Firm Balance Sheets and Unemployment in the Great Recession

The balance sheets of households and financial firms have received a lot of emphasis in research on the Great Recession. The balance sheets of non-financial firms, in contrast, have received less attention. At first glance, this is perfectly reasonable; households and financial firms had high and rising leverage in the years leading up to the Great Recession, while non-financial firms' leverage remained constant (Figure 1, below).

New research by Xavier Giroud and Holger M. Mueller argues that the flat trendline for non-financial firms' leverage obscures substantial variation across firms, which proves important to understanding employment in the recession. Some firms saw large increases in leverage prior to the recession and others large declines. Using an establishment-level dataset with more than a quarter million observations, Giroud and Mueller find that "firms that tightened their debt capacity in the run-up ('high-leverage firms') exhibit a significantly larger decline in employment in response to household demand shocks than firms that freed up debt capacity ('low-leverage firms')."

Source: Giroud and Mueller (2015)

The authors emphasize that "we do not mean to argue that household balance sheets or those of financial intermediaries are unimportant. On the contrary, our results are consistent with the view that falling house prices lead to a drop in consumer demand by households (Mian, Rao, and Sufi (2013)), with important consequences for employment (Mian and Sufi (2014)). But households do not lay off workers. Firms do. Thus, the extent to which demand shocks by households translate into employment losses depends on how firms respond to these shocks."

Firms' responses to household demand shocks depend largely on their balance sheets. Low-leverage firms were able to increase their borrowing during the recession to avoid reducing employment, while high-leverage firms were financially constrained and could not raise external funds to avoid reducing employment and cutting back investment:

"In fact, all of the job losses associated with falling house prices are concentrated among establishments of high-leverage firms. By contrast, there is no significant association between changes in house prices and changes in employment during the Great Recession among establishments of low-leverage firms."

(New) Economic Thinking

In "Can New Economic Thinking Solve the Next Crisis?," Mark Thoma writes:

There has been quite a bit of criticism directed at the tools and techniques that macroeconomists use, e.g. criticism of dynamic stochastic general equilibrium (DSGE) models, but that criticism is misplaced. The tools and techniques that macroeconomists use are developed to answer specific questions. If we ask the right questions, then we will find the tools and techniques needed to answer them.  

The problem with macroeconomics is not that it has become overly mathematical – it is not the tools and techniques we use to answer questions. The problem is the sociology within the economics profession that prevents some questions from being asked. Why, for example, were the very questions we needed to ask prior to the Great Recession ridiculed by important voices within the profession?

Since I didn't start studying economics until the Great Recession was in full swing, I don't have a full perspective on "new economic thinking" compared to old, or on what it was like to be in the economics profession prior to the Recession. I only gain second-hand perspective through reading and through studying economic history (which at Berkeley, coincidentally, is largely supported by the Institute for New Economic Thinking).  Thoma's article was prompted by the Rethinking Economics conference, but for me, I'm still learning how to think economics, much less rethink it.

One course that was particularly helpful in shaping my economic thinking was an elective on Empirical Macrofinance taught by Atif Mian. He made a point on one of the first days of class that really stood out. He told us not to see what questions we could answer with the data we have, but rather, to start with the question, and then think about what data we needed to answer it. More often than not, we'd need microdata. Not a problem! We are not in a data-scarce environment!

Mian's work with Amir Sufi on the role of household debt in the Great Recession is a great example of both his point and Thoma's point: start with the question, then choose your tools, techniques, and data. I realize this is easier said than done (trust me, I really do, after spending the last few years trying to implement it in my dissertation), but to me, that's just economic thinking.

Speaking of my dissertation, I'm preparing to go on the job market this year, which is why the blogging has been a bit less frequent! While the preparation is a lot of work, I am fortunate to be very enthusiastic about my research, because I did start with questions I care about, so working on it is a joy, even if it takes away blogging time. Eventually I will blog about my research, just not quite yet.

Recommended Reading from the Fed

There are two particularly good reads posted by Federal Reserve economists today. The first is "Deleveraging: Is it over and what was it?" by Claudia Sahm. The role of household deleveraging in the Great Recession has been heavily emphasized, notably at Atif Mian and Amir Sufi's very good new "House of Debt" blog. Sahm summarizes three new research papers on the topic of household deleveraging. The papers address three big questions:

1. When will deleveraging be over?
2. What do households do when they can't repay their debts?
3. Whose decision is deleveraging anyway?

The research on Question 2 is especially interesting:

"Given the increase in mortgage defaults in this recession, it took unusually long (averaging up to 3 years in some states) to go from initial delinquency to a completed foreclosure on a home. During the foreclosure process, households typically lived 'rent free' in their homes. So what did these households do with the extra cash? The authors find a significant improvement in the performance of credit card debt (reduced delinquency and lower balances). Although these households were under considerable financial stress and were already facing a huge hit to their credit scores due to a foreclosure, they used some of the freed up money to pay off their other debts...Normally economists think that if you give cash to households who are financially constrained they will spend it not use it to service debt."

Sahm's overall takeaway from the research she reviews is that:

"There was a big hit to 'permanent income' (households' expected lifetime income and net worth) and credit availability. Thus the level of spending and debt that made sense for households changed dramatically with the recession. Economists already understood this adjustment in the standard consumption framework even if the size and persistence of the shocks have been surprising. So in this sense "deleveraging" is simply a new way to frame the issue rather than a new behavior. And yet, we saw that the debt obligations that households made when everyone thought they were richer could not be easily undone."

Another Fed post worth reading today is a speech, "A Review of the Experience of Fielding the Survey of Consumer Expectations," by James McAndrews. The New York Fed's Survey of Consumer Expectations (SCE) is a relatively new monthly survey of consumers' inflation, labor market, and household finance expectations.

The effort that the NY Fed has devoted to developing this survey is testament to the increasing emphasis economists are placing on understanding the links between expectations and the economy. (This is near and dear to me, as a theme of my dissertation.) Expectations have long played a role in macroeconomic models, but are sometimes treated as an afterthought, probably because they can be difficult to observe and quantify. The SCE includes probabilistic survey questions, which ask respondents to describe their probability distribution over future outcomes. This reveals the uncertainty associated with consumers' expectations.

In the speech, McAndrews delves into some of the nitty-gritty of the multi-year survey development process, which is quite fascinating. He also summarizes the past research using the survey data.

Let's Not Invent New Ways to Measure Higher Inflation

Matthew Klein of Bloomberg View has just posted an interesting article called "A Better Way to Measure Inflation." He writes:

Sooner or later, most people end up retiring. You may not be working, but you still need money to eat and live. In the U.S., retirees get some income from Social Security, while Medicare covers their healthcare expenses. These programs by themselves aren't enough for most people, which is why it's a good idea to take some of the money you earn during your working life and use it to buy assets that can be consumed later. 

The amount of money you need to spend on assets to guarantee a given standard of living in retirement is determined by your assets' average yield. The higher the yield on your assets, the less money you need to spend today to get an equivalent amount of money in retirement. Falling yields therefore mean you need to spend more money today to guarantee the same amount of money in the future. In other words, the price of retirement, which is a price almost everyone is exposed to, goes up when yields go down.

The Consumer Price Index calculates inflation as the percent change in the price of a "market basket" of goods and services. Klein implies that the Consumer Price Index understates inflation because retirement is left out of the market basket.

"Consumption smoothing" is the usual name for the fact that people want to spread their consumption across their lifetime more smoothly than their income. For example, when people retire and have little or no income, they still want to consume around the same amount as they did before, as Klein describes. So over the lifecycle, a typical person will try to borrow (reduce their net assets) when their income is low and save (increase their net assets) when their income is high. Interest rates, and correspondingly, yields, figure prominently in the analysis of lifetime consumption.

I am a teaching assistant for undergraduate macroeconomics this summer, and we have been teaching the students a variety of different ways to think about interest rates. One way we explain is that interest rates are like a "price" in the market for loanable funds. They are familiar with supply and demand curves from their prerequisite course, so we show them a graph like this:

Klein, I think, is implying that Fed policy has shifted the supply curve to the right, lowering the real interest rate, making the price of loanable funds lower and in turn making the cost of saving for retirement higher. He pays attention to the second part (the higher price of saving), but not the first part (the lower cost of borrowing.) He says that:

People who already own a lot of assets tend to see things differently. For them, falling yields are great because it means that the value of their savings is rising relative to their other expenses. By contrast, workers struggling to save for retirement have to cut back on current purchases of goods and services in order to cover the added cost of their future liabilities. Rising yields have the opposite effect: it makes the asset-rich feel poorer and makes the asset-poor freer to spend more today.

Monetary policy does have different effects on different people, for a variety of reasons, but not really in the way Klein describes. He is considering only people who are currently increasing their net assets. In terms of lifetime consumption models, these are people who are in a part of their lifecycle when their current income is higher than their expected average future income. (These people have earnings above the red line in the figure below.) What he calls the "asset-rich" and the "asset-poor" do not together make up the entire population-- and a lot of "struggling workers" would not accurately fit into his characterization of the "asset-poor."

Especially when unemployment and underemployment are high, a lot of people's current income is lower than their expected average future income. (Somewhere around the blue star in the figure below.) These people are quite rational to want to spend more than their current income. Rising yields would certainly not make them "freer to spend more today." Klein's "asset-poor" leaves out the people with falling (and in many cases also negative) net assets.  In short, Klein argues that our measured inflation leaves out the price of consumption smoothing, but he only considers the saving part of consumption smoothing, and not the borrowing part.

Image Source: Kotlikoff and Burns (not including blue star)

I hope the Fed does not start finding inflation where it doesn't exist as an excuse to raise rates.

The Sword of Greenspan

According to an ancient Greek parable, Dionysius, the tyrant of Syracuse, had a courtier named Damocles who complemented Dionysius on his wealth and power. Dionysius asked Damocles if he would like to experience the kingly lifestyle. Damocles accepted the offer, and was enjoying the great luxury, until he noticed, hanging above him by a single horsehair, a gleaming sword. He then begged Dionysius to be allowed to leave the throne and return to his position as a courtier.

Common usage of the phrase "sword of Damocles" often misses the point of the story. According to classics scholar Daniel Mendelsohn, the sword of Damocles has come to refer to impending doom, even though:

"The real point of the story is very clearly a moral parable. It's not just, oh, something terrible is going to happen, but it's about realizing that what looks like an enviable life, a life of wealth, a life of power, a life of luxury is, in fact, fraught with anxiety, terror and possibly death.
And so that's the moral lesson of the original story, which has completely, I would say, gotten lost in the common usage. We all use that expression, oh, it's a sword of Damocles. But the point was all this stuff is meaningless, power, luxury and wealth, and if you know what's good for you, you'll be happy to be a much lesser kind of person."

The sword of Damocles frequently is used and misused in economic references. An Irish news article in 2011 titled "Inflation is sword of Damocles over Irish economy" uses the expression just to reference (alleged) impending doom. In "The Sword of Damocles hangs over Cyprus," the expression is slightly more correctly, as an analogy is made between Cyprus' decision to join the EU and Damocles' decision to try out the life of a king: "Like Damocles, some older Cypriots are now longing for their old farming lives, where living off the land was part and parcel of living here." And of course, the sword is used in the context of the Federal Reserve. Andy Kessler, for example, writes "The Fed’s inevitable Sword of Damocles could be brutal for bonds and stocks. Some of us recall the massacre of 1994."

Now, the original sword of Damocles was not used for massacre or brutality, so I think Kessler misuses the reference, missing the moral lesson of the story. He actually makes two sloppy allusions-- first to the sword, and second to 1994. Gavyn Davies writes that "The 1994 example, when the Fed failed to guide the markets about the likely pace of tightening, is of course part of the folklore of the bond market." Just as with the ancient parable of the sword of Damocles, the real lessons of the "parable" of 1994 are getting lost--dangerously--in the common usage.

Lately, the Fed's tightening actions in 1994 are coming into the spotlight as people wonder, and worry, about when the Fed will taper its bond buying program. The problem is that the more nuanced points of the 1994 episode have been lost to a simpler, cruder interpretation: that a move by the Fed (to slow the pace of purchases, for example) will be shortly followed by a succession of rate hikes. The lesson of 1994 is not that once the Fed starts tightening, it will just keep going, but unfortunately that is the lesson the markets choose to remember.

Let's look back at the Federal Reserve transcripts from 1994, when Alan Greenspan himself alluded to the sword of Damocles on multiple occasions. At the first meeting of the year, on February 3-4, the federal funds rate was at 3%, after having been lowered repeatedly since 1989. Discussions centered around how much to raise the rate. Mostly it was a question of raising by 25 or 50 basis points.

Vice Chairman McDonough: ... It seems to me that the question is not so much whether we should tighten but by how much...I think there are two downside aspects to a 50 basis point firming. First of all, it could be interpreted--and in my own view would be interpreted by a fair number of market participants--as a one-time fix, a one-time adjustment which would be followed by a "Fed-on-hold" period. Secondly, I think it could be deemed, especially in light of some of the discussion in this town and others, a macho response, and I've always thought macho responses confused brains and bravado. A 25 basis point move, on the other hand, I believe would send the right signal in the sense that the Federal Reserve, the central bank, is being watchful, as it should be...I think it would be interpreted as the first of a series of moves and thus would be deemed, in my view, to be a stronger signal than a 50 basis point increase--if the 50 basis point increase were seen, as I believe it would be, as a one-time adjustment to be followed by the "Fed on hold."

President Jordan: ... I would come down on the side of 50 basis points even though Bill McDonough's argument about that being viewed as a one-time adjustment followed by the "Fed on hold" is interesting. The other side of that would be that 25 basis points would be viewed clearly as the first of a series of moves. And if the market quickly built in pricing and expectations of the next 25 basis point move, then the equilibrium rate would move
at least as much as our move, implying de facto that we eased conditions relative to where the market is if it's ahead of us. I don't know what the timing might be as to market expectations, but if it's a fairly short horizon--maybe no further out than the next FOMC meeting--we may find that 25 was not enough to restrain reserve growth...

Chairman Greenspan: I thought about 50 basis points, or I thought about it in the sense of trying to move the rate to where we want to put it and then sticking with it. But I think it may be very helpful to have anticipations in the market now that we are going to move rates higher because it will subdue speculation in the stock market; at this particular stage having expectations hanging in the market that we may move again, and move reasonably soon, could have a very useful effect. If it is in any way contemplated that we have moved and are going to stop, that could create the type of erosion in the economy that I've watched over the past decades, which is precisely what we don't want. If we have the capability of having a Sword of Damocles over the market we can prevent it from running away... If we're going to move, I would not mind moving again at the next meeting or the meeting after that, for example. That depends on the evolution of events, frankly.

Greenspan got his way, after imploring the committee to "act unanimously." The February 14, 1994 New York Times reported that "in the two weeks since the rate action, it appears that rather than reassuring traders and investors, the Federal Reserve has managed to leave them with a worse case of the jitters. The financial markets seem to have increased their focus on inflation amid a general consensus that the Federal Reserve will have to raise short-term interest rates again soon. Both factors have led to a sharp selloff in the bond market and a jump in both long- and short-term interest rates." Later the article adds,

The interest rate hike validated the market's inflation fears," said Matthew F. Alexy, a government securities specialist at CS First Boston. "The market must have asked itself: Why would the Fed move to raise interest rates unless there was, in fact, a problem with inflation?"  

The added sensitivity was demonstrated Thursday when traders and investors chose to overlook the positive report on consumer prices in January, which were unchanged, and instead focused on a Federal Reserve Bank of Philadelphia report that suggested that prices had been on the rise in early February. 

The markets saw inflation where there was none. By the March 1994 meeting, Greenspan raised the case of the missing inflation. "...we are pretty far along in this business cycle. So why is inflation not showing its head a little more? Now, the next set of numbers may come out and I'll be sorry I said this, but the earlier experience raises the question: Is it automatically the case that when the economy is tightening up that inflation takes hold?" He recognized that inflation was nowhere to be seen, but halfway expected it to rear its head at any minute. And then he brought it up again: the Sword of Damocles!

Greenspan:  One of the elements that I think we have all been observing with respect to the markets--and one of the reasons why there has been such a level of instability in the markets--is that when we were perceived as moving on the basis of economic data, the markets had a certain sense of what it was we were doing...Now they are worried that they don't know when we are going to move, so we have this Sword of Damocles hanging over the market. They don't know whether we are going to move in 2 days, 5 days, or 12 days; they have no basis to judge and they are understandably nervous. So the question is, having very consciously and purposely tried to break the bubble and upset the markets in order to sort of break the cocoon of capital gains speculation, we are now in a position--having done that and in a sense succeeded perhaps more than we had intended--to try to restore some degree of confidence in the System. And that means we have to find a way, if at all possible, to move toward a policy stance from which we will not be perceived as about to move again in any short period of time.

The distinction between Greenspan's two uses of the sword is astounding and tragicomic. In February, the Sword is his tool; he controls it to serve his purpose. "If we have the capability of having a Sword of Damocles over the market we can prevent it from running away." By March, the Sword still hangs over the markets, but it is not Greenspan's tool; it works against him instead of for him. Greenspan is king of the markets, and the sword hangs above the throne. In February he speaks of the Sword as useful, and by March he wants it removed. He proposes this plan to remove it:

I think there is a certain advantage in [raising the rate by] 25 basis points because the markets, having seen two moves in a row of 25 basis points at a meeting, will tend almost surely to expect that the next move will be at the next meeting--or at least I think the probability of that occurring is probably higher than 50/50. If that is the case and the markets perceive that--and they perceive we are going to 4 percent by midyear, moving only at meetings--then we have effectively removed the Damocles Sword because our action becomes predictable with respect to timing as well as with respect to dimension. 

The plan is what in today's lingo we'd call "calendar objectives" as opposed to data objectives. Greenspan thought interest rates ultimately needed to get up to 4 or 4.5%, and wanted to set up a timeline to get there in movements of 25 basis points at each scheduled meeting. He thought that by moving by 25 bps at two meetings in a row, the markets would catch on and expect 25 bps at subsequent meetings (regardless of inflation, or lack thereof.) This timeline was not to be. At a conference call on April 18, before the next scheduled meeting, the rate was raised another 25 bps, then 50 in May, 50 in August, and 75 in November. Overall, 1994 was a bad year for bond investors and speculators (including Orange County, CA, which went  bankrupt after the rise in interest rates), but decent for the real economy. The Fed's actions that year were not ideal, but they also were not disastrous, except for certain categories of investors.

The real economy today faces a shakier recovery which could more easily be thrown off course. Inflation has not "shown its head" no matter how hard the markets and the Fed have looked for it. Since the data give no impetus toward reducing accomodation, the Committee, eager to exit, has switched to a calendar-based policy. President Bullard's press release describing his dissent to the FOMC decision announced on June 19, 2013, includes the following:

President Bullard also felt that the Committee’s decision to authorize the Chairman to lay out a more elaborate plan for reducing the pace of asset purchases was inappropriately timed. The Committee was, through the Summary of Economic Projections process, marking down its assessment of both real GDP growth and inflation for 2013, and yet simultaneously announcing that less accommodative policy may be in store...President Bullard felt that the Committee’s decision to authorize the Chairman to make an announcement of an approximate timeline for reducing the pace of asset purchases to zero was a step away from state-contingent monetary policy.

Tim Duy summarizes,

Bullard clearly felt the mood in the room was something to the effect of "We know the data is soft, but we want out of this program by the middle of next year, so we are going to lay out a program to do just that."...After weeks of being soothed by analysts saying that the data was key, that low inflation would stay the Fed's hand, Bernanke laid out clear as day a plan for ending quantitative easing by the middle of next year. Market participants then concluded exactly what Bullard concluded: It's the date, not the data.

Perhaps Chairman Bernanke looked up and glimpsed Greenspan's sword suspended above his head. I hope he can react to it with composure and not panic. The Committee in 1994 tried to manipulate market expectations through actions and through cryptic communications. While the expectations instrument was powerful, it was not precise. Although the Fed has improved its communications strategy since 1994, its messages still can have unintended consequences; 10-year yields rose sharply following the latest FOMC statement. Very clearly state-contingent monetary policy would be less confusing, and would project more confidence in the economy's eventual recovery, than semi-state-contingent, semi-calendar-driven policy. And if bond market participants look back to 1994 and expect a rapid succession of interest-rate hikes in the near future, the Fed should clearly communicate that this time will be different.

Depressing Slow Recovery Graphs

Earlier this year, Fed Vice Chair Janet Yellen described the economic recovery as "painfully slow," and said that an "important tailwind in most economic recoveries is one that tends to be taken for granted--the faith most of us have, based on history and personal experience, that recessions are temporary and that the economy will soon get back to normal." This tailwind, she implied, was particularly weak. Here I've made two graphs that give an indication of the painfully slow recovery.

The Michigan Survey of Consumers asks respondents, "Compared with 5 years ago, do you think the chances that you (and your husband/wife) will have a comfortable retirement have gone up, gone down, or remained about the same?"

Before 2008, on average 45% of people would say that their chances of a comfortable retirement had stayed the same. About 28% would say their chances got worse, and 26% would say their chances got better. Figure 1, below, shows the percent of respondents who chose better or worse each month. By October 2008, only 11% of respondents thought their chances of a comfortable retirement were better than 5 years ago; 45% thought they were worse. 

As of October 2012, the numbers are barely improved: 15% of people think their chances of a comfortable retirement are better than they were in 2007, and 41% think they are worse.

Figure 2 shows the percent of respondents in the highest and lowest income terciles who think their chances of a comfortable retirement are worse than 5 years ago. For the top income tercile, hit harder by falling asset prices, this number peaked at 62% in February 2009, and averaged 41% over 2012. For the bottom income tercile, hit harder by the deteriorating labor market, this number peaked later, at 56% in May 2011,  and averaged 45% over 2012.

Figure 1: Constructed with data from Michigan Survey of Consumers

Figure 2: Constructed with data from Michigan Survey of Consumers

Europeans' Biggest Problem

The European Commission's Eurobarometer survey monitors public opinion on a variety of political and economic issues across European Union member states. One question on the Eurobarometer survey asks:

Personally, what are the two most important issues you are facing at the moment? 

This question was only asked in May 2012. For the EU as a whole, by far the most common response was rising prices/inflation. In fact, 45% of people in 2012 said that inflation was one of the top two most important issues they were facing. The pie graph below shows, for the EU as a whole, the responses people chose. Only 15% of people chose the financial situation of their household as a top issue. Health and social security also had a mere 15%. I was stunned that three times as many people consider inflation a top issue as consider health and social security a top issue.

In the graphs below, the results are broken down by country. First I show the percent of respondents in each country who choose inflation as a top-two issue. Then for a few countries, I show the percent who choose inflation and the percent who choose unemployment. In twelve countries (including Austria, France, and Germany), at least half of respondents say that inflation is a top-two issue. Sweden is a major outlier-- only 5% think that inflation is a top-two issue. The next lowest is Greece, at 26%. Sweden and Greece did have the lowest inflation in the EU in May 2012, but really just about ALL countries in the EU had (and still have) low or reasonable inflation.

Half of Germans and French thought that rising prices were a top issue, even when inflation was just 2.5%. The EC Consumer Survey, asks people how much they think prices have risen in the past 12 months. In May 2012, 28% of German, 36% of French, and 40% of Austrians thought that prices had risen "a lot."

Neil Irwin recently wrote that "The leading economies of the industrialized nations may not have a lot in common, but they are all afflicted by this: Inflation is too low." Even though inflation is too low, a lot of people think it is high-- and think that rising prices personally affect them more than unemployment. Public opinion is a powerful force, so we see policymakers being more reluctant to raise inflation when it it too low, than to lower it when it is too high.

Services and the Slow Economic Recovery

The Berkeley Economic History Laboratory (BEHL) launched a series of working papers earlier this year. The BEHL website notes that "These papers are preliminary works, and their circulation is intended to stimulate discussion and comment." To further that goal, as I mentioned in an earlier post, I'll be spotlighting these working papers on the blog. Three new papers are out; the one I'd like to write about today is called "Goods, Services, and the Pace of Economic Recovery," by Martha Olney and Aaron Pacitti.

The authors cite Lazear and Spletzer's argument that “the problem [with the U.S. economy now] is not that the labor market is underperforming; it is that the recovery has been very slow” (2012 pg. 35). Olney and Pacitti offer an explanation for the slow recovery based on a hypothesis that recoveries from downturns should be slower when services are a larger share of the economy. This comes from the simple idea that goods, and not services, can be produced ahead of an anticipated increase in demand, because only goods can be inventoried. Here is the abstract:

Do service-based economies experience slower economic recoveries than goods-based economies? We argue they do. An economy recovers from a downturn when businesses increase production. Both goods and services can be produced in response to actual demand. But only goods—and not services—can be produced in response to anticipated increases in demand, allowing optimistic forward-looking producers to inventory goods until anticipated buyers appear. Services can’t be inventoried. The more services an economy produces relative to goods, the more production is dependent upon only actual increases in demand, and the slower the recovery. We exploit variation across time and states in the share of services in output. Controlling for the depth of the downturn, the higher is the share of services, the longer is the recovery. Extending our results to the current downturn, given the depth of the downturn, the rise in services alone will make the post-2009 recovery last about 1 year longer than it would have a half-century ago.

The authors use national data for the 10 recessions in the United States from 1948 to 2001, and a panel of state data for 50 states and 5 recessions from 1969 to 2001. They use the depth of each recession as a control variable. Getting the state-level data on service sector shares and business cycles was not an easy feat, and is an important contribution of this research. They are able to document interesting, and changing, variation in the share of services by state. My home state, Kentucky, had the second lowest share of services (39%) in the nation in 1967-1969; the share has risen to 50%. Now oil-rich states Wyoming, Alaska, and Louisiana have the lowest share of services. (Take a look at figure 6 and very cool figure 7 in the paper.)

I am left wondering about the other side of the business cycle. The story in this paper is that businesses can anticipate an increase in demand and build up an inventory. What happens when a decrease in demand is anticipated? Wouldn't goods-producing businesses decrease production and start using up their inventory? This would lengthen the downturn part of the cycle by making it start sooner. If this is the case, service-oriented economies would have longer recoveries and shorter downturns. I don't know if the effect would be asymmetrical. For the state-level data, the authors measure recovery as the length of time from one peak to the next peak of the business cycle. This actually captures the length of the downturn plus recovery. I think it would be preferable to use trough-to-peak length instead of peak-to-peak length if the data allowed it, since share of services could plausibly effect peak-to-trough length and trough-to-peak length in different ways.


Overall, I think this working paper documents an intriguing empirical fact. Has anyone out there read (or written) a macro model with two firms with heterogeneous inventory costs? Please comment or send it my way if you have.Setting the inventory costs of one of the firms to infinity could represent the service sector. I think it would be useful to have a model to go along with this paper-- both to help think about my point in the last paragraph and because I am having trouble thinking about GE implications for relative prices and wages in the goods and services sectors and what role that could play. Any other comments or suggestions on the paper are of course welcome, and I will pass them along to the authors.

Krugman and Plosser on Deleveraging

On March 6, 2013, Philadelphia Fed President Charles Plosser argued that low interest rates are actually causing people to save more, not less, because the income effect currently outweighs the substitution effect. In his words:

The conventional view is that by lowering interest rates, monetary accommodation tends to encourage households to reduce savings and thus consume more today. However, as I’ve noted, in the current circumstances, consumers have strong incentives to save. They are deleveraging and trying to restore the health of their balance sheets so they will be able to retire or put their children through college. They are behaving wisely and in a perfectly rational and prudent way in the face of the reduction in wealth.

In fact, low interest rates and fiscal stimulus spending that leads to larger government budget deficits may be designed to stimulate aggregate demand or consumption, but they could actually do the opposite. For example, low interest rates encourage households to save even more because the return on their savings is very small. And large budget deficits suggest to households that they are likely to face higher taxes in the future, which also encourages more saving. In my view, until household balance sheets are restored to a level that consumers and households are comfortable with, consumption will remain sluggish. Attempts to increase economic “stimulus” may not help speed up the process and may actually prolong it.

This reminds me of an article by Paul Krugman last year called Deleveraging Shocks and the Multiplier (Sort of Wonkish).

So, the simple but surely broadly correct story of the mess we’re in is that we had a period of excessive complacency about leverage, which came to a sudden end. Household debt in particular surged, then was suddenly perceived as excessive...

Leveraging up, other things equal, leads to high aggregate demand — but this can be and is in practice offset by the central bank, which can always raise rates. Deleveraging, on the other hand, can’t be offset equally easily; the central bank can cut rates, but only to zero, and unconventional monetary policy is both controversial and an iffy proposition (which doesn’t mean that it shouldn’t be tried).

So far, Plosser and Krugman more or less agree. Households are deleveraging because they really want to deleverage, we're at the zero lower bound, and unconventional monetary policy is iffy. (As Plosser puts it, "We are operating in an uncertain environment and using nontraditional policies with which we have limited experience.")

Here's where the big, big difference comes in. Plosser also said that fiscal stimulus wouldn't work in this scenario because "large budget deficits suggest to households that they are likely to face higher taxes in the future, which also encourages more saving." Let's break this down.

An increase in the deficit raises both current income and expected future taxes. If the government spending multiplier is one, an increase in the deficit is neutral for consumption. So people consume the same amount they otherwise would have, and save the additional income to use to pay future taxes.Yes, large deficits encourage more saving, but without reducing consumption. In other words, they increase the total level of savings people have, but they decrease the rate of saving out of current income. The rate versus level distinction is important. If households follow some heuristic about a minimum theshold level of saving they want to achieve (e.g. make sure to have $5,000 saved in case of emergency), then they could reach that threshold quicker (and stop deleveraging) through fiscal stimulus. And that is just assuming the multiplier is one. Even better if it is larger...which of course brings us back to Krugman:

Now, the same thing that makes deleveraging so hard to handle also makes the fiscal multiplier larger than it is in normal times. Normally, expansionary fiscal policy is offset by monetary tightening, contractionary policy by monetary loosening. Hence the lowish multiplier estimates based on recent history. But if deleveraging has pushed you into a liquidity trap, there are no offsets...Start by provisionally assuming a frictionless world in which consumers have perfect foresight and perfect access to capital markets. In that case the multiplier should be exactly 1...A rise in government spending does mean higher expected future taxes — but it also means higher incomes right now, and those two effects should exactly cancel each other.

Now add in realistic frictions, notably households that are liquidity-constrained and/or use rules of thumb based on current income to make spending decisions. (By the way, as Gauti Eggertsson and I have pointed out, once you’re using a debt/deleveraging model you are already in effect assuming that many households face liquidity constraints). These frictions will mean that a rise or fall in current income due to fiscal policy will lead to at least some movement of consumption in the same direction. So we get a multiplier bigger than 1.

But I would add that this is not just a question of whether the multiplier is bigger than one. Whether or not the multiplier is bigger than one, in fact just as long as it is bigger than zero, fiscal policy will at least help people reach their level-of-savings targets quicker, if that is the way some people decide how much to save (which seems intuitively reasonable.) Unfortunately, as Meryl Motika pointed out in her post yesterday, we don't know enough yet about how people decide to save. And that's getting to be a highly pressing issue for both monetary and fiscal policy.

The Great Recession and Preferences for Redistribution

Differences in attitudes towards welfare and redistribution are an important source of political tension, especially during recessions. What factors shape people's attitudes towards welfare and redistribution? There are two main strands of thought on this question in the literature. One strand emphasizes economic self-interest as a key determinant of attitudes toward welfare and distribution. According to this view, people’s position in the labor market, exposure to layoff risk, and financial status are the main factors determining their attitudes. Another strand emphasizes different ideological dispositions on issues such as fairness, equality, and the role of government.

It is empirically difficult to distinguish between the two strands, since material circumstances and ideology may influence each other. Two recent papers take advantage of the Great Recession in their empirical design to study social preference formation. First is a paper by Yotam Margalit titled "Explaining Social Policy Preferences: Evidence from the Great Recession":

I use an original panel study that consists of four waves of surveys in which the same national sample of respondents was contacted for repeat interviews between July 2007 and March 2011. In these repeat interviews, detailed information was collected not only on respondents’ changing labor market circumstances but also on their political attitudes. Utilizing this rich longitudinal data, covering periods both before and after the eruption of the financial crisis, I estimate how individuals’ preferences on welfare policy shift in response to the personal experience of three types of economic shocks: a substantial drop in household income, a subjective decrease in perceived employment security, and the actual loss of a job. 

The central finding of the analysis is that voters’ preferences regarding welfare policy are strongly affected by changes in their own economic circumstances. In particular, the loss of employment is found to have a major effect, increasing the average probability of support for greater welfare spending by between 22-25 percentage points.

An interesting secondary finding is the following:

The analysis also reveals that the experience of the economic shock does indeed lead to a convergence in the welfare preferences of harmed individuals who prior to the shock held distinct political views. In particular, I find that in response to a personal economic shock such as layoff, Republicans and Independents grew significantly more supportive of welfare assistance, while among Democrats the effect was much smaller.

The effect may not be permanent:

I find that with the passing of time, as job losers regain employment, their support for the expansion of welfare spending decreases significantly. This shift in attitude among the re-employed is more frequent among voters on the right. 

The other paper is a working paper by Raymond Fisman, Pamela Jakiela, and Shachar Kariv called "How did the Great Recession Impact Social Preferences?" This paper focuses on the formation of ideological dispositions toward equity and redistribution. This is an experimental paper utilizing the Xlab at UC Berkeley. Subjects were drawn from the UC Berkeley student body, the socioeconomic composition of which is held fairly constant by the admissions office. The same experiments were conducted both before and during the Great Recession. Subjects played different variations of the "dictator game," in which one player decides how much money (or tokens) to allocate to herself and to other players. The game is an experimental test of people's self-interestedness. Variations of the game, discussed in the paper, allow researchers to disentangle selfishness from the willingness to tradeoff efficiency and equity.

Our main fi nding is that the Great Recession had a dramatic eff ect on individual social preferences: subjects who participated in laboratory dictator games prior to the economic downturn are signi ficantly more altruistic than those who took part in identical experiments after the onset of the recession. Our experimental design--employing graphical representations of modified dictator games that vary the price of redistribution--enables us to distinguish indexical selfi shness from the willingness to tradeoff equality and e fficiency. Moreover, our experimental method generates many observations per subject, and we can therefore analyze both types of social preferences at the individual level. We fi nd that subjects exposed to the economic downturn place greater emphasis on effi ciency and display greater levels of indexical sel fishness.

The Long and Short of It

This guest post is written by Sandile Hlatshwayo, a graduate student in economics at UC Berkeley, on forthcoming research with her co-authors Michael Spence and Nicolo Cavalli. 

In the post-crisis environment, issues of sustainability in the trajectory of the U.S. economy have come to the fore. However, many of these issues—persistently high unemployment, a large current account deficit, deleveraging in the household and financial sectors, and fiscal pressure—are better understood when placed in the context of changes in the economy’s structure over a broader horizon. As a follow-up to a 2012 publication, my co-authors and I are examining U.S employment, real value-added, and real value-added per job over the past two decades, while also conducting parallel analyses on Germany and Italy; this note focuses solely on the preliminary U.S. results. We separated U.S. industries into internationally tradable and nontradable components using Jensen & Kletzer’s (2005) approach. The approach determines the tradability of an industry based on its geographic concentration—the more regionally concentrated the industry, the higher its tradability (and vice versa). For example, take retail trade: its ubiquitous geographic presence implies that it is highly nontradable. The same could be said for dry cleaners, construction, and most health care services. On the other hand, mining tends to be geographically concentrated, which points to its tradability.

In the long term, the structure of the American economy has changed dramatically. Nontradable employment increased by 22.5 million from 1991 to 2011, while tradable employment fell by 1.2 million. Job gains in tradable service industries were offset by larger losses in manufacturing and agriculture. On the nontradable side, almost 60 percent of the employment increase can be attributed to government, accommodation and food services, and the health care sector.

Both tradable and nontradable value-added increased, both on the order of 50 percent. Manufacturing sectors that suffered a loss of employment also experienced rising value-added. Therefore value-added per job—a measure that correlates closely with annual income—rose, in some cases dramatically (e.g. electronics saw a 250 percent increase in value added per job from 1991 to 2011). High-income jobs remained in the tradable sector (e.g. in industries like finance and consulting). For the tradable sector as a whole, value-added per job rose substantially, an increase of 53 percent from 1991 to 2011, far above the increase of 37 percent in the economy as a whole. The tradable sector is gravitating toward higher value-added components of global supply chains. These consist, in broad terms, of high-end services, some in manufacturing industries, and some, like finance and insurance, in pure service industries.

Notably, and in contrast to employment trends where the sector drove increases, the nontradable sector saw growth in value-added per job of only 18 percent, far below the tradable sector’s 53 percent increase. The health care sector, the second largest employer after government, actually saw value-added per job fall by 5 percent over the 1991 to 2011 period, implying that, on average, health care workers are making 3 thousand dollars less in per year today than they were making in 1991, in real terms.

Turning to the short term, employment experienced a larger drop than value-added during the crisis and has also been slower to recover; on average, value-added has rebounded two percentage points faster than employment in 2010 and 2011, which should come as no surprise. Tradable industries like professional services, auto manufacturing, and electronics are driving the value-added rebound, while largely nontradable industries like health care and education are driving employment’s recovery. Ongoing job losses in government, information, and manufacturing account for employment’s relatively muted recovery. Unfortunately, the short-term dynamics of the U.S. recovery are reinforcing a long-standing trend--the mismatch between the sectors driving employment and the sectors driving value-added and value-added per job, resulting in rising income inequality.

Until the crisis of 2008, the economy did not have a conspicuous unemployment problem. The expanding labor force was absorbed in the nontradable sector. In our view, it is unlikely that this pattern will continue. Chances are good that the pace of employment generation on the nontradable side will slow. As mentioned above, government—the country’s largest employer—has already started to shed jobs, with employment falling two percent from 2010 to 2011, a fall of almost 400 thousand jobs occurring largely at the state and local levels. Moreover, incomes in the nontradable sector have been stagnating for years. Fiscal conditions, the costs of the health-care sector, a resetting of real estate values, and the elimination of excess consumption all point to the potential for a longer-term structural employment problem.

To avoid this predicament, expanding employment in the tradable sector almost certainly has to be part of the solution. Otherwise, our current unemployment predicament will become a permanent feature of the American economy. The absence of rewarding employment opportunities in the lower- and middle-income ranges breaks an important part of the social contract in America, which holds that you are largely on your own but that if you work hard the opportunities will be there. The second part of that contract is now in question.

In describing these trends, we have been asked several times what the nature of the market failure is. The answer seems fairly clear. Multinationals, businesses that operate in the global economy, and those who have a role in creating and managing global supply chains are good at what they do and getting better all the time. They identify and respond to growing market demand, especially in the emerging economies, and to evolving supply chain opportunities. The resulting efficiency of the global system is high and rising. So we argue that there is no market failure. The system is complex and constantly evolving, but the operatives in the system adapt to the shifting sands of comparative advantage and market size, and move economic activity to the places where it can be performed at high efficiency and low cost.

If the issue is not about efficiency or market failure, what then is the problem? The answer is that market forces have distributional consequences for employment opportunities and incomes. Subsets of the world’s population, including those within advanced economies, experience adverse effects. What our policy makers need to address is the fact that there are real choices between aggregate income levels and efficiency on one hand, and distributional equity and employment opportunities on the other.

Assuming that the markets will fix these problems by themselves is not a good idea; it may be approximately true for the global economy as a whole, but is not necessarily for its parts. In truth, all countries, including successful emerging economies, have addressed issues of inclusiveness, distribution, and equity as part of the core of their growth and development strategies. Now advanced countries need to follow suit.

The late Paul Samuelson once said that every good cause is worth some inefficiency. Morally, pragmatically, and politically that seems right. Delivering on the opportunity part of the social contract is one such cause.

How I Wish this Book Existed

There already exist many books about the financial crisis and Great Recession, but not the one I am most dying to read. Imagine this: a book about the crisis and recession written each chapter written by a different  top female macro or financial economist. Here is my dream chapter line-up.

Chapter 1: Signs of Impending Crisis, Janet Yellen

Chapter 2: International Integration, Contagion, and Domestic Vulnerability, Graciela Kaminsky

Chapter 3: Bank Competition and Systemic Stability, Asli Demirguc-Kunt

Chapter 4: Minding Our Money: Financial Literacy and the Crisis, Olivia Mitchell

Chapter 5: Unconventional Monetary Policy in Exceptional Times, Lucrezia Reichlin

Chapter 6: Quantitative Easing and Portfolio Choice, Annette Vissing-Jorgensen

Chapter 7: Evaluating TARP, Loretta Mester

Chapter 8: Public and Private Spending, Valerie Ramey

Chapter 9: Inventories and the Delayed Recovery, Martha Olney

Chapter 10: Beyond Unemployment Rates: The Great Recession and Material Hardship, Janet Currie

Afterword: Policy and the Power of Ideas, Christina Romer

What do you think? Would other people be excited to read this too? What chapters and authors am I missing?