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On th e Way to a New M on etary Union:
The E u ro p ean M on etary Union
T he P -S tar Model in Five Sm all E co n o m ie s
Is th e D iscou n t W indow N ecessary ? A
Pen n C en tral P e rs p e c tiv e
Can D eposit In s u ra n c e In c re a s e th e Risk
of B ank F a ilu re ? Som e H isto rical Evid en ce

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F e d e ra l R e s e rv e B an k of St. L o u is
R eview
May/June 1994

In This Issue . . .
3

On th e W ay to a New M o n etary U nion: T h e E u ro p e a n M o n etary U nion
Helmut Schlesinger
In the last two centuries, only a handful of m onetary unions have been
created successfully. Now, Europe has em barked on the creation of one
of the most ambitious to date: the European M onetary Union, w hich will
encom pass nearly 400 million people and have the highest gross domestic
product in the world.
In the Eighth Annual Homer Jones Memorial Lecture, Helmut Schlesinger,
form er president of the Deutsche Bundesbank, briefly traces the econom ­
ic and political history of the European Community, from its beginning in
1957 with six m em bers to its likely expansion to 16 m em bers in 1995. He
also reflects on the cu rren t situation in light of the M aastricht Treaty of
1993, which established the fram ew ork for the m onetary union. Although
the actual date of the European M onetary Union is in question, Schlesinger
concludes that its birth is imm inent and that one of the most critical
elem ents in determ ining its success will be the establishm ent of a single
curren cy that is as stable as the best-perform ing national currencies
within Europe.

11




T h e P -S tar Model in F iv e Sm all E co n o m ie s
Clemens J.M. K ool and John A. Tatom
A nation’s exchange rate regim e affects the link betw een its m onetary ag­
gregates and its general level of prices, according to Clemens J.M . Kool
and John A. Tatom . They explain an em pirical specification of a quantity
theory of money called the P-star model, which indicates that a country's
price level depends principally on its own money stock. This theory,
however, applies only to a closed econom y or one with a flexible ex­
change rate. In contrast, they argue, a small open econom y which pegs
the value of its curren cy to another country’s cu rren cy also pegs its
prices to that cou ntry’s money stock.
Kool and Tatom explain how the P-star model can be adapted for use in
small open econom ies with fixed exchange rates. The}' test their openeconom y P-star model on five countries bordering Germany: Austria, Bel­
gium, Denm ark, the Netherlands and Switzerland. These countries have
pegged their curren cies to the deutsche m ark to varying degrees since
the breakdow n of the Bretton Woods agreem ent. Kool and Tatom ’s evi­
dence supports the theoretical model, especially the principal hypothesis
that, to the extent a country pegs the value of its cu rren cy to the Ger­
man m ark, its own inflationary developments are determ ined by m one­
tary conditions in German)'.

MAY/JUNE 1994

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31

Is th e D isco u n t W in d o w N e ce ssa ry ? A P e n n C en tral P e rs p e c tiv e
Charles II . Calomiris
Policym akers generally regard the discount window as an essential tool for
preventing the spread of financial crises, but some critics have argued that
it is an unnecessary—and costly—policy instrum ent. The argum ents against
the discount window emphasize that it may unwisely postpone bank
failures or underm ine the Fed’s control over the supply of reserves. Fu r­
therm ore, the critics argue, open m arket operations are a sufficient tool
for policy objectives.
Charles W. Calomiris argues that the discount window, properly ad­
ministered, can help the governm ent direct tem porary credit subsidies
through the banking system to firm s suffering from a “panic” in a non­
bank financial m arket. He looks at the com m ercial paper crisis of mid-1970,
w hich revolved around the failure of Penn Central, a w atershed event in
the history of the com m ercial paper m arket. Penn Central, Calomiris con­
tends, is an example of a beneficial discount window intervention. He
concludes that the discount window in the future could have a potential­
ly stabilizing effect on nonbank financial m arkets, including new, u ntest­
ed m arkets for credit and derivative instrum ents.

57

Can D eposit In s u ra n c e I n c re a s e th e R isk of B an k F a ilu re ?
S om e H isto rica l E v id en ce
David C. VVheeloch and Paul W. Wilson
Many econom ists have argued that unless prem ium s are risk-based, deposit
insurance will encourage banks to take g reater risks than they otherw ise
would, thereby increasing the likelihood of failure. Because virtually all
banks today are insured, isolating the effects of deposit insurance from
other regulatory and econom ic conditions that affect bank perform ance
is problem atic.
David C. W heelock and Paul W. Wilson study the impact of deposit insur­
ance by drawing on historical evidence from a voluntary insurance sys­
tem that operated in Kansas betw een 1909 and 1929. Because insurance
was optional in this system, com parison of insured and uninsured banks
facing otherw ise similar regulations and econom ic conditions is possible.
The authors find that insured banks held less capital and reserves than
uninsured banks, and that banks with low capital and reserves, or a
heavy reliance on borrow ed funds, w ere m ore likely to fail. In short,
risky banks w ere m ore likely to fail, and m em bers of the state deposit
insurance system tended to be riskier than nonm em bers.

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3

Helmut Schlesinger
Helmut Schlesinger, former president of the Deutsche Bundes­
bank, is professor at the Post-Graduate School of Administra­
tive Sciences, Speyer, a guest professor at the University of
Karlsruhe, and will teach in the fall at Princeton University. This
article is taken from the Eighth Annual Homer Jones Memorial
Lecture, delivered at the Federal Reserve Bank of St. Louis on
April 14, 1994. The author’s comments do not necessarily
reflect the views of the Federal Reserve Bank of St. Louis or
the Federal Reserve System.

On the Way to a New Monetary
U n io n: The European Monetary
U n io n

jf jO O K IN G BACK IN HISTORY over the last two
centuries, we will find only a few cases of a
successful creation of a m onetary union but a
far larger num ber of cases w hich failed. As far
as the final goal is concerned, it m eans having
only one single currency for all the nations in
the European Union and replacing the individual
national currencies; it is a very big undertaking.
It means that one has to create a m onetary un­
ion ultimately encom passing nearly 400 million
people and a region which would have the
highest gross domestic product (GDP), the most
extensive foreign trade, and so on, in the world.
In oth er words: It is an ambitious goal which
has not yet been reached, but we are on the
way to reaching it.

A MONETARY UNION: IN THE
BEGINNING
The goal of a m onetary union must be seen as
one specific objective along the road from the
European Community (EC) created by the 'IY'ea ly
of Rome in 1957 and the European Union shaped
by the Treaty of M aastricht which was ratified




in 1993. The long way we have com e from the
beginning to the present state of the European
Union is impressive; this holds true not only of
the progress made, but also of the time span
which has been necessary to make it, and it has
not been without a num ber of crises, set-backs
and periods o f stagnation.
From the beginning, the way went along the
econom ic integration of the national economiesin direction of a single European economy. But
the real target was a political one. This was very
clear at the outset. The first step was the crea­
tion of the European Coal and Steel Community
in 1952. At that time, three politicians were of
particular im portance: Robert Schum an, Alcide
de Gasperi and Konrad Adenauer. It is worth
rem em bering that these three statesm en all
cam e from bord er regions, betw een France and
Germany or betw een Italy and German-speaking
Austria. Schum an and de Gasperi were both
bilingual, that is, they spoke French and Ger­
man, and Italian and German, respectively.
Adenauer came from the w estern banks of
the Rhine River and was, to a certain extent,
French-oriented. These three men, who had all

MAY/JUNE 1994

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experienced the two big wars in Europe b e­
tw een the nations w hich actually belonged so
close together, had the courage to create this
European Coal and Steel Community as the first
Community organization. To a certain extent,
coal and steel w ere considered to be the most
im portant strategic materials. In Germany at
that time, the production of such materials was
limited and under the control of the Allied
Forces. Later, the production of these materials
cam e into surplus and lost its particular strateg­
ic im portance. But the Coal and Steel Communi­
ty, which exists even today, fulfilled the role of a
nucleus for the development of the European
Common Market.
The subsequent steps towards the European
Community should be well-known. I m ean the
creation of the Community of six nations, West
Germ any France, Italy, the Netherlands, Belgium
and Luxembourg, in 1957. The next important
step was the extension of the Community to in­
clude the United Kingdom, Denm ark, Ireland and
later Spain, Portugal and Greece. At the begin­
ning of 1993 the target to create a so-called sin­
gle m arket had been reached. Since that time,
no governm ent b arriers have been in place b e­
tw een the m em ber countries as far as the trade
in goods and services is concerned, as well as
the movement of labor and capital. A fter the ex­
tension of the Community from six to 12 coun­
tries, the so-called deepening of the Community
had reached an im portant point.
Now, Europe is on the brink of doing both: an
extension of the Community to include new
m em bers com prising the Scandinavian countries
and Austria, and the deepening on the way to a
m onetary union. Even now, the prim ary target
is a fu rth er strengthening of the econom ic in­
tegration. It means achieving a large, single m ar­
ket for the w estern and central European
countries and, at the end, to use only one cu r­
rency in that market.
But one should not forget that the target even
now is political. It should bring the European
countries with a rather stable dem ocratic consti­
tutions closer together and allow them to de­
velop into a political union. The end of the Cold
War has given them m ore freedom to do so. Be­
fore that, Austria and Finland, in particular, had
to take care not to provoke the Soviet Union.
The development of free and dem ocratic socie­
ties in Poland, the Czech Republic and Hungary
is another new elem ent which must be handled
with care.

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CONFLICTS IN MONETARY
POLICY: “MONETARISTS” VS.
“ECONOMISTS”
From the beginning of the EC there were
differences in the attitudes in the various cou n­
tries, especially in France and Germany, as far
as the role of m onetary policy in the econom ic
integration was concerned. The dispute was
seen as a conflict betw een "m onetarists” and
“economists,” which m eans something different
in St. Louis. The “m onetarists” believed that
m onetary integration has to start first and that
econom ic and political integration would follow.
The “econom ists” believed that econom ic conver­
gence betw een the national econom ies m ust oc­
cur before any move into very close m onetary
integration and a m onetary union.
At the end of the 1960s and the beginning of
the 1970s, the "m onetarists” gained stronger in­
fluence. An EC Community study, the so-called
W erner Plan, described a step-by-step introduc­
tion of a m onetary and econom ic union. But the
first step under this plan, that is, the obligation
to have fixed but changeable exchange rates b e­
tween the national currencies, was rath er un­
successful. The tim es were characterized by the
end of the Bretton Woods system, and later by
the first oil price hike and a world-wide reces­
sion in 1975. Only the core of hard-currency
countries w ere able to stay together without in­
terruption, specifically, Germany and the Bene­
lux countries.
The real reason for the failure of this first at­
tempt to have a system of fixed but adjustable
exchange rates for all countries was the strong
deviation in the rates of inflation. Between 1973
and 1979, for instance, the annual rate of infla­
tion was 11 percent in France and 16 percent in
Italy, but only 4.7 percent in Germany. For the
Federal Republic of Germany, however, this was
the highest rate of inflation in a medium-term
average in four decades. The heavily engaged
politicians in this field were following the doc­
trine of the so-called m onetarists: Giscard d'Estaing in France and Helmut Schmidt in Germany
tried to base the integration in the m onetary
field on a stronger institutional platform than
before. They created the European M onetary
System (EMS), which came into effect in March
1979 and is practically existing up to now. I do
not think it is unfair to explain the common in­
terest of the French president and the German
chancellor, d’Estaing and Schmidt, respectively,

5

apart from very im portant points, with one
com m on motive: The dominance of the deutsche
mark was of particular concern for Giscard and
the dom inance of the Bundesbank seemed to be
a big concern in the eyes of Helmut Schmidt,
even though this was not actually true.
The EMS was constructed as a system of fixed
but adjustable exchange rates betw een the EC
countries, w hich allowed fluctuations of these
exchange rates only within a relatively narrow
band. And which, secondly, established a large
fram ew ork of partly unlimited credit facilities
for the m em ber central banks. This credit
mechanism was to make it possible to keep the
exchange rates stable, even under strong pres­
sures on one particular currency, through the
obligation of central banks to intervene in the
foreign exchange markets, if necessary, with un­
limited amounts.

THE INHERENT WEAKNESS OF
THE EMS
Looking back, the creation of the EMS was a
very im portant step towards a European m one­
tary union at a later date. It worked in two
directions. First, all countries learned what is
possible under given conditions in Europe and—
w here necessary—how these conditions had
to be changed. Second, all m em ber countries
learned that a fixed exchange rate can stimulate
the integration of trade and other transactions
across the borders of the m em ber countries of
the Community. We observed that the m em ber
countries felt a systemic pressure to try to
orient their own domestic development, especial­
ly as far as the price developments were con­
cerned, to that of the best-perform ing countries.
Taking the same countries which I have m en­
tioned before, for the period from 1979 to 1990,
we can see that the annual increase of prices in
France then was only 6.9 percent, com pared to
10.7 percent in Italy and 2.9 percent in Germany.
The inflation rate differentials had diminished,
and the average rate of inflation in the EC was
lower. In the years after 1990, these differences
were sm aller still and partly the oth er way
around.1
But we also experienced that even those
sm aller d ifferences—whenever they existed over
a longer period of tim e—create a need for a

change in the exchange rate structure. In other
words, they result in the need for a realign­
ment. If one counts exactly, we have had 16
bigger and sm aller realignm ents since 1979,
namely 11 betw een 1979 and 1987, but there
w ere no general realignm ents up to Septem ber
1992, the rest later. This seems to be a relative­
ly good experience of a system of fixed ex­
change rates aimed at achieving a convergence
of the economies.
But even in the period from 1987 to 1992,
price differentials accumulated, with the conse­
quence that those countries w hich kept their
nominal exchange rates stable experienced an
increase in their real exchange rates. Italy, for
instance, recorded a real appreciation of its cu r­
rency vis-a-vis the deutsche m ark and other
hard currencies in an amount of nearly 15 p er­
cent betw een 1987 and 1992, and the same was
m ore or less true for the pound sterling. Such
real appreciation leads to a loss of the com peti­
tive position of a country, and it depresses its
exports and the overall domestic situation. The
latter is aggravated by the fact that it becom es
necessary to increase the interest rates in these
countries far above the level in the hardcurrency countries. The solution to eliminate
these tensions was not ideal: The United King­
dom and Italy withdrew from the ERM in au­
tum n 1992.
These events show the real w eak flank of a
fixed exchange rate system. To avoid these
events, a realignm ent would have been n eces­
sary at an earlier stage, a devaluation of the
m ore inflationary currencies vis-a-vis the rather
stable currencies, that is, the deutsche m ark,
the Dutch guilder, the French franc, and so on.
But realignm ents are highly political affairs—at
least the politicians have made them into that.
Mv long-standing experience with this—reflected
by Oscar Wilde, who wrote: “Experience is the
sum of the failures”—is that realignments are
made only under the strongest pressure in the
foreign exchange market, not on the basis of
any profound backward and forward-looking
analysis. This was also the case in the Bretton
Woods system and one of the reasons why it
broke down. In oth er words, this is the inherent
weakness of the EMS or, to be more precise, of
any system with fixed but adjustable exchange
rates.

1See Fischer (1994).




MAY/JUNE 1994

6

One solution to ease the problem —having a
change of the exchange rates but not n ecessari­
ly a political decision about a realignm ent—was
found by widening the band of fluctuation of
the exchange rates. This was done in August
1993 by widening this band to ±15 percent; in­
stead of ± 2 .2 5 percent and ± 6 percent, respec­
tively. In fact, since we have had this wider
band, the exchange rates of the EU countries
have been behaving rath er calmly. No country
was forced, or prepared, to use the wider band
for a stronger devaluation or revaluation. Each
country now has a clear responsibility for its
own currency and for the exchange rate of its
currency. In my opinion, this is a rather good
basis for fu rth er developments on the way to a
European m onetary union. A fter a longer peri­
od, in which the exchange rate stru ctu re of the
EMS currencies would have com e into a longerlasting equilibrium, the fluctuation band could
be diminished somewhat.

TH E CONCEPT OF THE ECONOM­
IC AND MONETARY UNION (EMU)
The 'Iteaty of M aastricht, called the Treaty on
European Union, the most im portant extension
of the Treaty of Rome, is rather clear about the
different steps needed for a m onetary and eco­
nomic union, but rath er vague concerning the
elem ents of a political union, that is, a common
foreign policy, defense policy, harm onization of
laws or social policy. By the way, a new in ter­
governmental conference is to take place in
1996 to implement the political part of the
Union. Coming back to my earlier rem arks,
however, the Treaty of M aastricht contains more
of the ideas of the “m onetarists” than of those
of the "economists.” But this type of victory was
easier to reach than anything in the purely po­
litical field. A m onetary union means that all
m em ber countries have to give up their national
sovereignty in this area. It m eans m onetary un­
ion first and political union later. A monetary
union is a sacrifice of sovereignty for each
country. And, as French President Mitterand
said before the referendum in France in 1992,
the biggest sacrifice is in Germany, the country
with the anchor currency in the EMS and,
therefore, the country with the m onetary policy
that is most independent from the policies of
the other m em ber countries. Having said this,
however, I should add that Germany has never
been completely independent from the others in
the past and that it has usually had to take into

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 RESERVE BANK OF ST. LOUIS


consideration the consequences of its own poli­
cy decisions for the p artn er countries. But,
nevertheless, this has been done on its own
judgment.
In the oth er political areas, the national
sovereignty is not given up. T h ere are some limi­
tations, some common rules, some Community
directives, but there is no direct interference,
for instance, in foreign policy decisions. Even in
the case of fiscal policy, the national govern­
ments are sovereign. They agreed to a process
of m ultilateral surveillance and they agreed in
the M aastricht H'eaty on some soft sanctions for
misbehaving countries, but each state decides in
full sovereignty on its own taxation system and
on tax rates and public expenditures. Of course,
some rules have been formulated, but only for
the public sector deficit and for the level of
governm ent debt. Agreem ent on comm on Euro­
pean foreign and defense policies is very difficult
and can be seen in the role which the European
Union played—or did not play—in the b reak­
down of the Yugoslav Republic and the conse­
quences that followed.
Having said this, the m onetary union described
by the M aastricht Treaty is not an illusion. It
takes into account many of the experiences
gained in the EMS period, and it proclaim s a
path toward the EMU in three stages. Stage I
means freedom for international capital move­
ments; this is given now. It also calls for m em ­
bership in the EMS, preferably in the ERM,
but—as I have said b efore—the latter is not yet
given for all countries. For example, the United
Kingdom, Italy and Greece are not in the ERM.
Stage II started at the beginning of this year. It
includes the establishm ent of a European M one­
tary Institute (EMI) as the foreru n n er of EMU
and the European Central Bank. The Institute
has started with its work and now definitely has
its seat in Frankfurt, the financial cen ter o f Ger­
many and the place w here the Bundesbank has
its headquarters. The EMI has to clarify the
technical and operational questions for the com ­
ing European Central Bank; it has to continue
and intensify the coordination of the m onetary
policies of the m em ber countries and it has to
control the EMS and the development of the
ECU.
In the final stage, the heads of state of the Eu­
ropean Union will m eet and decide if EMU can
start, in 1997 or 1999. This decision is to be
made on the basis of which countries fulfill the

7

so-called entry criteria. This will be a very im­
portant exercise. The Treaty gives indications of
how to proceed in this process of examination.
They have to clarify w hich countries have
enough and sustainable price stability have
sound public finances, and have no strong ten­
sions as far as the exchange rates of their par­
ticular currencies are concerned .2
The purpose of this examination is to ensure
that only those countries w hich fulfill these
criteria can join the EMU at the beginning,
thereby guaranteeing that only countries with a
sound econom ic basis can be founding m em ­
bers. This means also that, at the beginning,
presum ably not every m em ber country would
qualify for mem bership in EMU. In oth er words,
the Tl'eaty opens the way for a two- or threespeed solution. Those countries w hich are not
in EMU at the beginning can com e in when
the)' fulfill the entry criteria. The United King­
dom and Denm ark, however, have the right to
stay out under anv circum stances, even if they
fulfill the criteria.
I think the idea of entry criteria can be consi­
dered a “victory" on the side of the "economists,”
on paper at any rate. One cannot forget that the
politicians will have a certain degree of discre­
tion in their final judgem ent about w hich coun­
try should join the EMU and which should not.
By the wav, the room for discretionary assess­
ment is strongly limited for the German govern­
ment, because the German Parliament as well as
the Federal Constitutional Court are forcing the
governm ent to be very strict in its judgements
in this. Nevertheless, it is a highly political issue.
Everyone knows it cannot be solved solely on
the basis of statistics, and even the interpreta­
tion of the statistical criteria is now under
dispute.3
In my opinion, the Tl’eaty o f M aastricht is a
rath er well-balanced document. The question is
w h eth er this concept can be filled with real life
and w hether this life could satisfy the wishes
and hopes which many are connecting with it.

If I w ere to try to give an answ er as far as the
whole content of this new European Union, the
political Union, is concerned, I would have to be
very vague. I would have to start with the ques­
tion of w hether the nations are prepared to give
up their identities. Are they prepared to forget
the experience which they have had with each
other during for the past hundreds of years?
Can they give up w hatever judgm ents and
prejudgments they may have made and—
especially—can they forget all the injustices they
have inflicted on each other?
O ther open points are the consequences of
widening the European Union from 12 to 16
states, and what consequences would be for
opening for m em bership for the central Europe­
an states, that is, Hungary (which has already
applied for m embership), Poland, the Czech
Bepublic, and so on. All these are im portant
questions and not really new. More than 35
years ago in Germ any Ludwig Erhard, the
Minister of Economics who contributed so much
to the "German revival” (Henry Wallich, 1955),
was strongly engaged in the European debate.
Even then, he was against a Europe of only six
countries. He published an advertisement in
newspapers, writing only:
6 + 7 + 5 = 1.
He m eant that six alone would not comprise one
Europe; the seven EFTA countries and the rest
of the non-comm unist countries in Europe
should be included. In 1995, presum ably 16
countries will form the European Union—only
Switzerland and Iceland will be missing to com ­
plete the Erhard formula.
I do not want to go into this grand design of
European questions, even if I have indicated that
I have always been inclined to be on the side of
Ludwig Erhard. Let me com e back to the ques­
tion as to how a European M onetary Union can
function. The cen ter piece of the EMU is the es­
tablishm ent of the European Central Bank, the
only central bank w hich could issue the single

*Sea: “ Protocol on the Convergence Criteria Referred to in
Article 109j of the Treaty Establishing the European Com­
munity,” Office for Official Publication of the European
Communities (1992).
3For instance, “ price stability” is given if a member state
has an inflation rate not more than 1.5 percentage points
higher than “ the three best-performing member states.”
The question is, does it mean the average of these three
states or that of the worst (or the best) of these three
states?




MAY/JUNE 1994

8

European currency. In many respects, this Bank
will be modeled on the German Bundesbank,
w hich m eans that it will have the priority target
of keeping the value of the currency stable and,
for that purpose, it will:
• be independent from the national and supra­
national governments (not accepting orders
nor being allowed to ask for any);
• have a Central Bank Council consisting of the
governors of the national central banks and
six m em bers of an executive board who can ­
not be dismissed during their term in office
for decision-making;
• be granted the necessary instrum ents for
m onetary policy, that is, open m arket policy,
interest rate policy, minimum reserve require­
ments, if necessary, and so on; and
• the European Central Bank will not prim arily
be responsible for banking supervision, but it
is possible to tran sfer corresponding tasks to it.

CENTRAL BANKING GOALS AND
MONETARY AGGREGATES
As I have already m entioned, the m onetary
union is well constructed on paper and a Euro­
pean Central Bank could work. The European
Central Bank is to be established as a federal in­
stitution, much like the Bundesbank in Germany,
which has the federal elem ents of the United
States as its “grandfather,” so to speak. Why
should it not be possible for such an institution
to fulfill its tasks for Europe? Many people are
asking w hether such a new central bank com ­
prising people from different countries with a
somewhat different “culture" of m onetary policy
could really work. I have to answ er that m one­
tary policy decisions are never made on the ba­
sis of a full conform ity of opinions among the
decision makers. This is not the case in the Cen­
tral Bank Council of the Bundesbank with its 16
mem bers, nor is this the case in the Federal
Open Market Committee (FOMC) of the Federal
Reserve System, as we can all see from the
record of policy actions. Both Councils are
dem ocratic institutions in which decisions are
made through majority, but certainly these insti­
tutions have a basis of a com m on attitude, and
have a certain consensus about what to decide
and how to work.
Take the U.S. case. David Mullins, the form er
vice chairm an, says that 4 percent inflation is

FEDERAL RESERVE BANK OF ST. LOUIS




unacceptably high. And Wayne Angell, a long­
standing m em ber of the Board of Governors,
w rote in his letter of retirem ent to the President
of the United States that “I am pleased... [that]
the Board of Governors was enunciating a goal
of zero inflation. But if the quest for price-level
stability is replaced by an acceptance of an infla­
tion rate stabilized at say 2-1/2 percent per year,
then we are accepting the fact that the domestic
value of the dollar will be cut in half every
generation, 28 years.” Thus, there is a consen­
sus, with some room for interpretation, betw een
both (ex-)members.
In the German case, the Bundesbank is som e­
times attacked because part of its interm ediate
m onetary target—the growth of M3—is derived
on the basis of a so-called unavoidable increase
of about 2 percent in the price level. Presum a­
bly, Wayne Angell would also be a little bit dis­
appointed about this.
W hich price level target will the European
Central Bank form ulate, if it w ere to form ulate
one at all? The 1.5 percentage points over the
average of the best-perform ing countries cannot
be a target, it is the entry criterion. Up to now,
there seems to be no discussion about a price
stability target for this future Central Bank. The
core countries would presum ably agree on a
figure like that of the Bundesbank, and—if that
were done—one would be also in agreem ent
with Professor Stanley Fischer, who recently
wrote “that anyone should be com fortable with
a 1-3 percent target”
.
I do not want to go into the details of the use
of a declared price stability target. Canada and
New Zealand are using one, and have indeed
reached and kept to it up to now. It is worth
noting that the last Governor of the Bank of
Canada, whose bank was successful, had to re ­
sign w hen a new governm ent came into power.
Price stability targets in the sense of a stable
consum er price level are a very ambitious exer­
cise. So far, New Zealand’s central bank keeps it
at 0-2 percent inflation, even against opposition.
Nobody would be surprised—especially not at
the Federal Reserve Bank of St. Louis—if I were
to suggest that the European Central Bank should
start immediately with targeting on the basis of
a money supply target. I m ust admit that this
would be rath er complicated at the beginning,
because nobody could know exactly how the Eu­
ropean money supply, the money demand fun c­
tion, and so on, will behave. But, in my opinion,

9

it is indispensable that this new central bank
has an idea o f how strongly the money stock
should grow and, especially, of how far the
m onetary basis should be extended, the money
w hich this new European Central Bank System
will create itself. This question reminds me of
the fact that after the deutsche m ark had been
introduced in 1948, the military government
prescribed that any additional increase of cu r­
rency in circulation, exceeding a total circulation
of $10 billion, needed a very restricted proce­
dure of agreem ents by a three-fourths majority
of the Central Bank council and had to be ap­
proved by the Lander Governments. This
was a primitive way of control, but it made
clear that any extension of money must be limit­
ed, especially if it is a new money, which does
not inspire the same confidence at the begin­
ning than a well-proven old currency.
The discussion of w hether or not to have
money supply targets will be a point of con ­
troversy in the EMI. The President of the EMI,
Baron Lamfalussy (1994), has form ulated the
different positions that will presum ably be held,
for example, using the money supply as an in­
term ediate target, as is practiced in Germany
and some other countries. Or, having no in ter­
mediate target but a concrete price stability tar­
get, such as New Zealand. Or neither of them,
which he seems to p refer—reading betw een the
lines—by saying “can one not use m onetary ag­
gregates at least as an inform ation variable?”
.
This seems to be a new form ula which was
described, for instance, by Benjamin Friedman
(1994). I find this new label sounds good but I
have to add that such eclecticism , as a m atter of
fact, is not new. I think that advanced central
banks follow the development of the money sup­
ply aggregates everyw here and at all times, b e­
cause they value the inform ation that m onetary
aggregates provide and their im portance to the
econom ic developments, but they also take other
factors into account.

CONCLUSIONS
W hen the EMI has completed its w ork of
preparing the future European Central Bank,
when the examination of the entry criteria has
been made and the heads of state of the Euro­
pean Union have decided that the m onetary un­
ion can start, then the adventure will begin. At
the beginning, only the exchange rates betw een
the different national currencies of the m em ber
countries have to be fixed without any margin




and without any possibility of changing them in
future. In a later stage, the single curren cy can
replace these national currencies: This would be
the fulfillment of the European M onetary Union.
It may seem to you that the way to EMU is a
relatively long one, that many preconditions
which have been form ulated give the impression
that the fathers of this program are themselves
not sure about the success o f the whole plan.
And you could add that Europe needs too much
time to find solutions com parable with the dy­
namics in the United States. But even here in
the United States, it took quite a long time b e­
fore you got a Federal Reserve System, even
though one currency existed. Now, in Europe,
we have central banks. In quite a num ber of
our countries we have currencies which are
relatively stable and we have a situation in
w hich the exchange rates are no longer fluctuat­
ing very strongly, although they could. In other
words: The integration of the econom ies in Eu­
rope and, especially, in the European Union can
and will continue to progress toward m ore com ­
plete econom ic integration. For this purpose, it
is not so im portant—either for our countries or
the rest of the world—w hether the European
M onetary Union starts in 1997, 1999, or even a
little later. W hat is decisive is that we replace
the different European currencies with a single
currency that is as stable as the best-perform ing
national currencies.

REFEREN CES
Board of Governors of the Federal Reserve System. Federal
Reserve Bulletin. Board of Governors of the Federal
Reserve System, 1994, p. 235.
Brash, Donald. Speech delivered to the Wellington Chamber
of Commerce, in Bank for International Settlements BIS
Review, No. 45 (1994).
Erhard, Ludwig. “ Was Wird aus Europa?” (What Will Be­
come of Europe?), Handelsblatt (December 23-24, 1960),
reprinted in Ludwig Erhard, Deutsche Wirtschaftspolitik.
Diisseldorf, Wien, Frankfurt, 1962, p. 530.
Fischer, Stanley. “ Costs and Benefits of Disinflation,” in A
Framework for Monetary Stability: a paper and proceedings
of an international conference organized by De Nederlandsche Bank and the Center for Economic Research at
Amsterdam, the Netherlands, October 1993. J. Onno de
Beaufort Wijnholds, Sylvester C.W. Eijffinger, and Lex H.
Hoogduin, eds. Kluwer Academic Publishers, 1994,
pp. 31-36.
Friedman, Benjamin M. “ Intermediate Targets Versus Informa­
tion Variables as Operating Guides for Monetary Policy,” in
A Framework for Monetary Stability, J. Onno de Beaufort
Wijnholds, Sylvester C.W. Eijffinger, and Lex. H. Hoogduin,
eds. Kluwer Academic Publishers, 1994, p. 109.

MAY/JUNE 1994

10

Lamfalussy, M. Alexandre. Address at the Hessian Bankers’
Association, in the Bank for International Settlements BIS
Review, No. 41 (1994).
Mullins, David W., Jr. “ A Policy Maker’s Perspective,” in A
Framework for Monetary Stability, J. Onno de Beaufort Wijn
holds, Sylvester C.W. Eijffinger, and Lex H. Hoogduin, eds.
Kluwer Academic Publishers, 1994, p. 6.

Digitized forFEDERAL RESERVE BANK OF ST. LOUIS
FRASER


Office for Official Publication of the European Communities.
Protocol on the Convergence Criteria Referred to in Article
109j of the Treaty Establishing the European Community.
Luxembourg, 1992.
Wallich, Henry C. Triebkrafte des deutschen Wiederaufstiegs.
Frankfurt: F. Knapp, 1955.

11

Clemens J.M. Kool and John A. Tatom
Clemens J.M. Kool is associate professor of international and
monetary economics at the University of Limburg, the Nether­
lands. John A. Tatom is an assistant vice president at the
Federal Resen/e Bank of St. Louis. Jonathan Ahlbrecht provided
research assistance. The authors are grateful to Martin M.G.
Fase, Eduard Hoechreiter and Dieter Proske for helpful
comments.

The P-Star M odel in Five Small
Economies

/ h e QUANTITY THEORY a n d its equation
of exchange provide a proven and useful fram e­
w ork to empirically analyze the relevance of
money in the econom y. During the past decade,
however, doubts about this approach arose b e­
cause of the perception that the links betw een
money and prices and money and output had
loosened or vanished.1 Recently, Hallman, Porter
and Small (1991)—h en ceforth HPS—have drawn
new attention to the quantity theory by explicitly
linking the determ inants of long-run equilibrium
prices to the short-run dynamics of actual infla­
tion in the so-called P-star approach. In this
fram ew ork, deviations of the actual price level
from equilibrium push cu rren t prices and infla­
tion in the direction of equilibrium.
The em pirical results obtained so far for a
wide set of countries, are supportive of the Pstar approach, although it seems to w ork b etter
for larger than sm aller countries.2 One neglected
aspect w hich may explain this apparent dichoto­
my is the im portance of the prevailing exchange
rate regime for the determ inants of prices and

inflation. T he original P-star approach assumes
that the equilibrium price level is a function of
the domestic money supply. Under a system of
fixed exchange rates, however, the domestic
price level in a small country is determ ined
abroad and the domestic money stock becom es
endogenous and demand-determined.
This article develops a generalized P-star
model that accounts fo r this international effect
by including cross-country price gaps. It is test­
ed using annual data from 1960 to 1992 for five
small European cou ntries—Austria, Belgium,
Denmark, the Netherlands and Switzerland.
During the Bretton W oods period, these coun­
tries pegged their exchange rates to the United
States dollar. Since then, fou r of the five pegged
their curren cies to the German m ark, with
varying degrees of success. Only Switzerland
has had a floating exchange rate regim e con­
tinuously since the breakdow n of Bretton
Woods. W e investigate the extent to which
prices in these countries have been affected by
developments in Germany, as well as domesti-

1For an overview of past discussions on this issue, see Bat­
ten and Stone (1983), Dwyer and Hater (1988) and Dewald
(1988).
2See, for example, Hoeller and Poret (1991). They also indi­
cate that there generally are superior models for forecast­
ing inflation movements, even for countries where the
P-star model is not rejected.




MAY/JUNE 1994

12

cally. To assess the tests used here, we also in­
vestigate the effect of U.S. price developments
on the price level in these five countries and in
Germany.
The results below indicate that the five small
countries’ equilibrium price levels are d eter­
mined in Germ any under the fixed exchange
rate regim e and that this effect has been pro­
portional to the tightness of the exchange rate
peg. In contrast, foreign-based equilibrium prices
are found to be insignificant for the United
States and Germany, the tw o countries that
generally floated over the period exam ined here.
In the next section, the theoretical fram ew ork
is developed, focusing first on the P-star model
for a closed econom y. Then, a generalized vari­
ant of the m onetary approach to the balance of
payments is used to show that under fixed ex­
change rates, domestic price developments in a
small country are determ ined abroad, and that
domestic money becom es endogenous. Combin­
ing these ingredients, it is shown that both their
own price gap and a price gap based on equi­
librium prices determ ined abroad can affect a
cou ntry’s inflation, depending on the exchange
rate regim e. The subsequent sections discuss
the data, present the em pirical results, and
summ arize the paper.

TH E P-STA R MODEL IN CLOSED
AND OPEN ECONOMIES
The Closed E conom y M odel
The simple Quantity Th eory’s equation of
exchange is

w here P* denotes the equilibrium price level to
w hich actual prices converge in the long run,
Y* is potential real output, and V* is the equi­
librium velocity of money. Following the Quanti­
ty Theory, they assume that V* and Y* are
determ ined independently, and, m ore im portant­
ly, that both are independent of the m oney
stock. Thus, the equilibrium price level moves
proportionally with the stock of money. HPS
fu rth er hypothesize that the equilibrium price
gap, (In P -ln P *), has a theoretical value of zero
so that P adjusts to equal P*. The com bination
of equations 1 and 2 implies that the change in
the actual price level should be negatively relat­
ed to the existing gap betw een P and P*.
This relationship is form ally indicated by the
hypothesis that a, is negative in the second
term of the inflation equation:
(3) AlnPt = a {) +

+ I!

(ln P -ln P *)t x

Pj MnP,_j

+ e,.

The inflation lags AlnPtJ are added to the equa­
tion to account for short-run dynamics and e, is
the random erro r term .
If actual inflation, AInP, is nonstationary, then
it does not have a fixed theoretical mean, possi­
bly leading to problem s in the estimation of
equation 3. To accom m odate this possibility,
equation 3 can be rew ritten w ithout loss of
generality as
(4) Ax, = a 0 + a, U n P -ln P *),_,
N - 1

(1) P = M (V/Y),
w here -ir now denotes inflation.
w here P denotes the price level, M is the do­
m estic stock of money, Y is real output and V is
the velocity of money. For convenience, time
subscripts are omitted. Equation 1 simply pins
down (nonobservable) actual velocity for given
observations on P, M and Y.
HPS (1991), how ever, hypothesize the follow­
ing long-run equilibrium relationship based on
the identity in equation l : 3
(2) P* = M(V*/Y*),
3Humphrey (1989) gives a review of the precursors of this
approach and shows that a variant can be traced back to
the work of David Hume.


FEDERAL RESERVE BANK OF ST. LOUIS


If inflation is not stationary (and its first
difference is stationary), then 6n in equation 4
has a theoretical value of zero, and lagged infla­
tion can be omitted. Thus, equation 4 would
contain only stationary variables (since tti i can
be omitted). Since this is not the case in equa­
tion 3 unless inflation is stationary, equation 4
is generally a m ore useful equation to estimate.
Although it would be possible to include other
transitory influences on prices, such as pricecontrol proxies or energy price shocks, we

13

abstract from these factors and focus on the
interaction betw een changes in inflation and
deviations from long-run equilibrium.
HPS (1991) originally applied a version of
equation 4 to quarterly U.S. data. They use M2
as the money stock and assume that the c o r­
responding equilibrium velocity is a constant.4
HPS conclude that the model is supported by
the data.3 Hoeller and Poret (1991) extend the
P-star approach to 20 m em ber countries of the
Organization for Econom ic Co-operation and
Development (OECD). They use the HodrickPrescott filter to extract equilibrium time series
for output and velocity from the data.6 The evi­
dence provided by Hoeller and Poret is mixed.
The P-star approach leads to satisfactory esti­
mated equations for most, but not all, countries.
In particular, the evidence fo r small countries
tends to reject the P-star model, while the evi­
dence for larger countries tends to conform to
the P-star model.
So far, research on the link betw een exchange
rate regim es and m acroeconom ic adjustm ent of
prices and output is quite limited. Recently,
Bayoumi and Eichengreen (1992) use impulseresponse functions to analyze the differences
betw een the Bretton W oods and post-Bretton
Woods period in this respect fo r the G7 coun­
tries (United States, Canada, United Kingdom,
Germany, France, Italy and Japan). They find
evidence that, under the floating rate regime,
countries' aggregate demand curves becom e
steeper so that various shocks give rise to less
output variability and greater price variability
than under a fixed rate regim e. Tatom (1992)
analyzes Austrian price behavior; the P-star
model for Austria is rejected but, due to the
fixed exchange rate regim e, a long-run relation­
4Tatom (1990) points out that M2 velocity has exhibited
semipermanent trends over time, so that the assumption of
a constant equilibrium velocity may be flawed.
5HPS also split up the total price gap in separate output
and velocity gaps, but find no additional explanatory power
from this less-restricted variant.
6Hoeller and Poret also conduct tests using simple linear
trends for the equilibrium levels of output and velocity. The
Hodrick-Prescott filter allows time series with stochastic
trends to be detrended. See Hoeller and Poret (1991) for a
discussion. King and Rebelo (1989) contains a more tech­
nical analysis. An application and an appendix with the ap­
propriate formulas can be found in Mills and Wood (1993).

ship betw een German and Austrian inflation is
not rejected .7
Here, we intend to investigate in more detail
how foreign price developments affect domestic
prices under a system of fixed exchange rates
and the implications of this linkage for the
P-star model.

The Generalized M onetary
Approach to the Balance o f
Payments
The starting point of our analysis is a fixed
exchange rate regime in which one large country
(such as Germany) is the anchor of the system
and sets its m onetary policy to achieve its own
domestic objectives, independent of the ob jec­
tives of the smaller countries within the system.
The large country is assumed to be sufficiently
large so that it is unaffected by policy actions
and outcom es in the small countries.8 Each small
country, in contrast, takes the anchor cou ntry’s
m onetary policy as given and is committed to a
fixed exchange rate objective.
Equations 5 and 6 represent money demand
and money supply, respectively, in the large
foreign cou ntry:9
(5) M[j =

PfYf

(6) M{ = Mf,
w here the inverse of velocity is assumed to be a
function of real output (KO and a vector of nomi­
nal interest rates (fV).10 W hen both output and
the real interest rate are at their long-run
equilibrium values determ ined elsew here in the
economy, money m arket equilibrium determ ines
9A superscript f will be used to denote the large foreign
country (Germany or the United States), while a super­
script d will be used for the small domestic country (Aus­
tria, Belgium, Denmark, the Netherlands and Switzerland).
10The relationship of equilibrium velocity and equilibrium
nominal interest rates is generally ignored in formulations
of the P-star model. This practice is consistent with the as­
sumptions that movements in the equilibrium real rate are
not empirically significant and that movements in the ex­
pected rate of inflation have little effect on velocity; more­
over, even if this latter effect is not small, it is captured in
the growth of the money stock or, given the dynamics in­
cluded in the P-star model, in the lagged inflation terms.

7The Bundesbank (1992) develops and tests a P-star model
for Germany based on its M3 measure.
8ln the P-star model, this means that the large country’s
potential output, equilibrium velocity and long-term inflation
objectives are independent of foreign developments.




MAY/JUNE 1994

14

the equilibrium price level in the large foreign
econom y (Germany).
The exchange rate constraint in a fixed ex­
change rate system then determ ines the
equilibrium domestic price level for a small
country as
(7)

= E P r*/ER *,

w here E is the fixed nominal exchange rate,
equal to the num ber of equilibrium domestic
curren cy units per unit of foreign currency,
and ER * is the corresponding equilibrium real
exchange ra te .11 W ith the domestic price level
conditioned by equation 7, the domestic money
stock must adjust to bring about equilibrium in
the domestic money market.

P-Star in Open Econom ies Under
Fixed Exchange Rates
The above analysis has two m ajor implications
for the short-run price dynamics in small coun­
tries under fixed exchange rates. First, a price
gap determ ined abroad through the exchange
rate constraint should be expected to influence
domestic inflation. This gap can be defined as

Second, the domestic price gap should lose its
influence if the exchange rate is pegged; domes­
tic money becom es endogenous. Suppose, for
example, cu rren t domestic prices are consistent
with the foreign-determ ined P-star m easure,
that is, the foreign-determ ined gap is zero,
while simultaneously the domestic gap is posi­
tive, because actual prices exceed the equilibri­
um m easure of prices indicated by the domestic
money stock. In this case, the domestic gap is
expected to close by adjustm ent of the money
stock, not by an adjustm ent of domestic prices
and inflation. The extent to w hich this holds
will be a function of capital mobility. The litera­
ture on sterilization and capital offset suggests
that small countries m ay have some freedom to
manipulate the domestic money supply in the
interm ediate run to determ ine m onetary condi­
tions at home to the extent that capital mobility
is limited.14
Both of these hypotheses are tested below.
In particular, the model in equation 4 is sup­
plem ented with the foreign price gap so that
the appropriate equilibrium gap m easure is a
weighted average of the domestic gap in equa­
tion 4 and the foreign-determ ined gap in equa­
tion 8 or
(9) (1 —w) (p d- p *) + w {pd- p d*)l

(8) GAPf = (p d- p d*) = [pd - ( pf * + e -e r * )],
w here low er-case symbols denote logarithm ic
levels and a d superscript has been added to
the logarithm of the domestic price level to
distinguish it from a foreign m easure. W hen
domestic prices exceed the foreign-determ ined
equilibrium price level, downward pressure on
cu rren t domestic inflation and prices results.12
The am ount of pressure this gap exerts on cu r­
ren t domestic inflation and the speed of adjust­
m ent tow ard equilibrium depend on the extent
of arbitrage in goods and capital m arkets,
and the degree to w hich the econom ies are
integrated.13

11ln the traditional pure monetary approach to the balance of
payments, the real exchange rate is assumed to be a constant and may be deleted from the analysis.
^Alternatively, the gap can be closed by a discrete decision
to correspondingly devalue the currency. Afterwards, the
peg could be resumed.
13Although the degree of integration may have increased
over time and may also be a function of the exchange rate
regime, rising with a credible fixed rate regime, the effects
of these changes are ignored below.


FEDERAL RESERVE BANK OF ST. LOUIS


w here w is the weight attached to a fixed ex­
change rate regime. For a closed econom y or a
floating exchange rate regime, w equals zero
and the appropriate equilibrium price level and
gap m easures are the conventional, domestically
determ ined ones used in equation 4. If th ere is
a credible fixed exchange rate regime w ith the
domestic cu rren cy pegged to the foreign coun­
try, /, then w equals one and the equilibrium
price level is that determ ined abroad and indi­
cated as p d* in equation 8. In this case, the ap­
propriate P-star and its related gap m easure are
determ ined abroad. Since w may change over
the sample period, but is unobservable, the

,4See Roubini (1988) for an overview of the literature, and
Kool (1994) for a recent empirical analysis. Also, see Stockman and Ohanian (1993).

15

coefficients on the gaps are theoretically the
m ean levels reflecting the sample experience
and they sum to the mean level of
W hile it would be desirable to characterize
the prevailing exchange rate regim e over time
for each country and to incorporate this in for­
mation in the analysis, this is not feasible. It
may seem straightforw ard to distinguish b e­
tw een fixed and floating exchange rate regimes,
but departures from these idealized extrem es
are econom ically and qualitatively im portant in
practice and are hard to quantify. Moreover,
changes in the degree of international capital
mobility and econom ic integration over time
may change the speed of response to existing
gaps. Finally, the limited num ber of observa­
tions available below severely constrains the use
of extensive sets of dummy variables. For these
reasons, we include both the domestic price
gap (defined in equation 4) and the foreigndeterm ined price gap (defined in equation 8)
in the final specification.

TH E DATA AND TH EIR TIME
SERIES P R O P ET IE S
Annual data for seven countries—Austria,
Belgium, Denm ark, Germany, the Netherlands,
Switzerland and the United States—for the
period 1960-92 are used to test the model. Con­
sistent nominal and real GDP data have been
obtained from the Organization fo r Economic
Co-operation and Development (OECD, 1993) for
the six foreign cou ntries.15 U.S. Departm ent of
Com m erce data are used for the U.S. nominal
and real GDP m easures. These series have been
used to compute the implicit GDP deflator.
Average U.S. dollar exchange rates have been
taken from the International M onetary Fund's
Internation al Financial Statistics (IFS) database

(line rf). Similarly, two money stock definitions
from the IFS have been used: narrow money
(line 34), w hich is called M l here, and the sum
of narrow money and quasi-monev (line 35),
w hich is com parable to M2 and will be denoted
here as broad money, MB. The main advantage
of using these series is their harm onization
across countries. For Belgium, the m onetary
aggregates series stop in 1990.

Exchange Rate M ovem ents
Figure 1 presents the nominal exchange rate
(defined as the domestic cu rren cy price of Ger­
man marks) time paths for all countries relative
to Germany, with the 1960 exchange rate in­
dexed to 100. The Bretton Woods fixed ex­
change rate regim e is clearly visible until the
late '60s. Note, that although the form al end of
Bretton Woods is often set in 1973 and some­
times in 1971, exchange rates start moving
already in the period 1967-70. A fter the b reak ­
down of Bretton Woods, exchange rates move
least for Austria and the Netherlands. These
countries have most persistently sought fixed
exchange rates with Germany in the '70s and
'80s.
Much m ore exchange rate variability has been
present, on the oth er hand, for the United
States, w here the exchange rate has floated and,
to a lesser extent, fo r D enm ark and Belgium.
Despite a floating rate, the Swiss exchange rate
has exhibited less variability than that in Den­
m ark and Belgium. The latter tw o countries
have had mixed exchange rate regimes. W hile
they have been on fixed exchange rates, at least
nominally, they periodically devalued to escape
the exchange rate constraint on domestic m one­
tary policy. Some degree of exchange rate
stabilization appears to have set in the middleand late-’80s for Belgium and Denm ark, however,
due to the effective functioning of the European
M onetary System during that period.16

15Series in this publication are for 1960 and from 1963 to
1991. We are grateful to Amber DeBayser at the OECD for
providing the consistent 1961 and 1962 data, which are not
listed in the publication cited. Data for 1992 were comput­
ed from comparable OECD data. In Belgium, Denmark and
Germany, 1992 data were not included due to lack of com­
parability.
16ln August of 1993, both the Belgian franc and Danish
krone were forced to accept wider fluctuation margins in
the European exchange rate mechanism and experienced
a considerable depreciation; subsequently, their exchange
rates moved back into the narrow bands that existed earli­
er, although the wider margins officially still are in place.
This experience is outside the sample used here.




MAY/JUNE 1994

16

Figure 1
Exchange Rates Relative to Germany
Index (1960 = 100)

The decision by the four countries, Austria,
Belgium, Denm ark and the Netherlands, to peg
their curren cies to the m ark is motivated by a
desire to "im port” German inflation, one of the
lowest rates in the world from I9 6 0 until re ­
cently. W hile the Swiss chose to float, their
m onetary policy has also achieved a similarly
low inflation rate. The decision of the four
small, open econom ies to peg to the m ark is
also presum ably influenced by the fact that they
are closely tied to Germany through trade. For
example, in 1985-89, trade with Germany (both
exports and imports) was 20 percent of Den­
m ark’s total trade, 21.4 percent of Belgium’s,
26.5 percent of the N etherlands, 27.4 percent
of Sw itzerland’s and 39.2 percent of Austria’s.
For trade within the six-country block, the
shares w ere 28.8 p ercen t for Germany, 30.6
percent for Denm ark, 38.7 percent for Sw itzer­
land, 41.3 percent fo r Belgium, 44.8 percent for
the Netherlands and 51 percent for Austria.
Real exchange rates, defined as the nominal
exchange rate multiplied by the ratio of German

FEDERAL RESERVE BANK OF ST. LOUIS


prices relative to each cou ntry’s price level, are
displayed in Figure 2. For the United States,
Switzerland and Belgium, sizeable perm anent
real exchange rate changes relative to Germany
appear to have taken place. Nominal and real
exchange rate patterns are quite similar for
these th ree countries. Real exchange rate move­
ments have been smaller in magnitude for Aus­
tria, Denm ark and the Netherlands. W hile the
Danish krona has continuously depreciated in
nominal term s over time, the real exchange rate
has fluctuated around the same level fo r the en­
tire sample.

Unit R o o t Tests
One important issue for the co rrect specifica­
tion of the price equation to be estimated, is the
(non)stationarity of the variables involved.
Tables 1 and 2 report the results of standard
augmented Dickey-Fuller (ADF) tests for both
log levels and grow th rates of prices, output,
narrow and broad money, the corresponding
velocities of narrow and broad money, and the

17

Figure 2
Real Exchange Rates Relative to Germany
Index (1960 = 100)

nominal and real exchange ra tes.17 In the tables,
we report the t-statistic on the one-period
lagged level for the p referred specification; this
specification is given below the f-statistic. Sig­
nificance at the 5 percent level is indicated (*)
and implies rejection of nonstationaritv.
W ith few exceptions, Table 1 indicates that
the nonstationarity of the logarithm of the levels
of the variables cannot be rejected. Consequently,
com putation of the equilibrium values of V* and
Y* by m eans of a regression with a determ inistic
trend generally is incorrect. The most im portant
implication of these results is that a procedure
capable of handling stochastic trends is required
to model the equilibrium levels of V* and Y*.
The Hodrick-Prescott filter is used to find the
equilibrium output and velocity paths.
17The specification used in each case is a regression of the
first difference of the series on a constant, a trend, the
one-period lagged level, and up to three lags of the firstdifferenced variable. Insignificant lags of variables are re­
moved step by step starting at the longest lag, for specifi­
cations that include or do not include a time trend. If the




The grow th rates of output, narrow money,
and narrow and broad money velocity, and the
nominal and real exchange rates, all appear to
be stationary according to the unit root tests
reported in Table 2. For inflation and broad
money grow th, a unit root generally cannot be
rejected .18 Note that th ere are a considerable
num ber of borderline cases. The (marginal) non­
stationarity of inflation suggests that equation 4
is appropriate for the ensuing gap analysis.

TESTS O F TH E P-STA R MODEL
In this section, we analyze the impact of
different price gaps on short-run inflation dy­
namics. First, we focus on country-by-country
estim ation using each country’s domestically de­
term ined price gap only. Then we proceed to
trend is statistically significant, this version is reported in
the table; otherwise, the estimate without the trend is
reported.
18Unreported results show that a unit root for the change in
inflation and broad money growth can be rejected.

MAY/JUNE 1994

18

Table 1
ADF Unit Root Results (log levels)
P

Y

M1

V1

MB

VB

E

ER

Austria

Country

-2 .1 9
(T,1)

-2 .6 7
(C,0)

-1 .8 2
(C,0)

- 2 .5 4
(T,0)

-2 .0 8
(C,1)

-2 .0 6
(C,0)

-1 .7 8
(C,0)

-1 .4 5
(C,1)

Belgium

-1 .1 7
(C,1)

-3 .2 6 *
(C,0)

-1 .4 5
(C,1)

-3 .0 0
(T,0)

-1 .2 1
(C,1)

-2 .9 5
(C,0)

-2 .6 7
(T,1)

-3 .3 6
(T,1)

Denmark

-1 .9 8
(C,1)

-2 .7 8
<C,0)

-2 .9 3
(T,3)

-2 .3 6
(C,3)

-2 .2 3
(T,1)

-0 .8 9
(T,0)

-2 .0 7
(T,2)

-5 .3 1 *
(T,3)

Germany

-2 .1 9
(T,3)

-1 .9 3
(C,0)

-2 .6 1
(T,3)

1.73
(C,2)

-4 .1 1 *
(C,0)

-2 .2 4
(C,0)

NA

NA

Netherlands

-1 .6 4
(C,1)

-4 .6 2 *
(C,0)

-2 .0 3
(C,0)

-1 .7 2
(C,0)

-1 .9 5
(C,1)

-2 .1 6
(T,0)

-1 .0 9
(C,0)

- 1 .7 7
(C,0)

Switzerland

-2 .2 2
(T,1)

-1 .6 7
<C,1)

-3 .0 7 *
(C,2)

0.96
(C,2)

-1 .7 9
(C,1)

-3 .8 2 *
(T,1)

-1 .4 9
(C,3)

-2 .3 2
(T,0)

United States

-1 .3 3
(C,1)

-2 .6 5
(T,0)

-2 .2 8
(T,1)

-2 .2 5
(C,1)

-1 .3 1
(C,1)

—3.01
(T,1)

-2 .8 6
(T,1)

-1 .9 3
(C,1)

Note: The entries show the relevant test statistic; the information in parentheses indicates the
use of a constant only, C, or a constant and trend, T, followed by the number of lagged depen­
dent variables included. For the longest sample period used, the 5 percent significance level critical
values are -3 .5 6 and -2.96, with and without the inclusion of a trend, respectively.

Table 2
ADF Unit Root Results (growth rates)
Country

P

Y

M1

V1

MB

VB

E

ER

Austria

-2 .1 9
(C,0)

-4 .6 0 *
(T ,0)

-4 .7 2 *
(C,0)

-6 .3 3 *
(C,0)

-1 .5 4
(C,0)

-4 .5 2 *
(C,0)

-4 .2 1 *
(C,0)

-3 .2 5 *
(C,0)

Belgium

-2 .2 1
(C,0)

—5.06*
(T,0)

-3 .0 9 *
<C,0)

-5 .2 8 *
(C,0)

-2 .4 3
(C,0)

-5 .5 3 *
(C,1)

-3 .8 2 *
(C,0)

-3 .8 4 *
(C,0)

Denmark

-1 .0 6
<C,0)

-5 .6 6 *
(T,0)

-5 .3 4 *
(C,0)

-5 .6 8 *
(T,0)

-2 .4 7
(C,0)

-3 .5 8 *
(C,0)

-4 .0 8 *
(C,0)

-4 .5 9 *
(C,0)

Germany

-2 .1 5
<C,0)

-3 .8 2 *
(C,0)

-4 .4 2 *
(C,0)

-5 .5 8 *
(T,1)

-3 .9 0 *
(T,0)

-4 .0 7 *
(C,0)

NA

NA

Netherlands

-3 .2 6
(T,0)

-3 .8 7 *
(T,0)

-3 .8 1 *
(C,0)

-5 .0 4 *
(C,0)

-2 .7 1
(T,0)

-5 .6 8 *
(T,0)

-4 .7 0 *
(C,0)

-4 .0 1 *
(C,0)

Switzerland

-2 .7 5
(C,0)

-3 .0 1 *
(C,0)

-6 .0 7 *
(T,1)

-6 .1 6 *
(C,1)

-2 .9 6
(C,0)

-4 .5 5 *
(C,1)

-5 .4 8 *
(C,0)

-6 .0 5 *
(C,0)

-1 .6 6
(C,0)

-3 .9 6 *
(C,0)

-3 .8 1 *
(T,1)

-3 .8 9 *
(T,1)

-2 .8 3
(C,0)

-4 .1 7 *
(C,0)

-3 .8 6 *
(C,0)

-3 .6 9 *
(C,0)

United States

Note: The entries show the relevant test statistic; the information in parentheses indicates the
use of a constant only, C, or a constant and trend, T, followed by the number of lagged depen­
dent variables included For the longest sample period used, the 5 percent significance level critical values are - 3 .5 7 and -2 .9 6 , with and without the inclusion of a trend, respectively

 RESERVE BANK OF ST. LOUIS
FEDERAL


19

(11) GAP2 = (p - p * 2
>
=

(InVB-InVB*)

-

( I n Y - l n Y *),

Table 3
ADF Unit Root Results: Own Price
Gaps Based on M1 and MB________
Country__________________ GAP1
_______________GAP2
Austria

-3 .1 4 *
(C,0)

-3 .3 9 *
(C,1)

Belgium

-4 .8 3 *
(C,1)

-3 .6 8 *
(C,1)

Denmark

-2 .7 5
(C,0)

-3 .9 1 *
(C,3)

Germany

-3 .1 7 *
(C,3)

-3 .2 5 *
(C,1)

Netherlands

-3 .4 4 *
(C,1)

-2 .9 9 *
(C,0)

Switzerland

-6 .4 7 *
(C,1)

-3 .9 9 *
(C,1)

United States

-4 .3 9 *
(C,1)

-4 .2 8 *
(C,1)

Note: The entries show the relevant test statistic; the in­
formation in parentheses indicates the use of a constant
only, C, or a constant and trend, T, followed by the num­
ber of lagged dependent variables included. The critical
value for 5 percent significance level is - 2.96, for the
longest sample period used.

the m easurem ent and inclusion of foreignbased price gaps.

The Dom estic Price M odel
The Hodrick-Prescott filter is used to deter­
mine equilibrium time paths fo r output QnY),
narrow money velocity (InVl) and broad money
velocity (InVB).19 Subsequently, two domestic
price gaps are computed for each country:
(10) GAP' = (p - p
=

*')

U n V l- ln V l* ) - (InY -InY *),

19Basically the trend is derived by minimizing an objective
function that consists of the sum of squared deviations of
actual observations from the (unobservable) trend and a
multiple, A, times the sum of squared changes of this
trend. A smoothing factor A of 100 is used here, following
Kydland and Prescott’s (1989) suggestion that this value is
appropriate for annual data. Hodrick and Prescott (1981)
show, using quarterly data, that a choice of A of up to four
times or one-fourth as large has no practical effect on the
results of applying the filter. The limiting case, A approach­
ing infinity, is a linear trend; this case was also examined
(for Y, V and the real exchange rate below). Differences
arising from the use of linear trend filters are noted below
because the results are sensitive to this choice.




w here p * 1 equals (InMl + ln V l* - I n Y * ) , and p *2
equals (lnMB + In V B *-In Y *), the respective meas­
ures of the equilibrium price level based on
domestic M l and broad money. Table 3 shows
ADF test results for these price gaps. The layout
follows that of Tables 1 and 2. Overall, the
price gaps appear to be stationary, with the ex­
ception of the M l price gap for Denmark. This
Danish price gap is stationary only at the 10
percent level. Stationarity of the price gap is a
necessary condition for the fu rth er analysis.
Short-run inflation dynamics are theoretically
assumed to be influenced by the price gap b e­
cause of the existence of an underlying
equilibrating adjustm ent process. If actual prices
do not converge to the computed equilibrium
prices, as is the case with nonstationary gaps,
the fundamental P-star hypothesis that, in the
long run, prices converge to these equilibrium
m easures is rejected; no theoretical foundation
exists for including such a m easure of the gap
in the inflation specification. This is the case for
the Danish M l-based P-star model.20
Table 4 presents estim ates of the domestic
P-star model based on each country’s own M l
(GAP1) and broad money (GAP2). In the general
specification, one lag of the dependent variable
and the lagged inflation level are included along
w ith the gap and a constant. The reported
results are for estim ates in which insignificant
lagged inflation variables have been dropped
from the general specification.
The results are supportive of the P-star ap­
proach. Save for Denm ark, the price gap with
respect to broad money is significant with the
correct negative sign. The price gap calculated
with narrow money is significant only for the
United States, Switzerland and Denmark, and

20When linear trends are used to construct equilibrium
measures for the broad money-based P-star variables, only
the U.S. and Swiss gap measures are stationary; the
domestic gap measures for Germany and for the four other
countries based on these measures are not stationary. The
domestic version of the P-star model based on these
equilibrium estimates is rejected because these measures
cannot be equilibrium levels. Thus, the failure to reject the
P-star model in the text is conditional upon the method of
estimating equilibrium output and velocity. The Swiss and
U.S. models using linear trends do not fit the data as well
as the estimates reported below.

MAY/JUNE 1994

20

marginally so for Germany. Since D enm ark’s
M l-based domestic price gap is nonstationary,
this result in D enm ark may well be spurious.
Thus, D enm ark’s evidence rejects the domestic
P-star model, a result obtained by Hoeller and
Poret (1991) as well. In the other countries, the
broad money-based P-star model generally fits
the data som ew hat b etter (judged by the adjusted-R2) and fails to reject the model (judged
by the statistical significance of the negative
coefficient on the price gap).21
For five of the seven countries there is a high
coh eren ce betw een the narrow and broad
money price gap; the exceptions are Austria and
the Netherlands.22 Apparently, deviations from
equilibrium levels fo r narrow and broad money
velocity or, m ore precisely, deviations from
equilibrium nominal GDP, usually are closely
related. Based on the superior results for broad
money in Table 4 and the close coherence of
the broad and narrow gaps, only the broad
money-based domestic gaps are used in the
discussion of the open econom y model.

To com pute this price gap, how ever, one needs
a m easure of the equilibrium value of the real
exchange rate (er*).23 Two alternative m easures
o f the equilibrium real exchange rate are p re­
sented here. The first m easure assumes that the
equilibrium real exchange rate is a constant,
w hich is equivalent to assuming that purchasing
pow er parity (PPP) holds in the long run. The
second m easure is based on using the HodrickPrescott filter to find the equilibrium com po­
nent of the real exchange rate. This m easure is
less restrictive and m ore consistent with the
data, but the oth er assumption, the PPP-based
m easure, has strong theoretical appeal.24

PPP-B a sed Measures
Suppose that each real exchange rate is
stationary and converges to a constant longrun equilibrium level.25 Then, the gap with
this constant, equilibrium real exchange rate
removed is
(12') GAPf1 = [pd - {pr* + e)].

Calculating An Appropriate
Foreign-Based Price Gap
To exam ine the German influence on each of
the five small European countries, the foreign
(German) gap is defined as
(12) GAPf = [pd - (p>* + e - er*)].

2 Hoeller and Poret (1991) also report that the domestic
1
P-star model is rejected for Austria and the Netherlands
when the Hodrick-Prescott filter is used, but not when
linear trends are used to find equilibrium output and veloc­
ity. Their study uses semiannual data and, for the seven
countries examined here, uses sample periods beginning
in 1962 for the United States, 1963 for the Netherlands,
1964 for Denmark, 1969 for Austria and Germany, 1971 for
Belgium and 1973 for Switzerland. The last data point is in
1989 in each country. Their results also differ in choosing
the monetary aggregates used for each country based on
each country’s target. These are generally broad meas­
ures, but not necessarily the broad measure used here.
22The correlation coefficient for the U.S. broad-money and
narrow-money-based price gaps is 0.74 and that for the
German broad-and narrow-based price gaps is 0.71. The
correlations of the gaps based on narrow and broad
domestic monetary aggregates are 0.79 in Belgium and
Switzerland, and 0.83 in Denmark. In the Netherlands, this
correlation is only 0.25 and in Austria it is only 0.09; neither
of these is statistically significant at a 5 percent level.
23For an analysis of the U.S. impact on the six European
countries, see the appendix to this article.
24A third measure was also investigated. It assumes that the
measured real exchange rate is always the equilibrium
value, so that all changes in the real exchange rate are

Digitized forFEDERAL RESERVE BANK OF ST. LOUIS
FRASER


This gap is consistent with the pure theory of
the m onetary approach to the balance of pay­
m ents.26 As could be expected, however, this
gap is generally nonstationary. Relevant ADF
test results are shown in the first column of
Table 5. This gap m easure is generally not the
p referred specification because the statistical

permanent. With this measure, the foreign-based price gap
is Germany’s domestic price gap, which is stationary (see
Table 3). The inflation model using this real exchange rate
assumption is consistently dominated by the fit of the
model using the Hodrick-Prescott filtered real exchange
rates.
25Although the analysis above and the evidence in Figure 2
suggest this assumption is incorrect, it provides a con­
venient and insightful benchmark. Tatom (1992) uses this
assumption for Austria; the constant level of the exchange
rate is also removed from the foreign gap measures, so
that Austrian prices are hypothesized to equal a German
P-star in equilibrium. This model is rejected, however,
although Austrian inflation is found to be tied to such an
equilibrium German inflation measure. These results could
arise from ignoring the effects of real exchange rate move­
ments on the level of prices, but the same results—the ab­
sence of a tie of the level of prices to an equilibrium level,
but a strong tie of inflation to an equilibrium inflation
rate—occur for a German money (M3)-based P-star mea­
sure and German prices.
26For recent discussions of the evidence against PPP, see
Coughlin and Koedijk (1990), Dueker (1993) and Huizinga
(1987).

21

Table 4
Short-Run Inflation Equations Including Own Price Gaps
Country

C

An_i

Belgium

-7 .7 8
(1.24)

—

-0 .2 5
(2.01)

-14 .4 1
(1.41)

—

-0 .2 7
(2.59)

—

1.23
(1.84)

—

Germany

-0 .0 6
(0.26)

—

—

-0 .0 6
(0.22)

Denmark

—

—

1.55
(2.78)

GAP1

-0 .3 2
(2.41)
-0 .2 8
(2.23)

1.40
(2.21)
1.23
(2.05)

1.36
(2.38)

Austria

"-1

0.33
(1.89)

-0 .3 9
(2.92)

—

—
-1 1 .3 6
(2.15)
—

-1 0 .2 8
(1.86)

1.26
(3.02)
Netherlands

Switzerland

United States

—

-0 .3 2
(3.22)

0.82
(1.29)
0.80
(1.40)

—

-0 .1 9
(1.71)
-0 .1 9
(1.86)

-1 1 .1 8
(1.32)

-0 .4 4
(3.05)
-0 .5 0
(4.09)

-1 2 .8 3
(2.71)

—

1.87
(2.64)
2.12
(3.53)

—

0.07
(0.40)
0.01
(0.04)

—

—

—

—

—

—

—

—

-2 1 .1 2
(4.13)
—

R2

SEE

LM
(4)

CHOW
(77)

Last
Period

0.137

1.242

0.71

0.76

92

0.221

1.180

0.64

2.29

92

0.148

1.610

0.89

0.75

91

0.355

1.400

1.53

2.52

91

—

0.111

1.381

0.53

0.72

91

-6 .4 8
(1.19)

0.014

1.454

0.27

1.01

91

0.260

1.069

0.46

1.36

91

0.511

0.860

2.57

2.36

91

0.080

1.775

0.43

1.98

92

0.242

1.612

0.61

5.43*

92

0.333

1.653

3.13*

1.07

92

0.523

1.400

0.89

0.78

92

0.349

1.027

0.40

1.46

92

0.408

0.978

0.68

1.58

92

GAP2_ i
—

-2 4 .1 7
(2.17)
—
-3 5 .2 9
(3.36)

—

-29.01
(4.82)
—

-4 2 .3 4
(2.84)
—

- 20.28
(4.63)
—

-2 1 .0 0
(4.66)

Notes: LM (4) is a Breusch-Godfrey test on serial correlation of the residuals using four lags of the residual; it has a * 2(4)
distribution. CHOW (77) is a test on parameter stability with the break point in 1977; it follows an F-distribution.

evidence rejects the hypothesis that domestic
prices have a long-run relationship to this m ea­
sure of the foreign-determ ined, equilibrium
price level. The irrelevance of this m easure, ex­
cept for Denm ark, is consistent with the evi­
dence for real exchange rates in Table 1, which
indicates that the real exchange rate is nonstationary in all cases except for Denmark.

Equilibrium Real Exchange Rates
f r o m the Hodrick-Prescott Filter
The second alternative explicitly tries to find
a statistical estim ate for the time path of the
equilibrium real exchange rate. To this end, we
w rite the real exchange rate as



(13)

er = e + pf - p d = er * + u,

w here u is a stationary, unobservable erro r
term . In this case, the actual real exchange rate
is equal to its long-run value (er*) plus a transi­
tory deviation. Neither e r * nor u are observable.
It is possible, how ever, to obtain an estim ate of
the equilibrium com ponent of the real exchange
rate, e r * , again using the Hodrick-Prescott filter.
This equilibrium com ponent, er * , is substituted
into equation 8 to obtain:
(12")

GAPf* = [pd - (pf* + e - er*)].

T he second column of Table 5 shows this gap
to be stationary at the 5 percent level for Aus­

MAY/JUNE 1994

22

tria, Belgium, Denm ark and the Netherlands.
For Switzerland, a unit root can be rejected
only at the 10 percent level.27

A Comparison o f Alternative
Foreign Gap Measures
To com pare the alternative m easures of the
foreign-determ ined domestic price gap, labeled
GAP?', and GAPf2, respectively, equation 4 is
reestim ated with each of these gaps replacing
the domestic gap. Table 6 contains the coeffi­
cient on the gap, the absolute value of its
f-statistic in parentheses, and the adjusted
fi-squared of the equation in square b rackets.28
GAPf1 is only relevant for Denm ark, w here its
stationarity and that of the real exchange rate
are supported by the data; nevertheless, this
gap has been included as a benchm ark for the
other countries as well. All coefficients in Table
6 are of the co rrect sign. Judged both by sig­
nificance and the amount of explanatory power,
GAPf2 outperform s the other m easure, except in
Denm ark, w here GAPf' is better.
Table 7 similarly contains results for regres­
sions with both the domestic price gap and the
Germ an-based price gap included. The dynamic
specifications are the same as those in Tables 4
and 6.29 In Austria, the com parison of explana­
tory pow er favors GAPf1 slightly, but GAPr' is
nonstationary and, judged by the most relevant
com parison of perform ance shown in Table 6,
GAP^ again has m ore explanatory pow er. Over­
all, the evidence suggests that GAP^ is the
p referred m easure fo r both em pirical and theo­
retical reasons, except in Denm ark, w here GAP1'
is preferred . These gaps are shown in Figure 3
along with the domestic price gaps based on the
broad m oney aggregate.

27When linear trends are used to find equilibrium real ex­
change rates, output and velocity, the foreign-based gaps
are not stationary, indicating that this approach to deriving
the foreign-based P-star measure is inappropriate.
28The dynamic specifications used for the results reported in
Table 6 follow those used in Table 4, although different
specifications could have been used in two cases without
changing the qualitative results. For Denmark, the lag of
inflation is statistically significant at a 10 percent level (f=
-1.83) when GAP1 is used, but it is omitted in Table 6 to
2
facilitate comparison to the GAP'1 case and to the Table 4
results. When this term is included using GAP'1 and
G AP1 , the comparable adjusted-R2 are 0.266 and 0.240,
2
respectively. For Switzerland, adding the first lagged de­
pendent variable is statistically significant with either for­
eign gap; in this case, the adjusted-R2 is 0.386 and 0.616
for GAP1 and GAP'2, respectively.
1


FEDERAL RESERVE BANK OF ST. LOUIS


Table 5
ADF Unit Root Results: Price Gaps
Relative to Germany (only MB)
Country

GAP’1

GAP*2

Austria

-1 .5 2
(C,1)
-2 .4 4
(T ,0)
—3.72*
(C,1)
- 1 .4 4
(C,0)
-0 .7 5
(C,0)

-3 .0 1 *
(C,1)
-3 .3 6 *
(C,1)
-3 .6 0 *
(C,1)
-3 .0 2 *
(C,1)
-2 .7 2
(C,0)

Belgium
Denmark
Netherlands
Switzerland

Note: The entries show the relevant test statistic; the infor­
mation in parentheses indicates the use of a constant
only, C, or a constant and trend, T, followed by the num­
ber of lagged dependent variables included. For the lon­
gest sample period used, the 5 percent significance level
critical values are -3 .5 7 and -2 .9 6 , with and without the
inclusion of a trend, respectively.

The Impact o f Foreign-Based
Price Gaps
Table 8 restates the results of estimating equa­
tion 4 using the m ost appropriate foreign price
gap for each country. For each of the five,
small, European countries, Table 8 contains an
equation with only the German-based gap in­
cluded (from Table 6) and an equation with
both the domestic gap and the German-based
gap (from Table 7).
Comparing the results of Tables 4 and 8, a
num ber of findings em erge:

29For the Swiss equation, using G APf1, a lagged dependent
variable is significant at a 10 perent level (f = 1.85), but it is
omitted in the table to facilitate comparison with the equa­
tion containing the second foreign gap measure in which
the lagged dependent variable is not statistically signifi­
cant. When this lagged dependent variable is included with
each foreign gap measure, the relevant adjusted-R2 is
0.624 for the first foreign gap measure and 0.680 for the
second foreign gap measure, so the comparison of the two
remains unaffected.

23

Table 6

Table 7

Comparison of the Impact of Two
German-Based Price Gaps_______

Comparison of the Impact of Two
German-Based Price Gaps, including
Own Price Gap

GAP*1
Austria

Belgium

Denmark

Netherlands

Switzerland

GAP «

-1 1 .0 7
(3.86)
[0.406]

-1 9 .6 4
(3-91)
[0.411]

-2 .1 5
(0.58)
[0.097]

GAP2

GAP'1

GAP2

GAP*2

Austria

- 24.02
(3.52)
[0.373]

-1 4 .1 5
-9 .8 1
(1.41)
(3.32)
[0 .427]

-1 3 .1 8
-1 7 .3 9
(1.30)
(3.31)
[0.425]

Belgium

-1 6 .7 3
(3.00)
[0.216]

-1 8 .8 9
(2.68)
[0.176]

- 35.67
-2 .6 2
(3.37)
(0.83)
[0 .348]

-3 0 .1 9
-2 0 .8 0
(3.39)
(3.54)
[0.548]

Denmark

-1 0 .7 3
(2.21)
[0.168]

- 27.79
(3.23)
[0.288]

-1 1 .0 6
-2 0 .0 8
(2.38)
(3.75)
[0 .328]

-1 0 .4 0
-2 2 .5 3
(2.16)
(3.29)
[0.271]

Netherlands

-4 .5 2
(2.32)
[0.293]

-2 7 .2 9
(5.35)
[0.583]

-3 5 .7 9
-7 .8 3
(2.39)
(1.68)
[0 .288]

-2 4 .7 2
-2 0 .0 7
(1.49)
(2.03)
[0.318]

Switzerland

-1 8 .9 6
-3 .5 8
(4.64)
(2.40)
[0. 592]

-11 .8 1
-1 9 .1 9
(2.66)
(3.47)
[0.658]

Note: In each cell, the top entry is the coefficient for the
gap, the middle entry is the absolute value of the f-statistic
and the R2 is the lowest entry given in brackets.

• The German-based gap provides greater ex­
planatory pow er than the cou ntry’s own
domestic price gap w hen each is considered
alone.
• Table 8 indicates that adding the Germanbased gap to a specification already containing
the domestic gap (Table 4), on the other hand,
always leads to a statistically significant im­
provem ent in the inflation model.
• In the case of Denm ark, the addition of the
foreign gap means the d ifference betw een
rejecting the P-star model and not doing so.
The closed econom y model rejects the P-star
model in Denm ark, but the open econom y
model does not.
• Adding the domestic gap to the specification
already containing the German-based gap
30The appendix shows that U.S.-based price gaps have had
little impact on European inflation developments over the
sample, regardless of the measure used. This provides ad­
ditional support for our hypothesis that the exchange rate
regime determines which price gaps are relevant, that is,
to what “ equilibrium” measure of prices, foreign or domes­
tic, will actual domestic prices converge. Under floating
rates, it should be domestic price gaps that matter, while
under fixed rates, the foreign influence will increase. It is




leads to a significant im provem ent in the
cases of Belgium, Denm ark and Switzerland.
• Overall, the results are supportive of the
hypothesis that the domestic price gap is of
little im portance under a regim e of fixed ex­
change rates, but that, instead, cu rren t infla­
tion developments at home are determ ined by
m onetary conditions abroad.30
A com parison across countries reinforces
these conclusions. Austria, for instance, has
been most closely linked to Germany over
most of the sample, followed by the N ether­
lands. Consequently, no significant additional
inform ation is provided by their own domes­
tic price gap, once account has been taken of
Germany’s impact. For Belgium and Denmark,
on the oth er hand, both the domestic price
gap and the German-based price gap are imtrue that for a few years early in the period studied here,
all these countries were pegged to the dollar, but the P-star
influence of U.S. prices due to this experience is not
statistically significant. Presumably, the period of the dollar
peg in this sample is too brief for the dollar-based gap to
be significant.

MAY/JUNE 1994

24

Figure 3
Domestic and Foreign-Based Price Gaps
Austria

Belgium

Denmark*

*The average value o f the log o f the real m ark exchange rate for Denmark was added to
the foreign gap.


FEDERAL RESERVE BANK OF ST. LOUIS


25

Figure 3 (continued)
Netherlands

Switzerland

portant. This may reflect the difficulties these
two countries have experienced during the
'70s and ’80s in keeping their cu rren cies’ values
and their inflation rates in line with Germ any’s.
By infrequent devaluations, they have allowed
their own m onetary policy—and related domes­
tic price gaps—to affect dom estic inflation.
Through their continued efforts to converge to
German inflation levels over time, however,
German price gaps have m attered as well.
The m ost interesting set of results is for
Switzerland. In contrast with the oth er four
small European countries under consideration,
Switzerland has followed a floating exchange



rate policy since the breakdow n of Bretton
Woods. As a result, the impact of German-based
price gaps should be insignificant, according to
the hypothesis. Our estim ates, how ever, suggest
that the German-based price gap has dominated
the domestic Swiss gap in the sense that the
form er has m ore explanatory pow er, considered
alone, than the latter.
Although far from conclusive, th ere are some
possible reasons fo r this apparent anomaly. First,
m onetary policies in Switzerland and Germany
have been quite sim ilar during much of the
sample period. Both countries faced similar infla­
tionary pressures towards the end of Bretton

MAY/JUNE 1994

26

Table 8
Short-Run Inflation Equations Including a German-Based Price Gap
GAP*2. ,

R2

SEE

LM
(4)

CHOW
(77)

Last
period

—

-1 9 .6 4
(3.91)

0.411

1.026

1.50

1.33

92

- 0 .3 7
(3.33)

-1 3 .1 8
(1.30)

-1 7 .3 9
(3.31)

0.425

1.014

1.15

1.83

92

1.46
(2.59)

- 0 .3 0
(2.84)

—

-2 4 .0 2
(3.52)

0.373

1.381

0.77

3.05*

91

1.45
(3.01)

- 0 .2 9
(3.32)

-3 0 .1 9
(3.39)

- 20.80
(3.54)

0.548

1.172

1.61

1.33

91

Country

C

"-1

Austria

1.72
(3.24)

-0 .3 9
(3.52)

1.62
(3.06)
Belgium

Denmark

GAP2, ,

—

—

-1 6 .7 3
(3.00)

0.216

1.296

1.73

0.34

91

- 26.48
(3.76)
Netherlands

-2 2 .0 6
(3.01)

—

-1 1 .0 6
(2.38)

-2 0 .0 8
(3.75)

0.328

1.200

1.96

0.44

91

-0 .2 3
(2.30)

—

-2 7 .7 9
(3.23)

0.288

1.562

0.78

1.94

92

0.94
(1.71)

-0 .2 2
(2.23)

-2 4 .7 2
(1.49)

-2 0 .0 7
(2.03)

0.318

1.529

0.34

2.78

92

2.42
(4.27)

-0 .5 5
(4.83)

—

- 27.29
(5.35)

0.583

1.306

1.49

0.83

92

2.38
(4.63)

Switzerland

1.00
(1.78)

-0 .5 5
(5.31)

-11.81
(2.66)

-1 9 .1 9
(3.47)

0.658

1.184

1.39

0.52

92

Notes: For Denmark, the foreign gap used is GAP*1 instead of GAP'2. LM (4) is a Breusch-Godfrey test on serial correla­
tion of the residuals using four lags of the residual; it has a x2(4) distribution. CHOW (77) is a test on parameter stability
with the break point in 1977; it follows an F-distribution.

Woods, and implem ented similar m onetary ta r­
geting policies in the mid-'70s to reduce inflation.
Second, the Swiss fran c and the German mark
have been attractive—and closely substitutable—
investm ent cu rren cies in international portfolios.
T he Swiss results could also be interpreted as
stemming from close coordination of m onetary
policies under floating exchange rates.31
Similar tests w ere conducted for the United
States and German domestic P-star models to ex­
amine the pow er of the tests of the significance
of foreign gaps reported here. In particular, fo r­
eign gaps constructed like the gap m easure
GAPf2, using the five European countries, w ere
constructed and added to the domestic P-star
model for the United States and Germany. Also,

31This is not equivalent to fixing nominal exchange rates, as
evidenced by the appreciation of the Swiss franc during
the time period considered (see Figures 1 and 2).


FEDERAL RESERVE BANK OF ST. LOUIS


a German-based gap was added to the domestic
P-star model for the United States. In no case
was one of the foreign gap term s statistically
significant in the dom estic model fo r the United
States or Germany. This strengthens the evi­
dence that in floating countries the appropriate
P-star model is a domestic one, while the
domestic P-star is determ ined by the anchor
country in a fixed rate regime.

SUMMARY AND CONCLUSION
The systematic link betw een domestic money
and the general level of prices is central to the
P-star model, w hich emphasizes this long-run

27

relationship as a determ inant of short-run move­
m ents in the level of prices and inflation. M one­
tary authorities in countries with fixed exchange
rate regim es do not determ ine th eir own long-run
level of prices, however. Instead, their long-run
equilibrium price level is im ported from the
countries w hose curren cy is the basis of the peg.
To varying degrees five, small open European
countries have pegged their cu rren cy to the
German m ark. Econom ic theory suggests that,
to the degree they did so, these countries’ longrun equilibrium price levels and their inflation
rates should be dominated by the German price
developments, w hich, in turn, are presum ably
controlled by the Bundesbank. An open econom y
model of inflation in countries with fixed ex­
change rates must take into account the external
basis of the equilibrium price level.

evidence shows that the long-run equilibrium
price level tow ard w hich domestic prices adjust
is determ ined by foreign m onetary policy.

This article develops such a P-star model for
domestic prices from 1960 to the 1990s in five
European countries: Austria, Belgium, Denm ark,
the Netherlands and Switzerland. These econo­
mies b ord er Germany and have, to varying
degrees, fixed their domestic exchange rates
based on a peg to the German m ark. The evi­
dence presented h ere shows that the open econ­
omy, fixed exchange rate P-star model is not
rejected for the countries considered. The infla­
tion model’s fit improves for all five countries
when allowance is made for the statistically sig­
nificant foreign (German) influence on equilibri­
um domestic price levels during fixed exchange
rate periods.

Dewald, William G. “ Monetarism is Dead; Long Live the
Quantity Theory,” this Review (July/August 1988),
pp. 3-18.

Perhaps the best example is Denm ark, w here
the domestic P-star model is rejected. In the
open econom y model, how ever, the broad
money-based domestic gap and the German
P-star-based gap are both highly significant and
with the co rre ct sign, showing the im portance
of accounting for the foreign influence. Two
other countries in w hich the domestic gap is
significant in tests of the open econom y model
are Belgium, the oth er interm ediate case, and
Switzerland. In Austria and the Netherlands,
w here currencies have been m ost tightly pegged
to the m ark, the German-based P-star model
outperform s the respective domestic models
and, w hen included with the domestic gap, the
domestic gap is not statistically significant.
Overall, the results confirm the long-run link
betw een m onetary aggregates and domestic
prices for both closed or large, flexible exchange
rate countries, as well as for fixed exchange
rate countries. In the latter case, how ever, the



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an Endangered Species?,” this Review (May 1983),
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Bayoumi, Tamim, and Barry Eichengreen. “ Macroeconomic
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ing Paper No. 4169 (1992).
Coughlin, Cletus C., and Kees G. Koedijk. “ What Do We
Know About the Long-Run Real Exchange Rate?," this
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Deutsche Bundesbank. “ The Correlation Between Monetary
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Germany,” Monthly Report of the Deutsche Bundesbank
(January 1992), pp. 20-8.

Dueker, Michael J. “ Hypothesis Testing with Near-Unit Roots:
The Case of Long-Run Purchasing-Power Parity,” this
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Dwyer, Gerald P., Jr., and R.W. Hafer. “ Is Money Irrelevant?,”
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Hallman, Jeffrey J., Richard D. Porter, and David H. Small.
“ Is the Price Level Tied to the M2 Monetary Aggregate in
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Hoeller, Peter, and Pierre Poret. "Is P-Star a Good Indicator of
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Hodrick, Robert J., and Edward C. Prescott. “ Post-War U.S.
Business Cycles: An Empirical Investigation,” Northwestern
University Discussion Paper No. 451 (May 1981).
Huizinga, John. “An Empirical Investigation of the Long-Run
Behavior of Real Exchange Rates,” Carnegie Rochester
Conference Series on Public Policy (autumn 1987),
pp. 149-214.
Humphrey, Thomas M. “ Precursors of the P-Star Model,”
Federal Reserve Bank of Richmond Economic Review
(July/August 1989), pp. 3-9.
King, Robert G., and Sergio T. Rebelo. “ Low Frequency
Filtering and Real Business Cycles,” University of
Rochester, Center for Economic Research Working Paper
No. 205 (October 1989).
Kool, Clemens J.M. “ The Case for Targeting Domestic Money
Growth Under Fixed Exchange Rates: Lessons from the
Netherlands, Belgium, and Austria: 1973-1992,” METEOR
research memorandum 94-011 (February 1994), University
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Kydland, Finn E., and Edward C. Prescott, “A Fortran Subrou­
tine for Efficiently Computing HP-Filtered Time Series,”
Federal Reserve Bank of Minneapolis research memoran­
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Mills, Terence C., and Geoffrey E. Wood. “ Does the Ex­
change Rate Regime Affect the Economy?,” this Review
(July/August 1993), pp. 3-20.
Organization for Economic Co-operation and Development,
National Accounts, Main Aggregates, vol. 1, 1960-91. OECD,
1993.

MAY/JUNE 1994

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Roubini, Nouriel. "Offset and Sterilization Under Fixed Ex­
change Rates with an Optimizing Central Bank” NBER
Working Paper No. 2777 (1988).
Stockman, Alan C., and Lee E. Ohanian. “ Short-Run In­
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Research Working Paper No. 361 (September 1993).
Tatom, John A. “ The P-Star Model and Austrian Prices,” Empirica, vol. 19 (1992), pp. 3-17
________“ The P-Star Approach to the Link Between Money
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Appendix
Are European Prices Influenced By U.S. Monetary
Policy?
The analysis in the text focuses on the con­
nections betw een Germany and a num ber of
small European countries with strong ties to
Germany. A similar analysis can, of course, be
applied to the United States in relation to the
six European countries. Our maintained
hypothesis suggests that under the floating ex­
change rate regime for the U.S. dollar over
most of the period, European countries should
have been insulated from inflationary or defla­
tionary pressures arising from the United
States. For the '60s and early ’70s, on the other
hand, U.S.-determined price gaps should have
influenced Europe, because the United States
was the anchor country in the fixed exchange
rate system of Bretton Woods.
Figure 1 shows, however, that the relevant
Bretton Woods period in our sample has been
too short to perform a meaningful test of
the significance of U.S.-determined gaps. Our
regressions start in 1962 or 1963, depending on
the lags included, and nominal exchange rates
start moving in 1967-68, thereby reducing the
potential impact of U.S. m onetary conditions
abroad. Thus, for our sample, we do not expect
coefficients on U.S.-determined gaps to be sig­
nificantly different from zero.
First, we present test statistics on the stationarity of the relevant gap variables in Table A l.
Gap definitions are similar to those in the main
text, with Germany replaced by the United States.
The results are very close to those in Table 5,
w here unit root statistics for German-based
gaps are displayed. GAPfl is nonstationary, while
GAP& is stationary. Tables A2 and A3 are com ­
parable to Tables 6 and 7, respectively, and
have the same layout. Estimated gap coefficients
are generally small in magnitude and insignifi
FEDERAL RESERVE BANK OF ST. LOUIS


Table A1
ADF Unit Root Results: Price Gaps
Relative to U.S. (only MB)________
Country

GAP’ 1

G AP'2

Austria

-2 .7 0
(T.1)

-3 .3 5 *
(C,1)

Belgium

-2 .6 7
(C,1)

-3 .4 6 *
(C,1)

Denmark

-1 .9 4
(C,1)

-3 .3 2 *
(0,1)

Germany

-1 .8 3
<C,1)

-3 .4 3 *
(C,1)

Netherlands

-1 .5 6
(C,1)

-3 .0 8 *
(C,1)

Switzerland

- 0 .7 7
<C,0)

-3 .2 0 *
(C,1)

Note: For the longest sample period used, the 5 percent
significance level critical values are - 3 .5 6 and -2 .9 6 ,
with and without the inclusion of a trend, respectively.

cant. Only fo r Belgium are small significant
coefficients found fo r GAPf1 and GAP& in Table
A3. Overall, the evidence rejects a link from
U.S. m onetary conditions to inflationary pres­
sures in Europe. This supports our hypothesis.
To address the issue of the potential impact of
the United States on other countries during the
Bretton W oods period adequately, a longer sam­
ple going back to the early ’50s or late ’40s would
be required. This is left for future research.

29

Table A2

Table A3

Comparison of the Impact of Two
U.S.-Based Price Gaps

Comparison of the Impact of Two
U.S.-Based Price Gaps, Including
Own Price Gap_________________

0.21
(0.14)
[0.09]

0.12
(0.05)
[0.09]

-1 .0 4
(0.91)
[-0 .0 1 ]

0.42
(0.18)
[-0 .0 3 ]

- 0 .2 7
(0.27)
[0.16]

- 1 .0 4
(0.56)
[0.17]

-0 .7 4
(0.57)
[0.03]
- 1 .3 9
(1.41)
[0.28]

Belgium

Denmark

Germany1

Netherlands

Switzerland1

Country

GAP2

GAP'1

GAP2

GAP1
2

Austria

-2 5 .6 7
(2.23)

- 0 .5 7
(0.61)
[0.20]

-2 7 .8 6
(2.39)

-2 .1 2
(1.04)
[0.22]

Belgium

-5 1 .6 3
(4.34)

-3 .5 3
(2.37)
[0.45]

-5 3 .8 3
(4.57)

-5 .7 1
(2.65)
[0.47]

Denmark

(1.02)

CD

- 0 .6 3
(0.30)
[0.09]

I
o

GAP'2

-0 .1 3
(0.13)
[0.09]

—
i.

GAP'1

I
cn

Country
Austria

(0.68)
[0.00]

-7 .7 2
1.52
(1.32)
(0.62)
[-0 .0 1 ]

Germany

-2 9 .9 7
(4.95)

-3 0 .6 0
(5.23)

0.59
(0.20)
[0.02]

-0 .8 0
(1.08)
[0.51]

-2 .4 4
(1.79)
[0.55]

Netherlands

-5 0 .4 0
(3.31)

-5 4 .1 3
(3.20)

-3 .3 5
(1.25)
[0.27]

-1 .9 6
(1.68)
[0.29]

-4 .1 4
(1.40)
[0.27]

Switzerland

-19 .5 1
(4.34)

-0 .6 7
(0.85)
[0.52]

-2 1 .8 0
(4.38)

1.64
(0.67)
[0.51]

’ The specification includes a statistically significant
lagged dependent variable which was not significant and
not included in that used in Table 4.




MAY/JUNE 1994




31

Charles W. Calom iris
Charles W Calomiris is associate professor of finance,
.
University of Illinois at Urbana-Champaign; faculty research
fellow, National Bureau of Economic Research; and visiting
scholar at the Federal Reserve Bank of St. Louis. Greg Chaudoin,
Thekla Halouva and Christopher A. Williams provided research
assistance. The data analysis for this article was conducted in
part at the University of Illinois and the Federal Reserve Bank
of Chicago.

Is the Discount Window
Necessary? A Penn Central
Perspective

XN

RECENT YEARS, ECONOMISTS have come
to question the desirability of granting banks
the privilege of borrow ing from the Federal
Reserve’s discount window. The discount win­
dow’s d etractors cite several disadvantages.
First, the Fed’s control over high-powered
money can be ham pered. If bank borrow ing b e­
havior is hard to predict, open m arket opera­
tions cannot perfectly peg high-powered money,
w hich some econom ists believe the Fed should
do. Second, there are m icroeconom ic concerns
about potential abuse of the discount window
(Schwartz, 1992). Critics argue that the discount
window has been misused as a tran sfer schem e
to bail out (or postpone the failure of) troubled
or insolvent financial institutions that should be
closed quickly to prevent desperate acts of fraud
or excess risk taking by bank m anagem ent. In
response to growing criticism of Fed lending to
prop up failing banks, Congress mandated limits
on discount lending to distressed banks, which
w ent into effect on D ecem ber 19, 1993.




Some econom ists (Goodfriend and King, 1988;
Bordo, 1990; Kaufman, 1991, 1992; and Schwartz,
1992) have argued that th ere is no gain from al­
lowing the Fed to lend through the discount
window. These critics argue that open m arket
operations can accom plish all legitim ate policy
goals without resort to Federal Reserve lending
to banks. Clearly, if the only policy goal is to
peg the supply of high-powered money, open
m arket operations are a sufficient tool. Similar­
ly, the Fed could peg interest rates on traded
securities by purchasing or selling them . Any
argum ent for a possible role fo r the discount
window must dem onstrate that pegging the ag­
gregate level of reserves in the economy, or
controlling the riskless interest rate on traded
securities, is insufficient to accomplish a legiti­
m ate policy objective that can be accomplished
through Fed discounting.
In this article, I exam ine theoretical assump­
tions that may justify the existence of the dis­
count window. I argue that th ere is little cu rren t

MAY/JUNE 1994

32

role for the discount window to protect against
bank panics. The main role of the discount win­
dow is in defusing disruptive liquidity crises
that occu r in particular n on ban k financial m ar­
kets. I discuss evidence from the Penn Central
crisis of 1970, which seems consistent with that
view, and conclude by considering w h eth er this
evidence is relevant for today’s relatively sophisti­
cated financial environm ent.
Backup protection for financial m arkets
through the discount window could be achieved
at little cost if access to the discount window
w ere confined to periods of financial disruption.
During norm al times, open m arket operations
and interbank lending would be sufficient for
determ ining the aggregate amount of reserves
in the banking system and their allocation
among banks.
A first step tow ard envisioning a role for any
financial institution or policy instrum ent, includ­
ing the discount window, must be the relaxation
of the assum ptions of zero physical costs of
transacting and/or sym m etric inform ation. The
discount window’s benefit, if any, must be relat­
ed to its role in helping to econom ize on costs
in capital m arkets, w hich them selves are a fun c­
tion of physical or inform ational "im perfections.”
I divide the discussion of potential justifications
for the discount window into two parts—
assistance to financial interm ediaries and
assistance to particular financial m arkets.

THE DISCOUNT WINDOW AND
BANKING PANICS
The Federal Reserve System was created in
1913 with three prim ary objectives: to eliminate
the "pyram iding” of reserves in New York City
and replace it with a polycentric system of 12
reserve banks; to create a m ore seasonally elas­
tic supply of bank credit; and to reduce the
propensity for banking panics. The discount
1lf money-demand disturbances were the cause of banking
panics, as envisioned in Diamond and Dybvig (1983), then
open market operations, as normally defined, would be a
sufficient tool for policy if the central bank were permitted
to purchase bank loans. Since bank loans are not “ spe­
cial” in that framework (that is, there is no delegated con­
trol and monitoring function performed by the banker and,
hence, no potential for adverse selection or moral hazard),
it is natural to think of standard open market operations as
including purchases of bank debt in the context of that
model. If, however, banking panics are produced by confu­
sion over the incidence of shocks to the value of bank as­
sets, as argued in Calomiris and Gorton (1991), and if

 RESERVE BANK OF ST. LOUIS
FEDERAL


window was the prim ary m echanism for achiev­
ing these goals. The 12 regional Federal Reserve
Banks offered an alternative to the private in ter­
bank deposit m arket as depositories of bank
reserves. T he architects of the Fed expected to
eliminate reserve "pyram iding,” w hich chan­
neled interbank deposits to New York, w here
they often w ere used to finance securities m ar­
ket transactions (White, 1983). Interbank lend­
ing was viewed by some as a problem because
it encouraged dependency of the nation’s banks
on New York bankers and placed funds into the
hands of securities m arket speculators.
The discount window also promised to reduce
the seasonal volatility of interest rates and in­
crease the seasonal elasticity of bank lending by
providing an elastic supply of reserves, allowing
bank balance sheets to expand seasonally without
increasing the loan-to-asset ratio. Prior to the
creation of the Fed, bank expansion o f loans in
peak seasons led to costly increases in portfolio
risk (a higher loan-to-asset ratio), or costly
seasonal im portation of specie. This implied an
upward sloping loan supply function with large
interest rate variation over the seasonal cycle
(Miron, 1986; Calomiris and Hubbard, 1989; and
Calomiris and Gorton, 1991).
Finally, the availability of the discount window
was also expected to reduce the risk of bank
panics in two ways. First, by increasing the
availability of reserves, the discount window
limited seasonal increases in portfolio risk and
reductions in bank liquidity during high-lending
months, thus reducing the risk of panics. Sec­
ond, the discount window would provide a
source of liquidity to banks if an unpredictable
withdrawal of deposits in the form of curren cy
created a shortage of reserves that threatened
the liquidity of the banking system (as in Dia­
mond and Dybvig, 1983).1 But the discount win­
dow offered limited protection to banks from
a panic induced by adverse econom ic news.
Because access to the discount window was
banks have special information about their portfolios, then
a government policy of purchasing bank loans during a cri­
sis at pre-panic prices would have the same costs and
benefits as allowing banks access to the discount window.

33

limited by strict collateral requirem ents, bank
borrow ing was limited to the amount of eligible
collateral the bank possessed.2 Thus, Federal
Reserve Banks could not use the discount win­
dow to shore up banks if their depositors lost
confidence in the quality of the bank’s illiquid
loan portfolio. The collateral required for
discount window lending was subsequently
broadened in the 1930s.
The history of the pre-Fed era suggests that
the early limitations on discount window lend­
ing w ere im portant. Gorton (1989), Calomiris
and Gorton (1991), and Calomiris and Schweikart (1991) have argued that sudden w ithdraw ­
als from the banking system occu rred w hen
depositors received news about the state of the
econom y that was bad enough to make them
think that some banks w ere insolvent. Because
depositors w ere uninform ed about the incidence
of this disturbance across individual banks (be­
cause of depositors’ limited inform ation about
bank portfolios) all banks’ depositors had an
incentive to withdraw funds from their banks
until they could b etter ascertain the risks of in­
dividual banks. Thus, relatively small aggregate
insolvency risk could have large costs through
disinterm ediation from banks.
Costs associated with banking panics can moti­
vate a m ore aggressive policy than one req u ir­
ing riskless collateral for all central bank lending.
The central bank could provide loans to the
banking system on illiquid collateral to offset
the tem porary withdrawal of depositors’ funds.
The rationale for this intervention lies in in for­
mational externalities caused by panics. Banking
panics create negative externalities among banks
and their custom ers. Banks whose assets have
not declined in value, and their b orrow ers and
depositors, su ffer because of the confusion over
w hether they are among the banks holding lowvalue assets. The banks lose business, the b o r­
row ers lose access to credit, and the depositors
lose interest and pay transaction costs of tran s­

ferring funds out of the banking system. Banks
and their borrow ers benefit by keeping the
banking system from shrinking.
If bank credits and deposits play special roles
in financing and clearing transactions, then con­
tractions in bank activity will be costly. The dis­
count window can be thought of as a way to
coordinate a mutually beneficial decision among
depositors not to w ithdraw their deposits during
panics. Removing the private incentive fo r depo­
sitors to w ithdraw th eir funds makes all deposi­
tors better off. W hile private deposits fall,
public “deposits” made through the discount
window (the indirect assets of the public) rise to
com pensate. Open m arket operations would not
be an adequate substitute policy. Open m arket
operations would simply insulate the money
supply from the reduction in the money mul­
tiplier as bank deposits and bank credit fell;
they would not reduce withdrawals from banks.
Thus, one could argue for central bank adop­
tion of the following rule for use of a “backup”
discount window: Under norm al circum stances
(when there is no general systemic banking pan­
ic reducing private deposits in banks), the cen ­
tral bank provides no loans to banks. During a
systemic crisis, the central bank agrees to pro­
vide loans to banks up to the amount of deposi­
tor withdrawals (at an interest rate that fairly
com pensates the governm ent fo r the default
risk of the average bank). Such crisis loans must
be short-term and paid in full after the crisis
passes (which, if history is any guide, should be
no longer than two months). The governm ent
might increase the interest rate it charges on
loans to banks over time to encourage them to
assist in resolving the inform ation asymmetry
m ore quickly (for example, by sharing inform a­
tion about themselves and one another). The
central bank might even charge a fee to banks
ex post as a function of actual losses, to fu rth er
encourage good banks to bring the crisis to a

2These limitations were eliminated in the 1930s. For a dis­
cussion of changing collateral requirements on Fed lend­
ing, see Friedman and Schwartz (1963, pp. 190-5). Note
that lending from the Fed, even on riskless collateral, can
provide special assistance to banks (up to the amount of
their riskless collateral) because the Fed enjoys a special
right to “jump the queue” of debt seniority. By taking the
best assets of the bank as collateral, the Fed effectively
subordinates existing debt claims. Private creditors would
not be able to do so and, thus, would not be able to lend
to the bank on the riskless collateral.




MAY/JUNE 1994

34

speedy conclusion.3 As deposits retu rn to the
banks, they would use them to repay the
governm ent loans. Banks that fail to attract
depositors (relative to other banks) as the crisis
draw s to a close would be denied continuing ac­
cess to credit and would be allowed to fail.
In principle, banks might be able to prevent
panics by pooling resources privately without
any intervention by the central bank. If the
banking system w ere able to allocate funds to
insure against banking panics by agreeing to
treat deposits as a collective liability of all banks
during a systemic crisis (as some groups of
banks did historically), then, so long as the pub­
lic was confident of the aggregate solvency of
the banking system, th ere would be no threat
of systemic bank runs and no need for a
governm ent-run discount window to reduce the
costs of banking panics.4 Kaufman (1991) argues
that interbank m arkets did not operate e ffec­
tively historically, but that this is no longer the
case. He claims that the existence of the
m odern federal funds m arket obviates the need
fo r the discount window during crises because
open m arket operations, com bined with in ter­
bank tran sfers, can funnel cash to w hichever
solvent banks experience large withdrawals. If
banks as a group are willing to pool their
governm ent security holdings during a crisis,
then Fed purchases of securities com bined with
interbank tran sfers to banks that lack sufficient
governm ent securities can keep the banking sys­
tem afloat, and possibly prevent runs (if in ter­
bank insurance is credible ex ante).
Despite the existence of a delivery m echanism
(the fed funds market), lending among banks
during a crisis may not occu r due to asym m et­
ric inform ation. If banks are unable to regulate
and credibly m onitor each o th er’s portfolios and
behavior, they will be reluctant to insure one
another during a banking panic. Even though
the interbank m arket operates quite well during
norm al tim es among most banks, it cannot

3There must be an implied “ subsidy” relative to the terms
by which private lenders would be willing to lend to the
bank, or else government lending cannot prevent runs. The
actuarialy fair government lending will be lower than the
rates banks would pay in the private market, since govern­
ment intervention reduces default risk.
4Calomiris (1990, 1992c) argues that a nationwide branch
banking system would not have experienced aggregate in­
solvency risk even during the worst episodes of bank
failure and bank panic.


FEDERAL RESERVE BANK OF ST. LOUIS


necessarily be relied upon to protect the bank­
ing system from panics.
The interbank loan m arket can operate effec­
tively so long as banks have adequate inform a­
tion about and control over each oth er’s actions.
Lending banks m ust be confident that b orrow ­
ers are not abusing the interbank m arket to
subsidize excessive risks o r provide a bailout to
insider depositors of a failed bank. Although
this "incentive com patibility” requirem ent may
be difficult to satisfy, th ere are many examples
that show it is possible to do so. Gorton (1985,
1989), Calomiris (1989a), Calomiris and Kahn
(1990, 1991), and Calomiris and Schw eikart
(1991) argue that inform ation asym m etry about
bank borrow ers and the consequent risk of
panics prompted cooperative behavior among
banks historically. Coordination among banks in
response to panics characterized many coun­
tries’ banking systems (notably England's during
the Baring Crisis of 1890, and Canada's repeatedly
during the 19th and 20th centuries). But in the
United States, laws limiting bank branching and
consolidation effectively limited interbank
cooperation. As the num ber of U.S. banks and
their geographical isolation from one another in­
creased, the feasibility of national cooperation
was undermined. A bank’s cost of monitoring
and enforcing cooperative behavior rises with
fragm entation, while the benefit to any bank
from m onitoring and enforcing declines with
the num ber of m em bers in the coalition (the
benefit is shared by all).
Thus, the need for discount window assistance
to banks is magnified by unit banking laws that
make private interbank cooperation, lending
and mutual insurance infeasible. Absent such
regulations, the potential for costly banking pan­
ics would be substantially reduced, and the ex­
pected benefits of discount window protection
of the banking system would be sm aller.5
In closing, four points are w orth noting. First,
I have not assumed that the governm ent has

5See the related discussion of other countries’ experiences
in Bordo (1990) and Calomiris (1992a).

35

superior inform ation regarding individual bank
solvency—an alternative justification for govern­
m ent lending to banks even in noncrisis states.
W hile such an argum ent can be made (based on
the governm ent’s access to inform ation by vir­
tue of its supervisory role), the recen t history of
bank failures and losses, and of regulatory agen­
cies’ inabilities to anticipate, observe or prevent
widespread abuse seems to argue against such a
presumption. Kane (1988) argues that regulators
face distorted incentives to collect and report
inform ation about banks. These incentive prob­
lems may outweigh regulators’ special channels
of inform ation due to supervisory authority.
Second, discount lending can be motivated by
physical transaction costs that limit interbank
lending. Such physical costs m ean that open
m arket operations will have uneven effects on
the supply of reserves available to different
banks if the m arket fo r reserves is segmented.
Although this may have been a legitimate moti­
vation fo r the discount window historically, as
Kaufman (1991) argues, cu rren t interbank
reserve tran sfers are accom plished at little cost.
Third, I have not addressed the possible role
o f the discount window in bailing out a banking
system that is insolvent as a whole. Even in a
concentrated, mutually insuring banking system,
interbank insurance and lending could never
deal with enorm ous adverse asset shocks (that
is, those larger than aggregate bank capital).
Partial governm ent deposit insurance (with large
deductibles) for mutually insuring groups of
6lt is beyond the scope of this article to examine all of the
relative advantages of government deposit insurance or
discount lending for stabilizing a fragmented (uncoordinated)
banking system. Perhaps the most obvious potential advan­
tage of discount window lending is that government inter­
vention can be state-contingent. If a bank fails when there
is no systemic panic, the bank’s depositors will not be
bailed out by government insurance. This reduces the
moral-hazard costs of the government’s “ safety net.” This
argument for the relative desirability of the discount window
as a means to insure against panics presumes that the
central bank will not cave in to the political pressures of
special interests to bail out banks in noncrisis times. Recent
accusations by the House Banking Committee of inap­
propriate lending by the Federal Reserve to insolvent
banks cast some doubt on the ability of current institutions
to make and enforce appropriate distinctions regarding
when banks should have access to the discount window
(see Business Week, July 15, 1991, pp. 122-3). Schwartz
(1992) argues that the history of the discount window is
replete with such examples. Congress has mandated, and
the Fed has implemented, specific new guidelines that limit
Fed lending to distressed banks (The American Banker;
August 12, 1993, pp. 1-2).

banks can protect against this unlikely event
b etter than w holesale bailouts through discount
window "lending” (Calomiris, 1992b).
Fourth, the need fo r the discount window to
protect the cu rren t U.S. banking system from
financial panic has been substantially curtailed
by deposit insurance.6 Under the cu rren t deposit
insurance system, discount window intervention
would be largely redundant as protection against
systemic risk. Insured depositors have little incen­
tive to run their banks during a financial crisis.
Although deposit accounts in excess of $100,000
under cu rren t law are not protected (de jure)
by governm ent deposit insurance, larger
deposits may be covered if a general run on the
banking system ensued. The FDIC Im provem ent
Act (FDICIA) of 1991 establishes a form ula for
determining w h eth er a system ic threat w arrants
the coverage of larger-denom ination deposits.7
Fed lending does retain a potentially im portant
role in providing implicit protection for the in ter­
bank clearing system, w hich is discussed below .8

NONBANK LENDING AND THE
RO LE O F THE DISCOUNT
WINDOW
In an econom y in w hich physical costs of in­
terbank tran sfers are small, and interbank coor­
dination and mutual insurance, or governm ent
deposit insurance, protects the banking system
from the risk of panic, there is no additional
need for the discount window to facilitate the
in 1995, the FDIC, the Secretary of the Treasury (in consul­
tation with the President), and a supernumerary majority of
the boards of the FDIC and the Federal Reserve, must
agree that not doing so “ would have serious adverse ef­
fects on economic conditions or financial stability.” If unin­
sured deposits are covered through this provision, the
insurance fund must be reimbursed through emergency
special assessments. Because the nation’s largest banks
would end up paying a disproportionate cost of such a
bailout, they would be expected to lobby against the exten­
sion of insurance to uninsured deposits, unless the criteria
for assistance were truly met.
8The protection afforded to bank clearing houses is consi­
dered in more detail in the conclusion to this article.

7Under 12 U.S.C. § 1823 (c) (4) (G) of FDICIA, for insurance
to be extended to uninsured liabilities of a bank, beginning




MAY/JUNE 1994

36

operation of the banking system. But even in
such an environm ent, problem s that arise out­
side the banking system may motivate central
bank lending through the discount window. In
particular, securities m arkets may be vulnerable
to externalities arising from asym m etric in for­
mation. I will argue that these problem s may be
addressed effectively by channeling funds
through banks that borrow from the window,
rath er than through direct lending from the
cen tral bank to nonbank firm s.9 The example
that I will focus on is the com m ercial paper
m arket "ru n ” that followed Penn Central’s 1970
bankruptcy.
As many research ers have stressed, the bank­
ing system is particularly vulnerable to confu­
sion about the incidence of disturbances for
tw o reasons. First, its assets (that is, bank loans)
typically are not traded in centralized m arkets.
Thus, it is difficult for an uninform ed bank
depositor to keep abreast of the effect of a
given news item on the value of his bank’s as­
sets. Second, the fact that banks finance through
large quantities of demandable debt allows n er­
vous depositors to withdraw from the bank
rath er than wait to see w h eth er their bank will
survive or fail.
Although these two attributes that make
banking panics possible—nontraded assets and
demandable debt—seem to set the banking sys­
tem apart from oth er m arkets, the banking sys­
tem is just an extrem e case of a m uch m ore
general phenom enon. The condition necessary
to generate a costly panic in a d e b t m a r k e t is
that the tim e horizon for rolling over debt is
less than the time it takes to m ake accurate
reappraisals of firm -specific risk during episodes
of general bad news. Lenders’ lack of inform a­
tion about the attributes of specific firm s may
result in the pooling of borrow ers w ith com ­
mon observable characteristics. In such circum ­
stances, firm s will face tem porarily high
“lemons prem ia” in debt and equity m arkets,
w hich will increase the cost of finance and
reduce investm ent, even for firm s whose true
“fundam entals” are u naffected by the bad news.

9Mishkin (1991a) also argues that asymmetric information
is relevant outside the banking sector. He uses data on
interest rate spreads between risky and riskless debt
instruments to support this view. He finds evidence of an
increase in these spreads (which he interprets as reflecting
an increased inability to sort borrowers according to risk)
coinciding with or prior to the Penn Central crisis of 1970
and the stock market crash of 1987.


FEDERAL RESERVE BANK OF ST. LOUIS


Firms with short-term debts (which must be
rolled over regularly) can be particularly vulner­
able to systemic risk and the possibility of a
run. A liquidity crisis that would prompt a
general calling in of debt by creditors could
lead firm s with outstanding short-term debt to
experience high costs of debt rollover or asset
sale not experienced by oth er firms.
Furtherm ore, if interm ediaries for particular
m arkets (for example, com m ercial paper deal­
ers) su ffer losses from one firm ’s issues, they
may be less able to deal in the paper of other
firm s. This, too, can force firm s to pay higher
costs for funds tem porarily in the affected m ar­
ket, or switch to new, higher-cost sources of
funds.
Firms that face liquidity problem s in nonbank
debt m arkets may have difficulty borrow ing
from bankers, too, particularly if they lack exist­
ing bank-lending relationships. To the extent
that banks have special inform ation about b o r­
row ers’ attributes, due to their past involvement
with firm s and their ongoing m onitoring of firm
com-pliance with lending covenants, banks may
be able to assist firm s w hen their costs of funds
rise in other credit m arkets. For firm s that
moved away from reliance on bank credit, how­
ever, th ere may be no strong banking relation­
ship to fall back upon. Assistance from banks
for these firm s would be forthcom ing only at
higher interest rates, which would com pensate
banks for the transaction and inform ation costs
of drafting em ergency lending arrangem ents. In
particular, if the bank expects only a tem porary
relationship with the firm in need (for the dura­
tion of the “em ergency”), the bank will have to
charge higher in terest rates to recoup its fixed
costs over a sh orter lending period.
Given the high cost of substituting bank credit
for oth er credit on short notice, a credit m arket
run may force some solvent firm s into financial
distress, or simply reduce their ability to invest
or to lend to other firm s.10 If the social costs of
such disruptions to short-term debt m arkets are
large, Fed intervention to defuse such crises
may be w arranted. Specifically, the Fed could

10Calomiris, Himmelberg and Wachtel (forthcoming) find that
nonfinancial commercial paper issuers of the 1980s tended
to be net lenders to other firms through accounts
receivable.

37

supply banks with funds at low cost through
the discount window for the express purpose of
refinancing maturing short-term debts of firm s
suffering from disruption in the short-term debt
m arket. In a competitive banking system, this
subsidy would be passed on to borrow ers and
would mitigate high short-run costs of switching
to banks for credit.
New financial m arkets may be particularly
vulnerable to negative externalities among firms
or tem porary disruptions to m arket dealers.
The lack of data on the risks and liquidity of
new products, and relatively thin trading, in­
creases the likelihood of systemic risk in new
m arkets.
In the following section, I consider w hether
the com m ercial paper m arket experienced such
a financial crisis in mid-19 70, and w h eth er that
crisis w arranted discount window intervention.
The com m ercial paper m arket o f m id-1970 is an
especially interesting case to exam ine for six
reasons. First, most com m ercial paper m atured
quickly—with an average m aturity of under 30
days (Stigum, 1983, p. 632). This meant that a
sudden disinclination by investors to hold com ­
m ercial paper would entail substantial problems
for firm s trying to roll over their com m ercial
paper debt.
Second, com m ercial paper was a new and
growing method of finance during the 1960s.11
Institutional arrangem ents for rating and sup­
porting com m ercial paper issues w ere virtually
nonexistent; thus, inform ation im perfections
w ere potentially im portant.
Third, com m ercial paper finance originated as
a substitute for bank credit. Many firm s that
had moved to this m arket in the 1960s may
have curtailed or term inated their relationships
with com m ercial banks (making the disruption
in the supply of paper m ore costly).
Fourth, during the early years of rapid grow th
in this m arket, there was a m ajor shock to the
com m ercial paper m arket, namely the failure of

Penn Central in 1970, which w as associated
with substantial contraction of outstanding
paper (that is, a "ru n ”).
Fifth, com m ercial paper issuers include many
of the econom y’s largest firm s, and other firm s
often depend upon them for credit (Calomiris,
Himmelberg and W achtel, forthcoming). In­
creases in the cost of funds for this class of
b orrow ers thus may have significant secondorder effects on the cost of credit fo r other
firms.
Finally, the Fed intervened during this crisis
largely by encouraging banks to com e to the
discount window to finance the payoff of com ­
m ercial paper. Evidence from the Penn Central
com m ercial paper crisis of 1970 allows a
detailed case study of “inform ation externali­
ties,” the potential for a run in m arkets for
traded short-term debt, and an evaluation of
Fed intervention in response to such a crisis.

Penn Central's Failure and the
Liquidity Crisis o f Mid-1970
The facts surrounding the com m ercial paper
run following the Penn Central failure are com ­
monly known (see Schadrack and Breim yer,
1970; Maisel, 1973; Tim len, 1977; Brim m er,
1989; and Mishkin, 1991a), but some important
details are w orth reviewing. Along with many
other firm s, Penn Central's financial condition
deteriorated during the recession of 1 9 6 9 -7 0 .
Penn Central was a m ajor issuer of com m ercial
paper, w ith m ore than $84 million outstanding,
m uch of w hich cam e due in June, July and
August of 1970. As Penn Central’s cash flow
declined, its debt holders and their agents ap­
pealed to the federal governm ent for financial
assistance, w hich the Nixon Administration sup­
ported.
The Administration proposed a $200 million
loan guarantee to a syndicate of some 70 banks,
w hich w ere to provide a two-year loan in that
amount. The loan guarantee would be autho­
rized through a loose interpretation of the

"T h e re had been an earlier incarnation of the commercial
paper market that thrived from the 1870s and declined in
importance during the 1920s. Calomiris (1992a) argues that
this operated effectively as an interbank loan-sale market,
moving high-quality borrowers from high credit-cost areas
to low credit-cost areas. Consistent with that argument,
James (1994) views the demise of this market as the result
of the bank merger wave of the 1920s, which provided an
alternative means to channel credit through the financial
system.




MAY/JUNE 1994

38

Defense Production Act. Although th ere was in­
creasing congressional opposition to this plan,
as late as Friday, Ju n e 19, the Wall Street J o u r ­
nal reported that "the opposition doesn't yet ap­
pear strong enough to halt the $200 million loan
guarantee.” That article also reported the possi­
ble existence of a secret m em orandum from
the Federal Reserve Bank o f New York, recom ­
mending "that the loan be granted, based on an
investigation that bank is believed to have con ­
ducted into the credit-w orthiness of Penn Cen­
tral.” Contrary to the Wall Street Jo u rn a l report,
no such m em orandum existed, and that same
Friday the Penn Central plan was rejected by
Congress. T he Nixon Administration then asked
the Federal Reserve Board (through the New
York Fed) to make a loan to Penn Central to
help it m eet immediate obligations. T he New
York Fed recom m ended against the loan, and it
was denied. This news forced Penn Central’s
bankruptcy on Sunday, Ju n e 21.
The surprising news of the unwillingness of
Congress and the Fed to prop up Penn Central
created widespread concern over the weekend
that the Penn Central failure would have rep er­
cussions elsew here in the econom y, particularly
for other firm s that had large outstanding com ­
mercial paper issues. It is not easy to explain
this con cern w ithout invoking an "inform ation
externality” of some form . That is, one needs to
explain why the bad news about Penn Central
would raise doubts about oth er firms.
The bad new s about Penn Central on Ju n e 19
had two parts. First, prior to that date, the Wall
Street Jo u rn a l reported that the New York Fed
had made a favorable audit of Penn C entral’s
underlying financial strength. A fter Friday,
quite the opposite was known. The reaction of
the m arket, as reported in the press, was that if
Penn Central's financial state could so rapidly
and unexpectedly have turned sour in the previ­
ous year, w hat other "blue chip” com m ercial
paper issuers might be in the same position?
This con cern was fueled by the fact that the
incom e reductions during the recession of
1 9 6 9 -7 0 , which potentially affected many firms,
w ere not know n at the firm level with any p re­
cision at the time. Those concerns about other
firm s began to be voiced even b efore the revela­
tion of the New York Fed’s audit. For example,
a lead article in the Jo u rn a l on June 12 queried:
“How many other U.S. corporations are so short
12See Schadrack and Breimyer (1970, p. 283).


FEDERAL RESERVE BANK OF ST. LOUIS


of cash that they may soon find themselves
similarly unable to pay their bills?” Until the
m arketplace could assess the extent to which
Penn Central’s financial position was the result
of idiosyncratic shocks and mismanagement, as
opposed to a signal of a com m on problem likely
to be faced by many firm s, Penn C entral’s
failure would cast doubt on the financial posi­
tion of other firm s.
The second elem ent of general bad news
revolved around the fate of Penn Central and
its creditors. It becam e clear that, w hatever its
underlying condition, the governm ent would not
guarantee Penn Central’s debt and that, th ere­
fore, Penn Central’s creditors faced the possibili­
ty of substantial losses. The incidence of losses
on the firm 's com m ercial paper was unknow n,
but it was rum ored that ow nership was quite
concentrated. For example, on June 15 the J o u r ­
nal reported that Morgan Guaranty owned or
acted as “agent” for nearly $84 million in Penn
Central’s com m ercial paper. According to Federal
Reserve data on holdings of com m ercial
paper, in early 1970 nonfinancial corporations
owned about 74 percent of outstanding paper.12
The Ju n e 12 Jo u rn a l article cited above also
asked: "If even one m ajor corporation should
becom e insolvent, would its failure bring down
other cash-short com panies because the failing
company couldn’t pay its bills? Could that, in
turn, intensify the present severe strain on the
cash resources of banks and corporations into a
liquidity crisis, draining the flow of money and
credit and plunging the nation into a depres­
sion?” W hile this “domino” scenario o f economywide depression may seem a bit farfetched, it
would have been less farfetch ed to imagine that
one or two m ajor com m ercial paper issuers
(who may have been creditors of Penn Central)
might also find it hard to repay their debts.
Thus, lack of inform ation about the effects of
the recession on oth er firm s (which Penn Cen­
tral’s failure indicated might be large), and about
the identities of Penn Central’s creditors and
their creditors in turn, could have produced
legitimate, rational con cern about rolling over
the com m ercial paper of oth er firm s at p re­
existing term s. The com m ercial paper m arket
was especially vulnerable to these sorts of doubts
because it was a fast-growing new financial m ar­
ket, as shown in Figure 1. From 1956 to 1966,

39

Figure 1
Commercial Paper Outstanding
Billions of dollars

Source: Schadrack and Breimyer (1970), Chart I.

the am ount of nonbank com m ercial paper is­
sued rose at a 16 percent compounded annual
rate. From 1966 to 1970, it rose 29 percent per
year. The num ber of com panies issuing paper
rose from 335 in 1965 to 575 in April 1970. In
the later period, grow th was especially con cen ­
trated in dealer-placed paper (which includes all
nonfinancial com m ercial paper), which grew
from 1966 to 1970 at an annual rate of 57 per­
cent. Rising interest rates and regulatory restric­
tions on banks (especially Regulation Q ceilings)
are widely cited as the cause of this boom in
the com m ercial paper market.
The m arket pricing and rating of paper issues
on a large scale was in its infancy (Stigum,
1983, p. 635; Standard and Poor's, 1979, p. 1),

and the recession of 1 9 6 9 -7 0 was the first
dow nturn to test the burgeoning com m ercial
paper m arket. Fu rtherm ore, com m ercial bank
lending or standby com m itm ents for com m ercial
paper issues did not exist at this time; thus,
com m ercial paper holders faced g reater risk
than they do today.13 It would not be farfetched
to argue that learning was occurring “in real
tim e” and that the first time a recession oc­
curred, and a com m ercial paper issuer failed,
the m arket might have found it difficult to as­
sess the ram ifications for others with any great
confidence. Indeed, it may have been necessary
for the m arket to reevaluate its methods for
pricing paper generally in light of this surpris­
ing event. Professor Roger M urray o f Columbia
University argued that com m ercial paper mar-

13The nature of these arrangements for supporting commer­
cial paper issues is discussed below, as well as in
Calomiris (1989b).




MAY/JUNE 1994

40

ket pricing had been too optimistic in the 1960s.
His (post-crisis) study of Penn Central’s financial
position in the 1960s concluded that there was
m uch to be learned from the Penn Central col­
lapse about the need for g reater caution in valu­
ing com m ercial paper: "A carefu l financial
analyst might well have recom m ended...against
the purchase of Penn Central com m ercial paper
a year or m ore b efore the events of May and
Ju n e 1970.”14 M urray accounted for the poor
ex ante evaluation of risk by the fact that so
"m any new faces appeared in that m arket for
large sums at the time and Penn Central was
hardly noticed as an unusual case.”
Schadrack and Breim yer (1970) provide a simi­
lar perspective. They claim that before the Penn
Central failure, "the confusion of corporate size
with liquidity tended to mask some deteriora­
tion during [the late 1960s] of the quality of
com m ercial paper outstanding...the fact that a
num ber of firm s in the m arket by 1970 had
very high debt-to-equity ratios and/or income
flows of dubious quality (some conglom erate,
franchising and equipm ent leasing companies,
fo r example) suggests such a deterioration in
the quality of outstanding paper.”15 They also
argue that, in addition to the con cern about
other com m ercial paper b orrow ers brought on
by the failure of Penn Central, the bank’s failure
raised con cern about some of the m ajor b ro k er­
age houses, w hich acted as dealers and pur­
chasers in the m arket. Commercial paper dealers
maintain open positions in the paper they sell
eith er as part of an underw riting arrangem ent,
or through a com m itm ent to m aintain a secon­
dary m arket in the paper (Stigum, 1983, p. 640).
The th reat of a liquidity crisis for firm s and
their dealers led to a collapse of demand for the
debt instrum ents o f others. These fears fueled
the flight to cash. Schadrack and Breim yer
(1970) also argue that the crisis led to refined
methods of pricing com m ercial paper, which is
consistent w ith M urray’s view that th ere was
room for im provem ent. In particular, after the
Penn Central crisis they found a w ider disper­
sion of rates for dealer-placed paper, w hich

14See Murray (1971). Whitford (1993) applied Altman’s (1968)
“ z-score” model to Penn Central’s accounts as of Decem­
ber 1969, and found a remarkably low z-score of 0.135. Alt­
man had found that no healthy firms had z-scores of below
1.81 and no bankrupt firms had a score above 2.99.
15See Schadrack and Breimyer (1970, p. 289).

Digitized for FEDERAL RESERVE BANK OF ST. LOUIS
FRASER


they interpreted as the result o f “greater inves­
tor selectivity.” Also, they noted a persistent
shift tow ard bank CDs and Treasury bills.
As Mishkin (1991a) and Schadrack and Brei­
m yer (1970) point out, the spread betw een com ­
m ercial paper and Treasury bills widened during
and after the crisis. This widening seems to
reflect a persistent revision in the evaluation of
com m ercial paper risk. Schadrack and Breim yer
(1970) report that in November 1970 the dealer
paper rate averaged 103 basis points above the
Treasury bill rate, com pared to previous spreads
of roughly half that amount. A similar pattern is
visible in Table 1, w hich reports the federal
funds rate, three-m onth T reasury bill yields, the
discount rate, and the four-to-six-month prime
com m ercial paper rate before, during and after
the crisis.
The "flight to quality,” visible in the declining
yields of T reasury bills and rising short-term
spreads, is also visible in long-term yields and
spreads, shown in Table 2. From Ju n e 20 to
Ju n e 27, Treasury bond yields fell as corporate
bond yields rose. The spread betw een the
Treasury bonds and the Aaa corporates reached
a peak on July 11. Interestingly, the spread b e­
tw een Aaa- and Baa-rated bonds was essentially
constant during the crisis, but rose afterw ards.
This is consistent with the view that during the
crisis, increased riskiness was attributed to all
securities, but that, after the crisis, investors
w ere b etter able to sort firm s into risk categories.
Concerns about the financial condition of
com m ercial paper issuers and dealers proved
unw arranted ex post (since no other com m er­
cial paper issuers defaulted), but seem to have
been im portant ex ante, as evidenced by move­
ments in the stock m arket and com m ercial
paper m arket. Firms, especially those with large
outstanding debt, saw large stock price declines
in the first three days of the crisis. During that
time, the Dow Jones Industrial Average lost 28
points (a fall of roughly 4 percent). Chrysler,
General M otors and IBM all saw large losses as
rum ors circulated that they faced risks of being
unable to m eet their debts (W all Street Jou rn al,

41

Table 1
Selected Yields and Interest Rates
Date
1970
January
February
March
April
May
June 1
2
3
4
July 1
2
3
4
August
September
October
November
December

3-month Treasury
bill yield

Federal funds rate

7.89%
6.88
6.16
6.59
7.00
6.82
6.76
6.71
6.51
6.46
6.62
6.46
6.34
6.25
5.80
5.84
4.99
4.83

9.04%
8.41
7.45
8.43
7.64
7.84
7.98
7.80
7.21
7.23
7.34
7.59
7.16
6.34
6.05
6.11
5.16
4.82

Discount
rate

6.00%
6.00
6.00
6.00
6.00
6.00
6.00
6.00
6.00
6.00
6.00
6.00
6.00
6.00
6.00
6.00
5.85
5.52

4-6 month prime
commercial paper

8.55%
8.50
8.03
8.00
8.13
8.13
8.15
8.25
8.25
8.38
8.35
8.25
8.35
7.70
7.20
6.63
5.75
5.75

NOTES: Data are all end-of-month, except for June and July, which are reported end-of-week. Trea­
sury bill and commercial paper yields are quoted on June 6, 13, 20 and 27 and July 4, 11,
18 and 25. Federal funds rates are for June 3, 10, 17 and 24, and July 1, 8, 15 and 22.
SOURCES: Board of Governors of the Federal Reserve System (1976), Table 12.5B, Table 12.6B,
and Table 12.7B; Federal Reserve Bank of St. Louis.

Ju n e 23-25, 1970, "A breast of the M arket”). Busi­
n ess W eek quoted one stock m arket analyst as
saying that "investors think that any company...
w ith...debt is going bankrupt” (June 27, p. 42).
Perhaps the best indicator of the extent of
these fears is the contraction in the volume of
com m ercial paper outstanding from late Ju n e to
mid-July. Total outstanding nonbank com m ercial
paper fell from $32 billion on Ju n e 24 to $29
billion on July 15, with $2.3 billion of that decline
in the first week of the crisis (see Figure 2).
Interestingly, com m ercial paper rates showed
little change during the crisis, although the
spread betw een paper rates and other money
m arket rates did widen. T he reason for this was
the speedy reaction o f the Federal Reserve to
the failure of Penn Central. Luckily, it occurred
over a weekend, which gave the Fed time to
prepare for the opening of financial m arkets on
Monday. The Fed pursued four courses of
action.

The Fed's Discount W indow Policy
During the Crisis
First, the Fed contacted m em ber banks and
notified them that “as they made loans to enable
their custom ers to pay off m aturing com m ercial
paper and thus needed m ore reserves, the Fed­
eral Reserve discount window would be availa­
b le."16 The meaning of "available” is of paramount
im portance. The Federal Reserve let m em ber
banks know that if they borrow ed at the dis­
count window for purposes of making loans to
com m ercial paper issuers, they would be able to
do so w ithout incurring any costs other than
the discount rate. The Fed was inform ed by
banks when their discount borrow ing resulted
from financing com m ercial paper rollovers, and
the total amount o f such discount borrow ing to­
taled some $500 million in the weeks im mediate­
ly following Penn Central (Melton, 1985, p. 158).
Beyond the amount lent through the discount
window, access to the window for com m ercial

16See Treiber (1970, p. 16).




MAY/JUNE 1994

42

Table 2
Long-Term Yields and Spreads

Date1

Long-term
government
bonds2

1970
January
February
March
April
May
June 6
13
20
27
July 4
11
18
25
August
September
October
November
December

Aaa corporate
bonds3

6.84%
6.25
6.33
6.70
7.21
7.00
7.09
7.05
6.89
6.73
6.56
6.61
6.54
6.73
6.52
6.65
5.97
6.05

7.91%
7.83
7.92
7.83
8.21
8.30
8.42
8.55
8.60
8.60
8.55
8.49
8.40
8.13
8.06
8.07
8.02
7.51

Baa corporate
bonds3

Spread between
Aaa and government
bonds

Spread between
Baa and Aaa
corporate bonds

1.07
1.58
1.59
1.13
1.00
1.30
1.33
1.50
1.71
1.87
1.99
1.88
1.86
1.40
1.54
1.42
2.05
1.46

0.90
0.90
0.74
0.91
0.89
0.83
0.76
0.71
0.76
0.81
0.89
0.90
0.98
1.34
1.26
1.27
1.35
1.51

8.81%
8.73
8.66
8.74
9.10
9.13
9.18
9.26
9.36
9.41
9.44
9.39
9.38
9.47
9.32
9.34
9.37
9.02

1All data are end-of-month, unless otherwise indicated.
2Maturity varies.
3Rated by Moody’s.
SOURCE: Board of Governors of the Federal Reserve System (1976), Table 12.12B.

paper rollovers gave
assurance to the financial markets that the liquidity
essential to their operation would be preserved. If
panicky investors refused to renew their holdings
of commercial paper, preferring Treasury bills,
bank deposits— anything!—instead, their extreme
preference for safety would not be allowed to
contribute to widespread insolvency. Once every­
one understood that, there was little reason for
panic (Melton, 1985, p. 158).

Fed encouragem ent to use the discount w in­
dow to finance the payoff of com m ercial paper
was associated with reduced costs of borrow ing
from the Fed, even though the discount rate re ­
mained unchanged. Normally, the costs of b o r­
rowing from the discount window include the
discount rate and a nonpecuniary “hassle” cost.
That is, the Fed does not want to encourage
abuse of the privilege of borrow ing from the
discount window and banks that may be seen
as abusing the privilege run the risk of exam i­
nation and regulatory sanctions. This penalty
explains the positive d ifference betw een the fed

Digitized for FEDERAL RESERVE BANK OF ST. LOUIS
FRASER


funds rate and the discount rate. If th ere w ere
no penalty, banks would be indifferent betw een
borrow ing from oth er banks and the Fed’s dis­
count window. In this case, the two rates would
be identical. In the presence of a nonpecuniary
cost of borrow ing from the Fed, as long as b o r­
rowings are positive, the fed funds rate will be
higher than the discount rate since, on the m ar­
gin, banks will be indifferent betw een paying
the fed funds rate in the interbank m arket and
borrow ing from the Fed (which entails a dis­
count rate cost and a hassle cost).
Figure 3 provides a simple illustration of the
simultaneous determ ination of the federal funds
rate and borrow ed reserves, w hich is helpful in
analyzing the effect of discount window lending
during the Penn Central crisis. Reserve demand
is shown as a negative function of the federal
funds rate. The position of the demand sched­
ule varies with loan demand, reserve requ ire­
ments, and the demand for excess reserves. The
Fed determ ines the am ount of nonborrow ed

43

Figure 2
Commercial Paper and Business Loans
June-August 1970
Billions of dollars

Billions of dollars

June
July
* Including business loans sold to affiliates.
Source: Schadrack and Breimyer (1970), Chart V.

reserves through its open m arket operations.
Borrow ed reserve costs are given by an upward
sloping schedule, w hich sums a constant pecuni­
ary cost (the discount rate) with an increasing
nonpecuniary hassle cost. The m ore reserves
that are borrow ed, the more the Fed is liable to
penalize borrow ing. Figure 3 illustrates equilibri­
um in the reserve m arket for Ju n e 17 and July
15, 1970, using actual data on the discount rate
(which rem ained at 6 percent throughout the
crisis), nonborrow ed reserves, borrow ed reserves
and the federal funds rate. Assuming equilibri­
um in the reserve m arket, we can identify shifts
betw een these two days in reserve demand (as
bank loans rose to com pensate for the con trac­
tion in com m ercial paper) and in reserve sup­
ply. The reserve supply function shifted in
slightly (nonborrow ed reserves fell due to in­
creased cu rren cy demand, w hich was only
partly offset by open m arket operations) and
rotated dow nward as the Fed reduced its non­
pecuniary penalty fo r borrow ing.



August

The downward rotation of the borrow ed
reserve supply function illustrates how the Fed­
eral Reserve lowered the nonpecuniary cost of
borrow ing from the discount window during
the crisis. O ther evidence on the composition of
bank lending, bank borrow ings from the Fed,
and the different rates charged to different
types of bank custom ers suggests that the
reductions in nonpecuniary costs w ere linked
(as the quotation above suggests it was) to in­
direct subsidies for com m ercial paper rollovers.
That is, it seems that loans to m em ber banks
for this purpose w ere granted a special "subsi­
dy” by the Fed (in the form of lower, or possi­
bly zero, nonpecuniary costs).
Consistent with this account, the composition
of m em ber bank borrow ings changed during
the crisis. As of Ju n e 24, large com m ercial
banks (primarily m oney-center banks) accounted
for only 75 percent of borrow ing from the Fed.
The trebling of m em ber bank borrow ing from

MAY/JUNE 1994

44

Figure 3
Shifts in the Reserve Market
June 17-July 15

* Discount rate

Ju n e 24 to July 15 was due to an increase in
m oney-center borrow ing, as one would expect if
it was earm arked for com m ercial paper payoff.
As shown in Table 3, total borrow ed reserves
rose by $1,196 billion, while borrow ed reserves
of large com m ercial banks rose $1,224 billion.
These same banks w ere the only ones that saw
a large grow th in loans to businesses and
finance com panies during the crisis. Loans in­
creased by $2.3 billion from Ju n e 24 to July 15,
almost an exact offset of the amount by which
com m ercial paper was reduced during this peri­
od. This rise of 2.6 percent in total loans for
this group of banks was highly unusual. The
average rate of increase for the preceding four
years during this period of the y ear had been
0.03 percent, and the highest rate of grow th in
the preceding four years had been 0.25 percent
in 1968.
Finally, there is w eak evidence that large b o r­
row ers from m oney-center banks as of August
1970 (which would have included form er com ­
m ercial paper issuers) received loans on rela­

FEDERAL RESERVE BANK OF ST. LOUIS


tively favorable term s. Available data on average
loan interest rates fo r the first two weeks of
May and August 1970 by size of borrow er and
region show that large, short-term b orrow ers in
N ortheastern financial cen ters experienced the
smallest increase in lending rates over this peri­
od (although differences are small). As Table 4
shows, the largest classes of borrow ers in New
York City actually saw slight reductions in aver­
age loan interest rates.

Other Fed Reactions to the Crisis
The discount window announcem ent ta r­
geting assistance to com m ercial paper issuers
was only the first of the Fed's fou r policy
responses to the crisis. On Tuesday, Ju n e 23,
the Fed suspended regulation Q ceilings on
large-denomination bank CDs. This allowed
a flood of m oney into the com m ercial banks,
so that maturing com m ercial paper could be
directly recycled through CDs, which financed
bank loans to form er issuers. As shown in
Table 3, from June 24 to July 15, large negotia­

45

Table 3
Banking System Changes During the Penn Central Crisis

Date1

Federal funds
rate minus
discount rate

1970
January
February
March
April
May
June 3
10
17
24
July
1
8
15
22
August
September
October
November
December

3.04
2.41
1.45
2.43
1.64
1.84
1.98
1.80
1.21
1.23
1.34
1.59
1.16
0.34
0.05
0.11
-0 .6 9
-0 .7 0

Loans to
business
Large negotiable
Borrowed reserves
and finance
companies
CDs at large
Total
of large
commercial
by large
commercial
borrowed
banks
commercial banks
banks2
reserves

$1,071
873
1,594
926
979
1,335
834
459
840
923
1,598
2,036
1,216
1,044
852
418
1,144
252

$ 807
522
1,334
680
675
1,063
624
273
613
671
1,402
1,837
1,044
941
788
341
1,098
224

$83,423
83,549
83,903
84,122
83,265
83,545
83,811
85,785
85,331
87,212
87,161
87,590
87,472
86,067
88,426
86,514
86,385
89,130

U.S. government
securities held
by Federal
Reserve Banks

$10,444
10,839
11,795
13,022
12,984
12,964
12,956
12,741
12,949
14,118
15,199
15,980
16,911
20,157
22,227
23,546
25,201
26,075

$55,568
55,749
55,621
56,085
57,115
57,698
57,552
57,823
57,005
57,714
57,671
58,839
58,138
59,618
60,055
59,283
61,209
60,632

1 data are end-of-month, unless otherwise shown. Dollar amounts are in millions.
All
2These are the sum of commercial and industrial loans by large commercial banks, and loans to personal and sales
finance companies, etc.
SOURCES: Table 1 and Board of Governors of the Federal Reserve System (1976), Table 4.1B, Table 10.1D.

ble CDs at large com m ercial banks increased
from $13 billion to $16 billion, and the growth
continued, with CDs of large banks in excess of
$26 billion by the year's end .17
The third policy intervention by the Fed was
open m arket operations. From Ju n e 17 to July
15, total U.S. governm ent securities held by the
Fed increased from $57.8 billion to $58.8 billion.
As noted above, how ever, open m arket opera­
tions w ere not sufficient to m aintain the stock
of nonborrow ed reserves, given the increased
demand for cu rren cy by the public. Thus, b o r­
rowed reserves w ere relied upon as the primary
vehicle fo r expanding reserves during the crisis.

loans, directly or indirectly, to "w orthy” b o r­
row ers who w ere otherw ise unable to secure
credit. The Fed never made such loans because
its other policies proved sufficient to contain
the run on com m ercial paper, but it is clear
that the Fed was willing to provide direct lend­
ing if banks had been unwilling to m ake ap­
propriate loans for com m ercial paper rollovers.
In his statem ent to Congress on July 23, the
Chairman of the Board of Governors, Arthur
Burns, made this com m itm ent clear. He viewed
the discount window as the key to preventing a
liquidity crisis, and saw direct lending by the
Fed to firm s in need, if necessary, as an ap­
propriate fail-safe m easure:

The Fed was also prepared to use “standby
procedures” so that, if necessary, it could make

Credit demands on the banking system at large
can be accommodated by open market operations,

17An unintended cost of Regulation Q was that it removed an
“ automatic stabilizer” from the financial system by making
it less attractive for investors to hold bank debt at times of
crisis in other markets.




MAY/JUNE 1994

46

Table 4
Average Loan Rates on
Short-Term Loans_________________
New York City
Loan amount
All sizes
1,000- 9,000
10,000- 99,000
100,000-499,000
500,000-999,000
1 million and over

$

May

August

8.24%
9.05
8.91
8.53
8.31
8.13

8.24%
9.07
8.95
8.59
8.23
8.12

Other Northeastern
financial centers
May
8.86%
9.23
9.34
9.01
8.72
8.45

August
8.89%
9.41
9.42
9.01
8.68
8.49

SOURCE: Board of Governors of the Federal Reserve
System (1976), Table 12.9A.

while the needs of individual banks can be met
through the discount window...We have found,
also, that minor adaptations of conventional mone­
tary tools can provide solutions to special financial
problems...it was made clear that the discount
window would be made available to assist banks
in meeting the needs of businesses unable to roll
over maturing commercial paper, and member
bank borrowings for this purpose subsequently
have risen...These conventional tools are but­
tressed with standby procedures to permit the
Federal Reserve to make funds available to credit­
worthy borrow ers facing unusual liquidity needs
through 'conduit loans’—that is, loans to a mem­
b er bank to provide funds needed for lending to
a qualified borrower...Furtherm ore, the Federal
Reserve could—under unusual and exigent cir­
cumstances—utilize the limited power granted by
the Federal Reserve Act to make direct loans to
business firms on the security of Government obli­
gations or other eligible paper, provided the bor­
row er is creditworthy but unable to secure credit
from other sources.18

Here, Burns explicitly allows for Fed loans
backed by com m ercial paper or other eligible
collateral.
In dealing with the Penn Central crisis, the
Fed did not simply focus on controlling the
money supply or an interest rate, which it
could have done easily through open m arket
operations. Rather the Fed coaxed deposits into
banks by relaxing Regulation Q ceilings, and
18See Burns (1970, pp. 624-5).


FEDERAL RESERVE BANK OF ST. LOUIS


used the discount window to encourage banks
to make loans to custom ers experiencing distress
—especially com m ercial paper issuers. T he logic
of the Fed’s com bined approach was that m one­
tary aggregates, bank credit and assistance to
the com m ercial paper m arket could b e targeted
independently by using th ree instrum ents.
Relaxation of Regulation Q, rath er than expan­
sionary open m arket operations, allowed bank
credit grow th w ithout (narrow) m oney grow th.
The discount window was directed tow ard the
special difficulties in the com m ercial paper m ar­
ket. The Fed left open the possibility of lending
directly to firm s in need if they w ere turned
down by bankers.

Evaluating Discount W indow Policy
During the Crisis
It is not self-evident that the Fed’s policy
response was correct. Schw artz (1992) has a r­
gued that the Penn Central crisis was not a
"real” financial crisis and that discount lending
served no useful purpose. Of course, the ab­
sence of a financial collapse in m id-1970 may
have been attributable to Fed intervention itself,
a possibility Schw artz does not take into ac­
count. But even if Schw artz is too quick to
dismiss the potential seriousness of the Penn
Central crisis—particularly given the evidence
on yield-spread m ovements and contraction of
the volume of com m ercial paper—that does not
prove that the discount window was a n eces­
sary instrum ent for dealing with the crisis. If
the failure of Penn Central increased doubts
about the solvency of all firm s in the economy,
then a tem porary expansion of open m arket
operations or a Regulation Q relaxation—to in­
crease the supply of credit available to all b o r­
row ers through relatively inform ed financial
interm ediaries—would have been a desirable
response to an economy-wide need for liquidity,
and there would have been no need to use the
discount window.
On the other hand, if the crisis involved a
special reappraisal of the creditw orthiness of
com m ercial paper issuers and com m ercial paper
dealers in particular, and a reassessm ent of the
desirability of lending through the com m ercial
paper m arket, then increasing the supply of
loanable funds from banks may not have been
as effective as targeting tem porary assistance (a
short-run subsidy fo r bank loans to com m ercial

47

paper issuers) using the discount window as a
means to smooth issuers’ costs of rollover.19 In
this case, open m arket operations or Regulation
Q relaxation would have been a blunt instru­
m ent for dealing with a run on com m ercial
paper p e r se, while discount window subsidies
for the payoff of com m ercial paper would have
provided targeted assistance without a ffect­
ing m onetary aggregates or interest rates on
all traded assets. If some com bination of an
economy-wide reassessm ent of firm s and a com ­
m ercial paper run characterized the crisis, then
policy could have com bined an aggregate in­
crease in open m arket operations or Regulation
Q relaxation with targeted assistance to com ­
m ercial paper issuers.
Thus, to assess the desirability of the use of
the discount window during the crisis, one
must exam ine the incidence of the crisis across
firm s. Was it purely an economy-wide phenom e­
non or did it pose a special threat to com m er­
cial paper issuers?

An Event Study o f the Penn Central
Crisis
To investigate the extent to w hich the Penn
Central crisis posed a special threat to com m er­
cial paper issuers, I exam ine data on firm s’
abnorm al stock returns during the crisis. Did
firm s with outstanding com m ercial paper suffer
abnorm al negative retu rns relative to other
firm s during the onset of the crisis, and w ere
those negative retu rns reversed by Fed in ter­
vention? To answ er this question, I com bine
CRSP data on daily stock retu rns with Compustat data on annual incom e and balance sheet
variables for nonfinancial corporations to m ea­
19The moral hazard costs of government pass-throughs were
minimal, since the banks, not the government, bore the
default risk on the loans. This statement requires some
qualification. If the pool of borrowers faced large aggregate
default risk, then bank failures might have resulted from
the loans, in which case the government would have borne
some of the losses. Moreover, if some banks had been on
the brink of failure, they might have been willing to make
subsidized loans to the riskiest firms, thus concentrating
overall default risk and making the government’s indirect
default risk greater. The central assumptions underlying my
claim that the government’s share of the risk was small are
that banks were not on the verge of failure at the time, and
that the average quality of the commercial paper borrowers
pool was high. The relaxation of Regulation Q ceilings on
CDs was also helpful in limiting the government’s risk,
since it limited the amount of borrowing from the Fed. CDs
also provided a natural vehicle for financing fixed-term
commercial paper, and did so without affecting the money
supply.




sure cross-sectional differences in abnorm al
retu rns over various dates, and to link them to
firm financial characteristics m easured at the
beginning of 1970. I employ standard m easures
of abnorm al returns, using residuals from fore­
casts of m arket retu rns based on estim ates of
firm s’ betas (from a 100-day pre-sample period)
and the aggregate contem poraneous movements
in the m arket.
Specifically, consider a standard model of
firm s’ stock returns, which decomposes retu rns
into system atic and idiosyncratic factors:
(1)

RIt = a + b I R, + e I,,'
t
t

w here R m easures returns, z indexes firm s, t
denotes the date, and a and b are param eters to
be estimated. The erro r term e m easures ab n o r­
mal retu rn s—the firm -specific, idiosyncratic
daily retu rn at each date—or, in other words,
the part of the stock retu rn that is not forecastable using the simultaneous aggregate
return for the m arket and the firm s' estimated
correlations with the m arket (b ). Each firm ’s b
is estim ated using observations on daily stock
retu rns fo r 100 trading days prior to the event
(in this case, June 12).
Cumulative abnorm al retu rns over any “win­
dow” are the accum ulation of abnorm al retu rns
for each of the dates included in the window.
Cumulative retu rns generated from the above
forecasting equation are “standardized” such
that they can be interpreted to have been
drawn from a unit normal distribution.20 This
adjustm ent results in a cross-section of stan­
dardized cumulative abnorm al retu rns (SCARs)
for each firm in the sample over the event
w in d o w .
20For details, see Wall and Peterson (1990).

MAY/JUNE 1994

48

The event windows are defined as Ju n e 12Ju n e 22 and Ju n e 23-July 9. Early concerns
about com m ercial paper issuers reported in the
Wall Street Jo u rn a l date from Ju n e 12. Ju n e 22
is the date after w hich Fed intervention should
have improved the position of com m ercial paper
issuers. By the second w eek of July, the con­
traction in outstanding com m ercial paper began
to be reversed.
T he goal of the event study is to examine
w hether (likely) com m ercial paper issuers
suffered abnorm al negative stock retu rns dur­
ing the Penn Central crisis, and w hether Fed in­
tervention reversed those costs to com m ercial
paper issuers, after controlling for other m eas­
ures of cross-sectional d ifferences among firms.
To control for other influences that would not
have been specific to the com m ercial paper
m arket, I add a variety of balance sheet and in­
com e statem ent variables taken from the Jan u ­
ary financial reports of these nonfinancial firms.
All firm balance sheet and incom e data are
m easured as of the beginning of 1970.21 The
control variables included are: the ratio of debt
to assets; the ratio of short-term debt to assets;
the size of the firm (m arket value of capital);
the ratio of net incom e to m arket value of capi­
tal; the ratio of inventories to sales; and the
squares of each of these variables. These varia­
bles are included to control for the possibility
that the share prices of firm s w ith high ex­
posure to m acroeconom ic shocks (firms with
high leverage, or with large financing needs
relative to sales) may have responded m ore
strongly to econom ic news, irrespective of
w hether or not they w ere com m ercial paper
issuers. For example, if Penn Central’s failure
increased the cost of debt for all firms, then
leverage ratios or inventory-to-sales ratios would
identify cross-sectional d ifferences in SCARs.
Isolating the effect on SCARs of reliance on
the com m ercial paper m arket is not straightfor­
ward, since data on outstanding com m ercial
paper issues of firm s are not available fo r this
period. The regular reporting of com m ercial
paper ratings was largely a consequence of the
Penn Central crisis. Standard and Poor's began
publishing some com m ercial paper ratings in
The B on d O utlook in July 1970, but these rat­

21This was dictated by the superior data available on the
annual Compustat tape. Quarterly Compustat data for this
period are often incomplete.


FEDERAL RESERVE BANK OF ST. LOUIS


ings w ere for only a handful of issuers, most of
w hich w ere financial firm s. M oody’s Industrial
M anual and other similar publications, which
today provide some data on com m ercial paper
issues by firm s, did not provide such data in
1970. Outstanding com m ercial paper cannot be
inferred by looking at firm s’ reported balance
sheets. Commercial paper can appear in firm
balance sheets either as long-term or short-term
debt. Although it is usually included in short­
term debt, even in that case it cannot be sepa­
rated from oth er short-term debt (loans from
banks, finance companies, and so on). The
Board of Governors of the Federal Reserve Sys­
tem did not collect firm-level data on issuers,
only on aggregate am ounts of outstanding is­
sues, based on dealers’ reports. Despite searches
of various publications by the rating agencies, I
have been unable to uncover any com prehen­
sive listing of firms w hich issued com m ercial
paper in 1970.
Given the lack of data identifying issuers, I
use bond ratings to sort firm s according to
w hether they w ere likely to have issued com ­
m ercial paper in 1970. In the 1970s, com m ercial
paper issuance was usually restricted to the
firm s with the highest bond ratings (Standard
and Poor’s, 1979, p. 47). Having a AA or AAA
rating in 1970 is likely to be the best proxy for
the likelihood of being a com m ercial paper is­
suer. Eight of the 11 nonfinancial firm s whose
ratings w ere published in Standard and Poor’s
B on d O utlook in 1970 and 1971 w ere rated AA
or AAA (the rem ainder w ere A-rated). Also, data
from later years indicate a close relationship b e­
tw een high bond ratings and com m ercial paper
access. Standard and Poor's first com prehensive
listing of rated com m ercial paper issuers, The
C om m ercial P aper Ratings Guide, was published
in 1978. Of the 90 nonfinancial firm s that had
AA or AAA bond ratings in 1970, 64 w ere issu­
ing com m ercial paper in 1978. Of the 146 non­
financial firm s listed in Compustat with AA or
AAA bond ratings in 1978, 93 w ere com m ercial
paper issuers. In 1978, 94 of the 207 A-rated
nonfinancial firm s in Compustat w ere com m er­
cial paper issuers, and only 43 firm s with bond
ratings below A issued com m ercial paper (all of
these w ere firm s w ith BBB or BB ratings). Using
the AA rating as our cutoff, th erefore, seems

49

advisable. Based on available data, it seems
reasonable to assume that a m ajority of AA or
AAA nonfinancial firm s w ere com m ercial paper
issuers in 1970, and that a m uch sm aller p er­
centage of rem aining firm s w ere issuers.22 The
total num ber of nonfinancial firm s in our sam­
ple (that is, those without missing observations,
and covered by both CRSP and Compustat in
1970) is 1,482. Of these, 90 had bond ratings of
AA or AAA.
If com m ercial paper issuers experienced a
special problem during the crisis, and if Fed in­
tervention reversed the strain on issuers, the
coefficient on the high-rating indicator variable
should be negative during the onset of the crisis
and positive after Fed intervention. The use of
AA or AAA bond ratings as an indicator of a
com m ercial paper issuer provides a “conserva­
tive” m easure of the problem s in the com m er­
cial paper m arket, for three reasons. First,
m easurem ent erro r (the existence of some
A-rated com m ercial paper issuers, and of non­
issuers with AA or AAA ratings) biases the
coefficients on the high-rating indicator variable
toward zero. Second, the excluded A-rated com ­
m ercial paper issuers likely would have ex­
perienced the largest adverse effects of the
crisis, since their debt was riskier to begin with.
Third, the flight to quality during a financial
crisis should produce a relative im provem ent in
the value of high-rated firms, w hich would im­
ply positive effects on AA and AAA firm s, after
controlling for other firm characteristics, during
the onset of the crisis.
Table 5 reports regression results for SCARs
for two windows around the Penn Central
crisis—Ju n e 12 to Ju n e 22, and Ju n e 23 to July
9.23 It is im portant to emphasize th ree points
b efore reviewing Table 5. First, coefficients on
the control variables in this regression m ust be
interpreted cautiously. For example, while rela­
tively high leverage ratios may have created

22lt is less clear whether the data on A-rated firms in 1978 is
representative of A-rated firms in 1970. From 1970 to 1978,
market analysts argue that the growth in commercial paper
issuers brought more firms with lower ratings (A or BBB)
into the market; thus, it might not be appropriate to as­
sume that 1970 saw the same high proportion of A-rated
firms issuing paper as in 1978 (45 percent). For purposes
of constructing an indicator variable, given the uncertainty
about the number of issuers with A ratings in 1970, it is
best to exclude A-rated firms from the group of likely is­
suers because A-rated firms are a small fraction of total
firms with ratings below AA, but a large fraction of AA or
AAA firms.




problem s for firm s during the crisis, high debt
ratios may them selves have been associated
with firm attributes (like creditw orthiness) that
helped firm s w eather the crisis b etter (and led
to relatively higher stock values). Thus, it is not
possible to in fer "stru ctu ral” relationships from
these cross-sectional findings. The main point of
including the control variables is to separate the
effect of com m ercial paper issuance per se from
factors unrelated to com m ercial paper issuance.
Second, the abnorm al retu rns m easures are
purged of cross-sectional differences in firm s’
betas that might be correlated with the various
regressors. For example, higher debt ratios
might be associated with low er retu rns crosssectionally because leverage increases a firm's
beta. But, by construction, the abnorm al retu rns
used in Table 5 are uncorrelated with the firm ’s
beta. Third, squared term s w ere added fo r all
regressors, but they do not affect the direction
of the results. In no case does a squared term
m ore than offset the linear effect of the same
variable w hen both coefficients are evaluated at
the mean of the regressor (given in Table 6).
The direction of association betw een SCAR and
any regressor is that of the linear effect.
The results reported in Table 5 indicate that
the ratio o f debt to assets and the ratio of in­
com e to net w orth (both m easured at the begin­
ning of the year) may have been associated with
m ore negative retu rns cross-sectionally during
the onset of the crisis. Firm size per se had no
effect on retu rns in the presence of squared
term s for debt ratios. For the period after June
22, the total debt ratio and the profit ratio are
associated with a positive effect on returns,
indicating a reversal of the stock price move­
m ents during the period prior to Fed in ter­
vention. T he inventory-to-sales ratio and the
short-term debt-to-assets ratio are both nega­
tively associated with abnorm al retu rns after
Ju n e 22.

23The results reported below are not sensitive to whether
June 22—which arguably could have been included in the
second window— is included or excluded from either win­
dow. The results of the first period are driven by pre-June
22 returns, and the results of the second window are
driven by post-June 22 returns.

MAY/JUNE 1994

50

Table 5
Event Study Regression Results for
Standardized Abnormal Returns
(standard errors in parentheses)
6/12/70 - 6/22/70

6/23/70 - 7/9/70

(1)

(2)

(3)

(4)

Intercept

-0 .8 1
(1.19)

-0 .4 2
(1.20)

-1 .5 7
(1.30)

-2 .3 9
(1.31)

Debt/Assets

-0 .8 1
(0.55)

-0 .6 8
(0.55)

0.58
(0.60)

0.31
(0.60)

0.61
(0.74)

0.50
(0.74)

-0 .5 0
(0.81)

-0 .2 6
(0.81)

STD/Assets

-0 .7 1
(0.99)

-0 .8 0
(0.99)

-2 .1 4
(1.08)

-1 .9 6
(1.08)

(STD/A)-sq.

2.39
(2.30)

2.51
(2.30)

4.31
(2.52)

4.06
(2.50)

Size(MVE)

0.09
(0.21)

0.01
(0.21)

0.12
(0.23)

0.29
(0.23)

(MVE)-sq.

0.00
(0.01)

0.01
(0.01)

0.00
(0.01)

-0 .0 1
(0.01)

-0 .8 6
(0.33)

-0.82
(0.33)

1.67
(0.36)

1.60
(0.36)

(NI/MVE)-sq.

0.82
(0.43)

0.80
(0.43)

-0 .6 4
(0.47)

-0 .5 9
(0.47)

INV/SALES

-0 .3 9
(0.40)

-0 .5 1
(0.41)

- 1 .8 5
(0.44)

-1 .5 9
(0.44)

(INV/SALES)-sq

-0 .0 4
(0.41)

0.04
(0.41)

0.76
(0.45)

0.59
(0.45)

—

-0 .3 0
(0.15)

—

0.64
(016)

(D/A)-sq.

NI/MVE

AA or AAA

Adj. R-squared

0.040

0.042

0.080

0.089

A fter controlling for observed balance sheet
and incom e characteristics, firm s with AA or
AAA bond ratings experienced significant, nega­
tive, abnorm al retu rns during the onset of the
crisis and significant, positive retu rns after Fed
intervention. The addition of this indicator vari­
able increases the adjusted R-squared in both
regressions. The evidence provides support for
the notion that, in addition to the economy-wide
liquidity crisis during the Penn Central crisis,
com m ercial paper issuers faced a special prob­
lem. This, in turn, lends support to the argu­
ment that discount window subsidization of
lending may have been useful in targeting

FEDERAL RESERVE BANK OF ST. LOUIS


assistance to the com m ercial paper m arket.
Thus, the Fed may have been co rrect to divide
policy into tw o com ponents: Regulation Q relax­
ation to provide liquidity to all firm s through
banks, and discount window lending to target
subsidized assistance to com m ercial paper is­
suers to offset the special disorder in that m ar­
ket. That is not to say Fed policy achieved the
right mix. For example, negative retu rns for
firm s with high inventory-to-sales ratios or high
short-term debt after Ju n e 22 may indicate that
credit supply was too tight overall.

Changes in the Commercial Paper
Market After the Crisis
The com m ercial paper m arket changed as a
result of the Penn Central crisis. In addition to
increased diligence in evaluating credit risk, two
oth er changes have reduced the possibility of a
similar problem in the future. First, in August
of 1970, the Fed passed a regulation to restrict
the grow th of bank com m ercial paper. Bank
paper would be treated, for reserve req u ire­
ment purposes, the same way as demand or
time deposits, depending on the m aturity of the
paper. This eliminated the advantages of offbalance sheet financing through bank com m er­
cial paper and led to the contraction of bank
paper. This had little effect on banks or on the
grow th of the com m ercial paper m arket, which
has been robust (Post, 1992). It simply propelled
banks tow ard relying on negotiable CDs (virtual­
ly identical to com m ercial paper) as an alterna­
tive source of funds.
Of g reater im portance w ere institutional
changes in the way com m ercial paper is m ar­
keted. First, rating agencies made finer distinc­
tions in their ratings of com m ercial paper issues
(Stigum, 1983, p. 637). An im portant elem ent in
the rating becam e evidence of com m ercial bank
backup arrangem ents behind com m ercial paper
programs. Commercial bank support for com ­
m ercial paper program s was a private innova­
tion. After, and largely as a result of Penn
Central, com m ercial paper issuers increasingly
sought “hurricane insurance” in the form of
backup loan com m itm ents (Stigum, 1983, pp.
633-4; Standard and Poor’s, 1979, p. 47). Most of
these loan com m itm ents (roughly 85 percent in
1989) are not credit guarantees to com m ercial
paper holders, but rath er promises for as­
sistance during a general liquidity crisis if the
borrow er rem ains creditw orthy (Calomiris,
1989b). W ithin a few years of the Penn Central

51

Table 6
Means, Standard Deviations, and Correlations Among
Regressors_______________________________________
Mean

Standard
deviations

C orrelations (p-values in parentheses)
STD/A

MVE

NI/MVE

I/S
-0 .0 5
(0.05)

AA +
0.11
(0.000)

D/A

0.28

0.21

0.52
(0.000)

-0 .1 1
(0.000)

0.28
(0.000)

STD/A

0.07

0.09

—

-0 .2 8
(0.000)

0.06
(0.03)

0.26
(0.000)

-0 .0 8
(0.003)

MVE

11.2

1.6

—

—

-0 .0 3
(0.22)

-0 .1 3
(0.000)

0.32
(0.000)

NI/MVE

0.17

0.13

—

—

—

-0 .1 3
(0.000)

0.07
(0.004)

I/S

0.17

0.13

—

—

—

-0 .1 9
(0.000)

AA +

0.06

0.23

—

—

—

crisis, backup lines w ere almost always 100 p er­
cent of outstanding issues, except for large, toprated, highly liquid issuers like GMAC or large
com m ercial banks. These loan com m itm ents
w ere issued by banks for the same reason bank
assistance had been relied on during the Penn
Central crisis: Banks have access to the discount
window and believe that they can rely on the
Fed (which m aintains no official policy in this
regard) to tem porarily suspend norm al non­
pecuniary discount window penalties to grant
lending subsidies during an em ergency. Institu­
tionalizing Fed discount window protection
through explicit bank loan com m itm ents, one
could argue, reduces the tim e to process credit
rollover during a crisis. Furtherm ore, the exis­
tence of clear com m itm ents to lend during a
crisis may itself reduce the threat of a general
liquidity squeeze and, thus, m ake crises less
likely.
Currently, the use of backup lines of bank
credit, "backed” by access to the discount win­
dow, has virtually eliminated risk of another
Penn Central crisis in the com m ercial paper
m arket. But this does not imply an end to the
role played by the discount window. The pro­
tection offered through backup lines of credit
depends on banks’ potential access to funds
through the discount window.



—

EVALUATING O TH ER PO SSIBLE
FED INTERVENTIONS
Thus far, I have argued that both economywide policy (open m arket operations and Regu­
lation Q relaxation) and targeted discount lend­
ing may have been desirable interventions
during the Penn Central crisis. But the Fed was
willing to go beyond these interventions, if
necessary, as Chairman Burns’ com m ents cited
above indicate. W as the Fed right to have
provided fo r the possibility of direct lending to
firms, or should it have been willing to rely
only on the discount window and open m arket
operations? Was the Fed right to have allowed
Penn Central to fail in the first place?
The Fed’s decision not to prevent the failure
of Penn Central is easy to defend. The success
o f the capitalist system requires that firm s face
"hard ” budget constraints. As refo rm ers in
Eastern Europe and the Soviet Union have been
saying for years, protecting large corporations
from bankruptcy through assistance from the
state imposes large costs on m ore successful
growing enterprises. More fundamentally, allow­
ing corporations to fail is what encourages them
to succeed. It is w orth emphasizing that the
public policy rationale for insulating financial
m arkets from tem porary inform ation externali­

MAY/JUNE 1994

52

ties during panics does not in any way justify
bailing out discernably insolvent institutions.
W ith regard to the other question—w hether
direct Fed lending to corporations is ever justifi­
able—it is also hard to justify intervention. As
Mishkin (1991b) notes, it is b etter to d ecentral­
ize the decision over who receives how much,
and place it in the hands of relatively inform ed
bankers who have incentives to avoid making
bad loans. If banks had been unwilling to
finance the payoff of the com m ercial paper of
certain firm s, even on highly subsidized term s,
that would have indicated the likely insolvency
of those individual issuers.24 Discount window
protection should not be used to save individual
firm s w hich are viewed as insolvent by their
creditors. Of course, creditors are not always
right, but part of the rationale for corporate re ­
organization under bankruptcy law (increasingly
popular since the 1978 changes in the bankrupt­
cy code) is to minimize unnecessary costs of li­
quidating defaulting firm s who turn out to be
solvent. Given the availability of the reorganiza­
tion option, it may be best for the governm ent
to allow private m arkets to decide w h eth er in­
dividual corporate borrow ers are viable.

COULD A SIMILAR CRISIS
HAPPEN TODAY?
Although I have argued that the possibility of
another Penn Central crisis today in the com ­

24Of course, the Fed could have done even more to en­
courage banks to make pass-throughs than it did during
Penn Central by making its subsidy larger. The subsidy
that the government can grant is potentially very large. By
lowering the discount rate to zero and discriminating in
imposing nonpecuniary penalties across banks (for exam­
ple, charging a zero hassle cost to banks borrowing for tar­
geted pass-throughs and a prohibitive rate on other
borrowing), the subsidy can be increased to the level of
the equilibrium fed funds rate without affecting monetary
control.
25Gorton and Pennacchi (1992) argue that there is no evi­
dence for “ contagion” among commercial paper issuers or
finance companies. They examined the failures of several
issuers and finance companies and found that a failure did
not lead investors in securities markets to lower the price
of other issuers’ or finance companies’ securities, ceteris
paribus. It is premature, however, to interpret this as evi­
dence that issuers or finance companies are now immune
to panics, or more broadly, that financial technology has
improved so much that intermediaries are not potentially
vulnerable to panics. Gorton and Pennacchi’s sample of
events is small, and the events they examine may simply
have been transparently idiosyncratic (unlike, for example,
the Penn Central crisis). It is possible that events unlike
those in their sample could produce panics.

Digitized forFEDERAL RESERVE BANK OF ST. LOUIS
FRASER


mercial paper m arket is rem ote, in other new
and growing financial m arkets the potential for
a crisis similar to Penn Central may loom larg­
e r.25 For example, w ithin the banking system a
large overdraft default in the Clearing House In­
terbank Payments System (CHIPS) might lead to
a general run of uninsured liabilities o f CHIPS
m em bers, due to problem s of unraveling which
banks stood to lose from the default. Subsidized
lending to CHIPS m em bers might be w arranted
to prevent a panic.20 The Fed is cognizant of its
potential role in assisting banks in the event of a
systemic crisis in the payments system, and it
regulates the payments system accordingly. Like
many other central banks, the Fed limits over­
drafts of bank accounts with the central bank
and requires private bank clearing systems to
limit overdrafts among their m em bers. Such
limits include collateral requirem ents, quantity
limits on overdrafts, and pre-established losssharing arrangem ents. These regulations are
m eant to ensure that the potential protection af­
forded by the Fed is not abused.
It is also conceivable that discount window in­
tervention could be used to target assistance to
m arkets fo r financial derivatives. In the swap
m arket, for example, if a m ajor swap provider
becam e insolvent, its counterparties, and third
parties who have contracted with those coun­
terparties, could experience unpredictable
changes in their m arket risk exposures and,
consequently, in their default risks. Because of
the interrelatedness of the various positions and

260 f course, the discount window is not the only way to deal
with such a problem. Alternatively, deposit insurance could
be extended to the CHIPS clearinghouse as a whole. For
example, the government could offer insurance to CHIPS
with a large deductible, with the liability for the deductible
shared by all clearing members.

53

uncertainty as to w hich swap contracts will su r­
vive the crisis, it might be difficult for cou n ter­
parties to gauge their true exposure to m arket
risk. This could produce a flight to cash by all
parties. Fu rtherm ore, a reversal of m arket opin­
ion about the reliability of swaps as hedging
devices could suddenly affect the m arket’s per­
ception o f firm s with large swap positions. In
this case, tem porary disruptions to the supply
of credit to certain classes of firm s could con ­
ceivably result. These problem s could motivate
discount window subsidies as in the Penn Cen­
tral crisis.
T he lesson in this dismal scenario is not that
swaps are a bad idea. They offer real long-run
systemic risk reduction as a low-cost vehicle to
hedge interest rate risk. But reaping the advan­
tages of this and other financial innovations
requires a period of learning about how to
m easure and control the risks created by new
financial instrum ents. The existence of the dis­
count window provides a safety valve to protect
the financial system from growing pains like the
ones it suffered in 1970. Recent financial inno­
vations in derivatives and asset securitization
may have increased the need fo r the discount
window as an instrum ent of public policy. Its
role is not just to protect the banking system
from systemic runs on com m ercial banks (in­
deed, it may have little im portance here in the
presence of deposit insurance); rath er, its role is
to effect occasional, contingent and focused
credit subsidies to particular m arkets through
banks during mom ents of tem porary disruption,
like that of the Penn Central crisis.
Another example of a potential application of
the discount window is a run on a futures
clearing house. Individual clearing m em bers
stand betw een all contracting parties and the
clearing house provides mutual insurance among
all m em bers against default. To limit the risk of
default by clearing m em bers, clearing houses
impose reserve requirem ents in the form of
cash or Treasury bills on open positions and
frequently m onitor those positions. Still, it is
conceivable that a very large, sudden price drop
(say, in the stock market) might bankrupt a
clearing m em ber with a large open position and
conceivably threaten the clearing house. This
could cause a run on the futures m arket as
holders of contracts, w ary of the credibility of
the clearing house’s solvency, try to sell their
contracts. This could amplify the losses to the
clearing house and legitimize the initial con­



cerns that prompted the run, leading to fu rth er
cashing-in of positions. If the clearing house
w ere to fail, many hedges would disappear with
its demise, increasing the risk of many financial
claims and causing confusion about the inci­
dence of the increased risk in ways that might
provoke a general liquidity crisis.
The Fed could reduce the chance of a run on
a futures clearing house and the negative ex ter­
nalities attendant to such a run by agreeing
tem porarily to lend through the discount win­
dow without penalty to banks making loans to
clearing house m em bers, and could even lower
the discount rate if necessary to encourage such
subsidies. Indeed, this seems a reasonable
characterization of the Fed’s response to con ­
cern s about futures m arkets posed by the stock
m arket collapse of O ctober 1987.
T h ere is a m ore difficult policy question,
however, that so far has not been addressed.
If banks are unwilling to lend to a clearing
house—even on highly subsidized term s—should
the Fed let the clearing house fail? On one
hand, ad hoc direct lending by the Fed runs the
risk of encouraging lax self-regulation within
the clearing house. On the oth er hand, the
financial disruption from a clearing house
failure might generate substantial negative
externalities in the financial system. It might
be desirable for the Fed to decide w hether it
would stand behind the liabilities of failed fu­
tures clearing houses. If so, the Fed should con­
sider w h eth er existing private risk-management
devices (like margin rules) are adequate. If not,
it might recom m end changes to the Commodity
Futures Trading Commission, w hich regulates
these exchanges. As the volume of derivative
transactions expands, so does the need to de­
velop policies fo r dealing with possible systemic
risks related to these m arkets.
Identifying a potential benefit from a "backup”
discount window does not justify the cu rren t
form of the discount window. T h ere may be no
benefit from Fed lending to banks during n or­
mal times, and as Schw artz and others have ar­
gued, such lending may be costly. T h ere also
rem ains the risk that governm ent agencies will
abuse even a “reform ed ” discount window by
defining noncrises as crises to make loans to fa­
vored parties. The evidence presented in this
paper, th erefore, does not prove that the dis­
count window has been a net benefit as a poli­
cy tool, only that it has the potential to provide
benefits as well as costs.

MAY/JUNE 1994

54

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Calomiris, Charles W. “ Regulation, Industrial Structure, and
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Change in Banking. Business One Irwin, 1992a, pp. 19-116.
________ “ Getting the Incentives Right in the Current
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The Reform of Federal Deposit Insurance: Disciplining the
Government and Protecting Taxpayers. Harper Business,
1992b, pp. 13-35.
. “ Do ’Vulnerable’ Economies Need Deposit Insur­
ance?: Lessons from U.S. Agriculture in the 1920s,” in Phil­
lip L. Brock, ed., If Texas Were Chile: A Primer on Banking
Reform. ICS Press, 1992c, pp. 237-314.
________"Is Deposit Insurance Necessary? A Historical Per­
spective,” Journal of Economic History (June 1990), pp.
283-95.
________“ Deposit Insurance: Lessons from the Record,”
Federal Reserve Bank of Chicago Economic Perspectives
(May/June 1989a), pp. 10-30.
________ “The Motivations for Loan Commitments Backing

Commercial Paper,” Journal of Banking and Finance (May
1989b), pp. 271-7.
, and Gary Gorton. “ The Origins of Banking Panics:
Models, Facts, and Bank Regulation,” in R. Glenn Hub­
bard, ed., Financial Markets and Financial Crises. University
of Chicago Press, 1991, pp. 109-74.
_______ , Charles P. Himmelberg, and Paul Wachtel. “ Com­
mercial Paper and Corporate Finance: A Microeconomic
Perspective,” Carnegie-Rochester Series (forthcoming,
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_______ , and R. Glenn Hubbard. “ Price Flexibility, Credit
Availability, and Economic Fluctuations: Evidence from the
United States, 1894-1909,” Quarterly Journal of Economics
(August 1989), pp. 429-52.
_______ , and Charles M. Kahn. “ The Role of Demandable
Debt in Structuring Optimal Banking Arrangements,” The
American Economic Review (June 1991), pp. 497-513.

Cummins, Claudia. “ Fed Proposes Curbing Access to Ad­
vances by Troubled Banks,” The American Banker (August
12, 1993), p. 2.
Diamond, Douglas W., and Philip H. Dybvig. “ Bank Runs,
Deposit Insurance, and Liquidity,” Journal of Political Econ­
omy (June 1983), pp. 401-19.
Friedman, Milton, and Anna J. Schwartz. A Monetary History
of the United States: 1867-1960. Princeton University Press,
1963.
Goodfriend, Marvin, and Robert G. King. “ Financial Deregu­
lation, Monetary Policy, and Central Banking,” in William S.
Haraf, and Rose Marie Kushmeider, eds., Restructuring
Banking and Financial Services in America. American En­
terprise Institute, 1988, pp. 216-53.
Gorton, Gary. “ Self-Regulating Bank Coalitions,” University of
Pennsylvania Working Paper (March 1989).
________“ Clearing Houses and the Origin of Central Bank­
ing in the U.S.” Journal of Economic History (June 1985),
pp. 277-83.
_______ , and George Pennacchi. “ Money Market Funds and
Finance Companies: Are They the Banks of the Future?,”
in Michael Klausner, and Lawrence J. White, eds., Structur­
al Change in Banking. Business One Irwin, 1992,
pp. 173-214.
James, John A. “ The Rise and Fall of the Commercial Paper
Market, 1900-1930,” Paper presented at Anglo-American
Finance: Financial Markets and Institutions in 20th-Century
North America and the U.K., a conference held at New
York University, New York, N.Y., December 10, 1993.
Janssen, Richard F., and Charles N. Stabler. “ Empty Coffers:
Cash Shortage Causes Worry that Big Firms Could Col­
lapse,” Wall Street Journal, June 12, 1970, p. 1.
Kane, Edward J. “ How Incentive-Incompatible Deposit Insur­
ance Funds Fail,” Ohio State University Working Paper No.
88-35 (1988).
Kaufman, George G. “ Lender of Last Resort, Too Large to
Fail, and Deposit-lnsurance Reform,” in James R. Barth,
and R. Dan Brumbaugh, Jr., eds., The Reform of Federal
Deposit Insurance: Disciplining the Government and Protect­
ing the Taxpayer. Harper Business, 1992, pp. 246-58.
________“ Lender of Last Resort: A Contemporary Perspec­
tive,” Journal of Financial Services Research (October 1991),
pp. 95-110.
Maisel, Sherman J. Managing the Dollar. Norton & Co., 1973.
McLean, David. “Abreast of the Market,” Wall Street Journal,
June 25, 1970, p. 29.
________“Abreast of the Market,” Wall Street Journal,
June 24, 1970, p. 31.
_______ . “Abreast of the Market,” Wall Street Journal,
June 23, 1970, p. 33.
Melton, William C. Inside the Fed: Making Monetary Policy.
Dow Jones-lrwin, 1985.
Miron, Jeffrey A. “ Financial Panics, the Seasonality of the
Nominal Interest Rate, and the Founding of the Fed,” The
American Economic Review (March 1986), pp. 125-40.
Mishkin, Frederic S. “Asymmetric Information and Financial
Crises: A Historical Perspective,” in R. Glenn Hubbard,
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Chicago Press, 1991a, pp. 69-108.

_______ , a n d ________ “ The Efficiency of Cooperative Inter­
bank Relations: The Suffolk System,” University of Illinois
Working Paper (1990).

________“Anatomy of a Financial Crisis,” NBER Working
Paper No. 3934 (December 1991b).

_______ , and Larry Schweikart. “ The Panic of 1857: Origins,
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tory (December 1991), pp. 807-34.

Murray, Roger F. “ Lessons for Financial Analysis: The Penn
Central Debacle,” Journal of Commercial Bank Lending
(December 1971), pp. 42-9.


FEDERAL RESERVE BANK OF ST. LOUIS


55

Post, Mitchell A. “ The Evolution of the U.S. Commercial
Paper Market Since 1980,” Federal Reserve Bulletin
(December 1992), pp. 879-91.
Schadrack, Frederick C., and Frederick S. Breimyer. “ Recent
Developments in the Commercial Paper Market,” Federal
Reserve Bank of New York Monthly Review (December
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Schwartz, Anna J. “ The Misuse of the Fed’s Discount W in­
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Standard and Poor’s. Standard and Poor’s Ratings Guide.
McGraw-Hill, 1979.
_______ . Commercial Paper Ratings Guide. Standard and
Poor’s Corp., February 1978.
________The Bond Outlook. Standard and Poor’s Corp.,
various issues.
Stigum, Marcia. The Money Market. Dow Jones-lrwin, 1983.
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Financial Crises: Institutions and Markets in a Fragile En­
vironment. John Wiley and Sons, 1977.




Treiber, William F. “ Problems of Financial Community Under
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1990), pp. 77-99.
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___________ “ Three Outside Directors Quit Penn Central,
Rail Unit; Bank Conflict May Affect Others,” June 15, 1970,
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pp. 122-3.

MAY/JUNE 1994




57

D a vid C. W h eelock and Paul W. W ilson
David C. Wheelock is a senior economist at the Federal
Reserve Bank of St. Louis. Paul W Wilson is associate
.
professor of economics at the University of Texas at Austin.

Can Deposit Insurance Increase
the Risk o f Bank Failure?
Some Historical Evidence

l i O M i LOSSES ASSOCIATED WITH declines
in energy and agricultural prices, and the col­
lapse of com m ercial real estate m arkets were
the proximate cause of the high num ber of
bank and savings and loan (S&.L) failures of the
past 12 years. Many researchers also blame
governm ent policies, however, such as restric­
tions on branch banking and limitations on the
services that banks and S&,Ls may offer. Such
restrictions ham per diversification, thus leaving
depository institutions particularly vulnerable to
downturns in the regions w hich they serve.
Deposit insurance has probably been the most
criticized governm ent policy related to bank and
S&L failures. Many econom ists believe that
deposit insurance encourages banks and S&Ls
to take excessive risks, thereby increasing their
chance of failing.1

This article investigates empirically the con ­
nection betw een deposit insurance and bank
failure. Today, virtually all banks are insured by
the Federal Deposit Insurance Corporation
(FDIC) and, consequently, isolating the effects of
insurance from oth er regulations and exogenous
econom ic conditions that affect bank p erfo r­
m ance is difficult. We study the effects of
deposit insurance by drawing on historical evi­
dence from a voluntary insurance regime that
operated in Kansas betw een 1909 and 1929. Be­
cause m em bership in the Kansas deposit insu r­
ance system was optional, we are able to
com pare insured and uninsured banks facing
otherw ise similar regulations and econom ic con­
ditions in a way not possible with modern data.
We estimate a model of bank failure to test for
the impact of insurance on the likelihood of
failure.2 We find that insured banks were less
well capitalized and, in some years, less liquid

1Kane (1989) examines the problems of the S&L industry
and the role of government policy. Mishkin (1992), Keeley
(1990) and O’Driscoll (1988) discuss the relationship be­
tween deposit insurance and bank failures in the 1980s.

ures of managerial inefficiency help distinguish failing from
surviving banks. Grossman (1992) also investigates the
effects of deposit insurance by comparing insured and
uninsured S&Ls during the 1930s.

2Wheelock (1992b) also investigates how deposit insurance
affected the probability of failure for Kansas banks in this
era, but employs a different methodology and somewhat
different data. Wheelock and Wilson (1993) use the same
data set as the present study, but while considering the
effects of insurance, focus largely on whether or not meas­




MAY/JUNE 1994

58

than uninsured banks, and that capitalization
and liquidity w ere im portant determ inants of
failure.
The next section discusses how deposit insu r­
ance might increase the likelihood of bank
failure. Next, we describe the Kansas deposit in­
surance system and the effects of a collapse of
commodity prices in 1920 on com m ercial banks.
The final sections develop the econom etric
methodology used to model failure, specify the
model, and present results and conclusions.

D EPO SIT INSURANCE AND BANK
FAILURE
Federal deposit insurance was enacted in
response to the bank failures of the Great
Depression. Thousands of banks failed from
1930 to 1933, wiping out the funds of deposi­
tors, producing a collapse of the money supply,
increasing the costs of interm ediation and in ter­
fering with the clearing of payments.3 Although
large banks and many econom ists vigorously op­
posed deposit insurance, and President Franklin
Roosevelt was reluctant to accept it, Congress
deemed deposit insurance necessary to protect
small, unsophisticated depositors from losses
due to bank failures, and the payments system
from a wholesale banking collapse like that of
1930-33.4
Until the 1980s, deposit insurance was g en er­
ally hailed for eliminating the possibility of
widespread bank failures.5 M erton (1977) and
Kareken and Wallace (1978) showed, however,
that w hen insurance premiums are unrelated to
the expected cost of failure to the insurance sys­
tem, banks have an incentive to take greater
risks than they otherw ise would. Because depo­
sitors are protected in the event of bank failure
(to the limit of insurance coverage), they have
little or no incentive to m onitor their banks’ ac­
tivities or to demand risk premiums on deposit
interest rates. Deposit insurance thus raises

3Studies of the causes and effects of bank failures during
the Depression are too numerous to list. Friedman and
Schwartz (1963), however, is the seminal investigation of
the impact of bank failures on the money supply, and Bernanke (1983) is the most important investigation of non­
monetary effects of bank failures.
“Golembe (1960) and Flood (1992) investigate the rationale
for federal deposit insurance.
5For example, see Friedman and Schwartz (1963, pp.
434-42).
6For example, see Kane (1989).

Digitized forFEDERAL RESERVE BANK OF ST. LOUIS
FRASER


the expected retu rn to banks from investing in
risky loans and investments and encourages
them to substitute debt, in the form of insured
deposits, for equity. Consequently, unless regula­
tions inhibit risk-taking, the presence of deposit
insurance could lead to m ore bank and S&L
failures than there would otherw ise be.
Many econom ists blame deposit insurance,
coupled with inadequate regulation and supervi­
sion, political interference and a failure by regu­
lators to promptly close insolvent institutions,
for the high num ber of S&L failures and bank­
ruptcy of the Federal Savings and Loan Insur­
ance Corporation during the 1980s.6 The bank­
ing industry’s problem s were, by comparison,
less notorious. Banks faced higher capital re ­
quirem ents and were m ore stringently super­
vised than S&Ls, w hich lessened banks’ incentive
and ability to take excessive risks. But deregula­
tion of deposit interest rates, initiated by the
Depository Institutions Deregulation and M one­
tary Control Act (DIDMCA) of 1980, the gradual
removal of b arriers to branch banking, more
liberal chartering polices and increased com peti­
tion from foreign banks and from nonbank
financial institutions, all worked to lessen ch art­
er values and increase the incentive for banks
(as well as S&Ls) to take greater risks.7 M ore­
over, in 1980, deposit insurance coverage was in­
creased from $40,000 per account to $100,000
for both banks and S&Ls, while the failure reso­
lution policy known as "too-big-to-fail” effectively
extended insurance to all deposits at the largest
banks, thereby enhancing their incentive to take
risks.8
As is all too often the case, the bank and
thrift debacle of the 1980s stemmed in part
from the failure of policy m akers to heed les­
sons from the past. Flood (1992) argues that
when deposit insurance legislation was being
considered in 1933, policy makers understood
the temptation that insurance gives bankers to
take excessive risks. Accordingly, coverage was

7Keeley (1990) draws the connection between increased
competition, deposit insurance and increased risk-taking.
8Too-big-to-fail was implemented to reduce
that the failure of a very large bank could
temic crisis, with depositor runs on many
(1992) and Boyd and Gertler (1993) argue
increased risk-taking by very large banks.

the possibility
produce a sys­
banks. Mishkin
that this policy

59

limited to $2,000 per account and regulations
were imposed to constrain risk-taking. Deposit
interest rate ceilings prevented weak institutions
from growing rapidly by bidding up interest
rates, and regulators gave bankers added incen­
tive to act conservatively by limiting the issu­
ance of new bank charters. Many of the
sources of increased com petition for banks and
S&Ls that had em erged by 1980, such as money
market mutual funds and the com m ercial paper
market, were the product of technological
changes that could not be foreseen in 1933.9 But
deregulation of bank and S&L deposits and the
expansion of deposit insurance coverage at a
time w hen the industry was facing increased
com petition contradicted the regulatory princi­
ple that underlay deposit insurance legislation
in 1933.

tions.1 Contemporaries believed that deposit in­
1
surance had contributed to the high num ber of
failures because it protected incom petent and
dishonest bankers from m arket discipline.1 In
2
the following sections, we investigate empirically
how deposit insurance might have contributed
to the failure of banks operating under the
deposit insurance system of Kansas during the
1920s. We study this case because just th ree of
the eight state insurance systems had optional
mem bership for state-chartered banks and,
hence, perm it com parison of insured and unin­
sured banks facing otherw ise similar conditions.
Of these, only the Kansas system lasted for
many years with a large num ber of banks elect­
ing to join the system and a significant num ber
remaining uninsured.

The insights that policy m akers had in 1933
about deposit insurance cam e partly from prior
state experiences with deposit insurance. Six
states had experim ented with insurance in the
pre-Civil War era, as did eight others betw een
1908 and 19 3 0 .1 None of the 20th-century sys­
0
tems was able to fully protect depositors of
failed banks from loss, and each closed before
the onset of the Great Depression. The commodity-price collapse of 1920-21 triggered a wave of
bank failures throughout the Midwest and the
South, including seven of the eight states with
deposit insurance. Although loan losses associat­
ed with the decline of state incom es was the
proximate cause of bank failures, insured banks
generally suffered higher failure rates than
uninsured banks facing similar exogenous condi­

D EPO SIT INSURANCE IN KANSAS

9See Wheelock (1993).
10The 20th-century states and the years in which their insur­
ance systems operated are Oklahoma (1907-23), Texas
(1909-25), Kansas (1909-29), Nebraska (1909-30), South
Dakota (1909-31), North Dakota (1917-29), Washington
(1917-29) and Mississippi (1914-30). Cooke (1909), Robb
(1921), American Bankers Association (1933), Federal
Deposit Insurance Corporation (1956) and Calomiris (1989)
compare the features and performance of the systems.

The Kansas deposit insurance system began
operation in Ju n e 1909 and officially closed in
1929. Kansas was the second state to enact in­
surance legislation following the Panic of 1907,
and was motivated partly by the adoption of an
insurance system by Oklahoma in 1908.13 In
contrast to the Oklahoma system, in w hich all
state-chartered banks were required to carry in­
surance, the Kansas system was made optional
for state banks because of complaints that insur­
ance forces conservatively managed banks to in­
sure depositors of banks that are m ore likely to
fail.1 The state o f Kansas, like oth er states with
4
deposit insurance systems, did not guarantee in­
surance payments. In contrast to the experience

of Reserve City Bankers (1933) and Robb (1921) for con­
temporary views about insurance.
13Robb (1921) describes previous attempts to enact deposit
insurance legislation in Kansas and other states, and notes
that Kansas banks located near the Oklahoma border were
especially strong proponents of deposit insurance in Kan­
sas (pp. 107-12).
14The Comptroller of the Currency ruled in 1908 that national
banks could not join state deposit insurance systems.

1'Thies and Gerlowski (1989) and Alston, Grove and Whee­
lock (1994) find that a state’s bank failure rate during the
1920s was higher if it had a system of deposit insurance,
holding constant other possible causes of failure. Wheelock
(1992a) reports similar evidence at the county level for
Kansas.
12Commenting about the effects of the Kansas deposit insur­
ance system, Harger (1926, p. 278) wrote that insurance
“ gave the banker with little experience and careless
methods equality with the manager of a strong and conser­
vative institution. Serene in the confidence that they could
not lose, depositors trusted in the guaranteed bank. With
increased deposits, the bank extended its loans freely.”
See also American Bankers Association (1933), Association




MAY/JUNE 1994

60

with federal insurance in the 1980s, depositors,
not taxpayers, suffered from any insurance fund
deficiencies.1
5
Kansas banks were required to operate for at
least one year and undergo an examination by
state authorities before being admitted into the
insurance system .1 Insured banks w ere also re­
6
quired to maintain total capital of at least 10
percent of total deposits, and surplus and undis­
tributed profits of at least 10 percent of total
capital.1 At first, deposit insurance was restrict­
7
ed to noninterest bearing accounts, savings
deposits of $100 or less, and time deposits of b e­
tw een six and 12 m onths maturity. Banks with
insured deposits were not permitted to pay
more than 3 percent interest on any deposit,
w hether insured or n ot.18 Regulations were
relaxed in 1911; insurance was extended to all
deposits not otherw ise secured, including sav­
ings accounts in excess of $100, and the state
banking com m issioner was given authority to
adjust interest rate ceilings as he deemed
appropriate.
Insured banks were assessed annual premiums
equal to 1/20 of 1 percent of their insured
deposits less total bank capital. Although a bank
could reduce its premium by increasing its capi­
tal, the saving was small. A bank with $100,000
of insured deposits and $10,000 o f capital was
assessed an insurance premium of $45, w hereas
a bank with $15,000 of capital had a premium
of $42.50. Additional premium s could be as­
sessed to cover shortfalls in the insurance fund,
but total annual premium s w ere capped at 1/4
of 1 percent of insured deposits less capital.
Banks also w ere required to place cash or eligi­
ble bonds with the state banking com m issioner
equal to 0.5 percent ($500 minimum) of their in­
sured deposits to guarantee insurance premium
payment. Banks could withdraw from the insur­
ance system at any time, but rem ained liable for
any premium s needed to reim burse depositors
of banks which failed while the withdrawing
15Mississippi, however, ultimately issued bonds
deficit of its insurance system.

to retire the

16The requirement of one year of operation was waived if no
other bank in the applicant’s town was an insurance sys­
tem member.
17The former requirement was eliminated in 1917. Warburton
(1958, p. 21) argues that, if maintained and enforced, the
requirement could have prevented much of the rapid
growth of banks that ultimately resulted in large losses to
the insurance system.

Digitized forFEDERAL RESERVE BANK OF ST. LOUIS
FRASER


bank was insured, including the six m onths fol­
lowing notice of withdrawal.
Deposit insurance proved popular in Kansas,
and before 1920 the deposits of insured banks
grew m ore rapidly than those of uninsured state
and national banks. Figure 1 plots the participa­
tion rate of all Kansas banks and of those eligi­
ble for deposit insurance. Figure 2 illustrates the
shares of all bank and eligible bank deposits
held by insured banks.19 The percentage of the
state’s bank deposits held by insured banks
peaked in 1921 at 43.8 percent, and membership
in the system peaked at 65.6 percent of eligible
banks in 1923. In that year, 681 banks, holding
$168 million of deposits, belonged to the insu r­
ance system, while 357 state banks, holding $64
million of deposits, did not.

THE CHARACTERISTICS OF
INSURED BANKS
This section identifies some im portant differ­
ences betw een insured and uninsured banks
that may explain why the failure rate of insured
banks exceeded that of uninsured banks.
If depositors believe that they will be protect­
ed from loss in the event of bank failure, they
will be willing to accept a lower rate of retu rn
on their deposits than they would in the ab­
sence of such protection. Because it lowers the
cost of deposits, deposit insurance encourages
banks to rely m ore heavily on deposits to
finance their activities, as opposed to equity and
nondeposit liabilities, than they otherw ise
would. Economic theory suggests that banks
also will choose to hold riskier assets w hen
deposits are insured.20 Insured banks in Kansas
had a higher failure rate than uninsured banks,
which might have been caused by "m oral haz­
ard,” that is, by high-risk behavior encouraged
by deposit insurance. Alternatively, because
risky banks would stand to gain the most from
insurance in term s of lower deposit costs, the
18For comparison, the annual average interest rates on prime
four-six month commercial paper and on call loans in 1909
were 4.69 and 2.71 percent, respectively.
19AII banks include those with federal charters, trust compa­
nies and unincorporated banks. The source of these data
is the FDIC (1956, p. 68).
20See Merton (1977) or Kareken and Wallace (1978).

61

Figure 1
Proportion of Banks Participating in the Deposit Insurance System

Figure 2
Proportion of Deposits in Insured Banks




MAY/JUNE 1994

62

failure rate of insured banks might have been
higher simply because risky banks were more
likely to join the voluntary insurance system,
that is, because of “adverse selection." Of course,
both effects might have been present and con­
tributed to the higher failure rate of insured
banks.
T he troubled history of the Kansas deposit in­
surance system raises the question of w hether
depositors expected an insurance payoff in the
event of bank failure. If they did not, then depo­
sitors would have had an incentive to m onitor
their banks' activities and to demand the same
term s from a m em ber of the insurance system
as from an uninsured bank with equal likeli­
hood of failure. Indeed, if depositors thought
that insured banks had, on average, a higher
probability of failure and that an insurance
payoff was unlikely, then they would have had
an incentive to tran sfer deposits from insured
banks to uninsured banks. No doubt some depo­
sitors did so, as the relative share of deposits in
insured banks fell after 1921. Large num bers of
depositors left their funds in insured banks,
however, and because of the difficulty of assess­
ing the extent of protection from deposit insur­
ance at any point in time, might have expected
at least partial reim bursem ent in the event of
bank failure.2’
To investigate the relationship betw een deposit
insurance and bank behavior, we com pare vari­
ous financial ratios of insured and uninsured
banks in our sample in different years. Table 1
reports the m ean capital/assets, deposits/assets
and cash reserves/deposits ratios of insured and
uninsured banks in our sample in each year for
which data are available.22 In general, insured
banks maintained less capital relative to assets
than uninsured banks and, hence, w ere more
likely to fail as a result of loan losses or other
declines in asset values. The hypothesis that the
mean capital/assets ratios of insured and unin­
sured banks are equal can be rejected (at the
.10 level or better) in each year.

2,Wheelock and Kumbhakar (1994) argue that before 1926,
depositors had a reasonable expectation of an insurance
payoff, and show that deposit insurance enabled members
of the insurance system to hold lower capital ratios than
uninsured banks until that year.
22The biennial reports of the state banking commissioner
(Kansas, various years) provide balance sheet data for all
state-chartered banks and trust companies on August 31 of
each even-numbered year (except 1912 and 1916).

Digitized forFEDERAL RESERVE BANK OF ST. LOUIS
FRASER


The greater reliance o f insured banks on
deposits is indicated by the fact that, except
for 1924, insured banks had higher deposits/
assets ratios than uninsured banks. Insured
banks also held few er liquid assets (“reserves”),
defined here as cash, cash items and the liabili­
ties of other banks, relative to deposits than
uninsured banks in 1910, 1914 and 1924. Thus,
for some of the period, insured banks w ere less
liquid than their uninsured competitors. We
find the reserves/deposits ratio to be particularly
useful for distinguishing failing and nonfailing
banks. The comparatively low capital/assets
and reserves/deposits ratios of insured banks
indicate that they w ere m ore risky than unin­
sured banks and, hence, the higher failure
rate of insured banks is not surprising. We
fu rth er examine the impact of deposit insurance
on the probability of failure, and seek to identi­
fy oth er characteristics which distinguish fail­
ing from nonfailing banks in the following
sections.

THE BANKING COLLAPSE OF THE
1920s
The num ber of banks and total bank deposits
grew rapidly throughout the United States in
the first two decades of the 20th century, espe­
cially during the inflationary boom of World
War I. Kansas experienced a 30 percent increase
in the num ber of banks betw een 1910 and 1920,
w hen it had 1,096 state-chartered banks, 266 na­
tional banks and 18 unincorporated banks (Kan­
sas, 1920, and Bankers Encyclopedia Company,
M arch 1921). After 1920, the num ber of banks
in the United States fell sharply, especially in the
Midwest and the South, w here waves of bank
failures followed a collapse of commodity prices.
Between Ju n e 1920 and January 1921, an index
of wholesale commodity prices fell from 167 to
114; by January 1922, it had fallen to 91 (Board
of Governors, 1937, p. 174). Sharply lower in­
comes left many farm ers who had borrow ed to

63

Table 1
Mean Financial Ratios of Insured and Uninsured Banks
Year

Type of
bank

Capital/
assets

Deposits/
assets

Reserves/
deposits

Number
of banks

1910

Insured
Uninsured

.188***
.238

.793***
.728

.320***
.424

41
186

1914

Insured
Uninsured

.205**
.227

.755***
.717

.303**
.341

124
128

1918

Insured
Uninsured

.124***
.142

.864***
.824

.328
.308

149
97

1920

Insured
Uninsured

.133**
.148

.836**
.806

.207
.200

158
84

1922

Insured
Uninsured

.162**
.179

.784*
.755

.205
.206

159
74

1924

Insured
Uninsured

.163*
.179

.808
.798

.224***
.282

150
63

1926

Insured
Uninsured

.150**
.172

.835**
.810

.227
.233

135
63

Note: ***, ** and * indicate that the difference in the means for insured and uninsured
banks is statistically different from zero at the .01, .05 and .10 levels (two-tailed tests).

finance land acquisition and improvements b e­
fore 1920 unable to repay their loans. Loan loss­
es, in turn, caused the failure of many banks in
commodity-producing regions, including 220 in
Kansas betw een 1920 and 1929.
The impact of agricultural distress on in­
dividual Kansas banks reflected the portfolio
choices they had made prior to the collapse
and as it unfolded. Between Septem ber 1920
and Septem ber 1926, 122 state-chartered Kansas
banks failed. Of those, 94 had been m em bers of
the insurance system (a 4.6 percent failure rate)
and 28 had not (a 2.3 percent failure rate). By
contrast, just six national banks failed (a 0.8
p ercent failure rate). Over the life of the insur­
ance system, depositors of just 27 failed banks
recovered the entire amount of their insured
deposits, and those of two oth er banks received
93 and 95 percent of their deposits, respectively
(Warburton, 1958, pp. 27-9). No insurance pay­
m ents w ere made to depositors of 88 m em ber
banks that failed (FDIC, 1956, p. 58). On aver­
age, holders of insured deposits received 53 p er­
cent of their funds from liquidation of bank
assets and 18 percent from the deposit insur­
ance fund (7 percent o f which cam e from the




reorganization of one bank, the American State
Bank of Wichita). The rem aining 29 percent of
insured deposits w ere never recovered.
The sharp increase in bank failures beginning
in 1920 quickly swamped the resources of the
Kansas deposit insurance fund. W hen a m em ber
of the Kansas insurance system failed, its depos­
itors were given interest-bearing certificates
immediately upon closure, and received reim ­
bursem ent only after the bank’s assets had been
entirely liquidated. If the proceeds from liquida­
tion were insufficient to reim burse insured
depositors, the insurance system was supposed
to make up the difference. Depositors of the two
banks that failed before 1920 w ere eventually
fully reim bursed, but inadequate insurance
funds m eant that depositors of most banks that
failed after 1920 were not as fortunate.
Because depositors were not reim bursed until
after liquidation of a failed bank’s assets, the
condition of the fund and the prospect that
depositors of failed banks would eventually
receive full reim bursem ent were difficult to de­
term ine at any point. The failure in Ju n e 1923
of the Am erican State Bank of Wichita, the
state’s largest insured bank, presented the insur­

MAY/JUNE 1994

64

ance system with its greatest challenge. Eventu­
ally, the bank was reorganized with oth er in­
sured banks assuming $1.4 million of the loss
and depositors accepting, on average, 40 percent
of their deposits in the form o f stock in the
new bank. The event marked a turning point in
the history of the Kansas insurance system,
however, as the num ber of banks and the
deposits held in insured banks began to
decline.23
Although a special insurance assessm ent was
collected in 1922 and insurance premium s w ere
set at their legal maximums beginning in 1924,
losses from bank failures exceeded insurance
system revenues from 1921 onward. In 1925, the
state bank com m issioner stopped making pay­
m ents on all insurance claims, and in 1926 a
state suprem e court decision effectively ended
the system. The court decision resulted from
the refusal of several banks that had withdrawn
from the insurance system to pay additional in­
surance premiums. The court ruled that banks
could withdraw w ithout additional liability by
simply giving up the bonds they had pledged to
guarantee premium payments. This led many
banks to withdraw and, by 1927, insurance sys­
tem m em bership had fallen to less than 10 p er­
cent of eligible banks.
Kansas appears to have suffered many of the
problem s that have been associated with the
bank and S&L debacle of the 1980s. In the
1980s, many depository institutions, especially
insolvent S&Ls, bid up deposit interest rates and
grew rapidly by issuing deposits through brok­
ers.24 In the 1920s, some banks appear to have
evaded deposit interest rate ceilings in order to
grow rapidly. In his report for 1922 (Kansas,
1992, p. 5), the state bank com m issioner also felt
it desirable to limit deposit insurance to only the
original holder of a deposit, and not to any as­
signee. Supervision was also reported to have
been weak in Kansas, especially during the
w orst failure years, and for a time state banking
authorities perm itted weak and insolvent
banks to rem ain open rather than closing them
immediately upon recognition of trouble (War-

23See Wheelock and Kumbhakar (1994) and Warburton
(1958) for additional detail about this failure.
24See Kane (1989).
25Kiefer (1988) provides a good introduction to the analysis of
duration data; Kalbfleisch and Prentice (1980) and Lan­
caster (1990) provide more advanced treatments of the
subject.

 RESERVE BANK OF ST. LOUIS
FEDERAL


burton, 1958, p. 19). W hether any such banks
recovered is not known, but the lack of m ention
in the biennial reports of the state banking com ­
m issioner suggests that, like the attem pts at fo r­
bearance during the 1980s, the policy was
probably not successful.

MODELING TIME-TO-FAILURE
W hile many Kansas banks failed during the
1920s, a m ajority of banks survived the decade.
W hat characteristics distinguish the survivors
from the failures? To identify im portant ch arac­
teristics o f failing banks, we employ an econo­
m etric technique that explicitly models timeto-failure. The analysis of duration data is rela­
tively new in economics. Engineers and bio­
medical scientists have analyzed time-to-failure
for electrical and m echanical com ponents of
m achinery and the survival times of subjects for
many years, but econom ists have only recently
begun to apply similar models, prim arily in the
area of labor econom ics with a focus on the du­
ration of spells of unem ploym ent.25 Although
models developed to analyze duration data are
sometimes called time-to-failure models, the
event of interest need not be characterized as a
"failure”; all that is necessary is that the event
be well-defined.
Duration models differ from standard discrete
choice models (such as probit or logit models) in
that duration models use inform ation about how
long banks survive in the estim ation of the in­
stantaneous probability of failure for a given set
of observations on the independent variables.
Param eter estim ates thus indicate w h eth er an
increase in the value of an individual indepen­
dent variable will reduce or extend the expected
time until failure occurs. By contrast, discrete
choice models typically ignore inform ation about
the timing of failures, and provide an estimate
only of the probability o f failure within a given
interval of time. Discrete choice models treat all
banks that fail during an interval the same, as
they do all surviving banks. Thus, for example, a
bank that fails on the first day of a two-year in-

65

terval is treated the same as a bank that fails
on the last day, and a bank that survives the
interval but fails one day after that period
ends is treated the same as a bank that sur­
vives an additional 10 years. Duration models
explicitly incorporate such inform ation, and
thus yield m ore efficient param eter estim ates.26
A detailed description of the duration model
used in this article is presented in the
appendix.
In the present application, we observe the
ch arter date for each bank in our sample. For
some banks, we observe a failure date, w here
failure is defined as the date on which the bank
was ordered closed by the state banking com ­
missioner. For the remaining banks, no failure
date is observed if a bank had not failed by the
end of our observation period (1928) or if it liq­
uidated voluntarily, m erged with another bank
or switched to a federal charter. These observa­
tions are considered censored; inform ation
about these banks is available for part of their
lives, but we do not observe them failing. Cen­
soring is common in duration data of all types
and must be addressed within the statistical
model used to examine the data.
Figure 3 illustrates the types o f censoring that
may occu r in duration data. Assume that the in­
terval over which banks are observed runs from
time tt to f,. The horizontal lines in the figure
represent the time betw een the ch arter date
and the date of failure for individual banks.
Given the observation period (tt, f2), the observa­
tion for Bank A will be both left- and rightc e n s o r e d . For this bank, neither the ch arter
date nor the failure date occu r within the ob ser­
vation interval. The observation for Bank B will
be left-censored; the ch arter date does not oc­
cu r within the observation interval, but the
failure date does. For Bank C, both the ch arter
and failure dates occu r betw een ti and tz, and
so the observation is uncensored. Finally, the ob­
servation for Bank D will be right-censored; the
ch arter date occurs within the observation in ter­
val, but the failure date occurs after f,.

26While deriving a direct relationship between the parameters
of a duration model and a discrete choice model would be
difficult, in principle one could integrate the hazard func­
tion estimated from a duration model to obtain the proba­
bility of failure within a given interval of time.

EXPLANATORY VARIARLES AND
ESTIMATION RESULTS
O ther researchers have employed hazard and
discrete choice models to identify characteristics
that distinguish failing and surviving banks in a
variety of settings. W hite (1984), for example, es­
timates a probit model to distinguish failing
from nonfailing banks during the Banking Panic
of 1930. W heelock (1992a) uses a similar model
to study Kansas bank failures betw een 1920 and
1926. Both studies found that banks were more
likely to fail, the lower their capital/assets, sur­
plus/loans, bonds/assets, reserves/deposits, or
deposits/assets ratios.27 Banks were m ore likely
to fail, the higher their loans/assets or sh ort­
term borrowed funds/assets ratios.28
Many Kansas banks experienced significant
loan losses following the collapse of agricultural
prices and incom es in 1920-21, and banks with
low capital/assets ratios were less well-cushioned
against declines in the value of their assets.
Banks with little cash and oth er reserve assets
were less able to m eet deposit withdrawals, and
the smaller a bank's reserves/deposits ratio, the
more likely it was to close due to illiquidity.
Often a lack of cash was the first sign that a
bank was in trouble, and would prompt closure
by state banking authorities.
Just as a low level of reserves signaled trou ­
ble, so too did a heavy reliance on borrowed
funds such as rediscounts of loans with other
banks or with the Federal Reserve. Banks that
relied heavily on borrow ed funds to finance
their operations, or that had to resort to b o r­
rowing because of loan losses or deposit w ith­
drawals, appear to have been relatively more
likely to fail.
Loans are generally the most risky and least
liquid of bank assets, and the loan portfolios of
the rural unit banks of Kansas were undoubted­
ly not well-diversified. Accordingly, the higher a
bank’s loans/assets ratio, the greater the likeli­
hood that it would fail. On the other hand,
banks with substantial bond holdings might

28Borrowed funds consisted largely of rediscounted loans
with the Federal Reserve or other banks,

27Surplus refers to paid-in capital beyond the par value of a
bank’s stock plus undistributed profits. Reserves refer to
cash, cash items and the liabilities of other banks.




MAY/JUNE 1994

66

Figure 3
Possible Types of Censoring

Time

have been less likely to fail, especially since U.S.
Government bonds and bonds of the state of
Kansas and of Kansas municipalities probably
com prised most of the bond holdings of Kansas
banks in this era.29

full impact of insurance may not be captured by
observable variables. The deposit insurance
dummy variable might reflect the incentive that
insurance gives banks to hold riskier loans and
investments than they otherw ise would.

W heelock (1992b) includes bank size and a
dummy variable indicating w hether or not a
bank was a m em ber of the state deposit insur­
ance system as additional explanatory variables.
If larger banks w ere better diversified, or could
capture econom ies of scale, they might have
been less likely to fail. W heelock found, how­
ever, no significant relationship betw een size
and failure. Deposit insurance, on the other
hand, did significantly affect the probability of
failure. Even though the capital/assets ratio and
other m easures of risk-taking should reflect
w hether or not a bank had insured deposits, the

W heelock (1992b) did not test for interaction
effects betw een deposit insurance and the finan­
cial ratios. One might expect, however, that the
effect of a change in a financial ratio on the
likelihood of failure would depend in part on
w hether or not the bank had deposit insurance.
For example, the depositors of an insured bank
might have been less concerned w ith a decline
in the capital/assets ratio of their bank and,
hence, less likely to demand a higher deposit in­
terest rate than depositors of an uninsured
bank. The scope for risk-taking and, thus, the
probability of failure, resulting from a change

29The state banking commissioner accepted only U.S.
Government, state of Kansas and Kansas municipal bonds
to guarantee payment of deposit insurance premiums.
Unfortunately, we do not have information on the composi­
tion of each bank’s bond holdings.

Digitized forFEDERAL RESERVE BANK OF ST. LOUIS
FRASER


67

in a financial ratio might therefore depend on
w hether or not a bank was insured. We test this
hypothesis here.

Estimation Results
Our data consist of a panel of Kansas banks
for which we have collected balance sheets and
other inform ation as of August 31 of each evennum bered year from 1910 to 1926 (except 1912
and 1916, w hen these data w ere not pub­
lished).30 Our sample includes 259 banks (ap­
proximately one-fourth the total operating in
1914).3' Of these, 4 7 (18 percent) had failed by
Septem ber 1, 1928. Banks that merged with
other banks, liquidated voluntarily or switched
to a federal ch arter are treated as censored on
the date of m erger or change in charter. Banks
that did not fail or otherw ise ceased operating
prior to August 31, 1928, are treated as cen ­
sored on that date.
In addition to the independent variables used
by W heelock (1992b), we include dummy varia­
bles for each interval of 1920-22, 1922-24,
1924-26 and 1926-28 to investigate w hether the
probability o f failure differed across periods for
a given set o f bank attributes. Only two banks
in our sample failed before 1920 and, hence, we
do not include dummies for those years. In one
specification we also include interaction term s
of deposit insurance and the financial ratios.32
Table 2 reports estim ates of the failure model
that include alternative com binations of explana­
tory variables. In column one, the coefficient on
the capital/assets, bonds/assets and reserves/
deposits ratios indicate that the higher each of
these ratios was, the less likely a bank was to
fail. Better capitalized banks, and those with
substantial bond holdings and significant
reserves, could b etter absorb the shock of loan
losses and deposit withdrawals accompanying
the agricultural downturn in Kansas. Banks that
had substantial borrow ed funds relative to assets
had a greater chance of failing while, contrary

to expectations, it appears that the higher a
b ank’s loan/assets ratio, the less likely it was to
fail. This finding appears due to multicollinearity, however. T he loans/assets ratio is highly co r­
related with the reserves/deposits ratio. If the
latter is omitted, as in the specification reported
in column two, the sign of the coefficient on the
loans/assets ratio is positive, though not statisti­
cally significant.
The coefficient on deposit insurance is not
statistically significant, suggesting that any effect
that insurance had on the probability of failure
is captured by its relationship with the financial
ratios also included in the model. If the dum­
mies for the biennial observation intervals are
omitted, the coefficient on insurance is larger
and statistically significant. It may be that the
strain on the portfolios of all banks caused by
the collapse of commodity prices overwhelmed
the effect of deposit insurance on the unob­
served portfolio risk of insured banks, which
could explain why the coefficient on insurance
is not significant w hen the time dummies are in­
cluded. Not surprisingly, for given values of the
financial ratios, banks were m ore likely to fail
after the collapse of commodity prices and on­
set of severe agricultural distress in 1920. Final­
ly, none of the coefficients on the interaction
term s of deposit insurance and the financial ra­
tios is statistically significant. Again, it appears
that any impact of deposit insurance on the
likelihood of failure is captured by differences in
the financial ratios betw een insured and unin­
sured banks.

CONCLUSION
Researchers have blamed federal deposit insur­
ance for contributing to the high num bers of
bank and th rift failures and large deposit insur­
ance payoffs since 1980. Unless insurance
premiums increase proportionately with risk,
banks will be encouraged to take greater risks
than they otherw ise would. This article presents

30The source of our data is Kansas (various years).
3,We dropped seven banks because of missing data. Others
fall out of the panel after failing, closing voluntarily, merg­
ing with other banks, or switching to a national charter.
32Few state-chartered Kansas banks were members of the
Federal Reserve System during this era. None of the failed
banks in our sample was a member, and so differences in
supervisory agency or regulation, except those pertaining
to deposit insurance, cannot explain variation in failure
probabilities across banks.




MAY/JUNE 1994

68

Table 2
Failure Model Estimates
Variable
0.17
(0.43)

0.35
(0.90)

-0.23
(0.03)

Capital/Assets

-12.10
(2.76)***

-13.42
(3.02)***

-17.48
(2.52)

Bonds/Assets

-7.98
(1.84)*

-1.56
(0.35)

-14.84
(1.19)

Loans/Assets

-6.05
(2.18)**

2.12
(0.96)

-4.82
(0.53)

Reserves/Deposits

-9.80
(3.79)***

—

-9.83
(1.20)

Borrowings/Assets

8.10
(5.16)***

Insurance

Total Assets

8.34
(5.45)***

5.31
(1.80)

-0.78
(0.84)

-1.00
(1.00)

-0.77
(0.83)

1920-22

1.10
(1.18)

1.33
(1.43)

1.07
(1.14)

1922-24

2.30
(2.68)***

2.66
(3.12)***

2.29
(2.65)

1924-26

2.46
(2.75)***

3.10
(3.57)***

2.47
(2.77)

1926-28

3.08
(3.44)***

3.67
(4.15)***

3.11
(3.46)'

Ins x capital/assets

—

—

6.66
(0.74)

Ins x bonds/assets

—

—

8.32
(0.63)

Ins x loans/assets

—

—

-1.53
(0.16)

Ins x reserves/deposits

—

—

-0.26
(0.03)

Ins x borrowings/assets

—

—

3.79
(1.09)

Psuedo-R2
Log-likelihood

.29
-138.25

.26
-144.61

.30
-137.16

Notes: Absolute values of f-statistics are in parentheses; ***, ** and * indicate statistically
significant at the .01, .05 and .10 levels.

some historical evidence of how deposit insur­
ance can alter bank behavior and increase the
likelihood that a bank will fail. As in the 1980s,
when falling incom es in agricultural and energyproducing states caused large loan losses and
led to many bank and thrift failures, a sharp
decline in agricultural incom es in the early
1920s caused the failure of many com m ercial
banks in rural areas. Not all banks failed,

 RESERVE BANK OF ST. LOUIS
FEDERAL


however; in fact, most survived the collapse.
Banks that carried deposit insurance had a
higher rate of failure than oth er banks. Our
findings, along with those of similar historical
studies, show that insured banks were less well
capitalized and less liquid than other banks. Es­
timates of a model of time-to-failure indicate
that among banks in our sample, those with
high ratios of capital to assets, reserves to

69

deposits, large bond holdings relative to their to­
tal assets, or that relied little on borrowed
funds, were less likely to fail. In short, conserva­
tively managed banks w ere less likely to fail
and, at the same time, banks that carried
deposit insurance were m ore risky and, hence,
more likely to fail than their uninsured com ­
petitors.

Johansen, Soren. “ An Extension of Cox’s Regression Model,”
International Statistical Review (August 1983),
pp. 165-74.
Kalbfleisch, J. D. and R. L. Prentice. The Statistical Analysis
of Failure Time Data. John Wiley and Sons, 1980.
Kane, Edward J. The S&L Insurance Mess: How Did It Hap­
pen? The Urban Institute Press, 1989.
Kansas. Biennial Report of the Bank Commissioner (various
years).

REFEREN CES

Kareken, John H., and Neil Wallace. “ Deposit Insurance and
Bank Regulation: A Partial-Equilibrium Exposition,” Journal
of Business (July 1978), pp. 413-38.

Alston, Lee J., Wayne A. Grove and David C. Wheelock.
“ Why Do Banks Fail? Evidence from the 1920s,” Explora­
tions in Economic History (1994, forthcoming).

Keeley, Michael C. “ Deposit Insurance, Risk, and Market
Power in Banking,” The American Economic Review
(December 1990), pp. 1183-1200.

American Bankers Association. The Guaranty of Bank
Deposits (1933).

Kiefer, Nicholas M. “ Economic Duration Data and Hazard
Functions,” Journal of Economic Literature (June 1988), pp.
646-79.

Anderson, Per K., and Richard D. Gill. “ Cox’s Regression
Model for Counting Processes,” Annals of Statistics
(December 1982), pp. 1100-20.
Association of Reserve City Bankers. The Guaranty of Bank
Deposits (1933).
Bankers Encyclopedia Company. Polk’s Bankers Encyclopedia
(March 1921).
Board of Governors of the Federal Reserve System. All Bank
Statistics, 1896-1955 (1959).
________Banking and Monetary Statistics, 1914-1941 (1943).
_______ . Annual Report (1937).
Calomiris, Charles W. “ Deposit Insurance: Lessons from the
Record,” Federal Reserve Bank of Chicago Economic Per­
spectives (May/June 1989), pp. 10-30.
Cooke, Thornton. “ The Insurance of Bank Deposits in the
West,” Quarterly Journal of Economics (Nov. 1909),
pp. 85-108.
Cox, David R. “ Partial Likelihood,” Biometrika (May/August,
1975), pp. 269-276.
_______ . “ Regression Models and Life Tables,” Journal of
the Royal Statistical Association (1972), pp. 187-220.
Efron, Bradley. “ The Efficiency of Cox’s Likelihood Function
For Censored Data,” Journal of the American Statistical As­
sociation (September 1977), pp. 557-565.
Federal Deposit Insurance Corporation. Annual Report (1956).
Flood, Mark D. “ The Great Deposit Insurance Debate,” this
Review (July/August 1992), pp. 51-77.
Golembe, Carter. “ The Deposit Insurance Legislation of 1933:
An Examination of its Antecedents and its Purposes,” Politi­
cal Science Quarterly (June 1960),
pp. 181-200.

Lancaster, Tony, The Analysis of Transition Data. Cambridge
University Press, Inc., 1990.
Merton, Robert C. “ An Analytic Derivation of the Cost of
Deposit Insurance and Loan Guarantees,” Journal of Bank­
ing and Finance (June 1977), pp. 3-11.
Mishkin, Frederic S. “ An Evaluation of the Treasury Plan for
Banking Reform,” Journal of Economic Perspectives (Winter
1992), pp. 133-53.
O’Driscoll, Gerald P. “ Bank Failures: The Deposit Insurance
Connection,” Contemporary Policy Issues (April 1988),
pp. 1-12.
Robb, Thomas B. The Guaranty of Bank Deposits. Houghton
Mifflin Co., 1921.
Warburton, Clark. Deposit Guaranty in Kansas, unpublished
manuscript, Federal Deposit Insurance Corporation, 1958.
Wheelock, David C. “ Is the Banking Industry in Decline?
Recent Trends and Future Prospects From a Historical
Perspective,” this Review (September/October 1993),
pp. 3-22.
_______ . “ Regulation and Bank Failures: New Evidence from
the Agricultural Collapse of the 1920s,” The Journal of Eco­
nomic History (December 1992a), pp. 806-25.
_______ . “ Deposit Insurance and Bank Failures: New Evi­
dence from the 1920s,” Economic Inquiry (July 1992b),
pp. 530-43.
_______ , and Paul W. Wilson. “ Explaining Bank Failure:
Deposit Insurance, Regulation and Efficiency,” working
paper no. 93-002A, Federal Reserve Bank of St. Louis
(1993).

Grossman, Richard S. “ Deposit Insurance, Regulation and
Moral Hazard in the Thrift Industry: Evidence from the
1930s,” The American Economic Review (September 1992),
pp. 800-21.

_______ , and Subal C. Kumbhakar. ‘“ The Slack Banker
Dances’: Deposit Insurance and Risk-Taking in the Bank­
ing Collapse of the 1920s,” Explorations in Economic His­
tory (1994 forthcoming).

Harger, Charles Moreau. “ An Experiment that Failed: What
Kansas Learned by Trying to Guarantee Bank Deposits,”
Outlook (June 23, 1926), pp. 278-79.

White, Eugene N. “ A Reinterpretation of the Banking Crisis of
1930,” Journal of Economic History (March 1984),
pp. 119-38.




MAY/JUNE 1994

70

A p pen dix
The P ro p o rtio n a l H azard M odel
This appendix describes the proportional haz­
ard model estimated in this article in some de­
tail for interested readers who are unfam iliar
with duration models, but have some und er­
standing of econom etrics or statistics. We wish
to estim ate the effect of deposit insurance and
other variables on the probability of failure at
particular tim es for the n banks in our sample.
Let T , i = 1, ..., n, represent the failure time for
the zth bank in our sample; w here T is not ob­
served, we say that the observation is censored.
Time is m easured relative to the individual
bank's ch arter date, with a zero value at the
ch arter date. Hence, for each bank in the sam­
ple, the corresponding time scales will have
different values for a given calendar time. If T is
a continuous random variable with a continuous
probability distribution/(f), w here f is a realiza­
tion of T, then the cumulative probability is

ration of banks. Furtherm ore, all four functions
are related. From equations 2 and 3, it follows that

Also, rearranging term s in equation 3 yields
(5)/(f) = S(f)A(f).
Another useful function is the integrated hazard
function,
(6) A(f) = f0A(u) du.
Then, from equations 4 and 6 the survival fu n c­
tion may be w ritten as
(7) S(t) = e~A
(”,
and from equation 7 we have

(1) P robiT < f) = F(t) = \ f{u ) du.
0
‘
The function F(t) gives the probability that a
bank fails b efore time f (subscripts are omitted
w here no ambiguity results). Alternatively, the
same inform ation may be expressed in term s of
the survival function
(2) S(t) = 1 - F(f),
which is m erely P rob (T > f).
Given that a bank has survived until time f,
what is the probability that it will fail during
the next short interval of time, A? The function
characterizing this aspect of the problem is the
hazard rate, given by
(3) A(f) = lim

Prob(t < T < t + A|T > f)
~

A0
—

= lim
A0
—

A

F(t + A - Fit)
)
7~7T
AS(t)

= M .
S(t)
The hazard function gives the instantaneous
rate of failure per unit time period at time f.
The density function f(t), the cumulative densi­
ty function F(t), the survival function S(f) and
the hazard function A(f) each characterize the du­

FEDERAL RESERVE BANK OF ST. LOUIS


(8) AU) = -lo g S(f).
Estimation of the failure time relationship re ­
quires specifying a functional form for either
/(f), F(f), S(t), A(f), or A(f). Note that a functional
form need only be specified for one of these
functions; the relations in 1 and 4-8 will imply a
functional form for the rem aining functions.
We use the proportional hazard relationship
developed by Cox (1972), w here
(9) A(f|*,p) = A
0(f)exP
,
w here ^ is a row vector of m easured covariates
and ft is a column vector of param eters with the
appropriate dimensions. This model assumes a
baseline hazard, A
0(f), w hich in principle amounts
to an unidentified param eter for each bank in
the sample. Thus, A accounts for any unob­
0(f)
served heterogeneity among the banks that
might otherw ise bias the param eter estimates.
The covariates in x influence the overall hazard
for each bank through the exponential term s in
equation 9 (the choice of an exponential form
here is common throughout the literature on
hazard estimation and simplifies the estimation
problem relative to choices of other functional
forms). The model is sem iparam etric since the
exponential in 9 is a param etric form, while the
baseline hazard involves an unspecified form

71

and, hence, is nonparam etric. Consequently, the
model is m ore flexible than models in which the
failure time distribution is assumed known ex­
cept perhaps for a few scalar param eters.
Given the hazard specification in equation 9,
the corresponding survivor function (which
gives the probability of survival up to time t)
may be w ritten as
(10) S(f|*,/}) = exp

- (X (u)e^ du

For uncensored observations with failure at time
T, the contribution to the likelihood is f(T\?c)-, for
observations censored at time T, the contribu­
tion to the likelihood is S(T|x), that is, the proba­
bility of survival until time T.
Cox (1972, 1975) suggests a partial-likelihood
approach w hich can be used to estim ate the
param eters of the hazard function in 9. Assume,
for the m oment, that no observations are cen ­
sored, and that the observations are ordered by
their completed, untied durations such that tt <
t., < ... < tn. The conditional probability that
observation 1 fails at time tt, given that any of
the n observations could have failed at time tt, is

A jjtj,/?
U
)
(1 1 )

Attjx,,/?)

The equality results from the assumption of the
proportional hazard in 9; the baseline hazard
A(f) cancels out of the expression on the left in
11. The expression in 11 gives the contribution
of the first observation to the partial likelihood.
Analogously, the contribution of the yth observa­
tion to the partial likelihood is

eV1
1
S .

<-j

.

e'.»

The partial likelihood is given by the product of
the individual contributions and, hence, its log is
(12) L(p) = E U,/J - log

E

j->

Andersen and Gill (1982) and Johansen (1983)

'A atively, o e co specify a param fo fo the
ltern
n uld
etric rm r
baseline hazard inequation 9and m ize the co
axim
rresponding likelih o fu ctio . A o ghthe p
o d n n lth u
artial-likelih o
od
approach avoids the needfo an arbitrary param
r
etric
specification o the baseline hazard, there is a loss o
f
f
efficiency inthe resulting estim relative tothose o ates
b



show that the partial likelihood can be treated
as an ordinary likelihood concentrated with
respect to A
0.33
The model represented by equation 12 can be
easily adjusted to accom modate censoring in the
data. For the data used in this study, each bank
i in the sample is observed at J different times
ti l, < ti2 < ... < t.„ with either failure or ceniJ ’
soring occurring at time tu. Note that tim es here
refer not to calendar time, but to time relative
to the date of ch arter for bank i so that ti0 = 0
w here tiB is the date of ch arter for the ith bank.
The balance sheet inform ation used in ^ co r­
responding to time t.., j = 1, ..., { J .- l ) , are as­
sumed to reflect the position of bank i over the
interval [f.., tjij+1)). The model estimated in this
paper is time-varying in the sense that covariates in are assumed constant for intervals of
time [f , tllj+t)), but may vary across different in­
tervals. Thus, for the ith bank there are ( J .- l )
observed intervals; the first ( J.-2 ) are both leftand right-censored, and the last is left-censored
and also right-censored if failure tim e is not ob­
served for the ith bank.
To accommodate the censoring in the data, let
*.{/), i = l ,
n, j = l ,
J denote the vector of
covariates for bank i during period j. Covariates
are fixed within a given period, but may vary
over different periods. Let d equal 1 for banks
that are observed to fail at some time within the
entire observation period, and zero otherwise.
Assume that banks are ordered by increasing
date of failure. Then, the log-partial likelihood
becom es

S

I

k-i

e 'V

Kiefer (1988) suggests that the intuition behind
the partial-likelihood approach used here is that,
in the absence of any inform ation about the
baseline hazard, only the order of the durations
provides inform ation about the unknown param e­
ters of the model. In both 12 and 13, the instan­
taneous probability of failure is normalized by
the sum of instantaneous probabilities of failure
for all other banks that could have failed at the
same time as the ith bank.

tained b m izin the fu likelih o . See E n(1 7 )
y axim g ll
od
fro 9 7
fo a discussion o this efficiency lo
r
f
ss,

MAY/JUNE 1994

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