
0

1
0

2
150

160

0
0
Railroad
(Trains per day)

0

0

0

90

40

1
100

100

100

0

30

Railroad
has rights

– 80

2
150

150

150

Table 3

Railroad Pays Tax to Government
0

1
0

2
150

160

0
0
Railroad
(Trains per day)

0

0

0

0

0

90

0
40

1
100

0

40

60

0

–20

30

120
– 80

2
150

0

30

120

to make an agreement with the farmer not to
plant the second field. The railroad could offer
the farmer, say, $11 not to plant the field, increasing the railroad’s net profit to $29 and
increasing the farmer’s payoff to $161 (for a total
of $190 still).2
Coase then considered the alternative or
reciprocal situation in which the railroad has the
right to destroy whatever crops are planted near
the tracks. In Table 2, if the farmer again plants
one field and the railroad runs one train, the
railroad earns $100 while the farmer earns only

25

ECONOMIC REVIEW THIRD QUARTER 1996

–90

240

Pigovian
tax on
railroad
paid to
third party

$90 (= $150 – $60). However, now the railroad
has an incentive to run another train, increasing
its profits to $150 and lowering the farmer’s
profits to $30. But, again, in a world of zero
transaction costs, it would now pay the farmer
to offer, say, $51 to the railroad to not run the
second train, raising the railroad’s payoff to $151
and raising the farmer’s from $30 to $39. This is
again the social optimum, where the total
gain to society is still $190.
In comparing Tables 1 and 2, when there
is full and costless cooperation between the two
parties, the resulting allocation of resources is
the same: one field is planted and one train per
day is run. The only difference is the distribution of the spoils. This is the celebrated Coase
theorem: in a world of zero transaction costs,
the allocation of resources does not depend on
who has the property rights but rather on the
existence of well-defined rights.
Why was this analysis so innovative in
its impact on economics? To understand the
Coasian contribution, it is useful to go back to
the original Pigovian analysis of externalities. In
Table 3, the railroad pays a tax to the government equal to the damages imposed on the
farmer. The tax revenue is then redistributed to
a third party, shown in the lower-right-hand
corner of each cell. If the tax revenue is paid to
the farmer, we are again back to Table 1, and it
is necessary for the railroad to bribe the farmer
into planting only one field.3 If the tax is paid to
a third party, a profit-maximizing railroad will
run one train per day if the farmer plants one
field; a profit-maximizing farmer will plant one
field if the railroad runs one train per day. The
total benefit to society is again $190 (= $40 + $90
+ $60). The optimum appears to be achieved
without any necessity of negotiation between
the parties. It is an equilibrium because if the
farmer is planting one field, the railroad maximizes its income with one train per day; and if
the railroad is running one train per day, the
farmer maximizes his income with one field.
The problem with the Pigovian analysis is
threefold.4 The first is that the optimum solution
need not be the only equilibrium. In this example, there are two equilibria. Imagine the
railroad just happens to come along after the
farmer has planted two fields (the optimum with
no railroad). Then if there is a Pigovian tax, the
railroad would not find it optimal to run any
trains. This, too, is an equilibrium because there
is no incentive for either the railroad or the
farmer to deviate from zero trains and two fields.5
But this solution is not Pareto-optimal. The total
social surplus is only 160 instead of 190 as in the

previous equilibrium. If we take the reverse,
where the farmer comes along after the railroad
is established, the railroad initially would run
two trains per day and the farmer would have
the incentive to plant one field, causing the
railroad to run only one train per day. In other
words, historical accident can determine the equilibrium and whether or not the solution is optimal in the case of a Pigovian tax scheme.
The second problem is that if the farmer
receives the payments to the government (the
$60) and is aware of the link between his actions and government payments, he again will
have an incentive to plant two fields. Therefore,
there is still no solution to the externalities problem. To solve the externalities problem by a
Pigovian tax requires that the tax receipts be
paid to a third party who will not alter his or her
behavior as a consequence of the payment. But
as our first point illustrates, this is a necessary
but not a sufficient condition due to the possibility of multiple equilibria.
The Pigovian solution seems rather strange
because who in society would push for a tax on
the railroad other than the farmer who is having
to suffer the damages created by the sparks?
Why pay the tax revenue to a third party? But if
the tax revenue is paid to the farmer, we again
have the original problem of having to make an
agreement between the railroad and the farmer
to reach the optimal solution. Thus, the Pigovian
“solution” is no solution at all.
A third problem with the Pigovian solution
can be seen if we broaden the example. Suppose that we are discussing the damages imposed by smokers on nonsmokers. There are
many smokers and many nonsmokers. It is clear
that in the real world, smokers and nonsmokers
cannot negotiate to reach the optimum because
the transaction costs are prohibitive. It seems to
make sense, therefore, for the government to
step in and, say, impose a Pigovian tax on
smokers. But this has one problem: who is
going to get the revenue from the tax? Tullock
(1967), in a path-breaking article, pointed out
that people in a democratic society will compete
for tax revenues. This competition for revenues
can dissipate all or part of the gains because
lobbying has opportunity costs (hiring lawyers,
public relations experts, word processors, and
so forth). Thus, in Table 3, if the $60 revenue is
dissipated by such actions, the total gain to
society from a Pigovian tax would be only $130
if the farmer planted one field and the railroad
ran only one train per day.
A precursor of Coase was the great institutional economist and legal scholar, John R. Com-

26

mons. According to Commons (1923, 326), judges
have often ruled that “taxes may not be used for
private purposes.” But Commons pointed out
that taxes are always used for some type of
private purpose. The question is whether that
private purpose is tinged with enough public
interest to make the taxes worthwhile. For example, property taxes in many localities are
used to support “public education.” Teachers’
unions consistently lobby to increase their share
of the public purse, and the educational bureaucracies expand at the cost of sacrificing the very
goal of teaching students. This example can be
multiplied many times. Taxes imposed on the
working population are used to support large
segments of the nonworking population. Government employees become a central clientele
to the political party that hires them.
Coase’s basic insight is really that we cannot separate the analysis of externalities from
the real-world situation we are describing. What
we have just said simply shows that there is
no a priori role for government policy in controlling externalities. It does not say that there is
no role. But instead of concocting abstract
theories about externalities and what to do
about them, the Coasian research agenda requires the economist to actually study the
detailed setting in which the alleged externality
is taking place. We must examine the institutions, the property rights, and the costs of contracting in each and every instance. As Coase
(1993, 97) once put it, “What I object to is
mindless abstraction or the kind of abstraction
which does not help us to understand the
working of the economic system.”

because, from the point of view of the railroad,
it is a cost of preventing damages. When a
lawyer is hired to write a contract, it is done to
protect the firm in a legal dispute. Whether the
railroad is liable or not, a firewall will be built
by profit-minded agents. But now we get a
different allocation of resources. If railroad is
liable, it will run two trains a day and the
farmer will plant two fields. But if the farmer
must build the firewall, the farmer will only
plant one field because of the exorbitant cost of
protecting two fields and diminishing returns.
The major implication, then, of the existence of
transaction costs is that changing the rules of
liability has an impact on resource allocation.
The Coasian hypothesis suggests that it
makes a real difference what the law stipulates
about what is legal and not legal. If the law
imposes the rule that companies are responsible
for whatever illnesses are caused by their products and the standard of proof is relatively ambiguous, there will be a strong tendency for the
product to disappear from the marketplace. Indeed, there are many examples of products that
have disappeared in the United States that can
be obtained elsewhere.6
Whether or not the change in the allocation of resources is beneficial requires a detailed
study of costs and benefits. For example, a
recent study by Richard Manning (1994) of the
effect of changes in the tort law on the prices of
childhood vaccines shows that the price of the
DPT vaccine has increased by 2,000 percent
over the past decade, with 96 percent of the
price increase due to litigation costs.

Public goods
Positive transaction costs and
property rights

In the classic treatment of public goods
(Samuelson 1955), it is supposed that public
goods exhibit two characteristics: nonrivalry in
consumption and the inability of providers to
exclude users. A lighthouse has been used by
economists of the stature of John Stuart Mill,
A. C. Pigou, and Paul Samuelson as an example
of a pure public good (Coase 1974). Apparently,
the light from any lighthouse could be used by
any number of ships and no ship could be
excluded from using the light. Thus, the problem of free riding would make it difficult to
privately finance a lighthouse. Coase (1974) used
the lighthouse as a real-world illustration of his
method of examining the argument for government interference into the economy. Coase surveyed the history of lighthouses and discovered
that lighthouses were built by private parties
even though everyone within sight of the lighthouse can use its services without any conges-

A transaction cost is a cost of using a
market. “There are negotiations to be undertaken, contracts have to be drawn up, inspections have to be made, arrangements have to be
made to settle disputes” (Coase 1992, 715). It is
important to distinguish between what has been
called the Coase theorem and what I will call the
Coasian hypothesis. This is the hypothesis that
the legal system under a system of positive
transaction costs “will have a profound effect on
the working of the economic system and may in
certain respects be said to control it” (Coase
1992, 718).
To illustrate this at the simplest level, in
the parable of the railroad and the adjacent
farmer, suppose it costs the railroad $10 or the
farmer $20 for each planted field to build a
protective firewall. This is a transaction cost

FEDERAL RESERVE BANK OF DALLAS

27

ECONOMIC REVIEW THIRD QUARTER 1996

tion costs. Coase simply pointed out that ships
usually arrive one at a time, they can be easily
identified, and if a captain never pays, the light
can simply be turned off, as it had throughout
the early history of the lighthouse. The lighthouse operators also charged ships according to
their tonnage, so that the price paid roughly
corresponded to the benefits received by the
owner of the ship. This is a market: a price is
charged, and if the price is not paid, the next
time the service will be denied. The institutional
structure of production is important. If the lighthouse is made liable for any accidents caused by
turning off the light, suddenly a service that
could be provided privately is turned into one
that will not be provided at all unless by some
governmental agency.
This point and our analysis of externalities
illustrate how even the greatest economists
cannot, through deductive reasoning, decide
whether government action is required to correct some perceived market failure. Some type
of institutional examination of the facts is necessary before any policy prescription can be
reached.

1

2

3
4

5

Conclusion
In this article, I have tried to clarify the
debate that has raged over the Coase theorem
since its inception. Basically, Coase pointed to
a flaw in the argument for correcting market
failures. While public production or Pigovian
taxes might correct for market failures, theory
cannot solve the problem without a detailed
analysis of the institutional structure of the problem at hand. We pointed out that even if Pigovian taxes can be calculated, the solution requires
(1) third-party payments, and (2) relatively small
costs due to the competition for government
revenues. As Coase (1990, 185) colorfully put
it, presumably recalling Humphrey Bogart in
the Maltese Falcon, “Such tax proposals are the
stuff that dreams are made of.” Similarly,
whether a good is public or private depends on
technology, transaction costs, and the institutions of the economy. At the same time, while
there is no a priori argument for government
intervention, there is also no a priori argument
for laissez faire. Each case must be decided on
the pragmatic principle of what works best in
the real world.

6

in Samuelson (1995). The current essay does not
answer Samuelson’s questions but simply tries to
clarify the nature of the Coasian debate.
Some might raise the issue that a farmer might locate
next to the tracks just to sue the railroad. This is really
just a transaction cost in disguise. We are assuming
here that the example represents the technological
opportunities available to the society as well as all the
possibilities. The conclusions would not be changed
by assuming N farmers, each with some clear-cut
damage. If a farmer has the option to locate elsewhere with the same fecundity, there is no externality
to worry about. I am indebted to Steve Brown for this
point.
Paul Samuelson (1995) has raised the issue of bargaining and negotiation failures. But this is, once
again, a situation in which there are costs of contracting. The zero-transaction-cost world in economics is
like the law of inertia when no forces are operating on
an object: nothing stops perfection.
See Coase (1990, 151) and Baumol (1972).
The following analysis does not try to replicate the
views of Coase (see, for example, Coase 1990,
179–85).
It is an established point in economic theory that in the
presence of externalities, competitive behavior can
result in multiple equilibria (see Ruffin 1972).
Diving boards are disappearing from neighborhood
pools in the United States (Investor’s Business Daily,
May 13, 1996, A2). See also Peter W. Huber (1988,
155–61), for other examples, such as contraceptive
devices and leprosy drugs.

References
Baumol, William J. (1972), “On Taxation and the Control
of Externalities,” American Economic Review 62: 307–22.
Coase, R. (1937), “The Nature of the Firm,” Economica 4
(n.s.): 386–405.
——— (1960), “The Problem of Social Cost,” Journal of
Law and Economics 3: 1–44.
——— (1974), “The Lighthouse in Economics,” Journal of
Law and Economics 17: 357–76.
——— (1990), The Firm, the Market, and the Law (Chicago: University of Chicago Press).
——— (1992), “The Institutional Structure of Production,”
American Economic Review 82: 713 –19.

Notes

——— (1993), “Coase on Posner on Coase,” Journal of
Institutional and Theoretical Economics 149: 96 – 98.

I wish to thank Stephen Brown for his valuable comments on an earlier version of this article. The article
was stimulated by the author’s communications with
Paul Samuelson over the penetrating analysis of Coase

Commons, John R. (1923), The Legal Foundations of
Capitalism (Madison: University of Wisconsin Press).

28

Huber, Peter V. (1988), Liability (New York: Basic Books).

Samuelson, Paul. A. (1955), “Diagrammatic Exposition of
a Theory of Public Expenditures,” Review of Economics
and Statistics 32: 350–56.

Manning, Richard L. (1994), “Changing Rules in Tort Law
and the Market for Childhood Vaccines,” Journal of Law
and Economics 37: 247.

——— (1995), “Some Uneasiness with the Coase Theorem,” Japan and the World Economy 7: 1–7.

Pigou, A. C. (1932), The Economics of Welfare, 4th ed.
(London: Macmillan).

Tullock, Gordon (1967), “The Welfare Cost of Tariffs,
Monopolies, and Theft,” Western Economic Journal 5:

Ruffin, R. J. (1972), “Pollution in a Crusoe Economy,” The
Canadian Journal of Economics 5: 110 –18.

FEDERAL RESERVE BANK OF DALLAS

224 – 32.

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ECONOMIC REVIEW THIRD QUARTER 1996