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CONTENTS
Vol. 40
No. 3
SEPTEMBER 1993
Auctions: Theory and Applications
ROBERT A. FELDMAN and RAJNISH MEHRA
•
485
Testing the Neoclassical Theory of Economic Growth:
A Panel Data Approach
MALCOLM KNIGHT, NORMAN WAYZA, and DELANO V ILLANUEVA
•
512
Capital and Trade as Engines of Growth in France:
An Application of Johansen's Cointegration Methodology
DAVID T. COE and REZA MOGHADAM
•
542
French-German Interest Rate Differentials and
Time-Varying Realignment Risk
FRANCESCO CARAMAZZA
•
567
Stabilization Programs and External Enforcement:
Experience from the 1920s
JULIO A. SANTAELLA
•
584
Risk Taking and Optimal Taxation in the Presence
of Nontradable Human Capital
ZULJU HU
•
622
Cash-Flow Tax
PARTHASARATHI SHOME and CHRIST IAN SCHUTTE
•
638
Portfolio Performance of the SDR and Reserve Currencies:
Tests Using the ARCH Methodology
MICHAEL G. PAPAIOANNOU and T UGRUL TEMEL
•
663
lnterenterprise Arrears in Transforming Economies:
The Case of Romania
ERIC V. CLIFTON and MOHSIN S. KHAN
•
680
Shorter Paper
The Budget Deficit in Transition: A Cautionary Note
VITO TANZI
•
697
lll
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CONTENTS
IMF Working Papers
•
708
IMF Papers on Policy Analysis and Assessmellf
•
709
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IMF Staff Papers
Vol. 40, No. 3 (September 1993)
ll:> 1993 International Monetary Fund
Auctions
Theory and Applications
ROBERT A. FELDMAN and RAJNISH MEHRA
•
This paper assesses alternative auction techniques for pricing and allocat­
ing various financial instruments, such as government securities, central
bank refinance credit, and foreign exchange. Before recommending ap­
propriate formats for auctioning these items, the paper discusses basic
auction formats, assessing the advantages and disadvantages of each,
based on the existing, mostly theoretical, literature. It is noted that auction
techniques can be usefully employed for a broad range of items and that
their application is ofparticular relevance to the impetus in many parts of
the world toward establishing mDrket-oriented economies. [JEL C70,
D40, D44, D60, P21, P23, P50]
UCfiONS an important role in economics. In their most basic
form, they are one of the ways in which various commodities and
A
financial assets are allocated to individuals and firms, particularly in a
PLAY
market-oriented setting. Examples of items that are commonly auctioned
include original art, livestock, fresh fish, used cars, construction con­
tracts, and a range of financial assets such as government securities,
central bank refinance credit, foreign exchange, and equity shares. These
*Robert A. Feldman is Assistant to the Director of the IMP's Research
Department and holds a Ph.D. in economics from the University of Wisconsin.
RaJnish Mehra is Professor of Finance at the University of California at Santa
Barbara and holds a Ph.D. in finance from the Graduate School of Industrial
Administration, Carnegie-Mellon University. A first draft of this paper was
completed while Professor Mehra was a visiting scholar in the Research Depart­
ment.
The authors would like to thank Eduardo Borensztein, V.V. Chari, Edward
Dumas, Chi-Fu Huang, Peter Isard, Mohsin S. Khan, Paul Milgrom, Merton
Miller, Edward Prescott, Cheng-Zhong Qin, and Vincent Reinhart for numerous
helpful discussions and suggestions.
485
©International Monetary Fund. Not for Redistribution
486
ROBERT A. FELDMAN and RAJNISH MEHRA
items exhibit considerable diversity, but a common denominator among
them is that the valuation of each item varies enough to preclude any
direct pricing schedule.
The use of auction mechanisms to guide price determination and the
allocation process can offer certain advantages, which this paper dis­
cusses. The major effort taking place in many parts of the world to
establish market-oriented institutions makes a paper on these mecha­
nisms opportune. Against this background, one of the main goals of this
paper is to survey the extensive literature on auctions in order to shed
some light on the advantages and disadvantages of various auction tech­
niques. 1 A second main goal is to assess the application of alternative
auction techniques to various financial instruments, using the three
examples of government securities, central bank refinance credit, and
foreign exchange.
We emphasize that the implications of theoretical models do not easily
carry over into real world settings. Therefore, our recommendations on
the appropriate auction technique for different assets depend heavily on
individual country circumstances. Indeed, the array of country experi­
ences would suggest no clear-cut answer to the question of which is the
appropriate auction technique. In this connection, it is instructive to
note that in looking at individual country experiences across a range of
countries-both industrial and developing-techniques used to auction
similar items vary considerably.
This experience includes several countries that in auctioning govern­
ment securities have awarded them at whatever price was bid (including
France, Germany, Japan, and the United Kingdom) and others that have
charged a single, market-clearing price (Denmark and Switzerland).2
Some countries have recently changed the way they run their auctions.
Mexico in 1990 shifted from a multiple-price to a uniform-price approach
for treasury bills and then in 1993 shifted back.3 Italy in 1991 switched
·
1 Reviews of the literature on auctions in different contexts can be found
elsewhere, and our paper builds on the insights of these authors. See Maskin
( 1992 ) , McAfee andMcMillan (1987), Milgrom (1987, 1989), Milgrom and Weber
( 1982 ) , and Smith (1987). In relation to recent assessments of the U.S. govern­
ment securities market, excellent reviews of selected aspects of auction tech­
niques are contained in Bikhchandaoi and Huang (1992), Chari and Weber
(1992), Reinhart (1992), and the Joint Report on the Government Securities
Market (1992).
2 The former is called a discriminatory or multiple-price auction and the latter
a uniform-price auction. Definitions of different auction formats are provided in
the next section of this paper. For the industrial countries, a very useful summary
of the auction techni ques used to sell government debt is found in the Joint Report
on the Government Securities Market (1992), pp. B-29-B-40.
3 See Umlauf (1991) and Hernandez (1993).
©International Monetary Fund. Not for Redistribution
AUCTIONS
from uniform to multiple pricing in its local-currency treasury bill auc­
tions, but has auctioned its treasury bonds and ECU-denominated bills
on a uniform-price basis. Currently, in the United States, the U.S. Trea­
sury is experimenting with uniform-price auctions for some government
securities while also running discriminatory auctions.
Relevant examples are also found for foreign exchange and refinance
credit. Several countries have conducted discriminatory-price or Dutch
auctions for refinance credit (Romania) and for foreign exchange
(Bolivia, Ghana, Jamaica, and Zambia). Other countries have used
uniform-price auctions for refinance credit (the former Czechoslovakia)
and for foreign exchange (Guinea, Nigeria, and Uganda).4 Double
auctions have been used for foreign exchange (Romania).
I.
Types of Auctions
An auction is simply an allocative mechanism. Since auctions can play
valuable
role in the price discovery process, they are most useful in
a
situations where the item being auctioned does not have a fixed or
determinable market value or where the seller is uncertain about the
market price. These situations typically involve some degree of informa­
tional and cost asymmetries in the sense that economic agents differ in
their access to, and evaluation of, information pertaining to the auctioned
commodity. Auctions may be for a single object or unit-as is typical in
the proceedings of such well-known auction houses as Sotheby's and
Christie's-or for a "lot" of nonidentical items, as with land tracts (a
practice in many countries) or used cars (a practice in the wholesale U.S.
automobile market). Alternatively, auctions may be for multiple units of
a homogeneous item, such as gold or treasury securities.
Our concern in this paper is mostly with auctions for multiple homo­
geneous assets, such as government securities, refinance credit, and
foreign exchange. The theoretical literature relies frequently, however,
on the assumption of a single unit being auctioned. Partly for this reason,
the definitions given below cover both single- and multiple-unit auctions.
Of course, auctions of single units are also relevant in economics. For
example, countries' efforts to privatize may involve auctioning a single
item, such as a public enterprise.
Following the pioneering work of Vickery (1961), we distinguish be• These examples for foreign exchange are from Quirk and others (1987). It is
interesting to note that when the International Monetary Fund auctioned part of
its gold stock in 1976-80, the auctions were divided between discriminatory
first-price and uniform second-price formats.
©International Monetary Fund. Not for Redistribution
488
ROBERT A. FELDMAN and RAJNISH MEHRA
tween four primary types of auctions, classifying each according to its
corresponding institutional arrangement. Each of the following classifi­
cations entails its own set of rules that affects the bidding strategies of the
auction participants and therefore the outcome of the auction itself.
English auction. This type of auction is also referred to as an ascending­
price auction and is commonly seen in the art world. It is perhaps the most
familiar form of auction. Starting with a low first bid or a specified
reservation price-that is, a price below which the item will not be
sold-the auctioneer solicits increasingly higher bids. As the bid price
increases, there are normally fewer takers. The process continues in the
case of a single item until that item is "sold!" to the last and highest bidder
for the amount bid (see Figure la). In an auction involving multiple units,
the process continues until arriving at a price at which the fixed amount
supplied at auction is just matched by total demand.
Dutch auction . This type of auction is also referred to as a descending­
price auction . It gets its name from the technique used in the Netherlands
for auctioning produce and fresh flowers. The bidding commences at a
high level and is progressively lowered until a buyer claims the item being
auctioned by shouting "mine!" (see Figure lb). Practitioners have long
since streamlined the proceedings through the use of an automated
"clock" with a hand running counterclockwise through progressively
lower prices. Any buyer can stop the descent by pressing a button when
an acceptable price is reached. When multiple units are being auctioned,
there are normally more willing takers as the price declines; this process
continues until arriving at a price whereby the fixed amount supplied is
just matched by total demand.
First-price auction. This type of auction is an example of a sealed-bid
auction, as opposed to the above two formats, which are open auctions.
The term "first price" is commonly used when referring to the sale of a
single item. The highest bidder is awarded the item at a price equal to
the amount bid. When multiple units are auctioned at the same time, this
procedure is called a discriminatory auction. The sealed bids are sorted
from high to low, and the auctioned items are awarded at the highest bid
prices until the supply is exhausted. Thus, the auction discriminates
among bidders in the sense that they can pay different prices according
to the amount they bid (see Figure lc). The terminology "first-price" or
"discriminatory" auction follows the academic literature. In the financial
community-and here is where one source of confusion may arise-this
type of auction is referred to as an English auction; an exception being
in the United Kingdom where it is called an American auction. This type
of auction is also referred to as a multiple-price (or, in some cases, a
multiple-yield) auction.
©International Monetary Fund. Not for Redistribution
AUCTIONS
489
Figure I. Auction Formats
a. Ascending-price (English) auction
Price
b. Descending-price (Dutch)
Price
Awarded price
Awarded price
Quantity
Quamity
d. Uniform-price auction
c. Discriminatory auction
Price
auction
Awarded prices :
D
Auction size
/I I
I
I
I
Price
Au,·tion siu
:/
Awarded price
J
I I I I i I I I I
Source: Reinhan ( 1992).
Quantity
Quantity
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490
ROBERT A. FELDMAN and RAJNISH MEHRA
Second-price auction. This type of auction is also a sealed-bid auction.
When a single item is auctioned, the highest bidder is awarded the item
at a price equal to the highest unsuccessful bid-hence, the name second
price. The multiple-unit extension of the second-price, sealed-bid auction
is referred to as a uniform-price auction (or competitive auction), since
all winning bidders receive the auctioned items at the same price (see Fig­
ure ld). Here, some confusion in terminology also arises from the use of
the term "second price" or "uniform price" auction because in the finan­
cial community these auctions are referred to as "Dutch auctions,"
although this would appear to be a misnomer.5 This type of auction is also
referred to as a marginal-price auction.
A final type of auction worthy of mention is a double auction. Using
this format, both sellers and buyers submit bids, which are then ranked
from highest to lowest to generate demand and supply profiles. From
these profiles, the maximum quantity exchanged can be determined by
matching sell offers, starting with the lowest price and moving up, with
demand bids, starting with the highest price and moving down. The
"equilibrium" price may, however, be indeterminate using this method­
ology. 6 An example of a double auction is the market-clearing mechanism
in organized exchanges, Like stock exchanges and commodity markets,
where a specialist matches bid and ask prices in a "specialist's book,"
making the market for a particular security traded on the exchange.
In addition to the institutional arrangements governing the workings
of a particular type of auction, a second aspect of classifying different
auction mechanisms concerns how each bidder values the item(s) on the
auction block. Economists customarily distinguish between "private­
value" auctions and "common-value" auctions. The former term refers
to objects acquired for personal consumption with no primary motive to
resell. The bidder therefore has a personal maximum that he or she would
be willing to pay, quite independent of the valuations of rival bidders. If
this is the case, one speaks of the bidder as displaying "independent
private values." A frequently cited example is an object of art purchased
for personal pleasure rather than for profitable resale.
The same painting, however, can be purchased to be resold. The bid
5 The traditional Dutch auction follows a discriminatory, not a uniform,
multiple-unit pricing procedure.
6 This is most easily illustrated by a simple example. Suppose (i) there are four
sellers of foreign exchange who each offer to sell one unit at the respective prices
of 100, 200, 300, and 400 units of domestic currency and (ii) there are four
demanders of foreign exchange who each demand one unit at the respective prices
of 400, 300, 250, and 50 units of domestic currency. In this example, supply and
demand would match at three units of foreign exchange; the equilibrium price
would be indeterminate in the sense of lying between 200 and 250.
©International Monetary Fund. Not for Redistribution
AUCTIONS
491
is then predicated on both personal valuation and the valuation of
prospective buyers in the secondary market. This situation is referred to
as the common-value assumption because each bidder places the same
value on the object-that is, each one tries to estimate what the object
is ultimately worth on the basis of the same objective standard. This
common value may be an unobservable variable at the time of the
auction, as would be the case when a government security is purchased
to be resold later in the secondary market.
In general, aU auctions are "correlated-value auctions," a category that
includes the common-value and private-value auctions as polar ex­
amples. This concept of correlated values captures the notion that in each
auction situation, bidders' values are to some extent related to each
other: they are correlated. Milgrom and Weber (1982) use the term
"affiliation" to express the same idea more precisely. However, as Ras­
musen (1990, p. 246) points out, "as always in modeling, we must trade
off descriptive accuracy against simplicity, and private value versus com­
mon value is an appropriate simplification." We retain this distinction
throughout the paper.
For the four basic types of auctions just defined, Table 1 summarizes
the rules associated with each institutional arrangement (see Rasmusen
(1990)).7 It also outlines some simple aspects of the bidder's strategy,
which are implied by the rules and payoffs to the bidder.
II.
Auction Theory
Since auctions follow well-defined rules, they can be viewed as
"games," making the application of game theory an appropriate
paradigm for gaining insight into their dynamics. 8 But to gain these
insights, the theoretical literature relies on a number of simplifying
assumptions. Although these assumptions allow one to derive key results,
they make the application of auction theory to real world settings an
7 In contrast to what we term the four basic auction types, the theoretical
literature on double auctions is sparse and the strategy and payoffs associated
with them are difficult to summarize, as is done for the others in Table 1. Because
of these considerations, we exclude double auctions from the next section, which
focuses on theory.
8 Although double auctions are excluded from this section, the interested
reader can turn to Wilson (1979, 1986), Friedman (1984), and Easley and Ledyard
(1982) for technical articles that demonstrate the problems of modeling strategic
behavior in this framework. Double auctions are applicable, as we will see, to
foreign exchange fixings. More broadly, however, the operations of such well­
established markets as those for equities, in which dealers and brokers match
supply and demand in their books, can be viewed as examples of double auctions.
©International Monetary Fund. Not for Redistribution
492
ROBERT A. FELDMAN and RAJNISH MEHRA
Table 1.
Characteristics of Different Types of Auctions
Expected
payoffs
Bidder's valuation of auctioned item(s)
minus his or
her highest
bid.
Type
English, or
ascending-price,
open-bid auction
Rules
Seller announces
initial low bid,
which is progressively increased
until demand falls
to match the fixed
amount at auction.
It is important to
note that bidders
are able to reassess
bids during the
bidding process.
Strategy
Bidder's strategy
is a function of
(a) personal valuation, (b) prior
assessment of
rival valuations,
and (c) new
information obtained from the
bidding process.
Dutch, or
descendingprice, open-bid
auction
Seller announces
initial high bid,
which is progressively lowered until
demand rises to
match the fixed
amount at auction.
Strategy is a
function of (a)
personal valuation, (b) prior
assessment of
rival bids, and
(c) no new information being
obtained from
the bidding
process.
Bidder's vatuation of the
auctioned
item(s) minus
his or her
actual bid.
First-price,
sealed-bid auction; or, with
multiple objects,
discriminatory
auction
Bidders submit
written bids in
ignorance of all
others. Highest
bidder wins the
item and pays
the amount bid.
Same as for
Dutch auction
above.
Same as for
Dutch auction
above.
Second-price,
sealed-bid auction; or, with
multiple objects,
uniform-price
auction
Bidders submit
written bids in
ignorance of all
others. Highest
bidder wins the
item and pays
the amount of the
second highest bid.
Same as for
Dutch auction
above.
Bidder's vaJuation of the
auctioned
item minus
the second
highest bid.
©International Monetary Fund. Not for Redistribution
AUCTIONS
493
exercise to be undertaken with caution. In addition to reviewing some
common assumptions, this section discusses auction strategy, first from
the bidder's and then from the seller's perspective, before turning to
issues of economic efficiency and the incentives to collude under different
auction formats.
The assumptions most commonly used, depending on the context, are
(1) Bidders are risk neutral;9
(2) Either the independent private-value assumption applies or the
common-value assumption applies; and
(3) The bidders are symmetric-that is, they use the same distri­
bution function to estimate their valuations-implying bidders
cannot discern differences among their competitors.
Following the earlier theoretical literature, it is initially assumed that
one item is being auctioned.
0
Bidder's Perspective 1
We briefly examine bidding strategies that emerge from the intersec­
tion of auction format rules with the earlier stated assumptions regarding
bidder values.
Private-Value Assumption
If, as is fairly standard, the English auction has a specified bid incre­
ment, then, in the limit, as the increment becomes infinitesimal, the
English and second-price formats result in the same price and allocation,
or more formally in the same "normal form." Similarly, the Dutch
auction is strategically equivalent to the first-price, sealed-bid auction
since there is a one-to-one mapping between the strategy sets and the
equilibrium of the two games. In both of the latter formats, no relevant
information is revealed in the course of the proceedings, only at the
conclusion of the auction when it is too late for any bidder to act upon
or change a bid. In the first-price format, the bid is relevant only if it is
the highest. Likewise, in the Dutch format, the stopping price or bid is
irrelevant unless it is the highest (the winning bid stops the price descent).
9Risk neutrality is assumed in order to focus on profit-maximizing behavior.
Many of the theoretical results do not hold when risk aversion is introduced.
1° Clearly, any auction needs to ensure the q uality of the bidding participants
(such as their credit risk) to avoid problems li ke adverse selection, whereby the
riskiest bidders always bid the highest prices. The theoretical literature, by
comparison, assumes auction participants are homogeneous.
©International Monetary Fund. Not for Redistribution
494
ROBERT A. FELDMAN and RAJNISH MEHRA
Common-Value Assumption
Under this assumption the equivalence between the English and the
second-price auction does not hold, a although between the Dutch and
first-price auctions it continues to hold. See Milgram and Weber (1982)
and Smith (1987).
What optimal strategies evolve in the course of the competitive bidding
process under the common-value assumption? Take the example of com­
petitive bidding for a construction contract. In this case, the contract is
awarded to the lowest bidder. Assume that bidders are identical except
that their valuations are based on information to which they (differen­
tially) have access. In calculating his or her bid, each player faces a
trade-off between the probability of winning the contract and the ex­
pected profit if he or she does. If all contenders specify their bids by
adding a markup to their estimated costs, the winning bid will have the
lowest estimated project costs and will, on average, be too low. In the case
of auctions for items such as art or mining rights, where the highest bidder
wins, the winning bidder is faced with the realization that his or her
assessment of the item's value exceeded all other bidders' assessments.
That is to say, the highest bidder wins the auction but loses by decreasing
his or her expected profit! This contrary observation is termed the "win­
ner's curse." The best-known study in economic literature of this phe­
nomenon is by Capen, Clapp, and Campbell (1971), who look at the
bidding for offshore mining rights auctioned by the U.S. Government.
One implication of the "winner's curse" is that inexperienced bidders
profit less than expected since such bidders are more likely to place the
highest bid when they have overestimated the value ofthe item. A bidder
would be disconcerted to discover that he or she bad outbid 20 experts!
Experienced bidders are aware of the winner's curse and factor it into
their calculations.
The winner's curse has several implications for optimal bidding strate­
gies. In a first-price auction, for example, the winner by implication can
expect a lower profit when he or she attempts to resell, since competing
bidders display a lower valuation of the object. Being aware of this
possibility, bidders are likely to "shade" their bids below their own
estimates in an effort to move closer toward the market consensus. 12
Other things being equal, as the number of bidders increases, it is prudent
to bid more conservatively, since the range of the distribution of bids, and
11
In an English auction, as noted in Table 1, new information is obtained from
the bidding process, which is not the case with a second-price auction.
12 Because it is advantageous to better anticipate the market consensus, market
participants may be encouraged to devote resources to the competitive assessment
of rival bids and information.
©International Monetary Fund. Not for Redistribution
AUCTIONS
495
thus the highest bid, is likely to expand with the number of bidders. Thus,
the winner's curse is reinforced as the number of bidders increases,
creating a greater shading of bids below their true estimate.
Second, the gap between the highest bid and the "true" value of the
item decreases as the amount of information available about the auc­
tioned item rises. The winner's curse is therefore muted by increasing
information about the value of an auctioned item. With the curse muted,
it is optimal for bidders to be less conservative in their bids, implying that,
as more information is available, bidding will become more aggressive
and the selling price will, on average, be higher.
Milgrom (1987, p. 6) provides a useful summing up: "The most impor­
tant lessons to be learned . . . are that the returns in bidding come from
cost and information advantages, that naive bidding strategies can squan­
der these advantages and that bidders without some advantage have Little
hope of earning much profit, but could with a little bit of carelessness
suffer large losses."
Seller's Perspective
The two assumptions described above also influence and modify seller
behavior.
Private-Value Assumption
Under specific assumptions, the theoretical literature demonstrates
that all four basic types of auctions will yield the same expected price and
revenue to the seller. 13 This central result in auction theory, termed "the
revenue equivalence theorem" (Vickery (1961)), assumes that bidders
display symmetric and independent private values in auctions that are
free of distortions and that have only a single unit sold. The theorem does
not imply that every realization of the game, independent of the auction
type, will yield the same price and revenue, only that the expected price
and revenue are the same. The revenue equivalence theorem does imply,
however, that the specific auction format chosen by the seller in this
stylized theoretical world is not crucial, since each format yields, on
average, the same payoffs to the seller.
A construct termed the "revelation principle" is used to prove a num­
ber of theoretical propositions in auction theory, including the revenue
equivalence theorem. It describes the optimal mechanism from the
13This section is partly based on Chari and Weber (1992).
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496
ROBERT A. FELDMAN and RAJNISH MEHRA
seller's point of view.14 The term "mechanism" in this context acts as a
black box: a process that takes bi:ds as inputs and produces the winning
bidder and the winning price as outputs. Thus, each of the auction forms
can be viewed as a mechanism. In a direct mechanism, each bidder is
simply asked to report his or her personal valuation of the item. A
mechanism is termed "incentive compatible" if the auction is structured
in such a way that it is in the bidder's interest to state honestly his or her
personal valuation of the object-for example, if the proceedings require
each bidder to state a valuation and the object is awarded to the bidder
with the highest valuation. Under the assumption of private value, this
is precisely what occurs in the first-price, sealed-bid auction. Each bidder
is optimizing when he or she submits the bid, and the revelation principle
designs the payoff structure so as to make it optimal to be honest.
Note that the revelation principle is a purely theoretical construct, and
few, if any, resource allocation procedures used in practice are direct
incentive-compatible mechanisms. Its main application is to facilitate the
search for a resource allocation mechanism that is optimal, subject to the
constraints of asymmetric information. 15
Common-Value Assumption
Under the set of common-value assumptions, we see different results
and also move closer to some of the auctioned items with which we are
concerned, such as government securities; in these auctions, assets are
acquired with the intention of profitable resale in secondary markets.
More specifically, it can be shown that the revenue equivalence theorem
does not necessarily hold under the assumption of common values when,
in determining a bid, an individual bidder faces common uncertainties,
such as energy prices, pollution considerations, and changing consumer
tastes, that might impinge on possible resale values. In these circum­
stances, Milgram and Weber (1982) demonstrate that the expected reve­
nue from selling a single object in one of the four auction formats can be
ranked from highest to lowest:
(1) The English, ascending-price auction;
(2) The second-price, sealed-bid auction;
14 The literature distinguishes between direct and indirect mechanisms. The
direct revelation principle states roughly that corresponding to an eq uilibrium
outcome of an in direct mechanism there is a direct mechanism that will generate
the same outcome.
15 A detailed discussion of the optimal auction mechanism when the indepen­
dent private-value assumption is relaxed is beyond the scope of this paper. For
an expanded discussion, see Cremer and McLean (1985a, 1985b). They provide
a method, based on an assumption of correlated values, that involves the use of
a lottery plus participation in a subsequent second-price auction.
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(3) Tied: The Dutch auction and the first-price, sealed-bid auction.
The rankings clearly illustrate the advantage of increased information.
As an English auction proceeds, it reveals information about rival
bidders' valuations and permits a dynamic updating of an individual
bidder's personal valuation. This updating results in more aggressive
bidding, thereby raising the seller's revenue. A first-price (discrimina­
tory) auction awards the object to the highest bidder. Thus, other bidders
place a lower value on the object, reducing the profit that the winning
bidder can hope for in the resale market. In response, bidders in first­
price auctions will tend to shade their bids well below their estimates,
resulting in reduced revenue for the seller. The same reasoning applies
to the strategically equivalent Dutch auction. In the second-price (uni­
form), sealed-bid format, by contrast, the winner pays the bid of the next
highest bidder. Hence, bidders would tend to offer higher bids than in
a first-price auction bid, secure in the knowledge that they will not be
disadvantaged if rival bidders' valuations are much lower.
As we have seen, the theoretical analysis deals with bidders who
demand only one indivisible unit of the commodity being auctioned.
If bidders want more than one unit-as in the government securities
market-and are allowed to submit bids for different quantities at differ­
ent prices, then the above results need not hold. In particular, Maskin
and Riley (1989) show that in the independent and private-value models
the unit-demand assumption (in which each buyer wishes to purchase at
most a single unit) is crucial for revenue equivalence results. The theoret­
ical situation in which this assumption does not hold has not been fully
worked out, but it is conjectured that the economic logic of the arguments
for the single-object environment will carry over. No proposition states,
however, that the revenue rankings given above will hold when the
unit-demand assumption is relaxed. 16 Hence, on purely theoretical
grounds one cannot assert that a particular auction format is superior to
another. Indeed, one cannot overemphasize that the nuances and details
of any particular auction are exceedingly important in deciding which
format to use.
A number of theoretical studies have also suggested that uniform
pricing is revenue superior to discriminatory pricing. 17 The crux of the
16 In a recent paper, Back and Zender (1992) prove formally that if the unit­
demand assumption is relaxed it is possible that discriminatory-price auctions can
yield higher revenues than the uniform-price auction.
17 See, in particular, Milgrom and Weber (1982), who offer a formal proof for
the superiority of second-price over first-price common-value auctions. Reinhart
(1992) provides an excellent discussion of the issues involved in the context of the
U.S. treasury bill market.
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ROBERT A. FELDMAN and
RAJNISH MEHRA
matter is that in using a uniform-price format, the winner's curse is
muted, owing to the linkage of the final auction price to the highest losing
bid. Put simply, the essence of the "linkage principle" is that auctions
yielding the highest payoffs to the seller are those that are most effective
in undermining the benefit to bidders of holding private information, thus
transferring some of the profits from bidder to seller. As Milgram (1987,
p. 4) puts it, "privacy is undermined by linking price to information other
than (but correlated with) the winning bidder's private information."
In any auction format, the seller can influence bids, and hence the final
payoffs, by revealing information about the auctioned object. Intuitively,
an individual bidder's expected profit is highest when he or she can
exploit information asymmetries-that is, when the bidder has access to
useful information about the object's "equilibrium" value that is not held
by other auction participants. In general, more accurate information
about the item's "equilibrium" value mitigates the effect of the winner's
curse, and hence the price-dampening effect of bidder caution. 18 Thus,
the seller's optimal strategy is to reveal all available information and to
link the price to exogenous indicators of value. If a seller adopts a policy
of revealing information, the price becomes linked to the seller's informa­
tion; this undermines the winner's surplus value, siphoning off some
portion to the seller. 19
Efficiency Considerations
The theoretical literature on auctions puts less emphasis on economic
efficiency than on other aspects of the various auction formats, such as
their revenue-generating potential. Nevertheless, it is extremely impor­
tant to underscore the efficiency of auctions.20 Available evidence indi­
cates that auctions, in the absence of distortions, function efficiently­
that is, they ensure that resources accrue to those that value them most
highly (and where they will be most productive) and that sellers achieve
the maximum value for the auctioned item. It can be shown on theoretical
18
Gilley and Karels (1981), in a study of bidding in oil-rights auctions, find that
the smaller the variance in the initial estimates of a tract's value, the higher the
bids. With high investments at stake, oil firms evidently recognize and avoid the
winner's curse.
19 As Milgrom points out, the linkage principle implies that sellers should use
royalties when auctioning mineral or publication rights, thus linking the price paid
to actual value, and, on average, increasing the seller's profit
20 See Holmstrom and Myerson (1983) for a discussion of efficiency in
games with incomplete information. They propose ex ante, interim, and ex
post efficiencies.
.
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grounds that there exists an equilibrium, arising from the competitively
submitted bids, in which the auctioned item is allocated endogenously in
an efficient way when the price of the item is unknown. Empirical
evidence also suggests that, in the absence of distortionary factors, auc­
tions function efficiently.21 In addition, the auction mechanism can
achieve this objective more effectively than alternative trade arrange­
ments, such as price setting by the seller or negotiation between buyer
and seller.
Of the four auction formats, the English and second-price settings
result in an efficient or Pareto-optimal allocation in the case of private­
value auctions.22 Complications arise in the case of the first-price, sealed­
bid auction and the Dutch (descending-price) auction. In the most
commonly analyzed case of "symmetric" environments-where bidders
are identical, draw their information from the same distribution, and
cannot differentiate among their competitors-these auction formats are
efficient. In general, however, with first-price, sealed-bid and Dutch
formats, it is not optimal to bid one's reservation price, a condition that
results in bid shading and consequently an inefficient allocation.ll
In the case of common values, efficiency also requires the assumption
that all bidders base their strategies on information drawn from the same
distribution, as opposed to asymmetric information. Under the more
realistic assumption that different bidders have private information, the
analysis is not so straightforward. In particular, Maskin (1992) distin­
guishes between two cases: (a) where private information can be modeled
as a scalar (that is, as a single item of information); and (b) where the
bidders' private information can be represented by a vector (that is, by
multiple units of information). In the former case, under fairly general
conditions, the English auction is efficient but the uniform-price (second­
price, sealed-bid) format is efficient only if there are two bidders. In this
case, the first-price and the Dutch auctions will typically not be efficient
except in highly restrictive cases. In the second case, when bidders have
several items of private information, efficiency is unattainable in any
auction format. It can be shown, however, that when the informational
asymmetry among bidders is not too great, the English and second-price
auctions function better than alternative formats. 24
To summarize the evidence on efficiency, the auction of choice would
hf! the English auction followed closely by the second-price, sealed-bid
21
Smith (1987).
22 See
In both these formats, bidders bid their reservation price since, in both cases,
this is the dominant strategy to pursue; thus, both formats are efficient.
23 See Milgram (1987) for an illustrative examp le.
24
See, in particular, Section 4b of Maskin ( 19 9 2).
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ROBERT A. FELDMAN and RAJNISH MEHRA
auction. The two formats are identical only in the case where there are
two bidders.
Collusion
The extent to which incentives to collude vary under different auction
formats can be of great practical concern in deciding on which type of
auction to use. Indeed, the indictment in the United States of a primary
securities dealer in 1991 for fraudulent activities in the government secu­
rities market has focused attention on the collusive potential of standard
auction formats. These concerns are briefly dealt with below. It is im­
portant to keep in mind that all auctions are susceptible to collusive
behavior-what we review here is the comparative incentive for collusion
under different auction formats.
A basic hypothesis, first formulated in the literature by Mead (1987),
is that ascending-bid formats are more susceptible to collusion than
sealed-bid auctions. This belief may explain the popularity of sealed
bidding, even though the ascending-bid format has superior revenue­
generating potential. Intuitively, auction formats where covert "side
deals" are possible are more likely to support bidder manipulation. Thus,
an open-bid English auction is particularly vulnerable to manipulation,
since a subset of bidders (a "ring") must simply agree not to outbid each
other to effectively lower the winning bid. The item can then be re­
auctioned among the ring members, and the profits shared. The open
format inculcates adherence to the agreement since any ring member
attempting to exploit the ring by a side deal of his or her own would,
effectively, negate the ring and restore the auction to a competitive
footing. The open format ensures that compliance among ring members
is easily monitored. It should be noted, however, that the problems with
collusion under the English format should diminish as either the actual
number of bidders or the potential number of bidders increases. Intu­
itively, for a ring to be successful it must have a significant proportion of
the total number of bidders under its control. To achieve this result, it
is advantageous to have no new bidders entering the auction. Further,
with a higher number of actual bidders, it becomes more difficult to
control a significant proportion of them, and more than one ring can form
and try to outbid the others.
Sealed-bid auctions, by comparison, are vulnerable to collusion that
involves the auctioneer-that is, between the auctioneer and one or more
bidders, or between the auctioneer and the seller.25 This format is,
25This vulnerability reflects the fact that fraudulent activity by the auctioneer
is easier to hide when bids are sealed than when they are open.
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501
however, less prone to rings, since sealed bidding tempts the participants
in any conspiracy to bid just above the agreed-on price, effectively
dissolving the cartel. This result also holds true for the Dutch format.
even though it is an open, instead of sealed-bid, auction, since the first
bidder to defect from the ring ends the auction. As Smith (1987. p. 52)
points out, the Dutch auction is perhaps most effective against collusion:
"In this auction, since none of the losing bids is known to anyone. they
cannot even be leaked let alone announced and conspiracy is therefore
infeasible.'· Milgram (1987, p. 27) succinctly states that "collusion is
hardest to support when secret price concessions are possible. and eastest
.
to support when all price offers must be made publicly . .
Theoretically at least, the four formats can be ranked from most prone
to collusion to least prone:
(1)
(2)
(3)
(4)
English auction;
Uniform second-price auction�
Discriminatory first-price auction;
Dutch auction.
The English auction is potentially the most susceptible to collusion
because there is no incentive to betray the ring-more aggressive bidding
does not win the item-and such attempts are highly visible to the other
members of the ring. On the other hand . the Dutch. descending-price.
auction is potentially the least susceptible to collusion because of the
difficulties that ring members would have supporting and enforcing col­
lusive behavior. Once a ring member bids more aggresshely than '"•"
agreed, his or her actions are not only obvious but the auction ts won
before the others can react.
III.
Applications
This section discusses three applications of the various mechant"m"
for auctioning different items. taking in turn the auction of go,·ernmcnt
securities, refinance credit. and foreign exchange. At the outset ot thl"
section, it should be emphasized that there is no unambiguou., an"''W tn
the question of which is the "best" auction technique to u<.e. This con­
clusion reflects the difficulties of applying the theoretical literature to
real world settings as well as the importance of individual countn·
circumstances.
Government Securities
There is considerable controversy over the type!> of auction� that arl;!
most suitable for selling government securities. As \\'C have "�en the
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ROBERT A. FELDMAN and RAJNISH MEHRA
theoretical analysis deals with bidders who demand only one indivisi­
ble unit of the commodity being auctioned. However, frequently in the
case of auctioning government securities, bidders may submit bids for
multiple units of the security, and they may also be permitted to submit
multiple bids-in effect, demanding differing quantities and prices at the
same auction. In such circumstances, theoretical models can offer only
limited insight, and care must be taken in applying theoretical results to
real world settings.
Consider first the U.S. government securities market. The weekly
auction of treasury securities by the U.S. Government is structured
differently from the simpler theoretical formats discussed earlier and
offers an excellent example of the gap between stylized models and real
world settings. In addition, this market has been subject to much recent
analysis and proposed changes; accordingly, the details of the market are
readily available.
The U.S. Treasury's offering of some two and a half trillion dollars
in new debt annually is auctioned in a multiple-price, sealed-bid auction
with active, open trading both preceding and following each event.
Thirteen- and 26-week maturities are auctioned weekly; longer matu­
rities are offered several times a year. The Department of the Treasury
publicly announces the amount of debt securities it is offering, which are
traded in an active "when-issued" market. This market is essentially a
forward market for the securities, in which the actual issue date is the
delivery date for the forward contract. This "forward market" serves two
important functions: allocative and evaluative. In the latter, it provides
insight into the participant's common-value beliefs about the securities'
marketability.
At present, there are 39 bidders-"primary dealers"-who can partic­
ipate in the U.S. Treasury auction. They submit sealed bids specifying a
price and the number of securities they are willing to purchase at that
price. These are referred to as "competitive bids" and approved dealers
can submit them in several price-quantity combinations. In addition, the
proceedings are open to the general public and individual investors
through the submission of "noncompetitive" bids that specify a quantity
sought, up to a fairly conservative maximum, determined by the Treas­
ury. The price paid by these noncompetitive bidders is a quantity­
weighted average of the winning competitive bids. To the highest com­
petitive bidder, the Treasury awards the amount specified at the stated
price; the next highest bidder is awarded the amount demanded at his or
her stated price; and so on until the supply is allocated. Winning bidders
thus pay their bid, and all of them may pay different prices. The securities
are delivered within a few days and may be resold in active secondary
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markets. Recently, starting in September 1992, the Treasury began
selling two- and five-year bonds using a uniform-price auction on an
experimental basis.
In addition to the forward market, there is a "repurchase and reverse"
market in treasury securities, in which short-term borrowing and lending
are collaterized by these instruments. One can borrow funds overnight
by selling securities with an agreement to repurchase them the next day
at a predetermined price, with the difference between the buying and the
selling price being the return earned.
The potential for profit in Treasury auctions lies at the intersection of
the three trading forums-the auction itself, the forward market, and the
repurchase and reverse market. Sealed bidding combined with multiple
prices creates the potential for any determined bidder to corner the
postauction market. Well-informed and deep-pocketed groups can, by
submitting deliberately high-valued bids, receive the bulk of awarded
securities. Unsuccessful bidders who have taken a position in the "when­
issued," or forward, market are caught in a "short squeeze," where they
are forced either to pay heavily to close their positions or to purchase
securities at a premium in the repurchase market to honor their commit­
ments. Under current Treasury auction procedures, the winner's curse
places a premium on information regarding competitive bids (an impor­
tant outcome of the "when-issued" market), creating the basis for a bid
that will corner the primary auction and squeeze the postauction market.
Having described how the market works, we look at the arguments in
favor of switching to a uniform second-price auction. One main argument
rests on the belief that it will probably increase the revenue to the
Treasury because, following the theoretical section, the new format
would mute the "winner's curse," leading to more aggressive bidding.
The magnitude of this increase may, however, be small in the United
States. 26 In any case, it is not clear that revenue maximization is an
appropriate goal for the U.S. Treasury. Economic efficiency seems to be
more appropriate.
Another often cited advantage of uniform auctions is that they increase
participation, and hence competition, since the winner's curse is muted.
It can, however, be argued that the number of bidders (n) participating
in a Treasury auction is endogenously determined. The potential number
of competitive bidders includes the primary dealers (39) and all deposi­
tory institutions (a couple of thousands). There is nothing to prevent the
(n + l)th bidder from entering. Clearly, the intramarginal investor does
not think it profitable to bid. It is possible that this is related to the costs
26
See Vogel (1993).
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ROBERT A. FELDMAN and RAJNISH MEHRA
of "certification" and of establishing "creditworthiness." These costs are
unlikely to change if one changes auction formats. Hence, we would not
expect any significant increase in the number of competitive bidders if the
Treasury moved to a uniform-price auction. 27 The recent experiences in
Mexico, when it moved to a uniform-price auction from a discriminatory
auction, and in Italy, when it moved from a uniform to a discrimina­
tory auction, bear this out. The number of primary dealers in either
country has not changed significantly.
A third advantage of a uniform-price auction is that it reduces socially
suboptimal information gathering. The incentive to collect information
diminishes in a uniform auction. Since gathering this information only
redistributes wealth among bidders, it adds nothing to society as a whole.
This, we believe, is a strong argument in favor of a uniform auction:
it promotes economic efficiency. A final consideration is that it may be
easier to implement.
Hence, any policy recommendation must be country specific. If a fairly
active (competitive) market exists, a uniform-price auction would seem
appropriate, since collusion is minimized and there could be some gain
to society from less information acquisition. Revenues to the government
may also increase.28
If the market in a particular country is thin and subject to collusion,
a discriminatory auction would seem more appropriate. The benefits
would exceed the deadweight loss implied by excessive information
gathering. In an immature market, information collecting encouraged by
the discriminatory format may be useful in the initial stages of market
development. Nevertheless, if concerns about collusion are minimal, a
later shift to a uniform format would be desirable. Needless to say, we
would recommend measures to increase participation to make the market
more competitive and safeguard against monopoly positions. These mea­
sures might include lowering barriers to entry and increasing the number
of participants.
In some situations, English auctions might also be chosen, particularly
in situations where it is possible to run a centralized, open auction (as in
27 Bear in mind, however, that even if the number of bidders were not to
increase, there may still be more ag�ressive bidding.
It should also be noted that discnminatory pricing provides real incentives,
because of the winner's curse, to know the market consensus, and may therefore
create a concentration of information among more experienced auction partici­
pants, with less specialized bidders deferring to those holding information. In
such a situation, primary dealers have some information advantage reflecting the
added information on the distribution of bids from their customers. When infor­
mation becomes overly concentrated, there is the possibility of collusion and
market manipulation. Uniform auctions would help mitigate this concern.
28
As noted earlier, such increases may be small in the case of the United States.
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a small country where all direct auction participants could meet in one
location, as, for example, with the foreign exchange auction in Roma­
nia).29 In such a situation, a Dutch auction may also constitute a feasible
and desirable option.
Refinance Credit
Another situation in which auction techniques can be usefully applied
is in the allocation of refinance credit. In general terms, refinance credit
represents direct lending by a central bank, usually to the financial sector
but sometimes directly to ultimate users. Lending to the financial sec­
tor can be for the specific purpose of implementing monetary policy-for
example, by providing liquidity to commercial banks to meet specified
monetary targets. It can also represent "targeted" lending-for example,
in some developing countries to support investment and economic devel­
opment in key sectors-in which the central bank provides funds to the
financial sector for on-lending to targeted activities. When collateral
(such as government securities) is required to obtain refinance credit,
such credit is more likely to be called a repurchase agreement. 30 In this
case, instead of extending a simple credit, the transaction entails an
agreement that the borrower sell to the central bank a given security
and later buy it back at the maturity date specified in the repurchase
agreement. Alternatively, "refinance" facilities are also referred to as
"rediscount" facilities when lending takes place against securities. 31
A main issue that arises with refinance credit is how to allocate it. One
nonprice, less market-oriented approach has been to set the price of
refinance credit at a given interest rate and provide the credit on a
first-come, first-serve basis up to some quantity limit. Some countries
allocate refinance credit entirely on an administrative basis, directing
such credit and setting its price. Frequently, when such lending is at
administered rates, a substantial subsidy js involved because the adrnin29This alternative has been proposed recently by Reinhart (1992) for the U.S.
government securities market. However, the approach is different from what is
being discussed here because the institutional setting does not rely on the auction
physically taking place at one location but rather in a computer-based setting.
The development of such a computer-based setting may be many years off in the
United States because of the current state of technology, and may therefore be
im�ractical for less technologically advanced countries.
A similar transaction, but one that involves commercial bank lending to
the central bank, and therefore a drain of liquidity, is a reverse repurchase
agreement.
31 Some might say that "rediscount" is a misnomer in this case, as the term may
refer only to buying a security and holding it until maturity.
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ROBERT A. FELDMAN and RAJNISH MEHRA
istered rate is low compared with market-based interest rates. Opera­
tionally, in these cases, commercial banks have recourse (sometimes
automatically) to the refinance facility at the central bank at below
market-related interest rates for loans to specified sectors. Direct con­
trols are sometimes used, instead of the first-come, first-serve approach,
to achieve the desired distribution of credit and deal with the excess de­
mand that would arise. In any event, the types of transactions described
above can create significant distortions in the financial system.
Auction techniques may be viewed as a mechanism to allocate refi­
nance credit. 32 They have the advantage of tying the refinance rate to
market conditions and of improving efficiency. A potential added benefit
is that auctions may improve transparency while lessening discretion in
the allocation of credit. Although a topic outside the realm of this paper,
it should be noted that to the extent that refinance credit is directed
toward development objectives-for example, by providing subsidized
credit to key sectors of the economy-such policy actions might more
appropriately be handled as a fiscal matter, with subsidies being budgeted
directly instead of implemented through interest rate policy. Otherwise,
the central bank may be carrying quasi-fiscal operations on its balance
sheet, potentially generating central bank losses and complicating mon­
etary policy, as well as disguising the underlying fiscal position. In any
event, whether the lending takes place through the fiscal authority or the
central bank, auction techniques would be useful.33
The discussion of auction techniques in the context of auctioning
government securities is largely applicable to refinance credit. Thus,
much of the analysis presented earlier on government securities is rele­
vant here, although an important qualification deserves emphasis. Auc­
tioning refinance credit may differ in that payment to the seller of the
auctioned item may not be required upfront as is the case with govern­
ment securities. Instead, payment is effectively made when the refinance
credit matures, thus subjecting the seller to the risk of nonpayment in the
interim. Collateral requirements would reduce this risk, as would an
appropriate evaluation of the creditworthiness of the auction participants
and associated certification. A concern is to avoid the problems of ad­
verse selection: allocating credit by price alone may create a situation
where borrowers with the poorest credit risk always place the highest
bids. Such a situation might arise, for example, when demanders of
32The former Czechoslovakia, Indonesia, Romania, and Tunisia are examples
of countries that use an auction approach.
33The World Bank and the Inter-American Development Bank have begun to
allow some of their on-lent funds to be auctioned. See, for example, Guasch and
Glaessner (1992b) for the case of Chile.
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refinance credit have strong incentives to seek credit at higher prices
because they themselves hold "nonperforming" assets in their portfolios
and are ready to go under. 34
Foreign Exchange
Countries adopting market-related arrangements for their exchange
rate have been confronted with two basic choices: operating an interbank
type of market within the private sector, which may, in addition to
commercial banks, include other licensed foreign exchange dealers; or an
auction system, whereby foreign exchange is surrendered to the central
bank for auction to the highest bidders. 35
As noted earlier, under the auction system countries have used differ­
ent techniques, which basically divide into discriminatory-pricing (in­
cluding Dutch auctions) and uniform-pricing approaches. A possible
difficulty with discriminatory pricing is that it may discourage potential
participants from entering the market or impede more aggressive bidding
because of the winner's curse. 36 Other difficulties, using this format, con­
cern the appropriate exchange rate to be used for transactions outside the
auction (such as for: government transactions and customs purposes).37
Uniform pricing would deal with some of these difficulties and more
closely match how private foreign exchange markets work. In any event,
based on country experience, the interbank approach has gained compar­
ative favor because it involves less government control over the availabil­
ity of foreign exchange to the private sector than is implied by auctions,
which rely on the government specifying the quantity available, at times
meeting its own needs first.
The double auction is less restrictive in terms of limiting the supply of
foreign exchange, as it brings in the private sector on both the supply and
demand sides. This technique is implicit in an interbank market when
brokers match the supply and demand orders that they receive. A main
difference is that rather than being a continuous market, as with an inter­
bank market, a double auction is run at discrete points in time-like a
fixing session. Such an approach may be appropriate when a country has
34 Guasch and Glaessner (1992a) discuss institutional approaches to dealing
with adverse selection.
35 Quirk and others (1987) reviews the experience with these two arrangements
up to January 1987.
36Some countries have argued that this result can be advantageous in deterring
speculators or at least in ensuring that they pay the full price for their bids. See
Quirk and others (1987, p. 12).
37 See Quirk and others (1987).
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ROBERT A. FELDMAN and RAJNISH MEHRA
insufficient institutional capacity or experience to operate an interbank
market, but some of the flexibility of the interbank approach is desirable.
IV.
Summary and Conclusions
Auctions play a useful role in price discovery and resource allocation
and are routinely used in market economies. This paper has focused on
three applications of auction techniques, namely, auctioning government
securities, refinance credit, and foreign exchange. In assessing the pros
and cons of different auction formats, our starting point was to survey the
theoretical literature. We described how auctions offer the advantage of
simplicity in determining market-based prices where markets may be thin
or nonexistent and in allocating the auctioned items efficiently. The
appropriate choice of an auction format is less clear-cut. This ambiguity
stems from the difficulties of applying theoretical results to real world
settings and from the importance of individual country circumstances.
Based on our earlier discussion, we conclude that there are no unam­
biguous answers to the question of which is the "best" auction technique
to use.
We attempt to provide broad guidelines to appropriate auction formats
in different circumstances. Our survey indicates that uniform second­
price auctions, because of their administrative simplicity, economic
efficiency, and revenue-enhancing potential, are perhaps the most
widely applicable format. The ascending-price, English auction may be
preferred in auctioning government securities or refinance credit. How­
ever, unless individual country circumstances provide for a bidding forum
conducive to the open-outcry format, this mechanism is technically in­
feasible. In addition, the English auction is, potentially, the most
prone to collusive agreements and should be avoided if prevailing insti­
tutional arrangements are conducive to "side deals. "38 We emphasize
that, independent of the chosen format, auctions should be conducted
competitively, with stringent safeguards against monopoly positions.
Some of the arguments need to be qualified in the case of foreign
exchange auctions, in part because auctions may not be desirable in the
first place. In using any of the four basic formats, the government retains
a great deal of discretion in determining the amount of foreign exchange
to be auctioned. This discretion can be disadvantageous at a time when
the thrust of the reform effort is to develop the private sector. Double
38In recommending the English, ascending-price format for auctioning U.S.
Treasury securities, Reinhart {1992) argues that collusion is not a problem.
©International Monetary Fund. Not for Redistribution
AUCfiONS
509
auctions offer a favorable alternative, as the government participates on
the same bas�s as the private sector. Nevertheless, the end goal is to
encourage foreign exchange trading among participants of double auc­
tions, and other participants in the economy, not only at the time of the
auction but on a more continual basis. Thus, while auctions, especially
double auctions, may be a useful intermediate step, development of an
interbank market should ultimately be pursued under a floating-rate
system.
In closing, we emphasize that there is a wide range of potential appli­
cations for auctions, both in terms of the specific items to be auctioned
and across country groupings. In this regard, auctions can have an impor­
tant role to play in the emerging market economies of the former Soviet
Union and elsewhere. At present and to varying degrees, the institutional
structures in these countries may not be conducive to free-market eco­
nomic arrangements, and the advantages accruing from the use of auction
techniques could be productively exploited. Indeed, auctions can play a
pivotal role in acclimating economic agents to decisionmaking in a world
of market-determined, changing prices and in efficiently allocating re­
sources in the absence of alternative market mechanisms. More gen­
erally, the usefulness of auction mechanisms as a way to guide price
determination and resource allocation applies to developing as well as
industrial countries. Among the potential applications of auction tech­
niques-in addition to those already discussed-are the privatization of
state assets and the auctioning of quotas or trade licenses.
As stressed earlier, the choice of an appropriate auction format de­
pends crucially on the specific item being auctioned and on the institu­
tional arrangements prevailing in the country choosing between different
auction techniques.
REFERENCES
-Back, Kerry, and Jaime Zender, "Auctions of Divisible Goods," Working Paper
(St. Louis: Washington University, 1992).
Bikhchandani, Sushil, and Chi-Fu Huang, "The Economics of Treasury Securi­
ties Markets," Sloan School of Management Working Paper (Cambridge,
Mass.: Massachusetts Institute of Technology, 1992).
Capen, E.C., R.B. Clapp, and W.M. Campbell, "Competitive Bidding in High
Risk Situations," Journal of Petroleum Technology, Vol 23 (June 1971),
pp. 641-53.
Chari, V.V., and Robert J. Weber, "How the U.S. Treasury Should Auction Its
Debt," Federal Reserve Bank of Minneapolis, Quarterly Review (Fall 1992),
pp. 3-12.
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©International Monetary Fund. Not for Redistribution
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ROBERT A. FELDMAN and RAJNJSH MEHRA
Cremer, Jacques, and Richard P. McLean {1985a), "Full Extraction of the
Surplus in Bayesian and Dominant Strategy Auctions," CARESS Working
Paper No. 85-17 (Philadelphia: University of Pennsylvania, 1985).
(1985b), "Optimal Selling Strategies Under Uncertainty for a Discrimi­
nating Monopolist When Demands Are Independent," Econometrica , Vol.
53 (March 1985), pp. 345-61.
Easley, David, and John Ledyard, "A Theory of Price Formation and Exchange
in Oral Auctions," Technical Report No. 461 (Evanston, 111.: Northwestern
University, 1982).
Friedman, Daniel, "On the Efficiency of Experimental Double Auction Mar­
kets," American Economic Review, Vol. 74 (March 1984), pp. 60-72.
Gilley, Otis, W., and Gordon V. Karels, "The Competitive Effect in Bonus
Bidding: New Evidence," Bell Journal of Economics, Vol. 12 (Autumn
1981), pp. 637-48.
Graham, Daniel, and Robert Marshall, "Collusive Bidder Behavior at Single­
Object Second-Price and English Auctions," Journal of Political Economy ,
Vol. 95 (December 1987), pp. 1217-39.
Guasch, J. Luis, and Thomas Glaessner (1992a), "Auctioning Credit," World
Bank Working Paper, Report No. 15 (Washington: World Bank, 1992).
-- (1992b), "Auctioning Credit: The Case of Chile," World Bank Working
Paper, Report No. 15 (Washington: World Bank, 1992).
Hernandez, Jaime Arias, "Nueva Subasta de Tasas Multiples de Cetes," Excel­
sior, January 21, 1993.
Holmstrom, B., and R.B. Myerson, "Efficient and Durable Decision Rules with
Incomplete Information," Econometrica, Vol. 51 (1983), pp. 1799-1819.
Joint Report on the Government Securities Markel (Washington: U.S. Depart­
ment of Treasury, Securities and Exchange Commission, and the Board of
Governors of the Federal Reserve System, 1992).
Laffont, Jean-Jacques, and Eric Maskin, "Optimal Reservation Price in the
Vickrey Auction," Economic Letters, Vol. 6 (1980), pp. 309-13.
Maskio, Eric, "Auctions and Privatization," in Privatization Symposium in
Honor of Herbert Giersch, ed. by Horst Siebert (Kiel: lnstitut fur Weltwirt­
schaft an de.r Universitat Kiel, 1992)
Maskin, Eric, and John Riley, "Optimal Multi-Unit Auctions," in The Econom­
ics of Missing Markets and Information , ed. by F. Hahn (Oxford: Oxford
University Press, 1989).
McAfee, R. Preston, and John McMillan, "Auctions and Bidding," Journal of
Economic Literature, Vol. 25 (June 1987), pp. 699-738.
Mead, Walter J., "Natural Resource Disposal Policy: Oral Auction Versus Sealed
Bids," Natural Resources Journal, Vol. 7 (April 1987), pp. 195-224.
Milgrom, Paul, "Auction Theory," in Advances in Economic Theory , 1985: Fifth
World Congress , ed. by Truman Bewley (London: Cambridge University
Press, 1987).
Milgram, Paul, and Robert Weber, "A Theory of Auctions and Competitive
Bidding," Econometrica, Vol. 50 (November 1982), pp. 1089-1122.
--
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Quirk, Peter J., and others, Floating Exchange Rate in Developing Countries:
Experience with Auction and Interbank Markets, Occasional Paper No. 53
(Washington: International Monetary Fund, 1987).
Rasmusen, Eric, Games and Information (Oxford: Basil Blackwell, 1990).
Reinhart, Vincent, "An Analysis of Potential Treasury Auction Techniques,"
Federal Reserve Bulletin (June 1992), pp. 403-13.
Robinson, Marc S., "Collusion and the Choice of Auction," Rand Joumal of
Economics, Vol. 16 (Spring 1985), pp. 141-45.
Satith, Vernon, "Auction Theory," in The New Palgrave: A Dictionary of Eco­
nomic Theory and Doctrine, ed. by J. Eatwell, J.M. Milgate, and P. Newman
(London: Macmillan, 1987).
Umlauf, Steven R., "An Empirical Study of the Mexican T-Bill Auction,"
London Business School Working Paper (London: London Business School,
1991).
Vickery, William, "Counterspeculation, Auctions, and Competitive Sealed
Tenders," Journal of Finance, Vol. 16 (March 1961), pp. 8-37.
Vogel, Thomas T., Jr., "Dutch Auctions Appear to Be MixedBlessing for U.S.,"
Wall Street Journal, January 4, 1993, p. C l .
Wilson, Robert, "Auctions of Shares," Quarterly Journal of Economics , Vol. 93
(November 1979), pp. 675-90.
---, "Double Auctions," in Information, Incentives, and Econometric Mech­
anisms: Essays in Honor of Leonid Hurwicz, ed. by T. Groves, R. Radner,
and S. Reiter (Minneapolis: University of Minnesota Press, 1986).
©International Monetary Fund. Not for Redistribution
IMF StaffPapers
Vol. 40, No. 3 (September 1993)
@ 1993 International Monetary Fund
Testing the Neoclassical Theory
of Economic Growth
A Panel Data Approach
MALCOLM KNIGHT, NORMAN LOAYZA, and DELANO VILLANUEVA*
Recent empirical studies have examined the determinants of economic
growth using country-average (cross-sectional) data. By contrast, this
paper employs a technique for using a panel of cross-sectional and time
series data for 98 countries over the 1960-85 period to determine the
quantitative importance for economic growth ofboth country-specific and
time-varying factors such as human capital, public investment, and out­
ward-oriented trade policies. The empirical results support the view that
thesefactors exert apositive and significant influence on growth. They also
provide estimates ofthe speed at which the gap between the real per capita
incomes of rich and poor countries is likely to be reduced over the longer
term. [JEL 041, C23]
HE neoclassical model of Solow (1956) and Swan (1956) has
Tbeen the workhorse of economic growth theorists for the past three
BASIC
and a half decades. Its simple assumptions and structure-a single
homogenous good, a well-behaved neoclassical production function, ex­
ogenous labor-augmenting technical progress, full employment, and
* Malcolm Knight, Senior Adviser in the Middle Eastern Department, holds
a doctorate from the London School of Economics and Political Science.
Norman Loayza, a doctoral student at Harvard University, was a Summer
Intern in the Developing Country Studies Division when this study was prepared.
Delano Villanueva, Assistant to the Director, Middle Eastern Department,
received his Ph.D. from the University of Wisconsin.
The authors wish to thank Professors Zvi Griliches and Gary Chamberlain for
helpful advice on the econometric methodology, J ong-Wha Lee for providing the
data on tariffs, Jose De Gregorio, Graham Hacche, Manmohan Kumar, and Julio
Santaella for valuable comments, and Ravina Malkani for excellent research
assistance.
512
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NEOCLASSICAL THEORY OF ECONOMIC GROWTH
513
exogenous labor force growth-provide an elegant solution to the "knife­
edge" problem posed by Harrod (1939) and Domar (1946) and ensure
the attainment of a balanced equilibrium growth path (Hacche (1979)).
The Solow-Swan growth model predicts that in steady-state equi­
librium the level of per capita income will be determined by the prevailing
technology, as embodied in the production function, and by the rates of
saving, population growth, and technical progress, all three of which are
assumed exogenous. Since these rates differ across countries, the Solow­
Swan model yields testable predictions about how differing saving rates
and population growth rates, for example, might affect different coun­
tries' steady-state levels of per capita income: other things being equal,
countries that have higher saving rates tend to have higher levels of per
capita income, and countries with higher population growth rates tend
to have lower levels of per capita income.
Recently, the Solow-Swan model has come under attack by the new
growth theorists, who dismiss it in favor of "endogenous growth" models
that assume constant or increasing returns to capital. These critics allege
that the standard neoclassical model fails to explain observed differences
in per capita income across countries. The different implications of the
two growth models have led to renewed empirical work in recent years.
A major concern of this work has been whether one should see a long-run
tendency toward convergence of per capita income levels across coun­
tries. "Unconditional convergence" imp[jes that in a cross-country sam­
ple the simple correlation between the growth rate of real per capita GDP
and the initial level of real per capita GDP is negative. In other words,
the lower the starting level of real per capita income, the higher is its
subsequent rate of growth. In a recent cross-section study, however,
Barro and Sala-i-Martin (1992) find that this simple correlation is positive
rather than negative, albeit statistically insignificant.
In itself, the empirical evidence against unconditional convergence is
not inconsistent with the implications of the neoclassical growth model.
The Solow-Swan model does not predict unconditional convergence of
per capita income across countries; rather, it predicts convergence only
after controlling for the determinants of the steady state (that is, it
predicts "conditional convergence"). Recent work by Mankiw, Romer,
and Wei! (1992) contends, using a cross-sectional approach, that the
Solow-Swan model's predictions are indeed consistent with the empirical
evidence. They also find, however, that if human capital is not accounted
for in the model the quantitative implications of different saving and
population growth rates are biased upward (in absolute value), since
human capital is positively correlated with both saving and population
growth.
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KNIGHT, LOAYZA.
and VILLANUEVA
Accordingly, in an effort to understand the quantitative relationships
among saving, population growth, and income, Mankiw, Romer, and
Weil augment the Solow-Swan model to include human capital accumu­
lation. They find that this variable is indeed correlated positively with
saving and population growth. Relative to estimates based on the text­
book model, this augmented Solow-Swan model implies smaller effects
of saving and population growth on per capita income growth and ex­
plains about 80 percent of the cross-country variation in per capita
income.
Despite the evidence on the failure of per capita income to converge
across countries-the failure of the "unconditional convergence" hy­
pothesis-Mankiw, Romer, and Weil find evidence of conditional con­
vergence at about the rate predicted by the Solow-Swan model once
cross-country differences in saving and population growth rates are taken
into account. Moreover, they interpret the available evidence on cross­
country variations in the rates of return to capital as being consistent with
the Solow-Swan growth model. Thus, their work provides empirical
support for the model and casts doubt on the new endogenous growth
models that invoke constant or increasing returns to capital.
This paper extends the Mankiw, Romer, and Wei! analysis in two
directions. First, a panel of time series cross-sectional data is used to
determine the significance of country-specific effects that are assumed
away in the cross-sectional approach employed by Barra and Sala-i­
Martin (1992) and Mankiw, Romer, and Wei! (1992), as well as nearly
all other studies. In order to exploit the additional information contained
in these panel data, we extend the econometric analysis by applying an
estimation procedure outlined in Chamberlain (1984). Second, we as­
sume that labor-augmenting technical change is influenced by two poten­
tially important factors: (1) the extent to which a country's trade policies
are outward-oriented-whether they increase or decrease its openness to
international trade (see Edwards (1992)); and (2) the stock of public
infrastructure in the domestic economy.
As already noted, our first extension of the Mankiw, Romer, and Wei!
analysis refers to the econometric treatment of the data. In the empirical
part of their paper, they use cross-sectional data for various groups of
countries. Essentially, they take averages of the relevant variables over
the whole period, 1960-85. Since only one cross-section of countries is
used for the entire time period, they are obliged to make some restrictive
assumptions about the nature of the shift parameter (technology) in the
neoclassical production function and its relation to other variables.
Specifically, all unobservable factors that characterize each economy
(and are contained in the shift parameter) are assumed to be uncorrelated
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NEOCLASSICAL THEORY OF ECONOMIC GROWTH
515
with the available information. Econometrically, this means that "coun­
try-specific" effects are ruled out by assumption. Our procedure, on the
other hand, allows for a more general econometric specification of the
model by appropriately using panel data to account for important coun­
try-specific effects. Tbis approach yields a number of interesting exten­
sions to the empirical results of Mankiw, Romer, and Weil, particularly
when the estimates for the full sample of both industrial and developing
countries are compared with those for developing countries only.1
Provided the assumptions required for using the panel data hold, our
approach also improves the efficiency of the estimates by using more
information.2
Our second, related, extension of Mankiw, Romer, and Weil's empir­
ical analysis refers to the country-specific variables-trade policies, hu­
man capital, and government fixed investment-that we include in the
model. Policies that foster more openness in a country's international
trade regime help to stimulate labor-augmenting technological change in
two ways. 3 First, the import-export sector serves as a vehicle for technol­
ogy transfer through the importation of technologically advanced capital
goods, as elucidated by Bardhan and Lewis ( 1 970), Chen ( 1979), and
Khang (1987), and as a channel for intersectoral external economies
through the development of efficient and internationally competitive
management, the training of skilled workers, and the spillover conse­
quences of scale expansion (Keesing (1967) and Feder (1983)). Second,
rising exports help to relieve the foreign exchange constraint-that is, a
country's ability to import technologically superior capital goods is aug­
mented directly by rising export receipts and indirectly by the higher
flows of foreign credits and direct investment caused by the country's
increased ability to service debt and equity held by foreigners.4
As regards government fixed investment, it is reasonable to assume
that an expansion in the amount of public goods concentrated in physical
infrastructure (such as transport and telecommunications) will be associ­
ated with greater economic efficiency. Empirical studies that emphasize
1 Our sample of industrial countries consists of the 21 developed countries that
are members of the OECD; our sample of developing countries consists of
76 non-OECD developing countries. See the appendix.
2 The panel data set increases the number of observations from 98 to 490-that
is, 98 countries multiplied by five time periods of five years each.
3 See the discussion on the production linkage summarized by Khan and Vil­
lanueva (1991). See also Edwards (1992), Roubini and Sala-i-Martin (1992), and
Villanueva (1993).
4Tbe transfer of efficient technologies and the availability of foreign ex­
change have featured I?rominently in recent experiences of rapid economic
growth (Thirlwall (1979)).
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516
KNIGHT, LOAYZA, and VILLANUEVA
other productive public expenditures, such as education and health
spending, include Diamond (1989), Otani and Villanueva (1990), and
Barra (1991); those that focus on fixed investment include Diamond
(1989), Orsmond (1990), and Barra (1991).
I.
The Model
The Mankiw, Romer, and Wei! model is an augmented neoclassical
Solow-Swan model that accounts for human capital in the production
function and saving decisions of the economy.
Consider the following Cobb-Douglas production function:
(1)
where Y is real output, K is the stock of physical capital, H is the stock
of human capital, L is raw labor, A is a labor-augmenting factor reflecting
the level of technology and efficiency in the economy, and t refers to time
in years. We assume that a + 13 < 1, so that there are constant returns
to factor inputs jointly and decreasing returns separately.
Raw labor and labor-augmenting technology are assumed to grow
according to the following functions,
L, = Loent,
A, = Aoegrpe,peP,
(2)
(3)
where n is the exogenous rate of growth of the labor force, g is the
exogenous rate of technological progress, F is the degree of openness of
the domestic economy to foreign trade, and P is the level of government
fixed investment in the economy. (For simplicity, we normalize L0 to
unity.) Thus, our efficiency variable A differs from that used by Mankiw,
Romer, and Weil in that it depends not only on exogenous technological
improvements but also on the degree of openness of the economy (with
elasticity e1) and on the level of government fixed investment (with
elasticity eP). We believe that this modification is particularly relevant to
the empirical study of economic growth in developing countries, where
technological improvements tend to be absorbed domestically through
imports of capital goods and where the productive sector's efficiency
may depend heavily on the level of fixed investment undertaken by the
government.
As in the Solow-Swan model, the savings ratios are assumed to be
exogenously determined either by savers' preferences or by government
policy. Thus, physical and human capital are accumulated according to
the following functions,
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NEOCLASSICAL THEORY OF ECONOMIC GROWTH
517
where sk ands" are the fractions of income invested in physical capital and
human capital and o is the depreciation rate (assumed, for simplicity, to
be the same for both types of capital).
To facilitate analysis of the steady state and the behavior around it, we
redefine each variable in terms of its value per effective unit of labor, by
dividing each variable by the efficiency-adjusted labor supply. Lower­
case letters with a hat represent quantities per effective worker: for
instance, output per effective unit of labor (.9) is equal to YIAL.
We now rewrite the production and accumulation functions in terms
of quantities per effective worker:
A
k."
Yr = r hA��r ,
(1')
(4 ')
and
(5 ' )
The Steady State
In the steady state, the levels of physical and human capital per effective
worker are constant. (Variables in the steady state are represented by a
star superscript.) From equations (4') and (5'), this assumption implies
(n +stgfls+g o)!11-a-f!'
a 1-ah )111-a-fj'
h*
sks
=(
n +g+o
k.* =
(6)
and
lny* =
-(1 �:� ) ln(n + g + o) + (1
+
(r ! ) ln(s11).
�
_
_
_
:
_
) ln(sk)
�
�
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518
KNIGHT, LOAYZA, and VILLANUEVA
Furthermore, in the steady state, output per worker (y) grows at the
constant rate g (the exogenous component of the growth rate of the effi­
ciency variable A). This result can be obtained directly from the definition
of output per effective worker:
loy, = ln 1-; - lnL, - lnA,
= lny, - lnA0 - gt -
e1
ln F - eP lnP.
(7)
Taking time derivatives of both sides of the equation gives
d lny,
dt
d lny,
dt
-- = -- - g .
Therefore, in the steady state, when the growth rate of output per
effective worker is zero, the growth rate of output per worker is equal
to g:
d lny;"
(f t = g.
Dynamics Around the Steady State
Following Mankiw, Romer, and Wei!, we do not impose the restriction
that the economy is continuously in the steady state. However, we do
assume that the economy is sufficiently close to its steady state that a
linearization of the transition path around it is appropriate. Such a
linearization produces the following result:5
d lny,
dt
=
'T)
A*
(ln y - ln y,)'
(8)
A
where 'TJ = (n + g + 5)(1 -
a
- [3).
The parameter 'TJ defines the speed of convergence: how fast output per
effective worker reaches its steady state. We want to obtain an expression
that can be treated as a regression equation for our empirical study.
Accordingly, we integrate equation (8) from t = t0 to t = t0 + r:
ln.Yro + r = (1 - e-11') lny* + e-11' ln.Y,o·
5The linearization of the transition path around the steady state is derived in
Appendix I of our original working paper (Knight, Loayza, and Villanueva
(1992)).
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NEOCLASSICAL THEORY OF ECONOMIC GROWfH
519
Next, we substitute for In :9*,
lny,0 + , = -(1 - e-11')
( 1 �:� 13) ln(n + g + 8)
(1 ; 13) lnsk
l3
+ (1 - e-11')(
) lnsh + e-'lr lny, .
1 - a - 13
+ (1 - e-11')
_
_
o
For purposes of estimation, we need an expression in terms of output
per worker rather than output per effective worker. Accordingly, follow­
ing Mankiw, Romer, and Wei!, we substitute for loy, using equation (7).
Finally, we rearrange terms to get the change in the natural logarithm of
output as the left-hand variable:
( �:� 13) ln(n + g + 8)
C _; 13) lnsk
+ (1 + (1 - e-'�')C ! 13) lns11
lny,0 + r - lny,0 = -(1 - e-'�')
1
_
e-'�')
_
_
+ (1 - e-'�')61 In F + (1 - e-'�')6p In P
- (1 - e-'�') lnyr0 + [(1 - e-11')(to + r)g
+ e-'�'rg] + (1 - e-'�') lnAo.
(9)
Equation (9) provides a useful specification for our empirical study.6 We
will use it as a guide but not apply it literaJiy.
The growth effects that we next discuss apply to the transition to the
steady state. As noted earlier, in the steady state, output per capita grows
at the exogenous rate g. If the speed of convergence TJ is positive (as we
expect), we can predict the sign of the coefficients in equation (9). The
13
fust coefficient indicates that for given a, , 8, and g the rate of growth
of per capita output is negatively related to the growth of the working-age
population. The second and third coefficients indicate that the more a
country saves and invests in physical and human capital, the more rapidly
it grows. The fourth coefficient is positive if e1 is positive, meaning that
6 Note that as t0 goes to infinity, both sides of equation (9) go to the value rg.
This is so because in the limit (steady state), the growth of per capita output is
equal to g, the exogenous growth rate of technology.
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520
KNIGHT, LOAYZA, and VILLANUEVA
greater openness to international trade-by contributing to the efficiency
of production-raises the rate of economic growth. A similar analysis
holds for the fifth coefficient, which applies to the level of government
fixed investment. The sixth term indicates that countries grow faster if
they are initially below their steady-state growth path, what is known as
"conditional convergence" in the growth literature (Barro and Sala-i­
Martin (1992), Mankiw, Romer, and Weil (1992), and Loayza (1992)).
Next, the term in brackets suggests the presence of a time-specific effect
on growth. The last term contains A0, which represents aU the unobserved
elements that determine the efficiency with which the factors of produc­
tion and the available technology are used to create wealth. Of course,
the greater is such efficiency, the higher the growth rate of the economy.
This last term suggests the presence of a country-specific effect, which
may well be correlated with the other explanatory variables considered
in the model.
The above interpretation of equation (9) suggests a natural specifica­
tion for the regression that can be used to study output growth and its
determinants using panel data for a sample ofdifferent countries and time
periods. Let us write a more general form of equation (9) for a given
country
i:
Lny;,, - lny;,r-L =
el
ln(nl. t + g + 8) + 82 lnski,t + e3 lnsh,
+ 64 ln F; + 65 In P;
+
'Y
lny;,r- L + � +
f.l.;
+
€;,,,
(10)
where �� and f.l.; represent time-specific and country-specific effects and
where St. . . , 65 and 'Y are parameters to be estimated.
The use of the time index requires some explanation. First, we have
normalized the "time length" between the first and last observations for
each period to equal unity (in equation (9), r = 1). Second, we are
indexing the physical capital investment rate sk by time to allow it to
change from period to period. Notice that the rate of human capital
investment sh, the level of openness F, and the stock of government fixed
investment P may differ from country to country, but owing to the limited
availability of data their levels in each country are assumed to remain
unchanged for all time periods in the sample.7 Notice also that neither
the value for g nor that for 8 is specific to each country. In essence, we
assume that, conditional on the other variables in the model, the exoge.
7This refers to
available.
those data in our study for which only cross-sectional data are
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NEOCLASSICAL THEORY OF ECONOMIC GROWTH
521
nous rate of technological change and the rate of depreciation are equal
across countries. 8
The disturbance term E;.1 is not assumed to be identically and inde­
pendently distributed. Thus, the model does not impose either condi­
tional homoskedasticity across countries or independence over time on
the disturbances within each country. We want to allow for serial corre­
lation in the error term because there may be some excluded variables
that result in short-run persistence. The IJ.; component accounts for
long-run persistence in excluded variables that are correlated with the
independent regressors.
IT. Panel Data Estimation
As we have noted, previous empirical studies of long-run growth have
made use of cross-sectional data. This practice forced the use of some
rather restrictive assumptions in the econometric specifications. For in­
stance, Mankiw, Romer, and Weil, who take averages of the relevant
variables over the period 1960 to 1985, assume that lnA0 is independent
of the investment ratios and growth rates of the working-age population.
This amounts to ignoring country-specific effects. For example, their
assumption implies that government policies regarding taxation and in­
ternational trade do not affect domestic investment and that the en­
dowment of natural resources does not influence fertility. Furthermore,
since only one cross-section is considered, the time-specific effect be­
comes irrelevant. Fortunately, panel data are available for most vari­
ables of interest. Thus, we exploit the additional information contained
in the panel data to analyze regression equation (10), using a technique
suggested by Chamberlain (1983).
We rewrite equation (10) as follows:
z;.1-1
= O'v;. , + "{Z;. ,-J + � + !J.; + E;.,
(10')
wherez;. , = ln(y;.,); v;.1 = [ln(nu + g + 8), ln(sk,), ln(s�r,), In F; , In P;]';
and 9 = (e�> . . . , 65)'. First, we need to process the data to eliminate the
time effects, which we do by removing the time means from each variable.
The �,'s can then be ignored, and the regression can be estimated without
constants (McCurdy (1982)).
Taking account of the country-specific effects is not so simple. If the
Z;.,
-
8This assumption corresponds to that in Mankiw, Romer, and Weil. The value
for g + B that JS used in the estinoation procedure actually matched the available
data.
©International Monetary Fund. Not for Redistribution
522
KNIGHT, LOAYZA, and VILLANUEVA
fJ.;'s are treated as fixed (as in a fixed-effects model), we may be tempted
to use the "within" estimator procedure, which is obtained by removing
the country means prior to least-squares estimation.9 However, this pro­
cedure would result in inconsistent estimators because of the presence of
a lagged dependent variable in the right-hand side of the regression
equation. The inconsistency comes from the fact that the error term
obtained after removing the country means is correlated with lagged
output.
Our chosen estimation method is the fi matrix approach outlined
in Chamberlain (1983). Chamberlain's fi matrix procedure consists of
two steps. In the first step, we estimate the parameters of the reduced­
form regressions for the endogenous variable in each period in terms
of the exogenous variables in all periods. Thus, we estimate a multi­
variate regression system with as many regressions as periods for the
endogenous variables we consider. Since we allow for heteroskedasticity
and correlation between the errors of all regressions, we use the seem­
ingly unrelated regression (SUR) estimator. As a result of this first step,
we obtain estimates of the parameters of the reduced-form regressions
(the elements of the fi matrix) and the robust (White's (1980) hetero­
skedasticity-consistent) variance-covariance matrix of such parameters.
The specific model we are working with implies some restrictions on
the elements of the n matrix: the parameters of interest are functions of
the fl matrix. This takes us to the second step in the procedure: we
estimate the parameters of interest by means of a minimum-distance
estimator using the robust variance-covariance of the estimated n as the
weighting matrix:
min[vec fl - f('\lt)]'O[vec fl - f('\lt)],
where $ is the set of parameters of interest and a is the robust variance­
covariance of the fi matrix. Chamberlain (1982) shows that this procedure
obtains asymptotically efficient estimates.
In order to use this method, we need to make explicit the restrictions
that our model imposes on the IT matrix. After removing the time means,
our basic model in equation (10') can be written as
(11)
= 6'v;,1 + 'YZi. r-1 + f.l.; + E;,.
At this point it is necessary that we distinguish the two kinds of
variables contained in the vector V;,,: those that are both country and time
specific (Jn[n;,, + g + 8] and ln(sk;,,]) and those that are only country
Z;,1
-
Z;, r-1
9 References on the "within" estimator include Mundlak (1978) and Greene
(1990, chapter 16).
©International Monetary Fund. Not for Redistribution
NEOCLASSICAL THEORY OF ECONOMIC GROWfH
523
specific (ln[s"1], ln[F;) and ln[P;]). Then we rewrite equation (11) as
follows:
(12)
Z;,t - Z;,r- 1 = a; X; r + a,; W; + 'YZt,t- 1 + IJ.; + E;,,
.
where X;,/ [ln(nu + g + 8), ln(sk1)]', w; = [ln(s".), In F;, In P;)',
aa={8t, 82 )', and ab = (83, 84, 8s)'.
By recursive substitution of the z,_1 term in each regression equation,
we bave10
Z;. 1
Z;.o = a; X;.1 + a,; W; + 'YZ;.o + IJ.; + Wi.J,
=
-
Z;. 2 - Z;. 1 = -ya; X;, 1 + a; X;, 2 + (1 + -y)ab W; + -y(1 + -y)z;,O
Z;, 3 -
Zt,2
+ (1 + 'Y) IJ.; + W;. 2,
= -y(1 + -y)a; X;. 1 + -ya; X1. 2 + a; X1.3 + (1 + -y)2 a,; W;
+ -y(1 + 'Y)2 Z1,o + (1 + 'Y)21J.; + W1. 3 ,
Z;,T - Z;,T- 1 = -y(1
+
-yf-2 a; xi. l + -y(1 + 'Y)T-Ja; xi. 2 +
+ -y(1 + -y)a; X;. T-2 + -ya� X;. T-1
· · ·
T
T
+ a; Xr + (1 + -y) - I ab W; + -y(l + -y) - l Z;.o
+ (1 + -yf-l f..L; + w;. r,
E*(w;,, I X;, t, . . . , X;. r, w1) = 0,
for t = 1, . . . , T.
Chamberlain (1983) proposes to deal with the correlated country-specific
effect IJ.; and the initial condition z1.o by replacing them by their linear
predictors:
E* (IJ.; I x1•1, X1,2 , • • • , x1. r, w1) = T( x1• 1 + T2 x1• 2 + · · ·
+ Tr X; T + T� W;;
,
E*(z1. o l x1.h xi.2, . . . , x1.r, w1)
=
A.;xi.l + A.2 x1• 2 +
· · ·
+ ATX;, T + A� W;.
In order to identify the coefficients of the variables for which we have only
cross-sectional data (sh,, F;, and P;), it is necessary to assume that T' w = 0.
This assumption is not very restrictive if one believes that the partial
correlation between w1 and IJ.; is low, given that the panel data variables
x1.1 are accounted for.
As Chamberlain points out, assuming that the variances are finite and
10ln the term z,_�, the index "1"
refers to five years.
©International Monetary Fund. Not for Redistribution
524
KNIGHT,
LOAYZA, and VILLANUEVA
that the distribution of (x;, h . . . , x;. r, w;, f..L;) does not depend on i, then
the use of the linear predictors does not impose any additional restric­
tions. However, using the linear predictors does not account completely
for the presence of country-specific effects when the correct specification
includes interactive terms (that is, nonlinear terms including products of
the observed variables and the country-specific factors). Of course, we
assumed away such a possibility when we declared that equation (10)
represented our maintained model.
We now write the IT matrix implied by our model. As will be seen in
the next section, our panel data consist of five cross-sections for the
variables (z;, , - z;.t-I) and X;,,, six cross-sections for the variable Z;,, (the
additional cross-section being the initial condition z;.o), and one cross­
section for the variables W; . Thus, the multivariate regression implied by
our model is
Z;.o
Zi.l - Z;,o
Z;.2 - Z;, l
Z;, 3 - Z;,2
Z;, 4 - Z;, 3
Z;. s - Z;,4
IT
=
X;, I
=
IT
X;, 2
X;,3
X;,4
X;,s
(13)
W;
[B + 'ItA.' + 4>-r'],
0
0
0
0
0
0
0
9�
0
0
9�
)'9�
B=
0
e�
'Y(1 + )')9�
)'9�
9;
)'9;
'Y(1 + 'Y? 9; 'Y(1 + 'Y)9;
'Y(1 + 1)3 9; -v(1 + -v)2 9; -v(1 + 'Y)9; -y9�
0
0
0
0
0
e;
0
6b
(1 + 'Y)9i
(1 + 'Y)2 9k '
(1 + 'Y)3 9i
(1 + -y)49i
1
'Y
'ItA.' =
'Y(1 + -y)
[A.; A-2 A-3 A-4 As A�),
'Y(1 + -y)2
'Y(1 + -v?
-y(1 + 'Y)4
0
1
-y)
+
(1
[T1 T2 Tl T4 Ts Tw' ] .
4>-r' =
(1 + 'Y)2
(1 + 'Y)3
(1 + -y)4
I
I
I
I
I
©International Monetary Fund. Not for Redistribution
525
NEOCLASSICAL THEORY OF ECONOMIC GROWTH
III.
Data and Results
We consider three different specifications of the growth model in our
econometric analysis. The first is a simple Solow-Swan model; the second
is a version of the Solow-Swan model that includes investment in human
capital; and the third, which was presented in Section I, is a version that
includes human capital investment, openness to foreign trade, and the
stock of public infrastructure. The first two models can be obtained by
applying appropriate exclusion restrictions to the third model. Thus, the
basic Solow-Swan model is obtained from equation (9) by setting
� = e1 = eP = 0. Its corresponding regression equation is
ln y,, ,
- lnyi,t1
= el ln(n;,, + g + 8) + e2 lnsk;, ,
+
-y
ln y;. t- t +
�' + f.L1 +
(10")
E,,,.
The second model can also be obtained from equation (9) by setting
e, = ep = 0. Its regression equation is
ln y1, ,
- lny1,t-t
=
81
ln(n;, , + g + 8) + 62 lnsk1., + 63 lnsh1
+
"'
In Y1.t- 1 + �' +
J.L;
+ E1.c·
(10111)
We will consider an alternative specification for this second model in
which panel data rather than cross-sectional data are used as a proxy for
the ratio of human capital investment to GDP. The regression equation
for this alternative model is the same as equation (10111), except that the
investment ratio for human capital is also indexed by time.
The definitions and sources of the data used for estimation are de­
scribed in the appendix. Our sample extends over the period from 1960
to 1985. We work with regular nonoverlapping intervals of five years.
Thus, our five cross-sections correspond to the years 1965, 1970, 1975,
1980, and 1985. For the variables y, and sh,, the observations for each
cross-section correspond exactly to the year of the cross-section. For
others-such as n, and sk,-such observations correspond to averages over
the previous five years. For the variables sh and P, the observations
correspond to averages over the whole period 1960 to 1985. For the
openness variable, F, the observation for each country is taken from
various years in the first part of the 1980s.
Each of the variables under consideration is now explained in more
detail. The dependent variable is the five-year difference in the natural
,
logarithm of real GDP per worker-that is, ln(Yi.6s) - ln(y,. 60),
In(y1.85) - In(y1, 80). As noted above, the most general model considers six
explanatory variables. The first is the natural logarithm of the average
growth rate of the working-age population, plus (g + 8); we follow
Mankiw, Romer, and Weil in assuming that (g + 8) = 0.05. The average
• •
©International Monetary Fund. Not for Redistribution
•
526
KNIGHT, LOAYZA, and VILLANUEVA
growth rate of the working-age population is taken over the preceding
five-year interval. Thus, we also have five observations of this variable
for each country-that is, ln(n,, 65 + 0.05), . . . , Ln(n,,85 + 0.05).
The second explanatory variable is the natural logarithm of the average
ratio of real investment (including government investment) to real GDP.
These averages are also taken over the preceding five-year intervals, so
that we have five observations for each country-that is, log(sk,. 65),
,
log(sk1.ss).
The third explanatory variable is a proxy for the ratio of human capital
investment to GDP. Specifically, following Mankiw, Romer, and Wei!
(1992), we use the percentage of the working-age population that is
enrolled in secondary school, a measure that is approximated by the
product of the gross secondary-school enrollment ratio times the fraction
of the working-age population that is of secondary-school age (aged 15
to 19). 11 In the.main specifications of the second and third models, we use
cross-sectional data for this variable: its average over the whole period
from 1960 to 1985. In the alternative specification of the second model,
we use panel data for the proxy of the human capital investment ratio­
that is, for each country we have five observations, namely ln(s�r,. 65),
,
ln(s�r,.ss).
The fourth variable, In F, is a proxy for the restrictiveness of the
economy's foreign trade regime: it is a weighted average of tariff rates
on intermediate and capital goods. The weights are the respective import
shares, and each tariff rate is calculated as the percentage ad valorem
import charge. Thus, the larger the value of this variable, the less open
is the domestic economy. We obtain the data from Lee (1993). This
measure of openness to trade is used because we are interested in the
relation between the availability of foreign technology (embodied in
intermediate and capital goods) and the efficiency parameter in the
production function. Lee points out that there are some problems with
this measure of the weighted-average tariff rate, the most important of
which is that the data refer to various years in the first part of the 1980s
and thus may not be representative of our entire sample period (1960 to
1985). Nevertheless, we believe that this simple proxy is likely to be
inversely correlated with openness for the majority of countries under
consideration during our sample period.
The fifth variable, In P , is a proxy for the level of the public capital
stock; it is defined as the average level of the ratio of general government
fixed investment (central government plus public enterprises) to GDP in
• • •
.
•
•
11
For a discussion of the appropriateness of this proxy, see Mankiw, Romer,
and Wei! (1992).
©International Monetary Fund. Not for Redistribution
NEOCLASSICAL THEORY OF ECONOMIC GROWTH
527
each five-year period. There are obvious problems in using this flow
variable as a proxy for the stock of public capital. It does not account for
the initial level of public capital (in our case the 1960 level). Nor does it
allow for country-specific differences in depreciation rates or in the
quality of investment expenditures. Nevertheless, it is likely that our
proxy is positively correlated with the level of public capital, and the
omitted factors discussed above will be reflected in the country-specific
constants.
The sixth explanatory variable is the natural logarithm of real GDP per
worker, lagged one "period" (that is, five years back). The observations
for each country are therefore ln( Y;.oo), . . . , ln( Yt. so).
The appendix lists the countries used to obtain the empirical estimates
for each of the three models of interest. The sample includes all industrial
and developing countries for which data are available and for which
petroleum production is not the primary economic activity.12 Excluding
the countries for which data are not available may create sample selectiv­
ity problems, particularly since these countries are frequently the poorest
ones. Thus, it is not appropriate to assume that the results could be
extrapolated to those economies that bad to be excluded from the sample
owing to data problems, most of which are also in the lowest-income
category. We estimate each of the models using two samples of countries.
The first is the full sample of 98 countries (22 industrial OECD-member
countries and 76 developing countries), and the second consists of the 76
developing countries only. Hence, a second aspect of the empirical work
is a comparison of the estimated coefficients obtained from the two
samples. Our main results are presented in Tables 1, 2, and 3. In all
models, time-specific and country-specific effects are deaJt with using the
methodology outlined in Section II above.
Before presenting the results, we need to clarify the meaning of the
"country-specific effects" in each of the estimated models. All empirical
growth models implicitly assume that the excluded variables can be
grouped into a single factor that affects the included variables in a given
uniform way. This is rather restrictive, since each unobserved variable
may affect the included variables in a different way. Thus, grouping them
together introduces biases and inefficiencies. Much is gained by identify­
ing and obtaining information on the different components of the coun­
try-specific factor. This is precisely our intention when we go from the
first to the second and third models. In a sense, adding information on
12
It is well known that standard growth models do not account for growth in
economies that specialize in the extraction of depletable resources (see Sala-i­
Martin (1990)).
©International Monetary Fund. Not for Redistribution
0.05)
a
167.21
0.0000
1.093
0.2959
164.53
0.0000
0.798
0.3718
-0.2782
( -6. 37)
-0.1401
( -9. 52)
0. 1401
(9.52)
0.0652
(5.39)
0.335
-0.2707
(-6.47)
-0.1474
( -6.64)
0. 1 184
(7.03)
0.0631
(5.50)
(n = 98)
All countries
Developing countries
(n = 76)
=
76)
-0.2660
( -6.63)
-0.12&5
( -9.55)
0.1285
(9.55)
0.0619
(5.66)
0.326
(n
Developing countries
©International Monetary Fund. Not for Redistribution
.. Ln(yH) is the logarithm of real GDP per worker lagged one period (five years). Ln(n, + 0.05) is the logarithm of the 3\'erage
growth rate of the working-age population plus the sum of technological progress and depreciation. Ln(s.t,) is the logarithm of the
average ratio of real investment to real GDP. lmplied 11 is the speed of convergence per year. T-ratios are in parentheses. Implied
a is the incom e share accruing to nonhuman capitaL
b These estimates are obtained by imposing the restriction implied by the Cobb-Douglas assumption-namely. that -81 = 92.
Wald test for
uncorrelated effects
(P-value)
Wald test for 91 = -9�
in equation (10")
(P-value)
Implied
Implied 11
ln(st,)
ln(n, +
ln(j·,-1)
(n = 98)
-0.2686
(-5 .90)
-0. 1220
( -4. 90)
0. 1489
(8.36}
0.0626
(5.03)
All countries
Simple restricted Solow-Swan modelb
1 . Two Ver.sions of the So/ow-Swan Model
Simple Solow-Swan model
Table
r
r
>
z
c
m
<
>
:s
"'
::l
c..
>
-<
N
>
b
.-1
:r:
6
"
z
NEOCLASSICAL THEORY OF ECONOMIC GROWTH
529
human capital, public capital, and openness to the simple Solow-Swan
model may be viewed as an attempt to disaggregate the components of
the all-inclusive country-specific factor assumed in the first model.
Specifically, in the second model we identify the human capital compo­
nent of the country-specific factor, while in the third model we add prox­
ies for public capital and openness to disaggregate the country-specific
effects further.
We begin with the simple Solow-Swan model (regression equation
(10'')). Results for this specification are reported in Table 1 . Using a
Cobb-Douglas production function in the Solow growth model, we ex­
pect the estimated values of 'Y to be negative, those for 01 to be negative,
and those for e2 to be positive; furthermore, we expect el and e2 to have
approximately the same absolute value. As can be seen from Table 1, all
these predictions of the Solow-Swan model hold true for the sample that
includes all countries, as well as for that including developing countries
only.
Moreover, our estimated values for the speed of convergence 11 are
0.0626 a year for the sample containing all 98 countries and 0.0631 for
that containing developing countries, implying that the economy moves
halfway to the steady state in about 11 years. 13 These estimates are much
larger than those reported in Barro (1991) and Mankiw, Romer, and Wei!
(1992), but similar to the predicted value of the simple Solow-Swan model
(see the formula for 11 in equation (8), setting 13 = 0 and using sensible
values for n, g, and 8). Mankiw, Romer, and Weil find that the implied
estimate for the speed of convergence to its steady-state growth path is
0.0137 a year. Barro (1991), using variables such as school enrollment
ratios, the government consumption expenditure ratio, proxies for polit­
ical stability, and a measure of market distortions, finds an estimated
speed of convergence equal to 0.0184 a year. These estimates correspond
to a half-life for the logarithm of output per effective worker of between
37 and 50 years. 14 We believe that the large difference between their
estimates and ours can be explained by the fact that their studies do not
account for the correlation between the country-specific effects and the
independent variables in the model, thus producing biased coefficients.
Specifically, when country-specific effects are ignored, the coefficient on
lagged output is biased toward zero because there is a positive correlation
between country-specific effects (defined to be positive) and the initial
levels of income in every interval (lagged output).
13 Note that in the estimating equation (9) the parameters lJ and r appear on
both sides; we set r = 5 years in our panel data regressions.
14The half-life formula is T = ln(2)/lJ, where T is number of years.
©International Monetary Fund. Not for Redistribution
TJ
0.05)
-0.2095
( -4.27)
(-3.86)
0.0844
(5.54)
0.0995
(5.38)
0.0470
(3.79)
178.&5
0.0000
-0.1775
( -3.41)
-0.0873
( -3.02)
0.1061
(6.60)
0.1064
(4.91 )
0.0391
(3.09)
87.91
0.0000
12.31
0.0000
5. 16
0.02317
-0.1007
Developing countries
(tl = 76)
(n = 98)
All cotmtries
Using cross-sectional data
for human capital investment
12.23
0.0000
3249.00
0.0000
O.D7
0.7974
60274.42
0. 0000
-0 . 1 108
( - 13 .26)
-0.0652
(-5.09 )
.
1 2%1
( - 95.73)
-0.0114
(1 .45 )
0. 1048
(10. 16)
-
Developing countries
(n = 75)
- 1 .0383
(-34.55)
-0.0389
(-5.25)
0.02.33
(1 .61)
All countries
(n = %)
Using panel data for
human capital investment
Solow-Swan Model Augmented 10 Include Human Capital lnvesrment
•
©International Monetary Fund. Not for Redistribution
Ln(y,-1) is the logarithm of real G DP per worker lagged one period (five years). Ln(n, _... 0.05) is the logarithm of the average
growth rate of the working-age population plus the sum of technological progress and depr-eciation. Ln (sk, ) is the logarithm of the
average ratio of real investment to real GDP. Ln(sh,) is the logarithm of the ratio of human capital investment to GDP, proxied
by the product of gross secondary-school enrollment ratio times the fraction of the working-age population aged 15 to 19. T-ratlos
are in parentheses.
Wald test for
uncorrelated effects
(P-value)
Wald test for El1 = -(EI1 .,- e3)
in equation (10"')
(P-value)
Implied
ln (sh, )
ln(s� )
ln(sk.)
ln(n, +
Jn(yH )
Variable•
Table 2 .
�
m
r
r
>
z
c:
.:::
<.;
:::>
0.
N
>
?<
r
0
:=i
0
z
;>::
NEOCLASSICAL THEORY OF ECONOMIC GROWTH
531
We can test for the presence of such a correlation. Consider the null
hypothesis of "uncorrelated effects," which means that the country­
specific effects have no correlation with the independent variables. From
the equation for the linear predictor of 1-L; and equation ( 16). it is evi­
dent that the null hypothesis of uncorrelated effects. in the framework.
of our maintained model, is equivalent to H0: At = · · · = As = 0. As can
be seen in Table 1, the Wald test strongly rejects the null hypothesis of
uncorrelated effects.
In Table 1, we also report the results of an estimation that assume� the
coefficients on In(n, + 0.05) and ln(sk, , ) are the same in absolute valu�
but opposite in sign (8 = -82). We do this in order to obtain estimates
for the implied capital share, ex, in the Cobb-Douglas production func­
tion. The estimates for ex are 0.335 for all countries and 0.326 for de\ el­
oping countries. These estimated capital shares are very close to the
value of 0.350 that Maddison (1987) obtains for the share of nonhuman
capital in production. Our estimated nonhuman capital shares imp!� that
diminishing returns set in quickly, which explains the rapid convergence
predicted by the model.
Table 1 also allows us to examine the differences in the estimated
coefficients obtained using the two samples. For the sample of developing
countries, the absolute value of the coefficient on population growth is
larger than that for the sample of all countries. This can be explained b)
the fact that the developed industrial countries have tended to sh<)\\
relatively steady per capita growth over the sample period while expcn­
encing relatively low population growth. Accordingly. when the� are
excluded from the sample the estimated effect of population gro\\ th i-,
larger. Our estimates also suggest that investment in physical capital is
less productive for developing countries than for developed countries.
The fact that we do not obtain the same parameter estimates using the
two different samples has to do with sampling error and with the inabillt)
to control completely for the country-specific effects.
Table 2 presents the econometric estimates for the second vers1on nf
1
15
1"
15 Somehow contradicting our finding that the capital share in production i�
approximately the same for both industrial and developing countries. De Grego­
rio (1992) finds an estimate for the capital share of about 0.5 for a sample of Latrn
American economies.
16There are two basic reasons for this imperfection. The first has to do w1th
the fact that we are grouping together all unobservable factors into the countn·­
specific effects; thus, if an unobserved variable affects the two �ample� differ­
ently, we obtain sharper estimates by separating the two samples. The second
reason may be the presence of nonlinear interactions between physical cap1tal
investment and the variables that are left out of the first model, such a� educat ion.
public infrastructure, and openness to trade (linear interactions are accounted for
by our methodology).
©International Monetary Fund. Not for Redistribution
532
KNIGHT, LOAYZA, and VlLLANUEVA
the Solow-Swan model (regression equation (10"')). As might be ex­
pected, the inclusion of a proxy for the ratio of human capital investment
to GDP has the effect of lowering the absolute value of the estimated
coefficients on the other variables in both the full sample and the devel­
oping country subsample. However, the changes are relatively small,
apparently because most of the effect of human capital investment has
already been captured by the country-specific effects in the estimates of
the first model. As also expected, the coefficient on the proxy for the
human capital investment ratio is significantly positive. In tbis second
model, a Cobb-Douglas production function implies that -81 = 82 + 83
in equation (10'"). This restriction, however, is rejected by the data on the
basis of the Wald test. This result may be due to the fact that education
is more closely related to the efficiency variable than to human capital
proper as an accumulatable factor of production. The reason why this
assumption does not appear to be consistent with the sample data could
be that the aggregate production function is more complex than the
Cobb-Douglas form allows. It is also interesting to note that for both
samples the speed of convergence is now estimated to be lower than in
the first model. We believe this is due to higher returns to capital broadly
defined to include human capital. In fact, when only physical capital is
accumulated its marginal productivity decreases rapidly. Thus, the steady
state is achieved more quickly but at a lower per capita output level (see
the definition of TJ in equation (8) and set the share of human capital 13
at a positive level).
Table 2 also reports the results of the second model when panel data
for the human capital proxy, rather than only cross-sectional data, are
used. We find that the estimated coefficient on this proxy is now signif­
icantly negative for both samples. This result is at first surprising. Why
does the addition of the time series dimension to the proxy for human
capital change the sign of its effect on growth? Our explanation for this
result is that when we incorporate time series data on education for each
country we use not only the cross-country differences in the relation
between education and growth but also the effect of changes in the human
capital proxy over time in each country. This temporal relationship has
been negative over the years, especially in developing countries (see Tilak
(1989) and Fredriksen (1991)). In other words, adjusted secondary­
school enrollment ratios rose steadily in most developing countries during
1960-85, sometimes by large amounts, while output growth remained
17
17 De Gregorio (1992) reports similar results for a sample of Latin American
countries.
©International Monetary Fund. Not for Redistribution
NEOCLASSICAL THEORY OF ECONOMIC GROWfH
533
stable or fell. Apparently, this time series relation is strong enough to
override the cross-sectional effects in the estimation.
This empirical result points to the possibility that the adjusted sec­
ondary-school enrollment ratio may not be a good proxy for the ratio of
human capital investment to GDP when relatively short intervals (in our
case, five-year intervals) are compared. The length of the interval is
important for the quality of such a proxy because there is a considerable
lag between the completion of education and its appropriate use as a
factor of production (see Psacharopoulos and Ariagada (1986)). There­
fore, cross-sectional data (data where the observation for each country
is an average of its respective time series observations) may be the
preferred proxy in estimating the growth effects of human capital invest­
ment. The implication is that when the secondary-school enrollment ratio
is used as the proxy, we can obtain good estimates of cross-country
differences in human capital investment but not of changes in the rate of
human capital investment within a country over time.
Table 3 reports the results for the third augmented version of the
Solow-Swan model. Its corresponding regression is represented by equa­
tion (10). Considerations of data availability obliged us to restrict the
sample of countries used in this last estimation (see the appendix).
Therefore, one would have to be particularly cautious about extrapolat­
ing the results described below to countries that are not included in the
sample. The negative sign of the coefficient on lagged output indicates
"conditional convergence," which means that-controlling for the de­
terminants of the steady state across countries-poor countries would
tend to grow faster than rich ones (see Barro and Sala-i-Martin (1992)).
By including the investment ratios as well as the proxies for openness
and public infrastructure in the regression equation, we appropriately
condition for different preferences and technologies.
The growth rate of the labor force is estimated to be negatively re­
lated to per capita output growth, especially when the estimates come
from the sample that includes only developing countries. Investments in
both physical capital and human capital are strongly and positively cor­
related with growth. When proxies for openness and public capital are
included in the model, the coefficient on the rate of investment in physical
capital becomes twice as large as it was in the second model, for both
samples. This seems to indicate that the quality of physical investment
increases when the international transfer of technology is allowed and
when better public capital is provided. We believe that this has to do with
the fact that greater openness and better public services create a market
environment where allocative efficiency is enhanced. In addition, the
rate of investment in human capital becomes much stronger in the case
©International Monetary Fund. Not for Redistribution
534
KNIGHT, LOAYZA, and VILLANUEVA
Table 3. Solow-Swan Model Augmented to Include Human Capital
Investment, Openness to Foreign Trade, and Public Infrastructure
Variable•
ln{y,-t)
In(n, + 0.05)
ln(sk,)
In(s�r,)
In(F)
In(P)
Implied Tt
Wald test for
uncorrelated effects
(P-value)
Wald test for 61 = -(a. + 63)
in equation (10)
All countries
(n 81)
Developing countries
(n = 59)
-0.2208
( -9.45)
-0.1470
( -12.52)
0.2013
(18.17)
0.0945
(8.18)
-0.0650
(-11.76)
0.0128
(0.78)
0.0499
(8.32)
-0.6836
(-17.75)
-0.1760
( -9.01)
0.2057
(14.24)
0.3197
(18.15)
-0.0820
(-15.97)
0.0978
(6.47)
0.2301
(9.45)
526.03
0.0000
5596.77
0.0000
=
61.76
238.19
0.0000
0.0000
• Ln(y,-t) is the logarithm of real GDP per worker lagged one period (five
years). Ln (n , + 0.05) is the logarithm of the average growth rate of the working­
(P-value)
age population plus the sum of technological progress and depreciation. Ln(sk,)
is the logarithm of the average ratio of real investment to real GDP. Ln(s11,) is
the logarithm of the ratio of human capital investment to GDP, prox.ied by the
product of gross secondary-school enrollment ratio times the fraction of the
working-age population aged 15 to 19. Ln(F) is the logarithm of the "closedness"
of the economy, proxied by the weighted average of tariff rates on imported
intermediate and capital goods. Ln(P) is the logarithm of the ratio of public
infrastructure to GDP, proxied by the average ratio of general government fixed
investment (central government plus public enterprises) to GDP. T-ratios are in
parentheses.
of the developing country sample when the aforementioned proxies are
included.
The variable F, defined as the weighted average of tariffs on interme­
diate and capital goods, has a significant negative effect on output
growth. This measure of openness ("closedness" may be a better term
given how this variable is defined) affects growth not only through the
investment ratios, as indicated above, but also through the efficiency
term, which accounts for technological improvement. The evidence of
such an independent role for openness, combined with the fact that the
absolute value of the coefficient's point estimate is larger for the devel-
©International Monetary Fund. Not for Redistribution
NEOCLASSICAL THEORY OF ECONOMIC GROWTH
535
oping countries, lends support to the view that for many countries,
particularly developing ones, liberal trade regimes provide a source of
technological progress via the freedom to import sophisticated goods
from the most technologically advanced nations. At a broader level, this
result provides a measure of empirical confirmation for the familiar argu­
ment that outward-oriented trade strategies tend to promote economic
growth in developing countries.
The ratio of government fixed investment to GDP (the variable P) has
a positive coefficient for both samples, but this coefficient is statistically
significant at the 95 percent level only for the developing country sample.
The statistical insignificance of this coefficient in the full sample may be
due to the fact that our proxy for public capital is based on flow data that
do not account for the initial level of the associated stock. This is espe­
cially important for the industrial countries, which by 1960 had accumu­
lated substantial stocks of public capital, relative to those in developing
countries. In that sense, our proxy is better suited to developing coun­
tries, which may explain why we find a much larger and highly significant
coefficient in the sample for the latter group. As in the case of the
openness variable, it is interesting to note that, at least for the latter
sample, the proxy for public capital has an independent role in economic
growth, even when physical and human capital are already included.
IV.
Concluding Remarks
This paper has extended the work of Mankiw, Romer, and Wei! (1992)
in two directions. Unlike their analysis, which relies exclusively on cross­
sectional data, we find evidence of significant country-specific effects,
which our panel data estimation procedure is able to detect. One impor­
tant consequence of this result is the faster rate of conditional conver­
gence that we find in our model, relative to that estimated by Mankiw,
Romer, and Wei! and by Barro (1991). We surmise that this difference
occurs because the latter studies do not take into account the correlation
between country-specific effects and the independent variables in the
growth equation. The other new result is that overall economic efficiency
is influenced significantly and positively by the extent of openness to
international trade and by the level of government fixed investment in the
domestic economy.
Like Maokiw, Romer, and Weil, we find that the Solow-Swan model's
predictions are consistent with the evidence. These include the positive
effects of saving ratios and the negative effects of population growth
on the steady-state level and on the transitional growth path of per capita
GDP. We also find (conditional) convergence to be approximately the
©International Monetary Fund. Not for Redistribution
536
KNIGHT, LOAYZA, and VILLANUEVA
rate predicted by the Solow-Swan model. We estimate the share of capital
at about one-third, which is close to the value estimated by Maddison
(1987) for the share of nonhuman capital in GDP. Our estimated capital
shares imply that diminishing returns to physical capital set in quickly,
explaining the rapid convergence predicted by our model.
Comparing the results between the two samples of industrial and
developing countries, we find that the absolute value of the estimated
coefficient on population growth is larger for our sample of developing
countries alone, reflecting the fact that many countries in this group have
tended to exhibit slow growth in per capita terms while experiencing rapid
rates of population growth. Moreover, there is evidence that investment
in physical capital has been less productive for those developing countries
that have had lower initial stocks of human capital and of government
fixed investment as well as higher rates of effective protection, aU of
which have tended to reduce the overall efficiency of physical investment.
Our results on the growth effects of a country's openness to interna­
tional trade and on government fixed investment deserve some elabora­
tion. When openness and the level of public infrastructure are taken into
account, physical investment becomes quantitatively more important in
the growth process, implying that a better quality of investment is encour­
aged by a more liberal international trade regime and by more govern­
ment fixed investment. Particularly for the developing countries, invest­
ment in human capital also becomes more quantitatively important when
a more open trading environment and a better public infrastructure are
in place.
There are two channels through which the negative impact on growth
of a restrictive trade system (proxied by the weighted average of tariffs
on intermediate and capital goods) is transmitted, particularly in devel­
oping countries where the capital goods industries are in their infancy or
nonexistent: through the rate of investment and through its efficiency. A
high tariff structure discourages imports of capital goods and leads to less
technology transfer, and thus to less technological improvement. The
strong statistical significance of the proxy for "closedness" provides
evidence that outward-oriented development strategies have a positive
impact on economic growth.
The government fixed investment variable is statistically and positively
significant only in the developing countries, and appropriately so. This
can be explained by the failure of our proxy for public infrastructure to
account for its initial level. Among the industrial country group, the level
of public infrastructure in 1960 was a large multiple of the level in the
developing country group. As in the case of the outward orientation of
development strategies, better provision of public infrastructure exerts
an independent influence on the rate of economic growth. This may mean
©International Monetary Fund. Not for Redistribution
NEOCLASSICAL THEORY OF ECONOMIC GROWTH
537
that the government is in a better position to provide infrastructure than
the private sector. In other words, either the private sector, if it had the
resources, would tend to underinvest in infrastructure or the marginal
productivity of public sector resources devoted to infrastructure is higher
than that of private sector resources (presumably owing to significant
externalities).
APPENDIX
Data Sources, Definitions, and the Sample of Countries
The basic data used in this study are annual observations for the period 1960 to
1985. The following variables were taken from Penn World Tables in Summers
and Heston (1991):
y = real GDP per worker;
sk = real investment to GDP ratio (five-year average);
n = growth rate of the number of workers (five-year average).
The following variable was taken from Mankiw, Romer, and Wei! (1992):
sh
= percent of working-age population enrolled in secondary school
(average for the 1960-85 period).
Panel data for the proxy of human capital investment were obtained from the
UNESCO Statistical Yearbook 1991 and were adjusted for age using population
data from UN Population Division (1991). Data on tariffs were taken from Lee
(1992):
F
=
import-share weighted average of tariffs on intermediate and capital
goods (from various years in the early 1980s).
The DEC Analytical data base from the World Bank (1991) was used to obtain
a proxy for public infrastructure:
P average ratio of general government fixed investment to GDP.
The sample of countries was as follows.
=
Industrial countries
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany (West)
Greece
Ireland
Italy
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
Japan
Netherlands
New Zealand
Norway
Portugal
Spain
Sweden
Switzerland
Turkey
United Kingdom
United States
©International Monetary Fund. Not for Redistribution
538
KNIGHT, LOAYZA, and VILLANUEVA
Developing countries
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
25.
26.
27.
28.
29.
30.
31.
32.
33.
34.
35.
36.
37.
38.
Algeria
Angola
Argentina
Bangladesh
Benin
Bolivia
Botswana
Brazil
Burkina Faso
Burundi
Cameroon
Central African Republic
Chad
Chile
Colombia
Congo
Costa Rica
Cote d'Jvoire
Dominican Republic
Ecuador
Egypt
El Salvador
Ethiopia
Ghana
Guatemala
Haiti
Honduras
Hong Kong
India
Indonesia
Israel
Jamaica
Jordan
Kenya
Liberia
Madagascar
Malawi
Malaysia
39. Mali
Mauritania
41. Mauritius
42. Mexico
43. Morocco
44. Mozambique
45. Myanmar
46. Nepal
47. Nicaragua
48. Niger
49. Nigeria
50. Pakistan
51. Panama
52. Papua New Guinea
53. Paraguay
54. Peru
55. Philippines
56. Republic of Korea
57. Rwanda
58. Senegal
59. Sierra Leone
60. Singapore
61. Somalia
62. South Africa
63. Sri Lanka
64. Sudan
65. Syrian Arab Republic
66. Tanzania
67. Tb.ailand
68. Togo
69. Trinidad and Tobago
70. Tunisia
71. Uganda
72. Uruguay
73. Venezuela
74. Zaire
75. Zambia
76. Zimbabwe
40.
Tables 1, 2, and 3: The sample in these tables covers all of the 98 industrial and
developing countries listed above.
Table 4 (96 countries): The sample in this table is the same as that for Tables 1-3,
except that South Africa and Switzerland have been dropped owing to the
unavailability of data.
Table 5 (81 countries): In the sample in this table, the following countries have
been dropped from the sample of Tables 1-3 for the same reason: Botswana,
Cameroon, Central African Republic, Chad, Cote d'Ivoire, Dominican Repub­
lic, Honduras, Israel, Liberia, Mali, Mauritania, Mozambique, Myanmar, Niger,
Panama, South Africa, and Togo.
©International Monetary Fund. Not for Redistribution
NEOCLASSICAL THEORY OF ECONOMIC GROWTH
539
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Q 1993 International Monetary Fund
Capital and Trade as Engines
of Growth in France
An Application of Johansen's Cointegration Methodology
DAVID T. COE
and REZA MOGHADAM*
An aggregate production function is estimated using recent cointegrating
techniques particularly appropriate for estimating long-run relationships.
The empirical results suggest that the growth of output in France has been
spurred by increased trade integration within the European Community
and by the accumulation not only of business sector capital-the only
measure of capital included in most empirical studies-but also by govern­
ment infrastructure capital, residential capital, and research and develop­
ment capital. Calculations of potential output indicate that trade and
capital-broadly defined-account for all of the growth in the French
economy during the past two decades. [JEL E23, F15, 032, 052]
HE IMPORTANCE of trade and capital as determinants of trend or
Tpotential
economic growth is widely acknowledged. The collapse of
world trade following the passage of the Smoot-Hawley tariffs in the
United States in 1930 helped to trigger the great world depression of the
1930s. By contrast, the brisk expansion of world trade in the 1950s and
1960s contributed to unusually rapid growth in the industrial countries.
More recently, the fast-growing economies of Southeast and East Asia
* David T. Coe is in the Research Department and holds a doctorate from
the University of Michigan. Reza Moghadam is in the European I Department
and holds a doctorate from the University of Warwick. The authors thank
Julia Darby, Robert Ford, John Ireland, Flemming Larsen, Paul Masson, Mark
Taylor, Hari Vittas, and Simon Wren-Lewis as well as analysts from Directions
de Ia Prevision and INSEE and two anonymous referees for helpful comments
and suggestions, and Toh Kuan for research assistance.
542
©International Monetary Fund. Not for Redistribution
CAPITAL AND TRADE AS ENGINES OF GROWfH IN FRANCE
543
have built their success on an outward orientation and rapid increases in
intraregional trade. High rates of capital accumulation also spurred
growth in the industrial countries in the postwar period and in the dy­
namic economies of Asia more recently. The slowdown in growth after
the mid-1970s in France and other industrial countries coincided with a
moderation in the growth of world trade and, in some countries, with a
reduced pace of capital formation, particularly by the business sector.1
Although, empirical studies based on aggregate production functions
have always emphasized the importance of capital accumulation by the
business sector, the importance of other types of capital accumulation has
received considerably less emphasis; the role of trade has generally
been emphasized only in empirical studies based on computable general
equilibrium models. This paper presents new estimates of an aggre­
gate production function for France, focusing on the role of trade and the
importance of capital accumulation by government, households, and
businesses, including their expenditures on research and development
(R&D).
The production function is estimated with recent cointegrating tech­
niques suggested by Johansen (1988). This methodology emphasizes the
identification of long-run relationships, and hence is particularly appro­
priate for studying the determinants of potential output. The empirical
results suggest that increased trade within the European Community has
raised efficiency and productivity in France. The empirical results also
indicate that in addition to the stock of business sector capital-which is
the only measure of capital included in most empirical studies-the stock
of government infrastructure capital, the stock of residential capital, and
the stock of R&D capital have also contributed to the growth of output
in France.
The estimated production function is used to calculate potential output.
These calculations indicate that trade and capital-broadly defined­
account for all of the growth in the French economy in the two decades
1971-91. Although labor input is also an important determinant of out­
put, its contribution to growth has been nil over the 1971-91 period.
Thus, during the past two decades, trade and capital have been the
engines of growth in France. The growth of· potential output is esti­
mated to have averaged about 2\12 percent a year in 1984-91 and to
continue at about 21;2 percent a year in 1992-97. To foster more robust
1 This slowdown has rekindled interest in the determinants of growtb and in
growth theory, as evidenced by the recent emergence of a large and expanding
literature on endogenous growth. See Lucas (1988), Sala-i-Martin (1990), and
Helpman (1992).
©International Monetary Fund. Not for Redistribution
DAVID T. COE and REZA MOGHADAM
544
growth, France must encourage capital accumulation, implement labor
market policies to reduce unemployment, and take steps to revitalize the
trade liberalization process.
I.
Johansen's Cointegration Methodology
Over the past few years, important advances have been made in co­
integration techniques to estimate long-run relationships.2 The basic idea
of cointegration is that two or more variables may be regarded as defining
a long-run equilibrium relationship if they move closely together in the
long run, even though they may drift apart in the short run. This long-run
relationship is referred to as a cointegrating vector. Because there is a
long-run relationship between the variables, a regression containing all
the variables of a cointegrating vector will have a stationary error term,
even if none of the variables taken alone is stationary.
Stock (1987) demonstrates that, in the case of cointegrated nonstation­
ary series, ordinary least squares (OLS) estimates of the cointegrating
vector are not only consistent but they converge on their true parameter
values much faster than in the stationary case. This property is referred
to as "super consistency. "3 The proof of consistency does not require the
assumption that the regressors be uncorrelated with the error term. In
fact, the estimates will remain (super) consistent if any of the variables
in the cointegrating vector is used as the dependent variable.
More generally, most of the classical assumptions underlying the gen­
eral linear model are not required in order for OLS or maximum likeli­
hood estimates of the cointegrating vector to have desirable properties.
This is particularly important because errors in variables and simul­
taneity-both of which would normally be cause for concern in the data
set used here-will not affect the desirable properties of the estimates.
Moreover, because the cointegration approach focuses on long-run rela­
tionships, problems associated with variations in factor utilization and
with autocorrelation do not arise.
A popular approach to cointegration has been to use unit-root tests,
2 Cuthbertson,
Hall, and Taylor (1992) present a survey of cointegration.
3The intuition behind the super-consistency result is that, for values of the
parameters that do not cointegrate, the residual series will itself be nonstationary
and therefore have a very large estimated variance. When the estimated parame­
ters are close to the true cointegrating parameters, the residual becomes station­
ary and its variance shrinks. Since least squares and maximum likelihood methods
essentially minimize the residual variance, they will be extremely good at picking
out the cointegrating parameters if they exist. The super-consistency result does
not hold if there are multiple cointegrating vectors.
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CAPITAL AND TRADE AS ENGINES OF GROWTH IN FRANCE
545
such as the Dickey-Fuller (DF) or the augmented Dickey-Fuller (ADF)
test (Dickey and Fuller (1981)), to determine the degree of integration
of the relevant variables and then to apply the Engle and Granger (1987)
two-step procedure, which is based on an OLS estimate of the cointe­
grating vector and a unit-root test of its residuals. Although it is easy to
implement, there are a number of problems with the Engle and Granger
two-step procedure. Banerjee and others (1986) show that there may be
significant small-sample biases in such OLS estimates of the cointegrating
vectors, and Hendry and Mizon (1990) illustrate that conventional DF
and ADF tests generally suffer from parameter instability. In addition,
the limiting distributions for the DF and ADF tests are not well defined,
implying that the power of these tests is low (Phillips and Ouliaris (1990)).
Perhaps most damaging is the possibility that any given set of variables
may contain more than one long-run relationship: there may be multiple
cointegrating vectors. OLS estimates of the cointegrating vector cannot
identify multiple long-run relationships or test for the number of cointe­
grating vectors.
Johansen (1988) and Johansen and Juselius (1990) present a cointegra­
tion estimation methodology that overcomes most of the problems of the
two-step approach. The Johansen procedure is based on maximum likeli­
hood estimates of all the cointegrating vectors in a given set of variables
and provides two likelihood ratio tests for the number of cointegrating
vectors. Johansen and Juselius (1990) consider the following general
model:
X, = II1 Xr- 1 +
· · ·
+ IIk Xr-k + fl. + e,,
for t = 1 , . . . , T,
(1)
where X, is a vector of p variables; e�> . . . , e, are independent normal
errors with mean zero and covariance matrix A; Xr-ko . . . , X0 are fixed;
and fl. is an intercept vector. Economic time series are often nonstation­
ary, and systems such as the above vector autoregressive representation
(VAR) can be written in the conventional first-difference form:
AX, = fk-1 AXr-k+l + IIX,_k + fl. + e,,
(2)
where
f; = -(1 - 111 -
• • •
- II;), for i = 1, . . . , k - 1 ,
and
II = -(I - Il1 -
· · ·
- Ilk)·
The only level term in equation (2) is IIXr-k. Thus, only the matrix II
contains information about the long-run relationships between the vari­
ables in the data vector. There are three cases:
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546
DAVlD T. COE and REZA MOGHADAM
1 . If the matrix II has rank zero, then all the variables in X, are
integrated of order one or higher and the VAR has no long-run
properties;
2. If II has rank p (it is of full rank), the variables in X, are stationary;
and
3. If II has rank r (0 < r < p ), II can be decomposed into two
distinct (p x r) matrices a and Jl such that II = afl'.
The third case implies that there are r cointegrating vectors. The parame­
ters of the cointegrating vectors are contained in the Jl matrix. Therefore,
Jl'X, is stationary even though X, itself is nonstationary. The a matrix
gives the weights with which the cointegrating vectors enter each equa­
tion of the system.
To determine the number of cointegrating vectors, r, Johansen and
Juselius describe two likelihood ratio tests. In the first test, which is based
on the maximal eigenvalue, the null hypothesis is that there are at most
r cointegrating vectors against the alternative of r + 1 cointegrating
vectors. In the second test, which is based on the trace of the stochastic
matrix, the null hypothesis is that there are at most r cointegrating vectors
against the alternative hypothesis that there are r or more cointegrating
vectors. The first test is generally considered to be more powerful because
the alternative hypothesis is an equality. These tests can also be used to
determine if a single variable is stationary by including only that variable
in X,.
Johansen demonstrates that the likelihood ratio tests have asymptotic
distributions that are a function only of the difference between the
number of variables and the number of cointegrating vectors. Therefore,
in contrast with the DF and ADF tests, the Johansen likelihood ratio tests
have well-defined limiting distributions. Johansen and Juselius also
provide a methodology for testing hypotheses about the estimated coef­
ficients of the cointegrating vectors based on likelihood ratio tests with
standard chi-squared distributions.
n. Production Function
We estimate a Cobb-Douglas-type production function augmented to
include R&D capital as a distinct factor of production and to allow a
measure of trade to influence the productivity of the factors of produc­
tion. More specifically, we estimate the long-run relationship between
real value added in the nonfarm business sector (y ), hours worked in the
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CAPITAL AND TRADE AS ENGINES OF GROWfH IN FRANCE
547
nonfarm business sector (h), the stock of capital (k), the stock of R&D
capital (k'&d), and intra-EC trade as a percent of total EC output (EC) :
y =
ah + �k + -yk'&d + SEC + constant,
(3)
where variables represented by lower-case symbols are logarithms.
The production function has some novel features. One unusual feature
is the inclusion of a measure of European trade integration as a determi­
nant of the productivity of capital and labor in France. The theoretical
justification for including a measure of trade integration has recently
been developed by Grossman and Helpman (1991) and Rivera-Batiz and
Romer (1991). The EC variable captures the beneficial effects of trade
integration in the European Community on French enterprises from
heightened competition, increased specialization, exposure to new ideas
and techniques, and increasing returns to scale in production and in
research and development (Figure 1). As noted below, the same variable
has been used to explain long-run developments in total factor productiv­
ity in Germany; a similar variable (per capita trade) is used by Mao and
Rivera-Batiz (1993) in their study of growth and regional convergence
in China.
A second unusual feature is the treatment of capital. The physical
capital stock is broadly defined to include the stock of government
infrastructure capital and residential capital, in addition to the capital of
private and public enterprises (Figure 2). The potentially important role
of infrastructure capital in increasing productivity and output has re­
ceived considerable attention recently, although it has proven difficult to
estimate separate elasticities for infrastructure capital.4 Including resi­
dential capital is appropriate since value added in the business sector
includes imputed services from the housing stock. More generally, hous­
ing is an important aspect of an economy's infrastructure, which, like
roads, bridges, and nonresidential structures, contributes to its ability to
produce real goods and services. 5 This focus on a very broad definition
of capital differs from most empirical studies, which typically consider
only the business sector capital stock. Although infrastructure capital
may not be an important determinant of short-run movements in output,
it is particularly important to include infrastructure capital when studyin�
the long-run determinants of output.
In addition to the stock of physical capital, the stock of R&D capital
4See the cross-country evidence presented in Ford and Poret (1991) and the
evidence for the United States presented in Munnell (1990).
5 An increase in the stock of housing, for example, may increase labor mobility.
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DAVID T. COE and REZA MOGHADAM
Figure
I . EC Integration
(In percent)
1 5 r-
----�
14
lntra-EC trade
as a percent ofEC output
""
13
12
II
10
1975
1977
1979
1981
198;\
1985
1987
1 989
1991
is included as a distinct factor of production. This allows the process of
technological progress to be modeled explicitly, as suggested by Griliches
(1988). The importance of R&D capital, which is complementary to
human capital, has been emphasized in endogenous growth theories
(Lucas (1988) and Helpman (1992)).
A final unusual feature of the production function is that the coeffi­
cients on capital and labor are neither constrained to sum to unity nor
constrained to equal their factor shares, in which case the production
function becomes a total factor productivity equation. One reason to
freely estimate the coefficients on capital and labor is that R&D capital
is included as an additional factor of production, and it is not clear how
its factor share would be calculated. More generally, the elasticities of
output with respect to each factor of production will only be equal to
factor shares if factor markets are perfectly competitive, and this is not
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CAPITAL AND TRADE AS ENGINES OF GROWTH IN FRANCE
549
Figure 2. Capiral Srocks
1 9 7 1 : I= I 00)
(In logarithms,
100 �------�
180
170
160
150
140
130
Srock ufR&D capiro/
. · •
120
1 10
1 00 .------.
Residenrial capiro/
180
170
160
150
...
...
...
... ...
... ...
Business secrur capiro/
140
130
120
110
alncluding business sector, residential, and government capital stocks.
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550
DAV[D T. COE and REZA MOGHADAM
assumed here. In addition, endogenous growth theories have questioned
the assumption of constant returns to scale, and some have argued that
the coefficient on capital should be much larger than suggested by its
factor share. 6
m. Empirical Results
The production function has been estimated using quarterly data for
France from 1971:1 to 1991:4 (84 observations). Estimation results based
on alternative specifications are discussed below and data sources and
definitions are reported in the Appendix.
Table 1 reports the results of tests for the order of integration of the
basic set of variables. The results in Table 1 have been obtained using the
Johansen procedure, which, as noted above, has well-defined limiting
distributions. These tests for the orders of integration do not suffer from
the parameter instability associated with the DF and ADF tests and are
consistent with our use of the Johansen procedure to estimate the co­
integrating vectors. The null hypothesis that the levels of the variables
are stationary is rejected, but the null hypothesis that the first differ­
ences are stationary cannot be rejected. Therefore, all series appear to
be integrated of order one.
The test statistics and the estimated cointegrating vectors from the
Johansen procedure are reported in Table 2, where r denotes the number
7
Table 1 . Johansen Maximum Likelihood Tests for the Order of Integration
(1971:1 to 1991:4, maximum of four lags in VAR)
Variable
y
h
Test statistic
Variable
Test statistic
13.34
1.53
L\y
L\h
1.96
9.25
k
L\k
4.31
2.04
£\kr&d
kr&d
0.23
7.48
EC
3.44
L\EC
4.44
Note: The null hypothesis is stationarity. The critical values are 3.76 at the 95
percent confidence level and 2.69 at the 90 percent confidence level. Delta is the
fi
rst-difference operator.
6 See, for example, Romer (1987) and Sala-i-Martin (1990). There are a number
of practical problems with imposing factor shares, one of which is that they are
not constant over the sample period. In addition, there are a variety of ways to
calculate factor shares, depending, for example, on the way that self-employment
income is allocated to capital or labor.
7 The DF and ADF tests give the same result.
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CAPITAL AND TRADE AS ENGINES OF GROWTH IN FRANCE
Table 2. Johansen Maximum Likelihood Tests and Parameter Estimates
(1971:1 to 1991:4, maximum of four lags in VAR;
eigenvalues in descending order: 0.34, 0.21, 0.18, 0.14, 0.13E-5)
A. Cointegration likelihood ratio test
based on maximal eigenvalue
of the stochastic matrix
Null
r=O
r :5. 1
r :5. 2
r :5. 3
r :5. 4
Hypothesis•
Alternative
r=1
r=2
r=3
r=4
r=5
Test
statistic
35.27
20.14
17.15
12.43
0.0001
95 percent
critical value
33.32
27.14
21.07
14.90
8.18
90 percent
critical value
30.84
24.78
18.90
12.91
6.50
95 percent
critical value
70.60
48.28
31.52
17.95
8.18
90 percent
critical value
66.49
45.23
28.71
15.66
6.50
B. Cointegration likelihood ratio test
based on trace of the
stochastic matrix
Null
r=O
r c5. 1
r c5. 2
r :5. 3
r :5. 4
Hypothesis•
Alternative
r�1
r�2
r�3
r�4
r =5
Test
statistic
85.00
49.73
29.58
12.43
0.0001
C. Estimated cointegrating vectors (coefficients
normalized on y in parentheses)
y
h
k
k'&d
-10.76
7.66
1.80
5.71
( -1.00)
(0.17)
(0.53)
(0.71)
-2.64
3.17
8.40
-7.60
2
(-2.88)
(3.18)
(1 .20)
( -1.00)
•The number of cointegrating vectors is denoted by r.
Vector
1
EC
0.34
(0.03)
-0.10
( -0.04)
of cointegrating vectors.8 Panel A reports the maximal eigenvalue test of
the null hypothesis that there are at most r cointegrating vectors against
the alternative of r + 1 cointegrating vectors. Starting with the null
hypothesis that there are no cointegrating vectors (r = 0) against the
alternative of one cointegrating vector (r = 1), the test statistic (35.27)
8The Johansen procedure involves the simultaneous estimation of dynamic
vector autoregressive (VAR) equations, for which fourth-order Jags were in­
cluded. It is assumed that the variables have linear deterministic trends. Estima­
tion has been done on Microfit 3.0, see Pesaran and Pesaran (1991).
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DAVID T. COE and REZA MOGHADAM
is greater than the 95 percent critical value (33.32), rejecting the null
hypothesis and indicating that there is at least one cointegrating vector.
The null hypothesis of r ::::; 1 against r = 2, however, cannot be rejected,
suggesting that there is a unique cointegrating vector. Panel B reports the
trace test of the null hypothesis that there are at most r cointegrating
vectors against the alternative that there are more than r vectors. Both
the null of r = 0 against r � 1 and the null of r ::::; 1 against r � 2 are
rejected. However, the null of r ::::; 2 against r � 3 cannot be rejected,
indicating that there are at most two cointegrating vectors. 9
Panel C of Table 2 presents the two estimated cointegrating vectors.
The coefficients in parentheses are normalized on y. In th·e first cointe­
grating vector, all of the estimated coefficients have the expected signs
and are of reasonable magnitudes, although the normalized coefficients
for labor and capital are both somewhat higher than their factor shares
(see below). In the second cointegrating vector, the estimated coefficients
are either implausibly large in terms of factor shares, incorrectly signed,
or both. In light of these results, and given that the existence of two
cointegrating vectors is rejected by the maximal eigenvalue test, we take
the first cointegrating vector as our preferred estimate of the production
function.
Compared with the estimated parameters on the labor and capital
inputs, it is more difficult to judge the plausibility of the estimated
parameters on the stock of R&D capital and the variable for EC trade
integration. The estimated coefficient on R&D capital is similar to those
found in comparable studies for the United States, Japan, and Germany,
but is somewhat larger than typically found in studies based on firm- and
industry-level data, perhaps because the estimation of an aggregate pro­
duction function is better able to capture spillovers that increase the
social, and hence the aggregate, return to research and development. 10
Turning to the estimated coefficient on the EC variable, Coe and
Krueger (1990) find the same variable to be a determinant of total factor
productivity in the Federal Republic of Germany, although the estimated
coefficient for France is somewhat larger than that for Germany. The fact
that this variable helps to explain medium- to long-term output develop­
ments in other European countries suggests that it is a good proxy for the
9 Studies using the Johansen procedure often obtain much less clear-cut results;
see, for example, Moghadam and Wren-Lewis (1990), Boughton (1991), and
MacDonald and Taylor (1993).
10
Recent studies at the aggregate level for the United States, Japan, and
Germany find an elasticity of abo�t 0.13; see Adams and Coe (1990), Citrin
(forthcoming), and Coe and Krueger (1990), respectively. Griliches (1988) re­
ports that estimated elasticities from firm- and industry-level data tend to lie
between 0.06 and 0.1.
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CAPITAL AND TRADE AS ENGINES OF GROWTI-l IN FRANCE
553
economic impact of European integration. Moreover, as discussed be­
low, the estimated impact on French growth of European integration is
consistent with Baldwin's (1989) estimates of the impact of the single
market on EC growth.
An important question is whether the stock of R&D capital and the
proxy for EC integration are necessary for cointegration. The likelihood
ratio test that the coefficients on k'&d and EC are zero is strongly rejected
(chi-squared (2) = 14.9; 95 percent critical value = 5.99).11 If either k'&d
or EC is omitted, both of the Johansen likelihood ratio tests of the null
hypothesis that there are no cointegrating vectors cannot be rejected.
Thus, output, labor, and capital are not by themselves cointegrated; both
R&D capital and EC integration are necessary additional variables for
cointegration.
As discussed above, the measure of physical capital used in the esti­
mated equations includes not only the stock of business sector capital but
also the stock of government infrastructure capital and the stock of
residential capital. The specification of the equation does not, however,
allow the different components of capital-government infrastructure,
public enterprises, private business, and residential capital-to have
different impacts on output. Specifications that entered some or all of the
components of capital separately yielded implausible results.12
Because it is much more common to include only the stock of business
sector capital (kb), Table 3 reports estimation results using it instead of
the stock of total capital (k). 13 The two tests for the existence of a
cointegrating vector give conflicting results. At the 95 percent confidence
level, the test based on the maximal eigenvalue (Panel A) indicates that
there are no cointegrating vectors (test statistic of 31.96 against a critical
value of 33.32), whereas the test based on the trace (Panel B) indicates
11 A number of other tests were performed to check the robustness of this
result: (i) k'"'d and EC were excluded and a trend was added; (ii) EC was dropped
and a trend was included; and (iii) a trend was included along with the other
variables. None of these specifications resulted in a cointegrating vector with
sensible coefficients.
12 In theory it is possible to enter the components of the capital stock sepa­
ra�y _and _test the su_!!Hni.J.lg �striction-for example, <X ln(X + Y) =
[<XX !(X + Y) lnX) + [<XY !(X + Y)ln Y], where a bar indicates the sample
mean. However, entering the components of capital separately led to multiple
cointegrating vectors. Since the "structural" model can consist of a linear com­
bination of the Johansen vectors, the restrictions must be tested across all vectors;
when this was done, however, the likelihood ratio tests did not converge.
13 De Long and Summers (1991), based on cross-country data for industrial and
developing countries, find equipment investment has a stronger association with
gbrowth than other components of investment. Estimates using only the stock of
usiness equipment capital were not possible since this variable is not readily
available for France.
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DAVID T. COE and REZA MOGHADAM
Table 3. Johansen Maximum Likelihood Tests and Parameter Estimates
with the Business Sector Capital Stock
(1971:1 to 1991:4, maximum of four lags in VAR;
eigenvalues in descending order: 0.33, 0.25, 0.20, 0.13, 0.01)
A. Cointegration likelihood ratio test
based on maximal eigenvalue
of the stochastic matrix
Null
Hypothesis"
Alternative
r=O
r :s 1
r :s. 2
r=1
r=2
r=3
r :s. 4
r
r53
r=4
=
5
Test
statistic
95 percent
90 percent
critical value
critical value
33.32
27.14
21.07
30.84
24.78
18.90
8.18
6.50
31.96
22.77
17.61
11 . 09
0.78
14.90
12.91
B. Cointegration likelihood ratio test
based on trace of the
stochastic matrix
Null
Hypothesis"
r=O
r :s 1
r :s. 2
r :S. 3
r :s. 4
Alternative
r :2:: 1
r :2:: 2
r :2:: 3
r :2:: 4
r =5
Test
statistic
95 percent
critical value
84.21
52.24
29.48
11.87
0.78
70.60
48.28
31.52
17.95
8.18
90 percent
critical value
66.49
45.23
28.71
15.66
6.50
C. Estimated cointegrating vectors (coefficients
normalized on y in parentheses)
h
kb
kr&d
y
-9.83
9.31
2.87
3.50
(-1 .00)
(0.23)
(0.95)
(0.36)
-3.26
-10.69
-4.07
15.47
2
( -1 .00)
(0.21)
(0.69)
(0.26)
The number of cointegrating vectors is denoted by r.
Vector
1
EC
0.32
(0.03)
0.12
(-0.008)
•
that there are at most two cointegrating vectors. Panel C reports the
coefficient estimates from the two possible cointegrating vectors. Al­
though the estimated coefficients (normalized on y in parentheses) on h,
kb, and k'&d are correctly signed, their magnitudes are less plausible than
in the specification using total capital (Table 2).
Table 4 reports the results of testing the first cointegrating vector
reported in Table 2 for a number of restrictions on the estimated coeffi­
cients of the three factors of production: labor, capital, and R&D capital.
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CAPITAL AND TRADE AS ENGINES OF GROWTH IN FRANCE
Table 4. TestS of Parameter Restrictions
(y = cxh. + l3k + -yk'&.d + OEC + constant)
Parameter
restrictions
a + 13 1.0
a = 0.6
13 = 0.4
a + 13 + -y = 1.0
13 + -y = 1.0
=
Chi-squared test
Unrestricted statistic (degrees
Critical values
estimates
of freedom)
1.24
a = 0.71
13 0.53
1.41
0.70
1.03 (1)
11.45 (4)
95 percent
3.84
9.49
3.86 (1)
9.83 (1)
3.84
3.84
=
90
percent
2.71
7.78
2.71
2.71
The restriction that the sum of the coefficients on h and k is unity cannot
be rejected. However, the restriction that the estimated coefficients on
h and k are equal to the sample average of their factor shares (0.6 and
0.4, respectively) is rejected. The restriction that the estimated coeffi­
cients on all three factors sum to unity is also rejected; the fact that the
estimated coefficients sum to 1.4 suggests that there are increasing re­
turns to scale with respect to labor, capital, and R&D capital. Finally,
the restriction that the estimated coefficients on the two factors of pro­
duction that can be accumulated-physical capital and R&D capital­
sum to unity is rejected. In Sala-i-Martin's (1990) discussion of economic
growth, this condition is necessary for endogenous growth. This is be­
cause a sum of the coefficients on physical and R&D capital of less than
unity implies decreasing returns to capital, which in turn implies-in the
absence of exogenous technological progress-zero steady-state growth
of per capita output.
A number of alternative specifications of the production function were
estimated. A demographic variable measuring the proportion of youth
(15-24 years old) in total employment was added to capture the effect of
possible changes in the quality of labor input. Inflation was included to
test the hypothesis that high inflation diverts resources from productive
activity. The total stock of R&D capital in 21 of France's trading partners
was included to test if France benefited from R&D performed abroad. 14
None of these formulations generated meaningful cointegrating vectors­
either there was no cointegrating vector or there were multiple cointe­
grating vectors, the estimated coefficients of which had incorrect signs,
implausible magnitudes, or both.
Alternative measures of trade were also tried. To test whether the
EC variable was capturing the effect of increased world-rather than
14 Empirical evidence of the importance of international R&D spillovers is
presented in Coe and Helpman (1993).
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DAVID T. COE and REZA MOGHADAM
European-integration, world trade as a percentage of world GDP was
included both with and without the EC trade integration variable, but
we were unable to obtain a cointegrating vector. If France's EC trade
either as a percent of total French trade or as a perceht of French out­
put is included instead of the EC variable, the two likelihood ratio tests
for the existence and uniqueness of a cointegrating vector give incon­
sistent results. However, in both cases the estimated coefficients in the
vector with the largest eigenvalue were correctly signed and of plausible
magnitudes.15
IV. Potential Output
In the long run, actual output should equal potential output, and hence
the estimated cointegrating vector in Table 2 provides a direct and simple
means of calculating potential output (y*) : 16
y* = 0.71h + 0.53k + 0.17k'&d + 0.03EC - 0.39.
(4)
Because potential output is commonly thought to be relatively stable
compared with actual output, short-run fluctuations have been re­
moved from hours worked and from the EC integration variable in order
to calculate potential output-though not to estimate the production
function-in the case of the EC variable by estimating a cubic trend (see
Figure 1).
The sources of the cyclical movements in hours worked can be revealed
by decomposing it into hours per employee (hie), the employment ratio
(ellf), the participation ratio (If/pop), and population (pop): in loga­
rithms, h = (hie) + (e/lf) + (if/pop) + (pop).17 Cyclical variations in
hours worked mainly reflect movements in the employment ratio and in
the participation ratio (Figure 3). A polynomial trend has been used to
remove cyclical variations in hours per employee and in the participation
ratio. Cyclical movements in the employment ratio mainly reflect de­
viations of the actual rate of unemployment from the natural rate of
unemployment. Since it lies beyond the scope of the present study to
estimate the natural rate of unemployment for France as a function
15 According to one of the tests, the null hypothesis that there are no cointegrat­
ing vectors cannot be rejected.
16 See the references cited in the box on potential output in IMF (1991, p. 43);
and Torres and Martin (1990). The constant in eq uation (4) has been calculated
so that the average error over the sample period is zero.
17 Although hours and employment refer to the nonfarm business sector, labor
force and population refer to the full economy.
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CAPITAL AND TRADE AS ENGINES OF GROWTH lN FRANCE
Figure 3. Hours Workeda
(In logarithms,
1971: I =
I 00)
106
104
102
100
Hours 11·orked assuming
unemploymem ar rhe natural raft'
98
Hours 11·orked (h)
96
94
92
Hours worked with
90
cyclical variations removed
88
1977
1979
1981
198�
1987
1989
1991
120
1 16
1 12
108
104
100
' ....
96
_ ....
Participation ratio
_
(/jlpop)
_ _ _ , _ _ _ _ _ _ _ _
.....
92
···· ··
Employmem ratio
88
(eflj)
84
1 97 1
"Nonfarm business sector. The decomposition of hours worked in the lower panel
is calculated from
in logarithms.
h=(hle)+(ellj)+(lftpop)+pop, where all variables are
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558
DAVID T. COE and REZA MOGHADAM
of its structural determinants-two estimates of potential output are
presented corresponding to two assumptions about the natural rate of
unemployment.
One estimate of potential output uses the actual (cyclically adjusted)
employment ratio, on the assumption that the actual unemployment rate
is not too different from the equilibrium natural rate. This assumption
is consistent with a hysteresis view of equilibrium unemployment and
with the persistence of high unemployment and broadly stable wage
inflation during the past three to four years in France. The second
estimate of potential output incorporates an adjustment for hours worked
based on a very simple and straightforward estimate of the natural rate
of unemployment. 18 This estimate of the natural rate reflects two assump­
tions: that the actual unemployment rate was about the same as the
natural rate in the early 1970s and that increases in the natural rate
thereafter can be proxied by trend increases in the unemployment rate
for prime-age males (Figure 4). 19
The two estimates of potential output are shown in Figure 5. After
slowing from the mid-1970s to about 1986, the estimated growth of
potential output increases to a little more than 3 percent in the early
1990s.20 Since the mid-1970s, the estimated level of potential output
incorporating hours worked at the natural rate of unemployment is higher
than the estimate using actual hours worked, reflecting the assumption
of greater labor input. By the mid-1980s, when the gap between the
alternative estimates of the natural rate reached its maximum, the gap
between the two estimates of potential output was about 2V4 percent. In
terms of growth rates, however, the two estimates of potential output are
broadly similar. From the early 1980s until about 1988, both measures of
potential output exceeded actual output, and this contributed to the
sustained declines in inflation from double-digit levels in 1980 to less than
18
Using an asterisk to indicate that a variable has been cyclically adjusted or
that the unemployment rate (U) is at its "natural" level, the adjustment for hours
worked is h - h* ( U* - U) /100, which is obtained by substituting e /If=
log(1 - U/100) - U 1100 into the equation used to decompose h and making
a similar substitution for (e !If)* into an equation for h*.
1 9 Although the prime-age male unemployment rate is often used in estimated
wage equations instead of the aggregate unemployment rate (see Cotis and Loufir
(1990)), we simply use this vanable to capture the trend increase in the natural
rate since the early 1970s. The natural rate of unemployment is estimated as a
qduadratic trend on the male unemployment rate for 24-50 year olds plus the
ifferential between the aggregate and the prime-age male unemployment rates
in the early 1970s. The estimate of the natural rate at the end of the sample is
in line with estimates typically found in models of the French economy, which are
on the order of 7-8 percent.
20This may be a slight overestimate as the GDP figures for 1991 have recently
been revised downward.
=
=
©International Monetary Fund. Not for Redistribution
559
CAPITAL AND TRADE AS ENGINES OF GROWTH IN FRANCE
Figure 4. Unemployment Ra1es
(In percent of labor force)
II
10
9
8
7
,
,-.I
6
"
I
I
I Males aRed 25-50 years
5
I
4
3
2
1973
197 1
1 977
1975
1979
1 98 1
1983
1985
1987
1 989
1991
3 percent in 1988. Inflation rose to about 3Y2 percent in 1989-90 when
actual output rose above both estimates of potential output. Since 1990:4,
actual output has again fallen below both estimates of potential output,
and inflation has fallen back to about 3 percent. This relationship be­
tween the level of the output gap and changes in inflation is statistically
significant.21
21 Regressing the change in consumer price inflation (!12 p) against the output
gap, assuming hours worked at the estimated natural rate (y - y*), gives
!12p = 0.001 + 0.07(y - y*)-t - 0.45!12P-t - 0.29112P-2 - 0.26112P-3;
(2.36)
(2.49)
(4.04)
(2.45)
R2
0.20, s.e.e. 0.006, DW 2.03, LM[x2(1)] 0.30, LM[x2(4)] 5.23.
The regression has been estimated using OLS, and t-statistics are in parentheses.
=
=
=
=
=
Regressions with the output gap assuming actual hours worked gave similar
results.
©International Monetary Fund. Not for Redistribution
560
DAVTD T. COE and REZA MOGHADAM
Figure 5. Ourpuru
(In logarithms, actual output = I 00 in 197 1 : I )
170 r-------.
160
Polential
(based on hours ll"orked
ISO
assumin[i •memploymenl
a/ 1he na/ura/ rare)
140
Polential
130
(based on amwl
hours 11·orked)
120
110
1 00
/
"
/
/
/
1971
"
"
"
"
1973
"
1975
1977
1979
1981
1983
1985
1987
19
89
199 1
aReal value added in the nonfarm business sector.
Turning to the estimated sources of potential output growth summa­
rized in the top section of Table 5 and Figures 1-3, it is clear that capital
and trade have been the engines of growth in France during the past two
decades. The slowdown in growth from the mid-1970s to the mid-1980s
is accounted for by the sharp reduction in hours worked and by the
slowdown in physical capital formation-real gross fixed capital forma­
tion actually declined in six of the ten years from 1975 to 1984. Increases
in R&D capital account for more than 15 percent of the total increase in
potential output over the 1971-91 period. The contribution of R&D
capital to the growth of potential output increased slightly in the late
1980s.
The estimation results suggest that European trade integration has
given a substantial boost to the growth of potential output in France. The
©International Monetary Fund. Not for Redistribution
561
CAPITAL AND TRADE AS ENGINES OF GROWfH IN FRANCE
Table 5. Potential Output Growth"
(Annual percentage changes)
1971-91
1971-75
1976-83
1984-91
Nonfarm business sector
2.4
5.2
3. 1
2.4
Potential outputb
due to:
2.9
2.0
1.4
Physical capital
2.0
R&D capital
0.5
0.4
0.4
0.5
1.3
0.7
0.3
European trade integration
0.7
-0.7
-0. 1
0.5
Hours workedb
0.1
3.7
2.3
Actual output
2.8
2.6
Gross domestic product"
2.5
4.9
Potential output
2.3
3.0
2.5
2.7
2.5
Actual output
3.4
Memoranda items
Unemployment rate (end year)
8.4
4.2
9.4
Actual
9.4
3.2
Natural
8.1
6.6
8.1
Nonfarm business output as a
-0.1
0.3
0.1
share of GDP
0 .1
• Calculations are based on annual data.
b Assuming unemployment is at the natural rate.
"The growth of GDP is equal to the growth of output in the nonfarm busi­
ness sector minus the growth of nonfarm business output as a share of GDP.
beneficial effects of European integration were most pronounced in the
early 1970s when intra-EC trade was increasing much more rapidly than
it has in the more recent period. As noted, Coe and Krueger (1990) report
a similar result for the Federal Republic of Germany.22 It is interesting
to note that Baldwin (1989) estimated that the 1992 single market pro­
gram would increase the EC's long-term growth rate by 0.2 to 0. 9 percent­
age points. This estimate, which is based on a completely different
methodology from the one used here, is consistent with our estimate of
the impact that European integration has had, and is likely to have in
1992-97, on growth in France.
Declines in hours worked contributed to a slight reduction in potential
output growth over the 1971-91 period. The drop in hours worked re­
flected sharp declines in hours per worker up to the early 1980s and, to
22The share of potential output growth over the past two decades attributable
to closer European integration is estimated to have been less in Germany than
in France, reflecting the somewhat less open French economy at the start of the
1970s.
©International Monetary Fund. Not for Redistribution
562
DAVID T. COE and REZA MOGHADAM
a lesser extent, declines in the employment rate from the mid-1970s to
the mid-1980s and in the participation rate in the 1980s (see the lower
panel of Figure 3). Population increased by an annual average of about
¥4 percent during the full 1971-91 period. In 1984-91, hours per worker
and the participation rate remained broadly stable and population growth
more than offset the relatively small increase in the natural rate of
unemployment, implying a small positive contribution of hours worked
to the growth of potential output.
To calculate potential output for 1992-97, it has been assumed that
weekly hours remain broadly stable. The contribution of capital reflects
the medium-term projection for fixed investment and an assumption that
the depreciation rate remains unchanged from the 1990-91 average. The
contribution of R&D capital is based on a regression relating real R&D
expenditures to real output.23 Given the completion of the single market
at the end of 1992, it is assumed that the contribution of intra-EC trade
as a percent of EC output to potential output growth will remain the same
as in the 1984-91 period but well below its contribution in 1971-83. These
projections and assumptions imply an average annual growth of potential
output of about 2.5 percent for 1992-97. The estimate of potential output
growth is similar to Artus's (1992) estimate for 1992-93 and is almost the
same as the 2.6 percent projected for 1989-95 in Adams, Fenton, and
Larsen (1987).
The IMF staff's medium-term projections for 1992-97 are based, in
part, on the projection for potential output presented hereY Below­
potential growth in the 1991-93 period results in a substantial widening
of the output gap. Growth is expected to recover during 1994 and to grow
above potential in 1995-97, thereby reducing the gap.
V.
Concluding Remarks
Recent cointegrating techniques that focus on the identification of
long-run relationships are particularly appropriate to the study of long­
run growth. The application of these techniques to French data has
yielded a number of interesting empirical results, two of which relate to
the role of capital. The first is the relatively large estimated elasticity of
23 The estimated regression is log(R&D expenditures) l . l log(output) +
0.8, for annual data 1970-89. The stock of R&D capital was
then calculated for 1992-97 by cumulating R&D expenditures with an assumed
obsolescence rate of 5 percent.
24The medium-term projections are summarized in Annex II of the IMF
(1993).
constant , R2
=
=
©International Monetary Fund. Not for Redistribution
CAPITAL AND TRADE AS ENGINES OF GROWTH IN FRANCE
563
output with respect to R&D capital. The second is that a broad concept
of physical capital-<>ne that includes public infrastructure, residential
and nonresidential structures, and plant and equipment capital-per­
forms better than the more common, narrower concept of business sector
capital. A third important-and new-result is the empirical estimate of
the beneficial effects of European trade integration on French growth.
The estimated production function is not, strictly speaking, character­
ized by endogenous growth. The factors of production that can be accu­
mulated-physical capital (broadly defined) and R&D capital-exhibit
decreasing returns to scale. As Sala-i-Martin (1990) emphasizes, this
implies, in the absence of exogenous technological progress, a steady­
state growth of per capita output of zero. More generally, the underlying
relationships are between the level of output and the levels of the factor
inputs and the degree of trade integration. Although capital accumula­
tion and increased trade have boosted growth, a higher level of capital or
trade integration will not, in the long run, have an impact on the growth
of output.
These results have a number of policy implications. European integra­
tion has boosted French growth in the past, and steps to accelerate the
process of integration can be expected to enhance potential growth in the
future. The large increases expected in the services trade with the com­
pletion of the single market, additional steps toward closer economic and
monetary union, and closer integration with central and eastern Eu­
ropean countries may result in a substantially larger contribution to
future potential output growth in France than assumed above. Similarly,
government infrastructure investment and policies that encourage-or
create an environment conducive to-productive investment and re­
search and development will also increase potential output. Finally, labor
market policies that reduce the natural rate of unemployment over the
medium term, thereby increasing labor input, will boost potential output
growth.
The empirical results suggest a number of areas for further study. In
order to fully appreciate the implications for inflation, it is necessary to
combine the estimates of potential output with a more satisfactory esti­
mate of the natural rate of unemployment in the context of a fully
specified wage-price system. A second area for further study is the
determinants of R&D expenditures and the extent to which R&D con­
tributes to endogenous growth. Finally, there is a need for further study
of the impact on growth of other structural features of the French econ­
omy, such as the Common Agricultural Policy, and how structural reform
would affect medium-term growth prospects in France.
©International Monetary Fund. Not for Redistribution
564
DAVID T. COE and REZA MOGHADAM
APPENDIX
Data Sources and Definitions
Real value added, hours worked, and employment in the nonfarm business
sector are from the INSEE data tape, in each case subtracting the farm sector
(secteur agriculture, sylviculture, peche) from the total for the business sector
(secteurs marchands). The relevant INSEE codes for real value· added are
PNLV008 and PNLU018; for hours worked, ACM_VOOl and ACM_UOll;
and for employment, EFM_V001 and EFM_UOll.
The stock ofbusiness sector capital, the stock ofresidential capital, labor force,
and population are from the OECD Analytical Data Bank. The stock of infra­
structure capital is taken from the annual estimates of Ford and Poret (1991),
reported by them as INF.N (p. 80), interpolated to a quarterly frequency. The
share of the labor force aged 15-24 is calculated from the OECD's Labour Force
Statistics .
The stock of R&D capital is calculated analogously to the stock of physical
capital with an assumed obsolescence rate of 5 percent: k'&d = k:�d(1 - 0.05) +
(real R&D expenditures). A benchmark for k'&dwas calculated using the proce­
dure suggested by Griliches (1980). Real R&D expenditures are gross domestic
expenditures on R&D deflated by an average of the GDP deflator and an index
of business sector wages. R&D expenditures are from the OECD's Main Science
and Technology Indicators (1991:1, p. 16). R&D expenditures for 1991 were
estimated using the same procedure reported in the text to project R&D expen­
ditures for 1992-97. Annual data for the stock of R&D capital were interpolated
to a quarterly frequency.
Data to construct the EC variable are from the IMF's Direction of Trade
Statistics. The EC variable is constructed with data for all 12 current members
of the EC, even though not all 12 countries were members during the full 1971-91
period. World trade as a percent of world output was constructed from the IMF
World Economic Outlook data base. Annual data were interpolated to a quarterly
frequency.
·
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©International Monetary Fund. Not for Redistribution
CAPITAL AND TRADE AS ENGINES OF GROWTH IN FRANCE
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Ford, Robert, and Pierre Poret, "Infrastructure and Private-Sector Productiv­
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Griliches, Zvi, "R&D and the Productivity Slowdown," American Economic
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metric Package" (Oxford: Oxford University Press, 1991).
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©International Monetary Fund. Not for Redistribution
IMF Staff Papers
Vol. 40, No. 3 (September 1993)
C 1993 International Monetary Fund
French-German Interest Rate
Differentials and Time-Varying
Realignment Risk
FRANCESCO CARAMAZZA*
This paper explores the determinants of realignment expectations for the
French franc-deutsche mark exchange rate. Expected changes in the cen­
tral parity are estimated by adjusting short-term Euromarket interest rate
differentials for the expected rate ofchange in the exchange rate within the
ERM fluctuation band and by the yield differential on long-term gov­
ernment bonds. The results indicate that the exchange rate within the band
is mean reverting and that expected changes are sizable. Realignment
expectations are found to be related to the evolution offundamental eco­
nomic variables and, for shorter horizons, the position ofthe franc in the
fluctuation band. (JEL E43, F31, F33]
INCE
of currencies in the exchange rate mechanism
(ERM) of the European Monetary System (EMS) in January 1987,
S
the differential between French and German interest rates has narrowed
THE REALIGNMENT
considerably.1 Nevertheless, the continuing existence of a differential
• Francesco Caramazza, a Senior Economist in the Monetary and Exchange
Affairs Department, was a Senior Economist in the European I Department
when this paper was written. He holds a doctorate from Johns Hopkins Univer­
sity. The author would like to thank Michael Deppler, John Green, and Harilaos
Vittas for helpful comments and Susan Becker for research assistance.
1 Short-term interest rate differentials widened sharply in September 1992 and
in the months following the ERM crisis. Recently, short-term differentials have
narrowed significantly.
567
©International Monetary Fund. Not for Redistribution
568
FRANCESCO CARAMAZZA
suggests that market participants do not rule out a realignment of central
parities in the EMS before exchange rates are irrevocably fixed in the
final stage of economic and monetary union (EMU). Specifically, the
positive interest rate differential in favor of Germany across the maturity
spectrum implies a perceived risk of devaluation of the franc-mark
exchange rate. Indeed, attempts to quantify the various factors that
might explain the French-German interest rate differential find that they
account for only part of the differential.2
The persistence of a positive interest rate differential suggests that an
announced commitment to a fixed exchange rate may not be sufficient
to eliminate devaluation risk completely. Economic performance and the
authorities' policy approach also influence investors' expectations. Thus,
exchange rate policy may not be fully credible if, for instance, problems
of unemployment, a weak external position, or other perceived weak­
nesses cast doubt on the authorities' ability to maintain their com­
mitment. In the same vein, a policy of keeping the exchange rate close
to the upper (weak) edge of the fluctuation band may also diminish
credibility.
This paper examines expectations of a realignment of the franc-mark
central parity over the period February 1987 to November 1991. The aim
is to estimate the expected rate of realignment and to attempt to identify
the factors that might influence market participants' expectations of
parity changes.
A commonly used measure of the expected rate of realignment of a
currency is the differential between the interest rates on assets denomi­
nated in the domestic currency and those denominated in a foreign
currency. This measure is imprecise, however, especially for interest rates
at the short end of the maturity spectrum, because interest rate differ­
entials are affected by expected exchange rate changes within the fluctu­
ation band of the exchange rate mechanism. In what follows, estimates
of the time-varying expected rate of realignment are first constructed by
adjusting interest rate differentials on 3-, 6-, and 12-month Eurofranc and
Euromark deposits for the expected rate of change of the franc-mark
exchange rate within the fluctuation band. The latter, in turn, is obtained
by assuming that the exchange rate inside the band follows a mean­
reversion process. The calculated expected parity changes are then re­
gressed on a number of macroeconomic variables that agents are thought
to consider in forming expectations of a currency's possible realignment.
A similar analysis is also conducted with long-term government bond
yields. Inflation differentials, competitiveness, unemployment rates,
relative fiscal situations, and the position of the exchange rate within the
2 See, for instance, Artus (1992).
©International Monetary Fund. Not for Redistribution
FRENCH-GERMAN INTEREST RATES AND REALIGNMENT RISK
569
band are found to play an important role in the formation of exchange
rate expectations.
I. Interest Rate Differentials,
Exchange Rate Bands, and Credibility
Under current EMS arrangements, interest rates on financial assets
that differ only in their currency of denomination can diverge because
of the discounting of two types of exchange rate uncertainty: the day-to­
day fluctuations in exchange rates within the ERM bands and the possi­
bility of a realignment ofthe central rates. It is widely accepted that since
the January 1987 realignment the EMS target zones have become much
more credible. This bas allowed devaluation risk premia to decline and
interest rate differentials to narrow considerably. For example, the differ­
ential on 12-month Eurofranc and Euromark interest rates (Figure 1)
Figure I . Parity Deviations of Franc-Mark Exchange Rate and
12-Month Interest Rate Differential
(In percem)
6.0
12-momh imerest rate dijJeremia/u
5.0
4.0
3.0
2.0
1.0
. .
0
-1.0
·..
.· ·
.
.
. ··
Del'iation ojfranc-mark exchanKe ratefrom central rtaet>
-2.0
-3.0
L_
_
_
_
_I
L_
_
_
_
_i_
_
_
_
__l
_
_
_
_
_.J.
_
_
_
_
__l..
__..j
1987
198!
1989
1990
1991
aEurofranc rate minus Euromark rate.
bPercent deviation.
©International Monetary Fund. Not for Redistribution
1992
570
FRANCESCO CARAMAZZA
declined from a mean differential of 4. 7 percentage points in 1987 to 0.25
percentage points in 1991.
A simple way to test the credibility of the EMS target zones is tc
suppose that investors at time t expect with certainty that there will b€
no realignment (or change in the width of the exchange rate band) up tc
time t + m, the time of maturity of a given asset. Then, at time t + rr
the spot exchange rate is expected with certainty to be bounded by
SL s u
u
F�' S,
(1
where S is the domestic currency price of foreign exchange (franc /mark
and and are the lower and upper marginsofthe exchange rate band
Hence, the net profit from a forward sale of one unit of foreign currenc:
is bounded by
-
::;
F�'
-
S,+m
::;
F�'
-
(2)
S�,
where F;n is the forward exchange rate at time t for maturity m (measured
in years). Further assuming that arbitrage eliminates certain positive
minimum profits, it follows that if the forward exchange rate lies outside
the exchange rate bands, then the target zone is not credible. If the
forward exchange rate lies within the exchange rate band, then the test
is inconclusive. 3 Alternatively, invoking covered interest parity, the
domestic interest rate under full credibility is bounded by
[ {1 + ii'm)(SSL)Jtm 1] i, [(1 i;'m)(SS u)um 1] ,
(3)
,
,
where i;n and i,*m are the domestic currency (franc) and foreign currency
(mark) interest rates on assets of the same default risk and maturity m ,
-
:5
:5
+
-
expressed as annualized rates of return. If at any time t the domestic
interest rate is outside these "credibility bounds," then agents expect
with positive probability · that over the time to maturity, t + m , the
exchange rate band will shift by way of either a realignment or an increase
in the band's width.
Eurofranc interest rates for 3-, 6-, and 12-month maturities and their
corresponding "credibility bounds" are shown in Figure 2. The three­
month interest rate was almost always within its credibility bounds;
hence, the exchange rate band may or may not have been credible. The
one-year interest rate, however, was consistently above the upper bound
from January 1987 to March 1990, and thereafter consistently inside the
3 This test of target zone credibility was first applied by Svensson (1990)
to the Swedish krona and has since been applied to a number of currencies
by Giovannini (1990), Koen (1991), and Geadah, Saavalainen, and Svensson
(1992).
©International Monetary Fund. Not for Redistribution
FRENCH-GERMAN 1NTEREST RATES AND REALIGNMENT RJSK
571
Figure 2. Eurofranc /merest Rates and "Credibility Bounds"
(In percent)
20.0
15.0
10.0
5.0
0
-5.0
- 1 0.0
-15.0
1987
1988
1989
1 990
199 1
1992
1987
1988
1989
1990
1991
1992
1989
1990
1991
1992
15.0
10.0
5.0
0
-5.0
12.0
12-month imerest rate
10.0
8.0
.·
• • •
. . .. . . I
0
. .
.
· ·..
6.0
4.0
2.0
0
1987
1988
©International Monetary Fund. Not for Redistribution
572
FRANCESCO CARAMAZZA
bounds. Thus, it may be inferred that until March 1990 agents expected
with positive probability a devaluation of the franc-mark exchange rate.
In the case of one-year interest rates, the test is less inconclusive as the
credibility bounds are significantly narrower than those for three-month
interest rates. The next section outlines a more precise empirical method
(from Bertola and Svensson (1991)) for extracting the implicit expected
rate of realignment from exchange rates and interest rate differentials.4
II. A Model of the Expected Rate of Realignment
Let s, sL , and su denote the natural logarithms of S , S L, and S u (the
franc-mark spot exchange rate and its lower and upper intervention rates,
respectively). By definition, the exchange rate can be decomposed as
s, = c, + s,,
(4)
where c, = (s� + ) 12 is the log of the central parity of the franc-mark
exchange rate and s, is the deviation of the franc from the central parity.
Taking first differences of equation (4), the total expected rate of change
of the franc from time t to t + m, conditional on information available
at time t, is equal to the expected rate of realignment (that is, the change
in the central parity) plus the expected rate of change of the franc within
the band:
u
s,
E,tls,+mlm = E,�Cr+mlm + E,M,+mlm.
(5)
Assuming uncovered interest parity (UIP)
(6)
it follows that
- (l,'"
A"'r+m Im .
EI A
' - l,'*nl) - E, L.1.)
L.lCc+ m Im -
(7)
UIP is an appropriate assumption if the foreign exchange risk premium
is small. Theoretical support is provided by Svensson (1990), who argues
that the risk premium is likely to be small in exchange rate target zones,
even in the presence of devaluation risk. Empirical support of UIP for
the franc-mark rate is provided by Rose and Svensson (1991), Andersen
and Sorensen (1991), and, indirectly, Frankel and Phillips (1991).
From equation (1) and the definition of s,, it can be shown that the rate
of change of the exchange rate within the band is bounded by
(8)
4 For an app lication to the Swedish krona, see Lindberg, Svensson, and
Soderlind (1991).
©International Monetary Fund. Not for Redistribution
FRENCH-GERMAN INTEREST RATES AND REALIGNMENT RISK
573
which combined with equation (7) gives the following maximal bounds
for the expected rate of realignment:
(i;" - ii"') - (s,u - s,)lm
:S
:s
E, t:..c,+mlm
(i;" - i,*"') - (s,L - s,)!m.
(9)
These bounds are shown as the solid lines in Figures 3 and 4. As can be
seen, the bounds for the expected parity changes are wider the shorter
the maturity. This reflects the fact that the maximal bounds for the
expected rate of change of the exchange rate within the band are wider
for shorter maturities.
III.
Estimation of Expected Exchange
Rate Changes Within the Band
To calculate the expected rate of realignment from equation (7), it is
necessary to filter out expectations of exchange rate changes within the
fluctuation band. As noted earlier, the simplest procedure is to assume
that the expected change in the exchange rate within the band is zero­
that is, E, t:..s,+m lm 0-in which case the expected change in the central
parity is simply equal to the interest rate differential. This case can be
ruled out a priori, however, since the exchange rate within the band
cannot follow a random walk. Indeed, an augmented Dickey-Fuller test
rejects the hypothesis that s has a unit root.5 An alternative procedure,
following Bertola and Svensson (1991), Svensson (1990, 1991), and Rose
and Svensson (1991), assumes initially that the future exchange rate
within the band may be well approximated by the current exchange rate.6
The change in the exchange rate within the band, conditional upon no
realignment, may thus be estimated from
=
(10)
Estimates of the above equation are presented in Table 1 and plotted in
Figure 3.
Two points about the estimation of equation (10) should be noted.
One, a consequence of the target zone model is that the conditional
distribution of the exchange rate within the band is heteroskedastic. Two,
the projection horizons employed (m 3, 6, and 12 months) are longer
than the sampling interval of the data (monthly). The use of overlapping
=
5 The regression of f:..s, on $,_ " three lags of f:..s , and a constant yiel ds a DF
statistic of -2.312 with a corresponding p-value of 0.46, so that the null of
cointegration is accepted.
6Supporting evidence is also reported by Chen and Giovannini (1992).
©International Monetary Fund. Not for Redistribution
FRANCESCO CARAMAZZA
574
Figure 3. Expected Rate ofChange of Franc-Mark Exchange Rate
Within the Intervention Band
(In percent)
15.0
10.0
5.0
0
-5.0
- 1 0.0
-15.0
-20.0
1987
1988
1989
1990
1991
1992
1987
1988
1989
1990
1991
1992
1987
1988
1 989
1990
1991
1992
8.0
6.0
4.0
2.0
0
-2.0
-4.0
-6.0
-8.0
- 10.0
4.0
3.0
2.0
1.0
0
-1.0
-2.0
-3.0
-4.0
-5.0
©International Monetary Fund. Not for Redistribution
FRENCH-GERMAN INTEREST RATES AND REALIGNMENT RISK
575
observations implies that the error terms will follow a moving-average
process of order m - 1. Ordinary least squares will give consistent esti­
mates of the coefficients, but their standard errors will be inappropriate.
Consequently, generalized method of moment (GMM) estimates have
been used for the standard errors, which are robust to heteroskedasticity
and serial correlation as in Newey and West (1987).
The results indicate that the exchange rate within the band is mean
reverting: within the band, the expected exchange rate is closer to the
long-run mean of the exchange rate at longer time horizons. The esti­
mated slopes are negative for all maturities, as implied by mean rever­
sion, and are large relative to their standard errors. Moreover, the longer
is the maturity, the larger is the estimated slope in absolute value. The
estimates also show that the expected change of the franc-mark exchange
rate within the band has narrowed over the January 1987 to March 1992
period and has gradually turned from an expected depreciation to an
expected appreciation by the end of the period (Figure 3).
An attempt was made to refine the estimates in Table 1 by the inclusion
of additional explanatory variables in equation (9). First, s2 and s3 were
included so as to capture possible nonlinearities in the relationship. They
were found to be insignificant. Second, the mark-dollar interest rate
differential for the corresponding maturity was included on the assump­
tion that its movements may affect the franc-mark exchange rate (Artus
and others (1991 )). This, too, proved insignificant. The estimates in
Table 1. Estimated Expected Change in the Franc-Mark Exchange Rate Within
the Intervention Band, January 1987-December 1991
(s,..m - s, = 13o + 13a s, + E,)
Maturity (m)
Coefficient
13o
13t
3 months
6 months
12 months
0.454
(2.553)
-0.443
( -3.073)
0.768
(3.756)
-0.732
(-3.792)
1.033
(7.628)
-0.943
(-15.541)
Summary statistics
0.633
Standard error
0.577
0.550
0.269
0.444
R-squared
0.652
43.93
91.64
£-statistic (13t 0)
21.34
57
Number of observations
51
60
Note: T-statistics are in parentheses. The franc-mark rate within the band (s)
is measured in log deviations from the franc-mark central parity. The standard
errors of the coefficients are GMM estimates allowing for heteroskedastic and
serially correlated error terms using the method of Newey and West (1987).
=
©International Monetary Fund. Not for Redistribution
576
FRANCESCO CARAMAZZA
Figure 4. Bounds for Expected Rare ofRealignme111
ofFranc-Mark Exchange Rare
(In percent)
25.0
20.0
15.0
10.0
5.0
0
-5.0
-10.0
1987
1988
1989
1990
1991
1992
1987
1988
1989
1 990
1 991
1992
987
1988
1 989
1990
199 1
1992
14.0
12.0
10.0
8.0
6.0
4.0
2.0
0
-2.0
-4.0
10.0
8.0
6.0
4.0
2.0
0
-2.0
©International Monetary Fund. Not for Redistribution
FRENCH-GERMAN INTEREST RATES AND REALIGNMENT RISK
577
Table 1 are thus used to calculate the expected rate of realignment of the
franc-mark exchange rate. It is shown in Figure 4 for different maturities.
IV. Explaining the Expected Rate of Realignment
This section examines whether the calculated expected rate of re­
alignment can be explained by generally observed macroeconomic vari­
ables. 7 It is assumed that in forming expectations of a currency's possible
realignment, agents consider a number of factors, at home and abroad,
that may cause a change in the central parity. These include inflation
differentials, changes in foreign exchange reserves, fiscal developments,
unemployment rates, relative money supply growth, and other macro­
economic variables. They may also include other factors that influence
market sentiment, such as the authorities' perceived policy behavior or
commitment.
The results of regressing the calculated expected rates of realignment
on a selected set of macroeconomic variables that are believed to enter
agents' information sets are shown in Table 2. 8 For all three maturities
the results are quite similar. More than 70 percent of the variation in the
expected rate of devaluation is explained by the change in foreign ex­
change reserves, the government financing requirement (as a ratio to
GDP) of France relative to Germany, the inflation differential, France's
export price competitiveness relative to Germany's, the unemployment
rate, and the position of the franc-mark rate within the fluctuation band.
7The two-ste p estimation procedure used in this paper, namely first estimating
the expected ch ange in the exchange rate within the intervention band and,
subsequently, estimating the determinants of the expected rate of realignment
(constructed by adjusting interest rate differentials for the estimates from the first
step), is not the only possible estimation strategy. For instance, one could esti­
mate simultaneously the expected change in the exchange rate within the band
and the determinants of the expected rate of realignment by estimating
(i;n - i: m) - (.ft+m - Sr) /m
on the rational expectations assumption that E,(s,+m - f,), conditional on no
realignment, is equal to (f,...m - f,). In this case, the disturbance of the estimated
equation would include the expectations error f,+m - E,(f,+m)· The point to note
is that, whether in two steps or simultaneously, estimation of the expected rate
of realignment requires an estimate of the expected change in the exchange rate
within the band. Tests of hypotheses of the determinants of expected changes in
the central parity are thus jomt tests of the expected changes in the exchange rate
within the band. It should also be noted that the estimated standard errors are
conditional on the estimated series of realignment risk.
8 Since numerous variables can be considered, the results reported in this
section should be regarded as an examination of some plausible determinants of
market expectations.
©International Monetary Fund. Not for Redistribution
578
FRANCESCO CARAMAZZA
Table 2. Determinants of the Expected Rate of Realignment Based on Filtered
Euromarket Interest Rate Differentials, February 1987-November 1991"
Maturity (m)
Variableb
Change in foreign exchange
reserves
Government financing
requirement<
Inflation differentiala
Export price competitivenesse
Unemployment rate
3 months
-0.118
( - 1.42)
0.939
(2.86)
0.744
(5.36)
-0.245
(-5.10)
1.284
(4.31)
1.502
(6.63)
6 months
-0.097
( -1.29)
0.853
(2.38)
0.794
(7.70)
-0.249
( -5.58)
1.376
(5.34)
1.256
(6.41)
12 months
-0.088
( -1.23)
0.733
(2.18)
0.842
(10.21)
-0.243
(-7.79)
1.400
(6.75)
0.800
(4.61)
Deviation of franc-mark
rate from upper edge of band
Summary statistics
Standard error
0.91
0.71
0.83
0.73
0.76
R-squared
0.81
F-statistic (6, 51)
22.75
26.32
36.41
Number of observations
58
58
58
Note: T-statistics are in parentheses.
The expected rate of realignment is defined as the French-German Euro­
market interest rate differential minus the estimated expected rate of deprecia­
tion within the band. The standard errors of the coefficients are GMM estimates
allowing for heteroskedastic and serially correlated error terms using the method
of Newey and West (1987).
bAll variables enter the estimated equations with a one-period lag, except the
governmentborrowing requirement variable, which enters with a two-period lag.
The regression equations also include a constant term, which is not reported.
0Tbe percent ratio of the government borrowing requirement to GDP in France
relative to Germany.
d Differential in the annual rates of change of consumer prices.
Annual rate of chan�e of real exchange rate in terms of export prices. An
increase represents an unprovement in France's competitiveness relative to
Germany's.
•
e
Relative money supply growth rates and the trade balance were also
included, but they were found to have no additional explanatory power.
The government financing requirement and inflation variables are
found to be positively related, and the competitiveness variable nega­
tively related, to the expected rate of realignment. Thus, decreases in
France's government financing requirement and in its inflation rate
relative to Germany's lower the expected rate of devaluation of the franc,
as does an improvement in France's export price competitiveness relative
to Germany's. Moreover, the null hypothesis that the coefficient on the
©International Monetary Fund. Not for Redistribution
FRENCH-GERMAN INTEREST RATES AND REALIGNMENT RISK
579
inflation differential is equal to one cannot be rejected at the 5 percent
significance level. The change in foreign exchange reserves enters the
equations for the expected rate of realignment with the expected negative
sign: an increase in reserves decreases the expected rate of devaluation.
Its statistical significance, however, depends on the specification of the
equation. In particular, when the unemployment rate is also included its
statistical significance declines considerably. The unemployment rate
itself, however, is highly significant.9 This raises an interesting point. In
a recent paper, Drazen and Masson (1992) extend the notion of policy
credibility to encompass not only the role of government policies in
signaling the "type" of government (how "tough" it is, to use their
terminology) but also the situation in which a government finds itself­
since in very adverse circumstances even a policymaker with a reputation
for being "tough" may renege on a commitment. Applied to the EMS,
this suggests that the increased credibility of the EMS reflects the dom­
inance of the signaling motive for setting policies as governments main­
tain their commitment not to realign. However, under the Drazen­
Masson notion of credibility, expectations of realignment also reflect
pressures to increase employment and growth after a period of restrictive
policies. The expected rate of devaluation will, therefore, be positively
correlated with the rate of unemployment.
The position of the exchange rate within the fluctuation band­
expressed as the deviation of the franc-mark rate from the upper (weak)
edge of the band-may be interpreted as capturing intangible market
sentiment about the credibility of the target zone. Its statistical signifi­
cance suggests that when the franc trades close to the upper intervention
margin, market expectations of a realignment intensify and a devaluation
risk premium is built into franc interest rates. As an alternative way of
capturing market sentiment, the deviation of the franc-mark rate from
the upper band was replaced "in the regression equations by a dummy
variable that takes increasing values as the exchange rate approaches the
upper intervention margin.10 The results were not qualitatively differ9The unemployment rate is more appropriately measured with respect to its
natural rate. But assuming that over the sample period the natural rate is con­
stant, it makes no difference-except for the constant term-whether the actual
unemployment rate or its deviation from the natural rate is used. In the regression
using the 12-month Euromarket rates, for example, the estimated constant term
is - 0.95 when the natural rate is assumed to be 8.5 percent and -0.25 (and not
significantly different from zero) when the natural rate is assumed to be 9 percent.
In view of the uncertainty about the perceived value of the natural rate, and since
it makes no difference for the other coefficients, the constant term is not reported.
10 Specifically, the dummy variable takes values of one when the franc-mark
rate is in the top half of the intervention band, two when it is in the top quarter,
and three when it is in the top eighth.
©International Monetary Fund. Not for Redistribution
580
FRANCESCO CARAMAZZA
ent.11 The statistical significance of these variables suggests that the
recent policy of allowing the franc to strengthen in the ERM may pay off
by way of reducing the devaluation risk premia on French short-term
interest rates. One interpretation of these results is that agents may
consider it more difficult to defend a currency that is close to the weak
edge of the band by sales of reserves (since reserves are limited) than it
is to sterilize capital inflows when a currency is at the strong edge of the
intervention margin. In the event of a shock, therefore, a country whose
currency is in the weak part of the band may have to raise interest rates
in order to maintain its currency within the band. If this is seen as
introducing a conflict between the domestic and the exchange rate objec­
tives of monetary policy, the credibility of the central parity may suffer.
The analysis thus far has been conducted using short-term Euromarket
deposit rates. Euromarket rates have the advantage over domestic money
market rates of not being affected by the existence of capital controls.
Since capital controls were being phased out over the sample period, it
seemed preferable to use Euromarket rates. 12 Euromarket rates are not
available for long maturities, however, and the latter have an advantage
in that the expected rate of mean reversion of the exchange rate within
the band becomes very small at long horizons.13 Since E, t:J.S is bounded,
the term E, t:J.S,+mlm in equation (7) becomes progressively smaller as the
forecast horizon lengthens, so that the expected rate of devaluation is well
approximated by the interest differential.
Table 3 reports the results of regressing the differential in the yield on
long-term government bonds on the same set of macroeconomic variables
used in the equation for the expected rate of realignment derived from
Euromarket rates. The results are broadly similar. The inflation rate,
competitiveness, and the unemployment rate are again the major factors
influencing devaluation expectations. 14 The relative government financ­
ing requirement, however, is not as significant as in ·the regression equa11 The estimated coefficients on the dummy variable (with t-statistics in paren­
theses) i.n equations using the 3-, 6-, and 12-month interest rates, respectively,
are 1.205 (6.89), 1.00 (6.41), and 0.66 (5.33).
12 Regulations other than capital controls, political and default risk, informa­
tion and transaction costs, and other factors may also introduce a wedge between
domestic market and Euromarket rates. Changes in domestic market rates may,
therefore, be due to actual or anticipated changes io these characteristics rather
than in exchange risk. Empirically, however, capital controls have been found to
constitute the major explainable component of spreads between Euromarket and
domestic market rates.
13 The results in the preceding section indicate that the expected rate of mean
reversion decreases as the horizon lengthens.
14 In contrast to the results in Table 2, however, the null hypothesis that the
coefficient on the inflation differential is equal to one is rejected in the second
of the equations reported in Table 3.
©International Monetary Fund. Not for Redistribution
581
FRENCH-GERMAN INTEREST RATES AND REALIGNMENT RISK
Table 3. Determinants of the Expected Rate of Realignment Based on Long­
Term Interest Rate Differential, February 1987-November 1991
Regression
Variable
Change in foreign exchange reserves
Government financing requirement
Inflation differential
Export price competitiveness
Unemployment rate
(1)
-0.123
(-2.21)
0.562
(1. 73)
0.967
(8.17)
-0.150
( -2.90)
(2)
-0.055
( -1.37)
0.179
(1.25)
0.538
(9.55)
-0.169
(-8.44)
1.065
(8.52)
Deviation of franc-mark
0.086
(0.61)
rate from upper edge of band
Summary statistics
Standard error
0.52
0.34
0.92
0.80
R squared
41.49
F-statistic (5, 52)
116.41
Number of observations
58
58
Note: T-statistics are in parentheses. Interest rates are yields on 7-10 year
government bonds. The method of estimation is OLS; robust standard errors are
estimated using a spectral density kernel. The coefficient for the constant term
is omitted. Variables are define d as in Table 2.
-
tions based on short-term rates, and the market sentiment variables are
insignificant. This last result is not surprising, as the current position of
the franc in the intervention band should be of little relevance in forming
expectations of exchange rates several years hence: views of the long­
term viability of the central rate are shaped by the unfolding of more
fundamental economic factors.
V. Conclusions
The differentials between French and German interest rates have
narrowed considerably since the EMS realignment in January 1987 as the
franc-mark exchange rate band has become increasingly credible. Expec­
tations of realignments of the centraJ parity have been found to be
influenced by the evolution of fundamental economic factors such as
inflation differentials, competitiveness, unemployment, government fi­
nancing requirements, and foreign reserves. France's favorable economic
performance, especially with regard to inflation, the external position,
©International Monetary Fund. Not for Redistribution
582
FRANCESCO CARAMAZZA
and its fiscal situation, has allowed the implicit expected rate of de­
valuation to decrease considerably. The results further suggest that the
devaluation risk premium on franc interest rates could be reduced further
and differentials with respect to Germany additionally narrowed by an
improved labor market performance and, in the case of short-term rates,
by a strengthened position of the franc in the ERM band.
APPENDIX
Data Sources
Consumer prices: IMF, International Financial Statistics, line 64.
Exchange rates: IMF, average of daily observations.
Export prices: IMF, International Financial Statistics, line 74.
Foreign exchange reserves: IMF, International Financial Statistics , line 1l.d
(total reserves minus gold).
Gross domestic products: IMF, International Financial Statistics, line 99b.c for
France, line 99a.c for Germany (monthly values obtained by interpolating
from industrial production index).
Government financing requirements: IMF, International Financial Statistics ,
line 84.
Industrial production indices: IMF, International Financial Statistics, line 66c.
Interest rates (Euromarket rates): IMF; 7-10 year government bond yields:
Banque de France (average of daily observations).
Unemployment rates: OECD, Analytical Data Base.
REFERENCES
Andersen, Torben M., and Jan Rose Sorensen, "Exchange Rate Risks, Interest
Rates and European Monetary Integration," Memo 1991-18 (Aarhus: Cen­
tre for International Economics, University of Aarhus, 1991).
Artus, Patrick, "Peut-on comprendre l'ecart de taux d'interet entre Ia France et
l 'Allemagne?" Document de Travail No. 1992-01 /E (Paris: Caisse de Depots
et Consignations, 1992).
Artus, Patrick, and others, "Transmission of U.S. Monetary Policy to Europe and
Asymmetry in the European Monetary System," European Economic Re­
view, Vol. 35 (1991), pp. 1369-84.
Bertola, Giuseppe, and Lars E.O. Svensson, "Stochastic Devaluation Risk and
the Empirical Fit of Target-Zone Models," NBER Working Paper No. 3576
(Cambridge, Mass.: National Bureau of Economic Research, 1991).
Chen, Zhaohui, and Alberto Giovannini, "Estimating Expected Exchange Rates
Under Target Zones," NBER Working Paper No. 3955 (Cambridge, Mass.:
National Bureau of Economic Research, 1992).
©International Monetary Fund. Not for Redistribution
FRENCH-GERMAN INTEREST RATES AND REALIGNMENT RlSK
583
Drazen, Allan, and Paul R. Masson, "Credibility of Policies Versus Credibility
of Policymakers" (unpublished; Washington: International Monetary Fund,
1992).
Frankel, Jeffrey, and Steven Phillips, "The European Monetary System: Credible
at Last?" NBER Working Paper No. 3819 (Cambridge, Mass.: National
Bureau of Economic Research, 1991).
Geadah, Sarni, Tapio Saavalainen, and Lars E.O. Svensson, "The Credibility of
Nordic Exchange Rate Bands: 1987-91," IMF Working Paper 92/3 (Wash­
ington: International Monetary Fund, 1992).
Giovannini, Alberto, "European Monetary Reform: Progress and Prospects,"
Brookings Papers on Economic Activity 2 (1990), pp. 217-91.
Koen, Vincent, "Testing the Credibility of the Belgian Hard Currency Policy,"
IMF Working Paper 91 /79 (Washington: International Monetary Fund,
1991).
Lindberg, Hans, Lars E.O. Svensson, and Paul Soderlind, "Devaluation Expec­
tations: The Swedish Krona 1982-1991," Seminar Paper No. 495 (Stock­
holm: Institute for International Economic Studies, 1991).
Newey, Whitney K . , and Kenneth D. West, "A Simple, Positive Semi-Definite,
Heteroskedasticity and Autocorrelation Consistent Covariance Matrix,"
Econometrica, Vol. 55 (1987), pp. 703-8.
Rose, Andrew K., and Lars E.O. Svensson, "Expected and Predicted Realign­
ments: The FF /DM Exchange Rate During the EMS," International Fi­
nance Discussion Paper No. 395 (Washington: Board of Governors of the
Federal Reserve System, 1991).
Svensson, Lars E.O., "The Foreign Exchange Risk Premium in a Target Zone
with Devaluation Risk," Discussion Paper No. 494 (London: Centre for
Economic Policy Research, 1990).
Svensson, Lars E.O., "Assessing Target Zone Credibility: Mean Reversion and
Devaluation Expectations in the EMS," IMF Working Paper 91/96 (Wash­
ington: International Monetary Fund, 1991).
©International Monetary Fund. Not for Redistribution
IMF Stoff Papers
Vol. 40, No. 3 (September 1993)
Cl 1993 International Monetary Fund
Stabilization Programs and
External Enforcement
Experience from the 1920s
JULIO A. SANTAELLA*
Credibility and financing problems are important reasons why countries
may seek to involve external institutions in the design and implementation
ofstabilization programs. In particular, governments may rely on external
institutions to "enforce" programs that would otherwise lack credibility.
This paper analyzes six European currency stabilizations sponsored by the
League of Nations in the 1920s. It emphasizes the means by which the
League provided a "commitment technology" and enforced compliance,
thereby helping to ensure successful stabilizations. Empirical evidence
indicates that countries with greater credibility problems relied more
heavily on external enforcement to stabilize their currencies. [JEL E61,
F33, N14]
of the international debt crisis in the early 1980s,
Smany developing countries have been striving to stabilize and adjust
their economies. More recently, Eastern European countries and states
INCE THE ADVENT
of the former Soviet Union have been facing an equally challenging task:
to achieve domestic and external stability while simultaneously trans­
forming their economies from central planning to market-oriented sys­
tems. Some countries have undertaken adjustment and reform on their
* Julio A. Santaella is an Economist in the Research Department. He holds a
Ph.D. from the University of California, Los Angeles. This p aper draws on two
chapters of the author's Ph.D. dissertation. Comments by Se b astian Edwards,
Jeffrey Frieden, Arnold Harberger, Daniel Heymann, Malcolm Knight, Axel
Leijonhufvud, Kenneth Sokoloff, and Jean-Leaurant Rosenthal are gratefully
acknowledged.
584
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STABILIZATION PROGRAMS AND EXTERNAL ENFORCEMENT
585
own, but many others have embraced stabilization and structural pro­
grams endorsed by the International Monetary Fund, the World Bank,
and other institutions. As a result, there has been a very substantial
increase in the number of countries implementing stabilization and re­
form programs under IMF arrangements during the past decade, as well
as in the level of financial resources committed by international organi­
zations and bilateral donors. The widespread recourse to these programs
by developing countries is unlikely to abate in the near future. Although
considerable progress has been achieved in resolving the debt crisis of the
middle-income countries, many low-income developing countries, as well
as formerly socialist economies, are now initiating adjustment and seek­
ing financial assistance. It is, therefore, a propitious time to examine the
role that external institutions can play in assisting an adjusting country
and to ascertain the general factors that can influence the success or
failure of such programs.
For the adjusting nations and for the international institutions that have
been involved in the process, there are many interesting lessons to be
drawn from past experience. One episode that is particularly rich in
insights for today's adjustment efforts is the currency stabilizations that
were implemented by a number of European countries during the 1920s.
Most of the features of these post-World War I European stabilizations
have already been extensively discussed in the literature. 1 Yet a central
aspect of these episodes, which has received much less discussion, is the
extent of foreign assistance and external enforcement that were involved
in these early but comprehensive macroeconomic adjustment programs.
During the 1920s, six European countries undertook macroeconomic
adjustment programs under the auspices of the League of Nations: Aus­
tria, Hungary, Greece, Bulgaria, Estonia, and Danzig.2 Why did these
countries resort to the League for external enforcement of their currency
stabilization programs, while others, in fact the majority of the European
countries, stabilized their currencies without recourse to external loans
or the discipline of the League? This paper addresses some issues that are
raised by this question and their relevance for current adjustment pro­
grams. The paper's central purpose, then, is to examine the role that an
external institution can play in adjustment-in particular, the effective­
ness of the League of Nations in enforcing and making credible the
stabilization programs it endorsed during the 1920s.
1 A recent study of the economic history of the 1920s can be found in Eichen­
green (1992).
2There has been a recent interest in the dissolution of the Austro Hungarian
empire and the similarities with the former Soviet Union. See Garber and
Spencer (1992) and Dornbusch (1992).
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JULIO A. SANTAELLA
To tackle these issues, the paper first reviews the theoretical justifica­
tion for an external agent's intervention in a macroeconomic adjustment
program. The paper discusses a number of arguments that go beyond the
standard explanation, which has focused almost exclusively on the tech­
nical advice and financial support that external institutions can provide.
The paper finds that credibility and financing problems play an important
role in explaining reliance on external institutions. A major reason why
countries may seek external intervention is that they lack the credibility
or "reputation" needed to ensure the success of their stabilization efforts.
An external agent may be able to provide a "commitment technology"
that enhances the credibility of the program. The credibility problem and
the role of external enforcement are illustrated with a simple model. In
particular, the paper argues that the extent of nominal instability is likely
to be an important determinant of external participation in a stabilization
program.
Once the theoretical framework has been outlined, the paper analyzes
the experience with stabilization programs endorsed by the League of
Nations during the 1920s. The comprehensiveness of the economic re­
forms is emphasized. A brief analysis of the general macroeconomic
accomplishments of the programs is also presented. Furthermore, be­
cause the credibility of the commitment to stabilize the economy appears
to have been a crucial element in a program's success, this paper places
special emphasis on the instruments of control that the League of Nations
employed to enforce its programs. A program that is not expected to be
enforced will not be credible; in turn, a noncredible stabilization program
is less Likely to be successful. An empirical assessment of the enforcement
by the League is undertaken based on the outcomes of several programs.
By contrasting the European currency stabilizations that had recourse
to external enforcement with those that did not, the paper attempts to
test the theoretical explanations that have been offered for the reliance
of some adjusting countries on external institutions. The paper presents
empirical evidence to support the view that enhancing credibility and
resolving financing problems were important determinants of a nation's
decision to rely on an external agent to carry out its stabilization.
Policy implications can be drawn from this experience for both coun­
tries and external agents. The importance of fiscal adjustment and mone­
tary discipline are confirmed by these episodes. In addition, the experi­
ence of the 1920s highlights the necessity of undertaking fundamental
institutional reform to establish macroeconomic stability. The analysis
suggests that the League of Nations enforced such regime changes with
remarkable success.
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STABILIZATION PROGRAMS AND EXTERNAL ENFORCEMENT
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I. Theoretical Arguments for External Enforcement
This section analyzes the reasons why external institutions may become
involved in a country's macroeconomic stabilization and the specific role
they can play in its implementation and enforcement. These issues have
not been dealt with in detail by the theoretical and empirical literature
on macroeconomic stabilization. For the most part, this literature has
been concerned with the instability of nominal variables, as well as the
proper way to carry out the stabilization and adjustment.3 Beyond the
traditional explanation, which stresses the technical advice that external
institutions can give, two conceptually distinct but not mutually exclusive
arguments have been advanced to explain a country's recourse to external
assistance: (1) an external agent can help solve a national authority's
credibility problems, and (2) an external institution can ease a country's
external position through financing.
Credibility, External Enforcement, and Financing
Beginning with the seminal papers by Kydland and Prescott (1977) and
Calvo (1978), the theoretical literature on stabilization policies has em­
phasized the time inconsistency problem-that is, the conflict between
the ex ante and ex post optimality of economic policies in rational
expectations models. In the case of monetary policy, this problem occurs
because the government has an ex post incentive to renege on an an­
nounced policy that was optimal ex ante.4 The time inconsistency prob­
lem undermines the credibility of any announcements that are made
about future policy because rational private economic agents anticipate
that the authorities may later have an incentive to deviate from the
announced course of policies. Time inconsistency can impart an infla­
tionary bias to monetary policy, thus making stabilization of the aggre­
gate price level more difficult. However, the time inconsistency problem
will only emerge if the authorities have the opportunity to reoptimize
later, after announcing their policy stance-that is, only if they operate
under a discretionary regime. On the contrary, if the government finds
itself with a binding commitment that prevents the reoptimization in the
future, then the rational expectations policy that was optimal originally
will remain optimal in subsequent periods. Thus, under a commitment
�Dornbusch, Sturzenegger, and Wolf (1990) describe these issues. In this
section, the terms stabilization and adjustment are used interchangeably.
4 See Barro and Gordon (1983a).
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JULIO A. SANTAELLA
regime there are no surprises and the inflationary bias of monetary policy
can be avoided.5 This kind of regime can be established, in principle, by
imposing various institutional checks on the government's conduct of
monetary policy.
The literature on repeated games provides some solutions to the time
inconsistency problem.6 In this framework it is possible for a government
to build a reputation as a low-inflation policymaker. Unfortunately, the
reputation-building process found in the game-theoretic literature is not
generally available to the authorities of a country that is suffering from
a macroeconomic disequilibrium involving nominal instability. The exis­
tence of strong inflationary pressures reflects the government's lack of
reputation as a tough inflation fighter. Under these circumstances, a gov­
ernment that wants to stabilize the economy in the context of a monetary
regime characterized by discretion may have to change regimes, specifi­
cally shift to a commitment regime that embodies consistent low-inflation
policies. A change of regime requires a fundamental redirection of the
policy strategy or the rules that determine the whole sequence of mone­
tary and fiscal policies, and not simply an isolated shift in policy measures
(Sargent (1986)). In order to change a monetary regime, it is necessary
to modify not only the nature of monetary policy itself but also the expec­
tations held by economic agents about that policy.7 In order for this al­
ternative solution to be successful, it is necessary that both the announce­
ment of and the commitment to a regime change are credible to economic
agents. Only then will they adjust their inflationary expectations to
conform with the new monetary rules.
A stabilization program is said to "lack credibility" if it is not perceived
as a definite and permanent change in the way economic policy is deter­
mined. If the credibility of a stabilization program is in doubt, the attempt
to stabilize can entaiJ heavy costs in terms of higher unemployment, lower
levels of economic activity, capital flight, and higher interest rates. In
these circumstances, the government may have to support the announce­
ment of a regime change with some signaling behavior. This action is
needed in order to influence expectations favorably by convincing eco­
nomic agents that the "rules of the game" have indeed been modified.
If economic agents believe in the attempt, stabilization can be achieved
5 On the outcomes under different regimes, see Sarro and Gordon (1983b) and
Fischer (1980).
6See Barro (1986) and Backus and Driffill (1985). Blackburn and Christensen
(1989) survey the literature. See also Persson and Tabellini (1990) for a compre­
hensive review of the literature on time inconsistency and modern political
economy.
7 See Leijonhufvud (1983, 1984) for a definition and discussion of a monetary
regime.
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STABILIZATION PROGRAMS AND EXTERNAL ENFORCEMENT
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at a lower cost. It is precisely at this point that the presence of an external
agent in the stabilization effort is justified: one way for the monetary
authority to "signal" that it is really altering the policy regime is by
committing to a stabilization program that is endorsed by some external
or international agency, especially some agency that bas an established
reputation as a firm enforcer of stabilization. Sachs (1989) and Edwards
(1989) suggest that the role played by the external agent is to provide the
government with a commitment technology and, hence, to improve the
chances of resolving its credibility problems. 8
Of course, it is not necessary for the commitment technology to be
supplied by an external agent. For example, domestic institutions could
be altered by setting up institutional checks that establish a commitment
regime giving the monetary authority the credibility it requires. In many
countries, however, the combination of economic, social, and political
disorder, as well as institutional weaknesses, is such that credibility
problems plague not only the economic authorities themselves but also
the economic policymaking institutions. The widespread existence of
credibility problems confronting national governments suggests that
achieving the needed commitment technology solely from domestic
sources will often be difficult or infeasible. In such cases, reliance on an
external institution may be a viable option for restoring credibility.
In most analyses, the commitment technology is simply assumed to be
exogenous. It is possible, however, to forn1Ulate a weaker version in
which the credibility is not assumed at the outset but instead is derived
endogenously in a (subgame perfect) equilibrium. This weaker version
can be used to explain the involvement of an external agent in a country's
stabilization program, provided the external agent is credible in that it
possesses all the necessary means to enforce adjustment and guarantee
full compliance with the stabilization scheme. In order to deter the
government from violating its commitments, the external agent must
provide compliance incentives. In general, an optimal combination of
these would include a combination of "carrots and sticks" that constitutes
a credible threat to the government.
The intervention of an external agent can also entail some costs for
national policymakers. To the extent that an external agent imposes
simple rules for the behavior of national authorities rather than optimal
rules that are contingent on the state of nature> the rules will lack a
discretionary regime's flexibility in reacting to unanticipated shocks.
Moreover, intervention by an external institution in a country's domestic
affairs is likely to generate a political burden on the government that
8
Also see the recent work by Dominguez (1993).
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JULIO A. SANTAELLA
requests the intervention. Accordingly, only in cases of extreme crisis will
an external institution be sought; these cases are exactly the ones where
credibility problems are most severe.
A second reason for recourse to an external agent is that the agent can
provide the resources to finance an external imbalance, as well as serve
a catalytic role in mobilizing other credits. Of course, the credibility and
financing arguments for seeking external enforcement, though different
in nature, are not mutually exclusive. In order to obtain external re­
sources, the government may first need to resolve its credibility problem
so that external creditors are more willing to extend credits.9 The latter
reasoning implies that the government's credibility problem is multi­
dimensional: it has a domestic aspect-the need for the government to
establish credibility with its own citizens and economic agents; and it
has an external aspect-the need for credibility in the eyes of foreign
creditors and the international community. 10 In practice, the existence
of credibility problems and the need for financial assistance are so
intertwined that the empirical section does not test for them separately.
Most economists agree that the urgency of needed macroeconomic
adjustment is greater for economies facing high nominal instability and
large macroeconomic disequilibria than for economies with milder infla­
tions and smaller imbalances. When macroeconomic disequilibria are
large, a stabilization strategy that relies on reputation-building strategies
alone will be more difficult to implement than if the imbalances were
small. It follows that the greater the degree ofnominal instability, the more
likely it is that the authorities will be nclined
i
to stabilize the economy
through a regime change, rather than through a gradual buildup of
reputation. In particular, if the authorities are truly concerned about
stopping inflation they will try to switch to a new regime that embodies
low inflation rules or commitments; this, in turn, may cause them to seek
enforcement of the adjustment program by an external institution. The
greater the costs imposed by the nominal instability, the more likely it is
that they will exceed the costs of intervention by an external agent.
In summary, the general explanation for why some countries resort
to external agents to stabilize their economies is that the latter may help
See Sachs (1989).
The credibility and financing arguments for external intervention are not the
only possible explanations. Countries can also rely on an external agent to get
technical assistance, in fiscal, monetary, or other areas. A different explanation
from the public choice literature suggests that governments use external agents
as scapegoats and blame them for undertaking painful adjustment programs and
other "dirty work." See, for example, Vaubel (1986).
9
10
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591
to ease adjustment in two ways. First, an external agent can restore
credibility to a stabilizing authority by providing a commitment tech­
nology. Second, the external institution may lend new resources to
finance the stabilization effort, thereby making the adjustment less dras­
tic than it otherwise would have been. Both credibility and financing
problems seem more pressing in high-inflation countries; therefore,
these countries are more likely to appeal to an external agent to stabilize
their economies. It is shown below that both arguments seem to have
played a role in the European stabilizations of the 1920s, helping to
explain the reliance of some countries on the external enforcement of
their adjustment programs.
Modeling Credibility Problems and External Enforcement
A simple model is provided here to illustrate the credibility argument
associated with external enforcement of a stabilization program. The
model allows a comparison of the different outcomes, in terms of mon­
etary expansion and rates of inflation, of two regimes: commitment and
discretion. The stabilization is understood as a change of regime from
discretion to rules. The framework stresses the role of inflation in financ­
ing a fiscal deficit and is based on a simplified version of the model in
Barra (1983). In this model, there is a natural interpretation of the role
of external enforcement. The model uses standard notation and the
convention that upper-case letters denote levels of a variable (or parame­
ter) and lower-case letters denote its logarithm.
In this model, the government wants to find the rate of growth of the
money supply f.Le = me - me-J that minimizes its loss function. In partic­
ular, the problem of the government is given by
. (kl)
for k t. k2, b' e > 0,
mJO Z, = b exp(b'TTe) + b exp(b1r�+ 1) - eRe,
(k2)
(1)
where 1r1 :=; p, - Pe-t is the actual rate of inflation and 1r�+L =
E(Pt+J I I�) Pt-t is the expected rate of inflation in period t + 1 condi­
tional on the available information at time t. The first two terms of the
loss function (1) are intended to capture two different kinds of costs
associated with inflation. The term 1r�+J represents the usual distortionary
costs of inflation, while the term 1T1 reflects other costs, such as the
so-called menu costs of changing nominal prices or the costs derived from
the fiscal lag (Tanzi effect). The last term in equation (1) represents the
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JULIO A. SANTAELLA
benefit the government obtains from inflation; it is proportional to the
revenue from inflation R, defined as
,
R
=
M, - M,_ t = M, (M•-)t (P•-t).
(2)
P, P, P.- t P,
The demand for real money balances is of the Cagan type and given by
m� - = - a1r�+t.
for a, "' > 0.
(3)
_
p,
"'
Taking first differences in equation (3), the inflation rate that clears the
money market is given by
(4)
The rate of money growth J.L, can be found from equation (4) and substi­
tuted into the loss function (1) to solve the optimization problem faced
by the government; alternatively, one can solve for 1r, and find the rate
of money growth implied by equation (4). The assumption that
er > kt + k2 implies that the equilibria are characterized by positive
rates of inflation.
The solution for the discretionary regime is characterized by the fact
that the government cannot make binding commitments about its future
behavior; hence it will be solving loss function (1) in every period. Under
these circumstances, the government will not take into account the effect
of its current behavior on the future expectations of private agents, and
as given. In other words, the government will be playing
it will take
Nash. After substituting equations (2) and (3) into (1) and using the fact
that o7r,/oJ.L1 = 1 from equation (4) and that o7r�+ 1 /oJ.L, = 0 (because
is taken as given), the first-order condition is
1r�+t
1r�+t
(5)
kt exp(b7r,) = er exp( -a'Tr� - 7r,).
Private agents understand the government's behavior. Therefore, to
obtain the expected inflation rate the mathematical expectation operator
E( I I,) is used in equation (5) conilitional on
E I,. The expres­
sion for 'IT� can then be substituted back into the logarithm of equation
(5) to find the inflation rate that will prevail under discretion. In this
equilibrium the full solution is
{M, P,}
.
.
dLScretwn:
1r, = 1r, =
•
J.L,
=
1
+
1
b +a
( )
er > 0.
1og "k;
(6)
On the other hand, in the rules regime the government is able to make
binding commitments about its future behavior. Thus, it will take into
account the effect of its current decision on the future expectations of
private agents when choosing the (constant) rate of monetary expansion,
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which is to be in place forever. In other words, the government will
be playing like a Stackelberg leader. To find the rate of inflation under
this regime, it is easier to impose the equilibrium condition 1r, 1r� IJ.,
in loss function (1) and then to take the first-order condition. To sim­
plify the algebra, the approximation that log[(1 + a) exp(-1r) - a]=
-(1 + cx)1r around zero is used and then the full equilibrium for the
regime under rules is
=
(
)
1
ar
log
rules: 1T, = 1T� = IJ., =
>
1 + b + 2cx
kl + k2
0.
=
(7)
Using superscripts D for discretion and R for rules to denote the regime
in place, it is straightforward to see from equations (6) and (7) that
1r0 > -rrR. The reason is simply that under the commitment regime, the
government internalizes the effects of its actions on the behavior of the
private agents. In particular, the government understands that by com­
mitting to a lower rate of monetary expansion it can alter the inflationary
expectations of the private sector and hence achieve a lower rate of
inflation. Moreover, after some manipulations it is easy to show that
Z(1r0) - Z(1rR) > 0, the rules regime is Pareto superior to the outcome
under the discretion regime. The government is worse off with the equi­
librium inflation rate obtained in the discretion regime than with that
obtained under the rules regime.
In this model, there is a straightforward role for external enforcement
of a stabilization program. It is clear that a government that finds itself
under a discretionary regime will want to switch to a rules regime.
However, it can only do so by being able to make a credible commitment
to follow a binding rule forever. If the external agent is capable of
guaranteeing compliance with this commitment, then external enforce­
ment restores the government's credibility and the involvement of the
external agent becomes an alternative to effecting a regime change do­
mestically: the external agent provides the commitment technology. To
sharpen the analysis further, assume that the presence of an external
agent imposes a fixed and positive cost C on the government. This cost
may be a fee paid to the external institution, a political penalty involved
in accepting foreign intervention in domestic affairs, or the loss to the
government from the diminution of its "sovereignty." Then it is obvious
that the government will seek external enforcement of the stabilization if
(8)
Note that, as argued above, the higher the inflation under discretion
relative to rules, the higher will be the likelihood of an external agency's
involvement.
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JULIO A. SANTAELLA
II. Stabilization Programs Implemented
with the League of Nations During the 1920s
The stabilizations in a number of European countries following World
War I can be better understood in light of the previous section's analysis
of why a government might choose to rely on an external institution to
enforce the stabilization of its economy. In particular, it is important to
determine whether the two arguments mentioned earlier can throw some
light on the involvement of the League of Nations. During the 1920s, the
League endorsed six macroeconomic adjustment programs, or "recon­
struction schemes" as they were then called, which were supported with
foreign loans and credits. In the programs in Austria (1922) and Hungary
(1924), the reforms tackled the financial reconstruction of two countries,
which had been devastated by war, dissolution, and hyperinflation. In
Greece (1923) and Bulgaria (1926), the initial involvement of the League
was in refugee settlement schemes; it took on a financial character later
(in 1927 and 1928, respectively). Other programs under the auspices of
the League included the mortgage loan to Danzig (1925) and the currency
reform loan to Estonia (1927). In all six cases, the government voluntarily
appealed to the Council of the League of Nations for assistance to tackle
a given macroeconomic problem. After an agreement was reached, the
League endorsed the reconstruction scheme.
In order to assess the effectiveness of these programs in resolving
credibility problems one needs first to understand the policy content of
these schemes as well as the means of enforcement that the League
possessed. Together, the contents of each scheme and the enforcement
of the program determined the force of the commitment technology.
The procedures and workings of the League's adjustment programs are
explained in detail in League of Nations (1930), but a summary of the
relevant elements is provided below.1 1
Policies Recommended by the Lea gue of Nations
In each financial reconstruction scheme, the Financial Committee of
the League of Nations closely followed the guiding principles of the
International Financial Conference that had been convened in 1920 by
the Council in Brussels. The basic premise was simply that, in order to
11
Garber and Spencer (1992) describe the League's involvement in Austria and
Hungary. This paper emphasizes the enforcement of each of the six reconstruc­
tion schemes as a necessary condition to increase the likelihood of the program's
success in effecting a change of regime.
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stabilize a currency, fiscal equilibrium was of paramount importance. If
the budget was balanced, there was no need for the central bank to extend
credits to the government or to increase the note iss-ue beyond the amount
that was demanded at a stable price level. Thus, the centerpiece of
financial reconstruction was a set of fiscal and administrative reforms
intended to eliminate the budget deficit. The reforms included a number
of measures to increase tax and nontax revenues, eliminate subsidies,
reduce the size of the bureaucracy, and cut other expenditures. In prin­
ciple, the League only set targets for aggregate tax collections, leaving
government officials free to decide which taxes were to be raised.
The administrative reform also comprised the establishment of domes­
tic institutions and practices permitting better control and monitoring of
the public finances by a central authority. Among the institutions estab­
lished or reformed were the central bank and other accounting or audit­
ing offices. Through these reforms, policies to achieve fiscal balance were
complemented by monetary discipline. The creation of money through
note issue was to be halted, especially that of monetization through
advances to the public sector. In order to enforce this discipline, the
League's schemes viewed the central bank of issue as constituted of pri­
vate capital and independent of the government. To achieve the needed
degree of monetary discipline, it was recommended that the central bank
should try to maintain the following guidelines: (1) central bank indepen­
dence; (2) monopoly of note issue; (3) prudence in lending and discount­
ing operations; (4) limits on new advances to the government (sometimes
even an overall reduction in the stock of public debt held by the central
bank); (5) centralization of the monetary transactions of aU public sector
entities in the central bank; and (6) proper cover and reserve backing for
the note issue. 12
In most cases, the financial reconstruction included a currency reform,
the main purpose of which was to consolidate the stabilization of the
currency by implementing a gold exchange standard. As is evident from
this brief description, programs undertaken with the support of the
League were very comprehensive in that the attack on inflation and
currency depreciation was undertaken simultaneously on various fronts:
fiscal, monetary, currency, financial, and administrative reforms were
incorporated. Special emphasis was given to establishing institutional
structures that would give the government both the needed incentives to
stabilize and enough policy instruments to maintain sound public fi­
nances. In order to implement such comprehensive schemes, govern­
ments were asked to appeal to their parliaments for special emergency
powers.
12
See League of Nations (1930).
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JULIO A. SANTAELLA
The League of Nations stressed that the reconstruction schemes imple­
mented under its auspices were not all the same. But it acknowledged that
when circumstances were similar, adjustment schemes were also similar.
These similarities were evident for the financial reconstruction schemes
followed by Austria and Hungary and for the refugee settlement pro­
grams and later financial restructurings of Greece and Bulgaria. Other
programs of the League, such as those for Danzig and Estonia, differed
in both scope and content.
Structure of the League and Its Instruments of Control
The ultimate responsibility for a financial reconstruction scheme under
the sponsorship of the League of Nations fell on the Council of the
League. However, the Council instructed either the Secretariat or the
Financial Committee to carry out the detailed work. The duties of these
organs included preliminary investigations, negotiations with the govern­
ments and institutions involved (both debtors and potential creditors),
the design and formulation of the actual stabilization program, prepara­
tion of the draft resolutions, and supervision of the scheme. The Council
also set up special committees to address certain international politi­
cal problems that needed to be cleared up before the adjustment
agreement-the Protocols-could be signed.
The League recognized that the execution of the program was as
crucial as its design in restoring confidence in the adjustment effort.
Moreover, the League was keenly aware of the repercussions that
sponsoring a stabilization program would have on its own reputation. 13
For this reason, it took care to arrange various means to guarantee the
enforcement of its program, as well as safeguard the interests of for­
eign creditors. Basically, there were three direct aspects of control in
the Protocols and other official documents of the League's financial
reconstruction schemes.
The first was the appointment by the Council of a League Commis­
sioner to the country undertaking the League-sponsored stabilization.
The Commissioner, whose tenure was to last until the reconstruction was
completed, controlled two important instruments: the external loan ac­
count and the security revenues account. The external loan account was
extended to the debtor government by the foreign creditors to cover fiscal
deficits during the transition period. 14 The authorities of the country were
13 See League of Nations (1930, p. 24).
14The financing for the refugee settlement schemes
specific expenses to settle them .
was
aimed at meeting
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not allowed to draw on this account without the consent of the Commis­
sioner, who in tum would only authorize disbursements when the funds
were to be spent on an agreed objective. The second account under the
control of this League official held all the proceeds from those revenue
sources that were set as security for the foreign loan. Security revenues
usually included customs receipts or income from state monopolies. The
Commissioner would set aside enough funds to service the external
obligations, plus any precautionary margin, and refund the rest to the
government only if the program was being carried out in conformity with
the agreement. Furthermore, the Commissioner usually had the power
to veto any government action that would endanger the value of the
revenues assigned as security for the loan or even to call for additional
receipts to serve as collateral. The Commissioner was to be assisted in his
duties by the domestic government and provided with all relevant infor­
mation. This official had enough power to control public finances and to
influence the behavior of the government. In principle, he could be
reappointed if the Council decided to reinstall control over the authorities
when the achievements of the reconstruction scheme were being com­
promised. In modern game-theoretic parlance, the presence of the
Commissioner represented a credible threat to the government.
The second instrument of control by the League was the nomination
of an Adviser to the central bank. Although this official was a bank
subordinate and not part of the Financial Committee staff, in practice he
maintained close contact with League representatives. His duties were
established in the statutes of the central bank, which were drawn up by
the Financial Committee. They included supervising the bank's adminis­
tration by the Board of Management and Board of Directors, in par­
ticular ensuring that the domestic component of the monetary base was
not unjustifiably expanded. To enforce this discipline, the Adviser was
sometimes entrusted with a veto in the Board of Directors.
The final aspect of control by the League of Nations was the Trustees
of the external loan, who represented the interests of the foreign bond­
holders. Their usual duties were minor, such as the delivery of interest
payments or the control over those revenues meant to service the ex­
ternal debt once the Commissioner's tenure had ceased. Their major role
was in the case of default, a contingency that was foreseen in the official
documents of the reconstruction scheme. If default occurred, the Trustees
could make good the payment using the entire assigned revenues.
Other support functionaries with different control capabilities were
sometimes appointed, such as experts to supervise the conditions of the
foreign loan subscriptions or special committees to address certain issues
during the preparation and execution stages. As with the design of the
©International Monetary Fund. Not for Redistribution
598
JULIO A . SANTAELLA
financial reconstruction schemes, not all the programs used the same in­
struments of control. Again, variations were made depending on the
gravity of the economic situation and institutional structure; not all the
programs had a Commissioner and not all schemes endowed the central
bank Adviser with the same powers. 15
Effectiveness of External Enforcement
As discussed earlier, the degree of credibility attached to a stabilization
program depends on firm enforcement of the new rules. Thus, it is
important to evaluate the League's effectiveness in inducing compliance
with its stabilization programs. Although it is difficult to make a precise
assessment, there are signs that the League was a tough enforcer of its
programs. For example, there was no recorded instance of an appointed
Commissioner having to withhold a portion of a loan in order to exercise
the League's prerogatives. Similarly, the legal veto powers of the central
bank Adviser were never brought into play. Nor was it deemed necessary
to apply sanctions on any government. 16 In itself, the absence of such
sanctions does not necessarily imply that enforcement was fully credible.
However, as shown below, the economic outcomes of the programs were
so remarkable that one can safely dismiss the case of a noncredible
enforcement.
Another clue to the credibility of the League's enforcement is provided
by one incident involving the Austrian program. In 1924, the Austrian
government asked to use some part of the reconstruction loan for a
purpose other than that of meeting its budget deficit. The government
wished to use some of the loan proceeds for productive investment to
stimulate the Austrian economy. But the Financial Committee and the
Commissioner denied such a release of funds, arguing that it was incon­
sistent with the reconstruction program and with ensuring the security of
the bondholders' investment. 17
The degree of control exercised by the League was so strict that the
number of countries willing to undertake its programs remained small.
15 For example, in the two Greek schemes the International Financial Commis­
sion, which had been used by foreign creditors since 1898 to control some state
revenues assigned as security to foreign loans, continued to function during the
period of the League's involvement. In the case of Danzig, a High Commissioner
had already been appointed by the League to reside there, because, according
to the Treaty of Versailles, Danzig was made a free city under the protection of
the League.
'6 League of Nations (1930, 1945).
17See League of Nations (1926a, pp. 58-59) and Pietri (1983).
©International Monetary Fund. Not for Redistribution
STABILIZATION PROGRAMS AND EXTERNAL ENFORCEMENT
599
In 1928, for example, Portugal refused to sign an agreement even though
all the preliminary investigations and recommendations had taken place.
The loss of sovereignty and policy discretion under the program was
unacceptable to the Portuguese government. 18 The cases of Poland and
Romania appear to be similar. The Polish authorities tried to avoid the
intervention of the League in the issuance of their stabilization loan,
perhaps because they did not want to be identified with the losing parties
of World War I that had programs with the League. 19
The enforcement of, monitoring of, and compliance with the original
programs were far from perfect. In the case of Austria in 1924, for
example, the League felt that the reduction of expenditures and the
dismissal of government employees did not proceed at the expected
pace.20 This perceived delay in the reform caused further program adjust­
ments and a prolongation of the League's control beyond the original
schedule in the Protocols. In addition, the League was not fully satisfied
with the performance of the Austrian and Hungarian central banks
because the proportion of short-term paper in the assets of the banks was
thought to be excessive.
The only major enforcement difficulty of the reconstruction programs
came to light not during the 1920s but years later when, in 1931, Hungary,
Bulgaria, and Greece defaulted on their international reconstruction
loans. However, by that time most of the financial reconstructions were
regarded as complete and the League was not in a position to intervene
effectively.
Macroeconomic Performance Under League Programs
This section provides a general evaluation of the macroeconomic out­
comes of programs endorsed by the League of Nations during the 1920s.
Clearly, the overall assessment of League programs is favorable: they
were able to stop the Austrian and Hungarian hyperinflations; resettle
more than 750,000 refugees in Greece and Bulgaria; establish or re­
form central banks in all six countries; and stabilize six national curren­
cies. A more detailed account of the performance of the economies under
these programs is given in Figure 1 and Tables 1-6. Although only a
small number of indicators are shown, they give a general sense of
18Portugal carried out a program of its own, which was similar to the one
recommended by the Financial Committee. See League of Nations (1930) and
Derartrnent of O verseas Trade (1930).
1 Meyer (1970) discusses in detail the Polish and Romanian cases.
20 League of Nations (1926a), De Bordes (1924), and Pietri (1983).
©International Monetary Fund. Not for Redistribution
600
JULIO A. SANTAELLA
Figure
I . Exchange Roles and Price Levels
E:.•·clwnfir l'me (leji scale)
•·•··
Priu le•·el (riglu sctlie)
1 9 1 4:7=1
34
160
(logarithmic
scale)
100
10
0.01
100
22
80
0.001
1919
•'
1 921
1923
1927
1925
1 914=1
1.8
Gulden/US dollar
6.0
Danzig. 1924-28
60
1922
1.6
5.6
5.4
1.4
5.2
1 924
18
1930
1928
1926
Eesri kroon/US dollar
4.6
4.2
5.8
1913=1
1.5
E�tonia. 1921-29
3.8
.
. ..
3.4
1 .3
1. 1
3.0
1925
1926
DrachmaiNS dollar
Greece. 1921-29
80
1927
2.6
1921
1 928
19 14:7=1
20
. . .....
•'
1923
1925
1927
1929
0.9
19 14:7=0.1
---------• 1000
.Hu ngary. 1920-26
PengoNS dollar
I0
(logarithmic scale)
100
16
60
40
20
26
120
0.1
1 OO
30
140
·.
_.,·. :
.
.
�
�
-�
�
�
-�
�
? L
�
I�
92
1923�
1 92 S
1927
1929
10
12
8
0.1
1924
1926
Sources: League of Nations, lnrernational Statistical Ye01·hook (various years),
and Young ( 1 925).
Notes: Exchange rates as quoted in New York; the price level refers
to retail prices for Austria. Bulgaria. Greece, and Hungary ( 192 1-23) and
to wholesale prices for Danzig, Estonia, and Hungary ( 1924-26).
©International Monetary Fund. Not for Redistribution
0.1
-39.6
490.8
100.4
5.9
0.6
1921
-18.5
81.3
1 ,991.3
-68.0
74.7
54.1
9.0
62.3
1923
2,153.6
81.9
7.7
0.0
1922
1920-27
9.2
©International Monetary Fund. Not for Redistribution
-4.6
9.4
6.1
6.3
30.3
82.6
1927
on Public
- 13.8
21.2
10.7
28.9
- 1 .4
6.4
34.4
7.5
77 . 6
1926
6.1
48.3
10.9
65.5
1925
17.7
69.6
1 1 .6
44.8
1924
Sources: Estimates are based on data from League of Nations. international Statistical Yearbook, Memorandum
Finance, and Memorandum on Currency and Cen.fral Banks; League of Nations (1926a); and Young (1925).
• The figure for 1920 was es.timated using fiscal years 1919/20 and 1920121.
-59. 1
77.6
5.0
3.3
1920
Austria: Monetary and FIScal indicators,
Fiscal balance'"
(percentage of government expenditure)
FIScal policy
Note circulation
(annual rate of growth)
Money supply (M1)
(annual rate of growth)
Monewry policy
Rate of discount
Discounts, loans, and advances
(percentage of note circulation)
Gold and foreign assets reserves
(percentage of note circulation)
Central bank
Table 1.
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z
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....,
i3
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139.3
6.7
-2.3
- 1 .7
9.4
142.6
9.4
20.0
1924
-2.3
4.6
2.3
- 1 1.3
-4.8
195.3
10.0
-8.8
1926
- 19.3
179.5
10.0
9.8
1925
-0.1
16.4
7. 1
168.4
10.0
10.8
1927
-7.4
28.6
12.0
1 27.2
10.0
67.9
1928
- 18.6
-3.1
2.8
-35.8
-8.7
1 19.9
10.0
25.7
1930
- 13.5
141.3
9.5
33.5
1929
•
�
©International Monetary Fund. Not for Redistribution
Sources: Estimates are based on
data from League of Nations, international Sraristical Yearbook. Memorandum on Public
Finance, and Memorandum on Currency and Central Banks.
Fiscal year beginnin that calendar year. The fiscal balance includes expenditure incurred as a consequence of the 1923-25 war.
and paid by advances om the National Bank. For 192&-30 it includes special funds incorporated in the budget.
Fiscal balance
(percentage of government expenditure)
Monetary policy
Note circulation
(annual rate of growth)
Money supply (M1)
(annual rate of gr owth)
Fiscal policy
6.5
1 .0
Gold and foreign
Discounts, loans, and advances
(percentage of note circulation)
Rate of discount
1923
assets reserves
(percentage of note circulation)
Central bank
Table 2. Bulgaria: Monetary and Fiscal Indicators, 1923-30
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27. 2
9.2
2 .9
77. 1
53. 1
1 1.3
9.-+
60.9
108.3
1926
90.ti
1925
O.fl
6.8
46. 1
9-U
1927
�
8 ..J
Yearbook
:!6.9
5.8
1 10.3
1928
©International Monetary Fund. Not for Redistribution
Sources: Estimate.; are ba�ed on data from Lea!!ue of �ation�. Jmemarional Sratistical
Finance . and \lemorandum 011 Crtrrcnc_l and Cemial Ba11f.s.
Gold and foreign assets resen·es
(percentage of note circu lation)
Discountl.. loan�. and ad\'anct:�
(percentage of note circulation)
Rate o f di�rount
.\fonetary poiiC}
Note circulation
(annual rate of gro" t h )
Central bank
1 92-l
Table 3. Danzig: Jlonerar
y and Fiscal lndicacors, 1914-30
.
0.0
Public
-2.6
.\Jemorandum on
5.0
1 1 .8
liSA
1930
6.5
27.1
107.9
1929
:;<:!
n
m
s::
m
z
-l
Cl
;-n
z
183.2
10.0
146.2
8.9
4.6
4.7
0.9
156.0
8.0
-7 .6
6.0
4.8
4.5
6.9
-2.8
37. 1
1925
36.1
1924
40.7
1923
.
2 9
3.2
14.5
-
189.6
9.5
41.2
1926
2.9
26.8
14.7
75.9
8.0
56.4
1927
1.5
17.8
-7.7
86.4
7.5
86 . 1
1928
-4.6
0.0
-5.6
109.7
7.6
79.4
1929
-7.4
5.7
-5.9
74.7
7.8
71.9
1930
©International Monetary Fund. Not for Redistribution
Sources: Estimates are based on data from League of Nations, International Statistical Yearbook , Memorandum on Public
Finance, and Memorandum on Currency and Central Ban ks; and Pullerits. The Estonian Yearbook (various issues).
Central bank
Gold and foreign assets reserves
(percentage of note circulation)
Discounts, loans, and advances
(percentage of note circulation)
Rate of discount
Monetary policy
Note circulation
(annual rate of growth)
Money supply (Ml)
(annual rate of growth)
Ftscal policy
Fiscal balance
(percentage of government expenditure)
Table 4. Estonia: Monetary and Fiscal Indicators, I923-30
r
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165.4
7.5
151 .6
7.5
48.7
183.9
6.5
45.7
4.0
35.9
1924
38.0
1923
31.9
1922
9.7
164.5
8.7
39.3
192.5
166.9
10.4
2.1
-8.9
50.3
1927
171.5
10.5
50.0
1926
1922-29
14.6
68.5
9.9
74.5
1928
-8.7
75 .5
9.0
60.0
1929
•
©International Monetary Fund. Not for Redistribution
-4.1
- 17.2
- 19.2
-21.2
-15.0
-49.7
13.3
-33.4
Sources: Estimates are based on data from League of Nations, International Statisrical Yearbook. Memorandum on Public
Finance, and Memorandum on Currency and Cemral Banks; and Mazower (1991).
Hscal year ending that calendar year. Proceeds and utilization of various loans that ,-.·ere not formerly entered into the budget
were accounted for in 1929.
Central bank
Gold and foreign assets rer.erves
(percentage of note circulation)
Discounts, loans, and advances
(percentage of note circulation)
Rate of discount
Monetary policy
Note circulation
(annual rate of growth)
FiScal policy
Fiscal balance�
(percentage of government expenditure)
Table 5. Greece: Monetary and Fiscal indicators,
expenditures)
727. 6
142. 2
64.3
-26.4
1 , 126.8
201. 4
76.0
-39.0
105.7
14.0
97.4
6.5
1 1 1 .8
6.0
-48 .0
34.9
0.0
1923
0.1
1922
-45.9
693.7
385.0
84.7
14.1
64.5
1924
8.5
57.0
15.2
69.7
9.8
97.4
1925
7.7
42.5
13.2
74 . 9
6.7
88. 7
1926
1 2. 1
34.2
3.4
91.0
6.0
83.2
1927
©International Monetary Fund. Not for Redistribution
Sources: Estimates are based on data from League of Nations, lncernarional Statistical Yearbook . Memora11dum on Public
Finance , and Memorandum on Currency and Cenrral Ba11ks : League of Nations (1926b) ; and Young (1925).
• Fiscal year ending that calendar year.
Fiscal
balance•
(percentage of government
Cenrral bank
Gold and foreign assets reserves
(percentage of note circulation)
Discounts. loans, and advances
(percentage of note circulation)
Rate of discount
Monetary policy
Note circulation
(annual rate of grmvth)
Money supply (Ml)
(annual rate of growth)
Fiscal policy
1921
Table 6. Hungar-y: Monetary and Fiscal Indicarors, 1921-27
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STABILIZATION PROGRAMS AND EXTERNAL ENFORCEMENT
607
the macroeconomic performance of the countries that undertook the
programs sanctioned by the League of Nations.
The first and clearest characteristic apparent in Figure 1 is that the
programs succeeded in stabilizing the exchange rates. Under the pro­
grams, all six currencies were brought onto a gold exchange standard. In
the cases of Estonia and Bulgaria, stability was achieved in 1924, before
the intervention of the League in financial matters, but was consolidated
under the auspices of the League. The behavior of the price level also
reveals that the programs endorsed by the League were disinflationary.
Prices in Austria and Hungary were quickly stabilized-in 1922 and 1924,
respectively. The cases of Greece and Bulgaria also show how rates of
inflation were reduced; the price level actually fell in Bulgaria. Interest­
ingly, some of the disinflation in the latter two cases began with the
League's intervention in the settlement of refugees (1923 for Greece and
1926 for Bulgaria). Although these schemes were not dealing strictly with
a macroeconomic problem, the League insisted that governments should
make every effort to balance their budgets. Price stability in Greece
seems to have been reaffirmed with the subsequent financial re­
construction of 1928: inflation, which had exceeded 80 percent in 1923,
was .reduced from an average 15 percent during 1925-26 to about
7 percent during 1927-28. In the cases of Estonia and Danzig, no dra­
matic price instability was evident before the League's intervention, and
the programs preserved this stability.
One important feature of the League's programs was their emphasis
on reestablishing sound fiscal and monetary policies. In order to make
a currency convertible, it was necessary to reshape the balance sheet of
the monetary authority into a more conservative and orthodox composi­
tion. Tables 1-6 show how, as the central bank was being established or
reformed in each country, the program involved a portfolio reshuffling,
away from domestic credit granted by the central bank toward gold and
other external or metallic assets. In some cases, the change in the balance
sheet of the monetary authority was quite spectacular: the Austrian
central bank's ratio of gold and foreign reserves to note circulation went
from almost nil to more than 75 percent by the end of the program (Table
1); conversely, the ratio of discounts by the central bank went from 100
percent of note circulation in 1921 to only 34 percent by 1926.
With respect to rates of monetary expansion, there are some interest­
ing features. First, in cases where there was initially hyperinflation,
money growth was substantially reduced but never eliminated. In fact,
the money supply grew 81 percent in Austria during 1923 (Table 1) and
57 percent in Hungary during 1925 (Table 6). The monetary expansion
immediately after the stabilization of the exchange rate and the price level
©International Monetary Fund. Not for Redistribution
608
JULJO A. SANTAELLA
permitted a replenishment of real money balances. Second, in the cases
where there was no initial hyperinflation, the rates of monetary expan­
sion were kept under control for most of the stabilization period, except
for small increases in Bulgaria, Estonia, and Greece during the reform
years. The money supply increased 29 percent in Bulgaria during 1928
(Table 2) and 27 percent in Estonia during 1927 (Table 4), and the
circulation of notes increased almost 15 percent in Greece during 1928
(Table 5). Given the relatively stable behavior of prices, these rates of
money growth may also be explained by upward shifts in the demand for
real money balances caused by the new regime, with its lower antici­
pated inflation. Finally, it is also worth mentioning that well before the
League's financial intervention in Greece its rate of monetary expansion
was substantially reduced. In fact, the reduced growth in note circulation,
from 49 to 4 percent after 1924 (Table 5), coincided with implementation
of the refugee program, which was also under the control of the League
of Nations.
The fiscal data that are presented in the tables tend to confirm the
movement toward more conservative macroeconomic policies, including
balanced budgets. This is particularly striking in the cases of Austria and
Hungary (Tables 1 and 6), where budget balances were substantially
improved. In other cases, the movement was not so drastic. Nevertheless,
in some cases, such as Greece in 1929 (Table 5), accounting practices
distorted the fiscal data to the extent that a precise assessment is difficult.
Ill.
Determinants of External Enforcement:
Empirical Evidence
The previous theoretical discussion predicts that countries with more
severe credibility problems and more pressing financial needs should be
more prone to rely on an external agent to help stabilize the economy.
Moreover, it also argues that both kinds of problems should be more acute
in economies with high nominal instability. This section provides some
empirical evidence on the experience of countries that relied on external
agents during the European currency stabilizations of the 1920s. The
theoretical arguments are compared with the empirical evidence in two
stages. The first stage involves casual observation of the relations among
the degree of nominal instability, the issuance of external loans, and the
external enforcement of stabilization. The second stage is more rigorous
and attempts to test the credibility-financial problems hypothesis using
discriminant and probit analyses.
©International Monetary Fund. Not for Redistribution
STABILIZATION PROGRAMS AND EXTERNAL ENFORCEMENT
609
Nominal Instability, Loans, and External Enforcement
During the 1920s, most of the European countries returned to the
prewar gold standard and stabilized their currencies. World War I had left
these countries with relatively high rates of inflation and currency depre­
ciation, which had been ignited by rapid monetary expansion to finance
large continuing fiscal deficits. The gold standard was attractive because
it had eliminated currency instability from the international financial
system before World War I ; therefore, almost every country tried to
establish convertibility of its currency into gold. The third column of
Table 7 gives an idea of the magnitude of nominal instability suffered by
various European countries, as proxied by the level at which these cur­
rencies were stabilized with respect to their prewar gold value. There
were only six countries whose currencies returned to the pre-World War
I gold value, and they were mostly nations that had remained neutral
during the war. These countries were only able to achieve this objective
by deflating prices enough to compensate for the decline in the purchas­
ing power of money that bad occurred during the war years. At the other
extreme of nominal instability, five countries suffered hyperinflations
and had to implement draconian reforms to stabilize their currencies.21
Between these two extremes, the table shows that the currencies of 15
countries were stabilized at levels ranging from! to �
1 5 of their prewar gold
values.
Table 7 also indicates whether there was external enforcement during
these episodes. The six countries with programs endorsed by the League,
together with Germany, are shown as having external enforcement. The
German case is interesting because it is another instance during this
period where stabilization was supported by external enforcement. The
German hyperinflation was stabilized in 1923 without any initial external
support. However, the final consolidation of a stable currency was at­
tained with the assistance of a foreign loan floated under the Dawes Plan.
This plan was formulated by a committee of experts appointed by the
Reparation Commission to study German reconstruction and reparation
problems. The monetary restraint envisaged by the Dawes Plan was
enforced through two different channels. The first was foreign interven­
tion in the German central bank (Reichsbank): half of the 14 members
of the General Board would be foreigners, who would monitor the
21
Some studies of the hyperinflation experiences can be found in the seminal
paper by Cagan (1956) or the more recent ones by Sargent (1986), Dornbusch
and Fischer l1986), and Heymann (1986).
©International Monetary Fund. Not for Redistribution
1922
1926
1924-28
1923
1923
1926
1924-27
1923
1926-28
1923-24
1928
1924
1927
1922
1922
1924
1928
1926-27
1929
1927-29
1 92 2
1922-24
1924
1925
1925-31
Austria
Belgium
Bulgaria"'
Czechoslovakia
lfll
13
X
7
X
X
X
X
X
X
l
X
X
X
X
X
X
X
X
X
X
X
X
credits
Temporary
X
Dawes Plan
League of Nations
League of Nations
League o f Nations
League of Nations
League of Nations
No
credits
I
.1
Hyperinflation
1 122
1 133
Hyperinnation
I
1
Hyperinflation
114
1 n zs
New currency
l/15
Hyperinflation
1 15
1 /8
New currency
1
1 190
tn
1 127
1n
League of Nations
External
agent of
enforcement
No specific loans
c
©International Monetary Fund. Not for Redistribution
5
X
X
X
Jl
5
X
X
Jl
9
X
X
X
X
X
X
X
X
11
Jl
X
X
X
Jl
Jl
X
X
X
X
loans
Specific
X
X
credits
Temporary
X
X
credits
No
No specific loans
Final stabilization and
currency reform
X
loans
Specific
Sua:essful preliminary
stabilization
Source: Elaborated from League of Nations (1946).
" The serond year is the de jure stabilization when different from the actual stabilization.
b Second stabilization (first attempt was unsuccessful).
Stabilized in 1924 but abandoned in 1925.
d Stable currency during 1925-28.
Total
Netherlands
Norway
Poland'
Portugald
Romania
Soviet Union
Sweden
Switzerland
United Kingdom
Yugoslavia
Lithuania
Latvia
Italy
Germany
Greece
Hungal)'
France
Danzig
Denmark
Estonia
Finland
value
Year of
stabilization�
Country
Hyperinflation
stabilization
relative to
prewar gold
currency
Level of
Table 7. European Stabilizations of the 1920s
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STABILIZATION PROGRAMS AND EXTERNAL ENFORCEMENT
611
Reichsbank's note issue. The second was an agent appointed by the
Reparation Commission to monitor Germany's currency policyY
Although the Polish case is similar to the German experience, Poland
is not shown as having external enforcement in Table 7. Like Germany,
Poland relied entirely on monetary and fiscal reforms to stabilize its
currency in 1924, after a terrible hyperinflation, with no external support.
However, inflationary pressures recurred and a second stabilization took
place in 1927, this time assisted by foreign credits. The difference from
the German case is that foreign interests were not directly represented
on the board of the central bank. The presence of external agents in
Poland was reduced to an American financial adviser sent by the
Kemmerer mission in 1926.23 This external involvement was so minimal
that Poland is not classified as having external enforcement in Table 7.
Table 7 also shows external involvement through the provision of
external credits. It indicates that in only 5 of 25 countries were specific
currency stabilization loans involved. This is reproduced in the seventh
column and refers to preliminary or de facto stabilization-that is, when
the monetary authority is defending the parity. Temporary credits were
extended to seven countries, though they were not necessarily used for
the purpose of stabilizing their currencies. By contrast, 13 countries did
not have recourse to foreign loans to stabilize their currencies. With
respect to the final legislation of the parity, nine countries had temporary
credits but hardly made any use of them. Only 5 consolidated their
stabilization without any access to specific credit arrangements, while 1 1
adopted an official parity with the aid of specific loans.
Although the majority of European countries achieved preliminary
stabilization without specific financial assistance from abroad, the foUow­
ing observations are relevant. First, the 11 countries that received loans
for the final stabilization were among those with the highest rates of
currency depreciation and included 4 economies that were suffering from
hyperinflation. In fact, after applying the straightforward nonparametric
test of medians, it turns out that the median currency depreciation in
countries with specific external loans (tenth column of Table 7) was sig­
nificantly higher than the median currency depreciation in countries with­
out specific loans.24 This suggests that nations with higher nominal insta22 See Schacht (1925, 1927) and Heymann (1986).
Meyer (1970). Dornbusch and Fischer (1986) also mention the presence
of a British adviser to Polish authorities before the Kemmerer mission.
24The significance level is 0.002. The test was performed by ordering the
countries according to their percentage currency depreciation during the period
of nonconvertibility (third column of Table 7) and sorting the countries that were
above and below the median country. The test then analyzed the relative position
of countries with and without external loans with respect to the median country
23 See
©International Monetary Fund. Not for Redistribution
612
JULIO A. SANTAELLA
bility relied more heavily on external credits to stabilize their currencies
than nations with lower nominal instability.25
Second, there was external monitoring of stabilization programs in six
of the countries: Austria, Bulgaria, Danzig, Germany, Greece, and
Hungary.26 As before, these six countries were among those with the
highest rates of nominal instability as measured by exchange rate depre­
ciation. Again applying the test of the medians, it turns out that the
median currency depreciation for the countries with external enforce­
ment was higher than that for countries with no external enforcement. 27
This observation supports the assertion that countries with higher nom­
inal instability sought external enforcement to stabilize their currencies
more frequently than countries with lower instability.
Third, one must take into account the possible effect that anticipated
future external assistance may have on the initial stabilization of the
currency. For instance, Llach (1987) argues that the announced forma­
tion of a commission of experts on the problem of war reparations
contributed to the success of the German hyperstabilization. Similarly,
in the Austrian case, the anticipation of a League of Nations' reconstruc­
tion scheme appears to have stabilized the Austrian crown.29 Thus, even
if 13 countries did not actually have recourse to foreign loans to stabilize
their currencies, the fact that in 8 of them some future credits were
anticipated may have helped to effect the stabilization.
Finally, it is interesting to note that four of the five countries that
experienced hyperinflation during the 1920s (Austria, Germany, Hun­
gary, and Poland) had access to foreign loans and to external enforcement
of the conditionality attached to these loans. 30 The sole exception was the
stabilization of the Soviet Union in 1922. This latter case suggests, con­
sistent with the view in the League's own 1946 report, that external loans
28
to determine if their currency depreciation was the same (null hypothesis). Those
countries that issued a national currency for the first time (Danzig and Lithuania)
were excluded.
25 Further support for this statement comes from the fact that there was re­
course to external loans in all the high-inflation episodes studied by Dornbusch
and Fischer (1986).
26The Eesti mark of Estonia was stabilized in 1924, well in advance of the 1927
loan obtained by Estonia through the League. It is thus plausible that the external
involvement was not anticipated at the moment of the stabilization. Danzig was
drop.ped from the analysis owing to a lack of data for 1923.
he significance level is 0.024.
2 T
28The same is admitted by the Reparation Commission (as quoted in Bresciani­
Turroni (1937, p. 339)).
29 See Sargent's (1986) interpretation of Pasvolsky (1928) and Dornbusch and
Fischer (1986).
30The degree of external control in the Polish case seems very mild.
©International Monetary Fund. Not for Redistribution
STABILIZATION PROGRAMS AND EXTERNAL ENFORCEMENT
613
and foreign enforcement are not strictly necessary to implement a hy­
perstabilization. 31 Later episodes in Hungary (1945) and China (1949)
furnish additional examples of socialist stabilization without external
intervention.
Discriminant and Probit Analysis
The basic hypothesis that emerges from the earlier theoretical dis­
cussion is that economies that face more severe credibility problems or
more pressing financial needs are more likely to require external enforce­
ment. Moreover, the preceding analysis of the League's programs sug­
gests that those programs were characterized by binding commitments
that enhanced the credibility of the stabilization attempts. Hence, it
seems natural to test whether countries with greater credibility problems
and financial needs did indeed rely more heavily on external agents to
stabilize their economies. The previous subsection indicated that coun­
tries with higher nominal instability did have recourse to such external
involvement.
Unfortunately, the observed counterpart of a "credibility problem" is
hard to find, and the investigator is forced to rely on proxies that may
indicate the existence of such problems. The difficulty in finding suitable
variables to measure the degree of credibility is exacerbated by the lack
of reliable data for the 1920s. Moreover, as discussed above, credibility
problems and financial needs are likely to appear together, increasing the
difficulty of finding a proxy that isolates a credibility problem. Therefore,
they are handled as a single hypothesis. Given these Limitations, three
variabLes have been chosen to serve as proxies for the "credibility" of the
economic policymaking authority. The first variable, BACK" is the ratio
of the sum of gold and net foreign assets held by the central bank to the
amount of note circulation. The idea is that lower values of BACK, should
mean that the government is less able to defend a given exchange rate
objective. This measure was emphasized by the League itself as a good
indicator of sound financial practices. The second variable, FISC" is the
ratio of the fiscaL balance to the level of government expenditures. The
value of FISC, is intended to capture the degree of sustainability of fiscal
policy: lower values should mean less sustainable (and credible) policies.
This variable can also be interpreted as a measure of the severity of the
financial needs that a government faces. Finally, the third value consid31 League of Nations (1946). The Soviet stabilization was of a different type.
Llach (1987) calls it stabilization "by coercion" as opposed to other cases that
were "by consent."
©International Monetary Fund. Not for Redistribution
614
JULIO A. SANTAELLA
ered, DEPR, is the percentage rate of depreciation in the end-of-period
vaJue of the domestic currency (as observed on the New York market);
the logic is that a higher rate of depreciation suggests that markets
displayed less confidence in the policies followed by that country. All
variables are measured for the year in which the stabilization took place.
An endogenous binary variable is used to classify the episodes. This
dummy variable takes a value of unity if the country stabilized during-or
in clear anticipation of-participation by an external enforcing agency,
and zero if not. The countries for which this dummy takes a value of unity
are Austria, Bulgaria, Germany, Greece, and Hungary. Descriptive
statistics for the three variables and data sources are provided in Table 8,
where the countries are classified according to whether or not there was
external enforcement. Notice that the credibility measures of countries
that stabilized without external enforcement clearly dominate (first-order
stochastically) the credibility measures of countries with external en­
forcement. Indeed, countries with external enforcement not only per-
Table 8. Summary Staristics of the Credibility Indicators
Without external
With external
enforcement
Variable
enforcement
Banking variable (BACK)
32.9
10.2
First quartile
57.4
38.3
Median
71.7
Third quartile
69.5
39.5
53.6
Mean
26.6
30.7
Standard deviation
Fiscal variable (FISC)
-78.5
-10.2
First quartile
-2.9
-45.9
Median
1.9
-10.7
Third quartile
-5.0
-44.8
Mean
8.6
Standard deviation
35.0
Depreciation variable (DEPR)
-22.1
11.4
First quartile
-11.2
688.2
Median
17.9
6,916.6
Third quartile
2,908.8
Mean
-0 .7
29.3
5,279.0
Standard deviation
Note: See text for definition of the variables.
Sources: League of Nations, International Statistical Yearbook, Memorandum
on Public Finance, and Memorandum on Currency and Central Banks ; Pullerits,
The Estonian Yearbook (various issues); League of Nations (1926a, 1926b, 1927);
Young (1925); Mazower (1991); Department of Overseas Trade (1929); Lithu­
anian Ministry of Finance (1924); and Mitchell (1980).
©International Monetary Fund. Not for Redistribution
615
STABILIZATION PROGRAMS AND EXTERNAL ENFORCEMENT
Table 9. Discriminant Analysis of the European Stabilizations of the 1920s
(Number and percentage of observations)
Actual classification
Without external enforcement
With external enforcement
Total
Predicted classification
Without external With external
enforcement
enforcement
1
15
(6.25)
(93.75)
2
(40.00)
17
(80.95)
Total
16
(100.00)
3
(60.00)
5
(100.00)
4
21
(100.00)
(19.05)
Classifying variables: BACK, FISC, and DEPR,.
Note: Percentages are in parentheses.
formed worse, on average, according to the distributions in that table, but
they also suffered from a greater degree of variability.
A first step in testing the credibility and financial needs hypothesis of
external involvement is implemented through a discriminant analysis.
The objective is to determine whether countries can be classified into
those that did and those that did not rely on external assistance on the
basis of the three variables described. The classification is carried out
using the generalized squared distances between the two groups of
countries, assuming equal prior probabilities. The results presented in
Table 9 are very suggestive and indicate that most of the countries can
indeed be identified through the use of these three variables. In par­
ticular, 15 of the 16 countries that did not rely on external enforcement
are correctly classified by the discriminant analysis, and 3 of the 5 that
were supported by international institutions are also identified. The only
countries that are rnisclassified are Bulgaria, Greece, and ltalyY
The second step in testing the credibility and financial needs hypothesis
is to carry out a probit analysis to verify the robustness of the results
obtained from the discriminant analysis. This approach also provides a.
way to estimate the predictive powers of each of the three variables
chosen in the forecast of the dummy variable. The results of this probit
estimation (Table 10) are very interesting. All of the variables have the
expected signs, except for BACK, in equation (5); both FISC, and DEPR,
32 Bulgaria and Greece are probably misclassified because they did not exhibit
exchange rate depreciations as large as those in the hyperinflation countries. In
the case of the Italian misclassification, it is likely due to the substantial fiscal
deficit.
©International Monetary Fund. Not for Redistribution
- 1 . 184
BACK,
23
1 . 098
0.046
78.3
1 1.079
0.470
86.4
22
- 6.108
(-2.020)
- 1.697
( - 3 . 181)
(2)
11.437
0.485
86.4
22
- 1 . 176
( - 1 . 196)
- 0.960
( - 0.588)
-6.324
( -1. 961)
(4)
Equation
0.208
(2.313)
6.940
0.301
90.5
21
- 1 .253
( - 1 .533)
0. 170
(0.118)
(5)
©International Monetary Fund. Not for Redistribution
0.205
(2.437)
7.384
0. 320
90.5
21
- 1 .170
(-3.221 )
(3)
(Maximum likelihood estimates)
Probit Analysis of the European Stabilizations of the 1920s
T-statistics are reported i n parentheses.
a Log of likelihood ratio times -2.
2
b
McFadden pseudo-R •
c Percentage of accurate predictions.
Note:
Acc:uracyc
N
LRa
Rz b
DEPR,
FISC,
-0.220
( -0.360)
I n te rcept
( - 1 . 017 )
(1)
Variable
Table 10.
-3.77 7
( - 0.895)
0.245
(0.795)
1 1 .014
0.478
90.5
21
- 1 .502
( - 2.656)
(6)
- 1 . 192
( - 1 . 189)
-0.640
( -0.365)
-4.132
( - 0.952)
0.242
(0.744)
1 1. 1 15
0.482
90.5
21
(7)
>
m
rr-
�
>
z
"'
>
0
....
c
r
STABILIZATION PROGRAMS AND EXTERNAL ENFORCEMENT
617
are always statistically significant when they are not in the same regres­
sion. The likelihood ratio tests whether the coefficients on those variables
other than the intercept are all equal to zero; this null hypothesis is
rejected for all specifications except equation (1). The results are further
corroborated by McFadden's R2•33
More interesting is the predictive power of the explanatory variables:
more than 78 percent of the observations are classified correctly in the
worst specification. In this respect, it is worth noting that the fiscal
balance has 86 percent of the observations as correct predictions. The
countries that are not correctly classified by FISC, are Bulgaria, Greece,
and Italy. When the fiscal balance variable is supplemented by the rate
of depreciation, the percentage of correct predictions increases to more
than 90 percent, and Italy is no longer misclassified. However, BACK,
is an indicator that performs poorly.34
In sum, the empirical tests described here support the hypothesis that
the presence of credibility problems and financial needs, when proxied
by the fiscal inconsistency and instability of the exchange rate, did influ­
ence the decision to rely on external agents. Of course, the interpretation
of the results presented here does not make a strong distinction between
the two different arguments. However, the need for financing is often
aggravated by credibility problems, so even though the two explanations
are conceptually different, in practice it is difficult to disentangle them.
IV. Conclusions and Lessons from the 1920s
There are two main reasons why a government may rely on external
assistance to stabilize its economy. The first is that an external agent can
restore credibility to the government's macroeconomic stabilization ef­
forts: this has been referred to as the "commitment technology" argu­
ment. The second explanation is that external assistance, in the form of
foreign loans and credits, can help to finance both the imbalances of an
economy in disequilibrium and the stabilization confronting the econ­
omy. This paper has argued that both these incentives to rely on external
33 Similar results are obtained by running logit regressions instead of the probit
specification, as well as by lagging the variables one period instead of using
current values.
34 This performance seems to be compatible with the evidence found by
Harberger and Edwards (1980) in their study of modern devaluation episodes.
They found that countries that abandoned a fixed exchange rate reacted to a
decrease in their equivalent measure of BACK only after it had reached a critical
level. A similar scenario in which a critical value of BACK triggers external
enforcement of a stabilization program may be possible in this sample.
©International Monetary Fund. Not for Redistribution
618
JULIO A. SANTAELLA
intervention are likely to be more pressing in those countries experiencing
high nominal instability.
The broad conclusion that emerges from the analysis of the reconstruc­
tion schemes carried out by the League of Nations in the 1920s is that for
a stabilization effort to succeed it must be effected through a fundamental
change in the fiscal and monetary regime. To achieve such a regime
change, the League of Nations supported a comprehensive series of
reforms in each country where it was involved. Of vital importance in
these countries was the goal of achieving sound and sustainable public
finances, the establishment of independent central banks, and the return
to convertible currencies. Nevertheless, the attempt to carry out all of
these reforms might have been in vain if the League had not had the
means to control and monitor enforcement of the programs. The control
machinery, together with the League's concern to protect its own repu­
tation, appears to have ensured that the League's reconstruction schemes
constituted credible changes of regime. In sum, the stabilization pro­
grams of the League achieved an impressive record of success, at least
in the period before the Great Depression.
This study of the historical experience of the currency stabilizations of
the 1920s yields suggestive results in several areas. The paper finds
preliminary evidence that, consistent with the analytical argument in
Section I, countries that suffered from higher nominal instability dis­
played a higher reliance on both external loans and external enforcement.
The empirical analysis of the role of external assistance compared indi­
cators of the credibility and financial needs of countries that resorted to
external intervention with those of countries that did not. The results
support the hypothesis that the presence of credibility problems and
financial needs, especially when proxied by fiscal unsustainability and
exchange rate instability, influenced the decision of European countries
to rely on an external agent to help enforce their currency stabilizations.
The currency stabilizations of the 1920s, in particular the experience
of programs implemented with the support and assistance of the League
of Nations, provide several lessons for current problems. First, these
episodes suggest the appropriate procedure for impleme�ting a monetary
stabilization: programs should be comprehensive and should place spe­
cial emphasis on the right institutional setting in order to provide lasting
stability. Second, these episodes give some insight into the sorts of
circumstances where external involvement becomes more desirable.
Countries with economies in profound disarray and that suffer credibility
and financing problems are more likely to require external enforcement
of an adjustment program. Third, the experiences also illustrate the
degree of sacrifice needed in terms of a country's sovereignty and discre-
©International Monetary Fund. Not for Redistribution
STABILIZATION PROGRAMS AND EXTERNAL ENFORCEMENT
619
tion in order to enable the external enforcer of a stabilization to achieve
the objectives of the program. The analysis suggests that in cases where
policymakers are willing to forgo the flexibility of a discretionary regime
in favor of a commitment regime, they are more likely to succeed in
implementing a credible, and hence successful, stabilization program.
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Present," Weltwirtschaftliches Archiv , Vol. 122 (1986), pp. 1-47.
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©International Monetary Fund. Not for Redistribution
IMF S/4/f Papers
Vol. 40, No. 3 (September 1993)
il:l 1993 International Monetary Fund
Risk Taking and Optimal Taxation
in the Presence of Nontradable
Human Capital
ZULIU HU*
This paper demonstrates that the stream of uncertain income from human
capital has systematic effects on the demand for risky physical capital
assets. Iflabor supply is inelastic and real wages are known with certainty,
then a labor income tax will reduce holdings of the risky physical asset.
However, if labor income fluctuates randomly, a labor income tax may
actually raise demand for the asset if human capital risk and physical
capital risk are positively correlated. The idiosyncratic risk and nontrad­
ability of human capital also have implicationsfor optimal taxation. [JEL
G l l , H21)
have long been concerned with the effects of taxation
Eon entrepreneurs'
risk-taking behavior. Since the seminal essay by
CONOMISTS
Damar and Musgrave (1944), such issues have been analyzed in a pure
portfolio choice framework. See Tobin (1958), Mossin (1968), Feldstein
(1969, 1976), Stiglitz (1969), Sandmo (1969), and Dreze and Modigliani
(1972). Presumably more risk taking leads to greater demand for risky
assets and thus lowers the cost of risky capital. In the long run, such
behavior helps to increase the economy's capital stock and national
income.
Although this literature bas succeeded in dispelling the popular per­
ception that taxing the returns on risky assets will necessarily reduce risk
* Zuliu Hu was an Economist in the Research Department when this paper was
written. He has since moved to the Fiscal Affalfs Department. He holds a
doctorate from Harvard University. The author is grateful to Robert Flood,
Robert Merton, and Larry Summers for helpful comments.
622
©International Monetary Fund. Not for Redistribution
RISK TAKING, TAXATION, AND HUMAN CAPITAL
623
taking, it suffers from some serious limitations. Chief among them is that
the earlier work Largely ignores some important and closely related
decisions, such as individuals' saving-consumption and labor-leisure
choices. Moreover, even if labor income is aJlowed, in addition to income
from capital assets, the pure portfolio choice model usually takes such
income as exogenously given (the labor supply is fixed) or assumes that
individuals receive a certain stream of wage income.
Ignoring labor income fails to capture the crucial role of human capital
in consumption and investment decisions, as human capital is often the
more important form of wealth for most individuals. 1 An extreme case
is that in the absence of bequests the young are endowed with only human
capital and no financial wealth.
To assume an exact stream of wage income is also unsatisfactory
because in reality individuals cannot foresee the flow of their future labor
income with certainty. For example, real wages are uncertain when the
prices of consumption goods are uncertain. For some people, their other­
wise smooth and continuous flow of labor income may contain jump
components over the life cycle if they face a positive probability of
temporary layoff or sudden loss of earning ability owing to health prob­
lems. Thus, like its physical counterpart, human capital is a risky asset.
The risk of human capital income probably has important interactions
with the risks of financial assets. Moreover, unlike physical capital,
human capital cannot be traded for obvious moral hazard reasons. No
claims on future wage income are actual1y traded on financial markets.
This feature of human capital will undoubtedly affect society's efficient
risk pooling and risk sharing. Consequently, an analysis of the effects of
taxation on risk taking should explicitly account for the riskiness and
nontradability of human capital.2
This paper recognizes the existence of risky, nontradable human cap­
ital income and attempts to offer an integrated treatment of individuals'
intertemporal consumption and labor supply as well as of their portfolio
choices. The paper presents a basic model and first considers the simplest
case with fixed labor supply and deterministic wage rate. Endogenous
labor income is then introduced. The paper then turns to analyze the case
when income from human capital follows geometric Brownian motion.
Finally, it explores the implications of the risk and nontradability of
human capital for efficient taxation.
1 Williams (1978) examines the effect of human capital on portfolio choice. In
addition, Williams (1979) analyzes individuals' decisions about their investment
in human capital through their level of education.
1In a similar model without human capital, Hamilton (1987) examines how
taxation of risky financial assets, such as dividend and capital gains taxes, can
affect individuals' risk-taking behavior.
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I. Basic
Model
It is assumed that the uncertainty in the economy is generated by a two­
dimensional stochastic process {dz, dq}, where dz and dq are standard
Brownian motions and where dz dq = TJzq dt (TJzq being the instantaneous
coefficient of correlation between dz and dq).
Individuals have two investment opportunities in this economy. One
is investment in a risk-free asset with an instantaneous rate of return, r(t),
and the other is investment in a risky capital asset, which may be viewed
as a real production possibility. The consideration of this two-asset case
proves convenient because it provides a well-defined measure of risk
taking, given by the portfolio share of the single risky asset. Moreover,
under certain conditions (such as with a constant consumption and invest­
ment opportunity set or with logarithmic utility functions), the continu­
ous-time version of the Sharp-Lintner-Mossin capital asset pricing model
(CAPM) obtains, and all individuals will hold the market portfolio, so
that the many-asset case can be simplified as if the market were the only
risky asset. The price of this risky asset can be modeled as an Ito process:
dP = aPdt + aPdz,
(1)
where a and a are the instantaneous mean and standard deviation of the
rate of return on the risky asset. With constant a and a, equation (1)
implies that the price of the risky asset is log-normally distributed.
The flow of stochastic real wage income can be written as
dY
=
fl.y Ydt + ay Ydq.
(2)
Consider an individual who lives for T years and whose preference
is described by a time-additive state-independent utility function,
U[c(t), L (t)]. Assume that U[c(t), L(t)] exhibits the standard properties
of monotonicity and concavity in consumption and leisure: that is,
Uc > 0, u�. > 0, Ucc < 0, and u�.�. < 0, where the subscripts on U denote
the first-order and second-order partial derivatives with respect to c(t)
and L(t), respectively.
At each point in time during the life cycle, the risk-averse individual
chooses the rate of consumption c(t), the current leisure L(t), and a
portfolio rule through which he or she can transfer wealth over time and
across the states of nature.3 Let w(t) denote the proportion of wealth to
3 This paper abstracts from the individual's retirement decision so that the indi­
vidual has an active working life until the termination date T. The retirement
problem has been extensively studied in the public finance and labor economics
literature, see Diamond and Mirrlees (1978). One can similarly explore the
problem of retirement with uncertainty ill this continuous-time framework.
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RISK TAKING, TAXATION, AND HUMAN CAPITAL
625
be invested in the risky asset. The general problem of intertemporal
optimization is
max E0
J T U(C, L,) dt
subject to a budget equation,
0
(3)
where Eo denotes the expectation conditional on the information avail­
able at time 0. With income derived from human capital, dl, the budget
constraint can be written as a stochastic differential equation:4
dW = {[w(a - r)
+
r]W - c}dt + d! + wWcrdz.
(4)
Assume that labor income is subject to a proportional tax rate ,., with
the government tax revenue being used to finance a public good that
enters the utility function separately. If the individual consumes a
fixed amount of leisure r and wage flow is deterministic (that is,
dY Y(t) dt), then the stream of after-tax labor income is dl =
6(1 - L)Y(t) dt, where 6 = ( 1 - T). Thus, the problem of equation (3)
reduces to one with a single consumption good and with exogenous
risk-free labor income. Defining the derived utility function of wealth as
=
J(W,t) = maxE,
r U[c(t), L(t)]dt
I
(5)
and the Bellman equation as
0 = max [ U[c(t), L]
C.OJ
+
J, + lw{[w(a - r) + r]W
1
+ 6(1 - L )Y - c}dt + 2 lww w·? W2ll,
(6)
one can write the first-order conditions for this problem:
Uc = lw,
0 = lw(a - r) + lwwwWa2,
(7)
(8)
where the subscripts on U and J denote partial derivatives with respect
to c, W, and t, respectively.
From equation (8), the share of the portfolio in the risky asset can be
written as
lw a - r
w* - - -- -(9)
- Wlww cr2
In general, the optimal proportion of wealth held in the risky asset
depends on the investor's risk preference, wealth endowment, and age
as well as on the parameters of the returns on traded assets a, r, and cr2.
4 See Merton (1971) for a detailed derivation.
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The individual's investment in the risky asset is determined by his or her
desire to attain a preferred risk-return trade-off in wealth. The more risk
the smaller
averse is the individual (the smaller the term
is his or her portfolio share in the risky asset. On the other hand, the
larger the premium on the market, a - r, or the smaller the market risk,
cr' the larger is the proportion of his or her wealth that the individual will
hold in the risky asset.
Note that a labor income tax affects the optimal portfolio demand by
changing individuals' risk-averse behavior and total wealth. To see this,
consider the case of a utility function with constant relative risk aversion
(CRRA) of consumption.5 Merton (1971) first derived explicit consump­
tion and portfolio rules for the CRRA utility function:
9(1 - L)Y{1 - exp(r(t =
+
(10)
'
cr 8
r
-lwi[Wlww]),
T)]}]
w*W �[ w
where is the reciprocal of the relative risk aversion of consumption.
Let WH denote the value of human capital; then,
- T))}
WH = J,r exp(-r(s - t)]ds = Y{1 - exp(r(t
(11)
r
8
Y,
.
In other words, the value of human capital is the present value of the
lifetime flow of maximal labor income discounted at the risk-free market
rate of interest. The crucial point here is that although human capital is
not directly traded the individual can, in effect, sell his or her risk-free
future labor income for present consumption by trading (shortselling)
financial assets. Thus, equation (10) can be rendered
w*W = a - r (W + 9(1 - L )WH]·
(12)
If there is only investment income (WH 0), the individual will wish
to maintain a constant share of the risky asset, w*, in his or her portfolio
cr2 8
-
=
over the life cycle. Then, the demand function for the risky asset is linear
in the level of wealth. Thus, one obtains the usual separation theorem,
wruch states that w* should be independent of the investor's wealth and
age for the case of the CRRA utility function. If the individual also
receives labor income, he or she will treat his or her net worth of human
capital as an addition to the current stock of wealth, and the inQ.ividual's
portfolio share of the risky asset will be age dependent. The individual
is willing to take more risk by investing more in the risky asset when he
or she is young since the value of human capital is greatest in the early
5Tbe constant relative risk aversion (CRRA) or isoelastic utility function
belongs to the family of hyperbolic absolute risk-aversion utility functions.
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RISK TAKING, TAXATION,
AND HUMAN CAPITAL
627
stage of Life. As a person gets older, his or her ratio of WH to W will
decline, and he or she will take a smaller position in the risky asset.
A labor income tax reduces the value of human capital and therefore
decreases an individual's holding of the risky asset. Fiscal policy is not
neutral with respect to the individual's risk-taking behavior. A current
tax cut matched by a future tax increase tends to encourage invest­
ment in the risky asset. Since the government does not share the invest­
ment risk faced by private agents through a labor income tax, total
(social) risk taking must also be reduced.
II. Interaction Between Labor Supply
and Portfolio Choice
This section introduces the labor-leisure choice into the individual's
decision problem but continues to assume that income from human
capital is nonstochastic.
The individual's problem now is
max £0
s.t. dW
=
JT U(c,, L,) dt
(13)
0
{[w(a - r) + r] + 0(1 - L)Y - c}dt
+ crwWdz .
From the Bellman equation,
0 = max[U(c, L) + J, + J111{[w(a - r) + r]W
2
1
+ 0(1 - L)Y - c} + 2lww cr w W2D,
(14)
the first-order conditions are
Uc = lw
(15)
and
= OYlw.
Combining equations (15) and (16) gives
UL = eYUc.
UL
(16)
(17)
Differentiate equation (17) with respect to T and assume that U is sepa­
rable in c and L; then,
dL
dT
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(18)
628
ZULIU HU
Thus, an uncompensated increase in the tax on riskless labor income
unambiguously discourages the individual's labor supply when his or her
preference is separable in the consumption good and leisure.
The optimal demand for the risky asset given by the first-order condi­
tions takes the same form as equation (9). To derive a closed-form
solution, a two-stage procedure is used. First, solve the following static
optimization problem at each t:
max V[c(t), L(t)] dt
s.t. C = c + eYL.
(19)
Define U(C,t) = V[c* (C,t),L*(C, t)]. Because real wages are non­
stochastic, there is no intertemporal uncertainty in the price of leisure
relative to the consumption good. Therefore U( C, t) remains state inde­
pendent. Then proceed to solve the following dynamic optimization
problem:
max £0
s.t. dW
=
r U(C , t ) dt
{[w(a - r) + r]W + eY - C}dt + wWadz.
(20)
Note that the leisure variable, L(t), no longer enters the budget con­
straint in equation (20). The problem now is formally identical to the one
with a single consumption good. For a CRRA utility function, the optimal
portfolio rule has the familiar form:
w**W
=
a;;'6r (W + eWH),
(21)
where wfl is given by equation (11).
Note that w** > w*. For the same ratio of human wealth to current
wealth, the individual takes more risk with an elastic labor supply than
with a labor supply fixed at (1 - L).6 Intuitively, the ability to adjust
labor supply conditional on investment performance provides insurance
for the individual's investment risk. The effect of a proportional labor
income tax, however, is to reduce private (and therefore social) risk
taking, as in the case with fixed labor supply.
6ln a closely related analysis, Bodie, Merton, and Samuelson (1992) show that
the ability to vary labor supply ex post induces the individual to assume greater
risks in his or her investment portfolio ex ante.
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RISK TAKING, TAXATION, AND HUMAN CAPITAL
629
ill . Uncertain Income from Human Capital
The presence of risky income from human capital complicates the
problem in two ways. First, it introduces uncertainty into the relative
price of leisure (denominated in the consumption good). As a result, the
utility function becomes state dependent, with the state variable repre­
sented by the wage variable, such that U = U(C, Y, t), where Cis rede­
fined from equation (19) as the consumer's aggregate expenditure, inclu­
sive of the value of leisure measured in terms of the consumption good.
Second, the presence of risky labor income has a wealth effect. It affects
the dynamics of wealth accumulation, so that both the drift and the
diffusion terms in the investor's budget constraint are modified.
Assume that the stochastic behavior of wage income is as specified in
equation (2): the wage income follows the geometric Brownian motion.'
Formally, the stochastic dynamic programming problem is
max Eo
r U[C(t), Y(t), t] dt
(22)
s.t. dW = {[w(a - r) + r]W + 6Yfl.y - C}dt + crwW dz
+ 6Ycrydq.
From the Bellman equation,
0 = max[U(C, Y,t) + It + fw{[w(a - r) + r]W + 6Yfl.y - C}
1
+ ]y 6Yfl.y + 2 fww(w2� Wl + 2wW6Ycr,q + 62 Y2cr;)
(23)
where CTzq = crcry "Y"Jzq is the covariance between the return on the risky
asset and income from human capital. Then, the first-order conditions
follow:
Uc(C* , Y, t) = lw(W,Y,t);
(24)
and
7Merton {1971) solves a problem in which the wage income is given exoge­
nously and is a Poisson process.
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The optimal demand for the risky asset can now be derived:
w*W =
JY
'.v 6Y�.
(- lw )�- 6Y� - lww
lww
rr
rr
rr
(26)
The optimal demand for the risky asset consists ofthree terms. The first
term, (-lwllww)(a - r) la.z, is the usual speculative demand for the
mean-variance maximizer.8 The second term, -6Ya,qla2 , is a labor
income hedging demand. The last term, -6Y(1Y'.vflww)(a,qlrr), is the
state-variable hedging demand. These hedging terms arise from the
nontradability of risky human capital. When the individual has human
capital income as well as financial investment income, the risk of human
capital income will play a role in determining his or her optimal portfolio
behavior. In other words, the interaction between the human capital risk
and the financial risk will affect the individual's optimal holding of the
risky asset. Compared with the case of riskless labor income in the previ­
ous sections, one can see that now, in addition to holding the risky market
portfolio to attain the desired risk-return trade-off in wealth, the individ­
ual also uses the risky market portfolio to hedge against the unanticipated
and possibly unfavorable changes in his or her labor income.
From the first-order condition (24),
Vee aC laW = lww
(27)
Vee aC laY + Vey = lwy.
(28)
and
If Vey = 0-that is, the direct utility function is state independent­
then JWY!lww = (aC laY) l(aC laW) > 0, because the propensities to con­
sume out of income and wealth are both positive. Then, the signs of both
the hedging terms depend on the sign of the covariances between the
return on the risky asset and wage income, azq· If the return on the risky
asset and that on wage income are negatively correlated ('l'Jzq < 0), the
existence of the risky human capital income produces a positive hedging
effect on the demand for the risky asset. The same observation was made
by Fischer (1975) in his exposition on demand for indexed bonds with a
state-independent utility function.
Since
a(w*W)
a,.
=
Y
rr
( 1 + lww
JY'.v) zq '
(29)
(]
8 With continuous trading, the r
isk premium on the traded asset, a r, is
determined by Breeden's (1979) consumption f3 model even with the existence
of nontraded human capital, as long as both the asset prices and the consumption
rate follow the Ito processes, as shown by Grossman and Shiller (1982).
-
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RISK TAKING, TAXATION, AND HUMAN CAPITAL
631
the effects of labor income taxation on risk taking will in general depend
on the covariance of human capital risk and physical capital risk. The
standard result under riskless real wage income no longer holds for the
more general case of an uncertain income stream from human capital.
If wages and the return on investment in physical capital are negatively
correlated, then a proportional labor income tax will reduce the hedging
demand for the risky asset. Because part of the labor income risk is now
shifted to the government,9 the individual then needs less of the risky
asset in order to hedge the risk of nontradable human capital.
If the instantaneous rate of return on the risky financial asset is posi­
tively correlated with the unanticipated changes in wage income
('Tlzq > 0), then the individual's hedging demand for the risky asset is nega­
tive: reverse hedging occurs. A labor income tax will actually encourage
risk taking in this case.
If the return on the risky asset and that on wage income are uncorre­
lated (TJzq 0), then both the hedging terms in equation (26) will vanish.
In this case, the individual's labor income risk is idiosyncratic. Holding
the risky financial asset cannot provide insurance against unanticipated
changes in labor income. Although the idiosyncratic labor income risk
will affect the individual's risk aversion and consumption behavior, it
does not affect his or her demand for the risky asset. 10 Therefore, the
hedging demand for the risky asset will be zero. In this case, the only
mechanism for sharing and pooling individuals' idiosyncratic labor
income risk is the government's taxation on labor income.
Which of these possibilities is empirically more relevant remains a
subject for further research. Fama and Schwert (1977) study the role of
human capital in the classical CAPM. They found that the relationships
between the returns on human capital and the returns on various port­
folios of traded assets are weak, so that the presence of human capital
does not significantly affect the measurement of risk for traded capital
assets. However, as the authors themselves acknowledged, their results
cannot be viewed as definitive because of a number of measurement and
estimation problems.
In addition to these hedging effects, the existence of labor income also
produces a wealth effect. The risky stream of labor income, when appro­
priately capitalized, is treated as part of wealth in the consumption and
portfolio demand functions.
=
9 Implicitly,
it is assumed that the tax code contains full loss-offset provisions.
A lthough the idiosyncratic labor income risk itself does not affect the demand
for the risky asset, the presence of human capital and labor income taxation will
still produce a wealth effect and financial risk taking will be affected.
10
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IV. Optimal Taxation with Nontradable Risky Labor Income
The analysis above points to the importance of the interaction between
the risks of financial assets and those of human capital income. The
individual will invest more of his or her wealth in the risky capital asset
if the return on the asset is negatively correlated with his or her labor
income. In effect, the financial market can provide insurance against the
labor income risk. This interaction between the individual's nonhuman
capital risk and human capital risk will, in addition to its effects on
portfolio choice and risk-taking behavior, have implications for efficient
income taxation, to which the discussion now turns.
Because human capital is nontradable, it clearly improves welfare to
have some kind of social scheme that pools and shares the human capital
risk when the private market fails to provide insurance instruments for
individuals to hedge against the uncertain stream of labor income. The
government, through its ability to tax, can play precisely such a role in
diversifying the idiosyncratic human capital risk. Indeed, it is tempting
to suggest a 100 percent wage tax combined with a lump-sum transfer.
In reality, however, this type of public insurance program is unlikely to
work because of its disincentive effect on labor supply. Therefore, one
needs jointly to consider the insurance and efficiency aspects of labor
income taxation.
Assume that a large number of individuals in the economy are identical
in preferences, beliefs, initial endowments, and abilities, so that varia­
tions in labor income arise only from differences in "luck. "1 1 In other
words, the random fluctuations in labor income are caused by "idiosyn­
cratic" risks that are uncorrelated among individuals. Formally, for each
individual i, the uncertain stream of wage income is represented by
equation (2), with dq;dz Tlqzdt, Vi and dq;dqj = 0, Vi :/= j.
Consider a representative consumer who chooses his or her optimal
consumption, labor supply, and portfolio share at each point in time,
taking the tax rate on labor income, -r, as given. The individual essentially
faces the following problem:
=
max £0
Lr U[C(t), L(t)] dt
(30)
s.t. dW = {[w(a - r) + r]W + 6(1 - L)Y!-1-r - c}dt
+ wW<Tdz + 6(1 - L)Ycrydq.
11
Stiglitz (1982) examines the problem of Pareto-efficient taxation when indi­
viduals differ in their productivities and the government has imperfect informa­
tion about the "true" distribution of abilities across people. The assumption here
is similar to that employed by Barsky, Mankiw, and Zeldes (1986), who examine
the interaction between individual income uncertainty and income taxation in the
face of a debt-financed tax cut.
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RISK TAKING, TAXATION, AND HUMAN CAPITAL
633
One can write the following first-order conditions with respect to c, L,
and w, respectively:
U, = lw,
(31)
UL = 6Yf..Lylw + [wW6Ya,q + 82 Yl(l - L)a;]Jww,
(32)
and
wW =
-�
.!.:t:_ - 8Y(l - L) �� '
� lww
(33)
where e 1 T' where J = J(W' t) is the derived utility function
of wealth, and where O"zq = aay lJ:q is the covariance between the
individual's financial risk and human capital risk.
How might the uncertainty about future wage income affect an individ­
ual's labor supply decision? To see this, consider some simple cases.
Substituting equation (33) into the first-order condition (32),
=
-
[
UL = eY f..Ly
- ? (a - r)] lw
+
82 Yl(1 - L*)a; (1
- l);q)lww· (34)
Suppose that the individual's utility function is additively separable in
the consumption good and leisure. If the individual's human capital
risk and financial risk are perfectly correlated (that is, IYJzql = 1), then
differentiating equation (34) with respect to T gives
[ - 2 (a - r)
J
a
aL *
ULL- = -Ylw f..Lr
aT
a
:::.El
.
(35)
Note that the term in the square bracket is positive. To see why, imagine
there is a traded asset that replicates the income from a unit of human
capital. At equilibrium, this traded asset is priced by the continuous-time
CAPM:
f..Ly
-
r
= ?<a - r),
(36)
where f..Ly is the instantaneous rate of return on the traded asset. It is then
easy to see that the square-bracketed term in equation (35) is positive
when the rate of return on the riskless asset r is greater than zero.
According to the standard assumptions about the utility function
U[c(t), L(t)], it can be established from equation (35) that aL* faT > 0.
Therefore, just as in the case of risk-free labor income, an increase in the
proportional wage tax will unambiguously reduce labor supply when the
labor income risk and investment income risk are perfectly correlated.
If, as a polar case, the human capital risk and the financial risk are
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ZULIU HU
uncorrelated ('llzq = 0), then differentiating equation (34) with respect to
,. gives
iJL*
(ULL + 02 Jl2o-;lww) a:;:-
=
[
- Ylw J.Ly
_
20o-;
Y(1
;L*) (
_
wj;v)] .
(37)
Equation (37) clearly shows the possibility of a positive response of labor
supply to an increase in the proportional wage tax. The greater the
nondiversifiable labor income risk, the larger the share of current labor
income in wealth, and the more risk-averse the individual, then the more
likely it is that the right-hand side of equation (37) will turn positive and
that the individual will increase his or her labor supply in the face of a
higher wage tax. This surprising result arises because the government's
taxation of income provides insurance against the individual's labor
income risk.
Suppose that the government chooses a linear income tax schedule. At
each point in time, the government taxes each individual's labor income
at the proportional rate ,. and makes a lump-sum income transfer dS(t)
to each individual. The government faces the following intertemporal
budget constraint:
dS
= ,.(1 - L)E,(dY) - dG
=
,.(1 - L)YJ.Lrdt - dG,
(38)
where dG is the government revenue requirement. The government
wishes to maximize the representative consumer's lifetime utility given
its budget constraint (38) so as to determine the optimal tax rate ,.*. In
other words,
max £0
r U[C(t), L(t)] dt
(39)
s.t. dW = {[w(a - r) + r]W + 0(1 - L)YJ.Ly - c}dt
+ dS + wWo-dz + 0(1 - L)Yo-ydq.
From the Bellman equation, the first-order condition with respect to
,. is
iJL*
iJL*
Vca;- = {YJ.Lyfw + OY[wW<T,q + OY(1 - L*)cr;)Jww}a:;:+ Y(1 - L*)[wWa,q + OY(l - L*)a;]fww·
(40)
The other two first-order conditions with respect to c and w are not
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RISK TAKING, TAXATION, AND HUMAN CAPITAL
635
presented here because they take the same forms as equations (31)
and (33).
Using these first-order conditions from the individual's maximization
problem, one can, after some manipulations, obtain
,.y1-Lyfw
2 )lww
iJL* e u
'2( 1
* )2 2 (1 - "Tlzq
a:;:- + I- - L IJy
c:x. - r
2 IJzq Y(1 - L* )Jw = 0.
- -(j
(41)
Let F(T) denote the left-hand side of equation (41). Obviously F
depends on the interaction between the labor income risk and financial
risk ("Tlzq) as well as on the labor income risk itself (1J;).
Suppose that individuals' labor income is risk free (<1, = 0), then
F(O) = 0. That is to say, the optimal taxation structure implies a zero tax
rate on wages if labor supply is elastic and if individuals do not face human
capital risk; this is for the usual reason that, under certainty, one can have
lump-sum taxation when all individuals are identical.
In general, a zero tax on wages cannot be optimal. Consider the case
when the human capital risk and financial risk are uncorrelated ("Tlzq 0).
The expression of F becomes
=
(42)
Because evaluating F at T = 0 gives
F(O) = Y2(1 - L*)21J;_,ww < 0,
(43)
the first-order condition cannot be satisfied at a zero tax rate. In fact, if
F(T) = 0, then equation (41) yields
T*
l
w'--L *"'---'Y2)(1
w "'----'
'-'....:.;_:;
-
)2if
(iJL *
2
YJ.Lyfwa:;:- - Y2( 1 - L * )2IJ>Jww
= -
(44)
Therefore, if labor supply responds negatively to changes in the wage tax
(iJL * /iJT > 0), the optimal marginal tax rate should lie strictly between
0 and 1 .
For the case of perfect correlation, it is straightforward to show that
0 < T* < 1 if "Tlzq = + 1 and that it may be optimal to have a wage subsidy,
T* < 0 if "Tlzq = - 1 . Therefore, even when individuals can diversify the
risk of human capital by holding a risky financial capital asset, the optimal
tax on their labor income is usually not zero.
These results closely parallel those obtained by Eaton and Rosen
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ZULIU HU
(1980), who use a static model of uncertainty with endogenous labor
supply. 12 They do not consider the interaction between investment risk
and wage risk because the nonlabor income in their paper is assumed to
be nonstochastic.
V. Conclusion
This paper has reexamined the effects of taxation on risk taking and
on labor supply in a continuous-time life-cycle model. It has shown that
the existence of income from human capital has systematic effects on
individuals' optimal portfolio choice and that the risk and nontradability
of human capital have implications for an efficient income tax structure.
Further work, especially empirical study, is needed to better understand
how taxation affects individuals' lifetime saving and portfolio decisions.
REFERENCES
Barsky, Robert, Gregory Mankiw, and Stephen Zeldes, "Ricardian Consumers
with Keynesian Propensities," American Economic Review , Vol. 76 (1986),
pp. 676-91.
Bodie, Zvi, Robert C. Merton, and William F. Samuelson, "Labor Supply
Flexibility and Portfolio Choice in a Life Cycle Model," Journal of Economic
Dynamics and Control, Vol. 16 (1992), pp. 427-49.
Breeden, Douglas, "An Intertemporal Asset Pricing Model with Stochastic Con­
sumption and Investment Opportunities," Journal of Financial Economics,
Vol. 7 (1979), pp. 265-96.
Diamond, Peter, and James Mirrlees, "A Mode of Social Insurance With Variable
Retirement," Journal of Public Economics, Vol. 10 (1978), pp. 295-336.
Domar, E.D., and Richard A. Musgrave, "Proportional Income Taxation and
Risk Taking," Quarterly Journal ofEconomics, Vol. 58 (1944), pp. 388-422.
Dreze, Jean, and Franco Modigiani,
l
"Consumptions Decisions Under Uncer­
tainty," Journal of Economic Theory, Vol. 5 (1972), pp. 308-35.
Eaton, Jonathan, and Harvey S. Rosen, "Labor Supply, Uncertainty, and Effi­
cient Taxation," Journal of Public Economics, Vol. 14 (1980), pp. 365-74.
Fama, Eugene, and William Schwert, "Human Capital and Capital Market
Equilibrium," Journal of Financial Economics , Vol. 4 (1977), pp. 95-125.
Feldstein, Martin, "The Effects of Taxation on Risk-Taking," Journal ofPolitical
Economy, Vol. 7 (1969), pp. 755-64.
12
Varian (1980) also examines the social insurance aspect of redistributive
taxation in a static model of uncertainty. He does not explicitly consider the
incentive effect of taxation on labor supply.
©International Monetary Fund. Not for Redistribution
RISK TAKING, TAXATION, AND HUMAN CAPITAL
637
, "Personal Taxation and Portfolio Composition: An Econometric Anal­
ysis," Econometrica, Vol. 44 (1976), pp. 631-50.
Fischer, Stanley, "The Demand for Index Bonds," Journal ofPolitical Economy ,
Vol. 83 (1975), pp. 509-34.
Grossman, Sanford, and Robert Shiller, "Consumption Correlatedness and Risk
Measurement in Economies with Non-traded Assets and Heterogenous
Information," Journal of Financial Economics, Vol. 10 (1982), pp. 195-210.
Hamilton, Jonathan, "Taxation, Savings, and Portfolio Choices in a Continuous
Time Model," Finances Publiques/Public Finance, Vol. 42 (1987), pp.
264-82.
Merton, Robert, "Optimum Consumption and Portfolio Rules in a Continuous­
Time Model," Journal of Economic Theory , Vol. 3 (December 1971), pp.
373-413.
Mossin, Jan, "Taxation and Risk-Taking: An Expected Utility Approach," Eco­
noniica, Vol. 35 (1968), pp. 74-82.
Sandmo, Agnar, "Capital Risk, Consumption, and Portfolio Choice," Econo­
metrica, Vol. 37 (1969), pp. 586-99.
Stiglitz, Joseph, "The Effects of Income, Wealth and Capital Gains Taxation on
Risk-Taking," Quarterly Journal of Economics, Vol. 83 (1969), pp. 262-83.
, "Self-Selection and Pareto Efficient Taxation," Journal of Public Eco­
nomics, Vol. 17 (1982), pp. 213-40.
Tobin, James, "Liquidity Preferences as Behavior Towards Risk," Review of
Economic Studies, Vol. 25 (1958), pp. 65-86.
Varian, H.R., "Redistributive Taxation as Social Insurance," Journal of Public
Economics, Vol. 14 (1980), pp. 49-68.
Williams, J., "Risk, Human Capital, and the Investor's Portfolio," Journal of
Business, Vol. 51 (1978), pp. 65-89.
--, "Uncertainty and the Accumulation of Human Capital over the Life
Cycle," Journal of Business , Vol. 52 (1979), pp. 521-48.
--
---
©International Monetary Fund. Not for Redistribution
IMF Staff Papers
Vol. 40, No. 3 (September 1993)
@ 1993 International Monetary Fund
Cash-Flow Tax
PARTHASARATHI $HOME and CHRISTIAN SCHUTTE*
The cash-flow tax has been proposed as an alternative to the corporate
income tax on grounds that it would define the tax base more clearly and
more simply in the face of widespread departures from the comprehensive
income tax of actual practice. The cash-flow tax, and its variants, would
require careful design. Simplicity may prove elusive because ofanticipated
administrative problems related to tax avoidance and evasion through
transfer pricing, to inflation adjustments, and to incompatibility with exist­
ing international tax regimes. Thus, the tax remains theoretically attractive
but difficult to implement. [JEL H24, H25, H87]
surveys some practical issues relating to an alternative
Tform of corporate
taxation: the cash-flow tax. Cash-flow taxation
HIS
PAPER
1
has long been discussed as an alternative to the taxation of income, both
at the personal and the corporate levels. There has been a renewed policy
interest in such proposals recently, motivated by long-standing concep­
tual arguments and increasingly by administrative reasons. It is argued
that despite a renaissance of the comprehensive income tax as an ideal
in many tax reform endeavors of the· 1980s, it is only poorly approxi­
mated in the existing tax codes. Cash-flow taxation might be a viable
alternative to the "uneasy compromise" (Aaron, Galper, and Pechman
(1988)) of a "hybrid income-consumption tax."
* Partbasarathi Shome is Chief of the Tax Policy Division in the IMF's Fiscal
Affairs Department. Christian Schutte was a summer intern in 1992 in the same
division when the paper was written; at the time, he was pursuing a master's
degree at the Kennedy School of Government at Harvard University. The authors
would like to thank Milka Casanegra de Jantscher, Ved Gandhi, David N�ll?r,
. and Howell Zee for many helpful comments. Remammg
Emil Sunley, Vito Tanzt,
errors are the responsibility of the authors.
1 In the literature, the tax is sometimes referred to as the Brown tax, after its
first classic proponent Brown (1948).
638
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CASH-FLOW TAX
639
Conceptually, cash-flow taxation is based on consumption; thus, it is
neutral with respect to capital formation. The practical advantages of
cash-flow taxation-its definitional clarity and its simplicity of measure­
ment-were first forcefully argued by Andrews (1974), as weU as dis­
cussed in a U.S. Treasury report (1977). Perhaps they have received more
interest recently as tax theorists have come to emphasize the implemen­
tation and administration of tax policy (Kay (1990), Slemrod (1990), and,
for developing countries, Khalilzadeh-Shirazi and Shah (1991)). The
classic Haig-Simons ideal of a comprehensive income tax, based on
consumption plus net accrual of wealth, seems to be rather problematic
when judged by these criteria. It has been argued that the hypothetical
nature of the accrual concept tends to create complexities in the tax code,
increase the burden of administration and compliance, and foster avoid­
ance and distortion (Kay (1990), p. 67). Under these circumstances, a
cash-flow tax seems a promising alternative especially at the corporate
level, where equity concerns about exemption of capital income are
irrelevant and where some technical problems are less salient. 2
Opponents of the cash-flow tax question the superiority of its tax base
on equity grounds. Also, they are usually not optimistic about the admin­
istrative advantages of the tax. Regarding the corporate sector, they
decry it primarily because of implementation problems and the Jack of
international experience and coordination. The doubts emanate from
perceived difficulties in containing tax evasion, because of transfer­
pricing practices, and tax avoidance, because of intracompany leasing
arrangements, as well as because the tax may not be creditable in those
countries that export capital until they themselves introduce the tax.
Therefore, the tax may not be compatible with the existing international
tax regime. In addition, political forces that lead to the erosion of the
corporate income tax (CIT) base are also likely to affect the corporate
cash-flow tax (CCFf) base. Although the cash-flow tax may address
some inherent shortcomings of the income tax, it is not any less vulner­
able to the political pressures working to undermine the system through
special provisions and targeted incentives.3
The objective of this paper is to survey some of the practical problems
2 Among the problems confined to personal taxation are the treatment of
consumer durables, education, and gifts and bequests. For a discussion of these
and other problems of a cash flow-based personal consumption tax, see Pechman
(1980).
3 For instance, claims have been made that the CCFf is "an alternative way to
attain the obj ective of fiscal neutrality without a significant erosion of the tax
base" (King (1986), p. 2) and that it "avoids the Eroblem of targeted incentives;
the need to pick winners and losers" (McLure (1991), p. 15).
©International Monetary Fund. Not for Redistribution
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PARTHASARATHI SHOME and CHRISTIAN SCHUTTE
associated with the introduction of a CCFf-namely, its effects on rev­
enue, the possibilities for tax avoidance and evasion, the international
compatibility of the tax, and transition issues. We begin by discussing the
conceptual background of the tax and pointing to some of the advantages
and disadvantages that arise from its definition. We next assess the CCFf
on practical grounds rather than on its conceptual merit, addressing
issues that would arise in the transition to a CCFf, as well as consider­
ations of a more general nature. Among the latter are the revenue effects
arising from the CCFf's impact on investment, the often express�d
preoccupations regarding increased tax avoidance and evasion, and the
implications of the relatively uncoordinated cross-country tax arrange­
ments that currently prevail. However, many of the difficulties associated
with administration of the cash-flow tax are not reviewed in any detail.
Finally, many middle-income developing countries, especially in Latin
America, are considering the introduction of a cash-flow tax. Therefore,
the paper, at several points, gives specific consideration to issues relevant
for them.
I. Conceptual Elements
Conceptually, the CCFf has been discussed as a supplement to a
personal expenditure tax, a personal income tax, and a value-added tax
(VAT), and as a tax on economic rent. The CCFf base also varies in
conception, reflecting whether real transactions or real and financial
transactions are taxed. These and related issues are discussed below.
What Is a CCFf?
Although the focus seems to have shifted over time, the CCFf rests
within a tradition of consumption tax proposals (Sunley (1989)). Thus,
it is usually advocated first as a supplement to a personal expenditure tax
(ET) that is designed (1) to withhold tax on economic rents and nonwage
labor income,4 (2) to discourage evasion of the ET by individuals through
business activities, and (3) to capture foreign capital income. It would
also curtail the windfall capital gains accruing to shareholders if an ET
were adopted.
Second, the CCFf has been discussed as a separate corporate tax
alongside a personal income tax system. Such a system would fall short
of the ideal consumption tax "package." But given the difficulties of an
4Note here its similarity to the value-added tax, a point taken up below.
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CASH-FLOW TAX
641
ET, a CCFf may be a second-best alternative, correcting the administra­
tive and economic shortcomings of the CIT (Mintz and Seade (1991),
King (1986)).
Third, the CCFT was suggested, in an array of variants, as a tax on
economic rent. For example, it has been recommended as an ideal
resource tax (Garnaut and Clunies Ross (1983)). 5
Fourth, there seems to be an argument for combining the cash-flow tax
with the VAT. Thus, if a VAT is calculated using the subtraction method,
the same tax return could be used to deduct wages and investment in
order to compute the cash-flow tax.
The following discussion is not confined to any particular form of the
CCFf. For practical purposes, the most relevant option seems to be
the CCFT as a complement to a personal income tax. However, most of
the points raised will be equally valid for other variants.
CCFr Tax
Base
Following Meade (1978), there are three types of CCFTs:
-The R-based CCFT is one in which the tax base is net real trans­
actions-that is, the difference between sales and purchases of real
goods and services. As opposed to an income tax, the distinctive features
of such a tax base are the immediate expensing of capital outlays and
the nondeductibility of interest payments. At the same time, interest
received is no longer taxable.
-The RF-based CCFT (real plus financial) is one that also includes
nonequity financial transactions-that is, the difference between borrow­
ing and lending. Interest and retirement of debt would be deductible, but
borrowing and interest received would be taxable: RF base =
(sales + borrowing + interest received) - (purchases + interest paid +
debt repaid).
-The S-based CCFT taxes the net flow from the corporation to
shareholders-that is, S (dividends paid + purchases of shares issues of new shares).6 The S base is conceptually equivalent to the RF
base minus the CCFT, as can be seen from a basic accounting identity:
any difference between total business inflows and outflows has to be paid
out either to shareholders or as tax, RF = S + CCFT. Since taxes enter
=
5 Cash
flow-based rent resource taxes have actually been used for mining
l?rojects in Papua New Guinea, Tanzania, and several other developing countries
( Garnaut and Clunies Ross (1983)).
6 Since share transactions between corporations cancel out, the aggregate S
base represents the net flow from the corporate sector to shareholders.
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642
PARTHASARATHI SHOME
and CHRISTIAN SCHUTrE
into the sources and uses-of-funds statement, the rate of the RF-based
tax would be tax inclusive. The S-based rate would be tax exclusive-it
could well be higher than 100 percent.
The S base was favored by Meade (1978) because it was perceived as
administratively simpler. However, the conceptually equivalent RF base
is closer to current tax base configurations and is therefore more com­
monly discussed as an alternative to the CIT. Nevertheless, an
R-based CCFT system has been advocated recently by McLure (1991)
and by McLure and others (1990), who suggest it as part of a simplified
alternative tax, which is essentially a consumption-flow tax for business
and personal taxation. McLure argues that the exclusion of financial
transactions makes an R-based tax easy to administer. On the other hand,
the exclusion of the financial sector from the R-based CCFT is an obvious
drawback. Further, it increases the problems of transition and seems
particularly prone to tax avoidance schemes, points that are elaborated
upon later.
Selected Characteristics
A classic interpretation of the CCFT is that government acts as a "silent
partner" in an investment (Brown (1948)). This is most clearly seen for
the S base where the government sustains tax losses from the equity raised
and receives revenue from the distributed earnings. Alternatively, with
immediate expensing and a tax rate tc, capital outlays K produce a tax loss
of tcK· This can be interpreted as a reduction in the corporation's own
investment outlay, so that its effective financing becomes (1 - tc)K. If
one assumes a constant tax rate, government will then share a proportion
tc of all subsequent inflows. As outflows and inflows for the corporation
are reduced proportionately by the "silent partnership," the rate of
return on an investment remains unaffected by taxation.
The "silent partnership" enables the government to appropriate a
share of the above-normal returns that are generated in the economy.
Those returns may be economic rents from entrepreneurial activity, from
nonrenewable resources, or from monopoly, but can also be investors'
compensation for risks, which on average will be positive. Hence, the
CCFT can also be interpreted as a tax on pure profits and on returns to
risk taking (Stiglitz (1976)). For marginal projects that just cover the
opportunity cost of capital, the present values of initial tax losses and of
subsequent CCFT payments just offset each other.7
'For illustration, consider a simple two-period investment project of K 1,
which yields a pretax return of r. The present value of the CCFT payments from
=
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CASH-FLOW TAX
643
The marginal effective tax rate of zero is a crucial implication of the
CCFf. The tax is neutral with respect to the employment of capital. In
itself, the tax would not discourage any project that might have been
undertaken in its absence.
From a theoretical perspective, there are a number of other attractive
features of a CCFf (King (1986)):
-The exemption of marginal returns implicit in immediate expensing
does not discriminate between debt and equity.8 The income tax favors
debt over equity by allowing deduction of interest only. Partial inte­
gration of corporate and personal income taxation does not solve this
problem as long as there is a substantial spread between marginal investor
tax rates.
-Immediate expensing also ensures neutrality with respect to the rank
ordering of projects. Under the income tax, any divergences between
the profiles of "economic" and "tax" depreciation-which are virtually
inevitable-result in positive or negative tax wedges that distort this
ordering (Samuelson (1964)).
-Except for situations of hyperinflation (where even annual expens­
ing faUs short of a full deduction of real investment), the cost of capital
is not affected by inflation under the CCFf.
-If the CCFf is introduced alongside a personal income tax, there is
no need to integrate the two taxes. Because capital income is effectively
exempt at the corporate level under the CCFf, the appropriate treatment
would be the classical system under which the corporation is treated as
a separate entity and no effort is made to attribute its earnings to equity
holders.
-The CCFf is based on current transactions and hence avoids the
timing problems of a typical income tax: expensing replaces the calcula­
tion of "true economic depreciation" as well as the need for an inflation
adjustment of inventory and asset replacement values. The problem of
capital gains is irrelevant.
this project is given as
(r - i)tcl(l + i),
Tc = -tc + (1 + r)tc/(1 + i)
(1)
where -tc is the tax benefit from initial expensing and (1 + r) is the cash inflow
in the second period; i is the risk-free market rate of interest, equal to the
government discount rate, so that (1 + i) is the discount factor. As can be seen,
revenue is raised on the difference r - i, that is, on above-normal returns. A
marginal project, with r = i, is effectively untaxed.
8 Financial decisions under the CCFT may still be d
istorted by the personal
i , if there is differential treatment of capital gains and dividend
income tax-that s
income.
=
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PARTHASARATHI SHOME and CHRISTIAN SCHUTTE
For practical purposes, however, two critical assumptions underlying
the theoretical neutrality results need to be stressed: it is assumed that
tax rates are constant and that taxable inflows are always sufficient to
offset expenses, so that an investment will actually produce an initial tax
reduction. These points are considered next.
Rates of a neutral CCFf must not be progressive and must be stable
over time. The latter, especially, may be a problem, since governments
have a short-run incentive to raise rates once investors have committed
themselves (King ( 1986)). 9 An unexpected rate hike in itself will not affect
the allocation of capital but only generates windfall-tax revenue. How­
ever, the effects of a CCFf on investment activity will depend crucially
on the credibility of the government's pledge not to change rates in the
future.
If inflows are insufficient to offset expenses, a cash refund for unused
deductions would be required to make an ideal CCFf work. Alterna­
tively, a provision to carry forward losses at an appropriate interest rate
could be used to preserve the present value of the initial deduction.
Following the silent-partner interpretation, one might also say that with
a loss-carry forward provision the government's "equity share," tc, is
effectively financed by a forced loan from the firm. For the CCFf to
remain neutral, the loss then has to be carried forward at the firm's
discount rate. Timing issues obviously would sneak in through the back
door if loss-carry forwards are used. Grossing them by firm-specific
discount rates is hardly possible. Thus, there seems to be a clear trade-off
between practical and conceptual considerations in some important
aspects of the application of a CCFf.
II. Practical Considerations
While the CCFf cannot be strongly criticized for lacking theoretical
foundations, it does come up against some practical hurdles. The im­
portant practical considerations for the CCFf fall into two categories:
those that involve the transition phase and those that involve its general
implementation.
9 This incentive is particularly strong under the CCFf because t�ation con­
sists of two separate stages: first the government contnbutes to an mvestment
by granting expensing ; then it collects revenue from the inflows. Defecting
from initial tax rules after the first stage is more attractive than in the case of the
income tax, where depreciation allowances and tax payments are calculated
simultaneously over the lifetime of the project.
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645
Transition Issues
There are numerous concerns that arise during the transition from a
CIT to a CCFr. First, a "cold turkey" transition would produce windfall­
tax revenue by denying companies their existing depreciation allowances.
On the other hand, allowing immediate expensing of remaining depreci­
ation could adversely affect revenue. A hybrid of allowing continued
depreciation might be the only practical solution. As Sunley (1989) points
out, however, such "transitional" arrangements may have to last for a
number of years.
Most authors (Gordon (1989), Sunley (1989)) suggest that a short-term
revenue loss is likely during the transition. Various arrangements could
accommodate the amortization of old investment, while new investment
could generate substantial tax losses. In order to mitigate this effect, one
may resort to "present value expensing" (McLure and others (1990))-­
that is, during the transitional period, deductions for new investments
could be spread out over several years, grossed so that their present value
would still equal the initial outlay. This obviously would raise the issue
of using the right discount rate.
The particular choice of the CCFT base and transitional provisions
would obviously affect the financial position of firms (King (1986)).
Under an R-based CCFr, leveraged firms could face financial distress
because interest would no longer be deductible. Yet, continued interest
deductibility for old debt might be prone to manipulation. The solution,
therefore, would seem to be an RF-based CCFT.
In the very short term, the tax may have undesirable announcement
effects. Investment might collapse in anticipation of future expensing
unless the tax can be introduced retroactively. If the prospective
CCFr is RF based, firms may increase borrowing and later repay debt
by raising equity. Whether retroactive enactment is possible could
depend on political factors (King (1986)).
General Issues
Under a CCFT, issues such as the stability of revenue, a high possible
incidence of tax avoidance and evasion, and international compatibility
assume particular importance. These are addressed below.
Revenue Implications
The CIT is an important source of revenue in many developing coun­
tries. Following a bell-shaped curve, its share of GDP and total revenue
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646
PARTHASARATHI SHOME and CHRISTIAN SCHUTTE
generally increase in the initial stages of development, 10 so that for
different income groups in developing countries the CIT makes up be­
tween 1 1 and 23 percent of total the revenue. In a few cases, tax CIT
accounts for more than one-fourth, even more than one-half, of total
revenue (Tanzi (1990)).
The revenue implications of any change in corporate taxation have to
be weighed very carefully in this context-even if one were to argue that,
in the long run, the CCFf is likely to foster growth through increased
investment and improved capital allocation and that the government
would participate in such growth. If we leave aside both the purely
transitional issues and the longer-term structural and dynamic effects,
what can be said about the revenue implications of the CCFf?
Smaller Tax Base? There are conflicting views about the likely differ­
ences in the size of the corporate tax base under a CIT and a CCFf. The
straightforward argument against the CCFf is that full and immediate
expensing seems to reduce the tax base. The government forgoes tax on
the marginal returns to capital, and one would therefore expect the CCFT
rate to be higher than the initial income tax rate if present-value revenue
is to be sustained. 11
On the other hand, proponents of the CCFf have based their case
partly on the massive erosion of the tax base under the CIT (Kay (1990),
King (1986)). They argue that most marginal returns escape taxation
anyway. Firms find it advantageous to finance their investments through
debt, as nominal interest payments are deductible. Foreign investors may
choose "thin capitalization" to shield their income from host country
taxation and to facilitate repatriation. Legislative rules against excessive
interest deductions often are not fully effective. Firms may also avoid
taxation of capital income by making use of special incentives, such as
accelerated depreciation, tax arbitraging, tax-preferred activities, and
investing abroad.
10
11
In industrial countries, the CIT has become relatively unimportant over time.
If total returns r constitute the tax base of the CIT, above-normal returns
(r i) form the base of the CCFf, I; and lc are the respective tax rates, and T;
and X are the present value of revenue under both taxes, then revenue neutrality
requiring Tc T; implies
tc(r - i) = I1 r .
-
=
Thus, the revenue-neutral CCFf rate is
lc
l;[rl(r i)].
=
-
The right-hand expression in brackets, which is the ratio of total returns to
above-normal returns, will obviously decrease for increasing r, as above-normal
tion of total returns. If the CIT allows initial
returns make up an increasingpropor
expensing of a proportion a (
0:s a < 1), its base reduces to (r - ai): that is, the
necessary rate increase will also be smaller.
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The tractitional view of the CIT as a tax on the use of capital in the
corporate sector becomes questionable. According to the "new view,"
the CIT is instead a tax on immobile production opportunities in the
corporate sector. The CCFT is the "logical counterpart" (Kay (1990),
p. 29) of this "new view," since it would tax the same base while elimi­
nating the excess burden of the present system, for example, by restoring
debt-equity neutrality . 12
Empirical work on developed countries suggests that the CCFT and the
current income tax base would not be very different in many cases.
Assuming unchanged behavior on the part of firms, and ignoring tran­
sitional issues, several rough estimates of the potential yield from a
CCFT in the United Kingdom, the United States, and Canada indicate
that even for stable tax rates the revenue loss should not be a serious
problem (King (1986), Daly, Jung, and Schweitzer (1986)). Gordon and
Slemrod (1988) found that by 1983 the U.S. tax code offered so many tax
arbitraging opportunities that exemption of capital income through adop­
tion of a "pure" cash-flow tax would have increased revenue, even after
transitional losses were taken into account. 13
In developing countries where the corporate sector is dominated by
large mineral exporters, local cartels, monopolies, and debt-financed
foreign corporations, the existing CIT may also be fairly close to a pure
profits tax, as the tax base consists mainly of above-normal returns. 14
Mintz and Seade (1991) suggest that, in many cases, the CCFT might
actually increase revenue, because existing tax codes already provide
generous investment incentives. With fast write-offs and tax holidays,
income taxation is similar to the CCFT.
Investment and Current Revenue. The tax yield under the CCFT
would also tend to be very sensitive to investment. Under an income tax
with "true economic depreciation," gross returns and offsetting capital
allowances on an investment follow the same time pattern. But, under
the CCFT, taxable inflows from past investments are partly offset by the
expensing of new outlays. Hence, current revenue will depend on the
12
A classic reinterpretation of the CIT is Stiglitz (1976, p. 310): "In my
interpretation of the U.S. tax system the dominant feature [of the corporation
tax] IS the interest deductibility provision . . . . [The corporation tax] is partly a
tax on pure profits, partly a tax on entrepreneurship and partly a return on an
implicit government partnership in risk-taking. Quantitatively, I suspect that the
third role is the most important."
13 The strength of this argument should have declined after the 1986 tax reform.
14Economic rents (such as in the cases of monopoly and mineral deposits)
constitute a common tax base for the CIT and CCIT. Debt-financed corporations
can shield marginal returns by deducting them as interest under the CIT. Thus,
the CCIT and CIT become similar.
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PARTHASARATHI SHOME
and CHRISTIAN SCHUTTE
difference between the average rate of return and the rate of growth of
the capital stock. During periods of rapid expansion-which, for instance,
may follow structural adjustments in reforming socialist economies­
revenue could dry up or even become negative, at least theoretically. 15
In other words, revenue could drop during upswings in economic activity,
making the tax procyclical.
This does not imply that revenue would be permanently postponed. In
the long term, the capital stock would not, on average, grow faster than
the average rate of return on it. Nevertheless, the sensitivity of revenue
to investment is undesiiable both in terms of fiscal liquidity and business­
cycle effects. As far as the latter is concerned, the CCFf would tend to
generate more revenue during the downside of a business cycle since
investment would tend to be low, even as returns from earlier investments
could flow into the tax base.
However, to the extent that existing tax codes have special investment
incentives, such as accelerated depreciation or investment tax credits,
similar problems do arise under an income tax. Because of administrative
problems and collection lags, the stabilizing effects of corporate income
taxation are also less clear than they appear in theory. On the whole,
however, it seems that the ramifications of incentives and collection lags
under the income tax should be less pronounced.
Revenue Risk. As the government assumes the "silent partner" role
with full loss offset, revenue from individual projects becomes more
risky-though its expected value is still positive if investors are risk
averse. Still, the "silent partnership" should not cause substantial varia­
tions in total revenue as long as the independent risks of many projects
can be pooled. But in the case of a small country with only a few major
projects, or in the case where risks are correlated, variability of revenue
may be an additional concern.16
Other Effects. Two other revenue-related points deserve mention.
First, the introduction of the CCFf may require substantial improve­
ments in the loss-offset provisions of the existing CIT. Such improve15 Assume a sequence oftwo-period projects lf total investment in the previous
period was 1 but grows at rate g-so current investment is (1 + g}-then under
the CCFT current government revenue Rc is
.
Rc
=
tc(1 + r) - tc(1 + g) = tc(r - g).
Contrast this with an income tax that allows expensing of proportion a. Current
revenue R1 is
R1 = t1[(l + r) - (1 - a)] - t;a(l + g) = t;(r - ag).
For a = 0 (no expensing), current revenue R1 is completely independent of g.
16
This argument may be an imJ?ortant element in the reluctance of governments
to use the cash-flow base for mmeral taxation.
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ments may be costly in terms of revenue if previous loss trading between
corporations was imperfect. Second, there may also be a revenue-increas­
ing effect if the CCFT actually improves the administration of taxes on
small businesses and other hard-to-tax groups.
To conclude, the revenue effect of replacing a CIT with a CCFT
remains an empirical question. Whether or not a revenue-neutral CCFT
would require higher rates depends on the particular income tax laws to
be replaced, the value of economic rents earned in the corporate sector,
and the current debt-equity compositions of corporate portfolios. Tran­
sition rules might be needed to soften any adverse revenue effect of the
conversion, and such rules may have to be applied for a considerable
period of time.
Tax Avoidance and Evasion
The above discussion of revenue effects excluded possible behavioral
responses by corporations. However, as firms try to exploit any new
"loopholes" in the CCFT, revenue could be lost and tax administration
might face new challenges.
A number of new possibilities for "gaming the system" under the
CCFT have been discussed in the literature (Sunley (1989), McLure and
others (1990), Gordon (1989), Mintz and Seade (1991), Tait (1992)). Like
any avoidance scheme, the problems are enunciated by, and based on,
differences in tax rates between activities, jurisdictions, institutions or
individuals, legal forms, and points in time, all of which make arbitraging
profitable (Stiglitz (1988)). This section surveys some possible avoidance
and evasion schemes. It also discusses the related tax-exhaustion prob­
lem, the merits of the R base versus the RF base, and some general issues.
Gaming the System. Some tax avoidance possibilities are specific to
the R-based CCFT, as there is an entire class of schemes exploiting
the crucial difference between taxable real flows and tax-free financial
transactions (Sunley (1989)):
-Installment sales to a tax-exempt party may understate the taxable
purchase price but overstate the tax-free interest component of seller
financing.
-Labor, goods, and services may be sold at low prices and assets
leased at low rates to a tax-exempt party, who in return would provide
a low-interest loan to the employee, seller, or lessor; prearranged de­
faults and loan forgiveness would be extreme cases of such low-interest
loans, unless they are included as imputed flows in the tax base.
-Companies using different accounting years may reduce their tax
bases by increasing purchases from each other. At the end of its account­
ing year, company A could make large purchases from company B and
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PARTHASARATHT SHOME and CHRISTIAN SCHUTTE
vice versa. These intercompany transactions could be debt financed
without tax consequences.
-To circumvent nondeductibility of interest payments, financing may
be provided by a tax-exempt seller or lessor. Interest payments would be
transformed into deductible leasing payments or purchases.
In order to contain these arrangements, McLure and others (1990)
suggest that for tax deduction purposes, ceilings and floors may need to
be imposed on interest rates.
Under both the R and RF bases, taxpayers may try to shift the tax base
to an affiliated low-tax party, for instance a tax-exempt pension fund or
a foreign corporation with a lower rate. 17 Expensable capital outlays
would be allocated to the high-tax party, and subsequent cash inflows
would be directed toward the low-tax party. Such base shifting may take
the form of
-transfer pricing through the purchase of inputs from the low-tax
party at inflated prices, and the sale of goods at understated prices;
-low-rate leasing of capital acquired and expensed by a high-tax party
to a low-tax party; and
-selling expensed assets at understated prices to the low-tax party. 18
Such schemes could be operated under the income tax as well, but the
incentive for them is much more powerful under the CCFr. This is
because expensing makes the present value of deductions on any asset
equal to the purchase price. Under any other depreciation scheme, the
present value of deductions decreases with the longevity of an asset and
with the discount rate used by the corporation. 19 Also, because the entire
deduction is available up front under the CCFr, immediate sale of the
asset at an understated price becomes much more attractive. Under an
income tax, the high-tax party would have to hold on to the asset to
benefit from available depreciation.
A CCFr will hence increase the incentive for tax-saving leases and for
mergers between corporations with different tax rates. Foreign corpora1 7 This holds provided that international tax differentials are not washed out by
tax credit mechanisms.
1 8 The roblem arising from the ossibility that firms may move once they have
p
p
expensed an investment (Tait (1992)) could be alleviated by taxing them upon
migration. Since they previously benefited from expensing, such a tax should not
conflict with free international capital movement.
19There is very little to be gained from shifting long-lived assets under the
income tax. Think of land as the most extreme case. It is not depreciable under
the income tax-but should be expensable under CCIT.
The difference between expensing and straight-line depreciation for different
i illustrated below. For example, an asset depreciated over ten years
parameters s
by a firm using a 4 percent discount rate produces a present value of deductions
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tions may set up subsidiaries in the CCFT country only to take advantage
of expensing, then channel inflows to a lower-rate jurisdiction.
Manipulation of reported transactions may also be an important chan­
nel of tax evasion. Companies could try to overstate asset prices upon
purchase to the tax authorities. They could also buy equipment, take
the deduction, and immediately resell, concealing or understating the
price. These possibilities also arise under the income tax. Again,
however, expensing, which grants tax savings up front, increases their
attractiveness.
To counter base-shifting schemes, arm's-length prices and rates for
transactions between affiliates have to be enforced. But such monitoring
is notoriously difficult. Perhaps certain types of transactions, such as
leasing to foreigners or tax-exempt institutions, would need to be prohib­
ited. If there is a system of wealth taxation, it may put some checks on
the valuation of transferred assets. However, all such requirements would
result in considerable complications, essentially eroding the tax's main
characteristic, simplicity, on which proponents base its attractiveness.
Some general lessons from the income tax apply even more so to the
CCFT in this context. Tax treatment of activities and institutions should
be uniform to reduce arbitraging opportunities. For instance, some busi­
ness activities of tax-exempt institutions may be taxed. The rate structure
should be flat and low to the extent possible (given revenue needs), since
it determines the taxpayer's per-dollar savings from reducing or shifting
the tax base.
Tax Exhaustion and Tax Avoidance. A special case of uneven rates
arises from tax exhaustion, where available deductions exceed taxable
inflow. A tax-exhausted corporation has a marginal tax rate of zero,
that is roughly 80 percent of its initial value. The CCFT always provides a 100
percent deduction.
Present Worth of Straight-Line Depreciation Deductions
(As a percent of asset's cost)
Economic
life
(years)
Annual
deduction
(in percent)
5
10
20
50
20
10
5
2
Present worth of depreciation discounted
at interest rate (annually compounded)
2 percent 4 percent
8 percent
6 percent
94.3
89.8
81.8
62.8
89.0
81.1
68.0
43.0
84.2
73.6
57.3
31.5
79.9
67.1
49.1
24.5
Note: Straight-line depreciation is cost divided by length of life, assuming
scrap value.
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PARTHASARATHJ SHOME and CHRISTIAN SCHUTTE
though its statutory rate may be quite high. It is unable to benefit from
capital allowances.
Excess allowances (through tax losses) are likely to be much larger and
more frequent under the CCFT. However, especially with an R base,
whether the resulting lumpy tax profile will foster additional arbitraging
and mergers largely depends on the loss-offset provisions. To the extent
that such provisions ensure symmetrical treatment of profitable and
loss-making corporations, profitable arbitraging would be curtailed.
Loss offsets are crucial to the CCFT in conceptual terms as well, and
a refund would be the straightforward solution. Refunds may be prob­
lematic, though, in that they aggravate the problem of "hobby farms":
businesses set up solely to generate tax losses on consumptive, non­
profit-oriented activities. Rules against such abuses under the income tax
would have to be carried over to the CCFT (Gordon (1989)).
If statutory provisions are insufficient, additional tax arbitraging
through leases or mergers could take place. The objection against such
arrangements should not be that they cost revenue; in fact they could be
interpreted as a "market solution" to the tax exhaustion problem (King
(1986), Stiglitz (1988)), ensuring equitable treatment of loss-making and
profitable firms and preserving the investment incentive of the CCFT.
But the objection is that such solutions would be inefficient, because they
tend to distort economic activity through reduced competition and "par­
asitic tax-based industries" (Weeden (1988)). If full statutory loss-offset
provisions cannot be obtained, a second-best strategy for government
may be to facilitate loss trading.20
To conclude this section on tax avoidance and evasion, a summary
assessment of the R and RF bases may be called for. The administrative
advantage of the R base is that financial transactions can be entirely
ignored. This actually reflects the basic concept of the CCFT-equaJ
treatment of debt and equity. On the other hand, the R base is vulnerable
to the above-mentioned tax avoidance schemes. With the RF base, the
tax profile is less lumpy, and incentives for base shifting and evasion are
reduced. However, the RF base creates an incentive to raise capital as
equity and disguise payouts as interest payments, a problem that is shared
under the income tax. Therefore, the existing CIT provisions to amelio­
rate these problems would have to be carried over to an RF-based CCFT.
20 The so-called safe-harbor leases (legalization of purely tax-motivated leasing
arrangements) in the United States and flow-through shares (option to pass
losses on to shareholders) in Canada were controversial attempts in this direction
(Daly, Jung, and Schwettzer (1986), Stiglitz (1988)).
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International Issues
Since the CCFT is an untried tax, many legal and economic questions
remain with respect to its international compatibility, especially where
tax treatment of foreign investment income is concerned.
Basic Concerns. The introduction of the CCFT raises serious ques­
tions about international compatibility. These questions have legal as
well as economic aspects. As the CCFf might not legally qualify as an
income tax, its adoption could require the renegotiation of tax treaties.
Such negotiations could take many years and hence imply considerable
transactions costs and transitory arrangements. Moreover, tax treaties
for many host countries offer a stability that they may not want to risk.
Reforming socialist countries that ultimately want to join the European
Community (EC) may find the CCFT unacceptable simply because it
would not conform to the EC requirement for the CIT.2 1
Host countries are worried about losing existing options for ··soaking
up" foreign tax credits. Also, there has been an overriding concern that
home countries-in particular, the United States-might not grant for­
eign tax credit for the CCFf and that this might discourage foreign
investment. The creditability problem was the major obstacle for the
adoption of CCFf proposals in Canada, Mexico, Sweden. and Colombia
(Boskin and McLure (1990)).
Principles for Taxing Foreign Earned Income.
Briefly recalling
the basic principles applied to the taxation of foreign income (OECD
(1991 ), Slemrod (1992), Leechor and Mintz (1991)), three regimes can be
distinguished:
-Exemption: Home countries impose no tax at all on income earned
abroad. This is sometimes referred to as the territorial system. Income
is only taxed by the host country (source principle).
-Taxation upon accrual: Home countries reserve the right to tax
worldwide income of their resident corporations (residence principle).
and foreign income is taxed as it is earned. Taxation upon accrual is
typically applied to foreign branches of resident corporations.
-Taxation upon repatriation: Home countries apply the residence
principle. However, corporations can defer their domestic tax liability by
21
As a consequence of growing economic integration, the coordination of
capital income taxation will become even more important in the European
Community. Although there are advocates of ··spontaneous coordination"
through increased competition of tax systems, this approach has serious prob­
lems. Rather, the European countries will want to increase managed harmoniza­
tion of existing CIT systems (Tanzi and Bovenberg ( 1990)). A CCFT would hardly
fit into this process.
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retaining earnings abroad. Because of the time value of money, deferral
reduces the effective domestic tax rate. This type of tax is typically
applied to subsidiaries.
If borne countries apply the residence principle, foreign income is
potentially subject to double taxation in the host and borne countries.
Double taxation can be mitigated in different ways. First, the home
country can allow deduction of taxes paid abroad. This is an efficient
policy, since foreign taxes represent a social cost to the home economy.
If the deduction is granted, resident corporations will equalize the after­
tax foreign return to the pretax domestic return. However, tbis is not
optimal from a global point of view, since capital exports are discrimi­
nated against. To ensure capital-export neutrality, many home countries
grant a tax credit against foreign taxes paid. Corporations then equalize
the pretax rate of returns. In terms of revenue, the tax credit implies that
home countries bear the foreign tax burden of their resident corpora­
tions. Unless additional tax treaties impose restrictions, the host country
can "soak up" these tax credits-that is, it can tax foreign investors
without deterring them. However, the tax credit is usually limited to
domestic tax liability (on the sum of domestic and foreign incomes), so
that corporations ultimately face the higher of the (average) foreign or
domestic tax rate. If the domestic rate is higher, the corporation will face
the same effective tax rate at home and abroad. If the foreign rate is
higher, the corporation may accumulate excess tax credits. Under a
system of tax credit by source, such offsets are limited to income from
a particular host country. Under the more generous worldwide system,
excess tax credits may be used against tax on income from any host
country. In this case the corporation actually faces the higher of the
domestic and the average foreign tax rate.22
CCFT and Foreign Direct Investment. Here, two regimes can be
identified.
-Exemption at home: The concerns about revenue and creditability
are irrelevant for foreign investment from home countries that grant an
exemption for foreign dividend income; in this case the CCFT host
·
22 Countries often do not apply one principle consistently but have special
provisions for different circumstances. In general, tax exemption for foreign­
i provided by the
source dividend income, at least that from tax-treaty countries, s
following countries: Australia, Austria, Belgium, Canada, Denmark, Finland,
France, Germany, Luxembourg, Netherlands, Sweden, and Switzerland.
The tax credit system for foreign dividends is used by Greece, Iceland, Ireland,
Italy, Japan, New Zealand, Norway, Portugal, Spain, Turkey, the United Kin g ­
dom, and the United States. Iceland, Japan, and the United States provide
worldwide tax credit; all other countries use the more restrictive credit by source
(OECD (1991), p. 63).
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country will attract additional foreign investment until the pretax rate of
return is equal to the after-tax rate of return in the home country.
-A creditable CCFf: What if the home country taxes foreign earn­
ings? Let us first assume that the CCFf would be creditable. Another
crucial distinction has to be made between corporations whose available
tax credits are less than their domestic liability on foreign earnings (their
so-called excess limit position) and those who have excess credits.
If corporations are in an excess limit position, the tax credit mechanism
would wash out the effects of host country tax policy. The revenue
argument against the CCFf is based on this point. While the investment
incentive of the CCFT would be neutralized, revenue is forgone, simply
to be picked up by the home country.
Note, however, that this argument does not hold in the presence of"tax
sparing." Under tax sparing, the home country assumes that the full tax
has been paid in the foreign (host) country, in effect calculating foreign
tax credit on the basis of regular foreign tax rates regardless of the actual
taxes paid (on the basis of preferential treatment). This approach protects
host country tax incentives. With the notable exception of the United
States, many capital-exporting countries (such as Japan and the United
Kingdom) have signed tax-sparing treaties with developing countries.
Note also that under a "deferral system," retained earnings are tax
exempt in the home country. The investment incentive of the CCFf may
therefore remain effective. Hartman (1985) has argued that under defer­
ral the home country tax is in fact a tax on repatriation rather than on
foreign income. This "repatriation tax" is ultimately unavoidable and
therefore affects neither marginal investment decisions nor decisions to
retain or repatriate profitsY Hence, a corporation considering reinvest­
ment of funds earned abroad will compare after-tax rates of return just
as it would under the source principle. A tax credit will still alleviate the
overall tax burden but does not wash out the effects of host country tax
policy.
The "new view" of host country tax policy under the deferral system
has been criticized in the literature, however.24 The criticism does not
apply to "immature" investment-investment funded at the margin by
transfers from abroad, which may be predominant in many, especially
ex-socialist, economies. It bas also been pointed out that the formulas
used for the calculation of the domestic tax are such that the investment
23 However, it does affect the initial investment decision. Also note that the
argument regarding marginal decisions not being affecte? should be qualified by
the possibility that foreign income may never be repatnated.
2A Hines (1992) has a brief survey of this debate.
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PARTHASARATHI SHOME
and CHRISTIAN SCHUTTE
and financing decisions of the subsidiary do affect the total liability on
repatriated earnings. 25
To preserve the incentive for "mature" investment but still "soak up"
the foreign tax credit, the CCFT country may want to adopt a supplemen­
tary withholding tax on repatriated earnings (Sunley (1989), Mintz and
Seade (1991)). Such a tax would introduce some administrative compli­
cations, because foreign corporations' income would have to be calcu­
lated in order to distinguish dividends from the return on capital (Sunley
(1989)). Also, the tax should not apply to foreign investors whose earn­
ings are tax exempt at home. But discrimination between corporations
hardly seems feasible (Slemrod (1992)). Finally, the creditability of such
a tax is uncertain. It will probably depend on the creditability of the
CCFT itself (McLure and others (1990), Sunley (1989)).
If corporations have excess tax credits, their foreign earnings at the
margin are effectively shielded from domestic taxation. They do not
trigger any additional liability in the home country. Host country tax
policies therefore "matter" as they do under the source principle. Since
the Tax Reform Act (TRA) of 1986, whose main feature was a reduction
ofU.S. statutory rates, many U.S. corporations have accumulated excess
tax credits. This suggests that investment incentives of developing coun­
tries are likely to be more effective in the future, but some qualifications
are in place.
Not all foreign investors are in an excess credit position. For non-U.S.
multinationals the lowering of U.S. rates has meant a reduction of excess
credit positions at home. Those who have excess credits are likely to
adjust their behavior in order to make profitable use of them. 26
In the long run, an excess credit situation may not be stable because
(1) the home country, in this case the United States, may raise its tax
rates since it does not collect revenue from corporations with excess tax
credits; and (2) other host countries may lower their rates to attract
additional investment. Host country tax competition may ultimately lead
back to the usual situation, in which tax credits neutralize host country
policies.
Arguments based on the excess credits of foreign investors can thus be
easily overstated. "The TRA 1986 may have created a temporary disequi:zs See Leechor and Mintz (1991) who develop a model to quantify empirically
the effects of host country policy on effective tax rates and multinational invest­
ment. Using a related framework , Mintz and Tsiopoulos (1992) have estimated
the incentive value of a cash-flow tax in central eastern European countries for
U.S. corporations. They found that it would be reduced by about two-thirds on
average.
26 Possibilities for such adjustments are outlined by Slemrod (1992).
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librium" (Slemrod (1992), p. 13) rather than a fundamental change in the
international environment for developing country tax policy.
-A noncreditable CCFT: So far, it has been assumed that the home
country would grant foreign tax credit for the CCFT. Possible noncred­
itability of the CCFT in home countries, however, especially in the
United States, has been a major concern in countries considering the tax.
There is no clear answer in advance to the legal question of creditabil­
ity. Conceptually, the CCFT is based on cash flow rather than on income,
and thus seems likely to fail the "substitution test" required, for instance,
by U.S. legislation. However, while the United States grants tax credit
for income taxes, it also grants credit for taxes imposed "in lieu" of
income taxes (Sunley (1989)). In fiscal terms, the CCFT makes home
countries better off to the extent that they recover tax on marginal foreign
returns. Therefore, there should be no reason for them to deny creditabil­
ity (McLure (1991)).27 Also, home countries agreeing to protect host
country incentives through tax sparing should be willing to grant foreign
tax credit for the CCFT (Sunley (1989)).
What if the CCFT were not creditable? Would double taxation dis­
courage foreign investment? McLure (1991) points at three qualifications
to this common argument, two of which were discussed above. First,
"mature investment" may still be attracted by the CCFT because a
repatriation tax does not affect rates of return at the margin. Second,
corporations may have excess tax credits and therefore be back to source­
based taxation at the margin. However, lasting excess credit "protection"
of a noncreditable CCFT is only possible if the home country has a
worldwide credit system, such that new credits may be earned in high-tax
countries. If the home country grants credit only by source, excess tax
credits are available only from the previous income tax regime and will
be used up after some time. Third, it may be argued that a tax with a
marginal effective rate of zero "even when combined with a (home
country) tax on repatriated earnings is unlikely to have much disincen­
tive effect on investment in the host country" (McLure (1991), p. 21).
A noncreditable CCFT will not distort investment at the margin, because
for projects just earning the opportunity cost of capital net CCFT
payments will simply be zero.28
For a project earning above-normal returns, the CCFT burden that is
deductible but not creditable at home will become an additional cost. To
27The Internal Revenue Service may have a different view.
23This is most clearly seen for a marginal project that uses perfect loss-carry
forward. As cash inflows are just suffictent to offset the loss-carry forward, the
corporation never makes any actual payment to the host country.
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the extent that such investment is mobile, it will be discouraged by the
CCFf. One may argue, though, that above-normal returns on invest­
ments in developing countries are often earned on immobile production
opportunities (for example, the extraction of mineral resources or the
exploitation of a local monopoly by a multinational trademark). In these
cases, the noncreditability of a tax on pure profits will have no effect.
Note, however, that the noncreditability of the CCFf is likely to entail
the noncreditability of any supplementary withholding taxes. A noncred­
itable withholding tax would clearly introduce a distortion even for
marginal investment. 29
m. Conclusions
The CCFf has the drawback of any untried tax innovation, simply that
"no one does it" (McLure (1991), Mintz and Seade (1991)). There is no
experience or administrative know-how about the possibly complex de­
tails of a transition to the CCFf, its operation, and the avoidance schemes
that might emerge. No official ruling on the critical question of the
creditability of the CCFf has been required so far. The uncertainty costs
of experimenting with the tax may be reason enough for a developing
country or an economy in transition not to implement the CCFf. The
29The effects of a noncreditable CCFf and withholding tax can be illustrated
algebraically as follows:
1. The after-tax rate of return of a domestic investment is
ard
=
(1 - td)r.
Compare this with investment in a foreign country that has the CCFf. Domestic
tax liability if foreign taxes are deductible is 41 = td(r 7[), where foreign taxes
are 7f t1(r - i), assuming that a loss-carry forward bears interest at rate i. The
after-tax rate of return on foreign investment is
ar1 = (1 td)(r 7[),
and the wedge between the domestic and foreign after-tax rates of return is
[ard - ar1] lard [(1 - td)r - (1 - td)(r - 7[)] /(1 - td)r]
-
=
-
-
=
=
7[/r
=
t1(r - i)lr.
(1)
If r > i, foreign CCFf payments 7fare an additional cost and hence discourage
investment abroad.
2. A supplementary withholding tax with a rate oft... would increase foreign-tax
liability by t.,(r - tJ(r - i)], where the term in brackets represents repatriated
after-CCFf earnings. After a rearrangement of terms, total foreign tax liability
becomes 7f t1((r - i)(1 - t...)] + t... r, and, from equation (1), the new wedge is
7[/r t.., + t,((r - i)(1 - t )]tr;
which is positive even for marginal investments, where r = i.
For numerical illustrations of the effects of a noncreditable CCFT, see McLure
and others (1990).
=
=
...
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purpose of this paper, however, is to identify potential sources of prob­
lems and to understand better the conditions for a successful experiment
with a CCFT. It seems clear that, depending on the existing CIT struc­
ture, the structure of the corporate sector, the relative importance of
foreign investors, and the mix of countries they come from, some coun­
tries may find the CCFT less attractive than others.
The key conclusions of the paper may be summarized as follows:
1. The theoretical pros of the CCFf seem clear. It can be interpreted
as a "silent partnership" of the government in any investment, and as
such it is generally neutral with respect to the financial and real decisions
of corporations. The neutrality result has to be taken with a grain of salt
as the loss-offset provisions are likely to be imperfect and some erosion
of the tax base through lobbying and other political pressure is probably
unavoidable. Expectations of future rate changes may also modify the
results. Still , in a closed economy, the CCFf would tend to increase
investment and improve the allocation of capital. On the administrative
level, a tax based on observable cash flows rather than on a hypothetical
concept of the accrual of income promises to be simpler and more robust
(again, theoretically speaking). It would do away with the problems of
defining "true economic depreciation," measuring capital gains, costing
inventories, and accounting for inflation.
2. Possible revenue effects are an important aspect of the CCFf,
especially in developing countries, since the CIT to be replaced is often
a major source of revenue. Revenue losses are likely during the transition
period, but they need not be prohibitive if the transition is carefully
designed and tax rates are appropriately adjusted. However, a more
fundamental issue is that the CCFf as a tax on above-normal returns may
have a significantly smaller tax base than the comprehensive CIT. With
expensing, the tax base may also be more volatile. Nevertheless, the
actual difference between the CCFT and CIT bases remains an empirical
question, depending on the particular income tax laws to be replaced as
well as on the current compositions of corporate portfolios between debt
and equity. In some cases, the two bases may be fairly similar.
3. Tax-base erosion through tax avoidance and evasion may be a
serious problem for the CCFT. By choosing an RF-based CCFf over an
R-based one and by carefully designing the tax code, some of the CCFT
schemes could probably be contained at reasonable administrative cost.30
30 This is not to say that the R-based CCFf has no advantages over the
RF-based variant. After all, one attractive feature of the cash-flow tax is the
nondeductibility of interest, which eliminates incentives for debt financing over
equity financing and obviates any need for inflation adjustments to calculate real
interest. These are properties of the R-based, rather than of the RF-based,
CCFf.
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But the large up-front deduction that results from the expensing of capital
assets would create a powerful incentive for base-shifting schemes. The
administrative efforts required to contain these schemes could be consid­
erable and would involve the enforcement of arm's-length prices, which
is notoriously difficult. The "simplicity" argument for the CCFf has to
be qualified accordingly.
4. Any answer to whether international considerations favor the
CCFf would be complex. To the extent that host country tax policies
matter, a country with the CCFf may attract additional investment. This
is most clearly the case if home countries exempt the foreign earnings of
their multinationals-as do many Western European countries. Other
important capital-exporting countries, such as Japan, the United States,
and the United Kingdom, apply the residence principle with a foreign tax
credit. This system tends to neutralize host country tax policy, but not
entirely. The incentive offered by the CCFf is likely to remain effective
for those investors who benefit from tax sparing, which is granted by
many countries but not by the United States. The CCFf is also likely to
attract additional "mature" investment and investors who have excess
tax credits. Recently, many U.S. corporations have accumulated such
credits, although this position may not be stable in the long run.
To the extent that the effect of the CCFf is washed out by the tax credit
mechanism, the host country will lose. Tax forgone on marginal returns
is merely picked up by the home country. In the case where the home
country denies tax credit for the CCFT, some foreign investment would
be discouraged. The creditability of the CCFf is an issue related mainly
to the United States, since most other developed countries either exempt
foreign earnings or grant some form of tax sparing.
To conclude, at this point the CCFf remains a theoretically at­
tractive option with some practical disadvantages. Moreover, many un­
answered questions remain for its implementation by a single country­
especially a developing one-in an environment that will not necessarily
accommodate its smooth and effective operation.
REFERENCES
Aaron, Henry J., Harvey Galper, and Joseph A. Pechman, eds., Uneasy Com­
promise. Problems of a Hybrid Income-Consumption Tax (Washington:
Brookings Institution, 1988).
Andrews, W.D., "A Consumption-Type or Cash Flow Personal Income Tax,"
Harvard Law Review, Vol. 87 (April 1974), pp. 1113-88.
Boskin, Michael J., and Charles E. McLure, eds., World Tax Reform: Case
©International Monetary Fund. Not for Redistribution
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661
Studies of Developed and Developing Countries (San Francisco: Interna­
tional Center for Economic Growth, 1990).
Brown, E.C., "Business-Income Taxation and Investment Incentives," in In­
come, Employment and Public Policy , Essays in HonorofAlvin Hansen , ed.
by Lloyd A. Metzler and others (New York: W.W. Norton, 1948).
Daly, Michael J., Jack Jung, and Thomas Schweitzer, "Toward a Neutral Capital
Income Tax System," Canadian Tax Journaf, Vol. 34 (November-December
1986), pp. 1331-76.
Gamaut, Ross, and Anthony Ian Clunies Ross, Taxation of Mineral Rents (Ox­
ford: Clarendon Press, 1983).
Gordon, Roger H., Notes on Cash-Flow Taxation , World Bank Country Econom­
ics Department, Working Paper No. 210 (Washington: World Bank, 1989).
Gordon, Roger H., and Joel Slemrod, "Do We Collect Any Revenue from Taxing
Capital Income," in Tax Policy and the Economy, Vol. 2, ed. by Lawrence
H. Summers (Cambridge, Mass.: MIT Press, 1988).
Hartman, David G., "Tax Policy and Foreign Direct Investment," Journal of
Public Economics , Vol. 26 (February 1985), pp. 107-21.
Hines, James R . , "Credit and Deferral as International Investment Incentives,"
NBER Working Paper No. 4191 (Cambridge, Mass. : National Bureau of
Economic Research, 1992).
Kay, John A., "Tax Policy: A Survey," Economic Journal, Vol. 100 (March
1990), pp. 18-75.
Khalilzadeh-Shirazi, Javad, and Anwar Shah, eds., Tax Policy in Developing
Countries (Washington: World Bank, 1991).
King, Mervyn A., "The Cash Flow Corporate Income Tax," NBER Work­
ing Paper No. 1993 (Cambridge, Mass.: National Bureau of Economic
Research, 1986).
Leechor, Chad, and Jack Mintz, "Taxation of International Income by a Capital
Importing Country: The Perspective of Thailand," in Tax Policy in Develop­
ing Countries, ed. by Javad Khalilzadeh-Shirazi and Anwar Shah (Washing­
ton: World Bank, 1991)
McLure, Charles E., A Consumption-Based Direct Tax for Countries in Transi­
tion From Socialism, World Bank Country Economics Department, Work­
ing Paper No. 751 (Washington: World Bank, 1991).
.
McLure, Charles E., and others, The Taxation of Income from Business and
Capital in Colombia (Durham: Duke University Press, 1990).
Meade, James E., The Structure and Reform of Direct Taxation (Boston: Allen
and Unwin, 1978).
Mintz, Jack M., and Jesus Seade, "Cash Flow or Income? The Choice of Base
for Company Taxation," World Bank Research Observer (Washington:
World Bank, July 1991), pp. 177-90.
Mintz, Jack M., and Thomas Tsiopoulos, Corporate Income Taxation and Foreign
Direct Investment in Central and Eastern Europe (Washington: World Bank,
1992).
Organisation for Economic Cooperation and Development, Taxing Profits in a
Global Economy: Domestic and International Issues (Paris: OECD, 1991).
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PARTHASARATHI SHOME and CHRISTIAN SCHUTTE
Pechman, Joseph A., ed., What Should Be Taxed: Income or Expenditure? A
Report ofa Conference Sponsored by the Fundfor Public Policy Research and
the Brookings Institution (Washington: Brookings Institution, 1980).
Samuelson, Paul, "Tax Deductibility of Economic Depreciation to Insure Invari­
ant Valuations," Journal of Political Economy, Vol. 72 (December 1964),
pp. 604-06.
Slemrod, Joel, "Optimal Taxation and Optimal Tax Systems," Journal of Eco­
nomic Perspectives, Vol. 4 (Winter 1990), pp. 157-78.
, "Developing Country Tax Policy Toward Foreign Direct Investment in
the Light of Recent International Tax Changes," in Fiscal Incentives for
Investment in Developing Countries, Vol. 1, ed. by Anwar Shah (Washing­
ton: World Bank, 1992).
Stiglitz, Joseph E., "The Corporation Tax," Journal ofPublic Economics, Vol.
5 (April/May 1976), pp. 303-11 .
, Economics of the Public Sector (New York: W.W. Norton, 1988).
Sunley, Emil M., The Treatment of Companies Under Cash-Flow Taxes: Some
Adminstrative,
i
Transitional and International Issues, World Bank Country
Economics Department, Working Paper No. 189 (Washington: World Bank,
1989).
Tait, Alan A., "A Not-So-Simple Alternative to the Income Tax for Socialist
Economies in Transition: A Comment on McLure," World Bank Research
Observer (Washington: World Bank, July 1992), pp. 239-48.
Tanzi , Vito, "Quantitative Characteristics of the Tax Systems of Developing
Countries," in Taxation in Developing Countries , fourth edition, ed. by
Richard M. Bird and Oliver Oldman (Baltimore: Johns Hopkins University
Press, 1990).
Tanzi, Vito, and Laos Bovenberg, "Is There a Need for Harmonizing Capital
Income Taxes Within EC Countries?" lMF Working Paper 90/17 (Washing­
ton: International Monetary Fund, 1990).
U.S. Treasury, BlueprintsforBasic Tax Reform (Washington: Government Print­
ing Office, 1977).
Weeden, R., "The Effect of Introducing Cash-Flow Taxation for Companies in
the United Kingdom," in John A. Kay, The Implementation of a Cash Flow
Corporation Tax , prepared for a World Bank seminar on implementation
problems of the cash-flow tax (Washington: The World Bank, June 1988).
---
--
©International Monetary Fund. Not for Redistribution
IMF StaffPapers
Vol. 40, No. 3 (September 1993)
© 1993 International Monetary Fund
Portfolio Performance of the SDR
and Reserve Currencies
Tests Using the ARCH Methodology
MICHAEL G. PAPAJOANNOU and TUGRUL TEMEL*
In evaluating theirforeign exchange exposure, international nvestors
i
often
compare actual portfolios with those calculated under the assumption that
the variability ofreturns on various currency assets is time invariant. This
paper uses autoregressive conditional heteroskedastic (ARCH) models to
test that assumption. For major reserve currencies, including the SDR, we
find evidence that the variances of returns do vary over time and that
ARCH models that specify changing variances are superior to models that
assume constant variance. By incorrectly assuming a constant variability
ofreturns, the error introduced is smaller with the SDR than with any other
national currency. [JEL Gll, C22]
N CALCULATING optimal fixed-income portfolios, the standard assump­
Ition is that historical volatilities of returns from multicurrency invest­
ments in government securities remain constant over time. It' is an as­
sumption that is often used both by investors to determine the "best"
allocation of their wealth in terms of fixed-income investment instru­
ments and by some central banks to manage their external reserve assets.
The same assumption is also made in the capital asset pricing model and
* Michael G. Papaioannou is an Economist in the Treasurer's Department and
holds a Ph.D. from the University of Pennsylvania. Tugrul Temel, a doctoral
candidate in applied economics at the University of Minnesota, was a summer
intern in 1991 in the Treasurer's Department.
The authors would like to thank Lawrence K. Duke, Szeina Lurie, Inci Otker,
Anthony Richards, Orlando Roncesvalles, George Tavlas, George Tsetsekos,
and Michael Wattleworth for helpful comments and suggestions.
663
©International Monetary Fund. Not for Redistribution
664
MlCHAEL G. PAPAIOANNOU and TUGRUL TEMEL
modern portfolio theory when calculating the diversification benefits
from investing in multiple assets; it also enters into the Black-Scholes
model when calculating option pricing formulas. The implications of
incorrectly assuming a constant variability of returns are a loss of effi­
ciency in terms of portfolio allocations and inappropriate decisions in
terms of hedging the associated risk. Recent empirical work has shown
that large changes in equity returns and exchange rates, using high­
frequency data, tend to be followed by large changes of sign; that is, the
variance of returns and exchange rates is not constant, and the traditional
assumption of constancy in many standard models of portfolio allocation
does not hold. Very few studies, however, have addressed the issue of
returns from multicurrency investments in fixed-income assets.
A suitable model for dealing with nonconstant volatilities of returns is
the ARCH model. 1 This paper attempts to model total fixed-income
investment returns for a U.S. dollar-based investor as a univariate auto­
regressive conditional heteroskedastic process, as an alternative to the
more common portfolio model that assumes the variance of returns from
multicurrency-deoominated assets to be stationary or time invariant. The
ARCH model expresses the current conditional variance of a time series
of total returns as a linear function of its past residuals squared. ARCH
models can be used to predict changes in the conditional variance of asset
returns on different currencies but not the changes in the unconditional
mean value of asset returns. Knowledge of the statistical properties that
generate the observed rates of return on various investments-in partic­
ular how the process depends on developments in the financial markets­
is important for characterizing asset return volatility and for modeling
optimal portfolios of multicurrency assets.
Traditional models assume a constant one-period forecast variance and
covariance matrix for the returns on different investments. This assump­
tion can be generalized to introduce a new class of stochastic processes
called ARCH processes. These processes imply serially uncorrelated
errors with zero means and nonconstant variances conditional on past
returns. To test whether the error terms follow an ARCH process, the
autocorrelation of the squared ordinary-least-squares (OLS) residuals
has been calculated. After the detection of ARCH effects based on the
autocorrelation statistics, a factor ARCH model can be used to reduce
the number of parameters to be estimated.
Our empirical results show that the variability of returns from investing
in various currencies and currency composites is affected by lagged
residuals, although the number of lags differs among currencies. The
1 See
Engle and Rothschild (1992).
©International Monetary Fund. Not for Redistribution
PORTFOLIO PERFORMANCE OF RESERVE CURRENCIES
665
estimated constant terms in the ARCH specification, o:0, are significant
and nonnegative for all currencies, indicating a positive autonomous
conditional volatility for the returns on these assets. Further, the esti­
mated parameters of the lagged squared residuals in the ARCH process,
o:;, exhibit strong statistical significance for returns on all currency assets,
,
indicating that the stochastic processes generating these returns have
nonstationary variances. Investment in SDRs, however, provides greater
insulation to investors than investing in any other currency with one Jag
of ARCH effects, as SDR returns demonstrate the lowest transmission
of unexpected weekly shocks into volatility.2 In these circumstances and
as already noted, an ARCH specification is a more efficient approach for
modeling these asset returns than is the OLS approach. Finally, the
Lagrange multiplier statistic for first-order ARCH specification is signif­
icant for all currencies, which also indicates that the conditional variances
are not constant through time.
In addition, the results of several diagnostic checks on the distribu­
tional properties of total returns indicate that they deviate from the
normal distribution. In particular, the kurtosis statistics on the probabil­
ity distribution of returns on all currency investments are substantially
larger than those from a standard normal distribution, indicating that
these returns are Jeptokurtic (fat tailed). This result is further supported
by Bera-Jarque tests, which indicate not only a highly significant non­
normality of the probability function for returns on these currencies but
also a significant likelihood that the variance of these returns is not
constant over time. The BJ test for normalitf is highly significant for the
deutsche mark, the pound sterling, the French franc, the Japanese yen,
the European currency unit (ECU), the SDR, and gold with ARCH(1, 1)
as well as for the U.S. dollar with ARCH(6, 2). Only the BJ test for the
average composite index with ARCH(1, 1) is not statistically significant.
I. Brief Literature Review
The uncertainty of speculative prices has been observed to change
through time (Mandelbrot (1963) and Fama (1965)). The tendency of
large (small) price changes in high-frequency financial data to be followed
by other large (small) price changes is often called "volatility clustering."
2 Although the estimated coefficient a1 for the average composite index (ACI)
is lower than that for the SDR, the sum of the estimated coefficients a;
(i = 1 , . . . , 5) for the ACI process is greater than the estimated coefficient a1 for
the SDR.
3 For the use of this test, see Table 2.
©International Monetary Fund. Not for Redistribution
666
MICHAEL G. PAPAJOANNOU and TUGRUL TEMEL
One specification that has emerged for characterizing such changing
variances is the ARCH model (Engle (1982)) and various extensions of
it. In his seminal paper, Engle suggests that one possible parametrization
for variances is to express them as a linear function of squared past values
of the errors of the model. With financial data, the ARCH model cap­
tures the tendency for volatility clustering, and numerous empirical
applications of the ARCH methodology to asset return variances and
covariances have already appeared in the literature. ARCH effects have
generally been found to be highly significant in equity markets-for
example, highly significant test statistics for ARCH models have been
reported for various individual stock returns (Engle and Mustafa (1989) ).
In a series of papers, the ARCH model has been analyzed, generalized,
extended to the multivariate context, and used to test for time-varying
risk premia in financial markets. These papers include Engle (1983) and
Engle and Kraft (1983). The ARCH model was extended to the multi­
variate framework in Kraft and Engle (1983). Diebold and Nerlove (1989)
use a multivariate approach exploiting factor structure, a method that
facilitates tractable estimation via a substantial reduction in the number
of parameters to be estimated. The factor structure captures commonal­
ity in the volatility of movements in financial data over time. Engle, Ng,
and Rothschild (1990) suggest using the factor ARCH model to describe
the conditional covariance matrix of excess asset returns. One- and
two-factor ARCH models have been applied to the pricing of treasury
bills, with the results showing reasonable stability over time.
The importance of ARCH models in finance comes partly from the
direct association of variance and risk and from the fundamental trade-off
between risk and return. The ARCH-M (in mean) model developed by
Engle, Lilien, and Robins (1987) expresses the conditional mean as a
function of the conditional variance of the ARCH process. It thus pro­
vides a tool for estimating the (possibly) linear relationship between the
returns and variances of a given investment portfolio.
Another interesting observation in financial data is that the uncondi­
tional price and returns distributions tend to have fatter tails than the
normal distribution (they are Jeptokurtic) (Mandelbrot (1963) and Fama
(1965)). Ignoring the fat tails and the time-varying variances could lead
to erroneous detection of abnormal returns (De Jong, Kemna, and
Kloeck (1990)). Stock returns tend to exhibit nonnormal unconditional
sampling distributions, both in the form of skewness and excess kurtosis
(Fama (1965)). For many financial time series, the leptokurtosis cannot
be fully explained. The conditional normality assumption in ARCH
generates some degree of unconditional excess kurtosis, but it is typically
less than adequate to account fully for the fat-tailed properties of the
©International Monetary Fund. Not for Redistribution
PORTFOLIO PERFORMANCE OF RESERVE CURRENCIES
667
data. One solution to the kurtosis problem is the adoption of conditional
distributions with tails fatter than the normal distribution. Skewness and
kurtosis are shown to be important in characterizing the conditional
density function of returns on stocks (Engle and Gonzales-Rivera (1989)).
In addition to the leptokurtic distribution of stock return data, Black
(1976) noted a negative correlation between current returns and future
volatility. The linear generalized ARCH(p, q) model, where the variance
depends only on the magnitude and not on the sign of the estimated
residuals, cannot capture this negative relationship since the conditional
variance is linked only to past conditional variances and squared innova­
tions; hence, the sign on returns does not affect the volatilities. This
limitation of the standard ARCH formulation is one of the primary
motivations for the exponential GARCH(p, q) model by Nelson (1991).
In this type of generalized ARCH model, the volatility depends not only
on the magnitude of the past surprises but also on their corresponding
signs.
Bollerslev, Engle, and Wooldridge (1988) first estimated a multivariate
GARCH(p , q) process for returns on bills, bonds, and stocks where the
expected return was assumed to be proportional to the conditional covari­
ance of each return from a fully diversified or market portfolio. They
found that conditional covariances are quite variable over time and are
a significant determinant of the time-varying risk premia. Bollerslev
(1990) also applied a multivariate GARCH model to short-run nominal
exchange rates. Hall, Miles, and Taylor (1988) similarly undertook a
multivariate GARCH-M estimation of the capital asset pricing model.
Pagan and Schwert (1990) compared several statistical models for
monthly stock return volatility and showed the importance of nonlinear­
ities not captured by conventional ARCH or GARCH models. They also
showed the nonstationarity of the volatility of stock returns. Vries (1991)
compared stable and GARCH methods of modeling financial data and
showed that the unconditional distribution of variables generated by a
GARCH-like process, which models the clustering of volatility and ex­
hibits the fat-tail property, can be stable. Further, Bollerslev (1987)
extended the ARCH and GARCH models, called an integrated GARCH
model, to explain the persistence of variance over time.
II. Estimation and Testing for ARCH Effects
Autoregressive conditional heteroskedasticity models account for the
empirical observation that large changes in asset returns tend to be
followed by further large changes in these returns, although the sign is
©International Monetary Fund. Not for Redistribution
668
MICHAEL G. PAPAIOANNOU and TUGRUL TEMEL
unpredictable; also, small changes in asset returns tend to be followed by
small changes, thus leading to periods of persistently high or low volatil­
ity. We utilize the ARCH model by assuming that the conditional mean,
E(y, lyt-1), of each asset return, y,, is linearly unpredictable, while its
conditional variance, h,, is predictable by an ARCH model. It is well
known that the unconditional distribution of ARCH processes have
thicker tails, even though their conditional distributions are normal.4
The first-order autoregressive model, AR(1), for y,, combined with
ARCH(1, 1) errors, can be written as5
= <l>o + <I>1 Yr-1 +
where E(e, IYr-1) = 0 ,
var(e, I Yr-t) = E(e� IYr-1) = h, and
h, = o:o 0:1 E�-1 ·
Yr
E,,
+
(1)
(2)
For the regression to be stable, l<!>tl is assumed to be less than one. To
ensure that h, is positive and that the process is stationary, we must have
o:a � 0 and 1 � o:1 � 0. Intuitively, o:0 can be interpreted as a "normal"
stationary element in the series on asset returns and o:1 as the hetero­
skedastic coefficient, which shows the correlation between changes in
returns and their corresponding volatilities in the previous period. As an
illustration, for a U.S. dollar-based investor, y, would denote asset re­
turns in U.S. dollars obtained by investing in various currency assets; it
would be defined as the product of the three-month treasury bill rate for
each asset multiplied by the percentage change of the corresponding U.S.
dollar exchange rate, all expressed on a weekly basis.6
The generalization of the ARCH(p, q) model for asset return y, is as
follows:
= <l>o + <I>1 Yr-1 + + <l>pYr-p + E,,
(3)
where <I>P(L) = 2:f= t <!>; L; is the polynomial autoregressive lag operator.
Note that
···
Yr
y, - N[<l>p(L)y, h,]
(4)
with h, = o:o + 2: o:; E�-;,
(5)
q
{;;;l
4 See Engle (1982).
5That is, an AR(l) model means that y, depends on Yr-1 but not on earlier
(y,-2,Yr-3, . . . ) observations. An ARCH(l, 1) model means that y, depends on
Yr- 1 but not on earlier (Yr-z,y,-3, . . . ) observations and that h, depends on E�- 1 but
not on earlier square d errors (E�-2, E:_3, . . . ).
6 In calculating returns, we have omitted capital gains or losses resulting from
changes in the prices of bills, on the assumptton that such short-term securities
generally have relatively small price variations over the course of a week.
©International Monetary Fund. Not for Redistribution
PORTFOLIO PERFORMANCE OF RESERVE CURRENCIES
669
where E1 follows a white noise process defined by E(Er) = 0 for all t,
E(e, es) = 0 for t =I= s, and E(e?) = a-2 for all t. The conditional variance
of E�o h,, is allowed to vary over time and is a linear function of past
residuals squared.
Testing for ARCH effects requires a test of the null hypothesis that the
conditional variance h, is constant over time:
Ho:
H1 :
at = a2 = ·
·
· = aq =
at
•
•
=/:
a2
=/:
•
=I=
aq
0 (no ARCH effects);
=/: 0 (ARCH effects exist).
To test the null hypothesis H0, we have utilized the following procedure:
first, the residuals €, are estimated from equation (3) using ordinary least
squares; second, the number of lags of e, is determined, using all available
information, through maximization of its log-likelihood function; and
third, estimates of a0,
, aq are obtained by applying OLS to
q
h, = ao + 2: a; €.7-;.
•
.
•
i•l
In order to test for an ARCH process of order q, we form the regression
E(€7) = h, = ao +
q
L
i-=-1
a;
€.7-;,
(6)
where e.; is the square of the OLS residuals obtained from equation (3).7
To test for higher-order ARCH specifications and the joint significance
ofthe coefficients attached to equation (6), the Lagrange multiplier (LM)
statistic is calculated as T R2 (where R2 is the coefficient of determina­
tion and Tis the sample size), which has an asymptotic x2(q) distribution.
Significantly large values of the statistic will lead to the rejection of the
null hypothesis H0 of homoskedasticity in favor of an ARCH process of
order q.
Finally, if ARCH effects are detected, maximum likelihood estimation
rather than OLS should be applied,8 and the additional assumption of
(conditional) normality of returns should be employed in the third step
of the above procedure.
·
ill.
Empirical Results
In this section, the univariate ARCH model using weekly data is
estimated for a U.S. dollar-based investor. The data set contains returns
on short-term securities denominated in the U.S. dollar, the deutsche
'See Diebold (1988, p . 19); Greene (1990,
8See Engle (1982, pp. 996-99).
p.
417).
©International Monetary Fund. Not for Redistribution
Note:
*
..
10.99*
-84s.n
1 .355
(12 .767)*
0 .144
(2.473)*
·
6.09*
-829.02
1 . 25
(15.332)*
0.17
(4.74W
0.135
(2.406) ..
0.347
(7.394)*
Japanese
yen
·
8.18*
-857.23
1 .374
(14.310)*
0.181
(3.870)*
0.118
(2.038)*
0.311
(7.679)*
Pound
s.terling
19. 15*
-841.03
4.45*
-503 . 10
0.369
(13.072)*
0.114
(2.002)*
0.082
(2.883)*
0.330
(7.500) *
0. 136
(2.458)*
0.332
(8.119)*
1 .270
(14.431)*
0.197
(3.107)*
SDR
franc
French
10.21*
-755.69
l.l63
(10.963)*
0.203
(3.065)*
0.095
( 1 .714)*
0.302
(7.134)*
ECU
· + 41pYr-p + E, and h, = Qo + alE;_, + · · · + aq E;_q)
©International Monetary Fund. Not for Redistribution
16.69*
158.17
0.018
(5. 368)*
0.106
(1 .726)*
0.074
( 1 .467)**
0.108
( 1.452)**
0.130
(2.179)*
0.037
(0.708)
0.016
(1.939)..
0.362
(7.829)*
-0.105
(-2.094)*
0. 102
(1. 999) *
-0.039
( -0.816)
Average
composite
index
1982:5-1991:50
denote statistically significant t-statistics at the 0.05 and 0. 10 levels, respectively.
112.72*
2,234.24
and
Lagrange
multiplier
Log
likelihood
as
<4
al
a2
a,
ao
�
4-s
4>·
4>.
ck
�1
4>.,
0. 126
(2.262)*
0.331
(8.087)*
mark
0.001
(2.889)*
1 . 191
(27.0?...6 )*
-0.291
(-4.597)*
0.212
(4.184) ..
0.009
(0.211)
0.055
( 1 .565)
-0. 187
(-8 .73W
0.000
( 1 1 . 199)*
0.538
(9.665)*
0.162
(2.944)*
DeuiSche
u.s.
doUar
+
ARCH(p, q) Esrimation Results for Total Remrn.s, Weekly Data,
(y, = lbo + <!J,y,-1
Table 1.
Gold
0.60
- 1 ,081.92
3.329
(22.932)*
0.194
(4.369)*
-0.059
(-0.062)
0.248
(5.454)*
;::;
m
r
-1
m
3::
r
-1
c:
0
;:o
c:
0..
5
>
z
z
0
c:
0
>
"C
>
.,
0
r
:I:
>
m
s::
0..
-..l
c
PORTFOLIO PERFORMANCE OF RESERVE CURRENCIES
671
mark, the Japanese yen, the pound sterling, the French franc, the SDR,
the ECU, an average composite index (ACI), and gold. The ACI repre­
sents the average share of currencies in official holdings of foreign ex­
change reserves of IMF member central banks for the 1981-87 period.
Our sample spans the period February 1982 to December 1991. The data
set is described in the Appendix.
For given values of past-realized investment returns, a0 and a;
(i = 1 , . . . , 5) were estimated for the total return on each of the nine
types of currency assets (see Table 1). All estimated coefficients, &0 and
&;, are nonnegative, thus ensuring that a positive variance is obtained.
Furthermore, the summation of a;'s (i � 1) is always less than one,
indicating that the estimated variance is finite. The optimal lag length,
q, is determined as the value that maximizes the log-likelihood function
in a grid search over lags 1 to 6. To maximize the likelihood function, an
iterative procedure based on the method of BHHH9 was used. As can be
seen from Table 1 , the optimal lag length is one for the deutsche mark,
the pound sterling, the French franc, the Japanese yen, ECU, SDR, and
gold; two for the U.S. dollar; and five for the average composite index.
The difference in the optimal lag length between the U.S. dollar and the
rest ofthe employed currencies, except the average composite index, may
be attributed to the fact that U.S. dollar returns comprise only interest
earnings on the respective assets, without taking into account any coun­
teracting movements in the exchange rate as is the case with the other
currencies. The ARCH coefficients for almost all currency returns are
significantly greater than zero, as indicated by the asymptotic t-statistics
given in parentheses.
The specification test for qth-order ARCH disturbances is based on
the qth-order autocorrelation of the squared residuals. The presence of
first-order ARCH effects is accepted at the 5 percent level for the
deutsche mark, the Japanese yen, the pound sterling, the French franc,
SDR, and ECU returns. The null hypothesis of no second-order ARCH
effects is rejected for returns on the U.S. dollar; that of no fifth-order
ARCH effects is rejected for average composite investment returns.
These results appear to provide statistical evidence that the variances of
the respective currency returns are not independent over time, in that
they are related through the square of past residuals. With regard to gold
returns, the evidence is inconclusive, since the t-statistic of the corre­
sponding ARCH coefficient is statistically significant but the LM statistic
suggests the absence of ARCH effects.
9The Berndt and others (1974) iterative algorithm.
©International Monetary Fund. Not for Redistribution
672
MICHAEL G. PAPAIOANNOU and TUGRUL TEMEL
Table 2. Preliminary Data Analysis on Total Returns•
Skewness
Kurtosisb
Bera-Jarque
Augmented
Dickey-Fuller
-20.929*
4817.583*
10.506
0.998
U.S. dollar
- 17.363*
9.197*
3.133
0.281
Deutsche mark
-22.918*
220.964*
3.190
0.899
Japanese yen
- 12.918*
65.608*
3.218
0.443
Pound sterling
-17.542*
14.496*
3.264
0.074
French franc
- 12.293*
4.519*
3.081
-0.226
SDR
-16.671*
10.524*
3.282
-0.209
ECU
Average composite
-12.381*
2.689
3.245
0.070
index
-22.367*
1158.280*
3.254
0.651
Gold
Note: • indicates that statistic is significant at the 5 percent level.
The number of observation is 496.
b For the calculation of the kurtosis statistic, see Diebold (1988, pp. 8-11).
•
The significance tests for the ex; parameters and the LM statistics are
corroborated by several additional diagnostic tests on the distributional
properties of total returns (see Table 2). These statistics indicate that most
currency returns, except for the ECU and the SDR, display a negative
skewness. This characterizes a distribution of returns in which negative
changes are less than positive ones. A small negative skewness indicates
that large negative changes are outnumbered by positive ones of smaller
magnitude. Moreover, all of the currency returns considered here exhibit
high leptokurtosis, which commonly appears in high-frequency exchange
rate data. 10 As mentioned above, when the conditional distribution is
normal with ARCH disturbances, its unconditional distribution is known
to be leptokurtic, 11 implying that an ARCH model could partly eliminate
the associated leptokurtosis. The kurtosis statistics for all currency re­
turns are significantly larger than three, which is inconsistent with. a
standard normal distribution of total returns on these assets.
In addition, the Bera-Jarque (BJ) test statistic12 for the deutsche mark,
the pound sterling, the French franc, the Japanese yen, ECU, SDR, and
gold with ARCH(l , 1) is highly significant. Furthermore, the BJ tests for
the U.S. dollar with ARCH(6, 2) and for the average composite index
with ARCH(4, 5) are also significant. The resulting high negative values
10
See Diebold (1988, p. 5).
See Engle (1982); Diebold (1988, pp. 8-11); Kroner and Claessens {1991,
p. 136).
12The Bera-Jarque test statistic is approximately distributed as a central x2(2)
under the null hypothesis of normality in the underlying distribution of returns
(see Hendry (1989 , pp. 32-33)).
11
©International Monetary Fund. Not for Redistribution
PORTFOLIO PERFORMANCE OF RESERVE CURRENCIES
673
for the augmented Dickey-Fuller tests imply that the characteristic roots
of the Taylor expansion of the unconditional variance of €.� lie outside the
unit circle for all currency returns. 13
The finding that the LM statistic for the testing of ARCH effects is
significant for all currency returns (except gold) suggests that investment
in these currencies will result in increased estimated variances-and
therefore in increased risk during periods of large unexpected shocks to
returns and in diminished risk during periods of relative stability. This
result indicates that it might be desirable to split the sample into periods
of high and low variability of returns and examine whether ARCH effects
persist. The values for the parameter a0 range from zero for U.S. dollar
returns to 3.329 for gold, and all are statistically significant. The parame­
ter a; (i = 1 , . . . , 5) represents the relative contribution of the previous
period's squared error of returns to their conditional variance in the cur­
rent period. The parameter values of a1 range from 0.106 for the average
composite index to 0.538 for U.S. dollar returns, and all are statistically
significant at the 5 percent level. In the case of the U.S. dollar, this means
that about 54 percent of a week's disturbances is carried over into the
following week. Among currency returns displaying one lag of ARCH
effects, returns on the SDR demonstrate the lowest transmission of
weekly deviations from the mean into volatility of SDR returns, while
ECU returns had the highest. This result suggests that shorter-term
investment periods are likely to prove more "successful" for the SDR
than for the ECU and the rest of the currencies, in terms of achieving a
predicted risk-return trade-off. The result for the ECU may be attributed
to the fact that the currencies in its basket have higher volatilities than
those in the SDR basket.
The constant term, <j>0, takes into account a possible nonstationary
element (drift), like a time trend, in total returns. Under the null hy­
pothesis, currency returns would allow an autoregressive structure with
constant-variance residuals. Under the alternative, an ARCH structure
on the residuals is imposed. During the sample period, the constants on
all currency returns, except that of gold, were positive, and only those
on gold returns were not significantly different from zero. These terms
may be interpreted as mean weekly returns. Thus, the intercept (con13The augmented Dickey-Fuller test is a stationarity test, in which the coeffi­
cient of the Jagged deJ?endent variable is tested to see whether it is equal to or
greater than umty (umt-root test). A coefficient that is Jess than one indicates a
stationary time series. If the augmented Dickey-Fuller statistic is significant, the
existence of a characteristic root outside the unit circle cannot be rejected, and
therefore the respective autoregressive series is considered nonstationary. The
statistic is robust to ARCH specification.
©International Monetary Fund. Not for Redistribution
674
MICHAEL G. PAPAIOANNOU and TUGRUL TEMEL
stant) for deutsche mark returns indicates that the annualized average
weekly returns on deutsche mark investments were 10.28 percent.14 Fur­
ther, since for all currency returns <1>1 is less than one, it would seem that
all returns are stable. Note that U.S. dollar returns exhibit a different
pattern of generating process from other currency returns owing to the
fact that returns on U.S. assets consist only of the respective interest
earnings. Such dollar returns at time t are found to be affected by a six-lag
structure, although the coefficients on the fourth and fifth lags are not
statistically significant. However, the coefficient on the sixth lag of the
dollar returns process is highly significant, indicating an apparent cycli­
cality to U.S. interest rates of a similar periodicity (a six-week cycle).
Since the sum of the six coefficients in the lag structure is 0.989, U.S.
dollar returns also appear to be stable.
For most currency returns, the lagged squared errors contribute siz­
ably to the conditional variance, as indicated by the significant a; coeffi­
cients, which imply that currency returns are generated by processes with
nonconstant unconditional variance. Because the principal assumption of
constant variances of the error terms in an OLS estimation is violated,
the latter methodology should not be used as an estimation procedure for
currency returns. Furthermore, the coefficient structure in the ARCH
model of U.S. dollar returns is monotonically decreasing, indicating that
a squared error from the previous week has a greater effect on current
conditional variance than a squared error from two weeks ago.
An important observation on the statistical properties of the stochastic
process followed by SDR returns is that the conditional variance of the
SDR returns displays an optimal lag length of one, as only the coefficient
on the first-period (squared) residual is statistically significant. Thus, the
data indicate an ARCH process of order one. The estimated SDR returns
have finite variance since the coefficient on the lagged residuals is less
than one. The resulting ARCH effects for the SDR returns are further
supported by their distributional properties of high leptokurtosis and the
highly significant Bera-Jarque tests indicating � nonnormal distribution
14The implied annualized average weekly returns are calculated as
[(
1+
�t - 1J wo,
1 0
where y
= <l>o
��
<j>;.
Accordingly, the implied annualized average weekly returns for U.S. dollar
inve�tm�nts are 4.84 percent, Japanese yen investments 11.34 percent, pound
�terling mvestments 9.30 percent, french franc investments 11.15 fercent, SDR
mvestments 6.56 percent, ECU mvestments 7.33 percent, AC investments
1.23 percent, and gold 0.96 percent, during the period February 1982 to December
1991.
©International Monetary Fund. Not for Redistribution
PORTFOLIO PERFORMANCE OF RESERVE CURRENCIES
675
for these returns. These empirical findings indicate that the conditional
variance of the SDR returns is not constant over time and that optimiza­
tion of a portfolio that includes the SDR requires the use of techniques
such as the ARCH methodology to measure risk or variance accurately.
IV. Conclusions
This paper provides empirical evidence that would permit investors,
including central banks, to make more accurate calculations of optimal
strategies in the management of their reserves. The gains in accuracy
depend directly on how the variance, or risk, measures of the returns on
various currency investments change over time. To test whether the
variability of returns is constant, we employ the ARCH model, which was
further used to estimate the variability of the returns on various currency
investments.
On the basis of weekly data for returns on nine types of currency and
gold investments for the period February 1982 to December 1991, we
show that the variances of total returns on all currencies and gold change
significantly over time. Evidence of positive and highly significant auto­
correlation of the weekly returns on those assets and of their predictable
level of variability is not consistent with the assumption of constant
(time-invariant) risk that is often used in asset allocation models. The
empirical results presented in this paper generally suggest that for a U.S.
dollar-based investor an ARCH model that takes into account the non­
stationarity of return variability provides more accurate estimates of the
variability of total returns on multicurrency investments than ordinary
least squares models.
In particular, the sign of the intercept in the ARCH specifications is
nonnegative for all currencies, indicating that the variability of asset
returns would increase in the absence of any influence from the previous
period's returns. Another interesting empirical result is that the volatility
of returns from investing in the deutsche mark, the pound sterling, the
French franc, the Japanese yen, the ECU, the SDR, and gold is affected
by the square of the residuals lagged one period, while the variability of
returns on U.S. dollar assets is affected by the square of the residuals
Jagged two periods and that of average composite index by the square of
the residuals lagged five periods. This result means that for individual
currencies the future effect of changes in variability lasts only a short
period and diminishes over time. The variability of returns on U.S.
investments may be attributed to the fact that they comprise only interest
earnings on the respective assets. Interest rates, as opposed to exchange
©International Monetary Fund. Not for Redistribution
676
MICHAEL G. PAPAlOANNOU and TUGRUL TEMEL
rates, tend to exhibit longer persistence: they are influenced by longer
lags. For a currency-composite investment, however, the effect lasts for
a significantly longer period.
The returns on investments in the SDR and ECU follow an ARCH
process of order one, and their probability distributions appear to be
highly leptokurtic. These results are broadly similar to those for individ­
ual currencies. In particular, the effect of the past-period error on the
variance of SDR returns is smaller than that found for any of the other
currency returns, largely owing to the built-in diversification of currencies
in the SDR basket. In contrast, ECU returns exhibit the highest transmis­
sion of unexpected weekly shocks into returns volatility during the sample
period. The difference between the statistical results for the SDR and
those for the ECU could be attributed to the fact that the ECU contains
more volatile currencies than those in the SDR. Further study of the SDR
and ECU returns might shed some light on more fundamental differences
between these two composite reserve assets.
APPENDIX
Calculation of Asset Returns
This Appendix describes the various calculations used to develop our returns
data.
Asset Returns in Different Currencies
Since exchange rates are expressed bilaterally against the U.S. dollar, our
analysis is dollar based. The same procedure could be repeated for the mark-,
yen-, or franc-based investors. We define dollar-based returns as follows:
Yt. k
=
where e,,k
[(1 + i,-u)(1 + e,. k) - 1]100,
=
(E,.k - E,-u)IE,-I.k; and
y,,k = U.S. dollar-based returns on investments in currency k at time t;
i,- 1,k
=
e,,k
=
E,,k
=
three-month treasury bill rate, on a weekly basis, for the country
corresponding to currency k at time t 1;
-
rate of appreciation or depreciation of currency k against the U.S.
dollar at time t;
spot rate, defined as U.S. dollar per unit of local currency k at
time t.
The source for exchange rate and interest rate data for the various countries is
the IMF Treasurer's Department data base.
©International Monetary Fund. Not for Redistribution
PORTFOLIO PERFORMANCE OF RESERVE CURRENCIES
677
Gold Returns in Different Currencies
The formula used in the calculation of returns on gold is
g, = ((G, - G,_ .) /G,_.)lOO,
where g, and G, denote, respectively, the weekly percentage change in the U.S.
dollar price of gold and the level of the U.S. dollar price of gold at time t. Further,
we define
GR,,k = g, + e,.k 100,
where GR,.k denotes the weekly gold returns in U.S. dollars by investors of
currency kat time t. The source for gold prices is the IMP Treasurer's Department
data base.
Average Composite Exchange and Interest Rates
The hypothetical currency basket consists of seven currencies: the U.S. dollar
(US), the pound sterling (PS), the deutsche mark (DM), the French franc (FF),
the Swiss franc (SF), the Netherlands guilder (NG), and the Japanese yen (JY).
A prespecified amount15 of these currencies and an average of their exchange
rates (the noon quotations from London in terms of U.S. dollar) for the 1981-87
period are used to calculate the weight of each currency in the average composite
exchange and interest rate.
Calculation of Weights for the Composite Exchange and Interest Rates
U.S. dollar
Pound sterling
Deutsche mark
French franc
Swiss franc
Netherlands guilder
Japanese yen
Amount of
currency in the
basket
0.7217
0.0118
0.2775
0.0576
0.0423
0.0225
12.7213
Exchange rate
(noon quotation
from London)
(US/US =) 1.000
(PSIUS =) 0.420
(DMIUS =) 1.974
(FFIUS =) 4.560
(SF/US =) 1.781
(NGIUS ) 2.142
(JYIUS =) 202.870
=
Weights =
amount /rate
(wl ) 0.721654
(w2 =) 0.028120
(w3 =) 0.140601
(w4 ) 0.012631
(w5 =) 0.023759
(w6 =) 0.010526
(w7 =) 0.062706
=
=
The formulas by which the average composite exchange rates (ACE) and the
average composite interest rates (ACI) are computed follow:
ACE, = [w1( US IUS), + · · · + w7(JYIUS),]
ACI, = [w1(USJ), + w2(PSJ), + · · · + w7(JYI),]
where (US/), (PSI), . . . , (JYI) denote three-month treasury bill interest rates in
the United States, United Kingdom, . . . , Japan, respectively.
15 It represents the average share of currencies in total official holdings of
foreign exchange reserves for the 1981-87 period.
©International Monetary Fund. Not for Redistribution
678
MICHAEL G. PAPAIOANNOU and TUGRUL TEMEL
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Journal of Econometrics , Vol. 52 (April/May 1992).
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©International Monetary Fund. Not for Redistribution
IMF Staff Papers
Vol. 40, No. 3 (September 1993)
Q 1993 International Monetary Fund
Interenterprise Arrears in
Transforming Economies
The Case of Romania
ERIC V. CLIFTON and MOHSIN S. KHAN*
This paper reviews Romania's experience with interenterprise arrears
during 1991 with the purpose of extracting lessons that might prove useful
for other economies in transition to market-based systems. The rapid
growth of interenterprise arrears poses a serious policy problem in many
of the transforming economies of Eastern Europe, as well as in the re­
publics of the former Soviet Union. Among the more striking cases is that
of Romania, where gross interenterprise arrears grew almost 18-fold (to
about 50 percent of GDP) in only one year. This paper discusses the de­
velopment of these arrears and the policies implemented by the authorities
to try to resolve the problem. [JEL E51, E65]
RAPID GROWTH of interenterprise arrears poses a serious policy
THEproblem in many of the transforming economies of Eastern Europe,
a phenomenon that is now evident as well in the republics of the former
Soviet Union. 1 Undoubtedly, some part of these arrears can be consid­
ered "voluntary" credits, in the sense that they represent credit extended
* Eric Y. Clifton, Deputy Division Chief in the European I Department, holds
a doctorate from Indiana University.
Mohsin S. Khan, Deputy Director of the Research Department, is a graduate
of Columbia University and the London School of Economics and Political
Science.
The authors are grateful to Daniel Daianu, Luis Mendon�a. and Erik Offerdal
for helpful discussions and comments.
1 See, for example, the studies by Begg and Partes (1992) for Czechoslovakia,
Daianu (1993) for Romania, Ickes and Ryterman (1993) for Russia, and Ros­
towski (1992) for Poland and Russia.
680
©International Monetary Fund. Not for Redistribution
INTERENTE RPRISE ARREARS IN ROMANIA
681
by one enterprise to another as part of normal business practice, much
like trade credit is used in market-based economies. However, it is gen­
erally acknowledged that most ofthe arrears are involuntary, with enter­
prises simply not making payments to each other (or to the banks and
government), and creditors unwilling or unable to enforce the due pay­
ments. Given the interlocking nature of enterprises in Eastern European
countries-a legacy of the centrally planned system-such involuntary
credits can rapidly balloon out of control, as they have in several of these
countries.
Many reasons have been advanced to explain the phenomenon of
interenterprise arrears in the transforming economies. They range from
financial underdevelopment and credit market failures, which cause en­
terprises to assume banking-type functions (Begg and Partes (1992),
Ickes and Ryterman (1993)); tight credit policies, which create a liquidity
crunch (Calvo and Coricelli (1992)); lack of credibility of the govern­
ment's reform program (Rostowski (1992)); and the particular structure
of industry in a command economy, which is based on chain links between
enterprises (Daianu (1993)). It is clear that no one explanation domi­
nates, and it would be fair to say that interenterprise arrears are due to
a combination of factors, the relative weights of which vary from country
to country.
If allowed to grow unchecked, interenterprise arrears can, as argued
recently by Begg and Partes (1992), place the entire reform process in
jeopardy. In particular, hard budget constraints are softened for enter­
prises, and relative price changes become less meaningful. As a result,
enterprises continue to behave as in the past and the restructuring to
conform to market realities is delayed. This delay in the structural trans­
formation of the economy and the weakening of contract enforceability
are perhaps the most important adverse effects of interenterprise arrears.
In addition, interenterpri'se arrears have significant macroeconomic
consequences. First, arrears can undermine monetary control and thus
limit the effects of tight credit policy on inflation and the balance of
payments. More specifically, recourse to arrears to finance expenditures
can lead to shifts in the demand for bank credit and in the income velocity
of money, making it more problematic for the authorities to design and
execute monetary policy. Second, interenterprise arrears can lead to
inefficiencies in, and the eventual breakdown of, the payments mecha­
nism, with obvious adverse effects on production and output. As enter­
prises bypass the banking system and arrears begin to reach a level they
consider undesirable, cash transactions become more and more preva­
lent. This "cash-in-advance" constraint on transactions becomes binding
and, if the authorities are unwilling to provide the needed currency,
©International Monetary Fund. Not for Redistribution
682
ERIC V. CLIFTON and MOHSIN S. KHAN
production begins to suffer. 2 Finally, the arrears of state-owned enter­
prises represent a potential fiscal liability of the government. At some
point in time, the government would have to cover these quasi-fiscal
deficits, thereby affecting private sector behavior both now and in the
future.
Since large-scale restructuring, involving closures and privatization,
does not seem to be in the cards in the short run-indeed it is the absence
of such restructuring that has caused arrears to emerge and grow as they
have-the government has to find a solution. But it is very important that
this solution not give rise to a moral hazard problem. A generalized
"bailout" runs the risk of creating expectations of future bailouts, with
enterprises having an incentive to run up arrears again. Of course the
government could ignore the problem, letting it resolve itself over time
as arrears eventually stop growing and some type of adjustment occurs,
but this adjustment is bound to be disorderly. All enterprises, viable and
nonviable alike, would suffer from the chain reaction of closures that
would occur. Widespread production collapses and soaring unemploy­
ment would certainly create difficulties for the reform process. Thus,
governments in the transforming economies are placed in the position of
having to find an optimal solution that falls somewhere between the two
undesirable extremes of a general bailout and doing nothing.
While the interenterprise arrears problem is evident in other Eastern
European countries, the case of Romania during 1991 is perhaps the most
striking.3 Gross interenterprise arrears grew almost 18-fold4-from lei
100 billion to nearly lei 1,800 billion-in a span of only 12 months, giving
rise to many of the adverse consequences mentioned above: inflation was
substantially higher and output much lower than had been expected at
the beginning of 1991. Also, at the end of the year the authorities were
forced to take actions to clear these arrears. This paper reviews the
Romanian experience of 1991 with the express purpose of extracting
lessons-both positive and negative-that might prove useful for other
economies in transition.
2 Although lack of credit may be a factor in the decline in output, as ar�ued
by Calvo and Coricelli (1992), arrears can compensate for this, at least parttally.
Eventually, however it is the lack of currency that becomes the relatively more
important factor.
3 In many respects, as argued by Rostowski (1992), the Romanian situation is
more akin to that of Russia than to the other Eastern European cases of
Czechoslovakia and Poland.
4 Gross arrears are the total stock of arrears before netting out bilateral and
multilateral payables and receivables.
,
©International Monetary Fund. Not for Redistribution
!NTERENTERPRISE ARREARS IN ROMANIA
683
I. Developments in Interenterprise Arrears
This section reviews the history of interenterprise arrears in Romania
during the centrally planned regime and subsequently.
Practices Under the Centrally Planned Regime5
Under the strict system of central planning that operated in Romania
until December 1989, the Government had virtually complete control
over enterprise management and finances. The authorities also had com­
plete discretion in determining the tax burden on individual enterprises.
Thus, the distinction between whether state-owned enterprises-which
covered virtually all means of production except for a small proportion
of land cultivated by private farmers-were actually paying taxes or just
transferring to government the profits that already belonged to it in its
capacity as owner of the enterprises was not clear.
The tax burden of enterprises steadily increased during the 1980s as the
Government needed to generate large fiscal surpluses as part of the policy
to repay the external debt. 6 As a result, enterprises were left with inad­
equate funds to finance current operations and investment, and often
with substantial after-tax losses. These losses were financed by the exten­
sion of bank credit, but to the extent that these loans were unserviceable
the quality of the banks' balance sheets eroded. In addition, bank credit
was typically extended to clear domestic payments arrears. Thus, under
the centrally planned regime there were no interenterprise arrears as
such. All arrears were to banks since they automatically provided credit
to those enterprises that were unable to make their payments to other
firms and creditors. The arrears, then, simply showed up as bad debts on
the books of the banking system.
Developments Since 1990
From December 1989, policymakers in Romania have had to deal with
the twin problems of bad debts of enterprises to banks and arrears with
other enterprises.
5 For details of economic developments and policies during the pre-reform
period, see Demekas and Khan (1991).
6Tbis tax came to be known as the "Ceaucescu tax."
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684
ERIC V. CLIFTON and MOHSIN S. KHAN
Unserviceable Bank Loans
After the change of government in late 1989, the bad debts of enter­
prises to banks resulting from the practices of the centrally planned
regime started being written off against government bank deposits from
past fiscal surpluses. In this way, all enterprise bad debts from before 1989
and most from 1989 (a total of lei 265 billion) were eliminated. After
government deposits were exhausted in mid-1990, lei 96 billion of bad
debts from 1989 remained on the books of banks carrying a 0.5 percent
interest rate. These credits were refinanced by the National Bank of
Romania (NBR) at the same rate. Part of the debt (about lei 5 billion)
was cleared in the last two months of 1990, leaving lei 91 billion of the
bad 1989 debts (already refinanced by the NBR) with banks.
Enterprises realized further losses in 1990, some of which (especially
in the mining and energy sectors and in the food industry) were covered
by budgetary subsidies. The subsidies did not cover all enterprises, how­
ever, and lei 41 billion of 1990 losses was l�ft. This balance was mostly
covered by automatic bank credit (about lei 31 billion), as in the past.
Thus, at end-1990, there were about lei 122 billion of enterprise bad debts
to banks (lei 91 billion from 1989 and about lei 31 billion from 1990). In
1991, the amount of bad debts outstanding declined as enterprises were
forced to clear their overdue bank debts using the proceeds from sales
of revalued stocks.
In order to increase the effectiveness of credit policy and to ensure that
the past losses of enterprises were not a burden on the financial system,
the authorities decided to eliminate the remaining amount of 1989 and
1990 unserviceable bank loans from bank balance sheets with the issuance
of long-term government debt instruments. This operation began in
August 1991 and was formalized on February 5, 1992, when the Roma­
nian Parliament approved Law 7 , transforming 90 percent of these claims
on enterprises into a special public debt account. The other 10 percent
of the loans were charged off against banks' profits. The sale of state
assets and the recovery of outstanding claims of enterprises are to cover
the principal and interest payments.
Interenterprise Arrears
Starting in late 1990, enterprise payments difficulties-in addition to
the problem of bad debts to banks-appeared in the system. They were
reflected in mounting interenterprise payments arrears, which on a gross
basis at end-1990 reached an estimated lei 100 billion.7 As banks became
7 No information is available on interenterprise credits as distinct from arrears.
Starting in late 1990 direct payments between enterprises stopped being docu­
mented by the banking system.
©International Monetary Fund. Not for Redistribution
685
fNTERENTERPRISE ARREARS IN ROMANIA
Table 1. Romania: Money, Credit, lnterenterprise Arrears,
and Industrial Production
(In billions of lei)
Period
December 1990
January 1991
February
March
April
May
June
July
August
September
October
November
December
January 1992
Broad
money
Credit
to nongovernment
Interenterprise
arrears
514
519
546
517
525
568
567
595
600
602
671
815
885b
1,066c
684
703
731
756
765
788
811
839
806
749
839
899
954b
1 ,312c
100
206
307
400
482
550
600
637
691
800
1,000
1,317
1,777b
Industrial
production"
100.0
79.8
79.8
86.1
90.0
90.6
92.6
83.8
80.9
81.3
77.9
70.1
68.2
69.8
Sources: Romanian authorities and IMF staff estimates.
• Index, December 1990 100.
b Excludes the effect of the global compensation of December 1991.
c Includes the effect of the global compensation of December 1991.
=
more selective in granting credit, partly because of the tight credit policy
implemented through bank-specific credit ceilings, enterprises started
to run arrears among themselves as a way of financing current opera­
tions. By end-March 1991, interenterprise payments arrears reached an
estimated lei 400 billion (see Table 1 and Figure 1).
The growth of arrears accelerated sharply in the second half of 1991,
primarily because of two factors. First, price increases resulting in part
from the elimination of price controls and the removal of subsidies were
much higher than projected, while credit expansion through September
was kept on target (consistent with the lower projected rate of inflation).
Real credit thus declined far more than had been envisaged and enter­
prises came under considerable strain. Second, from about midyear it
became increasingly evident that the Government would need to arrest
the progressively deteriorating economic situation. Output continued to
fall, and its slide was partly attributable to the so-called blockage of the
payments system brought about by interenterprise arrears (see Table 1).8
8 As mentioned earlier, cash transactions became more prevalent. For exam­
pble, the ratio of currency to deposits rose from 20 percent in January to 32 percent
y September-October. For a discussion of the factors behind the decline in
output, see Borensztein, Demekas, and Ostry (1993).
©International Monetary Fund. Not for Redistribution
686
ERIC V. CUFfON and MOHSIN S. KHAN
Figure I . Romania: Broad Money, l111eremerprise Arrears,
and Consumer Price Index
Billions of lei
2500
Index. October 1990-100
450
2000
380
Consumer price index
(rif/111 scale)
1500
310
... . ..
1000
Arrrars
(left seait!)
.
.... ...
soo
240
170
Broad money
(leji Sc(l/1.')
0
D
1990
F
M
A
A
M
s
0
N
D
100
1991
Sources: Romanian authorities and JMF staff estimates.
In July, for example, industrial production fell by nearly 10 percent, and
again in August by another 3.5 percent. Enterprises were very vocal at
the time in blaming the financial payments blockage for these develop­
ments and began pressing hard for a resolution. Thus, a bailout looked
likely, and by September-October the issue was even being discussed in
Parliament. Enterprises therefore had an incentive to increase arrears
further, and did so in the expectation that they would receive government
assistance to cover their debts.
On a gross basis, arrears rose to lei 1,777 billion at end-1991, represent­
ing about 50 percent of GDP valued at December 1991 prices. Net
arrears-the amount of payments owed by net debtor enterprises to net
creditor enterprises, plus arrears to the state (largely for tax payments)-
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INTERENTERPRISE ARREARS IN ROMANIA
687
were lei 426 billion at end-1991.9 (The tax arrears amounted to about lei
40 billion.) The growth of gross interenterprise arrears closely matched
the rise in the consumer price level during 1991 (Figure 1). Indeed, it
appears that the arrears were implicitly indexed to the price level, in that
when creditor enterprises were not paid on time they would rebill the
debtor enterprises at the new, higher prices.
Reflecting a tight monetary policy stance, broad money grew by 17 per­
cent through September 1991, while bank credit to the nongovern­
ment sector grew by 10 percent (inflation was 132 percent over the
period). Starting in October, however, the NBR began to allow an
expansion of bank credit to enterprises to reduce the problem of inter­
enterprise arrears, and bank-specific credit ceilings were suspended.
Through December 1991, broad money grew by 71 percent and credit to
the nongovernment sector grew by 40 percent (compared with a cumula­
tive inflation of 223 percent). At end-1991, gross interenterprise arrears
were equivalent to 208 percent of broad money and 194 percent of credit
to the nongovernment sector.
The income velocity of broad money rose from about 1.8 in 1990 to 4.0
in September 1991 before falling back to 3.7 in December 1991 (Fig­
ure 2). Interenterprise arrears were, of course, also liquidity being pro­
vided to the system in addition to the normal money supply. The effects
of the additional liquidity can be judged by adding interenterprise arrears
to broad money. The ratio of GDP to the sum of gross interenterprise
arrears and broad money was 1.2 in December 1991 (Figure 2). A similar
calculation using net interenterprise arrears yields a value of 2.5, which
is close to the average velocity observed during the early 1980s and
considered to be "normal" velocity.
II. Policies to Control and Clear Interenterprise Arrears
To combat the interenterprise arrears problem, a series of selec­
tive measures was considered and adopted starting in May 1991, culmi­
nating in a generalized scheme, termed "global compensation," in late
December 1991.
Early
Attempts
To reduce the interenterprise arrears problem, on May 8, 1991, the
a refinancing line of lei 15.5 billion for banks, which were
NBR opened
9Historically, net arrears have been approximately 20-30 percent of gross
arrears.
©International Monetary Fund. Not for Redistribution
688
ERIC V. CLIFTON and MOHSIN S. KHAN
Figure 2. Romania: Income Ve/ociry ofMoney. 1980-9/
GOP/broad money ratio
4.0 .-------,,--,
.l5
ExdudinK imerenrerprise
arrears"
3.0
2.5
.
20
lndudill8 imerenterprise
arrearsa
1.5
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
,
..
.
1991
Sources: Romanian authorities and IMF staff estimates.
"Monthly data for 1991.
instructed to extend credit to net debtor enterprises. These credits were
extended through special accounts, so that the banks could ensure that
the credits were used solely for the clearance of arrears. The operation
was to last through June, by which time banks were to have closed the
special accounts and repaid the lei 15.5 billion to the NBR. In the two
weeks following the scheme's introduction, lei 10.5 billion of credits were
extended to enterprises. The operation did not work as expected, how­
ever. About lei 65 billion of gross arrears were cleared by end-June, but
the special NBR credits-plus an additional lei 5 billion extended through
the same special accounts in June-were not repaid as planned. In effect,
the arrears shifted from the enterprise sector to the banking system and
ultimately to the NBR. By the end of June 1991, gross interenterprise
arrears had reached an estimated lei 600 billion.
In July, the authorities developed another plan to clear interenterprise
©International Monetary Fund. Not for Redistribution
INTERENTERPRISE ARREARS LN ROMANIA
689
arrears. The new scheme aimed to cover all losses and arrears through
bank credit refinanced entirely by the NBR and extended through special
accounts. After banks recorded all enterprise claims against each other
(a process that was to be completed by end-July), they were to extend as
much credit as necessary to enable all enterprises to service the claims
against them through a special "compensation" account. The settlement
of interenterprise claims was to take place in the first two weeks of
August. By August 15, all enterprises were to have no claims outstanding
against each other. As a result, some would hold a net creditor position
in their compensation accounts with banks; others would hold a net
debtor position. By August 28, banks were to close the compensation
accounts by consolidating them with the current accounts of enterprises.
Net creditor enterprises would then find their overall bank debt reduced
by the amounts available to them in their compensation accounts,
whereas compensation credit extended to net debtor enterprises would
be reclassified as regular credit, and normal interest rates would apply.
It was estimated that clearing the interenterprise arrears through this
scheme would require a net infusion of credit on the order of lei 150-300
billion. 10
The authorities decided not to implement the scheme, however, until
more accurate estimates of the size of interenterprise arrears were avail­
able. The NBR was instructed to collect data on gross interenterprise
arrears and to reconcile them with independent estimates from the
Ministry of Industry (which were substantially smaller). It was then to
estimate the net position of the enterprise sector vis-a-vis the banking
system and the Government, as well as to identify the "worst offend­
ers"-those enterprises with large net debtor positions. Once this infor­
mation was available, the NBR was to determine the amount of bank
credit needed for the operation. Moreover, the compensation scheme
was to be combined with the closing down of insolvent enterprises.
A scaled-down version of the arrears-clearing scheme was imple­
mented in late August 1991. Affected enterprises deposited 10 percent
of their current receipts into a special account, which was used to clear
overdue payments between enterprises. 11 These deposits, together with
certain payments by the Government and very short-term credits ex­
tended by banks, were used to clear about lei 150 billion of gross inter­
enterprise arrears. However, the authorities estimated that arrears con10
Gross interenterprise arrears were estimated at the time to be around lei
600-700 billion (Table 1).
11
The affected enterpri ses covered all but 100 of the some 6,000 enterprises in
Romania.
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690
ERIC V. CLIFTON and MOHSIN S. KHAN
tinued to rise, so that the balance of gross arrears at the end of September
was about lei 800 billion. In the authorities' view, the operation was not
a success because it was basically a voluntary operation on the part of
enterprises and the net amount of credit that was injected into the system
was considered too little.
Global Compensation
On December 23, 1991, Parliament passed Law 80 calling for a gener­
alized expansion of bank credit to clear all interenterprise arrears. This
operation, termed "global compensation," was completed on Janu­
ary 27, 1992. Under the global compensation scheme, enterprises were
asked to list their arrears to other enterprises and to the state, and banks
were instructed to expand credit, carrying a government guarantee, to
clear the gross amount of interenterprise arrears. The initial bank credit
extended under the scheme was lei 1,777 billion. All payments under the
scheme were made as overdrafts from special "compensation accounts,"
and the same accounts were also debited with the payments received by
enterprises. Thus, the gross amount of credit extended was automatically
transformed into the net amount. The net amount of arrears-lei 426
billion-was retroactively reflected in bank balance sheets as of end­
December 1991. Of the net credit extended under the global compensa­
tion scheme, only lei 163 billion was refinanced by the NBR at the normal
refinance rate; the rest was financed by banks out of deposits. The
compensation credits had a six-month maturity with interest rates at
market levels. 13 Because many enterprises that were net creditors to other
enterprises were net debtors to the banking system, much of the net credit
extended under the scheme went initially toward reducing overdrafts with
banks.
Some enterprises-mostly agricultural cooperatives-chose not to par­
ticipate in the scheme since they were receiving, in effect, an interest-free
loan in the form of arrears. It is believed, however, that the number of
debtor firms that refused to participate in the global compensation was
small, and all large enterprises participated in the scheme. As a result,
almost all known interenterprise arrears were eliminated.
Following from the global compensation operation, the money supply
increased by an additional lei 149 billion in December to reach lei 1,033
12
12Basically Law 80 was closely related to the July scheme that bad been
considered and then rejected by the Government.
13 It is worth noting in this regard that at end-1992 some of these credits were
still outstanding.
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lNTERENTERPRJSE ARREARS IN ROMANIA
691
billion by year end. Thus, the increase in broad money over the year was
99 percent. Also, through end-December, the net domestic assets of the
banking system increased by lei 522 billion. The rise in prices over the
year was 223 percent, compared with a projected increase of 105 percent.
Resolving the
Liquidity and Moral Hazard Problems
The first order of business after the global compensation scheme had
been completed was to sterilize the injection of liquidity to prevent an
upsurge of inflation. In February 1992, the authorities introduced a
10 percent reserve requirement on deposits in the banking system. This
move was followed by additional measures, including requiring some
enterprises and banks to repay certain credits that had not yet matured
and requiring importers to make payments to cover letters of credit that
had been guaranteed by the Government. As a result of these sterilization
measures, the money supply rose by only 4 percent from December 1991
through April 1992 in the face of cumulative inflation of 54 percent. Bank
credit to the nongovernment sector declined by 6 percent over the same
period.
Although controlling the expansion of liquidity was necessary, the
moral hazard problem was the more serious consequence of the global
compensation. At issue was how to convince enterprises that there would
be no future compensations and that the Government was determined to
control interenterprise arrears. Toward this end, the authorities insti­
tuted a system to monitor arrears and introduced legislation designed to
control the arrears.
As part of a general reporting system established in 1991, all of the
6,000 state-owned enterprises are required to provide the Ministry of
Economy and Finance with operating accounts on a monthly basis,
balance sheets on a quarterly basis, and more detailed accounts annually.
This reporting system was expanded in 1992 to coverarrears. The buildup
of new arrears is now reported on a monthly basis for domestic suppliers
(interenterprise arrears), foreign suppliers, other credits (including wage
arrears), and foreign services (such as freight charges). Overdue pay­
ments to domestic suppliers are reported in three categories: more than
30 days overdue, more than 90 days overdue, and more than one year
overdue. Information on arrears on loans to banks is reported monthly
by commercial banks through the NBR. With these reporting systems in
place, the authorities have up-to-date information on the financial posi­
tion of each enterprise, including any arrears, and thus can take selective
action against those enterprises running arrears.
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ERIC V. CLIFTON and MOHSIN S. KHAN
Possible actions are spelled out in a new law on enterprise financial
discipline (Law 76).14 This law specifies the procedures to be followed by
all enterprises irrespective of their form of ownership. The more salient
items in the law include the following:
i. Economic agents with overdue payments obligations that remain un­
settled for more than 30 calendar days after the due date shall be considered
insolvent. Payments insolvency must be communicated to the debtor by
any creditors, including the state, after the period of 30 days has expired
(Article 9).
ii. Following a court decision confirming insolvency, creditors can take
action to "liquidate" the unsettled claims they have on their debtors. Eco­
nomic agents having unsettled claims shall be sued and subjected to "forced"
payment or the sale of their assets in the following order: monetary means,
including deposits in banks; inventories of raw materials and finished prod­
ucts; claims and fixed assets; and other estate items (Article 10).
iii. The list of economic agents declared insolvent shall be made public
(Article 12).
As passage of Law 76 by Parliament took considerably longer than
expected, the Government adopted two decisions (Decision 82 and De­
cision 162) to enforce the provisions of the new law. Under these deci­
sions, if enterprises are unable to reach agreement on overdue payments,
creditors can initiate bankruptcy proceedings against debtors under the
provisions of the existing commercial code, with the Government actively
involved in the process. The largest and most important arrears problems
can be considered by the Cabinet, which can decide on measures to be
taken against the defaulting enterprise-including accelerated privatiza­
tion, full or partial liquidation, directed labor shedding, financial restruc­
turing, and management changes. The Government also launched a
public campaign to convince enterprises that arrears are to be avoided
and no further bailouts are likelyY
The delays in the passage of the law on financial discipline, and more
fundamentally the inability and unwillingness of the Government to
move forcefully and quickly to improve the financial discipline of enter­
prises, meant that the moral hazard issue was not resolved. Enterprises
14The full title of the new law is "Concerning Measures to Reimburse Credits
Extended in Connection with the Global Compensation Operation, to Introduce
a New Regime of Payments for Economic Agents, to Prevent Payments Insol­
vency and Financial Blockage." It was enacted on July 16, 1992.
15 In addition, a World Bank Structural Adjustment Loan also puts a condition
on the level of arrears for second-tranche release-the ratio of arrears of state­
owned enterprises to state-owned enterprise turnover should not exceed 7.5
percent. Since turnover is approximately twice nominal GDP, this condition
would imply that gross arrears could not exceed 15 percent of GDP (as compared
with 50 percent of GDP in 1991).
©International Monetary Fund. Not for Redistribution
INTERENTERPRTSE ARREARS IN ROMANIA
693
continued to behave largely as before, presumably confident that the
Government would do nothing drastic in terms of closures or downsizing
and that there was every likelihood of future bailouts. Arrears, therefore,
grew once again in 1992, although at a somewhat slower pace as com­
pared with the previous year. By December 1992, gross interenterprise
arrears were approximately lei 1.9 trillion (20 percent of GDP valued at
December 1992 prices). This time, however, the Government has not
contemplated any kind of global compensation and has made public
statements to this effect. Also, in mid-1993, the Parliament passed an
amendment to Law 76, which would impose interest penalties on overdue
obligations and establish an expedited judicial procedure to enable cred­
itors to obtain payment. Nevertheless, the question of how to resolve the
stock problem of existing arrears and the flow problem of new arrears is
again confronting the Government. More generally, changing the culture
of nonpayment, which was pervasive in 1991 and continued through 1992,
remains the major task for the Romanian Government.
III. Conclusions
Transforming the enterprise sector in Romania, as in other formerly
centrally planned economies, has proved a much slower process than
originally expected. Three years into the reform effort, a network of
large state-owned monopolies still dominate the economy. The down­
sizing, restructuring, technological upgrading, and reorienting required
of Romania's production sector remain to be done.
One of the major fallouts of the slow transformation was the phenom­
enal rise in interenterprise arrears in 1991. Enterprises, faced with a new
environment in which banks were no longer willing to supply credit
passively, in effect created their own means of payment. Running arrears
became a substitute for bank financing, with obvious adverse impli­
cations for the stabilization effort. Output eventually suffered as the
payments system became progressively inoperative and cash transfers
became the principal means of settlement.
The global compensation scheme implemented by the Government at
the beginning of 1992 was successful in clearing most of the interenter­
prise arrears and thus in unblocking the payments system. The particular
way this scheme was designed minimized the net injection of liquidity into
the economy, and even that liquidity was largely sterilized by the author­
ities. All in all, the monetary consequences of the operation were fairly
small relative to the size of the gross interenterprise arrears. To combat
the moral hazard consequences of the global compensation scheme, the
©International Monetary Fund. Not for Redistribution
694
ERIC V. CLIFTON and MOHSIN S. KHAN
Government introduced a new law that laid out specific procedures for
controlling any future interenterprise arrears and thus the need for any
further compensation operations. The provisions of this law, however,
have yet to be effectively implemented, and the problems with arrears
remain.
A permanent solution to the problem of interenterprise arrears must
involve the restructuring and privatization of state-owned enterprises.
The Government of Romania is proceeding in this direction. It has
selected a number of major enterprises for restructuring, primarily in the
chemical, metallurgy, and machine-building sectors, and is implementing
the Law on Privatization, which was passed in 1991. Under the Jaw,
"vouchers" for 30 percent of the share capital of enterprises were dis­
tributed in 1992 to Romanian citizens. Further, the State Ownership
Fund (which holds the Government's 70 percent share) and the National
Agency for Privatization are responsible for developing the privatiza­
tion strategy with the aim of promoting a more competitive industrial
structure through enterprise restructuring.
Jointly, the restructuring and privatization plans are expected to re­
store the financial health of enterprises in Romania. Once they are
achieved, and the appropriate legal framework established and operative,
the interenterprise arrears problem will presumably take care of itself,
as in Western economies (Begg and Portes (1992)). This is not to suggest
that government-sponsored bailouts will never occur. Even in the most
developed market economies, governments have needed to intervene
financially to support financial sector institutions and other large enter­
prises. This intervention has been selective rather than industry wide,
however, and can be rationalized on a variety of grounds.
The Romanian experience of 1991 with interenterprise arrears and the
attempts to resolve the problem have lessons for other countries that bear
spelling out.
• The problem of interenterprise arrears is a serious one; if not ad­
dressed, arrears can explode and create serious difficulties for the stabi­
lization and reform efforts. As the owner of the enterprises running
arrears against one another, the state has a direct responsibility to
intervene; it cannot take a hands-off approach.
• However, once the government has decided on a course of action
to resolve the arrears situation, it should proceed rapidly to imple­
ment the chosen measures. Public discussion over an extended period of
time, as the Romanian experience shows, creates obvious incentives for
enterprises to run larger arrears.
• The selected scheme should aim to clear most or all arrears or it
should not be undertaken at all. Too limited a scheme will leave the
©International Monetary Fund. Not for Redistribution
INTERENTERPR1SE ARREARS IN ROMANIA
695
problem unresolved and set up expectations of further extensions and
repetitions.
• In any scheme to eliminate arrears, the monetary consequences of
the operation must be taken into account. It must also be clear who is
to pay for the operation-enterprises, the banking system, or the budget.
Otherwise, behavior will not change, as each group will expect the others
to bear the cost.
• The scheme also must be designed so that credits are extended only
toward the clearance of arrears and so that there are no leakages. The
use of special compensation accounts in the Romanian operation pre­
vented enterprises from using credits to finance current expenditures and
make wage payments.
• To minimize the moral hazard problem, a method of ensuring that
arrears do not reappear must be adopted in conjunction with any chosen
scheme. Closing down a large, nonviable enterprise may provide an
important signal of the government's commitment to enforcing financial
discipline. This step has proven extremely difficult in all transform­
ing economies, however. Nonetheless, some way must be found to
demonstrate that the government's statements about future bailouts are
credible.
• The government will have to take the lead in initiating bankruptcy
proceedings against defaulting enterprises. Experience has shown that
banks and other creditors are highly unlikely to take debtor enterprises
to court. Regardless of the fact that the state owns the enterprise, the
government must become involved anyway when it comes to enter­
prises considered "too big to fail." In Romania, for example, past policies
have emphasized the geographical dispersion of enterprises, leaving
many towns hostage to the fortunes of one or two large enterprises.
Liquidation of these large "Kombinats" would cause serious unem­
ployment and severe regional distress, making government intervention
necessary anyway.
• Ultimately, privatization is the solution-the faster this occurs, the
faster arrears will disappear. In a largely private system, interenterprise
credits will be part of normal business, and overdue payments will be
handled appropriately through the legal system.
REFERENCES
Begg, David, and Richard Portes, Enterprise Debt and Economic Transforma­
tion: Financial Restructuring in Central and Eastern Europe" (unpublished;
Centre for Economic Policy Research, 1992).
"
©International Monetary Fund. Not for Redistribution
696
ERIC V. CLIFTON and MOHSIN S. KHAN
Borensztein, Eduardo, Dimitri Demekas, and Jonathan D. Ostry, "An Empirical
Analysis of the Output Declines in Three Eastern European Countries,"
Staff Papers, International Monetary Fund (March 1993), pp. 1-31.
Calvo, Guillermo, and Fabrizio Coricelli, "Stabilizing a Previously Centrally
Planned Economy: Poland 1990," Economic Policy, Vol. 14 (1992), pp.
176-226.
Daianu, Daniel, "Inter-Enterprise Arrears in Post Command Economy:
Thoughts from a Romanian Perspective" (unpublished; International Mon­
etary Fund, 1993).
Demekas, Dimitri, and Mohsin S. Khan, The Romanian Economic Reform
Program, Occasional Paper No. 89 (Washington: International Monetary
Fund, 1991).
Ickes, Barry W., and Randi Ryterman, "Inter-Enterprise Arrears and Financial
Underdevelopment in Russia" (unpublished; International Monetary Fund,
1993).
Rostowski, Jacek, "The Inter-Enterprise Debt Explosion in the Former Soviet
Union: Causes, Consequences, Cures" (unpublished; International Mone­
tary Fund, 1992).
©International Monetary Fund. Not for Redistribution
IMF StaffPapers
Vol. 40, No. 3 (September 1993)
Q 1993 International Monetary Fund
Shorter Paper
The Budget Deficit in Transition
A Cautionary Note
VITO TANZI*
This paper discusses major fiscal issues faced by the previously centrally
planned economies in their transition to market economies. It focuses on
the extent to which the budget deficit should guide policy and the in­
teractions between fiscal policy and other aspects of the macroeconomy.
[JEL H2, H3, HS, H6, P2, P3)
D
URING CENTRAL PLANNING, it was not really meaningful to speak of
since these concepts imply the exis­
tence ofprivate finance and thus a significant private sector. 1 In that era,
all was public in a way. However, many "fiscal" functions, as defined in
market economies, were carried out not by government but by state
enterprises. These enterprises often provided to their workers housing,
hospital care, vocational training, kindergarten facilities, shops, pen­
sions, various forms of welfare assistance, employment, and so forth.
They were also responsible for much "public" investment. Because the
state enterprises were required to hire workers even when they did not
need them, official unemployment was nonexistent. As a consequence,
no programs existed to protect unemployed workers. In economies in
transition, state enterprises are still carrying out many of these fiscal
fiscal policy and public finance
* Vito Tanzi is Director of the Fiscal Affairs Department. He holds a doctorate
from Harvard University. Very useful comments were received from S .J. Anjaria,
Gerard B elanger, Guillermo Calvo, Carlo Cottarelli, Manuel Guitian, George
ling-Smee, and several colleagues within the Fiscal Affairs Depart­
lden, John O d
ment. The author is solely responsible for the views expressed.
1 Recall that, in market economies, p ublic sector activ1 ty is largely justified by
(private) market failure See Stiglitz (1989) and Musgrave (1959).
.
697
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VITO TANZI
functions and are still hoarding workers. For the transformation to mar­
ket economies to be completed, most legitimate social functions must
be shifted from the state enterprises to the government. As this shift
takes place, spending by the enterprises will fall and spending by the
government will rise. 2
In spite of occasional divergent views, most economists agree that, in
market economies, the fiscal deficit is a useful guide for assessing fiscal
policy. A large deficit indicates that (unless a strong case to the contrary
can be made) fiscal policy should become more restrictive. The concept
of fiscal deficit implies that government activities can be sharply delin­
eated from those of the private sector.3 Thus, expenditures and revenues
are either public or private. The measure of the fiscal deficit requires that
the difference between what the public sector spends and what it collects
can be accurately calculated. With full employment, if the public sector
spends more, the private sector must spend less, unless the economy is
able to attract foreign saving. Thus, the existence of a fiscal deficit implies
some (unwanted) crowding out of the private sector unless Ricardian
equivalence or a Keynesian multiplier can be assumed to operate.
I. Budget Deficit Limits and Perverse Incentives
There are several reasons for caution when using this concept to guide
policy action during the transition. Some of these reasons are conceptual.
Others deal with measurement problems. Still others originate from the
possibility that strict limits on an inadequate measure of the fiscal deficit
may create perverse incentives, which may slow down the transformation.
Transferring
Social Expenditure Responsibility
State enterprises in economies in transition continue to dominate eco­
nomic activity and provide social services to workers and their families.
Some of these services are provided in place of higher money wages.
Others are provided in place of higher budgetary expenditure. In other
words, these enterprises continue to perform some functions that in
market economies are financed through the government budget.
The transition to a market economy requires that the budget assume
the responsibility for those social functions that the country wishes to
2 This does not imply that the government needs to assume all the functions now
carried out by the enterprises.
3 It also implies that the fiscal activities of the government can be separated
from the monetary activities. For example. the fiscal activities of central banks
must be assessed as part of fiscal policy.
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BUDGET DEFICIT IN TRANSITTON
finance publicly.4 This transfer to the budget should occur regardless of
whether the state enterprises are privatized or not. The faster it occurs,
the easier it will be for the enterprises to be privatized or to become
economically viable while remaining state owned.
The transfer of these functions to the budget will increase
budgetary
expenditure and, unless revenue is raised correspondingly, will also in­
crease the budget deficit.5Thus, the transfer should also reduce the credit
needs of the state enterprises. For most of these countries, however, there
is little solid knowledge about the potential impact on the budget of a
total or partial transfer of these functions.6 In Russia, "the government
appears not to have quantified the dimensions of this problem or planned
a solution" (Wallich (1992, p. 7)). The more important are these func­
tions and the faster and the larger is their transfer to the budget, the
greater will be the growth of budgetary expenditure. Thus, ex ante limits
on the size of the budget deficit should explicitly allow for the budgetary
cost of transferring some of these functions from the state enterprises to
the budget.7 The possibility must be recognized that a limit on the budget
deficit that ignores this transfer might be met by the government delaying
the transfer of
these social functions from the enterprises to the budget.
This delay would slow down the process of transformation but would not
reduce credit expansion if the banking system continues to react to the
needs of the enterprises.
If a decision were made to subsidize some loss-making state enter­
prises, it would be better economic policy if they were subsidized through
the budget rather than through soft and cheap loans from the banking
system.8 However, subsidies financed through the budget increase the
budget deficit, and cheap loans do not.
It would be unrealistic to assume that subsidies to enterprises, whether
4 The functions not taken over by the budget should no longer be the re­
sponsibility of the public sector and the state enterprises. By adJUSting money
wages, workers could be given greater discretion over the use of the total compen­
sation they receive while the state enterprises could stop having to provide social
services.
5Throughout the paper, the term "budget deficit" is used for that part of the
fiscal deficit that is actually accounted for by the budget. This is the measure of
deficit normally reported in newspapers and in government reports. The theoret­
ical concept of the fiscal deficit is much more comprehensive and much more
difficult to measure (see various papers in Blejer and Cheasty (1993)). It extends
to the whole public sector and includes quasi-fiscal deficits.
6There is no available estimate of the magnitude of these social functions. The
World Bank is attempting to quantify them for Russia. The assumption is that
they are quite important.
7These limits may be self-imposed or negotiated with international institutions
or other creditors.
8The current situation in Russia, where the central bank continues to subsidize
the state enterprises in particular sectors through subsidized credit and, in the
process, creates inflationary pressures. shows the importance of this issue.
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VITOTANZI
through the budget or through cheap and soft loans, could be completely
and permanently abolished in the short run. Some of these enterprises
(especially those in the defense industry) will be able to restructure and
become economically viable only if they receive financial support for
some time. It would also be unrealistic to assume that those who make
or influence economic policy would look at cheap credit given directly
through the banking system in the same way as they look at subsidies
financed through the budget. 9 Thus, the argument that has occasionally
been made-that the provision of subsidies through the banking system
or the budget is only an accounting issue and would disappear if one
measured the fiscaJ deficit in a comprehensive and economically sound
way10-ignores the important point that economic policy is not always
guided by the most economically correct concepts and that, in any case,
the measurement of the all-embracing fiscal deficit is next to impossible
under the circumstances prevailing in these countries. Thus, the mea­
sured (budget) deficit is likely to continue exerting more influence on
policymakers and public opinion, both within and outside the countries,
than the true but unknown (fiscal) deficit. For this reason, policymakers
have an incentive to show a smaller budget deficit even when this action
may conflict with other important economic and social objectives, such
as the speed of transition to a market economy.
If the government raised taxes on state enterprises' profits at the same
time that the banking system extended cheap or soft loans to these
enterprises, the budget deficit would fall
expansion.
without reducing monetary
This implies that focusing on the budget deficit may lead
observers and policymakers to miss the underlying cause of monetary
expansion and could lead to the apparently anomalous situation (experi­
enced by Poland and, especially, Yugoslavia) of high inflation with the
budget in surplus.
Budget Deficit and Inflation
The relationship between inflation, the budget deficit, and the public
debt is also relevant to this discussion. To the extent that there is a
9 For one thing, it is difficult to calculate the subsidy element of subsidized
credit. See, for example, the paper by Michael Wattleworth, "Credit Subsidies
in Budg etary Lending: Computation, Effects, and Fiscal Implications," in Blejer
and Chu (1988). Also, subsidies, given through the budget, would most likely be
associated with more careful, or at least more politically debated, decisions about
which enterprises should be subsidized.
10This measure would count the social expenditure by state enter rises in the
p
same way as budgetary expenditures. It would also count the subsidies given by
the banking system as public spending. See, for example, Begg and Portes (1992).
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701
BUDGET DEFICIT IN TRANSlTION
domestic public debt, an increase in the nominal interest rate paid on the
public debt will be reflected in government expenditure and in the size
of the budget deficit even if the rate of the increase matches exactly the
increase in inflation-in other words, even if the
real interest
rate does
not change. Given a significant public debt and a potentially high but
unknown future rate of inflation, it is difficult to predict the effect on the
deficit if the government pays a given
real interest rate on its debt. Given
a real rate of interest, the rise in the deficit will be a direct function of
the size of the debt and the level of the nominal interest rate, which, in
turn, will depend on the inflation rate. The potential effect of a change
in the rate of inflation on the conventionally measured budget deficit
could be very large.
11
In the situation described above, a government that has an interest in
showing a smaller budget deficit might be tempted to
repress
nominal
interest rates, thus creating difficulties for the development of the finan­
cial sector and for the allocation of financial resources. Under inflation­
ary conditions, concepts such as the operational or the primary deficit,
which attempt to eliminate the impact of inflation on the deficit, may have
to be used. But they will only correct the
budget
deficit rather than
measure the true fiscal deficit. Furthermore, these concepts have their
own limitations.
Budget Deficit and the Unemployment Rate
If state enterprises lay off redundant workers in order to improve their
efficiency and, as a consequence, the government's spending for unem­
ployment compensation increases, the change will cause the budget
deficit to rise. The rise will depend on the level of unemployment com­
pensation per worker and on the
number of unemployed
workers. For a
given level of unemployment compensation per worker, the larger the
adjustment in the work force by the state enterprises, and thus the greater
the number of unemployed workers, the larger will be the potential
impact of this adjustment on the budget deficit. Should the government
be excessively concerned about the size of its budget deficit, it may
encourage the state enterprises to continue hoarding workers.
The potential impact of this factor on the budget deficits of countries
in transition can be appreciated by the fact that falls in output that have,
at times, been as large as, or larger than, 30 perc ent of GDP have
11
The relationship between the fiscal deficit, public debt and the inflation rate
discussed in Tanzi, Blejer, and Teijeiro (1987). For references to the impact
of this factor on the fiscal deficit of Latin American countries, see Tanzi (1992).
was
,
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VlTOTANZI
generally not resulted in corresponding increases in unemployment.12 If
these countries had behaved like market economies, they would have
experienced unemployment rates not seen since the Great Depression of
the 1930s. 13 As long as the state enterprises continue to hoard workers,
they will not be able to restructure and become efficient and competitive.
It will also be more difficult to privatize them. 14 However, when the
enterprises fully adjust their employment to their greatly reduced pro­
duction needs, and the governments take responsibility for financing the
cost of unemployment, budgetary expenditures will go up. This increase
must be taken into account in setting ex ante limits on the deficit, but it
may be very difficult to forecast.
Budget Deficit and the Exchange Rate
If a country devalues its official exchange rate, its interest payments on
foreign debt
measured in domestic currency
will rise, thus increasing
public spending, and government expenditure on imports measured in
domestic currency will also rise. Both of these factors would tend to raise
the budget deficit.15 On the other hand, the devaluation will also increase
the domestic value of exports by the public sector and the revenue from
some taxes. However, if the proceeds from the public sector exports are
outside the budget, even if the exporters are public institutions, the
improvement will not be reflected directly in the budgetary accounts
unless the exporters contribute significantly to tax revenue.16 In other
words, the budget deficit will rise, and the rise will depend on the size
12 The situation is changing. For example, the unemployment rate in Hungary
has risen from less than 1 percent in the first half of 1990 to more than 11 per­
cent in September 1992. In Bulgaria, it has risen from 1.6 percent in 1990 to
14 percent in 1992; in Poland, from 6.3 percent in 1990 to 13.5 percent in October
1992; and in Romania, from zero in 1990 to 10 percent in 1992. For the fall in
output up to 1991, see IMF {1992a, p. 46). For the estimated fall in 1992, see IMF
(1992b, p. 19).
13 Rates of 25 percent or higher were recorded.
14 In fact, privatization may in some cases raise the size of the fiscal deficit if
the social expenditures that the government has to take over from the state
enterprise exceed the revenue from the sale of the enterprise.
15 If the government is unable to pay the interest on the foreign debt, there will
be a difference between accrued and cash measures of the budget deficit. Domes­
tic arrears to and from the government also create differences between cash and
accrued measures of the budget deficit.
16The difficulties of the central governments of many of these countries, in
controlling the accounts and the actions of the whole public sector, indicate that
the budget may not be the beneficiary of devaluation.
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BUDGET DEFICIT IN TRANSITION
703
of the devaluation. 17 Rigid ex ante limits on the measured size of the fiscal
deficit (that is, limits on the budget deficit) might encourage the author­
ities to delay the needed exchange rate adjustment especially when the
external debt is large and the government's imports are significant.
Shifting Expenditures out of the Budget
Another perverse incentive that may arise from the attempt to show
a smaller budget deficit or to stay below a too rigid limit is that of pushing
expenditures out of the budget and into other parts of the public sector,
whether extrabudgetary accounts or lower levels of government. Indeed,
extrabudgetary accounts have proliferated in many economies in transi­
tion, though information on them has been elusive. Also, sizable expen­
ditures have been shifted onto local government. In this context, it may
be worthwhile to cite from a study on fiscal decentralization in Russia by
Christine Wallich
(1992,
p. 3):
In the fiscal program for 1992, most of the major cuts were made in central
government expenditures-centrally financed enterprise investment, pro­
ducer and consumer subsidies, and defense. These cuts were followed by a
decision to delegate an important part of social expenditures (early in 1992),
and investment outlays (later on) to the subnational level. On the tax side,
the budget envisages a marked increase in taxes, primarily on petroleum
products and foreign trade. Thus, virtually all additional revenue will accrue
to the federal government, while most of the additional social expenditures
will emerge at the subnationa/ level (italics in original).
Wallich's conclusion is also worth citing:
The basic strategy has been to · push the deficit downward'. by shifting
unfunded expenditure responsibilities down in the hope that the subnational
level will do the cost cutting (pp. 3-4).
'
These are just a few examples of the possibilities that call for caution
in the use of the budget deficit in guiding economic policy during the
transition. They do not exhaust the possibilities. 18 They all point to the
17This discussion points to the importance of bringing the foreign trade area
within the tax net. For example, it is important for imports to be subjected to the
value-added tax.
18For example, a solution to the bad debt problem of the commercial banks
and the arrears among enterprises might be delayed by the fact that the solution
would raise the budget deficit. Begg and Portes (1992) have argued that if the
deficit were properly measured, these policies would not change its size. How­
ever, the assumption of the bad debt of the banks by the government, by replacing
bad assets with good assets would allow them to give more loans that might
increase th e liquidity of the economy.
,
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VITOTANZI
need to ensure that perverse incentives are not created by reliance on
narrow concepts ofthe deficit. These incentives will exist when the deficit
covers only a part of the public sector and when the limits imposed on
it are too rigid. In this case, there will be an incentive to "park" the deficit
where it cannot be measured or to postpone structural adjustments that
may tend to increase the size of the measured deficit. 19
11. Need to Separate Fiscal from Monetary Policy
A total and sharp separation between fiscal and monetary policy is next
to impossible in any economy. There are always overlapping areas. For
example, when central banks change the discount rate or engage in open
market operations, these actions have an impact on the budget deficit.
In general, these two policies are less clearly separated in developing
countries than in industrial countries. In Latin America, for example, the
central banks have, in several cases, engaged in activities that have caused
them to experience large quasi-fiscal deficits.20 In Chile, for example, a
quasi-fiscal deficit arose during the 1980s as a result of the central bank
assuming the bad debts of the commercial banks. This assumption was
clearly a fiscal operation that could have been carried out by the budget
if budgetary conditions at the time had been more sound. In other cases,
the central banks assumed the foreign debt of enterprises.
In general, the less developed the institutions of a country, the more
difficult it is to separate monetary and fiscal policies and the more difficult
it is to measure the true size of the fiscal deficit. More often than not it
is the weakness ofthe fiscal institutions (for example, the inability to raise
needed revenue) that forces the monetary institutions to assume a fiscal
role. However, making the budget deficit look better than it is also plays
a role.
Normally, economic policy is improved when monetary and fiscal
policies are pursued according to their own specific roles. In this case, if
an enterprise needs to be subsidized, the subsidy should be given through
the budget. If this results in a budget deficit, the deficit should be financed
by the country's treasury through the sale of bonds carrying market
2
interest rates. 1
19There will also be an incentive to reduce the cash deficit by postponing
palcments, thus increasing arrears.
0 See the recent paper by Fry (1993).
21 When the financial market is not well developed, or when the credibility of
the government is not good, this source of financing is not available. However,
if the deficit is to be financed through inflationary finance, it may still be better
if this finance is directJy allocated to the budget and the budget finances the
various activities includmg subsidies to state enterprises.
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BUDGET DEFICIT IN TRANSITION
705
The budget deficit is a highly watched economic barometer. A larger
deficit always sends warning signals, both domestically and internation­
ally. Therefore, countries have an incentive to limit its size either by
genuine fiscal adjustment or by pursuing second-best policies, the result
of which may be even more damaging than if the budget deficit had been
allowed to rise. In other words, the bias is almost always for showing a
budget deficit that appears smaller than it would be if the true fiscal deficit
were correctly measured. At times, this reduction is achieved through
policies that do not reduce the real or underlying fiscal deficit but only
the measured budget deficit. In other words, gimmicks are used to lower
the budget deficit artificially.22
During the transition, to the extent possible, it is important to contain
the inflation rate without resorting to direct price controls.23 To achieve
this objective, the most important macroeconomic instrument for both
market economies and economies in transition is credit expansion, not
the budget deficit. Once total credit expansion is determined, the coun­
tries should be encouraged to continue improving the efficiency of the
economy as well as the fiscal accounts. They should be encouraged to
reduce particular categories of public expenditure, to make others more
productive, and to raise government revenue in an efficient way to
contain the public sector fiscal deficit. They should also be encouraged
to speed up the various adjustments mentioned above, even when these
adjustments may result in increases in (measured) budget deficits. Impor­
tant among these adjustments is the transfer to the government of the
essential social functions shouldered by the state enterprises.
Another important point to recognize is that which makes the
economies in transition different from normal market economies: for
given total credit, an increase of the (measured) budget deficit does not
necessarily crowd out what, in market economies, is the private sector.
Much of the credit expansion goes to the state enterprises and the
government, and only a small residual goes to the emerging private
sector. A large reallocation of credit between the budget and the state
enterprises can take place without necessarily affecting the private sector.
This reallocation could be fully consistent with the objectives of the trans­
formation. If state enterprises (a) shed redundant workers, (b) transfer
to the government the responsibility for
essential social
functions, (c) no
longer finance nonessential social functions (such as vacation for work22This is not only a problem of economies in transition. In fact, it has been a
fre uent problem m adjustment programs. See Tanzi (1989).
JHowever, because of the changes in relative prices during the transition, it
may not be wise to aim for an inflation rate that is too low since this would require
a fall in prices in some sectors.
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VITOTANZI
ers), and (d) compensate the workers for a fraction of these reductions
through some adjustment in the level of nominal wages, then the net
result of these changes could very well be a larger budget deficit
more efficient economy.
with a
This change could also be achieved without
additional credit expansion if the additional credit to the budget to
finance its new responsibilities were compensated by lower credit to the
state enterprises to reflect their reduced social responsibilities.
Ill. Concluding Remarks
The paper has shown that in situations where the role of the govern­
ment has not yet been determined, where the budget must assume some
responsibilities now carried by state enterprises, and where "property
rights"
within the public
sector are ill-defined, the budget deficit, which
is calculated by looking at the behavior of budgetary revenue and expen­
diture, has less informational value than generally assumed. This deficit
may often widely differ from the true fiscal deficit for the whole public
sector and may even move in a different direction. The true fiscal deficit
would include the fiscal activities of the state enterprises and the central
bank.
Under particular circumstances, containing the budget deficit will not
necessarily make more resources available to the private sector and may
even slow down the structural reforms necessary to make the transition
successful. The above conclusion should not, however, be understood to
mean that fiscal policy is irrelevant. If there is a message that follows from
the discussion, it is (a) that the most comprehensive and economically
sound measure of the fiscal (not
budget)
deficit should be used to guide
policy and (b) that the transfer of functions from state enterprises to the
government will need to.be taken into account in setting limits to the size
of the deficit. If this is not possible, then the budget deficit should be
deemphasized. In any case, structural reforms and total credit expansion
must receive the full attention they deserve.
REFERENCES
Begg, David, and Richard Portes, "Enterprise Debt and Economic Transforma­
tion: Financial Restructuring of the State Sector in Central and Eastern
Europe," CEPR Working Paper No. 695 (London: Centre for Economic
Policy Research, 1992).
©International Monetary Fund. Not for Redistribution
BUDGET DEFICIT IN TRANSITION
707
Blejer, Mario, and Adrienne Cheasty, eds., How to Measure the Fiscal Deficit:
Analytical and Methodological issues (Washington: International Monetary
Fund, 1993).
Blejer, Mario, and Ke-young Chu, eds., Measurement ofFiscal Impact: Method­
ological Issues, IMF Occasional Paper No. 59 (Washington: International
Monetary Fund, 1988).
Fry, Maxwell, "The Fiscal Abuse of Central Banks,'' IMF Working Paper No.
93/58 (Washington: International Monetary Fund, 1993).
International Monetary Fund (1992a), World Economic Outlook (Washington:
International Monetary Fund, October 1992).
-- (1992b), World Economic Outlook, Interim Assessment (Washington:
International Monetary Fund, December 1992).
Musgrave, Richard, The Theory of Public Finance (New York: McGraw-Hill,
1959).
Stiglitz, Joseph, The Economic Role of the State (Oxford: Basil Blackwell, 1989).
Tanzi, Vito, "Fiscal Policy and Economic Reconstruction in Latin America,"
World Development, Vol. 20 (May 1992), pp. 641-57.
,·'Fiscal Policy, Growth, and the Design of Stabilization Programs,·· in
--
Fiscal Policy, Stabilization, and Growth, ed. by Mario Blejer and Ke-young
Chu (Washington: International Monetary Fund, 1989).
Tanzi, Vito, Mario Blejer, and Mario 0. Teijeiro, "Inflation and the Measure
of Fiscal Deficits," Staff Papers, International Monetary Fund, Vol. 34
(December 1987), pp. 711-38.
Wallich, Christine I., Fiscal Decentralization: lntergovernmemal Relations in
Russia (Washington: World Bank, 1992).
©International Monetary Fund. Not for Redistribution
IMF StaffPapen
Vol. 40, No. 3 (September 1993)
� 1993 International Monetary Fund
IMF Working Papers
Staff Papers draws on !MF Working Papers, which are research studies
by members of the Fund's staff. A list of Working Papers issued in 1993:2
follows.
"Labor Market Issues in Belgium: An International Perspective," by Reza
Moghadam [93/32]
"Net Foreign Assets and International Adjustment: The United States, Japan,
and Germany," by Paul R. Masson, Jeroen Kremers, and Jocelyn Home
[93/33]
"Do Capital Flows Reflect Economic Fundamentals in Developing Countries?"
by Atish R. Ghosh and Jonathan D. Ostry [93/34]
"Reserve Requirements and Monetary Management: An Introduction," by
Daniel C. Hardy [93/35]
"Experience with Floating Interbank Exchange Rate Systems in Five Developing
Economies," by Vicente Galbis [93/36]
"Private Saving, Public Saving, and the Inflation Tax: Another Look at an Old
Issue," by A. Javier Hamann
[93/37]
"Real Exchange Rate Targeting Under Imperfect Asset Substitutability," by
J. Saul Lizondo [93/38]
"Economic Reform in Arab Countries: A Review of Structural Issues for the
Remainder of the 1990s," by Mohamed A. EI-Erian and Shamsuddin Tareq
[93/39]
"Toward an Economic Theory of Multilateral Development Banking," by Gerd
Schwartz (93/40]
"Exports and Economic Development," by Delano Villanueva [93/41)
"Poland: The Social Safety Net During the Transition," by Xavier Maret and
Gerd Schwartz [93/42]
"On Improving Public Expenditure Policies for the Poor: Major Informational
Requirements," by S. Ehtisham Ahmad and Nigel Chalk (93143]
"The Relation Between Skill Levels and the Cyclical Variability of Employment,
Hours, and Wages," by Michael Keane and Eswar Prasad (93/44]
"The Behavior of Nontradable Goods Prices in Europe: Evidence and Interpre­
tation," by Jose De Gregorio, Alberta Giovannini, and Thomas H. Krueger
(93/45]
"Viet Nam: Reform and Stabilization, 1986-92," by Gabrielle Lipworth and
Erich Spitaller [93/46]
"Price Reform and Durable Goods in the Transition to a Market Economy," by
Pierre-Richard Agenor (93/47]
"DEER Hunting: Misalignment, Debt Accumulation, and Desired Equilibrium
Exchange Rates," by Michael J. Artis and Mark P. Taylor
(93/48]
708
©International Monetary Fund. Not for Redistribution
IMF WORKING PAPERS
709
''Introduction of a New National Currency: Policy, Institutional, and Technical
Issues," by Richard K. Abrams and Hernan Cortes-Douglas (93/49]
"Optimal Tariffs: Theory and Practice," by Arvind Subramanian, Ali Ibrahim,
and Luis A. Torres-Castro [93/50]
"Public and Private Investment and the Convergence of Per Capita Incomes
in Developing Countries," by Mohsin S. Khan and Manmohan S. Kumar
[93/51]
"Revisiting Japan's External Adjustment Since 1985," by Guy Meredith [93/52]
"An Analytical Framework of Environmental Issues," by Jonathan Levin [93/53]
"Lessons in Fiscal Consolidation for the Successor States of the Soviet Union,"
by George Kopits [93/54]
IMF Papers on
Policy Analysis and Assessment
Papers on Policy Analysis and Assessment, a new series of research
papers, are intended to make staff work in the area of policy design
available to a wide audience. A list
of all PPAAs issued in 1993:2 follows.
Papers may also be considered for inclusion in the journal.
"Restructuring of Commercial Bank Debt by Developing Countries: Lessons
from Recent Experience," by Charles Collyns [93n]
An annual subscription to IMF Working Papers is available for US$200.00. It
includes 12 monthly shipments and priority mail delivery. Requests should be
made to:
International Monetary Fund
Publication Services
Washington, D.C. 20431, U.S.A.
Telephone: (202) 623-7430
Telefax: (202) 623-7201
Inquiries about individual IMF Papers on Policy Analysis and Assessment should
also be directed to the address above.
©International Monetary Fund. Not for Redistribution
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In statistical matter throughout this issue,
dots (... ) indicate that data are not available;
a dash (-) indicates that the figure is zero or less than half the final
digit shown, or that the item does not exist;
a single dot (.) indicates decimals;
a comma (,) separates thousands and mi 11ions;
''billion'' means a thousand million, and "trillion'' means a thousand
billion;
a short dash(-) is used between years or months(for example. 199 1-93
or January-October) to indicate a total of the years or months inclusive
of the beginning and ending years or months;
a stroke(/) is used between years(for example. 1992/93) to indicate a
fiscal year or a crop year;
a colon (:) is used between a year and the number indicating a quarter
within that year (for example, 1993:3);
components of tables may not add to totals shown because of
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