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FEDERAL RESERVE BANK OF ST. LOUIS MAY 1978 CONTENTS il f e A Perspective on the Economy: Three Years of Expansion JEAN M. LOVATI M ARCH 1978 marked the third anniversary of the current economic expansion. Over the course of the expansion, growth in production of goods and services has been comparable to the average output growth in similar three-year periods of prior recov eries. By other measures, however, this recovery has not been average. Growth in employment, for ex ample, has been exceptional. Moreover, the level of unemployment and the pace of inflation both have remained relatively high. Production In the most recent quarter, production of goods and services, as measured by real gross national product, declined at a 0.6 percent annual rate. This recent decline reflected the pervasive effects of severe winter weather early in 1978 combined with an extended strike in a major portion of the coal industry. The effects of these factors, while having a debilitating impact on the economy, are temporary in nature. The decline in aggregate production early this year should not be regarded as a signal of a failing expansion, as economic fundamentals remain strong. Over the entire expansion, from first quarter 1975 to first quarter 1978, real gross national product in creased at a 5.1 percent annual rate. This is about average compared to other postwar recoveries. Dur ing the first three years of four previous expansions, output grew, on average, at a 5.6 percent rate1 (see Table I). While growth seems to be on track with other recoveries after three years, the path of the current recovery has taken on its own unique characteristics. Initially, the economy expanded at a rapid pace, ex periencing a 9 percent rate of growth in real output iPostwar expansions used for comparison in this article are those whose troughs are October 1949, May 1954, February 1961, and November 1970. The expansion beginning in April 1958 was eliminated because it lasted only two years. Page 2 1970 1971 1972 1973 1974 1975 1976 1977 1978 Source: U.S. D e partm en t of C om m erce P e rc e n tage s are an n u a l rates of c h a n g e for p e rio d s indicated. Q _ G N P in current d ollars. 12 G N P in 1972 d ollars. Latest d a ta plotted: 1st q u a rt e r p r e lim in a r y of goods and services between the first and third quarters of 1975 (Chart I ) . During this time, inven tory stocks continued to decline, but did so at a re duced rate. This slowing down of inventory decumu lation as well as the dramatic rise in real final sales were reflected in the exceptional rate of growth early in the recovery. Over the first year of expansion, real output grew 7 percent. The second year of the recovery was marked by more sustainable growth. Production of goods and services advanced 4 percent between first quarter 1976 and first quarter 1977. Real final sales expanded stead ily, registering a fairly strong 4.4 percent gain in the expansion’s second year. MAY FEDERAL RESERVE BANK OF ST. LOUIS 1978 Table 1 A C O M P A R IS O N O F SELECTED P O S T W A R E X P A N S IO N S 1 Rates of change after 3 years for expansions beginning: October 1949 (IV /1949) May 1954 (11/1954) Real GNP 7 .8 % 4 .0 % 5.3 % 5 .1 % 5 .6 % 5 .1 % Real final sales 6.8 3.6 4.9 4.4 5.0 4.2 Industrial production February 1961 (1/1961) November 1970 (IV /1970) AVERAGE March 1975 (1/1975) 12.2 6.5 8.1 7.9 8.7 8.1 Retail sales 8.0 5.8 5.7 11.9 7.9 11.1 Real disposable personal income 4.9 4.6 4.5 5.0 4.8 5.0 G NP deflator 3.8 2.7 1.6 5.4 3.4 5.7 Consumer price index2 4.1 1.3 1.2 5.1 2.9 6.4 Wholesale price index — all commodities 4.4 1.8 - 0.2 7.9 3.6 6.2 Wholesale price index — industrial commodities 4.1 3.0 -0 - 5.4 3.2 6.6 - 0.1 1.6 1.1 2.5 1.3 2.6 1.6 2.2 1.6 2.9 2.1 3.5 Civilian labor force/population 16 years + 5 8 .7 % 5 9 .5 % 5 8 .8 % 6 1 .2 % - 6 2 .8 % Civilian employment/population 16 years-f- 56.9 57.1 55.6 58.2 - 59.0 3.0 4.1 5.4 4.8 - 6.2 1 .1 % - Civilian labor force Civilian employment Levels as of 36th month of expansion Unemployment/labor force Change in the unemployment rate3 - 4 .9 % - 1 .8 % - 1 .5 % - - 2 .4 % ^ o e s not include expansion beginning April 1958 2Series for urban wage earners and clerical workers 3From trough to 36th month of expansion In the latter part of 1976, the economy experienced some inventory adjustments which induced a slow down in the growth of total output. At the end of the year, the ratio of inventories to monthly sales in man ufacturing and trade industries fell precipitously. The situation was compounded by severe weather condi tions in the first quarter of 1977. Such complications limited inventory rebuilding and output growth. These temporary effects were offset, however, by faster growth in the two subsequent quarters, so that the recovery regained its footing and achieved a 5.7 percent increase over 1977 as a whole. Many of the same factors were at work at the end of 1977 and the beginning of 1978. Inventories again declined relative to monthly sales. As noted above, severe weather combined with the coal strike tempo rarily hampered production. Despite these factors, output grew 4 percent in the third year of the expansion. Sector Activity The over-all expansion has been reflected in sub stantial growth of spending by different sectors in the economy at different stages of the recovery. In the first year, for example, consumer spending made sub stantial advances, while spending by businesses on plant and equipment and by the Federal Government were rather sluggish. As the expansion progressed in the next two years, growth in these sectors gradually reversed. Personal consumption expenditures, which com prise about 64 percent of gross national product, in creased rapidly early in the expansion, advancing 13 percent in the first year of the recovery as substantial gains were made in personal income. Even after ac counting for inflation, real household spending regis tered a 7 percent growth between first quarter 1975 and first quarter 1976. Spending on consumer durables, which increased 25 percent in the first four quarters of the recovery, was boosted by heavy purchases of autos and appliances. Expenditures on nondurable consumer goods rose 9 percent over the same period. While remaining relatively strong, growth of consump tion expenditures has slowed from initial rates in the recovery. Since the first quarter of 1976, spending on consumption goods and services grew in nominal terms at a 10 percent annual rate. Investment in residential structures has also made significant gains over the course of the current expan Page 3 FEDERAL RESERVE BANK OF ST. LOUIS sion. Residential housing advanced at a nominal rate of 28 percent per year over the three years of ex pansion. Housing starts surpassed 2 million units in 1977, with single-family starts exceptionally strong. This strong demand for housing partially reflected an attempt to make up for new house purchases post poned during the recession. Between second quarter 1974 and first quarter 1975, investment in residential structures had declined at more than a 21 percent rate. Recent strength of demand for housing is prob ably also influenced to some extent by homebuyers’ uncertainty about future home prices. As housing prices have risen sharply in the last several years,2 some housing purchases were based on the assump tion that new homes would become even more expen sive relative to income in the future. Spending on plant and equipment, on the other hand, demonstrated little strength during the first year of the recovery, growing 4 percent in nominal terms. This relatively slow growth in investment spending was due in large part to continued busi ness uncertainty resulting from the indefinite status of various Government regulations, proposed changes in Federal energy and tax programs, and the future course of inflation. Higher replacement costs and lower productivity of capital goods due to higher energy costs have impeded growth of capital outlays. Inflation, combined with the tax structure, has low ered the yield on, and increased the cost of obtaining the necessary funds for a given investment program, thus eroding incentives to invest.3 Recently, however, business fixed investment has shown signs of renewed strength. Since the fourth quarter of 1976, plant and equipment spending has advanced at about a 14 per cent rate. Government purchases of goods and services showed little strength in the first two years of the expansion. Between first quarter 1975 and first quar ter 1976, real Government spending advanced 2 per cent and over the following four quarters declined slightly. This pattern has been reversed, however, since the beginning of 1977. Real Government spend ing has increased more than 4 percent in the past year. The recent rise in the growth of Government spending has been sharpest among state and local governments, which coincides with increased grantsin-aid through the Federal Government’s 1977 eco2Housing prices, as measured in the consumer price index, have risen at an 8 percent annual rate since 1970. :lSee John A. Tatom and James E . Turley, “Inflation and Taxes: Disincentives for Capital Formation,” this Review (January 1 9 7 8 ), pp. 2-8. Page 4 MAY 1978 nomic stimulus program. This program includes local public works, public service employment, and other employment and training programs. Labor M arket D evelopm ents A significant characteristic of the present expansion has been the rapid growth of employment. In the 36 months of the expansion, civilian employment has grown at an annual rate of 3.5 percent. This growth is exceptionally high by historical standards. Over comparable 36-month periods in past expansions, civil ian employment grew at an average 2.1 percent rate. Labor force growth also has been rapid over the recovery. A record 62.8 percent of the civilian noninstitutional population aged 16 and over were mem bers of the labor force in March 1978. In other periods of relatively high employment, 1956 and 1967-69 for example, 60 and 59.8 percent, respectively, of the working-age population were in the labor force. In the three years of the current expansion, the civilian labor force has grown at a 2.6 percent rate, twice the average rate of growth achieved during the first three years of previous expansions. Demand for labor has been relatively strong, so that many in the labor force have been placed in jobs. The number of employed persons in the working-age population reached a postwar peak of 59.0 percent in March, higher than at any time in the prior 29 years. Significant progress has been made in lowering the unemployment rate over the past three years. The unemployment rate declined from 8.6 percent in March 1975 to 6.2 percent in March 19784 (see Chart II). Despite such progress, the rapid growth in the labor force left more than 6.1 million workers currently recorded as being unemployed. The level of the unemployment rate reflects var ious factors, including structural changes in the com position of the labor force, which have tended to maintain its relatively high position. The labor force now contains relatively more women and teenagers than heretofore. Adult women comprised 37.1 percent of the labor force as of March of this year, a record high. Moreover, while the participation of women has been increasing throughout the postwar period, it has intensified within the past five years. Participa tion of adult women (aged 20 and over) in the labor force reached a peak of 49.1 percent in March, com pared to an average participation rate of 37.8 percent 4In April, the unemployment rate fell to 6.0 percent. FEDERAL RESERVE BANK OF ST. LOUIS MAY 1978 Chart II Labor M a r k e t Trends 1948 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 Shaded areas represent periods of business recessions. Latest data plotted: 1978, based on first four months in prior periods of expansion.5 Much of the impetus for the recent rise can be attributed to married women (spouse present) whose participation in the labor force has risen over 3.6 percentage points since 1974. Of these women, many have small children ( infant to 5 years old), a characteristic whose inhibit ing influence on labor market participation seems to be diminishing. Teenagers also account for a larger proportion of the labor force than in previous periods. Labor force participation of workers aged 16-19 stood at 56.7 per cent in March, nearly the highest in recent history. Partially because of the level of skills of these groups of workers, plus the restrictions of the min imum wage and the tenuous nature of labor force ■’Participation rates measure the proportion of persons in a specific population group that are in the civilian labor force. attachment in the case of teenagers, higher rates of unemployment are generally experienced by women and teenagers. Due to the increased size of these groups, their unemployment rates are weighted more heavily which, in turn, tends to raise the average level of the overall unemployment rate. In March 1978, unemployment rates for adult women and teenagers were 5.8 and 17.3 percent, respectively. In the same month, adult men had an unemployment rate of 4.5 percent. According to current data, the average duration of unemployment is less than 13 weeks. This is well within the present maximum limit for receipt of unemployment compensation. The broad scope of benefit programs, coupled with savings and other sources of aid such as food stamps, tend to reduce the economic hardship suffered by the unemployed. However, such unemployment programs also tend to reduce incentives for the jobless to obtain work, pre Page 5 FEDERAL RESERVE BANK OF ST. LOUIS MAY serving a high number of unemployed, even under fairly tight labor market conditions.6 Prices Another feature of the current expansion which distinguishes it from others is the much higher rate of inflation which prevails. The implicit price deflator, a measure of the general level of prices, rose at a 5.7 percent rate over the twelve quarters of this recov ery. In the first twelve quarters following the troughs of past recessions, the general level of prices rose an average of 3.4 percent per year. C h a rt III Prices Ra ti o Scale 1967=100 230 Ra ti o Scale 1967=100 S e a s o n a lly Adjusted |------- 220 ---------- 1978 The difference between the inflation experience in the current recovery and that in previous recoveries primarily reflects differences in the growth of money. Growth of prices is primarily determined by the trend growth rate of money. In the five years preceding this recovery, the money stock grew at a 6.2 percent rate, greater than money had grown in the five years prior to any other postwar recovery. While money stock increased at a 5.7 percent rate between Novem ber 1966 and November 1970, in the corresponding periods preceding the expansions beginning May 1954 and February 1961, money had grown at only 3.1 and 1.4 percent rates, respectively. Moreover, money growth has been accelerating since the current recov ery began, reaching a 7.3 percent rate in the period from the third quarter 1976 to first quarter 1978 (Chart IV ). 2 1 0 -------------- This expansion in the money supply reflects growth in the monetary base, its prime determinant, which has shown a marked acceleration during the recovery. In the first two years of this expansion, the monetary base had grown at an 8.2 percent rate, from the 7.7 percent rate recorded in the previous three quarters. In the expansion’s third year, the base growth accel erated to a 9.3 percent rate. C h art IV M o n e y Stock a n d M o n e ta ry Base 1970 1971 1972 1973 1974 1975 1976 1977 1978 P ercentages are a n nu a l rates o f cha n ge for p e rio d s indicated. * C P I for U rb a n W a g e Earners an d C le rical W o rk e rs (revised series b e g in n in g Ja n u a ry 1978). Note: CPI, se a so n a lly adjusted, (old series) term inated b egin n in g J a n u a ry 1978. L a te st d a t a p lotted: C o n su m e r-M a rc h ; W h o le sa le -A p ril Prices, as measured by the consumer and wholesale price indexes, show a similar pattern. The consumer price index (C P I)7 rose at a 6.4 percent rate between March 1975 and March 1978 (Chart III). In the past, however, the CPI averaged a 2.9 percent annual rate of growth over similar recovery periods. On the whole sale level, prices of industrial commodities rose at a 6.6 percent rate in this expansion, compared to an average rate of 3.2 percent in other expansions. 6See Martin Feldstein, “The Economics of the New Unem ployment,” T he Public Interest (F all 1 9 7 3 ), pp. 3-42. 7This CPI refers to the series for urban wage earners and clerical workers. Page 6 nonm em be r banks. A djustm ents are m ade for reserve requirem ent c h a n g e s a n d shifts in deposits am on g classe s of b anks. D ata are com puted b y this Bank. Percentages are an n u a l rates of chan ge for p erio d s indicated. FEDERAL RESERVE BANK OF ST. LOUIS SUMMARY The current expansion has reached the average length of other postwar recoveries and, in terms of production of real goods and services, has posted about the same rate of growth from the trough as have other expansions. However, specific characteris tics of the current situation are unique. Plagued by severe winters and temporary shortages of energy, growth of real output has been hampered at various stages of this recovery. Inventory investment, al though accelerating recently, has also been impeded by various adverse factors. Business fixed invest ment expenditures still remain low relative to other recoveries. While the expansion has been reflected primarily in growth of private consumption, investment and Government expenditures may take on more prom inent roles in the future. Investment expenditures as well as Federal purchases of goods and services have rebounded from their sluggish behavior in the earlier stages of the recovery. During 1977, gross private domestic investment, after accounting for inflation, MAY 1978 grew nearly 17 percent; real Federal Government purchases advanced at a 10 percent rate over the last three quarters of the year. Housing growth, on the other hand, which has shown exceptional strength during the recovery, may be tempered due to rising interest rates and exhaus tion of “pent-up” demand forces. Rates on short-term market instruments, such as 3-month Treasury bills, have risen to levels equal to the ceiling limits on sav ing and loan time deposit accounts. If disintermedia tion becomes a serious problem, the housing sector may suffer more serious slowing. Two problems, formerly an unusual combination, are likely to continue to be characteristic of the pre vailing economic environment. The unemployment rate, which has been primarily influenced by struc tural and supply factors, is generally expected to re main relatively high. Inflation is also not likely to show any slowing in 1978. Based on past rates of monetary growth, inflation can be expected to run in the neighborhood of 6 percent during this year. Page 7 Comparing Per Capita Output Internationally: Has The United States Been Overtaken? JAI-HOON YANG I n 1950 the United States was generally recognized as having the highest per capita output in the world. Using exchange rates to convert foreign output into dollars, the level of U.S. per capita output in 1950 was more than 50 percent higher than that of any other industrialized country.1 During the next two decades the conventional exchange rate-based meas ure of comparison indicated that these industrialized countries markedly narrowed the U.S. lead. By 1970 U.S. per capita output was still more than 15 percent higher than the next highest industrialized country, Sweden. By 1974, however, that same conventional measure indicated that Sweden and Switzerland had over taken the United States. Reportedly, Canada, Den mark and West Germany have joined the club.2 Citing these developments, one critic of the U.S. economic system speculated that “the lack of government planlThe concern here is with the relative per capita levels of actual output of goods and services produced (such as per capita gross national product or gross domestic product as conventionally measured in accordance with the prevailing United Nation’s System of National Accounts) and not with the elusive and speculative measures of relative levels of economic welfare. The primary reason for focusing on a measure of production, such as per capita output, rather than on a measure of welfare, such as consumption per capita adjusted for length and conditions of work, is that in most studies and popular discussions of international comparisons, measures of per capita output have been used. For a discussion of reasons why measures of production, rather than of welfare, are compared, see Milton Gilbert and Irving B. Kravis, An International Comparison of Na tional Products and the Purchasing Power of Currencies (Paris: Organization for European Economic Cooperation (O E E C ), 1 9 5 4 ), pp. 72-76. Fo r a discussion of the distinc tion between a measure of welfare and a measure of output, see Edward F . Denison, “Welfare Measurement and the GNP,” Survey of Current Business (January 1 9 7 1 ), pp. 13-16, 39. “West Germany was reported to have become “just a bit richer” than the U.S. on a per capita basis on June 24, 1973. See J. W . Anderson, “The Relative Wealth of Nations,” Washington Post, 2 July 1973. Denmark’s leap forward was reported in early 1977. See Lester C. Thurow, “The Myth of the American Economy,” Newsweek (February 14, 1977), p. 11. These reports are based on a temporary (as short as a day) dip in the value of the dollar. Based on an annual or even on a quarterly average basis, Denmark and W est Ger many have yet to pass the United States, even in terms of the conventional measure. Canada’s entry into this exclusive club was reported recently in “U.S. Slips to 4th in National In come,” Washington Post, 13 May 1978. Page 8 ning, worker participation, and social spending may in fact be at the heart of our poor performance in recent decades.”3 There is good reason to question the conclusion about the comparative levels of per capita output based on the conventional (exchange rate-based) measure. Specifically, the method of using exchange rates to convert output of different countries into a common currency, such as the U.S. dollar, has sev eral serious drawbacks. First, actual per capita out put of goods and services in different countries does not necessarily change every time exchange rates be tween the countries change, although the conven tional measure of comparison would indicate such a change. Second, the exchange rate between curren cies serves to equalize, at best, the prices of goods traded between countries. However, total output in each country also consists of goods and services which are not traded but are consumed domestically. Price differences in these non-traded goods are not neces sarily captured in the exchange rate. To the extent the exchange rate does not reflect such a difference in the prices of non-traded goods, any comparison based on the conventional measure would be dis torted. In addition, the prevailing exchange rate may not even equalize the prices of goods traded interna tionally for a variety of reasons, including govern ment interventions in the markets for foreign exchange. To overcome these shortcomings of the exchange rate-based measure, economists have developed an alternate measure based on the relative purchasing power of different currencies over both traded and non-traded goods. This alternate measure of inter national comparison indicates that the U.S. lead in per capita output in the earlier period (1950 through 1970) was generally much narrower than that indi cated by the conventional measure. Also, these esti mates indicate that the U.S. lead has yet to be overtaken. 3See Thurow, “The Myth,” p. 11. FEDERAL RESERVE BANK OF ST. LOUIS T h e Conventional M easure of International Comparisons of P er Capita Output The conventional measure of international compar isons using exchange rates between two countries, say, Germany and the United States, is quite simple. First, the per capita German output in Deutsche marks (D M ) would be converted to dollars by the prevail ing exchange rate. The resulting per capita German output in dollars would be divided by the per capita U.S. output, also measured in dollars. The resulting quotient, expressed in percentage form, is the conven tional measure of the relative level of per capita output between Germany and the United States. For example, suppose that per capita German output in a given year is DM4,000 while U.S. per capita output is $2,000. Assume that the exchange rate is DM4/$1.00.4 To derive the conventional measure of international comparison, the per capita German output would be converted to dollars (DM4000 DM4/$1 = $1000) and then expressed as a percent of U.S. per capita output ($1000/$2000 = .50, or 50 percent). For the sake of illustration, if the exchange rate in this ex ample changes to DM2/$1.00 (the dollar depreciates), the conventional measure becomes 100 percent. In other words, per capita output in Germany would be estimated to be equal to that of the United States. This conventional measure of international compar isons is a unique number for given estimates of per capita output of any two countries (denominated in their respective national currencies) and a given ex change rate. Also, the conventional measure is easy to construct. These attractive features explain why the conventional measure is regularly published and widely quoted.5 However, this procedure is fraught with conceptual difficulties. So much so that since the early 1950s, there have been concerted attempts to construct more appropriate measures.6 The im4D M 4/$1.00 denotes that 4 units of the German currency (Deutsche mark) can be exchanged for one U.S. dollar. sStatistical Yearbook, 1976 (N ew York: United Nations, 19 7 7 ), pp. 686-88; The World Bank Atlas: Population, Per Capita Product, and Growth Rates (W orld Bank, 1 9 7 6 ); “East vs. W est: W ho’s Richer — and W hy,” The Morgan Guaranty Survey (February 1 9 7 8 ), pp. 6-9; and “A Special Report — Socialism: Trials and Errors,” Time (M arch 13, 1 9 7 8 ), espec ially pp. 26-27. ''For a pioneering study of international comparisons based on an extensive collaboration with the statistical agencies of the countries involved, see Gilbert and Kravis, An International Comparison of National Products. Fo r a follow-up study with an expanded coverage, see Milton Gilbert and associates, Comparative National Products and Price Levels; a Study of Western Europe and the United States (Paris: O EEC , 1 9 5 8 ). For a recent study, see Irving B. Kravis, Zoltan Kenessey, Alan Heston and Robert Summers, A System of International Comparisons of Gross Product and Purchasing Power (Balti- MAY 1978 portant point to note for now is that the allegation that the United States has lost its lead in per capita output in the 1970s has been based exclusively on the conventional measure of international comparisons. T h e Nature of the Difficulty W ith the Conventional M easure International comparisons of per capita output must be based, in principle, on a comparison of the quantities of both internationally traded goods (such as radios) and non-traded goods (such as haircuts) produced in different countries.7 The basic difficulty with the conventional measure, which uses prevailing exchange rates, is that this measure is known to be valid only when (a ) the relative prices of traded and non-traded goods are identical between the countries (a haircut costs the same amount in terms of radios in both countries), and (b) the prevailing exchange rate is such that the prices of traded goods are equalized (an American-made radio costs just as much as one of similar quality made in Germany). These conditions, especially the one calling for iden tical price structures (relative prices) in each coun try, are unlikely to be met. Therefore, there can be no presumption that the procedure underlying the conventional measure would yield a valid measure of comparison. To clarify this point, consider the example given in Table I. There are two hypothetical countries, Alpha and Beta. Prices in Alpha are denominated in pounds, denoted by £ . Beta’s prices are denom inated in dollars, denoted by $. Country Beta is assumed to produce greater amounts per capita of both traded goods, such as radios, and non-traded goods, such as haircuts. Country Alpha produces % as many radios per capita as country Beta and % as many haircuts per capita. If we compared only the traded goods, Alpha’s output would be % or 66.7 percent of Beta’s; on the basis of non-traded goods, Alpha’s output would be % or 33.3 percent of Beta’s output. However, the task of comparing per capita output internationally is to express country Alpha’s more and London: the Johns Hopkins University Press for the World Bank, 1 9 7 5 ). The first two studies are based on the comparison of GNP and its components. The study by Kravis, et al. deals with the GDP and its components. 7Non-traded goods, of course, include government provision of goods and services which are not priced in the market place. Valuation and comparison of such government output present difficult conceptual and measurement problems which are ignored in this paper. For a recent attempt to deal with the problem of valuing government output, see Keith Leffler, “Government Output and National Income Estimates: The Effect on International Comparison” (forthcoming in Carnegie-Rochester Conference Series, 9, 1 9 7 8 ). Page 9 FEDERAL RESERVE BANK OF ST. LOUIS MAY 1978 Table 1 H ypothetical E x am ple W ith Identical Relative Prices Traded Goods: Radios (per capita) Non-Traded Goods: Haircuts (per capita) (1) (2) (3) = ( 1 ) X (2) (4) (5) (6) = ( 4 ) X ( 5 ) Country Price Quantity (per capita) Expenditure (per capita) Price Quantity (per capita) Expenditure (per capita) (7) = ( 3 ) + (6) Total Expenditure (per capita) Alpha £10 10 £100 £50 4 £200 £300 $1 30 $30 $5 6 $30 $60 Beta total output per capita as a percentage of country Beta’s total output per capita. Therefore, a valid measure of comparison would fall somewhere within the upper and lower limits of the ratios (expressed in percentages) of the quantities of each good and service produced in one country to those of another. For this example, a valid measure of comparison must place the total per capita output of Alpha somewhere between 33.3 percent and 66.7 percent of that of the total per capita output of Beta. Conversely, any meas ure that does not fall within these limits is not a valid measure. In Table I, the relative price of radios and haircuts is assumed to be identical in both countries, that is, radios cost 5 times as much as haircuts in both coun tries (£ 5 0 / £ 1 0 and $5/$l). The average level of prices in Alpha (in £ ) is assumed to be 10 times higher than that in Beta (in $). If the exchange rate is £10/$1.00, as is likely under free trade, the under lying condition that justifies the use of the conven tional measure is met. The relative level of per capita output of Alpha would be computed by first dividing the aggregate value of its per capita output (£.300) by the exchange rate and then expressing the result ing figure of $30 (£ 3 0 0 £10/$1.00) as a percent age of the aggregate value of Beta’s per capita output ($60). In this instance, the resulting conventional measure is 50 percent which falls within the limits required for a valid measure. However, there is no presumption that the proce dure underlying the conventional measure would yield a valid measure of comparison when relative prices differ between countries. To analyze a more likely case where relative prices of traded and non traded goods are different between countries, con sider the example given in Table II (which is identi cal to Table I except that the price of radios in Alpha is now £ 1 5 rather than £ 5 0 ). Relative prices in the two countries are no longer identical. Radios cost 5 times as much as haircuts in Beta whereas radios cost only 1% times as much as haircuts in Alpha. Since the prices of traded goods are assumed to be equalized internationally through adjustment in the exchange rate, the equilibrium exchange rate would be £3/$1.00 for this example. The conventional measure for comparing per capita output in this in stance would be 88.9 percent [( £ 1 6 0 -r- £3/$1.00) -f- ($60) = .889]. Thus, the conventional measure is immediately seen to be an invalid measure for com paring per capita output since it is even higher than the highest of the relative quantities in the example (66.7 percent for radios, the traded good). As these examples demonstrate, only under the twin assumptions of (a) identical domestic price structures (relative prices) across countries and (b) a market determined exchange rate which equalizes the prices of traded goods would the procedure underlying the conventional measure yield a valid measure for com paring per capita output between countries. These special assumptions are not generally met for a variety of reasons. Inter-country productivity differ entials across commodity groups (such as traded vs. non-traded goods) would result in different domestic price structures. Also, government interference, Table II H ypoth etical E x am ple W ith Different Relative Prices Non-Traded Goods: Haircuts (per capita) Traded Goods: Radios (per capita) (1) (2) (3) — (1) X (2) (4) (5) (6) = (4) X (5) Country Price Quantity (per capita) Expenditure (per capita) Price Quantity (per capita) Expenditure (per capita) Alpha £10 10 £100 £15 4 £60 £160 $1 30 $30 $5 6 $30 $60 Beta 10 Digitized for Page FRASER (7) = (3) + (6) Total Expenditure (per capita) MAY FEDERAL RESERVE BANK OF ST. LOUIS through such devices as exchange controls and import quotas, distorts the exchange rate such that it may not equalize the prices of traded goods between the two countries. Even where the exchange rate is allowed to be determined freely in the foreign exchange market, one is not likely to observe equal prices for traded goods. Some prominent reasons given for this are the differences in (a) the cost of transportation, proc essing and distribution, both between and within countries, (b) tax structures (indirect vs. direct taxes), and (c) selective subsidies on certain classes of commodities.8 Hence, the conventional measure based on the ex change rate is not necessarily a valid measure for comparing per capita output between countries. The point to note is that the conclusions regarding the comparative levels of per capita output since 1950 and the allegations about the United States falling behind in the 1970s are founded on no more substan tive basis than the conventional measure of interna tional comparison discussed and illustrated in this section. Table III C o m p u tatio n o f PPPs a n d M e a su re s o f In tern ation al C o m p a riso n 1 C o m p u tatio n o f PPPs For Table I £ 1 0 (1 0 ) + £ 5 0 (4 ) PPPOt = $1 (10) + $ 5 (4 ) = [PPPOC denotes an estimate using (1 0 haircuts and 4 radios) A generally valid measure for comparing per capita output between countries can be constructed by using what is known as the purchasing power parity (PPP) of currencies. PPP is defined as the ratio of the num ber of units of one country’s currency (say Deutsche mark) to the number of units of another country’s currency (say the U.S. dollar) which are required to purchase the same bundle of both traded and non traded goods. To estimate PPP, the total per capita output of a given country is priced first by the prices prevailing in the given country and then by the other country’s prices. An estimate of PPP is obtained by the ratio of the resulting market values of the total per capita output which has been priced. An alterna tive estimate of PPP may be obtained by pricing the total per capita output of the other country. Ex amples of PPP calculations are shown in Table III. For the example in Table I where the price struc tures are identical, PPP is unique (at £10/$1.00) 8Fo r a discussion of the limitations of the conventional measure, see Gilbert and Kravis, An International Comparison of Na tional Products, pp. 14-17. Also see Paul A. David, “Just How Misleading Are Official Exchange Rate Conversions?” E co nomic Journal (September 1 9 7 2 ), pp. 979-90; Robin Rarlow, “A Test of Alternative Methods of Making GNP Compari sons,” Economic Journal (September 1 9 7 7 ), pp. 450-59. £300 „ , W = £ , 0 / $ ’ -00 Alpha's quantities as weights] £ 1 0 (3 0 ) + £ 5 0 (6 ) £300 . ^ PPPli = $ 1 (3 0 ) + $ 5 ( 6 ) = 130" = [PPPP denotes an estimate using Beta's quantities (3 0 haircuts and 6 radios) as weights] For Table II £ 1 0 (1 0 ) + £ 1 5 (4 ) PPPOt = $ 1 ( 1 0 f + $ 5 ( 4 ) ... = pppP £ 1 0 (3 0 ) + £ 1 5 (6 ) $1 (3 0) + $ 5 ( 6 ) — £160 -$ 3 T = £390 $60 _ _ ^-33 /$l .00 £ 6 .5 / $ 1 .0 0 Com pu tation o f P P P -b ase d M e asu re s of C o m p a riso n 2 For Table I £300 PPP-based measure = £300 Alternative M easure of International Comparisons Based on Purchasing Power Parities 1978 1 1 = "W $30 £ 10/$1.00 = $ ^ = -5 or 50 percent For Table II £160 1 Estimate Based on PPPCX — _ £ 16 0 ~ pppcc 1 £ 5 . 3 3 / $ 1.00 = Estimate Based on PPPp — = '5 £ 1 60 1 ~$£0~ PPP|3 £160 1 ~$6cT £ 6 .5 / $ 1 .0 0 = ° r 50 percen' ' 41 ° r 41 percen‘ C o m pu tatio n o f the C o n ve n tio n a l M e a su re 3 For Table I Conventional measure — £300 = “ $^o~ £300 $$0 1 1 $30 £ 1 0 /$ 1.00 = $15 - -5 or 50 percent For Table II Conventional measure = £160 $60 1 £ 3 / $ l .00 £160 1 ^ $53.33 $60 = .889 or 88.9 percent *A detailed explanation of the procedures used in this table is pro vided in the unpublished technical Appendix which is available from the author upon request. 2Obtained by deflating the ratio of per capita total expenditure by the estimated P PPs. 3Obtained by deflating the per capita expenditure ratio by the exchange rate. The exchange rate is assumed to be such that the prices of traded goods are equalized. Page 11 FEDERAL RESERVE BANK OF ST. LOUIS and would be equal to the exchange rate if the ex change rate is such that the prices of traded goods are equalized.9 When the price structures are different as in Table II, however, the PPP is not, in general, equal to the exchange rate.10 Hence, the alternative measure for comparing per capita output based on PPP is not in general equal to the conventional measure based on the exchange rate. To illustrate the difference in the exchange rate-based conventional and the PPP-based alternative measures of international comparisons of per capita output, refer to Table III. Computations reported in Table III illustrate that the PPP-based measures are valid for comparison in the sense that they (being 41 percent and 50 percent) lie between the upper and lower limits (66.7 percent and 33.3 percent) of relative quan tities of traded and non-traded goods. As noted above, the conventional measure derived by the use of the exchange rate, on the other hand, is inappro priate in that it, being 88.9 percent, lies outside of these limits. In general, the use of PPP first to con vert the per capita output of a given country into common currencies and then to express it relative to the per capita output of the base country yields without exception a valid measure for comparing the per capita output of the two countries.11 9For a discussion of the relationship between the exchange rate and the purchasing power parities (P P P ) of currencies, see Bela Baiassa, “The Purchasing-Power Parity Doctrine: A Reappraisal,” Journal of Political Economy (Decem ber 19 6 4 ), pp. 584-96. When PPP is equal to the exchange rate, the absolute version of the purchasing power parity doctrine is said to hold. The doctrine posits a relationship between the rate of exchange between two currencies and the purchasing power of currencies over both traded and non-traded goods in two countries. The absolute version links the level of exchange rates one-for-one to the purchasing power parities, whereas the relative version of the doctrine relates the re quired adjustment in the exchange rate (from the posited base-period equilibrium exchange rate) to the relative changes in the general price levels. There are no theoretical reasons for either one of these versions of the doctrine to hold, unless the relative price structures either remain unchanged or become identical. See Baiassa, “Doctrine,” pp. 584-87. 10Computations given in Table III show that PPP is not equal to the exchange rate (assumed to be £ 3 / $ 1.00) but ranges between £ 5 .3 3 /$ 1 .0 0 and £ 6 .5 /$ 1 .0 0 . This reflects the fact that, given the lower relative price of traded goods in Alpha, the comparative purchasing power in Alpha’s currency over both traded and non-traded goods is lower than that indicated by the exchange rate which takes into account only the prices of traded goods. Thus, whereas the exchange rate indicates £ 3 is equivalent in purchasing power ( over the traded good) to $1.00, the PPP indicates that £ 5 .3 3 (or £ 6 . 5 ) is equivalent to $1.00 in buying power over both the traded and non-traded goods. Further, the use of own quantity weights, rather than the quantity weights of Beta, results in a larger estimate of the purchasing power of £ ( that is, a smaller estimate of P P P ) because relatively cheaoer traded goods get a greater weight in the estimation of PPP. When PPPs are not unique, geometric averages of the different estimates of PPP are often used. U A more general substantiation of these points, made so far Digitized forPage FRASER 12 MAY 1978 International Comparisons of P er Capita Output Based on PPPs The alternative PPP-based measures for comparing per capita output have not been widely used in the past, however, primarily because of the relatively high cost of constructing them. Conventional meas ures can easily be constructed with data routinely available in regularly published statistical releases. The data collection and processing requirements for the construction of the PPP-based measures are stag gering. Such measures require, in principle, price and quantity information on each individual good and service produced in different countries.12 In addition to the cost of data collection, the existence of com modities which are unique or not identical in quality (such as a Rolls-Royce vs. a Volkswagen) poses both conceptual and measurement problems.13 The high cost of using the PPP method explains why the estimates based on this method are available for only a selected number of countries and only for selected periods.14 Essentially, PPP-based estimates are available for 1950, 1960 and 1970. Table IV lists PPP-based estimates relative to the United States for a sample of countries for which data are available for some years through 1970 (with the exception of Switzwith the aid of simple examples, is provided in an unpub lished technical Appendix which is available from the author upon request. It is shown in that Appendix that the basic diffi culty with the conventional measure is that the procedure un derlying its computation does not yield, in general, a measure called a quantity index (th at is, a weighted average of the quantity ratios or relatives of each distinct group of commod ities). It is a quantity index which must be constructed in order to make an international comparison of per capita out put of goods and services. The procedure underlying the conventional measure is shown to be equivalent to deflating the ratio of per capita expenditures (expressed in different currency units) by the prevailing exchange rate. An alter native approach by which the per capita expenditure ratio is deflated by an estimate of the purchasing power parity ( P P P ) of currencies is shown to yield — without exception — a quantity index. Hence, the alternative, PPP-based estimates of comparative levels of per capita output must be used to make a valid comparison of per capita output across countries. 12In practice, however, price and quantity data on aggregate categories — such as men’s clothing, passenger cars, furni ture, and physicians’ services — are constructed by decom posing the more readily available expenditure data, using primarily the price data on selected components of each category, for example, dress shirts and business suits for the men’s clothing category. The most recent U.N. study uses for example, 153 such expenditure categories. See Kravis, et al., A System of International Comparisons, p. 171. 13For a discussion of the statistical procedures used to deal with these problems, see Gilbert and Kravis, An International Comparison of National Products, pp. 79-91; Kravis, et al., A System of International Comparisons, pp. 31-34. 14Fo r an exhaustive list of the countries and the time periods for which the PPP-based measures are available, see Irving B. Kravis, “A Survey of International Comparisons of Pro ductivity,” Economic Journal (M arch 1 9 7 6 ), p. 19. FEDERAL RESERVE BANK OF ST. LOUIS MAY 1978 Table IV Intern ational C o m p a riso n s o f Per C a p ita O utput 1950, 1960, (U .S. = 1970 100) Conventional Measure Via Exchange Rates 1950 United Stales Canada Switzerland Sweden Belgium Denmark United Kingdom France Norway Netherlands West Germany Italy India Japan 100 66 52 47 43 39 38 37 34 26 25 16 N.A. N.A. 1960 100 79 52 67 44 46 49 48 46 35 46 25 N.A. 16 Alternative Measure Via Purchasing Power Parities 1970 1950 1960 1970 100 80 72 86 55 66 46 58 60 51 64 36 2 39 100 75 N.A. 58 52 55 55 46 52 45 37 25 N.A. N.A. 100 77 N.A. 100 83* N.A. 78' 72 72 * 60 75 63 * 72 75 46 7 62 69 57 63 64 58 55 52 64 33 N.A. N.A. Source: International Monetary Fund, In tern a tio n a l F in a n c ia l S tatistics (May 1977), O EEC, Balassa and the United Nations. * Based on extrapolation using the growth rates of real per capita output. N .A .: not available. erland). Compared to the conventional measure given in the same table, the PPP-based measure indicates that the U.S. lead in per capita output was not as great in 1950. For example, the U.S. per capita output was a trifle more than twice that of the Nether lands according to the PPP-based measure, rather than the nearly four fold lead indicated by the ex change rate-based measure. Both measures indicate that the gap has narrowed over the 20-year period and that the U.S. lead has yet to be overtaken through 1970.15 The alternative (PPP-based) measure indicates, however, that the narrowing of the gap in most cases has not been as dramatic as indicated by the conventional measure.16 15For those countries for which the PPP-based measure was available for 1960 and earlier but not for 1970, the 1970 estimate was obtained by extrapolating the 1960 measure by the differential growth rates of real per capita output be tween the given country and the United States. laTable IV also indicates that the conventional measure based on the exchange rate tends to be lower than the PPP-based estimate over this period. However, given the varying de grees of intervention in the foreign exchange markets and changes in the role a national currency (such as the U.S. dollar) plays as international means of payment and store of value, there is no necessity for the conventional measure to be systematically lower than the PPP-based measure, espec ially for countries with relatively similar price structures and productivity. The fundamental point to note is that the PPP-based measure is a valid measure without exception and that the conventional measure can be on either side of the PPP-based measure, depending upon the particular histori cal circumstances that happen to prevail. Even the direction of bias in the conventional measure cannot be assessed a In order to assess the allegation, based on the con ventional measure, that the United States has lost its lead in per capita output in the 1970s, we proceed as follows. For each selected country the latest available PPP-based estimate of per capita output is projected forward in time by using the various countries’ actual growth rate in per capita output. The PPP-based estimate for the United States is similarly projected. Comparison of the projections for each country, ex pressed as percentages of the projection for the United States, is then made. As an illustration of the method, the PPP-based estimate for West Germany in 1970 can be used. The PPP-based estimate of per capita output for Germany in that year is 75 percent of that of the United States. To derive the PPP-based estimate for 1976, for ex ample, the German per capita output for 1970 was calculated by first multiplying the 1970 U.S. per capita output by the PPP-based measure of comparison for priori but must be determined on a case-by-case and countryby-country basis, that is, only after the conventional measure is compared to the PPP-based measure. The observed ten dency of the conventional measure to be lower than the PPP-based estimate over this period has been explained in terms of greater inter-country productivity differential in the traded-goods sector (such as manufacturing and agriculture) than in the non-traded goods sector (such as personal serv ices and government). The presumption has been that there is a greater opportunity for technological innovations in the traded goods sector. Fo r details, see Balassa, “Doctrine.” Page 13 FEDERAL RESERVE BANK OF ST. LOUIS MAY 1978 Table V Intern ational C o m p a riso n s o f Per C a p ita O utput 1970, 1 974-76 (U .S. = 100) Conventional Measure Via Exchange Rates Alternative Measure Via _________ Purchasing Power Parities 1970 1974 1975 1976 1970 1974 1975 1976 100 100 100 100 100 100 100 100 Canada 80 100 100 105 83 91 93 91 Switzerland 72 115 122 117 N.A. N.A. N.A. N.A. Sweden 86 103 118 114 78 78 80 77 Belgium 55 83 90 87 72 79 79 N.A. Denmark 66 90 98 96 72 72 72 72 United Kingdom 46 51 57 49 60 61 61 59 N.A. United States France 58 76 89 83 75 81 N.A. Norway 60 87 99 98 63 67 71 71 Netherlands 51 79 84 82 72 76 75 75 76 West Germany 64 92 95 92 75 76 76 Italy 36 42 44 38 46 47 46 46 N.A. N.A. N.A. 7 N.A. N.A. N.A. 62 62 62 62 68 71 70 India Japan 2 39 Source: The same as Table IV . Computations of PPP-based measures are based on extrapolation using relative rates of growth of real capita output. Germany for 1970. The German per capita output in 1970 (in 1970 U.S. prices) is $3596 (75 percent of $4795 for the U.S. in 1970). This 1970 German per capita output was extrapolated to 1976 by using the average growth rate (2.3 percent per year) of the German real per capita output over the 1970-1976 period. The resulting figure of $4125 was 76 percent of the 1976 per capita U.S. output (in 1970 U.S. prices). Consequently, the estimated PPP-based meas ure in 1976 was 76 percent for West Germany.17 Table V provides comparisons based on these extra polated estimates and on the conventional measure 17This method admittedly involves the assumption that the price structure in one country has not changed relative to that of the other country over the extrapolation period. It may appear that the objection raised to the use of the exchange rate, that it assumes identical price structures across countries, is applicable to this method of extrapolat ing the PPP-based estimate. However, this extrapolation method is superior for the purpose of comparing the levels of per capita output since the use of the PPP provides a correct gauge of the comparative levels of per capita output for the initial period. The use of the exchange rate would not lead to a correct measure of relative levels of per capita output at any time over the entire period of comparison, as long as the price structures are not identical. The basic reasons of course, are that the PPP-based method, unlike the exchange rate method, is not distorted by the different de grees of intervention in the exchange market and that the method allows for the differences in the prices of both traded and non-traded goods. The available evidence indi cates that this extrapolation method is superior to the exchange rate-based method. See the discussion below and Kravis, et al., A System of International Comparisons, pp. 8-9, especially footnote 13. 14 Digitized for Page FRASER for 1970, and for 1974 through 1976.18 The numbers are in index form, with the United States scaled at 100. Therefore, if a number exceeds 100, it sustains the claim that the United States has been overtaken by that country. The conventional measure indicates that some coun tries have overtaken the United States in the 1970s. Per capita output in Switzerland, for example, was 72 percent of the United States in 1970. By 1974, Swiss per capita output exceeded that of the United States, standing at 115 percent of that of the United States. Such a reversal in the comparative position is hard to accept, however, because of what it implies about the relative growth rates of per capita output over the 1970-1974 period. The conventional measure implies that per capita output in real terms in Switzer land has grown at the annual rate of 14.9 percent over this period while U.S. per capita output has grown at a 2.3 percent annual rate. Per capita output in 18Contrary to the pattern observed in Table IV, the conven tional measure using the exchange rate is higher after 1970 than the PPP-based measure in most cases. However, as noted in footnote 16, there is no necessary reason for the conventional measure to fall on either side of the PPP-based measure. In this paper, there is no discussion of the factors producing this difference in pattern. It can be noted, how ever, that key factors explaining the difference are ( a ) a steady increase over the period in the number of convertible currencies; ( b ) varying degrees of intervention in the foreign exchange markets; ( c ) varying degrees of constraints on goods and capital movements; and (d ) the changing role of the U.S. dollar as a reserve currency. FEDERAL RESERVE BANK OF ST. LOUIS Switzerland, in fact, has grown even slower than that of the United States over this period, at 2.1 percent per year compared to 2.3 percent. Such an anamolous result holds in general. Per capita output in Sweden, for example, has grown at the same rate as that for the United States over the same (1970-1974) period. The conventional measure, however, shows that per capita output in Sweden has increased substantially (close to 20 percent) relative to that for the United States. Comparison of estimates derived from the more appropriate PPP-based measure does not support the claim that the U.S. lead in per capita output has been overtaken in the 1970s. For example, whereas the conventional measure for Sweden reached its high of 118 in 1975, the PPP-based measure was only 80 per cent of U.S. per capita output. The conventional meas ure also placed Canada ahead of the United States in 1976; however, its PPP-based measure was below that of the United States, at 91 percent. As noted in Table V, PPP-based estimates of per capita output for Switzerland are not available. However, in view of the low growth rate of per capita output in Switz erland relative to the United States since as far back as 1960 (1.98 percent vs. 2.36 percent), when the U.S. lead was judged to have been substantial (see Table IV ), it is not likely that Switzerland had over taken the lead by 1976. CONCLUSION The allegation that the United States has been over taken in its per capita output by a number of indus MAY 1978 trialized countries in the 1970s is based on an ex change rate-based measure which has been shown to be unreliable. When estimates of the more appropriate PPP-based measure are constructed, the allegation is not supported. That does not mean that one should be complacent about the performance of the U.S. econ omy. But it denies the factual basis for the claim that “[rjelative to achievements in the rest of the world, the U.S. economy no longer ‘delivers the goods.’ ”19 Although the United States has yet to lose its lead in per capita output, the estimates of PPP-based measures through 1976 indicate that the U.S. lead has indeed narrowed since 1950. One could cite many contributing factors to this development — such as the imperatives for reconstruction provided for some countries by the ravages of World War II, and the opportunities for adapting available production tech nologies.20 However, the fact that the U.S. lead has been narrowed does not necessarily mean that it is bound to be overtaken in the future. The future is not necessarily an extrapolation of past trends. The comparative levels of U.S. per capita output in the future will be determined solely by this country’s relative success in harnessing opportunities for growth in per capita output. 19Thurow, “The Myth.” 20See Edward F . Denison, “The Contribution of Capital to the Post-War Growth of Industrial Countries,” in U.S. Economic Growth From 1976 to 1986: Prospects, Problems, and Pat terns — Volume 3 Capital, Studies prepared for the use of the Joint Economic Committee, 94th Cong., 2nd Sess., No vember 15, 1976. Page 15 Rising Farmland Prices and Falling Farm Earnings: Is Agriculture in Trouble? N EIL A. STEVENS U.S. farm real estate values have risen rapidly in recent years.1 In the five-year period from 1972 to 1977, the average price of an acre of U.S. farmland increased 114 percent, or at an annual rate of 16.5 percent. This rate of gain for farmland is the most rapid for any five-year period in this century and compares with a 6 percent annual rate of increase in the thirty years ending in 1972. At a time when some alternative investments, notably many common stocks, have performed less spectacularly, and when assets which offer a hedge against inflation are highly desired, farm real estate has been very at tractive. In fact, ownership of farmland has provided more than simply a hedge against inflation as in creases in farmland values have substantially out paced the rate of general price inflation. These increases in farmland values have brought about substantial gains in the wealth of landowners who made land purchases prior to, or in the early stages of, the present farmland price boom. Yet, while most landowners have become wealthier, lower farm commodity prices and sharply higher costs of production in recent years have substantially de pressed farm earnings from the level of three to four years ago. These conditions, in turn, have led to sub stantial cash flow problems for those farmers who financed purchases of land at the elevated prices of recent years and who must continue to meet periodic large interest payments as well as other fixed costs. Such a financial “squeeze” apparently underlies the recent farmers’ strike movement. to changes in its price, especially in the near term, changes in the price of land reflect primarily changes in the demand for the services it provides. In addi tion to agricultural uses, land is demanded for many other uses including residential, industrial, commer cial, and recreational. The price of most agricultural land, however, re flects primarily the value of the agricultural prod ucts that it can produce. That is, the demand for farmland is derived primarily from its role as an input into the production process for food and fiber. Thus, the earnings accruing to farmland are affected by numerous supply and demand factors affecting agricultural products. Among these factors are ag gregate incomes in the economy, population, export demand, prices of nonagricultural goods, prices of non-land inputs into agricultural production, agricul tural technology, and government farm programs.2 Farmland is a durable asset, yielding a stream of services, or earnings, over time. Consequently, the price of farmland, although influenced by current earnings, reflects the stream of earnings which are expected over its life.:i Investors must, therefore, ana 2For a summary discussion of the outlook for agriculture in 1978, see Clifton B. Luttrell and Neil A. Stevens, “Outlook for Food and Agriculture,” this Review (January 1 9 7 8 ), pp. 15-22. Fo r a discussion of the problems and effects of Gov ernment price supports on agriculture, see Clifton B. Luttrell, “Farm Price Supports at Cost of Production,” this Review (Decem ber 1 9 7 7 ), pp. 2-7. 3In investment theory terminology, the stream of earnings is discounted or capitalized in order to determine its present value. The present value ( P ) of a constant stream of earnings i Determ ination of Land Values Land is an asset which is relatively fixed in sup ply. Since the quantity of land is not very responsive 'F arm real estate values and farmland values are used inter changeably. Farm real estate values is the more appropriate term for the U.S. Department of Agriculture data used in this paper since it includes the value of buildings and other per manent structures on the land. 16 Digitized forPage FRASER . -r. can be written as P = 1^° jq j. i + i i + ••• + (l+i)n > where E 0 is net earnings, i is the opportunity cost of credit, and n is the number of periods over which the earnings are expected. This formula can be written in shorthand form as t £ 2 ------"— . For example, earnings of $100 per year for the n=l (l+i)n next ten years discounted at a 5 percent interest rate is worth approximately $772 today. When n becomes very large, the T7 formula reduces to the simple formula P = ~ y . When a FEDERAL RESERVE BANK OF ST. LOUIS MAY 1978 lyze the demand and supply factors which can in fluence the future income stream of the asset and form some judgment as to the probable pattern of that income stream. If, for example, population growth is expected to increase from 2 percent a year to 3 percent a year, investors would probably raise their expectations of future earnings from farmland, other things equal, and the price of farmland would be bid up immediately to incorporate this change.4 Farm land Values and Earnings T h e Historical R ecord — Farmland has been a “good” investment over the past thirty-five years in the sense that the average value of an acre of U.S. agricultural land has increased more rapidly than the rate of inflation. Farmland values, deflated by the GNP implicit price deflator, rose at an average rate of 2.6 percent per year from 1942 to 1972. Beginning in 1972 farmland values ac celerated sharply, rising almost 9 percent per year faster than the general inflation rate from 1972 to 1977 (Chart I). Farmland investments have also performed well when compared with most common stock invest ments. In the past ten years, farm real estate values in nominal terms have advanced at an 11 percent an nual rate while common stock prices, as measured by the Standard and Poor’s 500 Index, have remained about unchanged.5 In the previous twenty years com mon stock prices rose at a 9.4 percent rate, compared with a 5.2 percent rate for farmland prices. Such a divergent pattern for these two types of investments is symbolic of a substantial shift in investors’ expecstream of returns is expected to increase g percent per year, the formula can be rewritten as Z E "( ^ When n n= l (l+i)» becomes very large and i is greater than g, the formula bep comes P0 — Eo . 4For studies which have attempted to determine which factors underlie real estate movements, see Marvin Duncan, “Farm Real Estate Values — Some Important Determinants,” Federal Reserve Bank of Kansas City Monthly Review (M arch 1 9 7 7 ), pp. 3-12; Luther G. Tweeten and Ted R. Nelson, “Sources and Repercussions of Changing U.S. Farm Real Estate Values,” Technical Bulletin T -120, Oklahoma State University (April 1 9 6 6 ); Robert W . Herdt and Willard W . Cochrane, “Farmland Prices and Farm Technological Advance,” Journal of Farm Economics (M ay 1 9 6 6 ), pp. 243-63. “While different growth rates were observed for the two assets, the rates of return on investments are not necessarily differ ent. In fact, over the longer term, rates of return for assets tend to equalize when differences in risks are taken into ac count. If, for example, the rate of return of a particular asset is substantially above that of other investments, investors will tend to switch into the higher-yielding assets, thereby bidding up the price of the asset relative to that of other assets. L l_ N o m in a l farm real e state v a lu e s a re d e fla t e d b y the G N P im plicit p ric e d eflato r. tations about the future earnings of these two investments. Historical data on earnings from farmland as a sep arate factor of production are not readily available. However, a measure of earnings on total farm assets is computed by the U.S. Department of Agriculture and can be used here as a proxy measure for farm land earnings.6 As shown in Chart II, these earnings on farm production assets (in nominal terms) have trended upward since 1950. Especially noticeable is the sharp rise in earnings in the early 1970s when earnings from farm assets rose 200 percent from 1971 to 1973, then subsequently fell. Earnings adjusted for changes in the general price level also increased sharply in the 1971-73 period, but by 1977 real earn ings were only 15 percent above the 1971 level. An Analysis of Price and Earnings The ratio of the value of farm production assets to earnings on these assets is a useful tool for analyz ing the behavior of farm earnings and farm real estate values. This ratio, similar to the price-earnings ratio used in stock market analysis, is a measure of 8Farm real estate comprised approximately 80 percent of all farm production assets in 1977. Earnings on farm assets are total net income of farm operators from farming plus net rent to nonfarm landlords and interest on farm debt, less adjust ments for farm operators’ labor and management. Page 17 FEDERAL RESERVE BANK OF ST. LOUIS MAY 1978 however, the ratio has continued to rise and by 1977 the value of farm assets was estimated to be 31 times current earnings, well above the average ratio of the 1950s and 1960s. One interpretation of this most recent rise in the P/E ratio is that investors revised upward their ex pectations concerning long-run prospects for future eamings on farm assets following the surge in eam ings in 1972 and 1973. An acceleration in real estate prices would accompany such an upward revision in eamings as these expectations are capitalized into cur rent land prices. In this case, the recent shortfall in farm earnings would appear to reflect an investor view that such low eamings were a temporary phenomena. S o u rc e : U.S. D e p a rt m e n t o f A g ric u ltu re LL A n n u a l a v e r a g e o f 1 9 5 0 -5 4 p e rio d is 6 6.4 12 A n n u a l a v e r a g e o f 1 9 5 0 -5 4 p e rio d is 2 0.6 the confidence that investors have in the future earn ings of one investment relative to another. For ex ample, the higher the price-earnings ratio (P/E), the greater is the expected growth rate of earnings from the current level and the more certain investors are that a given stream of earnings will be realized.7 As shown in Chart II, earnings on farm production assets and the value of these assets generally trended upward together in the 1950s and 1960s. Fluctuations in the P/E ratio occurred, but the price of farm assets averaged 26 times earnings from 1950 to 1971. The P/E ratio fell sharply in 1972 and 1973, but has risen significantly since then. These recent movements in the P/E ratio reflect the unusual pattern of earnings in this period. The sharp rise in earnings in 1972 and 1973 was not im mediately and completely incorporated into future expectations. Thus the P/E ratio fell to an abnormally low level when compared with historical values. Earn ings subsequently began falling and the P/E ratio began rising. Instead of reestablishing a value at around the average ratio of the 1950s and 1960s, 7The greater the degree of certainty the less is the return re quired to compensate for risk. The investors’ perception of risk may be based, for example, on the variability of eamings. To compare P /E ratios among alternative investments, the useful life of the investment must be similar since assets with a longer life span will have higher P /E ratios than shorterlived investments. Page 18 The fact that farmland prices relative to other prices have grown at an accelerated rate beginning in 1972 strongly suggests that investors’ expectations of eamings, indeed, have increased in real terms. Because of higher eamings expectations, investors have bid up the price of farmland. This has meant substantial wealth gains to landowners, but the rate of return to new farmland owners depends upon the correctness of these expectations of higher eamings which have been incorporated into land values. Should these expectations be revised downward in the market, thus leading to a general decline in farmland values, new owners will either have to sell their land at a loss or continue to farm the land at a lower rate of return than was anticipated when they made their original investment. Cash flow problems can develop when asset values are bid up considerably above that level which is consistent with current earnings. When purchases are heavily financed, as is usually the case for most farm land purchases, large interest payments, as well as other fixed costs, must be covered by current earn ings, unless other sources of income are available. Farmers who borrowed heavily to purchase land or who have borrowed on the increased market value of their land and who do not have other sources of income will experience financial trouble when realized earnings are considerably below the level anticipated at the time of purchase. The higher expectations for farm earnings reflected in the recent upsurge in land prices may be traced back to the 1972-73 period when farm commodity prices and farm asset earnings rose dramatically. The sharp rise in eamings in this period reflected changed supply and demand conditions for agricultural prod ucts. Unexpected sales of wheat and feed grains to the Soviet Union in mid-1972 served to reduce domes FEDERAL RESERVE BANK OF ST. LOUIS tic stocks and increase prices. A sharp decline in the production of Peruvian fish meal led to a shortfall in world protein supplies and an unanticipated in crease in export demand for soybean meal. The un expected decline in world crop production in 1972 and a realignment of world currencies led to large increases in export demand for U.S. crops. U.S. farm exports rose from about 15 percent of farm commod ity sales in 1971 to 25 percent in 1975. In addition to sharply increasing export demand, domestic de mand for food in the early 1970s was boosted by increases in government food assistance programs such as the food stamp program. Also, a number of factors adversely affected U.S. agricultural production in the early 1970s, such as wage-price controls, envi ronmental regulations, sharp increases in energy prices, and a drought-induced shortfall in U.S. crop produc tion in 1974. C h a rt III Price Trends ANNUAL -D A T A - Q U ARTERLY ---- D A T A ------ Farm Product Prices; Consumer Price I - T ( A I I Items) 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 So u rc e : U.S. Departm ent of L a b o r a n d U.S. D e p a rtm e n t o f Agricu ltu re All of these factors contributed to a sudden, large increase in agricultural earnings. Most of the factors behind this bulge in earnings were temporary as is indicated by the decline in earnings and farm com modity prices in recent years. As shown in Chart III, farm commodity prices rose much faster than con sumer prices from 1971 to 1973, but have since come back in line with the general price level in the economy. World grain production, aided by more favorable weather, has increased 14 percent since 1972-73, and oilseed and meal production across the world has risen 38 percent. U.S. crop production also snapped back from the 1974 disaster as weather con ditions normalized. In addition, funding for domestic MAY 1978 food assistance programs has levelled off and many of the factors, such as mandatory wage-price controls, which had disruptive effects on agricultural produc tion in the early 1970s have disappeared in recent years. If the bulge in earnings in the early 1970s was mostly temporary, then current earnings may not be too far out of line with longer-run supply and de mand forces. To the extent this bulge was the basis for the upward revision in investors’ expectations about farmland earnings, then farm assets, and farm land in particular, have become overvalued on the basis of fundamental supply and demand conditions in the market for agricultural products.8 Implications The farmers’ strike movement has brought consider able attention to the current “low” earnings in agri culture. One might infer from this movement that U.S. agriculture is in trouble and is near widespread bankruptcy. However, the fundamental factors affect ing U.S. agriculture appear relatively sound. The health of U.S. agriculture is heavily dependent on its ability to compete effectively in world markets. U.S. agriculture is very efficient and enjoys a com parative advantage in trade with most countries of the world. While the long-run prospects appear sound for U.S. agriculture, “hard times” may be experienced by some farmers who possibly made incorrect decisions based, perhaps, on misinterpretation of the bulge in earnings in the early 1970s. Cash flow problems have already developed for some farmers. Should earnings not rise in accordance with the expected earnings now built into land values, then agricultural land values will decline. Continued “low” earnings, if maintained, would eventually prompt a change in expectations by investors since farmland must compete with other in vestments. If farmers and other investors in farmland begin to doubt the future prospects for earnings growth, they will lower their bid prices for farmland coming into the market or attempt to sell land in order to take advantage of higher-yielding investment oppor tunities elsewhere. Farmland values would then de cline until the return on farmland has risen to a com parable level with returns on alternative investments.9 8Based on 1977 data, either a 20 percent rise in earnings or a 17 percent fall in the value of farm assets, or some com bination, would be necessary to reestablish the average ratio between farm assets and earnings which prevailed in the period from 1950 to 1971. 9The rate of increase for nominal farm real estate values has shown a tendency to slow in the past year. From February Page 19 If land values do decline, owners of farmland will experience losses in wealth. For most, this would simply reduce some of the gains experienced as prices rose. But those farmers who bought at the higher prices of the past few years will realize a lower rate of return on their initial investment than they ex pected, and some who are highly leveraged may be forced to leave agriculture, and the rate of bank ruptcy might increase for a time. Yet, equity in agriculture is large. In fact, the ratio of farm real estate debt to the value of farm real estate has actually fallen in recent years, from 1977 to February 1978, the average price of farmland rose about 9 percent compared with a 16.5 percent increase per year in the previous five years. about 14 percent in 1971 to about 11 percent in 1977. It would appear that most farmers would be able to weather some decline in land values without incur ring bankruptcy. In recent years over one-half of all farmland transfers have been to existing owner-operators of farms, where equity is often substantial in existing acreages, so cash flow problems are not as severe for these farmers. In the final analysis, the health of the agricultural industry reflects its efficiency in producing food and fiber products and the level of demand for these products. While investors’ expectations determine the value of farm real estate as well as other investments, these expectations cannot stay out of line with the fundamental supply and demand conditions for these investments for very long.