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FEDERAL RESERVE B A N K
OF ST. L O U IS
JW 1975
-V
I
S-
DtS
LOUISVILLE
Mr
IE
I
The Changing Competition Between
Commercial Banks and Thrift
Institutions for Deposits ................................... 2
Paying More Taxes and Affording
It L e s s ...................................................................... 9
Balance-of-Payments Concepts —
W hat Do They Really M e a n ? ...................... 14
Vol. 57, No. 7
The Changing Competition Between Commercial
Banks and Thrift Institutions for Deposits
JEAN M. LOVATI
OM M ERCIAL banks and thrift institutions (sav
ings and loan associations and mutual savings banks)
compete in various ways for deposits of customers.
Commercial banks offer a full range of services and
attract customers with “one-stop” banking. One of
these services is the checking account. This type of
account provides depositors with a convenient and
widely accepted means of making third party pay
ments, but because of Federal regulations, deposits in
these accounts do not explicitly bear interest.
the institutions to compete more effectively with com
mercial banks for customers’ deposits. Innovations at
savings and loan associations and mutual savings
banks are discussed in the first sections of the paper.
The impact of the changes on competition between
commercial banks and thrifts is examined in the next
section. The response of commercial banks and their
regulators to the challenge posed by the increased
competition is then described.
Thrift institutions, on the other hand, historically
have not been able to offer checking accounts. If de
positors of a thrift institution desire to make payments
to third parties, they either withdraw cash from their
savings accounts or withdraw funds in the form of
checks written by the thrift institution on its demand
deposit account at a commercial bank. While the de
positors may find this method of payment less con
venient than using a checking account, they earn
interest on their deposited funds. Moreover, the rate
of interest that thrift institutions are allowed to pay
on savings deposits is somewhat higher than that
permitted for commercial banks.
NEW SERVICES AT
THRIFT INSTITUTIONS
Recent competition for deposits between commer
cial banks and thrift institutions has been undergoing
rapid change and intensification. Thrift institutions
(thrifts) have started to offer new services which re
move much of the inconvenience associated with mak
ing payments from savings accounts. As a conse
quence, savings accounts at thrifts are now becoming
more like checking accounts at commercial banks.
This article describes changes occurring at some
savings and loan associations and mutual savings
banks which, by making deposit accounts at these in
stitutions more attractive for making payments, enable
Page 2
Savings i? Loan Associations
The Federal Home Loan Bank Board (FH LB B ),
which regulates Federally chartered savings and loan
associations (S & Ls), has encouraged greater compe
tition between S & Ls and commercial banks by allow
ing Federal S & Ls to offer a number of new services
to their customers. In January 1974, the FHLBB
adopted a temporary regulation which permits Fed
eral S & Ls to operate experimental place-of-business
funds transfer systems. These systems allow customers
to conduct financial transactions through the use of
electronic signals generated by on-line computer ter
minals as well as off-line automated teller machines.1
The terminals, which are called remote service units,
allow depositors to conduct transactions with their
S & Ls at places of business other than the associa
tions’ offices. The remote service units, which may be
transactions initiated through the use of on-line computer
terminals are instantly communicated to and verified by the
S & L’s central computer. Off-line facilities generally are not
connected directly to the computer of the S & L; transactions
initiated at these terminals are recorded on magnetic tape or
a like medium which is subsequently delivered to and read by
the S & L ’s computer.
JULY
F E D E R A L R E S E R V E BANK O F ST. LOUIS
shared with other Federally insured financial institu
tions, are not treated as branch or satellite offices of
the S & Ls by the FHLBB.
Also, in January 1974 the funds transfer system
initiated by the First Federal Savings and Loan Asso
ciation, Lincoln, Nebraska was approved under the
new regulation.2 This place-of-business system allows
depositors of First Federal to make deposits to or
withdrawals from their interest-bearing savings ac
counts at two Hinky Dinky supermarkets in Lincoln.
Transactions are made with the use of plastic cards
on which account information is encoded on magnetic
stripes. At the supermarket, Hinky Dinky employees
transmit transaction data to First Federal’s central
computer which records the actions. Settlement is
accomplished electronically by entries to the accounts
of depositors and Hinky Dinky at First Federal. At
the supermarket, money is accepted from or disbursed
to the customer-depositor by the employees through
cash drawers maintained by Hinky Dinky for com
pletion of the physical part of the transactions.
Within two months after the installation of the sys
tem, legal action interrupted this service. The state of
Nebraska first brought suit against Hinky Dinky on
the grounds that the supermarket was offering bank
ing services without a license. The Nebraska Banking
Association also brought suit, charging that First Fed
eral was violating the state’s anti-branching laws. With
litigation still pending, the savings and loan services
in the two Hinky Dinky stores resumed operation in
September of last year. Since resumption of the serv
ice, First Federal has installed its funds transfer units
in three additional Hinky Dinky stores in Lincoln and
has received FHLBB approval to expand the service
to 19 of the supermarket chain’s stores in eastern
Nebraska.
1975
An electronic facility began operation in July 1974
on a 24-hour basis in Bellevue, Washington.3 In this
case, the unit is shared by four mutual savings banks,
ten Federal savings and loan associations, and two
state-chartered S & Ls. Unlike the Hinky Dinky ter
minal, this automated teller machine is unmanned and
is operated by the depositor, independent of any busi
ness. Cash disbursements are made through the use
of automatic cash dispensers which are activated by
the depositor’s magnetic card. Deposits are handled
in a manner similar to that used for night depositories.
Other S & Ls across the country have also initiated
funds transfer systems, implementing place-of-business
terminals and automated teller machines similar to
those just described. Because of the rapid develop
ment and implementation of these systems in many
states, only two have been described here in detail. A
list of the savings and loan associations which have
received FHLBB approval for electronic transfer
systems is presented in Exhibit I.
In addition to these electronic innovations, other
changes have taken place which permit savings and
loan associations to compete more effectively for de
posits. One such change involves the bill payment
services which S & Ls are able to offer. At the de
positor’s request, Federal S & Ls may honor nontransferable orders to transfer funds, periodically or
otherwise, from the depositor’s savings account to
third parties. In the past, such payments were limited
to housing-related items and loans on these items,
such as payments on mortgages, rent, taxes, utilities,
and home improvements. The FHLBB recently re
moved the housing-related restriction, thus allowing
Federal savings and loan associations to offer a
full range of bill payment services.
In April of last year, the state of Washington en
acted legislation which allows state chartered com
mercial banks, mutual savings banks, and S & Ls to
establish any number of unmanned facilities through
out the state, provided that those operating the facili
ties share the costs and operation of the terminals
when asked to do so by the state authorities. Com
mercial banks are required to share facilities with
other commercial banks and have the option of
sharing with thrift institutions. Thrifts are permitted,
but not required, to share facilities. These facilities
are not considered branches under Washington law.
In December of last year, the FHLBB also adopted
a regulation which gives depositors traveling more
than 50 miles from their home access to their savings
account balances through any other Federally-insured
savings and loan association by means of a Travelers
Convenience Withdrawal. The S & L at which a cus
tomer has requested such a withdrawal notifies, by
wire or telephone, the S & L at which the customer
has a deposit account to deduct the amount of the
withdrawal from that account. Funds are then dis
bursed by the cooperating savings and loan associa
tion, and the S & Ls which have chosen to offer this
service make settlements among themselves.
- “Nebraska S & L Begins Point-of-Sale EFTS,”
Banker, January 16, 1974.
3“ 15 Washington State Thrifts to Test Electronic Teller,”
American Banker, February 21, 1974.
American
Page 3
F E D E R A L R E S E R V E BANK O F ST. L OUI S
JULY
Mutual Savings Banks
Exhibit I
EFTS A p p lic a tio n s A p p ro ve d by FHLBB
(M a y 2, 1975)
In s titu tio n 1
Number and Type2
C alifornia
C a lifo rn ia Federal Savings &
Loan Association, Los Angeles
G lendale Federal Savings &
Loan Association
San Diego Federal Savings & Loan
Association
Colorado
Joint Denver Project
(6 Federal Savings & Loan
Associations, 6 State Savings & Loan
Associations)
Florida
Boca Raton Federal Savings & Loan
Association
Joint Project
West Palm Beach
(4 Federal Savings & Loan
Associations)
United Federal Savings & Loan
Association, Fort Lauderdale
Illinois
Iroquois Federal Savings & Loan
Association, W atseka
Iowa
First Federal Savings & Loan
Association o f Council Bluffs
Kansas
C apitol Federal Savings & Loan
Association, Topeka
M innesota
Twin City Federal Savings & Loan
Association, M inneapolis
Location
5 M
supermarkets
70 POS
supermarkets
4 A
airports
1 A
free standing building
7 A
shopping centers
2 A
supermarkets
4 A
shopping centers
1 A
shopping center
2 M
supermarkets
4 M
supermarkets
1 A3
7 M
6 M
a irp o rt
supermarkets
departm ent stores
Nebraska
First Federal Savings & Loan
24
Association o f Lincoln
(shared w ith First Federal Savings
&
Loan Association o f Omaha and 3
State Savings and Loan Associations)
New Jersey
Collective Federal Savings & Loan
1
Association, Egg H arbor
O hio
Buckeye Federal Savings & Loan
27
3
Association, Columbus
O klahom a
Tulsa Federal Savings & Loan
2
Association
Pennsylvania
First Federal Savings & Loan
Association o f Pittsburgh
5
W ashington
2
Bellevue Project, Seattle
(1 0 Federal Savings & Loan
Associations, 4 M utual Savings Banks,
2
State Savings & Loan Associations)
Wisconsin
First Federal Savings & Loan
Association of Madison
3
M4
M
M
M
supermarket
supermarkets
departm ent stores
A5
shopping centers
M
supermarkets
A
M
Financial institutions in New England
have attracted widespread attention by
offering Negotiable Order of With
drawal (N O W ) accounts. Unlike con
ventional savings accounts, NOW ac
counts permit depositors to make check
like withdrawals from their interestbearing savings accounts for making
payments to third parties. The with
drawal orders are cleared through the
Federal Reserve System’s check clearing
facilities by means of special routing
numbers which are assigned to the thrift
institutions.
This type of account was first offered
in 1972 by the Consumers Savings Bank
of Worcester, Massachusetts, and was
rapidly initiated at other savings banks
in Massachusetts and New Hampshire.4
At the time, commercial banks in those
states opposed the use of NOWs and
urged a ban on them by Congress. Leg
islation was subsequently enacted which
limits the use of N OW accounts to these
two states, but allows not only mutual
savings banks but also commercial banks
and savings and loan associations within
these states to offer such accounts.
supermarkets
shopping centers
superm arket/discount
departm ent stores
institutions are listed alphabetically by state.
2Type refers to automated teller terminal (A ) or merchant operated terminal (M ). POS
terminals are located at the check-out counter.
3Terminal is operational.
4Five terminals are operational.
5One terminal is operational.
Source: Federal Home Loan Bank Board EFTS Status Report.
Page 4
1975
This legislation, which permitted an
additional 427 depository financial insti
tutions to offer NOW accounts, affected
the competitive balance among institu
tions in the two states. Of these newly
eligible institutions, commercial banks
introduced the majority of the new
NOW accounts. The 200 mutual savings
banks in Massachusetts and New Hamp
shire, which were previously the only
financial institutions permitted to offer
N OW accounts, experienced a decline
in their NOW account deposits during
the initial implementation of the legis
lation. As more financial institutions be
gan to offer NOW accounts, service
charges on drafts from the accounts
were reduced or eliminated by many
4“ Early History and Initial Impact of NOW
Accounts,” New England Economic Review
(January/February 1975), pp. 17-26.
JULY
FEDERAL. R E S E R V E BANK O F ST. LOUIS
institutions and, in addition, some commercial banks
began to offer free checking accounts.
Thrift institutions have also been involved in a new
system for making payments, called “pay-by-phone,”
which was initiated last fall by a savings bank in
Connecticut and one in Minnesota. Under this system,
depositors at these savings banks who open special
interest-bearing accounts may make payments to third
parties without writing checks or negotiable orders of
withdrawal. Depositors use their telephones to make
payments to utilities, merchants, and other organiza
tions which participate in the system.
Approval by state banking authorities is necessary
before such a system can be put into effect. Although
the pay-by-phone system was judged to be illegal
under Connecticut’s existing statutes, the People’s Sav
ings Bank, Bridgeport, has been permitted to con
tinue its pay-by-phone operations on a test basis until
the end of 1975. At the same time, it was ruled that
under the current provisions no other Connecticut
mutual savings bank should be permitted to initiate
such a system.
At the People’s Savings Bank, depositors who open
a special account are given a personal identification
code number in addition to an account number. The
customer can then dial a special telephone number
and give these numbers to the operator who is told
which companies and what amounts to pay. This
information is transcribed by the operator, who tallies
the total amount paid and informs the customer of the
balance left in the account.
Minnesota is the only other state in which regulatory
authorities have approved a pay-by-phone plan on a
test basis. At the Farmers and Mechanics Savings
Bank, Minneapolis, the pay-by-phone system operates
either through an operator, as above, or by computer
for those depositors with push-button telephones. With
a push-button phone, the depositor indicates the
amounts to be paid by depressing the corresponding
telephone digits. The companies which participate in
the Minnesota system, as well as those using the
Connecticut system, receive daily printouts listing the
name, account number and amount paid by every
customer, along with a cashier’s check issued by the
savings bank for the total amount of payments.
1975
IMPACT OF THE CHANGES
Advantages of Thrifts in Competing for
Deposits
Until recently, thrift institutions have not provided
commercial banks with much competition in offering
checking account services. Although deposit accounts
at thrifts pay interest, it is less convenient to make
payments from these accounts than from checking ac
counts. With the recent changes in services at some
thrift institutions, much of the inconvenience asso
ciated with making payments from saving accounts
has been eliminated, thus making such accounts better
substitutes for checking accounts at commercial banks.
Thrift institutions have had an advantage over com
mercial banks in two other important respects: maxi
mum interest rates thrifts are allowed to pay and re
serves they are required to hold. Commercial banks
have been prohibited from explicitly paying inter
est on demand deposit accounts by legislation first
enacted in the 1930s.5 Thrift institutions, on the other
hand, have introduced accounts which approach de
mand deposit accounts in function but which con
veniently circumvent the interest rate prohibition on
the accounts. Moreover, thrift institutions are per
mitted by law to pay higher maximum rates of interest
on time and savings accounts than commercial banks
may pay on comparable accounts. From the deposi
tor’s standpoint, interest rate regulations help make
new accounts at thrifts more attractive than traditional
checking accounts.
Although both thrift institutions and commercial
banks are required to hold reserves against time and
savings deposits, the amount and form of these re
serves are different. Commercial banks are generally
required to hold much larger reserve ratios than are
thrift institutions. The amount of reserves thrifts are
required to hold may be satisfied with earning assets;
much of commercial bank reserves are held in a form
that does not earn interest.
Response by Commercial Banks and
their Regulators
The response of the banking sector to the changes
initiated by thrift institutions has been varied. In gen
eral, independent commercial banking organizations
5This legislation was passed to prevent a recurrence of “exces
sive” interest rate competition which was thought to be an
important factor in the large number of bank failures during
the 1930s.
Page 5
F E D E R A L R E S E R V E B A N K O F ST . L O U I S
have forcefully opposed the changes
initiated by the FHLBB, especially re
garding the use of automated tellers
and place-of-business terminals by sav
ings and loan associations. Commercial
bankers claim not only that they are
competitively disadvantaged by the
changes, but also that such piecemeal
actions frustrate legislative financial re
form now being advanced. If the new
services are to be maintained at the
thrifts, many commercial bankers say,
then thrift institutions and commercial
banks should be subject to equivalent
reserve requirements and interest rate
limitations.
The Comptroller of the Currency was
the first Federal bank regulator to re
spond to the FHLBB’s ruling on the use
of remote service units by S & Ls. The
Comptroller, whose office regulates na
tional banks, issued an interpretive rul
ing in December 1974 concerning the
use of off-premise electronic funds trans
fer terminals. The ruling permits na
tional banks to operate Customer-Bank
Communication Terminals (C B C Ts).8
Through these remote terminals, exist
ing bank customers can initiate transac
tions resulting in deposits to or cash
withdrawals from their accounts, trans
fers of funds between checking and
savings accounts, and payment transfers
from their own accounts to accounts
maintained by other bank customers.
In the ruling, the Comptroller stated
that banks should be permitted to meet
competition from savings and loan asso
ciations which have taken advantage of
the new FHLBB regulations on remote
facilities. It was specified in the ruling
that CBCTs are not branch banks; a
definition of these units as branch banks
would have imposed on the banks geo
graphic and capital restrictions which
might have prevented them from meet
ing the competitive challenge posed by
JULY
Exhibit II
CBCT N o tifica tio ns file d w ith the C o m p tro lle r o f the Currency
{M a y 3 0 , 1975)
In stitu tio n 1
Page 6
Number and Type2
C alifornia
Bank of America N ation al
Trust and Savings Association,
San Francisco
C olorado
First N a tio n a l Bank, Fort Collins
Florida
First N a tio n a l Bank in Ft. Myers
Sun First N ation al Bank o f Leesburg
Georgia
First N ation al Bank o f A tla n ta
Illinois
C ontinental Illin o is N ation al
Bank and Trust Company, Chicago
M id-W est N a tio n a l Bank of
Lake Forest
Iowa
lowa-Des Moines N a tio n a l Bank
Minnesota
Zapp N ation al Bank, St. Cloud
Missouri
First N ation al Bank in St. Louis
Nebraska
The United States N ation al
Bank o f Omaha
Omaha N a tio n a l Bank
New Jersey
The N ation al State Bank, Elizabeth
O hio
The Central Trust Company,
C incinnati
O klahom a
First N a tio n a l Bank & Trust
Company o f Enid
Utica N ation al Bank, Tulsa
Oregon
United States N a tio n a l Bank
o f O regon, Portland
Tennessee
First N a tio n a l Bank o f Memphis
W ashington
Peoples N ation al Bank of
W ashington, Seattle
Seattle-First N a tio n a l Bank
Wisconsin
First N a tio n a l Bank in
M enomonie
Location
3 A
supermarkets
1 A
loan production office
1 A
shopping center
2 A
m obile home parks
1 A
1 A
university campus
shopping center
2 A
1 A
124 M
central financial district
tra in station
62 supermarkets
1 M
supermarket
5 M
supermarkets
1 A
shopping center
1 A
1 A
factory
supermarket
2 M
1 M
2 M
supermarkets
departm ent store
yet to be determ ined
14 M
5 M3
supermarkets
restricted line departm ent
stores
1 A
4
2 A
1 A
supermarkets
plan t
1 A
shopping center
2 M
shopping centers
1 A
shopping center
2 A5
supermarkets
1 A
4
5 A
1 A
shopping centers
business district
1 A
1 A
shopping center
supermarket
institutions are listed alphabetically by state.
2Type refers to unmanned automated CBCT (A ) or manned CBCT ( M) .
3Facilities shared with First Federal Savings & Loan of Lincoln.
4Additional information requested.
5Cash dispensers only.
6The original December ruling sanctioned CBCTs without
geographic restrictions. However, in a recent modification of
this ruling, the Comptroller limited the location of CBCTs to
within 50 miles of the main office or closest branch of a bank,
effective June 1, 1975. The revised ruling permits exception
to the geographic limit if the terminal is to be shared with
one or more local depository financial institutions.
1975
the thrifts. Since CBCTs are not considered to be
branches, a bank is required only to file a written 30day notice with the Comptroller’s office of its inten
tion to install remote point-of-sale terminals or auto
mated teller machines. No formal approval is
F E D E R A L R E S E R V E B A N K O F ST . L O U I S
JULY
1975
required. Exhibit II presents a listing of CBCT noti
fications filed with the Comptroller of the Currency
as of May 30, 1975.
make the payments either by a transfer of funds to the
creditor’s account or by drawing a check on itself
payable to the creditor.
The First National Bank in St. Louis was the first to
make use of the Comptroller’s ruling when it opened
one remote facility at a supermarket and another at
a factory in December of last year. Both CBCTs are
located beyond the boundaries of the City of St. Louis.
Under Missouri law, facilities of St. Louis banks must
be situated within the city limits. A legal controversy
followed the installation of the CBCTs when the
Missouri Commissioner of Finance filed suit against
First National Bank claiming that by conducting
banking business at sites other than those prescribed
by law (within the city limits), First National Bank
violates Missouri’s branching statutes. First National
Bank contends that CBCTs are communication de
vices, not branches, and as such are not subject to
the state’s branching law. The St. Louis bank defends
its use of CBCTs on the grounds that they are neces
sary to meet the rising competition from the thrifts.
In a similar action, the Board of Governors of the
Federal Reserve System has proposed permitting
member banks to offer preauthorized bill payments
from savings accounts of their depositors. These with
drawals could be used to pay any type of indebtedness
to a third party and may be made by a transfer be
tween accounts in the bank or by transmitting a check
drawn on the bank to the creditor or to another bank
for the account of the creditor. In addition, effective
April 7, 1975, the Board of Governors authorized
member banks to allow their customers to use the
telephone to initiate withdrawals or transfers of funds
from savings accounts. In revoking a policy in effect
since 1936, the Board of Governors noted that security
and technological improvements now make such tele
phone transactions safe.
State authorities remain divided on the issue of
CBCTs as branch banks. Oregon, Washington, and
Massachusetts have authorized remote automated fa
cilities through legislation and do not define them as
branches. In Michigan, the Commissioner of the Fi
nancial Institutions Bureau ruled that automated
facilities are branch banks and therefore fall under
Michigan’s branching laws. The Attorneys General of
Texas, Florida, and Kansas also have authorized the
use of CBCTs in some circumstances, although branch
banking is prohibited in these states. In Missouri, as
in many other states, bills have been presented to
the legislature which provide state chartered banks
competitive equality with national banks in issues
concerning the establishment of electronic terminals.
The larger scope of services now offered by thrift
institutions represents an emerging trend toward
closer alignment of deposit powers of thrifts with
those of commercial banks. Thrifts have initiated serv
ices which have given these institutions an edge over
commercial banks in competing for customers’
deposits. Commercial banks have then made simi
lar changes in order to maintain their competitive
position.
Other Federal bank regulators have advanced
changes in an attempt to match in some ways
actions taken by the FHLBB. The Federal Deposit
Insurance Corporation (F D IC ), the primary Federal
supervisor of insured state banks that are not members
of the Federal Reserve System, has proposed an
amendment which would permit banks under its su
pervision to expand the scope of withdrawals made
from savings accounts of depositors for the purpose of
bill payment. Preauthorized withdrawals are currently
sanctioned for the payment of charges related to real
estate or mortgage loans. Under the proposal, a de
positor may give the bank written authorization to
make withdrawals from a savings account to meet a
wider range of recurring obligations. The bank would
IMPLICATIONS
For customers, this trend creates a greater number
of alternatives for demand deposit services. Conveni
ence of making financial transactions has been signifi
cantly increased, especially through the use of elec
tronic funds transfer systems and telephone services.
Nonpecuniary costs of transactions have decreased.
With the new services, customers are able to have
accounts which approach the convenience and func
tion of checking accounts and earn a higher rate of
interest than on comparable accounts at commercial
banks.
The more competitive financial system which is
evolving is primarily the result of competitive forces
set in motion by financial institutions which are striv
ing to obtain customers’ deposits. Some of the changes
which have already been adopted by financial institu
tions have been included in financial reform legislation
which has been proposed in recent years.
In 1970 the Presidential Commission on Financial
Structure and Regulation (better known as the Hunt
Page 7
F E D E R A L R E S E R V E BANK O F ST. L OUI S
Commission) was appointed to study the framework
of the nation’s financial system and propose changes
which would improve its functioning. Among other
proposals, the Commission recommended expanding
the power of thrift institutions and enabling them to
offer limited checking account and credit card serv
ices. The proposed Financial Institutions Act of 1975
incorporates many of the proposals of the Hunt Com
mission and addresses itself to issues which have ap
peared since that time.
These proposals favor allowing thrifts and com
mercial banks to offer NOW accounts on a nationwide
basis. In order to further competitive equality among
different types of institutions, the proposals recom
mend phasing-out interest rate ceilings on all time
and savings deposits and subjecting depository in
stitutions to uniform reserve requirements. Indeed,
if thrift institutions and commercial banks are becom
ing more similar in function, regulations governing the
Page 8
JULY
1975
institutions should reflect these similarities. None of
the reform proposals, however, has been enacted into
legislation.
CONCLUSION
The move by thrift institutions to make savings ac
counts more convenient for making payments and
thus more similar to checking accounts at commercial
banks has intensified competition for deposits between
the two types of institutions. Although legislation de
signed to achieve a more competitive financial system
has failed to be enacted, competitive forces within the
system are leading the financial institutions toward
this end. It remains to be seen how the financial sys
tem will ultimately be affected by the changes taking
place. In any event, these changes present evidence
that competition remains an integral force in our
financial system.
Paying More Taxes and Affording It Less
NANCY JIANAKOPLOS
( ^N E of the many side effects of inflation is that it
results in a transfer of resource command from the
private sector to the public sector of the economy.
The Government’s status as a net monetary debtor
and the progressive income tax structure are the
vehicles by which this resource transfer occurs. This
article discusses how inflation and the progressive tax
structure interact to generate Government revenue
and reduce the take-home pay of taxpayers.1
Figures from the Bureau of Labor Statistics show
that from the fall of 1973 to the fall of 1974, personal
income taxes for a family of intermediate income rose
by 25.1 percent, while the budget necessary to main
tain their standard of living rose by 13.5 percent.2
Thus, even if a family’s income before taxes kept pace
with inflation, their disposable income (total income
less taxes) decreased as taxes took up an increasing
proportion of their budget.
How and why did taxes increase faster than in
come? What are the economic consequences of this
resource transfer and are there possible remedies? In
order to answer these questions, the tax liabilities of
an individual family over a number of years are ex
amined. Next, the aggregate effects of increased taxa
tion are discussed. Finally, possible remedies for these
tax increases are presented.
One Family’s Experience
In 1967 the Bureau of Labor Statistics calculated
that an income of $9,076 would be required to main
tain a family of four at an intermediate standard of
living. From this budget $1,365, or 15 percent, would
be paid as personal taxes (social insurance contribu
tions and personal income taxes). In 1974 the same
family would require a budget of $14,333 to maintain
an intermediate standard of living. O f this amount
$2,790, or 19.5 percent, would be paid as personal
taxes.
1For another aspect of inflation serving to finance the govern
ment, see Charlotte E. Ruebling, “ Financing Government
Through Monetary Expansion and Inflation,” this Review
(February 1975), pp. 15-23.
-A family budget for an intermediate income level totaled
$14,333 in autumn 1974, according to BLS figures. See U.S.
Department of Labor, Bureau of Labor Statistics, Autumn
1974 Urban Family Budgets and Comparative Indexes for
Selected Urban Areas, No. 75-190 (April 9, 1975).
In order to understand why taxes have taken up
an increasing proportion of the family budget, the
income and tax liabilities of a typical family are exam
ined over a number of years. The examination con
sists of comparing the rise in actual tax liabilities with
the rise in income, assuming income increases equal
the rate of inflation. The Bureau of Labor Statistics
( BLS) provides budget information for a hypothetical
family of four which consists of a husband, employed
full-time; a wife, not employed outside the home; a
boy, 13; and a girl, 8. The BLS constructs budgets for
this family at three standards of living — low, inter
mediate, and high. This study considers the inter
mediate level family budget. In the spring of 1967,
which is regarded as the base year, this budget
equalled $9,076.3
For illustrative purposes, this base period budget is
increased each year at the same rate as the consumer
price index (C P I). This increase would allow pre-tax
income to keep pace in some measure with the rate
of inflation. The CPI is not a complete measure of in
creases in the cost of living, but it has several attri
butes which make it suitable for the purposes of this
analysis.4 The CPI is frequently used in union con
tracts as the measure of changes in the cost of living,
activating wage increases for workers covered by the
contract. The effects of increases in income and social
security taxes are not included in the CPI, but in
creases in excise, sales, and real estate taxes are in
cluded. For this reason only the effects of Federal and
state income taxes and social security contributions
are considered here.
It is assumed that by increasing the family
income each year at the same rate as the increase in
the CPI, the pre-tax real income of the family remains
constant in terms of 1967 purchasing power. On this
basis the family’s money income before taxes rose from
$9,076 in 1967 to $13,407 in 1974.6
3Jean C. Brackett, “ New BLS
Review (April 1969), pp. 3-16.
Budgets,”
Monthly
Labor
4For a review of the adequacies and shortcomings of the CPI,
see Denis S. Karnosky, “A Primer on the Consumer Price
Index,” this Review (July 1974), pp. 2-7.
5This figure differs from the 1974 BLS budget of $14,333
because the BLS budget includes not only those cost-ofliving increases included in the CPI, but also allowances for
increased personal income and social security taxes.
Page 9
F E D E R A L R E S E R V E BANK O F ST. L OUI S
JULY
1975
Exhibit I
FEDERAL TAXES
Federal
Tax
L ia b ility
A fter-Tax
M oney
Income
A fter-Tax
Real
Income3
$
$ 8,120
$ 8 ,1 2 0
8,359
8,022
Year
Real
Family
Income
Money
Family
Income1
Taxable
Income
1967
$9,076
$ 9,0 76
$5,768
1968
9,0 76
9,4 57
6,1 11
1,0 9 8 2
956
Tax as a
Percent of
Money Incon
10 .5%
11.6
1969
9,076
9,968
6,571
1,21 9 2
8,749
7,968
12.2
1970
9,0 76
10,556
7,056
1,2 3 1 2
9,3 25
8,018
11.7
10.6
1971
9,0 76
11,010
6,879
1,167
9,843
8,115
1972
9,0 76
1 1,373
6,6 67
1,127
10,246
8,1 77
9.9
1973
9,076
12,078
7,2 66
1,241
10 ,837
8,142
10.3
1974
9,0 76
13,407
8,4 07
1,4 7 0 4
11,937
8,082
11.0
inflated by the annual growth rate in the consumer price index.
2Includes surcharge.
3Deflated by the annual average consumer price index for each year.
4Excludes rebate.
Federal Income Tax
The family’s Federal income tax liability is calcu
lated using the status of “married filing jointiy,” claim
ing four exemptions and using the standard deduction,
actual tax rates, exemptions, and deductions applica
ble from 1967 through 1974.6 During this period there
were several changes in the Federal income tax struc
ture: income tax surcharges were implemented dur
ing 1968, 1969, and 1970, and there were changes in
the value of allowable exemptions and the standard
deduction in 1970, 1971, and 1972. Tax rates and tax
brackets, however, did not change during this period.
The 1974 tax rebate is excluded from consideration in
this article since it was not paid until 1975.
The family’s Federal income tax liability increased
every year except for 1971 and 1972 (see Exhibit I).
In 1974, for example, the family paid $229 more in
Federal income taxes than in 1973, even though the
family’s real income before taxes was held constant.
Their real income after Federal income taxes actually
decreased from $8,120 in 1967 to $8,082 in 1974.
Despite tax cuts in 1970 through 1972, the portion
of family income paid in Federal income taxes in
creased from 10.5 percent in 1967 to 11 percent in
1974. The increases were much sharper in the periods
when tax laws remained the same. For example, from
1967 to 1969, Federal income taxes as a percent of
the family income increased from 10.5 to 12.2.
The progressive tax structure in combination with
inflation was a major cause of taxes accounting for
6If applicable exemptions and deductions in either 1967 or
1974 had been used for all years, the conclusions reached
would have been the same, but the real income lost through
the combination of inflation and taxes would have been
greater.
Page 10
an increasing share of the family budget. Taxes are
paid on money income, and as money income in
creases, the taxpayer can be pushed into a higher tax
bracket. The hypothetical family was pushed into a
higher bracket in 1974 when its taxable income rose
above $8,000. Prior to this, 19 cents of the marginal
dollar of taxable income was collected as tax, whereas
in 1974, 22 cents of the marginal dollar was paid in
taxes. Therefore, the effect of the progressive tax
structure is to tax more than a proportional share of
income increases, even if these increases do not result
in increased purchasing power.
Social Security Taxes
The family’s social security tax liability is calculated
by applying the rates in effect from 1967 to 1974 to
the family’s money income (see Exhibit II). This
family’s income is above the taxable ceiling in every
year and, therefore, the maximum contribution is paid
each year.
In every year from 1967 through 1974, except 1970,
the family’s social security tax liability increased. This
is because in every year, except 1970, the taxable in
come ceiling and/or the rate of employee contribution
was raised. The family’s social security liability in
creased from $290 in 1967 to $772 in 1974. Social
security taxes as a percent of the hypothetical family’s
money income rose from 3.2 percent in 1967 to 5.8
percent in 1974. Increases in social security taxes were
much greater than increases in family income. The
family’s money income rose by 48 percent in the
period from 1967 to 1974 while social security con
tributions increased by 166 percent. Real income, after
social security contributions were deducted, fell from
$8,786 to $8,555. This was a loss of $231 of 1967 pur
chasing power due to this tax alone.
JULY
F E D E R A L R E S E R V E BAN K O F ST. LOUIS
1975
E xhibit II
SOCIAL SECURITY CONTRIBUTIONS
Percent
Social
Security
Employee
C ontribution
Social
Security
Tax Lia b ility
After-Tax
M oney
Income
After-Tax
Real
Income2
4.4 %
Year
Real
Family
Income
Money
Family
Income1
Social
Security
Income
Ceiling
Tax as a
Percent c
Money
Income
1967
$9,076
$ 9,076
$ 6,6 00
$2 90
$ 8,786
$ 8 ,786
1968
9,076
9,4 57
7,8 00
4.4
343
9,1 14
8 ,7 4 7
3.6
3.8
3 .2 %
1969
9,076
9,968
7,8 00
4.8
374
9,5 94
8,738
1970
9,076
10,556
7,8 00
4.8
374
10,182
8,755
3.5
1971
9,0 76
11,010
7,800
5.2
406
10,604
8,742
3.7
1972
9,0 76
11,373
9,0 00
5.2
468
10,905
8,703
4.1
1973
9,0 76
12,078
10,800
5.85
632
1 1,446
8,600
5.2
1974
9,0 76
13,407
13,200
5.8 5
772
12,635
8,555
5.8
inflated by the annual growth rate in the consumer price index.
2Deflated by the annual average consumer price index for each year.
Source: Social Security Bulletin
The social security tax changes were implemented
in order to finance increased benefits which were
legislated in an attempt to help recipients keep pace
with the rising cost of living. Therefore, inflation was
a major factor necessitating increased social security
taxes.7 Beginning in January 1975, increases in social
security benefits are linked directly to changes in the
consumer price index, making the inflation-social se
curity tax relationship more direct.
State Income Taxes
The family’s state personal income tax liability is
calculated by assuming that they lived in Missouri,
filed a “joint-married” return, claimed four exemptions
and used the standard deduction. The Federal income
tax calculated in Exhibit I, as well as the standard
deduction and personal exemptions applicable, were
deducted from income in order to obtain a figure for
income taxable by the state. Missouri tax rates were
increased in 1971. The structure of the Missouri per
sonal income tax was changed in 1973 to conform
with the Federal income tax structure.
State personal income taxes affected the family’s
budget in a manner very similar to Federal personal
income taxes (see Exhibit III): the state tax liability
increased from $82 in 1967 to $198 in 1974; the per
centage of the family’s money income paid in the form
of state income taxes increased from 0.9 percent in
1967 to 1.5 percent in 1974; and after-tax real income
7The changing age distribution of the population and ex
panded programs were also contributory factors. For a fur
ther discussion of the social security system, see Richard A.
Musgrave and Peggy B. Musgrave, Public Finance in Theory
and Practice (N ew York: McGraw-Hill Book Company,
1973), pp. 346-350, 390-395, 666-676.
fell from $8,994 to $8,943 over the period. Since Mis
souri state tax rates are lower than Federal tax rates,
the dollar increase in state tax liabilities was not as
great as for the Federal tax.8 However, Missouri
brackets are narrower than Federal brackets so that
the family was pushed into higher brackets more
frequently.
The family did receive some relief from increased
state income taxes as a result of their increased Fed
eral tax liability. Federal income taxes are deductible
items in calculating Missouri state income tax, and
thus the increasing Federal tax reduced to a certain
degree the amount of income taxable by the state.
Nevertheless, the family lost purchasing power over
the period as a result of increasing state taxes.
Combined Tax Burden
A look at the composite effect of Federal and state
income taxes and social security contributions shows
that in every year taxes increased above the previous
year’s level (see Exhibit IV ). The hypothetical fam
ily’s combined tax liability increased from $1,328 to
$2,440. In terms of 1967 purchasing power, the fam
ily’s income remained unchanged at $9,076, while
their tax liability, also in terms of 1967 purchasing
power, increased by $324. In 1967, taxes took 14.6
percent of the family budget. By 1974 the figure had
climbed to 18.2 percent. Inflation and taxes had com
bined to erode their income despite the fact that they
received annual cost-of-living increases.
8The family’s income was in the 4.5 percent bracket for 1974
Missouri state income taxes, compared to the 22 percent
bracket for Federal income taxes.
Page 11
JULY
FEDE RAL . R E S E R V E BAN K O F ST. L OUI S
1975
Exhibit
STATE TAXES
Year
Real
Family
Income
Money
Family
Income1
Taxable
Income
State Tax
Liab ility
A fter-Tax
Money
Income
A fter-Tax
Real
Income2
Tax as a
Percent of
Money
Income
0 .9 %
1967
$9,076
$ 9,076
$ 4 ,466
$ 82
$ 8,994
$ 8 ,994
1968
9 ,0 7 6
9,4 57
4,6 86
87
9,3 70
8,992
1969
9,0 76
9,968
5,051
97
9,871
8,990
1.0
1970
9,0 76
10,556
5,625
114
10,442
8,979
1.1
1971
9,0 76
11,010
6,143
171
10,839
8,9 36
1.6
1972
9,0 76
11,373
6,5 46
190
1 1,183
8,925
1.7
1973
9,0 76
12,078
5,8 25
158
11,920
8,956
1.3
1974
9 ,0 7 6
13,407
6,7 37
198
13,209
8,943
1.5
0.9
inflated by the annual growth rate in the consumer price index.
2Deflated by the annual average consumer price index for each year.
The Aggregate Experience
In times of inflation, the tax system generates an
Inflation in combination with the progressive tax
structure serves to increase the government’s share of
automatic restraint on private spending by increasing
the government’s proportion of private income. Like-
Exhibit IV
COMBINED TAX LIABILITY — FEDERAL, STATE, A N D SOCIAL SECURITY
Year
Real
Family
Income
Money
Family
Income1
Federal
Tax
Lia b ility
1967
$ 9 ,076
$ 9,0 76
$
1968
9,0 76
1969
9,0 76
9 ,4 5 7
9,968
Social
Security
Liab ility
State
Tax
Liab ility
Combined
Tax
L ia b ility
A fter-Tax
Money
Income
A fter-Tax
Real
Income2
Taxes as a
Percent o f
Money
Income
14 .6 %
956
$290
$ 82
$1,328
$ 7,748
$ 7 ,748
1 ,0 9 8 3
343
87
1,528
7,929
7,6 09
16.2
1 .2 1 9 3
97
1,690
8,278
7,539
17.0
1970
9,0 76
10,556
1,231 3
374
374
114
1,719
8,8 37
7,598
16.3
1971
9 ,0 7 6
1 1,010
1,167
406
171
1,744
9,266
7,639
15.8
1972
9,0 76
1 1,373
1,127
468
190
1,785
9,588
7,652
15.7
1973
9,0 76
12,078
1,241
632
158
2,031
10,047
7,548
16.8
1974
9 ,0 7 6
13,407
1,4 7 0 4
772
198
2,440
10,967
7,425
18.2
inflated by the annual growth rate in the consumer price index.
2Deflated by the annual average consumer price index for each year.
3Includes surcharge.
4Excludes rebate.
national income. The increase is more than propor
tional to the increase in household incomes because
as incomes rise, some people whose incomes were too
low to be taxed are now taxed, and others, as in the
previous example, are pushed into higher marginal tax
brackets. Inflation has the effect of an “unauthorized”
( in contrast to a legislated change in the tax structure)
tax rate increase. This increase in taxes shifts com
mand over resources from the private sector to
the government sector, and thus dampens private
demand.
The tax system, as currently formulated, has what
is often referred to as a “built-in stabilizing” feature.9
9For a theoretical discussion of built-in stabilizers, see Armen
A. Alchian and William R. Allen, University Economics: Ele
ments of Inquiry, 3rd ed. (Belmont, California: Wadsworth
Publishing Company, Inc., 1972), pp. 716-718.
Page 12
wise, in times of demand-induced recessions, the
tax structure is intended to exhibit a stabilizing influ
ence on private incomes by reducing the proportion
of income which is transferred from the private sector
to the public sector by taxes. In all previous postwar
recessions, personal taxes as a percent of personal in
come declined or remained constant ( see accompany
ing chart). However, the recent recession, which in
its early stages was supply-induced rather than
demand-induced, was accompanied by severe infla
tion.10 Taxes as a percent of personal income in
creased from 14.3 percent in 1973 to 14.8 percent in
1974. Rather than cushioning the recessionary tenden
cies, the “built-in stabilizers” associated with taxes
10See Norman N. Bowsher, “ Two Stages to the Current Re
cession,” this Review (June 1975), pp. 2-8.
F E D E R A L R E S E R V E B A N K O F ST . L O U I S
JULY
1975
Table I
TAX INCREASES RESULTING FROM
Excess Taxes
in 19 74,
A verage
Per Return
Income
INFLATION
Excess Tax as
a Percent of
Present-Law Tax
$
0 — $
3,000
31
44%
$
3 ,0 0 0 — $
5,0 00
37
16
$
5 ,0 0 0 — $
7,0 00
46
9
$
7 ,0 0 0 — $ 10,000
54
7
$ 1 0 ,000 — $ 15,000
75
6
$
$ 15,000 — $ 20 ,000
118
6
$ 2 0 ,000 — $ 5 0 ,0 0 0
243
6
934
5
1,738
3
$ 5 0 ,0 0 0 — $ 1 0 0 ,0 0 0
$1 0 0 ,0 0 0 and over
Source: Joint Committee on Internal Revenue Taxation
served to amplify this cyclical downswing in private
spending.
Some Possible Remedies
There are several ways that “unauthorized” tax in
creases resulting from inflation could be controlled. A
tax rebate system could return to the taxpayer pre
cisely the amount of inflation-induced tax collections.
The Committee on Internal Revenue Taxation has
estimated that $7 billion of the $15 billion increase in
1974 Federal income taxes resulted from the inter
action of inflation and the tax structure. It also esti
mated the average inflation-induced tax per return
by income brackets (see Table I). Using these esti
mates of the impact of inflation on Federal income
taxes, the hypothetical family would have received a
$75 rebate.11 Rebates would be higher for higher
income families, but a greater percentage of the taxes
paid by lower income families would be returned.
As the examples of the hypothetical family’s tax
liabilities indicated, increased deductions and exemp
tions gave the family some short-term relief from in
flationary tax increases. An annual increase in the size
of the standard deduction, exemptions, and tax
bracket ceilings could offer a long-term solution. The
increases could be based on the increase of a particular
price index in a manner similar to the treatment of
family income in Exhibits I-IV. This indexation would
help to eliminate “unlegislated” tax increases.1
2
11It should be noted that the rebate system described in this
case would be used only to return inflation-induced taxes,
not to stimulate economic activity.
12For a more complete discussion of indexation, see Jai-Hoon
Yang, “The Case For and Against Indexation; An Attempt
at Perspective,” this Review (O ctober 1974), pp. 2-11.
An alternative method of indexation would be to
deflate family income and itemized deductions by the
price index rather than inflate the exemptions and
the standard deductions. The tax calculated in this
manner would then have to be reinflated so that pay
ments would be in current dollars. The tax system
would then approach a system of taxing real income
rather than money income.
Conclusion
The most effective method to avoid inflationinduced increases in tax payments is to attack the
problem at the core. It is the interaction of inflation
and the tax structure which results in the more than
proportional increase in taxes. Either stabilizing the
price level or changing the progressive structure of
the tax rates could relieve the taxpayer of the burden
of inflation-induced tax increases.
By using tax rebates, indexing the tax structure, or
stabilizing prices, inflation-induced tax increases
could be avoided, but such schemes deal with symp
toms, not the disease of inflation itself. Since 1967, a
taxpayer whose income kept pace with inflation ac
tually lost purchasing power, and inflation in combi
nation with the progressive tax structure served as a
vehicle to transfer resources from the private sector
to the public sector. Stabilization policy takes on even
greater importance when not only the obvious conse
quences of a changing price level are noted, but also
when the less apparent consequences, such as the
“unauthorized” tax increases resulting from inflation,
are recognized.
Page 13
Balance-of-Payments Concepts—
What
Really Mean?
DONALD S. KEMP
X HE Advisory Committee on Balance-of-Payments
Statistics Presentation of the Office of Management
and Budget is currently holding meetings on the use
fulness of current balance-of-payments concepts. The
Committee is interested in hearing suggestions regard
ing ways in which international data may be pre
sented in a more useful format. These hearings reflect
a growing concern in government, academia, and the
business community over the meaning of balance-ofpayments data as currently reported.
While the subject of balance-of-payments reporting
techniques has been debated since the inception of
the practice, the debates have intensified lately as a
result of a number of factors. On the one hand, there
has been a surge of interest in what has been called
the monetary approach to the balance of payments.1
This approach to payments theory views international
transactions within a framework that differs signifi
cantly from the current conventional wisdom.- If one
views international transactions within this monetary
framework, the currently employed balance-of-pay
ments concepts have little meaning. On the other
hand, the problems of interpreting current balanceNOTE: The author acknowledges the helpful comments on
earlier drafts from Allan H. Meltzer and Wilson E. Schmidt.
They are, of course, blameless for any remaining errors.
xFor a discussion of this approach, see Donald S. Kemp, “A
Monetary View of the Balance of Payments,” this Review
(April 1975), pp. 14-22.
-The monetary approach is concerned with the impact of the
balance of payments on the domestic economy via its impact
on the money supply. In contrast, the current conventional
wisdom in payments theoiy (the elasticities and absorption
approaches) is concerned primarily with the balance of trade
alone and assumes that either there are no monetary con
sequences associated with international transactions or, to
the extent the potential for such consequences exists, they
can be and are neutralized by domestic monetary authorities.
Page 14
of-payments concepts have further intensified as a
result of the evolution of a system of floating exchange
rates among the world’s major trading countries and
the rapid accumulation of international reserves by
the members of the Organization of Petroleum Ex
porting Countries (O P E C ).
This article discusses the general concept of the
balance of payments as well as the appropriateness
of various measures of this concept. Its aim is to foster
a better understanding of the balance of payments
and the meaning of the various measures of this con
cept that are currently used. In light of the issues
raised in this discussion, some proposals for the reform
of the method of presenting data relating to interna
tional transactions will be made. The discussion will
allude to the following propositions:
1) There is a widespread misunderstanding of the
forces that give rise to, and the impact of, balanceof-payments deficits and surpluses and exchange rate
movements.
2) This misunderstanding has led to undue concern
on the part of policymakers, inducing costly recom
mendations for trade restrictions, controls on capital
movements, and export promotion in order to solve
balance-of-payments and exchange rate “problems”
which simply do not exist.
3) The way balance-of-payments statistics are
currently reported serves to exacerbate these
misunderstandings.
4) The above propositions apply under both fixed
and floating exchange rates. However, the problems
alluded to are particularly acute now that we have
switched from one exchange rate regime to another.
F E D E R A L R E S E R V E BAN K O F ST. L OUI S
This is because the implications of the switch are
confusing in themselves and because many of the
ways in which balance-of-payments statistics are re
ported have been made completely obsolete as a re
sult of the switch.
FUNDAMENTAL MISUNDERSTANDING
The fundamental misunderstanding alluded to in
the first proposition stems from the fact that most
balance-of-payments analyses focus on either the cur
rent or the capital account separately. In order to
place the balance of payments in its proper perspec
tive, it is necessary that all accounts be considered
simultaneously. In addition, one must recognize that
the transactions recorded in balance-of-payments sta
tistics bear the same relationship to foreign and do
mestic monetary policies as do purely domestic trans
actions to domestic monetary policy.
Viewed within a monetary framework, balance-ofpayments surpluses and deficits and movements in
exchange rates are the result of a disparity between
the demand for and supply of money. The exact
process by which the disparity is corrected is a tech
nical issue and subject to alternative interpretations.3
Basically, however, when such a disparity exists,
spending units attempt to draw down (build up)
their money balances through the purchase (sale) of
real and/or financial assets. In so doing they increase
(decrease) the demand for all assets. Under alterna
tive situations the exact pattern by which spending
units adjust their money balances in this fashion will
be different. The pattern will depend on, at a mini
mum, the cause of the change in the quantity of
money supplied relative to the quantity demanded,
the initial conditions under which the change oc
curred, and the impact of other exogenous events on
spending units. However, the point is that an excess
supply of or demand for money will be cleared
through the markets for goods, services, and securi
ties. Furthermore, and what is crucial for an under
standing of the balance of payments, in an open
economy (one in which there are international trade
and capital transactions) the markets through which
money balances are adjusted extend beyond national
boundaries.4
:i For a thorough discussion of the process by which such a
disparity is corrected, see Roger W . Spencer, “ Channels of
Monetary Influence: A Survey,” this Review (November
1974), pp. 8-26.
4The existence of free international markets for goods, services,
and securities is a fundamental assertion of the monetary
approach to the balance of payments. See Kemp, “A Mone
tary View of the Balance of Payments,” p. 16.
JULY
1975
Suppose, for example, that the domestic monetary
authorities increase the money supply in country j,
which leads to an increase in the demand for goods,
services, and securities in that country. Any such in
crease in domestic demand will result in a tendency
for prices of domestic real and financial assets in
country j to rise, in the short run, relative to those in
foreign markets. As a result, spending units in country
j will simultaneously reduce their purchases of domes
tic real and financial assets in favor of foreign assets
while domestic suppliers of these assets will seek to
sell more at home and less abroad. At the same time,
foreign spending units will decrease their purchases
of the assets of country j and foreign suppliers will
attempt to sell more of their own assets in country j.
All of these factors work in favor of an increase in
the demand for imports and a decrease in the demand
for exports in country j.5
Adjustment Under a System of Fixed
Exchange Rates
Under a system of fixed exchange rates, the adjust
ments described above will result in an accumulation
of money balances by foreigners in return for the real
and financial assets they sell to spending units in
country j. This exchange of money balances for real
and financial assets will be captured in the balanceof-payments statistics as an overall deficit in the trade
and capital accounts.0 The foreign recipients of these
money balances have the option of converting them
into their own currencies at their respective central
banks. These foreign central banks will then present
the balances they accumulate through such conver
sions to the central bank in country j in return for
primary reserve assets. Since these primary reserve
assets are one of the components of a country’s mone
tary base (and thus a determinant of its money sup
ply), the effect of this transaction will be a decrease
in the money supply of country j back towards its
initial level and an increase in the money supplies of
its surplus trading partners.
5The terms “imports” and “exports” refer to more than just
imports and exports of goods and services. It includes all
transactions which involve the purchase or sale of domestic
assets (real and financial) in foreign markets. For example,
the purchase of a foreign security by a U.S. citizen would
be considered an import.
1A deficit in the trade account reflects an exchange of money
1
balances for real assets (goods and services). A deficit in the
capital account reflects the exchange of money balances for
financial assets. In order to determine the total accumulation
of money balances by foreigners, it is necessary to combine
all of the trade and capital accounts.
Page 15
F E D E R A L R E S E R V E B A N K O F ST . L O U I S
Under a system of fixed exchange rates, the primary
channel by which international trade - and capital
transactions can have an impact on aggregate eco
nomic activity is via the international reserve flows
described above and their subsequent impact on the
money supply (both foreign and domestic).7 However,
one is unable to gauge the magnitude of this impact
by looking at either the trade or the capital accounts
separately. For example, the effects on aggregate eco
nomic activity of a deficit in the merchandise trade
account alone could be partially or fully neutralized
by a surplus in one of the capital accounts. If such a
situation arose, the negative aggregate demand ef
fects resulting from an increase in imports of goods
would be partially or fully offset by an inflow of capi
tal and a resulting increase in investment demand.
If the two effects fully offset each other, there would
be no gain or loss of international reserves and the
money supply would not be affected by the inter
national trade and capital transactions.
In light of the above considerations, the crucial
balance-of-payments concept is that which captures
all transactions reflecting the adjustment of the supply
of money to the level demanded. That is, the balanceof-payments concept which is most useful as a meas
ure of the impact of international transactions on the
domestic economy is one in which the only transac
tions considered “below the line” are those which have
an influence on domestic and foreign money supplies.8
"Within the monetary approach framework there are other
channels through which international transactions can have
an impact on aggregate economic activity. For example, some
changes in the terms of trade and in the volume of trade and
capital flows can affect the productive capacity of a given
economy. However, it should be noted that both of these
channels relate to the concept of the gains from trade, which
is distinctly different from the concept of the balance of
payments. The only other channel through which interna
tional transactions can have an impact on aggregate economic
activity is through their impact on the ownership of the total
money stock. For example, the size of the total U.S. money
stock (as currently measured) is not affected by changes in
foreign-owned deposits at U.S. commercial banks. However,
the distribution of the total U.S. money stock between U.S.
and foreign ownership is affected by such changes. This
source of international influence on the U.S. economy would
be significant only if the volume of foreign-owned deposits
was large and if the behavior pattern of foreign dollar owners
differed significantly from that of domestic dollar owners.
The evidence relating to this issue is, as yet, highly tentative.
However, the consensus seems to be that the influence of
foreign-owned deposits on the U.S. economy is minimal. For
a discussion of the concept of a domestically owned money
stock, see Albert E. Burger and Anatol Balbach, “ Measure
ment of the Domestic Money Stock,” this Review ( May
1972), pp. 10-23.
8Balance-of-payments accounting is based on the principle of
double entry bookkeeping. Total debits must equal total
credits, and therefore it is impossible for the entire balance of
payments to show either a deficit or a surplus. The only way
we can observe a difference between credits and debits is to
JULY
1975
Henceforth, we will refer to this balance as the money
account. For the United States this account would be
composed of a composite of changes in U.S. primary
reserve assets (gold and holdings of foreign currency
balances) and changes in foreign deposits at Federal
Reserve Banks.9
Adjustment Under a System of Freely Floating
Exchange Rates
Under a system of freely floating exchange rates the
balance of payments (on a money account basis) is
always in equilibrium (total imports equal total ex
ports) and there are no money supply changes asso
ciated with foreign transactions. In this case the ad
justment to the disparity between the supply of and
demand for money is accomplished by changes in
domestic prices and exchange rates (which change
concomitantly with, and accommodate, the required
movement in domestic price levels).
In order to analyze the process by which the re
quired adjustment takes place under freely floating
exchange rates, it is necessary to begin with an analy
sis of the market for foreign exchange. The demand
for imports determines the demand for foreign ex
change and the demand for exports determines the
supply of foreign exchange. The exchange rate will
always seek the level at which the quantities of for
eign exchange supplied and demanded are equal, and
thus also the level at which the value of import de
mand equals the value of export demand. Thus, in
value terms, imports will always equal exports and
there is never either a surplus or a deficit in the
balance of payments ( on a money account basis).
select certain items out of the balance of payments and com
pare credits and debits for the given subset of items. A
particular subset is usually chosen because the net of the
transactions included therein is significant, for some reason,
in sign and amount. According to current usage, an imagi
nary line is drawn through the balance of payments so that
the items selected for a subset appear “ above the line” and
the remaining items are said to be “below the line.” For a
more thorough discussion of standard balance-of-payments
statistics presentation, see John Pippenger, “ Balance-of-Payments Deficits: Measurement and Interpretation,” this Review
(November 1973), pp. 6-14.
“The money account captures the net impact of all interna
tional transactions on the U.S. money supply. Of all interna
tional transactions, the only ones that affect the money supply
are those that affect some component of the monetary base.
Since U.S. holdings of gold and foreign currency balances
(primary reserve assets) and foreign deposits at Federal Re
serve Banks are the only components of the monetary base
that are affected by international transactions, the entire im
pact of these transactions on the money supply can be cap
tured by observing the changes in these items. As such, the
money account includes changes in only these items below
the line.
F E D E R A L R E S E R V E BANK O F ST. LOUIS
Let us now return to the previous example in which
there is an increase in the quantity of money sup
plied relative to the quantity demanded. As in our
previous example, there will be an increase in the
demand for imports (the demand for foreign ex
change) and a decrease in the demand for exports
(the supply of foreign exchange). Under freely float
ing exchange rates, the inevitable consequence will
be a rise in the exchange rate (the price of foreign
currencies in terms of the domestic currency).10 As
such, a rise in the exchange rate is the natural con
sequence of the existing money stock exceeding the
quantity of money demanded.
The upshot of the foregoing analysis is that under
fixed exchange rates the crucial balance-of-payments
concept for gauging the impact of international trade
and capital transactions on the domestic economy is
the balance in the money account. Furthermore, ex
change rate movements and money account deficits
and surpluses are merely part of the adjustment mech
anism by which a disparity between the existing sup
ply of and demand for money is being corrected.
They are symptoms of a problem, but they them
selves are not the problem. The fact is that equality
between the supply of and demand for money must
and will be restored, and the money account deficits
and surpluses and exchange rate movements are
merely a mechanism by which the required adjust
ment is accommodated.
Most furor over balance-of-payments statistics and
exchange rate movements stems from the failure to
recognize the above proposition. For example, the
belief is widespread that deficits in the trade account
are “bad” because they represent a net drain on de
mand for the output produced in the deficit country.
In reality, however, one is unable to gauge the im
pact of international transactions on domestic demand
by focusing on the trade account alone. Even if a
trade account deficit is not offset by a surplus in the
capital account, the resultant deficit in the money
account merely reflects the fact that the stock of
money exceeds the quantity of money demanded.
Somehow this disparity must be and is corrected. In
a regime of fixed exchange rates, the money stock
will be decreased automatically through the outflow
of international reserves which is associated with the
money account deficit.
In a similar fashion, most concern over the depre
ciation of a currency in a regime of floating exchange
10That is, the domestic currency will depreciate in value
relative to other currencies. Other currencies will now be
worth more units of domestic currency than before.
JULY
1975
rates is also misdirected. It is curious that the belief
is widely held that the depreciation of a nation’s cur
rency is a cause of domestic inflation. To the contrary,
depreciations are not the source, but are the result of
inflationary pressures. The depreciation occurs for the
same reason that money account deficits occur with
fixed exchange rates — that is, because there exists a
disparity between the supply of and demand for
money which must be corrected.
When such a disparity exists under floating ex
change rates, the excess supply of money itself will
result in an increase in the demand for domestically
supplied real and financial assets as well as for for
eign exchange (the demand for foreign supplies of
real and financial assets). Consequently, all prices
(the price of foreign exchange included) will rise.
As with all increases in the price level, the result
will be an increase in the demand for money as spend
ing units attempt to maintain the real value of that
proportion of their wealth that they elect to hold in
the form of money balances. In short, the original
disparity between the demand for and supply of
money will be corrected via a rise in domestic prices
and a depreciation in the foreign value of the domes
tic currency ( a rise in the price of foreign exchange).
In view of the foregoing analysis, balance-of-pay
ments deficits and surpluses and exchange rate move
ments should not be viewed as evils that are to be
avoided at all costs. They are not problems in them
selves, but are one of the means by which other
problems are corrected. In fact, in light of the nature
of the forces which give rise to them, they are, in a
sense, desirable.
BALANCE-OF-PAYMENTS CONCEPTS
Since they are summaries, balance-of-payments
data are presented in categories composed of similar
types of international transactions (for example, mer
chandise trade, long-term capital, etc.). The trans
actions grouped together in any particular category
are similar in that, given the existing institutional
framework within which they occur, the forces giving
rise to, and the impact of, them is supposed to be
similar.1 To the extent that any set of groupings ever
1
was appropriate or informationally useful, this useful
ness can be greatly diminished if there are changes
in the forces which give rise to, or the impact of, that
11See Exhibit I and Table I for an outline of the group
ings currently employed in balance-of-payments data pres
entation. These illustrations will be useful references for the
remainder of this article.
Page 17
Table I
Exhib it I
SUMMARY EXPLANATION OF U.S. BALANCE
OF PAYMENTS
(To be used in conjunction w ith Table I)
The U.S. balance o f payments is a summary record of a ll in te r
n a tional transactions by the Government, business, and private
U.S. residents occurring during a specified period o f time.
As a series o f accounts and as a measure o f economic behavior,
balance o f payments transactions are grouped into seven cate
gories: merchandise trade, services, transfer payments, long-term
ca p ita l, short-term private c ap ital, miscellaneous, and liq u id p r i
vate cap ital. W e successively add the net balances o f the above
categories in order to o b ta in :
Merchandise Trade Balance
Goods and Services Balance
Current Account Balance
Basic Balance
N et Liqu idity Balance
O fficial Settlements Balance
Below the dashed line there are tw o a d d itio n a l categories, U.S.
lia b ilitie s to foreign o fficia l holders and U.S. reserve assets. These
serve to finance the transactions recorded above the dashed line.
There are interrelationships between these accounts. For e x
am ple, the credit entry associated w ith an export of goods could
result from the de bit entry o f a private bank loan, a Government
grant, a private grant, or an increase in U.S. holdings of foreign
currency or gold.
Merchandise Trade: Exports and imports are a measure of
physical goods which cross U.S. boundaries. The receipt of
dollars fo r exports is recorded as a plus and the payments
fo r imports are recorded as a minus in this account.
Services: Included in this account are the receipt o f earnings
on U.S. investments abroad and the payments o f earnings on
foreign investments in the U.S. Sales o f m ilita ry equipm ent to
foreigners and purchases from foreigners fo r both m ilita ry
equipm ent and fo r U.S. m ilita ry stations abroad are also in
cluded in this category.
Transfer Payments: Private transfers represent gifts and sim ilar
payments by Americans to foreign residents. Governm ent tra ns
fers represent payments associated w ith foreign assistance p ro
grams and may be utilized by foreign governments to finance
trade w ith the United States.
Long-term C apita l: Long-term private capital records a ll changes
in U.S. private assets and lia b ilitie s to foreigners, both real
and financial. Private U.S. purchases of foreign assets are
recorded as payments o f dollars to foreigners, and private
foreign purchases o f U.S. assets are recorded as receipts of
dollars from foreigners. Governm ent cap ital transactions rep
resent long-term loans o f the U.S. Governm ent to foreign
governments.
Short-term Private C apita l: N o n liq u id lia b ilitie s refers to capital
inflow s, such as loans by foreign banks to U.S. corporations,
and n o nliquid claims refers to capital outflow s, such as U.S.
bank loans to foreigners. These items represent trade financ
ing and cash items in the process of collection which have
maturities of less than three months. The distinction between
short-term private cap ital and liq u id private cap ital is th a t the
transactions recorded in the form er account are considered not
re a d ily transferable.
M iscellaneous: A llocations o f special d raw ing rights (SDRs)
represent the receipt o f the U.S. share o f supplemental reserve
assets issued by the Interna tiona l M onetary Fund. SDRs are
recorded here when they are in itia lly received by the United
States. The category errors and omissions is the statistical
discrepancy between a ll specifically iden tifia b le receipts and
payments. It is believed to be la rg e ly unrecorded short-term
private cap ital movements.
Liquid Private C apita l: This account records changes in U.S.
short-term lia b ilitie s to foreigners, and changes in U.S. short
term claims reported by U.S. banks on foreigners.
N O T E : For analytical purposes the dashed line below the official
settlements balance could be moved. For example, if this line were
placed under one of the balances above, then all transactions be
low that line would serve as financing, or offsetting, items for the
balance above.
Page 18
U. S. BALANCE OF PAYMENTS, 1974p
(B illions o f Dollars)
N et
Balance
M erchandise Trade:
Exports .................. ........................... .................... + 97.1
Imports ....................................
-1 0 3 .0
Merchandise Trade Balance ....
- 5.9
Services:
M ilita ry Receipts ....................
4~
3.0
M ilita ry Payments .... .............
5.1
Income on U. S. Investments
A broad ..............- ................
4 " 29.9
Payments fo r Foreign
Investments in U. S. ___ _
— 16.7
Receipts from Travel &
T ransportation ...................
4“ 10.2
Payments fo r Travel &
T ransportation ...................
— 1 2.7
O ther Services (n e t) .........
4“
0.3
Balance on Services .......
4 “ 9.1
Goods and Services Balance ...
Transfer Payments:
Private .....................................
1.1
G o ve rn m e n t............... ........- ....
— 6.1
Balance on Transfer
Payments ....- ................
- 7.2
Current Account Balance .......
Long-term C apital:
Direct Investment Receipts ... 4 “
2.3
Direct Investment Payments...
— 6.8
P ortfolio Investment Receipts
4“
1.2
Portfolio Investment
P aym ents.............................
2.0
Government Loans (n e t) ....
4“
1.0
O ther Long-term (n e t) ____
2.4
Balance on Long-term
C apital ...........................
- 6.7
Basic Balance _________ __ ___
Short-term Private C a p ita l:
N o nliq uid Liabilities ............
4"
1.7
N o n liq u id C la im s ........... .......
- 14.7
Balance on Short-term
Private C apital ...........
-1 3.0
M iscellaneous:
A llo cation o f Special
D rawing Rights (SDR) ......
*
Errors and Omissions .........
4"
5.2
Balance on Miscellaneous
4" 5.2
Items ................... ..........
Net Liqu idity Balance ... .........
Liquid Private C apita l:
Liabilities to Foreigners .......
4 “ 15.7
Claims on Foreigners ..........
— 5.5
Balance on Liquid
Private C apital .......... ..................
4 *1 0 .3
O fficial Settlements Balance ...
The O fficia l Settlements Balance
is Financed b y Changes in:
U. S. Liabilities to Foreign
O fficia l Holders:
Liquid Liabilities ..............
4“
8.3
Readily M arketable
Liabilities ......................
4"
0.6
Special Liabilities ............
4"
0.7
Balance on Liabilities
to Foreign O fficial
Holders ........ ...........
4 " 9.5
U. S. Reserve Assets:
G old ............... .......... ..........
0.0
Special D raw ing Rights ...
— 0.2
Convertible Currencies ......
0.0
IMF G old Tranche ............
1.3
Balance on Reserve
Assets .......... ..............
- 1.4
Total Financing o f O fficial
Settlements Balance ______
♦There was no SDR allocation fo r 1974.
P — P relim in ary
N O T E : Figures may no t add because o f rounding.
Cumulative Net
Balance
-
+
-
5.9
3.2
4.0
-1 0 .6
-1 8 .3
-
8.1
-j- 8.1
F E D E R A L R E S E R V E BANK O F ST. LOUIS
particular set of transactions, or if there are changes
in the institutional framework within which these
transactions occur. Thus, given the changes which
have occurred in the field of international trade and
finance in the last few years, it would not be at all
surprising to find that some previously meaningful
balance-of-payments groupings had become almost
meaningless.
Foremost among these changes has been the move
ment of the world’s major trading nations from a
fixed to a floating exchange rate regime and the surge
in the accumulation of official reserves by OPEC
members. In this section the current methods of pre
senting balance-of-payments statistics will be analyzed
in light of these changes. Each individual account
will be discussed in terms of its relevance prior to
these changes and, where appropriate, in light of the
movement to floating exchange rates and the rapid
growth of OPEC reserves.
Current Account
The current account measures the extent to which
the United States is a net borrower from, or net lender
to, foreign countries as a group. With the exception of
unilateral transfers (gifts and similar payments by
American governmental units and private citizens to
foreign residents), all of the transactions recorded
above the line in this account represent the transfer of
real assets (goods and services) between the United
States and its trading partners.1 The transactions re
2
corded below the line in this account represent the
means by which the United States is able to finance
the purchase of net imports from other countries or,
in the case of a surplus, how net exports have been
financed by our trading partners. For example, the
United States had a $4 billion deficit on current ac
count in 1974. This means that, on balance, the United
States received $4 billion more in goods and services
(imports) than it gave up (exports) in return. The
United States was able to do this by borrowing $4
billion from foreigners. The borrowing was financed
through a net of all of the transactions which appear
below the line in the current account. Thus, for the
purpose of balance-of-payments analysis, the value of
,2The current account excludes earnings on direct invest
ments which are both earned and reinvested abroad. How
ever, these reinvested earnings are no different than other
sources of U.S. income from abroad in the sense that they
represent a transfer of command over real resources. In recent
years these reinvested earnings have been quite large. For
example, in 1971 they amounted to $3.2 billion, while in
1972 and 1973 they amounted to $4.7 billion and $8.1
billion, respectively.
JULY
1975
the current account balance lies in its usefulness as a
measure of the net transfer of real resources between
the United States and the rest of the world. Another
way of viewing this balance is that it measures the
change in our net foreign investment. In other words,
in 1974 foreigners invested (made loans amounting
to) $4 billion in the United States.
This balance carries additional significance in that
it is a component of the nation’s GNP accounts. It is
included in the GNP accounts because it is supposed
to capture the contribution of foreigners to domestic
aggregate demand. However, it alone tells us very
little about the impact of international transactions on
domestic economic activity. It only measures the
magnitude of foreign demand for current output
(goods and services) and completely ignores the im
pact of foreign investment decisions on U.S. economic
activity. As mentioned previously, transactions in the
capital account could offset completely the impact of
current account transactions on the U.S. money sup
ply. As such, implications drawn from the current
account regarding the domestic impact of foreign
transactions can be highly misleading.
These same objections are equally appropriate, if
not more so, to the two more narrowly defined bal
ance-of-payments concepts — the merchandise trade
balance and the goods and services balance. While
these balances are among those which receive the
greatest amount of attention, their implications for the
domestic economy are greatly overstated.
Basic Balance
The basic balance isolates long-term capital trans
actions above the line along with all of the transac
tions included in the current account. All capital flows
involving assets whose original maturity exceeds one
year are defined as long term, and therefore “basic”
transactions. The original theoretical justification for
the basic balance seems to be that it catches the
persistent forces at work in the balance of payments
and thus could be a leading indicator of long-run
trends.
However, this is clearly not the case. Both portfolio
investments and long-term private loans are included
in long-term capital, and both are now highly sensi
tive to short-run changes in interest rates and changes
in expectations about relative inflation rates, mone
tary policies, and growth. The meaningfulness of the
long-term capital concept might have some appeal on
a theoretical basis, but data problems make its em
Page 19
FEDERAL. R E S E R V E BANK O F ST. L OUI S
pirical counterpart extremely difficult to construct
and, therefore, it is not very useful.
Net Liquidity Balance
The net liquidity balance may be thought of as a
measure of the total of U.S. dollars which accrue to
foreigners, during an accounting period, as a result of
all of the transactions recorded above the line — that
is, imports and exports of goods and services, unilat
eral transfers, inflows and outflows of long-term capi
tal, and nonliquid short-term capital. Below the line it
combines the changes in our reserve assets and the
changes in our liquid liabilities to both private and
official foreigners. The original intent of this balance
was to measure the change in potential pressure on
our reserve assets. The thinking was that official in
stitutions could use their dollar assets to buy our re
serve assets; private holdings of dollars were a poten
tial threat if private foreigners sold their dollars to
central banks, who could in turn use them to buy
our reserve assets.
There are a number of problems with this measure
which make its relevance and usefulness highly ques
tionable. These problems are both theoretical and
empirical and are greatly magnified by the recent
institutional changes which have occurred in inter
national finance.
The main empirical problem with this measure is
that it attempts to distinguish between liquid and
nonliquid liabilities. Every U.S. liability to foreigners
has a combination of attributes, some of which qualify
them for classification as liquid and some of which
qualify them for classification as nonliquid. As a re
sult, the classification of many assets as liquid or
nonliquid must be somewhat arbitrary. For example,
foreign portfolio investments in the United States are
classified as nonliquid liabilities. However, these lia
bilities of the United States are readily convertible
into liquid form — that is, they may be sold at any
moment in time for cash or a demand deposit. Thus,
the exchange market implications of the growth of
foreign portfolio investments in the United States are
not much different from those of a growth in foreignheld bank deposits (which are classified as liquid).
Suppose, however, that all liabilities to foreigners
could be meaningfully subdivided into liquid and
nonliquid categories. It would still be inaccurate to
declare that all liquid liabilities to foreigners repre
sent potential pressure on our reserve assets. There
are many reasons why foreigners wish to hold liquid
Page 20
JULY
1975
claims against the United States, not the least of which
is for transactions purposes. The U.S. dollar is indeed
an international currency which may be used in trans
actions throughout the world. Only those foreign-held
claims which are in excess of those desired for trans
actions purposes can be rightfully considered as a
potential source of pressure on our reserve assets.
While it is surely impossible, for empirical as well
as theoretical reasons, to determine what proportion
of total U.S. liabilities are being held for transactions
purposes, the proportion is probably large. In order to
determine accurately potential pressures on our re
serve assets, it would be necessary to further subdivide
U.S. liquid liabilities to foreigners into those held for
transactions purposes and those held for speculative
(or other) purposes. Indeed, it is only this latter cate
gory of liquid claims that represent potential pres
sures on our reserve assets.
The above problems have become decidedly more
acute in the wake of the quadrupling of petroleum
prices and the surge in the dollar holdings of OPEC
members. Since the transacting currency of OPEC
members is the U.S. dollar, the role of the dollar as
an international medium of exchange, and thus its
transactions demand, has been greatly enhanced. At
the same time, many OPEC members have been ac
cumulating extensive dollar denominated liquid
claims. While this may be only a short-run phenome
non, the fact is that these liquid U.S. liabilities do not
represent a potential threat to our reserve assets.
Rather, these liabilities represent only a short-term
depository for OPEC receipts while they decide how
they wish to extend the maturity distribution of their
claims into long-term (and therefore nonliquid in
balance-of-payments parlance) investments.
To the extent that there ever did exist a conceptual
basis for trying to measure the net liquidity balance,
that basis no longer exists as a result of the shift from
a system of fixed to one of floating exchange rates.
With floating exchange rates there is no potential
pressure on our primary reserve assets because the
dollar is no longer convertible into them.1
3
13Under fixed exchange rates the United States stood ready to
buy and sell foreign currencies in order to support the value
of the dollar at a specific price in terms of other currencies.
Primary reserve assets ( international reserves) are stocks of
gold and foreign currencies held by the U.S. Government
in the event that such market intervention became neces
sary. For example, a decrease in the demand for dollars
vis-a-vis gold or foreign currencies was accommodated by
the purchase of dollars in return for foreign currencies or
gold from the stocks of reserve assets. Thus, the dollar was
said to be readily convertible into our reserve assets. How
F E D E R A L R E S E R V E BAN K O F ST. L OUI S
Official Settlements Balance
The official settlements balance is intended to
measure the change in dollar balances which accrue
to foreign official institutions only. In this balance-ofpayments concept all private transactions are counted
above the line, whereas in the net liquidity balance
some private transactions (liquid private capital
flows) are counted below the line. The original intent
of this balance was to measure directly the net ex
change pressure on the dollar and on U.S. reserve
assets.14 Since only those dollar denominated U.S.
liabilities which are held by foreign official institu
tions could be exchanged for reserve assets, this bal
ance focuses on only those transactions which give
rise to changes in these liabilities.
The usefulness of this balance has always rested on
the questionable distinction between private and offi
cial transactions. The idea is that all transactions
listed above the line are the result of market-determined private (autonomous) actions and all transac
tions below the line are the result of official
(accommodating) actions undertaken in support of
fixed exchange rates. The thinking was that all official
transactions could be considered as accommodating
and all private transactions as autonomous. This prob
ably never was the case and certainly is not the case
now, given recent institutional changes in international
finance.
The rapid accumulation of reserves by official
agencies of OPEC members are included below the
line in this balance, but they are clearly not the result
of official action aimed at stabilizing exchange rates.
These OPEC reserves largely represent investment
decisions by OPEC members which are based on con
siderations of income, liquidity, and risk. In other
words, many official transactions are clearly autono
mous and not accommodating, and should therefore
ever, with floating exchange rates the U.S. Government
is no longer obligated to intervene in the market for foreign
currencies and changes in the demand for the dollar are
accommodated by movements in the dollar exchange rate.
In other words, with floating exchange rates the U.S. G ov
ernment no longer guarantees the convertibility of the dol
lar into its reserve assets.
14The official settlements balance was originally supposed to
reflect the effects of past measures taken in support of the
fixed dollar exchange rate, while the net liquidity balance
was supposed to reflect the potential need for such measures
in the future. This is because the net liquidity balance in
cludes liquid private capital, a potential source of future
pressure on fixed exchange rates, below the Line. On the
other hand, in the official settlements balance the only
transactions carried below the line are those which reflect
past official measures.
JULY
1975
be included with other autonomous transactions above
the line.
While the above discussion relates to the blurred
distinction between autonomous and accommodating
transactions, there are other problems which blur the
distinction between private and official transactions.
For example, many foreign official institutions invest
their dollar balances in the Eurodollar market. The
result of such transactions on the balance-of-payments
accounts is to increase private (Eurodollar bank)
claims on the United States and reduce official
claims. However, in reality, since the foreign official
institution still maintains ownership and control of a
claim against the United States, there has been no
reduction in official claims against it.
To the extent that the official settlements balance
ever did measure what it was supposed to measure,
the relevance of this concept has disappeared as a
result of the shift to floating exchange rates. As a re
sult of this shift, exchange rate authorities are no
longer obligated to prevent movements in exchange
rates through official intervention in the foreign ex
change market. The net exchange pressure on the
dollar is no longer captured by changes in reserve
asset holdings.
PROPOSALS FOR REFORM
In view of the considerations aired in the foregoing
discussion, it is often the case that the present method
of presenting balance-of-payments data is more mis
leading than useful. In some instances the balances
currently reported have absolutely no economic mean
ing and often do not give an accurate measure of the
impact of international trade and capital transactions
on aggregate economic activity. This is because none
of the currently reported balances capture the effects
of international transactions on the money supply,
and it is primarily through their effects on the money
supply that these transactions have any appreciable
impact on aggregate economic activity.
Under fixed exchange rates there is only one really
meaningful balance — the balance in the money ac
count. This account is the only one that captures the
effect of international transactions on the money sup
ply. However, at present this balance is not reported.
Under freely floating exchange rates there are no
meaningful balance-of-payments concepts, because in
this case international transactions have no impact on
the money supply. In this case the money account is
always in balance, and therefore of no significance.
Page 21
F E D E R A L R E S E R V E BAN K O F ST. L OUI S
Thus, there is little, if any, reason why the publica
tion of balance-of-payments data in the currently em
ployed format should be continued. Not only is this
format virtually without economic meaning, but it is
often quite misleading. While there are many theoreti
cal and empirical problems associated with any kind
of aggregation of data pertaining to international
transactions, the problems are unnecessarily exacer
bated by the present practice of drawing balances on
the various subaccounts (that is, the merchandise
trade balance, the goods and services balance, the
current account balance, etc.). These problems could
be significantly reduced if the data were just pre
sented and no balances were drawn.
In a world of freely floating exchange rates, chang
ing pressures on the dollar are captured by move
ments in the exchange rate and not by some theo
retically and empirically meaningless balances. For
this reason, it would be helpful if international trade
data were to include changes in the effective ex
change rate.15 However, we recognize that the cur
rent exchange rate arrangement cannot be realistically
considered as an experiment with freely floating ex
change rates. It is rather an experiment with a
“managed float.”16 Whether recent official interven
tion activities have had any effect on the exchange
rate or not, the fact is that they, as will any official
exchange rate intervention activities, have had an
impact on the U.S. monetary base. Thus, as it turns
out, given the current “managed float,” both the
money account balance and changes in the effective
exchange rate each convey some useful information.
Thus, any proposals for reform of the methods of
presenting balance-of-payments data should include,
at a minimum, a recommendation that the currently
employed balances not be drawn and that the words
“deficit” and “surplus” be dropped from any reference
to international data. This would not prevent individ
uals from computing balances if they wished; it would
only remove the implied government sanction of
these concepts as economically meaningful.
JULY
1975
Exhibit II
INTERNATIONAL TRANSACTIONS, 1974p
M illions
o f Dollars
Merchandise Exports .............................................................. $ 1 0 0 ,0 4 7
Merchandise Imports ............. ..........-....................................
108,02 7
Service Exports ...................................... ................................
4 2 ,6 0 0
Service Imports ........................................................................
31,431
U nilateral Transfers (N e t) .................................................
9,005
Direct Investment A broad .................................................
6,801
Direct Investment in U.S............................... ..........................
2,308
P ortfolio Investment A broad ...............................................
1,951
P ortfolio Investment in U.S....................................... ..........
1,199
Deposits A broad (Dem and, Time, a t Central Bank) ...
1,129
Deposits in U.S. (Dem and, Time, a t Central Bank) ....
20 ,746
Money Account Balance ......................................................
46
Sources: Survey of Current Business, Board of Governors of the
Federal Reserve System Bulletin, Treasury Bulletin.
Nominal and Effective Dollar Devaluation
1970
1971
197 2
197 3
19 7 4
197 5
So urces: IM F a n d th e F e d e r a l R eserve B a n k o f N e w Y o rk
N o te : N o m in a l d e v a lu a tio n is m e a s u re d b y th e c h a n g e in th e d o ll a r p r ic e o f g o ld .
In addition, any proposed reforms should address
themselves to the obviously arbitrary classification of
certain transactions as relating to liquid, illiquid, short15The change in the effective exchange rate is a trade
weighted average of changes in the exchange rate between
the dollar and the currencies of the United States’ trading
partners.
,6In other words, exchange rates are currently neither fixed at
an officially specified level nor are they allowed to move
completely free of official foreign exchange market
intervention.
Page 22
E ffe c tiv e d e v a lu a tio n is m e a s u re d b y th e a p p r e c ia tio n o f e le v e n m a jo r c u rre n c ie s
r e la t iv e to th e p a r v a lu e s w h ic h p r e v a ile d a s o f M a y 1 9 7 0 . The a p p r e c ia tio n is
th e n w e ig h te d b y s e p a r a te e x p o r t a n d im p o r t sh a re s w ith th e U n ite d S tate s
b a s e d on 1972 tr a d e d a ta .
L a te s t d a t a p lo t t e d : M a y
term, or long-term capital flows. They should also
recognize that under a managed float changing pres
sures on the dollar are captured by movements in the
exchange rate and the money account balance. With
these goals in mind, a classification scheme similar
to that presented in Exhibit II is suggested.
F E D E R A L R E S E R V E BANK O F ST. L OUI S
The advantages of this type of approach to the
classification of international data are as follows:
1) No balances are computed or reported.
2) It allows individuals to make their own judg
ments regarding whether or not a particular transac
tion is related to liquid, illiquid, short-term, or long
term capital flows and to draw their own conclusions
regarding the significance of changes in these flows.
3) It recognizes that pressures on the dollar are
reflected in changes in exchange rates and in the
money account balance and not by changes in the
volume of a particular subset of transactions.
CONCLUSION
The current method of presenting data relating to
international commerce attempts to group transac
tions so that the net of the transactions included in
any category (the balance in that account) is signifi
cant for some reason in sign and amount. The trans
actions grouped together in any particular category
are supposed to be similar in that, given the existing
institutional framework within which they occur, the
forces giving rise to, and the impact of, them is
supposed to be similar. The idea is that the balance
in that account should serve as a guide to policy
makers as they attempt to gauge the impact of inter
national transactions on domestic economic activity.
A particular balance is an appropriate guide to
policy or is informationally useful only to the extent
that it is based upon a correct perception of the forces
which give rise to, and the impact of, the transactions
included therein. The thrust of this article is that the
balances highlighted in current balance-of-payments
statistics are based on an incorrect perception of such
JULY
1975
forces and impacts. As such, these balances have very
little economic meaning and are, therefore, often a
misleading guide to policymakers. As an alternative,
it is suggested that international trade and capital
transactions be viewed within the framework pre
sented in the first sections of this article.
Therefore, the conclusion of this article is that the
present methods of presenting data concerning inter
national transactions should be reformed so that it
more closely reflects the underlying economic realities
of international commerce. At a minimum, any such
reform should include a discontinuation of the prac
tice of calculating the balances which are currently
presented. While this would not prevent individuals
who wish to do so from calculating such balances, it
would remove the implied governmental sanction of
these balances as having some special economic or
policy implications.
In addition, the above reform would also result in
a discontinuation of the constant references to “defi
cits” and “surpluses” in the balance of payments. The
words “deficits” and “surpluses” in this regard convey
meanings that are not at all appropriate to the reali
ties of the impact of international commerce on do
mestic economic activity. For example, every month
we hear that the merchandise trade account was
either in “deficit” or “surplus.” A deficit in this account
merely means that the United States imported more
merchandise than it exported during that month. In
other words, the United States received more goods
during that month than it was forced to give up, and
it was able to do so by borrowing from foreigners.
Despite the stigma associated with the word “deficit”,
this information tells us virtually nothing about the
overall impact of international commerce on domestic
economic activity.
Page 23
@FedFRASER