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ABSTRACT
FLUCTUATIONS IN FOREIGN EXCHANGE RESERVES AND IN THE
VOLUME OF CONSTRUCTION: THE SIMILARITY BETWEEN
INDUSTRIALIZED AND NON-INDUSTRIALIZED

COUNTRIES IN 1870-1914 AND THEIR
DIVERGENCE IN 1955-1968

By

Thomas C. Edens

This thesis examines the relationship between building
cycles of industrialized and non-industrialized nations. Two
time periods are analyzed. During the 1870-1914 period the
building cycles of the industrialized and non-industrialized
countries were inversely related. This relationship was re-
versed by the time of the Korean War; the building cycles
of the developed and less developed countries were in phase
after this period. During the pre-World War I period, do-
mestic construction activity in both the industrialized and
non-industrialized nations was not well protected from for-
eign exchange reserve fluctuations. By 1955, the developed
countries had managed to keep their total domestic construc-
tion from fluctuating passively with foreign exchange levels.
However, the construction of dwellings in these countries
was still strongly influenced by external shocks. This
sensitivity is due primarily to the nature of financial in-

stitutions which affect the private sector.

Thomas C. Edens

In the less developed countries, the opposite pattern
is observed for the 1955-68 period. Total construction is
not protected from external movements in exchange reserves
while the construction of dwellings is less affected on
balance. This pattern is due to the inability of governments
in the less developed countries to maintain construction
spending when fluctuations in the foreign exchange reserve
positions force changes in fiscal and monetary policy.

The construction of dwellings is protected rather well be-
cause most of the funds needed for home building are not
public or secured in private financial markets. In most
cases, the purchaser must rely on his own accumulated wealth
for the purchase of a home. Thus this sector is less af-
fected by domestic interest rates and the availability of
credit.

A cross-sectional-time-series pooled statistical test
is used to evaluate the model. The basic hypothesis that
construction in non-industrialized countries is positively
more sensitive to foreign exchange reserve fluctuations than
construction in the industrialized countries is supported.

The development of more sophisticated financial inter-
mediaries especially designed to Supply funds for housing
construction appears promising for employment and better
living conditions in the developing countries but may raise

the instability of the construction sector. More frequent

Thomas C. Edens

adjustment of exchange rates will help to lessen exchange re-
serve and monetary fluctuations if the relative export and
import elasticities are favorable. The domestic economy,
especially construction, would thus be spared unnepessary

contractions.

FLUCTUATIONS IN FOREIGN EXCHANGE RESERVES AND IN THE
VOLUME OF CONSTRUCTION: THE SIMILARITY BETWEEN
INDUSTRIALIZED AND NON-INDUSTRIALIZED
COUNTRIES IN 1870-1914 AND THEIR
DIVERGENCE IN 1955-1968

By
Thomas C. Edens

A THESIS

Submitted to
Michigan State University
in partial fulfillment of the requirements
for the degree of

DOCTOR OF PHILOSOPHY
Department of Economics

1972

For Mary, Russ and Chris

ii

ACKNOWLEDGMENTS

I wish to express my gratitude to all of my friends and
colleagues who have been a constant source of encouragement.
Without their support and encouragement this project would not
have been possible.

I extend my deepest appreciation to Professor W. Paul
Strassmann who gave freely of his time and ideas in guiding
this thesis from the initial proposal through the final draft.
Without his continuing assistance, it would still be in the
planning stages.

My thanks go also to Professor Mitchell Stengel, who com-
bined expeditious reading of the manuscript with helpful sug—
gestions for improvement, and to Professor Subbiah Kannappan
who freely adjusted his schedule to help me meet my deadlines.

To my parents, Harold and Lillian Edens, I can only say
that words will never be able to convey my feeling for their
unstinting support of this, as of all my undertakings.

This thesis is dedicated to Mary, Russ, and Chris, who
have given much, asked little, and waited so long. They make

everything worthwhile.

iii

TABLE OF CONTENTS

LIST OF TABLES.

LIST OF FIGURES

Chapter
I.
II.

1.3

INTRODUCTION

REVIEW OF PREVIOUS STUDIES

Introduction .

National Building Cycles . ,

International Building Cycles , ,

Building Cycles in the U. S. and U. K. -
1870 to 1914

THEORETICAL STRUCTURE
Introduction

Foreign Exchange Reserves in Industrialized.

and Non- Industrialized Countries .
The Relationship Between Foreign Exchange
Reserves and Construction
The Basic Model (1870- 1914) , ,
Domestic Ramifications of External Changes
Summary.

ADAPTABILITY OF THE BASIC MODEL.
Changing International Conditions
Altering the Model

Summary. ,

METHODOLOGY ,

Classification System , ,

Specification of Variables

Hypothesis.

Selection of Dependent Variables ,

Selection of Independent Variables,

Foreign Exchange Reserves.

Exports. .

Gross National Product ,

Exports as a Percentage of GNP ,

Per Cent of Population Residing in
Urban Areas

Exchange Rate Valuation Index

Sources of Data . .

Estimation Techniques .

Summary

iv

Page

. vi

. vii

H

NO‘O‘Cfi

Chapter

VI.

THE EMPIRICAL RESULTS
Introduction

Listing of Empirical Results
Evaluation of the Model.

The Construction of Dwellings.

Exports .
Additional Findings
Summary
VII. SUMMARY AND CONCLUSIONS.
Summary of the Thesis
Implications .
Policy Recommendations
Limitations of the Study
BIBLIOGRAPHY.

Page

86
86
87
90
95
96
99
99

101
101
102
104
107

109

Table

II.

III.

IV.

VI.

LIST OF TABLES

Foreign Exchange Reserves in Low and High
Income Countries.

Countries Grouped According to Income.

The Countries in the Sample Grouped According
to Income . . . .

Percentage Change in Urban Population,
1950-1960 (Sample Countries).

Estimated Coefficients for Total
Construction (C1)

Estimated Coefficients for Dwelling
Construction of Dwellings (C2)

vi

Page

32
59

60

76

85

89

Figure

10.

11.
12.

LIST OF FIGURES

Building Cycles in the United States and
the United Kingdom Between 1870 and 1914,

Building Cycles in U.S. and U.K. (1870-1914)
and U.K. Terms of Trade . . , ,

Foreign Exchange Reserves in Industrialized
and Non-Industrialized Countries
(1870-1914)

The Relationship Between Foreign Exchange
Levels in Group I and Group III
Countries (1955-68).

The Relationship Between World Reserves
and Group I and Group III Reserves
(1955-1968)

Construction and Foreign Exchange Reserves
in Industrialized Countries (1870-1914)

Construction and Foreign Exchange Reserves
in Non-Industrialized Countries
(1870-1914)

Four Quadrant Model with All Quadrants
Given (1870-1914) . . .

Four Quadrant Model with Three Quadrants
Given

Construction in Developed and Less Deve10ped
Countries: 1956-1968 (Sample Data)

Four Quadrant Model
The Four Quadrant Model with the

Hypothesized Coefficients for Two
Quadrants

vii

Page

19

21

30

33

35

37

38

40

41

52

54

91

CHAPTER I
INTRODUCTION

The share of construction activity in Gross National Pro-
duct (GNP) varies with the level of total output of a
country. According to Kuznets, in countries with per capita
GNP in the $100-$400 range, construction accounted for 8.5
per cent of Gross Domestic Product (GDP) in the early 1950's.
In countries within the range of $650 to $1000, the share of

construction was 11 per cent.1

In the $1700 per capita in-
come range it was nearly 12 per cent of GDP. For 1955-1964,
Strassmann found that gross construction as a proportion of
GDP averaged 8 per cent for underdeveloped countries and 11.7
per cent for the developed group. He found housing construc-
tion as a per cent of GDP to be 2.5 per cent for the under-
developed group, 4.6 per cent for middle income countries

and 4.4 per cent for developed countries.2

Residential building alone in the United States comprises

 

lKuznets, Simon, "Quantitative Aspects of the Economic
Growth of Nations, Part V. Capital Formation Proportions:
International Comparisons for Recent Years", Economic Devel-
opment and Cultural Change, July, 1960, Part II, pp. 4,53.

 

2Strassmann, W. P., "The Construction Sector in Econ-
omic Growth", Scottish Journal of Economics, November, 1970,
Table II, Lines 5 and 7, p. 401.

 

between 20 and 30 per cent of gross investment.3
Building is one of the largest and most
widespread of all industries. It ram-
ifies from the brick-making, timber,
cement, steel and other building mater-
ial at the one end into the plastering,
plumbing and painting trades at the
other, and it sets the pace for a wide
range of industries.4

Coupled with the overall significance of the construc-
tion industry in the economy is the fact that it is charac-
terized by large fluctuations, especially in the housing
construction sector. According to Clark and Cohen,
"...fluctuations in housing expenditures represent one of
the major sources of instability in the (U.S.) economy".5
The impact of this sector in other countries is also very
important.

Until recently, construction was usually treated as de-
pendent only on investment. Economic planners in India
called housing construction 'social services'. The re-
mainder of the construction sector falls under miscellaneous

categories and is subsumed in the total cost figures of the

appropriate industrial sector.6 The problem with this type

 

3O'Leary, P. J., and Lewis, W. A., "Secular Swings in
Production and Trade" in Grodon and Klein (ed), AEA Readings
in Business Cycles, Volume X, Irwin, Homewood, 111., 1965,
p. 550

 

 

4Cairncross, A. K., Home and Foreign Investment: 1870-
1913, Studies in Capital Accumulation, Cambridge University
Press, London, 1953, p. 12.

5Clark and Cohen, Business Fluctuations, Growth, and
Economic Stabilization, Random House, New York, 1963, p. 60.

6Lewis, John P., Quiet Crisis in India, Doubleday and
Company, New York, 1964, p. 87.

 

of classification is that it disguises the construction
sector and prevents observers from viewing the interaction
of construction withother important variables in the econ-
omy. Incomplete and inaccurate reporting in the less devel-
voped nations is partially to blame for the poor statistics.
Only in the past two decades has the United Nations com-
piled reliable estimates of the disaggregated data in some
of the poorer countries. In others, it is still impossible
to find reliable figures.

In the 1950's and 60's, efforts were made in the more
highly developed countries to list separately the main com-
ponents of the construction sector in order to study the
'cyclical' trends and to ascertain the direction of causa-
tion between fluctuations in the construction sector and
the general business cycle. Over the past two decades, em-
phasis on the construction sector as a separate entity has
developed. Currie, for example, singled out the housing and
construction sector as an important ingredient in development.7

The empirical work of Kuznets8 and the theoretical in-

vestigations into capital formation by Nurkse9 and Cairncross10

 

7Currie, Lauchlin, Accelerating Development, McGraw-Hill,
New York, 1966.

 

8Kuznets, op, cit.

9Nurkse, Ragnar, Problems of Capital Formation in Under-
developed Countries, Oxford Press, New YErk, 1953.

10Cairncross, A. K., op. cit.

have furthered this trend toward the analysis of less aggre-
gated data and have called into question the alleged direc-
tion of causality. Certainly the rapid influx of rural resi-
dents to the center cities which has been observed in most
countries provided the stimulus for deeper analysis of the
construction sector. The attendant pressures of massive un-
employment and the spread of sub-standard housing reinforced
the need for further investigation.

In Chapter II I shall review some of the older notions
concerning the nature and magnitude of building cycles and
introduce some new variables which are relevant in explain-
ing the direction of causation.

It will be shown that the building cycles experienced
by the industrial nations were inversely related during the
1870-1913 period. This relationship was reversed by the
time of the Korean War. The building cycles of high and
low income nations are directly related in the 1955-68 period.

In Chapters III and IV a model will be introduced to
analyze those factors which account for the reversal in the
building cycle relationship between the rich and poor coun-
tries. Stress is placed on fluctuations in foreign exchange
reserves in the high and low income countries and on policies
which might allow nations to protect domestic construction
from fluctuations in external reserve holdings.

Chapter V is devoted to testing the model. In Chapter

VI, the empirical results will be presented. Finally, in

Chapter VII, the conclusions stemming from the empirical work

will be advanced.

CHAPTER II

REVIEW OF PREVIOUS STUDIES

Introduction

 

There are two sections in Chapter II. In Part I we
shall consider the building cycles of individual countries
and review some of the previous studies which were concerned
with this question.

Part II is concerned with the relationship between the
building cycles of several countries. Previous work in this
area will be discussed and an attempt will be made to iso-
late the key variables which influence international building
cycles.

The focus of interest is the total construction sector
and the construction of dwellings. There is reason to sus-
pect that these two sectors do not respond the same to changes
in external reserve positions. This point will be discussed

in more detail later.

National Building Cycles

 

The uniqueness of the fluctuations or cycles in the
construction industry is generally appreciated. Paldam
states that there are two conspicuous factors with regard to
the construction sector. First, "...the swings are indeed

very considerable..." and second, "...they do not follow the

general business cycle very consistently".1 Indeed there is

considerable disagreement as to the length and severity of
building cycles in the United States. Burns2 and Campbell3
argue that residential construction in the United States ex-
hibits long cycles because of the long-life, durability, and
immobility which characterize this sector. Cooney has shown
that "building in London between 1865 and 1914 experienced
cycles in its activity of greater length than the ordinary
trade cycle, and of considerably greater amplitude".4
Guttentag, more recently, has argued the case for shorter
cycles in the United States during the 1946-59 period.5
Perhaps more relevant to this study is Cairncross's view
that ”If we are to speak of long waves....we must limit our-
selves to a local fluctuation. Long waves that are not

H 6

local are revolutions rather than cycles .

In the passage above, Cairncross asserts that long waves

 

lPaldam, Martin, "What is Known About the Housing Demand?",
Swedish Journal of Economics, June, 1970, p. 133.

 

2Burns, Arthur, "Long Cycles in Residential Construction"
in Business Fluctuations, Growth and Economic Stabilization,
Edited'by John J. Clark andIMorris Cohen, RandOm House, New
York, 1963.

 

3Campbell, Burnham 0., "Long Swings In Residential Con-
struction: The Postwar Experience, American Economic Review,
May, 1963.

 

4Cooney, E. W., "Capital Exports and Investment in Build-
ing in Britain and the U.S.A., 1856-1914", Economica, Novem-
ber, 1949, p. 349.

 

SGuttentag, J. M., "The Short Cycle in Residential Con-
struction", American Economic Review, June 1961, Vol. LI, No.
3, pp. 275-98.

 

6Cairncross, A. K., Home and Foreign Investment: 1870-
1913, Studies in Capital Accumulation, Cambridge University
Press, London, 1953, p. 11

 

 

in the construction cycle must be limited to a particular na-
tion. When we observe cycles in several countries which con-
tinue their swing for long periods of time (e.g., more than
20 years), we are witnessing basic structural changes which
accompany the development process. Since this study in-
volves several countries, our emphasis will be on finding
probabilistic causality over the relatively short time per-
iod of 15 years.

Further disagreement is found in attempting to assign
causality to the fluctuations observed in the construction
sector. An early attempt to link this sector to the accel-
erator theory was made by J. M. Clark.7 More recent writers
have abandoned this view and have focused on variables such
as the rate of interest and the institutional structures
which influence the availability of funds for housing con-
struction.8

Leo Grebler, for example, suggested that:

The rate of interest moves as a rule
with the business cycle, showing a ten-
dency to rise in a period of 'boom' and
to fall in a period of 'slump'. This is

in accordance with the fact that the de-
mand for capital rises and falls with the

 

7Clark, J. M., "Business Acceleration and the Law of
Demand: A Technical Factor in Economic Cycles", The Journal
of Political Economy, Vol. XXV, No. 3, March 1917, pp. 217-235.

 

 

8See especially, Long, C. D., Building Cycles and the
Theoryof Investment, Princeton, 1940; Newman, W. H}, The
Building Industry and Buildinngycles, Chicago, 1945; PETdam,
Martin, 22- cit., andTDuesenberry, James 8., Business Cycles
and Economic—G?owth, McGraw Hill, New York, 1958, Chapter 3,
pp. 31-48. '

 

 

 

 

 

increase and decrease in business activ-

ity. House building, therefore, receives

a special stimulus during a recession be-

cause of the low rate of interest.9
This implies that the income effect which accompanies an
increase in Gross National Product (GNP) has less impact on
the home building sector than the price effect which is re-
flected in the interest rate change. Grebler also found
that house building was countercyclical prior to World War I
and that due to government intervention in the form of public
grants after the War, the trend was reversed. Duesenberry's
empirical observations support this View. During the 1948-59
period, Guttentag observed a "broad countercyclical tendency
of residential construction”.10

Cullingsworth also points out that:

The role of government in supplying or

influencing the capital market for housing

in the post war period has coincided with

an increased concern with national invest-

ment programmes. State intervention in

the capital market for housing has been

necessary in all West EurOpean countries.11

Paldam further states that "In most countries in EurOpe

the housing market is affected by political intervention

 

9Grebler, Leo, "House Building, The Business Cycle and
State Intervention", The Industrial Labor Review, March 1936,
Vol. XXXIII, No. 3, pp. 339.

10Guttentag, gp. cit., p. 93.

11Cullingsworth, R. "Housing and State", in Nevitt, A., (Ed.),
Economic Problems of Housing, Proceedings of a Conference
Held by the InternatIonal Economic Association, MacMillan,
New York, 1967.

10

including direct price control, which distorts the price
structure...”.12
In attempting to discern the causal factors operating
in the building industry, studies focus on either the demand
or supply side of the equation. On the demand side, several
problems arise. In the majority of countries we must dis-
tinguish between effective demand which is the willingness
and ability to purchase housing and what I shall call po-
tential demand, which is the willingness to purchase a dwell-
ing unaccompanied by the ability. Thus we see that demand
and supply are inextricably interconnected; demographic
changes may indicate an intense desire for additional housing,
however financial markets (either domestic or international)
might not permit the necessary flow of funds to realize this
desire. In the conventional phraseology, we would say that
there is a very strong demand for additional housing; how-
ever, at the same time, financial restrictions prohibit this
potential demand from becoming effective.
This is not to suggest that demographic factors are un-
important. However, in most countries they act indirectly
as a form of derived demand by placing pressure on the re-
gional or federal government to initiate directly or at least
to allow the necessary programs and/or funds to be made available.
Another element which further complicates the demand
for housing is the variability of rents. If rents increase

more rapidly than the general cost of living, we would

 

12Paldam, gp. cit., p. 130.

11

experience an increased effective demand for owner-occupied
housing, since the monthly rental payments, if they in-
crease relative to housing construction costs, will even-
tually overtake the monthly payments of financing the pur-
chase of a home.13 Again it must be emphasized that demand
can only be effective if the various agencies which control
the availability of funds make them available.

We must also allow the possibility of shifts in demand
between various income classes. This question was put for-
ward, but not specifically answered, by De Leeuw and Ekanem
in a recent journal article.14

The widespread use of rent-control by many countries
compounds the problem of isolating causal factors. A govern-
ment or housing authority which maintains a policy of con-
taining effective demand for dwelling construction can do so
easily by administering a low rent policy or by making it
more difficult for the home buyer to secure the credit needed
for the purchase of a house. In the former situation, the
opportunity cost of renting is artificially increased. In
most cases this policy merely shifts the demand from the
private sector to the public sector.

When we turn to the supply side of the analysis, we

face similar problems. As usual, demand and supply are

 

13Cairncross, 92. cit., p. 215-220.

14De Leeuw, F., and Ekanem, N. P., "The Supply of Rental
Housing", American Economic Review, December, 1971, Vol. LXI,
No. 5, p. 807.

 

12

difficult to separate. From the buyer's point of View

finance is part of supply. However, if the interest rate in
mortgage markets is high, it is demand that seems low to the
builder. The same upswing that makes investment appear lucra-
tive during 'boom' years keeps many potential buyers of

houses from realizing their desires.

When we approach demand and supply projections on the
national level and attempt to compare several countries, the
problems are intensified. Elasticity concepts are difficult
to employ and the evaluation of demographic changes must in-

clude a close examination of relative migration patterns.

International Building Cycles

 

The studies which are concerned largely with domestic
fluctuations in the building cycle provide a necessary back-
ground and a logical starting point for the inquiry into the
international sector. We must now turn to the main focus
of this study.

We are interested in determining the similarity in
timing of building cycles in several countries at different
levels of development. What is the role of government in
determining when resources are to flow to or be withdrawn
from construction and housing? If the governments are cog-
nizant of the role of this sector in Western European coun-
tries, certainly the planners in the less developed countries

should be equally concerned, although their reasons and

13

policy options might be different. We must find those var-
iables which affect government decisions in the allocation
of scarce capital and foreign exchange among competing pro-
grams.

In the less developed countries, the relationship be-
tween foreign trade policy and housing policy was examined
by Maisel for the 1950's. He found that "In addition to con-
suming large amount of scarce capital, it was found that in
a majority of cases a high percentage of the materials going
into houses had to be imported."15

Even if Maisel's assertion that housing construction re-
quires large amounts of foreign exchange is not true, for
many countries the construction industry is likely to be sen-
sitive to changes in the level of exchange reserves. During
the era of the gold standard, when the level of foreign ex-
change reserves fell, the domestic money supply was con-
tracted. Although this mechanism did not operate as per-
fectly as some observers claimed, the direction of the ef-
fect was predictable.

Because the operation of the gold standard linked inter-
national and domestic monetary markets to each other, many
countries attempted to manage their domestic affairs by
adopting countercyclical programs of public works. In the

more industrialized nations of Western Europe and North

15Maisel, A., "The Economic Problems of Housing, in
Nevitt, A. (Ed.), 22° cit., p. xxii.

14

America, the main objective prior to World War I was to pro-
vide work relief. This type of program was motivated by so-
cial considerations and regarded as a temporary measure to
minimize the need for direct welfare payments.16

During the post-war period, the policy of work relief
evolved into something quite different. According to
Howenstine, "...after the First World War, there was a grow-
ing interest in public works policy as a means of combatting
unemployment. The emergent theory about public works policy
had an essentially economic, as Opposed to the previous social
orientation".17

Compensatory programs also differ among individual coun-
tries. Western European economies have a history of 'work
postponement' policies which date back to the early 1920's.18
Under this system work on public projects is undertaken dur-
ing periods when unemployment is rising and the economy is
contracting. The implementation of these projects required
that each country accumulate adequate financial reserves dur-
ing full employment periods which could be released at the
appropriate time. The need for the prior accumulation of
financial reserves was especially acute during the 1920's and

30's, prior to the Keynesian revolution and the development

 

16Howenstine, E. Jay, Compensatory Employment Programmes,
Organization for Economic Co-operation and DeveIOpment, Paris,
1968, p. 32.

 

17Ibid., p. 33.

18Ibid., p. 35.

 

15

of more sophisticated fiscal tools.

In the less-developed nations, the ability to accumulate
financial reserves for the purpose of countercyclical public
work programs is limited. Furthermore, when less developed
countries engage in deficit spending programs in order to
maintain full employment, the effect on the economy can be
damaging. Deficit spending certainly increases aggregate
demand. If unemployment is the result of structural problems

rather than inadequate domestic spending,19

increased govern-
ment spending is also likely to result in an increase in
prices. Inflation will reduce exports and threaten the for-
eign exchange reserve position of the country.

The advanced countries have adopted a wide variety of
other countercyclical programs. Most of these programs rely
on traditional monetary and fiscal policies. Sweden has de-
veloped an imaginative approach to offset fluctuations in
her national product. The retained earnings of private busi-
ness firms are subject to special tax rates depending upon
the phase of the general business cycle. During downswings,
firms are given special tax credits on funds invested. Dur-
ing periods of full employment and stable prices, firms

20

which invest are penalized by a high tax. This program,

 

19Ibid., p. 48.

20Johnson, F. Reed, The Swedish Welfare State: A Sys-
tematic Approach, Working Paper No. 64, May, 1972, Department

of EconomiCs, State University of New York, Stoney Brook, New
York, p. 16.

 

 

16

called the 'investment reserve mechanism', is administered by
the Finance Minister.

During the late 1950's, many less developed countries
were faced with high levels of inflation. In 1958 and 1959,
Spain and Turkey ”...were compelled to adopt stabilisation

programs which, inter alia, involved restrictions on public

 

works expenditures." In 1965, Spain was forced to restrict
house-building in order to ease inflationary pressures.21
In this respect, Spain was beginning to resemble the more
developed countries.

In 1964, an Organisation for Economic Co-operation and
Development (OECD) study suggested that a public works pro-
gram be adopted in Turkey in order to attack the problem of
disguised unemployment. One of the sectors singled out for
the program was the construction of social housing.22

Clearly, individual countries use different policies to
counteract movements in their reserve positions. We are in-
terested primarily in the results of the policies imple-
mented. Below it will be shown that regardless of the coun-
tercyclical policies pursued, success or failure of the pol-
icies depends largely upon the ability of the country's finan-
cial institutions to direct the flow of funds into the con-
struction sector. We shall attempt further, to show that

there exists a degree of homogeneity among countries of

 

21Howenstine, 9p. cit., p. 430.

221bid., p. 431-2.

17

similar per capita income levels. That is, the non-indus-
trialized nations as a group tend to react differently to
fluctuations in foreign exchange reserves than the indus-
trialized countries. Data limitations force us to focus on
a few countries during the 1870-1914 period. In Chapter IV,
a larger group of countries will be examined for the 1955-68
period in order to determine whether or not there has been

a change in the relationship between construction cycles in
the industrialized and non-industrialized countries over the

past several decades.

Building Cycles in the U.S. and U.K. - 1870-1914

 

Cairncross has pointed out that
...while commercial and industrial building
has generally fluctuated more or less in
phase with the trade cycle, the building of
dwelling-houses has often shown a marked
divergence.
Derksen has also pointed out the importance of distinguish-
ing between aggregate construction and the construction of
dwellings.24 The data for the 1870-1914 period which is
discussed below focuses on aggregate construction. In our
examination of construction and exchange reserves for the
1955-68 period, the construction of dwellings will be exam-

ined as a separate category in order to determine the

different effects of reserve fluctuations on each sector.

 

23Cairncross, pp. cit., p. 12.

24Derksen, J. B. D., ”Long Cycles in Residential Build-
ing: An Explanation”, Econometrica, Vol. 8, No. 2, April
1940, p. 100.

 

18

Several studies have shown cyclical variations between
the same sectors in different countries and between differ-
ent sectors in the same country. O'Leary and Lewis,25 among
others, have shown that the building cycles of the United
States and the United Kingdom during the period 1870-1910 were
inversely related. This relationship is illustrated in
Figure 1.

During this same period, Cairncross found that ”the
terms of trade of Australia and Canada tended to move in the
opposite direction to those of the industrial countries."26
The "industrial countries" cited by Cairncross were Britain,
France, and Germany (after 1900). He points out that little
capital was exported from Britain and France to the U.S.
during the 1870-1913 period "due largely to banking and fi-

27 and not, as was the case of Aus-

nancial difficulties”,
tralia and Canada, to a disastrous agricultural output.

This relationship bears some resemblance to the current
situation where the less developed countries, largely reliant
on agricultural and raw material exports, import capital
from the industrialized countries. In the Cairncross study,

the less developed countries of the period were Australia,

Canada and the United States, while the industrialized nations

 

25O'Leary, P. J. and Lewis, W. A., "Secular Swings in
Production and Trade” in Gordon and Klein (Eds.), ABA Readings

 

in Business Cycles, Vol. X, Irwin, Homewood, 111., 1950.

 

26Cairncross, 9p, cit., p. 190, Table 44.

271bid., p. 190.

19

 

 

U.S.
\’I\/\ f/
\A
on
C1
~r-4
FD /\
H
-.—1
g U.K
v.14
0
>4
0)
"U
E.
I l l l
1870 80 90 1900 1910

Figure l.--Building Cycles in U.S. and U.K. (1870-1914)

 

Source: O'Leary and Lewis, 9p. cit., Chart I, p. 548 and
Chart II, p. 551.

20

were Britain, France and Germany.

In order to explore possible intra- and inter-country
relationships between international financial variables and
building cycles, I have illustrated on Figure 2 the commodity
terms of trade of the U.K. and the building cycles for both
the U.K. and the U.S.

The relationship between U.K. building and U.K. terms of
trade is positive throughout most of the period. But the cor-
respondence between building in the U.K. and the U.S. is in-
verse. Also note the relationship between the U.K. terms of
trade with the U.S. and the building cycle in the U.S.; the
correlation between these two series is negative and very
strong after the late 1880's. These findings suggest the ex-
istence of a systematic connection between the terms of trade
and the building cycle of the U.S. and the U.K.

Further investigation points to the difficulty of assign-
ing much weight to the terms of trade variable. On the
surface it appears that when the U.K. terms of trade fall,
there would be pressure on Britain to curtail imports and
foreign investment in other countries in order to preserve
a healthy balance of foreign exchange reserves. Closer exam-
ination shows that this need not be the case. Foreign ex-
change reserves are not directly related to the commodity
terms of trade. In order to determine the sign and magni-
tude of such a correlation, we must first know the elastici-
ties of U.K. imports and exports, or the change in the volume
of exports and imports. The terms of trade might decrease
for the U.K., while at the same time the volume sold in-

creases. This could even result in a more liquid financial

21

U.S. Building
Cycle

 

 

00
a
-H
3 U.K. Terms of
'3 Trade
m
o
x
0)
c
E
U.K. Building
Cycle
1870 80 90 1900 1910

Figure 2.--Building Cycles in U.S. and U.K. (1870-1914)
and U.K. Terms of Trade

 

Source: U.S. Building taken from O'Leary and Lewis, Chart 1,
p. 548, _p. gig.
U.K. Building taken from O'Leary and Lewis, Chart II,
p. 551, ibid.
U.K. Terms of trade taken from Cairncross, Table 44,
p. 191, pp. 913. '

22

position for the U.K.28

Although there is no a priori reason to assume a posi-
tive relationship between foreign exchange reserves and terms
of trade, some general observations concerning the elastici-
ties of the exports and imports of the U.K. can be noted.
The primary exports of the U.K. during this period consisted
of manufacturing goods and textiles. Imports consisted largely
of foodstuffs and raw materials.29 It is well established
that the elasticities of the former group is relatively high-
er than the latter group.30

In order to complete this argument let us assume that
the price elasticity of U.K. exports is greater than one and
that of her imports is less than one. If the U.K. terms of
trade are falling, either the price of her exports is de-
creasing or the price of imports is rising, or both. If
price of exports is falling, and the price elasticity is
greater than one, then her total receipts for exports will
increase.

If at the same time, the price of her imports is in-

creasing and the price elasticity is less than one, then her

expenditures on these items will also increase. Thus if

 

28Maisel, A., Industrial Growth and World Trade, Cam-
bridge University Press, 1963.

 

29Ibid., Chapter II.

30Ibid., and Watson, Donald S., Price Theory in Action,
Second Ed1tion, Houghton Mifflin, New York, 1969: ‘Also see
Prebish, Raul, ”External Bottlenecks Obstructing Development”,
in Meier, Gerald M., Leading Issues in Economic Development
Studies in InternationaI’Poverpy, Second EdItion, Oxford Uni-
versity Press, London, 1970, p. 490.

 

 

 

23

worsening terms of trade are caused by price changes in both
exports and imports, the effect on financial reserves is am-
biguous. Yet it is likely that it was export prices which
were largely responsible for the change in the terms of
trade. As Cairncross pointed out, ”Export prices, being the
price of manufactured and of capital goods, tended to fluc-
tuate more violently than import prices which were chiefly

31

the prices of foodstuffs". Nurkse also points out that

prices of food imported by the British were falling during
the 1870-1913 period because of lower transport costs.32
Thus the correspondence which was illustrated in Figure 2 is
not likely to be the result of random changes. For given

the relative elasticities and the movement in the prices of
imports and exports, it follows that the terms of trade

must have moved in the same direction as foreign exchange re-
serves for the British during the 1870-1913 period.

Another investigation which supports the relationship
between building cycles in the less developed and developed
countries found by Cairncross and O'Leary and Lewis was
conducted by Cootner in his analysis of social overhead cap-
ital and economic growth. He points out that during the
19th century the construction cycles in the United States

and the United Kingdom were inversely related and further

that, "...the cycles in developed countries are all

 

31Cairncross, pp. cit., p. 205.
t.,

32Nurkse, Ragnar, pp. ci

p. 133.

24

simultaneous, while the cycles in underdeveloped areas are
similarly simultaneous but out of phase".33 In this passage
he is referring to 'social-overhead capital' in general,
however he points out that these cycles ”coincide with similar
cycles in building construction".34
Further support of the inverse relationship between

building cycles in the United States and the United Kingdom
during the 1870-1913 period is provided by Brinley Thomas.

When the output of producer durables and

construction in the United States was in-

creasing rapidly, the United Kingdom ex-

perienced a falling rate of real invest-

ment at home, a growing surplus in the

balance of payments, heavy unemployment

and a large net outward flow of migrants.35

Cooney, citing building fluctuations in London and
several U.S. cities during the same period, notes the exis-
tence of an inverse relationship between the cycles in the
two countries. He states further that "...this relationship
cannot be explained by any direct connection between the con-
n 36

structional industries in the two countries .

What is the indirect connection between the two cycles?

 

33Cootner, Paul H., ”Social Overhead Capital and Econ-
omic Growth”, in W. W. Rostow (Ed.), The Economics of Take-
off Into Sustained Growth, St. Martins Press, New York, 1963,
p. 267.

34

 

Ibid., p. 267.

35Thomas, Brinley, Migration and Economic Growth, Cam-
bridge University Press, 1954, Cambridge, p. 111.

 

36Cooney, pp. cit., p. 350

25

O'Leary and Lewis and Cooney understandably refrain from as-
signing causality. Thomas suggests that migration may have
been the dynamic force and that ”each major inflow of popula-
tion was accompanied by (and perhaps induced) a 'widening' of
the capital structure in the receiving country".37 This
further allowed the receiving country "...to take maximum
advantage of the technical innovations of that time...”38
This same shifting of population can also be observed in-
ternally.

What variable or variables might explain these empirical
findings? Assuming for the moment that we are able to mean-
ingfully separate and classify less developed countries,
let us focus on those international variables which might pro-
vide the necessary link. Thomas provided empirical evi-
dence of an important relationship. During 1840-1913, build-
ing and exports in Britain show a strong inverse relation-
ship.39 Thomas concludes his argument with the following
statement:

There has been a tendency to look
upon swings in building activity as if
they were a kind of weather cycle ex-
ternal to the business cycle; if a down-
turn in the latter coincides with very

bad weather, so much the worse for it.
More promising results could be obtained

 

37Thomas, pp. cit., p. 163; See also, Colean and Newcomb,
Spabilizing_Construction: The Record and Potential, McGraw-
Hill, New York, 1952.

38Ibid., p. 174.

39Ibid., p. 189.

 

26

by recognizing that there has been a

fluctuation in the production of fixed

capital equipment, with a span corres-

ponding to that of the building cycle.

Perhaps the 'real' type of theory now

being developed would fit this kind of

fluctuation best, and the short busi-

ness cycle might be covered by a mone-

tary explanation. The present inquiry,

tentative though it is, suggests that

theory of the rhythm of economic expan-

sion should start with a two-country

model.40
In the 1950's and 60's, commodity fluctuations due to wars
may have been important, while in the 19th century. long
term capital movements led to a more fully market integrated
world community.

We move now to Chapter III, where a two-country model,
as suggested by Thomas above, will be developed and subse-
quently tested empirically. We recognize the difficulty
of assigning causality to one or more of the partial deriva-
tives selected to depict the operation of but a portion of
our economic system. Therefore, this model should be viewed
as an heuristic device enabling us to increase our focus on

a few specific relationships.

401bid.

 

CHAPTER III

THEORETICAL STRUCTURE

Introduction

 

 

I“.
It was shown in Chapter II that the commodity terms of
trade between the United Kingdom and the overseas raw mater- .
ial suppliers were inversely related during the 1870-1914 ’
period. An examination of the composition of trade between bi

these countries and the price elasticities associated with
their exports and imports showed that changes in the terms

of trade between the U.K. and overseas producers were paralled
by changes in their foreign exchange reserves. During the
same period, it was shown that the building cycles of the

U.K. and the overseas areas and, more generally, of the in-
dustrialized and non-industrialized countries, were inversely
related.

We have taken the U.K. and the U.S. in the 1870-1914
period as representative of the industrialized and non-
industrialized nations in the post-Korean war period. This
representation is based on the composition of goods traded
in the early period by the U.K. and the U.S. and in the
1950's and 60's by the developed and less developed coun-
tries. U.K. exports in the 19th century were composed pri-

marily of manufactured products and capital goods, while

27

28

British imports from the U.S. consisted of food-stuffs and

raw materials.1

The post-Korean War composition of trade
between the industrialized and non—industrialized nations
parallels that of the U.K. and the U.S. in the 19th century.
Exports from the less developed to the developed countries
in the later period consisted mainly of agricultural com- F7
modities, minerals, and raw materials while exports from
the developed to the less developed nations were composed

largely of manufactured and capital goods.2 F

 

Foreign Exchange Reserves in Industrialized

 

and Non-Industrialized Countries

 

KThe task of the present chapter is to construct an
heuristic model which will enable us to sharpen our focus
on exchange reserves and construction. We are interested in
two time periods: 1870-1914 and 1955-1968. 'Evidence pre-
sented in Chapter II showed that there was an inverse rela-
tionship between exchange reserves in the more industrialized
and the less-industrialized countries during the earlier

period. This relationship is abstracted graphically in

 

1Cairncross, A. K., Home and Foreign Investment: 1870-
1913, Studies in Capital Accumulation, Cambridge University
Press, London, 1953, p. 205.

 

 

2Maisel, Alfred, ”The Economic Problems of Housing”, in
Nevitt, Adela A. (Ed.), Economic Problems of Housing, Proceed-
ings of a Conference Heldiby the International Economic Asso-
ciation, MacMiIIan, New York, 1967, p. 19.

 

29

Figure 3.

\Fpr illustrative purposes the inverse relationship be-
tween the two groups is shown as a straight line. We know
only that the slope of the line is negative; it is drawn
as a straight line in order to simplify exposition of the
correspondence and to facilitate the incorporation of this
concept into a larger and more general geometric model.

An increase in the share of total reserves held by this
group of industrialized and non-industrialized nations repre-
sented in Figure 3 would result in a shift from F to F'.

This change in shares could occur with or without an increase
in world reserves, because the distribution of reserves among
a group of countries is variable.

We wish to construct a model which is general enough
to analyze the interactions between exchange reserves and
construction in both the pre-World War I and post-Korean War
periods. In order to do so it must be shown that fluctua-
tions in exchange reserves in the industrialized and non-
industrialized nations were inversely related during the
1950's and 60's as well as in the earlier period depicted in
Figure 3.

To establish the empirical relationship between reserve
levels in deveIOped and less developed countries, data were
collected for a sample of high and low income countries for
the 1955-68 period. The construction of a workable two-

sector model requires that the countries chosen for inclusion

 

30

Non-
Industrialized
Countries

Foreign
Exchange
Reserves
(U.S. Dollars)

F1

 

 

Industrialized Countries
Foreign Exchange Reserves (U.S. Dollars)

Figure 3.--Foreign Exchange Reserves in Industrialized
and Non-Industrialized Countries (1870-1914)

in the sample be defined as either non-industrialized or in-
dustrialized. The former group includes 11 countries whose
per capita income is less than $500 per year, and will be
designated as Group I. The latter group consists of 12 coun-
tries whose per capita income is greater than $1000; this
group will be referred to as Group 111.3 Middle income
countries (Group II) will be omitted at this point because

the construction of the model requires two groups which are

 

3The specific countries selected for the sample are
listed in Table 3, p. 60.

 

31

clearly separable. This point will be discussed in detail
later.

{The limited availability of reliable data for many
countries (especially in the low income group) precluded the
selection of a larger and more balanced sample.4
exchange reserves of the sample groups are shown in Table I
and Figure 4. With the exception of the last two years we
observe an inverse relationship between exchange reserves in
Group I and III countries.1 Because of the constraints oper-
ating on our selection of countries we must admit the possi-
bility of having chosen a biased sample.

,Suppose we were to divide all countries in the world
into two groups and designate them as either developed or
underdeveloped on the basis of their per capita income.
There is a fixed stock of international reserves for the
entire system during any particular time period. Because
all countries are included, there is no leakage of reserves
from the system. Thus we could represent the relationship
between foreign exchange reserves in the two groups as a
negatively leped, 45 degree straight line. If the indus-
trial countries collectively hold x dollars as reserves, the

the non—industrialized nations, by definition, must hold

 

4A larger group of countries could have been chosen if
we were interested only in foreign exchange reserves. How-
ever, we are also examining aggregate construction and the
construction of dwellings; data for these sectors are dif-
ficult to obtain for many countries.

The foreign

I}.

 

32

.oamfi .NemH ..u.n
.coumcfigmmz .muflumfiumum Hmfiocmcfim HmcoflumchoucH .m::m zhmpocoz HmcoHumcpoucH "mowsom

 

 

o.oa cam.oa H.QAMNH ow m.mmmm ON w.m~em mama
o.AH oop.ma m.ameH an m.moooa H~ o.~me Roma
m.aH owm.fia 3.4mmofi an m.Owa HN m.mH~N ooafi
o.eH c~m.oa m.aowa Hm N.aama ma H.5wwfi mama
o.eH oaa.wo m.mwwoa aw e.HAHm 0H m.HHAH aemfi
o.o~ 044.00 w.mmmOH ow m.mmom ea m.opefi momfl
c.4H OHo.mo o.~mwm mm N.Nemh mH w.aNmH Noafi
m.afi oom.No m.aoom ow N.Nohn 4H N.N¢NH Homfi
m.aH oaa.am o.omem aw H.4mma pH m.omea coma
o.mH ooo.am A.aama Hm o.wmce ma A.Hmefl mmmfi
o.mH oam.am m.mmpa Hm H.oafie aH N.meaa mmafl
m.NH oam.pm H.~aoa an o.mocm AN H.awaH amafi
m.NH oaw.mm m.amoa ma o.aomm NN m.NmmH omaa
wo.mfi oeN.am o.maoa NA m.eNHm mm w.maaa mmmfi
Hence pfipoz ”fiance mapped pflauce magammv a HHH asopu a H asopo pap»
Happy mangam o>ppmpm p>pompm amv m .m.: :OAHHHE “my ANS flag

an OS u Amy oweaeoxm pmeaeoxm flay

Hmhmwmm Hahmwom
flaw flow

 

 

1.5.1‘0 ‘1'- 0 011|n011.1' I '01: 5-101555111 O a . 0 .5 6.“‘ '..1 0.0 In 'O‘A’III c '.1

 

moflpucsou oEoucH Lwflz paw 304 CH mo>pomom owcmcoxm swamped--.H magma

33

Ampafi-mmmflv mpappcsou HHH asopo pea H macho an

mo>pomom omcmauxm :mwopom coozuom aficmcofiumaom one--.v whamflm

woma Noma

Nmmaw

Dollars

GROUP I

Million U.S.
Foreign Exchange Reserves

mmvmm

ommH

 

I

1

 

_

_

HHH macho mm>pmmom omcwcoxm :wflopom

_

H macho
mm>pomom omcmsoxm cmfiopom

 

momma

Dollars

GROUP III

Million U.S.
Foreign Exchange Reserves

ommwm

34

T - x dollars, where T is the total volume of world reserves.
This is simply a tautological relationship derived from the
assumptions and definitions. Of course this device cannot
be used for our sample groups.

Clearly, we would like to work with a sample which is
representative of the universe. What happens, for example, I?
to total reserves for sample Groups I and III when world re-
serves change? A close correspondence between fluctuations

in the reserves of the sample and of the world would be a

 

desirable property and could serve as a criterion for estab- fl.
lishing confidence in the sample used.

We can establish empirically the relationship between
the sample and the universe by referring again to Table I.
In column seven, total world reserves are shown. The rela-
tionship between this series and total reserves for the sample
(column 6) is represented by a scatter diagram in Figure 5.
The approximation of the regression line indicates nearly a
one-to-one relationship between the two series. If the sample
groups were atypical of the universe we would observe outlying
points much further above and below the regression line. On
the basis of this evidence, it appears that the sample groups
are a reasonably good approximation for the world which the
sample is taken to represent. rFor heuristic purposes, the
relationship between foreign exchange reserves in the indus-
trialized and non-industrialized countries dn both the 1870-

1914 period and the post-Korean War period)can be abstracted

35

 

 

 

2}?

$4

CU

F1

H

O

Q

as

3 67. 68

(I)

:12.2.

0 ,

.H ,

“11.8?

S 1 r
53 I

._.11.4-1 .
”11.01
:1. s i
8 5 5
5 10.61 i
210.2

m -

Q 9.8-

:3

8 9.4_,

(3

m 900'-

(D

f: 8.6.

(D

(I)

0)

d 8.21

<1)

00

g 708.

.1:

ii 7.4_

LL}

{2

m 7.0.

.H

G)

H

0

LL 5 7 I I I I I T I v I —'j

 

 

54 56 58 6O 62 64 66 68 7O 72 74 76

World Foreign Exchange Reserves
(Billions U.S. Dollars)

Figure 5.--The Relationship Between World Reserves and Group
I and Group III Reserves (1955-1968)

36

graphically as a negatively sloped line as depicted in
Figure 3. We move now to a discussion of foreign exchange
reserves and construction during the 1870-1914 period and

further specification of the model.

The Relationship Between Foreign Exchange

 

9

Reserves and Construction (1870-1914)

 

It was illustrated earlier in Chapter II, Figure 2,

that during the 1870-1913 period the terms of trade and the

 

ill—n" "351...“!

building cycle were positively related in the United Kingdom. w
Also both of these series were inversely related to build-
ing in the United States. If, as our earlier analysis sug-
gested, the terms of trade series can be used as a rough
approximation (at least in sign) for foreign exchange re-
serves (f), we find that an increase in F will be accompanied
by an increase in domestic construction activity (C) in the
same country (or group). This relationship is represented
in Figure 6.

The empirical justification for this correspondence is
further supported by Cairncross. He points out that in
Britain, "The boom of 1900 was perhaps the only one in which

it was not foreign investment and the prosperity of the ex-

 

port industries that set the pace for domestic construction".S

 

SCairncross, A. K., Home and Foreign Investment: 1870-
1913, Studies in Capital Accumulation, Cambridge University
Press, London, 1953, p. 188 (emphasis mine).

 

 

37

C
Group III

 

 

F Group III
Figure 6.--Construction and Foreign Exchange Reserves
in Industrialized Countries (1870-1914)
This points to a positive relationship between prosperity in
the external financial position of a country and its domestic
construction sector.

In Figure 7 the relationship between F and C for the less
developed countries (Group I) is illustrated. Note that the
sign of the coefficient implied is positive as in Group III
above, since there is no 3 priori reason to predict a change.
A four quadrant model will be constructed below; from this it
will be shown that this relationship must be the case, given
the relationship in the other quadrants.

The magnitude of the coefficient (i.e., 510pe of the line)
is assumed higher for Group I. The reason for this assump-

tion is that Group III countries are better able to offset

 

38

Group I

1"..—

 

 

 

F Group I
Figure 7.--Construction and Foreign Exchange
Reserves in Non-Industrialized Countries
(1870-1914)
domestic repercussions from changes in their international
financial position. This is true because Group I countries
lack the administrative ability and institutional structures
needed to transfer and redirect domestic activity within the
economy. Also the ratio of tax revenue to gross domestic
product is very low for less developed countries.6 The diffi-
culty of applying fiscal and monetary policy under these con-
ditions is apparent. Fluctuations in F therefore, can be ex-

pected to affect the countries in Group I more directly and

 

6UNCTAD, "The Tax Structure of Developing Countries", In
Meier, G. (Ed.), Leading Issues in Economic Development, Oxford
University Press, 1970, 2nd Edition, pp. 200-203. Also see,
MacBean, A., Export Instability and Economic Development,
Harvard University Press, Cambridge,iMass., 1966, pp. 245-53.

 

 

39

and more severely. This point will be discussed more fully

in Chapters V and VII.

The Basic Model (1870-1914)

 

In Figure 8, the three relationships presented above

are consolidated. Quadrant I depicts the empirical relation-

ship between foreign exchange reserves in Group I and mm

Group III countries. E
In quadrant II and IV, the relationship between construc-

tion (C) and foreign exchange reserve holdings (F) is de- 1.

 

picted; note that dC/dF is greater in Group I than in Group '
III but is greater than zero for both. Quadrant III illus-

trates the interaction between C in Group I and Group III

countries. This relationship is identical to the empirical

findings discussed in Chapter II showing that the building

cycles in industrialized and non-industrialized countries are

inversely related.

It was also shown that in the industrialized country
(U.K.) the level of foreign exchange reserves and the level
of construction were positively related and that exchange re-
serves of the two countries were inversely related. The
three quadrants which have been justified empirically are
shown in Figure 9.

The fourth quadrant of this model is determinate. The
relationship between F and the less industrialized countries
must be positive. In fact, even without the information re-

lated in quadrant II, we can be quite certain that the slopes

40

Group I

IV I i.

 

   
 

A

 

C Group I

 

C Group III

Figure 8.——Four Quadrant Model with All
Quadrants Given (1870-1914)

41

 

 

F
Group I
IV I
C Group I F Group III
III II
C
Group III

Figure 9.--Four Quadrant Model With
Three Quadrants Given

 

I!"I‘lll11.l‘ll§lil

 

in both quadrants II and IV are positive.

42

It can be easily

demonstrated that the signs of the slopes in quadrants II and

IV must be the same, given the inverse structure of quadrants

I and III.

strongest argument can be advanced, I and III.

 

 

 

we have:
Equation 1 CI = f(CIII)
Equation 2 CI = f(g(FIII))
Equation 3 CI = f(g(h(FI)))
- dCI = v, ., :
Equat1on 4 dF‘ f g h
I
dC dC dF
- . _ I III . III
Equation 5 —-—dCIII dFIII —-a—F—I——
dC
Since: I is less than zero
dCIII
dF
and III is less than zero
aF1
dC dC
both __1 and III
dFI dFIII

than zero or greater than zero.

Let us take the two quadrants for which the

Mathematically

must be either less

Their signs cannot differ.

If the signs for these two groups must be the same, it

is apparent that they must have been positive for the 1870-

1913 period.

One might speculate that for the high income

country it might have been possible at this early stage of

industrialization to protect itself partially from external

financial fluctuations.

However,

for the non-industrialized

countries to have been able to accomplish this, they would

 

43

have required tools far beyond their reach. Even today it is
difficult for the poorer countries to exercise control over
their domestic monetary mechanism in order to stabilize their
country.7
In jumping from the foreign exchange reserves directly

to domestic construction in the respective groups, it might
be charged that we have bypassed the machinery which acts as
the transmission device for this process. However, the ten-
dency for countries at all levels of development to maintain
restrictive monetary policy in order to alleviate shortages
in foreign exchange reserves is well documented.8 As Mundell
pointed out

The money supply is...increased indirectly

through the back door of exchange rate

policy. Foreign Exchange reserves accumu-

late by the full amount of the increased

cash reserves needed by the banking system

to supply the increased money demanded by

the public as a consequence of the increase

in income.

In this passage, Mundell is referring to the present gold ex-

change system. The mechanism he describes operated even more

 

7See for example: Tun Wai, ”Interest Rates in the Organ-
ized Money Markets of Underdeveloped Countries", International

 

 

Monetary Fund Staff Papers, Vol. V, No. 2, August, 1956, pp.
249-78.

 

8Meier, Gerald M., Leading Issues in Economic Development:

 

Studies in International Poverty, 2nd Edition, OxfordiUniVer-
sity Press, Cambridge, 1970, p. 293.

 

9Mundell, Robert F. International Economics, MacMillan,
New York, 1968, p. 255.

 

44

directly under the old gold standard when domestic currency

was tied to gold holdings.

Domestic Ramifications of External Changes
There are several domestic ramifications of changes in a

country's foreign reserve holdings. As stated earlier, when

 

.3.
reserves are relatively high, 'easy' money policies and fall-
ing rates of interest are observed. If Mundell's policy recom-
mendations were explicitly followed, "...monetary policy ;
(would) be aimed at external objectives and fiscal policy at if

internal objectives...”.10

Perhaps this is an overstatement
since it implies complete domination of domestic monetary
policy by balance of payments concerns. This certainly is not
the case. However, the direction of changes in the money sup-
ply should hold true.

Mundell also points out that "The restrictive monetary
impact of the foreign exchange sales (to foreign governments)
...are offset by further open market purchases that induce
further sales of foreign exchange”.11 This series of events
continues until explicit policy is introduced to deal with
the imbalance or until the supply of reserves is exhausted.

The effect of exchange sales depends upon the type of policy

adopted and the vigor with which it is applied.

 

l01bid., p. 233.
111bid., p. 257.

45

The practice of 'sterilizing' the mone-
tary effects of foreign exchange (or
gold) purchases and sales has become
widespread as countries look for means
of adjusting balance of payments other
than that implicit in price level (or
interest rate) adjustments. Central
banks may prefer to delay adjustment
for a time by allowing reserves to be
built up or depleted. 2

The variability of foreign exchange reserves induces changes
in the interest rate, which in turn, if not dealt with by the

central bank, will affect the domestic price level. The

 

direction of this effect is clear. When reserves are low ii
there is upward pressure on the interest rate and the con- ~
traction of the money supply exerts a downward pressure on
the price level. Conversely, when reserves are high, there
is a tendency for the price level to increase.13
The interaction between reserve positions and domestic
interest levels and prices are especially pronounced under
the gold standard system of international exchange. Both
the direction and the strength of the movements are predict-
able. Under the gold exchange standard, the fluctuations
in reserves are transmitted to the domestic economy. The
direction of change is predictable. The degree to which
external shocks are transmitted to the internal economy is
one of the central questions of this study.
A complete discussion of the transmission mechanisms

and the statistical verification of the direction and

 

121bid., p. 233.
13Ibid., p. 161.

46

magnitude of the changes induced by external factors would
entail a study as large as the present one. The character-
istics of the transmission mechanism will be largely inferred
in the model discussed above. The model relies on such a
mechanism and its operation can be indirectly observed when
the model is tested in Chapter V.

To some extent, the fluctuations set into play by re-
serve variations are self-correcting, unless the imbalance is
induced by deficits (or surpluses) and is considered to be
chronic. The fact that reserves are low leads to policies
which favor a higher rate of interest which in turn stimu-
lates capital flows and reverses the direction of reserves.

In the fixed-exchange-rate case an
interest rate below its equilibrium
level creates inflationary pressure
and a rise in the price level, which
in turn generates a balance of trade
and payments deficit, prompfiing a
rise in the 1nterest rate.

The direct relationship between foreign exchange re-
serves, the interest rate, and construction activity seems
apparent. As reserves increase, domestic interest rates
will be kept low for two reasons. Under the gold standard,
the first effect is automatically put into play; when re-
serves increase, the domestic money supply increases. The

result of an increased money supply is to lower interest rates.15

 

14Ibid.

 

15Petersen, Wallace C., Income, Employment, and Economic
Growth, W. W. Norton 8 Co., New York, ReVised Edition, 1967,
pp. 303-340. '

 

 

47

The second effect stems from the actions of the central
bank and is a characteristic of the gold exchange standard.

Ifirserves are regarded by the central bank as high (deter-

mined historically), they are "...more likely to allow a

deficit in the current balance to continue before remedial

action is taken...”.16 If and when the remedial action is F1;
taken, interest rates will be pushed up in order to stop

the capital outflow. P

 

Summary “I

In summary, the more a country is able to mitigate the

effects of external fluctuations domestically during a per-

iod which exhibits the accumulation of more reserves, the

less expansionary domestic policies would be anticipated.
Favorable international conditions allow a reduction of the

domestic interest rate because the necessity of attracting

foreign funds is lessened. The lower interest rate would in

turn make domestic investment in industry and construction

more profitable.

We are concerned with the ability of countries to pro-

tect their domestic building activity from the international

financial sector. The relationships postulated directly

zflxyve and in Figures 5 and 6 correspond to a time period

pricnr to World War I. The direct correspondence between

forwaign exchange reserves and construction in both the in-

diurtrialized and the less industrialized countries during

 

16Mundell, pp. cit., p. 163.

 

48

thisrmriod was the result of national policy goals and the

Inevafling institutions in both groups. Not only is it likely

thatthe policies have changed; the ability of countries to
copexfith fluctuations in reserve positions has been vastly

altered. Howenstine has pointed out that:

As an economy grows more and more accustomed
to continuing full employment and a high
economic growth rate, construction activ-
ity may be expected to exhibit an increas-
ingly greater degree of stability from

year to year.

Thus we might expect domestic construction to be better pro-

tected from external factors as countries deve10p. On the

other hand, to obtain these policies, construction may have

to do more compensatory fluctuating. At any rate, we would

expect domestic construction to be affected less by external

factors as the level of development increases.-

Chapter IV will discuss and compare the similarities and

differences between the two time periods under considera-

tion. During the 1870—1914 period, the positive relationship

between foreign exchange reserves and construction was de-
termined empirically. For the 1955-68 period, the sign and

:strength.of this relationship will be tested empirically. It

will.13e shown that alterations in the model might be neces-

sarjr, and that the model will still be useful under different

assumptions.

 

:17Howenstine, E. J., Compensatory Employment Programmes,
(Jrgarrization for Economic Co-operatibn and Development,

.Parixs, 1968, p. 361.

 

 

‘__. _,

A

 

 

CHAPTER IV

ADAPTABILITY OF THE BASIC MODEL

Changing International Conditions

 

 

F?-

The pre—World War I period discussed at length in Chap- 1'
ters II and III was characterized by a stronger financial .
interdependence between countries than exists today because 3
their economies were linked together by the gold standard. ’

”For well before 1900, the widening circle of economic devel-

opment had transmuted the economies of other important coun-

l

 

tries”. Approximation of the gold standard during this per-

iod made it difficult for even the most highly developed na-
tions to protect their domestic activity from the vagaries of
international finance.

Karl Polanyi, in a detailed examination of the 'trans-
formation' of the self-regulatory characteristics of the
market system, states with some exaggeration:

That system developed in leaps and bounds;
it engulfed space and time, and by creating
bank money it produced a dynamic hitherto
unknown. By the time it reached its max-
imum extent, around 1914, every part of

the globe, all its inhabitants and yet un-
born generations, physical persons as well
as huge fictitious bodies called corpora-
tions, were comprised in it.

 

1Supple, Barry E., The Experience of Economic Growth,
Random House, New York, 1963, p. 39.

 

49

50

Yet simultaneously a counter movement was
on foot. This was more than the usual
defensive behavior of a society faced with
change; it was a reaction against a dis-
location which attacked the fabric of
society, and which would have destroyed
the very organization of production that
the market had called into being.2

Clearly a dramatic change was in the making. An economic sys-
tem which had previously been 'laissez-faire', at least in
phiIOSOphy, was under attack as early as 1914. Events were

destined to press even harder for the needed alterations in 3

 

the economic order, especially in the most industrialized ii
countries where the familiar categories of land labor and
capital had gradually become monetized.
The need for positive action was widely recognized during
the depression of the thirties. In 1935, J. M. Keynes stated

in the General Theopy that

Recently, practical bankers in London have
learnt much, and one can almost hope that
in Great Britain the techniques of bank
rate will never be used again to protect
the foreign balance in conditions in which
it is likely to cause unemployment at home.

We have since come to view governmental 'interference'
designed to insulate domestic markets from international

fluctuations as a necessary, if not desirable, national policy

objective.

 

2Polanyi, Karl, The Great Transformation: The Political

and Economic Origins of our Time, Beacon Press, Boston, 1957,
p. 130.

3Keynes, J. M., The General Theory of Emplqyment, Inter-
est and Money, Harcourt, Brace and Co., New York, 1960, p. 339.

51

The question we shall address ourselves to in the next
section is how uniformly is the practice of stabilization em-
ployed. More specifically, do the less developed countries
have sufficient tools and receptive institutions which will
allow the successful manipulation of their economies. We
mentioned earlier that the less developed nations are less
well equipped to undertake such operations. We must now ascer-
tain the degree to which they have been successful. This

will entail the relaxation of some of the assumptions intro-

 

w... -r__ -...... ,

duced in the model for the 1870-1913 period.

Altering the Model

 

In Chapter 11, Figure 1, building cycles in the United
States (non-industrialized) and the United Kingdom (industri-
alized) were shown to be inversely related. In a more recent
period (1955-68) cycles in construction in two groups of coun-
tries were analyzed. These groups were introduced earlier in
the previous chapter as Group I (income less than $500) and
Group III (income greater than $1000). The results of this
inquiry are illustrated in Figure 10.

Unlike the earlier period where the cycles were shown to
be inversely related, the relationship in the more recent per-
iod is direct. In fact we can observe no cycle at all. The
cycles usually observed in these trends are diminished be-
cause an average of all the countries in each group is calcu-
lated. However, both series are monotonic throughout nearly

the entire period under consideration. What implication does

Dollars (Real) Indexed

U.S.

Construction

 

1956

52

1 1 g 1 4' I l 1 l 1 J

57 S8 59 60 61 62 63 64 65 66 67

Figure 10.--Construction in Developed and Less Developed
Countries: 1956-1968 (Sample Data)

 

J

68

 

53

this have for the model postulated earlier under somewhat
different assumptions and empirical evidence? Clearly some
revision is called for.

Reconstructed in Figure 11 is the four quadrant model
introduced earlier. The relationships which have been estab-
lished for the 1955-68 period are illustrated in quadrants
I and III. In the remaining quadrants (II and IV) the out-
come is, p priori, not known. We cannot determine the signs
of the coefficients in these two quadrants. However, we do
know that they cannot have the same sign. This can be shown
by returning to our earlier mathematical argument in Equa-

tions (4) and (5) in Chapter III.
dC

 

 

 

Equation (4): 3F% = f'-g'-h'
Equation (5); dCI = dCI , dCIII , dFIII
dFI dCIII dFIII dFI
. dFIII - dCI -
Since 15 less than 0 and CIII is greater than 0,
either %%% is greater than zero and dFiii<z 0 or %%%<: 0 and
dCIII
——— — 0.
dFIII >>

This implies that one of the groups of countries has
become less sensitive to international vibrations while the
other continues to experience difficulty in insulating domes-
tic activity from external shocks. Intuitively we suspect
the more highly developed countries have not only sharpened

their ability to insulate the domestic economy from outside

54

 

 

F

Group I

IV I
\\.
\\
\\
\\
\\
‘\\
\\\
C Group 1 F Group III
,-
/
/
/
’,r
x’
/

III C II

Group

III

 

 

Figure 11.--Four Quadrant Model

55

disturbances, but perhaps some part of this insulation con-
sists of countercyclical stimulation of the construction sec-
tor. Polanyi's thesis, presented earlier in this chapter,
stated that the industrialized countries first made the trans-
formation. .And the awareness of the need for the increased
intervention occurred during the period when the rapidly
developing countries experienced the depersonalization of

the factors of production and the monetization of nearly all
productively related activities. If our reasoning is sound
the relationships in quadrants II and IV should be negative
and.positive respectively as shown in Figure 11 by the dotted
lines.

The line depicted in quadrant I of Figure 10 also shifts
outward (to the northeast) over time. This movement reflects
increases in world reserves. During the 1870-1914 period,
this movement was primarily the result of world gold produc-
tion which was rapidly though sporadically expanded.4

During the 1950's and 60's, there was a ”...glaring in-
adequacy of new gold production and supplies for interna-
tional reserve usage".S Most of the increased reserves were
held in the form of hard currencies, especially the U.S.

dollar.

4Henderson, W. O., The Industrial Revolution in Europp,
Quadrangle Books, Inc., Chicago, 1961, p. 46

 

5Kurihara, Kenneth K., "The Gold-Dollar Problem and
World Monetary Reform", Journal of Economic Issues, Vol. I,
No. 4, December 1967, p. 271.

 

 

56

The insufficient supply of monetary gold
is brought into relief by the fact that
during the 1958-1964 period new gold pro-
duction, including sales of gold by
Russia, contributed the average annual
amount of $500 million to the reserves

of the Western world while the American
payments deficits supplied the average
annual amount of $2 billion to those
world reserves.

During the post-Korean War period, reserves were held
largely in dollars, made possible by the deficits incurred
by the U.S.. As confidence in the dollar fell, countries
cashed in their dollar reserves for gold. This precipitated
the recurring crises experienced during the 1960's.

Thus the shifts observed in total reserves occurred for
different reasons in the two time periods observed. In the
earlier period, reserve levels provided sufficient liquidity
because of increasing gold production. In the latter period,
when the dollar was the primary reserve component, loss of con-
fidence in the dollar led to speculation against the dollar.

It is difficult to assess the adequacy of reserves in
the post World War II period. In Western Europe, there ex-
isted a liquidity Shortage "...even after the realignment of
exchange rates in 1949".7 However, the "...flexibility of the

gold-exchange standard...enabled European reserves to be re-

established in the 1950's...".8 In the 1960-66 period,

 

6Ibid., p. 271.

7Gilbert, Milton, "Problems of the International Monetary
System", Essays in International Finance, No. 53, April 1966,
Princeton University, New York, p. 15

 

81bid., p. 11.

 

57

"...the large U.S. deficit has necessarily meant that the in-

crease in gross official reserves in the system has been large”.9
Discussions centered around the liquidity problem in

recent years are addressed primarily to expectations of insuf-

ficient liquidity because of the method of providing reserves.

If speculation against the dollar occurs on a large scale, the

willingness of trading partners to hold dollars as a reserve

currency will be lessened. In the absence of alternate

sources of liquidity (e.g., Special Drawing Rights), this

would result in a sharp reduction of world reserves.

Summary

I have postulated a basic model in this chapter. Of
the four functional relationships presented, empirical evi-
dence provides the signs of the coefficients for at least
three of the four relationships during the 1870-1914 period.
The remaining one is deduced from these. The development of
financial intermediaries over the last several decades in the
more advanced countries suggests that these relationships
have changed. Further investigation of data during the 1955-
1968 period justified this skepticism. The building cycles
were inversely related in the 1870-1913 period. During the
more recent period examined, the cycles were directly related.
The relationship between foreign exchange reserves of the

two groups has not changed. Thus, it was determined that the

 

91bid., p. 12.

 

 

 

 

58

relationship between foreign exchange reserves and construc-
tion in one of the groups has changed.

It appears likely that the change occurred in the high
income group (III). Yet intuition, however helpful in organ-
izing ideas, is not conclusive. The next task is to deter-
mine specifically which group did in fact change. In Chap-
ter V, the hypotheses will be formalized and methods of test-

ing the hypothesis will be explicitly presented.

 

 

 

CHAPTER V
METHODOLOGY

Classification System

In the investigation of the empirical questions raised

 

 

earlier, the following classification system will be employed:

.
t
.

I

E

.

.

D

I 414.1

 

 

 

Table II.--Countries Grouped According to Income
Average
Per Capita Income
Gropp _(in U.S. dollars 1966)
I 0-500
II 501-1000
III Over 1000

 

 

The data are taken primarily from United Nations'
sources and cover the period 1955 through 1968. The sample
data are compiled from 36 countries which are classified
according to the schedule in Table II. Table II provides
the list of countries contained in the study and the group
to which they are assigned.

It was noted in Chapter II that it is important to dis-
aggregate residential building from total construction. One
of the main criteria used for the selection of countries in
this study was the availability of separate data for each

activity. The list which appears in Table III represents

59

60

all those countries for which reliable data was available.

Table III.--The Countries in the Sample Grouped According
to Income

 

 

 

Group I- Group II Group III
China (Taiwan) Argentina Belgium
Columbia Austria Canada
Dominican Republic Chile Denmark
Ghana Cyprus Finland
.Honduras Greece France
Korea Ireland Germany
Panama Italy Israel
Philippines Japan Netherlands
Portugal South Africa Norway
Thailand Spain Sweden
Turkey Uruguay Switzerland
Venezuela United Kingdom

 

The United States is omitted from the sample because no
meaningful measure of foreign exchange reserves is possible.
As long as U.S. dollars are acceptable as foreign exchange
abroad, reserves are hard to distinguish from the domestic
money supply in the United States.

In several of the sample countries, the data were taken
from selected portions of the country. In China, Columbia,

Thailand, and Turkey, only urban construction was included

 

 

 

 

61

in the sample. Ghana and Panama gathered data only in their
capital cities. Argentina extrapolated data for construc-
tion from occupancy permits which were issued during the
year. while Chile relied on construction statistics compiled
from sixty cities.

These differences in data collection procedures are
characteristic of less developed countries. This data has
drawbacks for simple cross-sectional studies, but this study
is interested primarily in the relationship between variables
over time. Thus, if changes in the level of construction
reported in selected cities are typical for the country, we
may assume the data are reliable for our purposes.

Countries in Group I, with the possible exception of
Ghana, have largely followed orthodox international mone-
tary policies. Many less developed countries often resort
to import and exchange controls and ad hoc arrangements to
correct for imbalances in their reserve position. Thus,
the sample used in this study is biased in that the group
of countries analyzed may not be representative of low in-
come countries in general.

Even if both the Group I and III countries were attempt-
ing to stabilize their construction sector through the use
of similar policies, the success or failure of these policies
depends ultimately on the mechanisms available for imple-
menting them. As mentioned in Chapter II, these mechanisms

differ considerably among countries. The developed countries

 

 

 

62

are characterized by relatively sophisticated and fairly well
developed mortgage markets. Mortgage markets in the less
developed nations are usually less efficient and poorly or-
ganized. This is especially true in the housing market
where home-buyers in poor countries must rely largely on
their own financial resources when purchasing a dwelling.
The basic aim of the statistical analysis is to deter-
  mine the effect of foreign exchange reserves on total con-
struction and the construction of dwellings. These rela-
tionships will be examined separately for each group of
countries. We shall also determine the degree to which do-
mestic construction in each group is associated with the
following variables: Exports, exports as a percentage of
gross national product, foreign exchange reserves, gross na-
tional product, the per cent of total population which re-
sides in urban areas, and an index of currency valuation.
Multiple regression techniques will be employed to discern
the magnitude and direction of the influence of the various
independent variables selected. All variables are in real

terms.

Specification of Variables
Two general equations will be estimated, one using con-
struction, the other using residential construction of

dwellings. These systems are specified as follows:

 

 

 

63

1. C(1)t = 80 + BlaEt‘l '1' BZYEt'l + 830Et_1 + B4aFt‘l

Where C(l)t

BOBN

(1

V
Ut

+ BSYFt-I + B65Ft-1 + B7Yt-1 + B8IE/Y1t-1

+ BgP + 810V + Ut

Domestic construction (excluding public
works)

Coefficients to be determined

1 if per capita income is less than or
equal to 500

0 otherwise

1 if per capita income is between 500
and 1000

0 otherwise

1 if per capita income is greater than or
equal to 1000

0 otherwise

Foreign exchange reserves lagged one time
period

Exports lagged one time period

Gross national product lagged one time
period

Exports as a per cent of gross national
product lagged one time period

Per cent of population residing in urban
areas (i.e.. over 20,000 in 1960)

Exchange rate valuation

Error term

2. C(2)t = Same as Equation 1 above

Where C(Z)t

Domestic construction of dwellings and all

 

 

64

other variables are identical to those in
Equation 1.

Hypothesis

 

The simple null hypothesis is:
H : B4'= 85 = 86 = O (For equations (1) and (2))
The alternate (composite) null hypothesis is:

HA : 84 > 0 ; 86 < 0

The null hypothesis (HO) simply states that there is no
relationship between foreign exchange reserves and construction
in any of the groups. If this is rejected, the alternative
hypothesis (HA) is then tested.1 This states that foreign
exchange reserves and construction are directly related in
Group I countries and inversely related in Group 111 countries.
These relationships were anticipated and illustrated in Chap-
ter IV, Figure 2.

In Chapter III, the model presented employed only two
groups (I and III). In the preparation of the statistical
analysis I have added a middle group (II). There is some
question as to the effectiveness of including this group.
Obviously, the delineation of the countries in this group

will be less distinct than the others since it includes

 

1The use of two hypotheses is common. ”The null hypoth-
esis usually states that the postulated relationship does
ppp exist, which normally means that the value of one or
more of the parameters is equal to zero, while the alterna-
tive hypothesis states that the relationship does exist."
Kmenta, Jan. Elements of Econometrics, MacMillan Co., N.Y.,
1971, p. 115.

 

 

a

 

65

countries whose per capita income might be a few dollars above
the low group or a few dollars below the high one. At any
rate, we can utilize this group as a buffer, separating the
other two.

The inclusion of Group II does not, however, affect
our test of the assumptions presented in the model. In fact,
its inclusion should allow us to provide additional informa-
tion. As pointed out in Chapter I, Strassmann has shown re-
cently that ”Construction grows less than GDP in underdevel-
Oped countries, more than GDP in the developed, but the posi-
tive differential is greatest in the middle group.”2 These
results differ from earlier tests run by Kuznets.3 Since we
will be regressing construction against income for the high,
middle and low income groups, this study should provide addi-

tional information which might help to settle this issue.

The Selection of Dppendent Variables

Two dependent variables are observed in this study:

Total construction (CI) and the construction of dwellings (C2).4

 

2Strassmann, W. P., "The Construction Sector in Economic
Growth", Scottish Journal of Economics, November, 1970, p. 399.

 

3Kuznets, Simon, "Quantitative Aspects of the Economic
Growth of Nations, Part V, Capital Formation Proportions: In-
ternational Comparisons for Recent Years," Economic Develop-
ment and Cultural Change, July 1960, Part II, pp. 4-33.

 

4The specific components of these categories and the
sources of data will be discussed in detail later in this
chapter. '

 

 

 

 

 

.1: ll

66

It was pointed out earlier that disaggregation of the con-
struction sector is necessary. If total construction and dwel-
ling construction are affected differently by the independent
variables, failure to separate them would result in the esti-
mation of coefficients which would be representative of
neither.

The way in which a country reacts to changes in its re-
serve position will influence each sector differently. In
most developed countries cited in this study, the construc-
tion of dwellings depends primarily on the initiative of pri-
vate building firms and their response to fluctuations in
the interest level in mortgage markets.

In many less developed countries, it is nearly impossible
for the average worker to secure funding for the purchase of
a home. Alluding to the Philippines, Abrams states that
"... for the average man, getting a mortgage was like hunting
big game in Mindanao with a sling shot."5

In most of the developed countries, the housing shortage
is also very severe. However, the methods of financing home
purchases is quite different. There exists in most of the
wealthier nations a well functioning mortgage market. Even
when the financing of housing construction is undertaken by
social housing associations, the recipient of the loan must

secure additional funds from conventional mortgage sources

 

5Abrams, Charles, Man's Struggle for Shelter, Massachu-
setts Institute of Technology Press,TCambridge, Massachusetts,
1964, p. 151.

 

 

 

 

67

such as savings and loan associations.

This need for additional borrowing means that interest
rate fluctuations will influence the domestic construction
of dwellings in the developed countries even when a portion
of the funds is secured through government agencies. Thus
we found an inverse relationship between foreign exchange
reserves and the construction of dwellings in the high income
countries.

The strength of the influence exerted by the domestic
interest rate is determined by the extent of social housing
undertaken and the portion of the total cost of the dwelling
and site which is covered by the social loan. In Austria,
approximately one-third of the dwellings built are financed
by the social housing associations.6 However, "...the loans
granted on first mortgage are generally limited to 40% of
the value of the real-estate."7

In France, between fifty and sixty-five per cent of the
market value of the purchase can be secured through public
sources. Yet "In order to finance a third of the building
Operations...it is then necessary to get complementary loans

at higher rates of interest and with a shorter redemption

 

6International Standing Committee for Social Housing
(Ed.), The Financing of Social Housing in 11 European Coun-
tries and Israel, Secretariate of the Standing Committee for
SoCial Housing, Confederation Francaise Pour L'Habitation
et L'Urbanisme, Paris, 1965, p. 253.

71bid., p. 255.

 

 

68

delay.”8
According to some analysts, housing in the United States
'h..has been a residual user of credit market funds”9 since
World War 11. However, since 1966, ”...major changes have
been made in Federal housing policy designed to loosen the
link between housing and credit market conditions and provide
more housing for the poor.”10 If funds used for home-building
can be viewed as a residual, this implies that housing is
elastic with respect to the interest rate. During periods
of tight money and high rates of interest, housing construc-
tion should fall. In order to determine the significance
of the 'residual' concept discussed above and its relevance
to the model used in this study, it is necessary to examine
the relationship between the rate of interest and foreign
exchange reserves. Unfortunately, this effect is difficult
to ascertain. In the United States, a high rate of interest
is usually associated with the latter stages of a boom period.
If prosperity is the result of domestic private investment
and government Spending in excess of domestic savings and
government revenue respectively, both national income and
imports should increase. The effect of increased imports is

to lower exchange reserves; however, the effect of the high

 

81bid.

 

9The Chase Manhattan Bank, "Housing and Credit Conditions;
Breaking the Link”, Business in Brief, No. 104, June 1972, p. 4.

 

lolbid.

 

 

 

69

interest rate on international capital flows should tend to

increase foreign exchange reserves through an increase in

capital flows. The relative strength of these two effects

is difficult to assess p priori.
It is also possible that domestic prosperity could be

the result of a boom in export markets. In this case, the

increase of exports, other things equal, should increase

foreign exchange reserves. If we can again associate higher

rates of interest with the upward swing of the business cycle,
the effect of an export induced expansion is unambiguous.

Both the higher rates of interest and the increase in exports

tend to increase foreign exchange reserves.
During the 1950's and 60's, the United States did not

enjoy a boom in its export sector. On the contrary, exports

were falling rapidly.11 Thus the effect of high interest
rates in this period are ambiguous. The increase in imports
has the opposite effect on reserves as the increase in the

rate of interest. The combined effect is uncertain, at

least for the United States.

These examples cited above illustrate the different char-

acteristics displayed by the industrialized and non-industri-

zrlized countries in this study. The developed countries rely

largely on specialized mortgage institutions for the financing

 

11MacDougall, Sir Donald, ”The Dollar Problem: A Re-
aruxraisal”, Essays in International Finance, Princeton Univer-
sity7 International Finance Section, No. 35, November 1960.

Pr11n2eton, New Jersey, pp. 44-47.

 

 

 

70

of housing construction. The less developed countries, on

the other hand, have not yet developed these institutional
structures to the extent that they can provide for the financ-
ing of a significant portion of the home building sector.

Some possible policies which might be introduced to help

solve the problems faced by both the low and high income
countries will be discussed in Chapter VII.

Strassmann shows that housing construction as a per cent
of gross national product is 2.5 per cent for under-developed
countries and 4.4 per cent for developed countries.12 Thus,
even if both groups react the same way to a change in reserves
(transmitted through the domestic interest rate structure),
the deve10ped countries' construction of houses would be
more directly affected than the less developed countries be-
cause their construction sector is more responsive to changes
in national income. The strength of these relationships will

be tested in Chapter VI.

The Selection of Independent Variables

 

Six independent variables will be employed to estimate

equations 1 and 2 above. Two of these. foreign exchange re-

serves and exports, were blocked according to per capita income

levels and assigned dummy variables in the regression. The
remaining four variables were estimated for each country, and

entered into the regression as a single variable.

 

12Strassmann, W. P., pp. cit., Table II, p. 407.

 

 

71

Foreign Exchange Reserves
The foreign exchange reserve variable (F) is basic to
the model presented in Chapter III and the hypothesis stated
above. The reasons for its inclusion were discussed in depth

in Chapters I through IV.

Exports

Exports were selected for inclusion in the regression
for several reasons. It seemed desirable to include a measure
of the physical movement of goods and services as well as
the financial variable (F) which includes capital movements.
In the early stages of the development of this study it was
decided to use the balance of payments as an independent
variable. However, further inquiry suggested that exports
could be more suitable employed in the context of this model.
In the less developed countries ”exports...tend to generate
parallel fluctuations in their imports."13 This is true
because when export proceeds fall, the weakened reserve posi-
tion forces countries to reduce their imports. It is possible
that the government will attempt to apply countercyclical
measures. This will be discussed in Chapter VII.

In the developed countries we notice the same parallel
movement. In this case, however, the reason for the corres-

pondence is different. When exports fall there is a tendency

 

13MacBean, Alasdair, I., Export Instability and Econ-
omic Development, Harvard University Press, Cambridge, Mass-
achuSetts, 1966, p. 31.

 

 

 

72

to restrict imports in order to maintain equilibrium in the
"...quantitative restrictions are often

They
l4

[alance of payments.
introduced to improve a country's balance of payments.
have an immediate visable impact on a country's imports".
In both cases, the fluctuation in exports is followed
by similar movements in imports. However, there is a lag
involved in the adjustment process. The length of this lag
varies among countries and depends upon the nature of the
policies implemented and the speed with which they take ef-

fect.15 Some of these policies were discussed earlier in

this chapter. Attempting to adjust for this effect on a

country-basis would have entailed a separate study as lengthy

as the present one. Since foreign exchange reserves and

balance of payments tend to move together,16 it was considered
unnecessary to use the balance of payments as an independent

variable since it would simply reflect foreign reserve move-

ments.

Gross National Product
Gross National Product was introduced in order to provide

a country adjustment for variations in income during the per-

iod under consideration. The effect of including GNP is to

 

14Sodersten, Bo, International Economics, Harper and Row,
Publishers, New York, 1970, p. 369.

15MacBean, pp. cit.. p. 259.
16Ibid., p. 84.

 

73

sort out the business cycle effect. The coefficients esti-
mated for the remaining variables are indicative of the ef-
fect of the variables after the influence of all other vari-
ables has been accounted for.

It was noted earlier that GNP has a strong effect on

 

construction activity.17 The exclusion of an independent :3
variable which is statistically significant will damage the
tests of significance. Thus, even though it is well known ~

.
that GNP is directly related to construction activity, the
strength of this correspondence must be isolated in order to t!

test the other variables.

Exports As A Percentage Of GNP

 

The dependence of a large portion of national income
on earnings from the export sector was recently thought to
be a characteristic of less developed countries. Both
Higgins18 and Singer19 have promulgated this view. Later
empirical studies have not substantiated this argument.

20

Kuznets and Michaely21 report that the level of development

 

17cf. Chapter I above.

18Higgins, Benjamin, Economic Deve10pment, W. W. Norton,
New York, 1959, p. 155.

 

19Singer, Hans, The Districtueion of Gains Between In-
vesting and Borrowing Countires," American Economic Review,
May 1950, p. 473.

 

ZOKuznets, Simon, Six Lectures on Economic Growth, The
Free Press, Glencoe, Illinois, 1959, pp. 89-107.

 

21Michaely, Michael, Concentration in International

Trade, N. Holland Publishing Company, Amsterdam, 1962,
Table 12.

 

74

is not related to the share of exports in GNP generation.
Thus an early attempt to link instability experienced by the
less developed countries to their purportedly large volume
of exports as a percentage of GNP was shown to be incorrect.

The 'engine of growth' view of trade implies that as
trade becomes more prominent in the economy of a country,
d.22

the rate of growth will be sustained or accelerate

Cairncross states that:

 

The common experience in under-developed
countries is not that exports are already
a dangerously large element but that they
are not large enough to give adequate el-
bow room in the financing of new invest-
ment.

E:
l

Thus we should expect that in countries where the volume of
exports relative to GNP (E/Y) is rising, domestic activity
will similarly increase.

The equations which are being estimated in this study
lend themselves nicely to a test of the 'engine of growth'
theory. If Nurkse and Cairncross are correct in their as-
sertions, we should find that movements in the variable E/Y
are directly related to the growth of National Income. And,
since we have shown earlier that there exists a strong direct

relationship between the growth of income and construction,

 

22Nurkse, Ragnar, "Trade Theory and Development Policy",
in H. 8. Ellis, (ed.), Economic Development for Latin America,
MacMillan and Co., St. Martin Press, New York, 1961, ppTV236-45.

23Cairncross, A. K., Factors in Economic Development,
George Allen Unwin, London, 1962, pp. 214-20.

75

the inclusion of E/Y in the regression equations 1 and 2 can
be accomplished with no alternation in the system.

If the coefficient estimated for E/Y is positive, the
engine of growth theory is supported. If this coefficient

is negative, the theory is not supported.

 

 

F’.
Per Cent of Population Residing in Urban Areas I
The effect of the population variable is somewhat am- 4
biguous. Because of data limitations, I was able to find only 6
the per cent of population residing in urban areas in 1960. *1

The most desirable variable to use in this context would
have been the percentage change in the per cent of population
living in urban areas; this data was not available for many
of the countries in the sample. However, I did uncover
enough data to ascertain the relationship between the abso-
lute per cent of population and the change associated with
it. Table IV lists those countries for which data was
available.

In 1960, 16 countries, reported 45 per cent or more of
their population residing in urban areas, while 14 countries
reported urban population to be less than 45 per cent. In
the former group, the percentage change in the population
variable over a 10 year period averaged 11 per cent, while
in the later group, a much larger change of 18 per cent was
observed. On this basis, it appears that those countries
which had a high percentage of people in the urban centers

during 1960, experienced rapid urbanization prior to 1960,

76

Table IV.--Percentage Change in Urban Population, 1950-60
(Sample Countries)

 

 

 

 

Per Cent Percentage Change in
Urban Population Urban Population
Country (1960) (1950-60)
Argentina 55 7
Austria 38 0
Belgium 52 2
Canada 53 11
Chile 53 21 r
China 29 17
Columbia 31 32 '
Denmark 49 8 g
Finland 39 21
France 48 6
Germany 52 12
Greece 35 14
Honduras 54 0
Israel 61 5
Italy 47 13
Japan 46 17
Korea 29 28
Netherlands 60 7
Norway 35 14
Philippines 17 12
Portugal 2- 11
S. Africa 36 14
Spain 45 11
Sweden 40 18
Switzerland 30 3
Thailand 9 33
Turkey 21 33
U.K. 69 O
Urugray S6 23
Venezuela 45 27

 

Source: United Nations,Statistical Yearbook, New York.
1967, pp. 78-100.

 

77

well before the effective date which this study commences
with. The other group was apparently experiencing rapid
rural-urban migration during the 1950's. The conclusion then
is that the coefficients on the population variable in this
study should be negative since on the average those countries
which had the lowest percentage of population residing in
urban areas in 1960 experienced the greatest rural-urban
migration in the prior decade which coincides with this
study. This indicates that considerable pressure was exerted
in the construction industry during this period in order to
house a rapidly expanding urban population and should be re-

flected by the negative sign on the coefficients.

Exchange Rate Valuation Index

 

Singh has recently hypothesized that "...over-valuation
of the exchange rate introduces inefficiencies all around;
and even for the same rate of investment, lowers the rate of

growth".24

The index used to estimate the degree of over or
under-valuation is the official rate of exchange divided by
the average unofficial rate for the period. Thus, if the Cur-
rency is over-valued, the index will be greater than one.

Unity in the index reflects perfect agreement between the

official rate and the unofficial rate.

 

24Singh, S. K., "Possibility and Implications of Em-
ployment Promotion; Aggregate Production Function, and
Causes of Growth," I.B.R.D., Domestic Finance Division,
Washington, D.C., unpublished paper, July 7, 1970 (Revised
February 10, 1971), p. 33

78

Following Singh, the anticipated relationship between

the exchange rate valuation index and construction is negative.

However, Gurley and Shaw state that:
Overvaluation of domestic currency on the
foreign exchanges may transfer real income
from an exporting sector...to an import-
ing sector... Depending upon relevant
elasticities of demand and supply, over-
valuation can also appropriate foreign
savings for domestic use.

In Chapter II above, I quoted Maisel's assertion that
materials destined for use in home building were largely im-
ported.26 Along with the Gurley and Shaw argument above,
this would suggest that the movements in exchange rate val-
uation and construction will be directly related. The
greater the over-valuation the greater the reserves trans-
ferred to an importing sector; and since house building is an
importing sector we should observe an increase in building
activity.

This argument is not very convincing. If a country has
an over-valued currency, domestic prices of export commodi-
ties will be relatively expensive (i.e., overpriced to the

degree that the currency is over-valued). Thus, we would ex-

pect a decrease in that country's reserve position, partially

 

25Gurley, John G. and Shaw, Edward 8., "Financial Devel-
opment and Economic Develo ment," Econom1c Development and
Cultural Change, Vol. 15, o. 3, Aprilv1967, p. 262.

 

26cf. Chapter II, p. 11, fn. 16.

 

 

79

reflecting a loss of export sales. As a result there exists
pressure to maintain higher real rates of interest internally

in order to facilitate capital inflows and to avoid an out-

flow of foreign investment. Higher interest rates domestically

tend to suppress all types of construction activity.

On the basis of the empirical results reported by Singh,
which show a negative relationship between growth and the
index of currency valuation and on the above argument, I
would predict that the coefficient in this study will also be

negative. In Chapter VI this test will be made.

Sources of Data

 

Data for the following variables were collected from
the United Nations Yearbook of National Accounts Statistics:
C(l), total construction excluding public works; C(2), the
construction of dwellings; (Y), Gross National Product;

(P), the per cent of population residing in urban areas.

The United Nations' description of dwellings is

All expenditure on new construction and
major alterations to residential buildings,
including the value of the change in work
in progress but excluding the value of the
land before improvement. Expenditure on
all permanent fixtures such as furnaces,
fixed stoves, central heating and water
supply installations is included.

The description of total construction used includes
that of dwellings stated above plus:
Non-residential buildingp. All build-
ings other than dwellings. It includes

industrial buildings, warehouses, office
buildings, stores, restaurants, hotels,

 

 

80

farm buildings and buildings for
religious, educational and similar
purposes. Major alterations and work

in progress are included. Movable
equipment which is not an integral

part of the structure is not included.27

The currency valuation index was constructed from data

presented in the Picks Currency Yearbook.28 Exports, foreign

 

exchange reserves, and price indices were taken from the
International Monetary Fund International Financial Statistics.

Originally this study contained a sample of 51 countries.
As the collection process proceeded, 15 countries were
dropped from the sample because of insufficient data. For
many of the low income countries, 1955 was the earliest year
for which data was available. Attempts to extend the time
period were frustrated by inadequate reporting of these
countries.

In each regression, it was necessary to exclude some
countries because of insufficient data. In equation (1) in
which total construction (Cl) is the dependent variable,
Ireland was dropped from the middle group (II) and Switzerland
was excluded from the high group (III).

In Equation (2), it was necessary to exclude three coun-

tries from the sample. The Philippines was drOpped from

 

27United Nations Yearbook of National Accounts Statistics,
Individual Country Data, New York, 1968, p. xxiv.

28Bame, Jack J. (ed.), Picks Currency Yearbook, Picks
Publishing Corp., New York, 1968.

 

 

81

Group I, Chile from Group II and Israel from Group III. Ob-
servations for each of the variables were found for all of

the remaining countries.

Estimation Techniques

 

The method used to estimate the coefficients in Equa- ,1
tions (1) and (2) can be described generally as a pooled,
cross-sectionally heteroskedastic and time wise nonjauto-

regressive model.29 The regression equation for this model

 

is a generalization of (l) and (2) above and can be expressed 6’
as

(3) Yit = leitl + BZXitZ + ...+ kaitk + 8it

Where: i = 1,2,...N (and N is the number of countries

in the cross section)
and t = 1,2,...T (where T is the number of years)

For this study, N = 36 and T = 15.

By pooling the data we combine cross-sectional observa-
tions over time. The total number of observations is N x T.
If we were to use the conventional ordinary least squares
method of estimation the number of observations would be
only 15 (one for each year). Thus we have gained 525 obser-
vations by the pooling procedure. This is most important

since we have lagged some of the variables, resulting in a

29For a general description of this model see: Johnston,,-
J. Econometric Methods, McGraw Hill, New York, 1960, pp.

179-192 and Kmenta, Jan, Elements of Econometrics, MacMillan

Co., New York, 1971, pp. 270-275.

 

 

82

loss of degrees of freedom. This method also increases the
efficiency of the estimates.

This method of pooling the data is essentially the same
as Aitken's generalized least squares estimation procedure.
However, it is necessary to introduce some additional assump-
tions and constraints.

The assumption of heteroskedasticity is common in dealing
with cross-sectional data. In this model, the assumption of
heteroskedasticity means simply that we do not expect the
variance of the disturbance term in each country to be of the
same magnitude. This seems to be a reasonable assertion,
especially since the sample being used includes countries at
all levels of national income. Failure to adjust for hetero-
skedasticity when it is present will result in estimators
which "...are unbiased and consistent but not efficient or
asymptotically efficient".30

A disturbance which is characterized by heteroskedasticity

over cross sections and is homoskedastic over time may be

represented as

(4) E(eit2) = 012 for all t

In order to increase the efficiency of the least squares
estimators we must adjust the observations in order to eliminate
the heteroskedasticity. If all of the variances were known,

we could divide each observation used in regression equations

 

30Kmenta, pp. cit., p. 254.

83

E

 

 

(1) 30d (2) by 012. This results in an error term a: = Cit
_ 1

vhich is distributed 6* (0 1) because E fit 2 = 012

s 1N , Ci 3?

The variances 012 are not known but consistent estimates

can be obtained by using the residuals from the ordinary least
squares estimation of the original data. This estimate is '3“

expressed as

2
z -- -
A _ tt. t
(5) 012 '- T11 K

 

‘HEL-

where N is the number of observations for each country.
The estimate was then calculated and used to weight all var-
iables in all countries.

This model deals not only with cross-sectional data. We
also are observing the variables over time within each cross-
section. The classical problem usually found in time-series
models is that of autoregression. If it is present, observa-
tions made in time period t will be correlated with those
made in period t-l within the same cross sectional observation.

This problem does not appear to be serious in this study.
The time interval used is one year. A longer time period
increases the likelihood that autoregression will not damage
the model. In the words of Kmenta, "...we would be more sus-
picious of the presense of autoregression when dealing with
monthly or quarterly observations than when the data are

given at annual intervals”.31

 

31Ibid., p. 270.

84

If autoregression is present, and uncorrected for, the
estimates will still be unbiased. Furthermore, it is likely
that the coefficient of correlation (0) between 5t and Et-l
will be positive (negative biaS). Kmenta points out that
”such a situation is fairly common with economic-time series".32
A negative bias (p > 0) means that

...in using the conventional least squares
formulas the calculated acceptance regions
or confidence intervals will often be nar-
rower than they should be for the specified
level of acceptance or confidence.3
Thus the significance of the estimates found in the regression

will be understated. This will be a problem only if the levels

of significance are too low for acceptance.

Summary
The strength of the statistical test described above

derives from the method of pooling time series and cross-
sectional data. Variables F and E are assumed to have dif-
ferent effects on (C1) and (C2) depending upon the group
which is being tested. The remaining variables are tested
for their effect on the entire sample.

Equations (1) and (2) represent 6 separate equations.

Thus Equation (1) becomes

 

321bid., p. 270.

 

331bid., p. 282.

 

 

85

Group I C(l)t

80 t BIEt-I + B4Ft-1 + B7Yt-1

+ B8[E/Y]t_1 + 89p + 810V + 6t

GTOUp 11 C(1)t 80 + BZEt'l + 85Ft_1 + B7Yt-1

+ 88[E/Y]t_1 + 89P + 810V + at

Group III C(1)t = 80 + B3Et-1 + BOFt’l + B7Yt‘1

+ B8[E/Y]t-1 + ng + 810V + at

Equation (2) can be disaggregated the same way. For
Operational reasons I have combined these equations by using
dummy variables to place variables E and F in the correct
group.

Except for the heteroskedasticity adjustment, the method
used is essentially the same as Aitkin's generalized least
squares. The data has been pooled over time and across
countries in order to increase the degrees of freedom neces-
sary for statistically significant estimates.

In Chapter VI the results of the statistical test will
be presented and evaluated. The anticipated signs of many
of the regressors was mentioned earlier. Where discrepancies

occur, an attempt will be made to explain the results.

CHAPTER VI

EMPIRICAL RESULTS

Introduction .1

 

The rationale for using Aitkin's generalized least

squares technique of estimation was provided in the previous i

 

chapter. Since this method is somewhat unorthodox, some in- ;

troductory remarks are in order. -
When cross-sectional and time series data are pooled,

the efficiency of the estimates is increased. That is, the

sampling distribution of the estimator has a variance smaller

than that found in the ordinary least squared method. This

increase in efficiency is the result of the assumption that

some of the independent variables behave in the same way re-

gardless of the income level of the country. That is, they

were entered into the regression equation as a single vari-

able without the use of dummies. This assumption was made

for the variables estimated by coefficients 87 through 810

in Equations (1) and (2) in Chapter V. The remaining para-

meters (80 through 86) are estimated separately for each in-

come group. (The real names of the coefficients are shown

on the following page.) The R2 estimates are based on the

regression fit for the entire pool of data and the coeffi-

cients 87 through 810 are estimated for the entire pool.

86

87

Listing of Empirical Results

 

The results of the regression analysis are shown in
Tables V and VI.
The results are expressed in terms of the disaggregated
regression equations below.
(6) Group 1: C(1) = .4870 - .8504 Et-l + .0005 Ft-l + .1096 Yt-l
(2.50) (5.40) (1.53) (39.36)

+ 2.5353 E/Yt_1 - 1.8909 P - .3652 V

(7.98) (6.34) (2 53)
(7) Group II: 0(1) = .9649 - .1183 Et_1 - .0034 Ft_1 + .1096 Yt-1
(3.68) (2.77) (8.04) (39.36)
+ 2.5353 E/Yt_1 - 1.8909 0 - .3652 v
(7.98) (6.34) (2.53)
(8) Group Inx C(l) = .7578 - .1680 Et-1 - .0002 Ft-1 + .1096 Yt_1
+ 2.5353 E/Yt_1 - 1.8909 0 - .3652 v
(7.98) (6.34) (2.53)
(9) Group 1: C(3) = .8708 - .3740 Et_1 - .0005 Ft_l + .0639 Yt_1
(4.97) (2.39) (1.80) (27.41)

+ 2.5455 E/Yt_1 - 2.9257 p - .3584 v
(8.83) (10.27) (2.85)

(10) Group II: C(3) = 1.0905 + .0912 Et-l - .0006 Ft-l + .0639 Yt-1
(4.96) (3.48) (2.51) (27.41)

+ 2.5455 E/Yt_1 - 2.9257 P - .3584 v
(8.83) (10.27) (2.85)

 

 

 

I‘-
I'll

Table V.--Estimated

Coefficients for Total Construction (Cl)

88

 

 

 

R2 = .92
Regression
Variable Coefficient t Value Significance
l GNP (Y) 87 = +.1096 + 39.36 < 0005
2 Currency
Valuation
Index (V) 810 = -.3652 - 2.53 .0110
3 Per Cent
Urban
Population (P) 89 = -1.8909 - 6.34 <.0005
4 Exports as
a Per Cent
of GNP (X/Y) B8 = +2.5353 + 7.98 <.0005
5 Intercept for
Group (I) a = +.4870 + 2.50 .0120
6 Intercept for
Group (II) y = +.9649 + 3.68 <.0005
7 Intercept for
Group (III) 6 = +.7578 + 3.00 .0030
8 Foreign Exchange
Reserves Group
(I) 84 = +.0005 + 1.53 .1240
9 Foreign Exchange
Reserves Group
(II) 85 = -.0034 - 8.04 <.0005
10 Foreign Exchange
Reserves Group
(III) 86 = -.0002 - 3.40 .0010
ll Exports (B)
Group (I) 81 = -.8504 - 5.40 <.0005
12 Exports
Group (II) 82 = -.ll83 - 2.77 .0060
13 Exports
Group (III) 83 = -.1680 - 9.73 <.0005

89

Table VI.--Estimated Coefficients for Dwelling Construction (C2)

 

 

 

R2 = .92
Regression
Variable Coefficient t Value Significance
l GNP (Y) 8*7 = +.0639 + 27.41 <.0005
2 Currency
Valuation
Index (V) 8*10 = 0.3584 - 2.85 .0050
3 Per Cent
Urban
Population (P) 8*9 = -2.9257 -10.27 <.0005
4 Exports as
a Per Cent
of GNP (X/Y) 8*8 = +2.5455 + 8.83 <.0005
5 Intercept for
Group (I) 6* = +.8708 + 4.97 <.0005
6 Intercept for
Group (11) y* = +1.0905 + 4.96 <.0005
7 Intercept for
Group (III) 6* = +.6009 + 2.73 .0070
8 Foreign Exchange
Reserves Group
(I) 8*4 = -.0005 - 1.80 .0700
9 Foreign Exchange
Reserves Group
(II) 8*5 = -.0006 - 2.51 .0120
10 Foreign Exchange
Reserves Group
(III) 8*6 = +.0008 +ll.44 <.0005
ll Exports (E)
Group (I) 8*1 = -.3740 - 2.39 .0160
12 Exports
Group (II) 8*2 = +.0912 + 3.48 .0010
13 Exports

Group (III) 8*3 = -.0513 - 3.16 .0020

90

(11) Group III: C(3) = .6009 - .0513 Et-l + .0008 Ft-l
(2.73) (3.16) (11.44)

+ .0639 Yt_1 + 2.5455 E/Yt_1 - 2.9257 P - .3584 v
(27.41) (8.83) (10 27) (2.85)

Evaluation of the Model

 

In Chapter IV an alternative model was introduced in
order to explain some of the changes in the building cycle

relationship between countries at different levels of devel- V

 

opment. It was shown in Chapters II and III that prior to by
1914, building cycles in the industrialized and non-industri- .
alized countries were inversely related. During the 1955-68
period this was reversed. Foreign exchange reserves of the
two groups now evidenced a positive correlation. Thus it
was shown that the correspondence between exchange reserves
and construction in either the high group or low group must
have changed.
Empirical evidence and intuition suggested that the high
group experienced institutional and administrative changes
which increased their insulation from external financial
fluctuations.
The graphical illustration of this hypothesis is repro-
duced in Figure 12. The solid lines indicate those relation-
ships which were verified ex-ante. The slopes of the dotted
lines represent the hypothesized signs of the unknown coef-
ficients.

Support for the hypotheses in Figure 12 is provided in

91

 

 

 

F

Group I :1.

IV I t
\ v
\\ .
\\
\\
\4
\
C Group I F Group III
/
/
1’
x’
//
’//
/
III II
C
Group III

Figure 12.--The Four Quadrant Model with the Hypothesized
Coefficients for Two Quadrants

92

equations (1) through (3). The simple set of null hypotheses

are:

HO . B4 - 0
H6 : 85 = 0
H8 1 86 = 0

The alternate hypotheses are:
HA 2 84 > 0
HA : 86 < 0

The null hypotheses (H0, H5 and H3) simply state that there
is no relationship between foreign exchange reserves and con-
struction in any of the three groups. If these are rejected,
the alternative hypotheses (HA and HA) are then tested.1
This states that foreign exchange reserves and construction
are directly related in Group I countries and inversely re-
lated in Group III countries. These anticipated relation-
ships are represented in Figure 12.

The null hypotheses H5 and H3 can be formally rejected
on the basis of the significance levels shown in Tableli and

equations (5) through (8) above. The coefficient for 84 is

 

1c.f., Kmenta, Ibid., p. 115, "The null hypothesis usu-
ally states that the postulated relationship does not exist,
which normally means that the value of one or more—6f the
parameters is equal to zero, while the alternative hypothe-
sis states that the relationship does exist.”

93

.0005; however, the level of significance is less than 90

per cent. Thus we must formally accept the null hypothesis
H0.

The alternative hypothesis HA does not require testing
since we have already accepted the null hypothesis for this
parameter. However, the alternative hypothesis HA is accept-
able. The regression coefficient is -.0034 and is signifi-
cant at the 99 per cent level. Thus we would formally reject
the alternative hypothesis (HA) that 84 > 0 and accept al-
ternative hypothesis (HA) that 86 < O.

I have consciously used the term 'formally reject' in
the previous passage. It was pointed out in Chapter IV,
Figure 11 that quadrants I and III were (ex ante) empirically
established. Thus if one of the two remaining quadrants can
be constructed the other is determinate. This was demon-
strated in Equations (4) and (5) in Chapter IV. The al-
ternative hypothesis (HA) that construction in developed
countries is inversely related with foreign exchange reserves
was accepted. It follows from the model then that construc-
tion in the less developed countries must be positively re—
lated with foreign exchange reserves.
The estimated coefficient for 84 was .0005. This is the

relationship we predicted; that is, dC/dF > 0 for Group I.
However, the level of significance is less than 90 per cent

(87.6). The results of the statistical test therefore appear

to be ambiguous.

 

94

One way to circumvent this contradiction formally is to
use a 'one-tail' test to evaluate the alternative hypothesis.

...sometimes we are able to make assump-
tions that permit a somewhat less general
specification of the alternative hypothe-
sis. In particular, sometimes we are rea-
sonably certain that the only claim that
/“-=/LO is the claim that it is greater
(or smaller) than/{,02

In the context of this analysis, we have shown deduc-

tively that if construction and foreign exchange reserves in

"(* _“fl

the high income countries (86) is less than zero, the rela-

 

tionship between these same two variables in the low income ’5
countries must be inverse. If a one-tail test is used, the
level of significance increases and falls within the ac-
ceptance range.
On the basis of the conventional two-tail test, the co-
efficient for 84 falls just below the acceptance level of
significance. However, the use of a one-tail test seems
appropriate since we do have a priori evidence of the pro-
jected sign of the coefficient. Since the magnitude of the
regression coefficient does not affect the relationships

postulated in the model, I am disposed to cautiously regard

 

the statistical evidence as supportive of the model.

 

2Ibid., p. 119.

95

The Construction of Dwellings

 

The construction of dwellings was also regressed
against the same independent variables. It was stated
earlier that the variation in this sector need not be the
same as total construction. Since the data was available
for most of the sample, and little effort was spent in Vi:

compilation time, I thought it expeditious to test Equa-

 

tion (2). 4
F
In Table VI the estimated coefficients for the regres- ‘.
sors on C(2) are shown. The null hypotheses to be tested are: ER
0
HO 84-0
1 _
H0 85 — 0
2 -
HO 86 0

No alternative hypothesis is advanced. The testing of
the model does not require any specific relationship between
foreign exchange reserves and dwelling construction.

All three null hypotheses are rejected; the lowest ac-
ceptance level is 93 per cent for 84 (Group I). The signs
of the coefficients are the opposite of those observed in
the regression of total construction. That is, 84 < 0 and
86 > O. This indicates that the construction of dwellings
is inversely related to foreign exchange reserves in the less
developed countries and positively related in the developed

group. Apparently this sector of the construction industry

96

is less isolated from external fluctuations in the indus-
trialized nations.

The plausibility of less deve10ped countries being more
isolated from external shocks because of greater government
participation in the house building sector was explored in
Chapter V (p. ). In the industrial countries, the fiscal
and monetary authorities are able to protect the domestic
construction industry from external financial variables.
However, the domestic house-building industry is subject to
the external fluctuations indirectly through the money markets.
Furthermore, the sophistication of the financial intermed-
iaries in the wealthier nations tends to hasten the trans-
mission of shocks generated in the external financial posi-

tion of the country.

Exports

The effect of exports on the construction sector is
apparently the same in all countries regardless of their in-
come level. In Table VI, lines 11 through 13. the estimated
coefficients for the export variable are listed. The para-
meters are negative for all groups. As exports increase,
total construction activity decreases. The coefficients for
the three groups are -.8504, -.1183, and -.l680 respectively.
All are acceptable at the 99 per cent confidence level.

As exports increase, domestic output in this sector
draws on the economy's productive resources. Those industries

which are engaged in export activity expand their output.

 

97

Since construction is uniquely oriented to domestic markets,
activity in this sector is decreased.

There are two factors which determine the strength of
this effect: The percent of total productive capacity being
used and the short-run elasticity of supply of the export
oriented industries. If these industries are operating at
capacity, any long-run increase in output must be accompanied
by an increase in the scale of the plant or the building of
new plants. Short-run increases in output under these condi-
tions will be accompanied by increasing average costs. This
increase in output leads to competition in the bidding for
productive inputs and capital. If in response to favorable
markets the export firms are able to increase supply easily,
greater output might be achieved in both the short and long-
run without affecting other industries in the economy. On
the other hand, if the short-run supply is highly inelastic,
considerable amounts of inputs destined for other industries
will have to be diverted to the export firms.

High supply elasticities are usually found in those
firms which are characterized by decreasing costs in the
range in which they are operating. Conversely, if the
short-run elasticity of supply is low and the representative
firm experiences increasing costs, it is likely that any ex-
pansion of output will be the result of new firms entering
the industry or established firms constructing new plants.

This, of course, results in the loss of productive resources

 

 

ll!!! Jilllhi [ll i '1'. J

98

by the non-export industries in the economy.

The negative relationship between exports and construc-
tion observed for all income groups indicates that the export
firms might have been operating at less than full capacity
during the time period under consideration. Increased ex-
ports did not lead to an increase in construction activity.
It is also possible that the short time period being con-
sidered (15 years) was not long enough to account for con-
struction of new plants in the export oriented industries.
Under the assumption of full capacity operation, the short-
run effect we would expect to observe would be an increase
in average cost and product prices in the export firms.
These effects are difficult to sort out and would entail a
separate study of the export industry. Several possible ef-
fects have been discussed; however, a detailed examination
of this question is beyond the scope of this analysis. The
need for further research is apparent and will be discussed
in Chapter VII.

In Groups I and III the relationship between exports and
the construction of dwellings was negative; in Group II the
coefficient was positive (cf. Table VI, Lines ll-l3, p. 89).
I can offer no convincing explanation for the sign change in
the middle group. It was mentioned earlier that the de-
lineation of the intermediate group is useful only because
it separates the other two. Since this group exhibits char-

acteristics of both the high and the low group, I do not

 

99

attach any importance to the estimated parameter for this

group.

Additional Findings

 

The estimated signs of the remaining independent var-
iables are Shown in Tables V and VI. The coefficients for
gross national product and exports as a per cent of gross
national product are positive as postulated in Chapter V.
Both are significant at the 99 per cent level.

The direct relationship between exports as a per cent
of GNP and construction lends support to the 'engine of
growth' thesis discussed in Chapter V. The estimated coef-
ficient of 2.5353 is significant at the 99 per cent level.

The other two variables tested were the currency valua-
tion index and the per cent of urban population. The esti-
mated coefficients for these variables were both negative
and highly significant (99 per cent level). These results

were anticipated and discussed in detail in Chapter V.

Summary

The results of the regression analysis are shown in
Tables I and II. These findings lend support to the model
introduced earlier. All of the estimated coefficients were
significant at the 90 per cent level or above with the ex-
ception of foreign exchange reserves in Group I countries.
It was shown that the sign was as postulated in the model.

The relationship between foreign exchange reserves and

100

construction in the high income countries was negative, as
predicted in the model, and highly significant. It was
then demonstrated that the sign of the coefficient for
foreign exchange reserves regressed on construction is deter-
minate and must be positive for the low income countries.

In the next and final chapter I shall present in sum-
mary form the nature of this study and an outline of the
policy implications. Finally the limitations of the study

and further suggested work in the area will be investigated.

CHAPTER VII

SUMMARY AND CONCLUSIONS

Summary of the Thesis

 

A great deal has been written about the cyclical trends
in the building industry. Early observers noted an inverse
relationship between construction in the industrialized and
non-industrialized countries. In this paper several empirical
studies have been cited and incorporated in a model. The
model sought to explain the relationship between interna-
tional payments and domestic construction during the 1870-
1913 period. It was shown that foreign exchange reserves
and construction were directly related. The main implication
of this correspondence is that both the industrialized and
the newer raw-material-exporting nations were unable to pro-
tect their domestic construction activity during this early
period; an increase in reserves was accompanied by an increase
in aggregate construction.

In Chapter IV an alternate version of the basic model
was presented. Some of the relationships observed during the
early period had changed. After 1955 the building cycles of
the industrialized and non-industrialized countries had
moved into phase with one another. During this same period

the relationship between exchange reserves in the high and

101

102

low income countries was the same as that observed in the 1870-
1913 period; that is, when foreign reserves are high in the
industrialized countries they are low in the non-industri-
alized nations (and vice versa). Domestic building in either
the high or low income groups must have become more pro-
tected from external fluctuations in exchange reserves or
construction was even used countercyclically. More inte-
grated financial markets but greater administrative ability

to protect the domestic economy with monetary and fiscal tools
characterized the most industrialized countries. The impli-
cation is that the less developed countries were still strong-
ly influenced by external shocks and unable to isolate domes-
tic building from fluctuations in exchange reserves. These
hypotheses were tested and supported in the statistical tests

reported in Chapter VI.

Implications

 

To stabilize domestic construction, one must first ascer-
tain the causes of instability. This study has provided evi-
dence that fluctuations in exchange reserves are among these
causes, although other variables affect construction and for-
eign exchange reserve fluctuations influence many other sec-
tors of the economy.

In the less developed countries, external shocks lead
to movements in aggregate construction, while the construction
of dwellings appears to be effectively protected. Quite the

opposite is observed in the developed countries. Here the

103

ability to protect domestic activity is seen in the total
construction sector but not in house building.

The two groups of countries use different methods to
meet changes in their balance of payments position. Gov-
ernment countercyclical programs can operate in different
ways in the two groups. In the developed countries, the gov-
ernment can influence the total construction sector by chang-
ing the pace and the timing of public projects. However they
do not appear to be able to affect the domestic construction
of dwellings outside of the public sector. One policy would
be to lower domestic interest rates. However, this action
would only intensify the loss of foreign exchange reserves
because funds would flow out in search of higher rates of
interest.

The role of protecting domestic construction and home
building against external factors appears to be reversed for
the less developed countries. They are apparently unable to
protect total construction from external shocks; however, the
construction of dwellings moves countercyclically.

These differences in the ability to protect the construc-
tion industry might, therefore, reflect the different ways
in which home buyers secure the necessary funds in the devel-
oped and less-developed countries. In the industrialized
countries. the financial structures are more sophisticated.
Fluctuations in reserve positions are quickly transmitted
through the domestic economy by way of changes in the interest

rate. If reserves are low, the central bank is likely to

104

raise the interest rate through restrictive monetary policy.
The higher interest rate causes a reduction of loanable funds
domestically and forces more stringent requirements to be
placed on prospective borrowers.

Balance of payments considerations might exert similar
pressures on the central banks of the non-industrialized na-
tions. However, the transmission mechanism does not Operate
as effectively in these countries; furthermore, the purchase
of new dwellings is largely restricted to the wealthier seg-
ment of society. When they choose to build, these individuals
can raise relatively large sums of money. But even "...where
the average family has small savings, a house must usually be

paid for outright”.1

Thus, even if the banking system re-
acted to a loss of reserves by raising interest rates, the
home-buyers have not been greatly affected. Therefore, it
is plausible that fluctuations in foreign exchange reserves

have had less effect on the dwelling sector of the construc-

tion industry in the non-industrialized countries.

Policy Recommendations

 

When all of the funds for housing must be provided by
the same sources as other investment programs, competition
for funds becomes acute. As Abrams stated, ”Capital accumu-
lations for housing should come as much as possible from

sources that are non-competitive with capital from other

 

1Abrams, Charles, Man's Struggle for Shelter, Massachu-
setts Institute of Technology Press, Cambridge, Massachusetts,
1964, p. 144.

 

105

enterprises".2

This is largely the case in the developed coun-
tries. In the less developed countries, quite the opposite is
true. Funds channeled through agencies which are oriented to
housing construction are presently inadequate to get the job
done.

It was stated earlier that the house-building in the less
developed group of countries was directly influenced by fluc-
tuations in foreign exchange reserves. The existence of a
significant relationship between these two variables was
attributed to the method by which individuals secured funds
for the purchase of a dwelling in the developing countries.
Financial institutions were found to play a very limited role
in these countries.

At the same time, several studies have concluded that the
non-industrialized nations should attempt to expand the role
of financial intermediaries such as savings and loan associa-
tions, in order to increase the efficiency of their finan-
cial systems.3

There appears to exist a rather important trade-off if
the financial institutions are developed more fully in the
poorer nations. The price they have to pay for more sophis-
ticated financial structures might well be increased insta-

bility in the house-building sector. This is not to deny

 

2Ibid., p. 144.

3See, for example, Gurly, John G., and Shaw, Edward 8.,
"Financial Development and Economic Development”, Economic
Develppment and Cultural Change, Vol. 15, NO. 3, Apr11, 1967.

 

106

the importance of developing financial institutions. It

does, however, serve to emphasize the need for specific stabil-
ization programs designed to maintain stability in the house-
building sector.

More generally a case might be made for the establish-
ment of freely fluctuating exchange rates. It was mentioned
earlier that under the gold standard, changes in reserve
holdings are transmitted directly to the domestic economy
unless specific policies are undertaken by countries to
delay the adjustment process. Under the current gold exchange
standard, this effect is weaker. However, the need to main-
tain equilibrium in both the trade and capital accounts of
the balance of payments often times forces central bankers
to restrict domestic activity. Since construction is one of
the most durable types of investment and can easily be post-
poned, it is severely affected by these restrictions.

Under the freely fluctuating exchange rate system, the
need for corrective expansion or contraction domestically is
eliminated if the relevant elasticities are not too unfavor-
able. As the foreign exchange rate is altered, changes in
exports and imports will be made almost automatically by the
trading partners. There should be no need for a central bank
to restrict the domestic money supply in order to alleviate
a deficit in the payments sheet.

Other implications for future policy can be deduced
from this study. Certainly there is a need for a more care-

ful analysis of financial sources in each country. The

107

possibility of international agencies lending their support

in the housing sector should be explored.

Limitations of This Study

 

The results of any empirical analysis are strictly sub-
ject to the limitations of the data. The practice of under
and over-reporting by all nations is well documented.4 Most
of the data are taken from United Nations and International
Monetary Fund publications; the picks index was constructed

from data published in the Picks Currency Yearbook. Although

 

these agencies specify which data are to be included in each
category, the reporting process is supervised largely by
individual countries. The broadest claim that can be made
is that no better data are readily available.

There are several Options in techniques Open to the re-
searcher. I have chosen to use a pooled statistical test
in order to increase the efficiency of the estimates. This
increase in efficiency is the direct result of the assump-
tions made concerning the homogeneity of the variables. The
cross-sectional stability of these variables can be challenged
and altered. However, if all simplifying assumptions are
dropped, the benefits of a pooled test are lost and the re-
maining degrees of freedom will not be sufficient to obtain

reliable estimates.

 

4cf. Kuznets, Simon, Modern Economic Growth, Rate Struc-
ture, and Spread, Yale Univer§ity Press, New Haven, Connec-
ticut, 1966.

 

 

108

Like all empirical studies, this one is an initial at-
tempt to discern some of the causal factors Operating indir-
ectly in the context of the international model employed.
The heuristic model which was deve10ped in order to focus
more clearly on a few relevant variables consists Of partial
derivatives. Many other variables could be examined and
tested for their significance. Other studies should examine
the web of interactions and alternatives in more detail in
specific cases, particularly to evaluate the reform of na-

tional and international financial practices.

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