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November 1981
Vol. 63, No. 9

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3 What Really Happened to Interest Rates?:
A Longer-Run Analysis
15 Trends in Federal Spending: 1955-86

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25 The Voluntary Automobile Import
Agreement with Japan — More
Protectionism

The Review is published 10 times per year by the Research Department o f the Federal Reserve
Bank o f St. Louis. Single-copy subscriptions are available to the public fr ee o f charge. Mail
requests fo r subscriptions, back issues, or address changes to: Research Department, Federal
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Articles herein may be reprinted provided the source is credited. Please provide the Bank’s
Research Department with a copy o f reprinted material.

What Really Happened to Interest Rates?:
A Longer-Run Analysis
G . J. S A N T O N I A N D C O U R T E N A Y C . S T O N E

In te r e s t rate movements have becom e increasingly
troublesome in recent years. Chart 1, which shows
representative short- and long-term bond yields over
the past 27 years, illustrates two perplexing prob
lems with interest rate movements during this
period. First, interest rates have risen considerably.
In 1954, 3-month Treasury bill rates were close to
1.00 percent and long-term government securities
yielded around 2.50 percent; during the second
quarter o f 1981, the 3-month Treasury bill rate had
reached nearly 17.00 percent while the yield on
long-term government securities approached 15.00
percent. Second, associated with this rise in their
general levels have been larger and more erratic
fluctuations in interest rates as well.
The purpose o f this article is to discuss the factors
primarily responsible for the rise and increased
variability in interest rates in recent years. The
analysis is not intended, norcan itbe used, to explain
every jiggle and jog in interest rates that occurred
during this period. Instead, it is meant to uncover
those factors that have influenced the longer-term
behavior o f interest rates over the past 15 years.

A Brief Summary o f Interest Rate
Movements: 1954-66 and 1967-81
This article focuses on the changes in the average
levels and variability o f interest rates that oc
curred between two extended time periods. The
first period, 1954 to 1966, was one in which interest
rates were both relatively low and comparatively

stable. The second period, 1967 to the present, is
one in which interest rates have reached relatively
high levels and demonstrated considerably greater
variability.
The major changes in interest rates over these two
periods are shown in tables 1 and 2 for four different
interest rates: the Aaa corporate bond rate, 20-year
Treasury security yield, 90-day commercial paper
rate and three-month Treasury bill rate. Whether
the interest rate analyzed is short- or long-term, or
whether a private or government interest rate is
chosen, the general picture remains unchanged. On
average, interest rates are considerably higher —
from 384 to 420 basis points higher — in the 1967-81
period than they were from 1954 to 1966. As the tstatistics in table 1 indicate, these increases are
statistically significant, allowing us to reject the
hypothesis that the differences in the average levels
o f interest rates in the two periods merely represent
sampling error.1
In addition, interest rates have becom e consid
erably more volatile in recent years. Their increased
variability since 1966 is demonstrated in table 2
using several different measures o f variability. Their
standard deviations, the commonly used measure o f
’ F or sam ple sizes used, a t value in excess of 2.00 is sufficient to
reject the (null) hypothesis that the ob serv ed differen ce in the
m ean valu es eq u a ls zero w ith 95 p e rce n t co n fid e n ce . T h is
statistical test is predicated on the use o f in d ep en d en t random
sam ples. Since ou r sam ples are n ot random ly ch osen , w e use
the t and F tests that appear later in the paper to “ p rovid e the
basis for a g ood edu ca ted guess — or what w e m ight term the
art o f in feren ce.” (Italics in original.) Thom as H. W onnacott
and Ronald J. W onnacott, In trod u ctory S tatistics f o r Business
and E con om ics, 2nd ed. (John W iley and Sons, 1977), p. 9. For
m ore on t and F tests, see virtually any statistics text.

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1981

R e p re s e n t a tiv e Short-Term a n d Long-Term Interest Rates

1954 1 95 5 1 95 6 1957 1958 1959 1 9 6 0

1961 1 9 6 2 1 96 3 1 96 4 1 96 5 1966

1967 1 9 6 8 1 9 6 9 1 9 7 0

1971 1 97 2 1973 1 97 4 1 97 5 1 97 6 1977

1 97 8 1979 1 9 8 0 1981

L a te st d a t a plotted : 2 n d q u a r t e r

variation around the mean, have more than doubled
from the earlier to the later period. In addition, their
average quarter-to-quarter absolute changes have
tripled, as have their standard errors from regres
sions o f interest rates on a time-trend variable.2
These various measures indicate that interest rates
have been considerably more variable over the past
15 years than they were from 1954 to 1966.
These increases in both the average levels and
variability o f interest rates are more than merely
statistically significant. The rising volume o f public
discussion and debate suggests that these changes
are econ om ically and p olitically significant as
w ell. If we are to devise an effective policy to
ameliorate the problems created by interest rate
movements, it is important that these changes in the
longer-term behavior o f interest rates be explained.
2Average absolute quarter-to-quarter changes and standard errors
from tim e-trend regressions w ere used as m easures o f variability
to see w hether changes in the trend growth in interest rates in
the later p e riod had distorted the usefulness o f the standard
deviation as a m easure o f variability. For further discu ssion on
this issue, see E dw ard Foster, “ T he Variability o f Inflation, "T h e
R eview o f E con om ics and Statistics (August 1978), pp. 346-48.

Components o f the Nominal Rate o f
Interest: The Crucial Importance
o f Expectations
Interest rates observed in financial markets are
nominal interest rates. They measure the premium
that the borrower must pay in a credit transaction
involving the exchange o f dollars now in return for
a promise to repay dollars at some specified future
date.3
The parties involved in such contracts are clearly
interested in the expected future value o f money in
terms o f goods and services that can be purchased
with it when the loan is repaid. Because the value o f
money varies inversely with movements in the
general level o f prices — falling during periods of
inflation and rising during deflationary periods — the
expected inflation rate over the period o f the loan is
one component o f the nominal rate o f interest.
3F or further discu ssion o f various interest rate con cep ts, see G . J.
Santoni and C ourtenay C. Stone, “ N avigating T h rou gh the
Interest Rate M orass: Som e Basic P rin cip les,” this R ev iew
(M arch 1981), pp. 11-18.

NOVEMBER 1981

FEDERAL RESERVE BANK OF ST. LOUIS

Table 1
Average Levels of Selected Nominal Interest Rates and
Average Annual Growth Rates in Money, Velocity,
Output and Prices1
1954-66

Difference

1967-81

t-statistics

Aaa corporate bond rate

4.06%

8.26%

4.20 2

16.43

7.62

3.842

14.33

20-year T reasu ry secu rity yie Id

3.78

C om m ercial paper rate

3.45

7.61

4.162

10.46

3-month Treasury bill rate

2 .8 6

6.76

3.902

10.24

2.19

6.43

4.242

11.58

M1B

2.46

6.52

4.062

3.55

2 .8 8

-.6 7

-1 .2 6

2.98

- .8 5

-1 .0 5

.16

.27

3.83

Y
V - Y

-0 .2 7

_ = annualized percentage rate
M 1 B = annualized percentage rate
growth used p rio r to 1959).
V
= annualized percentage rate
Y
= annualized percentage rate

of increase in the GNP im p licit price deflator.
of grow th in M 1 B money stock (M 1 money stock rates of

8.38

0 .1 1

of grow th in M1B velocity measure.
of grow th in real GNP.

'C alculated from quarterly data at annual rates through 11/1981.
S ig n ific a n tly diffe re nt from zero at the 5 percent significance level.

Table 2
Measures of Interest Rate Variability
1954-66

1967-81

Aaa corporate bond rate

.63%

1.83%

2 0 -year

.60

1.94

Commercial paper rate

1.05

2.82

7.231

3-month Treasury bill rate

1.05

2 .6 8

6.45'

F-statistic

Standard deviations
Treasu ry secu rity yield

8.44 1
10.601

Mean quarter-to-quarter absolute changes
Aaa corporate bond rate
20

-year Treasury secu rity yield

.1 0 %

.29%

.1 1

.32

Com m ercial paper rate

.28

.90

3-month Treasury bill rate

.27

.74

Standard errors from regressions of interest rate on time trend
.28%

.96%

.25

.79

C om m ercial paper rate

.71

2.38

3-m onth Treasury bill rate

.67

2.05

Aaa corporate bond rate
20

-yearTreasury secu rity yield

'T he ratio of the variances is sig nifica ntly greater than one at the 5 percent significance level.

FEDERAL RESERVE BANK OF ST. LOUIS

The other component of the nominal rate of inter
est is the expected or ex ante real rate o f interest.
The real rate o f interest is the relative price paid for
obtaining the use o f goods now rather than in the
future.4 Narrowly interpreted, it represents the
expected positive cost to the borrower (or return to
the lender) after an adjustment has been made for
the expected change in the general price level over
the loan period.
More importantly, however, the expected real
rate o f interest has a pervasive influence throughout
the economy because it reflects the premium that
individuals place on providing themselves with
present consumption goods relative to future con
sumption.5 Movements in the real rate o f interest
result either from changes in the underlying indi
vidual preferences for present consumption goods
relative to present capital goods (the sources o f
future consum ption goods) or from changes in
society’ s ability to transform current goods into
future goods via changes in the capital stock.
Regardless o f what triggers it, any change in the
real rate o f interest will be reflected in the behavior
o f the relative prices o f current consumption (short
lived) goods in terms o f capital (long-lived) goods.
A rise in the real rate o f interest will show up as a
general rise in the prices of current consumption
goods relative to capital goods; a decline in the real
rate o f interest will appear as a decline in these
relative prices.
In summary, the nominal interest rate consists o f
two components that, though not directly observ
able, influence the actions of borrowers and lenders.
The nominal interestrate (i) can be thought o f simply
as the sum o f the expected real rate o f interest (r) and
the expected future rate of inflation ( 7t*) over the
period o f the loan, or
(1) i = r + 77*.6
The important point to rem ember is that the
nominal rate o f interest is always forward looking. It

NOVEMBER 1981

depends upon the present expectations of borrowers
and lenders about future events.7

The “Problem” with Guessing Wrong
Of course, expectations can change — sometimes
drastically so. These changes are a source o f public
concern because lending and borrowing decisions
represent bets about the future that involve wealth
consequences for individuals. Changes in the nomi
nal rate o f interest signal the fact that, in the aggre
gate, individuals have revised their assessment of
the value o f present consumption goods in terms of
capital goods, their expectations o f the future rate
o f inflation or both. When these changes occur,
lenders, borrowers, investors and consumers face the
unanticipated wealth consequences o f their past
decisions. These changes capriciously redistribute
wealth among individuals.
Increased variability in the rate o f interest implies
that such revisions are occurring more often and/or
are more drastic in nature. As a result, financial
market participants are subject to greater and more
frequent unanticipated wealth changes and thus are
faced with increased risk.
To assess the factors that have produced increases
in both the average level and volatility o f nominal
rates o f interest, we must focus on the behavior o f
the two com ponents that make up the nominal
interest rate: the expected real rate o f interest and
the expected rate o f inflation.

Assessing Changes in the Real
Rate o f Interest
To what extent can the observed rise and in
creased volatility o f the nominal rate o f interest since
1967 be explained by changes in the real rate o f
interest? This question cannot be answered directly
because the expected real rate o f interest is not
directly observable.
Since relative price movements always result
from changes in the real interest rate, however, it
should be possible to detect when these changes

“Arm en Alchian and W illiam R. A llen , E xch an ge and Production:
C o m p etitio n , C oord in ation and C on trol (W adsw orth, 1977),
pp. 424-59.
5I b id . S ee a lso I r v in g F is h e r, T he R a te o f I n t e r e s t (T h e
M acm illan C o., 1907), p. 88; and Jack H irshleifer, In vestm en t,
In terest, and C apital (Prentice-H all, 1970), p. 117.
eT he exact relationship is: i = r + 77 * + (r) (7 t*). E quation 1 is
an approxim ation that is reasonably close to the exact relation
ship for relatively low rates o f inflation and real rates o f interest.

Digitized for 6
FRASER

7“ T he rate of interest is always based upon expectation, h o w e v e r
little this may b e ju stified b y realization. M an makes his guess
o f the future and stakes his action upon it. . . . O ur present acts
must be con trolled b y the future, not as it actually is, but as it
looks to us through the veil o f ch a n ce.” Fisher, The R ate o f
In terest, p. 213. See also, Irving Fisher, The T heory o f In terest
(K elley and M illm an, 1954), pp. 13-16, 36-58, 61 and 206-27.

FEDERAL RESERVE BANK OF ST. LOUIS

have occurred.8 Recall that an increase in the real
interest rate will be reflectedby increases in the prices
of current goods and services relative to present
prices o f durable goods and capital assets. Similarly,
a fall in the real interest rate is reflected as a decrease
in prices o f current goods and services relative to
present prices o f durable goods and capital assets.
There are a wide variety o f such relative prices
that can be observed, several o f which were ex
amined for the 1954-66 and 1967-80 periods. Each
price ratio expresses the price o f a present consump
tion good relative to the price o f a more durable
good or capital asset. For example, the consumer
price index (CPI) is heavily weighted in terms o f
present consumption goods; as such, it represents
an index o f the prices o f these goods.9 The Standard
and Poor’ s Stock Price Index is a price index o f the
present prices (actually, net values) of capital goods.
Therefore, an increase in the ratio o f the CPI to the
Standard and Poor’s Index can be interpreted as a
reflection o f an increase in the real rate of interest; a
decrease in the ratio denotes a fall in the real interest
rate. Similar reasoning applies to the other price
ratios examined.10 Because it is always possible that
special factors may cause individual price ratios to
change for reasons other than a change in the real

8O n e alternative approach e m p loy ed has b een to estimate the
exp e cte d inflation rate and subtraetthis from the nom inal interest
rate. In essen ce, this procedu re transposes equation 1 to
re = i — tr|,
w here tt% den otes an estim ate o f the exp ected inflation rate
and re is the derived estim ate o f the real rate. Unfortunately,
these em pirical estimates are subject to tw o major criticism s.
First, during certain periods, these real interest rate estimates
have b e e n negative. This is a nonsensical result. T h e exp ected
real rate o f interest is always positive. See Friedrich A. H ayek,
The Pure T heory o f C apital (The University o f C hicago Press,
1941), pp. 223-24; and Fisher, The T heory o f In terest, pp. 186-94.
S econ d, co m m o n ly d erived estimates ol the exp ected inflation
rate are biased if the real rate is changing, leadin g to erroneous
estim ates o f the real rate if this m ethod is em p loyed . See W . W.
Brow n and G . J. Santoni, “ Unreal Estimates o f the Real Rate
o f Interest,” this R eview (January 1981), pp. 18-26.
9Bureau o f L a b or Statistics, H an d book on M eth od s, Bulletin
1910 (1976). For a discu ssion o f the various price in dices cu r
rently used, see W illiam H. W allace and W illiam E. C ullison,
M easuring Price C hanges: A Study o f the Price Indexes, 4th
ed. (Federal Reserve Bank o f R ichm ond, 1979).
1“T h ese ratios are n o t equal to the ex ante real rate o f interest.
H ow ever, they are functions o f the real rate o f interest. T o see
this, let P0 equal the price o f a present con su m p tion g o o d and
let Pc equal the present price ol a capital g ood . Pc can be
represented as follow s:

Pt <lt

TTT75

NOVEMBER 1981

rate o f interest, the behavior o f several such price
ratios must be examined.11

Has the Real Rate o f Interest Changed?
The price ratios examined provide evidence that
the rise in the average levels o f nominal rates of
interest was not produced by a rise in the average
level of the real rate o f interest.12 Data on the average
level o f four price ratios are presented in table
3; differences in the average levels o f the price
ratios between 1954-66 and 1967-80 are presented
in column 4.
Two of the price ratios, the ratio o f the CPI to the
Standard and Poor’ s Stock Index and the ratio o f the
price o f lamb to the price o f sheep, declined on
average, presumably an indication that the real rate
of interest declined. Neither o f these changes,
however, is statistically significant, which means
that we cannot reject the hypothesis that the average
real rate o f interest was actually unchanged between
the two periods. Two price ratios, the ratio o f the
nondurable goods com ponent o f the CPI to the
durable goods component and the ratio o f the price
o fb e e f to the price o f cattle, rose, on average, osten
sibly signaling a rise in the real rate o f interest.
H ow ever, the rise in the average ratio o f b e e f
to cattle prices is, again, not statistically significant;

w here qt represents the quantity o l good s and services pro
du ced at time t, Pt are the prices (net o f costs o f production) at
tim e t, and i is the nom inal rate o f interest.
Inflation can b e in trod uced into the analysis as follow s (using
the exact relationship show n in footn ote 6):
Qt
( ii)P c -2
^

tt o

(1r *
/(1PI oiT-\t /I
+ r ) f (1

)tqV
-L

+ "* )*

r o |
t io

(1 + r )4

w here r and rr* are the ex ante real rate and the exp ected rate
o f inflation, respectively. This results in

(iii) Index = Pq /P c =

t=o

qt
(1 + r)t

This index rises w h en ever r rises and falls w h en ev er r falls.
"C h a n g e s in special circum stances tend to occu r random ly and
are as lik ely to raise as to lo w e r the price ratio.
12O f course, year-to-year fluctuations in the real rate w ill occur.
For exam ple, there is e v id e n ce that the real rate o f interest rose
in 1973-75. See B row n and Santoni, “ U nreal E stim ates.”
T h ese fluctuations are not critical to the present question. W e
are interested here in w h eth er the average level around which
these fluctuations occu r is different during the m ore recent
p e r io d and, i f so, to w hat extent this ch ange exp lains the
d ifferen ce in the average level o f the nom inal interest rate
b etw een the tw o periods.

NOVEMBER 1981

FEDERAL RESERVE BANK OF ST. LOUIS

Table 3

Table 4

Average Levels of Proxies for Changes
in the Real Interest Rate1

Standard Deviations of Proxies for
Changes in the Real Interest Rate

1967-802

1954-66

1967-80

F-statistic

Ratio

1954-66

1.599

1.549

-.0 5 0

-.3 0

.450

.404

1.24

.935

1.074

.139

7.87

.025

.059

5.571

.163

.166

.003

.39

.017

.023

1.83

.385

.352

-.0 3 3

-1 .7 3

.044

.053

1.45

Difference

t-statistic

R1 = R a tio o fth e c o n s u m e rp ric e in d e x (C P I)to th e S ta n d a rd
and P oo r’s Index of common stock prices.

1The ratio o f the variances is sig nifica ntly greater than one at
the 5 percent significance level.
For footnotes, see table 3.

R2 = Ratio of the nondurable good com ponent of the CPI
to the durable good com ponent of the CPI.
R3 = Ratio of the price of beef per cwt. to the price of cattle
per head.
R4 = Ratio of the price of lamb per cwt. to the price of sheep
per head.
'C alculated from annual data.
2Data fo r R3 and R4 are currently available only through 1979.
Sources: U.S. Departm ent of Labor, Bureau of Labor Statis
tics; Standard and P oor's; U.S. D epartm ent of
Commerce, Statistical Abstract o f the U.S.; and
U.S. Department of Agriculture, A g ricultu ral Sta
tistics Annua! (1979).

we are unable to determine whether the change in
the average level o f the ratio o f the nondurable
to the durable good s co m p o n e n t o f the CPI
is significant.13 Thus, these ratios provide no
statistical evidence that the real rate of interest has
changed, on average, between the two time periods.
Therefore, the increase in the average level o f nomi
nal interest rates in recent years cannot be attributed
to an increase in the average level of the real interest
rate.
Nominal interest rates were more volatile during
the 1967-81 period than during the 1954-66 period
as shown by the statistically significant increase in
their variances in the more recent period (see table
2).14 This increase in volatility however, can not be
13W h en em p loyin g the t test for d ifferen ces in m eans for sm all
sized sam ples (less than 30 observation s), the sam ples are
assum ed to b e drawn from n orm ally distributed populations
having the same standard deviations. This assum ption is v io
lated in the case o f R2 (see the F-statistic in table 4) and, thus,
the t-test for the significance o f the differen ce in means is
inappropriate.
14T h e F-test is the ratio o f the larger variance to the smaller
variance, w h ere the variance is the square o f the standard
deviation. F or the sam ple sizes used, an F-ratio in excess of
1.60 is sufficient to reject the (null) hypothesis that the variances
are equal w ith 95 percent con fid en ce.

explained by increased volatility in the real rate o f
interest. As shown in table 4, only one relative price
ratio, the ratio o f the nondurable to the durable goods
component o f the CPI, demonstrates any significant
increase in variance. For three price ratios, there is
no statistically discernible change in their variances
between the two periods. Again, the preponderance
o f evidence suggests that the increased volatility in
nominal interest rates did not arise from greater
variation in the real rate o f interest. Therefore, the
solution to the puzzle o f nominal interest rate b e
havior in the more recent period lies elsewhere.

Expected Inflation, Actual Inflation and
Measured Inflation
The econom ic theory summarized by equation 1
suggests that if changes in the real rate o f interest
do not explain the increases in the mean level and
volatility o f nominal interest rates between the two
periods, then changes in the expected rate o f inflation
mustbe responsible. To analyze properly the impact
o f inflation on nominal interest rates, however, three
different concepts regarding the rate o f inflation must
be distinguished: 1) the expected rate o f inflation in
the general level o f prices, 2) the actual or true rate
o f inflation in the general level o f prices and 3) the
measured rate o f inflation.
It is the expected rate o f inflation ( 77*) that is impor
tant in explaining the behavior o f nominal interest
rates; this is the inflation variable that appears in
equation 1. Unfortunately, the expected inflation rate
is not directly observable.
The expected inflation rate represents the public’ s

FEDERAL RESERVE BANK OF ST. LOUIS

best “ guess” about what the actual or true future rate
o f inflation in the general level o f prices will be. This
guess generally will be incorrect for any specific
time period; the future is, after all, uncertain and,
therefore, subject to a variety o f random shocks.
However, econom ic theory suggests that because
there are large wealth consequences associated
with these predictions, estimates o f the true rate
o f inflation made by individuals will be unbiased;
that is, although these predictions generally will be
wrong due to the occurrence o f unexpected future
events, they will not consistently over- or underpredict the true rate o f inflation.15 As a result, if we
knew about changes in the true rate o f inflation, we
could use this information as a proxy for changes in
the (unobservable) expected rate o f inflation.
However, the true rate o f inflation in the general
price level is also unobservable. We have no direct
information on this rate; instead, we have informa
tion on several different measured rates o f inflation.
These are typically derived from changes in various
price indices, such as the CPI, the GNP deflator
and the Index o f Producer’ s Prices.
Unfortunately, the measured rate o f inflation may,
under certain circumstances, differ significantly
from the true rate o f inflation in the general level o f
prices. This potential divergence occurs because the
price indices mentioned above typically include a
relatively narrow sample o f all o f the goods that are
available for purchase. In particular, they generally
exclude the prices o f existing capital assets, thereby
placing greater w eight on the prices o f current

15“ B efore p r o ce e d in g to sp ecific statistics, it is im portant to
em p h asize the broad fact that . . . b usin ess foresight exists
and that the accuracy and p o w e r o f this foresight is greater
today than ev e r b e fo re . . . . E very chance for gain is eagerly
w atch ed. An active and in telligent speculation is constantly
g o in g on , w h ich . . . perform s a w ell-k n ow n and providen t
fun ction for society. Is it reasonable to b e lie v e that foresight
. . . has an excep tion as a p p lied to falling or rising p rices? Or,
if so, can the academ ic . . . assume h im self possessed o f a fore
sight o f w h ich he says the practical man is in capable? It is the
practical m an’ s business to foresee. It is he w h o first gathers
the facts and statistics. . . . It is he w h o w atches the trends. . . .
A n d it is in his trade journals that w e find the first discussions
o f the proba b le e ffe ct o f gold discov eries or silver legislation
on prices and trade. T h e theorist can aid in these predictions
o n ly b y supplying the p rin cip le on w h ich they are con stru cted .”
Irving Fisher, A p p recia tion and In terest (Augustus M. K elley,
1965), pp . 36-37. For further discu ssion o f efficien t markets,
see E u gen e F. Fama, “ E fficient Capital Markets: A R ev iew o f
T h eoretical and Em pirical W ork,” Journal o f F in ance, Papers
and P roceedin gs (M ay 1970), pp. 383-417.
16Arm en A. Alchian and Benjam in Klein, “ O n a C orrect Measure
o f Inflation,” Journal o f M on ey, C red it and Banking (February
1973), pp. 173-91.

NOVEMBER 1981

consumption goods.16 Measured rates o f inflation
will therefore produce biased estimates o f the true
rate o f inflation in the general level o f prices on those
occasions when the prices o f present consumption
goods are changing relative to the prices o f capital
assets. This specific bias occurs whenever the real
rate o f interest changes. Consequently, the mea
sured inflation rate overstates the true rise in the
general level o f prices when the real rate o f interest
rises, and understates the true rate o f inflation
when the real rate o f interest declines.
Fortunately, it is possible to “ link” the unobserv
able average rate o f expected inflation to the observ
able average rate of measured inflation, if expectations
o f individuals regarding the future rate o f inflation
yield unbiased predictions o f the true rate o f inflation
and if, in addition, the average level o f the real in
terest rate is unchanged over the period o f analysis.
The first “ i f ’ enables us to link the expected to the
actual rate o f inflation. The second “ i f ’ lets us relate
the actual to the measured rate o f inflation.
Note the critical importance o f our previous find
ing that the average level o f the real interest rate did
not change between the 1954-66 period and the
1967-80 period. Because o f this, we would not expect
the average measured rate o f inflation over these two
periods to differ from the true rate o f inflation.17
Because we believe that the expected rate o f inflation
is an unbiased estimate o f the actual rate o f inflation,
we can directly link the average rate o f expected
inflation to the average rate o f measured inflation.

The Relationship Between Measured
Inflation and Nominal Interest Rates
Inflation statistics using the GNP implicit price
deflator are reported in tables 1 and 5. The data in
table 1 indicate that, on average, the measured rate
o f inflation ( 77) was 4.24 percent higher during the
1967-81 period than during the 1954-66 period. This
increase closely parallels the 384 to 420 basis-point
increases in the average levels o f the nominal inter
est rates reported in table 1. In fact, none o f these

17W h ile it is true that year-to-year changes in the real rate o f
interest have occu rred and thus have in troduced a bias into the
m easured rate o f inflation at those points in tim e, these fluctua
tions have apparently averaged out. As a result, apart from other
p r o b le m s , any o b s e r v e d d iffe r e n c e b e tw e e n the a v era g e
m easured rate o f inflation b etw een the tw o subperiods can not
b e explained by m easurem ent error in trod uced by a change in
the average level o f the real rate o f interest.

NOVEMBER 1981

FEDERAL RESERVE BANK OF ST. LOUIS

increases in the average levels o f interest rates are
significantly different from the increase in the
average level o f inflation.18 The rise in the average
rate o f inflation fully “ explains” the average increases
in these nominal interest rates.
Data for various measures o f variability in the
measured rate o f inflation for the two periods are
reported in table 5. Tw o of the three measures indi
cate increased variability in the rate o f inflation. The
standard deviation of the measured rate of inflation in
the more recent period is almost twice that in the
earlier period; this closely parallels the increase in
the standard deviations of the nominal interest rates
reported in table 2. The standard error associated
with regressing the rate o f inflation on a simple time
trend has increased by 43 percent. Only the mean
quarter-to-quarter absolute change in the rate o f
inflation shows no increase in the later period.
This evidence suggests that the rise in the average
level o f nominal interest rates since 1967 and, to a
lesser extent, their increased volatility can be ex
plained by the increase in the level and volatility o f
the rate o f inflation. What remains, therefore, to
complete the analysis o f interest rate movements in
recent years is to determine why the rate of inflation
has changed.

Determinants o f the Rate o f Inflation
The increase in the average level and volatility
o f the rate o f inflation during the 1967-81 period
could have been produced by changes in the b e
havior of the growth in the money stock (Kl), in the
growth o f its velocity o f circulation (V), or in the
growth of real output (Y). The relationship between
the rate o f inflation and these variables is given by
the following identity:
(2) 7T = Id + V — Y.
The rate of inflation is positively related to changes in
the growth rates o f the money stock and its velocity
o f circulation, and inversely related to changes in the
growth rate o f output.
Econom ic theory converts this identity into a hy
pothesis about the long-term relationship between
the growth rate in money and the rate of inflation by

18T h e t-statistics for the (null) hypothesis that the change in the
interest rates b etw een the tw o periods is exactly 4.24 percent
are —0.16, —1.49, —0.20, and —0.89, for the interest rates
show n in table 1, respectively.

Digitized for 10
FRASER

Table 5
Measures of Variability in Growth Rates
of Prices, Money, Velocity and Real
Output1
1954-66

1967-81
F-statistic

Standard deviations

3.422

1.31%

2.42%

M1B

2.32

2.76

1.41

3.85

3.79

1.03

4.20

4.30

1.05

V -Y

2.62

3.58

1.872

Mean quarter-to-quarter absolute changes
TT

1.44%

1.38%

M1B

1.63

2.49

3.45

4.19

3.49

4.14

V -Y

2.05

2.80

Standard errors from regressions against time trend
TT

1.32%

1.89%

M1B

2.22

2.72

3.88

3.74

4.10

4.33

'C a lcu la te d from qu arterly data at annual rates throu gh
11/1981.
2The ratio of the variances is sig nifica ntly greater than one at
the 5 percent significance level.

arguing that the long-term growth rates in velocity
and output are essentially unaffected by changes in
the long-term growth rate in the stock o f money.19 As
a result, changes in the long-term rate o f growth in
the money stock will be directly matched by changes
in the rate o f inflation if the long-term rates o f growth
in velocity and output remain unchanged.
Since our analysis covers two relatively long time
periods, we should be able to determine the extent
to which each o f these factors has influenced the
long-term changes in the rate o f inflation and, by
extension, the changes in nominal interest rates.
19Irving Fisher, The Purchasing P ow er o f M on ey (Augustus M.
K elley, 1963), p. 14, notes that: “ This theory, though often
cru d ely fonnulated, has b een a ccep ted by L ock e, H um e, Adam
Smith, Ricardo, M ill, W alker, M arshall, H adley, Fetter, Kem merer, and m ost writers on the subject. T h e Rom an Julius
Paulus, about 200 A .D ., states his b e lie f that the value o f m on ey
d ep en d s u pon its quantity.” See also pp . 157-59. O n page
296-97, F ish er states that the “ Law [em phasis in original] o f
direct proportion b etw een [the] quantity o f m on ey and the
price l e v e l . . . is as im portant to the theory o f m on ey as B o y le ’ s
Law is to the physical theory o f gases.”

FEDERAL RESERVE BANK OF ST. LOUIS

Has the Long-Term Growth Rate in Real
Output Changed?
The long-term growth rate in output is primarily
determined by the rate at which capital is accumu
lated.20 The average growth rate in real output was
3.4 percent per year over the 1954-81 period. O f
course, the growth rate o f output fluctuates consid
erably from quarter to quarter around its long-term
average rate. The pattern o f the short-term variations
in output growth and the average rate o f growth over
the entire 1954-81 period are shown in the first tier
o f chart 2.
The quarter-to-quarter growth rates in real output
vary considerably, from a positive 11 percent during
the first quarter o f 1973 to a negative 10 percent
during the second quarter o f 1980. However, as the
summary statistics in tables 1 and 5 indicate, both
the average rate o f growth in output and its variance
are essentially unchanged between the two periods.
The reported differences in both the mean growth
rates and variances are not statistically significant.
Thus, the statistical evidence does not support the
claim that changes in the average growth in real
output and its variability are responsible for the
higher and more variable inflation rate.

Has the Long-Term Growth Rate in
Velocity Changed?
The velocity o f money measures the relationship
between total spending and the stock o f money. The
larger the velocity, the greater the amount o f spend
ing that a unit o f money will finance during any given
period.21 This is why, given the quantity of money
and real output, an increase in velocity is associated
with a rise in prices.
Like real output, velocity has been increasing.
The average rate o f growth in velocity was about 3.3
percent per year over the 1954-81 period, virtually
cancelling out the effect on prices resulting from the
average growth in real output as shown in equation 2.

20F or a com p lete discu ssion, see Fisher, The Purchasing P ow er
o f M o n ey, pp. 74-111. F ish er in clud es the quantity o f natural
resources, the div ision o f labor, tech n iq u e o f produ ction , variety
o f wants, facilities for transportation, institutional arrangements
regarding the rights o f in dividuals to contract, etc.
“ V elocity dep en d s u pon such things as the e x p ected rate o f
inflation, the rate at w hich ch ecks are cleared and the use o f
credit. In addition to these, Fisher, The Purchasing P ow er o f
M on ey, p. 79-89, adds preferen ces to hoard, the tim ing and
regularity o f receipts and disbursem ents, population density
and transportation facilities.

NOVEMBER 1981

The second tier o f chart 2 shows quarter-to-quarter
growth rates in velocity and the average growth rate
for the entire 1954-81 period. These quarter-toquarter growth rates fluctuate considerably around
the long-term average. However, as the data in tables
1 and 5 indicate, there has been no significant change
in the average rate o f growth in velocity or in its
volatility between the two periods. Differences in
the mean growth rates and the variances between
the two periods are not statistically significant.
Consequently, the increase in the average level and
variability o f the rate o f inflation can not be explained
by changes in the growth rate of velocity.

Has the Relationship Between Velocity
and Real Output Growth Changed?
Although the increase in the level and volatility
o f inflation since 1967 is not explained by changes in
the growth rates o f velocity and real output when
analyzed separately, it is really the difference b e
tween these two growth rates that measures the
longer-run, non-monetary influence on inflation (see
equation 2). Therefore, an explicit analysis o f this
difference may reveal significant changes that do not
appear when velocity and real output growth rates
are examined individually. Evidence bearing on this
issue is presented in tables 1 and 5; the difference is
depicted graphically in the third tier o f chart 2.
As shown in table 1, there has been no statistically
significant increase in the average difference be
tween the growth rates for velocity and real output.
Not only is this difference not significantly different
from zero in each period shown, the 0.16 rise in the
difference in the later period is explainable by
sampling error alone.22 Thus, the increase in the
average inflation rate since 1967 can not be attributed
to significant changes in the growth o f velocity and
real output, whether taken separately or in tandem.
The results in table 5 suggest, however, that the
increased volatility o f inflation since 1967 has been
accompanied by a significant increase in the vola
tility o f the difference between velocity growth and
real output growth. The rise in the standard devia
tion is statistically significant; the mean absolute
quarter-to-quarter changes have risen 37 percent in
the 1967-81 period. Therefore, the greater volatility
in this difference since 1967 has contributed to
increased variability in the rate o f inflation.
22T h e t-statistics for the d ifferen ce betw een velocity and output
grow th in each p eriod are —0.74 for 1954-66 and —0.23 for
1967-81.

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1981

C h art 2

G r o w t h Rates of Real O u t p u t a n d V e lo c ity

Perceit
12

erence b e tw e e n velocity g ro w th rate and re al output g ro w th rate

10
8

Quarterly velocity growth l1
■minus real output growth

ferem

0
-2
-4

-6

-6
1954 1955

1956

1957

1958

1959 1960

11 C o m p o u n d e d a n n u a l r a t e s o f c h a n g e ,
la t e s t d a t a plotte d : 2 n d q u a r t e r

Digitized for12
FRASER

1961

1962 1963

1964

1965

1966

1967

1968 1969

1970

1971

1972 1973

1974

1975 1976

1977 1978

1979

1980 1981

NOVEMBER 1981

FEDERAL RESERVE BANK OF ST. LOUIS

C h art 3

G r o w th Rates of G N P Implicit Price De flato r a n d M1B

1954

1955

1956 1957

1958 1959 1960

1961

1962 1963 1964 1965

1966

1967 1968 1969

1970

1971

1972 1973 1974 1975

1976 1977

1978 1979

1980 1981

U_ C o m p o u n d e d a n n u a l ra te s of c h a n g e .
L atest d a t a plotted : 2 n d q u a rte r

Money Growth and Inflation
As we observed above, the combined effect on the
rate o f inflation o f the average growth rates in velocity
and real output have been virtually of fsetting — their
net impact on the rate o f inflation was essentially
zero, as shown in the third tier o f chart 2. Therefore,
the rate of inflation since 1954 must be closely related
to the rate o f growth in the money stock. The close
long-run relationship between the growth in M1B
and the rise in the GNP implicit price deflator
in both periods is evident from a comparison
o f their mean growth rates in table l.23 During
23For e v id e n ce that M1B is the preferable monetary aggregate
to use in assessing the m on ey-price link, see Keith M. Carlson,
“ T he Lag From M on ey to P rices,” this R eview (O ctob er 1980)
pp. 3-10; Keith M. Carlson and Scott E. H ein , “ M onetary
Aggregates as M onetary Indicators,” this R ev iew (N ovem b er
1980), pp. 12-21; R. W . H afer, “ S electin g a M onetary Indicator.
A T e s t o f th e N e w M o n e ta ry A g g r e g a te s ,” this R e v ie w
(February 1981), pp. 12-18; and R. W. H afer, “ M uch A d o A bout
M 2 ,” this R eview (O ctob er 1981), pp. 13-18.

the 1954-66 period, M1B growth averaged 2.46
percent per year and prices rose, on average,
2.19 percent per year; since 1967, growth in MIBhas
averaged 6.52 percent per year and prices have risen,
on average, at an annual rate o f 6.43 percent. There
is no significant statistical difference between the
long-run growth in M1B and that in prices in either
period. The small differences that w e observe b e
tween inflation and money growth in both periods
can be attributed simply to random error.24
The close relationship betw een inflation and
money growth is important because, unlike the other
variables cited above, the long-term rate o f growth
in the stock o f money is a direct consequence of
monetary policy actions. Although the money stock
may vary randomly over periods up to a month or

24T he t-statistics for the h ypothesis that the rate o f inflation equals
the rate o f m on ey grow th are - 0 .7 3 for 1954-66 and —0.19 for
1967-81.

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1981

two, these short-run fluctuations have virtually no
discernible impact on inflation. As the data in table 1
point out, the crucial variable for explaining the
long-run behavior o f prices is the behavior o f the
policy-determined, long-term rate o f growth in
money.

money and their increased variability. These results
indicate that the increase in the average rate o f
inflation and, to a greatextent, the rise in its volatility
can be directly associated with similar movements
in the growth o f M1B.

The significant rise in the average rate o f growth
in the money stock (M IB) and its volatility are shown
in tables 1 and 5. The substantial increase in the
long-term average growth rate in money between
the two periods essentially accounts for the entire
change in the rate o f inflation. The average annual
growth rate in M1B increased by 4.06 percent
between the two periods; the average rate of
inflation rose 4.24 percent per year. There is no signif
icant statistical difference between the average
increase in the rate o f inflation and the rise in M1B
growth since 1967.25

Conclusion

Also, as shown in table 5, money growth has
becom e more volatile since 1967. Its standard devia
tion has increased by 19 percent over the more
recent period. Further, its mean absolute quarter-toquarter change has risen 53 percent; its standard
error (from a time-trend regression) has increased
23 percent.
Chart 3 provides evidence o f the close relationship
between the average rise in the growth of prices and

25T he t-statistic for the (null) hypothesis that the rise in the rate
o f inflation since 1967 actually equals 4.06 percent (the rise in
m on ey grow th) is 0.49.

Digitized for 14
FRASER

Over the past 15 years, nominal interest rates have
been higher and more volatile, on average, than they
were from 1954 to 1966. Judging from the volume o f
public discussion, these increases are economically
and politically disquieting. Besides satisfying a
natural curiosity about why such drastic changes in
financial markets have occurred, one major reason
for studying the factors responsible is to determine
the extent to which policy actions can influence
interest rate movements.
The evidence in this article suggests that higher
and more variable money growth since 1967 have
been primarily responsible for the longer-term rise
and increased variability in interest rates. Alterna
tive explanations o f the movements in interest rates
— that they are due, in part, to higher and more
variable real interest rates or to significant changes
in the behavior o f velocity or real output growth —
are not generally supported by the longer-run evi
dence cited here. A corollary to the analysis is that,
barring fortuitous (but so far unobserved) changes in
velocity and output growth, only an extended period
o f lower and less variable money growth is likely to
generate lower and more stable interest rates.

Trends in Federal Spending: 1955-86
K E IT H M . C A R L S O N

T HE Reagan administration has embarked on an
ambitious program to slow the growth of federal
spending, a program that is part o f an overall
econom ic plan to reduce inflation and promote
sustainable e con om ic growth. The purpose o f
slowing the growth o f federal outlays in the overall
program is to shift resources from the public to the
private sector.
As o f July 15, 1981, the administration had pro
posed a reduction in the growth o f federal outlays
over the next five years to a 6.2 percent annual rate,
down from an estimated 12.5 percent annual rate
from 1976 to 1981.1 The planned slowing in federal
spending is especially pronounced in the early years
o f the projection period. Outlays are projected to
grow at only a 4.7 percent rate from 1981 to 1984,
followed by an 8.6 percent rate from 1984 to 1986.
The spending plan is targeted to reduce federal
outlays to 18.6 percent o f GNP in 1986 from an
estimated 23.0 percent in 1981.
A considerable amount o f budget discussion is
couched in terms of expenditure “ cuts.” For the
most part, however, these spending plans are not
cuts at all, but reductions in spending from what they
would otherwise be. Thus, any attempt to assess
budget developm ents and/or the administration
program must come to grips with that elusive esti
mate o f what outlays “ would otherwise be.” The
Congressional Budget Office (CBO) has prepared a
set o f such estimates, which it calls “ baseline pro
1All references to years in this article are to fiscal years, unless
oth erw ise indicated.

jections.” 2 The administration’ s spending plan will
be presented in light o f these baseline projections.
Any assessment o f current developm ents and
future trends, moreover, requires a sense o f his
torical perspective.3 Thus, this article reviews the
course of federal spending over the last 25 years,
focusing on the growth o f federal outlays relative to
the size o f the econom y as measured by GNP.
Trends in the composition o f federal spending by
major program category also are summarized.

PAST TRENDS IN FEDERAL
SPENDING: 1955-80
To obtain a sense of historical perspective on
federal spending, trends are examined for the period
1955 through 1980. Using 1955 as a starting point
removes most o f the influence o f World War II and
the Korean War, periods o f extensive defense spend
ing, yet the period still includes the Cold War o f the
1950s and the Vietnam War. Excluding all defense
buildups is undesirable since political and inter
national conditions will always impinge to some
degree on decision-making processes relating to
federal spending.
C o n g r e s s io n a l B u d get O ffice , B aselin e B u d get P ro jectio n s:
Fiscal Years 1982-1986 (July 1981).
3T he pu rpose o f the article is to describe, rather than analyze,
federal spen din g trends. F o r a discu ssion o f the theoretical basis
for various governm ental activities, see Richard A. M usgrave and
P eggy B. M usgrave, Public F inance in T heory and Practice, 2nd
e d ., (M c G r a w -H ill B o o k C o m p a n y , 1 976). S ee a lso Sam
Peltzman, “ T he G row th o f G overn m en t,” The Journal o f Law
and E con om ics (O ctob er 1980), pp. 209-88.

FEDERAL RESERVE BANK OF ST. LOUIS

To review trends in federal spending, it is useful to
categorize federal outlays. The Office o f Manage
ment and Budget develops the budget each year in
two fundamental ways: by agency and by function.4
These categorizations are important for the budget
planning process, but for this article, a smaller
number o f categories is preferable. The categor
ization chosen is by major program, a categorization
used by the CBO.

Explanation o f Major Program Categories
Categorizing federal outlays by major program
essentially divides government activities into de
fense and non-defense spending. The latter category
is further subdivided according to the form that this
spending takes.
Table 1 summarizes the major program categories
used as a basis for assessing federal spending trends.
National defense consists mainly o f the military
activities o f the Department o f Defense. The de
fense category, how ever, also includes benefit
payments for retired military personnel and D e
partment o f Energy programs diverted toward
national defense.

NOVEMBER 1981

Table 1
Federal Spending by Major Program
Categories (billions of dollars)
Program
National defense
Non-defense
Benefit payments fo r individuals
Social security
Medicare and Medicaid
Unem ploym ent com pensation
Public assistance and related program s
Federal employee retirem ent and
disability
Food and nutrition assistance
Veterans com pensation, pensions and
readjustm ent benefits
Other

CBO estim ate
fo r 1981
$159.6
500.2
316.1
138.3
56.7
22.7
18.8
18.1
16.3
14.9
30.3

Other grants to state and local
governments

56.9

Net interest
Other federal operations

66.1
61.1

Total

$659.8

In the non-defense category, the largest com
ponent consists o f benefit payments to individuals.

4T h e bu d get breakdow ns used b y the O ffice o f M anagem ent and
Budget are as follow s:
By A g en cy
L egislative and ju d icia l
branches
Funds appropriated to the
president
Agriculture
D efen se — Military
D efen se — C ivil
Education
E nergy
Health and Human Services
H ousing and Urban
D evelop m en t
Interior
Justice
Labor
State
Transportation
Treasury
Environm ental Protection
A gen cy
National Aeronautics and
Space Administration
O ffice o f person nel
m anagem ent
Veterans administration
O th er agen cies
A llow an ces
U ndistributed offsetting
receipts

Digitized for16
FRASER

By Function
National defen se
International affairs
G eneral scien ce, space and
tech n ology
EnergyNatural resources and
environm ent
Agriculture
C om m erce and h ousing credit
Transportation
C om m unity and regional
d ev elop m en t
E ducation, training,
em p loym en t and social
services
Health
In com e security
Veterans benefits and services
Adm inistration o f ju stice
General governm ent
G eneral pu rpose fiscal
assistance
Interest
A llow an ces
U ndistributed offsetting
receipts

These programs include direct payments from the
federal governm ent to individuals (e.g., social
security and federal retirement pay) and indirect
payments through state and local governments (e.g.,
public assistance and child nutrition). Some pro
grams provide cash payments for recipients to use at
their discretion, w hile other programs provide
specific services (e.g., Medicare and Medicaid).
Grants to state and local governments, other than
benefit payments, include general revenue sharing,
the Comprehensive Employment and Training Act,
education, community development, highway con
struction, etc.
Net interest is the interest paid on that portion o f
the federal debt held by the public. This is a net
figure because it excludes interest paid to gov
ernment trust funds that hold government securities,
while including interest payments from federal
agencies and the public on borrowing from the
government.
Other federal operations include farm price sup
ports, domestic energy programs, foreign aid, gen
eral science research, space technology, etc. In
addition, general expenses required to run the
government are included in this category.

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1981

C h a rt l

Federal B u dg et O u t l a y s as a Percent of G N P 11

1955 56 57 58 59 60

61 62 63 64 65 66 67 68 69 70

71 72 73

74 75 76 77 78 79 80

81 82 83 84 85 1986

|J_ E stim ates fo r 1981-1986 a re a lte rn a tiv e p ro je c tio n s : d a s h e d lines are CBO b a s e lin e p ro je c tio n s a n d s o lid lines are a d m in is tra tio n
p ro je c tio n s fro m M id -S e ssion Review o f the 1982 B u d g e t (July 1981).
[2 O th e r f e d e r a l o p e ra tio n s , plus g ra n ts to state and lo c a l g o v e rn m e n ts o th e r th a n b e n e fit paym ents fo r in d iv id u a ls .

Outlays Relative to GNP
A very useful way to summarize trends in federal
spending is to compare them with the growth o f

GNP, a comparison that indicates the degree o f
government intervention in the economy. Chart 1
summarizes the historical record by showing total
federal outlays and the major program categories
as a percent o f GNP.
17

FEDERAL RESERVE BANK OF ST. LOUIS

The trend of total budget outlays relative to GNP
has been unmistakably upward during the 1955-80
period, rising from 17.9 percent in 1955 to 22.6
percent in 1980. This trend has not been smooth,
however, in that outlays relative to GNP have surged
in relatively short periods. Though the percentage
tends to subside after the surge, it returns to levels
higher than prevailed before the surge. The surges
during the 1955-80 period seem to be associated
with (1) the 1957-58 recession and the abbreviated
recovery that followed, (2) the Vietnam War, and (3)
the 1973-75 recession. But the reason outlays as a
percent o f GNP does not return to pre-surge levels is
unclear, except, perhaps, as a result o f the momen
tum o f the government spending process.
National defense spending relative to GNP de
clined throughout 1955-80 except for the period o f
the Vietnam War. In 1955, 10.4 percent o f the na
tion’s GNP was directed toward defense outlays, a
percentage that declined to 7.2 percent in 1965,
before rising to 9.4 percent during the Vietnam War
in 1968. Since then, the decline has been dramatic,
with the ratio plummeting to 5 percent in 1978 and
1979.
M eanw hile, benefit payments for individuals
were only 3.7 percent o f GNP in 1955 with social
security accounting for 31.4 percent o f the total. With
a major surge in the 1967-76 period, benefit pay
ments hit 10.6 percent o f GNP in 1980 as social
security rose to 43.2 percent o f the total. Given the
decline in national defense, the bulk o f the relative
rise in total outlays over the 1955-80 period is
attributable to the sharp increase in benefit pay
ments to individuals.
The remaining major program categories, though
relatively small, show some trends. Net interest was
virtually constant at 1.3 percent of GNP from 1955 to
1968. Since then, the trend has been upward as the
government runs continuous deficits and interest
rates keep rising. Net interest reached 2.0 percent o f
GNP in 1980.
Other grants to state and local governments, the
smallest category in 1955, has been trending upward
throughout the period (not shown separately in chart
1). Starting at 0.4 percent o f GNP in 1955, these
grants rose to 2.2 percent in 1980.
All other outlays relative to GNP, a residual com
ponent o f the total, changed little on balance from
1955 to 1980.
More recently, from 1975 to 1980, federal spend

NOVEMBER 1981

ing has grown only slightly faster than GNP. Total
outlays averaged 22.6 percent o f GNP in 1980, with
the decline in defense offset by an upward creep in
non-defense categories.

Program Categories Relative to
Total Outlays
Another way o f looking at federal spending is to
examine the composition o f total outlays. Using the
same program categories as before, chart 2 summa
rizes the composition o f federal outlays for 1955-80.
Chart 2 shows the changing composition o f budget
outlays more dramatically than chart 1, though the
same basic data are used in the construction of both.
The sharply declining portion o f the budget for na
tional defense is immediately evident. In 1955, 58.1
percent o f total outlays went to defense; by 1980, this
proportion had dwindled to 23.4 percent, though the
trend has been relatively stable since 1976.
The rise in benefit payments for individuals as a
percent o f total outlays, w hich has m ore than
doubled since 1955, actually took place during two
subperiods. First was the period from 1955 to 1961,
which included two recessions with a weak recovery
sandwiched in between. Second was the period from
1968 to 1976, a period o f expanding social programs
that also included two recessions.
Net interest held steady at about 1 percent o f total
outlays from 1955 to 1974. Since then, the percent
age has been rising slowly but steadily.
Other grants to state and local governments ex
hibited an upward trend from 1955 to 1973, but have
since leveled off. All other outlays, on the other
hand, have varied considerably, rising sharply from
1955 to 1965, declining until 1974, then stabilizing
in the late 1970s.
In summary, the composition o f the budget has
undergone a substantial change over the last 25
years. While national defense used to be far and
away the most important function o f the federal
government, this category has yielded to social
programs in the fonn o f benefits for individuals. The
sum o f these two large program categories has de
clined as a percent o f total outlays from 78.5 percent
in 1955 to 70.2 percent in 1980. The slack has been
taken up by an increasing proportion o f outlays
channeled to state and local government and paid in
interest to the public.

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1981

C h a rt 2

Federal Budget O u t l a y s as a Percent of Total O u t l a y s 11

|_L E stim ates fo r 1981-1986 a re a lte rn a tiv e p ro je c tio n s : d a s h e d lines a re CBO b a s e lin e p ro je c tio n s a n d s o lid lines a re a d m in is tra tio n
p ro je c tio n s fro m M id-S e ssion Review o f the 1982 B u d g e t (July 1981).
[2 O th e r fe d e r a l o p e ra tio n s , plus g ra n ts to state a n d lo c a l g o v e rn m e n ts o th e r th a n b e n e fit paym ents fo r in d iv id u a ls .

FEDERAL RESERVE BANK OF ST. LOUIS

BASELINE PROJECTIONS OF
FED ERAL SPENDING: 1981-86
An evaluation o f spending plans for the future
requires a baseline for comparison, namely, a course
that federal spending would follow were there no
changes in spending policies. A set o f such baseline
projections has been prepared by the CBO and is
presented here.

CBO's Economic Assumptions
The projections assume that expenditures are
based on spending policies and laws in effect as o f
Decem ber 1980. With respect to so-called entitle
ment programs (social security, Medicaid, veterans
pensions, federal employee retirement, etc.), it is
assumed that future spending will respond to eco
nomic and demographic changes in the same way as
in the past.
Since the remaining portion o f federal outlays are
discretionary, that is, they depend on annual appro
priations, special assumptions are required. The
general assumption is that programs in effect in
Decem ber 1980 will continue into the future with
increases in outlays a reflection o f the rate o f infla
tion. Thus, inflation rates are a critical part o f the
econom ic assumptions. In the case o f national de
fense, CBO’s baseline projections also include an
allowance for programmatic changes. Specifically,
projections o f outlays are consistent with a defense
force and investment program that is implied by
congressional action through Decem ber 1980.
The future course o f federal outlays thus depends
on the underlying econ om ic assumptions. The
CBO’ s econom ic assumptions are summarized in
table 2. With about 30 percent o f federal spending
directly indexed for inflation, the inflation as
sumptions bear considerable weight. In addition,
the costs o f many other programs are based on the
assumption that congressional actions will provide
the funding to keep the programs apace with in
flation. There are also programs like unem ploy
ment compensation and food stamps that depend on
the assumptions made about unemployment. Net
interest paid depends on interest rate projections as
well as future deficits.
In general, the CBO’ s economic assumptions are
taken as given for the baseline budget projections.
There is no allowance for the feedback o f fiscal
actions to the economy. For example, CBO notes
that the projected surplus in the baseline budget

NOVEMBER 1981

would be inconsistent with the underlying e co
nomic assumptions. In other words, their econom ic
assumptions do not represent the output o f a fullfledged econometric model.

CBO's Baseline Projections
Chart 1 summarizes the baseline projections as a
percent of GNP for 1981-86. The momentum o f total
outlays as well as high inflation projections in the
near term indicate a slight rise in total outlays in
1981-82 relative to 1980. After 1982, total outlays
decline relative to GNP. There are several reasons
for this. First, the baseline projections do not provide
for real growth in a number o f program areas, while
the GNP projections include substantial increases in
real GNP. Second, witli unemployment assumed to
decline, programs tied to the unemployment rate
grow more slowly. Similarly, net interest outlays
decline, assuming declines in interest rates and in
the deficit.5
The national defense component o f federal out
lays is assumed to hold fairly constant under the
baseline assumptions, im plying real growth in
defense outlays. The major reason for an increase in
real terms is an increase in the cost o f strategic forces,
namely, the inclusion o f funding for the MX missile
and a new manned bomber. Consequently, based on
programmatic changes im plied by congressional
action through D ecem ber 1980, defense outlays
would be 5.2 percent o f GNP in 1986, little changed
from 5.3 percent in 1980.
Benefit payments for individuals are projected to
rise in 1981-82 relative to GNP, but fall slowly from
1983-86. The proportion stays high relative to GNP
because so many o f the benefit programs are indexed
to inflation. The most important o f these are social
security benefits, railroad retirement benefits, sup
plemental security income, veterans’ pensions, and
civil service retirement benefits. Other programs,
like food stamps and child nutrition, unemployment
compensation, and Medicare and Medicaid, are in
directly tied to inflation. But in addition to keeping
pace with inflation, benefit payments for individuals
rise faster than the price level because the number o f

5It shou ld b e noted that the C B O ’ s baseline estimate o f net interest
d oes not reflect fully the surplus/deficit estim ates im p lied b y
their full set of baseline estim ates of reven ues and expenditures.
For purposes of their b a selin e spen din g projections, the bu d get
was assum ed to b e b a lanced b egin n in g in 1984, and the sub
stantial surpluses estim ated after 1984 w ere not assum ed to be
a p p lied to reductions in the p u b lic debt.

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1981

Table 2
CBO Economic Assumptions (calendar years)
Estimate

Actual

Gross national product
C urrent dollars
Am ount (billions of dollars)
Percent change, year to year
Constant (1972) dollars
Am ount (billion s of dollars)
Percent change, year to year
Deflator (percent change, year to year)
Unemploym ent rate
Interest rate (91-day Treasury bills)

1980

1981

1982

1983

1984

1985

1986

$2,626
8.8%

$2,941
12.0%

$3,323
13.0%

$3,734
12.4%

$4,135
10.8%

$4,541
9.8%

$4,963
9.3%

$1,481
-0 .2 %
9.0%

$1,511
2.0%
9.7%

$1,572
4.1%
8.6%

$1,651
5.0%
7.0%

$1,725
4.5%
6.0%

$1,797
4.2%
5.4%

$1,872
4.2%
4.9%

7.1%

7.5%

7.2%

6.6%

6.4%

5.9%

5.6%

11.4%

13.5%

10.5%

9.4%

8.2%

7.0%

6.0%

SOURCE: Congressional Budget Office, Baseline Budget P rojections: Fiscal Years 1982-1986 (July 1981)

retirees and disabled persons grows. Baseline
projections indicate benefit payments would be 10
percent o f GNP in 1986 compared with 10.6 percent
in 1980.
Other grants to state and local governments are
projected to decline to 1.5 percent o f GNP in 1986
compared with 2.2 percent in 1980. This would be a
decline in real terms and is accounted for in part by
statutory ceilings on social service grants and gen
eral revenue sharing. Furthermore, community de
velopment grants are projected to rise little under
existing law.
Baseline projections for net interest indicate a
substantial decline relative to GNP, from 2.0 percent
in 1980 to 1.2 percent in 1986. This projection is a
direct result o f the econom ic assumption that in
terest rates will decline throughout the period and
that the budget will be balanced by 1984.
The catch-all category o f “ all other” is also pro
jected to decline — from 2.4 percent o f GNP in 1980
to 1.7 percent in 1986. Implicit in the projection is
that “ all other” outlays will keep pace with inflation
though they will show no real growth.
The implications o f the baseline projections for
the composition o f federal outlays are summarized in
chart 2. Benefit payments are slated to stay high,
rising som ew hat relative to the total. Benefit
payments, 46.8 percent o f total outlays in 1980, are
projected to rise to 51.0 percent based on existing
law.

The future pattern o f national defense relative to
total outlays also is one o f steady increase. National
defense, which was 23.4 percent o f total outlays in
1980, is projected to rise to 26.7 percent in 1986
assuming the expansion o f strategic forces.
With the sum o f benefit payments and national
defense rising from 70.2 percent of total outlays in
1980 to 77.7 percent in 1986, there is a substantially
lesser proportion o f the total going toward the
remaining three categories. These categories share
the decline about equally, dropping about 2 or 3
percentage points from 1980 to 1986.

ADMINISTRATION PROJECTIONS OF
FEDERAL SPENDING: 1981-86
The new administration announced a program o f
spending cuts shortly after taking office early this
year. These proposals were first presented in March
and subsequently revised in the mid-session review
o f the budget in July.6 Controversy surrounding
these proposals probably will continue as the ad
ministration works with Congress in review ing
these proposals. For the purposes o f this article, the
estimates o f the administration as o f July 15, 1981,
are used because they are the most current set o f
officially published estimates. The final results will
differ from those presented here, but the July pro
posals are representative o f the administration’ s plan.
®Office o f M anagem ent and Budget, Fiscal Y ear 1982 Budget
R evisions (M arch 1981) and M id-Session R eview o f the 1982
B u dget (July 15, 1981).

NOVEMBER 1981

FEDERAL RESERVE BANK OF ST. LOUIS

Table 3
Administration Economic Assumptions (calendar years)
Actual

Gross national product
Current dollars
Am ount (billions of dollars)
Percent change, year to year
Constant (1972) dollars
Am ount (billions of dollars)
Percent change, year to year
Deflator (percent change, year to year)
Unem ploym ent rate
Interest rate (91-day Treasury bills)

Estimate

1980

1981

1982

1983

1984

1985

1986

$2,626
8.8%

$2,951
12.4%

$3,296
11.7%

$3,700
12.3%

$4,097
10.8%

$4,500
9.8%

$4,918
9.3%

$1,481
-0 .2 %
9.0%

$1,519
2.6%
9.6%

$1,570
3.4%
8.0%

$1,648
5.0%
7.0%

$1,721
4.5%
6.0%

$1,794
4.2%
5.4%

$1,870
4.2%
4.9%

7.1%

7.5%

7.3%

6.6%

6.2%

5.8%

5.5%

11.4%

13.6%

10,5%

7.5%

6.8%

6.0%

5.5%

SOURCE: O ffice of Management and Budget, Mid-Session Review of the 1982 Budget (July 1981)

Economic Assutnptions

Administration Spending Projections

As alluded to above, any spending proposals
depend on the particular econom ic assumptions that
are made. Table 3 summarizes the administration’ s
econom ic assumptions as presented in the mid
session review of the budget on July 15. These
assumptions are similar to CBO’ s in that they are
called assumptions, not projections. The adminis
tration goes slightly further, however, saying that
these assumptions are projections o f the trend o f
econom ic performance expected under the adminis
tration’ s new policy. So, even though these assump
tions do not appear to be based on a consistently
estimated econometric model, they do allow for the
feedback o f economic policies to the econom ic as
sumptions, albeit in an informal way.

In general, the administration plans to reduce total
outlays relative to GNP from 22.6 percent in 1980 to
18.6 percent in 1986. In comparison, the CBO pro
jects total outlays to be 19.6 percent o f GNP in 1986.
In 1986 dollars, this difference amounts to $55
billion (see table 4); in other words, the adminis
tration is proposing that total outlays be reduced by
$55 billion from what they would otherwise be,
based on existing law.

A comparison o f table 3 with the CBO ’s assump
tions in table 2 indicates that the general contours o f
the econom ic projections are similar. The course of
GNP and its distribution between prices and output
is essentially the same for the administration as for
the CBO. For example, the difference in the average
annual rate o f increase o f nominal GNP over the
1980-86 period is only 0.1 percentage point —
11.1 percent for the administration compared with
11.2 percent for the CBO. The principal difference
in the two sets o f econom ic assumptions is with
respect to interest rates; the administration assumes
Treasury bills will decline to 5.5 percent in 1986
compared with 6.0 percent for the CBO.
22

The major departure o f the administration’s plan
from the baseline projections is that it plans a sharp
increase in national defense spending even as a
percent of GNP. The administration’ s plan calls for
defense spending to be 6.7 percent o f GNP in 1986
compared with 5.2 percent for the baseline projec
tions. This would be the largest proportion o f GNP
diverted to defense since 1972.
With total outlays projected to decline relative to
GNP and national defense projected to increase,
non-defense must decline sharply as a percent o f
GNP. The largest component o f non-defense outlays
— benefit payments for individuals — is projected at
8.5 percent o f GNP in 1986 compared with a baseline
figure o f 10.0 percent. In 1986 dollars, this is a re
duction o f $73.1 billion, or 15 percent. Included in
the administration’ s reduction in benefit payments is
the cutback in social security benefits that generated
considerable controversy last spring and subse
quently was withdrawn pending the reeommenda-

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1981

Table 4
Federal Spending Projections: Administration vs. Baseline (billions of dollars)
1986 Projected

Annual rate of change:
1981-86

Actual
1980

Baseline

A dm inistration1

$135.9

$254.0

$325.7

Non-defense
Benefit payments for individuals

443.8
271.2

695.9
484.0

569.4
410.9

7.8
10.1

4.2
7.2

Other grants to state and local
governm ents

57.2

71.3

42.9

3.7

-4 .7

National defense

Baseline
11.0%

A dm inistratior
15.7%

Net interest

52.5

59.1

60.6

2.0

2.4

Other federal operations

62.9

81.5

55.1

4.4

-2 .2

579.6

949.9

895.1

8.6

7.5

Total

'In th e Mid-Session Review o f the 1982 Budget, total outlays included $42.7 billion of "co ntin gen cie s and additional savings to be
proposed.' For purposes of this table, this $42.7 b illio n was distributed proportionally among all of the m ajor program categories.

tions o f a new commission.7 Although social security
benefits as a percent o f total benefit payments to
persons would rise slightly, such benefits as a per
cent of GNP would drop from 4.5 percent in 1980 to
4.1 percent in 1986.
O f the remaining program categories, only net
interest is close to the baseline projection for 1986.
As a percent o f GNP, net interest is projected at 1.3
percent o f GNP, essentially the same as the 1.2 per
cent baseline projection.8 The other two remaining
categories are sharply below the baseline projec
tions. All other grants to state and local governments
are projected by the administration at 0.9 percent of
GNP compared with 1.5 percent for the baseline
projection, a cutback o f $28 billion in 1986 dollars, or
7T h e set o f proposals a ffectin g social security in clu d e d the
follow in g :
(1) R ed u cin g the w elfare-orien ted elem ents that d u plicate other
program s;
(2) Relating disability benefits m ore closely to a p erson ’ s work
history and m edical con ditions;
(3) R edu cin g the opportunity for “ w in dfall” benefits;
(4) Shifting the effective date for paying the automatic cost-oflivin g increases from July to O ctober;
(5) E n couraging workers to stay on the jo b , at least until the
traditional retirem ent age o f 65;
(6) L ow erin g future replacem en t rates — the initial benefit as
com pared with recent preretirem ent earnings.
8E ven though the adm inistration assumes that interest rates w ill
b e lo w e r b y 1986, its estimate o f net interest exceed s the baseline
projection b eca u se its deficit estimates are larger (or surpluses
are smaller) during the p rojection period. T h e reason for this is
that the b a selin e reven u e projections are based on tax laws as of
D e ce m b e r 1980, w hereas the adm inistration’ s plan in cludes the
tax cut.

40 percent, which would bring this category back to
1963 levels. Similarly with the “ all other” category,
the administration’s plan calls for all other outlays to
be scaled back to 1.1 percent o f GNP compared with
1.7 percent for the baseline projection. This would
be a reduction o f $26.4 billion in 1986 dollars, or 32
percent, and would bring this category lower than
ever recorded in the 1955-80 period.
The scope o f the administration’ s program is
dramatized even more when one examines the pro
gram categories relative to total outlays. In order to
reduce total outlays by $55 billion in 1986 relative to
baseline projections and at the same time increase
national defense by $72 billion, the administration
must reduce non-defense outlays by $126 billion.
Furthermore, with an administration net interest
projection o f $2 billion greater than the baseline
estimate, the remaining categories must be reduced
by $128 billion. Given the baseline projection of
$637 billion for non-defense excluding net interest, a
$128 billion cutback translates into a 20 percent re
duction from what they would otherwise be.
As a percent o f total outlays, the national defense
projection amounts to 36.4 percent compared with
26.7 percent for the baseline projection. To achieve
such a goal would give defense an importance in the
budget not realized since 1970.
The scaling back o f benefit payments would re
duce such payments as a percent o f the total to 45.9
percent compared with 50.9 percent for the baseline.
23

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1981

On this basis, this would be the lowest share for this
category o f spending since 1974.

non-defense spending, particularly benefit pay
ments for individuals.

With net interest being projected at 6.8 percent o f
total outlays compared with 6.2 percent for the base
line, the other reductions come from the two re
maining catch-all categories. All other grants to state
and local governments would be reduced to 4.8
percent o f the budget compared with 7.5 percent for
the baseline. This would be the smallest proportion
o f the budget for this category since 1963.

In planning for the next five or six years, the
administration has set forth proposals designed to
alter past trends. One goal is to reduce the overall
growth o f federal outlays relative to GNP. According
to the administration’s plan, outlays will be 18.6
percent o f GNP in 1986, down from 22.6 percent in
1980, reducing the relative size o f government to its
lowest level since 1966. Existing law indicates that
outlays are scheduled to be reduced relative to GNP
anyway, but to 19.6 percent rather than 18.6 percent.

The final “ all other” category, according to ad
ministration projections, would be reduced to 6.2
percent o f total outlays compared with an 8.6 percent
baseline projection. This would be lower than any
other year in the 1955-80 period.

SUMMARY AN D CONCLUSIONS
The administration has embarked on a budget
program designed to reduce the size o f government
in the U.S. economy. At the same time, they propose
to alter greatly the composition o f the budget. Over
the last 25 years, federal outlays grew more rapidly
than the nation’ s GNP. At the same time, the com
position o f these outlays shifted toward greater

Slowing the momentum o f government spending
is an ambitious goal, but the way in which the ad
ministration proposes to achieve it makes the task all
the more difficult. By announcing a goal o f acceler
ating defense spending while slowing the growth o f
total outlays, the administration implies that sharp
cutbacks are required for non-defense spending rel
ative to baseline projections. The scaling back o f
non-defense programs other than net interest
amounts to 20 percent compared with baseline pro
jections. Belative to baseline projections, this non
defense cutback is distributed as a 15 percent
reduction in benefit payments for individuals, 40
percent for other grants to state and local govern
ments, and 32 percent for the all other category.

The Voluntary Automobile Import
Agreement with Japan — More Protectionism
C L IF T O N B. L U T T R E L L

A HE signing o f “ voluntary” agreements to reduce
imports has made considerable headway in recent
years. The recent accord to limit automobile imports
from Japan is an example o f such an agreement. Ship
ments o f Japanese automobiles to the United States
in the first year following the agreement (April 1981
through March 1982) are to be held to 1,680,000 cars,
compared with 1,820,000 in 1980 — an 8 percent re
duction.1
The rationale given for this agreement is similar to
that traditionally offered to support protectionist
policies.2 For example, economist Marina v. N. Whit
man argued that the agreement was necessary to
help the auto industry adjust to sharply changed cir
cumstances and consumer preferences. In her view,
the U.S. automobile industry is similar to an “ infant
industry,” one that needs time and massive invest
ment to adjust fully to new circumstances.3

C h r is to p h e r C onte and Urban C. L eh ner, “ Car Im port Lim it
Eases U.S. - Japan Trade Rift; D om estic Makers Gain L eew ay to
Boost Prices,” The W all S treet Journal, M ay 4, 1981.
2For exam ple, see Charles P. K in dleb erger and Peter H. Lindert
in In tern ation a l E con om ics, 6th ed. (Richard D. Irw in, Inc.,
1978), pp. 130-47.
3W illiam H. Kester, “ E con om ist O utlines Auto W o e s ,” St. Louis
P ost-D ispa tch , A pril 8, 1981. T h e infant industry argum ent is
ty pica lly u sed to ju stify tem porary tariffs or other protection
measures that cu t dow n on im ports from m od em manufacturers
w h ile the infant dom estic industry learns h ow to p rod u ce at low
en ough costs to co m p ete w ithout the h elp o f protection.

“ Voluntary” Import Controls — Who
Gains? Who Loses?
The purpose o f “ voluntary” trade agreements b e
comes clear when one analyzes the recent agreement
with Japan. The agreement was made after months o f
discussion over the rising volume of Japanese auto
mobile sales in the United States. As a consequence
o f these rising imports, U.S. legislation had been
proposed to limit such imports to 1.6 million ve
hicles per year for three years. The proposed legis
lation was more stringent than the provisions o f
the so-called voluntary agreement. One government
spokesman was reported to have demanded “ that
the Japanese restrict car sales (to the United States)
to between 1.4 and 1.6 million for more than one
year.” 4 It is likely that the Japanese participated
in the agreement to avoid the imposition o f even
more stringent protectionist measures by the United
States.5
Some groups in the
U.S. auto workers and
m obile manufacturers,
ment. Presumably the

United States, specifically
stockholders o f U.S. auto
benefited from the agree
agreement will lead to an

4Secretary o f State A lexan der H aig as reported in H obart Row an,
“ T h e Japanese C ar C harade,” W ash in gton P ost, M ay 7, 1981.
5T h e agreem ent was not voluntary based on the usual sense o f the
w ord. T h e action d id not p ro ce e d from the free ch o ice of each
party in the absen ce o f co ercion or legal obligation.

FEDERAL RESERVE BANK OF ST. LOUIS

increase in sales o f U.S.-manufactured cars. H ow
ever, the current Japanese voluntary import control
represents simply a protectionist action. As such, its
impact on national and consumer well-being is no
less harmful than that from higher tariffs, import
quotas, or other devices designed to curtail foreign
competition in the domestic automobile market.

NOVEMBER 1981

Table 1
Imported Cars as a Percent of Total
United States Passenger Car Retail
Sales (thousands)

Total sales

Thirty Years o f Expanding Trade
The major impetus for the protection of American
industries from foreign competition has been rising
imports in a few industries. These represent, in part,
the consequences o f reduced tariffs and other moves
toward free international trade that began in the
1950s. These moves followed a period o f highly pro
tective tariffs authorized in the Smoot-Hawley Tariff
Act o f 1930. With the tariff reductions, trade with
other nations began to increase. Exports o f U.S. mer
chandise grew, risingannually ata 6.8 percent rate in
the 1950s and at an 8 percent rate in the 1960s.
Imports o f merchandise rose annually at a 5.0 percent
rate during the 1950s and at a 10.4 percent rate during
the 1960s. These imports generated increased com
petition for some U.S.-produced goods, such as
shoes, clothing and steel products.
In the 1970s, the volume o f U.S. international
trade spurted and other industries began to experi
ence competition from imports. During this decade,
imports and exports grew at 20 percent annual rates.

What Happened to Automobile Imports?
Automobiles were a major factor in the accelera
tion o f import growth. In the 1970s, the U.S. auto
mobile industry began to experience greater com
petition from imports, just as the shoe, clothing and
steel industries had in the previous decade. In the
automobile case, sharply higher gasoline prices,
escalating wage rates and mandatory environmental
and safety regulations increased the cost o f Ameri
can-manufactured automobiles relative to foreignproduced cars. These factors contributed to sales
reductions and increased unemployment in the U.S.
automobile industry.
The almost doubling o f real gasoline prices in
1979 and 1980 led to both a sizable reduction in de
mand for larger automobiles manufactured in the
United States and a sharp increase in demand for the
smaller cars produced by foreign manufacturers.

Percent im ported

Percent
im ported
from Japan1

1980

8,979

26.7%

22.2%

1979

10,671

21.9

15.2

1978

11,312

17.7

13.8

1977

11,185

18.6

12.0

1976

10,110

14.8

11.2

1975

8,640

18.4

8.1

1974

8,867

15.9

8.9

1973

11,439

15.4

5.5

1972

10,950

14.8

6.4

1971

10,250

15.3

6.9

1970

8,405

15.4

4.5

1969

9,583

11.7

3.7

1968

9,656

10.7

1.8

1967

8,337

7.2

0.8

'D ata are im ports of assembled cars and are not pre
cisely consistent with sales data included in first colum n.
SOURCE: MVMA M otor Vehicle Facts and Figures 1981,
pp. 13 and 71.

Consequently, the sales o f foreign-built cars, espe
cially those made in Japan, accelerated (table 1).
Total automobile sales leveled o ff in the early
1970s, and the percent imported held fairly stable
until 1979, when it jumped sharply, rising from 17.7
percent in 1978 to 21.8 percent in 1979 to 26.7 per
cent in 1980. Most o f the increase in imports came
from Japan. The Japanese penetration o f the Ameri
can market had been rising steadily since 1970,
reaching 15.2 percent o f total sales in 1979. These
imports then spurted in 1980 to 22.2 percent o f
total sales.
Contributing to the higher cost o f U.S. automobiles
have been the more liberal wage settlements o f the
automobile manufacturers since 1970. Prior to 1970,
hourly earnings o f production and non-supervisory
workers in the manufacture o f motor vehicles and car
bodies averaged 30 to 32 percent more than in all
manufacturing industries combined. By 1975, how
ever, the autom obile w orkers’ hourly earnings
exceeded the earnings o f all workers in manufac-

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1981

Table 2
Average Wage Levels of Production
Workers in Automobile Manufacturing
and All Manufacturing

value o f production. They will all have more real
goods for consumption and investment. This occurs
because trade serves to allocate production to lowercost manufacturers, and final goods to higher-valued
uses.7

.. .Rising Imports Lead to Rising Exports,...

Average hourly earnings

A ll
m anufacturing

A utom obile
m anufacturing

Percent earnings
of autom obile
to all manufacturin g workers
148%

1980

$7.27

$10.78

1975

4.83

6.82

1970

3.35

4.42

132

1965

2.61

3.45

132

1960

2.26

2.91

129

141

SOURCE: U.S. Department of Labor, Em ploym ent and
Earnings, United States, 1909-1978, and March
1981.

turing by 41 percent. By 1980 this differential had
risen to 48 percent (table 2).6

Increased Imports
Not Harmful to Economy, . . .
Because o f the employment consequences o f ris
ing automobile imports, the claim is often made that
the U.S. automobile market must not be opened
w ide to foreign automobile manufacturers. This,
how ever, is a short-sighted view o f the impact
that such imports have on the U.S. economy. There
are two general conclusions that follow from an un
derstanding o f the econom ic consequences o f trad
ing among nations. First, foreign trade (imports and
exports) in the longer run are neutral with respect to
total employment; that is, employment gains in some
industries will offset employment losses in other in
dustries. Second, all nations participating in trade
will experience gains arising from an increase in the

6It co u ld b e argued that such factors as greater productivity or
m ore overtim e work can explain the m ore rapid w age growth
in autom obile m anufacturing. Increased productiv ity o f auto
m o b ile workers (w hich rose at a 1 percent faster rate than pro
ductivity in all manufacturing) cou ld accou nt for part o f this rise.
H o w e v e r, a utom obile workers and all m anufacturing workers
w ork ed essentially the same n um ber o f hours per w eek in 1970
as in 1980. H e n ce, the faster grow th in hourly earnings o f auto
m ob ile w orkers does not appear to have arisen from lon ger work
w eek s in a u tom obile manufacturing.

Changes in U.S. imports o f goods and services are
closely associated with changes in exports. Nations
sell goods and services to other nations because they
wish to import goods or purchase capital assets from
them. Either directly or indirectly, U.S. imports o f
Japanese automobiles will create income abroad that
will be spent on U.S. goods and services or U.S. fi
nancial assets. Imports do not cause general unem
ployment; they create job opportunities in some
industries as part o f the very process by which they
reduce others.8 Export industries will increase total
sales and employment; industries facing increasing
imports (such as automobile manufacturing) will
realize reduced sales and employment.9

. . . Hence, Employment Gains Offset
Employment Losses
Offsetting the observed employment losses in
automobile manufacturing are the sizable gains in
sales and employment in a number o f other indus
tries resulting from the gain in purchasing power
abroad and the rising exports. Major employment
gains have occurred since 1964-65 in a number o f in
dustries as a result o f rising exports. Among those
industries with major employment gains from exports
are machinery, transport equipment (including auto
mobiles), chemicals, and farm products. Exports have
risen in these industries both absolutely and relative
to domestic production. Exports o f machinery and
transport equipment, for example, rose from an an
nual average o f $12.5 billion in 1964-65 to $37.5 bil
lion (constant dollars) in 1979-80. As a percent o f
domestic production, such exports rose from 7.3 per
cent in 1964-65 to 15.8 percent in 1979-80 (table 3).

’ F or a discu ssion o f the gains from trade, see Charles P. K indleberger and Peter H. Lindert, In tern ational E co n o m ics (Richard
D . Irw in Inc., 1978) chapter 3 and Arm en A. Alchian and
W illiam R. A llen , U n iversity E con om ics, 3rd ed. (W ordsw orth
P u blishin g C om pany Inc., 1972), chapters 35-37.
8G eoffrey E. W o o d and D ouglas R. M u dd, “ T he R ecen t U.S.
Trade D eficit - N o Cause for Panic,” this R eview (April 1978).
9See Clifton B. Luttrell, “ Im ports and Jobs - T h e O b served and
the U n observ ed,” this R eview (June 1978).

NOVEMBER 1981

FEDERAL RESERVE BANK OF ST. LOUIS

Table 3
Gains in Exports for Selected U.S. Industries
Exports annual average (1972 prices)
1964-65

(b illion dollars)
M achinery and
transport equipm ent
Chemicals and
allied products
A griculture

$12.5

1979-80

Percent of
dom estic
production
7.3%

(billion dollars)

Percent of
dom estic
production

$37.5

15.8%

3.1

6.8

9.2

11.9

8.0

14.1

18.6

25.3

SOURCE: U.S. Departm ent of Com m erce: S ta tistica l A bstra ct o f the U nited States, 1970,
91st ed., pp. 779-80; Survey o f Current Business, March 1981, pp. 12, S-19; Current
Ind ustrial Reports, 1958-77, pp. 8 ,1 1 ,1 4 , 24; Current Ind ustrial Reports, 1972-80, pp.
28,31, 34, 43; Econom ic Report o f the President, January 1981, pp. 337,341; U.S. De
partm ent of A gricultu re, A g ricu ltu ra l O utlook, January-February, 1981, p. 25.

Table 4
Trend in Exports of Selected Major Farm Products
1964-65 Average

Wheat
Rice (rough equivalent)
Corn
Soybeans
Cotton

1979-80 Average

P rod uctio n1

Exports1

Percent
exported

P rod uctio n1

Exports1

Percent
exported

1,314
75
3,784
733
15.0

796
47
629
228
3.5

60.1%
62.7
16.6
29.5
23.3

2,252
139
7,293
2,042
12.8

1,450
90
2,283
817
7.6

64.4%
65.0
31.3
40.0
59.4

’ M illion bushels of wheat, corn and soybeans, m illion cwt. of rice and m illion bales of cotton.
SOURCE: U.S. Department of A gricultu re, A g ricu ltu ra l O utlook, May 1981, and A g ricu Itu ra l S ta tis tic s , 1968.

Exports in the agricultural sector have achieved
even greater gains relative to production than in the
machinery and transport equipment sector. Exports
o f farm products rose from an average $8.0 billion
per year in 1964-65 to $18.6 billion in 1979-80. As a
percent o f domestic production, such exports rose
from 14.1 percent in 1964-65 to 25.3 percent in
1979-80.
The impact o f trade on five selected categories o f
farm products is shown in table 4. In the case o f two
groups, wheat and rice, almost two-thirds o f the crop
is exported. Furthermore, major gains in exports since
1964-65 have occurred both in real terms and as a

percent o f production for corn, soybeans and cotton.
Estimated employment gains attributed to export
increases in the three selected industries with rapid
increases in exports are shown in table 5. More than
130,000 workers in agriculture alone were required
to produce the increased quantity of farm products
exported in 1979-80, and over one million were
required to produce that portion o f farm production
which was exported (table 6). Export gains in
machinery and transport equipment accounted for
over 650,000 employees. Altogether, rising exports
in these industrial groups — machinery and trans
port equipm ent, chem icals, and agriculture —
required almost one million additional workers.

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1981

Table 5
Number of Employees Attributed to Rising Exports in Selected
Industries (thousands)
Employees 1964-65

Employees 1979-80

Required
fo r
exports'

Total

Required
fo r
exports'

Increase in
employees
required
fo r exports

Total
Machinery and
transport equipm ent
Chem icals and
allied products
A griculture

5,043.9

368.2

6,598.0

1,042.5

674.3

893.2

60.7

1,112.0

132.3

71.6

5,860.0

826.3

3,782.0

956.8

130.5

2,131.6

876.4

TOTAL

1,255.2

'Based on percent of dom estic production exported (see table 1).
SOURCE: Table 3 and U.S. Department of Commerce, Survey o f Current Business, March,
1981, p. S-12; E conom ic Report o f the President, January 1981, p. 339; U.S.
Departm ent of Labor, Handbook o f Labor S tatistics, December 1980, p. 152.

Virtually Everyone Loses From Import
Restrictions
Just as rising imports were a major factor in the
expanding market for farm products, so a reduction
in foreign imports will contribute to a reduction in
exports o f U.S.-produced goods. For example, in
1980-81, exports to Japan alone accounted for 7
percent o f all U.S. coarse grain production (com,
grain sorghum, barley and oats), 10 percent o f soy
bean production, 5 percent o f wheat production
and more than 12 percent o f cotton production.10 A
reduction in Japanese earnings on automobile ex
ports will reduce their demand for these products.11
O f course, in U.S. exports to Japan, the loss will not
equal exactly the dollar amount o f the reduction in
10U.S. D epartm ent o f Agriculture, F oreign A gricultu ral Trade
(M ay-June 1981), p. 10 a nd A gricu ltu ral O u tlook (June 1981),
pp . 34-35.
1'A reduction in im ports o f autom obiles from Japan tends to
red u ce the supply o f a u tom obiles on the Am erican market
(shifts the su p ply cu rve to the left). H en ce, the price o f auto
m ob iles w ill b e h igh er and a utom obile manufacturers in W est
G erm any and other nations w ill ten d to export m ore cars to the
U nited States. Thus, the d eclin e in dollar earnings b y the Japa
n ese w ill be partially offset b y an increase in dollar earnings in
other nations, and part o f this increase w ill b e u sed to purchase
U.S. farm products. Such bilateral com parisons overstate
the decline in autom obile im ports from all nations com bined,
and, thus, overstate the foreign earnings losses and farm exp ort
losses resulting from the restrictions.

Table 6
Employment for Farm Commodity
Export Sales
Farm com m odity sales

Employment on farms

T o ta l'

Percent
exported

T otal2

For
exports2

1980

140.3

29.4%

4,152

1,220.7

1979

131.5

26.4

4,375

1,155.0

1978
1977

112.5

4,343

1,133.5

95.8

26.1
25.4

4,152

1,054.6

1976

94.8

24.7

4,374

1,080.4

1975

88.2

25.2

4,342

1,094.2

1974

92.4

24.2

4,389

1,062.1
897.8

1973

87.1

20.7

4,337

1972

61.2

15.5

4,373

677.8

1971

52.9

14.7

4,436

652.1

1970

50.5

14.7

4,523

664.9

1969

48.2

12.7

4,596

583.7

'B illio n s of dollars,
th o u s a n d s of workers.
SOURCE: U.S. Departm ent of A griculture, A g ricu ltu ra l Sta
tistics 1980, p. 460; Econom ic Report o f the Presi
dent, pp. 289, 296; Econom ic Indicators, March
1981, p. 11; FATUS, February 1979 and JanuaryFebruary 1981.

FEDERAL RESERVE BANK OF ST. LOUIS

Japanese automobile sales in the United States.
Japan will be able to purchase U.S. products with her
earnings from exports to Western Europe or other
nations. However, to put the potential losses in
perspective, from 1969 to 1979, U.S. exports to Japan
totaled about 80 percent o f U.S. imports from Japan.
Moreover, Japanese imports from the United States
increased at approximately the same rate as exports
to the United States. Thus, all industries with net
exports to the Japanese — especially the farm sector
— will suffer losses.
The greatest losses from protectionism, however,
are not those employment and export losses experi
enced by specific industries. The greatest losses
occur in the reduction in real goods available
to both nations for consumption and investment.
With trade restrictions there will be fewer auto
mobiles available for consumers in the United States,
and consumers will pay a higher price for each car
purchased.
Similarly, there will be a smaller quantity o f farm
products available for the Japanese, and food prices
will be higher there. While food and farm commodity
prices in the United States will be slightly lower as a
result o f the restrictions, consumers would prefer
the larger number o f automobiles and smaller quan
tity o f farm commodities. Otherwise, the prior trade
pattern would not have been profitable.
The gains from trading occur because the Japanese
have a comparative advantage in the production o f
smaller automobiles relative to the United States,
while we have a comparative advantage in the pro
duction o f other goods, such as farm products. With
each nation specializing in the production o f those
goods in which it has a comparative advantage and ex
changing these goods with other nations, all nations
will benefit. Hence, the real gains from trade are the

NOVEMBER 1981

greater output and wealth that occur through greater
specialization and exchange. These gains will not be
fully realized if protectionist policies are adopted.

SUMMARY
The Japanese “ voluntary” autom obile import
agreement is not only involuntary, but represents
another form o f protectionism. Like all such mea
sures, it is predicated on specious logic and faulty
economics.
Although the major impetus for this agreement has
been the observed decline in employment in the
U.S. automobile industry, evidence suggests that
trade among nations has no impact on total domestic
employment over the long run. Rising employment
in industries with rising exports will offset em ploy
ment losses in those industries that experience
increased competition from imports. Reduced em
ployment has occurred in some U.S. industries due
to increased imports, but the decline has been offset
by employment increases in other industries such as
agriculture, machinery and transport equipment,
and chemicals, where sharp increases in exports
were realized.
The greatest loss from such agreements, however,
is the reduced wealth and w ell-being o f the pop
ulation at large. These losses occur because trade is
productive. Each nation gains by specializing in the
production o f those goods in which it has a compara
tive advantage and by exchanging these for other
goods produced at lower cost elsewhere. This results
in more wealth for all nations. Protectionist policies
reduce these gains, and, consequently, reduce the
wealth o f U.S. citizens as well.