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____________ Review____________
Vol. 68, No. 10




December 1986

5 Coping with Bank Failures: Some
Lessons from the United States and
the United Kingdom
15 W hy Has M anufacturing Em ploym ent
Declined?

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Federal Reserve Bank of St. Louis

Review
December 1986

In This Issue . . .




Although U.S. bank failures are occurring at an unusually rapid rate, they have
neither eroded public confidence in the banking system nor induced bank runs
by depositors. The stability o f the U.S. banking system in the face o f increased
bank failures reflects the success o f policies designed to prevent banking panics.
In the first article in this Review, "Coping w ith Bank Failures: Some Lessons
from the United States and the United Kingdom ,” R. Alton Gilbert and Geoffrey E.
W ood examine the history o f banking panics and the evolution o f government
policies designed to eliminate them in the United Kingdom and the United States.
The last U.K. banking panic occurred in 1866. In response to that panic, the Bank
o f England accepted the responsibility o f acting as lender o f last resort — by
increasing bank reserves w hen the public withdraws large shares o f their deposits
in the form o f cash — and bank runs ceased to be a problem. In contrast, the
United States experienced panics throughout the 19th and early 20th centuries.
In response to these panics, the Federal Reserve System was established in 1917
and federal deposit insurance was established in 193:5. Since 1933, although
individual banks have failed, no banking panics have occurred in the United
States.
*

*

*

Manufacturing em ployment in the U.S. econom y has declined since 1979,
furthering the view that the United States is losing out in an international
competition for manufacturing jobs. In the second article in this Review, "W hy
Has Manufacturing Employment Declined?” John A. Tatom examines the factors
that determine manufacturing employment. He argues that the decline in manu­
facturing em ployment has occurred for two reasons. Part o f the decline repre­
sents a transitory cyclical phenom enon. However, the decline is also due to the
relatively rapid growth o f productivity in manufacturing that has taken place
throughout the post-World War II period. The only recent period in which
manufacturing em ploym ent grew relatively rapidly since W orld W ar II was in the
early ’60s, when manufacturing wages declined sharply relative to wages paid in
the rest o f the economy.
Tatom explains that the relatively rapid growth in manufacturing productivity
has been an important source o f the rising standard o f living in the United States
and that it has been associated with a declining relative price o f these goods.
Consumers, however, have not chosen to realize all o f the gain in their standard o f
living through greater consumption o f manufactured goods. Instead, they have
dem anded more o f other goods and services as well. Thus, the proportion o f labor
resources em ployed in manufacturing has declined fairly steadily especially
since 1969. International com petition has played only a small role in overall
developments, the author savs. In the 1980s, he argues, manufacturing output
and em ploym ent have strengthened relative to the experience abroad.

3




FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1986

Coping with Bank Failures: Some
Lessons from the United States
and the United Kingdom
/{. Alton Gilbert and Geoffrey E. Wood

T

JL HE number o f U.S. bank failures has risen dra­
matically in the past few years. Banks failed at the rate
o f about six per year from 1950 through 1981. In 1984,
however, 79 banks failed, and 120 banks failed in 1985.'
Yet this sharp rise in the rate o f bank failure has not
produced the kind o f public “panic” that accom pa­
nied bank failures during much o f U.S. history.

system w ill not be disrupted by the failure o f one bank
or even by the failure o f several banks. The government
policies that create this public confidence in the sta­
bility o f the banking system reflect the histoiy o f each
nation. This paper contrasts the experience with
banking panics in the United Kingdom to that in the
United States.

In a banking panic, the failure o f one bank leads
people to fear for the safety o f their funds at other
banks. Subsequent attempts to w ithdraw their de­
posits from other banks put these banks in jeopardy as
well. Recent experience suggests that bank failures no
longer cause banking panics. There are now wellestablished and frequently tested principles for pre­
venting a bank failure from turning into a panic.

The last banking panic in the United Kingdom oc­
curred in 1866. At that time the Bank o f England acted
to prevent the disruption o f the banking system when
banks failed and the public in England came to believe
that the Bank o f England had accepted that responsi­
bility and w ould be successful in canying it out.

To fully appreciate the importance o f these princi­
ples in preventing panics, it is necessary to review
some episodes o f history during which panics oc­
curred. History illustrates the inherent vulnerability of
the banking industry to panics, when there are no
policies in place to prevent them; it also illustrates the
adverse effects o f panics on the operation o f banking
systems and econom ic activity.
To prevent banking panics, it is necessaiy to con­
vince the public that the operation o f the banking
R. Alton Gilbert is an assistant vice president at the Federal Reserve
Bank of St. Louis and Geoffrey E. Wood is a professor of economics at
City University, London. Sandra Graham provided research assis­
tance.
'A bank is declared to have failed when it is closed by the govern­
ment authorities. The government authorities close a bank when its
net worth falls close to or below zero.




The United States established a central bank in 1914,
but the Federal Reserve System failed to prevent bank­
ing panics in the early 1930s. Thus, the public in the
United States did not have the experience of observing
a central bank successfully dealing with banking pan­
ics. The last banking panic in the United States (1933)
occurred in the same year when the federal govern­
ment established deposit insurance. I bis observation
indicates that federal deposit insurance has been an
important feature o f the policies in the United States
for preventing banking panics.

WHAT ARE BANKING PANICS AND
WHY ARE THEY DANGEROUS?
Tw o features o f the operation o f commercial banks
make the banking system vulnerable to disruptions
when depositors lose confidence in their banks. First,

5

FEDERAL RESERVE BANK OF ST. LOUIS

a large part o f the liabilities o f banks is payable to
depositors on demand. Second, tbe cash reseives of
banks are a small fraction o f their deposit liabilities.
Thus, if large numbers o f depositors suddenly wanted
to convert their deposits to currency, the banking
system w ould not immediately have enough cash on
hand to honor their demands. W hen a banking panic
occurs, people attempt to be among the first to convert
their deposits to currency because they remember
that during previous banking panics, only those w ho
dem anded currency early enough were able to get it.2

Microeconomic Effects o f
Banking Panics
Deposits and reseives o f the banking system decline
one-for-one as depositors w ithdraw currency. If total
reserves w ere just equal to required reserves before
the withdrawals o f currency, reseives w ould be de­
ficient after the withdrawals. Each bank responds to
its reserve shortage by selling assets, producing a
decline in demand deposits that exceeds the initial
conversion o f dem and deposits to currency.
The vulnerability o f the banking system to panics is
illustrated in tables 1 and 2 by the use o f balance
sheets. Table 1 presents the hypothetical balance
sheet o f an individual bank that is required bv some
regulatory authority to keep a cash reserve o f at least
10 percent o f total deposits. Because o f concern about
the viability o f the bank, customers w ithdraw $10
m illion in the form o f currency, reducing the bank’s
cash reserves to zero. To raise cash reseives, the bank
sells $9 m illion o f its interest-earning assets.3
W hen the bank sells its assets to increase its cash
reserves, however, it draws cash from other banks,
causing their reserves and deposits to decline. These
banks must n ow sell some o f their assets to eliminate
their reseive deficiencies. Thus, the initial withdrawal
o f currency by depositors produces a chain reaction o f
reductions in deposits payable on demand.
The effects on the banking system o f the currency
withdrawals are illustrated in table 2. Prior to the
banking panic, the banking system has assets o f $1.1

2Several recent studies develop theoretical models of the behavior of
banks and their depositors to investigate the conditions that are
likely to cause a banking panic. See Batchelor (1986), Bryant
(1980), Diamond and Dybvig (1983), Gorton (1985a), Ho and
Saunders (1980), and Jacklin and Bhattacharya (1986).
3lf many banks sell assets at the same time, the prices of bank assets
may fall. In that case, the bank would have to sell additional assets
and charge losses against net worth.

6




DECEMBER 1986

Table 1
Balance Sheet of an Individual Bank
(millions of dollars)
Before the banking panic:
Assets
Cash
Interest-earning
assets

Liabilities
$ 10
100

Deposits payable
on demand
Time deposits
Net worth

$50
50
10

After withdrawal of $10 million in currency:
Assets
Cash
Interest-earning
assets

Liabilities
$

9
91

Deposits payable
on demand
Time deposits
Net worth

$40
50
10

trillion and deposits payable on dem and o f $500 bil­
lion. As the banking panic begins, bank customers
withdraw $10 billion in currency from their deposit
accounts payable on demand, (liven the 10 percent
reserve requirement, total deposits must decline until
the remaining cash reseives o f $!)0 billion are 10 per­
cent o f total deposits.
This shrinkage in the assets o f the banking system
may reduce the confidence o f the public in the bank­
ing system even more, inducing additional w ith ­
drawals o f deposits in the form o f currency. The addi­
tional loss o f reserves w ou ld force even larger
reductions in bank deposits, interest-earning assets,
net worth o f banks and number of banks.

Macroeconomic Consequences o f
Banking Panics
A banking panic causes a sharp reduction in the
m oney supply (currency held by the public plus bank
deposits payable on demand). Sharp and unexpected
reductions in the m oney supply usually cause reduc­
tions in econom ic activity and, consequently, an in­
crease in unemployment and business failures. The
panic will end when the public becomes convinced
that banks are safe and that it can withdraw currency
from deposit accounts whenever it wishes. At that
time, the public will again deposit part o f its currency
with banks.

FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1986

evolving traditions, w ere implicit rather than spelled
out in the Bank’s charter or other legislation. For
instance, by the 1800s, the government expected the
Bank to buy any part o f its new debt issues not pur­
chased by others.

Table 2
Balance Sheet of the Banking System
(billions of dollars)
Before the banking panic:
Assets
Cash
Interest-earning
assets

Liabilities
$ 100
1,000

Deposits payable
on demand
Time deposits
Net worth

$500
500
100

After withdrawal of $10 billion in currency:'
Assets
Cash
Interest-earning
assets

Liabilities
$

90
900

Deposits payable
on demand
Time deposits
Net worth

$400
500
90

'In the banking panic, sales of interest-earning assets cause the
prices of those assets to fall. In this illustration, banks reduce their
net worth by $10 billion, recognizing that loss on the sale of
assets that had a value of $100 billion before the panic.

HOW TO PREVENT BANKING PANICS
—
THE BRITISH EXPERIENCE
How can the failure o f one bank be prevented from
spilling over into the w hole banking system with such
catastrophic consequences? Only by removing the
fear that all banks are in danger o f failing. Can this be
done in practice? It can, and the wav to do it was
discovered before the theoiy behind the m ethod was
developed.

The Bank o f England
The histoiy o f the British approach to preventing
banking panics involves the histoiy o f the Bank o f
England. The British government chartered the Bank
in 1694 as a means o f raising funds to fight a war with
France. Those subscribing to the stock o f the Bank
made loans to the British government. In return, the
Bank was given some exclusive l ights to function as a
commercial bank.4
Although the Bank was privately owned, there was
always a close relationship between it and the govern­
ment. Some aspects o f the relationship, based on

“Clapham (1944), Fetter (1965) and Santoni (1984).




The Bank o f England maintained a large inventory o f
gold upon which it could draw in a panic to meet the
public’s demand for gold. Legislation in 1844 gave the
Bank a m onopoly on issuing bank notes and made the
notes o f the Bank legal tender. That legislation set a
limit on the amount o f the Bank’s notes that could be
outstanding, though it specified that the limit could be
exceeded in an emergency. The limit on the notes o f
the Bank could be lifted at the discretion o f the govern­
ment. Thus, the Bank o f England could expand the
monetary base (currency plus reserves) in an em er­
gency, since its notes were used as currency and were
held as part o f bank reserves.
One aspect o f the policies that evolved over time was
the Bank’s response to a banking panic. The evolution
o f that policy is described in this section by discussing
fir st, what happened during two banking panics that
occurred in England during the 1800s and second,
why no panics have occurred in the British banking
system since 1866.

The Panic o f 1825
In December 1825, a banking panic occurred in
London after the failure o f a bank (Sir Peter Pole and
Company). As people fled from deposits at other
banks to gold, gold reserves w ere drained from the
Bank o f England. To convince people that their bank
deposits w ere safe, the Bank lent gold freely from its
holdings.’’
The panic was allayed when it became clear to the
public that there was nothing about which to panic —
that there was indeed sufficient gold to meet the
public’s increased demand for gold. As a result, the
failure o f one bank did not turn into a general financial
crisis. Unfortunately, however, banking panics contin­
ued to occur in England after 1825 because the Bank o f
England had not made a public comm itm ent to act as

5The actions of the Bank in the panic of 1825 are described vividly by
Jeremiah Harman, director of the Bank, in Bagehot (1978), p. 73:
We lent it [gold] . . . by every possible means and in modes we had
never adopted before; we took in stock on security, we purchased
exchequer bills, we made advances on exchequer bills, we not only
discounted outright, but we made advances on the deposit of bills of
exchange to an immense amount, in short, by every possible means
consistent with the safety of the Bank and we were not on some
occasions over nice. Seeing the dreadful state in which the public
were, we rendered every assistance in our power.

7

FEDERAL RESERVE BANK OF ST. LOUIS

the “lender o f last resort” in all financial crises. A
lender o f last resort acts to increase the monetary base
if many people want to w ithdraw cash (gold and notes
o f the Bank o f England) from their banks.
The significance o f a lender o f last resort in a bank­
ing panic can be illustrated by referring to the balance
sheets in table 2. If depositors w ithdraw cash, the
lender o f last resort acts to increase the reserves o f the
banking system, thus preventing the contraction o f
the m oney supply that could be caused by a banking
panic. Until the English public became convinced that
the Bank o f England w ould act to increase the m one­
tary base (cash in the hands o f the public plus bank
reserves) in financial crises, many o f them tended to
withdraw cash from banks when there w ere problems
in the financial system.

The Lesson o f 1866
The last major banking panic in England occurred
in 1866. Since then, although events have occurred
that could have triggered banking crises (in 1873,1890,
1907, 1914, 1931 and 19731, they did not do so.1’ What
changed after 1866?
The panic o f 1866 began with the failure o f a major
English bank. Overend, Gurney and Company was a
large bank, founded early in the 19th century from the
amalgamation o f two banks that had been important
and active in the 18th century. Hit by a variety of
setbacks, Overend’s was com pelled to seek assistance
from the Bank o f England on May 10, 1866. The Bank
refused to provide assistance and that afternoon Over­
end, Gurney and Company was declared insolvent.
The next day, there w ere runs on all banks. People
scrambled for cash because no bank was trusted.7The
Bank o f England, which was being drained o f notes,
briefly made things worse by hesitating over w hether
to make its usual purchases o f newly issued govern­
ment debt. By the evening o f Friday, May 11, however,
the Bank gave assurance that it w ould provide support
to the banking system, and, though demands for small
bills continued for a week, the panic was essentially
broken in one day* The important consequence of
this episode was that the Bank had im plicitly accepted

6A succinct survey of the history of these episodes can be found in
Schwartz (1986).
7“ Panic, true panic, came with unexpected violence that day.”
(Clapham, 1944), p. 263. “ Terror and anxiety took possession of
men's minds for that and the whole of the succeeding day." (Bank­
ers Magazine, 1866). “ No one knew who was sound and who was
unsound.” (The Economist, 1866).
8A detailed description of the failure of Overend, Gurney, and Com­
pany and the events surrounding that failure can be found in
Batchelor (1986).

8




DECEMBER 1986

the responsibility o f acting as lender o f last resort and
the public understood that the Bank had accepted
that responsibility. For a discussion o f the historical
developm ent o f the concept o f a lender o f last resort,
see the insert on the opposite page.

HOW TO PREVENT BANKING PANICS
—
THE U.S. EXPERIENCE
The U.S. econom y suffered the effects o f banking
panics long after the British discovered h ow to prevent
them. The United States established the Federal Reserve as the central bank in 1914. There w ere eight
major banking panics before then and additional
financial crises that had more lim ited regional im ­
pact.” The formation o f the Federal Reserve, however,
did not end the problem o f banking panics; the last
panic occurred in 1933. The period since the last
banking panic coincides w ith the period o f federal
deposit insurance.

Banking Until the 1860s
(Civil War Period)"'
Bank Structure and Regulation — After the Revo­
lutionary War, the new U.S. government confined its
monetary role to the minting o f gold and silver coin.
State governments assumed responsibility for charter­
ing and supervising commercial banks. State banks
issued bank notes, w hich circulated as currency, and
had deposit liabilities against which customers could
write checks. Both the bank notes and dem and de­
posits w ere payable on dem and in the form o f the
coins m inted by the federal government.
The first banking panic occurred in 1814 during the
War o f 1812 with the British. In response to fears about
the outcom e o f the war, many people attem pted to
redeem bank notes and convert their bank deposits
into coin. The banking system responded by suspend­
ing coin payments, which kept the contractions o f the
m oney supply and bank assets from being as large as
they w ould have been (see the insert on page 10). In all
o f the major U.S. banking panics through 1907, the
banking system suspended cash payments to deposi­
tors and holders o f bank notes.
The Panic of 1837 — The panic described above
was unusual in that it was triggered by anxieties about
the war. Other banking panics in this period occurred

9The nine major banking panics occurred in 1814,1837,1857,1861,
1873,1884,1893,1907 and 1931-33.
10This section is based largely on Hammond (1963).

DECEMBER 1986

FEDERAL RESERVE BANK OF ST. LOUIS

The Lender of Last Resort and Walter Bagehot
The name and the work o f Walter Bagehot recur
continually in the discussion o f banking and bank
failures.' His main proposal called for the Bank o f
England to announce that it was willing to act as
lender o f last resort and that it would do so unhesi­
tatingly whenever necessary. By lender o f last re­
sort, he meant that the Bank would, in times o f
panic, "lend freely, at high interest rates.” It w ould
lend freely, so that banks could satisfy the demands
o f their customers for cash and thus allay panic. It
w ould do so at penally high interest rates to ensure
that the Bank was truly the lender o f last resort;
banks would com e to it only when the w hole bank­
ing system was short o f cash. The policy o f setting a
high lending rate was designed both to prevent
excessive monetary expansion in normal times and
to guarantee that banks repaid their borrowings
when interest rates dropped after the panic, so that
the money stock was not permanently boosted by
crisis borrowing.

'Bagehot was, among other things, a journalist. He became editor
of The Economist, and wrote voluminously on many subjects
(including The British Constitution). But he is most widely remem­
bered and discussed for his book, Lombard Street (first published
in 1873) (Bagehot, 1978), and for his campaign in The Economist
to have adopted his recommendations for the conduct of the
Bank of England.

when bank failures caused the public to lose con­
fidence in the value o f their bank notes and deposits.
The panic o f 1837 shows the nature of panics in this
period before the U.S. Civil War.
The U.S. econom y experienced an econom ic boom
from 1834 through 1836, supported by large invest­
ments in the United States by Europeans. Many of
these large investments w ere in railroads and pur­
chases o f public land by those moving to the western
frontier.
The boom stopped in 1837. Gold flowed from the
United States to Europe as European investors d e­
m anded payment o f their loans and liquidated their
U.S. investments. This outflow o f gold reduced the
cash reserves o f banks, which, along with failures by
business firms, caused some banks to fail. The Dry
Dock Bank, a major bank in N ew York City, closed on



Bagehot em phasized that the Bank should not
only behave in this way, but also should announce
in advance that it w ould do so whenever necessaiy.
He saw this “precom m itm ent,” w hich the Bank had
never made before the episode o f 1866, as vital. A
credible precom m itm ent w ould give assurance
that sound banks w ould not be allowed to fail as a
result o f the failure o f some other bank. Once this
assurance was given, panic w ould be less likely.
Indeed, the Bank might not actually have to act as
lender o f last resort at all; m erely standing ready to
do so might be sufficient to provide stability.2

Although now traditional, Bagehot s recommendation was not
accepted without demur. Thomson Hankey, a director of the
Bank, was particularly critical of the proposal. After the Overend
and Gurney affair, Hankey denied that the Bank had an unequivo­
cal duty to lend freely in panics. He was concerned with what has
become known as “ moral hazard." If bankers know that the
central bank will lend freely in a panic, he argued, they will take
more chances: hold lower reserves, make riskier loans or pay
higher dividends.
Hankey is plainly correct. The issue, however, is which is the
lesser evil, slightly riskier banks or the prospect of a collapse in
the money stock.
Hankey's criticism of Bagehot's principles for running a central
bank did not represent the official views of the Bank. Officially the
Bank neither accepted nor rejected Bagehot’s principles but
came to act in a manner consistent with these principles.

May 8, 1837. All other banks in N ew York City experi­
enced runs by depositors the next day. The N ew York
City banks suspended coin payments on May 10, and
Philadelphia banks follow ed suit on May 11. Within
the next 10 days, banks in all the leading cities sus­
pended coin payments.
N ew York City banks resumed coin payments to
holders o f bank notes and deposits on May 10, 1838,
exactly oneyear after the suspension. Banks in the rest
o f the nation resumed coin payments between August
1838 and early 1839.
This episode illustrates the vulnerability o f the
banking system to disruption. Without a central bank,
the supply o f cash in the econom y was determined by
the coins minted by the federal government and inter­
national movements o f precious metals. The bank
runs following the failure o f the Dry Dock Bank

9

FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1986

Suspending Cash Payments
Commercial banks in the major urban areas in
the United States suspended payments o f cash to
depositors and note holders during each o f the
major banking panics from 1814 through 1907. Dur­
ing suspensions, banks in an area w ould agree to
act together in refusing to pay out cash. Until the
1860s, the form o f cash dem anded by depositors
during panics was metal coins. In the early 1860s,
the cash demand during panics included currency.
During these general suspensions o f cash pay­
ments, banks remained open for business and per­
mitted their customers to use deposits to make
payments to others. Checks w ere cleared and de­
posit liabilities were transferred among banks. N on­
redeem ed bank notes continued to circulate as
currency. When banking panics w ere over, banks

showed that the public’s confidence in banks could be
undermined quickly when an important bank went
under. At this time, however, the U.S. banking system
had no institution comparable to the Bank o f England,
which had a reputation for financial strength and an
inventory o f cash that could cut short a panic. Conse­
quently, some banking panics in the United States, like
the panic o f 1837, w ere follow ed by long periods o f
suspended cash payments.

Money and Banking from the 1860s to
the Formation o f the Federal Reserve
System in 1914"
The National Banking System — Reforms were
begun in the 1860s to achieve two purposes: to estab­
lish a national currency, with all currency accepted at
par value in exchange throughout the nation, and to
make the banking system less vulnerable to panics. As
a first step, the federal government began chartering
national banks whose notes w ere to be the prim aiy
national currency. National banks w ere required to
hold both collateral with the Treasury Department
against their notes as w ell as cash reserves that w ere a
percentage o f their deposit liabilities and notes. The
collateral and reserve requirements w ere im posed to

"This section is based largely on Cagan (1963), Robertson (1964),
pp. 302-30, Scroggs (1924), and Sprague (1910).

10FRASER
Digitized for


resumed the payment on dem and o f coin for bank
notes and deposits.

The significance o f the suspension o f bank pay­
ments in the form o f coin or currency can be illus­
trated by referring to table 2, the balance sheet o f
the banking system. As soon as bankers realized
that the public was attempting to convert its m oney
holdings to coin or currency, the bankers as a group
refused to meet this demand for cash. In this case,
their cash reserves w ould stay at $100 billion, and
with that cash available to meet reserve require­
ments, the banking system w ould not have to sell
assets and reduce its liabilities. By suspending cash
payments, the banks w ould prevent the contraction
of the assets and liabilities o f the banking system.

restrain the growth o f bank liabilities and to prom ote
greater public confidence in the banking system.
The basic flaw in the design o f the new system was
the absence o f a central bank w ith the p ow er to in­
crease the monetary base should the public lose con­
fidence in the value o f bank deposits. In this period,
there w ere major banking panics in 1873, 1884, 1893
and 1907. Banks acted cooperatively during these pan­
ics to increase their reserves by creating clearing
house loan certificates (see the insert on the opposite
page). The creation o f clearing house loan certificates,
however, did not permit banks to meet the public
demand for currency. During each o f these panics
they also suspended payments o f coin and currency
to depositors.
The Panic of 1907 — The nature o f banking panics
in this period can be illustrated by the panic o f 1907,
which occurred in October and Novem ber o f that year.
This panic is interesting for several reasons. Its effects
on the nonfinancial sectors o f the econom y w ere rela­
tively severe, and its events provide a good illustration
o f h ow the loss o f public confidence in one bank can
lead to loss o f confidence in the banking system.
Finally, political reaction to this panic led to the for­
mation o f the Federal Reserve System.
For several years prior to 1907, gold flow ed from
Europe to the United States because Europeans in­
vested heavily in the U.S. econom y. In the fall o f 1906,

FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1986

Increasing the Monetary Base by Creating
Clearinghouse Loan Certificates
The banking system attempted to cope with the
banking panics through emergency actions other
than the suspension o f cash payments. One ap­
proach involved the issuance o f clearinghouse loan
certificates. Clearinghouses were cooperative insti­
tutions established by banks to econom ize on the
resources used in clearing checks and notes among
themselves. Checks and notes drawn on other
members o f a clearinghouse were presented to the
clearinghouse for collection, rather than being sent
to each bank for collection. Banks deposited cash
with their clearinghouses and, in turn, received cer­
tificates that were accepted by the other banks for
covering net debit positions in clearinghouse settle­
ments. Originally, the clearinghouse certificates
were merely receipts for cash held by clearing­
houses.
In each o f the banking panics from 1857 through
1907, the banking system acted cooperatively to
expand the m onetaiy base by increasing the
amount o f clearinghouse certificates outstanding.
The certificates issued during the panics w ere not
simply receipts for cash held by the clearinghouses
but w ere loans to banks with their assets pledged as
collateral. The standard practice was for a clearing­
house association to accept some o f the assets o f a
bank as collateral and issue certificates payable by
the clearinghouse association. A bank that received
such certificates w ould pay interest on them until
they w ere redeem ed after the panic was over. These

European investors began liquidating their U.S. invest­
ments, resulting in large gold outflows from the United
States. This disinvestment was associated with sharp
drops in U.S. stock prices in March and August 1907.
The U.S. econom y went into a recession after May
1907; the rate o f decline in real econom ic activity was
relatively low until the banking panic in the fall o f that
year, but relatively rapid after the panic.
The Panic of 1907 began with a depositor run on the
Mercantile National Bank in N ew York City, which had
suffered large losses. The N ew York clearinghouse



transactions effectively converted the clearing­
houses into fractional reserve banking institutions
by creating certificates that exceeded their holdings
o f cash.
Initially, clearinghouse certificates circulated
only among banks that w ere members o f the clear­
inghouse. During panics, clearinghouse members
agreed to accept these certificates in payment from
other member banks, rather than insisting on pay­
ment in cash. The circulation o f these certificates
among banks in place o f cash payments allowed the
participating banks to use their cash to meet the
cash demands o f their depositors. In some panics,
however, clearinghouse associations issued certifi­
cates in small denominations that banks offered to
their depositors as substitutes for cash. These
small-denomination certificates then circulated as
currency. This use o f clearinghouse certificates was
not legal, but the government banking authorities
did not challenge their use during panics.1

'Gorton (1985a,b) and Timberlake (1984). The Aldrich-Vreeland
Act of 1908 established a procedure for the emergency issuance
of national bank notes that was copied after the procedures that
banks had used for issuing clearinghouse loan certificates during
panics. The panic of 1914 tested the effectiveness of this innova­
tion just before the Federal Reserve System began operations.
By issuing notes that were available for such an emergency,
banks did not have to suspend cash payments. See Cagan
(1963), pp. 26-28, and Sprague (1915).

came to the aid o f the Mercantile National Bank in
October 1907, after the bank was put under new man­
agement. This action, however, was insufficient to
stem the panic. Depositor runs began at other institu­
tions, reflecting a general loss o f public confidence in
the stability o f the banking system. Within a few days,
all depository institutions in N ew York City faced
depositor runs. Banks in N ew York City suspended
cash payments in Novem ber 1907, and the suspension
o f payments spread quickly to other cities. The panic
and suspension o f payments ended in early 1908, but
only after a sharp decline in econom ic activity and a

11

DECEMBER 1986

FEDERAL RESERVE BANK OF ST. LOUIS

rise in bankruptcies in the nonfinancial sectors o f the
economy.

Banking Crises o f the 1930s and the
Beginnings o f Federal Deposit
Insurance'2
After the long series o f banking panics, culminating
in the Panic o f 1907, Congress finally responded by
passing legislation in 1913 to establish the Federal
Reserve System. There w ere no banking panics from
1914, w hen the Federal Reserve System began its oper­
ations, until the early 1930s. Then, however, a series o f
banking crises resulted in the closing o f all banks in
the nation in March 1933.
The Federal Reserve did not respond to these bank­
ing crises as the Bank o f England had nearly 70 years
before. U.S. commercial banks came under liquidity
pressures because o f cash withdrawals by depositors
and outflows o f gold from the United States. Yet, ex­
cept for a few months in 1932, the Federal Reserve did
not increase the monetary base in response to these
cash withdrawals from banks. Moreover, commercial
banks did not act cooperatively to suspend cash pay­
ments to depositors as they had in earlier banking
crises.13 Consequently, the deposit liabilities o f the
banking system declined sharply.
Congress took various approaches to dealing with
the general collapse o f the banking system in the
1930s. The most significant legislation was the estab­
lishment o f federal deposit insurance. There have
been no general banking panics in the United States
since 1933.

HAS DEPOSIT INSURANCE
PREVENTED BANKING PANICS IN THE
UNITED STATES?
The Pros and Cons o f Federal
Deposit Insurance
Recent experience indicates that large numbers o f
bank failures do not induce nationwide banking pan­
ics. A controversial issue, however, is w hether federal
deposit insurance could be elim inated without under­
mining public confidence in the banking system.

,2This section is based largely on Friedman and Schwartz (1963).
,3Friedman and Schwartz (1963, pp. 311 -12 ) argue that banks did not
suspend cash payments because they thought the need to do so
had been eliminated by the establishment of the Federal Reserve.

12FRASER
Digitized for


The British solved the problem o f banking panics
m ore than 100 years before they adopted a program of
deposit insurance administered by the governm ent.14
Some argue that it is time to eliminate federal deposit
insurance in the United States.15In their view, banking
panics are best prevented by a credible len der o f last
resort, and they argue that the Federal Reserve has
learned h ow to function as such. Federal deposit
insurance gives depository institutions the incentive
to assume greater risk than if deposit insurance w ere
eliminated or offered by private firms.
An opposing view is that federal deposit insurance
is essential for preventing banking panics. Since fed­
eral deposit insurance has been in effect for over 50
years, depositors rely on it, rather than on their assess­
ment o f the financial condition o f their banks. In this
view, banks w ou ld be vulnerable to runs by depositors
as they had been prior to 1933 if federal deposit insur­
ance w ere cancelled.

The Importance o f Credible Insurance:
The S&L Experience
Developments in Ohio and Maryland in 1985 pro­
vide some evidence on the importance o f federal d e­
posit insurance in preventing banking panics in the
United States. The deposits o f 80 Ohio savings and
loan associations (S&.Ls) had been insured by the Ohio
Depository Guarantee Fund (ODGF), a private deposit
insurance fund founded by the S&.Ls themselves to
insure their deposits. On March 4, 1985, the largest
S&.L insured by the ODGF incurred losses because o f
the failure o f a government securities dealer with
which the S&L had large investments. These losses
exceeded the capital o f the S&.L and the entire reserves
o f the ODGF. When these events w ere publicized,
depositors at other ODGF-insured S&.Ls began to
withdraw their deposits. Their confidence in the
safety of their funds was destroyed when the reserves
o f the ODGF w ere w iped out.1" Eleven days later, the
governor ordered all o f the S&.Ls insured by the ODGF
closed. One o f the conditions for reopening was that

14The British program of deposit insurance was introduced under the
Banking Act of 1979. With few exceptions, all depository institutions
are covered and must contribute to an insurance fund. Coverage is
75 percent of each account, with a maximum compensation of
£10,000 for each depositor. This program was introduced in re­
sponse to the secondary banking crisis of the early 1970s.
15Ely (1985), England (1985), O’Driscoll and Short (1984), Short and
O’Driscoll (1983), and Wells and Scruggs (1986).
16Federal Resen/e Bank of Cleveland (1985).

FEDERAL RESERVE BANK OF ST. LOUIS

they obtain federal insurance for their deposits.17
The loss o f confidence in the ODGF-insured institu­
tions did not lead to a general loss o f confidence in
depositoiy institutions. There were no runs on feder­
ally insured banks or S&.Ls in Ohio.
Similar events transpired in M aiyland in May 1985.
A private fund insured the deposits o f 102 Maryland
S&Ls. Losses at the largest S&L insured by the private
fund triggered runs by depositors on the privately
insured S&Ls throughout the state. Once again, there
were no runs on federally insured institutions. The
Maryland state government required the privately in­
sured S&.Ls to obtain federal deposit insurance. In
reaction to these developments in Ohio and Maryland,
several other states have required their privately in­
sured thrift institutions to obtain federal deposit in­
surance coverage.

DECEMBER 1986

bank with the responsibility o f acting as the lender of
last resort if a banking panic occurred. The Federal
Reserve failed in that responsibility in the early 1930s,
which resulted in a nationwide banking panic in the
United States in 1933. There have been no banking
panics in the United States since the federal govern­
ment established deposit insurance in the 1930s. Runs
by depositors on privately insured savings and loan
associations in Ohio and Maryland during 1985 pro­
vide some evidence that federal deposit insurance is
an essential feature o f the policies in preventing bank­
ing panics in the United States.

REFERENCES
Bagehot, Walter. Lombard Street, reprinted in Norman St. JohnStevas, ed., The Collected Works of Walter Bagehot (Hazell Wat­
son and Viney Ltd., 1978).
Bankers Magazine, June 1866, pp. 45-46.

SUMMARY AND IMPLICATIONS FOR
THE UNITED STATES
The rate o f bank failure in the United States is
currently high relative to failure rates in most years
since W orld War II. There have been many episodes in
U.S. histoiy when increased bank failures led to bank­
ing panics that disrupted the operation of the nation’s
banking system.
To prevent banking panics, it is essential that the
public maintain confidence in the safety o f their d e­
posits even though som e banks are failing. In the
United Kingdom, public confidence in the stability of
the banking system was established through the com ­
mitment o f the Bank of England to act as the lender of
last resort in financial crises. This policy was estab­
lished in the banking panic o f 1866, and the: U.K.
banking system has not experienced a banking panic
since. The basic feature o f that policy involves a com ­
mitment to increase the monetary base (currency held
by the public plus bank reserves) when bank runs
occur.
Policies in the United States reflect a different histor­
ical development. After various banking panics, the
Federal Reserve was established in 1914 as the central
,7The Federal Reserve attempted to stop the depositor runs by
lending cash to the privately insured S&Ls. Federal Reserve em­
ployees from throughout the System were put on special assign­
ment to accept the assets of these S&Ls as collateral for the cash
loans. This response, however, did not stop the depositor runs. This
indicates that, in a nation in which depositors have come to rely on
deposit insurance to maintain their confidence in the safety of their
funds, the central bank may not be able to maintain that confidence
by lending cash to depository institutions when the protection of
deposit insurance is suddenly eliminated.




Batchelor, Roy A. “The Avoidance of Catastrophe: Two Nineteenthcentury Banking Crises,” in Forrest Capie and Geoffrey E. Wood,
eds., Financial Crises and the World Banking System (St. Martin’s
Press, 1986), pp. 41-73.
Bryant, John. “ A Model of Reserves, Bank Runs, and Deposit
Insurance,” Journal of Banking and Finance (December 1980), pp.
335—44.
Cagan, Phillip. “The First Fifty Years of the National Banking Sys­
tem — An Historical Appraisal,” in Deane Carson, ed., Banking
and Monetary Studies (Richard D. Irwin, 1963), pp. 15—42.
Clapham, Sir John. The Bank of England: A History (Cambridge
University Press, 1944).
Diamond, Douglas W., and Philip H. Dybvig. “ Bank Runs, Deposit
Insurance, and Liquidity,” Journal of Political Economy (June
1983), pp. 401-19.
The Economist, June 1866, pp. 15-16.
Ely, Bert. “Yes — Private Sector Depositor Protection is a Viable
Alternative to Federal Deposit Insurance!” in Federal Reserve
Bank of Chicago, Proceedings of a Conference on Bank Structure
and Competition, held in Chicago, May 1-3, 1985, pp. 338-53.
England, Catherine. “A Proposal for Introducing Private Deposit
Insurance," in Federal Reserve Bank of Chicago, Proceedings of a
Conference on Bank Structure and Competition, held in Chicago,
May 1-3, 1985, pp. 316-37.
Federal Reserve Bank of Cleveland. 1985 Annual Report.
Fetter, Frank Whitson. Development of British Monetary Orthodoxy
(Harvard University Press, 1965).
Friedman, Milton, and Anna J. Schwartz. A Monetary History of the
United States, 1867-1960 (Princeton University Press, 1963).
Gorton, Gary. “ Bank Suspension of Convertibility,” Journal of Mon­
etary Economics (March 1985a).
________ _ “ Clearinghouses and the Origin of Central Banking in
the United States,” The Journal of Economic History (June 1985b).
Hammond, Bray. “ Banking before the Civil War,” in Deane Carson,
ed., Banking and Monetary Studies (Richard D. Inwin, 1963), pp. 1 14 .
Ho, Thomas, and Anthony Saunders. “A Catastrophe Model of
Bank Failure,” The Journal of Finance (December 1980), pp. 1189—
207.

13

FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1986

Jacklin, Charles J., and Supipto Bhattacharya. “ Distinguishing Pan­
ics and Information-Based Bank Runs: Welfare and Policy Implica­
tions,” First Boston Working Paper Series 86-16 (February 1986).

Short, Eugenie D., and Gerald P. O’Driscoll, Jr. “ Deregulation and
Deposit Insurance,” Federal Reserve Bank of Dallas Economic
Review (September 1983), pp. 11-22.

O’Driscoll, Gerald P., Jr., and Eugenie D. Short. “ Safety-Net Mech­
anisms: The Case of International Lending,” Cato Journal (Spring/
Summer 1984), pp. 185-204.

Sprague, O. M. W. History of Crises under the National Banking
System, National Monetary Commission, Sen. Doc. No. 538, 61
Cong. 2 Sess. (U.S. Government Printing Office, 1910).

Robertson, Ross M. History of the American Economy, 2nd ed.
(Harcourt, Brace and World, 1964).
Santoni, G. J. “A Private Central Bank: Some Olde English Les­
sons,” this Review (April 1984), pp. 12-22.
Schwartz, Anna J. “ Real and Pseudo-financial Crises” in Forrest
Capie and Geoffrey E. Wood, eds., Financial Crises and the World
Banking System (St. Martin’s Press, 1986), pp. 11-31.
Scroggs, William O. A Century of Banking Progress (Doubleday,
Page and Company, 1924).

14FRASER
Digitized for


_________ “The Crisis of 1914 in the United States,” American
Economic Review (September 1915), pp. 499-533.
Timberlake, Richard H., Jr. “The Central Banking Role of Clearing­
house Associations,” Journal of Money, Credit and Banking (Feb­
ruary 1984), pp. 1-15.
Wells, Donald R., and L. S. Scruggs. “ Historical Insights into the
Deregulation of Money and Banking,” Cato Journal (Winter 1986),
pp. 899-910.

FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1986

Why Has Manufacturing
Employment Declined?

u

John A. Tatom

NITED STATES manufacturing em ploym ent
grew little in 1986. Currently at about 19 million
workers, it is below the 21 million em ployed at its peak
in 1979. This disappointing performance often is at­
tributed to the declining international com petitive­
ness o f U.S. manufacturing. Such arguments, however,
are tenuous at best: U.S. manufacturing output ex­
panded more rapidly during the period o f dollar ap­
preciation fro in 1980-84 than it had over the previous
four years when the dollar’s value was falling. More
importantly, the growth o f manufacturing abroad has
been anemic during this decade. A variety o f output,
cost and productivity measures reveal that the
competitiveness o f U.S. manufacturing has actually
im proved.1
Concern over the recent performance o f manufac­
turing employment, however, is not so easily rebutted.
Indeed, viewed alongside the strength o f U.S. manu­
facturing output growth, there seems to be a “JekyllH yde” quality to the U.S. manufacturing sector perfor­
mance.- A longer-run perspective on manufacturing
employment and an understanding o f econom ic
forces contributing to it, however, reveals that the
recent decline is not unusual and simply reflects the

John A. Tatom is an assistant vice president at the Federal Reserve
Bank of St. Louis. Michael L. Durbin provided research assistance.
1See Tatom (1986). Clark (1986) has pointed to the unusual strength
of manufacturing output in recent years.
2See Clark (1986).




strength o f U.S. manufacturing productivity growth in
the 1980s.

DOMESTIC MANUFACTURING
EMPLOYMENT: CYCLICAL W ITH NO
PERSISTENT TREND
Chart 1 shows manufacturing em ployment and out­
put (1982 prices) since 1948. As one can see by examin­
ing the shaded periods o f business recession, both
manufacturing em ployment and manufacturing out­
put are strongly cyclical. What is equally evident is
that manufacturing em ployment has shown little ten­
dency to grow over the prior three decades, except for
its sharp rise from 1960 to 1967. Indeed, at its peak in
1979, there were fewer than one m illion more workers
in the manufacturing sector than in mid-1969, and
only about four million more workers than in 1956 and
early 1957. Thus, temporarily negative growth in man­
ufacturing em ployment is neither unprecedented, nor
should it be assessed relative to a presumption that
manufacturing em ployment has exhibited any signifi­
cant growth since 1948.
The cyclical explanation, however, does not fully
account for the decline in em ployment from 1979 to
1986. At manufacturing em ploym ent’s peak in 1979,
unemployment equaled 5.8 percent o f the civilian
labor force. If the nation’s output increased enough to
reduce the current unem ploym ent rate (7.0 percent)
back to 5.8 percent, about 1.4 m illion jobs w ould
result, given today’s labor force. Up to one-half o f these
jobs w ould likely be in manufacturing. Even w ith these

15

FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1986

C hart 1

U.S. M anufacturing O u tpu t and Employment

Latest d a t a p lo t t e d : 3 r d

q u a r te r 1986

additional jobs, however, manufacturing em ployment
w ould remain low er than in 1979.:‘

WHAT DETERMINES
MANUFACTURING EMPLOYMENT?
Economic theoiy points to several factors that in­
fluence manufacturing employment. At the simplest
level, firms choose their desired em ploym ent o f labor
based on a comparison o f the expected cost and the
expected revenue obtained from hiring additional
workers. The latter depends on both the change in
output associated with em ploying more (or less) work­
3The appendix to this article further discusses the importance of
cyclical movements in the decline of manufacturing employment
since 1979.

Digitized for
16 FRASER


ers and the expected output price. Another w ay o f
expressing this choice is to compare the relative price
o f labor, the wage relative to the price o f the output
produced, and the productivity o f additional workers.4
A rise in the manufacturing wage or a fall in the price
o f manufactured goods raises the cost o f labor relative
to its productivity, reducing the incentive to em ploy
labor. Similarly, a rise in the productivity o f workers for
a given level o f em ployment increases the incentive to
em ploy workers, given the relative cost o f labor.

“The relevant productivity measure is the marginal product of labor;
normally, however, output per worker, or average productivity, is the
most commonly used measure. As long as the ratio of the marginal
to average product of labor does not change, movements in the
average product of labor will reflect the same proportional move­
ments in the marginal product of labor.

FEDERAL RESERVE BANK OF ST. LOUIS

The manufacturing sector is only one part o f the
econom y. Producers o f m anufactured products,
therefore, must com pete with producers in other sec­
tors, such as agriculture, services, construction, m in­
ing, transportation, utilities and government, for sales
and for resources, including workers. Thus, manufac­
turing wages and prices must be competitive in order
to attract workers and sales. A simple statement o f this
relationship can be derived from the identical em ploy­
ment decisions made by firms throughout the econ­
omy. In particular, if wages equal some fraction ((3mfor
manufacturing, or (3 for the w hole econom y) o f the
revenue per worker in manufacturing and in the
w hole economy, then:

(1) W,„/W = (0„,/0) (P„,/P) (TT../TT),
where W,„ and W are wages in manufacturing and in
the w hole economy, respectively, P,„ and P are the
prices o f output in the two sectors, and tt,,, and i t are
the output per worker, or productivity, in the respec­
tive sectors. Because productivity is measured as the
ratios o f output to the number o f workers in each
sector, equation 1 can be rearranged to the following:

12! L„/L = ip„,/(3l (X„/X) (P,„/P) iWm/Wr',

where L,„ is the em ployment in manufacturing and L is
total civilian employment, and X„, and X represent
their respective output levels. According to equation 2,
the share of manufacturing em ploym ent (L„/L) de­
pends positively on the share o f manufacturing in the
nation’s total output (X,,,/X) and the price o f manufac­
turing output relative to prices generally (P„,/P), and is
inversely related to wages in manufacturing relative to
wages generally (W,„/W). Relative wages, o f course,
depend on relative skill differences, nonpecuniaiy dif­
ferences o f jobs in manufacturing com pared with the
remainder o f the economy, and barriers to labor m ove­
ment across sectors o f the econom y. Differences in the
relative degree of unionization or in regulation can
affect the latter factor.
Manufacturing output’s share in total output de­
pends on the dem and for manufacturing output com ­
pared with other goods. This demand is influenced by
permanent or transitoiy movements in real income
and by the relative price o f manufactured product.
The share o f manufacturing product in total output
can also be influenced by international trade. Low er
prices for im ported manufactured products could re­
duce both the share o f domestic manufacturing pro­



DECEMBER 1986

duction and its relative price. Similarly, a rise in the
relative price o f manufactured goods due to a rise in
foreign demand can increase domestic manufacturing
production (for export) relative to the econom y’s total
output.
Manufacturing output's share is o f interest not just
because o f its influence on employment; more im por­
tantly, it indicates the direct role o f manufacturing in
generating real incom e in the economy. In addition,
comparisons o f the em ployment and output shares o f
the manufacturing sector indicate the relative perfor­
mance o f productivity, or output per worker. The next
section examines the em ployment and output shares
in the manufacturing sector. Then the implications of
productivity growth for prices and output are dis­
cussed. The discussion links two o f the three factors
influencing the em ployment share, according to equa­
tion 2. The third factor, relative wages, is discussed
subsequently.

THE SHARE OF MANUFACTURING
EMPLOYMENT AND OUTPUT
Chart 2 shows the share o f manufacturing em ploy­
ment and output as percentages o f civilian em ploy­
ment and real gross national product (GNP) respec­
tively. The share o f m anufacturing output has
fluctuated cyclically, but shows no trend. Em ploy­
ment in manufacturing has been declining as a share
o f total em ployment for a long time. The principal
factor accounting for this decline has been relatively
more rapid growth in labor productivity in manufac­
turing than in the remainder o f the economy.
Chart 3 shows the ratio o f labor productivity in
manufacturing to that for the business sector as a
whole. Labor productivity is measured by output per
worker. From 1948 to 1960, there was little difference
in the growth rates o f productivity in manufacturing
and elsewhere, so the relative productivity level
shown in the chart changed little. Note that in chart 2,
the share o f labor em ployment in manufacturing also
changed little over this period. Since then, productiv­
ity has grown faster in the manufacturing sector, so
that between 1960 and 1985, labor productivity in
manufacturing increased almost 50 percent more in
the manufacturing sector than in the business sector.
As chart 2 shows, this rise in productivity was associ­
ated with a decline in the share o f labor employment
rather than a rise in the share o f manufacturing
output.

17

DECEMBER 1986

FEDERAL RESERVE BANK OF ST. LOUIS

C hart 2

Share of Employment and O u tpu t in M an u factu rin g

1947 49

51

53

55

57

59

61

63

65

67

69

71

73

75

77

79

81

83 1985

NOTE: P e r c e n ta g e s o f c iv ilia n e m p l o y m e n t a n d r e a l G N P , re sp e ctiv e ly .

Productivity Growth, Prices and Output
Why have productivity gains in manufacturing re­
sulted in a relative decline in em ployment rather than
a rise in the share o f output? A simple perspective on
this question is to examine the effect o f productivity
growth in a supply-demand framework. In figure 1,
the initial supply curve and demand curves are la­
beled S and D, respectively. Given other factors that
influence supply or dem and decisions, the curves
indicate that as the price o f manufactured product
rises, the quantity supplied rises and the quantity
dem anded falls. At the initial equilibrium price, P,„
producers desire to produce and sell exactly the
quantity of product that buyers wish to purchase.
A gain in output per worker, or productivity, raises
the quantity that producers could profitably produce,
given factor and product prices. Such a gain shifts the
Digitized for
18 FRASER


supply curve to the right, as shown in the shift from S
to S' in the figure. The shift in the supply results in an
excess supply.’ Buyers are unwilling to purchase
more, given the price, P„, and the other factors in­
fluencing demand. Thus, the product price falls as
producers com pete to enlarge their sales. At a new
equilibrium price, P, in the figure, buyers purchase
more and sellers are selling exactly the output they

Productivity growth in manufacturing also has a significant effect on
real GNP since this sector accounts for more than 20 percent of real
GNP. For example, a 10 percent increase in output per worker
would tend to increase real GNP by (0.2) (0.1) or 2 percent, other
things the same. This change in real GNP would raise the demand
for all normal goods and sen/ices. This shift is omitted in the figure.
The initial excess supply created by a productivity improvement in
manufacturing is reduced somewhat by this shift, as is the associ­
ated decline in price.

DECEMBER 1986

FEDERAL RESERVE BANK OF ST. LOUIS

C hart 3

Relative Productivity in M anufacturing

profitably choose to sell along the new supply cuive S'.
Thus, productivity growth increases output only to
the extent that buyers are willing to increase their
purchases; this willingness is influenced by the re­
sponsiveness o f dem and to a decline in the price of
the product.
The effect o f productivity growth on the size o f the
output increase in an industry is determ ined by pur­
chasers o f the product, not by the producers. If d e­
mand is quite responsive to price, then price falls
relatively less and the quantity purchased rises rela­
tively more. Economists refer to this responsiveness as
the “own price elasticity o f dem and” ; it measures the
percentage change in quantity dem anded induced by
a given percentage change in price. If the elasticity



equals one, a given percentage-point decline in price
induces an equal percentage rise in the quantity d e­
manded. If the elasticity exceeds one, the product is
said to have elastic demand; a given percentage d e­
cline in price induces a larger percentage rise in quan­
tity demanded. If the own price elasticity o f demand is
less than one, demand is said to be inelastic, indica­
ting a low er degree o f responsiveness o f dem and to
price changes.
An important implication o f the magnitude o f the
dem and response to a price change is the effect o f a
supply shift on total spending on the product. When
supply shifts from S to S' in the figure, the product o f
price times quantity, or total spending on the product,
can change. If dem and is elastic, the percentage rise in

19

FEDERAL RESERVE BANK OF ST. LOUIS

quantity dem anded will exceed the percentage d e­
cline in price that caused it; as a result, total spending
(P, X,) w ill rise (P, X, exceeds P„ XJ. If dem and is unit
elastic, total spending w ill not change. If dem and is
inelastic, the price w ill fall relatively more than quan­
tity dem anded rises and total spending falls.

DECEMBER 1986

Figure 1

The Supply and Dem and for M anufacturing Output

Implications f o r the Manufacturing
Sector
The estimated dem and for manufacturing output
shown in the appendix has a price elasticity that is
less than one, or inelastic. Thus, according to equation
2, faster productivity growth in manufacturing has
resulted in a declining share o f em ployment because
relative price reductions have more than offset the
price-induced gains in output
Relatively faster productivity growth in manufactur­
ing also has reduced the share o f nominal incom e
generated in manufacturing products. In effect, the
gain in the nation’s incom e and output occasioned by
productivity growth in manufacturing has been real­
ized in increased output elsewhere. To the extent that
consumers o f manufactured and other products are
unwilling to buy the increased manufacturing output,
resources that are saved by productivity improvement
are moved into other activities to produce goods or
services. The rise in the price o f nonmanufactured
product relative to prices o f manufactured goods
reflects this shift. Moreover, the share o f incom e spent
on the manufactured product declines, or the share of
income spent on other products rises.7
The relative price o f the manufactured product is
shown in chart 4; it is the ratio o f the implicit price
deflator for manufacturing output to that for business
sector output, where the price indexes are set to 1 in
1982. The share o f nominal GNP originating in domes-

6The price elasticity is not the only factor that influences the share of
spending on manufacturing output. The “ income elasticity," the
sensitivity of demand to real income changes, is also an important
determinant of the share of such output and spending in a growing
economy. As real income expands, the demand for all goods and
services normally rises, given unchanged prices. But if the income
elasticity of demand for manufactured product is less than one, then
the share of manufacturing output in total output would fall, given
unchanged product prices. This elasticity, with respect to permanent
income, is estimated to be less than one in the appendix. Transitory
or cyclical changes in income have much larger effects.
T h e agricultural sector is a more well-known area in which produc­
tivity gains have given rise to sharp increases in the nation’s real
income, despite a declining share of income being spent on the
product and relatively large flows of resources out of the sector.

20FRASER
Digitized for


tic manufacturing is also shown in chart 4. The decline
in the relative price o f manufacturing output since
1960 has been quite rapid and reflects the relative gain
in labor productivity in that sector." Since the propor­
tion of output has been unchanged (chart 21, the share
o f incom e originating in or spent on manufacturing
has declined in line with the falling relative price o f
manufactured product.
Tw o o f the principal factors determining the share
o f labor employment devoted to manufacturing in
equation 2 are summarized in the nominal spending
share in chart 4. The dominant factor o f the two has
been the declining relative price o f manufacturing
output, which reflects relative productivity gains in
the sector. Of course, its share o f output and its rela­
tive price could both fall if the demand for manufac-

8The sharp decline in the relative price of the manufactured product
from 1971 to 1973 and subsequent recovery to its previous path
may be due to errors in measurement. Darby (1974) has argued that
wage and price controls in this period initially biased down price
measures and artificially raised real output measures. If wage and
price patterns in 1971-75 were artificially distorted by controls, the
share of employment (chart 2) would not have been so flat in 1971—
73, nor would it have subsequently declined so sharply in 1973-75.

DECEMBER 1986

FEDERAL RESERVE BANK OF ST. LOUIS

C h a rt

4

The R elativ e Price a n d Share of N o m in a l Income
in M a n u fa c tu rin g

Index

Per cent

A n n u a l D ata

31.0

Price
|SCALE

tured goods w ere declining. Chart 2 clearly indicates,
however, that this has not been the case; the share o f
manufacturing output has been nearly unchanged for
the past 40 years.0

RELATIVE WAGES AND EMPLOYMENT
IN MANUFACTURING
The final factor in equation 2 that influences the
share o f em ployment in manufacturing is the relative
level o f compensation in manufacturing. W hen wages

9ln agriculture, even the share of output has declined, making it more
difficult to see the sector as an important source of expanding real
income.




rise more (less) in one sector relative to the rest o f the
economy, the relative amount o f em ployment gener­
ally is reduced (increased), given initially unchanged
relative price and output levels. One w ay to under­
stand this makes use o f equation 1. If relative wages in
manufacturing rise, it either reflects a relative im ­
provement in the value o f manufacturing productivity
for a given level o f em ployment or will be reflected in
such an improvement obtained by changing em ploy­
ment."’ In the latter case, a rise in wages relative to
prices forces firms to both substitute other factors of

,0That is, the relative employment demand depends on relative
wages. If relative wages change, there is either a movement along,
or a shift in, the relative demand for labor in manufacturing.

21

FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1986

C h a rt 5

Relative Labor Compensation in M anufacturing

production for labor to offset some o f the cost increase
and to reduce production, which tends to raise prod­
uct prices. Both types o f adjustment raise productiv­
ity, but output declines and product prices rise when
the source o f the productivity gain is an increase in
relative wages.
Relative wage movements have not been the dom i­
nant force in U.S. manufacturing. Chart 5 shows com ­
pensation in manufacturing relative to compensation
in the business sector generally. Over the past 38
years, there has only been one major shift in the
relative compensation levels that w ould induce a ma­
jor change in relative output, price or employment
patterns. From 1948 to 1960, compensation was over
20 percent higher in the manufacturing sector. This
differential narrowed from 1960 to 1966, resulting in
em ployment growth that was quite rapid (charts 1 and

22FRASER
Digitized for


2). With the exception o f that period, however, m ove­
ments in relative wages do not appear to have been
large enough to have affected the share o f labor em ­
ployed in manufacturing significantly.

INTERNATIONAL TRADE
The view that foreign com petition has led to rela­
tively large losses in manufacturing em ploym ent in
the 1980s is w idely held. But there is no evidence
above that the share of domestic manufacturing (chart
2) has been depressed by the appreciation o f the dollar
or by increased imports." There is also no apparent
"Fieleke (1985) has shown that there was no significant negative
correlation between employment changes in domestic employment
in manufacturing industries and changes in import penetration in
these industries over the period 1980 to 1984.

FEDERAL RESERVE BANK OF ST. LOUIS

evidence that relative wages in manufacturing (chart
5) have been depressed in the early part o f this decade
due to trade-induced reductions in the demand for
U.S. manufacturing output and employment. More
careful attention to the argument w ould further clarify
the analysis, however.
Domestic manufacturers com pete with foreign pro­
ducers. The dollar price o f domestic manufactured
product, therefore, must be competitive with the dol­
lar price of the foreign product. The latter price can be
expressed as (P*/EI, where P* is the price of the foreign
product in its own currency and E is the price o f a
dollar in units o f foreign currency. In the analysis in
the figure, productivity improvement lowers the price
of domestic product; for foreign goods, this requires
that the value o f the dollar, E, rise; to the same extent
for foreign goods to remain competitive with U.S.
products. In other words, productivity improvement
in U.S. manufacturing, given foreign prices, tends to
raise the value o f the dollar.
Many analysts, however, em phasize the causality
running in the opposite direction. Falling prices o f
foreign goods or a rise in the value o f the dollar
depress the domestic prices o f foreign goods. CM'
course, a decline in P,„ due to foreign competition
alone w ould lead to a reduction in the quantity o f U.S.
output supplied and increased purchases along tin;
demand curve; the difference between U.S. purchases
o f manufactured products and U.S. production (sup­
ply) w ould be made up by imports o f foreign products.
The evidence presented earlier is inconsistent with
the trade hypothesis. If this hypothesis w ere correct,
the share o f domestic manufacturing output in total
real incom e w ould have fallen in the 1980s. Instead,
the share has been relatively strong, especially when
adjusted for the domestic business cycle.12Also, if the
international hypothesis w ere correct, the growth of
manufacturing output and em ploym ent abroad
w ould have risen. But neither, in fact, occurred.11

DECEMBER 1986

Moreover, the appendix to this article shows that the
exchange value o f the dollar has not significantly af­
fected the dem and for dom estic m anufacturing
output.

CONCLUSION
Manufacturing em ployment in the United States
has declined slightly in recent years, but this decline
should be assessed against a previous sharply declin­
ing trend relative to overall em ployment in the econ­
omy. Part o f the recent decline is associated with a
reduction in the relative dem and for the manufactur­
ing product due to cyclical forces in the U.S. economy.
In 1979, w hen m anufacturing em ploym ent was
slightly larger, the nation’s unem ploym ent rate for
civilian workers was 5.8 percent, compared with re­
cent levels o f about 7 percent.14 Losses in incom e
associated with cyclical increases in unemployment
reduce the demand for manufacturing output rela­
tively more than demand in other sectors o f the econ­
omy.
But the longer-term "problem " is the strength o f
productivity improvement in the manufacturing sec­
tor generally. Faster productivity growth in this sector
has contributed significantly to real incom e growth in
the nation; it has also contributed to a significant
decline in the relative price o f manufactured goods,
reflecting their increased availability. While the share
o f manufacturing output has been maintained, its
shares o f em ployment and total spending have de­
clined. This long-standing pattern has continued from
1979 to 1985. Thus, there is no need to blame other
popular villains for manufacturing em ploym ent’s fail­
ure to regain its previous peak level.

REFERENCES
Clark, Lindley H., Jr. “ Productivity’s Cost: Manufacturers Grow
Much More Efficient, But Employment Lags,” Wall Street Journal,
December 4, 1986.
Darby, Michael R. “ Price and Wage Controls: Further Evidence,” in
Karl Brunner and Allan Meltzer (eds.), Carnegie-Rochester Confer­
ence Series, vol. 2 (Amsterdam: North Holland, 1976).

l2The share of manufacturing output in real GNP was 21.7 percent in
1985 and the first three quarters of 1986. This was higher than the
1948-80 average of 21.3 percent, despite the fact that measures of
transitory income losses due to unemployment or low capacity
utilization indicate a significantly lower-than-average share would
have been expected. Tatom (1986) indicates that manufacturing
sector growth exceeded that predicted by income growth alone by
about 1.6 percent per year for the period 1980-85.
13See Tatom (1986). The other countries examined were Canada,
Belgium, Denmark, Germany, Italy, the Netherlands, Norway,
Sweden and the United Kingdom.




l4The change in the unemployment rate is an accurate index of
cyclical output and income losses when the “ natural rate” of unem­
ployment, the noncyclical component, is unchanged. The substan­
tial slowing in the growth of new entrants into the labor force in the
1980s, especially young, inexperienced people, reduced the natural
rate significantly. Of course, the latter implies that a return to a 5.8
percent rate would leave the economy with a larger percentage
cyclical output loss than that associated with the same unemploy­
ment rate in 1979.

23

FEDERAL RESERVE BANK OF ST. LOUIS

Fieleke, Norman S. “The Foreign Trade Deficit and American In­
dustry,” New England Economic Review, Federal Reserve Bank of
Boston (July/August 1985), pp. 43-52.
Tatom, John A.

“ Domestic vs. International Explanations of Recent

DECEMBER 1986

U.S. Manufacturing Developments,” this Review (April 1986), pp.
5-18.
------------ “ Economic Growth and Unemployment: A Reappraisal
of the Conventional View,” this Review (October 1978), pp. 16-22.

Appendix
Cyclical Changes in Manufacturing Output
and Employment
Output and em ployment in U.S. manufacturing are
strongly cyclical: transitoiy incom e changes associ­
ated with recessions or booms have a greater impact
on demand for manufacturing output and the de­
mand for labor in this sector than in the rem ainder of
the economy. Thus, some part o f the reduction in
manufacturing em ployment from 1979; when such
em ployment averaged 21.0 m illion workers, to 1986,
when it averaged 19.2 million, is due to the cyclical rise
in the unemployment rate over the period from 5.8
percent to 7.0 percent. Some simple rules o f thumb
allow an assessment o f the current magnitude of cycli­
cal em ployment losses in manufacturing.
The first useful relationship in such an assessment
is called Okun's Law, which relates cyclical m ove­
ments in the unemployment rate to cyclical losses in
real GNP. According to recent estimates, each percent­
age point o f unemployment is associated with a 2'U
percent loss in real GNP.' Thus, the rise in unem ploy­
ment from 1979 to 1986 is associated with a loss of real
GNP o f about 2.7 percent, 12'/»I (1.2 percent). This
means that if the unemployment rate in 1986 had been
5.8 percent, nominal GNP w ould have been $115 bil­
lion larger in the first three quarters o f 1986, given
prices.
To see how this gain in incom e w ould have been
distributed between manufacturing and the rest o f the
economy, the demand for manufacturing output must
be estimated. The demand for such output is a func­
tion o f the relative price o f the manufactured product

'See Tatom (1878).

Digitized for
24FRASER


and income; manufacturing output, however, is rela­
tively more sensitive to transitory fluctuations in real
incom e than permanent changes [see Tatom (1986) ].
Using potential real GNP, XP, to measure permanent
incom e and real GNP to measure actual real income
(permanent plus transitoiy income), X, the estimated
demand for annual manufacturing sector output, in
growth rate form, for the period 1949-85 is:
A in XM, =

K2 = 0.86

-0 .5 3 3 Alnl PM/FI, + 2.284 Ain X, - 1.444 A in XP„
(- 3 .7 4 )
(22.59)
(- 1 1 .5 6 )

SE = 1.35%

DVV = 2.02

where XM is manufacturing sector output, X is real
GNP, (PM/P) is the implicit price deflator for manufac­
turing output deflated by the GNP deflator and XP is
potential real GNP. The constant is om itted because it
is not significant.
When potential and actual real GNP grow at the
same rate, the dem and for manufacturing output ex­
pands at about the same rate, but cyclical fluctuations
in real GNP result in much larger variations in the
demand o f manufacturing output. The permanent
income elasticity o f dem and is the sum o f the actual
and potential GNP coefficients, or 0.84; the cyclical
income elasticity is much larger, 2.28. The price elas­
ticity o f demand for manufacturing output is —0.53, or
less than one. To test w hether the dem and for dom es­
tic manufacturing output is negatively related to the
exchange value o f the dollar, changes in the logarithm
o f the Federal Reserve Board’s trade-weighted ex­
change rate were added to the equation. None o f the
coefficients above w ere significantly altered and the
exchange rate coefficient was positive, 0.003 (t = 0.07),

FEDERAL RESERVE BANK OF ST. LOUIS

although insignificant.- According to these estimates,
a 2.7 percent rise in real GNP, given prices and poten­
tial output, w ould result in a 6.2 percent gain in
manufacturing output. Such a gain w ould put the
share o f manufacturing output at about 22.5 percent,
essentially the same as at the post-World War 11 peak
achieved in 1966 and 1973.
O f course, a cyclical gain in manufacturing output of
this size w ould be associated with a cyclical rise in
output per worker, so that the increase in em ploy­
ment w ould be smaller than that for output. Equation
2 in the text and the demand equation estimate above
may be used to find the manufacturing em ployment
gain. The product (PM/P) (Xm/X) in equation 2 in the
text is the share o f nominal spending (GNP) on manu­
facturing product. Changes in this spending share
result in proportionate changes in manufacturing em ­
ployment relative to total employment.
Cyclical variations in the share o f nominal GNP
2When the relative price of imports is used instead of the tradeweighted exchange rate, its coefficient has the “ expected" negative
sign, -0 .0 2 , but it is not statistically significant (t = -0 .7 2 ). None of
the elasticity estimates is significantly affected in this test either. The
relative price of imports is the ratio of the implicit price deflators for
imports from the National Income and Product Accounts and for the
domestic manufacturing sector.




DECEMBER 1986

originating in domestic manufacturing equal (Ain XM
— AlnX + Aln(PM/P) ]; according to the dem and equa­
tion estimate above, holding (PM/P) and XP constant,
this sum is 1.284 AlnX. For a 2.7 percent change in real
GNP (AlnX = 2.7 percent), the change in the nominal
spending share is 3.5 percent. With an unchanged
relative compensation level, equation 2 in the text and
the demand function here indicate that a movement
from a 7 percent to a 5.8 percent unem ploym ent rate
w ill result in a difference (Ain LM — Ain L) equal to 3.5
percent; since Ain L is about 1.2 percent, Ain LM is
about 4.7 percent.3 Thus, manufacturing em ployment
w ould increase from about 19.2 million workers in
manufacturing to about 20.1 million, still below the 21
million level observed in 1979.4

3A more direct method of estimation gives about the same conclusion.
When Ain LM, where LM is manufacturing employment, is regressed
on a constant and the current and past two quarters' growth rates of
real GNP, quarterly for the period IV/1948—11/1986, the sum of the
coefficients on real GNP growth yield a manufacturing employment
elasticity of 1.5, so that a 4 percent gain in manufacturing employment
is associated with a 2.7 percent rise in real GNP, about the same as
that indicated above.
“These calculations presume that relative wages and prices would be
unchanged by a cyclical rise in real GNP. There is no indication, either
in the charts of these variables in the text, or in correlation analysis,
that these variables are cyclical.

25




FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1986

FEDERAL RESERVE BANK OF ST. LOUIS
REVIEW INDEX 1986

JANUARY

AUGUST/SEPTEMBER

Michael T. Belongia, “ Estimating Exchange Rate Effects
on Exports: A Cautionary Note”

Daniel L. Thornton, “The Discount Rate and Market
Interest Rates: Theory and Evidence”

Keith M. Carlson, “ Recent Revisions of GNP Data”

Salam K. Fayyad, “A Microeconomic System-Wide Ap­
proach to the Estimation of the Demand for Money”

FEBRUARY
R. W. Hafer, “The FOMC in 1985: Reacting to Declining
M1 Velocity”
R. Alton Gilbert, “ Requiem for Regulation Q: What It Did
and Why It Passed Away”

MARCH
R. IV. Hafer, “The Response of Stock Prices to Changes
in Weekly Money and the Discount Rate”
G. J. Santoni, “The Effects of Inflation on Commercial
Banks”

APRIL
John A. Tatom, “ Domestic vs. International Explanations
of Recent U.S. Manufacturing Developments”
Kenneth C. Carraro and Daniel L Thornton, “The Cost of
Checkable Deposits in the United States”

OCTOBER
Jerry L. Jordan, “The Andersen-Jordan Approach after
Nearly 20 Years”
Dallas S. Batten and Daniel L Thornton, “The MonetaryFiscal Policy Debate and the Andersen-Jordan Equa­
tion”
Keith M. Carlson, “A Monetarist Model for Economic
Stabilization: Review and Update”
Leonall C. Andersen and Jerry L. Jordan, “ Monetary and
Fiscal Actions: A Test of Their Relative Importance in
Economic Stabilization”
Leonall C. Andersen and Keith M. Carlson, “A Monetarist
Model for Economic Stabilization”

NOVEMBER
MAY
Alex Cukierman, “ Central Bank Behavior and Credibility:
Some Recent Theoretical Developments”
Zalman F. Shifter, “ Adjusting to High Inflation: The Israeli
Experience”

G. J. Santoni, “The Employment Act of 1946: Some
History Notes”
Michael T. Belongia, “The Farm Sector in the 1980s:
Sudden Collapse or Steady Downturn?”

JUNE/JULY

DECEMBER

Mack Ott and Paul T. W. M. Veugelers, “ Forward Ex­
change Rates in Efficient Markets: The Effects of News
and Changes in Monetary Policy Regimes”

R. Alton Gilbert and Geoffrey E. Wood, “ Coping with
Bank Failures: Some Lessons from the United States
and the United Kingdom”

John A. Tatom, “ How Federal Farm Spending Distorts
Measures of Economic Activity”

John A. Tatom, “Why Has Manufacturing Employment
Declined?”




27