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Economic Review

Economic Review
C O N T E N T S
Third Quarter 2000/Volume 85, Number 3

Economic Review articles are posted on the Web as they become available. Page numbers in the PDF file posted here may not reflect the page numbers of the printed version.

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PRESIDENT
JACK GUYNN

SENIOR VICE PRESIDENT AND
DIRECTOR OF RESEARCH

ROBERT A. EISENBEIS

RESEARCH DEPARTMENT
THOMAS J. CUNNINGHAM
Vice President and
Associate Director of Research

GERALD P. DWYER JR.
Vice President, Financial

JOHN C. ROBERTSON
Assistant Vice President, Regional

ELLIS W. TALLMAN
Assistant Vice President, Macropolicy

WILLIAM ROBERDS
Research Officer, Macropolicy

LARRY D. WALL
Research Officer, Financial

PUBLIC AFFAIRS
BOBBIE H. MCCRACKIN
Vice President

JOYCELYN TRIGG WOOLFOLK
Editor

LYNN H. FOLEY
Managing Editor

NANCY PEVEY
Editorial Assistant

CAROLE L. STARKEY,
PETER HAMILTON, AND JILL DIBLE
Designers

LYNNE ANSERVITZ
Marketing and Circulation

LINDA MUNDY
Administrative Assistance

The Economic Review of the Federal Reserve Bank of Atlanta, published quarterly, presents analysis of economic and financial topics relevant to Federal Reserve policy. In a format accessible to the nonspecialist, the publication reflects the work of the Research Department. It is edited, designed, produced, and distributed through the Public Affairs Department.

Views expressed in the Economic Review are not necessarily those of this Bank or of the Federal Reserve System.

Material may be reprinted or abstracted if the Review and author are credited. Please provide the Bank's Public Affairs Department with a copy of any publication containing reprinted material.

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ISSN 0732-1813

Dollarization: A Scorecard
Roberto Chang

In January of this year, Jamil Mahuad, then president of Ecuador, startled his compatriots by proposing to eliminate the national currency, the sucre. Instead, Mahuad advanced, the U.S. dollar would replace the sucre for all purposes. Although a popular uprising forced him out of office a week later, the succeeding government has actually implemented his proposal and recently announced that U.S. dollars will have completely replaced the sucre by September 2000.

The question remains as to whether the Ecuadorian plan will be successful and, more generally, whether other countries will follow Ecuador's lead. But one thing is clear: proposals to replace the domestic currency with the U.S. dollar, or to "dollarize" the economy, have taken center stage in Latin America and other developing regions. To illustrate why dollarization has risen from neglect to such a central role, this article discusses the currently fashionable proposals for dollarization in Latin America and other developing regions.

The article places special emphasis on identifying and analyzing various arguments for and against dollarization in the light of existing economic theory and evidence. The author compares the relative significance of the costs and benefits. Observing that measurement problems are significant, he concludes that, remarkably, the popular belief that dollarization is a desirable reform has been reached in spite of widespread uncertainty about its economic benefits.


Credit Crunch or What? Australian Banks during the 1986–93 Credit Cycle

There is ongoing debate about how the banking sector's financial condition affects the supply of credit to business and, ultimately, general macroeconomic conditions. The United States does not generate sufficient data to provide satisfactory answers to these questions, given the low frequency of credit cycles. However, the experiences of other developed countries may provide additional insight. This article investigates the 1986–93 credit cycle in Australia. A comparison of key differences and similarities between the U.S. and Australian banking systems allows a useful analysis of the Australian experience as it relates to the general economic issue of supply-based loan contraction.

Australian bank lending between 1986 and 1993 is of particular interest because it was the first credit cycle following financial deregulation in that country. Emerging from a regulated era, Australian banks had limited experience in managing portfolios that included risky commercial loans. During the downswing of the cycle, a decrease in loan growth followed the recognition of loan losses—but was the decrease due to lower borrower demand or at least partially to lower supply? The results suggest that while demand-side factors account for much of the credit cycle, evidence is consistent with the argument that supply-side elements also played a role. The authors conclude that there is a relationship, albeit a relatively weak one, between the loan-loss experience of the early 1990s and subsequent constrained lending behavior.


The Potential for Portfolio Diversification in Financial Services

The Gramm-Leach-Bliley Act sweeps away most of the barriers limiting the affiliation of banks with nonbank financial services providers. The focus now shifts to financial services executives who must decide which combinations provide the best opportunities to increase shareholder wealth. Existing empirical evidence suggests that an important consideration in this decision is the potential gain from portfolio diversification into new activities. The empirical evidence also suggests that the potential for such gain clearly exists.

This article builds on earlier studies, in particular updating the contribution of Wall, Reichert, and Mohanty (1993). After reviewing studies since the 1993 article of the potential gains from diversification, the authors summarize the legal changes resulting from passage of the Gramm-Leach-Bliley Act. The article then updates the 1993 analysis of return on assets using data from the Internal Revenue Service (IRS) to cover the 1991?97 period and also examines return on equity from 1991 to 1997.

The new empirical results are consistent with the prior study in finding substantial potential gains from diversification using IRS data. The results also support the earlier finding that the efficient combinations (lowest risk for any given level of return) vary through time, perhaps for reasons such as the macroeconomic environment or technology. For bankers, one positive change in the 1991–97 period over the 1970s and 1980s is that banks have become a larger part of the efficient financial services portfolio.


The Shifty Laffer Curve

Any number of U.S. politicians owe their success to emphasizing tax cutting. According to logic, voters are opting for fewer government services or for changes in the mix of services rendered. It is at this point that things become complicated, however, because what happens to expenditures influences how much revenue a government needs to collect. The author of this article observes that a good place to start in understanding the impacts of tax policy is with what is popularly known as the Laffer curve. This curve became famous early in the 1980s when tax rates fell but tax revenues did not rise as the curve predicted, and the United States resorted to deficit spending. This article examines the macroeconomic and conceptual issues that may have made a difference.

Because most analyses of the Laffer curve occur in a static framework that has proved inadequate, this analysis presents a simple dynamic model useful for analyzing the long-run effects of tax policies. The model also can easily be extended to analyze the disposition of government revenues and the consequent effects on national income.

It turns out that how the government spends its tax revenues—on consumption, investment, or transfers—is important for understanding the Laffer curve. In fact, a different Laffer curve is associated with the different ways revenues are spent, and it is important to know which curve one is operating on when designing tax policies.