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3 Are National Stock Markets Linked?
15 Are Econom ic Forecasts by
Government Agencies Biased?
Accurate?
24 The Link Between the Value o f the
Dollar, U.S. TVade and
M anufacturing Output:
Some Becent Evidence
38 The Dubious Success o f Export
Subsidies for Wheat
48 The M acroeconom ic Effects o f Deficit
Spending: A Bevievv

THE
FEDERAL
RESERVE
BANK of
ST. I/HIS

Federal Reserve Bank of St. Louis

Review
November/December 1988

In This Issue . . .

In the first article in this Review, “Are National Stock Markets Linked?”
Gerald P. Dwyer, Jr. and R. W. Hafer investigate the connection among
stock price behavior in the United States, Germany, Japan and the United
Kingdom. Much o f the recent com m entaiy about stock prices both before
and after the October 1987 crash suggests that stock prices in different
countries rose and fell as one. The authors show that, under certain as
sumptions, there is no reliable relationship between the levels o f prices in
various stock markets, even though changes in the different market m ea
sures may be related.
The empirical evidence presented is based on two data sets. One con
sists o f daily stock prices for the different countries from July 1987 through
January 1988. Using this data, which includes the w orldw ide decline in
stock prices in October, Dwyer and Hafer find no evidence to support the
notion that prices around the world “ratcheted up" before the crash, as
some have argued. To put their analysis in a historical perspective, the
authors examine a second data set, which consists o f monthly stock price
values for each country from 1957 through 1987. Test results based on
these data corroborate those using the daily data: there is no link among
the levels o f stock prices across national markets.
*

The econom ic policies advocated or implemented during the Reagan
presidency have elicited widespread disagreement among economists.
Annual econom ic forecasts o f output growth, inflation and unemployment
were a concentrated area of dispute, as economists disagreed, for example,
about the expansionary effects of tax cuts and deregulation. Most years
found administration supporter’s predicting strong real growth without
accelerating inflation; critics — including prominent members o f the ad
ministration — labelled these forecasts "rosy scenarios." Are the forecasts
o f government agencies unbiased and accurate judgments about the future
or are they more closely associated with advocacy and cheerleading?
In the second article of this Review, Michael T. Belongia analyzes this
question, comparing forecasts o f the Council o f Economic Advisers (CEA),
the Congressional Budget Office (CBO) and several private-sector groups.
He first tests for bias in forecasts o f real GNP growth, inflation and unem
ployment and finds each group’s forecasts to be unbiased. He then tests
for for ecast accuracy and finds little grounds for judging one government
agency’s forecast superior to the other’s. The author also finds little to
distinguish strongly between the accuracy o f private- and public-sector
forecasts. Overall, "rosy scenario” and other epithets appear to be ground
less rhetoric.
*

Does a decline in the international exchange value o f the dollar boost
the U.S. output o f manufactured goods? In this third article in this Review,

NOVEMBER/DECEMBER 1988

John A. Tatom examines the basis for this w idely assumed inverse rela
tionship and its opposing view, that movements in the dollar’s value are
positively related to changes in the U.S. capacity to produce output.
As Tatom explains, exchange rates can reflect movements in underlying
competitiveness. Thus, factors that reduce the ability o f U.S. producers to
compete are offset, in part, by a fall in the value o f the dollar. Similarly,
when those factors raise U.S. competitiveness, the associated gains in do
mestic output are accompanied by a rising dollar.
Examining the evidence, Tatom finds that when the dollar rose, U.S.
output and capacity growth, particularly in the industries most associated
with the trade deficit, w ere unusually rapid com pared w ith the past and
output growth abroad. These trends evidently have reversed since the
dollar began to fall.
Tatom concludes that the increased competitiveness produced by eco
nomic policy changes in the early 1980s has been reduced by a reversal of
some o f these policies in the mid-1980s. The confusion over the link be
tween the value of the dollar and U.S. output, according to Tatom, arises
from a tendency to see exchange rate movements as the result of mysteri
ous external influences, rather than rational responses to changes in the
domestic econom ic environment.
*

One pervasive feature o f agriculture throughout the w orld is government
involvement. In the case o f the European Community (EC) and the United
States, such government involvement in agricultural trade policies has
escalated a disagreement into a trade war. In 1985, the United States, re
sponding to the rapidly expanding EC agricultural exports that allegedly
were displacing U.S. exports, introduced an export subsidy program, the
Export Enhancement Program (EEP). The two goals o f the U.S. export sub
sidy w ere to expand U.S. agricultural exports and to persuade both the EC
and other subsidizing nations to negotiate the lowering and elimination o f
all production- and trade-distorting subsidies.
In the fourth article in this Review, Cletus C. Coughlin and Kenneth C.
Carraro examine this export program. The authors find that, w hile the EEP
has increased wheat exports, the short-run costs o f doing so have been
higher than other surplus disposal alternatives. In addition, the authors
provide evidence suggesting that the EEP may be ineffective, and possibly
counterproductive, in changing the EC's agricultural negotiating position.
*
*
*
In the final article in this Review, K. Alec Chrystal and Daniel L. Thorn
ton review the m acroeconom ic effect o f deficit spending. The authors dis
cuss the ways in which macroeconomists have asserted that society
benefits from deficit spending, citing arguments for and against each. They
observe that the once-com mon view that the market econom y is prone to
extended periods o f unemployment and below-potential output because
o f the private sector’s inability to generate sufficient aggregate dem and has
given way to the view that deficit spending can have little permanent effect
on output or employment. This means that the principal benefits from
deficit spending come from using it to stabilize output around this policyinvariant path. Chrystal and Thornton note that the information policym a
kers need to use deficit spending to stabilize output is extensive; m ore
over, the evidence that deficit spending has succeeded in stabilizing
output in weak.

FEDERAL RESERVE BANK OF ST. LOUIS

Gerald P. Dwyer, Jr. and II. W. Hafer
Gerald P. Dwyer, Jr., associate professor of economics, University
of Houston, is a visiting scholar and R. W. Hafer is a research
officer at the Federal Reserve Bank of St. Louis. Nancy D. Juen
and Rosemarie V. Mueller provided research assistance.

Are National Stock Markets
Linked?
A
1 M.NALYSTS generally agree that national asset
markets have becom e more integrated in recent
years. This process began with the relaxation of
controls on capital movements in the 1950s and
was followed, during the last decade or so, bv the
gradual relaxation o f exchange controls. Recently,
substantial improvements also have been made in
computer and communication technology that
have low ered the cost o f international information
flows and cross-border financial transactions.1
This globalization o f financial activities has led
some to argue that the behavior of stock prices in
1987 was influenced by international events to a
greater extent than anyone had thought previ
ously. For example, in its discussion o f 1987, the
report by the Presidential Task Force on Market
Mechanisms (comm only known as the Brady
Commission) suggests that “[i]nvestors made com
parisons o f valuations in different countries, often
using higher valuations in other countries as justi
fication for investing in low er valued markets. Con
sequently, a process o f ratcheting up among
w orldw ide stock markets began to develop.” - In

’Cooper (1986) and Bryant (1987) discuss these and related
issues.
Presidential Task Force on Market Mechanisms (1988), p. 10.
3lbid., Study I, p. 2. Most of the reasons offered in the report to
explain the decline, however, are related to economic develop
ments in the United States or changes in the dollar’s value in
foreign exchange markets. The primary reasons for the break
in equity prices given are: the persistent and large budget and

other words, a higher level o f prices in one market
increased the level in other markets. As for the fall
in prices, the Brady Commission report notes that
"(w]hat may have appeared strictly a ‘Wall Street'
collapse was the result o f the cumulative impact of
several developments occurring simultaneously in
several other financial centers.” 1
There appears to be no one reason that explains
the w orldw ide decline in equity values during
October 1987. The timing and magnitude o f the
declines differed across markets around the
world. Even so, all o f the organized markets fell.4
This coincident fall suggests that changes in the
markets are indeed related to one another.
The behavior of stock prices since the October
crash suggests that markets around the w orld do
not move in tandem. As interpreted by Cowan
(1988), "the first quarter o f 1988, if nothing else,
dispelled the popular notion that there is one
synchronized, global market.” While stock prices
in the United States w ere 9.8 percent below their
value on October 16, stock prices in Japan w ere

trade deficits in the United States; instability in foreign ex
change markets, stemming primarily from the continued fall in
the dollar after the Louvre accord; the international rise in
interest rates; and the threatened end to takeovers in the
United States. For more, see ibid., Study I, pp. 11-13.
“Roll (1988) provides an analysis of the different markets’ be
havior.

NOVEMBER/DECEMBER 1988

onlv 0.4 percent below their pre-crash level bv the
end o f the first quarter. The German stock price
index at the end o f March 1988, in contrast, was
28.3 percent below its pre-crash level. While some
markets had recovered some or all of their October
1987 loss, others clearly had not.
These disparate movements raise questions
about just how the different stock markets around
the world are related. Given the increase in Japa
nese stock prices since the crash, should w e be
surprised not to have had a similar rise in the
United States? Or is it really unusual for all mar
kets to move together as they did during the week
o f October 19, 1987?
In this article, w e examine the statistical rela
tionship between the levels and movements of
stock price indexes for Germany, Japan, the United
Kingdom and the United States, using daily data
for July 1987 through January 1988 and monthly
data for the past 31 years. Thus, w e can examine
the relationships both over a short period encom
passing the October crash and across a longer
horizon, in order to put the events o f last year into
some long-run perspective.

HOW SHOULD STOCK PRICES BE
LINKED?
In standard models o f stock price determina
tion, the level o f a stock's price equals the present
value o f expected future dividends. Anything that
changes the fundamentals — that is, the expected
future dividends or the interest rate at which
those dividends are discounted — affects the price
of the stock.1
One w av of thinking about linkages across na
tional stock markets is to start with an extreme
form o f linkage and to examine what loosens these
links. Suppose that the transaction costs o f buying
and selling stocks and foreign exchange anvwhere
in the w orld are zero. Suppose also that investors
are risk-neutral; that is, stockholders are indiffer
ent to holding different stocks only if they yield
the same expected return. For all stocks in the
w orld to be held, the expected return in terms of
any com m on currency must be the same for hold
ing any stock anywhere in the world. This idea
can be written as

5The major alternative to models based on the fundamentals is
known as a rational bubble model. Essentially, this model
allows prices to deviate from that predicated on the fundamen
tals. For a discussion of the differences between these models,
see Santoni (1987) and Santoni and Dwyer (1988).

FEDERAL RESERVE BANK OF ST. LOUIS

Hi Eh,, = Ehn + EAe,,
where Ehiit is the expected rate o f return from
holding a stock in country i in terms o f i s cur
rency in period t, EhMis the expected rate o f re
turn from holding a stock in country j in terms of
j's currency and EAe, is the expected rate of
change in the price o f country j's currency in
terms o f countiy i s currency. For convenience, we
can call this relationship "stock return parity.” " If
it existed, stock return parity w ould im ply that the
expected return from holding stock o f a domestic
firm is the same as the expected return from hold
ing the stock o f a foreign firm.

Linkages o f Price Levels
Even if stock return parity holds, unexpected
events will guarantee that there will be no reliable
relationship between the levels o f various stocks'
prices, even in the same currency. For example,
suppose there is an unexpected permanent in
crease in the dem and for Hondas relative to Fords
which increases the expected earnings and divi
dends o f Honda relative to Ford. Because o f the
change in expected dividends, the price o f Honda
stock will increase relative to the price o f Ford
stock. This will occur even with stock return par
ity. An unexpected increase in the price o f Honda
stock produces a capital gain, which means that
the e,v post rate of return from holding Honda
stock will be higher than from holding Ford stock.
This is perfectly consistent with stock return par
ity, which holds that the expected rates of return
are the same both now and in the future. M ore
over, once the price o f Honda stock increases, w e
should hardly expect that the price o f Ford stock
will rise just because the price o f stock in Honda is
higher.7This analysis holds both for companies in
the same national market and for companies in
different national markets. Internationally, even
though financial markets may be increasingly inte
grated, the relative levels o f stock prices lor in
dexes o f stock prices) around the w orld w ill d i
verge, because they represent the valuation of
different firms.
The preceding argument can be demonstrated
more formally. In terms o f e,\ post rates o f return,
equation 1 can be written as
121 h,,, = hi., + Ae, +

- eM -

6ln effect, this is uncovered interest parity applied to stocks. We
ignore the second-order term Eh, ,Ae,.
7lf firms have firm-specific capital, the relative change in price
levels can be permanent.

where e„ is the unexpected part o f the holding
period return for stock i in period t, eMis the unex
pected part o f the holding period return for stock j
and e,., is tin? unexpected part o f the rate o f change
of the exchange rate. If expectations are rational in
the sense o f iVluth (1961), then the e’s are indepen
dent o f the expected part o f the holding period
returns.'1Assume that the variances and covari
ances o f the e's are constant. If w e assume that
dividends are zero, then equation 2 can be written

(3i pil+l - pi., = Pj, +, - Pi, + e,+, - e, +
-

e,, -

e,.,,

where p is the logarithm o f the price o f the stock, e
is the logarithm o f the exchange rate and the sub
script t + 1 denotes the price one period in the
future. Rearranging terms, equation 3 can be w rit
ten as
141 Pi.,+, - Pi, +, - el+l = p,, - Pi, - e, + e,,
-

eM -

e,..,.

Define x = p, — p; — e. Then equation 4 can be
rewritten as
(51 X, + , =

X, +

6 j, -

correlations between the levels o f national stock
price indexes are unstable. The levels o f stock
prices in different markets may rise or fall to
gether, or move in opposite directions. Moreover,
the size o f correlations o f the stock price levels will
depend on the sample period used and the unex
pected changes in the two countries’ stock prices
and exchange rates in that period.
Another way o f thinking about a time-series
process that is a random walk is in terms o f a
"unit root.” 9Although a random walk is a particu
lar kind o f unit-root process, the two are not syn
onymous. While its evolution may have additional
components, a unit-root series wanders around in
the same way that a random walk does. For exam
ple, neither a random walk nor a unit-root process
has a tendency to return to anv particular value
over time. The algebra above has been simplified
considerably bv assumptions that make the rela
tive stock price indexes a random walk. Rather
than maintain these assumptions (for example,
constant variances o f the unexpected parts o f the
returns from holding stocks and the changes in
the logarithm o f the exchange rate), w e directly
test for unit roots in the empirical analysis.

Gj, -

Equation 5 shows that relative stock prices next
period simply are equal to relative stock prices
this period plus the difference between the unex
pected parts o f the holding period returns (e,, —
e,,) and the unexpected change in the exchange
rate (e,., I. In other words, even if expected rates of
return are identical, relative stock prices in terms
o f a com m on currency are a random walk. When
the relative stock price indexes take a random step
up or down, the relative stock prices show no
tendency to return to anv particular value.
This is important because it means that, even if
the expected holding period returns o f two stocks
w ere perfectly correlated, the levels o f the prices
will show no stable relationship. Because relative
stock prices are characterized as random walks,

8Actually, the only implication that we need is that the expected
part of the holding period return and the unexpected part are
uncorrelated.

Rates o f Return
Stock return parity, w hile useful for making the
point above, is illustrative rather than descriptive.
Stock return parity implies that, since the ex
pected rates o f return from holding different
stocks are the same, the correlation o f expected
returns is one. It is unlikely that stock return par
ity holds. If stock return parity holds across na
tional borders, it should hold within a countiy as
well; this means that differences between the ex
pected returns on domestic stock should be un
predictable. This prediction, however, is inconsis
tent with the data."1
Factors Decreasing the Correlations — Evi
dence indicates that expected returns from hold
ing stock in both the United States and other

,0See Malkiel (1985).

9The precise definition of a unit root is based on the autoregres
sive representation of a series. If the fundamental movingaverage representation of a series, say x, has an autoregres
sive representation, then it can be written as
[1 -t<(L)]x, = e,,
where L is the lag operator such that Lx, = x, , and a(L) =
Xa,L'. The polynomial in the lag operator «(L) always can be
written as «(L) = (1 - (3,L)p(L). If there exists a root (J, that is
equal to one, then the series x is said to have a unit root.

NOVEMBER DECEMBER 1988

6
countries are related to the riskiness o f holding
stock relative to other financial assets. To the ex
tent that the variability o f the return from holding
a stock cannot be diversified away, expected rates
o f return are higher for riskier stocks." This finding
suggests that stock return parity is unlikely to
hold. Expected rates o f return differ across firms
and industries; available evidence suggests that
country risk also is important.12
There also are transaction costs associated with
buying and selling stocks. Today, explicit transac
tion costs are relatively unimportant in buying
and selling large blocks of stock around the world.
With improvements in communication and the
ability to order trades over phone lines, the ex
plicit cost to someone in London o f buying AT&T
stock in N ew York is little more than the cost to
someone in N ew York.
Nonetheless, government restrictions are part of
the costs of executing a transaction, and these
restrictions have been important at times in exe
cuting international transactions. Exchange con
trols were one o f the ways that countries main
tained the fixed-exchange-rate regime in place
until 1973. By limiting access to foreign exchange,
governments sought to manipulate the demand
for their currency relative to foreign currency,
thereby assisting their attempts to maintain a fixed
exchange rate. In some cases, governments also
restricted foreigners’ ability to purchase domestic
financial assets. Both types o f controls have been
declining gradually since the demise of fixed ex
change rates."
Factors Increasing the Correlations — Some
forces make expected returns in different coun
tries positively related even if there were no inter
national financial transactions. If the demand for
automobiles increases in the United States, which
increases the expected earnings and dividends of
domestic automobile companies, it also can in
crease the expected earnings o f automobile com
panies like Honda, which are headquartered in
Japan and sell automobiles in the United States.
Consequently, changes in stock prices in the

11Malkiel (1985) summarizes the evidence. The riskiness of a
firm’s stock can be divided into its relationship with general
movements in the market (market risk) and the factors that
cause it to deviate from the market (non-market risk). Nonmarket risk includes those factors that influence a specific firm
or industry. The idea that there are factors that cause firms or
industry groupings of firms to deviate from the market portfolio
applies also to the divergent movements of national stock price
indexes.
12See Solnik (1974); Cho, Eun and Senbet (1986).

FEDERAL RESERVE BANK OF ST. LOUIS

United States and Japan can be positively corre
lated even if no foreigner can buy stock in either
country. This example, w hile triv ial in some re
spects, points out that international trade creates
a link between at least some stocks in different
markets.
In addition to trade, multinational operations bv
firms create links through ownership o f real assets
that can affect firms headquartered in different
countries. For example, Ford manufactures auto
mobiles in Europe. A recession in Europe would
likely decrease the demand for Ford automobiles
and low er Ford's earnings, dividends and stock
price on the N ew York Stock Exchange.
Finally, relative to data on individual firms'
shares, stock index data will have a higher correla
tion than the correlation of returns from randomly
selected stocks on different markets. All o f the
actual data that w e use below are indexes o f stock
prices. Consequently, the indexes average out
much o f the variation attributable to individual
firms or industries. Thus, if there w ere no factors
that differentially affect firms in different coun
tries, the expected returns in any com m on cur
rency measured by these indexes w ould be virtu
ally the same.

DAILY DATA SURROUNDING THE
CRASH
In this section, w e examine daily values o f stock
price indexes for seven months surrounding the
crash for evidence o f the “ratcheting u p ” in stock
markets suggested by the Bradv Report. Daily val
ues o f stock price indexes from Germany, Japan,
the United Kingdom and the United States for July
1, 1987, through Januaiy 29, 1988, are used.14This
period includes three months before the October
1987 crash and three months after it. To make the
relative values o f the indexes comparable, all o f the
measures are set to a base value of 100.0 on July 1,
1987. Because the markets are open in daylight
hours in different time zones, the markets in our
sample are not all open at the same time. We

l3For an annual discussion of changes in these controls on a
country-by-country basis, see any issue of the International
Monetary Fund’s Exchange Arrangements and Exchange
Restrictions.
14The daily stock market indexes, both in terms of local currency
and U.S. dollars, are from Morgan Stanley’s Capital Interna
tional Perspective. The indexes are market-weighted price
averages without dividends reinvested.

Chart 1
Levels of Stock Price Indexes (7/1/87

100) in local currency

United States

United Kingdom

Ratio Scale
120 I-----------------------------------------------------------------------------------------------------------------------------------

Ratio Scale

7/1

8/1

9/1

10/1

11/1

12/1

1/1

2/1

West Germany
Ratio Scale

...
•

...
7/1

define a trading day as starting with the opening
o f the European markets.
The levels o f the different indexes, measured in
terms o f local currency, are shown in chart 1. The
behavior o f the indexes reveals some comm on
movement during this period, especially around
October 19. All o f the indexes decline sharply from
the m iddle o f October to the end o f the month.1'’
Before and after the crash, however, there appears
to be little comm on movement in the levels o f the
indexes.
While the behavior o f the indexes in terms of
local currency is interesting, the indexes should
be measured in terms o f some com m on currency
to be directly comparable. Comparing stock prices
in the United States in dollars and stock prices in
the United Kingdom in pounds is much like mea

15The sizes of the decreases in stock prices in October 1987
differ substantially. The decline in the United States was 21.6
percent, slightly below the average decrease of 24.6 percent
for a sample of 23 countries. For example, stock prices fell as

i
8/1

9/1

10/1

11/1

i
12/1

l
1/1

2/1

suring the price o f apples in dollars and pounds
and comparing the movements o f the two. We
measure the different indexes in terms o f U.S.
dollars.
The dollar-denominated indexes in chart 2
show similar patterns to those in chart 1. The dif
ferences in behavior of the different indexes since
the crash, however, are striking. Based on the data
in chart 2, the U.S. and U.K. indexes increase only
slightly after the crash, w hile those in Germany
continue to fall. The index for Japan, however,
returns roughly to its value im m ediately fol
low ing the crash. By Januaiy 29, 1988, stock prices
in Germany, the United Kingdom and the United
States are still below their October 19 levels. For
example, stock prices in the United States at the
end o f Januaiy are about 17 percent low er than on

little as 5.8 percent in Austria and as much as 45.8 percent in
Hong Kong (measured in U.S. dollars). For further discussion,
see Roll (1988).

NOVEMBER/DECEMBER 1988

Chart 2
Levels of Stock Market Indexes (7/1/87

= 100) in U.S. dollars

United States

United Kingdom

Ratio Scale
1201-------------

Ratio Scale

West Germany
Ratio Scale
120

October 12, 1987 — one week before the crash.
Similarly, prices in the United Kingdom and in
Germany at the end o f January are about 18 per
cent and 33 percent below their October IE levels.
In sharp contrast, the Japanese stock market index
on January 29 is less than 1 percent low er than on
October 12.
Despite these different movements o f the levels
o f stock prices, there is some com m on behavior in
the changes in the different country indexes. A
simple way to see this is to calculate the number
o f days eveiy index increased or decreased. Din
ing the seven months covered in chart 2, there are
20 days when all the indexes increased and 16
days when all decreased. Little significance should

be attached to the greater number o f coincident
increases than decreases: with the exception of
Germany, increases predominate in each country
during the period. Coincident increases are more
likely than decreases even if the changes are unre
lated. Some coincident increases and decreases in
all o f the indexes are expected bv chance alone. If
the probability o f an increase in one country is
unrelated to events in other countries, the proba
bility o f a coincident increase in all o f the indexes
is about 7.7 percent, and the probability of a coin
cident decrease in all o f the indexes is about 4.85
percent."’ This implies that these data w ould have
about 19 days o f coincident movements due to
chance alone, substantially less than the actual 36
days with increases or decreases in all four in-

16For the data in chart 2, the indexes decrease in 52.7 percent of
the days in Germany, 49.0 percent of the days in Japan, 42.0
percent of the days in the United Kingdom and 44.7 percent of
the days in the United States. If the changes are unrelated, the
joint probability of coincident decreases is simply the product of
the proportions of days with decreases to the total, which is

4.85 percent or about 7.2 days. The joint probability of the four
indexes increasing or staying the same is about 7.7 percent or
about 11.5 days. If the changes in the indexes are unrelated,
the total number of days expected to have coincident move
ments is about 18.7 days, with a standard deviation of this
expected value of about 4.1 days.

FEDERAL RESERVE BANK OF ST. LOUIS

Table 1
Correlations of Stock Price Indexes:
July 1 ,1987-January 29,1988 (logarithms in terms of dollars)
Full period
Country
United States
Germany
Japan
United Kingdom

Germany

United States
1.00
0.93*
0.22*
0.90*

1.00
0.10
0.86*

Japan

United Kingdom

1.00
0.16

1.00

Before October 19
Country

United States

Germany

Japan

United Kingdom

United States
Germany
Japan
United Kingdom

1.00
0.75*
0.40*
-0 .5 6 *

1.00
0.61*
-0 .3 8 *

1.00
-0 .1 4

1.00

Japan

United Kingdom

After week of October 19
Country

United States

Germany

United States
Germany
Japan
United Kingdom

1.00
-0.01
0.22
0.56*

1.00
-0 .3 8 ’
-0 .3 2 *

1.00
0.52*

1.00

’ Significantly different from zero at 5 percent level.

dexes. If the changes across stock markets were
unrelated, the probability o f observing 36 coinci
dent changes or more w ould be much less than 1
percent. This suggests that it is likely that changes
in the indexes are related.

Correlations Among the Levels o f
Stock Prices
There does not appear to be a stable relation
ship among the levels o f stock prices (table II.
Except for Japan, the evidence for the w hole pe
riod suggests that the indexes are highly corre
lated. If one examines the correlations o f the levels
o f stock prices before and after the crash, however,
the correlations change dramatically. For example,
the correlation o f the U.K. index with the U.S. in
dex is about 0.90 for the w hole period. Before the
crash, however, the correlation is —0.56, while,
after the crash, it is 0.56. Conversely, the correla

,7The test essentially consists of implementing the Dickey-Fuller
test (1979) on the ratio of stock price indexes. The reported tratios are those on the lagged level of the ratio in the relevant
equation. All equations include a constant term and one lagged
value of the dependent variable. The critical values for the test
are from Fuller (1976), p. 373.

tions for the U.S. and German stock indexes are
0.93 for the w hole period, 0.75 before the crash
and —0.01 afterwards.
This instability is precisely what one would
expect if the relative stock price indexes are ran
dom walks with no long-run relationships be
tween their levels. The negative correlation be
tween the index for the United States and the
United Kingdom before October 19, though, is not
what w ould be expected if stock prices around the
w orld were "ratcheting upward” before the crash.

Tests fo r Unit Roots
W e can test whether, as equation 5 implies, the
relative stock price indexes have unit roots.17
l est statistics to determine whether the levels of
the relative stock indexes have unit roots are pre
sented in table 2. Tw o periods are analyzed: one
uses data from the full period; the other examines

An alternative interpretation of this test in terms of cointegra
tion as defined by Granger (1986) and discussed by Engle and
Granger (1987). Under this interpretation, we are testing
whether two stock price indexes are cointegrated with a coeffi
cient of unity in the equation relating the two indexes.

NOVEMBER/DECEMBER 1988

Table 2
Test Statistics for Unit Roots in
Relative Stock Price Indexes:
July 1 ,1987-January 29,1988
(logarithms denominated in dollars)
Full period
Country

Germany

Japan

United Kingdom

United States
Germany
Japan

-1 .6 7

-0 .6 5
0.53

-2 .1 6
-0 .4 3
-1 .0 6

Before October 19
Country

Germany

Japan

United Kingdom

United States
Germany
Japan

-1 .0 3

-0 .3 2
-1 .8 6

-0 .4 0
-1 .5 7
-1 .6 1

'Significantly different from zero at 5 percent level.

the relationship before the crash. A t-ratio less
than about —2.89 is inconsistent with the hypoth
esis that the levels o f two series have a unit root.
The test statistics in table 2 are well above the 5
percent critical value, consistent with the hypoth
esis that all o f the different relative stock indexes
have unit roots. These results provide no reason to
expect that, given an increase in the U.S. index, for
example, the Japanese index also will rise, or fall.
That is, there is no “normal” level o f these indexes
relative to each other. This is especially important
because, in contrast to the conclusion of the Brady
Commission, it is inconsistent with the notion
that the markets rose as one during 1987 before
the crash. Furthermore, it indicates that using the
levels o f the stock market indexes to judge
whether there is any relationship between the
markets is fallacious.

Correlations o f Changes o f the
Indexes
The evidence indicates that there is no reliable
relationship among the levels of the indexes. Sim
ple correlations o f changes in daily stock prices
can be used to measure the extent o f the associa
tion between the rate o f increases in the indexes

18The monthly data are from the International Financial Statistics
(IFS) data tape of the International Monetary Fund. The U.S.
data are the monthly averages of the daily close of 400 Stan
dard and Poor’s industrials on the NYSE, the figures for Ger
many are the averages of daily quotations covering 95 percent
of common shares of industrial companies headquartered in
Germany, the Japanese data are the averages of daily closing

FEDERAL RESERVE BANK OF ST. LOUIS

(table 3). For the w hole period, the correlations
among the changes in the U.S. index and those o f
the other countries range from 0.64 for Japan to
0.32 for Germany. The correlations among the
indexes for Germany, Japan and the United King
dom range from 0.56 to 0.15. At the 5 percent mar
ginal significance level, all but the Japan/United
Kingdom correlation are different from zero.
These correlations are, on average, noticeably
low er when the week o f the crash in prices is ex
cluded from the correlations. Correlations without
the data for the week o f October 19 are presented
in the low er part o f table 3. All but two are low er
than those for the whole period. The only higher
correlation for a subperiod is the correlation be
tween changes in the Japanese and German stock
indexes, a correlation o f 0.22 excluding the week of
the crash and 0.21 for the w hole period. These
results are consistent with the notion that m ove
ments in the indexes, unlike levels o f the indexes,
are indeed related.

Summary o f the Short-Term Results
The daily data for the period around the Octo
ber 1987 crash provide little support for the notion
o f prices ratcheting up or down together. Rather,
they indicate that there is no constant relationship
between the levels o f the indexes. There is, how
ever, a positive relationship among changes in the
indexes, a finding consistent with the view that
either financial transactions or international trade
o f goods and services affect the different indexes
in the same direction.

STOCK PRICE INDEXES SINCE 1957:
A LONGER-RUN VIEW
Investigating the link between stock markets
using monthly data spanning the past 31 years
provides a useful perspective on the preceding
results. Chart 3 shows monthly av erage indexes of
industrial share prices for each o f the four coun
tries for 1957 through 1987. All stock price indexes
are denominated in terms o f U.S. dollars.18Al
though changes in stock prices like those in Octo
ber have been quite rare during the past few de-

prices for all shares traded on the first section of the Tokyo
exchange and the U.K. data are the average of daily quotations
of 500 industrial ordinary shares on the International Stock
Exchange in London. The exchange rates used to convert the
stock indexes into dollars are the monthly average rates from
the IFS data tape.

Table 3
Correlations of Changes of Stock Price Indexes:
July 1 ,1987-January 29,1988 (changes of logarithms in terms of
dollars)
Full period
Country

United States

Germany

Japan

United Kingdom

United States
Germany
Japan
United Kingdom

1.00
0.32*
0.64*
0.46*

1.00
0.21*
0.56*

1.00
0.15

1.00

Country

United States

Germany

Japan

United Kingdom

United States
Germany
Japan
United Kingdom

1.00
0.21*
0.28*
0.46*

1.00
0.22*
0.36*

1.00
0.12

1.00

Deleting week of October 19

‘ Significantly different from zero at 5 percent level.

Chart 3
Stock Price Indexes (monthly averages, 1980 = 100) in terms of dollars
United States
Ratio Scale

Japan

United Kingdom
Ratio Scale

West Germany

NOVEMBER/DECEMBER 1988

cades, substantial decreases in the market indexes
are not uncommon. For example, stock prices in
the United States decreased by relatively large
amounts in several months: the index decreased
12.0 percent in June 1962, 11.6 percent in May
1970 and 10.5 percent in September 1974. The
decrease in October 1987, on a monthly average
basis, was 13.3 percent. Large single-month in
creases are not exactly unknown either: the index
for the United States increased 12.1 percent as
recently as September 1982.
It also is interesting to note from chart 3 that
stock price decreases in the different markets
often coincide. From 1957 through 1987, stock
prices declined in all four o f the markets in 31
months. Coincident increases occur more fre
quently during the sample: all four stock price
indexes increased in 79 months. How many of
these w ould be expected by pure chance? The
av erage proportion o f months with an increase is
about two-thirds for each countiy. If two-thirds is
the probability of an increase, the joint probability
that all o f the indexes w ould increase in anv
month is 19.75 percent. Given our sample of 371
months, this means that about 73 months o f coin
cident increases are expected. Since one-third is
the average proportion o f declines for each coun
try, the expected number o f coincident decreases
is about five. Because the sample contains 110
months o f coincident changes w hile only 73
w ould be expected by chance, this is longer-term
evidence that coincident changes in the indexes
occur more often than would be expected bv
chance.

Relationship Betw een the Levels o f

Stock Prices
Is there a long-term relationship between the
levels o f stock prices during the past 31 years? To
answer this, monthly data are used to test for unit
roots in the relative stock price indexes. The
results o f these tests are presented in table 4.1:1The
top panel o f the table reports the relevant test
statistics for the full period. The evidence indi
cates that the relative stock price indexes have
unit roots. With 371 monthly changes, a t-ratio less
than about -2.88 would be inconsistent with the
null hypothesis o f a unit root at the 5 percent
significance level. The t-ratios generally are greater
than the critical value, an outcome inconsistent

19ln order to allow for the first-order serial correlation in the
indexes due to the Working (1961) effect, we include one
lagged change of the relative index in the regressions. We
make no adjustment to the critical value for this estimated
coefficient.

FEDERAL RESERVE BANK OF ST. LOUIS

Table 4
Test Statistics for Unit Roots in
Relative Stock Price Indexes: January
1957-December 1987 (logarithms in
terms of common currency)
Full period
t-ratios
Country

Germany

Japan

United Kingdom

United States
Germany
Japan

-2 .9 5 *

0.73
-0 .5 1

-2 .4 2
-3 .2 7 *
-0 .2 8

Flexible-rate period
t-ratios
Country

Germany

United States
Germany
Japan

-1 .8 7

Japan
0.89
0.47

United Kingdom
-1 .5 8
-1 .5 9
-1 .3 0

'Significantly different from zero at 5 percent level.

with the existence o f any normal long-run level of
these indexes relative to each other. The test sta
tistics for Germany relative to the United States
and for the United Kingdom relative to Germany
are, however, less than the critical value. Unlike
the others, these results are consistent with the
notion that these indexes tend to some normal
level.
The results o f the unit root tests from the
flexible-rate period, a period characterized by
greater financial integration across national bor
ders than the fixed-rate period, uniformly are
greater than the critical value.-0Test statistics us
ing the data from the flexible-rate period are pre
sented in the bottom panel o f table 4. These
results indicate that in eveiy instance the relative
stock price indexes have a unit root. The empirical
evidence from the flexible-rate period clearly is
inconsistent with the notion that the lev els of
stock market indexes are linked across countries
over long-run periods.

Correlations o f Changes o f the
Indexes
Correlations o f the changes in the logarithm o f
the monthly stock price indexes are reported in

20The beginning of the flexible-rate period is defined as April

1973.

Table 5
Correlations of Changes in Stock Price Indexes:
January 1957-December 1987 (logarithms in terms of dollars)
Full period
Country

United States

Germany

Japan

United Kingdom

United States
Germany
Japan
United Kingdom

1.00
0.38*
0.31*
0.50*

1.00
0.31*
0.33*

1.00
0.33*

1.00

Fixed-rate period
Country

United States

Germany

Japan

United Kingdom

United States
Germany
Japan
United Kingdom

1.00
0.35*
0.20*
0.38*

1.00
0.16*
0.26*

1.00
0.17*

1.00

Flexible-rate period
Country

United States

Germany

Japan

United Kingdom

United States
Germany
Japan
United Kingdom

1.00
0.42*
0.39*
0.56*

1.00
0.48*
0.41*

1.00
0.42*

1.00

"Significantly different from zero at 5 percent level.

table 5. Because the sample period incorporates
both the fixed- and flexible-exchange-rate regimes,
the correlations are calculated for the full 31 years
and for each o f the two exchange-rate regimes.
The full period correlations are relatively high
across markets, and all are statistically significant.
All but one o f the correlations is between 0.31 and
0.38. The outlier is the higher correlation o f 0.50
between the United States and United Kingdom.
The evidence from the fixed-rate period
presents a rather different picture. Although the
correlation between changes in the German and
U.S. indexes is about the same as the correlation
for the whole period, the other correlations are
much smaller. For example, the correlations be
tween the stock price indexes for Germany and
Japan (0.16) and between Japan and the United
Kingdom (0.17) are about one-half the size of

21Controls on financial transactions were not suddenly axed with
the breakdown of fixed exchange rates; instead, they have
been lifted gradually with each passing year. This suggests
that, if changes in these restrictions account for at least part of
the increases in these correlations, the correlations should be
even larger for a period beginning later than 1973. Correlations

their correlations for the full period. There also is
a noticeably low er correlation between the U.S.
and Japanese indexes, 0.31 for the full period and
only 0.20 for the fixed-rate period.
The evidence from the flexible-rate period sug
gests that the relationship between U.S. stock
prices and the foreign markets is somewhat closer
relative to the fixed-rate period. The largest in
creases in the correlation are between the Japa
nese and the other indexes, and the largest of
these changes is between the German and Japa
nese indexes, which increases from 0.16 during
the fixed-rate period to 0.48 during the flexiblerate period. The correlation between stock price
changes in Japan and those in the United States
and the United Kingdom also increases substan
tially, from 0.20 to 0.39, and 0.17 to 0.42, respec
tively. This suggests that the markets are more
integrated in the latter half o f the period.-1

for 1980 through 1987 provide a tentative way of examining
this issue. These correlations provide modest support for this
hypothesis, with two of the correlations greater for the more
recent period relative to the results for the flexible-rate period in
table 5.

NOVEMBER/DECEMBER 1988

CONCLUSION

Cowan, Alison Leigh. "Global-Market Notion is Dispelled in
Quarter,” New York Times, April 4,1988, p. D8.

Are stock markets linked across countries? The
levels o f stock price indexes in different markets
need not move closely together; indeed, they do
not. Daily data for three months before and after
the October 1987 crash and monthly data for the
past 31 years show no evidence that the levels of
indexes for the United States, Japan, Germany and
the United Kingdom are related. This means that
the levels o f indexes show no tendency to return
to anv particular value relative to each other. Thus,
using different levels o f indexes in various coun
tries as evidence o f a link or lack thereof between
the markets is unfounded.

Dickey, David A., and Wayne A. Fuller. “ Distribution of the
Estimators for Autoregressive Time Series with a Unit Root,”
Journal of the American Statistical Association (June 1979),
pp. 427-31.

The changes in the stock price indexes, at least
in the four markets that we examine, generally do
move together. The tightness o f these links, while
real, is not exceptional. For example, the correla
tion o f monthly changes in stock prices in the
United States and the United Kingdom is about
0.56 based on data since the beginning o f flexible
exchange rates. While significantly different from
zero, this correlation also is quite far from one.

Engle, Robert F., and C. W. J. Granger. “ Co-integration and
Error Correction: Representation, Estimation, and Testing,”
Econometrica (March 1987), pp. 251-76.
Fuller, Wayne A. Introduction to Statistical Time Series (John
Wiley and Sons, 1976).
Granger, C. W. J. “ Developments in the Study of Cointegrated
Economic Variables," Oxford Bulletin of Economics and Statis
tics (August 1986), pp. 213-28.
Malkiel, Burton G. A Random Walk Down Wall Street, 4th ed.
(W. W. Norton & Company, 1985).
Muth, John. "Rational Expectations and the Theory of Price
Movements,” Econometrica (July 1961), pp. 315-35.
Presidential Task Force on Market Mechanisms.
ary 1988).

Report (Janu

Roll, Richard W. “The International Crash of October 1987,” in
Robert Kamphuis, Roger Kormendi, J. W. Henry Watson,
eds., Black Monday and the Future of Financial Markets (Mid
America Institute, October 1988), pp. 35-70.
Santoni, G. J. "The Great Bull Markets 1924-29 and 1982-87:
Speculative Bubbles or Economic Fundamentals?" this
Review (November 1987), pp. 16-30.

Bryant, Ralph C. International Financial Intermediation (Brook
ings Institution, 1987).

Santoni, G. J., and Gerald P. Dwyer, Jr. “ Bubbles or Funda
mentals: Some Evidence from the Great Bull Markets of
1924-29 and 1982-87,” paper presented at the Conference
on Crashes and Panics in Historical Perspective, Salomon
Brothers Center for the Study of Financial Institutions, New
York University, October 1988.

Cho, D. Chinhyung, Cheol S. Eun, and Lemma W. Senbet.
“International Arbitrage Pricing Theory: An Empirical Investi
gation,” Journal of Finance (June 1986), pp. 313-29.

Solnik, Bruno H. “ The International Pricing of Risk: An Empiri
cal Investigation of the World Capital Market Structure,”
Journal of Finance (May 1974), pp. 365-95.

Cooper, Richard N. “ The United States as an Open Economy,"
in R. W. Hafer, ed., How Open is the U.S. Economy? (Lexing
ton Books, 1986), pp. 3-24.

Working, Holbrook. “ Note on the Correlation of First Differ
ences of Averages in a Random Chain,” Econometrica (Octo
ber 1960), pp. 916-18.

REFERENCES

FEDERAL RESERVE BANK OF ST. LOUIS

Michael T. Belongia
Michael T. Belongia is a research officer at the Federal Reserve
Bank of St. Louis. Anne M. Grubish provided research assistance.

Are Economic Forecasts by
Government Agencies Biased?
Accurate?
“The CBO’s analyses and forecasts, while far from flawless, have come to be
viewed as the best objective evidence that economists can muster. In stark
contrast, everyone knows that Executive Branch estimates pass through many
political filters."
Alan S. Blinder, Business Week

I CONOMIC forecasts bv government agencies
often are tainted by allegations o f political parti
sanship. Forecasts by the Council o f Economic
Advisers (CEA) for example, which represent the
expected impacts o f the President’s econom ic
policies, have been characterized as “rosy sce
narios,” that are too optimistic about the pros
pects for strong real growth and low er unem ploy
ment. In recent years, even White House insiders
have alleged that the CEA’s numbers were
“ cooked” to portray favorable econom ic
outcomes.'
Congress has its own econom ic agency, the
Congressional Budget Office (CBO), that also pro
duces forecasts for real growth, unemployment
and inflation on a timetable similar to that o f the
CEA. In contrast to the CEA, the CBO forecasts
have been w idely regarded as being accurate and
objective. Still, they too have been criticized as

1The “ rosy scenario” characterization of Reagan administration
economic forecasts has been attributed to Stockman (1986).
Smith (1988) reports comments from a number of observers
who feel the CEA forecasts are biased. As a technical matter, it
is more accurate to talk about “ Administration” forecasts in
stead of “ CEA” forecasts during the Reagan years. During this

biased or inaccurate, especially when the CEA and
CBO outlooks have differed substantially.2
With several U.S. government agencies making
econom ic forecasts and allegations being raised
about the relative merits o f these alternative fore
casts, a number o f obvious questions arise. The
purpose o f this paper is to determine first w hether
econom ic forecasts made by the CEA and CBO
have been biased. Then, because allegations of
bias carry the implication o f inaccuracy, the fore
casts also are evaluated on this basis. Finally, to
provide some apolitical benchmarks, the forecasts
of several well-known private sector gr oups are
examined for bias and accuracy.

CEA AND CBO FORECASTS: A BRIEF
HISTORY
The Council o f Economic Advisers was estab
lished by the Employment Act o f 1946. The Eco-

period, the “troika” process involving the CEA, the Treasury
Department, and the Office of Management and Budget (OMB)
produced a consensus forecast not associated with the CEA
independently.
2See, for example, Meiselman and Roberts (1979).

NOVEMBER/DECEMBER 1988

Chart 1
CEA and CBO Real GNP Forecasts vs Actual GNP Growth
Percent

Annual Data

Percent

-2

1988

nom ic Report o f the President, which the CEA
publishes annually, includes a short essay bv the
President and a much longer report by the CEA
staff; typically, it also includes an econom ic fore
cast for the year ahead. The forecasts in the Report
can be regarded as true e,x; ante predictions be
cause they are released in late January or Febru
ary, w ell before any official econom ic data for the
calendar year are reported.
The Congressional Budget Office was estab
lished in 1974 as part o f the new budget process
created by the Congressional Budget and Im
poundment Control Act. The CBO was established
to provide Congress "with detailed budget infor
mation and studies o f the budget impact o f alter
native policies.” 1The CBO was created primarily to
provide budget analyses and econom ic forecasts
that are independent from those o f the CEA and
Office o f Management and Budget (OMB), both of
which the President and Executive Branch con

3U.S. Congress (1976), p. 1. For a detailed review of the CBO's
creation and stated mission, see Meiselman and Roberts
(1979) and the comments by De Leeuw, Phaup and Rivlin that
follow their article.

FEDERAL RESERVE BANK OF ST. LOUIS

trol. The CBO's forecasts are reported in its E co
nom ic and Rudget Outlook (or E con om ic Outlook
in earlier years), which is released early in the
calendar year.
Annual CEA and CBO forecasts for real GNP
growth, the inflation rate and the level o f unem
ployment are plotted in charts 1-3 for the period
1976-87. GNP and inflation values are fourthquarter-over-fourth-quarter rates o f change. The
unemployment rate showTi is the fourth quarter
level. Unemployment rate forecasts are generally
the fourth-quarter level but, for the last five years
o f the CBO forecasts, the predictions represent the
annual average unemployment rate.
Although the CEA has made econom ic forecasts
since the late 1940s, the data plotted in the charts
begin in 1976 for two reasons. First, the CBO’s
initial forecast was for the year 1976; thus, direct
comparisons between the two series are limited to
the post-1976 period. Second, before the early

Chart 2
CEA and CBO Inflation Forecasts vs Actual GNP Inflation '
Percent

Annual Data

12i----

Percent
12

2
1976

2
77

1988

Li Inflation rate is measured by the GNP deflator.

1970s, the CEA forecasts often w ere couched in
qualitative terms (for example, “low er inflation” or
"slightly faster growth"), which cannot be ana
lyzed statistically.4
An inspection o f the charts indicates that both
sets o f forecasts generally move in the same direc
tion; the correspondence seems particularly close
for the inflation forecasts. The GNP and unem ploy
ment forecasts, however, show some interesting
variations. Since 1981, the CEA’s forecasts o f real
growth have been generally higher than the CBO’s.
For the whole period, CEA unemployment rate
forecasts have been low er than the CBO’s. These
figures indicate that the CEA typically has forecast
stronger real econom ic activity than the CBO.
Whether these forecast differences represent a
systematic bias of significant magnitude, bv either
the CEA or the CBO, requires further analysis.1

4Moore (1977) has constructed a CEA forecast series for the
years 1962-76 based on inferences from the text of the Eco
nomic Report of the President. See footnote 8 for further discus
sion of these earlier forecasts.
5Carlson (1982) also has evaluated CEA forecasts and, in the
context of a monetarist model, found them to be internally
inconsistent.

STATISTICAL ASSESSMENT OF
FORECAST BIAS
Figure 1 shows a conceptual framework with
which to assess the relationships that might occur
if the actual values o f a specific series were plotted
against the values that had been predicted. If the
forecasts were perfect — that is, if the forecast
errors at each point in time w ere zero — a line
relating the actual to the forecast values w ould
have an intercept o f zero and a slope o f one; this
line, denoted LPF in the figure, is what M incer and
Zarnowitz (1969) call the “line o f perfect forecasts.”
Bias in a forecast m erely indicates that the mean
value o f the actual series (A) is not equal to the
mean o f the forecast series (P) and, therefore, that
the point E, determined by the ordered pair lA,P),
w ill not be on the LPF line.6The extent o f bias in

6ln more technical terms, the mathematical expectation of the
actual series, E(A), is not equal to the expectation of the fore
cast series, E(P). See, for example, Mincer and Zarnowitz
(1969), pp. 6-9. Webb (1987) provides further discussion of
what is and is not learned from tests for bias.

NOVEMBER/DECEMBER 1988

Chart 3
CEA and CBO Unemployment Forecasts
vs Actual Unemployment
Percent
11

Annual Data

Percent

5
1988

the forecast is depicted in figure 1 as the distance
between a point on the LPF line and point E,
which is defined by the means o f the actual and
forecast series.
In view o f this discussion, a standard test for
bias in a forecast can be constructed by estimating
a regression o f the form:
(1) Y, = a + b E(Y.) + e„
where Y, is the actual value o f a variable in period
t, E(Y,) is its “predicted” or “forecast" value and e,
is the forecast error (actual minus predicted
value).7If the forecast is unbiased, the regression's
intercept, a, should not be significantly different
from zero and its slope coefficient, b, should not
be significantly different from one; recall that
these values for a and b define the LPF line in

7Some research in this line of work has asked which measure of
the “ actual” value should be used: the first-announced (unre
vised) figure or the final (revised) value? Throughout, the final,
revised figure is used. This choice is defended, logically, on the
basis that this value, in fact, is what people are trying to fore
cast, even though it includes such unknowns as seasonal
adjustments and benchmark revisions. As a practical matter,

FEDERAL RESERVE BANK OF ST. LOUIS

figure 1. If a = 0 and b = 1 in equation \, the ac
tual and forecast values w ill differ only by random
error, as represented by e,. Moreover, the error
w ould equal zero, on average, over long periods o f
time.
The results o f estimating regressions like equa
tion 1 for the CEA and CBO forecasts o f real GNP
growth (y), the inflation rate (P) and unem ploy
ment rate (U) over the 1976-87 period are shown
in table 1. The important results for current pur
poses are the F-statistics corresponding to the
null hypothesis that an equation’s intercept term
is equal to zero and its slope coefficient is equal to
one. This hypothesis is not rejected for any o f the
six equations; none o f the F-statistics is greater
than 0.5 and the 5 percent critical value is 4.10.
Therefore, irrespective o f forecast accuracy and

estimates of equation 1 with first-announced data had no
qualitative effect on any of the results. McNees (1988) also has
found that the choice of measure for actual values has little
impact on annual forecasts, such as these, but apparently is
important for quarterly forecasts.

F igure 1
T h e P redictio n-R ealizatio n Diagram

Table 1
Bias Tests for CEA and CBO Forecasts

Realizations

F-statistic for H0:
a = 0 and b = 1
CEA
y = 0.168 + 0.836 E(y)
(0.12)
(0.44)

R2 = 0.27

0.27

P = -0 .8 9 9 + 1.083 E(P)
(0.62)
(0.37)

R2 = 0.67

0.46

U = 1.035 + 0.856 E(U)
(0.55)
(0.57)

R2 = 0.49

0.16

R2 = 0.20

0.26

P = -0 .7 0 9 + 1.054 E(P)
(0.58)
(0.28)

R2 = 0.73

0.49

U = -0 .2 1 9 + 1.024 E(U)
(0.14)
(0.12)

R2 = 0.68

0.02

CBO
y = 0.825 + 0.727 E(y)
(0.61)
(0.72)

— Mean realization

— Mean prediction

— Corrected mean point

despite assertions to the contrary, both the CEA
and CBO forecasts can be called unbiased.8

ARE PRIVATE SECTOR FORECASTS
BIASED?
The results in table 1 indicate that the forecasts
o f two government agencies are unbiased. Un
biasedness, however, is not unambiguously desir
able if some bias is associated with greater forecast
accuracy. Zellner (1986), for example, shows that a
biased forecast is the optimal predictor under
certain circumstances; M incer and Zarnowitz
(1969) also noted this characteristic. Still, many
observers associate bias with inaccuracy in a fore
cast. Is it possible instead that some other fore
casts are biased, but more accurate than those o f
the CEA and CBO?
As a first step to investigate this possibility, the
mean forecasts o f a panel surveyed by the Ameri
can Statistical Association and National Bureau of

8lt also is possible to evaluate CEA performance over a longer
period. Moore (1977) has constructed a CEA forecast series
back to 1962 for output and inflation, inferring quantitative
estimates from the qualitative forecasts presented. Although
this series is subject to error from such judgmental adjust
ments, the longer sample increases the power of the test
statistics. The results of estimating equations such as equation
1 over the longer sample indicate bias in the inflation equation
as the intercept is significantly greater than zero; this result

NOTE: Absolute values of t-statistics are in parentheses. For
the slope coefficients, the reported t-statistic applies to
the null hypothesis b = 1. The 0.05 percent critical
value for a t-statistic (two-tailed test) with 10 degrees
of freedom is 2.63. The 0.05 critical value for an
F-statistic with 2 and 10 degrees of freedom is 4.10.

Economic Research (ASA/NBER) and the forecasts
from the large econom etric models o f two wellknown consulting firms w ere evaluated by the
same tests described earlier.” To make these tests
comparable with those already reported in table 1
data w ere examined during the same 1976—87
interval for the forecasts published closest to the
release dates o f the CEA and CBO predictions;
plots o f actual vs. forecast values are shown in
charts 4—6. The bias tests for the private sector
forecasts are reported in table 2. The results do
not indicate bias in the ASA/NBER forecasts for any
of the three variables examined. Moreover, explan
atory pow er generally is higher for these equations
than for the comparable CEA or CBO equations.
The forecasts from the two consulting firms also
exhibit no bias in any equation and generally have
explanatory pow er comparable to that o f the ASA/
NBER forecasts. Overall, the results in tables 1 and
suggests that the CEA, on average, has been overly optimistic
about future inflation. No bias is evident in the GNP equation.
9Stephen McNees kindly provided these data. A condition for
their use, however, was that the specific firms remain anony
mous. Historical data on the economic forecasts of many
alternative forecasters also was available (until 1986) in the
Federal Reserve Bank of Richmond’s Business Outlook.

NOVEMBER/DECEMBER 1988

Chart 4
ASA/NBER, Firm A and Firm B Real GNP Forecasts
vs Actual GNP Growth

976

1988

Chart 5
ASA/NBER, Firm A and Firm B Inflation Forecasts
vs Actual Inflation a
Percent

Annual Data

Percent

------- 12

rm B

2
1976

2
77

LI Inflation rate is measured by the G NP deflator.

FEDERAL RESERVE BANK OF ST. LOUIS

1988

Chart 6
ASA/NBER, Firm A and Firm B Unemployment Forecasts
vs Actual Unemployment
Percent

Annual Data

Percent

1988

2 indicate that all five widely-cited forecasts of
aggregate econom ic activity are unbiased.

FORECAST ACCURACY
One way to compare the accuracy o f alternative
forecasts has been proposed by Fair and Shiller
(1988). The test is perform ed by estimating a re
gression of the form:
12) Y, - Y,_„ = a + b [,_„E(Ylt) —Y,_J
+ c[,_sE( Y,,) —Y,_J + (j l ,

where Y, and Y,_s are the actual values o f the vari
able being forecasted in periods t and t —s, respec
tively, while ,_,E(Ylt) and ,_s E(Y,,) are the predic
tions o f forecasters #1 and #2 at time t —s for the
value o f Y in period t. In this analysis, which uses
annual data and one-year-ahead forecasts, s is
equal to one. If the predictions o f either forecaster
embodies information beyond the estimate o f the

'“That a simple extraction of past trends might be considered an
alternative to “ expert” forecasts has been suggested by analy
ses of forecast performance. Meltzer (1987a,b), for example,
has shown that Federal Reserve forecasts were so imprecise
that, predicting one quarter into the future, it was impossible to
distinguish statistically between a forecast of strong real growth

one-period change represented bv the regression’s
intercept term, a, then one or both slope coef
ficients, b and c in equation 2, should be signifi
cantly different from zero. If CEA is forecaster #1
and b is significantly different from zero but c is
not, one concludes that the CEA forecast contains
useful information and forecast #2 has no infor
mation not contained in the CEA forecast. Finding
c, but not b, significant w ould cariy the opposite
conclusion. Finding neither b nor c significant
indicates that neither forecast has useful informa
tion beyond that contained in the intercept, which
is interpreted as the average s-period change in
y io

These tests were perform ed for all pairs o f the
CEA, CBO, ASA/NBER, Firm A and Firm B forecasts
o f output, inflation and unemployment. As table 3
reports, a direct comparison o f the CEA and CBO
forecasts shows neither agency adds new informa
tion to the other’s forecast o f real GNP growth,

and recession. Another interesting result is reported by
Strongin and Binkley (1988), who find that forecasts made later
in the year and incorporating more information than initial
forecasts were as likely to deteriorate as to improve.

NOVEMBER/DECEMBER 1988

Table 2

Table 3

Simple Bias Tests for Private Sector
Forecasts

Summary of Results from Fair-Shiller
Tests

F-statistic for H0:
a = 0and b = 1
ASA/NBER
y = 0.068 + 0.999 * E(y)
(0.06)
(0.00)

R2 = 0.41

0.01

'E(P)

R2 = 0.80

0.81

+ 1.010* E(U)
(0.04)

R2 = 0.57

0.00

y = - 1.017 + 1.156 *E(y)
(0.97)
(0.59)

R2 = 0.62

0.65

P = -0 .3 3 5 + 1.013 * Ef!-*)
(0.24)
(0.06)

R2 = 0.64

0.16

R2 = 0.54

0.47

P = -1 .2 9 2 + 1.166
(1.16)
(0.94)
U

= -0 .0 8 7
(0.05)

Consulting Firm A

U = 1.095 + 0.832
(0.64) (0.75)

* E(U)

R2 = 0.54

0.24

* E(P)

R2 = 0.74

0.19

= 0.047 + 0.968 * E(U)

R2 = 0.64

0.34

y = 0.467 + 0.958 * E(y)
(0.54)
(0.17)

= 0.083 + 0.951
(0.08)

(0.03)

Real
GNP

Inflation

Neither
CEA — CBO
Neither
CEA — ASA/NBER
Neither
Both
CEA — Firm A
Both
Neither
CEA — Firm B
Firm B
Neither
CBO — ASA/NBER ASA/NBER Neither
Neither
CBO — Firm A
Firm A
Firm B
Neither
CBO — Firm B
ASA/NBER — Firm A
Firm A ASA/NBER
ASA/NBER — Firm B Neither
Neither
Firm A — Firm B
Neither
Neither

Unemployment
rate
Neither
Neither
Neither
Firm B
ASA/NBER
Neither
Firm B
Neither
Neither
Neither

NOTE: Forecaster name listed under the “ Real GNP,”
"Inflation” or Unemployment rate” columns indicates
it adds significant information not embodied in the
other forecast.

pears to offer additional information to the CEA's
forecasts.

Consulting Firm B

Forecast pair

(0.30)
(0.15)

NOTE: Absolute values of t-statistics are in parentheses. For
the slope coefficients, the reported t-statistic applies to
the null hypothesis b, = 1.

inflation or unemployment. Although this result is
not surprising in view o f the very similar regres
sion results reported in table 1, it also indicates
there is no evidence to distinguish the forecasts o f
either agency as a better source o f information.
When CEA forecasts are evaluated against the
three private sector forecasts, a different picture
emerges. W hen evaluated against the ASA/NBER
survey, each institution’s forecast for inflation
adds to the information contained in the other
and in the regression’s intercept. Neither o f their
output or unemployment forecasts, however, adds
to the information contained in the other. This
evidence suggests that inflation forecasts can be
im proved bv combining the information in the
CEA and ASA/NBER forecasts. The comparisons
with the two private sector firms, w hile offering a
similarly mixed bag o f results, generally indicate
that, for real GNP and unemployment, Firm B ap-

FEDERAL RESERVE BANK OF ST. LOUIS

For the CBO, the results suggest that any o f the
three private sector alternatives adds information
to CBO’s output forecast; two o f the three also add
information to the CBO’s unem ploym ent forecast.
For inflation, however, there appear to be few
gains from looking at the alternative forecasts.
Among the three private sector firms, none o f the
results shows one to be superior to the others.
Overall, the results in table 3 generally indicate
that the private sector forecasts add to the infor
mation in the CBO forecasts while, aside from
Firm B’s contributions, the CEA and private fore
casts contain similar information.

CONCLUSIONS
Members o f both political parties sometimes
allege that econom ic forecasts by government
agencies are biased. An examination o f this issue
indicates that neither the CEA nor CBO forecasts
exhibit any discernable bias. An evaluation o f three
private sector forecasts also detected no forecast
bias. Absence o f bias, however, does not necessar
ily indicate that a forecast is better (specifically,
more accurate). When three private sector fore
casts w ere com pared with CEA and CBO forecasts,
however, the private sector forecasts generally
w ere more accurate than those o f the CBO; the
CEA fared less w ell only relative to the forecasts of
private sector Firm B.

REFERENCES
Blinder, Alan S. “ Dithering on Hill is Crippling a Key Agency,”
Business Week (September 26, 1988), p. 25.
Carlson, Keith. “ A Monetary Analysis of the Administration's
Budget and Economic Projections,” this Review (May 1982),
pp. 3-14.
Fair, Ray C., and Robert J. Shiller. “The Informational Content
of Ex Ante Forecasts,” Working Paper No. 2503 (National
Bureau of Economic Research, February 1988).
McNees, Stephen K. “ How Accurate Are Macroeconomic
Forecasts?,” New England Economic Review (July/August
1988), pp. 15-36.
Meiselman, David, and Paul Craig Roberts. "The Political
Economy of the Congressional Budget Office,” in Karl
Brunner and Allan H. Meltzer, eds., Three Aspects of
Policymaking: Knowledge, Data and Institutions,
Carnegie-Rochester Conference Series on Public Policy, Vol.
10, (1979), pp. 283-333.
Meltzer, Allan H. "Limits of Short-Run Stabilization Policy,”
Economic Inquiry (January 1987a), pp. 1-14.
_________ “ On Monetary Stability and Monetary Reform,”
Bank of Japan Monetary and Economic Studies (September
1987b), pp. 13-34.

Mincer, Jacob, and Victor Zarnowitz. “The Evaluation of
Economic Forecasts,” in Jacob Mincer, ed., Economic
Forecasts and Expectations, (National Bureau of Economic
Research and Columbia University Press, 1969).
Moore, Geoffrey H. “The President’s Economic Report: A
Forecasting Record," NBER Reporter (April 1977), pp. 4-12.
Smith, Hedrick.
Stockman, David.
Inc., 1986).

The Power Game (Random House, 1988).
The Triumph of Politics (Harper and Row,

Strongin, Steven, and Paula S. Binkley. "A Policymaker’s
Guide to Economic Forecasts,” Federal Reserve Bank of
Chicago Economic Perspectives (May/June 1988), pp. 3-10.
U.S. Congress. The Congressional Budget Office:
Responsibilities and Organization (U.S. Government Printing
Office, 1976).
Webb, Roy H. "The Irrelevance of Tests for Bias in Series of
Macroeconomic Forecasts,” Federal Reserve Bank of
Richmond Economic Review (November/December 1987),
pp. 3-9.
Zellner, Arnold. “ Biased Predictors, Rationality and the
Evaluation of Forecasts,” Economics Letters (No. 1, 1986),
pp. 45-48.

NOVEMBER/DECEMBER 1988

John A. Tatom
John A. Tatom is an assistant vice president at the Federal Re
sen/e Bank of St. Louis. Anne M. Grubish and Kevin L. Kliesen
provided research assistance.

The Link Between the Value of
the Dollar, U.S. Trade and
Manufacturing Output: Some
Recent Evidence

O
BSERVERS w idely believ e that the decline in
the dollar’s value against foreign currencies, which
began in 1985, has boosted U.S. manufacturing
output significantly. The dollar’s decline was ex
pected to raise the dollar prices o f U.S. imports
w hile lowering the foreign-currencv prices of U.S.
exports; in response, the quantity dem anded of
both U.S. exports and import-competing goods
w ould rise.
This demand-based linkage has been central to
analyses o f both the international and domestic
econom ic prospects o f this nation since early in
this decade. The emphasis on an inverse relation
ship between U.S. output and the value o f the dol
lar became preeminent from 1980 to early 1985,
when the dollar’s value rose dramatically and
when a historically large trade deficit emerged.'

1Usually this view is part of a broader analysis of economic
policy; see, for example, Meyer (1986), Jonas (1986), Business
Week (1987), Business Week (1988), Peterson (1987) and
Summers (1987). Feldstein (for example, 1987 and 1988) has
been the most vocal proponent of this view. Examples focusing
on the dollar-production linkage include Berry (1986), Deutsch
(1988), Revzin (1988) and Hickok, Bell and Ceglowski (1988).

FEDERAL RESERVE BANK OF ST. LOUIS

The relevance o f this inverse relationship, how
ever, rests on a faulty assumption. Im plicit in such
analyses is the view that changes in the value of
the dollar are independent o f U.S. industrial devel
opments rather than being caused by those very
changes. When econom ic policy boosts or retards
the productive capacity of the economy, the dom i
nant relationship between the value o f the dollar
and domestic manufacturing output should be a
positive one, so that a rise lor fall! in the value o f
the dollar is associated with a rise (or fall) in U.S.
output.
This article examines w hether the U.S. produc
tion o f manufactured goods in recent years has
shown an inverse relationship to movements in
the v alue o f the dollar. Its principal focus is
w hether the industries that are most closely asso-

According to Murray (1988), former Federal Reserve Board
Chairman Paul Volcker has endorsed the conventional view
stating: “ We had a great consumer boom in imports that left
manufacturing undernourished. Now manufacturing can carry
us for the next four years.”

Chart 1
Index of the Nominal and Real Trade-Weighted Dollar
Exchange Rate
INDEX (MARCH 1973=100)
150

ANNUAL AVERAGE OF MONTHLY DATA

INDEX (MARCH 1973=100)
150

70 1

1 70
1973
74
75
76
77
78
79
80
81
82
83
84
85
86
87
1988
SOURCE: FEDERAL RESERVE BOARD
NOTE: The Real Exchange Rate Measure uses Trade-Weighted Consumer Price Indices. 1988 Data based on
average of six months data.

ciated with the growing trade deficit during the
period o f the rising dollar also exhibited declining
output and, in turn, w hether their output has
been boosted by the general decline in the dollar’s
value since then.

THE EXCHANGE RATE,
PRODUCTION AND TRADE
The dollar’s value rose sharply from 1980 to 1985
and subsequently declined; chart 1 shows this
movement for measures o f both the nominal and
real exchange value o f the dollar. The real ex
change rate is the nominal exchange rate (E) m ul
tiplied by the ratio o f the U.S. price level (P,,s) to the
foreign price level IP,,).- This rate differs from the
nominal exchange rate in that it excludes m ove
ments that are attributable to changes in domestic
price levels like Pls or PK. For example, suppose
that U.S. prices rise X percent while prices abroad

2The Federal Reserve Board measures presented in chart 1 use
a weighted-average of foreign exchange rates and price levels
to construct E and PF, respectively; the weights are based on
shares of trade with the United States. A host of different

are unchanged. The nominal exchange value o f
the dollar w ould have to fall X percent for the dol
lar prices o f both U.S. and foreign goods to rise by
X percent and for the foreign prices o f both U.S.
and foreign goods to be unchanged. When price
levels and exchange rates change for such purely
monetary reasons, the real exchange rate and
decisions about production, consumption and
trade are unaffected. Both measures in chart 1
rose sharply from 1980 to 1985, then declined
roughly as much as they had risen, however. (Ref
erences to exchange rate changes below are to
both nominal and real changes unless indicated
otherwise.)

The Conventional Analysis o f the
Effects o f an Exchange Rate Change
A conventional analysis o f the effects o f a
change in the dollar’s value on domestic produc
tion and trade is shown in figure 1. The supply

measures have been developed with differing weights, baskets
of currencies and price indexes, but none shows a different
pattern for our purposes.

NOVEMBER/DECEMBER 1988

and the difference — the quantity im ported —
increases. Conversely, a fall in the value o f the
dollar is expected to raise the dollar prices o f
goods that are traded internationally, providing an
incentive to raise domestic production and reduce
domestic purchases; in this case, the quantity of
traded goods exported w ill rise and the quantity
imported will fall.

Figure 1

A Rise in the Value of the Dollar
Reduces Domestic Output
Price of
Traded Good
($ per unit)

Quantity per
Period

curve (S) shows that the domestic quantity sup
plied o f product (X) w ill increase if the domestic
price o f the product rises, given the other factors
influencing the position o f the curve. The demand
curve (D) indicates the quantity dem anded do
mestically at various domestic prices, given the
other factors that influence its position. The world
price (PJ and the domestic price are equal when
measured in dollars per unit o f the product; the
w orld price equals the price in a foreign countiy
measured in its currency units (P*) divided by the
foreign currency price of the dollar (E). The differ
ence between the quantities supplied and d e
manded domestically is the quantity either ex
ported (when the quantity supplied exceeds that
demanded) or im ported (when the quantity de
manded exceeds that supplied). As drawn in
figure 1, the U.S. exports product X at the initial
price P;;,.
If the value o f the dollar (E) rises and the foreign
price o f the good remains the same, the w orld
price expressed in dollars (P*/E) is reduced; in
figure 1, the price falls to P'v. As a result, the do
mestic quantity supplied w ould fall and the d o
mestic quantity dem anded w ould rise, reducing
the quantity o f X exported. For an im ported good,
the analysis is the same: when the dollar price
falls, U.S. consumption rises, U.S. production falls
3Factors reflecting overall price levels both in the United States
and abroad are held constant in figure 1. A given supply curve
for X assumes that the dollar factor cost of resources used to
produce product X are fixed, suggesting that the U.S. general
level of prices is held constant; the local currency price of the

FEDERAL RESERVE BANK OF ST. LOUIS

From the foreign perspective, the figure and
results are the reverse. Thus, when the value o f the
dollar rises, the w orld price measured in foreign
currency rises, inducing foreigners to produce
more traded goods but consume less o f them.
Thus, a rise in the value o f the dollar is expected
to redistribute the production o f internationally
traded goods from the United States to foreign
producers. Conversely, when the value o f the dol
lar falls, the U.S. output o f these goods is boosted,
while foreign output declines.

An Alternative View o f Recent
Exchange Rate Movements
While there is nothing inherently w rong with
the conventional analysis above, its relevance to
observed exchange rate movements is question
able. In the analysis in figure 1, the change in the
value o f the dollar is “ exogenous,” or external to
the domestic factors that influence the supply and
demand curves. The dollar’s value, however, is
determined in currency markets in w hich the
demand for dollars in foreign exchange is m oti
vated by factors influencing foreign dem and for
U.S. exports and assets, w hile the supply o f dollars
in foreign exchange is motivated by U.S. decisions
to purchase foreign goods or assets. If changes in
incentives in asset markets raise (lower) the rela
tive attractiveness o f investment in the United
States and raise (lower) the external value o f the
dollar, the exchange rate change can only be exog
enous to a U.S. market for a good if the domestic
supply and demand for that product are unaf
fected.3
A shift in the relative attractiveness o f U.S. vs.
foreign investment that directly affects asset mar
kets but not goods markets is impossible. After all,
the opportunity cost o f em ploying capital in pro
duction is influenced by expected rates o f return
both at home and abroad. The typical rationale for
product abroad also is held constant, suggesting that the price
level abroad is unchanged. Thus, the change in the external
value of the dollar represents a “ real” exchange rate change.

ignoring these related effects in the goods market
is that, in the short run at least, changes in the
capital stock (plant and equipment) are small rela
tive to the existing stock o f such goods. Thus, the
short-run output and productivity effects are also
presumed to be relatively small. This simplifica
tion is most questionable when the very purpose
of policy actions that give rise to such a shift in
investment incentives is to raise productivity and
output.
In the early 1980s, the real rate o f return on in
vestment in the United States was raised by tax
policy actions, especially those that extended the
investment tax credit and accelerated deprecia
tion allowances. In effect, these changes lowered
the cost o f capital to U.S. firms and raised the real
rates o f return that these firms were willing to bid
to maintain and acquire new equity and debt
financing. W hile tax changes provided a positive
incentive for firms to expand capacity and output
domestically, the higher rates o f return generally
discouraged output and investment in activities
without these new tax breaks, especially such
activities abroad.4
Proponents o f the conventional view described
above neglect these tax-policy-induced changes;
indeed, they focus only on the supposed budgetdeficit-driven rise in (real) interest rates and its
consequent effects on investment and the value o f
the dollar. From an alternative supply-side view,

“The hypothesis described is elaborated more fully in Tatom
(1985) and (1986a). This hypothesis is not widely endorsed.
Recent papers by Mutti and Grubert (1988) and, especially,
Sinn (1988) address the influence of tax policy changes on
international capital and trade flows and the value of the dollar;
see also the comments by Gravelle (1988) and Patrick (1988).
Ott (1984) and Fazzari (1987) also describe the 1981 and 1986
tax law changes for capital income and their effects. Ohmae
(1988) argues that the link between the value of the dollar and
U.S. competitiveness has been the opposite of that typically
put forward in the popular and academic press. Boskin and
Gale (1986) provide evidence on firm mobility that is consistent
with Ohmae's view. Poole (1988) indicates that the 1981 tax
act was the primary real disturbance in this decade and that it
raised the real after-tax rate of return on investment. He also
indicates the minority status of this view, however. Stockman
and Svensson (1987) provide a formal model in which changes
in wealth and its distribution can give rise to capital flows,
current account movements and exchange rate changes that
simultaneously match those described here.
5Krugman and Baldwin (1987) emphasize the importance of
relative productivity developments as the factor accounting for
the dollar’s decline and the growth in the trade deficit after early
1985, but do not address the possible connections of the
exchange rate, trade and relative productivity developments in
the 1980-85 period.

however, the rise in the dollar’s value was pro
duced by the same policy actions that also pro
duced an increase in the supply of domestic out
put."’
Similarly, econom ic policy changes that reverse
investment incentives and have adverse output
supply effects w ill both low er the value o f the dol
lar and reduce the supply o f domestic output.
From the outset o f the discussion o f tax reform in
late 1985, it was clear that earlier incentives to
invest, notably the investment tax credit (ITC) and
accelerated depreciation for structures, w ould
soon end. These changes were incorporated in the
Tax Reform Act o f 1986 (and made retroactive to
the beginning o f 1986 in the case o f the ITC). In
response, domestic investment plum m eted from
late-1985 to m id-igs?.6These tax changes should
be expected to reduce both the supply o f dom es
tic output and the exchange rate.7

Output and The Exchange Rate When
Domestic Supply Shifts
Figure 2 shows a shift in the domestic supply of
product X from S to S'; such a shift can arise be
cause o f a reduction in factor costs. For large
countries like the United States, the increase in
domestic supply w ill have an appreciable effect on
the w orld supply as well: the price o f product X
w ill fall as domestic output (XJ and total w orld
output rise.

corporate income (taxed at 51 percent) realized through re
tained earnings and capital gains (taxed at 20 percent) to 59.1
percent in 1988 for corporate income (taxed at 39 percent)
realized through capital gains or dividend income (taxed at 33
percent). This 1988 tax rate change excludes the end of the
ITC and reductions in service lives for depreciation that further
raised effective marginal tax rates, but includes a 5
percentage-point surcharge for individuals and corporations
that phases out at sufficiently high incomes.
From 1985 to 1987, corporate tax accruals (excluding the
Federal Reserve) rose from $58.5 billion to $88.1 billion, a 50.6
percent increase. As a result, real nonresidential fixed invest
ment fell from a peak of 12.6 percent of real GNP at the end of
1985 to 11.1 percent in 1/1987. This decline as a share of real
GNP is the equivalent of about a $56.7 billion reduction, or 13.6
percent of investment spending, in 1/1987 alone. Canto (1988)
also emphasizes the strong connection between changes in
the exchange rate and tax rates, but only for personal tax rates!
His explanation relies on an almost inconsequential reduction
in personal tax rates in 1981 and has difficulty accounting for
post-1984 exchange rate and investment developments.
T here are likely other factors that could account for the decline
in the dollar’s value, but the hypothesis here, explained in
Tatom (1987), is that post-1984 policy developments reflect a
reversal of earlier policies.

6The maximum marginal tax rate on personal and corporate
income declined only slightly, from 60.8 percent in 1985 for

NOVEMBER/DECEMBER 1988

the price reduction abroad w ill ensure that pro
duction abroad declines.9

Figure 2

An Increase in Supply Raises
The Quantity Produced

When the supply of all products in a country
changes, the analysis is more complex. For exam
ple, the monetary approach to the balance o f pay
ments indicates that a general rise in U.S. output
will low er the U.S. price level and raise the nom i
nal exchange value o f the dollar. In this approach,
the real exchange rate need not change, despite
the increase in domestic production.10This ap
proach typically does not take into account inter
national capital mobility; thus, it does not em pha
size the importance o f capital flows between
countries as the principal factor influencing re
cent exchange rate movements.

X Per Period

When the supply o f product X increases, its
price w ill tend to fall in both domestic and foreign
IP’ ) currency units to induce domestic and foreign
purchasers to buy more o f it. Thus, given the value
of the dollar (El, the w orld price falls to P„' and
purchases o f product X rise, both in the United
States and abroad. Production rises only in the
United States, however. Foreign production of
product X falls because its price declines and the
foreign supply curve remains unchanged. For
eigners w ould also consume more o f product X, so
they w ould increase their imports from the United
States.8
Similarly, for a good that the United States im
ports, an increase in the U.S. supply o f an importcom peting good w ill raise its w orld supply and
reduce its price. Just as for goods that the United
States exports, the price decline will raise pur
chases at home and abroad. The domestic supply
increase ensures that domestic output rises, while

8The productivity increase also explains why employment can
decline despite the boost to output. Fieleke (1985) makes a
similar argument about the relationship of net imports of an
industry’s product and employment in that industry. He pro
vides evidence showing that net import movements were
uncorrelated with industry employment, which is consistent
with the argument below. McKenzie (1988) has shown that
productivity advances, not imports, have been the major factor
behind employment losses in the textile industry. This view is
explained more generally in Tatom (1986b).
9Alternatively, given P* in the analysis above, a decline in P due
to an increase in domestic supply requires that E rise. Of
course, the rise in the world supply of traded goods will reduce
the world price of such a good measured in any currency, so

FEDERAL RESERVE BANK OF ST. LOUIS

In addition, real incomes will not remain con
stant for such generalized output changes. The
ensuing rise in U.S. incom e w ill also raise U.S. de
mand for goods and services. The U.S. demand
curve D in figure 2 w ill shift to the right, mitigating
but normally not offsetting part o f the rise in the
excess supply shown there. M ore importantly,
however, the supply and dem and for product X, or
products generally, w ill tend to fall abroad. U.S.
policy actions that raise the real after-tax rate of
return and shift domestic supply rightward from S
to S', also raise the cost o f capital abroad and shift
the foreign supply curve for output leftward, re
ducing foreign output, incom e and demand. A
decline in foreign incom e reduces foreign demand
for goods and sendees, including those im ported
from the United States.
The effects on trade flows are ambiguous when
both supply and dem and change. As long as the
dominant domestic effect o f policies that raise
(lower) the after-tax rate o f return in the United
States is to raise (lower) the U.S. supply o f traded
goods output and low er (raise) foreign dem and for
traded goods, the trade flows predicted in the
conventional analysis also are predicted in the
supply-side analysis. That is, a rise (fall) in the

that P* must decline as well. Thus, the share of domestic
producers in world production will rise because of increased
domestic production and reduced foreign production.
>°A second approach based on the flow supply and demand for
dollars, emphasizes the fall in import prices and quantities as a
source of a reduced supply of dollars in international exchange
and, under standard assumptions, a rise in nominal exports as
a source of a rise in the demand for dollars in international
exchange. The value of the dollar would rise for both reasons,
although the major factor affecting the exchange rate in either
view is international capital flows.

value o f the dollar will be associated with a rise
(fall) in the quantity o f imports and a fall (rise) in
the quantity o f exports. The central difference, and
the focus here, is on w hether the rise o f U.S. im
ports and the fall o f exports were indicators o f a
“ deindustrializing” econom y or “h ollow ed'’ corpo
rations, or instead were a symptom o f a redistribu
tion of capital, productivity and incom e toward
the United States.
In the supply-side view, U.S. goods that formerly
w ould have been exported are purchased at home
and not abroad where incom e reductions have
reduced demand; goods that formerly w ould have
been produced and consumed abroad face a
larger demand in the United States and a smaller
demand abroad." While these outcomes are not
inevitable for every traded commodity, the analy
sis suggests that the conventional result — that
domestic production o f exported and im ported
goods varies inversely with the value o f the dollar
— is a partial analysis less likely to hold if ex
change rate movements arise from forces that also
change domestic supply.
Figure 2 illustrates h ow domestic output in
creases can accompany an exchange rate appreci
ation. Increases in the supply o f U.S. output gener
ally w ill raise domestic output, reduce the U.S.
price level and raise the nominal exchange rate.
The result is a positive relationship between the
exchange rate and output, contrary to the conven
tional relationship. Figure 2 also challenges the
notion that a rise in the value o f the dollar neces
sarily redistributes production, including that of
U.S. export and im port-com peting goods, away
from the United States and toward our foreign
competitors. These implications are examined
below.1-

"Krugman and Obstfeld (1988) explain how a transfer of income
from the rest of the world to the United States causes the
changes in demand and trade described here. They also ex
plain that such a transfer raises the demand for U.S. goods
relative to those produced abroad so that the terms of trade,
the price of exports relative to imports, will rise. They apply
their analysis to the recent flow of financial capital, instead of
an increase in current and future U.S. income.

U.S. MANUFACTURING OUTPUT: A
REVIEW OF SOME AGGREGATE
EVIDENCE
The key difference between the hypotheses
above concerns the relationship between the
exchange rate and domestic output. In the con
ventional view, this relationship is negative; a
supply-side perspective emphasizes that it can be
positive. The difference centers on whether ex
change rate changes are exogenous or w hether
they reflect changes in domestic productivity and
output. One source o f evidence on this issue is the
share o f domestic manufacturing output in U.S.
real GNP. Additional evidence is the experience
abroad. Under the conventional view, when the
value o f the dollar rose, U.S. producers should
have lost market share to foreign producers as
output of U.S. manufactured goods fell and foreign
output rose. If, instead, the rise in the value o f the
dollar reflected a decline in domestic production
cost in the United States and a rise abroad — as
the supply side view suggests — precisely the
opposite should occur.1:1Thus, examining the per
formances o f U.S. manufacturing output relative to
other major industrial countries is also relevant
for distinguishing between these two explana
tions.

The Manufacturing Share o f U.S.
Output
The actual and cyclically adjusted shares of
manufacturing output in real GNP are shown in
chart 2 for the period 1/1948 to 11/1988. The actual
manufacturing share is an important, but easily
misinterpreted, source o f evidence bearing on the

anticipate productivity improvements that follow decisions to
change investment and capacity. Tatom (1986a) also provides
evidence on the reallocation of investment and productivity
growth toward the United States in 1980-85.

,JThe two theoretical approaches to exchange rate changes
touch on a multitude of economic factors besides production,
both at home and abroad, including purchases, relative prices,
price levels, nominal and real trade flows. The qualitative
predictions of the two theoretical analyses are the same for
most of these factors under fairly standard assumptions. The
critical difference involves production, and that is the focus
here.
,3Tatom (1986a and 1987) shows that changes in the exchange
rate occur two quarters earlier than their positively related
changes in domestic manufacturing output. Exchange markets

NOVEMBER/DECEMBER 1988

Chart 2
U.S. Manufacturing Output as a Percent of Real GNP
Percent
23

Percent
23

19
1948
51
54
57
60
63
66
69
72
75
Q Based on a constant 81.9 percent capacity utilization rate in manufacturing.

19
1990

com peting hypotheses here. Since 1983, this share
has been above the 1948-79 average o f 21 percent,
providing no evidence that manufacturing output
had weakened when compared to its previous
history, despite the rise in the value o f the dollar
from 1980 to 1985.14The manufacturing share also
rose moderately since the value o f the dollar be
gan falling in 1985. The share does not take a no
ticeable jump up because o f this decline, however,
just as it does not appear to have been depressed
earlier when the value o f the dollar rose.

ficantly stronger than w ould have been expected
based on the 1948-79 record. The actual share
varies cyclically because the dem and for such
output is strongly cyclical; for example, periodic
sharp declines in the share coincide with U.S.
recessions. Transitory or cyclical incom e losses in
the 1980-85 period (as indicated by a relatively low
capacity utilization rate or high unemployment
rate for labor) w ere relatively large, so that the
actual share w ould have been expected to be
low er than it actually was.

The potential misinterpretation o f the behavior
o f the actual share arises from the above-average
level since 1983, which suggests that its perfor
mance in the 1980s has not been unusual. In fact,
for most o f this decade, the actual share was signi

The cyclically adjusted share accounts for these
cyclical variations; it surged upward to a record
level in mid-1981 (after the 1981 tax act was
passed) and generally remained at a historically

,4Glick and Hutchison (1988) point to the actual share of manu
facturing in output as evidence against the deindustrialization
hypothesis, but express agreement with the existence of an
inverse relationship between the dollar's value and domestic
output.

FEDERAL RESERVE BANK OF ST. LOUIS

high level until 1985-86, when it began to decline.”
Relative to its past, the adjusted share appears
unusually strong in 1981-85, when the dollar was
rising. Moreover, it has not surged upward since
the dollar began to fall in 1985; instead, it has
weakened, especially in 1987. The decline in the
adjusted share in 1987 indicates that the rise in
the actual share was largely due to cyclical income
changes, not the belated effect o f the fall in the
value o f the dollar. The pattern shown by the ad
justed share is strongly at odds with the main
stream view, but is consistent with the supply-side
stoiy.

U.S. vs. Foreign Manufacturing
Output
Did the U.S. share o f the w orld ’s manufacturing
output rise or fall from 1980 to 1985? The Organi
zation o f Economic Cooperation and Development
(OECDI prepares indexes for the manufacturing
output o f its 24 m em ber countries, a group that
includes Europe, the United Kingdom, Canada,
Japan, Australia and N ew Zealand. These indexes
can be used to compute an index o f manufactur
ing output for the other 23 OECD nations.
Chart 3 shows this index and the index for the
United States since 1960. The gap between the
indexes that opens up in the 1980s indicates the
unusual strength o f U.S. manufacturing in this
decade. According to the OECD, the growth rate o f
U.S. manufacturing output, which constituted 31.7
percent o f total OECD output in 1980, grew at a 3.2
percent rate from 1980 to 1985 w hile the value of
the dollar was rising. This growth was w ell above
the 1.5 percent rate for the rest o f the OECD over
the same period. Moreover, the U.S. growth rate in
1980-85 was up sharply from a 2 percent rate in
1973—80, while production gr owth in the remain
der o f OECD hardly rose at all from the dismal 1.3
percent rate registered in 1973—80. From 1960 to
15The adjusted share is computed using the departure of the
capacity utilization rate in manufacturing (which captures
movements in manufacturing output common to all sectors and
hence is a representative business cycle measure) from the
1948-88 average of 81.9 percent. A regression of the growth
rate (change in the natural logarithm) of the share on a con
stant, lagged share and current and several lagged changes in
the logarithm of the capacity utilization rate indicates that the
lagged share and lags on the capacity utilization rate are not
statistically significant at a conventional (5 percent) significance
level. The equation estimated from 111/1948 to 1/1988 has an
insignificant intercept 0.02 percent (t = 0.37) and a coefficient
of 0.61676 (t = 27.69) for the current change in the capacity
utilization rate; the adjusted R2 is 0.80 the standard error is
0.83 percent, and the Durbin-Watson statistic is 2.02. The
estimate includes a significant first-order autocorrelation ad
justment with p equal to 0.21 (t = 2.66). Other methods that

1973, manufacturing production in the rest o f the
OECD countries had grown at a 6.4 percent rate,
outstripping the 5.3 percent rate in the United
States. Thus, the share o f U.S. manufacturing in
the total OECD output rose markedly while the
dollar rose from 1980 to 1985 — from 31.7 percent
in 1980 to about 33.5 percent in 1985 — contrary to
the conventional wisdom.
From 1985 to 1987, the relatively faster growth in
the United States eroded, despite the overall U.S.
cyclical expansion. The growth o f U.S. manufactur
ing output, according to the OECD, remained at a
3.2 percent rate, w hile the growth o f industrial
output in the other 23 countries accelerated to a 2
percent rate. Since U.S. growth still exceeded that
abroad, the U.S. share o f OECD manufacturing
output continued to rise slightly, but much more
slowly; it reached about 34 percent in 1986 and
1987. Thus, the comparison o f U.S. and foreign
output generally supports the supply-side view
that the competitive position o f U.S. manufactur
ers was boosted by econom ic policy changes in
the early 1980s, which subsequently w ere re
versed. Thus, an inverse relationship o f produc
tion and the value o f the currency does not hold
for the United States or the rest o f the OECD.

DISAGGREGATED EVIDENCE ON
PRODUCTION AND TRADE
If U.S. manufacturing production was not d e
pressed by the rise in the value o f the dollar, w hy
did the trade deficit balloon from 1980 to 1985?
The conventional explanation emphasizes that the
rise in the value o f the dollar reduced domestic
output, especially the output of exported and
import-competing goods.1" The supply-side view,
on the other hand, indicates that an expanded
trade deficit can accompany relatively strong d o
mestic output growth if domestic productivity,
output and incom e rise.17. Thus, a detailed examiuse changes in the unemployment rate or real GNP growth
result in the same pattern for the adjusted share.
16There are microeconomic arguments that emphasize other
sources of reduced domestic output of imported and exported
goods. See Arndt (1989), Arndt and Bouton (1987) and Hooper
and Mann (1989), for example.
"Wharton (1986) provides evidence supporting this view.
Krugman and Baldwin (1987), however, dismiss the impor
tance of relative income growth in accounting for the emer
gence or elimination of the trade deficit. Their argument fo
cuses on an asserted difficulty of raising U.S. export volumes.
It ignores the associated and currently more relevant problem
(in the sense that export volume was restored to its 1980
record level as a share of real GNP in late 1987). This problem
is the failure of U.S. export and import prices to rise relative to
the prices of non-traded goods and services.

NOVEMBER/DECEMBER 1988

Chart 3
Manufacturing Production in the U.S. and Other
OECD Countries
Index 1980=100

Index 1980=100
130

1960

SOURCE: Organization for Economic Cooperation and Developm ent (OECD).

nation o f the industries most closely associated
with the record trade deficit will allow us to assess
whether their experience provides support for the
mainstream view, despite its failure to explain
overall manufacturing performance.

Identifying the Deficit Industries
As the value of the dollar rose from 1980 to 1985,
the U.S. merchandise trade deficit also rose, climb
ing from $24.2 billion to $132.5 billion18This rise
was concentrated in manufacturing, where an
initial trade surplus o f $20.7 billion fell to a $104.3
billion deficit. Table 1 shows the latter change and
a breakdown for the two-digit standard industrial
classification o f 20 industries that make up the
manufacturing sector. The changes from 1980-85
and 1985-87 are indicated for each industiy. The

l8Nominal trade data are used here because it is precisely the
nominal deficit that is the trade-area focus of popular and
macroeconomic policy discussions. Real trade data by industry
are unavailable, but the output measure relevant to the hypoth
eses in the text is domestic output, where data are available.
The domestic industry deflators indicate that nominal prices for
the deficit-related industries below have barely changed over

FEDERAL RESERVE BANK OF ST. LOUIS

three largest changes in trade deficits from 1980 to
1985 are in transportation equipment, non-electric
m achineiy and electrical equipment. These ac
count for more than half o f the total and include
the largest net exporting sector in 1980, the non
electrical machinery industiy. The next largest
swings are in apparel products and primary metal
products. These five industries account for twothirds o f the swing in the manufacturing deficit,
and they are the five principal deficit-related in
dustries. The changes in these industries are fol
low ed by relatively small swings toward deficit in
14 o f the remaining 15 industries. Only the to
bacco industry m oved toward a greater surplus (or
a smaller deficit) over the period.
The table also shows that the fall in the dollar's
value from 1985 to 1987 was not accompanied by a

the seven years; for the five-industry aggregate, nominal prices
rose about 2 percent from 1980 to 1985 and fell 4.2 percent
from 1985 to 1987. Changes in the real trade deficits in manu
facturing and in this group, computed using domestic prices,
are nearly identical to those for the nominal trade deficit.

Table 1
U.S. Trade Surplus in Selected Industries: 1980,1985,1987
(billions of dollars)
Change
1985-87

Change
1980-85

1987

Agriculture

$19.6

$ - 12.3

Mining

-6 2 .4

32.6

29.8

28.6

4.0

Manufacturing
Food and kindred products
Tobacco manufactures
Textile mill products
Apparel products
Lumber and wood products

20.7
1.7
1.0
0.5
- 4.9
0.1

-1 0 4 .3
2.5
1.2
2.2
- 14.7
2.4

-1 2 5 .0
4.2
0.2
2.7
9.8
2.5

-1 3 2 .7
0.9
2.2
2.8
- 20.0
2.0

-2 8 .4
1.6
1.0
- 0.6
- 5.3
0.4

2.1
2.9
0.4
5.1
2.2

4.0
3.8
0.1
11.7
8.6

2.7
3.6
0.1
9.0
12.8

1.3
0.2
0.2
2.7
4.2

1.9
4.3
2.2
9.2
4.5

2.6
9.2
3.5
13.4
3.4

0.6
2.0
1.0
2.3
1.4

; -

7.3

Furniture and fixtures
Paper and allied products
Printing and publishing
Chemical products
Petroleum and coal products

0.6
0.7
0.5
14.1
-1 0 .6

Rubber and plastic products
Leather products
Stone, clay and glass
Primary metal products
Fabricated metal products

0.1
2.9
0.3
6.5
2.5

2.0
7.2
2.5
15.7
2.0

Machinery, except electrical
Electrical equipment
Transportation equipment
Instruments
Miscellaneous

23.9
0.9
- 0.7
3.0
- 2.5

6.2
19.0
27.9
0.2
9.4

- 17.7
- 19.9
- 27.2
3.2
6.9

3.3

3.8
- 22.2
- 42.0
1.4
- 11.9

1985

O
•St

1980

Industry

-1 0 .0
- 3.2
-14 .1
- 1.2
- 2.5

NOTE: Deficits are negative entries.
SOURCES: Data for 1980 and 1985 are from Arndt (1989) and Bureau of the Census, U.S. Department
of Commerce, Statistical Abstract of the United States, 1988; 1987 data are in Bureau of the
Census, Foreign Trade Division, Highlights of U.S. Export and Import Trade, FT 990,
December 1987.

decline in the trade deficit, the deficit in manufac
turing, or the deficit for the five deficit-related
industries. A decline in the deficit in mining was
offset bv a decline in the surplus for agriculture.
The manufacturing trade deficit grew by $28.4
billion over the period. Only sLx industries showed
positive movements in their trade surplus, and
this group included only one o f the deficit-related
industries, primary metals. Positive changes also
were recorded for chemicals, tobacco, food, lum
ber and petroleum. For the other four major de
ficit industries, the total deficit rose $32.6 billion:
when primary metals are included, the trade de
ficit o f the five principal deficit-related industries
rose $30.3 billion, slightly more than the $28.4
billion increase in the total manufacturing deficit.
Thus, these five industries account for all of the
1985-87 rise in the manufacturing trade deficit.

Comparative Output Performance fo r
the Deficit-Related Industries
The top panel o f table 2 shows the growth rates
in manufacturing output for the five deficit-related
industries and the other 15 industries for the pe
riod o f the rising value o f the dollar, the period of
the falling value o f the dollar, and the earlier
seven-year period that is roughly a comparable
cycle-peak-to-cvcle-peak period for the United
States. Over this earlier period, the value o f the
dollar declined somewhat (chart 1). The data in
the table show that the five deficit-related indus
tries boom ed during the period o f the rising dol
lar; indeed, they w ere the sectors that pushed the
overall manufacturing growth rate up to a 3.4 per
cent rate. The other 15 industries, as a group,
showed much less acceleration in output growth

NOVEMBER/DECEMBER 1988

Table 2
U.S. Output and Productivity
Growth Rates (compounded annual
rates of change)___________________
1973-80 1980-851985-87
Output Growth Rates
Manufacturing
1.0%
Five deficit-related industries'
1.0
Other 15 manufacturing industries
1.0
Real GNP
2.2

3.4%
4.9
2.2
2.6

3.3%
3.6
3.1
3.1

Productivity Growth Rates2
Manufacturing
0.9
Five deficit-related industries
0.7
Other 15 manufacturing industries
1.1
Real GNP
0.0

4.4
6.3
2.9
1.1

3.8
5.3
2.7
0.7

'Includes primary metals, nonelectric machinery, electric
equipment, transportation equipment, and apparel and other
textile products,
2The output growth rate minus the employment growth rate;
civilian employment is used for the real GNP productivity
measure.
SOURCE: National Income and Product Accounts, Table 6.2,
U.S. Department of Commerce.

value o f the dollar declined, but in a direction
opposite to that predicted by the mainstream
view. The further increase in the trade deficit was
associated with a switch to slower domestic pro
duction growth, both overall and in the five princi
pal industries.|1JManufacturing output growth
slowed slightly, led by a substantial slowing in
output growth in the five deficit-related indus
tries.2" This reduction in output growth o f the five
deficit-related industries, both absolutely and
relative to the other 15 industries, is inconsistent
with the conventional view, but is consistent with
the view that earlier incentives for domestic pro
ductivity growth had been reduced.
The bottom panel o f table 2 shows labor pro
ductivity growth, measured by the difference be
tween output and em ployment growth rates, for
the five industries and other manufacturing firms.
The sharp acceleration in productivity in manu
facturing in 1980-85, led by the five deficit-related
industries, clearly stands out, as does the relative
decline for these same industries since 1985.

in 1980-85, compared with the 1973-80 period.
The five-industiy group includes the steel and
automobile industries which are often viewed as
mature or declining, but it also includes the com
puter industry where rapid growth has led the
expansion o f the non-electric machinery industry
and o f overall manufacturing in this decade. The
comparisons made here using the data in table 2
are not reversed bv omitting non-electric machin
ery from the measures, however.

The evidence in table 2 confirms and strength
ens the aggregate evidence. The aggregate data are
not obscuring a negative relationship between the
value o f the dollar and output in the deficit-related
industries. In fact, the positive relationship is even
more apparent for the five industries.-1The results
are strongly at odds with the view that the expan
sion in the trade deficit in 1980-85 came at the
expense o f domestic production. Instead, declin
ing net exports reflected increased domestic pur
chases that outstripped the relatively rapid growth
of domestic production.-

The top panel o f table 2 also shows that the
pattern of production changed in 1985—87 as the

Moreover, as developm ents since 1985 suggest,
the declining dollar and the nascent rev ersal in

19The decline in output growth is much more pronounced when
non-electric machinery is omitted from the five-industry and
manufacturing measures. The growth rate for the four-industry
total slowed from 2.6 percent in 1980-85 to zero in 1985-87,
leading the decline in the growth rate of manufacturing which
fell from a 2.3 percent to a 2.0 percent rate for the same peri
ods. In 1973-80, the four-industry growth rate was 0.2 percent,
and manufacturing less non-electric machinery grew at a 0.7
percent rate.

2,The 1981 tax act generally provided a subsidy to structures
and to equipment that increased with its durability; these subsi
dies were reversed in the Tax Reform Act of 1986. If the five
deficit-related industries are relatively more equipment
intensive in production, then their supply is relatively more
affected by the changed taxation of capital income. Also, the
rise in the real after-tax rate of return domestically will raise the
cost of capital abroad, changing investment patterns so as to
reduce foreign productivity growth relative to what it would
otherwise have been, reinforcing the positive relationships
abroad.

“ The cyclically adjusted output growth rate for the five deficitrelated industries rose 2.5 percentage points from 1973-80 to
1980-85; this increase is statistically significant, t = 2.47,
according to a pooled t-test. The adjusted growth rate fell by a
statistically significant 2.9 percentage points in 1985-87 from
its 1980-85 rate (t = -5 .5 0 ). The cyclically adjusted growth
rate is found using the regression of the actual growth rate of
the five industries’ output for the period 1967-80 on the real
GNP growth rate. When the rate of change of the real ex
change rate is regressed on the cyclically adjusted growth rate
for 1967 to 1987, its coefficient is positive, 0.088, but not sig
nificantly so at conventional levels, t = 1.49.

FEDERAL RESERVE BANK OF ST. LOUIS

22When domestic industry price deflators are used to adjust
nominal trade deficits, the resulting real net imports can be
added to real output to obtain real domestic purchases. This
procedure indicates a 9.4 percent annual rate of growth of real
purchases in the five deficit-related industries from 1980 to
1985 and a slowing to a 6.7 percent rate from 1985 to 1987.
Comparable figures for real manufacturing purchases are 6.8
percent and 4.4 percent, respectively. For the other 15 indus
tries, the figures are a 4.6 percent rate in 1980-85 and a 2.2
percent rate in 1985-87.

Table 3
U.S. Manufacturing Capacity Growth and
Deficit-Related Industries
Industry1
Manufacturing
3-industry
4-industry
5-industry

1973-80
3.4%
4.2
3.6
3.3

1980-85
2.9%
4.4
3.6
3.6

Change

1985-87

Change

-0 .5 %
0.2
0.0
0.3

2.6%
2.4
1.8
2.3

-0 .3 %
-2 .0
-1 .8
-1 .3

’The three-industry group includes electrical equipment, nonelectrical machinery and transportation
equipment; the four-industry group adds the primary metals industry; the five-industry group adds other
nondurables. Other nondurables includes apparel and other textile products, tobacco products, printing
and publishing, and leather products.
SOURCE: Computed from data published by the Federal Reserve Board.

the trade deficit look to be the results of policy
actions that have reversed the earlier productivity
boom in these key industries. Thus, bv reducing
their competitiveness internationally, these policy
actions have allowed weaker sectors in the United
States and abroad to expand. On net, these
changes w ill reallocate w orld consumption and
production away from the United States.

Were Current Production Changes at
Odds with Longer-Term Output
Plans?
As noted earlier, manufacturing output is
strongly influenced by cyclical factors. One way to
avoid the influence o f such temporary factors at
the industry level is to examine capacity output
measures. The long-run choices o f capacity and
its optimal output are based on expected prices
and costs. The capacity choice is more forwardlooking and is based on more permanent consid
erations than the current output choice. If a rise in
the value o f the dollar w ill reduce the optimal
domestic output o f an industry, then, regardless of
current output developments, firms w ill cut back
on the growth o f capacity.-3

facturing capacity slowed in 1980-85, then slowed
further in 1985-87, two o f the three measures of
capacity growth in deficit-related industries accel
erated in 1980-85, then slowed in 1985-87.24This is
precisely the same pattern follow ed by actual out
put in table 2. The exception is the four-industry
measure, where the decline in primary metals
capacity growth held the group’s rate to the same
pace in 1980-85 as in 1973-80.
When the dollar was rising, capacity growth in
the deficit-related industries, by all three mea
sures, exceeded the overall average for manufac
turing capacity growth and accelerated relative to
the average for manufacturing. Thus, the share of
manufacturing capacity in these industries was
expanding and expanding faster than it had ear
lier. For the five-industiy measure, capacity
growth was slightly below the overall manufactur
ing growth rate in 1973-80, but it jumped to about
a 24 percent faster growth rate than in manufac
turing in 1980-85.

Table 3 shows the growth rates for manufactur
ing capacity and several industry groupings o f the
principal deficit-related industries over the same
periods as in table 2. While the growth o f manu

When the dollar fell from 1985-87, these devel
opments w ere reversed. The capacity growth rates
in the deficit-related industries declined and were
slower than for manufacturing as a whole. The
share o f capacity in the deficit-related industries
began to decline slightly. This result is inconsis
tent with the view that international com petitive
ness in these industries had im proved since 1985.

23The Federal Reserve Board compiles data on industrial capac
ity for the sectors in table 1, except that apparel products are
lumped into “other nondurable manufacturing” which also
includes tobacco products, printing and publishing, and leather
and products.

a 0.5 percent rate in 1985-87. The growth rate of manufactur
ing capacity per worker, measured by the difference in the
growth rate of capacity and employment, accelerated from 3.3
percent in 1973-80 to 3.9 percent in 1980-85, then declined to
3.1 percent in 1985-87.

^Manufacturing employment expanded at a 0.1 percent rate in
1973-80, then declined at a 1.0 percent rate in 1980-85 and at

NOVEMBER/DECEMBER 1988

CONCLUSION
The mainstream view that the dollar’s decline
has im proved U.S. competitiveness is based on a
partial and misleading econom ic analysis. This
view mistakenly focuses on the effects o f exoge
nous exchange rate movements on trade and out
put. In a broader analysis, the exchange rate is
determined precisely by those factors that drive
econom ic competitiveness. Thus, a rise in the
value o f the dollar can reflect an improvement in
competitiveness, rather than a cause o f its decline.
Similarly, a fall in the dollar’s value can reflect a
decline in competitiveness; it is not necessarily a
factor that w ill improve it. While there are firms
and even industries within the groups examined
here — for example, the primary metals sector —
in which relative productivity changes have not
been significant so that an inverse relationship
between the dollar exchange rate and production
and em ployment is observed, they are not typical.
For the U.S. manufacturing sector as a whole and
the industries most closely connected to the U.S.
trade deficit, the relationship between movements
in the value of the dollar and output growth dur
ing this decade has been a positive one.
In the early 1980s, U.S. manufacturing output,
especially when adjusted for the effect of the U.S.
business cycle, was unusually strong relative to
both its own past experience and output growth
abroad. The industries most closely related to a
$125 billion surge in the manufacturing trade de
ficit were the leading sectors in this strong growth;
these industries showed a sharp acceleration in
capacity growth over the same period that rein
forced their growing dominance in econom ic per
formance.
From 1985 to 1987, these trends, like the value of
the dollar, reversed. Only the trade deficit contin
ued its previous pattern, growing somewhat larger
over the period, and this increase was fully ac
counted for by the same key industries. Over the
period, the share o f manufacturing output in U.S.
production, on a cyclically-adjusted basis, did not
increase. Meanwhile, actual manufacturing output
growth abroad accelerated both absolutely and
relative to its counterpart in the United States. In
the United States, at least, this pattern was dom i
nated by the slowing o f output growth in the key
deficit-related industries. From 1985 to 1987, ca
pacity growth slowed in the deficit-related indus
tries to a pace below that for manufacturing.
A central lesson of this evidence is that the ef
fects o f changes in the dollar exchange rate on

FEDERAL RESERVE BANK OF ST. LOUIS

domestic production, at least during the 1980s, are
dominated by the effects o f the econom ic policy
changes that also have produced the exchange
rate movements. The evidence suggests that the
increased U.S. manufacturing competitiveness
produced bv econom ic policy changes in the early
1980s has been reduced by reversals o f some of
these policies in the mid-1980s.

REFERENCES
Arndt, Sven W. "An Evaluation of Policies to Resolve the
Trade Deficit," in Albert E. Burger, ed., The U.S. Trade Deficit:
Causes, Consequences and Cures (Kluwer Academic
Publishing Co., forthcoming 1989).
Arndt, Sven W. and Lawrence Bouton. Competitiveness: The
United States in World Trade (American Enterprise Institute for
Public Policy Research, 1987).
Berry, John M. "Narrower Trade Gap Will Require Cut in
Spending," Washington Post, November 2, 1986.
Boskin, Michael J., and William G. Gale. “ New Results on the
Effects of Tax Policy on the International Location of
Investment,” National Bureau of Economic Research Working
Paper No. 1862 (March 1986).
Business Week.
pp. 56—67.

“America After Reagan” (February 1,1988),

________ . “ It’s Time for America to Wake Up” (November 16,
1987), pp. 158-77.
Canto, Victor A. “Tax Rates Move Currencies, and There’s No
Easy Fix,” Wall Street Journal, September 22, 1988.
Deutsch, Claudia H. “ U.S. Industry’s Unfinished Struggle,”
New York Times, February 21, 1988.
Feldstein, Martin. “ Unwanted Advice From Abroad,” Wall
Street Journal, March 3, 1988.
________ _ “ Correcting The Trade Deficit,” Foreign Affairs
(Spring 1987), pp. 795-806.
Fazzari, Steven M.

“ Tax Reform and Investment: Blessing or

Curse?" this Review (June/July, 1987), pp. 23-33.
Fieleke, Norman S. “ The Foreign Trade Deficit and American
Industry,” New England Economic Review (July/August
1985), pp. 43-52.
Glick, Reuven, and Michael Hutchison. “The Dollar and
Manufacturing Output,” Federal Reserve Bank of San
Francisco Weekly Letter (August 26, 1988).
Gravelle, Jane G. "Discussion of ‘U.S. Taxes and Trade
Performance’,” National Tax Journal (September 1988), pp.
341-2.
Hickok, Susan, Linda A. Bell, and Janet Ceglowski. “The
Competitiveness of U.S. Manufactured Goods: Recent
Changes and Prospects," Federal Reserve Bank of New York
Quarterly Review (Spring 1988), pp. 7-22.
Hooper, Peter H., and Catherine L. Mann. “ The U.S. External
Deficit: Its Causes and Persistence,” in Albert E. Burger, ed.,
The U.S. Trade Deficit: Causes Consequences and Cures
(Kluwer Academic Publishers, forthcoming).
Jonas, Norman. “The Hollow Corporation,” Business Week
(March 3, 1986), pp. 57-59.
Krugman, Paul R., and Richard E. Baldwin. “ The Persistence
of the U.S. Trade Deficit,” Brookings Papers on Economic
Activity (1987:1), pp. 1-43.

Krugman, Paul R. and Maurice Obstfeld. International
Economics (Scott, Foresman and Company, 1988).
McKenzie, Richard B. “ Textile Gripes Are Made of Whole
Cloth,” Wall Street Journal, April 8, 1988.
Meyer, Stephen A. “Trade Deficits and the Dollar: A
Macroeconomic Perspective,” Federal Reserve Bank of
Philadelphia Business Review (September/October 1986), pp.
15-25.
Murray, Alan.
11, 1988.

"Improbable Growth," Wall Street Journal, July

Mutti, John and Harry Grubert. “ U.S. Taxes and Trade
Performance,” National Tax Journal (September 1988), pp.
317-25.
Ohmae, Kenichi. “ No Manufacturing Exodus, No Great
Comeback,” Wall Street Journal, April 25, 1988.
Organization for Economic Cooperation and Development.
Main Economic Indicators (June 1988).
Ott, Mack. “ Depreciation, Inflation and Investment Incentives:
The Effects of the Tax Acts of 1981 and 1982,” this Review
(November 1984), pp. 17-30.
Patrick, Robert J., Jr. "Comments On U.S. Tax Structures and
Competitiveness,” National Tax Journal (September 1988),
pp. 343-5.
Peterson, Peter G. “The Morning After,” The Atlantic Monthly
(October 1987), pp. 43-69.

Poole, William. “ Monetary Policy Lessons of Recent Inflation
and Disinflation,” Journal of Economic Perspectives (Summer
1988), pp. 73-100.
Revzin, Philip.
17, 1988.

“ Rude Awakening,” Wall Street Journal, March

Sinn, Hans-Werner. “ U.S. Tax Reform 1981 and 1986: Impact
on International Capital Flows,” National Tax Journal
(September 1988), pp. 327-40.
Stockman, Alan C., and L. E. O. Svensson. "Capital Flows,
Investment, and Exchange Rates,” Journal of Monetary
Economics (March 1987), pp. 171-201.
Summers, Lawrence H. "The Results Are in on the Deficit
Experiment,” Wall Street Journal, February 20,1987.
Tatom, John A. “Will a Weaker Dollar Mean a Stronger
Economy?” Journal of International Money and Finance
(December 1987), pp. 433-47.
________ . “Why Has Manufacturing Employment Declined?"
this Review (December 1986b), pp. 15-25.
_________ “ Domestic vs. International Explanations of
Recent U.S. Manufacturing Developments,” this Review (April
1986a), pp. 5-18.
_________ “Two Views of the Effects of Government Budget
Deficits in the 1980s,” this Review (October 1985), pp. 5-16.
Wharton Economics Forecasting Associates.
Outlook (November 1986).

Quarterly Model

NOVEMBER/DECEMBER 1988

Cletus C. Coughlin and Kenneth C. Carraro
Cletus C. Coughlin is a senior economist and Kenneth C. Carraro
is an economist at the Federal Reserve Bank of St. Louis. Thomas
A. Pollmann provided research assistance. The authors also
would like to thank Kenneth W. Bailey for providing data and
helpful suggestions.

The Dubious Success of Export
Subsidies for Wheat

O
N MAY 15, 1985, the U.S. Department o f Agri
culture introduced an export subsidy program
called the Export Enhancement Program (EEP).
The program's main goal is to increase U.S. agri
cultural exports.' The program also is intended to
induce European Community (EC) reductions in
agricultural subsidies during the current round of
multilateral trade negotiations under the General
Agreement on Tariffs and Trade (GATT).
Although the EEP focuses on exports and trade
policies, it is a direct outgrowth o f the domestic
farm policies o f the United States and the Euro
pean Community. The above-market price guaran
tees o f these policies have resulted in surplus
production. To dispose o f these surpluses, many
governments have chosen to subsidize agricultural
exports.-

'U.S. Department of Agriculture (May 1988).
2The General Agreement on Tariffs and Trade contains the
international rules governing export subsidies. Article XVI:4
prohibits export subsidies on industrial products that lead to
export sales at lower prices than domestic sales; however, this
does not apply to agricultural goods. U.S. farm interests were
sufficiently powerful to prevent the prohibition on export subsi
dies from encompassing agricultural goods. Article XVI :3
recommends that export subsidies on agricultural goods be
avoided, but, if they are used, the subsidizing country should
not garner a “ more-than-equitable” share of trade for the good.
While European farm interests prevented the extension of the

FEDERAL RESERVE BANK OF ST. LOUIS

This paper examines the EEP’s primary goal o f
expanding exports in the context o f disposing of
governm ent-owned wheat. Other research is used
to compare the cost o f reducing wheat stocks via
the EEP with the cost o f simply destroying the
wheat. Although this paper focuses on wheat,
chiefly because wheat has accounted for the bulk
o f EEP activity, the econom ic principles used here
can be generalized to similar programs for other
commodities.

The secondary goal o f influencing EC farm pol
icy is analyzed in the fi-amework o f the current
round o f GATT talks. In 1985, the United States
proposed that all trade- and production-distorting
subsidies be eliminated over a 10-year period.3
Other groups, including the EC and the Cairns

export subsidy prohibition to agricultural goods in the Tokyo
Round of Multilateral Trade Negotiations (1974-79), the mean
ing of equitable was clarified. For example, a more-thanequitable share includes the displacement of another country’s
exports. A reference period of the three most recent years in
which normal market conditions existed is to be used in deter
mining an equitable share. See Hufbauer and Erb (1984) for
additional details.
3Roningen, Sullivan and Wainio (1987) estimate annual welfare
gains for the United States of slightly less than $4 billion from a
multilateral removal of these measures.

Group, have offered alternative proposals.4The
prim aiy reason for changing the current agricul
tural policies that benefit domestic farmers at the
expense o f consumers, taxpayers and others is the
cost of such programs. For example, the ministers
o f the Organization for Economic Cooperation and
Development recently stated:
The cost of agricultural policies is considerable,
for government budgets, for consumers and for the
economy as a whole. Moreover, excessive support
policies entail an increasing distortion of competi
tion on world markets; run counter to the princi
ple of comparative advantage which is at the root
of international trade; and severely damage the
situation of many developing countries.’
This paper examines EEP's role in encouraging
successful negotiations to liberalize agricultural
trade in the G A IT process.
Before examining the issues o f export expansion
and trade negotiations, w e describe the export
subsidy programs o f the United States and Euro
pean Community and, in the process, provide
historical background necessary to understand
the EEP's objectives.

THE FARM POLICY ENVIRONMENT
UNDERLYING THE EXPORT
ENHANCEMENT PROGRAM
The stage for this export subsidy program was
set by steady losses in the share o f w orld agricul
tural trade held by the United States and by paral
lel EC gains in export shares. From 1977 to 1985,
the U.S. share o f the w orld ’s net wheat exports
declined from 41.9 percent to 28.8 percent, while
the EC’s share rose from —1.6 percent to 15.1 per
cent.'* These changing market shares can be linked
to EC export subsidies. Chart 1 shows that the U.S.
wheat export price generally exceeded the subsi
dized EC export price between 1978 and 1987.7
Since 1983, the gap has tended to widen. EC ex
port subsidies are responsible for this gap because
internal EC prices are far above U.S. market prices.
This EC subsidy is the catalyst for the U.S. export
subsidy program, which is targeted at those coun

“See Rossmiller (1988) for an outline of the major features of
the proposals by the United States, the European Community,
the Cairns Group, Japan and Canada. The Cairns Group
consists of Canada, Australia, New Zealand, Indonesia, Malay
sia, the Philippines, Thailand, Brazil, Uruguay, Argentina,
Columbia, Hungary and Chile.

tries where EC-subsidized exports have displaced
U.S. exports.

Surplus Production and Government
Wheat Stocks
To understand the EEP goal o f export expan
sion, one must examine the U.S. farm programs
used to support the production o f most crops.
The most important consequence o f these pro
grams is that they generate surpluses because
price guarantees, with the exception o f the earlv
1970s, have been above market-clearing levels.
There are two main instruments o f the crop pro
grams: loan rates and target prices. Both are price
guarantees that are announced well before
farmers make planting decisions. To participate in
these programs, farmers generally have been re
quired to reduce crop acreage. For example, wheat
farmers must set aside 10 percent o f their 1989
wheat acreage base to qualify for the wheat price
support program.
T he loan rate, set at $2.06 per bushel for the
1989 wheat crop, serves as a price floor. If the mar
ket price is low er than $2.06, a farmer pledges the
wheat crop to the government as collateral in ex
change for a “loan” o f $2.06 per bushel. If the price
o f wheat rises above the loan rate, the farmer can
repay the loan with interest, recover the crop and
sell at the higher market price. If the market price
does not recover, the fanner defaults on the
“loan,” thus ceding the crop to the government. Bv
law, the government keeps the acquired surpluses
off the market until the price reaches a higher
level, known as the release price, at which time
the surpluses can be sold on the market.
While the loan rate acts as an explicit price sup
port, the target price functions as an explicit in
come support device and is the final price that
farmers receive for their crop. At the end o f a crop
year, farmers receive “ deficiency payments” equal
to the difference between the target price and
either the market price or the loan rate, depending

EC was a net importer of wheat in that year. EC data have
been calculated for the EC-12 and exclude intra-EC trade.
T hese data are not adjusted for wheat quality and transporta
tion differentials. Such differentials, however, are relatively
constant and, therefore, do not distort significantly the rising
price gap trend.

5See Wilson (1988), p. 5.
6Net wheat exports represent exports minus imports. The nega
tive market share figure for the EC in 1977 indicates that the

NOVEMBER DECEMBER 1988

Chart 1
U.S. and EC W heat Price D iffe re n tia ld
Dollars per ton
50

Dollars per ton
50

_ 20L-------------------------------------------------------------------------------------------------------------------------------------- 1-20
JU LY 78

JU LY 79

JULY 80

JULY 81

JULY 82

JULY 83

JULY 84

JU LY 85

JU LY 86

SOURCE: International Wheat Council
□.(U.S. Gulf - EC Rouen fob Price)

on which is higher." Table 1 shows the target, loan
rate and market prices since the introduction of
the target price mechanism in the crop year end
ing June 30, 1975. For 1988, the target price w7as
$4.38 per bushel. Since the higher of the market
price and loan rate was the market price o f $2.60
per bushel, the deficiency payment was $1.78 per
bushel. Until 1988, the deficiency payment rose
throughout the 1980s.
As suggested above, as the market price declines
relative to the loan rate, farmers find it more pro
fitable to surrender their crops to the government
for the loan rate price rather than sell on the mar
ket. These surplus stocks are accumulated by the
Com m odity Credit Corporation, the agency of the
U.S. Department o f Argiculture (USDA) charged
with the administration o f the price support pro

8ln some years, farmers have received a portion of this pay
ment, an “ advance deficiency payment,” at the beginning of
the crop year.

FEDERAL RESERVE BANK OF ST. LOUIS

grams. Chart 2 shows the inverse relationship
between the accumulation o f wheat stocks and
the price gap measured by the market price minus
the loan rate. When the price gap increases be
cause o f crop shortages or strong demand such as
in the early 1970s, stocks are reduced. When the
price gap narrows, and especially if the gap is
negative, the accumulation o f stocks occurs. The
large increase in wheat stocks in the 1980s reflects
the relatively small price gap.

Disposing o f Government Wheat
Stocks
Various programs are used to dispose o f the
stocks that are ow ned by the government. Some of
the surplus disposal is directed to the domestic
market, but most is directed to foreign markets

Table 1
U.S. Wheat Prices (dollars per bushel)
Year'

Target
price

Loan
rate

Market2
price

Deficiency
payment

1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989

$2.05
2.05
2.29
2.90
3.40
3.40
3.63
3.81
4.05
4.30
4.38
4.38
4.38
4.38
4.10

$1.37
1.37
2.25
2.25
2.35
2.50
3.00
3.20
3.55
3.65
3.30
3.30
2.40
2.28
2.06

$4.09
3.56
2.73
2.33
2.97
3.80
3.99
3.69
3.45
3.51
3.39
3.08
2.42
2.60
NA

$0.00
0.00
0.00
0.65
0.52
0.00
0.00
0.15
0.50
0.65
1.00
1.08
1.98
1.78
NA

'The year ending June 30
2Average price received by farmers
SOURCE: Wheat Situation and Outlook (February 1988), p. 20.

Chart 2
Surplus Wheat Stocks and the Price Gap of the
Wheat Market Price minus Wheat Loan Rate
Dollars per bushel

Millions of bushels
1500

1250

2.00

Price Gap

1965
67
69
71
73
75
77
Stocks = CCC Inventories and Farmer-Owned Reserves

1000

1987

NOVEMBER/DECEMBER 1988

Table 2
Export Subsidies by the United States Under the EEP and Export
Restitutions by the European Community
(millions of U.S. dollars)
United States'

Year
1982
1983
1984
1985
1986
1987
1988

Total
EEP

European Community2
Wheat
EEP3

Total
export
refunds

Wheat
export
refunds

$209
701
744

$ 4,668
4,647
4,895
5,028
7,121
10,245
12,861

$550
720
388
365
681
NA
NA

$280
937
995

'Value of EEP bonus awards at market value. Data are for fiscal years. Fiscal year 1988 covers the
period from October 1, 1987 to September 30,1988.
2EC refunds for calendar years. Data for 1988 are estimates.
3Wheat subsidy values are estimated by taking wheat's share of the total bonus value, 74.8 percent,
and applying this percent to total subsidy value.

through export.11Obviously, the EEP belongs to the
latter category."1
More than 100 initiatives, targeting more than 60
countries and 11 comm odities have been an
nounced under the EEP since June 1985. The EEP
functions by giving governm ent-owned surplus
comm odities at no cost to private U.S. exporters.
This allows them to sell U.S. comm odities at prices
that are below U.S. market prices in order to be
competitive with other export-subsidizing coun
tries. An EEP/sales initiative states the targeted
country and the quantity of a specific com m odity
to be sold. Knowing that a subsidy is available,
private U.S. exporters can offer to sell the com
m odity at prices below the market cost o f acquir
ing it in the United States. These bids are contin
gent upon receiving the necessary subsidy from
the USDA.
The foreign buyer may accept bids made by
numerous U.S. exporters. The U.S. exporters then
bid against each other to receive the USDA’s sur
plus stocks as a payment for the export subsidy.
During this process, each exporter states how

9One of the most notable examples of domestic surplus dis
posal was the 1983 Payment-in-Kind (PIK) program that gave
surplus commodities to farmers who agreed to limit their pro
duction. The school milk program, which sells milk at belowmarket prices, and programs to distribute other dairy products
to food-stamp recipients are other domestic examples of sur
plus disposal policy.

FEDERAL RESERVE BANK OF ST. LOUIS

large a subsidy is required to make the export sale.
For example, if one exporter requests a subsidy of
$30 per ton and another requests $35 per ton for
sale o f the same com m odity to the same country,
the USDA w ould award the subsidy payment to
the low er bidder. Thus, the bid process helps the
USDA get a larger volum e o f exports per dollar of
subsidy. If the exporter s bid for the subsidy is
successful, the com m odity sale to the foreign
country is made; otherwise, the sale to the foreign
country is voided. Upon proof o f shipment and
landing o f the com m odity in the targeted market,
the exporter is paid by the USDA with a generic
com m odity certificate in the amount o f the bonus.
The certificate can be exchanged for its value in
any of the surplus stocks held by the USDA. The
exchange o f certificates for most comm odities is
made at the “Posted County Price,” which is rep
resentative o f an average local market price. The
exchange o f certificates for wheat is accomplished
through a USDA auction.
As shown in table 2, EEP subsidies have in
creased since their inception in 1985. Total EEP

'“Another example of surplus disposal through export is the
Food for Peace Program, also known as P.L. 480. The pro
gram provides surpluses either at no cost or at below-market
prices to low-income countries. In an analysis of P.L. 480,
Luttrell (1982) concluded that the food shipments were largely
a gift that reduced the incentive for food production in the
recipient nations.

subsidies in fiscal year 1986 amounted to $280
million and grew to $995 million in 1988. During
this time, the value o f wheat subsidies grew from
$209 million to $744 million Had it not been
slowed bv the severe drought in the United States
that reduced the availability of wheat surpluses,
EEP growth in 1988 would have been even more
substantial.

The European Community’s Export
Refunds
While the EEP is o f recent origin, the EC’s export
subsidy program has been in effect since the
founding o f the Common Agricultural Policy (CAP)
in 1962. The program, however, was not a source
of trade friction with other agricultural exporting
nations because the EC was an im porter of most
agricultural commodities. The CAP originally was
designed to encourage domestic production in
Europe following the food shortages during and
afterW orld War II. It encourages com m odity pro
duction by offering a guaranteed price that often
has been significantly higher than the w orld price.
Because domestic prices generally have been
higher than w orld prices, the CAP uses a variable
levy to protect EC farmers from lower-priced im
ports."
Over time, European farmers responded to the
high price guarantees with greatly increased pro
duction, resulting in large surplus stocks. To dis
pose o f the surpluses, the EC makes payments to
exporters, known as export restitutions or refunds,
to allow them to sell the higher-priced EC com
modities at the low er w orld price. As CAP price
guarantees have remained above w orld market
prices, export subsidies have expanded further to
dispose o f the mounting surpluses. Export re
funds by the EC have grown from $4.7 billion in
1982 to a projected $12.9 billion in 1988. Bailey
(1988a) states that EC export subsidies for wheat
rose from $365 million in 1985 to an estimated
$1.8 billion in 1988 and that the EEP probably ac
counted for 35 percent to 40 percent o f the
increase.12
"The variable levy taxes imports at the rate of the difference
between the world price and the EC threshold price. For exam
ple, in March 1987, the EC threshold price for wheat was $8.53
per bushel while the world price was $1.95 per bushel. Im
porters would have been required to pay a levy of $6.58 ($8.53
- $1.95). These payments represented a large income source
for the EC when it was a major importer.
12The EEP is only one device that the United States allegedly
has used to influence the EC. The Farm Bill of 1985 sharply cut
the crop loan rate which allowed the market price to plunge
while maintaining a high level of income support for farmers.

ANALYSIS OF THE EEP —
ATTAINMENT OF GOALS AND
COSTS
The EEP will be judged on the basis o f the costs
associated with expanding exports and inducing
negotiations to liberalize agriculture throughout
the world. First, w e examine the effect o f the EEP
on exports and assess its costs relative to simply
destroying the surplus production. Second, we
examine the effect o f the EEP on the EC’s w illing
ness to reduce governmental involvement in agri
cultural production and trade.

EEP and the Goal o f Export
Expansion
The primary goal o f the EEP is to increase the
volume of U.S. agricultural exports. Wheat exports
have increased sharply since 1985, the first year of
the EEP, growing about 60 percent in 1987. Not
only has the level o f exports expanded, but the
U.S. share o f the w orld's wheat market increased
from 28.8 percent in 1985 to an estimated 41.6
percent in 1988. To what extent can the rise in
exports be attributed to the EEP? The following
discussion highlights many of the empirical dif
ficulties involved in answering this question and
discusses one study that has addressed this ques
tion.
The EEP, as an export subsidy program, will
increase the quantity o f exports by driving down
the price o f exports. As Belongia (1986) has noted,
however, export revenues w ill not necessarily rise
as the quantity o f exports increases.11If the world
demand for wheat is inelastic, then the EEP would
cause a reduction in export revenues. Therefore,
the price elasticity o f export demand for U.S.
wheat is a crucial variable for determining the
overall effects o f the EEP.
Estimates o f the price elasticity of export de
mand for U.S. wheat cover a w ide range o f values.
Gardiner and Dixit (1987) summarized studies over
the past two decades that estimated this elasticity.

This cut in market prices led to higher export subsidy costs for
the EC. In addition, the 1985 Farm Bill introduced the practice
of marketing loans for cotton and rice. The marketing loans
also led to lower world prices while maintaining farmers’ in
come. Cotton and rice, however, are not exported in any signifi
cant quantities by the EC.
,3See Belongia (1986) for a discussion of the profitability of
farming and the pitfalls of using export volume as an indicator
of the farm sector’s economic health.

NOVEMBER DECEMBER 1988

The short-run (that is, one year or less) price elas
ticity ranged from —0.14 to —3.13 with an average
o f —0.72, while the long-run (that is, more than
one year) price elasticity ranged from —0.23 to
— 6.72 with an average o f —1.93. The lack o f a con
sensus estimate precludes a definitive assessment
about the desirability of EEP; however, some sug
gestive evidence can be assembled.
With 14 o f the 17 estimates o f the short-run
price elasticity in the inelastic range, evidence
suggests that increasing export subsidies will de
crease export revenues in the short-run. A one
time, across-the-board subsidy is clearly unwar
ranted in this case.'4
If the export subsidy continues, then the longrun price elasticity is relevant. A definitive conclu
sion is no longer possible. The studies suggest that
the long-run price elasticity is likely to be elastic. If
so, then export revenues w ill increase in the longrun due to the export subsidies. With export reve
nues likely decreasing in the short-run and in
creasing in the long-run, additional information
about the magnitudes o f the export revenues and
subsidy costs over time and the appropriate dis
count rate is required before a definitive conclu
sion can be reached.
In fact, information requirements are even
greater. An implicit assumption of the elasticity
discussion is that the EC, as well as other countries,
do not attempt to counteract the EEP. The parallel
rise in U.S. and EC export subsidies, as well as an
ecdotal evidence presented later, reveals this as
sumption is not appropriate. In addition, the EEP is
targeted to specific markets where U.S. exports have
been displaced by the EC. Thus, information is
required about the price elasticity of export de
mand for specific markets. Consensus estimates
concerning specific markets are simply not avail14Using a model of international wheat markets, Sharpies (1984)
simulated the 1983 effects of an across-the-board $34 per ton
($.93/bushel) U.S. subsidy on its wheat exports. A specific goal
was to compare the costs of using export subsidies to reduce
surplus stocks with using the payment-in-kind acreagereduction program. Assuming the EC counter-subsidized to
maintain its existing volume of wheat exports, the U.S. subsidy
would have caused a 300 million bushel increase in U.S. ex
ports, which represents a 20 percent increase above the level
of unsubsidized exports. The direct budget cost would have
totaled $1.6 billion or approximately $5.30 for each additional
bushel of wheat exported. A less costly alternative would have
been for the government to buy the additional 300 million
bushels at the existing $3.65 loan rate and then destroy it.
15The lower foreign-exchange value of the dollar, which might be
expected to have price effects similar to an across-the-board
subsidy, accounted for little of the increase in wheat exports.
16The cost of the wheat subsidy for the two crop years 1986/87

FEDERAL RESERVE BANK OF ST. LOUIS

able. Finally, other factors that influence the level of
U.S. wheat exports must be accounted for.
Despite the difficulty o f estimating EEP’s effect
on export revenues, the EEP clearly has boosted
the volume o f wheat exports by eliminating the
EC’s export price advantage. Since 1985, the U.S.
export price has been $30-$40 per ton higher than
the subsidized EC export price, a difference offset
by the average EEP subsidy o f approximately $33.
The effect o f this subsidy, along with four other
factors that influenced U.S. wheat exports over the
past three years, w ere analyzed by Bailey (1988b).
These other factors w ere the low er price support
loan rates for wheat, reductions in the yields o f
competing exporters, increased imports by the
Soviet Union and the Peoples Republic o f China
not attributable to the EEP and finally the low er
value o f the dollar. Other factors that influence
wheat exports, such as w orld econom ic health
and production in im porting countries, w ere not
evaluated. Bailey found that the EEP was responsi
ble for about one-third o f the increase in wheat
exports from 1985 to 1987 attributable to the five
factors.13The EEP was responsible for roughly a
305 m illion bushel increase in wheat exports over
1986/87 and 1987/88. Over this same period, the
cost o f the EEP subsidy given to exporters for
wheat sales was approximately $1.24 billion.10
These estimates translate to an approximate
cost o f $4.08 for eveiy bushel o f increased exports.
The average U.S. Gulf export price for wheat over
these two years was only $3.16. In terms o f its pri
mary goal, the EEP increased exports, but it did so
at a high cost in the short-run. Destroying the
governm ent-owned stocks, which entails an o p
portunity cost o f approximately $3.16 per bushel,
w ould be a more cost-effective form o f surplus
removal than the EEP with a cost o f $4.08 per
bushel.17
and 1987/88 was estimated because year by year cost data
were not available. The share of total EEP wheat sales
(through August 4,1988) made in the two years was approxi
mately 85 percent. The total market value of the wheat subsi
dies given to exporters through August 4,1988 was $1.46
billion. The two-year cost of wheat subsidies therefore was
estimated at $1.24 billion ($1.46 billion times 85 percent).
,7The availability of surplus commodities is another important
factor in the EEP which became apparent in the drought year
of 1988. When government stocks of wheat are depleted by
drought or by other factors, the EEP program would be forced
to reduce its activity. Such irregularity makes the program less
reliable from the perspective of importing countries. The reac
tion of importers likely would be to diversify sources and reduce
reliance on a single export source. In addition, the changes in
the EEP possibly prevent the full impact of the rising exports
from the higher price elasticities of demand in the long run from
occurring.

EEP and the Goal o f Liberalizing
Agriculture Worldwide
In addition to increasing exports, the EEP is
being used to pressure the EC to liberalize its agri
cultural production and trade policies. By increas
ing the costs o f the EC's agricultural support pro
grams, the United States hopes to induce the
European Community to negotiate major reduc
tions in these programs.18The political nature o f
the agricultural programs o f both the United States
and the European Community preclude any
definitive conclusions about the response o f the
EC to the EEP in the long run; however, insights
from strategic trade theory and the observed initial
EC responses that are identified below suggest the
EEP has been ineffective."1
In a strategic environment, a small number o f
econom ic agents make interdependent decisions.-0
A decision by one agent can alter the costs and
benefits facing another agent. Thus, agents at
tempt to judge the response o f their rivals before
determining the best course o f action. Contrary to
a w orld o f perfect com petition with many agents
each too small to influence the market outcome,
agricultural trade policy can be viewed as a strate
gic environment that can be altered by govern
mental decisions. Obviously, the United States and
the EC are major decisionmakers in this environ
ment.
Subsidies play an important role in strategic
trade policy. Export subsidies have been recom
m ended for strategic industries that are expected
to earn additional returns sufficient to exceed the
total cost o f the subsidy. Strategic trade policy is
controversial for a number o f reasons, one of
which is that strategic trade policy tends to create
an adversarial situation between countries.2'
Countries affected adversely are inclined to re

18The rising costs of the EC’s agricultural programs have already
lead to some reductions in price supports. In 1984, the EC
imposed dairy quotas and began charging farmers who ex
ceeded their quotas. More recently, the EC has stated its
willingness to reduce grain support prices if grain production
exceeds 160 million metric tons. The relationship of these cuts
to the EEP, however, is unknown.
19Strategic trade theory has become popular because of recent
developments that have focused on the importance of econo
mies of scale, production experience and technological change
as determinants of trade patterns. These determinants raise
the possibility that productive resources such as labor and
capital can earn higher returns in some industries than others
and that certain sectors generate benefits that accrue to other
sectors. Both possibilities can be used to justify an activist use
of trade policies to influence domestic as well as foreign activity

spond with their own subsidies. Mutually destruc
tive trade wars are a distinct possibility. In fact,
recent developments in w orld agricultural trade
are characterized as part o f a trade war.22Without
question, both U.S. and EC export subsidies for
wheat have increased rapidly in recent years.
Paarlberg’s (1988) recounting o f the trade war
between the United States and the EC provides a
number of incidents that tend to reinforce the
preceding discussion. In Januaiy 1983, the United
States subsidized the sale o f 1 million tons of
wheat flour to Egypt to undercut subsidized offer
ings by the EC. To prevent the EC from buying
back the market, the United States forced Egypt to
agree not to import wheat flour from anv non-U.S.
supplier until June 1984. In the short run, the
United States displaced the EC sales o f wheat flour
to Egypt. The EC, however, responded by subsidiz
ing exports o f 320,000 tons o f unmilled wheat to
Egypt in spring 1983 and new subsidized wheat
sales to Iran, Syria, Libya and Algeria. The EC also
began com peting in China and Latin America. In
addition, it reached an agreement with Egypt in
October 1983 on future subsidized sales.
One o f the major problems o f the EEP in liberal
izing agriculture is that m ixed signals are being
sent to the EC and other agricultural nations. The
U.S. proposals are a highly publicized initiative to
stimulate a cooperative search to reform agricul
ture through GATT. At the same time, the retalia
tory challenges to European-subsidized export
sales can be term ed "non-cooperative activism.”
Tangermann (1985) argues that the U.S. export
subsidies w ill be counterproductive in achieving a
reduction o f EC agricultural subsidies. His reasons
are both politically and econom ically based. First,
the EC’s costs o f matching the U.S. subsidies are
relatively small. If U.S. subsidies had reduced
w orld grain prices bv 10 percent in 1982, the EC

and increase income domestically. Strategic trade theory
combines international trade theory and political theory to
explain the dynamics of trade policies and assist in designing
policies that are in a nation’s best interest.
20See Richardson (1986) for a more lengthy discussion of strate
gic trade policy.
21Subsidies for research and development have been recom
mended for strategic industries whose competitive positions
depend on generating technological advances. In addition to
creating an adversarial situation between countries, there are
concerns that special interest groups will capture the benefits
from the subsidies at the expense of the nation.
22See Lochhead (1988) for a characterization of this trade war.

NOVEMBER/DECEMBER 1988

could have maintained its export volume by an
increase in its agricultural budget o f only 0.8 per
cent. Second, since the United States can be por
trayed as the enemy, there will be much political
support for expenditures to counteract the U.S.
subsidies.
Additional doubts about the effectiveness and
wisdom o f waging full-scale trade war have been
raised by Paarlberg (1988). Since the United States
has much larger foreign markets to defend,
Paarlberg estimates that it w ould have to outspend
the European Community by 50 percent in a fullscale war simply to retain its market share. In ad
dition, since some o f the U.S. major foreign com
petitors are also large importers, a full-scale war
w ould likely lead to foreign retaliation in the form
of import restrictions that w ould be costly to both
the United States and the other countries. As a
major im porter from the United States, the EC is in
a position to make a full-scale war more costly for
the United States.
In addition, the U.S. negotiating position in
GATT is weakened because the United States is
doing the same thing that is the source o f its irrita
tion with the EC.23For example, the Cairns Group,
a negotiating coalition o f 13 agriculturally oriented
nations, has objected strenuously to the contin
ued use o f agricultural export subsidies.-4Much
irritation stems directly from the econom ic conse
quences o f increasing subsidies by the United
States and the EC. Oleson (1987) has noted that
the U.S. and EC policies have caused the price of
wheat to fall, im posing major losses on such grain
exporters as Canada, Australia and Argentina.
Strategic trade theoiy suggests that the lack of
clarity about U.S. policy will inhibit the desired
foreign response. The United States is willing to
subsidize exports; however, it maintains that a
liberalized agricultural system is a goal. A basic
question, which focuses on the credibility o f the
U.S. proposal, is w hether the goal o f a complete
liberalization o f agricultural production and trade
in the United States is feasible politically.
Producers o f agricultural products in the United
States have been beneficiaries o f price support
programs since the 1930s.-3These programs pro
vide substantial benefits to the farm sector.
23The EEP also has sparked a diplomatic controversy. The
program was written to exclude subsidized sales to the Soviet
Union. The Soviet Union used this discrimination as a basis for
reneging on its commitment to purchase a minimum of 4 million
tons of U.S. wheat each year. Under pressure from domestic
producers and exporters, the exclusion was reversed and the
Soviet Union became eligible for subsidies on 4 million tons.

FEDERAL RESERVE BANK OF ST. LOUIS

Roningen, Sullivan and Wainio (1987) estimate that
a multilateral liberalization w ould cause a loss of
U.S. producers' surplus o f slightly less than $10
billion. Thus, w hether the U.S. Congress w ould
actually support legislation for the complete liber
alization o f agricultural production and trade is
uncertain. This uncertainty about the true U.S.
position likely deters the EC from agreeing to the
stated U.S. position.

CONCLUSION
The initial evidence from the Export Enhance
ment Program, although far from conclusive,
raises doubts about the wisdom o f U.S. agricultural
export subsidies for wheat and, by implication, all
commodities. While the EEP has contributed to
increased U.S. wheat exports, the cost o f disposing
o f the resultant surplus, even if one ignores the
escalating U.S.-European Community trade war, is
higher than the cost o f simply destroying the
wheat in the short-run. In addition, the U.S. has
im posed costs on agricultural exporters through
out the world.
Strategic trade theory and the EC’s initial re
sponse to the export program suggest that the EC
w ill be more likely to escalate the trade w ar than
agree to U.S. proposals for eliminating all
production- and trade-distorting agricultural p o li
cies. This, however, does not rule out the possibil
ity that negotiations to liberalize agriculture are
doomed, but rather suggests that the EEP w ill be
ineffective, and possibly counterproductive, in
affecting the EC’s position.

REFERENCES
Bailey, Kenneth W. “ What Explains Wheat Export Rise?”
Agricultural Outlook (July 1988a), pp. 22-25.
________ “ The Impact of the Food Security Act of 1985 on
U.S. Wheat Exports: An Econometric Analysis.”
Ph D. Dissertation, Department of Agricultural and Applied
Economics, University of Minnesota, September 1988b.
Belongia, Michael T. “The Farm Sector in the 1980s: Sudden
Collapse or Steady Downturn?” this Review (November
1986), pp. 17-25.
Gardiner, Walter H., and Praveen M. Dixit. Price Elasticity of
Export Demand: Concepts and Estimates, U.S. Department of
Agriculture, Economic Research Service (February 1987).
This reversal embarrassed U.S. diplomats and angered major
farm competitors such as Canada and Australia.
24See Houck (1988) for further details.
25See Gardner (1987) for a study using the public choice ap
proach to explain producer protection across agricultural com
modities since the 1930s.

Gardner, Bruce L. "Causes of U.S. Farm Commodity Pro
grams,” Journal of Political Economy (April 1987), pp. 290310.
Haley, Stephen L. Targeting of U.S. Agricultural Export Subsi
dies: A Theoretical Analysis, U.S. Department of Agriculture,
Economic Research Service (June 1988).
Houck, James P. “ What in the World is the Cairns Group?”
CHOICES (Second Quarter 1988), p. 34.
Hufbauer, Gary C., and Joanna S. Erb. Subsidies in Interna
tional Trade (Institute for International Economics, 1984).
Lochhead, Carolyn. “ Disarmament Negotiations in the Agricul
ture Trade War,” Insight (November 28, 1988), pp. 42-44.
Luttrell, Clifton B. “ Good Intentions, Cheap Food and Counter
part Funds,” this Review (November 1982), pp. 11-18.
Oleson, Brian T. “World Grain Trade: An Economic Perspec
tive of the Current Price War,” Canadian Journal of Agricul
tural Economics (November 1987), pp. 501-14.
Paarlberq, Robert L.
Company, 1988).

Fixing Farm Trade (Ballinger Publishing

Richardson, J. David. “The New Political Economy of Trade
Policy," in Paul R. Krugman, ed., Strategic Trade Policy and
the New International Economics (MIT Press, 1986), pp. 2 5 782.

Roningen, Vernon, John Sullivan, and John Wainio. “The
Impact of Removal of Support to Agriculture in Developed
Countries," paper presented at the American Agricultural
Economics Association meetings, August 1987.
Rossmiller, Ed. “ Agricultural Proposals in the GATT,” CHOICES
(Second Quarter 1988), pp. 30-31.
Sharpies, Jerry. “Are Export Subsidies the Answer to U.S.
Grain Surpluses?” U.S. Department of Agriculture, Economic
Research Service (October 1984).
Tangermann, Stefan. “The Repercussions of U.S. Agricultural
Policies for the European Community,” in Bruce L. Gardner,
ed., U.S. Agricultural Policy: The 1985 Farm Legislation (Amer
ican Enterprise Institute, 1985), pp. 329-44.
Wilson, Ewen M. "A CHOICES Debate: Export Subsidies on
Value-Added Products — Effects May Differ From Policy
Objectives,” CHOICES (Second Quarter 1988), pp. 5 and 7.
U.S. Department of Agriculture, Economic Research Service
Wheat Situation and Outlook, various dates.
U.S. Department of Agriculture, Foreign Agricultural Service.
FAS Fact Sheet — Export Enhancement Program, revised May
1988.
_________World Production and Trade: Weekly Roundups,
various dates.

NOVEMBER/DECEMBER 1988

K. Alec Chrystal and Daniel L. Thornton
K. Alec Chrystal is the National Westminster Bank Professor of
Personal Finance at City University, London, and Daniel L. Thorn
ton is a research officer at the Federal Reserve Bank of St. Louis.
Dawn M. Peterson provided research assistance.

The Macroeconomic Effects of
Deficit Spending: A Review

J . OLLOWING the Kevnesian Revolution in macroeconomics, a large number of economists argued
that deficit spending was required to achieve two
of the stated national econom ic objectives: full
employment and a high rate o f econom ic growth.1
Society was thought to benefit from deficit spend
ing because o f the reduction in lost output and
because the econom y w ould achieve a higher rate
of growth.
This view o f deficit spending has been chal
lenged increasingly over the years. A sizable num
ber o f economists now believe that deficit spend
ing has little effect on em ployment and output,
especially in the long run, and that it primarily
results in a redistribution o f output, either within
the private sector or as a transfer o f resources
from the private to the public sector.- Support for
this viewpoint has produced a growing concern
about the potentially harmful effects o f deficit
spending and the size o f the public debt.3

'One of Keynes' initial arguments was that saving would exceed
investment at a level of output consistent with the full employ
ment of labor. That is, the U.S. savings rate was too high. The
view that the budget should be in persistent deficit was termed
the “ new fiscal policy.” To see how opinions about deficit
spending have changed in two decades, compare the deficit
discussions in Levy (1963) with those in Levy, et. al. (1984).
2The once-common view that the market economy cannot
sustain full-employment equilibrium has given way to the

FEDERAL RESERVE BANK OF ST. LOUIS

The existence and magnitude o f the benefits
from deficit spending have important implications
for the public policy debate. Presumably, the deci
sion to incur deficits is affected by the public's
belief about whether deficits provide benefits to
some individuals at little or no cost to others, or
w hether they merely redistribute income. Hence, a
central issue in the debate over deficit spending is
whether, and to what degree, it can be used to
produce net benefits for society as a whole. The
purpose o f this paper is to examine some o f the
arguments and evidence on whether deficit
spending yields net benefits to society.

DEFICIT SPENDING: SOME KEY
TERMS
The phrases "deficit spending” and "fiscal pol
icy” are not necessarily synonymous. While deficit
spending is a particular fiscal policy action, not all

concept of the natural rate of unemployment. For a discussion
of these issues, see Modigliani (1986b), Blinder (1986) and
Laidler (1988).
’ For a discussion of the potential harmful effects of the public
debt, see Bruce and Purvis (1986), Barro (1987) and Levy, et.
al. (1984).

fiscal policy actions produce or involve deficits.4
For example, the government could devise a policy
whereby expenditures and taxes are changed bv
the same amount. This well-known "balanced
budget’’ operation affects aggregate demand, be
cause the change in government expenditures
affects aggregate demand more than the change in
taxes, but does not affect the deficit."
Despite the balanced-budget multiplier, the
stance o f fiscal policy today is often associated
with, and frequently measured by, the size o f the
federal budget deficit.11Thus, in this article, deficit
spending and the stance of fiscal policy w ill be
treated as synonymous. Furthermore, since they
both produce the same qualitative shift in aggre
gate demand, no distinction will be made between
deficits that arise from increases in government
spending and those that result from tax reduc
tions.

Cyclical and Structural Deficits and
Discretionary Fiscal Policy
It is important to differentiate between "cycli
cal” and '"structural’' deficits when examining the
effects o f policy changes on the economy. Tax
revenues rise during the expansion phase o f the
business cycle and fall during the contraction
phase; in contrast, certain government expendi
tures (e.g., unemployment compensation) fall dur
ing expansions and rise during contractions.
These counter-cyclical components o f the
“There is a well-known caveat to this statement. Government
tax rate changes are not neutral. The government may change
certain marginal tax rates and simultaneously alter government
expenditures to produce no net effect on aggregate demand,
all other things constant. The ultimate effect on aggregate
output, however, need not be neutral; the non-neutrality of the
tax rate change could produce changes in aggregate supply.
Such analysis underlies much of the recent work by Auer
bach and Kotlikoff (1987) and Kotlikoff (1988). Consequently,
they have challenged the usual convention of associating
deficit spending with fiscal policy. For example, Kotlikoff
(1988), pp. 489-90, states that “ .. . fiscal policies can matter a
lot, but deficits may nonetheless tell us nothing useful about the
true stance of fiscal policy.” They argue that, within their life
cycle model, the labels “taxes" and “spending” are arbitrary.
For them, a tight fiscal policy occurs when a larger burden of
“ government consumption” is borne by current rather than
future generations.
Aggregate demand increases because the marginal propensity
to spend of the public sector (1) is greater than the marginal
propensity to spend of the private sector (< 1 ). If the private
sector’s marginal propensity to spend is large, the difference
between the marginal propensities will be small and so, too, will
be the effect of tax-financed expenditures on aggregate de
mand.

deficit— the so-called automatic stabilizers— are
intended to smooth cyclical swings in income.
The structural deficit, on the other hand,
reflects discretionaiv fiscal policy actions.7It is the
part o f the deficit that is invariant to the phase o f
the business cycle. Chart 1 presents measures o f
the actual and cyclically adjusted budget deficit.
Although these measures depart substantially at
times, generally they move together. While the
analysis in this paper applies equally w ell to cycli
cal and structural deficits, from now on the dis
cussion will focus solely on structural deficits.

THE NET BENEFITS FROM DEFICIT
SPENDING
The effectiveness o f deficit spending depends
on two factors: the slope o f the aggregate supply
curve and the extent to which deficit spending
shifts the aggregate demand curve. These factors
are discussed in detail in latter sections o f the
paper. In this section, w e present some general
notions underlying the view that society can be a
net beneficiary from deficit spending.
The initial popularity o f using deficit spending
to increase output was based on the belief that the
market econom y is unable to sustain aggregate
demand at a level consistent with full-employment output. This idea o f persistent unem ploy
ment is illustrated in chart 2 which shows a gap
between actual and “ potential" real output.* The
7See de Leeuw and Holloway (1983) for a detailed discussion of
these concepts and Fellner (1982) for a critique of these mea
sures. For a discussion of these concepts and a breakdown of
the deficit, see Erceg and Bernard (1988).
8There is an issue, not taken up here, about the extent to which
such unemployment is “ involuntary." According to the usual
textbook definition, involuntary unemployment occurs when
individuals are willing to work at the market wage but are
unable to find employment; that is, when there is an excess
supply of labor at the market wage rate. If the market is com
petitive, the wage rate should fall to eliminate the involuntary
unemployment. Hence, nearly all theories of involuntary unem
ployment require some form of nominal or real wage rigidity.
In early Keynesian models, involuntary unemployment was
due to nominal rigidities in wages. This explanation requires
real wages to fall when output rises. Empirical evidence, how
ever, suggests that real wages are pro-cyclical. Recently,
research by “ New Keynesian Economists” suggests that
persistent under-employment equilibria and involuntary unem
ployment can result from nominal price rigidities in the output
market because of monopolistically competitive firms, and
because of rigidities in real wages due to “ efficiency wages.”
See Blinder (1988), Mankiw (1988), Rotemburg (1987), Pres
cott (1987), The New Keynesian Microfoundations (1987) and
the cited references.

6lt is common to measure fiscal action by the full-employment
budget surplus or deficit. For a discussion of this, see Carlson
(1987) and Seater (1985).

NOVEMBER/DECEMBER 1988

Chart 1
Actual and Cyclically Adjusted Budget
Surplus/Deficit
Billions of dollars
Billions of dollars
50 ----------------------------------------------------------------------------------------------------------------------------------- 50

-1 0 0

-1 5 0

-200

-2 5 0
1987

-2 5 0
1955

Chart 2
Actual and Potential GNP
Billions of 1982 dollars
4000

Billions of 1982 dollars
4000

3500

3000

2500

2000

1500

1000

1955

1000

FEDERAL RESERVE BANK OF ST. LOUIS

1987

potential path o f real output usually is associated
with some full-employment rate o f unem ploy
ment. Periods in which real output falls below its
potential represent episodes o f persistent exces
sive unemployment. If the econom y is prone to
periods o f prolonged unemployment due to de
ficient aggregate dem and for goods and services,
the government could run a sustained deficit to
make up for the deficiency. If successful, this de
ficit would keep output closer to its fullem ployment potential. Moreover, on average, real
output growth would exceed the rate that would
otherwise occur.

Deficit Spending and Capital
Accumulation
Deficit spending could have a secondary effect
on the rate o f econom ic growth. Production o f real
output Iv) is related to factor inputs, labor IN) and
capital (K), via a production function, that is, v =
f(N,K). The marginal products o f both labor and
capital are positive: for any quantity of capital
(labor), output increases as more labor (capital) is
used. The growth o f the labor force is often con
sidered synonymous with population growth,
w hich is determined in part by factors that are
independent o f econom ic considerations. The size
o f the capital stock, on the other hand, is usually
assumed to be related to econom ic factors. The
higher the rate o f capital formation (investment),
the higher the rate o f econom ic growth.
Firms determine the most profitable level o f
output and, simultaneously, the optimal capital/
labor ratio. Because o f the nature o f capital goods,
the decision to acquire capital is based (among
other things) on expectations o f output growth. If
the market econom y is subject to prolonged peri
ods o f unemployment and slow growth because of
insufficient demand, expectations for output
growth and investment will be low er than if these
periods did not occur. If deficit spending raises
the path o f real output over what it w ould achieve
otherwise, investment and, thereby, potential real
output growth should rise even higher. Thus, de
9Achieving a higher rate of economic growth was part of the
fiscal policy agenda during the 1960s. See Levy (1963).
'“Recently, Sickel (1988) has investigated the asymmetry of the
business cycles. He tests for both the “steepness’’ and “ deep
ness” of post-World War II cycles and finds evidence that
cyclical troughs are deeper than cyclical peaks.
"This discussion implicity assumes that deficit spending does
not alter the path of y*, i.e., that deficit spending merely
dampens the cycle.
12Many authors merely assert that there are benefits from more
stable output growth without identifying these gains, e.g.,

ficit spending could produce a higher rate o f ac
tual and potential growth because o f increased
capital formation.11

Deficits and Symmetric Business
Cycles
The gains in output discussed so far are predi
cated on the assumption that cyclical swings in
output around its potential path are asymmetric:
cyclical downturns are longer and more pro
nounced than cyclical upturns. Since w e are as
suming that cyclical swings are due to variation in
the demand for goods and services, this means
that increases in the demand for goods and ser
vices are less frequent and smaller than decreases.
If, on the other hand, fluctuations in aggregate
demand around potential output are symmetric,
periods during which output is above or below the
potential path also will be symmetric."’ This is
illustrated by path 1 in figure 1 and by the aggre
gate demand and supply curves in figure 2. Given
the slope o f the aggregate supply curve, symmetric
variation in aggregate dem and produces symmet
ric movements in output about the potential level,
v*. On average, there are no "net output” gains to
be achieved from deficit spending over the cycle.
Periods o f deficit spending w hen the econom y is
below the full-employment path w ould be
matched by periods o f budget surplus when out
put is above the path, so the budget w ould be
balanced over the cycle and the average output
level w ould be the same as with no fiscal action.
Society still may benefit, however, if the govern
ment runs deficits during the contraction phase o f
the cycle and surpluses during expansions. A cy
clically balanced budget could stabilize aggregate
demand and reduce the variability in output; this
is illustrated by path 2 in figure 1."

The Benefits From Stable Output
More stable output could reduce the risk associ
ated with capital investment and, as a result, in
crease investment.'- Consequently, the capital
Modigliani (1986a), (1986b) and Bossons (1986). At other
times explanations of these gains sound hollow. For example,
Bruce and Purvis (1986), pp. 60-61, argue for the benefits of
avoiding a cyclical downturn by stating that “ a government
deficit will provide some stimulus to the economy and hence
help reduce the dead-weight costs of unemployment that would
have occurred in the absence of the deficit." In the case where
the government runs a surplus in order to prevent an economic
boom, they argue that the surplus helps “ avoid the dead
weight costs that again arise because the economy is away from
its long-run equilibrium.” (Italics added.)

NOVEMBER DECEMBER 1988

Figure 1
Symmetric Swings in Output

stock w ould increase, as would the level o f poten
tial output .13The econom y w ould then achieve a
higher rate o f growth than otherwise.
Additional benefits could arise if more stable
output growth results in more stable consum p
tion. Economists usually argue that people maxi
m ize the utility o f their consumption over some
planning horizon and that the utility gains from
increased consumption are smaller than the
losses from equally probable decreases in con
sumption.14Even if the distribution o f shocks to
incom e and, therefore, consumption are symmet
ric, the distribution o f utility gains and losses will
be asymmetric. Consequently, the expected utility
o f consumption rises as incom e is stabilized.

The Benefits from Stabilizing
Nominal GNP
There are additional benefits from stabilizing
aggregate dem and if cyclical movements in nomi-

13The issue is whether the growth rate of real output is made
permanently higher. Certainly, if economic stabilization policy
merely causes the level of real output to be higher but does not
affect the rate of real output growth permanently, there would
still be a period immediately following the enactment of stabili
zation policy in which the observed rate of real output growth
would exceed the full-employment growth rate.
14That is, the utility function is concave. Such gains from eco
nomic stabilization have been suggested by New Keynesian
economics. See Rotemburg (1987), p. 83. To illustrate this
point, assume that consumption is a random variable that is
uniformly distributed on the closed interval 1 to 2, and let the
utility of consumption be the simple concaved function, u = C 5.
In this case, the expected value of utility is 1.22. Now assume
that income and, hence, consumption are more variable, but

FEDERAL RESERVE BANK OF ST. LOUIS

Figure 2
Symmetric Swings in Output
and Aggregate Demand and
Supply

nal GNP are symmetric, but cyclical movements in
real output are asymmetric. That is, the aggregate
supply curve is more steeply sloped above poten
tial output as in figure 3. In this case, random vari
ation in aggregate dem and w ould produce larger
changes in real output below the potential output
level than above it. Of course, the change in nom i
nal spending above and below potential output
must be the same if variations in aggregate de
mand are symmetric about the natural rate. Stabi
lizing discretionary fiscal policy reduces both in
flation and unemployment over the cycle and,
thus, the cost o f lost output associated with un
em ployment and the cost o f inflation.”
Finally, deficit spending could yield net benefits
if it merely offsets downward shifts in aggregate
demand. For example, assume that cyclical swings
in real output are symmetric so that there are no
output gains on average over the cycle from stabi
lizing aggregate demand. Deficit spending still
could result in net output gains for society, if de-

with the same expected value. Specifically, assume that con
sumption is now uniformly distributed on the closed interval 0 to
3. In this case, the expected value of utility of consumption is
reduced to 1.15. Hence, reducing the variability of consumption
increases the expected (average) utility of consumption. Of
course, consumption may fluctuate much less than output over
the business cycle if the life-cycle or permanent income theo
ries of consumption are correct.
15The costs of expected inflation are in terms of its effects on
long-term bond markets, the misallocation of productive re
sources and its effects on regulations. The casts of unexpected
inflation are primarily in terms of its redistribution of wealth. For
a discussion of these costs, see Leijonhufvud (1987) and the
references cited there.

Figure 3
Asymmetric Swings in Output
but Symmetric Swings
in Nominal GNP
AS

ficits w ere incurred when aggregate demand was
weak, but surpluses were not incurred when ag
gregate demand was strong. Of course, in this
case, the level o f government debt w ould rise, both
over the cycle and over time.

CRITICISMS OF THE ALLEGED
BENEFITS OF DEFICIT SPENDING
As we have seen, the gains from deficit spending
consist o f reducing “lost” output due to reduced
employment, increasing the growth rate o f real
output or stabilizing output and consumption. To
achieve these gains, deficit spending must shift
the aggregate demand schedule and the aggregate
supply curve must be upward-sloping, at least in
the short run. If the aggregate supply curve were
vertical, shifts in the aggregate demand schedule
w ould not affect output. Consequently, there
could be no output gains from offsetting shifts in
aggregate demand. Of course, if the aggregate sup
ply curve were positively sloped, deficit spending
w ould be effective only if it succeeds in shifting
the aggregate demand curve. Attacks on the ef
ficacy o f fiscal policy have focused, therefore, on

,6This applies to monetary policy as well.
17For an interesting discussion of Keynesian and classical eco
nomics, see Blinder (1986), Laidler (1988), Eisner (1986) and
Niehans (1987).
18There is a problem in defining ‘'persistent” unemployment and
establishing if and when it differs from cyclical unemployment.
Many economists argue that there is no such thing as persist
ent unemployment because the market economy eventually

the slope o f the aggregate supply cuive and the
ability of deficit spending to shift aggregate de
mand.1"

Asymmetric Cyclical Variation in
Output
Both the Great Depression o f the 1930s and the
rise o f Keynesian economics, with its emphasis on
underem ploym ent equilibrium, led to the accept
ance o f the notion that the market econom y is
neither able to sustain a full-employment level of
output nor able to move back to it quickly when
aggregate dem and failures occur.17Prior to Keynes,
it was com m only believed that output w ould natu
rally move to the level consistent with no involuntaiy unemployment. While shocks to either aggre
gate demand or supply might cause temporary
periods o f unemployment, resources were
thought to be sufficiently mobile and wages and
prices sufficiently flexible that the econom y w ould
return to its full-employment equilibrium fairly
quickly.
Keynes argued that the econom y might remain
permanently below its full-emplovment level be
cause o f insufficient aggregate demand and mar
ket imperfections.'" This below-full-emplovment
equilibrium requires an upward-sloping aggregate
supply curve. Typically, it was also argued that the
aggregate supply curve w ould becom e steeper
around the full-employment level o f output, like
the aggregate supply curve in figure 3.

The Phillips Cun e
The Keynesian view was strengthened by the
discoveiy o f what appeared to be a stable long-run
empirical relationship between the rate o f in
flation and the unemployment rate; this relation
ship was called the Phillips Curve."1If unem ploy
ment was too high (relative to the full-employment
rate), policymakers could achieve a permanent
increase in output by increasing aggregate de
mand through deficit spending. The cost w ould be
a permanent increase in inflation. The extent of
the cost is determined by the slope o f the Phillips
Cuive. The closer incom e was to its full-

will adjust to the point at which the labor market clears. Keynes
himself almost certainly believed this to be true in the long run;
however, he regarded the long run to be too long for the adjust
ment to be left to market forces alone. His much-quoted de
fense of his view was that “ . . . in the long run we are all dead.”
,9This apparent empirical regularity was first discovered by
Phillips (1958) who used wages and unemployment.

NOVEMBER/DECEMBER 1988

em ployment level, the steeper the slope and, con
sequently, the higher the inflation rate. Presum
ably, without deficit spending, the econom y
w ould be stuck permanently below the fullem plovm ent level o f output.

The Natural Rate Hypothesis and
Rational Expectations: A Counter View
to the Phillips Curve
The view that the econom y could remain per
manently at underem ploym ent equilibrium was
challenged by the Natural Rate Hypothesis.211It
reintroduced the once-prevalent argument that
the econom y eventually w ill return to its fullem ployment equilibrium. That is, the Natural Rate
Hypothesis im plied that the long-run Phillips
Cuive is vertical at the natural rate o f unem ploy
ment.
The implications o f the Natural Rate Hypothesis
were enhanced bv the rational expectations revo
lution, which argued for the same conclusions,
albeit along different theoretical lines. Rational
expectations models o f the business cycle showed
that systematic stabilization policies could not
affect real output permanently in markets popu
lated by 'rational” individuals."1
Both theories argue that the em ployment rate
w ill tend toward its natural rate; consequently,
demand management policies w ill be unable to
keep the unem ploym ent rate below the natural
rate in the long run. The natural rate o f output, y,„
is determ ined solely by the level of em ployment
N,„ consistent with the natural rate o f unem ploy
ment, given the stock of capital K. That is,
y„ = f(N„, Ki.
Since dem and management policies have no last
ing effect on em ployment or the capital stock, they

20See Friedman (1968) and Phelps (1967).
21Neither the Natural Rate Hypothesis nor many rational expec
tations models give rise to involuntary unemployment as de
fined in footnote 8. Many rational expectations models, how
ever, give rise to cyclical movements in the natural rate of
unemployment. See Fischer (1977), Taylor (1988) and McCallum (1986). For a list of other factors that could cause the
unemployment rate to change without involuntary unemploy
ment, see Blinder (1988).
22ln chart 2, “ potential” output is defined arbitrarily. Conse
quently, persistent unemployment can exist by definition. This
applies to estimates of “ potential” GNP as well as cyclicallyadjusted deficits, etc. See Fellner (1982) and de Leeuw and
Holloway (1982) for a discussion of this point.
23Also, it does not say explicitly what the level of the natural rate
is. See Carlson (1988) for a discussion of the level of the natu
ral rate.

FEDERAL RESERVE BANK OF ST. LOUIS

have no effect on the natural rate o f output. In
effect, these theories make it less likely that there
w ill be asymmetries in the business cycle, thus,
eliminating the possibility o f permanent gains in
net output from deficit spending. Unless shocks to
demand or supply are asymmetric, on average,
cyclical downturns need be no more pronounced
nor of longer duration than cyclical upturns ~
The Natural Rate Hypothesis asserts that the
long-run aggregate supply curve is vertical at an
output level consistent w ith the natural rate o f
unemployment. It does not assert, however, that
the short-run aggregate supply curve w ill be verti
cal at this level o f output.23Hence, accepting the
Natural Rate Hypothesis does not im ply that soci
ety cannot benefit from appropriately timed and
im plemented deficit spending; however, it limits
significantly the benefits that society can receive
from deficit spending. As discussed previously,
society benefits only if deficit spending reduces
cyclical swings in output or nominal GNP.24

CAN DEFICIT SPENDING SHIFT THE
AGGREGATE DEMAND SCHEDULE?
Even when the aggregate supply curve (short- or
long-run) is upward-sloping, deficit spending will
have little effect on output or prices if the increase
in aggregate dem and that it produces is largely
offset by a deficit-induced decrease in private
spending, that is, if deficit spending fails to change
aggregate demand.

Competition f o r Credit— Indirect
Crowding Out Through Interest Rates
When the government runs a deficit, it issues
government debt.21Thus, the demand for credit
increases relative to the supply. All other things

24Actually, in such models, deficits can provide benefits in the
absence of stabilizing output. These benefits come from
smoothing taxes over the cycle. Public finance theory asserts
that variation in tax rates across goods or activities results in
welfare losses under most conditions. Consequently, it would
be more efficient to run deficits and surpluses over the busi
ness cycle rather than balance the budget annually by altering
tax rates. See Bossons (1986) and the references cited there.
25ln models with a government budget constraint deficits are
often financed directly through money creation. Given the
current institutional structure, however, the government must
initially issue debt even if it is subsequently monetized. See
Thornton (1984a). See Thornton (1984b) for a discussion of
and evidence on debt monetization.

unchanged, this causes interest rates to rise, re
ducing private expenditures in interest-sensitive
sectors o f the economy. Hence, the increase in
aggregate demand associated with the deficit
could crowd-out private expenditures indirectly
by affecting interest rates.-" Since investment
spending is one o f the most interest-sensitive
components o f spending, analysts often argue that
deficit spending might retard the rate o f capital
formation and, hence, econom ic growth.-7

Deficit Spending and the Trade Deficit
Assuming that deficit spending increases the
demand for credit, its effect on interest rates d e
pends on whether the econom y is “ op en ” or
“ closed.” In the preceding example, w e im plicitly
assumed that the econom y was closed so that the
government ran a deficit by borrowing from the
private sector. In an open econom y with a floating
exchange rate and perfect capital flows, the results
w ould be somewhat different.28
An increase in the budget deficit puts upward
pressure on domestic interest rates. This leads to
inflows o f financial capital and an appreciation of
the exchange rate. This appreciation, together
with the higher domestic demand, is associated
with a current account deficit in the balance of
payments. In effect, the government deficit is
26This problem cannot be solved by monetizing the debt. The
increased rate of money growth will result merely in a higher
rate of inflation and, hence, higher nominal interest rates. Many
advocates of countercyclical fiscal policy view this as one of the
most serious drawbacks to deficit spending. See Modiqliani
(1986b).
27This argument ignores how the deficits are spent. Recently,
Heilbroner (1988) has argued that deficit spending is neces
sary to finance the purchase of public capital, that is, infrastruc
ture. Other economist (for example, see Sturrock and Idan
(1988)) argue that the real burden of deficits comes only when
they are used to finance current consumption. This does not
establish the desirability of deficit spending; it merely asserts
that spending for infrastructure capital may increase the rate of
economic growth, depending primarily on the relative produc
tivity of the factor resources in the two sectors and on the
productivity of public versus private capital.
The idea that such expenditures should be financed by
deficits rests largely on the long-lived nature of capital goods.
Since these capital goods provide services over a number of
years, it is argued that public sector capital goods should be
financed by borrowing just as businesses or households fi
nance their acquisition of durable goods. In the case of busi
nesses, however, debt service is financed out of the increased
earnings that the capital goods are expected to provide. In the
case of households, deficit financing is used to better match
the desired consumption with expected future income. Hence,
households, too, expect to service the debt through higher
incomes. No similar increased earnings necessarily accrues
from the acquisition of public capital. Income will increase only
if the marginal product of public capital is larger than that of
private capital. This is a difficult point to establish. Proponents
of this view point to the productivity gains that could accrue

financed bv a larger trade deficit.2” The econom y
may gain in terms o f higher short-term consum p
tion, but at a cost o f an increase in external debt.
The decline in private expenditures is affected
through higher interest rates, a larger trade deficit
or both. In any event, the result is the same: the
group that gains directly from deficit expenditures
does so at the expense o f those w ho lose, with
little or no net increase in aggregate demand. The
only difference is that those w ho gain directly are
more readily identified than those w ho suffer indi
rect losses through higher interest rates or in
creased foreign claims on U.S. assets.1"

Ricardian Equivalence
Another argument, referred to as the “ Ricardian
Equivalence Hypothesis,” holds that deficit spend
ing cannot shift the aggregate demand curve.'1The
closed-econom y conclusion that deficit spending
does not crowd-out private spending directly im
plies that government debt is net wealth to soci
ety. In other words, when the government issues
debt to purchase goods and services, the holder of
the debt views it as an asset; but the taxpayer does
not view it as a liability (or, at least, views it as a
smaller liability). That is, individuals believe that
they w ill not have to pay current or future taxes to
service or retire the debt.
from public expenditures on education and the like; however,
these services could be provided by the private sector. Hence,
this argument is about the appropriate role for government and
public goods. See Aschauer and Greenwood and Aschauer
(1988a, b and c) for a discussion of the benefits from social
infrastructure expenditures. Hence, the only real argument for
deficit financing of such expenditures is that it would equalize
their costs and benefits across generations. This implies,
however, that the increased indebtedness that such expendi
tures necessitate will eventually be retired through increased
taxes unless the infrastructure acquired is infinitely lived.
28The assumption of perfect capital flow s m eans that domestic

real interest rates could not rise above world levels without
inducing an inflow of financial capital from overseas. For a
situation in which there is no expectation of exchange rate
changes, this means that domestic and foreign nominal interest
rates must be equal.
^See Mundell (1963). This result assumes no change in mone
tary policy to accommodate the defict.
^In this model, the real market value of government debt is part
of society’s net wealth. In the closed economy model, at the
natural rate of unemployment, the increase in wealth resulting
from the increase in nominal debt due to deficit spending is just
offset by a decline in wealth due to higher prices, interest rates
or both. In the open economy model, it is offset by a reduced
stock of national wealth due to increased claims by foreigners
on U.S. assets.
3,Technically, Ricardian Equivalence argues that, for a given
level of government expenditures, aggregate demand will not
change as the government switches from tax to bond financing.
As O’Driscoll (1977) points out, Ricardo was merely offering
this as a theoretical possibility and did not himself believe it.

NOVEMBER/DECEMBER 1988

Ricardian Equivalence, on the other hand, as
serts that public and private debt are perfect sub
stitutes. Individuals believe that they or their heirs
will have to pay taxes equal to the deficit-financed
expenditures, so an increase in present value o f
the expected future taxes just equals the current
deficit.
At the macroeconom ic level, Ricardian Equiva
lence implies that deficit spending w ill not be
associated with increases in real interest rates,
output, prices or the trade deficit:* Consequently,
the Ricardian view yields a radically different no
tion o f the national debt. For those w ho believe in
the benefits o f deficit spending, the national debt,
which is the accumulated deficits, should be
viewed as a blessing, not a curse. For those who
believe in Ricardian Equivalence, deficit spending
merely results in a redistribution o f income and
the national debt represents the cumulative
amount o f this net transfer.

Can Discretionary Fiscal Policy Be
Successfully Implemented?
There is also an argument against the useful
ness o f deficit spending that is independent o f its
ability to shift aggregate demand. It is critically
dependent, however, on the Natural Rate Hypoth
esis and on whether shifts in aggregate demand
caused by other factors are temporary or perma
nent. It has been suggested that policymakers do
not have the information needed to offset shifts in
aggregate dem and to stabilize output.” This argu
ment is usually couched in a discussion o f the
lags in econom ic policymaking. For fiscal policy,
the most important o f these are the "recognition”
and "implementation” lags. The recognition lag is
the time between when a need for corrective
action arises (an exogenous shift in aggregate de
mand) and when policymakers recognize the
need. The issue is simply w hether policymakers
know where the econom y is in the business cycle
at any particular point in time.
The implementation lag is the time between
when the need for corrective action is recognized
and when policymakers take action. Thus, even if
policymakers are quick to recognize that the de
mand has shifted, by the time they react to the
situation, it may have changed and the need for
corrective action may have vanished.

32Analysts frequently argue that Ricardian Equivalence must be
invalid because the necessary microeconomic conditions for its
validity are so stringent that they cannot possibly be satisfied.
For example, see Buiter (1985). Also, see McCallum (1984).

FEDERAL RESERVE BANK OF ST. LOUIS

This argument is presented graphically in figure
4a. Assume that the Natural Rate Hypothesis holds
and that the short-run aggregate supply curve is
symmetric around the level o f output consistent
with the natural rate o f unemployment. Assume
further an exogenous decrease in aggregate d e
mand, shifting it from AD to AD'. N ow if policym a
kers did not react to the shift in demand im m edi
ately, the process o f adjustment toward the
natural rate w ould begin; the price level w ould
decline and the quantity o f output dem anded
w ould increase. Once policymakers reacted to the
problem bv increasing deficit spending, they
w ould shift the aggregate demand curve upward,
bringing output back to its natural-rate level.
If the shift in aggregate dem and were temporaiy, a delay in policy might actually exacerbate
the situation if deficit spending coincided closely
with the return o f aggregate dem and to its former
level. This is illustrated in figure 4b, where the
simultaneous increase in deficit spending and the
return o f aggregate demand to its form er level shift
aggregate demand to AD".
Of course, if the decline in aggregate demand
were permanent, the timing o f policy w ould be
less important. Deficit spending eventually w ould
move the econom y back to the natural rate; the
timing o f the policy action w ould determine only
how quickly deficit spending m oved the econom y
back to its full-employment potential. Of course,
the econom y w ould move back eventually to full
em ployment even without deficit spending.

Demand or Supply Disturbances
Another problem is that policymakers must be
able to differentiate between demand- and supplvside disturbances. Recently, some have suggested
that business cycles can be explained solely by
supply-side disturbances. Indeed, some "real busi
ness cycle” models have successfully produced
cyclical swings in output that mimic real w orld
data. W hether all cyclical swings in econom ic
activity can be explained by such models is the
subject o f intense debate. Nevertheless, to the
extent that some cyclical swings are the result of
supplv-side shocks, fiscal policy can succeed in
stabilizing output only by exacerbating m ove
ments in prices (or it can help stabilize the price
level only bv exacerbating movements in output).

33lt is argued that inappropriately timed policy might destabilize
the economy. See Friedman (1968).

Figure 4
The Timing of Changes in Fiscal Policy

Consequently, policymakers must know not
only where in the business cycle the econom y is
at any point in time, but whether its position was
caused by a shift in aggregate demand, aggregate
supply or, perhaps, simply the cyclical dynamics
o f the economy, unrelated to exogenous distur
bances in either aggregate dem and or supply. In
short, some would argue that the information
required to use discretionary fiscal policy effec
tively is simply too great.

WHAT IS THE EVIDENCE?
Assessing the evidence on discretionary fiscal
policy is difficult. Effective discretionary fiscal
policy implies that output should be more stable
and suggests that perhaps the rate o f real output
growth should be higher on average when fiscal
policy was used aggressively. It also suggests that
deficit spending should be positively correlated
with interest rates, prices (or inflation) or trade
deficits.
340ne of the earliest of these was the Andersen-Jordan equa
tion. See Andersen and Jordan (1968).
35See Barro (1987), Bernheim (1987) and Aschauer (1988a). For
more recent studies which report results consistent with Ricar
dian Equivalence, see Evans (1988), Koray and Hill (1988) and
Leiderman and Razin (1988).

A number o f large-scale econom etric models
suggest that fiscal policy has significant short-run
and, in some cases, long-run effects. Estimates of
reduced-form models, however, typically show no
long-run effects o f deficit spending and, often,
only weak short-run effects.34 Hence, such models
essentially substantiate the Natural Rate Hypothe
sis. These studies are subject to considerable con
troversy because o f the difficulty in finding com
m only accepted variables that reflect discretionary
changes in fiscal policy and the continued contro
versy over reduced-form estimation.
The greatest challenge to the orthodox view of
deficit spending comes from the Ricardian Equiva
lence H y p o th e sisM a c ro ec o n o m ic evidence from
three recent surveys is largely consistent with the
Ricardian view.31* In general, there is no statistically
significant relationship between structural deficits
and interest rates or inflation, or between the
budget and trade deficits.37These results are bol
stered by work that shows a high negative correla36The microeconomic evidence yields mixed results.
37Barro (1987) reports that he finds a statistically significant
correlation between government deficits and the trade deficit
only if 1983 is included.

NOVEMBER DECEMBER 1988

tion between public and private savings.’"

The Evidence on Stabilization
One com m only cited piece o f evidence that
demand management can stabilize the econom y
is a comparison o f the volatility o f U.S. output,
unemployment and industrial production, before
and after W orld War II. The fact that the pre-war
series are more volatile than the post-war series
has been cited as evidence o f both the inherent
instability o f unmanaged capitalism and the suc
cess o f demand management policies in stabiliz
ing the economy.
There are several criticisms o f this evidence.
First, pre- and post-war data vary in terms o f a
quality and uniformity. Indeed, some argue that
the excessive pre-war volatility o f the comm only
used series on unemployment, GNP and industrial
production is due to various quirks in their con
struction."
Second, even if the post-war econom y is more
stable, this may be due to other changes in eco
nomic fundamentals, not to discretionary fiscal
policy per se.40Furthermore, even if fiscal policy is
responsible for the apparently more stable post
war economy, this may be the result o f increased
relevance on the automatic stabilizers, not to dis
cretionary fiscal policy.
Also, post-war real output growth in the United
States is below its pre-war growth. The discrep
ancy is even larger if the Depression years are
omitted.41 Moreover, there has been a secular rise
in the u n e m p l o y m e n t rate. These adverse m ove
ments roughly coincide with a secular rise in the
U.S. structural deficit.4- Hence, if the more stable
post-war econom y is used as evidence on the suc
cess of fiscal policy, the associated slower output
growth and higher unemployment must be con
sidered the costs o f stability.

380 f course, in a closed economy with output unchanged, the
public sector deficit must equal the private sector surplus.
Other studies of consumption have tried to determine whether
government debt is net wealth, e.g., Tanner (1979) and Kochin
(1974). Again, the results are consistent with the Ricardian
Equivalence Hypothesis.
39See Romer (1986a, 1986b, 1986c and 1988). Romer's evi
dence has been challenged by Weir (1986) and Lebergott
(1986).
40Pre- and post-war real output series for the United Kingdom,
Germany and Italy show significant decreases in the variability
of real output of a similar order of magnitude as that of the
United States. The pre-war standard deviations of annual
output growth for the United States, United Kingdom, Germany

FEDERAL RESERVE BANK OF ST. LOUIS

CONCLUSION
This paper has examined the theoretical argu
ments about the wisdom o f deficit spending. The
once-prevalent Keynesian approach, which con
cludes that such gains clearly exist, has come
under attack. Increasingly, both theoretical inno
vations and empirical evidence suggest that m od
ern economies are not w ell characterized by the
Keynesian view. Support for the Natural Rate Hy
pothesis, which argues that deficit spending has
no effect on the equilibrium level o f output and
employment in the long run has grown. If this
hypothesis is valid, the gains from deficit spending
result from stabilizing output around the level
consistent with the natural rate o f unemployment.
Such an effective use o f deficit spending, however,
imposes information requirements on policym a
kers that are unlikely to be attained.
In general, empirical evidence on the effects of
deficit spending is sparse and, for the most part,
ambiguous. Most persuasive is the growing macroeconom ic evidence, consistent with Ricardian
Equivalence, that deficit spending has no long-run
effect. The challenge for those w ho argue that
deficit spending merely redistributes incom e and
that stabilization policy w ill likely hurt is to ex
plain phenomena like the Great Depression.
Through adherents to both extreme Keynesian
and extreme rational expectations views (and ev
erything between) usually are able to rationalize
historical events on their own terms, the Great
Depression is as likely to be seen as an example o f
what bad policy can create as it is o f what good
policy can eradicate.

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and Italy were 6.61, 3.98, 6.10 and 4.79, respectively. The
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Aschauer, David. “ The Equilibrium Approach to Fiscal Policy,"
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Kochin, Levis A. "Are Future Taxes Anticipated by Con
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Koray, Faik, and R. Carter Hill. “ Money, Debt, and Economic
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Kotlikoff, Laurence J. “What Macroeconomics Teaches Us
about the Dynamic Macro Effects of Fiscal Policy,” Journal of
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Auerbach, Alan J., and Laurence J. Kotlikoff. "Evaluating
Fiscal Policy with a Dynamic Simulation Model," The Ameri
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Lebergott, Stanley. “ Discussion,” The Journal of Economic
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Barro, Robert J. “The Ricardian Approach to Budget Deficits,”
Henry Thornton Lecture, City University Business School,
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Leiderman, Leonardo, and Assaf Razin. “Testing Ricardian
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Bernheim, B. Douglas. “ Ricardian Equivalence: An Evaluation
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Leijonhufvud, Axel. "Constitutional Constraints on the Mone
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Blinder, Alan S. “The Challenge of High Unemployment,” The
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Levy, Michael E. Fiscal Policy, Cycles and Growth (The Confer
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Bossons, John. “ Issues in the Analysis of Government Defi
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McCallum, Bennett T. “ Are Bond-financed Deficits Inflation
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NOVEMBER DECEMBER 1988

Romer, Christina D. “ Is the Stabilization of the Postwar Econ
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Federal Reserve System (1988).

FEDERAL RESERVE BANK OF ST. LOUIS

Sturrock, John, and George Iden. “ Deficits and Interest Rates:
Theoretical Issues and Empirical Evidence," Congressional
Budget Office Staff Working Paper (1988).
Taylor, John B. “ Aggregate Dynamics and Staggered Con
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nomic History (June 1986), pp. 353-65.

FEDERAL RESERVE BANK OF ST. LOUIS
REVIEW INDEX 1988
JANUARY/FEBRUARY

JULY/AUGUST

K. Alec Chrystal and Geoffrey E. Wood, “Are Trade
Deficits a Problem?”

William G. Dewald, “ Monetarism Is Dead; Long Live
the Quantity Theory”

Cletus C. Coughlin, K. Alec Chrystal and Geoffrey E.
Wood, “ Protectionist Trade Policies: A Survey of
Theory, Evidence and Rationale”

Michael T. Belongia, “ Prospects for International
Policy Coordination: Some Lessons from the EMS"

Daniel L. Thornton, “The Borrowed-Reserves Oper
ating Procedure: Theory and Evidence”
Kenneth C. Carraro, “ Farm Policy and Mandatory
Supply Controls — The Case of Tobacco”

Clemens J. M. Kool and John A. Tatom, “ Interna
tional Linkages in the Term Structure of Interest
Rates”
Keith M. Carlson, "How Much Lower Can the Unem
ployment Rate Go?”
R. Alton Gilbert, “ A Comparison of Proposals to
Restructure the U.S. Financial System”

MARCH/APRIL
R. W. Hafer and Joseph H. Haslag, “The FOMC in
1987: The Effects of a Falling Dollar and the Stock
Market Collapse”
Thomas B. Mandelbaum, “The District Business
Economy in 1987: The Expansion Continues”
Kenneth C. Carraro, “The 1987 Agricultural Recov
ery: A District Perspective”

SEPTEMBER/OCTOBER
Mack Ott, “ Have U.S. Exports Been Larger Than
Reported?”
Cletus C. Coughlin and Thomas B. Mandelbaum,
“Why Have State Per Capita Incomes Diverged
Recently?”

Lynn M. Barry, “ District Bank Performance in 1987:
Bigger Is Not Necessarily Better”

Michael T. Belongia and Kees G. Koedijk, “ Testing
the Expectations Model of the Term Structure:
Some Conjectures on the Effects of Institutional
Changes”

MAY/JUNE

Albert E. Burger, “The Puzzling Growth of the Mone
tary Aggregates in the 1980s"

Gerald P. Dwyer, Jr., and R. W. Hafer, “ Is Money
Irrelevant?”
G. J. Santoni, “The October Crash: Some Evidence
on the Cascade Theory”
Cletus C. Coughlin, “ The Competitive Nature of
State Spending on the Promotion of Manufacturing
Exports”
Tobias F. Rotheli, “ Money Demand and Inflation in
Switzerland: An Application of the Pascal Lag Tech
nique"
Daniel L. Thornton, “The Effect of Monetary Policy
on Short-Term Interest Rates”

NOVEMBER/DECEMBER
Gerald P. Dwyer, Jr., and R. W. Hafer, “Are National
Stock Markets Linked?”
Michael T. Belongia, “Are Economic Forecasts by
Government Agencies Biased? Accurate?”
John A. Tatom, “The Link Between the Value of the
Dollar, U.S. Trade and Manufacturing Output: Some
Recent Evidence”
Cletus C. Coughlin and Kenneth C. Carraro, “The
Dubious Success of Export Subsidies for Wheat”
K. Alec Chrystal and Daniel L. Thornton, “The Mac
roeconomic Effects of Deficit Spending: A Review”

NOVEMBER/DECEMBER 1988

Full text of Review (Federal Reserve Bank of St. Louis) : November/December 1988

FRASER