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May/June 1991

Vol. 73, No. 3




3 Pu blic C apital and P riv a te S ector
P e r fo r m a n c e
16 S u p ervision o f U n d e rc a p ita liz e d
Banks: Is T h e r e a Case
fo r C hange?
31 T h e FO M C in 1990: O nset o f
R ecession
53 U.S. P o lic y in th e B retton
W o o d s Era

THE
FEDERAL
> RESERVE
X IIA N K of
ST.I jOUIS

1

F ederal R eserve B ank of St. Louis
R e v ie w
May/June 1991

In This Issue . . .




A decline in the grow th o f U.S. productivity and international com ­
petitiveness has been caused by deficient public capital formation, accor­
ding to some public policy analysts. These analysts suggest that a sharp
rise in public capital form ation w ill be necessary to restore earlier
trends in productivity growth. In the first article in this Review, John A.
Tatom examines the production function estimates that provide the
underpinning fo r these arguments.
The author shows that simply accounting fo r the influence o f energy
price movements on productivity and fo r the slowing trend rate o f
technological change in the typical production function fram ew ork
reduces recent estimates o f public capital's effect on private sector out­
put by m ore than half. M ore important, Tatom argues, such findings are
examples o f “ spurious regression bias,” w h ere variables appear to be
statistically significantly related but are not. He explains this statistical
problem and shows how it applies to tests o f the public capital
hypothesis. W hen the private sector production function is appropriate­
ly estimated, Tatom explains, the public capital hypothesis is rejected;
the public capital stock has no statistically significant effect on business
sector output.
The author concludes that the pace o f public capital form ation has
played no role in accounting fo r movements in U.S. productivity.
* * *
Concern over the increasing number o f bank failures and the
resulting deposit insurance fund losses has led to numerous proposals
fo r bank regulatory reform . One recent proposal calls fo r bank super­
visors to undertake "prom pt corrective action” to achieve stronger en­
forcem ent o f bank capital requirements at undercapitalized banks, in­
cluding restrictions on their asset growth, shareholder dividends and in­
sider loans.
In the second article in this Review, "Supervision o f Undercapitalized
Banks: Is Th ere a Case fo r Change?” R. Alton Gilbert examines banks
whose capital ratios w ere below the specified minimum fo r periods
longer than one year during 1985 to 1989 to determine w hether they
generally violated the constraints that w ould be imposed under prompt
corrective action. He finds that, w hile most long-term undercapitalized
banks did not violate these constraints, a substantial m inority did so. He
also finds, how ever, that there was no significant difference in the
recovery rates betw een the banks that violated the "prom pt corrective
action” constraints and those that did not.
* * *

In the third article in this issue, "The FOMC in 1990: Onset o f Reces­
sion,” James B. Bullard presents this Review's annual synopsis o f the re-

MAY/JUNE 1991

2

cent actions o f the Federal Open Market Committee, the prim e policy­
making group in the Federal Reserve System. Calendar 1990 was an in­
teresting period from the perspective o f m onetary policy-watchers
because the national econom y slipped into recession in the latter half o f
the year, thus providing an opportunity to study policy-making during
the onset o f recession. In the context o f a chronology, the author em­
phasizes some difficulties that the Committee experienced in attempting
to implement its stated short-run policy goals. These include the p ro­
blems o f inaccurate short-term forecasting and the appropriate measure­
ment o f the policy stance.
* * *
In the final article o f this issue, Allan H. M eltzer, John M. Olin Pro­
fessor o f Political Economy and Public Policy at Carnegie Mellon U niver­
sity, discusses U.S. international economic policy during the Bretton
W oods era. His article, which was presented in St. Louis on April 8,
1991, as the fifth annual Hom er Jones Mem orial Lecture, review s the
roles o f the U.S. as the w o rld ’s strongest econom y and the dollar as its
reserve currency in a system o f fixed exchange rates. Key within this
review is the lack o f consistency betw een U.S. m onetary policy, which
ultimately (although unofficially) was responsible fo r maintaining the
fixed rate system and domestic policy objectives that often ran counter
to this goal. By noting this conflict and other tensions within the Bretton
W oods arrangements, M eltzer is able to trace the steps that led to the
collapse o f the fixed rate regim e in 1973.

FEDERAL RESERVE BANK OF ST. LOUIS



* * *

3

John A. Tatom
John A. Tatom is an assistant vice president at the Federal
Reserve Bank of St. Louis. Kevin L. Kiiesen provided research
assistance.

Public Capital and Private
Sector Performance

A

GROWING BODY o f literature now argues
that the public capital stock has significant,
positive effects on private sector output, pro­
ductivity and capital form ation.1 Most o f this
literature suggests that a decline in the grow th
o f the public capital stock since the early 1970s
caused a "productivity slump" in the private sec­
tor low ering profitability and investment.2
Unless these trends are reversed, say the studies,
the nation’s standard o f living w ill be further
threatened. This article explains this public capi­
tal hypothesis and evaluates the evidence sup­
porting it.

THE PUBLIC CAPITAL
HYPOTHESIS AND PRIVATE SEC­
TOR PRODUCTIVITY
Public capital comprises federal, state and
local governm ent capital goods. It includes high1
This argument will be referred to as the public capital
hypothesis; it has been developed most fully by Ratner
(1983), Aschauer (1989a), (1989b) and (1990) and Munnell
(1990). Also see Deno (1988) and Eberts (1990). The
hypothesis was suggested earlier by Schultze (1981), Ar­
row and Kurz (1970), Eisner (1980) and Ogura and Yohe
(1977).
2See The National Council on Public Works Improvement
(1988), Malabre (1990) and Reich (1991) for analyses that
attribute such consequences to the slowdown in public
capital formation. A previous article, Tatom (1991), ex­
plains how several factors account for the decline in the
rate of growth of the public capital stock. These factors
suggest that a reversal of this past decline would not be




ways, streets and roads, mass transit and air­
port facilities, educational buildings, electric, gas
and w ater supply facilities and distribution sys­
tems, w astewater treatm ent facilities, and ad­
ministration, police, fire, justice and hospital
facilities and equipment.
The public capital hypothesis is that the stock
o f public capital raises private sector output
both directly and indirectly. The direct effect
arises, according to the hypothesis, because pub­
lic capital provides intermediate services to pri­
vate sector firms, or the marginal product o f
public capital services in the private sector is
positive. The indirect effect arises from an
assumption that public and private capital are
"com plem ents” in production—that is, the partial
derivative o f the marginal product o f private
capital services w ith respect to the flow o f public
capital services is positive.3 Thus, a rise in public
capital raises the marginal productivity o f private
economically justifiable, even if the public capital stock
has the effects emphasized by the public capital
hypothesis.
3The notion of complementarity and substitutability used
here has been called q-substitutability and q-complementarity. It refers to the effect of the quantity of one resource
on the marginal product of another resource. The concept
of p-substitutes or p-complements is more common; these
terms refer to the effect on the demand for a resource of a
rise in the price of another resource, holding other
resource prices and output constant. See Sato and Koizumi
(1973) for a discussion of this distinction, or its use in
Tatom (1979b).

MAY/JUNE 1991

4

Figure 1
Business Sector Output per Worker and
Public Capital Stock per Worker
Thousands of dollars per worker
(1982 prices)
22.5

Thousands of dollars per worker
(1982 prices)

7.5
1947

53

59

65

71

1989

Note: capital stock is measured from the end of the previous year.

capital services so that, given the rental price o f
such services, a larger flo w o f private capital
services and a larger stock o f private assets p ro­
ducing them are demanded. The rise in the m ar­
ginal product o f capital increases private capital
formation, fu rth er raising private sector ouput.
The indirect effect o f a rise in public capital
on private output, how ever, is not necessarily
positive. In fact, this effect is negative if public
and private capital are substitutes. Economic
theory does not dictate w hether private and
public capital are complements or substitutes.4
The analysis below focuses on estimating the
direct effect, the private sector’s marginal p ro­
duct o f public capital. I f public capital does not
enter the production function fo r private out­

4There is, however, a growing literature that suggests that
government spending is a substitute for private sector
spending. Recent attention to this view owes much to its
elaboration by Aschauer (1985). Other research that
develops the direct substitution channel for crowding out
include Kormendi (1983), Kormendi and Meguire (1986)
and (1990) and Tatom (1985). Critics of the Kormendi and

FEDERAL RESERVE BANK OF ST. LOUIS



put, as is demonstrated below, the sign o f the
indirect effect must also be zero.

The Productivity Decline and
Public Capital Formation: A Look
at the R ecord
Advocates o f the public capital hypothesis
argue that a slowdown in public capital form a­
tion caused a "productivity slump” beginning in
the early 1970s. Some perspective on this issue
is provided by figure 1, which shows output
per w ork er in the business sector and the real
nonmilitary net stock o f public capital (1982
prices) per business sector w o rk er from 1947 to
1989. Public capital per w ork er is measured by

Meguire view include Barth, Iden and Russek (1986),
Feldstein and Elmendorf (1990), and Modigliani and Sterling (1986) and (1990).

5

the capital stock at the end o f the previous year
divided by the average level o f business sector
employment during the year.5
The grow th o f output per w ork er slowed
from a 2.5 percent annual rate from 1948 to
1973 to nearly zero (-0 .1 percent rate) from
1973 to 1982, before rebounding to a 1.8 per­
cent rate from 1982 to 1989. Advocates o f the
public capital hypothesis emphasize only the
post-1973 slowing. The grow th o f the public
capital stock per w ork er also slowed abruptly in
the early 1970s. Public capital per w ork er rose
at a 3 percent rate from 1948 to 1971, then
showed no grow th from 1971 to 1982, much
like the 1973-82 slowing in productivity. Since
1982, how ever, the grow th in the stock o f public
capital per w ork er slowed further, falling at a
1.6 percent rate. This inconsistent shift in
trends after 1982 does not contradict the fact
that both variables g rew m ore slowly after the
early 1970s than they did before then.
The simple correlation coefficient fo r the
logarithms o f the tw o measures shown in the
figure is 0.95 fo r the period 1947 to 1989. This
strong positive relationship is a classic case o f a
spurious time-series relationship. In fact, changes
in the public capital stock per w ork er are not
statistically significantly related to changes in
business sector output per w orker. The correla­
tion coefficient fo r changes in the logarithm o f
each measure is negative and equals only -0.03
fo r the period 1948 to 1989. The reversal in the
size, significance and sign o f the correlations
among levels and first-differences illustrates the
importance o f the issues explored below in
assessing the public capital hypothesis.

THE BUSINESS SECTOR PRODUC­
TION FUNCTION AND PUBLIC
CAPITAL FORMATION
The most direct aggregate evidence on the
positive effect o f public sector capital formation
5The net public and private capital stock data used in this
article were provided by John Musgrave from data he
prepares for the U.S. Department of Commerce, which is
described in U.S. Department of Commerce (1987) and
Musgrave (1988). The series are constructed by deducting
depreciation from gross stock measures, which cumulate
gross investment less discards (assets that are scrapped).
The depreciation methods use straight-line depreciation for
service lines equal to 85 percent of the U.S. Treasury
Department’s Bulletin F service lines. Constant cost
measures (1982 prices) are used throughout this article.




can be obtained from production function
estimates. The aggregate production function in­
dicates the maximum output that can be p ro­
duced w ith labor and capital given technology
and other factors influencing production. The
marginal product o f each resource is assumed
to be positive and inversely related to the quan­
tity o f the resource (diminishing returns).

The Conventional Approach
Ratner (1983) provides the first model that ex­
plicitly adds public capital to the production
function to test w hether the marginal product
o f public capital is positive. M ore recent
analyses by Aschauer (1989a) and Munnell
(1990) use a similar approach. Ratner assumes
that the business sector production function (Q)
can be represented by a Cobb-Douglas function:
(1) Q, = A h “kfkgf e (r,+l,),
w h ere A

= a scale parameter,

h t = business sector hours,
kt = the flo w o f services from K „ the
constant-dollar net nonresidential
stock o f private capital at the end
o f the previous year,
kg, = the flow o f services from KGt, the
public capital stock at the end o f
the previous year,
r

= a rate o f disembodied technical
change,

t

= a time trend, and

£t

= a norm ally and independently
distributed random disturbance
term.

The same utilization rate, c„
capital as fo r private capital,
private capital services, kt, is
o f services from governm ent
ctKG,.G The utilization rate is

is used fo r public
so the flo w of
ctKt and the flo w
capital, kg„ equals
measured by the

6The questionable assumption of an identical utilization rate
for public and private capital is not required, however. The
derivation of equation 2 requires only that the use of
public capital be proportional to that of private capital. In
this case, the constant term A in equation 2 will include
this factor of proportionality.

MAY/JUNE 1991

6

Federal Reserve Board's index o f manufacturing
capacity utilization.
Ratner also assumes that the production func­
tion is characterized by constant returns to
scale, w hich means that a proportional rise in
each resource raises Q by the same proportion;
this assumption is expressed as a + ft + 6 = 1.
Thus, the production function can be rew ritten
as:
(2) ln(Q,/kt) = InA + aln(h,/kt) + dln(KGt/K,)
+ rt + £,.
The public capital hypothesis that KG affects Q
is tested by determining w hether d, the output
elasticity o f public capital, is positive.7 The out­
put elasticity is the marginal product o f public
capital services divided by the average product
o f these services (Q/kg). The coefficient a is the
output elasticity o f labor which, in principle,
should equal the share o f labor cost in total
cost.
Ratner estimated equation 2 using data fo r
1949 to 1973. Since then, the data have been
revised numerous times, including changing the
base period fo r computing constant-dollar out­
put and capital stock data. W hen this equation
is estimated fo r the original sample period
1949-73, using the latest available data, the
estimate is (t-statistics in parentheses):

7There are two alternative transformations of the variables
that could be used to derive the theoretical specification.
Equation 2 arises from the substitution (p = 1 - a - d),
but a or d could have been eliminated instead. The alter­
native expressions are analytically and statistically
equivalent, however; in particular, the estimates are nor­
malized on output in all three specifications.
8The output elasticity of a resource equals the ratio of the
resource’s marginal product to its average product.
Ratner’s original estimate implied that the ratio of the
marginal product of private capital to that of public capital
was 3.8 times the ratio of the public to the private capital
stock. During the 1949-73 period, the latter averaged 55.4
percent, so that the private gross rate of return (rental
price of capital and marginal product) was about 2.1 times
the respective measure of the public sector, according to
his earlier estimate. The updated estimate of the relative
marginal product of private capital in equation 3 is 35 per­
cent of the marginal product of public capital.
9When equation 3 is estimated with a first-order autocor­
relation correction term, its coefficient is not statistically
significant.
10Munnell (1990) uses a capital input series prepared by the
U.S. Bureau of Labor Statistics (BLS) to measure the ser­
vices of capital rather than the services yielded by the
constant dollar net nonresidential private capital stock. The
BLS series is described by Oliner (1989). This series is
relatively new and is intended to measure the flow of ser­
vices as measured here, but does not appear to be much
different from the capital stock measure used here. The

FEDERAL RESERVE BANK OF ST. LOUIS



(3) ln(Q,/kt) = 1.410 + 0.548 ln(ht/kt)
(11.52) (9.32)
+ 0.277

R2 = 0.93

ln(KGt/Kt) + 0.0128 t
(2.81)
(6.24)

S.E. = 1.02%

D.W. = 1.65.

The statistically significant output elasticity of
public capital is estimated to be 27.7 percent.
This is much larger than Ratner’s earlier
estimate o f 5.8 percent.8 The rise in the output
elasticity o f the public capital stock arises from
data revisions subsequent to Ratner's study.9
Aschauer (1989a) and Munnell estimate similar
production functions fo r the business sector
over the period 1949-85 and the non-farm
business sector over the period 1949-87, respec­
tively.1 T h ey both find a positive and significant
0
output elasticity fo r public capital; their
estimates, how ever, are about 30 to 40 percent,
somewhat larger than that in equation 3.1
1

Three Potential Shortcomings o f
Existing Estimates
Estimates like that in equation 3 are suspect
fo r three reasons. First, they ignore the signifi­
cant influence o f the relative price o f energy on

capital stock measure and its utilization rate used in this
article are also used by Ratner and Aschauer. Both Mun­
nell and Aschauer (1989a) include the capacity utilization
rate in manufacturing as a separate variable to capture the
influence of the business cycle on productivity. They pro­
vide no theoretical justification, nor do they indicate
whether the capacity utilization rate is intended to capture
any influences besides the varying use of the stock of
business sector capital.
11Schultze (1990) has criticized such estimates for implying
implausibly large estimates of the rate of return to in­
frastructure. Aaron (1991) also questions the magnitude of
the effect, the conceptual basis for such an effect and
whether the estimate is spurious. A counterpart to the
relatively high rate of return, at least in equation 3, is that
the output elasticity of hours is only 54.8 percent. This is
well below the theoretically expected value, which equals
the share of labor cost in total cost of about 66.7 percent.
The output elasticity of private capital is about 17.5 per­
cent, about half of the expected value.

7

productivity found in similar studies (see the
shaded insert on page 10). Second, they omit a
significant time trend or reductions in the trend
found in other studies. Third, they contain
variables that are not stationary, raising the
possibility o f spurious estimates.1
2
Consider the Cobb-Douglas production func­
tion including the flo w o f energy, Et:

(4) Q, = A hrkfkgf E\ e (r,+t,),

w h ere y is the output elasticity o f energy. The
quantity o f energy is assumed to satisfy the
first-order condition fo r its employment, Et =
yQt/pt, w h ere p ' is the price o f energy measured
e
relative to the price o f business sector output.1
3
In addition, the production function is assumed
to be characterized b y constant returns to scale,
(a + / + y + d = l ) . 1 Substituting these tw o assump­
?
4
tions into equation 4 and taking logarithms o f
both sides yields:

12Eberts (1990) raises the issue of whether there is “ reverse
causation” in estimates of the effect of public capital on
private output; in other words, does a significant positive
correlation indicate that public capital raises private output
or does a rise in private output raise the demand for and
quantity of public capital? He provides regional evidence
suggesting that causality runs both ways.
13The quantity of energy is assumed to be proportional to
stock of energy-using capital and to its services. It is in­
cluded because conventional measures of the flow of
capital services, k (or kg), are not expected to reflect the
differential effect of energy price changes on the economic
value of the capital stock and its flow of services. Reduced
energy usage is only one of several reasons why higher
energy prices affect private sector output. The domestic
and foreign capital stocks (for example, the pools of oil
and gas, beds of coal and hydroelectric power sources)
that produce the energy used in U.S. production are not
included in the measured domestic nonresidential capital
stock. Therefore, if the relative price of energy rises and
producers respond by using less of this capital, the reduc­
ed flow of services from this capital will not be reflected in
kt. Moreover, the decline in the real value of the rest of
the capital stock due to higher operating costs also is not
reflected in kt, since replacement cost rather than market
prices are used to measure the value of existing assets in
computing the constant dollar net stock. See Rasche and
Tatom (1977a), (1977b) and (1981). Also see Helliwell,
Sturm, Jarrett and Salou (1986) for an alternative
approach.

(5) ln(Qt/kt) = InA* + a*ln(h,/kt) + d*ln(KGt/Kt)
+ y*Inp' + r*t +
a'
d*

=

a / (l- y )

= 6/(1- Y),
y* = —y/(l —y).
*
r
= r/(l -y ),
A* = A (1,|-y)y (T,1-r)) and
£
,* = £t/(l —y).
The omission o f en ergy price effects on produc­
tivity after 1973 could result in attributing
energy-related productivity losses to the decline
in the grow th o f public capital.
The second potential shortcoming o f existing
tests using production functions is that they
omit significant time trends or significant breaks
in the time trend found in similar studies.1
5
Trends are intended to control fo r the influence
o f the pace o f technical change; their omission
could bias the coefficients and the standard er­
rors fo r the included variables, especially those
correlated w ith the omitted time trends.1
6

tion in return for estimates of the coefficients that are
more efficiently estimated and more readily interpreted as
estimates of the theoretical parameters. The importance of
this issue and the inability to reject this constraint is
discussed in Tatom (1980).
15For example, Munnell (1990) includes no time trends and
Aschauer (1989a) includes no shift in the trend.
16A decline in the trend rate of technical change in 1967 is
discussed in Rasche and Tatom (1977b) and several
studies that discuss this trend-break are cited there. A
break in the trend rate (r) in 1967 for the business sector
was not significant in the data available at the time of
Ratner’s study, but it is significant in later data. See
Tatom (1988), for example, for a discussion of this change
in significance. Darby (1984) argues that a declining
quadratic trend arises from a post-depression and postWorid War II catch-up in the level of technology.

14The use of the constant returns to scale constraint in
estimating production functions is quite common because
of the intuitive appeal of this property and, more important­
ly, because the high correlations between hours, the flow
of private capital services, the time trend and, in this case,
the flow of public capital services, are expected to make it
difficult to interpret the coefficient estimates and to raise
their standard error estimates without this constraint.
When the constraint can be rejected, its imposition trades
off some explanatory power in fitting the production func­




MAY/JUNE 1991

8

The effect o f the first tw o shortcomings on an
estimate o f the production function like equa­
tion 3 can be seen by including the relative
price o f energy, as in equation 5, and by allow ­
ing fo r a quadratic trend component t2. Nearly
identical results arise from allowing fo r a one­
time decline in the linear time trend from 1.5
percent per yea r b efore 1967 to a 1.0 percent
rate afterw ard.1 For the period 1948 to 1989,
7
estimate is:
(6) ln(Q,/kt) = 1.595 + 0.614 ln(ht/kt)
(15.29) (12.88)
+ 0.132 ln(KGt/Kt) - 0.048 lnp't
(2.77)
(-6 .4 1 )
+ 0.019 t - 0.0001 t2
(8.42)
(-4.23 )
R2 = 0.97

S.E. = 0.95%

D.W. = 1.49

This estimate indicates a statistically significant,
positive effect o f the public capital stock on out­
put, but is less than half that given in equa­
tion 3 or the estimates obtained by Aschauer
and Munnell. Both the relative price o f energy
and the slowing in the time trend are statistical­
ly significant. Updating the equation 3 estimate,
but including the energy price and time trend
slowing, does not alter the statistical significance
o f the public capital stock effect, h ow ever.1
8
The third potential shortcoming in regression
estimates like equations 3 or 6 is that they con­

17The standard error of estimate using the time trend shift in
1967 instead of the quadratic trend is 0.99 percent; the
estimated output elasticity of the public capital stock is
0.135 in this case. Equation 3 and the Aschauer and Mun­
nell estimates are representative of estimates without a
declining time trend and energy price effects. For exam­
ple, when the quadratic trend term and energy price term
are omitted from equation 6, the output elasticity of the
public capital stock is 0.306 (t = 5.27), about the same as
in equation 3; when a significant first-order autocorrelation
term is added, this output elasticity rises to 0.343 (t =
4.91).
18Equation 6 contains the 1948 data point, as well, to in­
clude all available data. This does not affect the results,
however. When the relative price of energy is added to the
1949-73 estimate in equation 3, its coefficient (-0 .1 1 7 ) is
not statistically significant (t = 1.35). Its inclusion lowers the
coefficient on ln(KG/K) to 0.206, and it too becomes
statistically insignificant (t = 1.88) at a 95 percent con­
fidence level using a one-tail test. When a first-order
autocorrelation correction term is added to equation 6, its
coefficient is not statistically significant.
19This bias is explained by Granger and Newbold (1974) and
(1986). Some analysts refer to this potential bias as arising
only when two random walk variables are used in a
regression, because this was the example used by
Granger and Newbold (1974). Granger and Newbold (1986)

FEDERAL RESERVE BANK OF ST. LOUIS



tain variables that are not stationary, and so are
subject to a spurious regression bias.1 First9
differencing typically renders the data stationary
and rem oves the problem o f justifying or ex­
plaining the existence o f a deterministic trend
or trends. The evidence concerning this poten­
tial difficulty and its implications is explained
below.

Are the Production Function
Variables Stationary?
Table 1 reports Dickey-Fuller tests fo r a unit
root fo r the levels o f the variables in equation
6— ln(Q/k), ln(h/k), ln(KG/K) and lnp'—and fo r
their first-differences. The relevant statistic fo r
the unit root test is the t-statistic fo r the co effi­
cient on the lagged level o f the variable (Zt_,)
whose first-difference is used as the dependent
variable; this coefficient is labeled b in the table.
If this coefficient is significantly different from
zero w hen the tim e trend is statistically insigni­
ficant and, therefore, omitted, then the variable
Z is stationary. W hen the time trend is signifi­
cantly different from zero, its coefficient, d, is
included in the reported test equation. In this
case, if b is significant, the variable Z is said to
be trend-stationary.2 Only one lagged depen­
0
dent variable is statistically significant in any o f
the tests fo r the levels o f the data in the table;
these significant instances are reported in the

use other nonstationary variable combinations. Engel and
Granger (1987) explain that a linear combination of sta­
tionary and nonstationary variables is nonstationary, unless
the nonstationary variables are cointegrated. Thus, the er­
ror term in such an equation is potentially nonstationary,
giving rise to a potentially spurious regression.
20The t-statistics for the b coefficients are estimates of
Dickey-Fuller statistics called (t „), when the time trend is
omitted (d = 0), and r T when the time trend is included.
,
The critical values of t„ and tt for this size sample are
given in Fuller (1976) and equal about - 2 .9 5 and -3 .5 3 ,
respectively.

9

Table 1
Tests for Nonstationarity
Test Equation fo r Levels o f Variable (Z): AZ, = a + bZ M + d t + eAZ,
Levels o f Variable (Z):
a
(Sample period: 1950-89)1

S.E.

D.W.

0.29

0.023

2.00

0.12

0.034

2.31

0.10

0.034

2.44

0.22

0.031

1.75

0.420
(2.81)*

0.15

0.088

2.03

b

d

e

- 0.647
(-4 .2 9 )*

-0 .0 0 2
(-3 .5 9 )*

-

...

ln(Q,/k,)

0.101
(3.86)

ln(h,/kt)

-0 .3 2 4
(-2 .0 9 )

-0 .1 4 0
(-1 .8 1 )

- 0.003
(-1 .3 3 )

ln(h,/kt)

-0 .1 2 6
(-2 .9 1 )

- 0.040
(-2 .3 3 )

—

ln(h,/k,)

-0 .1 8 5
(-4 .1 5 )

-0 .0 5 9
(-3 .5 0 )*

-0.25 5

R*

( -1 .7 9 )
...

ln(p;)

0.252
(1.42)

-0 .0 6 3
(-1 .4 0 )

ln(p;)

0.401
(1.92)

-0.11 1
(-1 .9 4 )

0.002
(1.34)

0.436
(2.94)*

0.17

0.087

2.06

- 0.005
(-0 .4 6 )

-0 .0 1 9
(-1 .0 3 )

-0 .0 0 0 5
(-3 .5 2 )*

0.602
(6.77)*

0.68

0.007

1.91

d

R;

S.E.

D.W.

—

0.68

0.025

2.03

0.68

0.025

2.07

0.57

0.036

1.57

0.64

0.032

1.72

0.29

0.089

1.98

0.27

0.090

1.98

0.23

0.008

1.53

0.41

0.007

1.84

ln(KG,/K,)

Test Equation fo r D ifferences (AZ): A2 = a + bAZ, , + d t + £,
Z,
First-difference (AZ,)
a
(Sample period: 1950-89)2

b

Aln(Q,/kt)

-0 .0 0 6
(-1 .5 1 )

-1 .3 5 2
(-9 .0 9 )*

Aln(Q,/kt)

-0 .0 1 3
(-1 .6 4 )

-1 .3 6 4
(-9 .1 5 )*

Aln(h,/k.)

-0.03 1
(-4 .3 8 )

-1.14 1
(-7 .2 1 )*

Aln(h,/k,)

-0 .0 6 2
(-4 .9 9 )

-1 .2 6 6
(-8 .4 1 )*

Aln(p;)

0.004
(0.28)

-0 .6 1 2
(-4 .0 9 )*

Aln(p;)

0.0004
(0.014)

-0 .6 1 3
(-4 .0 4 )*

Aln(KG,/K,)

-0.001
(-0 .9 9 )

-0 .3 2 3
(-3 .5 3 )*

Aln(KG,/K,)

0.006
(2.35)

-0 .4 2 5
(-5 .0 0 )*

0.0004
(1.03)
...

0.001
(2.94)*
—

0.0002
(0.14)
...

-0 .0 0 0 4
(-3 .5 5 )*

* Significant at a 5 percent level.
1 When e is not significantly different from zero at a 5 percent level of significance, it is constrained to zero and the
period used begins one year earlier.
2 The lagged dependent variable is not significant at a 5 percent significance level for any of these variables, so it is
omitted.




MAY/JUNE 1991

10

Alternative Hypotheses About the Productivity
Decline
Several hypotheses have been put forth to
explain the slow dow n in productivity grow th
besides the one focusing on the slow dow n in
public capital form ation originally form ulated
by Eisner (1980), Schultze (1981) and Ratner
(1983). These other explanations include a
slowing in the trend o f resources m oving
from agriculture to the industrial sector; the
return to “ norm ality” from the tem porarily
rapid postwar grow th o f output and produc­
tivity associated w ith reversing the adverse
effects o f the Depression and W orld W a r II
on the private sector; a slow dow n in
research and developm ent spending; the costs
o f increased governm ent regulation; a
slow dow n in the grow th o f the private
capital stock per w orker; and the rise in
energy costs in 1973-74 and 1979-81.1
Rasche and Tatom (1977a) and (1981) ex­
plain h ow a rise in energy prices reduces the
economic capacity o f the typical firm and
renders capital obsolete. In the short run,
firms alter their optimal production tech­
1Kendrick (1979) contains papers dealing with most of
these hypotheses. Baily (1986) presents a more recent
summary of these hypotheses. Also, see Dennison
(1974), (1979) and (1985). Darby (1984) develops the
hypothesis about the postwar and post-Depression tem­
porary surge in growth. Griliches (1988) examines the
R&D hypothesis. Crandall (1980) and Gray (1980) ex­
amine the regulatory hypothesis.
2Jorgenson (1988) provides evidence of these ad­
justments within individual industries, while Baily (1981)
and Griliches (1988) have focused on energy price-

table. No lagged value o f the dependent variable
is significant (or reported) in the bottom half o f
the table w h ere the presence o f a unit root fo r
the first-differences is tested.
The evidence fo r the levels o f the variables
shown at the top o f the table indicates that
ln(Q/k) is trend-stationary. The level o f ln(h/k)
appears to be stationary when the insignificant
lagged dependent variable is included to reduce
the extent o f autocorrelation indicated b y the
relatively high Durbin-Watson statistic (D.W.).
W ithout this lagged dependent variable, the
hypothesis that ln(h/k) has a unit root, or

FEDERAL RESERVE BANK OF ST. LOUIS



niques, reducing their use o f energy and, in
some cases, obsolete capital, substituting
labor and other capital to econom ize on
higher energy costs. In the long run, reduc­
tions in the productivity o f labor and capital
resources lead, in the case o f capital, to a
smaller desired capital stock and flo w o f its
services.2
Except fo r an unexplained shift or a slow­
ing in the time trend, only the energy price
rise and associated slowing in the grow th o f
the capital-labor ratio provides explanations
that are consistent w ith the timing and
magnitude o f productivity movements since
1973. Tatom (1982), fo r example, provides
evidence that the entire decline in productivi­
ty grow th from late 1973 to 1981 resulted
from the rise in energy prices and the
associated reductions in the capital-labor
ratio.3 Tests o f the effects o f public capital on
private output have not controlled fo r these
effects.

induced obsolescence of capital and its effects on pro­
ductivity. Also, see Tatom (1979a) and (1982).
3The energy-price hypothesis is not universally ac­
cepted. For example, Berndt (1980), Dennison (1974),
(1979) and (1985), Darby (1984) and Olson (1988) have
been critical of its significance, arguing that the share
of energy in costs is too small or, in Darby’s case, that
a quadratic trend fits the data without any energy price
effect, so that the slowing in the 1970s was not a puz­
zle. With Darby’s view, the productivity pick-up in the
1980s becomes a puzzle, however.

is not stationary, cannot be rejected. For this
reason, ln(h/k) is considered to be nonstationary
here. According to the tests, lnp' and ln(KG/K)
are also nonstationary. The latter has a signifi­
cant trend term (d), but ln(KG/K) is not sta­
tionary w hen it is included. Based on the level
results in the table, nonstationarity cannot
be rejected fo r the fou r variables entering
equation 6.

The bottom panel o f the table conducts the
same test fo r unit roots fo r first-differences o f
the variables. Th e test fo r each o f the variables

1
1

rejects a unit root, but tw o variables, Aln(h/k)
and Aln(KG/K), are trend-stationary. The levels
o f ln(Q/k) and lnp' are integrated o f order 1,
1(1), which means that these variables must be
differenced once to achieve stationarity. The
levels o f ln(h/k) and ln(KG/K) are 1(2), because
they must be differenced tw ice to achieve sta­
tionarity.2 The presence o f a significant trend
1
in the first-differences suggests that there is a
significant quadratic trend in the levels o f the
data.
A first-difference version o f equation 5 in­
volves only stationary and trend-stationary vari­
ables. The first-difference o f the time trend
term, rt, in equation 5 is the constant, r, which
is the constant term in the first-difference equa­
tion. If the time trend consists o f broken linear
segments, then the average o f the coefficients
on these linear trends also is captured in the
constant term. I f there is a deterministic quad­
ratic trend, first-differencing results in a linear
trend remaining in the first-difference expres­
sion. Since tw o o f the variables in equation 5
are only trend-stationary, how ever, a time trend
must be included in the first-difference regres­
sion to maintain the desired stationarity. This is
consistent with the presence o f a deterministic
quadratic trend in the production function, so
that differencing does not avoid the considera­
tion o f deterministic trends in this case.
Estimating a first-difference equation avoids
both the problems arising from nonstationarity
and the difficulties o f selecting ad hoc breaks in
the time trend in equation 5.2
2
21The evidence that, in one test, ln(h/k) is stationary in table
1, while its first-difference is trend-stationary may appear
to be inconsistent. In the level estimate for ln(h/k), the
trend term is statistically significant when a statistically
significant break in 1967 is included or when the quadratic
term is included. In each instance, however, the
hypothesis that ln(h/k) has a unit root still is not rejected.
When the ln(h/k) equation containing the time trend and its
break in 1967 is first-differenced, Aln(h/k) is stationary; that
is, the addition of a time trend is not statistically significant
and a unit root is rejected. In this case, Aln(h/k) is sta­
tionary, not trend-stationary. When the ln(h/k) equation
containing the significant quadratic trend term is firstdifferenced, the result is that given in the table indicating
trend-stationarity. Whether the appropriate inference is that
Aln(h/k) is trend-stationary or stationary is not essential for
the analysis below, however, because another variable,
ln(KG/K), also has a trend-stationary first-difference.

NEW ESTIMATES OF THE EFFECT
OF PUBLIC CAPITAL ON PRIVATE
SECTOR OUTPUT
The variables used in equation 6 do not ap­
pear to be stationary, so the statistical signifi­
cance o f the public capital effect found there is
potentially spurious. This problem is avoided by
estimating the production function parameters
in a first-difference specification with a time
trend.2
3
The first-differenced (A) estimate o f the pro­
duction function fo r the period 1949 to 1989 is:
(7) Aln(Q,/kt) = 0.025 + 0.042 Aln(KGt/K,)
(6.30)
(0.33)

+ 0.737 Aln(ht/kt)
(14.34)

-0.058 Alnp' - 0.0005 t
(-3 .2 3 )
(-3 .0 5 )

R2 = 0.85

S.E. = 1.05%

D.W. = 2.25

The coefficient on public capital, w hile positive,
is much smaller than in estimates based on the
levels o f the variables, like that in equation 3 or
even in equation 6.2 M ore importantly, however,
4
tion by detrending these measures. This adjustment only
affects the t-statistic for the trend, which was -3 .0 5
without the correction. A slight rise in the trend coefficient
does not show up in the rounded value of the coefficient.
24When equation 3 for the earlier period (1949-73) is firstdifferenced and t is added, the government capital stock
coefficient reverses sign ( -.0 0 4 ) and is not statistically
significant (t= -0 .0 3 ). When the first-difference of the
logarithm of the relative price of energy is included, its
coefficient (-0 .0 2 3 ) is not significant (t= -0 .2 8 ) and the
public capital stock result is unaffected. In both cases, the
time trend is not statistically significant ( - 1 .4 4 and -1 .2 2 ,
respectively).

22The first-difference of the variable ln(KG/K) is not trendstationary for the sample period used in equation 3,
1949-73, or in 1949-89. In particular, for data from 1949 to
1989, the coefficient on its lagged growth rate in a regres­
sion of its second difference, including a significant trend,
is -3 .4 2 , which is smaller in absolute value than the
critical value of -3 .5 0 (5 percent significance).
23The standard errors and t-statistics have been corrected
for the time trend in Aln(KG/K) and Aln(h/k) in the estima-




MAY/JUNE 1991

12

this coefficient is not statistically significant.2
5
The coefficient on energy prices is significantly
negative, and that on hours per unit o f capital
remains significantly positive and rises to a
value that is closer to its theoretically expected
level.2 Thus, equation 7 indicates that the
6
public capital stock has no significant influence
on business sector output, given the capitallabor ratio and the relative price o f energy.2
7
The statistical insignificance o f the public
capital stock arises from first-differencing the
data; it does not arise from the inclusion o f
energy prices in the estimation o f equation 7 or
from allowing fo r a trend.2 The omission o f the
8
significant energy price term does not produce
a significant public capital stock effect either.
W hen it is omitted in equation 7, the coefficient
on the public capital stock variable, Aln(KG/K),
rises to 0.108; how ever, it remains statistically
insignificant (t = 0.77).2
9
The inferences from equation 7 are not sub­
ject to the spurious regression problem. Since
tests o f the variables in equation 6 generally fail
to reject nonstationarity, the results in equation
7 o ffe r the strongest evidence on the factors in­
fluencing, or not influencing, business sector
output. This estimate rejects the public capital
hypothesis.

25lf the insignificance of ln(KG/K) arose from over­
differencing an appropriate test equation, then the problem
could be corrected by estimating equation 7 with a signifi­
cant MA1 error process; the MA1 coefficient should be
equal to minus one in this case. When equation 7 is
estimated with an MA1 error process, the MA1 parameter
is only -0 .3 6 9 ; it is not statistically significant (t =
-1 .9 5 ). More importantly, it is significantly less than one
(t = 3.34). The coefficient on ln(KG/K) is reduced (0.021)
and it remains statistically insignificant (t = 0.22) when
this term is included.
26This theoretical value is derived in equation 5; it is condi­
tional on the share of labor in total cost and the coefficient
on the relative price of energy. For values of these
parameters of 0.667 and -0 .0 5 8 , respectively, this
theoretical value is 0.706.
27Rubin (1990) regresses the growth rate of multifactor pro­
ductivity in manufacturing and 11 two-digit SIC code in­
dustries on a constant, the growth rate of the Federal
Reserve Board’s measure of the industry’s capacity utiliza­
tion rate, and the growth of core infrastructure. Core in­
frastructure includes highways, streets, sewers and water
systems in her analysis. The period she uses is generally
from 1956 to 1986. She finds that there is no statistically
significant effect for core infrastructure in any industry ex­
cept petroleum refining, where a significant positive rela­
tionship is observed. Her result is consistent with the view
suggested above, that the decline in public capital growth
is, in part, a proxy for the pattern of increased energy
prices.
In papers prepared after this research was completed,
Hulten and Schwab (1991) and Jorgenson (1991) note the


FEDERAL RESERVE BANK OF ST. LOUIS


An Alternative Approach: Are
Private Sector Output and Public
Capital Cointegrated?
According to the evidence in table 1, the
variables in equations 6 are not stationary; tw o
o f them are 1(1) and tw o are 1(2). Engel and
Granger (1987), Johansen (1988) and Johansen
and Juselius (1989) develop procedures fo r ex­
amining w hether 1(1) variables have long-run
relationships or are cointegrated. These methods
cannot be used here because tw o o f the
variables in equations 6 are 1(2). Neither pro­
cedure addresses the problem o f h ow to incor­
porate a linear time trend, trend shift or
quadratic trend in a cointegration test.
Stock and W atson (1989) have developed a
m ethod fo r testing cointegration among higherorder integrated variables, including variables
that are integrated o f different orders. They ex­
plain that one approach to the problem o f non­
stationarity is to include significant lags and
leads o f first-differences o f the dependent and
independent variables as right-hand-side vari­
ables in tests o f functional relationships. They
argue that this practice avoids the spurious
regression problem fo r nonstationary variables
pointed out by Granger and N ew bold (1974) and
that it indicates the presence o f long-run (or
fragility of estimates of the marginal product of public
capital. Hulten and Schwab provide evidence of this fragili­
ty, but in their first-difference estimates, the private sector
input coefficients are fragile as well.
28Without the trend term in equation 7, the coefficient on the
public capital stock variable is 0.147, about the same as in
equation 6, but it is not statistically significant (t = 1.07).
The trend term is necessary to ensure that the error term
in equation 7 is stationary. A regression of the firstdifference of the residuals from equation 7 on the lagged
level of the residual, with no constant, yields a coefficient
on the lagged residual equal to -1 .1 5 2 (t= -7 .3 2 ). Even
without the trend term in equation 7, the t-statistic on the
resulting lagged residual is -5 .8 6 . Engel and Granger
(1987) indicate that the critical value for these t-statistics is
-3 .3 7 . Thus, the residuals are stationary in either case.
29Production function estimates are subject to simultaneous
equation bias, but this has no effect here. Virtually the
same results are obtained using a two-stage least-squares
estimation procedure. The instruments for the right-handside variables include the first-difference of the logarithms
of real wages, the AAA bond yield, and the relative price
of private capital goods, as well as lagged dependent and
independent variables.

13

cointegrating) relationships betw een variables as
the coefficients on the levels o f the variables.
This approach was taken in estimating the
level o f the production function in equation 5.3
0
Up to tw o leads and lags o f first-differences of
each variable in equation 5 w e re examined. The
equation estimate containing only significant
leads or lags, estimated over the period 1950-88
is:
(8) ln(Q,/kt) = 0.489 + 0.105 ln(h,/k,)
(10.76) (9.86)
- 0.046 lnp' - 0.075 ln(KGt/Kt)
(-2 .9 5 )
(-1 .4 7 )
+ 0.762 Aln(KGI+I/Kt+1)
(2.85)
+ 0.064 Alnp'_, - 0.065 Alnp'+
1
(2.11)
(-2 .4 0 )
R2 = 0.93

S.E. = 1.36%

D.W. = 1.69

In this estimate, the coefficient on the nonmilitary net stock o f public capital per unit o f
private capital (-0 .0 7 5 ) has the w ro n g sign and
is not statistically significant.3 Like the result
1
reported above, the nonmilitary public capital
stock has no statistically significant relationship
w ith business sector output. The levels o f busi­
ness sector output or productivity are uncor­
related w ith the level o f the nonmilitary public
capital stock. The statistically significant tstatistics on the coefficients fo r the levels of
ln(h/k) and lnp' in equation 8 suggest that only
the variables (InQ/k, lnh/k, lnp') are cointegrated.

CONCLUSION
An increasing num ber o f people are advo­
cating increased governm ent capital spending to
raise private sector output, productivity and
private capital formation. The evidence p re­
sented here, based on the post-World W a r II ex­
perience, suggests that a rise in public capital
spending w ould have no statistically significant
effect on these measures.
Earlier claims o f a positive and significant e f­
fect o f public capital on private sector output
have arisen from spurious estimates. In fact,
most o f these earlier estimates have ignored a

30The quadratic trend is omitted because it is not an in­
tegrated stochastic process; thus, production cannot be
cointegrated with it. See Stock and Watson (1988), p. 168,
for example.




trend or broken trends in productivity, as w ell
as the statistically significant influence o f energy
price changes. Simply accounting fo r these tw o
factors reduces the conventional estimates o f
the elasticity o f private output with respect to
public capital o f about 30 to 40 percent, to
about 13 percent. M ore importantly, how ever,
both the earlier estimates and those reported
here that find a statistically significant public
capital effect use equation estimates that con­
tain nonstationary variables. Thus, these
estimates are likely to be spurious.
W hen all o f these problems are addressed us­
ing a first-difference estimate o f the production
function, the public capital stock effect on pri­
vate sector output is not statistically different
from zero. Appropriately estimated, the hypo­
thesis that public capital has a positive marginal
private sector product cannot be supported.
The same result is found using a m ethod that
allows testing a long-run relationship among
nonstationary variables.

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MAY/JUNE 1991

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Shocks, Aggregate Supply and Monetary Policy: The
Theory and International Evidence,” in Karl Brunner and
Allan H. Meltzer, eds., Supply Shocks, Incentives and Na­
tional Wealth, Carnegie-Rochester Conference Series on
Public Policy (North Holland, 1981), pp. 9-93.

Johansen, Soren. “ Statistical Analysis of Cointegration Vec­
tors,” Journal of Economic Dynamics and Control (Vol. 12,
1988), pp. 231-54.
Johansen, Soren, and Katarina Juselius. “ The Full Informa­
tion Maximum Likelihood Procedure for Inference on
Cointegration— with Applications,” Institute of Mathematical
Statistics, University of Copenhagen, January 1989.
Jorgenson, Dale W. “ Fragile Statistical Foundations: The
Macroeconomics of Public Infrastructure Investment,” com­
ment on Hulten and Schwab (1991), presented at the
American Enterprise Institute Conference on “ Infrastructure
Needs and Policy Options for the 1990s,” Washington,
D.C., February 4, 1991.
________ “ Productivity and Postwar U.S. Economic
Growth,” Journal of Economic Perspectives (Fall 1988),
pp. 23-41.

FEDERAL RESERVE BANK OF ST. LOUIS



_______ . “ The Effects of the New Energy Price Regime on
Economic Capacity, Production and Prices,” this Review
(May 1977a), pp. 2-12.
_______ . “ Energy Resources and Potential GNP,” this
Review (June 1977b), pp.10-24.
Ratner, Jonathan B. “ Government Capital and The Produc­
tion Function for U.S. Private Output,” Economic Letters
(1983), pp. 213-17.
Reich, Robert B. “ The REAL Economy,” The Atlantic Month­
ly (February 1991), pp. 35-52.
Rubin, Laura. “ Productivity and the Public Capital Stock:
Another Look,” paper presented at the Regional Analysis
Committee meeting of the Federal Reserve System, Oc­
tober 4, 1990.

15

Sato, Ryuzo, and Tetsunori Koizumi. “ On the Elasticities of
Substitution and Complementarity,” Oxford Economic
Papers (March 1973), pp. 44-56.
Schultze, Charles L. “ The Federal Budget and the Nation’s
Economic Health,” in Henry J. Aaron, ed., Setting National
Priorities: Policy for the Nineties (The Brookings Institution,
1990).
________ “ General Discussion,” Brookings Papers on
Economic Activity (1:1981), p. 65.
Stock, James H., and Mark W. Watson. “A Simple MLE of
Cointegrating Vectors in Higher Order Integrated Systems,”
Harvard and Northwestern University, respectively,
November 1989.

_______ . “Are The Macroeconomic Effects of Oil Price
Changes Symmetric?” in Karl Brunner and Allan H.
Meltzer, eds., Stabilization Policies and Labor Markets,
Carnegie-Rochester Conference Series in Public Policy,
(North Holland, 1988), pp. 325-68.
_______ . “ Two Views of The Effects of Government Budget
Deficits in the 1980s,” this Review (October 1985), pp. 5-16.
_______ . “ Potential Output and the Recent Productivity
Decline,” this Review (January 1982), pp. 3-16.
________ “ The Problem of Procyclical Real Wages and Pro­
ductivity,” Journal of Political Economy (April 1980), pp.
385-94.
_______ . “ The Productivity Problem,” this Review
(September 1979a), pp. 3-16.

________ “ Variable Trends in Economic Time Series,” Jour­
nal of Economic Perspectives (Summer 1988), pp. 147-74.

_______ . “ Energy Prices and Capital Formation: 1972-77,”
this Review (May 1979b), pp. 2-11.

Tatom, John A. “ Should Government Spending on Capital
Goods be Raised?” this Review (March/April 1991),
pp. 3-15.

U.S. Department of Commerce, Bureau of Economic
Analysis. Fixed Reproducible Tangible Wealth in the United
States, 1925-85, (GPO, June 1987).




MAY/JUNE 1991

16

Ft. Alton Gilbert
R. Alton Gilbert is an assistant vice president at the Federal
Reserve Bank of St. Louis. Richard I. Jako provided research
assistance.

Supervision of Under­
capitalized Banks: Is There a
Case for Change?

T
h e RECENT REPORT on deposit insorance
reform b y the Department o f the Treasury (1991)
calls fo r stronger enforcem ent o f bank capital
requirements. Am ong the recom m ended changes
is “ prompt corrective action” by supervisors in
dealing w ith undercapitalized banks.1 Under the
Treasury’s plan, banks would be divided into
five groups, based on their capital ratios. Those
with the highest capital ratios w ould be subject
to the few est restrictions. As an incentive to
maintain relatively high capital ratios, holding
companies with banks in this first group would
be permitted to engage in nonbanking activities.
As banks move dow nw ard into groups with
low er capital ratios, they would be subject to in­
creasingly stringent sanctions, including restric­
tions on their dividends and the grow th o f their
assets. Banks in the lowest group, with relative­
ly low but still positive capital ratios, w ould be
closed unless their shareholders prom ptly in­
jected new capital.2
d e p a rtm e n t of the Treasury (1991), pp. 38-42, and Chapter
X. The U.S. General Accounting Office (GAO, 1991)
recently recommended a different system of prompt cor­
rective action by bank supervisors. The GAO’s proposal
requires that the actions of supervisors be tied to specific
unsafe banking practices, defined more broadly than
capital ratios below some required level. The GAO study
criticizes the Treasury proposal for focusing too narrowly
on these ratios.

FEDERAL RESERVE BANK OF ST. LOUIS



Prom pt corrective action b y bank regulators is
intended to reduce both the num ber o f bank
failures and the losses by the deposit insurance
fund. The Treasury proposal w ould reduce the
discretion that bank supervisors have in han­
dling troubled banks, making the sanctions
against banks w ith relatively low capital ratios
mandatory. The policy is designed to give healthy
banks the incentive to keep their capital ratios
above the critical levels at which they w ould be
subject to mandatory sanctions. Prom pt correc­
tive action also w ould constrain the actions of
undercapitalized banks which might increase ex­
posure o f the deposit insurance fund to losses
and give the owners o f banks w ith relatively
low capital ratios the incentive to inject capital
into their banks promptly, if they wish to retain
control o f their banks.
The effectiveness o f the proposed policy in
achieving its goals o f low er bank failure rates
and reduced losses to the deposit insurance
2The Treasury proposal is not as specific as some earlier
proposals. For instance, it does not specify the criteria for
classifying banks into the five groups nor does it provide
details about the sanctions to be imposed on banks in
each group. For a similar, but more detailed proposal, see
Benston and Kaufman (1988).

17

fund depend on w hether the actions to be taken
by supervisors under the new policy d iffer
substantially from the actions taken by super­
visors in recent years in dealing w ith under­
capitalized banks. The case fo r the policy o f
prompt corrective action rests on the assump­
tion that, fo r a given capital ratio o f a bank,
sanctions under the proposed policy w ould be
m ore severe than those imposed by supervisors
in recent years. In essence, the Treasury p ro­
posal is based on the view that supervisors in
the past have perm itted banks to remain under­
capitalized fo r overly long periods and that
undercapitalized banks have been permitted to
engage in activities that made them m ore likely
to fail and m ore likely to increase the deposit
insurance fund’s losses.
The purpose o f this paper is to investigate
w hether the behavior o f troubled commercial
banks in recent years is consistent w ith these
assumptions. The paper looks at banks whose
capital ratios fell below the minimum required
level fo r periods longer than one year. It ex­
amines w hether these undercapitalized banks
violated the types o f constraints that w ould be
imposed under the Treasury’s scheme fo r prompt
corrective action. The paper also considers
w hether such violations reduced the chances
that the banks would, once again, achieve ac­
ceptable capital ratios.

policy o f prom pt corrective action might specify
higher capital levels as the critical levels fo r
mandatory actions.
This paper examines the behavior o f banks
whose prim ary capital ratios rem ained below
5.5 percent fo r m ore than fou r consecutive
quarters betw een 1985 and 1989. This choice o f
period reflects the fact that most capital injec­
tions occur in the fourth quarter o f each year,
perhaps because o f the practice o f "w in d ow
dressing,” w h ere banks devote special attention
to the capital ratios that appear on their yearend balance sheets. By focusing on more than
four consecutive quarters, w e include only those
banks whose prim ary capital ratios remained
below 5.5 percent through the fourth quarter
o f the year in which they first became under­
capitalized.
Figure 1 illustrates some o f the characteristics
o f the banks included in this study. Undercapi­
talized banks fall into three groups. Those in
one group quickly raised their capital ratios by
increasing their capital and/or reducing their
assets. Another group consists o f those that
w ere closed quickly b y their supervisors. Clear­
ly, no banks in these tw o groups remained un­
dercapitalized fo r long. This study focuses on a
third group o f banks — those that rem ained
undercapitalized fo r m ore than fou r consecutive
quarters.

ENFORCEMENT OF CAPITAL
REQUIREMENTS

Slow R esponse to Enforcem ent
Actions

In 1985, federal supervisory agencies estab­
lished minimum capital requirements fo r all
commercial banks. Th e minimum ratio o f prima­
r y capital to total assets was set at 5.5 percent.
This minimum remained in effect until the end
o f 1990, when supervisors began phasing in new
risk-based capital requirements. The shaded in­
sert lays out the components o f prim ary capital
and total assets used to calculate the prim ary
capital ratio and indicates the effects o f loan
losses on this ratio.

There are several reasons w h y banks can re­
main undercapitalized fo r m ore than a year.
Some banks respond m ore slowly than others to
directives from supervisors to raise their capital
ratios, in part because they know that super­
visors lack the authority to close them because
o f their low capital ratios alone. Instead, banks
must be judged insolvent (that is, w ith zero or
negative net w orth) or nonviable by their char­
tering agencies to justify closure.

Because the objective o f this paper is to ex­
amine how rigorously and consistently super­
visors have enforced capital requirements in re ­
cent years, it is necessary to identify undercapi­
talized banks in terms o f the capital requ ire­
ments in effect at the time. This paper defines
undercapitalized banks as those w ith prim ary
capital ratios below 5.5 percent. The proposed




Supervisors do have a variety o f enforcem ent
actions that they can take against undercapital­
ized banks short o f closing them down. Am ong
the m ore severe are the rem oval o f their officers,
the imposition o f fines and the termination of
insurance coverage on the banks’ deposits.
Supervisors generally try first to induce a bank
to comply w ith banking regulations w ith less
form al or severe enforcem ent actions, like writ-

MAY/JUNE 1991

18

An Introduction To Bank Capital Accounting
Th e text assumes a basic understanding o f
accounting principles applied to the balance
sheets o f commercial banks and the items in
the capital accounts o f banks. This insert p ro­
vides an introduction to these topics. This in­
troduction abstracts from some o f the detail
o f bank capital accounting.1
Th e accounting principles can be illustrated
by referrin g to the balance sheets o f a hypo­
thetical bank in tables A1 and A2, constructed
as o f Decem ber 31, 1986. Table A1 indicates
the values o f balance sheet items under the
assumption that there are no loan losses in
1986. Table A2 is a revised balance sheet fo r
the same period, indicating the effects o f $1
in loan losses.
Table A1 provides definitions o f items in
the balance sheet. One o f the key items fo r
our purposes is the allowance fo r loan and
lease losses. The position o f the allowance for
loan and lease losses on the balance sheet, as
a negative item on the assets side, reflects its
position in the Report o f Condition, which
banks file w ith their supervisors. Increases in
the allowance, called provision fo r loan and
lease losses, are expense items in the calcula­
tion o f profit and loss. Through periodic pro­
visions, the bank increased its allowance fo r
loan and lease losses to $3. Loan losses are
charged against that allowance, rather than
against current income or equity capital
directly.
At some time in the past, the bank purchas­
ed another firm fo r m ore than its book value,
w ith the difference o f $1 recorded as "good ­
w ill.” The bank’s $4 in equity capital reflects
the dollar value o f shares sold to stockholders
and accumulated retained earnings. The items
under “ Capital Accounts” other than equity
capital, that is, limited life p referred stock
and subordinated notes and debentures, have
fixed m aturity dates. Supervisors consider
these items less desirable form s o f bank capi­
tal than equity because o f their fixed maturi­
ty dates. Funds raised b y selling stock, in
contrast, are not scheduled to be returned to
'For additional detail on the minimum capital re­
quirements adopted by the federal bank supervisors in
1985, see Gilbert, Stone and Trebing (1985).

FEDERAL RESERVE BANK OF ST. LOUIS



shareholders at any particular point in time
and, to conserve capital, banks can forego
dividend payments to shareholders. W ithin
limits, the limited life p referred stock and
subordinated notes and debentures are in­
cluded in total capital, but not prim ary capital.
In 1985, the federal bank supervisors set the
minimum requirem ent o f total capital to total
assets at 6 percent.
Based on the values o f the items in table
A l, the hypothetical bank has a prim ary capi­
tal ratio o f 6 percent. Table A2 indicates the
impact on the prim ary capital ratio if the
bank had a loan loss o f $1 in 1986. T o simpli­
fy the example, suppose the bank pays no
dividends or income taxes. A fter recognizing
the $1 loan loss, the bank wants to keep its
allowance fo r loan and lease losses equal to
$3, to cover potential losses on the remaining
$50 in gross loans.
Th e effects on the balance sheet can be il­
lustrated in tw o steps. First, the provision fo r
loan and lease losses in 1986 is increased by
$1, tem porarily raising the allowance fo r loan
and lease losses to $4. The increase in the
provision fo r loan and lease losses reduces
net income fo r 1986 by $1, relative to the
case illustrated in table A l . The reduction in
net income o f $1 reduces equity capital from
$4 to $3, reflecting low er retained earnings.
In the next step, gross loans are reduced by
$1, and the allowance fo r loan and lease
losses is reduced by $1, back to $3. Prim ary
capital is reduced to $5 and the prim ary
capital ratio to 5.05 percent. These entries il­
lustrate how the loan losses o f a bank can
reduce its prim ary capital below the
minimum required level.
The nature o f the change in balance sheet
items from table A l to table A2 can also il­
lustrate how losses can make the equity o f a
bank negative. Suppose the loan loss w ere $5,
instead o f $1. A provision fo r loan and lease
losses o f $5 w ould make equity capital equal
to negative $1.

19

Table A1
Balance Sheet of a Hypothetical Bank, December 31, 1986
Status of loan losses: none in 1986
ASSETS
Cash

$ 5

Securities

45

Loans
Gross loans
Reserye for loan and
lease losses
Net loans

LIABILITIES AND CAPITAL
Liabilities
Deposits

$92

Capital Accounts

$50
3
47

4
1
1

Equity capital
Limited life preferred stock
Subordinated notes and debentures

1

Goodwill

$98

$98
Definitions:

Allowance for loan and lease losses: the amount set aside to absorb anticipated losses. In­
creases in the allowance are an expense item in calculating profit and loss. All charge-offs of
loans and leases are charged against this capital account, and recoveries on loans and leases
previously charged off are credited to this capital account.
Goodwill: Purchase price of firms that have been acquired in excess of their book value.
Equity capital: Includes the following components:
a.
b.
c.
d.

Perpetual preferred stock
Common stock: the par or stated value of outstanding common stock
Surplus: amount received from the sale of common stock in excess of par or stated value
Undivided profits: accumulated value of retained earnings

Limited life preferred stock: Preferred stock with maturity dates.
Subordinated notes and debentures: Debt obligations with fixed maturity dates. They are subor­
dinated to deposits. If a bank fails, the holders of its subordinated notes and debentures receive
payment only if depositors are paid in full.
Primary capital: Equity capital, plus allowance for loan and lease losses, minus goodwill =
4 + 3 - 1 = 6.
Total capital: Primary capital plus limited life preferred stock plus subordinated notes and deben­
tures = 6 + 1 + 1 = 8.
Primary capital ratio: Primary capital divided by total assets plus allowance for loan and lease
losses minus goodwill = 6 + (98 - 1 + 3) = 0.06

Table A2
Balance Sheet of a Hypothetical Bank, December 31, 1986
Status of loan losses: loss of $1 in 1986
ASSETS
Cash

$ 5

Securities

45

Loans
Gross loans
Reserye for loan and
lease losses
Net loans

$49

Deposits

$92

Capital Accounts

3
46

Equity capital
Limited life preferred stock
Subordinated notes and debentures

3
1
1

1

Goodwill

$97
Primary capital: 3 + 3 - 1

LIABILITIES AND CAPITAL
Liabilities

$97

=5.

Primary capital ratio: 5 + (97 + 3 - 1) = .0505.




MAY/JUNE 1991

20

Figure 1
Classification of Undercapitalized Banks
C lassification o f banks
by capital adequacy

Status o f undercapitalized
banks

Reasons banks remain
undercapitalized

Behavior of
undercapitalized banks

ten or verbal agreements w ith the bank’s officers
and directors.3 Thus, considerable time can pass
before supervisors feel the need to resort to
m ore severe enforcem ent actions.
The terms o f such actions—w hether form al or
inform al—depend on the conditions and circum ­
stances at each bank. Most enforcem ent actions
require the banks’ officers and directors to sub­
mit a plan to restore their banks’ capital ratios
to adequate levels. Other actions include restric­
tions on grow th o f total assets, dividends, and
loans to officers and directors. Enforcement ac­
tions may also address violations o f specific
regulations.
The various restrictions typically imposed on
bank behavior are similar to those that would
be imposed under the Treasury proposal. This
proposal, therefore, does not involve new types

3Spong (1990), pp. 90-93. For descriptions of specific enforcement actions by the Office of the Comptroller of the
Currency in recent years, see articles entitled “ Special
Supervision and Enforcement Activities” in various issues
of the Quarterly Journal of the Comptroller of the Currency.

FEDERAL RESERVE BANK OF ST. LOUIS



o f restrictions on undercapitalized banks. Rather,
it calls fo r m ore rigorous and less discretionary
enforcem ent o f these restrictions, facilitated by
legislation that would limit the ability o f banks
to impede prom pt action by supervisors through
litigation.

Slow to Close D u e to P roblem s
with Finding Buyers
Another reason w h y banks may have prim ary
capital ratios below 5.5 percent fo r extended
periods is if they w e re kept open w hile their
supervisors searched fo r other banks to buy
them. Such cases w e re especially common in
Texas, w here considerable time passed before
buyers could be found fo r some troubled bank
holding companies.4

4Bovenzi and Muldoon (1990), p. 4.

21

Capital Forbearance
Still other undercapitalized banks w ere
granted official forbearance by their super­
visors. Forbearance occurs w hen supervisors
decide to forego enforcem ent o f some regula­
tions, including capital requirements, under
special circumstances. As their losses on agricul­
tural and energy loans rose in the 1980s, many
banks turned to Congress fo r relief from capital
requirements. In the Competitive Equality Bank­
ing Act (CEBA) o f 1987, Congress mandated cap­
ital forbearance fo r agricultural banks. Banks in
this program w ere perm itted to defer form al
acknowledgem ent o f losses on agricultural loans
fo r several years. The typical rationale fo r capital
forbearance is that the economic forces respon­
sible fo r the declines in capital ratios, such as
low er farm income and reduced prices o f farm
land, are only temporary.
In response to this evidence o f congressional
intent, the federal supervisory agencies estab­
lished capital forbearance programs that set
broader terms fo r participation than those speci­
fied in CEBA. Cobos (1989), fo r example, de­
scribes the capital forbearance program o f the
Federal Deposit Insurance Corporation (FDIC)
and gives his perspective, as an FDIC official, on
the objectives o f the program and the actions
that banks granted forbearance are expected to
follow . According to Cobos, banks granted fo r ­
bearance should be considered viable by their
supervisors; they also should be expected to:
1. limit the grow th o f their total assets and
relatively high risk investments.
2. restrict dividends to their shareholders.
3. limit the benefits o f forbearance to insiders,
including insider loans.5
Th ere is virtually no w ay to tell which of
these three reasons explains w h y any particular
bank rem ained undercapitalized fo r an extended
period. In fact, m ore than one o f these reasons
may apply. Knowing w h y these banks remained
undercapitalized is unimportant, how ever, if
bank supervisors generally expect them to con­
form to similar constraints on their behavior.
That is, regardless o f w hy they w ere allowed to
5Cobos (1989).
6The banks included in this study are domestically owned
commercial banks. Savings banks and foreign owned
banks are excluded, as are several special purpose banks,
including bankers’ banks.

remain undercapitalized fo r so long, these
banks should at the very least not have ex­
perienced rapid asset growth, paid dividends to
shareholders or increased their loans to in­
siders. This paper investigates w hether banks
that w e re undercapitalized fo r m ore than a year
indeed conform ed to these constraints.

THE CHARACTERISTICS OF
UNDERCAPITALIZED BANKS
Table 1 indicates that 531 federally insured
comm ercial banks w ere undercapitalized fo r
m ore than a year, about 4 percent o f the average
number o f banks operating in the years 1985-89.6
The vast m ajority (87 percent) o f these inade­
quately capitalized banks w ere relatively small,
with total assets o f less than $100 million.
Undercapitalized banks whose assets exceeded
$100 million w e re concentrated in the energyproducing states o f Louisiana, Oklahoma and
Texas (63 percent). Only one undercapitalized
bank (located in California) had total assets
greater than $1 billion.
Outside Texas, a majority o f the undercapital­
ized banks (60 percent) w ere state nonmem ber
banks, supervised by the FDIC. In Texas, in con­
trast, 73 percent w ere national banks, supervised
by the O ffice o f the Com ptroller o f the Currency
(OCC).7
As table 1 shows, a sizable proportion o f the
531 banks had prim ary capital ratios below 5.5
percent fo r tw o years or more. In this 20-quarter
period (1985-89), 178 banks had prim ary capital
ratios below the minimum level fo r eight or
m ore consecutive quarters, and six had capital
ratios below this level fo r 16 or m ore quarters.
Table 1 also shows that banks in 22 states had
negative equity capital fo r at least one quarter.8
Some o f these observations may reflect lags in
the process b y w hich supervisors get inform a­
tion on banks and arrange fo r their resolution;
they are not necessarily evidence o f supervisory
policies that perm it banks w ith negative equity
to remain in operation. Indeed, fo r most o f these
banks, the period o f negative equity lasted only
one or tw o quarters. Some banks, how ever, had
under the same federal supervisory authorities in the years
1985-89.
8See the shaded insert for a description of equity capital
and the type of accounting entries that can make equity
capital negative.

HTie undercapitalized banks included in this study remained




MAY/JUNE 1991

22

Table 1
Characteristics of Banks with Primary Capital Ratios Below 5.5 Percent for Over
Four Consecutive Quarters, 1985-89__________________________________

Number of
under­
capitalized
banks

Banks
with
assets
greater
than $100
million

OCC

FR

FDIC

Alaska
Arizona
California
Colorado
Connecticut
Florida
Idaho
Illinois
Indiana
Iowa
Kansas
Kentucky
Louisiana
Massachusetts
Michigan
Minnesota
Missouri
Montana
Nebraska
New Hampshire
New Jersey
New Mexico
New York
North Dakota
Ohio
Oklahoma
Oregon
Pennsylvania
Rhode Island
South Dakota
Tennessee
Texas
Virginia
West Virginia
Wisconsin
Wyoming

2
1
25
15
1
9
1
11
8
12
26
4
43
3
3
23
10
6
7
1
3
5
3
1
6
54
6
1
1
2
6
223
4
2
1
2

2
1
5
4
0
1
0
0
0
0
0
0
9
0
0
0
0
0
1
1
1
2
2
0
1
7
2
0
0
1
1
27
0
0
0
0

0
0
5
10
1
4
0
5
3
2
4
0
8
2
0
5
0
3
2
0
3
3
2
1
3
24
0
1
0
2
1
162
2
0
0
1

0
0
2
4
0
4
0
0
0
1
0
0
0
0
1
1
2
3
0
0
0
0
1
0
1
4
0
0
0
0
0
7
1
0
0
0

2
1
18
1
0
1
1
6
5
9
22
4
35
1
2
17
8
0
5
1
0
2
0
0
2
26
6
0
1
0
5
54
1
2
1
1

0
0
11
4
0
1
1
4
3
5
10
0
13
0
1
12
2
2
4
0
1
3
1
0
2
18
3
0
0
0
2
73
2
1
0
0

2
1
4
7
1
6
0
0
3
2
5
0
18
0
0
4
4
2
0
0
0
2
0
0
1
29
0
1
0
1
1
117
1
1
0
0

1
0
1
1
0
1
0
0
0
0
1
0
4
0
0
2
1
1
0
0
0
1
0
0
1
10
0
0
0
0
0
46
1
0
0
0

0
0
10
7
0
4
1
9
4
7
7
4
2
3
2
9
4
2
4
1
2
1
1
0
3
5
4
0
1
1
4
26
1
0
1
0

Totals

531

68

259

32

240

178

213

72

130

State1

Federal
supervisory
agency

Banks with capital
ratios below the
required level
for eight or more
consecutive
quarters

Banks with negative
equity capital for:

At least
one quarter

Four or
more
quarters

'States that are not listed had no banks that were undercapitalized for five or more consecutive quarters during 1985-89.
2Banks that recover are identified as those whose primary capital ratios were consistently above 5.5 percent by IV/1989.
Note: Identification of federal supervisory agencies:
OCC = Office of the Comptroller of the Currency
FR = Federal Reserve
FDIC = Federal Deposit Insurance Corporation

FEDERAL RESERVE BANK OF ST. LOUIS



Banks
that
recover2

23

negative equity fo r extended periods o f time. O f
the 72 banks w ith negative equity fo r fo u r or
m ore quarters, 83 percent w ere in Louisiana,
Oklahoma and Texas; tw o national banks in
Texas had negative equity fo r nine quarters.
The last column o f table 1 shows the number
o f undercapitalized banks that recovered, that
is, had prim ary capital ratios consistently above
5.5 percent, by the fourth quarter o f 1989.9 Only
130 o f the 531 banks had recovered by IV/1989,
an average recovery rate o f only 24 percent.
The 46 percent rate o f recovery fo r banks out­
side o f Louisiana, Oklahoma and Texas is much
higher than the 10 percent recovery rate fo r
banks undercapitalized fo r m ore than a year in
these energy-producing states.

As might be expected, the recovery rates
w ere significantly low er fo r banks w ith negative
equity. O f the 213 banks w ith negative equity
fo r at least one quarter, the recovery rate was
only 6.57 percent, com pared w ith a recovery
rate o f 36.48 percent among the remaining 318
banks.1
0
The geographic distribution o f the 531 under­
capitalized banks is quite uneven. For instance,
14 states and the District o f Columbia had no
banks that w ere undercapitalized fo r m ore than
a year. W hile these 14 are not clustered in any
particular part o f the country, they have one
characteristic in comm on—relatively liberal
branching laws (see table 2). Eleven o f the 14
states permit statewide branching and the three

Table 2
Relationship between Number of Undercapitalized Banks and
Bank Failures, 1985-89
States grouped by num ber
of banks undercapitalized
fo r more than one year

Number of
undercapitalized
banks

Number of
failed
banks

None1
1 or 22
3-63
7-264
More than 26s

0
16
49
146
320

17
45
40
258
483

Total

531

843

1 Alabama, Arkansas, Delaware, Georgia, Hawaii, Maine, Maryland, Mississippi, Nevada, North Carolina,
South Carolina, Utah, Vermont and Washington.
2 Alaska, Arizona, Connecticut, Idaho, New Hampshire, North Dakota, Pennsylvania, Rhode
Island, South Dakota, West Virginia, Wisconsin and Wyoming.
3 Kentucky, Massachusetts, Michigan, Montana, New Jersey, New Mexico, New York, Ohio,
Oregon, Tennessee and Virginia.
4 California, Colorado, Florida, Illinois, Indiana, Iowa, Kansas, Minnesota, Missouri and Nebraska.
5 Louisiana, Oklahoma and Texas.

9One objection to this definition of recovery is that it
understates the actual recovery rate, because many
banks’ capital ratios fell below 5.5 percent only near the
end of the 1985-89 period. This possibility is investigated
by examining capital ratios in the first three quarters of
1990 for those banks whose primary capital ratios were
below 5.5 percent in the fourth quarter of 1989. Reclassify­
ing these banks as recovered if their primary capital ratios
rose consistently above 5.5 percent in the first three
quarters of 1990 raises the recovery rate from 10 percent
to 12.5 percent in the energy-producing states and from
46 percent to 55.5 percent in the other states. The
significance of these increases in recovery rates may be




offset by the possibility that some other banks, previously
classified as recovered, might be reclassified if their
capital ratios for 1990 were examined. Since examination
of 1990 data did not change the recovery rates substantial­
ly, the recovery rates cited in the text are those based on
observations through IV/1989.
10The difference between these proportions is significant at
the 1 percent level. See, for example, Wonnacott and
Wonnacott (1990), pp. 273-75, for the equation to test the
statistical significance of the difference between two
proportions.

MAY/JUNE 1991

24

others perm it limited branching. Only 12 o f the
other 36 states are classified as statewide branch­
ing states.1
1
As table 2 indicates, many o f the banks that
failed during 1985-89 w e re not undercapitalized
fo r a year or longer. Instead, they w ere closed
w ithin a year after their capital ratios fell below
the minimum required level. For instance, 17
banks failed in the 14 states that had no banks
undercapitalized fo r m ore than a year. In the
nation, the num ber o f banks that failed exceed­
ed the num ber that w ere undercapitalized fo r
more than a year. These observations suggest
that many bank failures in recent years cannot
be attributed to actions taken by banks while
undercapitalized f o r extended periods o f time;
many banks failed before their prim ary capital
ratios had fallen below the minimum required
level fo r a year or longer, and many banks that
w ere undercapitalized fo r extended periods o f
time did not fail.

ENFORCEMENT OF CONSTRAINTS
ON UNDERCAPITALIZED BANKS
The Treasury proposal fo r prom pt corrective
action is based on the view that supervisors
have delayed too long in imposing constraints
on undercapitalized banks. This section investi­
gates w hether the banks that w ere undercapital­
ized fo r over m ore than a year violated the
types o f constraints that w ould be imposed
under the Treasury proposal.
T w o constraints on the behavior o f under­
capitalized banks mentioned in the Treasury
proposal are examined here: constraints on asset
grow th and dividend payments.1 A third con­
2
straint is also investigated: no increase in loans
to bank officers and directors (the bank in­
siders) w hile a bank is undercapitalized. An ex­
amination o f insider loans is included because
supervisory authorities often focus on such
loans w hen m onitoring the condition o f under­

1 See Conference of State Bank Supervisors (1986), p. 83.
1
This classification is based on state laws as of January
1986.
12Department of the Treasury (1991), p. 39.
13Kummer, Arshadi and Lawrence (1989).
14Twelve banks with asset growth in excess of 10 percent
were involved in mergers during the periods in which their
primary capital ratios were below 5.5 percent. Mergers
distort the measure of asset growth for the purposes of
this paper, because they increase capital and assets.
Asset growth of banks engaged in mergers does not
necessarily reflect greater leverage. Some mergers, for ex­

FEDERAL RESERVE BANK OF ST. LOUIS



capitalized banks. Also, undercapitalized savings
and loan associations in the recent past w ere
found to have increased the losses to their de­
posit insurance funds through loans to insiders,
and one study has found that banks w ith rela­
tively high ratios o f insider lending to total
assets had low er earnings and higher bank fail­
ure rates than other banks.1
3
Table 3 presents selected inform ation about
the behavior o f undercapitalized banks. The
results are divided into regions, except fo r Loui­
siana, Oklahoma and Texas, which account fo r
most o f the undercapitalized banks. This method
o f presentation highlights both regional concen­
trations o f undercapitalized banks and dif­
ferences in bank behavior.

Asset Growth
W hen the capital ratio o f a bank falls to a re ­
latively low level, its shareholders have less to
lose and, correspondingly, m ore to gain by
assuming additional risk, in the hope o f a suffi­
ciently large turnaround in income to eliminate
the capital deficiency. One w ay that a bank
assumes additional risk is to increase its assets.
Bank supervisors, o f course, p re fer to see under­
capitalized banks reduce their assets, to raise
their capital ratios.
Most o f the 531 banks reduced their assets
substantially w hile undercapitalized, consistent
w ith the desires o f bank supervisors. A sizable
number, how ever, actually experienced rapid
asset growth. At 84 banks (16 percent o f the
total), asset grow th exceeded 10 percent while
prim ary capital ratios w ere below 5.5 percent;
in fact, asset grow th exceeded 25 percent at 44
undercapitalized banks.1 Most banks whose
4
asset grow th exceeded 25 percent w ere Texas
national banks supervised by the OCC—26 o f
the 28 Texas banks in this study w ith asset
grow th in excess o f 25 percent w ere national
banks.1
5

ample, involve subsidiaries of the same holding com­
panies, which do not change the leverage of these holding
companies. For each of these 12 banks, asset growth in
the period in which their primary capital ratios were below
5.5 percent is measured as the percentage change in the
period before or after the merger, whichever is the longer.
15See O’Keefe (1990) for a thorough discussion of the per­
formance problems of Texas banks and the problems with
bank supervision in Texas in recent years.

25

Table 3
Behavior of Undercapitalized Banks
Banks w ith gro w th in assets
w hile capital ratios below
the required level

Census Region
New England
Middle Atlantic
South Atlantic
East South Central
West South Central1
Louisiana
Oklahoma
Texas
East North Central
West North Central
Pacific Northwest
Pacific Southwest
TOTAL

Number of
banks

Asset g ro w th
in excess
of 10 percent
4
4
3
1
53

6
7
15
10
320

Asset grow th
in excess
of 25 percent
2
0
2
0
28

0
3
50

43
54
223

Banks that
paid dividends
w hile
undercapitalized

Banks w ith the ir
highest levels of
insider loans when
undercapitalized
1
1
3
3
71

2
2
3
3
46
11
7
28

0
0
28

10
14
47

29
81
17
46

2
9
2
6

0
6
2
4

3
14
2
5

9
20
1
17

531

84

44

79

126

^ h e West South Central Region also includes Arkansas, which had no banks that were undercapitalized for more than four
consecutive quarters.
Note: States in census regions:
New England: Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island and Vermont
Middle Atlantic: New Jersey, New York and Pennsylvania
South Atlantic: Delaware, Florida, Georgia, Maryland, North Carolina, South Carolina, Virginia and West Virginia
East South Central: Alabama, Kentucky, Mississippi and Tennessee
East North Central: Illinois, Indiana, Ohio, Michigan and Wisconsin
West North Central: Iowa, Kansas, Minnesota, Missouri, Nebraska, North Dakota and South Dakota
Pacific Northwest: Alaska, Idaho, Montana, Oregon, Washington and Wyoming
Pacific Southwest: Arizona, California, Colorado, Hawaii, Nevada, New Mexico and Utah.

Dividends
A bank's capital absorbs its losses, thereby
protecting uninsured depositors and the deposit
insurance fund from the prospect o f the bank's
failure. Dividends reduce this capital cushion.
Thus, a bank must obtain permission from its
supervisors to pay dividends that exceed its cur­
rent earnings, and supervisors can restrict the
payment o f dividends if a bank's capital ratio is
below the required level.1 About 15 percent o f
6
the banks in this study, how ever, paid dividends
on their common stock w hile their prim ary capi­
tal ratios w ere below the minimum level.

16Spong (1990), pp. 64-71.
^D epartm ent of the Treasury (1991), pp. X-12 through X-14.




The recent Treasury study reports similar fin­
dings on dividends paid b y undercapitalized
banks. In 1989, fo r instance, about 14 percent
o f the 525 banks w ith ratios o f equity capital to
assets below 4.5 percent paid dividends.1
7

Loans to Insiders
Banks are perm itted to make loans to their o f­
ficers and directors (or "insiders").1 If a bank’s
8
shareholders and insiders are not exactly the
same group, the shareholders have an incentive
to limit insider loans, because o f the “moral
hazard” o f having insiders assess their ow n

18See Spong (1990), pp. 60-63, for a description of insider
lending regulations.

MAY/JUNE 1991

26

creditworthiness. If, how ever, a bank’s capital
(and, hence, its capital ratio) has fallen to a
relatively lo w level, shareholders may exert less
constraint on insider lending simply because
they have less to lose. Th erefore, w hen banks
becom e undercapitalized, supervisory actions to
limit insider loans take on greater importance in
limiting the deposit insurance fund’s losses.
Table 3 displays information on the number
o f undercapitalized banks that reported their
highest levels o f insider lending w hile under­
capitalized. This measure is important because
it reflects the maximum exposure b y these banks
to losses on such loans. A sizable minority of
the banks (about 24 percent) reported their
highest levels o f insider loans w hen their capital
ratios w e re below the minimum required level.1
9

Differences in Constraints Across
Supervisors
D ifferences in practices among the super­
visors o f comm ercial banks may explain some o f
the variation in behavior among the undercapi­
talized banks. As noted above, most undercapi­
talized banks w ith rapid asset grow th w ere na­
tional banks located in Texas. In Texas, h o w ­
ever, national banks are a majority o f all com ­
m ercial banks in the state. The concentration o f
national banks in Texas among the various
groups o f undercapitalized banks may reflect
simply the relatively large share o f national
banks in Texas.
Table 4 examines the behavior o f Texas banks
by federal supervisory agency. The first ro w
presents the distribution o f these banks by their
federal supervisory agency. The follow ing row s
show the numbers o f undercapitalized banks in
various categories by federal supervisory agen­
cy. Below the numbers o f undercapitalized banks
are their percentages o f the total num ber o f
Texas banks supervised by the same federal
agency. Asterisks indicate w hether the prop or­
19The 12 banks involved in mergers while undercapitalized
may have had their insider loans rise while undercapitaliz­
ed because they merged with banks that had insider loans
before the mergers. To avoid such biases, these 12 banks
are classified among those that did not have their highest
level of insider loans while undercapitalized.
20This paper compares recovery rates across banks rather
than failure rates because the distinction between failed
and surviving banks is rather arbitrary in some cases. For
example, banks with negative equity for several con­
secutive quarters would be classified as survivors simply
because they remained in operation.

FEDERAL RESERVE BANK OF ST. LOUIS



tions fo r national banks are significantly d if­
ferent from those fo r state-chartered insured
banks.
Table 4 shows substantial differences in the
representation o f national and state-chartered
banks among the undercapitalized banks in
Texas. Almost 18 percent o f the national banks
had prim ary capital ratios below 5.5 percent fo r
m ore than four consecutive quarters, compared
w ith about 8 percent fo r state-chartered banks.
O ver 6 percent o f national banks w ere under­
capitalized fo r eight or m ore consecutive quar­
ters, com pared with 1.8 percent fo r statechartered banks. Most o f the banks with
negative equity are national banks, especially
those w ith negative equity fo r four or m ore
quarters. National banks also account fo r most
o f the undercapitalized banks w ith rapid asset
growth.
Table 5 makes the same comparisons among
national and state-chartered insured banks out­
side o f Texas. The only significant differences in
proportions fo r banks outside o f Texas involve
undercapitalized banks w ith negative equity.
Significantly higher proportions o f national banks
had negative equity than fo r state-chartered
banks. The other differences in proportions are
not significantly different from zero. Thus, the
relatively high concentrations o f national banks
among the various groups o f undercapitalized
banks w ere prim arily in Texas.

The Behavior o f Undercapitalized
Banks and their R e c o v e ry Rates
Because some undercapitalized banks violated
the constraints that w ould be imposed under
the Treasury proposal fo r prom pt corrective ac­
tion, w e can test w hether these constraints
w ould have had a positive effect on bank capital
recovery rates. If such constraints tend to in­
crease the recovery rate, w e should expect
low er recovery rates among the banks that
violated these constraints.2
0

27

Table 4
Distribution of Federally Insured Commercial Banks in Texas by
Their Primary Supervisory Agency
Federal supervisory agency
OCC
FR
FDIC
Average number of banks
1985-89
Banks with primary capital
ratios below 5.5 percent
for more than four
consecutive quarters

916

162**
(17.69%)

Total num ber
of banks

76

705

1,697

7
(9.21%)

54
(7.66%)

223

Of these undercapitalized banks, number with the following characteristics:
Primary capital ratios
below 5.5 percent for eight
or more consecutive quarters

Negative equity for at
least one quarter

Negative equity for four or
more consecutive quarters

Asset growth in excess of
10 percent while
undercapitalized

Asset growth in excess of
25 percent while
undercapitalized

Paid dividends while
undercapitalized

Highest level of
insider loans while
undercapitalized

59**
(6.44%)

2
(2.63%)

12
(1.70%)

73

97 **
(10.59%)

2
(2.63%)

18
(2.55%)

117

45**
(4.91%)

0
(0.00%)

1
(0.14%)

46

40**
(4.37%)

4
(5.26%)

6
(0.85%)

50

26 **
(2.84%)

2
(2.63%)

0
(0.00%)

28

13
(1.42%)

0
(0.00%)

15
(2.13%)

28

30**
(3.28%)

3
(3.95%)

14
(1.99%)

47

Note: Figures in parentheses are percentages of the total number of banks supervised by that agency.




Single asterisk (*) indicates that the proportion of banks supervised by the OCC is
significantly different from the proportion of state-chartered insured banks at the 5 percent
level.
Double asterisk (**) indicates that the proportion is significantly different at the 1 percent
level

MAY/JUNE 1991

28

Table 5
Distribution of Federally Insured Commercial Banks Outside
Texas by Their Primary Supervisory Agency
Federal supervisory agency
OCC
FR
FDIC
Average number of banks
1985-89
Banks with primary capital
ratios below 5.5 percent
for over four consecutive
quarters

3,689

97
(2.63%)

Total num ber
o f banks

1,018

7,261

11,968

25
(2.46%)

186
(2.56%)

308

Of these undercapitalized banks, number with the following characteristics:
Primary capital ratios
below 5.5 percent for 8
or more consecutive quarters

Negative equity for at
least one quarter

Negative equity for 4 or
more consecutive quarters

Asset growth in excess of
10 percent while
undercapitalized

Asset growth in excess of
25 percent while
undercapitalized

Paid dividends while
undercapitalized

Highest level of
insider loans while
undercapitalized

31
(0.84%)

8
(0.79%)

66
(0.91%)

105

47**
(1.27%)

7
(0.69%)

42
(0.58%)

96

15*
(0.41%)

0
(0.00%)

11
(0.15%)

26

12
(0.33%)

4
(0.39%)

18
(0.25%)

34

3
(0.08%)

3
(0.29%)

10
(0.14%)

16

18
(0.49%)

0
(0.00%)

33
(0.45%)

51

28
(0.76%)

6
(0.59%)

45
(0.62%)

79

Note: Figures in parentheses are percentages of the total number of banks supervised by that agency.
Single asterisk (*) indicates that the proportion of banks supervised by the OCC is
significantly different from the proportion of state-chartered insured banks at the 5 percent
level.
Double asterisk (**) indicates that the proportion is significantly different at the 1 percent
level.

FEDERAL RESERVE BANK OF ST. LOUIS



29

Table 6
Recovery Rates of Undercapitalized Banks
Total num ber
o f banks

Percentage tha t recovered
by IV/1989

Banks with asset growth
exceeding 10 percent
Other banks

84
447

23.81%
24.61
(0.16)

Banks with asset growth
exceeding 25 percent
Other banks

44
487

22.73
24.64
(0.29)

Banks that paid dividends
while undercapitalized
Other banks

79
452

32.91
23.01
(1.75)

Banks that increased insider
loans while undercapitalized
Other banks

126
405

24.60
24.44
(0.04)

Note: Absolute values of t-statistics for tests of differences in proportions are in parentheses.

Table 6 compares the recovery rates o f banks
that violated the constraints w ith those that did
not. The recovery rates o f the tw o groups o f
banks are not significantly different. The recov­
ery rate fo r banks that paid dividends is slightly
higher than that fo r the other undercapitalized
banks, although this difference is not statistical­
ly significant at the 5 percent level. Similarly, the
other observed differences are not significantly
different from zero.
A comparison o f recovery rates in table 6
shows that asset grow th, dividends and insider
loans are not important determinants o f recov­
ery. These results im ply that imposing constraints
on this behavior should not significantly affect
the recovery rates o f undercapitalized banks.2
1

CONCLUSIONS
Bank supervisory reform is a major com po­
nent o f the overall plan fo r deposit insurance
reform recently proposed by the U.S. Depart­
ment o f the Treasury. Under this proposal, su­
pervision w ould be based on the capital ratios

2 Dahl and Spivey (1991) report similar results. They ex­
1
amine the characteristics of undercapitalized banks that
help distinguish between those that once again have
capital ratios above the required level and those that do




o f banks. I f a bank's capital ratio fell below the
level acceptable to supervisors, it w ould be sub­
ject to mandatory constraints on its behavior.
This proposal fo r prom pt corrective action would
limit the discretion o f supervisors in dealing
w ith undercapitalized banks.
The proposal's objective is to reduce the num­
ber o f bank failures and the losses by the de­
posit insurance fund. Advocates o f the proposal
assume that imposing sanctions on banks whose
capital ratios fall below critical levels w ould give
the managers o f healthy banks the incentive to
keep their capital ratios above the critical levels
at which the sanctions becom e mandatory. By
authorizing the closing o f banks with low but
positive capital ratios, the proposal gives
shareholders o f undercapitalized banks incentive
to inject capital promptly, if they wish to retain
control o f their banks. Finally, the sanctions are
assumed to constrain the types o f behaviors
that make undercapitalized banks m ore likely to
fail and to increase the losses o f the deposit in­
surance fund.

not recover. They find that asset growth and dividends do
not help distinguish between the banks that recover and
those that do not.

MAY/JUNE 1991

30

In the years 1985-89, many banks remained
in operation fo r extended periods o f time w ith
prim ary capital ratios below the minimum re­
quired level. Substantial minorities o f these un­
dercapitalized banks violated the constraints
that w ould be imposed under the proposed policy
o f prom pt corrective action. This behavior, p re­
sumably, w ould not be perm itted under the
proposed policy.
The evidence does not support the hypothesis
that once the capital ratio o f a bank falls below
the minimum required level, enforcing the sanc­
tions specified in the Treasury proposal w ould
increase the chances that the undercapitalized
bank w ill recover. The recovery rates o f under­
capitalized banks that violated these constraints
w ere no lo w er than the recovery rates o f other
undercapitalized banks. Data are not available
to test the hypothesis that the failures o f the
banks violating the constraints specified in the
proposal fo r prom pt corrective action imposed
relatively large losses on the deposit insurance
fund.
Thus, if the proposed policy o f prom pt correc­
tive action can be expected to reduce the rate
o f bank failure, this effect must w ork through
the incentives fo r healthy banks to keep their
capital ratios relatively high. T o draw conclu­
sions about the strength o f this incentive, it is
necessary to make assumptions about h ow bank
management w ould view the penalties to be im­
posed on banks w ith and without legislation re­
quiring prom pt corrective action by supervisors.
Evidence presented in this paper indicates that
the sanctions imposed on undercapitalized banks
in recent years have been similar to those to be
imposed under the proposed policy.
First, several hundred banks w e re closed in
recent years shortly after their capital ratios fell
below the minimum required level. Th eir failure
did not result from violation o f the types o f
constraints that w ould be imposed under the
Treasury proposal. Resolutions o f these cases
appear to have been handled much as they
w ould under the policy o f prom pt corrective
action.
Second, while a large number o f banks had
capital ratios below the required level fo r m ore
than a year, most o f them did not violate the
constraints to be imposed under the policy o f
prom pt corrective action.
Indeed, the fact that a large share o f the cases
in which undercapitalized banks violated these


FEDERAL RESERVE BANK OF ST. LOUIS


constraints involves banks in one state under
the jurisdiction o f one supervisory agency sug­
gests that such cases are the exception, rather
than the norm. Thus, there is some evidence
that the nature o f bank supervision in recent
years provided banks w ith the incentive to keep
their capital ratios above the required level w ith ­
out additional legislation.
The evidence on recovery rates o f the banks
that w ere undercapitalized fo r m ore than a
year provides empirical support fo r one element
o f the Treasury proposal: the prom pt closing o f
banks w ith low but positive capital ratios unless
their shareholders act prom ptly to raise their
capital ratios. As this paper shows, only 24 p er­
cent o f the undercapitalized banks recovered in
the period examined. Thus, the Treasury p ro­
posal w ould not result in prem ature closings of
large numbers o f banks that ultimately w ould
recover if given enough time.

REFERENCES
Benston, George J., and George G. Kaufman. Risk and
Solvency Regulation of Depository Institutions: Past Policies
and Current Options, Monograph Series in Finance and
Economics, Graduate School of Business Administration,
New York University, Monograph 1988-1.
Bovenzi, John F., and Maureen E. Muldoon. “ FailureResolution Methods and Policy Considerations,” FDIC
Banking Review (Fall 1990), pp. 1-11.
Cobos, Dean Forrester. “ Forbearance: Practices and Pro­
posed Standards,” FDIC Banking Review (Spring/Summer
1989), pp. 20-28.
Conference of State Bank Supervisors. A Profile of StateChartered Banking (1986).
Dahl, Drew, and Michael F. Spivey. "Moral Hazard, Equity Is­
suance and Recoveries of Undercapitalized Banks,” Pro­
ceedings of a Conference on Bank Structure and Competi­
tion, Federal Reserve Bank of Chicago, May 1991.
Department of the Treasury. Modernizing the Financial
System (February 1991).
Gilbert, R. Alton, Courtenay C. Stone, and Michael E. Trebing.
“ The New Bank Capital Adequacy Standards,” this Review
(May 1985), pp. 12-20.
Kummer, Donald R., Nasser Arshadi, and Edward C.
Lawrence. “ Incentive Problems in Bank Insider Borrowing,”
Journal of Financial Services Research (October 1989), pp.
17-31.
O’Keefe, John. “ The Texas Banking Crisis: Causes and Con­
sequences, 1980-89,” FDIC Banking Review (Winter 1990),
pp. 1-34.
Spong, Kenneth. Banking Regulation: Its Purposes, Imple­
mentation, and Effects, 3rd ed., (Federal Reserve Bank of
Kansas City, 1990).
U.S. General Accounting Office. Deposit Insurance: A
Strategy for Reform (March 1991).
Wonnacott, Thomas H., and Ronald J. Wonnacott. Introduc­
tory Statistics for Business and Economics (John Wiley and
Sons, 1990).

31

James B. Bullard
James B. Bullard is an economist at the Federal Reserve Bank
of St. Louis. David H. Kelly provided research assistance.

The FOMC in 1990: Onset of
Recession
T
HE FOURTH QUARTER OF 1990 marked
the end o f a long expansion o f the U.S. economy,
extending almost continuously from the final
quarter o f 1982. In Novem ber, industrial pro­
duction plummeted at an annual rate o f 19.8
percent, and civilian em ployment fell by nearly
450,000. The most recent estimate o f real gross
national product (GNP) indicates that it fell at an
annual rate o f 1.6 percent in the fourth quarter,
and the unemployment rate climbed from 5.3
percent in June to 6.1 percent by the end o f
the year. By all accounts, recession had arrived.1
Because the U.S. econom y entered the reces­
sion in the latter portion o f the year, calendar
1990 is an interesting period in which to sum­
marize the actions o f the Federal Open Market
Committee (FOMC).2 By considering FOMC direc­
tives chronologically, this paper w ill develop a
case study o f m onetary policymaking during the
onset o f a recession. W ithin the context o f the
chronology, emphasis w ill be placed on tw o
types o f uncertainty faced by the Committee.
First, there is uncertainty about the immediate
past, current and future path o f real output, a
prim ary measure o f economic activity. Second,
'According to the Federal Reserve Board’s 1991 Monetary
Policy Objectives (p. 3), “ The [U.S.] economy . . . fell into
recession in the latter part of 1990, and . . . that recession
has clearly continued into the early part of 1991.” The Na­
tional Bureau of Economic Research (NBER), which
makes official decisions on dating business cycle peaks
and troughs, recently announced that the expansion peak­
ed in July 1990.




there is uncertainty about the thrust o f m onetary
policy at a point in time, because o f the various
ways the policy stance can be measured. W hile
many other considerations enter into FOMC
policymaking, as w ill be shown, these tw o fac­
tors loom large in the Committee's attempts to
react swiftly and effectively to economic events.
The next section provides the background fo r
understanding Committee decision-making in
1990. It introduces the FOMC’s stated objectives
and illustrates briefly how the Committee might
hope to bring them into balance. This back­
ground is crucial to an understanding o f the
bulk o f the paper, the chronology o f FOMC
decision-making contained in the subsequent
section. The final portion o f the paper provides
summary comments.

A FRAMEWORK FOR ANALYZING
FOMC POLICY ACTIONS
No analysis o f FOMC actions can take place
until some context fo r the decision-making is
provided.3 T o make sense o f the subsequent
chronology, it is essential to understand what
2See the shaded insert, “ The Organization of the FOMC,”
for a description of the Committee.
3The terms “ decision-m aking” and “ policy actions” are
used interchangeably in this article.

MAY/JUNE 1991

32

The Organization o f the F O M C
The Federal Reserve Board o f Governors
consists o f seven members, and each o f these
members has voting rights on the Federal
Open Market Committee (FOMC). The presi­
dent o f the N ew York Federal Reserve Bank
also is a permanent voting m em ber o f the
FOMC. The remaining 11 Federal Reserve
Bank presidents attend meetings and present
views, but only four o f these 11 have voting
privileges at any one meeting. The voting
rights are held fo r terms o f one calendar
year and rotate among these presidents
annually.
Th e Committee typically meets eight times
per year, as it did in 1990, and sometimes
consults by telephone betw een scheduled
meetings. At the end o f each meeting, the
Committee agrees on a directive to issue to
the Federal Reserve Bank o f N ew York. The
directive contains instructions fo r the con­

the Committee is trying to do and h ow it might
hope to achieve its desires. These are matters o f
controversy in macroeconomics, and the con­
troversy w ill not be resolved in this article. In­
stead, the follow ing fram ew ork fo r understand­
ing FOMC decision-making relies prim arily on
official Committee statements and simple em ­
pirical illustrations.4 Potential interpretations or
conclusions are left to the reader.

F O M C M onetary P olicy Objectives
The FOMC stated its goals fo r m onetary policy
in each o f the eight directives it issued in 1990.
Specifically, the objectives o f the Committee
w ere to foster progress tow ard price stability
and to prom ote sustained real output grow th .5
Implementation o f these objectives was general­
ly achieved by Committee-ordered intervention
“The official summary of Committee deliberations is con­
tained in the ‘‘Record of Policy Actions of the Federal
Open Market Committee” for each meeting, released to
the press shortly after the subsequent regular meeting and
later published in the Federal Reserve Bulletin and the
Board’s Annual Report. References to ‘‘the Record” and
to press releases in this article refer to this document.
5The following sentence appears in every 1990 directive:
“ The [FOMC] seeks monetary and financial conditions that
will foster price stability, promote growth in output on a


FEDERAL RESERVE BANK OF ST. LOUIS


duct o f open market operations until the next
regularly scheduled meeting.
A summary o f each FOMC meeting is re ­
leased to the press within a fe w business
days follow ing the next regularly scheduled
meeting and is subsequently published in the
Federal Reserve Bulletin. The summary, known
as the "Record o f Policy Actions o f the Fed­
eral Open Market Committee,” is prepared by
the Board staff and review ed b y the Commit­
tee. It typically contains: (1) A synopsis o f re ­
cent econom ic data, (2) A review o f recent
open market operations and money market
conditions, (3) A Board staff projection o f
likely near-term econom ic developments,
(4) A summary o f Committee deliberations,
(5) The policy directive along w ith a record
o f votes and dissenting comments, and (6) A
summary o f any other business conducted.

in the market fo r reserves or, in Committee
parlance, by altering the " . . . degree o f
pressure on reserve positions.”6
Committee members sometimes reconcile the
tw o policy objectives by view ing price stability
as a long-run goal and, correspondingly, sustain­
ed real output grow th as a short-run goal. For
instance, one summary o f a Committee discus­
sion cites some members arguing that "an eas­
ing o f short-run policy if such w ere needed to
help avert a cumulative deterioration in econom ­
ic activity . . . w ould not be inconsistent with
the Committee’s long-term commitment to price
stability.”7 Similarly, references are sometimes
made to "the Committee’s long-run, anti-inflation
strategy.”8 The next section illustrates, via a sim­
ple empirical exercise, one sense in which price
stability is a long-run goal.
sustainable basis, and contribute to an improved pattern of
international transactions.” The third objective, more am­
biguous than the first two, also plays a role in the analysis
to follow.
6This terminology appears in every FOMC directive in 1990.
The market for reserves is discussed in more detail below.
7March Press Release, pp. 12-13.
8August Press Release, p. 13.

33

Controlling Inflation
The FOMC’s objective o f controlling inflation
arises out o f a generally accepted proposition
that the Committee has considerable influence
over the long-run rate o f price level change. For
instance, at the February 1990 meeting "the
Committee recognized that over time . . . slower
M2 grow th w ould be compatible w ith price
stability . . ,”9 Since all Committee decision­
making needs to be understood w ith this prop­
osition in mind, some evidence on long-run
inflation w ill be considered h ere.1
0

Figure 1
The Quantity Theory and
International Evidence 1970-1989
Average annual CPI inflation

Average annual CPI inflation

Following Lucas (1980), consider a version o f
the quantity theory o f m oney w ith the key im­
plication stated as follows: over the long term,
an increase in the quantity o f money, appro­
priately defined, is reflected in an equal and
proportionate increase in the price level.1 The
1
proposition can be investigated in an atheoretical
way, since there is a wealth o f available interna­
tional cross-section evidence. Th e evidence p re­
sented below constitutes an updated version of
that marshaled by Vogel (1974) and analyzed in
Lucas (1987, 1980) and D w yer and Hafer (1988).
Figure 1 provides a plot o f 20-year averages
o f grow th rates o f M2 and the associated 20year averages o f annual changes in the con­
sumer price index fo r 23 OECD countries, 11
Latin American countries and M exico.1 The
2
period covered is 1970 to 1989; each country is
a single observation in the figure. The quantity
theory predicts that the observations w ill lie on
a 45° line, that is, that changes in money stocks
and price levels w ill be proportional. The 45°
line in the diagram is adjusted to pass through
the mean o f the data, but it has a slope o f posi­
tive one. It is not a regression line; no attempt
has been made to fit the line to the data. The
fact that the observations lie near the 45° line

9March Press Release, p. 12.
10See also the work on money and inflation in the P* model,
such as Hallman, Porter and Small (1989).
1 For a discussion of the quantity theory and its variants,
1
see Laidler (1985).
12The countries are: Australia, Austria, Belgium, Brazil,
Canada, Denmark, Finland, France, (West) Germany,
Greece, Iceland, Ireland, Italy, Japan, Norway, The
Netherlands, New Zealand, Portugal, Spain, Sweden,
Switzerland, Turkey, United Kingdom, United States,
Argentina, Chile, Columbia, Guyana, Suriname, Paraguay,
Mexico, Peru, Bolivia, Venezuela, Ecuador and Uruguay.
Some observations were missing: Brazil, 1985-1989; Col­
umbia, 1986 and 1989; Chile, 1985-1989; Guyana,
Suriname, Paraguay, Peru, Bolivia and Ecuador, 1989.




Average Annual M2 Growth

provides some evidence o f the validity o f the
quantity theory.1
3
Lucas (1987) was happy enough w ith this type
o f evidence to pronounce the inflation problem
"successfully solved in a scientific sense.”1 The
4
figure does seem to reflect what many econo­
mists and market participants have in mind
w hen they think about the relationship betw een
central bank actions and inflation. The theory
appears to w ork surprisingly well, as the figure
contains information derived from countries

Where data are missing, averages are over available
years. M2 is used because the FOMC sets target ranges
for this aggregate and because information on this ag­
gregate is collected for all countries in the sample.
13One possible objection to this evidence is that the relation­
ships between monetary growth and inflation have chang­
ed in the 1980s. However, the plots of recalculated
averages using only 1980s data tell, by and large, the
same story as figure 1. See also Dwyer and Hafer (1988).
Recalculating the averages using M1 also does not alter
the general conclusion.
14Lucas (1987), p. 221.

MAY/JUNE 1991

34

w ith ve ry different social and economic struc­
tures. Most im portantly fo r the purposes o f
analyzing FOMC decisions, the figure provides a
basis fo r the Committee’s concern about infla­
tion because it relates inflation to money
grow th, and the Committee sets target ranges
fo r certain m onetary aggregates.
W hile lo w inflation countries tend to be low
m oney grow th countries, the relationship is far
from exact. For instance, Japan experienced a
5.5 percent rate o f annual inflation during the
period w ith an average M2 grow th rate o f over
11 percent, w hile the U.S. experienced inflation
o f 6.1 percent w ith M2 grow th averaging 8.3
percent per annum.1 W hile a fe w percentage
5
points on the inflation rate is substantial by U.S.
standards, it is not a lot b y w orld standards.
The good fit in the diagram is obtained b y ex­
amining countries w ith a broad range o f infla­
tion experiences, from near zero to m ore than
80 percent per year. The point is that the U.S.
Federal Reserve, when compared with other cen­
tral banks worldwide, tends to be in the low
m oney g row th —low inflation group.
Another important consideration, emphasized
by Lucas (1980), is that the FOMC’s influence on
inflation appears to be the product o f a great
many decisions over a ve ry long time frame.
The evidence presented says nothing about the
relationship betw een money grow th and infla­
tion on a quarter-by-quarter basis.1 Thus, even
6
when inflation control is taken very seriously,
the FOMC may have considerable room to ma­
neuver on a meeting-by-meeting basis and still
meet its stated long-run inflation objective.

Sustaining Real Output Growth
The nature o f the relationship betw een
m onetary policy and real activity is controver­
sial and remains an unresolved issue in m acro­
economics.1 Nevertheless, FOMC meeting sum­
7
maries indicate that Committee members believe
an easier policy can mitigate declines in real
15Simple measurement error is one possible reason for such
discrepancies.
16See Lucas (1980) for a method of recovering the close fit
for U.S. quarterly data.
17For a recent survey, see Blanchard (1990).
,8December Press Release, p. 12.
19February Press Release, p. 12.
20February Press Release, p. 12.
21 October

Press Release, p. 12.

FEDERAL RESERVE BANK OF ST. LOUIS



output, at least in the short term. In N ovem ber
1990, fo r instance, "the members agreed that a
limited degree o f easing at this juncture w ould
provide some insurance against a deep and p ro ­
longed recession. . . .”1 Similarly, in December,
8
“Mem bers noted that m onetary policy had been
eased . . . [and that] a limited fu rth er m ove
w ould provide some added insurance in cush­
ioning the econom y against the possibility o f a
deepening recession. . . .”1 At the same m eet­
9
ing, referen ce is made to “The stimulus p ro ­
vided by the recent easing. . . ,”2 In August
0
1990, Committee discussion noted that “a tight­
ening m ove . . . might stall an already weak
economic expansion.”2 Th erefore, w hile due
1
note is taken o f the theoretical controversy, fo r
the purposes o f this article, the real effects o f
m onetary policy are simply taken as given.

The R o le o f Forecasts in ShortRun P olicy Actions
The FOMC’s stated short-run policy objective
necessarily emphasizes the role o f forecasting.
The Committee must make an assessment o f the
likely direction o f the econom y in the near term
if it wants to cushion changes in real output
w hen warranted. In addition, the Committee
also must assess the current and immediate past
position o f the economy, since reliable data on
real GNP are not available fo r several quarters.
As w ill becom e clear in the next section, h ow ­
ever, economists have a difficult time forecasting
even a fe w quarters ahead. By proxying the in­
form ation on real GNP available to the Commit­
tee w ith the Blue Chip Consensus forecast, and
by using only data available at the time o f the
meeting, an appreciation o f the uncertainty the
Committee faced in 1990 m eeting by meeting
w ill be developed.2
2
The Blue Chip Consensus is not the only in­
dicator o f the perception o f economists regar­
ding real activity. The Board staff prepares a
forecast especially fo r each meeting, and that
projection is probably the most relevant one
22The Blue Chip Economic Indicators is a monthly survey of
about 50 mostly private sector economic forecasting firms.
The Blue Chip forecast for a variety of economic variables
is the average forecast of these firms.

35

H o w Much Uncertainty Exists in Forecasts of
Quarterly Real G1VP?
Forecasts o f quarterly changes in real GNP
tend not to be very accurate, as is w ell known.
T o get some idea o f the uncertainty involved,
consider the forecast errors based on the
Blue Chip Consensus fo r the time period
IV/1982 to IV/1989.
Each month, Blue Chip publishes a consen­
sus forecast fo r the annualized rate o f real
GNP grow th in the current quarter and each
quarter ahead fo r at least one year. Although
actual data are sometimes revised many years
after they are first published (so-called bench­
mark revisions), changes in real GNP are
often considered final w ithin about three
months o f the end o f the quarter. Taking the
published forecast at the midpoint o f the
quarter (e.g., February 10 fo r the first quar­
ter) and subtracting the final figure gives the
forecast erro r at various time horizons. The
mean erro r and the mean absolute forecast
error at these horizons are as follows (32
observations):

Forecast
H orizon
Contemporaneous
1 quarter ahead
2 quarters ahead
3 quarters ahead
4 quarters ahead

Mean
Forecast
E rro r

The difficulty o f aggregate economic fo re ­
casting w ill come as no surprise to many
readers, and it is not hard to identify plausi­
ble reasons fo r the problem. Th ere may
simply be considerable random variation in
real activity. Similarly, it may be that real
output reacts quite quickly to unpredictable
economic and political events. In 1990, one
such event stands out: the Iraqi invasion o f
Kuwait and the subsequent large variations in
the price o f oil. In addition, all forecasts are
conditional on policy, and actual policy may
d iffer from that built in at the time o f the
forecast.

Mean
A bsolu te
Forecast
E rro r

-.43
-.29
-.24
-.48
-.55

O f prim ary concern are the relatively large
mean absolute deviations. They suggest that
outcomes far from w hat is forecast often oc­
cur, as an average e rro r at any horizon is at
least 1.74 percent. Also interesting is that, fo r
this set o f forecasts, there is at least as much
uncertainty surrounding the current quarter
forecast as the four-quarter-ahead forecast.

2.03
2.04
2.00
1.74
1.76

fo r Committee decision-making.2 Unfortunately,
3
it is not declassified until five years after the
meeting. Using the Blue Chip forecasts as a
proxy fo r information available to the Commit­
tee is not much o f a concern fo r the analysis to
follow , how ever, because in every case, the
qualitative description o f the Board projection
given in the Record o f Policy Actions is consis­
tent with the Blue Chip Consensus. Further­

more, in only one case did the Committee's
assessment d iffer qualitatively from that o f the
Board staff; that case (the October meeting) w ill
becom e apparent. Finally, the forecasting d iffi­
culties discussed in detail below are not a mat­
ter o f decimal points but o f qualitative direction;
the Blue Chip forecasts w ill serve to illustrate
this point.2
4

23According to Meltzer (1990), p. 31, “ Fed forecasts of GNP
are as accurate as the forecasts from other models . . .”
See also Karamouzis and Lombra (1989) and Meltzer
(1987).
24See the shaded insert, “ How Much Uncertainty Exists in
Forecasts of Quarterly Real GNP?” for a description of the
uncertainty surrounding these forecasts.




MAY/JUNE 1991

36

Measuring the P olicy Stance
A n y summary o f FOMC m onetary policy ac­
tions requires some measurement o f the policy
stance at a point in time. One o f the problems
o f m onetary policymaking is that various mea­
sures can yield conflicting signals, sometimes
making it difficult to discern the thrust o f pol­
icy. Consideration in this paper w ill be given to
four possible measures, or "indicators,” o f the
m onetary policy stance: the language o f the di­
rective, the federal funds rate, the m onetary ag­
gregate M2, and total reserves.2 O f these, the
3
simplest and most straightforw ard measure, re ­
lied on heavily in the follow ing chronology, is to
examine the Record to find out the language o f
the directive. Th e other indicators are based on
a simple analysis that associates "easing” or
"tightening” w ith movements in measured
variables.
Th e implementation o f m onetary policy typical­
ly occurs via intervention in the market fo r
reserves, w hich are actively traded among banks.
The interest rate in this market is the federal
funds rate, and the total reserve supply is sub­
ject to control by the Federal Reserve. For a
given downward-sloping demand, the Federal
Reserve can increase (decrease) the federal funds
rate b y decreasing (increasing) the supply o f
total reserves. A common simple analysis relates
the sum o f total reserves and currency (the
m onetary base) to measures o f m oney such as
M2 by a proportional factor greater than one
known as the m oney m ultiplier.2 Generally
6
speaking, therefore, a decrease in the federal
funds rate, an increase in M2 and an increase
in total reserves can be indications o f easier
m onetary policy, w hile movements in the op­
posite directions can be indications o f tighter
policy. In practice things are not so clear be­
cause the demand fo r reserves (and also the

25This list is by no means exhaustive. There are many other
indicators that receive attention from economists, including
various monetary aggregates, reserve components, in­
terest rate spreads, commodity prices and so on.
Reference to these alternative indicators is suppressed in
this article in the interest of streamlining the discussion.
26See Papademos and Modigliani (1990) for a recent
exposition.
27ln the Record these fluctuations in demand are sometimes
referred to as short-run technical factors.
28The range for the federal funds rate was set primarily for
consultative purposes; that is, if the actual rate fluctuated
persistently outside the range during an intermeeting
period, the Committee agreed to discuss the situation. The
Committee did not set a range for the federal funds rate at

FEDERAL RESERVE BANK OF ST. LOUIS



demand fo r M2) may fluctuate over time, p e r­
haps swamping the effect o f a change in reserves
on the federal funds rate or on M2.2
7
Nevertheless, because total reserves are sub­
ject to control by the Committee, they constitute
a logical indicator o f policy. In addition, because
the Committee set target ranges fo r both the
federal funds rate and M2 in 1990, they are also
logical indicators o f the policy stance.2 Gener­
8
ally, how ever, one’s assessment o f the policy
stance at a point in time can d iffe r depending
on w hich indicator is used. As w ill be shown
below, the indicators can give conflicting
signals, differin g not only from the language o f
the directive but also from each other.
The data on indicators referen ced in the
subsequent chronology are plotted in figures 2
through 6. The prim ary referen ce fo r the federal
funds rate that w ill be used is the w eekly time
series fo r 1990 presented in figure 2.2 The
9
1990 w eekly series fo r M2 is plotted in figure 3;
the annualized w eekly grow th rates are plotted
in figure 4.3 The interpretation o f M2 is typical­
0
ly within the context o f the target cone, which
is review ed by the Committee tw ice yearly and
represents the FOMC’s long-term target. W ithin
the target cone, how ever, is some leew ay to
alter M2 grow th rates m eeting b y meeting. As
can be seen from figure 4, grow th rates o f
monetary aggregates tend to be fairly noisy.
The time series fo r total reserves in 1990 is
given in figu re 5. Unfortunately, these data also
tend to be noisy; in addition, the Committee
does not set a target grow th cone fo r total re­
serves. These facts sometimes combine to make
interpretation difficult. Figure 6, how ever, plots
the annualized interm eeting grow th rates o f
total reserves, based on the nearest available data
point (since total reserve data are biweekly).

its November or December meetings, saying it no longer
“ served [any] real purpose.” See the December Press
Release, pp. 15-16. Mention of the target ranges for the
federal funds rate and M2 is made only to show that the
Committee gives these indicators some official status.
Total reserves, on the other hand, does not have such a
status.
29For an assessment of this interest rate as an indicator of
monetary policy and a predictor of future real sector activi­
ty, see Bernanke and Blinder (1990).
30For discussions of monetary aggregates and their relation­
ship to real activity, see Christiano and Ljungqvist (1988)
and Stock and Watson (1987).

37

Figure 2
The Weekly Federal Funds Rate in 1990
Percent
9.0

Percent
9.0

6.0

2/6
3/27
5/15
7/2
Vertical lines represent FOMC meeting dates

8/21

10/2

11/13 12/12

Figure 3
M2 in 1990
Trillions of dollars
3.36.------------------

Weekly Data in Levels

Trillions of dollars
3.36

3.32

3.30

3.26




2/6

3/27

5/15

7/2

------------------ 13.20
8/21
10/2 11/13 12/12
Source: post 1991 benchmark data

Vertical lines represent FOMC meeting dates

MAY/JUNE 1991

38

Figure 4
M2 Growth in 1990
Percent change
Percent change
from previous week
Annualized Weekly Rates
from previous week
25,---------------------------------------------------------------------- ----------------------------------------------------- 25

20

20

15

10

-5

-10

-1 5

-1 5
2/6

3/27

5/15

7/2

8/21
10/2 11/13 12/12
Source: post 1991 benchmark data

Vertical lines represent FOMC meeting dates

Figure 5
Total Reserves in 1990
Billions of dollars
63.0

Biweekly Data in Levels

Billions of dollars
63.0
■

■
II
II
1
1
II
I I
l l

62.5

62.0

I

60.5

\

*

\

/ \/

* \

1

\a \

- y

i

I
I
I
I
I

I
I
I

i

I
I
I
i

,+/ \ a : ' j

vV \/
\
\/

59.0

I
I
I
I
I

I
I
I

■
"

i

61.5

I

I
I
I
I
I

61.0

59.5

62.0

I I
I I
I I

61.5

60.0

62.5

v

\/*
;
v

61.0
60.5

60.0

59.5

\!

!
i

<

»

59.0

58.5

58.5
1/10

3/7

FEDERAL RESERVE BANK OF ST. LOUIS



5/2

6/27

8/22
10/17
12/12
2/6
Source: post 1991 benchmark data

39

Figure 6
Intermeeting Growth of Total Reserves1
Percent change
from previous meeting
30

Annualized Rates of Intermeeting Growth

Percent change
from previous meeting
30

25

I
I
I
I
I
I
I
I
I
I
1
I
I
I
I
I
I
I
I
I
I
I
f
I
I
I

20

15
10

5

A

A

0

V

\
\

-5
-1 0

I
I

I

-1 5

V

-20

25
20

15

10
5

0
-5
-1 0

-15

-20
3/21

5/16

6/27

10/3
11/14
12/12
2/6
Source: post 1991 benchmark data
Vertical lines represent data point nearest meeting date
’ Data are Board series, adjusted for reserve requirements
2/7

For all indicator data, vertical lines represent
FOMC meeting dates.
The fram ew ork that w ill be used in this paper
to summarize FOMC decision-making is now
complete. The Committee states its major objec­
tives in every directive, and they are to control
inflation and to maintain sustained grow th in
real output. International evidence suggests that
low inflation rates can be achieved by maintain­
ing low rates o f m oney growth. The real output
effects o f monetary policy are theoretically less
certain, but summaries o f Committee delibera­
tions indicate that members believe tem porary
easing can mitigate downturns in economic ac
tivity. Pursuit o f this objective requires an assess­
ment o f the current and future time path o f
real output, but knowing w hether the incoming
data signal a change in direction fo r the econom y
is complicated by lags in data releases and er­
rors in even the best economic forecasts. To
summarize FOMC policy actions, some measure
o f the m onetary policy stance is required. Since

8/22

various measures sometimes suggest differing
interpretations o f the thrust o f m onetary policy,
several indicators w ill be employed.

CHRONOLOGY OF FOMC
DECISION-MAKING IN 1990
Meeting o f February 6-7, 1990
The February m eeting was one o f tw o during
1990 w hen the Committee review ed its long­
term objectives fo r grow th in the m onetary ag­
gregates. Much o f the discussion focused on the
grow th range fo r M2.3 A staff report suggested
1
that, given the current forecasts fo r nominal
GNP, the rate o f grow th o f M2 in 1990 was like­
ly to be in the "upper end o f the tentative range”
o f 3 to 7 percent set the previous July.3 In this
2
view, the Committee could retain "considerable
leew ay” to make "faster progress against infla­
tion without impairing the forw a rd momentum

3 March Press Release, p. 11.
1
32March Press Release, p. 12.




MAY/JUNE 1991

40

o f the econom y . .
range.3
3

by retaining the tentative

A fter contemplating the staff report and other
pertinent information, the Committee agreed on
a range o f 3 to 7 percent grow th fo r M2 during
the year, as computed from the final quarter o f
1989 to the final quarter o f 1990. The range set
fo r M3 was 2.5 to 6.5 percent, down from the
3.5-to-7.5 percent tentative range used in 1989.3
4
One interpretation o f these grow th rates is sug­
gested by the inform ation in figure 1. In par­
ticular, if maintained over a long period o f time,
these grow th rates are consistent w ith low aver­
age rates o f inflation relative to a w orld stan­
dard. In this sense the Federal Reserve contin­
ued to maintain its posture fo r preferring low
inflation relative to other central banks. In fact,
the Committee hoped to “ signal a [continued]
determination to m ove tow ard the objective of
price stability."3
5
The Committee also discussed policy fo r the
period until the next meeting. The outlook fo r
real GNP at the time o f the February m eeting is
given in figu re 7, which illustrates the beliefs o f
private forecasters on February 10. In the figure,
the boxes represent the most recently revised
data available at the time fo r points in the past,
plus the Blue Chip Consensus forecast at the
time fo r points in the future. The crosses rep re­
sent the evolution o f real GNP based on revised
data and the Blue Chip Consensus forecast for
1991 and 1992 available as o f April 1991.3
6
Considering the figure from the perspective
at the time, real GNP grow th appeared to be
near 3 percent in the third quarter o f 1989, but
approached zero in the fourth quarter. The
forecast called fo r increasing rates o f grow th
throughout 1990. In retrospect, the second and
third quarters o f 1989 w ere actually much
w eaker than they appeared at the tim e.3 W hile
7
the prediction that the econom y w ould rebound
slightly in the first quarter o f 1990 appears by

present estimates to have been correct, the pri­
vate sector forecasts o f a generally strengthen­
ing econom y throughout 1990 turned out to be
erroneous.
The Board staff projections w ere qualitatively
consistent w ith the private forecasts at the time
o f the February meeting, as they predicted that
“the econom y was likely to expand relatively
slowly over the next several quarters.”3 The
8
FOMC membership generally concurred w ith
this view, seeing "continuing grow th in economic
activity [as] a reasonable expectation fo r the
year ahead” and "some assurance that the ex­
pansion was no longer weakening and indeed
that a m odest acceleration might be under
way. . . .”3
9
Am ong the plethora o f other information con­
sidered by the FOMC in February, the Record
indicates that, internationally, Japan was experi­
encing strong grow th in real GNP and that, while
Germany, Italy and France appeared to be gain­
ing strength, the United Kingdom and Canada
rem ained sluggish. Th e trade-weighted value o f
the dollar in terms o f foreign currencies had
recently fallen, and most o f the depreciation
was against the German mark. U.S. civilian un­
em ployment was unchanged at 5.3 percent.4
0
At the conclusion o f the meeting, the FOMC
issued a policy directive to "maintain the exist­
ing degree o f pressure on reserve positions.”4
1
The policy fo r possible adjustments during the
interm eeting period was to be symmetric, with
no bias tow ard tightening or easing.4
2

Meeting o f March 27, 1990
Considering figu re 2, policy was indeed steady
in the six weeks follow ing the February meeting,
as the federal funds rate remained unchanged
at about 8.25 percent through late March.
W hile figure 3 shows that M2 was slightly
above the upper end o f the target cone during

33March Press Release, p. 12.

38March Press Release, p. 6.

34According to the Record, the change in the M3 range was
viewed as consistent with an unchanged M2 range for
“ technical reasons." See the March Press Release, p. 13.

39March Press Release, p. 7. The Committee also discussed
the risk of a downturn.

35March Press Release, p. 12.

4 March Press Release, p. 21.
1

36Blue Chip forecasts are released on the 10th of each
month.

42March Press Release, p. 18. The Committee sometimes
issues asymmetric directives, which augment the basic
directive by stating a direction of bias. In some cases, the
Committee ties the direction of bias to data or other infor­
mation forthcoming during the intermeeting period.

37The problem of data revision is acute, and an important
consideration to keep in mind is that the view of the data
today is itself subject to revision in the future. See also
Mankiw and Shapiro (1986).

FEDERAL RESERVE BANK OF ST. LOUIS



40March Press Release, pp. 1-4.

41

Figure 7
Private Forecasters’ View of Real Output,
February 1990
Percent change
from previous quarter
5

Percent change
from previous quarter
5

90

91

1992

Source: Blue Chip Forecasts and Data Revisions

February and into March, figure 4 indicates that
most o f the w eekly grow th rates w ere within a
range consistent w ith a 3 to 7 percent grow th
rate fo r the year. It does not appear, therefore,
that there was any change in policy according
to an M2 measure o f the policy stance during
the period immediately follow in g the February
meeting. Finally, figure 6 also shows little indi­
cation o f a change in the thrust o f policy, as
reserves continued to grow . All considered, pol­
icy appeared to be steady as the Committee con­
vened in late March.
Figure 7 indicates that the fou r quarters begin­
ning April 1990, only a w eek after the March
meeting was held, appear from today’s perspec­
tive to be one o f the weakest sequences o f
quarters since 1982. Nevertheless, at the time
the FOMC met, there was no indication, accord­
ing to the Blue Chip Consensus, that the na­
tional econom y w ould be entering a recession
later in the year. The private forecasters’ outlook

fo r real GNP grow th changed little betw een the
February and March meetings.
The Board staff projection was qualitatively
consistent w ith the Blue Chip forecast, suggest­
ing “the econom y was likely to expand at a
somewhat faster pace over the next several
quarters than in the fourth quarter o f 1989.”4
3
Growth in that quarter was reported to have
been less than 1 percent at an annual rate. The
Committee concurred, as “ on balance . . . the
members view ed sustained grow th in business
activity as a reasonable expectation fo r the next
several quarters.”4 In addition, the Committee
4
“ expressed a great deal o f concern about the ap­
parent lack o f im provem ent in underlying infla­
tion trends.”4 Considering the forecast fo r real
5
output, in addition to other pertinent inform a­
tion, the majority o f the Committee voted to
maintain the "current degree o f pressure on
reserve positions.”4 No direction o f interm eeting
6
bias was specified.

43May Press Release, p. 6.

45May Press Release, p. 7.

44May Press Release, p. 7.

46May Press Release, p. 13.




MAY/JUNE 1991

42

The Board staff w arned at the M arch meeting
that M2 grow th might be slow or non-existent
over the spring and early summer, partly fo r
special technical reasons and partly because o f
the general slowing in the rate o f nominal GNP
growth. A number o f Committee members, com­
menting on the Board staff report, felt a slow­
ing in the rate o f M2 grow th "w ou ld be a w el­
come developm ent,” since it w ould put M2
grow th m ore squarely within the Committee's
target range.4
7

Meeting o f M ay 15, 1990
Figure 2 suggests that policy was steady dur­
ing the period immediately follow ing the March
FOMC meeting, according to a federal funds
rate measure o f the policy stance. As the Board
staff report predicted, how ever, the m onetary
aggregate measure tells a different story: M2
grow th began to slow in March, m oving tow ard
the midpoint o f the Committee’s target cone by
July. Figure 4 shows that annualized w eekly M2
grow th rates w e re mostly at or below the 3
percent m ark in the w eeks betw een the March
and May meetings. O f course, the March staff
report had predicted a slowing in M2 growth,
and in addition, the data on m onetary aggregates
simply tend to be noisy. Figure 6, how ever,
shows that reserve grow th was negative betw een
the M arch and M ay meetings, which might be
construed as a relatively tight policy immediate­
ly follow ing the M arch meeting. Th erefore, as
the Committee convened in M ay it was not clear
by some measures that policy had been con­
stant during the interm eeting period. By one
measure, policy remained steady; by another,
policy tightened beginning at about the time o f
the March meeting.
The outlook fo r real GNP at the time o f the
May meeting, as summarized b y the Blue Chip
Consensus forecast, was again virtually un­
changed from February 10. Generally speaking,
the view at the time was much m ore optimistic
than the view from the present. Private fo re ­
casters at the time view ed real GNP grow th as

being faster fo r virtually every quarter in 1989,
1990 and 1991 relative to the view today. The
Blue Chip Consensus indicated a virtually flat
grow th rate o f 2 percent a quarter through
1990, increasing slightly in 1991.
The Board staff projection concurred with
private forecasts, suggesting "that the econom y
was likely to expand at a m oderate pace over
the balance o f the year.”4 In addition, the Com­
8
mittee "generally agreed that the current in for­
mation on business conditions pointed on balance
to relatively m oderate but sustained economic
expansion.”4 Considering the outlook fo r real
9
GNP as w ell as other economic information, a
large majority o f the Committee supported a
directive that called fo r unchanged policy with
no bias tow ard tightness or ease.5
0
The Board staff explained in an analysis
prepared fo r the Committee that M2 grow th
was expected to pick up somewhat b efore the
next meeting, even under a policy o f "steady
reserve pressure.”5 Several m em bers com ­
1
mented that “ a failure o f such grow th to pick
up w ould be a matter o f increasing concern”
and might be taken as a reflection, among other
things, o f “grow in g constraints on the availabili­
ty o f credit to potential borrow ers.”5 Generally,
2
how ever, the Committee felt it was too early to
reach a definitive conclusion since the observed
m oderation might m erely be a manifestation o f
the natural volatility in m onetary grow th
rates.5
3

Meeting o f July 2-3, 1990
The July meeting was the second o f tw o dur­
ing the year in which the Committee review ed
its long-term goals, including an assessment o f
the target cone set at the February meeting fo r
M2 growth. According to the Record, “the Com­
mittee took account o f the much slower than
anticipated expansion o f M2 . . . in the first half
o f the year. . . 5 Some m em bers noted that any
4
"shortfall from the current ranges should be
kept under careful scrutiny to judge w hether

47May Press Release, p. 12.

52July Press Release, p. 11.

48July Press Release, p. 6.

53July Press Release, p. 11.

49July Press Release, p. 7.

54August Press Release, p. 11.

s°July Press Release, pp. 10-11.
5 July Press Release, p. 11. This is possible because, while
1
a component of M2 is related to the monetary base by the
money multiplier, M2 is a broad aggregate with many
other components over which the Federal Reserve has lit­
tle direct influence.


FEDERAL RESERVE BANK OF ST. LOUIS


43

Figure 8
Private Forecasters’ View of Real Output,
July 1990
Percent change
from previous quarter

Percent change
from previous quarter

Source: Blue Chip Forecasts and Data Revisions

policy was indeed tighter than intended or de­
sired.”5 A fter this review , the Committee re ­
5
affirm ed its range fo r M2 grow th at 3 to 7 per­
cent fo r the rem ainder o f 1990.5 One argument
6
that played a role in this decision was that the
Committee should avoid making adjustments to
target cones, at least at mid-year. Some members
suggested, fo r instance, that “the ranges should
not be m oved up or dow n to fit special cir­
cumstances. . . ,5
7
According to the evidence from a num ber o f
countries presented in figure 1, the decision to
keep the M2 target range at betw een 3 and 7
percent continued to place the U.S. squarely in
a group o f relatively low m oney grow th coun­
tries. This is consistent w ith the Committee’s
low inflation strategy because these are the
countries that have tended to experience the
lowest average inflation rates over the last 20
years. In this sense, the Committee continued to
maintain its anti-inflation posture at this meeting.

O f course, in this context, “lo w ” is relative to
w orld standards, and the relationship betw een
m oney grow th and inflation is not exact even
over ve ry long time horizons.
The Committee also contemplated the policy
stance fo r the period until the next meeting.
During the interm eeting period, the federal
funds rate, M2 and total reserves measures all
seemed to indicate a steady policy. The Blue
Chip Consensus forecast and the available data
fo r real GNP appeared as the path represented
by the boxes in figu re 8. A recession was not
predicted b y private forecasters at the time, and
there was simply no w ay o f knowing that Iraq
w ould invade Kuwait during the forthcom ing in­
term eeting period. Available actual data as w ell
as private forecasts continued to be almost uni­
form ly optimistic relative to the actual outcomes
fo r quarterly real GNP grow th as view ed from
the present.

55August Press Release, p. 13.
56August Press Release, p. 14.
57August Press Release, p. 14.




MAY/JUNE 1991

44

The Board staff forecast fo r the rem ainder o f
1990 was again in general agreem ent w ith the
private forecasts, suggesting "the econom y w ould
expand . . . at around the rate estimated fo r the
first half o f the year.”5 Committee members
8
concurred w ith the Board staff and the private
forecasters as they "generally saw sustained but
subdued grow th in economic activity as a rea­
sonable expectation fo r the next several quar­
ters . . . [T]he econom y as a w hole gave no cur­
rent indications o f slipping into recession.”5
9
The forecast o f slow but positive grow th was
buoyed, according to the Record, by a number
o f other factors that the Committee considered
in addition to point predictions o f real GNP
growth. Unemployment, fo r example, remained
at 5.3 percent in M ay and had been at that level
fo r m ore than a year. Industrial production was
up substantially in May, and economic grow th
seemed to be satisfactory in the major indus­
trialized nations.6
0
Based on the forecasts fo r real GNP and the
consideration o f the most recent data on the
state o f the economy, the FOMC unanimously
endorsed an unchanged policy fo r the seven
w eek period until the next meeting. The majori­
ty o f the Committee also favored a bias tow ard
"some slight easing” depending on the interm eet­
ing data on M2 grow th and inflation. In particu­
lar, the m ajority wanted to ease slightly unless
M2 grow th picked up appreciably or inflation
began accelerating faster than expected.6 A c­
1
cording to the Record, “the marked slowing in
monetary grow th in the second quarter in par­
ticular suggested the possibility o f more
restraint than the Committee intended.”6
2
Figure 9 shows the M2 data available at the
time o f each FOMC meeting. The crosses rep re­
sent the revised data available today, w hile the
boxes show the time path as it appeared at the
time. A t the July meeting, the Committee saw
data suggesting a decline in M2 from the level
o f the previous meeting. The revised data avail­
able today show no such decline, how ever, and
indeed generally indicate an increase over the
previous 13 weeks. Data revisions can therefore
explain, to some extent, the discussion in the

58August Press Release, p. 6.
59August Press Release, p. 7.
60August Press Release, pp. 1-4.
61August Press Release, p. 18.


FEDERAL RESERVE BANK OF ST. LOUIS


Record o f the "m arked slowing in m onetary
g row th ” w hen it appears from figures 3 and 4
that money grow th was picking up in the w eeks
before the July meeting. The data revision prob­
lem fo r M2 does not seem to have been as acute
fo r other periods during 1990.

Meeting o f August 21, 1990
As it turned out, m oney grow th did not pick
up in the w eeks immediately follow in g the July
meeting, and in mid-July "pressures on reserve
positions w e re eased slightly.”6 Measuring pol­
3
icy by the federal funds rate indicates that, ac­
cording to figure 2, policy did ease slightly on
or about July 13, w ith the rate declining to just
over 8 percent b y early August. The effective
w eekly federal funds rate later rose, how ever,
and did not fall below the early August level
until mid-October.
According to figures 3 and 4, the grow th path
o f M2 also seemed to indicate some ease during
the interm eeting period. Th e annualized w eekly
g row th rates, which are near zero or negative
in the month immediately follow in g the July
meeting, are greater than 7 percent in the last
three weeks leading up to the August meeting.
O f course, these data are noisy and interpreta­
tion is difficult. Total reserves reached a low
fo r the year on July 25, reflecting a slight
decline overall during the interm eeting period.
The invasion o f Kuwait on August 2, 1990,
clouded considerably the outlook fo r the U.S.
econom y fo r the rem ainder o f the year and
through the first half o f 1991. The key
economic question was the magnitude and stay­
ing p ow er o f the resulting crude oil price in­
creases. According to the Record, at the August
meeting the Committee " . . . focused on both
the state o f the econom y b e fo re the increase in
oil prices and the likely consequences fo r real
output and inflation o f that rise.”6
4
A comparison o f the available data and the
associated Blue Chip Consensus forecasts fo r Ju­
ly, August and September, illustrated in figures
8, 10 and 11, respectively, demonstrate the
fluidity o f the forecasting situation during this
two-month period (July 10-September 10). First

62August Press Release, pp. 18-19.
63October Press Release, p. 4.
64October Press Release, p. 7.

45

Figure 9
M2 Data Available at FOMC Meetings

V ertical lin es rep rese nt FOMC m eeting dates

o f all, in July, the data fo r all o f 1989 and the
first quarter o f 1990 w ere revised downward,
revealing greater sluggishness in real GNP
g row th than had previously been estimated.
Secondly, the situation in the Middle East was
evolving on a daily basis, and the eventual out­
come simply could not be predicted. As figure
11 shows, by September 10, about three weeks
after the August FOMC meeting, the Blue Chip
survey put the consensus forecast fo r real GNP
grow th at zero fo r the fourth quarter o f 1990;
this reflects a dow nw ard revision fo r fourth
quarter output grow th from over 2 percent as
the year began.
Once again, the Board staff projection reflec­

-O c to b e r Press Release, p. 6.
66October Press Release, p. 6.




ted that o f the private forecasters. W hile the
staff "recognized that the recent steep rise in oil
prices could have important adverse effects . . .
[It also recognized that] it was not possible to
determine w ith any confidence how oil prices
might evolve over time. . . ,"6 Nevertheless, it
5
seemed to the staff that slow expansion o f real
output was likely over the balance o f the year,
albeit at a reduced rate from that previously
projected.6 The staff forecast was based, in
6
part, on substantial grow th in exports in the
quarters that lay ahead, because foreign indus­
trial economies w ere view ed as relatively strong
and a considerable depreciation had already oc­
curred in the foreign exchange value o f the
dollar.6
7

670 c tober Press Release, pp. 6-7.

MAY/JUNE 1991

46

Figure 10
Private Forecasters’ View of Real Output,
August 1990
Percent change
from previous quarter
5

Percent change
from previous quarter
5

-3
1988

90

91

1992

Source: Blue Chip Forecasts and Data Revisions

Figure 11
Private Forecasters’ View of Real Output,
September 1990
Percent change
from previous quarter


FEDERAL RESERVE BANK OF ST. LOUIS


Percent change
from previous quarter

Source: Blue Chip Forecasts and Data Revisions

47

FOMC members again concurred with the
staff and private forecasters that “limited grow th
in economic activity rem ained a reasonable ex­
pectation. 1 8 The Committee recognized that
,6
most o f the available data on the econom y per­
tained to a period b efore the Iraqi invasion. The
Record notes that unemployment rose from 5.3
percent to 5.5 percent in July and that domestic
industrial production was flat. Overseas, real
output grow th in both Japan and Germany re ­
mained robust. In addition, the trade-weighted
value o f the dollar had fallen substantially dur­
ing the interm eeting period in terms o f other
G-10 currencies.6
9
In the Committee’s view, the oil price shock
w ould tend to "w eaken economic activity while
also intensifying inflationary pressures.”7 Com­
0
mittee members tended to see changes in policy
as counterproductive, an easing probably fu el­
ing inflation, a tightening probably stalling a
weak econom y.7 Accordingly, the Committee
1
elected to maintain the current policy stance,
“ fostering a stable policy environm ent.” But sev­
eral members stated that they wanted "to avoid
any paralysis o f policy . . . in the weeks ahead.”
Some saw a likely need to ease "at some point,”
w eighed against continuing decline in the dollar
in markets fo r foreign exchange.7 Therefore,
2
while there w ere "some differences in view s,”
the majority o f the Committee membership sup­
ported a bias tow ard ease in the interm eeting
period.7
3

Meeting o f O ctober 2, 1990
According to the Record, the bias in the direc­
tive was not acted on in the interm eeting period
because inflation was “ not abating and the econ­
om y [was] continuing to advance, albeit slow­
ly. . . .” 7 Measures o f the policy stance in the
4
weeks immediately follow ing the August meeting,
in general, seemed to indicate a steady policy
without any bias tow ard ease. As figure 2 in­
dicates, federal funds traded at 8-8.25 percent
over the period, which represented no change
from the previous interm eeting period. Total
“ October Press Release, p. 8.
“ October Press Release, pp. 1-3.
70October Press Release, p. 11.
7 October Press Release, pp. 11-12.
1

reserves g re w somewhat during the interm eet­
ing period. M oney by an M2 measure displayed,
according to figure 4, considerable volatility in
annualized w eekly grow th rates in the weeks
follow ing the August meeting, to the point
w h ere an assessment o f the interm eeting policy
stance by this measure is quite difficult.
The private forecasts fo r July, August and
September indicate rapidly deteriorating expec­
tations fo r real output. Still, no recession was
forecast at the time o f the August m eeting—or
even three w eeks later on September 10—and
the private forecasters appeared to view the
slow grow th as tem porary, predicting annual­
ized gains in real GNP o f m ore than 2 percent
by the third and fourth quarters o f 1991. The
October meeting o f the FOMC occurred eight
days before the Blue Chip Consensus forecast il­
lustrated in figu re 12 was officially released.
October, the first month o f the fourth quarter,
was the first time this set o f forecasters envi­
sioned negative grow th on the horizon. By Octo­
ber 10, the Blue Chip Consensus forecast was
actually tw o consecutive quarters o f negative
grow th in real GNP—but just barely. A recession
was not definitively predicted by Blue Chip until
Novem ber.7
5
Figure 13 illustrates the dramatic change in
the outlook fo r real GNP as forecast b y the Blue
Chip Consensus from July 1990 to October 1990.
In the space o f only three months, the forecast
changed from one o f sluggish but increasing
rates o f real grow th to near zero and even neg­
ative grow th rates. In terms o f time fo r policy
reaction, this change was quite fast. If one ac­
cepts research evidence that m onetary actions
affect real activity only with a lag o f several
quarters, this rapid deterioration in the ex­
pected perform ance o f real output underscores
the difficulty o f making timely short-run adjust­
ments in the stance o f policy.
The Board staff, acknowledging a great deal
o f uncertainty linked to developments in the
Middle East, projected “ a mild downturn in eco­
nomic activity . . . fo r the near term.’’7 The staff
6

75See the Blue Chip Economic Indicators, October 10 and
November 10, 1990. The October consensus forecast call­
ed for two consecutive quarters of negative real GNP
growth, but the second of these quarters was nearly flat.
76November Press Release, p. 6.

72October Press Release, p. 12.
73October Press Release, pp. 13-14 and p. 16.
74November Press Release, p. 4.




MAY/JUNE 1991

48

Figure 12
Private Forecasters’ View of Real Output,
October 1990
Percent change
from previous quarter

Percent change
from previous quarter

Source: Blue Chip Forecasts and Data Revisions

Figure 13
Private Forecasters’ Changing Perceptions
Percent change
in data and forecasts
from July to October
0.4

Extent of Downward Revision, 7/90-10/90

Percent change
in data and forecasts
from July to October
0.4

-0.4

-

0.8

-

1.2

-

-

1.6

2.0

-2 .4

-

1988


FEDERAL RESERVE BANK OF ST. LOUIS


89

90

1991

Source: Blue Chip Forecasts and Data Revisions

2.8

49

continued to see strong exports as a mitigating
factor, propelled by the projection o f continuing
grow th in several other major industrialized na­
tions, especially Germany and Japan. The staff
forecast also relied to some extent on a drop in
oil prices during the first half o f 1991.7
7
For the first time in 1990, the FOMC m em ber­
ship dissented qualitatively from both private
forecasters and the Board staff in their view of
the likely future path o f real output. The Record
reports a sense o f the m eeting concluding that,
while the Committee felt the risk o f negative
real output grow th had increased, “overall eco­
nomic activity appeared to be continuing to ex­
pand, although at a slow pace. . . . [T]he avail­
able data did not point to cumulating weakness
and the onset o f a recession.”7 Many members
8
w ere concerned that surveys o f business confi­
dence seemed to indicate a declining faith in a
continued expansion, w hile traditional indicators
continued to suggest sluggish grow th .7 Some
9
members suggested that inflation was getting
w orse even after accounting fo r the effect o f
higher crude oil prices.8 According to the
0
Record, "A major concern was that the rise in
oil prices w ould becom e . . . firm ly entrenched
in the cost structure o f the econom y . . . and
[delay] progress tow ard price stability.”8 N ever­
1
theless, most members felt that "an easing move
was warranted in light o f the indications that
there was a significant risk o f a much
w eaker econom y.”8
2
The Committee also expressed concern about
an easing in response to the impending budget
deal being crafted by Congress and the W hite
House. The timing o f any m ove needed to be
considered carefully, as action before any bud­
get accord might create the expectation o f more
action after the deal was struck.8 In the discus­
3
sion, some members suggested that "associating
an easing m ove too closely w ith a fiscal policy
action might set an undesirable precedent in
terms o f producing expectations o f similar mon­
etary policy adjustments in the future.”8 The
4
advocates o f easing on the Committee agreed

that the "reasons fo r the easing w ere not keyed
to the enactment o f the new federal budget
alone but m ore broadly to developments in
credit markets and the economy. . . .”8 The
5
crux, according to the Record, was simply that
"market participants expected a m onetary policy
response to the fiscal policy actions. . . .”8
6
The Committee issued an unusual directive in
response to the concerns about declining out­
put, accelerating inflation and fiscal policy. The
directive called fo r no change in the degree o f
pressure on reserve positions initially, but as­
sumed “ some slight easing w ould be implement­
ed in the interm eeting period, assuming passage
o f a federal budget resolution . . . and the ab­
sence o f major unexpected . . . developments.”8
7
Thus, the directive was biased tow ard ease.
However, the Record indicates that an addi­
tional proviso was added; in particular, the
Committee agreed to ease further if real output
showed further signs o f deterioration.8 The
8
Record also notes that “ some slight firm ing”
was not ruled out, should inflation appear to
pick up.8
9

Meeting o f N o v e m b e r 13, 1990
During the interm eeting period, policy was in­
itially unchanged. Th e contingencies in the
directive w e re exercised late in October, when
“ pressures on reserve conditions w ere eased
slightly.” The Record cites both the “background
o f a weakening econom y” and "the conclusion
o f a budget agreem ent” as factors influencing
the decision and the timing o f the easing.9
0
Other indicators o f the thrust o f policy, h o w ­
ever, do not provide evidence o f an easing dur­
ing the w eeks leading up to the Novem ber m eet­
ing. The w eekly average federal funds rate,
plotted in figure 2, had drifted up to a level
near 8.25 percent by the time o f the October
meeting. As the figu re shows, federal funds had
been trading near 8.25 percent fo r most o f the
year, except fo r the period immediately fo llo w ­
ing the mid-July easing. The rate had fallen to a

77November Press Release, pp. 6-7.

85November Press Release, p. 13.

78November Press Release, p. 7.

86November Press Release, p. 14.

79November Press Release, p. 10.

87November Press Release, p. 15.

80November Press Release, pp. 11-12.

88November Press Release, p. 15.

8 November Press Release, p. 12.
1

89November Press Release, p. 15.

82November Press Release, p. 12.

90December Press Release, p. 5.

83November Press Release, pp. 13-14.
84November Press Release, p. 14.




MAY/JUNE 1991

50

point just below its early August level during
the interm eeting period. Based on a cursory
look at the level o f the federal funds rate,
therefore, the policy stance seemed to be about
the same as it was after the mid-July easing.9
1
Total reserves fell substantially betw een the Oc­
tober and N ovem ber meetings, suggesting a
tight policy instead o f an easy one. Finally,
beginning at about the time o f the October
meeting, M2 grow th nearly slowed to a stand­
still, reaching a level it w ould not again attain
until the final w eeks o f 1990. Figure 4 indicates
that most o f the annualized w eekly grow th
rates fo r the rem ainder o f the year w ere below
3 percent, and many w ere negative. By an M2
indicator, then, policy tightened considerably in
the fourth quarter.9
2
Private forecasters, as surveyed by Blue Chip,
reached a consensus view that the econom y
was entering a recession in Novem ber, accor­
ding to the forecast illustrated in figure 14. Re­
lative to current projections, how ever, the fo re ­
cast rem ained optimistic about the depth o f the
downturn. The Board staff also projected a mild
recession w ith recovery occurring in the first
half o f 1991. The staff assumed a drop in crude
oil prices early in 1991 and export grow th
driven by the expansion in foreign industrial­
ized nations. Th e staff forecast also emphasized
the uncertain environment prodded by the mili­
tary standoff betw een the U.S. and Iraq on the
Kuwaiti b ord er.9
3
The FOMC membership saw a relatively mild
recession ahead, thus establishing general quali­
tative agreem ent w ith private forecasters and
the Board staff. They also view ed a slow expan­
sion in 1991 as a reasonable expectation.9 A c­
4
cordingly, the Committee agreed to some slight
easing immediately and to some bias tow ard
further easing during the interm eeting period.
W hether the option to ease further was exer­
cised depended in part on "market reactions to
the initial action. . . ,”9
5
The Novem ber directive o f the FOMC is the
first to indicate a substantial commitment to

ease. At the time o f the Novem ber meeting, the
econom y was in the middle o f w hat appeared to
be the onset o f recession. No amount o f easing
was likely to change fourth-quarter real output
—industrial production was already in the midst
o f dropping 19.8 percent on an annualized basis
in Novem ber. Instead, according to the Record,
the Committee view ed the easing as providing
“ some insurance against a deep and prolonged
recession. . . ,”9
6

Meeting o f D ecem b er 12-13, 1990
As the Committee convened in mid-December,
the indicators o f policy w ere again sending con­
flicting signals. In the period betw een the No­
vem ber and D ecem ber meetings, the federal
funds rate dropped substantially, suggesting
dramatic easing relative to earlier actions (see
figure 2). As reflected in figure 6, how ever, the
data on total reserves pointed instead to a fu r­
ther tightening o f policy, as the previous nega­
tive interm eeting grow th rate is follow ed by a
steeper decline in reserves after the Novem ber
meeting. The annualized w eek ly grow th rates of
M2 plotted in figure 4 also do not o ffe r evi­
dence o f substantial ease during this period.
M oney grow th simply continued at a near zero
pace, on average, through to the Decem ber
meeting.
Figure 15 reflects the outlook fo r real GNP at
the time o f the FOMC's Decem ber meeting. The
assessment o f the private forecasters in the Blue
Chip survey continued to g row m ore pessimistic
by the month. In fact, one o f the striking fea ­
tures o f the evolution o f Blue Chip forecasts in
1990 is that they fairly consistently overpredicted real output growth.
The Board staff continued to project a mild
recession w ith a rebound before mid-year 1991.9
7
Committee members concurred that a short
downturn follow ed b y modest recovery seemed
reasonable, but they emphasized the risks o f a
prolonged downturn. Some Committee members
also recognized, how ever, the possibility o f pro-

9 According to the Record, the reason federal funds traded
1
at 8.25 percent early in the intermeeting period was “ more
cautious reserve management policies at some banks and
some carryover of end-of-quarter pressures. . . .” See the
December Press Release, p. 5.

93December Press Release, pp. 6-7.

92By the November meeting, “ the recent weakness in
monetary growth was becoming a matter of increasing
concern and was an important consideration for some
members in their support of some easing of reserve condi­
tions.” See the December Press Release, p. 12.

97February Press Release, p. 6.

FEDERAL RESERVE BANK OF ST. LOUIS



94December Press Release, p. 8.
95December Press Release, p. 13.
96December Press Release, p. 12.




51

Figure 14
Private Forecasters’ View of Real Output,
November 1990
Percent change
from previous quarter
5

1988

Percent change
from previous quarter

90

91

1992

Source: Blue Chip Forecasts and Data Revisions

Figure 15
Private Forecasters’ View of Real Output,
December 1990
Percent change
from previous quarter

Percent change
from previous quarter

Source: Blue Chip Forecasts and Data Revisions

MAY/JUNE 1991

52

cyclical policy, noting that because o f "the lags
involved, there was some risk o f overdoing the
easing o f policy at some point. . . .”9 N everthe­
8
less, members unanimously supported additional
easing in the directive in order to "provide
some added insurance in cushioning the econ­
omy against the possibility o f a deepening reces­
sion and an inadequate rebound.”9
9
In the w eeks follow ing the Decem ber meeting,
policy indicators suggested that further easing
occurred, if one considers a federal funds rate
measure o f the policy stance. In particular, the
rate dropped to 6.25 percent by the time o f the
February 1991 meeting. In addition, the inter­
meeting grow th rate o f total reserves plotted in
figure 6 seems also to indicate dramatic easing,
as reserves increased nearly 25 percent on an
annualized basis from the Decem ber meeting.
Th ere was little evidence o f M2 grow th in the
w eeks immediately follow ing the Decem ber
meeting, but then the aggregate began to show
substantial grow th beginning in late January
1991.1 0 By an M2 measure, policy remained
0
tight through the first weeks o f 1991 before in­
dicating signs o f ease. All measures seemed to
indicate ease by the first w eek o f February
1991.

SUMMARY
This article has presented a case study o f
FOMC actions during a year in w hich a reces­
sion began. The Committee states its goals in
each directive, and they are to provide fo r
stable prices and to prom ote sustained real out­
put growth. The article has emphasized, within
the context o f a chronology o f 1990 FOMC pol­
icymaking, some problems o f implementing a
policy to meet these stated objectives.
Evidence is presented early in the article
regarding the relation betw een money grow th
rates and inflation rates across countries and

98February Press Release, p. 12.
"F eb rua ry Press Release, p. 12.
1C
0Committee members showed concern for the flat growth in
M2 at the December meeting. The Record suggests that
while “ the behavior of M2 was not fully understood,”

FEDERAL RESERVE BANK OF ST. LOUIS



time. An argument is made that over very long
time periods, average inflation tends to reflect
average rates o f m oney growth. I f this evidence
is used as a guide, the Federal Reserve in 1990
recorded stellar success in maintaining grow th
rates o f m oney stocks that are much low er than
those achieved by many other central banks.
Coupled w ith other similar decisions over a long
period, this w ill continue to place the U.S. in a
small group o f countries that w ill likely con­
tinue to experience, relative to other countries
in the w orld, very low inflation rates. This arti­
cle has provided, therefore, one interpretation
o f the FOMC’s "long-run, anti-inflation strategy”
sometimes cited in the Record.1 1
0
The FOMC’s ability to achieve its real output
objective is hampered, how ever, by the d iffi­
culty o f forecasting real output changes far
enough ahead to take corrective action. The ar­
ticle assessed the information available on the
projected evolution o f real output at the m eet­
ings by presenting the unrevised data available
at the time along w ith the most current Blue
Chip Consensus forecast. According to the
Record, the Committee’s views rarely differed
substantially, at least qualitatively, from the
private sector forecast. This, along with evi­
dence in the Record, indicates that a negative
quarter o f real output grow th was not antici­
pated until October, and a recession forecast
did not come until Novem ber, already w ell into
the first quarter o f the downturn.
Another feature o f short-run policymaking is
that it requires some measurement o f the m one­
tary policy stance. This article has emphasized
h ow different indicators on some occasions im ­
ply different assessments o f the thrust o f m one­
tary policy. In particular, the total reserves and
M2 indicators suggested that policy was tight in
the fourth quarter, w hile an interest rate indi­
cator suggested the opposite. By the first quar­
ter o f 1991, how ever, all measures suggested
that the policy stance had shifted tow ard ease
in response to the onset o f recession.

it might be due to caps on credit availability as well as the
weak growth of the economy. See the February Press
Release, p. 13.
10'August Press Release, p. 13.

53

REFERENCES
Bernanke, Ben, and Alan Blinder. “ The Federal Funds Rate
and the Channels of Monetary Transmission,” NBER Work­
ing Paper No. 3487 (October 1990).

Lucas, Robert E., Jr. “ Two Illustrations of the Quantity
Theory of Money,” American Economic Review (December
1980), pp. 1005-14.

Blanchard, Olivier Jean. “ Why Does Money Affect Output?
A Survey,” in Benjamin M. Friedman and Frank H. Hahn,
eds., Handbook of Monetary Economics, Volume II (NorthHolland, 1990), pp. 780-835.

________“Adaptive Behavior and Economic Theory,” in
Robin M. Hogarth and Melvin W. Reder, eds., Rational
Choice: The Contrast Between Economics and Psychology,
(University of Chicago Press, 1987), pp. 217-42.

Blue Chip Economic Indicators, 1990 Issues.

Mankiw, N. Gregory, and M. G. Shapiro. “ News or Noise?
An Analysis of GNP Revisions,” Survey of Current Business
(May 1986), pp. 20-25.

Christiano, Lawrence J., and Lars J. Ljungqvist.
“ Money Does Granger-Cause Output in the Bivariate
Money-Output Relation,” Journal of Monetary Economics
(1988), pp. 217-35.
Dwyer, Gerald P., Jr. and R. W. Hafer. “ Is Money
Irrelevant?” this Review, (May/June 1988), pp. 3-17.
Federal Reserve Press Releases, Record of Policy Actions
of the Federal Open Market Committee, dated March 30,
1990; May 18, 1990; July 6, 1990; August 24, 1990;
October 5, 1990; November 16, 1990; December 21, 1990;
and February 8, 1991.
Hallman, Jeffrey J., Richard D. Porter, and David H. Small.
“ M2 Per Unit of Potential GNP as an Anchor for the Price
Level,” Staff Study 157 (Board of Governors of the Federal
Reserve System, April 1989).
Karamouzis, Nicholas, and Raymond Lombra.“ Federal
Reserve Policymaking: An Overview and Analysis of the
Policy Process,” Carnegie-Rochester Conference Series on
Public Policy (Spring 1989), pp. 7-62.
Laidler, David E. W. The Demand for Money: Theories,
Evidence, and Problems (Harper and Row, 1985).




Meltzer, Allan H. “ Limits of Short-Run Stabilization Policy,”
Economic Inquiry (January 1987), pp. 1-14.
_______ .“ The Fed at Seventy-Five,” in Michael T. Belongia,
ed., Monetary Policy on the 75th Anniversary of the Federal
Reserve System (Kluwer Academic Publishers, 1991), pp.
3-104.
1991 Monetary Policy Objectives: A Summary Report of the
Federal Reserve Board.
Papademos, Lucas, and Franco Modigliani. “ The Supply of
Money and the Control of Nominal Income,” in Benjamin
M. Friedman and Frank H. Hahn, eds., Handbook of
Monetary Economics, Volume I, (North-Holland, 1990), pp.
399-494.
Stock, James H., and Mark W. Watson. “ Interpreting the
Evidence on Money-lncome Causality,” NBER Working
Paper No. 2228 (April 1987).
Vogel, Robert C. “ The Dynamics of Inflation in Latin
America, 1950-1969,” American Economic Review (March
1974), pp. 102-14.

MAY/JUNE 1991

54

Allan H. Meltzer
Allan H. Meltzer is a professor of political economy and public
policy at Carnegie Mellon University and is a visiting scholar at
the American Enterprise Institute. This paper, the fifth annual
Homer Jones Memorial Lecture, was delivered at Washington
University in St. Louis on April 8, 1991. Jeffrey Liang provided
assistance in preparing this paper. The views expressed in this
paper are those of Mr. Meltzer and do not necessarily reflect
official positions of the Federal Reserve System or the Federal
Reserve Bank of St. Louis.

U.S. Policy in the Bretton
Woods Era

I t is a SPECIAL PLEASURE fo r me to give
the Hom er Jones lecture before this distinguish­
ed audience, many o f them H om er’s friends.
I first met Hom er in 1964 w hen he invited me
to give a seminar at the Bank. At the time, I was
a visiting professor at the University o f Chicago,
on leave from Carnegie-Mellon. Karl Brunner
and I had just completed a study o f the Federal
Reserve’s monetary policy operations fo r Con­
gressman Patman’s House Banking Committee.
Given its auspices, the study caught the atten­
tion o f many within the Federal Reserve. It was
not surprising, then, that Hom er invited me to
visit. The report had raised issues in which
Homer had a long-standing interest. One o f these
was the issue o f m onetary control procedures.
Although Hom er was sympathetic to our
criticisms, he was not easily persuaded about
our proposals—such as monetary base control.
Later, knowing him much better, I w ould say
he was not easily persuaded about ve ry much.
You had to convince Homer with facts. He re­
spected facts much more than clever arguments.
H om er’s concern fo r facts never left him. It is
not an accident that under his leadership, the
economic staff at St. Louis began publishing
those data triangles that economists all over the


FEDERAL RESERVE BANK OF ST. LOUIS


w orld now rely on w hen they want to know
what has happened to m onetary grow th and
the grow th o f other non-monetary aggregates. I
am persuaded that the publication and w ide
dissemination o f these facts in the 1960s and
1970s did much m ore to get the monetarist case
accepted than w e usually recognize. I don’t think
Homer was surprised at that outcome. He be­
lieved in the p o w er o f ideas, but he believed
that ideas w ere made pow erfu l b y their cor­
respondence to facts.
W hen Karl Brunner and I started the Shadow
Open Market Committee, w e invited Hom er to
be a member. He was a valuable and conscien­
tious m em ber w ho came to the meetings fo r
many years armed with the kind o f penetrating
questions that one learned to expect from him.
W hen he believed that his energy had declined
and he could not contribute as fully and fo rce­
fully as in the past, he o ffere d to resign. W e
persuaded him to stay on. He rem ained through
the first ten years, leaving after the September
1983 meeting, only a fe w years before his death
in 1986.
One o f the facts about m onetary policy during
H om er’s years at the St. Louis Federal Reserve
Bank is that the United States was part o f the

55

Bretton W oods system, in fact at the center of
the system. Bretton W oods and international
monetary policy w ere not major concerns o f
the Federal Reserve how ever, despite the form al
commitment to the system and the responsibili­
ty implied by the role o f the dollar. The failure
to honor the commitment is one part o f the in­
flationary policies o f that period. I am pleased
to review and interpret the main facts about
that experience in this lecture in honor o f
Hom er Jones.
In the 45 years follow ing W orld W a r II, there
was a remarkable transform ation o f the interna­
tional m onetary system. At the w a r’s end, the
dollar was the dominant currency fo r interna­
tional transactions and was universally held as a
reserve asset or store o f value. The Bretton
W oods system recognized this role by making
the dollar the principal reserve currency o f the
international system w ith the British pound as a
second reserve currency. Exchange rates o f
other currencies w ere fixed to the dollar but
w ere adjustable under conditions defined by the
agreement. But, by 1971 the Bretton W oods
system was in shambles, and in 1973 major
countries agreed to experim ent with fluctuating
exchange rates.
This paper is about the history o f U.S. inter­
national economic policy under Bretton W oods
from 1959 to 1973. The period begins w ith the
recognition o f a problem that was to become
the central problem o f the international m one­
tary system fo r the next decade. At first, the
problem was seen as a tem porary balance o f
payments problem —the inability o f the United
States to balance its trade and payments at the
prevailing fixed exchange rates. The end o f this
historical era is fixed b y the decision in March
1973 to abandon fixed exchange rates betw een
principal currencies. The starting point, 1959, is
the year major currencies became convertible,
subject in many cases to restrictions on capital
movements that w e re increased or relaxed as
reserve positions changed.
Soon after the start o f the period, and at the
end, policymakers expressed concern about the
competitive position o f the U.S. economy. This
concern about competitiveness returns again
and again in the next four decades, although
the focus o f concern and the principal manifes­
tation o f the alleged problem shift. The alleged
cause in 1959-60 was trade discrimination,
w hich had been accepted by the United States
at the end o f the w ar to assist in the recovery




from w artim e destruction abroad. Soon after,
the costs o f foreign assistance and foreign
military expenditures w ere added as causes. By
the late 1960s these concerns and concern
about foreign investment led successive adminis­
trations to restrict payments to foreigners by
means such as the interest equalization tax,
taxes on tourist expenditures, "buy Am erica”
programs, and "tem p orary” controls o f foreign
investment. Inflationary financing o f the w ar in
Vietnam and o f domestic social spending more
than offset any effect these programs may have
had on the equilibrium value o f the fixed,
nominal exchange rate. Increasingly, the p ro­
blem came to be seen as an exchange rate pro­
blem, specifically an overvalued dollar. As the
Bretton W oods system ended, the dollar was
first devalued against gold and major curren­
cies, then allowed to fluctuate.
In the U.S. system, principal responsibility fo r
international econom ic policy rests w ith the
Treasury. The Federal Reserve is form ally o f
secondary importance. Under Bretton W oods
the Federal Reserve’s main responsibility was to
conduct m onetary policy so as to maintain the
fixed exchange rate agreed to by the administra­
tion. Th ere is no specific legislative authoriza­
tion fo r the Federal Reserve to buy and sell
foreign currencies (Schwartz 1991). But the
Federal Reserve had a larger, informal role. O f­
ficials and staff participated in international
meetings, gave advice and counsel on what
w ere seen to be the principal problems o f the
Bretton W oo d system, and proposed solutions.
Th ey participated, as observers, at the regular
meetings o f the Bank fo r International Set­
tlements, w here central bankers held regular
discussions and review s o f U.S. policies. There
is little evidence, how ever, o f any systematic e f­
fo rt by the Federal Reserve to conduct
m onetary policy in a manner consistent with
the requirements o f a fixed exchange rate
system. And, there is no evidence that any o f
the administrations objected to this neglect. On
the contrary, from the Kennedy to the Nixon
administrations, domestic econom ic policy objec­
tives, though frequ ently changed, w e re o f over­
riding interest.

THE UNITED STATES IN THE
BRETTON WOODS SYSTEM
The Bretton W oods agreem ent o f 1944
established a system o f fixed exchange rates
based on gold valued at $35 per ounce. The

MAY/JUNE 1991

56

agreem ent was the product o f extensive negotia­
tions, w ith much o f the w ork done by the United
States and British Treasuries. The intention o f
the drafters, principally John Maynard Keynes
in Britain and Harry Dexter W hite in the United
States, was to establish a set o f rules to replace
the rules o f the international gold standard and
to avoid the rigidity o f that system. Because the
British feared that the United States w ould re ­
turn to the protectionist and deflationary
policies o f the interw ar years, there w ere
safeguards against that occurrence. U.S. infla­
tion was considered unlikely or, m ore accurate­
ly, was not considered at all, so there w ere no
rules fo r adjustment to prevent inflation from
spreading to countries in the fixed exchange
rate system.
The agreem ent obligated countries to in­
tervene to keep their currencies within 1 p er­
cent o f their fixed but adjustable (dollar) parities.
As the principal reserve currency, the United
States was obligated to buy and sell gold fo r
dollars (or convertible currency) at the $35
price. W hen the system started, the United States
held about % o f the w orld ’s m onetary gold stock.
Currencies other than the dollar w ere inconver­
tible. By 1960, the U.S. gold stock had fallen,
but the U.S. still held $20 billion, almost half of
all m onetary gold. In the early years, the United
States’s loss o f gold was looked on favorably as
a step tow ard convertibility. By the end o f 1958,
major currencies had becom e convertible fo r
current transactions.1
Th e strengthening o f foreign economies was a
major aim o f early postwar U.S. economic
policy. At first, balance o f payments deficits,
foreign accumulation o f dollars, and the redistri­
bution o f the gold stock w ere seen as desirable
steps tow ard a viable international monetary
system. By 1960, official concern about con­
tinued U.S. payments deficits began to be ex­
pressed.2 The President’s Economic Report fo r
1960, the last report prepared b y the Eisenhower
administration, discusses the competitive pro­
blems o f the steel and automobile industries in
w orld markets during 1959 and the grow th o f
U.S. investment abroad, problems that w e re to
remain fo r years to come (ERP, I960).3 Sug­
gested rem edies are limited to pro-competitive
'Germany permitted convertibility on capital account at the
same time. The Japanese yen did not become convertible
on current account until 1964.
2For the year 1959 as a whole, the U.S. balance on current
account was negative, -$1.3 billion, for the first time since
1953.

FEDERAL RESERVE BANK OF ST. LOUIS



policies, such as the rem oval o f quantitative
restrictions against imports from the United
States, and to recommendations that foreign
governm ents increase lending to developing
countries.
The major problem at the time was not a U.S.
current account deficit. Throughout the 1960s,
the United States typically had a surplus on cur­
rent account. The problem was that the trade
and current account surpluses w ere not large
enough to finance net private investment abroad
plus military, travel, and foreign aid spending
abroad. T o settle the balance, the United States
either had to sell gold or accumulate dollar lia­
bilities to foreigners. As the gold reserve declined
and liabilities rose, concern increased that the
liabilities w ould becom e too large relative to the
gold reserve to maintain confidence that the
gold price w ould remain fixed. Under Bretton
W oods rules, foreigners had the option o f con­
verting dollars into gold; the United States had
responsibility fo r keeping the gold price fixed
by perm itting conversions and, at a m ore basic
level, adjusting the production o f dollars to main­
tain confidence in future gold convertibility.
This part o f the agreem ent was an early casual­
ty. As foreign liabilities rose, restrictions w ere
placed on gold sales to private holders and pres­
sure or persuasion was used to discourage cen­
tral banks and governm ents from converting
dollars into gold.
Deficits and foreign dollar accumulation was
not the only problem in the system as seen by
U.S. policymakers at the time. A steady surplus
in the U.S. balance o f payments w ould have
transferred gold and dollars to the United States.
Since dollar balances w ere part o f foreign
reserves, but not U.S. reserves, total w orld
reserves w ould fall. A U.S. surplus was seen as
undesirable, therefore. Under a U.S. payments
deficit, conversion o f dollars into gold left w orld
reserves unchanged but low ered the gold re ­
serves behind the principal reserve currency.
W ith grow in g foreign trade, and an implicit
assumption that imbalances increase w ith trade,
reserves w ould prove inadequate to finance im ­
balances at fixed exchange rates and a fixed
gold price.
3I will refer to these reports as ERP (year),

57

Figure 1
U.S. Gold Reserves and Liabilities to
Foreign Central Banks and Governments
Billions of dollars
70

Billions of dollars
70

60

1960

61

62

63

64

65

Figure 1 shows U.S. gold reserves and dollar
liabilities to foreign central banks and govern­
ments fo r the period as a whole. The dollar
liabilities shown in the figure w ere generally
about half the size o f total U.S. liabilities to
foreigners. Dollar liabilities mounted, at first
gradually, then m ore rapidly. By 1964, liabilities
to central banks w ere equal to the U.S. gold
reserve and by 1970 w ere tw ice the level o f the
reserve.
It seems clear in retrospect, as it did to some
at the time, that the Bretton W oods system had
a serious flaw. If foreign trade and payments
imbalances rose w ith the grow th o f w orld in­
come, there w ould be grow th in the demand fo r
w orld reserves. For a time, the demand could be
met, as it had been, by increased foreign
holdings o f dollars and a decline in U.S. gold
reserves. By the time recovery from wartim e
destruction abroad reached the point that re ­




66

67

68

69

70

71

1972

strictions on convertibility could be removed,
the United States was losing gold and accumu­
lating liabilities at rates that threatened the
system’s long-term stability.

Under the Marshall Plan (1948-52) U.S. policy
encouraged foreign governm ents to rebuild
reserves as a step tow ard convertibility. Coun­
tries w ere permitted, and even encouraged, to
export to the U.S. w hile restricting imports
from the United States. W hen the Marshall Plan
ended, military expenditures to support military
commitments and aid to developing countries
maintained a flo w o f dollars equal to m ore than
$2 billion a year. This helped w estern European
countries as a group to achieve a current ac­
count surplus b y the mid-1950s, despite a conti­
nuing trade deficit. Convertibility fo r current
account transactions at the end o f 1958 (as well
as fo r capital account transactions in Germany)

MAY/JUNE 1991

58

plus the commitment to reduce internal trade
barriers as part o f a common market stimulated
U.S. investment in Europe.4 Hence, a capital in­
flo w augmented the stock o f foreign exchange
reserves in countries outside the United States.
In the tw o years 1958 and 1959, gold and dollar
reserves o f the principal European countries in­
creased by $5 billion, about 25 percent o f total
U.S. reserve assets at the end o f the period.5
Th ere w e re four possible solutions (Friedman,
1953): (1) devaluation against gold and major
currencies, (2) deflation, (3) b o rro w as long as
foreigners w ould lend, and (4) impose controls
o f various kinds. Several o f these solutions
could be achieved in different ways. For exam ­
ple, foreigners could revalue against the dollar.
Or, foreigners could inflate faster than the
United States, thereby changing the relative
prices o f domestic and foreign goods at fixed
exchange rates.

Policies o f the K ennedy and
Johnson Administrations
Under Bretton W oods rules countries w ere
perm itted to devalue up to 10 percent without
consultation w hen faced w ith “ fundamental
disequilibrium." The precise conditions char­
acterizing fundamental disequilibrium w e re not
spelled out, and the International M onetary Fund
(IMF) did nothing to clarify the conditions. The
drafters had w anted to avoid both the inflex­
ibility o f the classical gold standard and the
competitive devaluations o f the interw ar period.
The language may have been intended to permit
devaluation if the alternative was deflation w hile
avoiding devaluation if a country could expect
to restore payments’ balance and repay a shortor medium-term adjustment loan.
Devaluations by major countries occurred. In
the early years several countries follow ed the
United Kingdom in a 30% devaluation in 1949.
France devalued by 29 percent in 1958, and the
United Kingdom devalued again in 1967. The
United States chose to regard its problem as less
than “ fundamental.” President Kennedy came in­

4See ERP (1959).
5Total U.S. reserve assets include the total U.S. gold stock
and its reserve position in the International Monetary
Fund. At the end of 1959, these balances were $19.5 and
$2.0 billion respectively. ERP (1971).
6The Kennedy Treasury led by Douglas Dillon and Robert
Roosa was firmly opposed to devaluation. Dillon was an in­
vestment banker, and a Republican, who had served as

FEDERAL RESERVE BANK OF ST. LOUIS



to office committed to maintain the $35 gold
price but also to “ get the econom y m oving”
after the relatively slow grow th and tw o reces­
sions in the previous four years. The comm it­
ment to a fixed nominal gold price ruled out
devaluation o f the dollar against gold and all
other currencies; the commitment to higher
economic grow th rem oved the classical remedy,
deflation o f domestic prices and costs o f p ro­
duction to raise the real dollar value o f the U.S.
gold stock and low er the relative price o f U.S.
exports. That left borrow ing, controls and fo r ­
eign inflation as the principal options.
The decision to avoid devaluation and defla­
tion reflects some strongly held views o f the
period. The $35 gold price was seen as a firm
commitment under the Bretton W oods A gree­
ment. If the United States devalued once, it
could do so again, w ith costs to the stability
that Bretton W oods was supposed to provide.
Avoiding repetition o f the experience w ith defla­
tion in the early 1930s and the decade-long
depression was a major factor in the passage o f
the Employment Act and the Bretton W oods
agreement. Few wished to repeat the prew ar
experience even in m ilder form . Hence, the
Kennedy administration met little opposition
from business or political groups in excluding
the price options, devaluation and deflation.6
Kennedy’s main domestic campaign theme had
been getting the econom y "m oving” after the
relatively slow average grow th rate o f the se­
cond Eisenhower administration. The Kennedy
administration policies emphasized domestic
growth, full employment and price stability as
their major aims and relied on a so-called fiscal
m onetary mix to stimulate output w hile reduc­
ing the capital outflow. In practice, this trans­
lated into a series o f tax measures—faster de­
preciation fo r capital, an investment tax credit
and, later, reductions in personal and corporate
tax rates. T o limit the capital outflow, the ad­
ministration tried to prevent a sharp counter
cyclical decline in interest rates during the early
months o f the recovery from the 1960-61 reces-

ambassador to France. Roosa had been a senior econo­
mist at the N.Y. Fed and was very attracted to activist
policies whether in domestic credit markets or international
markets. At the Council of Economic Advisers (CEA),
Walter Heller was mainly interested in domestic policy.
Heller (1966) says very little about the dollar problem other
than noting that the balance of payments required higher
short-term interest rates. Kennedy saw the problem as a
matter of prestige. Sorensen (1965), pp. 405-12.

59

Figure 2a
Federal Funds Rate During the 1960s

sion.7 In cooperation w ith the Federal Reserve,
the Treasury attempted to "tw ist” the yield curve
by buying long-term bonds and selling short­
term Treasury bills.8 Since the market fo r
governm ent securities is ve ry active and highly
competitive, participants w e re able to reverse
any tem porary change in interest rates achieved
by the twist.

puted as the percentage rate o f change from
the corresponding month o f the preceding year.
Shortly after the Kennedy administration came
into office, grow th o f the base rose to about
1-1/2 to 2 percent. By mid-1963 the grow th rate
o f the base was consistently above the long­
term grow th o f output, 3 percent per annum.
Growth o f the base continued to rise in 1964.

Neither m oney grow th nor interest rates
shows evidence o f "tight m oney” in the early
1960s. Figure 2a shows the federal funds rate
fo r that decade. The funds rate is the rate most
tightly controlled b y the Federal Reserve. From
1961 to 1966, the rate rose slowly, and it did
not exceed 3 percent until late in 1963. Figure
2b shows the grow th rate o f the m onetary base
fo r the same period. The grow th rate is com ­

W ith the possible exception o f 1961-62, base
grow th shows no evidence that m onetary policy
was relatively restrictive. In fact, base growth,
far from being deflationary, was inconsistent
w ith continuation o f the relatively low rate o f
inflation inherited from the past. To prevent
higher inflation, the Kennedy administration in­
troduced inform al guidelines fo r prices and
wages. The prevailing view was set out in the

7See Heller (1966), p. 5.
8The Treasury also auctioned “ strips” of bills that required
dealers to buy more than one issue at a time on the im­




plausible assumption that the additional distribution cost
would be treated by the market as a rise in the effective
interest rate instead of a fee for service.

MAY/JUNE 1991

60

Figure 2b
Annual Growth of the Monetary Base
During the 1960s
Percent Change

Percent Change

8

8

1962 Econom ic Report o f the President. In this
view , a relatively stable Phillips curve permitted
policymakers to trade higher inflation fo r low er
unemployment. The price and w age guidelines
w ere supposed to im prove the trade-off by
reducing w age and price increases as the
econom y approached full employment.

monthly until 1966. CPIs are relatively com ­
prehensive measures but, as is w ell known, not
perfect measures o f traded goods and services.
Doubtless there are temporal differences bet­
w een the price ratio in figure 3 and ratios com­
puted using other prices, but the pattern o f per­
sistent decline w ould be little affected.

A slow recovery gave w ay in 1963 to robust
real growth. Inflation remained low. Until 1965,
the fixed w eight deflator rose betw een 1 per­
cent and 1-1/2 percent annually and the con­
sumer price index betw een 3/4 percent and 2
percent. Inflation was generally higher abroad,
so relative prices o f U.S. goods declined. Figure
3 shows the ratio o f the U.S. consumer price in­
dex to a trade-weighted average o f consumer
prices abroad, based on the weights in Federal
Reserve index o f nominal exchange rates. The
index shows the sustained relative decline in the
U.S. price level during the first half o f the
decade. W ith fe w exceptions, the ratio declined

Under the impact o f relative price changes
and other factors, the merchandise trade balance
increased. U.S. capital investment abroad con­
tinued to rise and domestic and foreign b o r­
row ers used the U.S. market to raise funds fo r
investment abroad, so the capital outflow
continued.

9Various definitions were used but the official settlements
balance appears to have been the main concern. This
balance consists of current account plus long-term capital
flows plus net private short-term capital flows. I report this
balance from time to time in the text, but I base my judg­
ments much more on the current account balance. The


FEDERAL RESERVE BANK OF ST. LOUIS


Special Measures
From 1960 on, each administration sustained
or strengthened controls on trade and payments
intended to reduce the balance o f payments
deficit.9 At first, the measures consisted o f
concern about profitable investment abroad puzzles me;
investment of this kind produces a subsequent inflow.
Also, the current account balance is more useful for com­
parison of the fixed and fluctuating rate periods. On the
role of the current account see Corden (1990).

61

Figure 3
Index of the Ratio of U.S. CPI to
Trade-Weighted CPI
1973 = 100
120

1973 = 100

---------------------------------------------------------------------------------------------------------------------------- —

— —

I 120

100

relatively modest steps to encourage exports (by
subsidized loans from the Export-Import Bank)
or to purchase military equipment and supplies
in the United States even if it imposed higher
costs. W ithin a fe w years, the list o f controls
and their efficiency cost increased. Development
aid was tied to dollar purchases. An "interest
equalization” tax was put on foreign borrow ing
and later raised. Most tourist expenditures w ere
made dutiable. And guidelines w ere used to fu r­
ther limit the expansion o f bank lending to fo r ­
eigners and to limit grow th o f foreign direct in­
vestment. Table 1 lists some o f the measures
proposed or adopted.
The efficacy o f the controls varied with the
opportunity or ability to substitute uncontrolled
fo r controlled transactions. Tieing military expen­




ditures is inefficient to the extent that it raises
costs, but substitution is probably limited. Re­
quiring foreigners to pay the cost o f U.S. troops
abroad increases exports and the current ac­
count and reduces the capital outflow. Tieing
foreign aid or military spending reduces the
real value o f the spending but may lead to high­
er appropriations, so that over time the actual
dollar outflow is not much affected. Restrictions
on foreign borrow ing in the U.S. market are
circumvented if foreigners or domestic citizens
sell their holdings o f dollar securities to pur­
chase new issues sold abroad. Further, restric­
tions o f foreign lending and investment affect
relative rates o f interest at home and abroad
thereby reducing the effect o f the restrictions.
And foreign firms im port fe w e r goods from the
United States.

MAY/JUNE 1991

62

Table 1
Selected Balance of Payments Measures
(Actual and Proposed)
1960

Expansion of Export-lmport Bank lending and guarantees of non-commercial risks.
Reduction in military dependents abroad (repealed in 1961).
Reduction in defense and non-defense government purchases abroad.

1961

Offsets for military expenditure in Europe and additional procurement at home.
Tieing development aid to dollar purchases.
Increased taxes on foreign earnings of U.S. corporations.
Reduced allowance for tourist purchases abroad from $500 to $100.
Treasury intervention in foreign exchange markets.
Repayment of German loans.

1962

Expansion of earlier programs.
Offset purchases by Germany and Italy.
Increased borrowing authority for the IMF.
Beginning of Federal Reserve “ swap” arrangements for currencies.
Treasury issues foreign denominated securities.

1963

An interest equalization tax of 1% on foreign borrowers in U.S. market.
Additional tieing of foreign aid to domestic purchases.

1965

Interest Equalization Tax on bank loans with duration of one year or more made to bor­
rowers in developed countries (except Canada).
Limits on growth of bank lending to foreigners.
Encourage private companies to increase exports and repatriate earnings.
Guidelines for direct investment by non-financial corporations to limit growth of foreign
direct investment.

1967

Permit higher tax rates (up to 2%) for interest equalization tax.
Expansion of lending authority of Export-lmport Bank.

Source: Economic Report of the President, various years.

Controls and restrictions w ere, at best, a short­
term solution. Most o f the controls and restric­
tions in table 1 w e re introduced as tem porary
measures, although several w ere extended and
strengthened w hen renewed. Even if these mea­
sures had succeeded in stemming the balance o f
payments deficit, they did not o ffe r a perm a­
nent solution at a new equilibrium without con­
trols. The problem w ould have returned when
the controls w ere removed.
T o smooth fluctuations in the gold price and
short-term capital movements, the Treasury in­
troduced several measures. Eight countries join­
ed a gold pool in 1961 to stabilize the London
gold market. Reciprocal credit agreements (call­
ed “ swaps”) w ith foreign central banks and the
Bank fo r International Settlements provided
10See Solomon (1982), p. 42.
"C anada, Japan, Belgium, France, Germany, Italy,
Netherlands, Sweden, United Kingdom, United States.

FEDERAL RESERVE BANK OF ST. LOUIS



loans o f foreign currencies and dollars. Typical­
ly the Federal Reserve b orrow ed to purchase
dollars held abroad instead o f selling gold.1
0
Swaps are a short-term accommodation. T o re­
pay the swaps, the Treasury began borrow in g
from foreign central banks at longer terms us­
ing bonds denominated in foreign currencies.
The proceeds from the bond sales (called Roosa
bonds) helped to repay the swaps without re ­
ducing the U.S. gold stock, again postponing the
problem. Lending facilities o f the IMF w e re ex­
panded under the General Agreem ents to Bor­
row . The agreements provided that 10 countries
would lend under specified conditions to aug­
ment the Fund's resources. This is the origin o f
the group o f 10 (G-10).1 Again, these w ere
1
mainly short-term measures.
Later, Switzerland joined the G-10, but the name
remained.

63

The United States supplied 60 percent o f the
gold sold in the London gold market; the other
members o f G-10 w ere supposed to provide the
rest. Foreign countries replaced some o f their
sales by purchases from the United States, so
the U.S. contribution to the pool, direct and in­
direct, became a major cause o f the decline in
the U.S. gold stock. In March 1968, w ith U.S.
gold reserves under $11 billion, the gold pool
was abandoned. The price o f gold fo r official
transactions rem ained at $35, but the G-10 gov­
ernments did not attempt to control the price
fo r private transactions. To prevent arbitrage,
foreign central banks agreed not to sell in the
gold market.
For the years 1960-67 as a whole, the non-U.S.
members o f the G-10 (including Switzerland) ac­
quired 150 million ounces o f gold, an increase
o f one-third over their holdings at the end o f
I960.1 Every country except Britain and Canada
2
added to its stocks. Britain sold 38 million ounces,
the U.S. 164 million ounces. France acquired
m ore than 100 million ounces, two-thirds o f the
total acquisition by G-10 countries.1
3
The year 1966 is the peak year fo r gold hold­
ings o f the G-10, excluding the United States,
and 1965 is the peak year fo r the eleven coun­
tries, measured in ounces o f gold. In these years,
the value o f the stock at $35 per ounce was ap­
proximately $15 billion. The value o f the U.S.
stock was approximately $13 billion, about equal
to the non-gold foreign exchange holdings of
the other members o f the G-10. A fter 1968, nonU.S. members o f the G-10 as a group reduced
their stocks slightly until 1971, but several ac­
quired gold in the market. The embargo can be
said to have succeeded in this limited sense.
Also in 1961, the Treasury's Exchange Stabili­
zation Fund (ESF) began operations in foreign
currencies fo r the first time since the 1930s.
The Federal Reserve joined in these operations
in 1962, and in 1963 the Fed began lending
dollars to the Treasury secured by Treasury
holdings o f foreign exchange. These so-called
“warehousing” operations perm itted the T rea ­
sury to expand its purchases o f foreign ex­
change without seeking Congressional appropri­

ations to support the activity. Warehousing re­
mained small in the 1960s but increased sub­
stantially in the 1980s.

Proposals f o r Long-Term
Adjustment
The policies o f the Kennedy and Johnson ad­
ministrations may have stabilized the level o f
foreign official holdings in the years 1963-66
but, as shown in figure 1 above, U.S. gold re ­
serves continued to decline. A popular analogy
at the time treated the United States as a bank
fo r the international m onetary system. Foreign
dollar holdings w ere considered the analogue o f
bank deposits and gold the analogue o f bank
reserves.1 The analogy suggests that the series
4
o f mainly short-term, one-time or allegedly tem ­
porary measures, such as the interest equaliza­
tion tax, had not solved the problem o f a future
run on the bank. The gold reserve continued to
fall absolutely and relative to official (or total)
dollar claims.
The Kennedy administration was aware o f the
long-term problem. In 1962, the administration
asked economists at the Brookings Institution to
study the longer-term prospects fo r balance of
payments adjustment. The report took the "basic
balance"—balance on goods and services, govern­
ment payments plus long-term capital flo w —as
its standard.1 It projected that by 1968 this bal­
5
ance w ould be betw een a surplus o f $1.9 billion
and a deficit o f $600 million, depending on the
assumptions about growth, prices and costs at
home and abroad. This section o f the report
was greeted warm ly by the administration. The
projected im provem ent reflected the assumption
o f a rise in foreign relative to domestic prices
and a slowing o f U.S. investment abroad as p ro­
fit rates rose in the United States relative to
abroad. The expected rise in domestic profit
rates reflected the direct effect o f the Adminis­
tration's proposed reduction in corporate tax
rates and the indirect, stimulative effect o f tax
rate reductions fo r households and businesses.1
6
As shown in figure 3, a relative increase in
prices abroad occurred, but the projections pro­
ved optimistic. The recorded 1967 balance was
-$2.1 billion.1
7

12AII data on gold are from IMF (1990), p. 65.

15See Salant et.al. (1963).

131967 is the peak for France’s accumulation of gold. The
following year France sold 40 million ounces to defend the
franc’s parity following the riots and disturbances.

16For the tax reduction to improve the basic balance, the
rise in expected real returns in the U.S. had to overcome
the expected positive effect of tax reduction on imports.

14The analogy neglects the role of the pound as an alter­
native reserve currency, but its role was small and of
declining importance.

17See ERP (1964), p. 131.




MAY/JUNE 1991

64

The Brookings report also considered the e f­
fects o f a U.S. surplus in its basic balance on
the supply o f w orld reserves and concluded that
either a new source o f w orld reserves w ould
have to be found, or there w ould have to be
greater flexibility o f exchange rates. The report
discussed a dollar-pound bloc and a continental
European bloc w ith fixed rates inside the bloc
and fluctuating rates betw een the blocs.1 The
8
Council o f Economic Advisers summary o f the
Brookings study has no reference to this
discussion.
The Council o f Economic Advisers argued
that, although the Bretton W oods agreement
permitted exchange rate adjustments, "fo r a
reserve currency country, this alternative is not
available.”1 And, they added, "fo r other major
9
industrial countries, even occasional recourse to
such adjustments w ould induce serious specula­
tive capital movements, thereby accentuating
imbalances.”2
0
W ith exchange rates adjustments ruled out,
only tw o alternatives w ere considered. One was
increased fiscal expansion by surplus countries
and less expansive policies fo r countries in defi­
cit. The other was introduction o f some type of
new reserve asset. The latter proposal led even­
tually to the creation o f special drawing rights
(SDRs).
This was the heyday o f Keynesian policy, so it
is not surprising that Keynesian policies have a
prom inent place in administration proposals.
The administration favored a policy mix and
what later became known as policy coordina­
tion. Under the fixed exchange rate system,
countries w e re expected to buy and sell dollars
to maintain their exchange rate. The economic
reports o f the President fo r the period assumed,
how ever, that countries can adjust capital flow
by varying the mix o f fiscal and monetary poli­
cies. The ERP argues that “flexible changes in
the mix o f fiscal and m onetary policies can serve
to reconcile internal and external policy goals.”2
1
For the United States, the prescription was tax
reduction to expand domestic spending w hile
holding short-term interest rates high to reduce
short-term capital outflow. Surplus countries

w ith strong domestic demand w e re called upon
to raise tax rates or low er governm ent spending
and expand money grow th to low er interest
rates. The idea was that the inflationary conse­
quences o f domestic m onetary expansion would
be reduced or avoided by the restrictive fiscal
policy.
The International M onetary Fund’s annual
report fo r the period offers similar advice, but
it warns o f an inflationary bias. Surplus coun­
tries are subject to upw ard adjustment o f wages
and prices, but deficit countries are not sub­
ject to dow nw ard adjustments.2 The IMF recog­
2
nized that w orld trade had grow n faster than
the gold stock, but they limited their recom m en­
dation to a study o f possible future needs.2
3
The Germans, to w hom the recommendation
fo r m onetary expansion and fiscal restraint was
often directed, w ere skeptical about the policy
mix proposals. Their expressed concern was the
inflationary consequences o f U.S. m oney growth.
They held to a m ore classical view that the probblem was expansionary U.S. m onetary policy, so
it must be solved by restrictive policies in the
United States, not expansive German policies.
Their skepticism about "coordination” becam e a
persistent feature o f the policy dialogue under
both fixed and fluctuating exchange rates.
Initially the German response was to discourage
capital inflows. For example, German banks w ere
required to hold relatively high reserve requ ire­
ments against foreigners' deposits. The Germans
argued, against the spirit o f the Bretton W oods
agreement, that deficit countries should adjust.
They opposed revaluation o f the mark even
m ore strongly than they opposed domestic ex­
pansion, since they could avoid revaluation but
could avoid expansive m onetary policy only by
imposing severe restrictions on capital inflows.
A fter much delay, and many denials, Germany
revalued the mark b y 9.3 percent in October
1969.2 W ith the revaluation, Germany rem oved
4
many o f the border taxes and special reserve
requirements on foreign deposits in German
banks that had been used to limit capital in-

18See Salanl et.al. (1963).

23lbid., p. 32.

19See ERP (1964), p. 139.

24The mark had been revalued by 5 percent in 1961.
Solomon (1982), p. 162, reports the May 1969 statement
given by a German official that the decision to not revalue
was “ final, unequivocal and for eternity.” This is one of
many strong denials during the period.

20lbid.
2 See ERP (1964), p. 143.
1
22See IMF (1964), p. 28.

FEDERAL RESERVE BANK OF ST. LOUIS



65

flows to Germany.2 A fter the revaluation Ger­
5
man prices rose m ore slowly than U.S. prices.
The experience o f the late 1960s had a lasting
effect on German m onetary policy. A fter the
mark re-entered a fixed exchange rate system
w ith the principal continental European coun­
tries in the late 1970s, Germany revalued more
frequently to avoid inflation and exchange con­
trols. In the late 1960s, how ever, revaluation
was delayed too long and was much too small
to offset the effects o f inflationary U.S.
monetary policy.2
6
W hile urging German revaluation, the United
States increased m oney grow th in 1968. A fter
the German revaluation, the Federal Reserve
shifted to a m ore restrictive policy, raising the
Federal funds rate (figure 2a) and slowing the
grow th o f the m onetary base. The sharp con­
traction in the grow th o f the base was follow ed
by the start o f a recession in the fourth quarter.
The reduction in m oney growth, the increase in
U.S. real rates o f interest, and the recession
helped to shift the current account balance to­
w ard surplus. By the middle o f 1970 the quar­
terly balance had returned to a level not
reached since the latter part o f 1965.

Proposals to Increase Liquidity
“Adjustment” was one o f a triad o f topics dis­
cussed at numerous official and unofficial inter­
national meetings. The other topics w ere “li­
quidity” and “ confidence.” Liquidity received the
most attention.
Proposals fo r additional liquidity differed. The
French position was one extreme, the U.S. posi­
tion the other. The International M onetary Fund
took a position close to that o f the United States.
Positions did not remain fixed, but they w ere
never fully reconciled.2
7
The U.S. position was that a new reserve asset
was needed to supplement the stock o f gold
and dollars. Sales from official holdings in the
London gold market had reduced official hold­

ings during the middle 1960s, and dollar
liabilities had continued to rise relative to the
U.S. gold stock. The United States argued that it
expected to bring its payment deficits to an end.
W hen this happened, the w orld trading system
w ould lack an adequate supply o f reserves to
finance future demand fo r reserve assets at the
fixed gold price. Hence, the United States
favored creation o f a new reserve asset that
could be increased w ith w orld trade or w orld
demand fo r reserves.
This argument is, at best, incomplete. I f the
United States had a payments surplus, other
countries w ould have deficits. The United States
could add to reserves by buying other stable
currencies, just as these countries bought dol­
lars. The Econom ic Report recognizes that this
argument is correct. Even if each country was
in balance, the United States could buy foreign
exchange fo r dollars to augment its reserves.2
8
The IMF combined the liquidity and adjust­
ment issues. They argued that the creation o f a
new reserve asset and additional reserves re ­
duced the need fo r deficit countries to adjust
and increased the pressure on surplus countries
to adjust.2 This is, o f course, an argument fo r
9
inflation as a solution to the adjustment prob­
lem fo r the deficit countries and revaluation as
the rem edy fo r the surplus countries. This p ro­
gram was asymmetric; w orld inflation w ould in­
crease but not decline.
Data in the IMF report, how ever, do not show
a general problem o f liquidity at the time. The
IMF used reserves as a percentage o f imports to
measure liquidity—on the usual assumptions
that reserves are used to finance imbalances
and imbalances increase with trade. The data
show that there was no general shortage o f li­
quidity on this measure. The problem was lim­
ited mainly to the United States and the United
Kingdom. Table 2 shows these data. Reserves in­
clude gold, foreign exchange and reserve posi­
tion at the IMF.

25See Solomon (1982), p. 164.

28See Economic Report (1964), p. 145.

260th er parity changes during the second half of the 1960s
include an 11.1 percent devaluation of the French franc in
1968 and a 14.3 percent devaluation of the British pound
in 1967. Many of the sterling bloc devalued following
Britain.

29See IMF (1966), p. 10.

27Solomon (1982) gives a thorough account of the discus­
sions, proposals and the meetings of various official groups.
Solomon was a senior civil servant at the Federal Reserve
with responsibility for international finance and an active
participant or observer at most of the discussions.




MAY/JUNE 1991

66

Table 2
Ratio of Reserves to Imports
1951
All countries1
All countries
except U.S.
G-10
Japan
Germany
United Kingdom
United States

1959

1965

67%
39

58%
44

43%
49

73
14
22
204

63
40
34
25
126

43
26
42
19
67

’ approximately 60 countries
Source: IMF, 1966, p. 13

The United States aside, w orld reserves w ere
a larger percentage o f imports in 1965 than in
1951 and not very different in 1965 than in
1959. The IMF notes that the ratio o f reserves
to imports fluctuated around a constant value.3
0
Am ong major countries, only the United King­
dom shows a relatively low ratio. For many
countries, the ratio had converged to 40 to 50
percent.3
1
The French complained about the special
role o f the dollar, the opportunity given to the
United States to use domestic inflation to ac­
quire foreign assets (at fixed exchange rates),
and what they called U.S. hegemony. As a first
step, they proposed to limit the size o f U.S.
payments deficits that other countries w ere
obligated to finance, but they also sought a per­
manent arrangement under which reserve assets
would be tied to gold. Later, they urged an in­
crease in the price o f gold. Jacques Rueff (1967)
proposed a doubling o f the price o f gold accom­
panied by commitments by the United States
and the United Kingdom to use part o f the p ro­
fit from revaluation to retire some o f the dollar
and sterling reserves held by foreign central
banks.3
2
In its official proposals, the French governm ent
did not at first go as far as R u eff in favoring an
increase in the gold price. Nor did it insist on a
return to the gold standard. It favored a larger

role fo r gold, restrictions on the financing o f
U.S. deficits, and a refunding o f the sterling and
dollar balances, particularly the latter.3 In early
3
discussions, France wanted to circum vent the
IMF by creating a reserve asset fo r use b y the
Group o f 10. The new asset w ould have a p er­
manently fixed relation to gold. The effect o f
this proposal was to increase the effective gold
stock and to devalue the dollar against gold.
The French proposal was not accepted. The
alternative chosen was to create a new asset. In
September 1967, at the Rio de Janeiro meeting
o f the International M onetary Fund, agreem ent
was reached on the general principles govern ­
ing creation o f a supplementary reserve asset
called Special D raw ing Rights (SDRs). The new
asset was to be a supplement to gold and dol­
lars. The United States was not required to
redeem dollar balances, and the gold price re ­
mained fixed. SDRs could be issued only if an
85 percent majority approved, and they w ould
be held only by official holders, central banks
and international m onetary institutions. Finally,
in July 1969, the amendments to the IMF agree­
ment w ere ratified by a sufficient number o f
members to come into effect. A t the Rio meeting
o f the IMF, the first allocations w ere agreed to
but not issued.
In the IMF view, reserves w e re “ less than ade­
quate."3 The report acknowledged that “the
4
signals w e re conflicting.”3 The principal argu­
5
ment fo r m ore reserves is that non-tariff bar­
riers, aid-tying, domestic preference and other
trade restrictions had increased. At the time, no
argument was made about the relation o f re ­
serves to trade or imbalances. And the argument
about trade restrictions makes no effo rt to link
trade restrictions to the liquidity problem. In
fact, the restrictions continued in many coun­
tries after 1973.
SDRs w ere issued in 1970-72 and again in
1979-81. The 1970 issue added $3.1 billion to
reserves. In the same year foreign exchange
reserves increased by $14 billion, and total
reserves reached $91 billion, a 50 percent in­
crease fo r the decade and a 22 percent increase
fo r 19 70.3 In total, 21.4 billion SDRs (valued in
6
SDR units) w ere issued through 1985 w hen new

30See IMF (1966), p. 12.

34See IMF (1969), p. 27.

3 Ibid., p. 14.
1

35lbid., p. 26.

32Rueff was Economic Adviser to President DeGaulle.

36See IMF (1971), p. 19.

33See Solomon (1982), p. 73.


FEDERAL RESERVE BANK OF ST. LOUIS


67

issues ceased. SDRs never became an important
means o f settlement. By the time the agreement
to create SDRs had been reached, the Bretton
W oods system was in its last days.
It seems doubtful that the SDR w ould have
becom e a dominant medium o f exchange or
store o f international reserves if the fixed ex­
change rate system had survived. The SDR was
a specialized money but did not dominate alter­
natives as a means o f payment or store o f value.
Gold is an established store o f value with a long
history. SDRs had to compete also with the dol­
lar and later the mark, the yen and other cur­
rencies as a reserve asset. Balances held in each
o f these assets earn interest. At first, SDR bal­
ances did not earn interest, so they w ere less
attractive than balances held in short-term gov­
ernment securities o f the principal countries.
Th ere was no source o f revenue or earnings;
interest payments could only be made by crea­
ting additional SDRs.
A fter 1973, flexible exchange rates rem oved
any need fo r a large stock o f reserves fo r settl­
ing balances betw een principal countries,
although countries continued to accumulate
reserves and to intervene in the foreign ex­
change markets. The SDR could not be held by
private wealthowners, so it could not be used
fo r intervention. Further, the introduction of
SDRs did not adjust relative prices or real ex­
change rates. Failure to solve the adjustment
problem meant that the major e ffo rt to sustain
the system by producing a supplementary
reserve asset was largely wasted effort.

Table 3
Rates of Growth of Money, 1969-71,
Selected Countries
Country

1969

1970

1971

United States
France
Germany
Italy
Japan
Netherlands
United Kingdom

5.9
6.1
8.2
15.0
18.4
9.4
- 0 .3

3.8
- 1 .3
6.4
21.7
18.3
10.6
6.8

6.8
13.7
12.0
22.9
25.5
16.7
12.9

Source: International Economic Conditions, Federal Reserve Bank of
St. Louis, June 1982.

inflation to the rest o f the world. Countries
w ere obligated to buy all dollars offered at a
fixed price. Sterilization o f the inflow could be
successful fo r short-periods, but as Switzerland,
Germany and others discovered at the time, the
fixed exchange rate gave speculators an oppor­
tunity to invest in one-way gambles with low
risk and relatively high expected return. The
Swiss franc or the m ark w ere unlikely to depre­
ciate, more likely to appreciate. Investors and
speculators knew this. Hence, flow s into these
currencies became difficult to curtail.

Additional creation o f SDRs in 1972 was again
divorced from events. W orld reserves (net o f
gold) had doubled in tw o years (from SDR 56 in
1970 to SDR 112 in 1972). Reserves in relation
to imports w ere at the highest level in the post­
w ar period before or after; countries held
reserves equal to m ore than 14 w eeks o f im­
ports at the end o f 1972. In 1963, at about the
time that the discussion o f additional reserves
began, the ratio was equal to nine weeks. In the
same period, 1963-72, total reserves (net o f gold)
quadrupled in nominal value.3
7

Table 3 shows the pattern o f money grow th
fo r a sample o f countries. Many countries show
a decline in m oney grow th from 1969 to 1970
and all show a rise from 1970 to 1971, co rre­
sponding to the pattern in the United States, as
France claimed. The size o f the changes differs
by country. All countries did not have the same
trade pattern, so they did not receive the same
proportional increase in base money. Some ster­
ilized part o f the increase fo r a time, and some
countries adopted controls to reduce the inflow.
In the w inter o f 1971, Germany allowed its ex­
change rate to appreciate relative to the dollar,
slowing the in flow o f dollars. This action recog­
nized, as France has insisted, that countries
could not prevent inflation w hile maintaining
their dollar parities.

The French w ere correct on tw o points that
U.S. officials (and others) refused to acknow­
ledge. First, the Bretton W oods system based on
the dollar permitted the United States to export

The second point on w hich the French posi­
tion was correct was that revaluation o f gold
w ould solve the liquidity problem. Their various
proposals w ould have devalued the dollar against

37Data are from International Financial Statistics, Yearbook
1990.




MAY/JUNE 1991

68

other currencies, thereby providing the addition
to the stock o f reserves that the SDR was sup­
posed to provide. French proposals did not limit
future changes in the price o f gold, so they are
open to the charge that expectations o f future
devaluation w ould lead to a run on the dollar
once it had been devalued. Much earlier, Keynes
(1923) had proposed a type o f commodity stan­
dard in w hich gold served as a medium o f ex­
changes. In this proposal, the gold price was
tied to an index o f commodity prices. Had a
scheme o f this kind been adopted, it seems like­
ly that the Bretton W oods system w ould have
lasted longer.
A devaluation o f the dollar against gold, with
other currency values unchanged, w ould have
rem oved the liquidity problem in the 1960s. At
the end o f 1968, the U.S. price level was ap­
proxim ately 2-1/2 times the 1929 level. I f the
gold price had been raised proportionally from
its 1929 value ($20.67), the 1968 price w ould
have been approximately $52. At that price, the
U.S. gold reserve w ould have been $17.6 billion,
$1.6 billion m ore than U.S. liabilities to central
banks and governments.
Although adjustments in the price o f gold
w ould have extended the life o f the Bretton
W oods system, it is unclear w hether the system
would have survived fo r m ore than a fe w addi­
tional years without some restriction on U.S.
m onetary policy, restrictions that the United
States was unlikely to accept. Inflationary pol­
icies in the United States continued through the
1970s w ith only b rie f interruptions. Countries
that chose to low er inflation in the 1970s would
have had to leave the system. Further, inflation
was not the only problem. The oil shocks o f
1974 and 1979 changed the terms o f trade, re­
quiring changes in exchange rates that Bretton
W oods system found difficult to accommodate.
At best, devaluation o f the dollar against gold
w ould have corrected fo r differences in produc­
tivity grow th and changing costs o f production
betw een the United States and the principal
surplus countries, Germany and Japan. U.S.
devaluation and the oil shocks w ould have
changed the relative positions o f other coun­
tries. Some w ould have found their trade bal­
ances in persistent deficit, requiring adjustment
o f their relative prices and costs or devaluations
and revaluations o f bilateral and multilateral
38The use of reserve currencies was not part of the Bretton
Woods plan. Britain's role evolved from its prewar position
and the holding of sterling balances by countries in the

FEDERAL RESERVE BANK OF ST. LOUIS



rates, adjustments that w ere difficult to make
and which would, in turn, have required fu r­
ther adjustments.
There is a plausible case to be made on the
other side—that devaluation o f the dollar w ould
have prolonged the life o f the Bretton W oods
system. The key assumption is that the oil pro­
ducing countries raised the price o f oil in re ­
sponse to the decline in their real incomes after
the dollar floated. A modest devaluation to a
new fixed parity might have avoided the first oil
shock. If so, the mistaken policies in the United
States, attempting to offset the real effects o f
the oil price rise by inflation, w ould have been
avoided. Inflation w ould have been low er and
U.S. nominal gold reserves larger. It seems
unlikely, how ever, that other countries would
have accepted a U.S. policy o f inflation and
repeated, periodic devaluation against gold.
Without a low er rate o f inflation in the United
States, the Bretton W oods system w ould have
failed sooner or later.
Nevertheless, the French proposal was a
straightforw ard solution to the liquidity prob­
lem o f the 1960s. It w ould have resolved the li­
quidity problem at least fo r a time but w ould
not have resolved the m ore difficult "adjustment
problem s” arising from changes in countries’
prices, productivity, and costs o f production.
This was not the main reason fo r rejecting the
proposal, how ever. Representatives o f the g o v­
ernments and central banks claimed that any
change in the $35 gold price or devaluation by
a reserve currency country w ould damage
"confidence.”

Confidence
Throughout the 1960s, there w ere concerns
about w hether the United States could avoid
default on its obligation to convert dollars into
gold at the $35 gold price. Expressions o f lack
o f confidence in the dollar often brought forth
speeches by Presidents, Treasury secretaries
and others to bolster "confidence.” W ords w ere
not the only response. Actions w ere taken to
strengthen or restore confidence.
The dollar and, to a lesser extent, the pound
had a special role in the Bretton W oods system.
They w ere “reserve currencies.”3 Central banks
8
held dollar or pound securities as reserves in
sterling bloc. The dollar’s role evolved from the dollar bloc
and the unique position of the United States in the early
postwar years.

69

place o f gold to earn interest on their balances.
Devaluation reduces the real value o f these re ­
serves, so anticipation o f a devaluation could
lead to a run on the dollar or the pound. Once
total claims against the reserve currencies ex­
ceeded the gold reserves held by the United
States and Britain, discussion o f the confidence
problem intensified.
The first evidence o f a lack o f confidence in
the dollar was a tem porary rise in the gold price
in 1960. In October, the gold price on the Lon­
don market m oved above the official inter­
vention price, $35.20 an ounce. Speculators said
that the market was concerned about the possi­
ble election o f John F. Kennedy as president
and the continued capital outflow from the
United States. Kennedy’s talk o f "getting the
econom y m oving” may have seemed inflationary.
T o counter these concerns, Kennedy made a
strong commitment to maintain the gold value
o f the dollar, and the Eisenhower administration
took the first steps (discussed above) to reduce
the U.S. payments deficit.
Th e tem porary increase in the London gold
price reflected both a rising demand fo r gold
from European central banks and private hold­
ers and a refusal by the United States to supply
gold to the market. The London gold price was
set to clear trading. To maintain the price
within its band, the Bank o f England bought or
sold gold fo r dollars, replacing the dollars or
gold in an exchange w ith the U.S. Treasury. In
October 1960, the Treasury appeared unwilling
to restore the Bank’s gold holdings, so the Bank
refused to buy dollars fo r gold. W ith the resid­
ual buyer o f dollars inactive, actual and p ro­
spective supply was reduced; the price o f gold
rose to $40 on October 27. The Treasury re­
sumed sales, and the price returned to $35.
T w o changes w ere introduced as a result o f
this experience. European central banks agreed
not to buy gold on the London market if the
price rose above the U.S. price plus shipping
cost, $35.20. In October 1961, seven European
governments and the United States created a
gold pool. Each m em ber o f the pool agreed to
let the Bank o f England buy and sell fo r the
group, and each received a pro-rata share o f
any gold purchases and supplied a share o f gold

39See Schwartz (1987), p. 342.
40Unit labor costs (ULC) are available for Canada, Japan,
Germany and the United Kingdom from 1963 to date. The
index of foreign ULC is based on these countries. All data




sales. During the years that the pool functioned,
m em ber countries sold gold w orth (net) $2.5
billion on the London market. The U.S. share
was $1.6 billion.3 As shown in figure 1, during
9
approximately the same period, 1961-67, U.S.
gold reserves fell m ore than $5 billion, the dif­
ference reflecting direct sales from the U.S.
gold stock. But, as noted earlier, during the
same period, the countries in the G-10, and
especially France, added m ore than 100 million
ounces ($3.5 billion) to their official gold
reserves. The amount added by the G-10
represents 97 percent o f the sales by the United
States outside the gold pool. These data suggest
that the pool did not function as intended; the
G-10 replaced their sales from U.S. stocks.
The years 1962-64 saw a substantial increase
in the U.S. current account surplus and reduc­
tion in the payments imbalance. The gold out­
flow, figure 1, slowed. Part o f the im provem ent
resulted from the restrictions on military and
other purchases abroad, but part was the result
o f rising exports, achieved despite the relatively
robust economic expansion in 1963 and 1964.
Figure 4 shows quarterly data on the current
account balance (in billion o f dollars) from 1960
to the end o f the Bretton W oods system. A fter
the increase in the surplus, to 1964, there is a
steady decline interrupted b y the recession o f
1969-70. The tem porary surplus o f 1970 was
soon replaced by a deficit that eliminated the e f­
fects o f the surplus; the observations fo r 1972
are on a straight line fitted to the data fo r the
second half o f the 1960s.
To slow the grow th o f dollar reserves abroad,
the United States had to reverse the current ac­
count balance sufficiently to cover private invest­
ment abroad, transfers, and other capital flows,
not in any particular year, but over time. By
this standard, policy can be said to have failed
to offset the negative trend in the current ac­
count balance after 1964.
One reason fo r the rising surplus in the U.S.
current account balance in the early 1960s is
that foreign costs rose relative to U.S. costs.
Figure 5 shows the unit labor costs (ULC) for
the United States relative to unit labor costs
abroad.4 The ULC ratio reaches a trough in
0

are from OECD, Main Economic Indicators, Historical
Statistics, 1990. The weights are Federal Reserve trade
weights normalized to sum to unity. 1985 is taken as the
base year for United States and the trade weighted ULC.

MAY/JUNE 1991

70

Figure 4

Current Account Balance
Billions of dollars

1960

61

Quarterly Data

62

63

64

65

third quarter 1963, then reverses to reach a
local peak in fourth quarter 1968. The current
account (figure 4) has a similar movement; al­
though its local peak is a bit earlier, the balance
remains relatively higher until second quarter
1965. The trough o f the current account is also
in second quarter 1968. The next swing contin­
ues the negative relation. The current account
rises until early 1970 while the ULC ratio falls.
Thereafter, the tw o charts m ove together, fall­
ing until the end o f Bretton Woods. A sharp
decline in the ULC ratio accompanied the decline
in the trade balance until 1972.
The comparison suggests that until 1970 or
1971, changes in the current account balance
are consistent w ith the movements o f relative

41The Federal Reserve uses shares of world trade to set in­
dividual country weights. The real interest rate index for
foreign countries is based on Treasury bills for Canada
and the United Kingdom and call money rates for Ger­
many and Japan. The Federal Reserve trade weights are


FEDERAL RESERVE BANK OF ST. LOUIS


66

67

Billions of dollars

68

69

70

71

1972

costs. A fter 1970 the situation changed. The fall
in the current account is not the result o f a
worsening o f the competitive position o f the
United States as reflected in relative costs o f
production. The fall in relative costs may have
continued to increase the current account bal­
ance, but their influence was m ore than offset
by pressures in the opposite direction.
One possible explanation o f the change in
1970-71 is that relative real rates o f return to
capital m oved against the dollar. Such m ove­
ments should be reflected in relative real rates
o f interest. Figure 6 shows the ratio o f the ex
post U.S. real interest rate to a trade w eighted
average o f real interest rates using Federal
Reserve trade weights.4 The figure shows the
1

standardized for the four countries to sum to unity. Infla­
tion is measured by the consumer price index for each
country. The ratio shown uses three-month moving
averages (not centered) for both series.

71

Figure 5
Ratio of U.S. Unit Labor Costs to
Trade-Weighted Unit Labor Costs
Quarterly Data
1.36

1.36

1.32

1.32

1.28

1.28

1.24

1.24

1.20

1.20

1.16

1.16

1.12

1.12

1.08
1963

64

65

66

67

ratio o f a three-month, non-centered, moving
average o f the U.S. short-term interest rate to a
three-month m oving average o f short-term rates
abroad. A ll rates have been adjusted fo r infla­
tion in the particular country.
These data show that from 1960 to 1969, U.S.
real interest rates rose on average relative to
rates abroad. The sharp rise in U.S. rates from
1962 to 1964 contributed to the reduction in
the net capital outflow and is reflected in the
rise in current account surplus. The movement
o f relative interest rates, on average, reinforced
the effect o f falling relative costs o f production
during this b rief period. A fter 1965, the relative




68

69

1.08

rate o f interest continued to rise, but the rise
was too small to reverse the falling current ac­
count balance. And the increase in relative in­
terest rates in the United States was apparently
too small to prevent the very large capital out­
flo w in that period. Th e path o f relative interest
rates does not explain the collapse o f the cur­
rent account balance and the large capital out­
flo w in the early 1970s.
Relative interest rates give little evidence o f a
grow in g lack o f confidence in the dollar in the
late 1960s. A flight from the dollar w ould have
pushed real U.S. interest rates above rates in
w orld markets to compensate fo r the risk o f

MAY/JUNE 1991

72

Figure 6
Ratio of U.S. Real Interest Rate
to Trade-Weighted Real Interest Rate
3-Month Moving Average

devaluation and a run on the dollar. W ith few
exceptions real rates in the United States w ere
below rates abroad, on average about 10 per­
cent below from 1966 to 1972. There is no evi­
dence o f a sustained rise in U.S. rates. The
Federal Reserve pumped out m onetary base to
hold dow n interest rates. The rest o f the w orld
absorbed the dollar ou tflow w ith little change in
real U.S. rates relative to rates abroad. Th e main
exception is a spike in 1968-69 that mainly re­
flects a decline in the w eighted average o f real
rates abroad.
The data on relative real rates o f interest sug­
gest that the Federal Reserve made little effo rt
to slow or stop the capital flow . During the w in ­


FEDERAL RESERVE BANK OF ST. LOUIS


ter o f 1971 relative real rates in the United
States fell until M arch along w ith U.S. real rates,
despite the large dollar outflow. The rise in rel­
ative rates in the spring and summer reflects
both a decline in foreign rates and a rise in
U.S. rates.
The gold and foreign exchange markets also
give little evidence o f a lack o f confidence lead­
ing to a flight from the dollar during the 1960s.
An exception is the w inter o f 1968 w hen the
gold price rose and the tw o-tier market began.
By 1969, the gold price in the fre e London mar­
ket had fallen back to $35.2 per ounce. The
same cannot be said fo r the other reserve cur­
rency, the pound sterling. By 1964, the pound
was subject to market pressure to devalue rela­

73

tive to gold and the dollar. Repeated attempts to
reduce the pressure each succeeded fo r a short
time, then failed. Finally in N ovem ber 1967, Bri­
tain devalued by 14.3 percent (from $2.80 to
$2.40). Mem bers o f the old sterling bloc
followed.
Pressure to devalue sterling occurred against
a w orsening problem o f U.S. domestic inflation
and a deteriorating relative cost position (figure
5). The Johnson administration’s main efforts to
slow price and w age increases w ere limited to
exhortation (jawboning). These efforts extended
to interest rates. W ith short-term interest rates
fixed by the Federal Reserve (figure 2a), rising
demand fo r goods and services and anticipations
o f higher inflation encouraged increased bor­
row in g and higher m oney growth. As shown in
figure 2b, the annual grow th o f the m onetary
base rose in 1965. Base grow th reached the
highest rate experienced in the postwar years
to that time. Efforts to hold dow n rates paid on
time deposits under Regulation Q ceilings added
to the pressure on the banks. Depositors drew
on balances to purchase securities in the open
markets at home or abroad.
Early in Decem ber 1965, the Federal Reserve
raised the discount rate from 4 to 4-1/2 percent
and raised ceiling rates on time deposits. A l­
though President Johnson criticized the change
publicly, the higher rates rem ained in effect. As
is often the case, how ever, the increase was too
little and too late. Annual grow th o f the m one­
tary base from the same month a year earlier
did not decline until the second half o f 1966, as
shown in figure 2b. Inflation rose early in 1966.
U.S. interest rates, after adjusting fo r inflation,
fell relative to foreign rates (figure 6). Declines
in relative unit labor costs and relative consumer
prices ended. Reflecting these changes, the nom­
inal current account balance plunged in the five
quarters follow ing the Decem ber 1965 decision,
eliminating most o f the increase achieved in the
previous six years.
The Federal Reserve made a short-lived effort
to slow the inflation in 1966. The federal funds
rate rose and the grow th o f the m onetary base
contracted in the second half o f the year. Re­
sponding to the less inflationary policy, sensitive
measures o f prices, such as the producer price
index, reversed direction o f change, falling from
42See Solomon (1982), p. 102.
43Haberler (1965) was one of the first to emphasize the
greater importance of the adjustment problem relative to




the local peak in third quarter 1966 to a local
trough in second quarter 1967. A six-month aver­
age o f consumer prices fell from a 4 percent
annual rate in January 1966 to 1.3 percent in
February 1967. Given the upw ard bias in con­
sumer prices, resulting from the heavy weight
on service prices (that are not adjusted fo r pro­
ductivity and quality changes in inputs and out­
puts), it appears that the Federal Reserve had
stopped the inflation. But, as figures 2a and 2b
show, the Federal Reserve did not continue the
policy. Federal funds rem ained at 4 percent fo r
most o f 1967 despite clear evidence o f recovery.
By early 1968, consumer prices w ere rising at
a 3 to 4 percent annual rate and, m ore im por­
tantly fo r the payments problem, rising relative
to a w eighted average o f foreign prices. Relative
unit labor costs rose sharply. The effects o f
changes in relative costs and prices on the U.S.
payments position w ere partially hidden at first
by a capital in flow from Europe; U.S. banks had
began borrow in g from the Eurodollar market.
In part, this reflected the rise in relative rates
o f interest by 0.25 in the United States (figure
6), in part efforts to circum vent ceilings on time
deposits including, at the time, all certificates o f
deposit (regardless o f denomination). The result
was a payments surplus in 1966, the first since
1957, and repaym ent o f earlier Treasury and
Federal Reserve borrow in g from central banks
and governm ents.4
2
Confidence in the administration's ability to
maintain convertibility into gold or avoid deval­
uation reached a tem porary low early in 1968.
The immediate problem began with a run on
gold w hen Britain devalued. The gold pool sold
$800 million in Novem ber 1967. The run subsid­
ed in January, follow ing the announcement that
President Johnson had placed new controls on
foreign investment by businesses, banks and
financial institutions.
Demands fo r gold rose again in March. Rumors
that the gold pool w ould end and the low cost
o f speculating against a price that could fall
very little encouraged renew ed speculation. A fter
sales o f $400 million on March 14, the London
gold pool closed the next day. That marked the
end o f the gold pool. The market did not reopen
until April. W hen it did, central banks no
the liquidity problem, but neither his remonstrance nor
others had much effect on official proposals. See also
Friedman (1953).

MAY/JUNE 1991

74

longer supported the market price. Th ere was
now a two-tier market. Private transactors
could buy and sell at the market determined
price, although the 1934 ban on U.S. citizens’
ownership o f gold remained. Transactions bet­
w een central banks w ere placed outside the
m arket and continued at the $35 price. Also,
the governm ents agreed that gold w ould not be
sold by the members o f the fo rm er pool to
replace any central bank sales to the private
market.
The central bank governors' communique’ put
a positive interpretation on their announcement,
repeated their intention to maintain existing
parities, and referred to the then forthcom ing
agreem ent to establish the SDR. It made no
mention o f adjustment o f parities.4 The central
3
banks agreed to "no longer supply gold to the
London gold market or any other gold market,”
but they hedged their statement to retain the
possibility o f buying gold.4 The two-tier agree­
4
ment remained in effect until N ovem ber 1973.
The free market gold price w ent to $38 per
ounce, suggesting that the market w ould have
been satisfied by 10 to 15 percent devaluation
o f the dollar. For the rest o f the year, the free
market price rem ained betw een $38 and $43.
Then the price fell back to $35 to absorb an
increased supply o f South A frican gold.4
5
For the year 1968 as a whole, the United
States had a surplus in the balance o f payments.
The reason is that banks continued to b orrow
in the Eurodollar market and, follow ing the
Soviet invasion o f Czechoslovakia, foreign inves­
tors purchased U.S. assets.4 These decisions
6
and events produced a payments surplus in
1968 despite a fu rth er decline o f $2 billion to
$0.6 billion in the current account surplus.
One lasting effect o f the w in ter’s events was
the elimination o f the gold reserve requirem ent
fo r Federal Reserve notes. On March 12, Con­
gress abolished the 25 percent gold reserve
behind Federal Reserve notes. The legislation
rem oved one o f the last links betw een gold and
the dollar in the original Federal Reserve Act.
The initial requirem ent ratios, or backing, fo r
bank reserves and currency had first been re ­
duced, then eliminated fo r bank reserves and,
finally, eliminated fo r currency. The stated pur­
pose was to make the gold stock available to de-

fend the $35 price. In fact, central banks did
not again convert dollars into gold until 1971.
The two-tier system and the decision b y cen­
tral banks to refrain from converting dollars in­
to gold had an unanticipated effect on the soon
to be created SDRs. The United States had spon­
sored SDRs and urged their use as a substitute
fo r gold in central bank reserves. Since central
banks refrained from selling gold, and bought
new ly mined gold from South A frica and the
Soviet Union, issues o f SDRs served as a substi­
tute fo r dollars in central bank reserves.
Looking back after the fact, it is surprising
how small was the loss o f confidence in the dol­
lar as a reserve currency b efore 1971. Central
banks and governm ents p referred to absorb
dollars rather than revalue their currencies.
Some private speculators purchased gold or
other assets, but the purchases w ere not large
enough to m ove the equilibrium gold price per­
sistently above the fixed price until 1970.
Meeting after meeting during the last five
years o f Bretton W oods mentioned the three
problems: confidence, liquidity, and adjustment.
Central bank governors, ministers and their
staffs gave most o f their attention to liquidity
and then to confidence. Aside from a fe w re­
latively small changes in parities, little was done
about adjustment. The attitude o f the IMF is
representative o f the period. Their 1969 report
mentions adjustment o f par values, follow ing
the French devaluation. The discussion reached
only one conclusion: the par value system should
be retained.4
7

THE END OF BRETTON WOODS
Concern about the rising budget deficit, the
payments problem and inflation led Congress in
June 1968 to accept the Johnson administration’s
proposed 10 percent income tax surcharge and,
in return, to require the administration to
reduce the grow th o f governm ent spending.
The response o f the Federal Reserve was almost
immediate; they reduced the federal funds rate
in an attempt to mix easier m onetary policy
w ith tighter fiscal policy. G row th o f the m one­
tary base declined briefly, then rose to a 7 per­
cent annual rate o f increase (figure 2b). The six
month average rate o f increase o f consumer

44See Solomon (1982), p. 122.

46lbid., p. 105.

45lbid., p. 124.

47See IMF (1969), p. 32.


FEDERAL RESERVE BANK OF ST. LOUIS


75

prices rose at a 4 percent rate in 1968 but the
annualized rate o f increase was 6.5 percent at
the end o f the year.

less than 4 percent the follow ing year. Growth
o f the m onetary base rose from 4 to 8 percent
annual rate in the same period.

U.S. consumer prices now began to rise rela­
tive to a trade w eighted average o f prices abroad
(figure 3), reversing the trend decline o f the
early 1960s. Unit labor costs rose sharply rela­
tive to costs abroad (figure 5). Th e trade and
payments position deteriorated; real net exports
(1982 dollars) fell to -$ 3 0 billion in 1968 and
-$ 3 5 billion in 1969 from -$ 1 7 billion in 1967
after a $6 billion surplus in 1964. As shown in
Figure 4, the nominal current account balance
continued to fall in 1968, reversed briefly dur­
ing the 1969-70 recession, then resumed its
decline.

To any outside observer, it must have been
clear that the United States did not intend to
follow the classical rules or the policies o f a
country that intended to maintain a fixed ex­
change rate. The run from the dollar began.
Foreign central banks experienced large in­
creases in dollar reserves. Germany added $3.1
billion in the first six months o f the year. Ger­
man money grow th rose from 6.4 percent in
1970 to 12.0 percent in 1971. German consumer
prices, which had increased 1.8 percent in 1969
rose 5.3 percent in 1971. Despite rigid exchange
controls, Japan could not escape the direct e f­
fect o f U.S. money grow th through the trade
account. Japan’s reserves nearly tripled in the
first nine months o f 1971, rising $8.6 billion.
The Japanese money stock (MJ rose m ore than
25 percent in 1971. Other countries had qualita­
tively similar experience.

The official settlements measure o f the balance
o f payments shows the United States in surplus
in 1968 and 1969 fo r the first time in the
decade.4 This was misleading, much o f it the
8
proximate result o f Regulation Q ceilings on
personal and corporate time deposits. As U.S.
interest rates rose above the legal ceiling rates,
commercial banks lost time deposits to the Euro­
dollar market.4 The U.S. banks then borrow ed
9
in the Eurodollar market acquiring many o f the
deposits they had lost and some additional funds.
The effect was to have a large inflow o f short­
term capital, $4.3 billion on the official settle­
ments basis fo r the tw o years.
Interest rates fell during the 1970 recession,
real rates declined on average relative to rates
abroad, and the capital flo w reversed w ith a
vengeance. The official settlements deficit o f
-$9.8 billion was by far the largest to that
time. But this flo w was soon dw arfed by the
-$ 3 1 billion outflow in the first three quarters
o f 1971.5
0
Figure 1 shows the surge in liabilities to
foreign central banks and governments. These
liabilities m ore than doubled to $50 billion in
1970, then rose another $11 billion in 1971. The
classic response to a capital ou tflow fo r a coun­
try on a fixed exchange rate is to raise interest
rates and reduce m oney growth. The Federal
Reserve did the opposite, the federal funds rate
fell from a peak o f 9 percent early in 1970 to
48The official settlements balance measures the change in
reserve assets minus the change in short- and long-term
liabilities to foreign official institutions (central banks or in­
ternational agencies).
49A Eurodollar is a dollar deposit liability of a European
based bank, including European branches of U.S. banks.




In 1969, after much delay, Germany had closed
the foreign exchange market, allowed the mark
to float, then revalued by 9.3 percent on Octo­
ber 24. W ithin tw o years, three major curren­
cies—the British pound, the French franc and
the German m ark—had been forced to change
exchange rates.5 Th e belief that economic
1
stability required exchange rate stability began
to erode.
The 1971 capital flo w dw arfed previous ex­
perience. Th e U.S. deficit on capital account
was almost $30 billion fo r the full year 1971
and $42 billion fo r the tw o years 1970-71. O f
this amount, $40 billion becam e dollar reserves
o f other countries. Japan and Germany accumu­
lated $11 billion each, m ore than half the total,
and the United Kingdom acquired nearly $10
billion.5 On May 5, seven European countries
2
closed their foreign exchange markets. Th e Ger­
man Finance Minister, Schiller, tried to persuade
principal European countries to agree to a joint
float, but France and Italy opposed. Four days
later the mark and the Dutch guilder began to
float. Switzerland revalued by 7 percent and
Austria by 5 percent.5 Belgium, w ith a split ex3
50See ERP (1972), p. 150.
5 France devalued by 11.1 percent on August 10, 1969.
1
Canada floated its currency against gold in May 1970.
52See IMF (1972), p. 15.
53See Solomon (1982), p. 180.

MAY/JUNE 1991

76

change rate, allowed the financial rate to float
up. Early in August, faced w ith slow recovery
from the recession, rising inflation, a persistent
payments deficit, and fifteen months to election
day, President Nixon decided to change economic
policy. A fter m eeting at Camp David on the
w eekend o f August 13 to 15, he ended the fixed
exchange rate system by suspending "tem porar­
ily the convertibility o f the dollar into gold or
other reserve assets.”
The plan announced on August 15 included
much m ore than the suspension o f gold conver­
tibility. W ages and prices w ere frozen fo r 90
days, allegedly to stop inflation then running at
an annual rate o f 3 percent fo r the six months
ending in July. Tax credits to increase em ploy­
ment and investment w ere introduced to in­
crease demands fo r output and labor and to
reduce unemployment below 6 percent. A 10
percent surcharge was put on imports.5 By the
4
end o f August, all major currencies except the
French franc floated against the dollar.5 The
5
last remaining tie o f the dollar to gold had
been severed, at least tem porarily.
Many o f the changes announced on August 15
had been discussed fo r some time in advance.
Chairman Burns o f the Federal Reserve had ad­
vocated a price-wage policy fo r months. John
Connolly, the secretary o f the Treasury, favored
strong action on trade and inflation. Stein
reports that President Nixon and Connolly had
agreed in the spring that they w ould impose
price and w age controls if foreign demand fo r
gold required them to close the gold w in d ow .5
6
The triggering event was renew ed demands
fo r gold from France and Britain. On August 8,
the press reported that France w ould ask fo r
$191 million in gold to make a scheduled repay­
ment to the IMF. Later in the same week, on
August 13, Britain also requested to exchange
dollars fo r gold. The combined requests w ere
54More precisely, the surtax was used to raise import duties
no higher than their statutory level from which tariff reduc­
tions had been made. For autos, the increase was, there­
fore, 6.5 percent (ERP, 1972, p. 148). Shultz and Dam
(1977), p. 115 explain that the surcharge was to be used
as a bargaining chip to keep other countries from following
the U.S. devaluation against gold. U.S. policy was to
devalue against gold and other currencies. The surcharge
raised the price of U.S. imports, so devalued the dollar
against other currencies until they agreed to a formal
devaluation.
55France adopted a dual exchange rate with financial tran­
sactions at a floating rate.
56See Stein (1988), p. 166. Herbert Stein was a member and
later chairman of President Nixon’s Council of Economic

FEDERAL RESERVE BANK OF ST. LOUIS



small in comparison w ith the $12 billion in­
crease in foreign holdings o f dollars in the first
nine months o f 1971. Reports o f demands fo r
gold, how ever, generated fears o f a run against
the remaining U.S. gold reserve.5 President
7
Nixon and his principal advisers met at Camp
David on the w eekend o f August 13 to 15 to
adopt the program based on the agreement
reached by Nixon and Connolly in the spring.5
8
The earlier policy had been called "steady as
you go.” In fact, U.S. m onetary policy had been
far from steady in 1970-71. The federal funds
rate was driven dow n from 9 percent early in
1970 to 3.7 percent in March 1971, then in­
creased 5.3 percent in July. During the same
period, grow th o f the m onetary base increased
from 4 percent to 8 percent. The effect, given
policies abroad, was to low er U.S. short-term in­
terest rates relative to a trade-weighted average
o f rate abroad as shown in figure 6.5 The de­
9
cline in relative real interest rates ended in
March, then reversed but, by March, the dollar's
fixed exchange rate was falling, reflecting g ro w ­
ing fears o f devaluation. These fears strength­
ened as currencies began to float or revalue
against the dollar.
W hen asset markets opened on Monday
August 16, traders greeted the new economic
policy enthusiastically. U.S. interest rates fell
and stock prices rose. Many o f the foreign ex­
change markets abroad w ere closed, but in the
United States and, later in markets overseas, the
dollar depreciated against most currencies. An
exception is the Canadian dollar w hich rem ain­
ed in a narrow band fo r the rest o f the year.
The Japanese yen was at the other extreme; it
revalued b y about 5 percent initially and rose
10 percent by the end o f September despite
much intervention by the Bank o f Japan. Be­
tw een D ecem ber 1970 and July 1971, the trade
w eighted index o f the real U.S. exchange rate
Advisers. The decision was told only to George Shultz,
director of the Office of Management and Budget and Paul
McCracken, chairman of the Council of Economic
Advisers.
57See Shultz and Dam (1977), p. 110; Stein (1988), p. 166.
58Arthur Burns, chairman of the Board of Governors, par­
ticipated in the meeting despite the independence of the
Federal Reserve. Burns also participated in the administra­
tion’s program as chairman of the Committee on Interest
and Dividends.
59The local peak in the relative rate is 1.27 in January 1969.
By March 1971 the relative rate reached 0.6.

77

Figure 7
Dollar’s Real Exchange Rate Index

declined by approximately 3 percent; betw een
July and the end o f Decem ber 1971 the rate fell
an additional 6.5 percent, so real devaluation
fo r the year was approximately 9.4 percent.
Figure 7 shows the real exchange rate fo r
the dollar against a trade-weighted basket o f cur­
rencies using Federal Reserve weights. Since
there are fe w parity changes p rior to 1971, the
real exchange rate reflects mainly relative price
changes. Hence, figure 7 fo r the most part dup­
licates figure 3 until 1971. Thereafter, the tw o
charts differ; the real exchange rate reflects
both the devaluation o f the nominal exchange
rate and the change in relative prices.




What Next?
The price-wage freeze, the surtax on imports
and the floating dollar w ere thought to be tem ­
porary measures. Th ere is no evidence that the
administration had developed a long-term pro­
gram by August 15, but they began to do so.
The 1972 Econom ic Report summarizes some
o f their thinking by discussing three questions.
Should realignment occur through market adjust­
ment or negotiation? H ow large is the structural
or permanent deficit? H ow should the reduction
in the U.S. payments deficit be distributed
among other trading countries? In practice, the
distribution w ould be determ ined by the choice

MAY/JUNE 1991

78

o f exchange rates, so the issue was the size o f
relative revaluations against the dollar.6 Other
0
countries, particularly France, wanted acknowl­
edgment by the United States o f its past infla­
tion in the form o f a devaluation against gold.
Perhaps m ore important was the effect on
country wealth. A devaluation by the United
States raised the value o f country gold stocks
w hile a devaluation by other countries reduced
the value o f their dollar assets.
In the first nine months o f 1971 the U.S.
short-term capital ou tflow rose to $23 billion,
and the basic balance declined to -$10.2 billion.
At an annual rate, these outflows w e re equiva­
lent to the entire short-term capital ou tflow fo r
1960-69. The ou tflow includes capital flight from
the United States in anticipation o f devaluation
and a deteriorating current account balance. In
part, deterioration reflected the w orsening rela­
tion in U.S. prices relative to foreign prices. The
ratio o f U.S. consumer prices to trade weighted
consumer prices in figure 3 shows an increase
o f fou r percentage points betw een 1966 and the
end o f 1970.
Although Treasury Undersecretary Paul
Volcker had testified in June that the basic im­
balance was about $2.5 to $3 billion, Volcker
now argued fo r a $13 billion adjustment to
reach equilibrium.6 The United States favored a
1
period o f fre e floating and offered to rem ove
the 10 percent surcharge on imports if other
countries w ould rem ove barriers to trade. In­
stead central banks intervened, and govern ­
ments imposed exchange controls. Exchange
rates w ere not perm itted to adjust freely; new
rates w ere negotiated.

The Smithsonian Agreement
In December, finance ministers and central
bank governors met at the Smithsonian Institu­
tion in Washington to agree on a new set o f
exchange rates. Gold was repriced at $38 per
ounce, and bands on exchange rates w ere rais­
ed from 1 percent to 2.25 percent o f central
rates. The United States eliminated the 10 per­
cent surcharge on imports, and the principal
countries agreed to discuss reductions o f trade
barriers.6
2

60See ERP (1972), p. 149.

The agreem ent on devaluation o f the dollar
against gold raised, or m ore accurately, con­
tinued a problem. The official gold price r e ­
mained below the open market price that had
now reached $42. Central banks, therefore, had
an incentive to convert dollars into gold and sell
the gold on the open market. The "solution” was
to raise the official price but not require the
dollar to be convertible into gold!
The new exchange rates revalued the mark
by 13.6 percent against the dollar, the yen by
16.9 percent, the pound and the French franc
b y 8.6 percent, and most other European cur­
rencies b y 7.5 to 11.6 percent. Th e Federal
Reserve’s calculation showed a trade weighted
devaluation o f the dollar o f 6.5 percent against
all currencies and 10 percent against the cur­
rencies o f the Group o f 10. The devaluation was
estimated to produce an $8 billion swing in the
U.S. trade balance in tw o to three years.6 The
3
IMF estimated the dollar devaluation as 7.9 p er­
cent o f its form er par value.6 Th e effect o f all
4
the parity changes was to raise the w orld im ­
port prices by about 7.5 percent.6
5
Prior to the agreement, inflexibility and lack
o f an adjustment mechanism had been major
problems. Surplus countries had been reluctant
to revalue because o f the effects o f their exports
on domestic employment. The United States had
been unwilling to devalue against gold. Many
countries had relied on exchange controls to
strengthen their currencies.
The Smithsonian agreem ent took tw o steps to
im prove adjustment. The gold price changed,
opening the possibility o f fu rth er changes, and
the dollar was devalued against the leading cur­
rencies. In addition, cross rates o f exchange
w ere altered to reflect, partially, the changes in
the w orld financial system. Also, the 2-1/4 per­
cent band on exchange rates perm itted diver­
gence o f up to 4.5 percent. But, nothing was
done to provide an orderly procedure fo r chang­
ing parities w hen there w ere persistent deficits
or surpluses. The system rem ained relatively in­
flexible and poorly designed fo r the event
which it soon faced.

sion of trade barriers produced very few changes.
(Solomon, 1982), p. 191.

6 See Solomon (1982), p. 192-93; ERP (1972), p. 154. The
1
$13 billion included a $6 billion surplus to provide for len­
ding to developing countries.

63See Solomon (1982), p. 211.

62Secretary Connally’s initial position included renegotiation
of defense costs, but this issue was dropped. The discus­

“ ibid., p. 22.


FEDERAL RESERVE BANK OF ST. LOUIS


64See IMF (1972), p. 38.

79

President Nixon called the agreem ent “the
most significant m onetary agreement in the
history o f the w orld .”6 In fact, it was a modest
6
agreement that lasted less than fifteen months.
W ithin a fe w months stresses reappeared in the
international m onetary system. In June, Britain
decided to let the pound float. W ithin a month
17 members o f the sterling bloc followed. In the
same month, Germany imposed controls on cap­
ital inflows fo r the first time since the 1950s.6
7
The underlying problem was that U.S. policy
remained inconsistent with maintenance o f a
fixed exchange rate system. Despite the price
controls introduced in August 1971, the rep ort­
ed rate o f change in consumer prices in 1972
was only 1 percent low er than in 1971. M ore
importantly, the future did not look promising.
The Federal Reserve made no e ffo rt to restrict
m oney growth. Despite a surge in aggregate de­
mand and industrial production, the federal
funds rate was reduced to below 3-1/2 percent
early in the year and was held below 5 percent
until the N ovem ber election. Growth o f the
m onetary base rem ained above 6-1/2 percent,
and grow th o f M, increased to 7 percent. Nomi­
nal imports surged, reflecting the devaluation
and the strong economic expansion. For the
year as a whole, real net exports w ere -$4 9
billion, a 20 percent rise in a single year and
the largest deficit to that time. Th e nominal cur­
rent account balance rem ained negative, -$5.8
billion, m ore than fou r times the deficit o f the
previous year.
For a fe w months in the summer and fall, the
dollar stabilized. Prices in the United States de­
clined relative to trade w eighted prices abroad
(figure 3) and, until September, U.S. real inter­
est rates rose relative to trade w eighted real
rates abroad (figure 6). The rise in the relative
real interest rate during the fall and early w in ­
ter was small, how ever, in relation to the capi­
tal outflow.
In late January 1973, a new foreign exchange
crisis began. Italy announced a two-tier exchange
market to discourage capital outflows. Sw itzer­
land floated to reduce the flo w from Italy and
to control money growth. Pressure shifted to
Germany and Japan. W ithin tw o weeks, Japan

floated, and the Europeans closed their foreign
exchange markets to halt the inflow o f dollars.6
8
The United States made its last attempt to re­
tain the par value system. On February 12, the
dollar was devalued by 10 percent (to $42.22).
Since the United States did not intervene to
maintain the new price, the action was more
symbol than substance. Secretary Shultz (who
had replaced Connally the previous summer)
also announced an end to U.S. exchange con­
trols, including the interest equalization tax and
restrictions on foreign loans and investments
scheduled fo r Decem ber 1974.6
9
Within a fe w weeks, there was a renew ed
flight from the dollar, requiring additional pur­
chases by foreign central banks under the rules.
During the first quarter o f the year, foreign
central banks, mainly in the G-10, bought an ad­
ditional $10 billion. The addition was m ore than
17 percent o f total G-10 foreign exchange bal­
ances at the end o f 1972.7 The new purchases
0
w ere sufficient to convince most countries to
bring the Bretton W oods system to an end. The
Europeans agreed on a joint float against the
dollar and other currencies. Th e yen had floated
earlier. De facto fluctuating exchanges rates
became the norm fo r major currencies.

W HY BRETTON WOODS FAILED
In retrospect, the Bretton W oods system o f
fixed but adjustable exchange rates appears to
have failed fo r tw o main reasons. First, the sys­
tem was poorly designed, and the flaws became
m ore apparent as tim e passed. Second, the
United States did not pursue the monetary pol­
icy necessary to maintain a fixed exchange rate.
On a fe w occasions, interest rates may have
been raised to support the exchange rates (or to
slow the capital flow ), but m onetary policy con­
centrated almost exclusively on a variety o f
domestic objectives. This was particularly true
w hen the climax came in 1970-72.

The Flaws in Bretton Woods
The designers o f the Bretton W oods system
wanted to reduce the role o f gold and make ad-

66See the Wall Street Journal, December 19, 1971.

69See Pauls (1990), p. 897-98.

67Previously Germany used reserve requirements on foreign
deposits to reduce capital inflows. In June 1973 sales of
German securities to foreigners were prohibited.

70IMF Yearbook (1990).

68The Bundesbank purchased $5 billion in the week ending
February 9, 1973.




MAY/JUNE 1991

80

justment by deficit and surplus countries more
nearly symmetrical. One o f the designers, John
Maynard Keynes, believed that w ith fixed but
adjustable exchange rates and adjustment by
both deficit and surplus countries, fluctuations
in economic activity would be reduced; deficit
countries w ould not be forced to contract, or
w ould contract less, w hen faced with a tem ­
porary loss o f reserves; instead, surplus coun­
tries w ould lend to deficit countries. In this
way, fluctuations in output w ould be damped.
There w ere tw o problems w ith this plan fo r
adjustment. First, surplus countries had no in­
centive to adjust, and they w ere generally reluc­
tant to do so. Keynes had proposed a penalty
on surplus countries that accumulated reserves,
but this proposal was eliminated early in the
developm ent o f the Bretton W oods system.7 Se­
1
cond, policymakers could not distinguish a tem ­
porary disequilibrium, to be resolved b y b o r­
row ing and lending, from a permanent disequil­
ibrium requiring a change in par values. In
practice, the system became m ore rigid w ith the
passage o f time. Britain delayed devaluation fo r
several years before 1967. France delayed de­
valuation in 1968. Germany, Japan and other
surplus countries delayed revaluations. Japan
supported the yen fo r a few w eeks even after
August 15, 1971, by intervening sizably to slow
the yen's appreciation.7
2
The flaws in the system appeared quickly, al­
though they w ere not always recognized as
such. A starting point fo r the full operation o f
the system is 1959, w hen currencies became
convertible. By 1968, the dollar was de fa cto
inconvertible into gold. Although the Bretton
W oods system stumbled through the next several
years, foreign central banks and governments,
after M arch 1968, w ere discouraged from con­
verting dollars into gold and did not do so.
W hen some tried to convert, in August 1971,
the U.S. form alized the restriction that had
been in effect fo r m ore than three years by
refusing to sell gold.
During the 10 years, 1959-68, from the m ove
to convertibility to the effective em bargo on
U.S. gold, restrictions on trade and payments
grew . The United States paid considerable costs
to avoid buying supplies abroad fo r its troops in

7 See Meltzer (1988).
1
72The European exchange rate mechanism had much
greater flexibility in its early years, and Germany and the


FEDERAL RESERVE BANK OF ST. LOUIS


Europe and Asia. Much foreign aid was tied to
purchases from the United States. Restriction o f
capital movements b y Britain, the United States
and other countries made the payments system
highly illiberal and complex.
The ideal o f Bretton W oods was a system o f
fixed but adjustable exchange rates among con­
vertible currencies. During its short life, the goal
became increasingly one o f maintaining fixed
rates. Adjustment o f exchange rates and conver­
tibility o f the dollar into gold w e re lost. Presi­
dent Nixon's August 1971 decision, in this light,
should be seen as a choice o f adjustment over
gold convertibility.

U.S. P olicy
The professed principal aims o f U.S. interna­
tional economic policy included maintaining con­
vertibility into gold and sustaining the Bretton
W oods system. The policy failed in part because
it was often short-sighted or w rong, in part be­
cause the United States placed much m ore
w eight on domestic concerns than on the main­
tenance o f the w orld m onetary system.
Throughout the 1960s, France urged, and
the United States opposed, a revaluation o f gold.
The French argument was correct insofar as
it recognized that a devaluation o f the dollar
against gold w ould increase the supply o f w orld
reserves and reduce dependence on the dollar
as a reserve currency. The French w ere correct
also in insisting that gold had a long history as
an international money, but this argument con­
fused rather than clarified the issues under dis­
cussion. Devaluation o f the dollar against gold
did not presuppose a change in the Bretton
W oods system. That system was based on the
dollar, a point that should have been completely
clear after March 1968 when, de facto, coun­
tries could no longer convert dollars into gold.
Had the United States agreed to revalue gold in
1965 or shortly after, it seems entirely possible
that the many discussions leading to the issuance
o f SDRs w ould have been avoided and an ade­
quate solution found fo r the liquidity problem
much earlier. The U.S. policy delayed the solu­
tion until long past the time w hen it should
have been apparent that a solution to the liquid­
ity problem w ould not sustain the system.

Netherlands revalued several times. By the late 1980s,
however, countries tried to avoid exchange rate changes.

81

Gold w ould have served as an effective means
o f payment betw een central banks, a role that
the SDR did not acquire. M ore im portantly fo r
the Bretton W oods system, a revalued gold stock,
if agreed to before 1968, could have imposed
some discipline on the United States to pay in
gold. Discipline was lacking once the de facto
em bargo on gold was in place after March 1968.
Devaluation was not a panacea, how ever. Coun­
tries w ould have been unlikely to accept the
cost o f high U.S. inflation and frequent large
devaluations against gold, so the system’s sur­
vival w ould have required some restriction on
U.S. policy. SDRs provided no discipline at all.
The arguments against gold revaluation w ere
weak. The principal arguments w ere: (1) a de­
valuation o f the dollar against gold w ould not
solve the adjustment problem if other countries
devalued against the dollar; (2) an increase in
the gold price w ould benefit South Africa or
the Soviet Union; (3) the gold standard was
too rigid.
It is true that if all countries had devalued
against the dollar, exchange rates w ould have
remained fixed. But, the "liquidity" problem
w ould have been solved and perhaps part of
the "confidence” problem as well. Countries
w ould have taken losses on their dollar reserves,
but devaluation o f the dollar w ould have reduc­
ed the risk that the system w ould collapse w ith
a run on the dollar. Simultaneous devaluation
w ould have focused attention on the adjustment
problem by rem oving the liquidity problem that
occupied so much time and attention.
Arguments about South A frica and the Soviet
Union addressed domestic political concerns.
These arguments had no practical relevance. In
the end, the revaluation o f gold was not avoid­
ed. South Africa and the Soviet Union continued
to sell gold. The IMF established rules fo r pur­
chasing South African gold that accepted South
Africa's right to sell gold in the market and to
m em ber governments.

liabilities.7 Th ey w ro te as if they did not want
3
a m ore flexible system o f adjustment; they
wanted greater discipline. They talked much
m ore about the losses on holdings o f dollars
than the gain from a m ore stable, adjustable
m onetary system. Although a return to a full
gold standard was not the consistent aim o f
French policy tow ard the international m one­
tary system, their proposals and arguments
made it easy fo r others to dismiss their argu­
ments. Neither France nor other governments
offered alternative proposals under which U.S.
monetary policy w ould be subject to discipline.7
4
Perhaps it was inevitable in the 1960s that any
alternative to U.S. policy w ould be dismissed.
The U.S. argument that the dollar could not
be devalued was, at most, a half truth. The
restrictions placed on various types o f transac­
tions w ere partial devaluations that changed the
relative prices o f those transactions. The most
obvious example was the interest equalization
tax which raised the cost o f borrow in g dollars.
Im port-export bank subsidies low ered the cost
o f favored U.S. exports. Other restrictions w o rk ­
ed in much the same w ay to selectively devalue
the dollar.
Some o f the restrictions w ere so short-sighted
as to raise doubts about the purpose o f the poli­
cy and the objectives o f the policymakers. Re­
strictions on investment abroad by U.S. firms
are an obvious example. Absent the restrictions,
investment abroad w ould have been higher and
the capital ou tflow larger. But, profitable invest­
ment abroad w ould have produced a return
flow , increasing the current account surplus in
the future. W hatever short-term gain the re ­
strictions achieved, they had long-term, negative
consequences. The problem was not a short­
term problem o f maintaining the Bretton W oods
system fo r a fe w months or years. From a
longer perspective the restrictions on invest­
ment w ere counter-productive.

Th ere is little reason to doubt that public opi­
nion in many countries wanted to avoid a return
to the gold standard. The gold standard was
w idely view ed as an excessively rigid, 19th cen­
tury system. Some o f the French, w ho favored
a greater role fo r gold, emphasized the "discipline
o f gold” and the repaym ent o f dollar and sterling

One reason fo r the investment restrictions
may have been that policymakers often focused
on the basic balance or broader measures such
as the official settlements balance. For these bal­
ances, U.S. long-term investment abroad is
equivalent to an im port o f goods and services.
Greater attention to the current account balance

73See Rueff (1969).

refers to such proposals as endowing “ the creation of
their fantasy with perfect foresight, infinite wisdom...”

74There were many other private proposals including pro­
posals for a world central bank. Haberler (1966), p. 9




MAY/JUNE 1991

82

w ould have shown the steady decline in that
balance, thereby concentrating attention on rela­
tive costs and prices. This focus w ould have
posed m ore sharply the basic issue: deflation or
devaluation. Reliance on investment controls
partially obscured this basic issue as w ell as
sacrificing the future fo r small, costly improvemments in the present.
The interest equalization tax was no less short­
sighted than the restrictions on investment. The
effect o f the tax was to raise the cost o f trading
in U.S. markets, thereby encouraging part o f
the financial service industry to m ove abroad. A
long-term result was loss o f the export o f some
financial services.
By far the major fla w in U.S. policy, and the
most damaging feature o f the Bretton W oods
system, was the failure to prevent U.S. inflation.
As the system developed, the United States was
able to choose domestic over international goals
w henever a choice had to be made. At times,
particularly in the early 1960s, U.S. nominal in­
terest rates w ere kept higher fo r a fe w weeks
or months to reduce the capital outflow. But
such choices usually w ere reversed if unem ploy­
ment rose. U.S. policymakers typically chose ex­
pansion to deflation and used controls o f vari­
ous kinds to get tem porary reductions in the
capital outflow. And, after 1966, policymakers
adopted m ore inflationary policies than before.
Given the priority placed on em ployment and
other domestic goods, such as housing, price
stability was ruled out.
All o f the responsibility fo r failure does not
fall on the United States, Germany, Japan and
others pursued export grow th as a holy grail
and either made fe w efforts to adjust their ex­
change rates or none at all. Spokesmen fo r Ger­
many could point correctly to the inflationary
policies o f the United States, and the failure o f
the United States to adjust domestic policies so
as to honor international commitments, but they
w ere less forthright about the adjustment o f
countries w ith sustained surpluses that had un­
dervalued currencies.7 A fter the Bretton W oods
5
experience, Germany changed its policies tow ard
adjustment. In the European M onetary System,
Germany revalued frequently to keep that

75See Emminger (1967) as an example. Otmar Emminger
was a director and later president of the Deutsche
Bundesbank.
76See Shultz and Dam (1971), p. 111. Milton Friedman sent
a long memo to President-elect Nixon in December 1968

FEDERAL RESERVE BANK OF ST. LOUIS



system from experiencing the adjustment p ro ­
blems o f Bretton Woods.
It is surprising how little attention was paid to
the adjustment problem. The Kennedy, Johnson
and Nixon administrations did not propose a
permanent solution.7 Each so-called crisis left
6
m ore controls on capital m ovements or other
transactions, but these efforts w e re not follow ed
by internal discussions o f policies leading to a
long-term solution in which controls w ould be
rem oved. The Econom ic Reports o f Presidents
Kennedy, Johnson and Nixon have lengthy sec­
tions each year on the international monetary
system, but the reports say little about adjust­
ment. The typical comment was that surplus
countries should revalue or expand demand. The
explanation fo r neglect o f adjustment is not that
such discussions w ere sensitive. Solomon (1982)
reports on the many meetings that w e re held
during these years. Th ere are pages on p ro­
posals and negotiations about liquidity, ve ry lit­
tle discussion o f adjustment. Th e G-10 and the
International M onetary Fund are no better.7
7
They, too, avoided the issue or limited their
comments to suggestions that surplus countries
expand without inflating. Even the devaluations
by Britain and France w ere not follow ed by
discussions o f the effect o f the devaluation on
the United States.
As the Bretton W oods system developed, it ac­
quired some o f the characteristics its designers
had hoped to avoid. Major countries w ere reluc­
tant to change parities. Surplus countries argued
that adjustment was the responsibility o f deficit
countries. Deficit countries made opposite argu­
ments, appealing to the need fo r symmetry.
The 1960s witnessed the beginning o f efforts
to solve international m onetary or economic
problem s by coordinating policy actions. In
practice, this usually meant that surplus and
deficit countries w e re supposed to agree on dif­
ferent mixes o f m onetary and fiscal policy ac­
tions. Discussions produced fe w concrete steps.
Foreign countries accepted the expansions im ­
plied by the flow s o f U.S. dollars, but they did
not systematically reduce governm ent spending
or raise taxes to slow their expansions and low er
domestic interest rates. And, as discussed earlier,
the United States focused mainly on domestic

urging a prompt, decisive change in policy. Nothing was
done. See Friedman (1988).
77See Solomon (1982), p. 173.

83

objectives. The dialogue about coordination, once
started, was hard to stop. It continued into the
1970s and 1980s. Countries that faced a balance
o f payments deficit usually favored coordinated
action. Countries in surplus usually w ere
opposed.
The end o f the Bretton W oods system was
follow ed by diverse predictions. Some saw fluc­
tuating exchange rates as a means o f increasing
stability or domestic policy. Some w arned about
the instability that w ould follow . It is n ow clear
that neither was correct. The warnings about
the consequences o f the collapse o f Bretton
Woods proved to be wrong. The inconvertible
dollar continued to function as an international
medium o f exchange and store o f value. The ac­
cumulation o f dollar assets b y foreign central
banks and governm ents continued to rise. By
the end o f the 1970s, nominal dollar reserves o f
the G-10 countries, excluding the United States,
had doubled from the level at the end o f 1972.
In the next decade, these reserves doubled again
to m ore than $300 billion. Central banks and
governm ents continued to be m ore willing to
acquire additional dollars than to allow the
dollar to devalue.
The end o f Bretton W oods im proved the ad­
justment mechanism, but did not quickly elimi­
nate inflation or inflationary policies. Countries
gained the opportunity to pursue independent
policies. Inflation differed betw een major cur­
rencies but both governm ents and some private
individuals complained about the variability o f
nominal and real exchange rates. During most
o f the next 20 years, the principal currencies
continued to fluctuate.
H ow ever, countries did not float freely. Dirty
floating, managed exchange rates, intervention,
exchange controls and trade restrictions w ere
retained or introduced. Despite these policies
and complaints about excessive variability o f ex­
change rates, there was no interest in a return
to Bretton Woods.

Economic Report of the President (Government Printing Of­
fice, various years).
Emminger, Otmar. “ Practical Aspects of the Problem of
Balance-of-Payments Adjustment,” Journal of Political
Economy, Vol. 75 (August 1967, Part II), pp. 512-22.
Friedman, Milton. “ The Case for Flexible Exchange Rates,”
in M. Friedman, ed., Essays in Positive Economics (Univer­
sity of Chicago Press, 1953), pp. 157-203.
_______ . “A Proposal for Resolving the U.S. Balance of
Payments Problem,” in Leo Melamed, ed., The Merits of
Flexible Exchange Rates: An Anthology (George Mason
University Press, 1988), pp. 429-38.
Haberler, Gottfried. Money in the International Economy (Har­
vard University Press, 1965).
_______ . “ The International Payments System: Postwar
Trends and Prospects,” in International Payments Problems:
A Symposium Sponsored by the American Enterprise In­
stitute (Washington: American Enterprise Institute, 1965),
pp. 1-16.
Heller, Walter. New Dimensions of Political Economy (Harvard
University Press, 1966).
International Monetary Fund. Annual Report, various years.
Keynes, J.M. A Tract on Monetary Reform (London: Mac­
millan, 1923), reprinted as vol. 4 of The Collected Writings
of John Maynard Keynes (London: Macmillan, 1971).
Meltzer, Allan H. Keynes’s Monetary Theory: A Different
Interpretation (Cambridge University Press, 1988).
Okun, Arthur M. The Political Economy of Prosperity.
(Washington: The Brookings Institution, 1970).
Pauls, B. Dianne. “ U.S. Exchange Rate Policy: Bretton
Woods to Present,” Federal Reserve Bulletin, vol. 76
(November 1990), pp. 891-908.
Rueff, Jacques. “ The Rueff Approach,” in R. Hinshaw, ed.,
Monetary Reform and the Price of Gold. (The Johns
Hopkins Press, 1967), pp. 37-46.
Salant, Walter, and others. The United States Balance of
Payments in 1968. (Washington: The Brookings Institution,
1963).
Schwartz, Anna J. “ The Postwar Institutional Evolution of the
International Monetary System,” in A.J. Schwartz, ed.,
Money in Historical Perspective (University of Chicago
Press for the National Bureau of Economic Research,
1987), pp. 333-63.
_______ . “ The Performance of the Federal Reserve in Pur­
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ing: The American Experience (Durrell Foundation, 1991).
Shultz, George P., and Kenneth W. Dam. Economic Policy
Beyond the Headlines. (Stanford University Press, 1977).
Solomon, Robert. The International Monetary System,
1945-1981 (Harper & Row, 1982).
Sorensen, Theodore. Kennedy. (Harper & Row, 1965),
pp. 405-12.

REFERENCES
Corden, Max. “ Does the Current Account Matter? The Old
View and the New,” unpublished paper (Johns Hopkins
University, 1990).




Stein, Herbert. Presidential Economics, 2nd rev. ed.
(Washington: American Enterprise Institute for Public Policy
Research, 1988).
The Wall Street Journal, December 19, 1971.

MAY/JUNE 1991