The Southwest Economy, Issue 4, 1995

FEDERAL RESERVE BANK OF DALLAS ISSUE 4 – 1995

economic activity in some of these Chart 1 states that observers proclaimed Real Oil Price and U.S. Oil and Gas The Energy Extraction Employment energy “the tail that wagged the dog.” Real oil price Oil and gas employment Since the early 1980s, however, 1994 dollars per barrel Thousands of people Industry: state economies have become less 60 800 sensitive to and more alike in their Oil and gas extraction 700 Past, Present responses to changes in oil prices. 50 employment 600 These changes are the result of 40 trends in the energy industry that 500 And Future are likely to continue throughout 30 400 300 the 1990s. 20 200 Real oil price 10 Forces Shaping the Energy Industry 100

0 0 he energy industry figures promi- Several forces have shaped the ’60 ’64 ’68 ’72 ’76 ’80 ’84 ’88 ’92 T nently in many states’ economies. U.S. energy industry’s recent history. In Texas, for example, the energy The most apparent are prices, which Iran–Iraq war continued to exert industry produces about 12 percent are determined by world oil market upward pressure on prices. Prices of gross state product. For Wyoming, conditions, and resource depletion. climbed to $39 per barrel by 1981. the figure exceeds 25 percent.1 Government regulation, taxes and Over the next few years, how- Because the United States is an technology have also affected the ever, increased prices led to fuel- energy-importing country, its eco- industry. switching, energy conservation and nomy is hurt by rising oil prices. In The past 25 years have brought increased oil production outside fact, the economies of 41 states and four price shocks, three long-lasting of OPEC. A loss of market share the District of Columbia suffer when and one rather short-lived. The first exacerbated by slow world eco- oil prices rise. Nine states—Alaska, shock came in 1973 after the Orga- nomic growth led to a breakdown Colorado, Kansas, Louisiana, New nization of Petroleum Exporting of OPEC solidarity. World oil prices Mexico, North Dakota, Oklahoma, Countries (OPEC) announced pro- plummeted to $11 per barrel in Texas and Wyoming—benefit from duction cutbacks and an embargo 1986. In recent years, oil has gen- rising oil prices. In six of these of oil supplies to the United States in erally traded in a range from $17 to states—Alaska, Louisiana, New retaliation for U.S. support of Israel $20 per barrel, Mexico, Oklahoma, Texas and in the Arab–Israeli war. By January with a brief Wyoming—the response to an oil 1974, world oil prices had more spike to $30 per INSIDE price change is much stronger than than tripled. barrel during Can Currency Boards in the average state. In fact, oil price The Iranian revolution led to the 1990–91 Prevent Devaluations and movements in the 1970s and 1980s another sharp increase in world oil Persian Gulf Financial Meltdowns? had such pronounced effects on prices in 1979. The subsequent war. — Just Say Yes to Chile

1 Chart 2 a general increase in oil consump- domestic refineries will retain a con- U.S. Petroleum Production, Consumption and Net Imports tion, although usage dipped slightly stant share of the U.S. market. The in 1991. The Federal Reserve Bank principal factors in this differing out- Millions of barrels per day of Dallas predicts that continued look are weaker demand growth 22 Outlook economic growth, coupled with and the relatively higher cost of 20 moderate price increases, will stimu- transporting products compared 18 Consumption 16 late oil consumption over the with crude oil. 14 coming decades. One reason for concern about 12 Production With rising oil consumption and rising oil imports is dependence on 10 declining domestic production, the oil from politically unstable parts of 8 6 United States has been importing a the world. World oil reserves are 4 Net imports greater percentage of the oil it con- approximately 1,000 billion barrels 2 sumes. Oil imports are expected to (Map 1). OPEC countries hold 770 0 1975 1980 1985 1990 1995 2000 2005 2010 surpass domestic production in the billion barrels or (77 percent) of next few years. Although oil imports these reserves. Within OPEC, 66 have been rising, the ratio of energy percent of world reserves are in the Although current oil prices are consumption to gross domestic Middle East. North America has 8 near $20 per barrel, real (inflation- product (GDP) has been declining percent of world reserves. At 50 adjusted) oil prices are just above over time, reducing worries about billion barrels (or 5 percent), Mexico preshock 1973 levels. Chart 1 shows U.S. dependence on foreign energy has the seventh largest reserve base how closely employment in oil and sources. in the world, and the former Soviet gas extraction tracks oil prices. As In the U.S. market for refined Union has about 6 percent of world the price of oil rises and falls, so products, output in domestic refin- reserves. does U.S. employment in oil and eries has closely tracked consump- As the reserve levels suggest, gas extraction. tion in the U.S. market. This tight much world oil production comes The United States has produced relationship may not be maintained from OPEC—more than 40 percent oil for more than a century, and U.S. in the future. The U.S. Department in 1994. As world oil consumption fields are considered mature. Peak of Energy (DOE) expects that current grows and resources are depleted production was in 1970 when out- environmental regulations will pre- elsewhere, OPEC’s share of world put reached 9.6 million barrels per vent much expansion of domestic oil production will grow over time. day. Since then, resource depletion refining as the U.S. market expands. In recent years, however, non-OPEC has led to a general decline in Instead, DOE expects new refineries supplies have surged, particularly domestic production. The general to be built in the Caribbean region, in the North Sea. Lower taxes and decline was interrupted from the where environmental restrictions improved technology have kept mid-1970s to mid-1980s as oil prices are less stringent. In contrast, some North Sea oil production higher increased and production from the energy industry analysts believe than many analysts anticipated. North Slope of Alaska began. Because the United States has mature oil fields, production is from Map 1 a large number of small wells. In World Reserves 1991, the United States had more Billions of barrels than 600,000 wells, with an average production of 12 barrels per day. 663 In contrast, Saudi Arabia had 1,400 wells with an average production of

nearly 6,000 barrels per day. With 57 Former mature fields, the outlook for U.S. Soviet Union 80 17 production is continued decline, at Western North Europe America a rate of about 2 percent per year. Middle East The demand for oil responds to 45 Far East/ its price and to economic growth. Oceania Oil consumption surged in the 1970s 74 62 as the economy expanded (Chart Central and Africa 2), but higher oil prices reduced South America consumption in the early 1980s. Since 1985, economic growth and lower oil prices have contributed to

2 Chart 3 OPEC capacity. The Dallas Fed price Chart 5 Real Oil Price Outlook outlook falls below the Department U.S. Energy-Related Employment 1994 dollars per barrel of Energy’s midrange forecast. We Thousands 60 expect that oil prices lower than 800

those forecast by DOE will attract 700 1982 50 the required investment. 1992 600 2000 40 The uppermost and lowest fore- 500 High DOE cast lines reflect the Department of 30 Mid DOE Energy’s reasonable upper and 400 20 FRB Dallas lower bounds for oil prices. Major 300 Low DOE technological breakthroughs or a 200 10 lack of demand growth could lead 100 0 to prices below the range shown 0 1975 1980 1985 1990 1995 2000 2005 2010 Coal mining Oil and gas Oil field Refining Petro- here, but the probability of a sus- extraction equipment chemicals tained price below the lower bound is quite small. That is not the case for the former It would be surprising to see energy.2 Natural gas prices did not Soviet Union, where output has prices sustained above the Depart- move fully with crude oil prices in been declining. Physical and institu- ment of Energy’s upper bound. The the 1970s because price controls tional problems suggest that no upper bound path is reminiscent restricted the movement of well- reversal of this downward trend is of the typical forecast made in the head prices for natural gas. Looking likely until 2000. In the United 1980s when increasing scarcity meant forward, the relatively flat outlook States, the decline in oil production oil prices were expected to escalate for oil prices suggests a similar is unlikely to reverse, unless the from their current levels at some outlook for natural gas prices. drilling restrictions in environmen- real interest rate. Such a price path tally sensitive areas, such as the forecast typically fails to take into Implications of Changes in the Alaska National Wildlife Reserve account technological improvement Energy Industry and California coast, are eased. and the effect of higher prices in The dynamics at work in the stimulating supply and curtailing Our research indicates that energy industry make it difficult to demand. Nonetheless, supply dis- changes in the energy industry can predict oil prices. Nevertheless, ruptions could lead to temporary affect how regional economic activity Chart 3 presents several forecasts: excursions above the range. responds to oil prices.3 Changes in three from the U.S. Department of As shown in Chart 4, the move- the response to oil prices could alter Energy (DOE) and one from the ments in natural gas prices mirror the regional flavor of the debate Federal Reserve Bank of Dallas. those of oil. Research by Yücel and over U.S. energy policy. In the past, All these forecasts abstract from a Guo (1994) shows that oil and debate over energy policy had a political disruption. The Dallas Fed natural gas prices move together regional tone. Energy-producing forecast expects oil prices to be soft over long periods of time, while states favored policies, such as re- for the next five years and to remain natural gas prices remain below oil strictions on oil imports, that would in a range between $17 to $20 per prices for an equivalent amount of increase domestic prices. Energy- barrel (1994 dollars) through 2000. consuming states favored policies, This outlook is consistent with the such as price controls, that would futures market, and it reflects current reduce domestic prices. Dallas Fed Chart 4 excess capacity and the return of Real Natural Gas Wellhead and research indicates that the grounds Iraqi oil to international markets Crude Oil Prices for these regional divisions may by 1997. 1994 dollars per million Btu be lessening. The Dallas Fed forecast relies on In the 1970s and early 1980s, the the expectation that OPEC will reach 10 Outlook U.S. energy industry grew to keep 9 full capacity around 2000, as world pace with increasing demand and 8 Crude oil price oil demand grows and non-OPEC 7 sharply rising oil prices. As Chart 5 supply declines. After that, the fore- 6 shows, in 1982 five key energy cast predicts oil prices will gener- 5 industries—coal mining, oil and ally rise, reaching about $27 per 4 gas extraction, oil field equipment, barrel in 2010. Higher oil prices 3 petroleum refining and petrochemi- seem necessary to overcome political 2 cals—accounted for 1.6 million and economic obstacles to obtaining 1 Natural gas wellhead price jobs (0.8 percent of total U.S. non- 0 the investment needed to expand 1975 1980 1985 1990 1995 2000 2005 2010 farm employment).

3 Chart 6 becoming more similar to each Energy-Related Employment for Select States other and the national average in Percent of total non-agricultural employment their response to oil price changes.

16 However, as the chart shows, the Delaware Louisiana Oklahoma Texas West Virginia Wyoming rate of change is slowing. 14 13.7 The Dallas Fed projects that the 12.8 response to oil prices in Alaska, 12 11.8 Delaware, Louisiana, New Mexico, 10.3 Oklahoma, Texas and Wyoming 10 9.1 will remain substantially different 8.0 8 from the national average. Energy 7.4 7.3 7.2 6.8 is and will continue to be an impor- 6 5.8 tant difference between the nation 4.8 4.9 and these energy-intensive states. 4.0 4 3.4 3.6 2.7 2.5 The Changing Environment 2 For U.S. Energy Policy

0 1982 1992 2000 1982 1992 2000 1982 1992 2000 1982 1992 2000 1982 1992 2000 1982 1992 2000 The next three maps extend our

Coal mining Oil and gas extraction Oil field equipment Refining Petrochemicals analysis nationwide to examine the economic environment for U.S. energy policy (Maps 2, 3 and 4 ). The decline and later collapse of energy-intensive states. From 1982 On each map, red indicates states oil prices in the 1980s touched off to 1992, employment in the five key that are hurt by rising oil prices. a drastic downsizing of oil and gas energy industries declined in each The darker the red, the greater the extraction and related services. Coal of the nine states. The Dallas Fed impact. Delaware is the state hurt prices also fell, and coal mining projects the trend will continue most by rising oil prices. Green was reduced. Continued adjustment throughout the 1990s but at a indicates states that are helped by to earlier increases in oil prices, slower rate. rising oil prices. The darker the more stringent government regula- Chart 7 depicts the implications green, the greater the gain. In 1982, tion and productivity gains led to of continued diversification away Oklahoma and Wyoming benefited falling employment in refining and from energy-intensive and energy- most from rising oil prices. petrochemicals. producing industries. The estimates The pattern depicted in Map 2 By 1992, employment in the five underlying this chart take into illustrates why regional divisions key energy industries had fallen by account how higher oil prices would have developed in the debate over more than 600,000 jobs. More than affect each of the five key industries, energy policy and why the resolu- 350,000 jobs were lost in oil and as well as the rest of each state’s tion of conflicts may have tended gas extraction alone. At the same economy. From 1982 to 1992 and to favor consumers over producers. time, U.S. nonfarm employment 2000, the effects of the same per- As the map shows, 13 states would grew by 23 percent. By 1992, the centage increase in oil prices on have been helped by higher oil share of total nonfarm employ- each state diminish. States also are prices in 1982. The other 37 and ment represented by the five key the District of Columbia would energy industries was halved to have been hurt. 0.9 percent. Projections suggest that Chart 7 Between 1982 and 1992, as Map Employment Response to a 10-Percent by 2000, employment in the five Oil Price Increase 3 shows, Utah, Mississippi, West key energy industries will further Virginia and Montana diversified Percent change decline while total nonfarm em- away from energy production to 4 ployment expands. Delaware Texas the extent that they no longer West Virginia Oklahoma While energy-related industries 3 Louisiana Wyoming benefit from higher oil prices. The

have been shrinking, individual state 2 map also shows that the states economies have increasingly diver- have become less sensitive and 1 sified away from energy-intensive more similar in their response to and energy-producing industries. 0 oil prices. These changes suggest Since the early 1980s, nearly every Ð1 that the grounds for regional divi-

state has become less dependent Ð2 sions in the debate over energy on the five key energy industries. policy have lessened since the Ð3 Chart 6 illustrates the point for select 1982 1992 2000 early 1980s.

4 Map 2 As shown on the map for 2000 Oil Price Sensitivity, 1982 (Map 4 ), the Dallas Fed projects Kansas will no longer be helped by higher oil prices and that states generally will continue to become less sensitive to and more alike in their response to oil price movements. These changes suggest the grounds for regional divisions in the debate over energy policy are likely to diminish further in the 1990s.

Conclusions

Market fundamentals suggest that oil prices are unlikely to rise or fall sharply for a sustained period during the next decade. Political events could lead to temporary deviations from this outlook. Natural gas prices Map 3 Oil Price Sensitivity, 1992 will move in concert with oil prices but will remain below oil prices for equivalent amounts of energy. Regulatory constraints could hinder the growth of the domestic refining industry as the U.S. market for refined products expands. Since 1982, state economies have become less sensitive and more similar to each other in their response to oil price movements. The convergence suggests that the grounds for regional divisions in the debate over national energy policy have lessened since the early 1980s. These trends are likely to continue in the 1990s but at a slower pace.

Map 4 — Stephen P. A. Brown Oil Price Sensitivity, 2000 Mine K. Yücel

Notes

1 These percentages were true for 1991, the most recent year for which data are available. 2 See Mine K. Yücel and Shengyi Guo, “Fuel Taxes and Cointegration of Energy Prices,” Contemporary Eco- nomic Policy 21 ( July 1994): 33–41. 3 See Stephen P. A. Brown and Mine K. Yücel, “Energy Prices and State Eco- nomic Performance,” Federal Reserve Bank of Dallas Economic Review, Second Quarter, 1995.

5 erosion of political support might boards suggest that they may have tempt governments to abandon successfully prevented devaluations Can Currency currency boards during financial solely because they were run by stress. Then, the policies govern- foreign powers. Indeed, currency Boards Prevent ments impose to replace currency matters in those colonies were the boards may lead to the same de- responsibility of the British Secre- valuations and financial crises the tary of State for the Colonies, who Devaluations boards were designed to prevent. issued currency board regulations The recent experience of Argen- and appointed board members. And Financial tina suggests that currency boards Obviously, monetary policy in are not the panacea their advocates Mexico would be more credible claim. (See the sidebar.) were it administered by the Bundes- Meltdowns? bank. Hanke and Schuler’s pro- A Historical Perspective posed model for a modern currency board confirms the suspicion that Advocates claim there have been currency boards succeeded not many successful currency board because of their structure but be- experiences. For example, Hanke cause foreign powers controlled and Schuler (1994, 54) assert that them. According to Hanke and “approximately 70 countries have Schuler (1994, 81), currency boards had currency boards....” They fail should be run by “foreign directors to mention that most of those 70 appointed by commercial banks.” o the surprise of most, if not all, countries were British colonies in It is difficult to conceive how the T analysts and economic advisors, Africa, Asia, the Caribbean and the authority of foreign directors could Mexico’s December 1994 currency Middle East. be enforced against eventual popu- crisis quickly spread to other emerg- Few currency boards have ever lar opposition. Enforcement could ing economies. Investors’ fears that operated in independent countries. require military intervention by a those economies would devalue Those that did—North Russia, foreign power, something that might soon became evident in a swift, Danzig and Malaya—never lasted be unacceptable to the international massive and indiscriminate outflow more than four years. No orthodox community. of capital from Latin America that currency board operates today in observers dubbed the tequila effect. any independent country. The so- Currency Boards and the As the tequila effect rippled called Singapore currency board is Money Supply across the continent, living standards actually a department of the Mon- deteriorated for millions of Mexicans etary Authority of Singapore, which The currency board is a rule for and other Latin Americans. Mexico’s has the formal powers and respon- money creation: the currency board heightened risk of debt default sibilities of a central bank. Argentina’s issues money only against a desig- prompted a bailout by the Interna- current regime is perhaps the nated reserve currency at a fixed tional Monetary Fund and the closest to an orthodox currency exchange rate. Two common re- United States. board that exists today. serve currencies are the U.S. dollar Some observers contend that the The institutional arrangements and German mark. Mexican crisis and its damaging of all the British colonies’ currency The example in Chart 1 relies on spillover effects might have been avoided had Mexico had a currency board. Their arguments may sound Chart 1 Money Creation in a Currency Board System convincing, but they presume that once a currency board system is in $2 million place, a country will adhere to it forever. This assumption is as un- XX Currency Board XXXXXX realistic and naive as the belief that XXXXXX Deposits X $1 = 2 pesos a wedding ring guarantees an ever- 4 million pesos XXXXXXXX

lasting marriage. XXX Public Stubborn adherence to a currency Bank’s vaults 4 million pesos 2 million board exposes societies to severe pesos and protracted credit crunches, as in the Great Depression. Rising Wallets unemployment and consequent 2 million pesos

6 the U.S. dollar as the reserve currency. An investor (foreign or domestic) decides to invest $2 million Argentina’s Currency Board During a Financial Crisis in a country with a currency board. To buy the local goods, machines Argentina’s recent experience demon- Chart A Argentina: Base Money and Foreign Reserves, 1995 and labor required for the invest- strates what can happen with a currency board during a financial crisis. Argentina’s Billions of pesos ment, the investor needs the local monetary policy has operated very much currency and to that end, hands as a currency board would have since April 17 over $2 million to that country’s 1, 1991, when the country’s congress 16 currency board. In exchange, the approved a convertibility law. 15 local currency board gives the The law obligated the central bank 14 Base money to issue domestic currency (the peso) only investor local currency (say, pesos) 13 against the dollar value of foreign re- at the rate established by the fixed 12 serves. The law also fixed the exchange exchange rate (say, 2 pesos per rate at 1:1, or $1 per peso. This standard 11 Foreign reserves dollar). In other words, the currency is the basic rule for money creation under 10 board gives the investor 4 million a currency board arrangement. 9 January February March pesos of the currency board’s money Under the convertibility law, Argen- in exchange for the investor’s $2 tina’s base money and foreign reserves should move very much in tandem, as they do in Chart A. This million. This currency board money pattern is typical of currency board regimes, under which base money increases as foreign reserves rise is nothing but the bills and coins and decreases as foreign reserves fall. As the chart shows, foreign reserves started to fall in Argentina in January 1995, when the tequila people carry in their wallets. These effect spread and investors withdrew capital from the country in fear of a devaluation. The chart makes bills and coins are actually the apparent that currency boards are not seen as everlasting protection against devaluation. The reason is currency board’s liabilities—that is, because the same currency board features that prevent devaluations can exacerbate fears that the currency upon demand the currency board board will be abandoned. Under a currency board, a relatively minor Orange County-like liquidity crisis must exchange those bills and can become a full-blown financial panic almost overnight. This is what happened in Argentina. In such coins for the reserve currency. circumstances, governments come under rising pressure to restore the lender of last resort function that Part of the fiduciary money issued is part of monetary policy under a central bank but is incompatible with a currency board regime. Argentina’s problem started with a liquidity squeeze in Bank Extrader, a small bank that held barely by the currency board will remain 0.2 percent of all the deposits in Argentina’s financial system. Extrader was heavily exposed in Mexican in the public’s wallets, but the rest bonds and securities. When the value of those assets fell dramatically in the aftermath of Mexico’s December will be deposited in commercial 20, 1994, peso devaluation, the bank could no longer cover its short-term liabilities, particularly time deposits. banks. Those bills and coins (that This shortage triggered a bank run, making matters even worse. On January 18 the central bank was forced is, the currency board’s liabilities in to liquidate Extrader. Suddenly, the effect seen elsewhere in Latin America spilled into Argentina’s domestic the form of money) in the banks financial markets. Fear that other banks were also heavily exposed to the collapsing Latin American capital become the commercial banks’ cash markets led depositors to withdraw their money from the banks for the security of their mattresses or accounts abroad. reserves, which they use to make By April 30, the financial system had lost 18 percent of the deposits it had before the Mexican peso loans and create deposits through devaluation. To cover the withdrawals, the banks were forced to liquidate assets. One liquidation method the standard money multiplier. was not to renew lines of credit to consumers and businesses. Many businesses and consumers could Chart 1 depicts a hypothetical not pay off the loans on such short notice. When they did, it was by not paying other obligations. In economy in which half the money turn, the beneficiaries of those debts could not meet their obligations, and so on. created by the currency board stays In the wake of this panic, many banks had to suspend the payment of deposits. Some investors— in the public’s wallets and the rest foreign and domestic alike—have not yet been able to recover their savings. Real economic activity in Argentina has followed the decline of financial indicators. Sales of cars, apparel and consumer electronics is deposited in commercial banks. had fallen 20 to 40 percent by the end of April. Although currency boards are supposed to prevent the Typically, the public withdraws only kind of financial meltdown Mexico experienced, Argentina found itself in a crisis despite its monetary policy. a fraction of the banks’ cash reserves Given the magnitude of Argentina’s credit crunch, one wonders why Argentina has not followed Great on any given day. In this example, Britain’s example and suspended its currency board arrangement until the financial crisis is resolved. The banks must satisfy, on average, answer, as a great deal of economic research suggests, lies in the monetary authority’s credibility. daily cash withdrawals of only half Argentina lacks the distinguished track record that the Bank of England had when it suspended the their cash reserves, or 1 million gold standard. In fact, Argentina has made into the Guinness Book of World Records for its historically high inflation rates and, in particular, its hyperinflations of 1989–90, when inflation rates reached 200 pesos. One million pesos, then, percent per month. Therefore, it’s likely that investors would perceive a temporary suspension of the currency would be left idling in the banks’ board announced by the monetary authority as permanent. Such a perception would weaken investor confidence vaults. Of course, profit-driven and make the reconstruction of the financial sector more difficult and protracted, which, in turn, would bankers will lend that money by validate the perception that the suspension was not temporary but permanent. opening accounts against which Argentina’s bad credit history is what motivated policymakers there not to follow the British example borrowers can issue checks for up but to stand by the currency board, even at the risk of defeat in the recent presidential election. The hope to 2 million pesos. is that investors will recognize that a country willing to endure a severe recession and soaring unemployment rates to preserve its commitment to avoid inflation has set aside policies of the past and achieved reform. In this example, total deposits in the banking system after the loans

7 are 4 million pesos: (1) 2 million Moreover, the bills and coins issued Chart 2 pesos of the original deposit plus by the currency board are fully The Currency Board Rule Amount of bills and coins (2) the 2 million pesos of the ac- convertible on demand at the fixed = Promised fixed exchange rate counts opened to borrowers. The exchange rate into the reserve cur- Amount of reserve currency cash reserves are 2 million pesos, rency, and vice versa. 6 million exactly enough to cover presumed Because a currency board views cash withdrawals for 50 percent of the money issued by banks (depos- Pesos the deposits. In other words, the 2 its) as the banks’ private business, 4 million million pesos of cash reserves sup- currency boards do not regulate, 3 million port twice as much in deposits. If, supervise or provide any lines of Pesos however, all depositors simul- credit to financial institutions. Finan- 2 million 2 million taneously decided to cash in their cial institutions make their own U.S. $ U.S. $ Pesos checking account balances, the credit policies and their own deci- 1 million U.S. $ financial system would not be able sions about how much to maintain Reserve Bills Reserve Bills Reserve Bills to satisfy the demand for 4 million in cash reserves. Under a currency currency and coins currency and coins currency and coins

pesos in cash. board, financial institutions are on The difference between the their own. There is no discount win- money created by the currency dow they can go to if they have a board can always buy back the board (actual bills and coins) and sudden and severe liquidity problem. base money at the fixed exchange the money created by the commer- This is why countries with currency rate of 2 pesos per dollar. There cial banks is important: the currency boards are more prone to bank runs will never be devaluations. board’s money is fully backed by and financial panics than countries foreign reserves. In other words, with full-fledged central banks. Central Banks and Devaluation the currency board is able to buy back all of its liabilities (bills and Armor Against Devaluation If a monetary authority does not coins) in exchange for foreign follow the strict rule of printing currency at the established fixed Why, then, are currency boards money only against foreign reserves, exchange rate. seen as protection against devalua- it is no longer a currency board. It’s In contrast, deposits in the private tion? The reason is because the a central bank. When the monetary financial system are not backed by base money is fully backed by authority prints money that is not the currency board’s foreign re- foreign reserves. If reserves shrink backed by reserves, the country serves. The currency board is not by $1 million, the money base has risks devaluation. responsible for these deposits be- to shrink by that amount times the Central banks can issue money cause they are private money, exchange rate. In the example through the discount window to money created by private financial shown in Chart 2, this loss of re- provide funds to financial institu- institutions and, therefore, the pri- serves means the currency board tions with short-term liquidity prob- vate banks’ liabilities. In particular, reduces bills and coins in circula- lems. In effect, this action adds to this means that the currency board tion by 2 million pesos ($1 million the base money (Chart 3 ) without does not exchange checks for re- times 2 pesos per $1). If foreign adding foreign reserves and breaks serve currency. Anyone who wants reserves increase instead by $1 mil- the delicate balance between them. to carry out such a transaction will lion (from $2 million to $3 million), This imbalance introduces the possi- first have to go to the bank, ex- the base money increases by 2 bility that the central bank will be change the private money (check) million pesos. forced to devalue the currency. If for the currency board money (bills In other words, under a currency the public decides to exchange all and coins) and then go to the cur- board, the mechanism for expand- the base money in circulation for rency board window to exchange ing and contracting the money foreign currency, the central bank the cash for the reserve currency at supply ensures that the proportion will not be able to defend the the fixed exchange rate. of base money to reserves stays current exchange rate. In sum, the currency board’s constant at the fixed exchange rate. In the case of Chart 3, the cen- money is the base money, or in less As Chart 2 shows, a currency board tral bank would need $3 million to technical terms, the bills and coins keeps the base money (bills and buy back the base money of 6 mil- in the public’s pockets. Under a coins) and the reserve currency lion pesos at the exchange rate of currency board, the base money is proportionate, the proportion im- 2:1. The central bank, however, has fully backed by foreign reserves plicit in the fixed exchange rate. only $2 million of foreign reserves, because the currency board prints For example, the ratio of the base so it must exchange at the rate of 3 money only against the reserve money to foreign reserves is always pesos per $1. Thus, the local cur- currency at a fixed exchange rate. 2:1, which means that the currency rency has devalued 50 percent.

8 Armor or Straitjacket? Given the serious recessions that this question. In the meantime, two usually follow the credit crunches facts are evident. The armor against devaluation associated with bank panics, it is First, if there are such institutions, provided by a currency board can easy to understand why countries the currency board is not one of become a straitjacket in times of will be tempted to abandon cur- them. Currency boards can be aban- financial panic. As explained earlier, rency boards and similar systems doned, and the fallacy behind their private banks typically keep only a during financial panics. In fact, that alleged effectiveness is the assump- fraction of their deposits in cash. is precisely what Great Britain did tion they will never be. With a currency board, banks do on three occasions with its gold Second, the track record of a not have the safety net of a dis- standard, which works much like a country seems far more important count window when they need to currency board, but with gold for policy credibility than the par- borrow short-term funds to face playing the role foreign reserves ticular label (central bank or cur- transitory liquidity problems. Under play under a currency board sys- rency board) of the institutions that a currency board regime, the de- tem. In 1847, 1857 and 1866, Great conduct policy. The monetary posits and the banking system are Britain suspended the gold stan- policy of a central bank in a country literally running on the confidence dard to abort incipient financial that has always shown fiscal and of depositors. When that confi- panics. monetary discipline and never de- dence is broken, a bank panic can Scholarly research has shown faulted on its debts will be far more ensue quickly. The mere suspicion that, in Great Britain’s case, investors credible than the monetary policy that a bank is insolvent can cause expected convertibility to resume of a currency board in a country depositors to fear for their savings eventually (Bordo and Kydland that has a history of letting inflation because a bank typically does not 1995). Argentina’s current financial run unleashed, confiscating deposits have enough cash to cover all crisis raises the question of whether and defaulting on its debt. outstanding deposits (See Chart 1). Argentina could do as England did A currency board might help an This fear will trigger a run against and temporarily suspend its currency inflation-addicted country avoid a the bank, whose failure will create board without hurting its credibility. devaluation, but only if the country fears of other bank failures, in a The answer is probably not, be- maintains the currency board at all chain reaction that can end up in cause Argentina’s monetary policy costs. Countries adopting currency a full-blown financial panic. track record is not what Great boards must be ready to endure the Bank runs are less frequent and Britain’s was at the time the gold severe financial crisis and high severe with a central bank system. standard was suspended. unemployment that come with the With a central bank, an essentially credit crunch that is sure to follow solvent bank with short-term liquid- Conclusions a financial panic. Such panics are ity problems will not automatically likely because a currency board is go under as it would in a currency A currency board does not not a magic pill that restores cred- board system because it can appeal magically restore the credibility of a ibility instantly and painlessly. to the discount window to cover country’s economic policies, as When recommending currency the temporary cash shortage. some advocates claim. The reason boards, their advocates should is because currency boards can be warn policymakers that currency abandoned. When investors fear a boards will not spare them the time Chart 3 Devaluation: Central Bank Lends to Banks government is about to abandon its and economic hardships necessary currency board, they take their to restore the credibility lost at the Promised Fixed Exchange Rate capital out of the country, and hands of bad policies of the past. $1 = 2 pesos Before After financial panic typically ensues, as 6 million it recently did in Argentina. In such —Carlos E. Zarazaga circumstances, the armor against Discount window = 2 million pesos devaluations that a currency board References supposedly provides becomes a 4 million suffocating straitjacket societies and Bordo, M.D., and Finn E. Kydland (1995), their governments will be tempted “The Gold Standard as a Rule: An Essay in to cast off. Exploration” in Explorations in Economic Pesos Pesos History (forthcoming). 2 million 2 million Behind these issues is a deeper U.S. $ U.S. $ one. Are there political and eco- Hanke, Steve H., and Kurt Schuler (1994), nomic institutions that can guarantee Currency Boards for Developing Countries: Reserve Bills Reserve Bills governments will never break their A Handbook (San Francisco: Institute for currency and coins currency and coins promises? Economists and social Contemporary Studies Press). Effective exchange rate Effective exchange rate $1 = 2 pesos $1 = 3 pesos scientists are still trying to answer

9 Beyond the Border

Federal Reserve Bank of Dallas Just Say Yes to Chile Robert D. McTeer, Jr. President and Chief Executive Officer A Commentary by William C. Gruben Tony J. Salvaggio Research Officer First Vice President and Chief Operating Officer Federal Reserve Bank of Dallas Harvey Rosenblum Senior Vice President and Director of Research W. Michael Cox Vice President and Economic Advisor egotiations began in June to add racy. A commonly used statistical Stephen P. A. Brown N Chile to the North American measure of corruption places the Assistant Vice President and Senior Economist Free Trade Agreement. But in the country at the same level as the Research Officers United States, naysayers from both United Kingdom and Denmark. John Duca sides of the political spectrum have Chile has already solved policy Robert W. Gilmer William C. Gruben begun to quibble about voting for problems that have kept other Latin Evan F. Koenig fast-track authority, which would American nations at the chalk- Economists allow the administration to negoti- board. As a result, Chile, unlike Kenneth M. Emery ate a trade agreement subject to other countries in the region, has had Beverly J. Fox congressional vote but without 11 years of uninterrupted growth. David M. Gould Joseph H. Haslag congressional amendment. The purpose of liberalizing trade D’Ann M. Petersen U.S. officials have from time to with any country is efficiency. Keith R. Phillips time complained that the glacial Trade protectionism at any level Stephen D. Prowse Fiona D. Sigalla procedures of the General Agree- really means that government is Lori L. Taylor ment on Tariffs and Trade kept us bestowing uncompetitively high Lucinda Vargas from agreeing to mutually benefi- profits on some industries, the pro- Mark A. Wynne Mine K. Yücel cial trade openings as large as U.S. tected ones, at the expense of the Carlos E. Zarazaga policymakers would prefer with all buying public. But trade protec- Research Associates countries. The United States has tionism also means that, because of Professor Nathan S. Balke for years been urging developing these uncompetitively high profits, Southern Methodist University countries toward free trade and has capital and labor are misdirected to Professor Thomas B. Fomby invoked sanctions when they didn’t firms and industries that are profit- Southern Methodist University move fast enough. The central able because they don’t compete Professor Gregory W. Huffman Southern Methodist University theme of the Summit of the Americas and directed away from firms and Professor Finn E. Kydland last year in Miami was Western industries that can compete without University of Texas at Austin Hemispheric economic integration. such interference. With freer trade, Professor Roy J. Ruffin Now is the time for the United capital and labor will go where University of Houston States to send a message that it they are most productive, instead of Editors isn’t kidding about free trade, even to a profitable but less productive Rhonda Harris when a potential partner is a devel- use. With free trade, market signals Judith Finn Monica Reeves oping nation that can’t use our will bring greater efficiency, which country as a safety valve for its un- is simply more total output from Graphic Design Gene Autry employment problems. Fast-track the same capital and labor. Laura J. Bell authority for negotiations with Chile With fewer than 14 million Ellah K. Piña would send a message to the rest people, Chile is a small country, of Latin America about the commit- considerably less populous than the The Southwest Economy is published six times annually by the Federal Reserve Bank of Dallas. The views ment the United States professes. state of Texas. It nonetheless holds expressed are those of the authors and should not be A free trade agreement with Chile opportunities for greater efficiency, attributed to the Federal Reserve Bank of Dallas or the ought to be a no-brainer. In the last and the message Chile’s member- Federal Reserve System. Articles may be reprinted on the condition that the decade, Chile has privatized the ship in NAFTA would send is a source is credited and a copy is provided to the Research great majority of its public corpora- cheap form of advertising for more Department of the Federal Reserve Bank of Dallas. tions, liberalized investment markets, open trade with much larger Latin The Southwest Economy is available free of charge by writing the Public Affairs Department, Federal slashed tariffs and moved from a American countries. Reserve Bank of Dallas, P.O. Box 655906, Dallas, TX military government to a democ- 75265-5906, or by telephoning (214) 922-5257.

10 April, single-family permits rose in May to their highest level since January 1994. Regional Update The recent decline in the Texas value of the dollar is another sign of regional economic strength. After surging from The economy of the Eleventh District has been centered in sectors supplying November to March, the real peso–dollar is continuing a gradual slowdown that single-family construction, such as lum- exchange rate dropped sharply in April began earlier in the year. After growing ber, furniture, brick, glass and primary and May. While the real peso–dollar at an annualized rate of 2.6 percent in metals. Employment has declined as exchange rate was 36 percent higher in the first quarter of 1995, employment well in other industries, such as paper, May than in November 1994, the deprecia- in Louisiana, New Mexico and Texas apparel, and food products. Employ- tion of the dollar relative to Texas’ other slowed further in April and May, to an ment in fabricated metals and computer- export markets has resulted in only a annual growth rate of 1.9 percent for related industries continues to grow 7.7-percent appreciation in the Texas- the two-month period. strongly. Texas industrial production in export weighted value of the dollar. The slowdown in employment manufacturing fell 1.3 percent in March The Texas index of leading economic growth became evident in the service and 4.9 percent in April, the first two indicators rebounded in April and May, sector during the first quarter and has months of consecutive decline since following a decline in the index since now spread to manufacturing. In May, June of 1991. last November. Recent movements in the manufacturing employment fell 3 percent Despite the recent slowing in employ- index suggest that the District economy’s in Texas and 7.4 percent in New Mexico. ment, the District economy still shows gradual slowing will continue in the Manufacturing employment in Louisiana signs of strength. Falling mortgage rates second half of 1995 but that growth accelerated in May to 4.5 percent. Much have sparked a rebound in District resi- will remain positive. of the slower growth in manufacturing dential construction. After declining in —Fiona Sigalla

Total Nonfarm Employment Texas Industrial Production Index

Index, January 1991 = 100 Index, January 1991 = 100 120 115 Manufacturing New Mexico Texas 110 115 Utilities Louisiana Total 110 United States 105

105 100

100 95 Mining 95 90 1991 1992 1993 1994 1995 1991 1992 1993 1994 1995

Texas Leading Index and Nonfarm Employment Net Contributions of Components to Change In Leading Index, February–May 1995 Thousands of persons Index, January 1981 = 100 8,000 115 –.35 Average weekly hours 0 Help-wanted index 7,500 110 Texas stock index .69 105 7,000 –.28 New unemployment claims 100 Real retail sales .13 6,500 –.05 Well permits 95 6,000 Real oil price .15 Employment 90 –.36 U.S. leading index 5,500 Leading index 85 Texas value of the dollar 1.04 5,000 80 –.6 –.4 –.2 0 .2 .4 .6 .8 1 1.2 1.4 ’81 ’82 ’83 ’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 Percent

REGIONAL ECONOMIC INDICATORS Texas Employment Total Nonfarm Employment FURTHER INFORMATION ON THE DATA Texas Private For more information on employment data, Leading TIPI Construc- Manufac- Govern- Service- New see “Reassessing Texas Employment Growth” Index Total Mining tion turing ment Producing Texas Louisiana Mexico (Southwest Economy, July/August 1993). For 5/95 112.4 118.5 156.4 399.5 1,030.3 1,435.1 4,930.1 7,951.4 1,787.0 686.0 more information on TIPI, see “The Texas Indus- 4/95 111.5 118.5 156.8 400.5 1,032.9 1,434.2 4,930.7 7,955.1 1,783.2 685.8 trial Production Index” (Dallas Fed Economic 3/95 110.0 118.6 157.3 403.1 1,031.4 1,430.5 4,900.5 7,922.8 1,784.4 685.3 2/95 111.1 119.1 157.0 404.8 1,028.8 1,430.8 4,880.7 7,902.1 1,782.4 684.3 Review, November 1989). For more information 1/95 110.5 118.9 157.0 405.4 1,024.5 1,429.2 4,851.4 7,867.5 1,781.8 681.5 on the Texas Leading Index and its components, 12/94 111.4 118.3 157.8 398.5 1,022.7 1,426.1 4,870.8 7,875.9 1,774.5 675.3 see “The Texas Index of Leading Indicators: 11/94 111.9 118.2 159.7 393.3 1,021.1 1,420.7 4,851.5 7,846.3 1,764.0 674.2 A Revision and Further Evaluation” (Dallas Fed 10/94 112.0 118.5 160.7 389.9 1,020.2 1,418.3 4,838.9 7,828.0 1,755.1 669.0 Economic Review, July 1990). 9/94 111.9 118.4 163.1 387.9 1,017.7 1,417.9 4,834.4 7,821.0 1,743.8 664.5 8/94 112.1 118.4 162.9 383.1 1,014.3 1,423.5 4,817.7 7,801.5 1,729.3 658.3 On-line economic data and articles are avail- 7/94 111.4 118.3 162.5 380.3 1,010.6 1,414.4 4,797.2 7,765.0 1,719.4 660.2 able on the Dallas Fed’s electronic bulletin board, 6/94 111.2 118.3 162.8 376.9 1,007.4 1,417.0 4,759.5 7,723.6 1,710.3 655.4 FEDFLASH (214-922-5199 or 800-333-1953).

11 EXCHANGE RATES, CAPITAL FLOWS and MONETARY POLICY in a CHANGING WORLD ECONOMY

A Federal Reserve Bank of Dallas Conference September 14–15, 1995

The dramatic growth of international capital flows has provided unprecedented opportunities and risks in emerging markets. Investors, policymakers, central bankers and other practitioners who interact in these markets on a daily basis need to keep abreast of the most up-to-date information. This conference will provide the insight and observations of some of the most highly respected policymakers and academicians in the field. WHO SHOULD ATTEND The conference is designed to meet the needs of central bankers, chief economists, government policymakers, international economists and senior-level management in trade offices, commercial banks, mutual funds, investment banks, international finance firms and multinational corporations. Place: Federal Reserve Bank of Dallas, 2200 N. Pearl Street, Dallas, Texas 75201 Fee: $150 (U.S.) per person For more information, call Agnes Mitchell at (800) 333-4460, ext. 5260

SPEAKERS INCLUDE • Andrés Bianchi, Banco Crédit Lyonnais • Alan S. Blinder, Federal Reserve Board of Governors • Vittorio Corbo, Catholic Uni- versity of Chile • John W. Crow, Lévesque Beaubien Geoffrion Inc. • Michael P. Dooley, University of California, Santa Cruz • Sebastian Edwards, World Bank • Jeffrey A. Frankel, University of California, Berkeley • Peter M. Garber, Brown University • Ricardo Hausmann, Inter-American Development Bank • Alan Meltzer, Carnegie Mellon University

FEDERAL RESERVE BANK OF DALLAS BULK RATE P.O. BOX 655906 U.S. POSTAGE DALLAS, TEXAS 75265–5906 P A I D DALLAS, TEXAS PERMIT NO. 151