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Making Monetary Policy:
What Do We Know and When Do We Know It?
Based on a speech given by President Santomero to the National Economists Club, April 7, 2005
BY ANTHONY M. SANTOMERO
C
onducting a successful monetary policy
presents real-world challenges, such as
evaluating where the economy is, where it
is going, and where it should be going. But
how do monetary policymakers make decisions about
the economy in a world with imperfect information? In
his message this quarter, President Anthony Santomero
discusses how policymaking is affected by both the
availability and reliability of economic information.
I’d like to take this opportunity to
share my thoughts on the difficult task
of conducting monetary policy for the
U.S. In particular, I would like to focus
on how policymaking is affected by
both the availability and reliability of
information on how well the economy
is performing. I want to emphasize that
my message this quarter reflects my
own thoughts on the subject and does
not necessarily reflect the views of the
Federal Open Market Committee.
We all know that monetary policy
responds to economic circumstances
and hence to incoming economic data.
Therefore, it is important every once
in a while to take a closer look at what
we know about the data we rely on
and, simultaneously, what we do not
know about the economy from the
information that is available.
However, this is more than a philosophical discussion; after all is said
and done, we must conduct monetary
policy. So I would like to focus on what
conducting real-time monetary policy
is like in a world with less-than-perfect
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information about the economy we are
attempting to affect.
At the outset, I want to reinforce
my view that appropriate monetary
policymaking requires attention to
long-run goals, not just short-term dynamics. Or to state it another way, our
short-run actions must take account
of our long-run objectives if we are
to be prudent and successful central
bankers.
The most important long-run goal
of good monetary policy is straightforward enough: a responsible central
bank must guarantee price stability.
Price stability is crucial to a well-functioning market economy. Prices are
signals to market participants. A stable
overall price level allows people to
see shifts in relative prices clearly and
adjust their decisions about spending,
saving, working, and investing optimally. Inflation, by contrast, jumbles
and distorts price signals and generates
suboptimal economic decisions.
For the past 25 years, the Fed has
been relatively successful in achiev-
ing the goal of price stability. Equally
important, as the relatively low level
of market interest rates attests, we
have succeeded in reducing long-run
inflation expectations over the past 15
years.
Maintaining confidence in sustained price stability is crucial to fostering the most productive saving and
investment decisions. In addition, it affords the Federal Reserve considerably
more latitude to take short-run policy
actions to help stabilize economic performance.
As you all know, the Federal Reserve is charged with setting monetary
policy so as to meet its dual mandate
of maintaining price stability and ensuring maximum sustainable output
growth. When the economy is weak,
monetary policy generally needs to
be accommodative, and when the
economy is growing strongly, policy
needs to be tighter. In this way policy
remains consistent with underlying
Anthony M. Santomero, President,
Federal Reserve Bank of Philadelphia
Q4 2005 Business Review 1
economic fundamentals. It is entirely
appropriate and consistent with our
long-term goals for monetary policy to
be countercyclical as long as we remain
cognizant of the inflationary environment.
But we must all recognize that a
central bank’s power is limited. One
thing we have learned — and it has
been an expensive lesson — is that
the best the Fed can do is cushion the
economy. It cannot in and of itself
force stronger growth than the economy is capable of delivering. Trying to
push an economy beyond its potential
may temporarily accelerate growth, but
it also creates imbalances and increases
inflationary pressures that must be addressed, and so boom leads to bust.
I believe that the Fed’s policy over
the past 25 years has demonstrated
both its commitment to, and the value
of, a stable price environment. Looking ahead, I am confident the Fed will
take policy actions consistent with
economic fundamentals and keep its
focus on the long-run objectives.
That said, I do not deny that conducting a successful monetary policy
presents plenty of real-world challenges. It requires an evaluation of where
the economy is, where it is going, and
where it should be going. Therefore,
the appropriate conduct of real-time
monetary policy requires policymakers
to gauge how strong or weak the economy is at any moment in time, what
its most likely trajectory appears to be,
and how that trajectory aligns with its
long-run potential.
This requires a detailed appraisal
of data and, importantly, of real-time
data on the current state of the economy. Unfortunately, these data often
give very noisy signals of what is really
going on.
WHERE DO WE WANT THE
ECONOMY TO GO?
So where does one start? A policy-
2 Q4 2005 Business Review
maker must first assess where he or she
wants the economy to go. For the U.S.
central bank, the goals of monetary
policy have been made explicit in relevant legislation. The Federal Reserve is
to maintain price stability and ensure
maximum sustainable output growth.
The first challenge is to quantify
each of these important objectives:
What is the highest growth rate for
output that is sustainable? What rate
of unemployment represents full utilization of labor? What rate of inflation
represents price stability? These are
tremendously difficult concepts to pin
down. Economists have taken many
different approaches to establishing
numerical guideposts for economic
performance, but, as I will illustrate,
these guideposts are very difficult to
estimate in practice.
POTENTIAL OUTPUT
There is general agreement in
macroeconomics that the relevant
measure of real activity for policymaking is the so-called “output gap”
between the level of actual output and
an underlying level of potential output.
This gap is important in that it not
only provides an output objective, but
it also provides information about possible future inflationary pressures. If
the economy were to grow faster than
the growth in potential output for a
sustained period of time, inflation
would be expected to accelerate over
time. By contrast, economic growth
slower than potential would lead to less
than full employment.
But what is this level of potential
gross domestic product (GDP), and
how fast does it grow? Recent theoretical work suggests that this notional
benchmark should be the level of
output that occurs when all wages and
prices are flexible and the economy
fully adjusts to balance supply and demand in all markets. This is a reasonable concept, but since not all wages
and prices are flexible, this output
level cannot be observed directly. So in
practice, this level of potential output
is impossible to measure.
As a practical alternative, potential output is commonly interpreted to
be the trend level of output. Unfortunately, there are many different ways
to estimate trend output, each with
its own set of issues. Sometimes these
estimates have strikingly different implications for monetary policy.
One reason that measures of potential GDP are difficult to estimate is
that many factors — demographic and
technological among them — affect
potential output in any given period.
So, potential output changes over time
and can only be roughly estimated
given current conditions.
For example, the “tech boom” of
the 1990s, whose effects are still being
analyzed today, has played a key role
in determining U.S. potential output.
However, the exact extent of the upward shift it caused in potential GDP
is still uncertain. As we all know, the
technological revolution’s effect on the
economy is still widely debated. Different interpretations of its effects lead to
different estimates of potential GDP.
So with these difficulties in mind,
how accurate have our estimates of potential GDP been? According to many
researchers both inside and outside of
the Federal Reserve, the accuracy of
contemporaneous measures of potential GDP is not encouraging. Comparing current estimates of the gap for
the period from the mid-1960s to the
mid-1990s, one Fed researcher finds
that more recent measures of the output gap lie almost uniformly above the
contemporaneous estimates: The realtime estimates of potential output over
this period were systematically overly
optimistic.1 He points to the late 1960s
See the article by Athanasios Orphanides and
Simon van Norden.
1
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as a particularly striking example. At
the time, the data show that the gap
between actual GDP and potential
GDP was believed to be about zero.
With the benefit of hindsight, almost
any estimate now would place that
gap at nearly five percentage points.
Taken at face value, this divergence
would imply that policymakers did not
recognize the considerable upward
inflationary pressure that the economy
was subject to at that time.
NAIRU
Another construct that has found
a place in countercyclical monetary
policy is NAIRU, or the non-accelerating inflation rate of unemployment
— the unemployment rate at which inflation remains constant. The NAIRU
model predicts that when unemployment is below the NAIRU, there is
pressure for the inflation rate to rise;
on the other hand, when unemployment is above the NAIRU, there is
pressure for inflation to fall.
This, too, is a reasonable concept.
Unfortunately, academic research
has shown that estimates of NAIRU
are very imprecise and are subject to
significant standard deviations. Work
by other economists suggests that this
imprecision exists in models where
NAIRU is presumed constant and
in models that allow NAIRU to vary
over time as well. This conclusion also
holds up when we use alternative series
of unemployment and inflation. The
Philadelphia Fed’s Research Department estimated that the NAIRU was
between 3.4 and 5.9 percent between
1983 and 2004 with a 95 percent confidence level. This is a fairly wide band
of uncertainty.
The problem is that estimates with
this level of imprecision are of limited
use when conducting monetary policy.
When policymakers are attempting
to evaluate whether there is still slack
in the labor market, or if any further
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decrease in unemployment may lead to
inflationary pressures, it clearly would
be preferable to have more precise estimates of NAIRU. For example, there
are substantially different implications
of a 5 percent unemployment rate if we
believe NAIRU is 3.4 percent or if we
believe NAIRU is 5.9 percent or even
if it is at the midpoint of 4.7 percent.
PRICE STABILITY
The imprecision of our estimates
goes beyond just real-sector economic
statistics. Take, for example, price
data. Price stability will be achieved,
to paraphrase Federal Reserve Chairman Alan Greenspan, when inflation
ceases to be a factor in the decision-
living and therefore covers direct outof-pocket expenditures of households.
PCE, on the other hand, is a broader
index that includes some consumption that is government funded, such
as Medicare and Medicaid, and some
goods and services that are consumed
without any explicit charge to the consumer.
Then there is the issue of whether
to use a core measure of the chosen
price index, that is, the price index
excluding the food and energy sectors, or to use the headline number.
The argument in favor of using a core
price index is that the energy and food
sectors have tended to be the more
volatile components of either index
According to many researchers both inside
and outside of the Federal Reserve, the
accuracy of contemporaneous measures of
potential GDP is not encouraging.
making processes of businesses and
individuals. While this is a reasonable
definition, it provides neither an exact
estimate of our inflation goal, nor does
it state which measure of inflation is
most germane.
In terms of the latter, the debate
has two parts: First, which price index should be used? Second, which
measure of that index best describes
inflation in today’s economy? The two
indexes most often cited as relevant
measures of inflation are the consumer
price index, or CPI, and the chain
price index for personal consumption
expenditures, or the PCE price index.
Which is more useful from a policymaker’s perspective?
While the CPI and PCE are similar measures, they do vary in several
important dimensions. One important
difference is the scope of the spending
they cover. The CPI is designed to approximate a typical consumer’s cost of
and that large volatility in monthly
data often disappears over time. Of
course, if the time horizon over which
one is measuring inflation is long
enough, it should not matter whether
volatile components are deleted, since
the noise in these components dissipates over the long horizon. But with
a shorter horizon, the core price index
would give the best measure of underlying price movement. On the other
hand, those who argue against using
core price indexes believe that the
volatile sectors are being systematically
removed by using core measures and
that these sectors may provide useful
information about current and future
price movement.
I mildly favor the core PCE deflator as my preferred measure of price
inflation because it is a broader and
more appropriate measure of underlying inflation than the CPI. Also, it is a
chain-weighted index, and so it takes
Business Review Q4 2005 3
account of consumers' changing buying patterns as relative prices change.
Therefore, to me, it reflects changes in
the overall price level more accurately
than the CPI, which is based on a
fixed basket of goods and services. Using the core PCE also helps reduce the
"noise" in the inflation signal, enhancing its value as a monitoring device.
IMPLICATIONS
Reading this, one might get the
feeling that data problems loom so
large in my mind that I have very little
faith in – or use for – quantitative
guideposts to economic performance.
That would be taking my comments
too far. These guideposts still contain
important and relevant information for
any policymaker. In fact, acknowledging their strengths and weaknesses
enables one to better use these admittedly imprecise estimates more effectively.
For example, if we look at the errors in measuring the level of potential
output and the output gap, we must
recognize that these statistical problems can be large and important. However, if we look at the growth of output
relative to trend growth we may find
it a more reliable guidepost for policy
evaluation because the errors in each
may well be offsetting.
This approach to policy suggests
that policymakers may be better off
looking at the growth rate of output
relative to the growth rate of trend
output and striving to achieve growth
in aggregate demand approximately
equal to the expected growth in potential aggregate supply.
DETERMINING THE CURRENT
STATE OF THE ECONOMY
Thus far, I have discussed the
difficulties policymakers face in determining where the economy should be,
but the challenge of assessing where
the economy actually is I consider only
4 Q4 2005 Business Review
slightly less daunting. In truth, current
economic conditions are not easy to
measure accurately in real time. We receive data only with a lag, and preliminary data are notoriously unreliable. In
short, the data about the current state
of the economy are constantly changing. History and recent events have
shown these changes, at times, can be
large.
Estimations and Imputations.
At the heart of this problem is that
data releases on the current state of
the economy are often a collection of
sampling, estimation, and imputation.
We recognize the first of these — we
do not count every item produced or
every good sold — but the other issues surrounding the timely release
of data have also proven to be quite
important. There is a tradeoff here. To
be timely, government agencies usually
issue preliminary numbers before all
the underlying information is available. Consequently, data available to
policymakers concerning the current
state of the economy are often based
on estimations and imputations of
data. As more complete information
becomes available, agencies regularly
revise their data series, and the revisions can be significant.
For example, the Bureau of Economic Analysis (BEA), the government
agency that issues GDP data, releases
its first report on the nation’s GDP near
the end of the month following the
end of a quarter. That release is called
the advance report. At the time of
the advance report, the BEA does not
have complete information, so it makes
projections about certain components
of GDP from incomplete source data.
As time goes on, the source data become more complete. But it usually is
not until the following year that better
information, such as income-tax records
and economic census data, is available.
So the GDP data undergo a continual
process of revision.
Benchmark Revisions. Once in
a while we make substantial changes
in addition to regular revisions of the
data. About every five years, the government makes major changes, called
benchmark revisions, to the data for
the national income and product accounts. Benchmark revisions incorporate new sources of data and may
also include changes in definitions of
variables or changes in methodology.
To be sure, these changes are necessary, in part because our economy is
constantly changing: Different types
of products enter the market and different accounting methods need to be
used. But they can be disruptive.
For example, a major alteration
undertaken in the 1999 benchmark
revisions changed the way the BEA
classifies computer software purchased
by business and government. Prior to
the revision, this type of spending was
counted as an office expense. This was
adjusted in 1999, and now this type of
spending is counted as investment.
The most recent benchmark revision took place in 2003, and it incorporated several new pieces of information and more reliable source data and
used a new price index in nonresidential construction that takes account
of changes in quality. Again, these are
important changes, but they disrupt
what we know or thought we knew.
The Real-Time Data Set. At the
Federal Reserve Bank of Philadelphia
we take these data revisions very seriously. We have developed a data set
that gives a snapshot of the macroeconomic data available at any given date
in the past.2 We call the information
set available at a particular date a vintage, and we call the collection of such
The data set is available to the public on
the Philadelphia Fed’s website at: www.
philadelphiafed.org/econ/forecast/reaindex.
html. See also the two articles by Dean
Croushore and Tom Stark.
2
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vintages a real-time data set. Using
the real-time data set one can pick a
point in history and see exactly what
data policymakers had at their disposal
at that time.
For example, suppose we were to
look at the growth rate of real output
for the first quarter of 1977. The first
time real output for that quarter was
reported, the national income and
product accounts showed that real
output grew 5.2 percent — that is the
reading in our May 1977 vintage of
the real-time data set. Over time, this
estimate was updated and changed as
better and more accurate data on that
quarter became available. Today, when
we look at the national income and
product accounts, the growth rate of
real output for the first quarter of 1977
is listed as 4.9 percent.
Importance of Data Revisions.
Now that we have established that
data revisions occur, the logical next
question is how significant are the revisions to our understanding of current
economic conditions. Not surprisingly,
revisions in any particular quarter can
be substantial, but in addition, our research suggests that these benchmark
revisions can go on for some time
and significantly alter our view of the
economy over longer periods.3
For example, consider the inflation rate from 1975 to 1979 as measured by the PCE deflator. In 1995,
the data showed inflation averaging
7.7 percent over that period. But it
was subsequently revised down to 7.2
percent in the 1999 benchmark revisions of the data. Similarly, real output
growth from 1955 to 1959 was as low
as 2.7 percent in the 1995 benchmark
vintage of the data but as high as 3.2
percent in the 1999 benchmark vintage.
See the working paper by Dean Croushore
and Charles L. Evans, and the one by Leonard
Nakamura and Tom Stark.
In short, our real-time data set indicates that data are revised extensively over time, and subsequent vintages
of the data may paint a much different
economic picture than earlier vintages.
For my purposes here, I would point
out that our real-time data set allows
us to see exactly what the economy
looked like to policymakers at the time
they made their decisions. Are there
episodes where the data available to
policymakers in real time indicated
they were in a much different situation
than the subsequently revised data
show they were? I believe there are.
As Dean Croushore and Tom
Stark pointed out, consider the situation in early October 1992.4 Today’s
ANOTHER EXAMPLE — THE
SAVING RATE
Let me offer another example that
has more contemporary relevance. Earlier this year, we made public several
new variables in the real-time data
set. Two variables of particular interest are personal saving and disposable
In short, our real-time data set indicates that
data are revised extensively over time, and
subsequent vintages of the data may paint a
much different economic picture than earlier
vintages.
data tell us the economy was in pretty
good shape in late 1992. Real output
grew 4.2 percent in the first quarter,
3.9 percent in the second quarter, and
4.0 percent in the third quarter. But if
you read accounts from that time, policymakers were clearly worried about
whether the economy was recovering
from the recession, and they were
contemplating actions to stimulate the
economy. Why were policymakers so
worried? According to the data available to them, the economy had grown
just 2.9 percent in the first quarter and
1.5 percent in the second quarter. Statistics for the third quarter had not yet
been released, but forecasts suggested
that economic growth had not picked
up much from the second quarter’s
3
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anemic 1.5 percent. In addition, a
number of monthly indicators pointed
to a decline in the economy. Later,
many of these indicators were also revised up significantly. The point is that
policymakers assessing their situation
in October 1992 saw themselves in a
much weaker economic environment
than we now know they were.
See the Business Review articles by Dean
Croushore and Tom Stark.
4
income. These variables are especially
interesting because these data lead to
the saving rate in the national income
accounts. The personal saving rate is
defined as personal saving divided by
disposable personal income.
Recently, there has been a lot of
talk about today’s low personal saving rate in the U.S. Many economists
have worried that the low personal
saving rate may signal an impending
slowdown in consumption growth and
a precursor to a decline in aggregate
demand. In light of this discussion, it
is interesting to ask: How good is our
measurement of the current saving
rate?
An examination of the historical
data by two of our researchers, Tom
Stark and Leonard Nakamura, shows
that the subsequent revisions in the
average saving rate and its variation
over time suggest that the saving rate
Business Review Q4 2005 5
looks very different today than it did
20 years ago.5 For example, the personal saving rate, according to today’s
statistics, peaked on an annual basis in
the early 1980s. Back then, however,
the early 1980s did not appear to be
a time of high saving. As reported in
the second quarter of 1980, the firstquarter 1980 personal saving rate was
3.4 percent, the lowest since 1950 and
down from a peak of 9.7 percent in the
second quarter of 1975. By contrast,
the first-quarter 1980 saving rate is
now reported to be 9.5 percent, and
much of the revision has been fairly
recent. Over the course of time, it
was revised upward by 6.1 percentage
points.
The problem with saving data for
early 1980 was not that exceptional. In
fact, the average saving rate between
1965 Q3 and 1999 Q2 has been revised
up by 2.8 percentage points over time.
The revision process typically has been
upward and surprisingly large.
Why such large revisions? Personal saving is the difference between two
aggregates: disposable personal income
and personal outlays. These two series
are collected from distinct bodies of
data. Disposable personal income is
the largest component of gross domestic income, which includes retained
corporate income, government income
from taxes and other sources, and capital consumption. These income data
are collected from payroll data, Internal Revenue income tax filings, and
corporate profit reports. Personal outlays are almost entirely due to personal
consumption expenditures, the largest
component of GDP. These data are
collected from the revenues of retailers,
service suppliers such as hospitals and
hotels, and so forth.
Among the immediately available
data, the more complete and reliable
See the working paper by Nakamura and
Stark.
5
6 Q4 2005 Business Review
data are on the demand or product
side; this is the source of GDP. Income
side data are aggregated to gross domestic income, conceptually the same
as GDP, but in practice differing by as
much as 2.3 percent — the so-called
statistical discrepancy. Typically, income is undercounted. All this suggests that our measure of the saving
rate is both somewhat suspect because
of substantial measurement error and
subject to substantial revision. In fact,
Recently, there has
been a lot of talk
about today’s low
personal saving rate
in the U.S.
large variations in personal saving
across time have typically been revised
away.
Will this happen again? We do
not know for sure, but the contention
that the current low estimate of the
personal saving rate implies that consumption in the future will rise more
slowly may be incorrect, as benchmark
revisions may well result in a substantial upward revision in the current
estimate. This is a good example of the
difficulty experienced when a policymaker is forced to respond to data that
traditionally have been significantly
revised.
MONETARY POLICY IN THIS
ENVIRONMENT OF IMPERFECT
INFORMATION
We have established the fact
that information about our goal of
monetary policy is imprecise and our
understanding of current economic
conditions is imperfect; what is a policymaker to do? Put another way, what
are the implications of these real-world
uncertainties and imperfections in
information for the proper conduct of
monetary policy?
More Real-World Evidence. Here
I can offer a few observations. The first
of these is that we must remember that
we live in a data-rich environment.
There are many pieces of economic
data that can be examined when making policy decisions, and no one piece
of data ought to get too much weight.
As my examples indicate, when data
are measured imprecisely, putting too
much emphasis on any one number
can lead to problems.
Second, it should be remembered
that some of the imprecision fades with
time. As I have said many times before,
high frequency data tend to be highly
volatile and subject to substantial revision. A policymaker must look at available data in a broad context.
In this most recent business
cycle, employment was very slow to
come back to pre-recession levels. As
a result, a lot of emphasis was being
put on the monthly payroll growth
numbers. When a good value was
reported, people would assert that the
labor market had finally returned to
solid growth; when a bad number was
reported, people grew concerned. The
fact is that the standard error for the
one-month change in payroll numbers is nearly 70,000, and making too
much of any one monthly number is
ill-advised. Given all the data issues,
it is important not to overemphasize
short-term deviations while ignoring
long-term trends.
Third, it is important not to focus
exclusively on quantitative data. Our
interpretation of the numbers must
be nuanced by real-world experience.
As a Reserve Bank president I gather
information from around my District
and around the country. I believe it is
of crucial importance to have ties and
open communication with leaders in
the worlds of business and finance. We
need insight from both Main Street
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and Wall Street when trying to understand the underlying dynamics of
the aggregate economy. I also listen to
reports from my board of directors on
how they see the economy performing
in their sectors. In addition, the Philadelphia Fed has set up several advisory
councils and ad hoc roundtables that
meet for the sole purpose of discussing how the members of these bodies
see the economy progressing and the
current state of price pressures in the
economy.
If I see some small signs of inflation coming through in the data and
I hear from these contacts that they
are raising their prices and they are
constantly facing higher input prices,
those small signs of inflation would be
more of a concern than if my contacts
were not reporting evidence of price
pressure.
This type of touch and feel of the
marketplace is of great import and is
one of the benefits of the decentralized structure of the Federal Reserve
System. The fact that there are 12
Reserve Banks allows us to gather a
large amount of regional intelligence
that adds depth to our understanding
of current economic conditions.
A CASE FOR GRADUALISM
Beyond all this, the fact that there
is uncertainty surrounding the state of
the economy and new economic information becomes available on a nearly
continuous basis supports the notion
that it makes sense for policymakers to
move in a slow and cautious manner.
William Brainard, the well-known
Yale economist, made the case for
gradualism in a classic article that
is now about a half century old.6 He
suggested that policymakers should
be conservative in light of this lack
of complete information, meaning
6
See the article by William Brainard.
www.philadelphiafed.org
that their policy responses should be
attenuated. In fact, he argued that
policymakers operating in a world of
uncertainty should compute the direction and magnitude of their optimal
policy response and then do less.
This type of attenuated policy
action has several intuitive benefits.
First, it guides the economy in a particular direction but probably will not
uncertainties surrounding it and the
large number of shocks that occurred
along the way. In the months following
the sharp stock market decline, it was
unclear how rapidly economic activity was decelerating. Once it became
clear, the Federal Reserve responded
aggressively, ultimately cutting the target federal funds rate to a record low 1
percent. On the other side, in light of
By moving slowly, policymakers have time
to assess the effects of their actions on the
economy and update their views on what
further action needs to be taken.
allow policymakers to overshoot the
goal. Second, by moving slowly, policymakers have time to assess the effects
of their actions on the economy and
update their views on what further action needs to be taken. As Chairman
Greenspan has explained, monetary
policymaking is risk management. The
case for gradualism rests on the assessment that the cost of taking too large
of an action is larger than the cost of
taking too small of an action.
However, the story does not end
here. While it is true that moving in a
gradual manner reduces the chances
of overshooting with all its attendant
costs, the policymaker cannot afford
to be consistently behind the curve.
Given that monetary policy affects the
economy with long and variable lags,
there is a chance that by acting in this
attenuated fashion, we will undershoot
the optimal policy stance. This can be
at least as costly as overshooting. Our
challenge is to weigh these costs and
respond appropriately to the data and
attendant risks involved.
Our experience during the most
recent business cycle underscores
the need to be flexible in choosing
the speed with which we respond to
unfolding economic developments.
This was a cycle noteworthy for the
the pattern of recovery and expansion,
the Federal Reserve has taken a gradualist approach to removing the monetary accommodation and returning to
a more neutral policy stance.
TRANSPARENCY
Because the Fed must respond to
incoming information differently in
different situations, the Fed must communicate the rationale for its actions
as clearly as possible in order to maintain public confidence in its commitment to its long-run goals
Of course, this openness has
been an important aspect of recent
monetary policy. The FOMC has been
moving toward increased transparency
for some time, and its communication with the markets has improved
greatly over the past decade. Information about the Fed’s policy goals, its
assessment of the current economic
situation, and its strategic direction are
increasingly part of the public record.
Recently, the Federal Reserve
has also taken action to expedite the
release of the minutes from the FOMC
meetings. Just this year, the FOMC
began releasing the minutes of each
meeting prior to the next meeting. The
minutes not only report our decisions
concerning immediate action but also
Business Review Q4 2005 7
our sense of the key factors driving
near-term economic developments and
the strategic tilt to our actions going
forward.
The goal of all these steps toward
increased transparency is to inform
markets about where the FOMC sees
the economy today and where it thinks
the economy is headed in the future.
This is hopefully useful information
that will improve the markets’ understanding of our view of the economy
and offer them insights into the direction of possible future policy actions.
All of these actions are steps in
the right direction. It is important
for the FOMC to be as open as possible. My hope is that by providing
relevant information about our view
of the economy and our current areas
of concern, our actions will be more
transparent and surprises will be the
exception rather than the rule. With
the benefit of hindsight, I think we can
say that we have come a long way in
this regard, as the list of changes I just
offered you suggests.
CONCLUSION
In this message, I have tried to
convey to you some of the challenges
monetary policymakers face because
they operate in a world of imperfect
information.
Given our mission, the lagged
effect of our policy actions, and the
inevitable imprecision with which an
economy as large and complex as ours
can be measured, these challenges will
not go away. So we must find ways to
meet them.
Some of the problems I have
outlined suggest that we often must
rely on our theoretical knowledge of
economics as we make decisions that
affect the economy.
In addition, data gathered from
our regional contacts are also of value
in this process, even while the national
data change shape with the arrival of
new information that leads to their
revision. There is value in listening
and gathering the perspectives of our
Reserve Bank boards of directors,
advisory councils, and other regular
contacts in our Districts.
Another part of the solution is
to take care in choosing the pace at
which we act and react to incoming
data. Gradualism has a role to play in
monetary policy, but not at the expense of falling behind the curve.
The last solution mentioned here
is transparency and increased communication with market participants.
Communication is an important part
of the solution to operating in the real
world of imperfect information. The
increased transparency that has been
the hallmark of the Greenspan Fed is
an important part of optimal monetary
policy in a world of uncertainty. BR
Croushore, Dean, and Tom Stark. “A
Funny Thing Happened on the Way to
the Data Bank: A Real-Time Data Set for
Macroeconomists,” Federal Reserve Bank
of Philadelphia Business Review, September/October 2000.
Stark, Tom. “A Summary of the
Conference on Real-Time Data Analysis,”
Federal Reserve Bank of Philadelphia
Business Review, First Quarter 2002;
www.philadelphiafed.org/files/br/
brq102ts.pdf.
Nakamura, Leonard, and Tom Stark.
“Benchmark Revisions and the U.S.
Personal Saving Rate,” Federal Reserve
Bank of Philadelphia Working Paper 05-6
(2005); www.philadelphiafed.org/files/
wps/2005/wp05-6.pdf.
Stark, Tom, and Dean Croushore.
“Forecasting with a Real-Time Data Set
for Macroeconomists,” Federal Reserve
Bank of Philadelphia Working Paper 01-10
(2001); www.philadelphiafed.org/files/
wps/2001/wp01-10.pdf.
REFERENCES
Brainard, William. “Uncertainty and the
Effectiveness of Policy,” American Economic
Review, 57 (May 1967), pp. 411-25.
Croushore, Dean, and Charles L. Evans.
“Data Revisions and the Identification of
Monetary Policy Shocks,” Federal Reserve
Bank of Philadelphia Working Paper 03-1
(2003); www.philadelphiafed.org/files/
wps/2003/wp03-1.pdf.
Croushore, Dean, and Tom Stark. “Is Macroeconomic Research Robust to Alternative Data Sets?,” Federal Reserve Bank of
Philadelphia Working Paper 02-3 (2002);
www.philadelphiafed.org/files/wps/2002/
wp02-3.pdf.
8 Q4 2005 Business Review
Orphanides, Athanasios, and Simon van
Norden. “The Reliability of Output Gap
Estimates in Real Time,” Finance and Economic Discussion Series 1999-38, Board of
Governors of the Federal Reserve System
(August 1999); www.federalreserve.gov/
pubs/feds/1999/199938/199938pap.pdf.
www.philadelphiafed.org
Whither Consumer Credit Counseling?
BY ROBERT M. HUNT
F
or more than 50 years, nonprofit credit
counseling organizations have been helping
consumers manage debt. Despite this long
track record, credit counseling is not without
controversy. In recent years, concerns about conflicts
of interest and the emergence of a new type of credit
counseling agency have triggered significant legislative
and regulatory activity. In this article, Bob Hunt outlines
the history and development of credit counseling in
the United States, highlights the concerns raised about
consumer protection, and describes industry, regulatory,
and legislative responses.
The availability and use of consumer credit in the U.S. has grown
dramatically over the last 50 years.1
While this is undoubtedly beneficial,
one consequence is that, at any time,
there are a million or more consumers
1
This article was inspired by two workshops
organized by the Philadelphia Fed’s Payment
Cards Center in 2001 and 2003. These workshops are summarized in the article by Anne
Stanley and the one by Mark Furletti. I thank
Patti Hasson for many helpful discussions. Chris
Ody and Paul Weiss helped me compile the data
for this article.
Bob Hunt is a
senior economist
in the Research
Department of
the Philadelphia
Fed.
www.philadelphiafed.org
having difficulties in managing their
unsecured debts. For a half century,
nonprofit credit counseling organizations have offered financial education
and budget counseling sessions for free
or at nominal cost to borrowers. They
also negotiate comprehensive repayment plans (debt management plans)
with a borrower’s unsecured creditors.
These repayment plans provide an
alternative to bankruptcy that is valuable to many consumers.
But credit counseling is not without controversy. The older counseling
organizations rely primarily on creditors for their revenues, and this may
create the appearance of a conflict
of interest. More recently, many new
debt counseling organizations have
appeared on the scene. This new breed
relies less on creditors for revenues
because they charge borrowers significantly more for their services. If these
higher fees are drawn from a borrower’s
limited reserves, he or she may have
additional difficulty completing the
repayment plan. In addition, creditors
worry that at least some of these new
organizations are not screening their
clients—proposing concessions for
borrowers who could have paid their
debts on the original terms. This has
affected how creditors work with counselors. These concerns and others have
triggered significant legislative and
regulatory activity in recent years.
The credit counseling industry
is an important one, but its activities
and effects are not widely understood.
Still the available research does
give us some insight into the effects
of consumer credit counseling and
debt management plans on borrower
behavior and the implications for the
industry and regulation.
Any conclusions, unfortunately,
must be tentative. There are few
formal studies of the contribution of
credit counseling organizations, and
they must wrestle with a difficult
methodological problem: Do borrowers
who seek credit counseling perform
better because of the counseling (a
treatment effect) or because they are
somehow different from borrowers
who don’t seek counseling (a selection
effect)?
BACKGROUND
Credit counseling organizations
typically provide four types of services
to consumers: (1) they offer consumer
financial education; (2) they offer
budget counseling to individual households; (3) they negotiate debt management plans with creditors on behalf of
borrowers; and (4) when appropriate,
Business Review Q4 2005 9
they refer consumers to other support
organizations or recommend that they
seek advice about a bankruptcy filing.
A debt management plan is a
schedule for repaying all of the borrower’s unsecured debts over three to
five years.2 Ideally, the credit counselor
is able to include all of the borrower’s
unsecured creditors in the plan. While
the principal is repaid in full, creditors typically reduce interest rates and
other charges. Creditors are sometimes
willing to re-age accounts in a debt
management plan. In other words,
assuming plan payments are made,
the creditor considers the account as
current and reports it this way to credit
bureaus. This improves the borrower’s
payment history and credit rating.
An essential feature of the benefit
credit counselors offer is the ability to
coordinate the concessions made by
a borrower’s creditors. Of course, borrowers can negotiate with individual
creditors, but they must overcome each
creditor’s concern that any concession it makes benefits the borrower’s
other creditors at its expense. Winton
Williams coined a phrase for this phenomenon—the creditor’s dilemma.3 All
creditors would likely benefit if they all
agreed to refrain from legal action and
allow the borrower more time to repay.
But if all creditors agree to this approach, any individual creditor might
do better by insisting on being repaid
from the proceeds of the concessions
offered by other creditors. If creditors
distrust each other, they will refuse to
make concessions and possibly race to
secure claims on the borrower’s cash
flow (by garnishing wages) or assets
(by placing liens on the borrower’s
2
An unsecured debt is one in which the borrower does not pledge collateral (e.g., a house
or car) that may be taken by the creditor in the
event the borrower defaults on the loan. Credit
card debts are almost always unsecured.
3
See Williams’s book, Games Creditors Play.
10 Q4 2005 Business Review
property). If this happens, the borrower is more likely to file for bankruptcy,
and all the unsecured creditors are
likely to recover very little.
Credit counselors can often avoid
this outcome. Through repeated interactions with creditors, they have established a reputation for securing the
agreement of most or all of a borrower’s
creditors and establishing repayment
plans that put each creditor on more
states deliberately exempted nonprofit
counseling organizations from these
laws in the hope that they would continue to develop.4
A national trade organization,
what is now called the National Foundation for Credit Counseling (NFCC),
became active in 1951. At its peak,
NFCC membership included about 200
organizations with about 1,500 offices
around the country.5 Today, NFCC
An essential feature of the benefit credit
counselors offer is the ability to coordinate the
concessions made by a borrower’s creditors.
or less the same footing in terms of
the borrower’s resources. This reduces
the risk of a run against the borrower,
which, in turn, increases the chances
the creditors will be repaid.
Note that participation in debt
management plans is entirely voluntary. Borrowers need not seek a credit
counselor, and they may abandon
a repayment plan if they so choose.
Similarly, creditors cannot be forced to
agree to a debt management plan, and
they are free to resort to collections
activity or other legal activity at any
time. Clearly, what makes these plans
work, when they do work, is a good
deal of trust that is fostered by the
credit counselor.
Origins of the Nonprofit Credit
Counseling Industry. The traditional
nonprofit credit counseling organizations emerged in the 1950s and 1960s,
partially in response to the rapid
growth in unsecured consumer debt
during that time. Many were organized
by or with the support of creditors.
During this same period, many states
enacted legislation to regulate or simply ban the operation of the existing
for-profit debt counselors (sometimes
called debt poolers or proraters) on
consumer protection grounds. Most
member organizations counsel 1.5 million borrowers each year. They administer nearly 600,000 debt management
plans, which pay unsecured creditors
at least $2.5 billion a year. To put these
numbers into perspective, very roughly
speaking, each year NFCC member
agencies counsel about 1 percent of
American bankcard holders, and there
is one debt management plan for every
two personal bankruptcy filings.
These nonprofit credit counselors
rely primarily on contributions from
creditors for their revenues. Under
a norm called fair share, creditors
would return to the credit counselor
about 12 percent of debt payments it
helped to facilitate. These contributions accounted for two-thirds or more
See the book by Perry Hall; section V of the
Northwestern University Law Review Consumer Credit Symposium; the article by Abbey
Sniderman-Milstein and Bruce Ratner; and the
article by Margery Kabot Schiller. For a recent
review of state regulations, see the report by the
California Department of Corporations and the
report by Deanne Loonin and Heather Packard.
4
Not all credit counseling organizations are
NFCC members. Others are members of the
Association of Independent Consumer Credit
Counseling Agencies (AICCCA).
5
www.philadelphiafed.org
of the revenues of traditional credit
counselors, but the share has fallen in
recent years.6 In the past, fair share
receipts exceeded the cost of administering debt management plans, which
afforded resources for the agencies’
consumer education and budget counseling programs.
Some argue that a dependence
on creditors for revenues creates at
least a potential conflict of interest.
For example, does a credit counselor
that relies on fair share payments have
an adequate incentive to suggest that
a consumer seek legal advice about
bankruptcy? 7 About 6 percent of borrowers who contact an NFCC member
agency are referred to legal assistance,
while 30 to 35 percent are enrolled
in a debt management plan.8 While
these numbers suggest that counseling
agencies might steer some borrowers
away from bankruptcy, we need to
know a good deal more about borrowers’ circumstances and preferences to
conclude that this pattern is inappropriate from the standpoint of borrowers or society.
OPTIONS AVAILABLE TO
DISTRESSED BORROWERS
Why do borrowers enter into debt
management plans? Why are unsecured creditors willing to accept these
plans? The answer is that participating
in the plans is better than the alternatives for some borrowers and their
creditors (see Pros and Cons of Options
Available to Borrowers). Depending on
Until recently, this source of funding was not
always disclosed to borrowers. In 1997, the
NFCC reached an agreement with the Federal
Trade Commission (FTC) to make such disclosures a matter of policy.
6
7
This question applies equally to credit counselors that rely primarily on fees charged to
consumers.
Another third of borrowers receive financial
education or household budget counseling.
8
www.philadelphiafed.org
the resources available, borrowers can
choose between repaying on the original terms, not paying but not filing for
bankruptcy either (informal bankruptcy), and formal bankruptcy. Creditors
can be either more or less aggressive
in their collection efforts, or they may
take legal action, such as obtaining an
order to garnish wages.
One factor that influences borrowers’ choice is the effect on their
future access to credit. Obviously,
timely repayment on the original terms
Most borrowers can
choose between two
forms of bankruptcy:
Chapter 7 (liquidation)
or Chapter 13 (a
wage-earner plan).
preserves the borrower’s credit history
and is most likely to ensure future
access to credit on good terms. Under
the informal or formal bankruptcy
options, borrowers will have difficulty
obtaining new credit on affordable
terms for a long time. A bankruptcy
flag remains on a borrower’s credit
report for 10 years.
Another factor that influences
borrowers’ choice is the size of the
payments they make and how creditors
respond. Payments are typically largest if the debt is paid on the original
terms. Alternatively, the consumer
can simply stop making payments
(informal bankruptcy). But this option
affords borrowers few protections from
debt collectors. They can’t prevent
repossession of their car or foreclosure
on their house. They can’t prevent
creditors from placing liens against the
real property they own. They have few
ways of avoiding garnishment of their
wages. Still, many distressed borrowers
choose not to repay and not to file for
bankruptcy.9
Two Forms of Bankruptcy for
Consumers. Most borrowers can
choose between two forms of bankruptcy: Chapter 7 (liquidation) or
Chapter 13 (a wage-earner plan).10
Both chapters impose a stay on collections and legal actions by creditors. In
the case of Chapter 13, this may allow
the borrower to catch up on mortgage
payments and avoid foreclosure.
Under Chapter 7, the borrower’s
assets (except for certain exempt
property) are used to pay some portion
of the debts owed to unsecured creditors.11 The remaining unsecured debt
is discharged, so the consumer’s future
income is unencumbered. In practice,
borrowers filing under this chapter
rarely have assets to surrender, so unsecured creditors receive little or nothing. The claims of secured creditors
are unaffected, so they can eventually
foreclose on those assets if they choose.
It is not uncommon for borrowers to
reaffirm their secured debts in order to
retain the collateral (such as the car or
the house).
Alternatively, the borrower can
file under Chapter 13 of the bankruptcy code. Under this chapter, the
borrower can keep his or her assets
but must propose a repayment plan
financed by a significant share of his
or her future income over the next
several years. The plan must offer
See the paper by Lawrence Ausubel and
Amanda Dawsey and the article by Michele
White.
9
Good summaries of consumer bankruptcy
law are found in the article by Wenli Li and the
one by Loretta Mester. Significant changes to
U.S. bankruptcy law were enacted in 2005 (see
page 17).
10
Exempt property is typically determined by
state law. It may include some portion of equity
in the borrower’s home, automobiles, household
goods and clothing, and tools used for one’s
trade.
11
Business Review Q4 2005 11
Borrowers
Unsecured Creditors
Repayment on original terms
Preserves access to credit on better terms
Assumes sufficient cash flow to pay principal & interest
Principal repaid in full
Earns interest & fee income
Informal bankruptcy
Preserves cash flow for other expenses
Little or no access to new credit
Little protection from legal action by creditors
Lose most or all principal
Collections & legal action are costly
Chapter 7 bankruptcy filing*
Unsecured debts typically discharged
Future income unencumbered by debt payments
Prevents collections & legal action by creditors
Borrower must undergo credit counseling prior to filing and obtain financial education prior
to the discharge
Nonexempt property sold to pay debts
Filing and attorney fees
Bankruptcy flag on credit report for 10 years
Cannot file again for Chapter 7 bankruptcy for 8 years
Chapter 13 bankruptcy filing
Borrower retains his or her property
Repayment plan based on future income (3-5 years)
Unsecured debts are not repaid in full
Prevents collections & legal action by creditors
Part of future income devoted to debt payments
Filing, attorney, and trustee fees
Bankruptcy flag on credit report for 10 years
Cannot obtain a Chapter 13 discharge within 2 years of a previous Chapter 13 discharge, or within
4 years of a discharge under another chapter
Debt management plan
Creditors voluntarily abstain from collections & legal action
Lower interest & fees
Improved credit history should ensure access to new credit sooner than bankruptcy
Diverts cash flow from payments on secure debts
Must pay entire principal
Plan fees (see text)
Stay against collections & legal action
Lose most or all principal
Stay against collections & legal action
Planned payments typically cover a
small portion of original principal
Many repayment plans fail
If successful, principal repaid in full
Part of repayment (fair share) goes
to counselor
Lower interest & fee income
Many repayment plans fail
Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, access to a Chapter 7 discharge is subject to a means test. For details, see the January-March 2005 issue of the
Federal Reserve Bank of Philadelphia’s Banking Legislation and Policy (www.philadelphiafed.org/econ/blp/index.html).
*
12 Q4 2005 Business Review
Option
www.philadelphiafed.org
Pros & Cons of Options Available to Borrowers
unsecured creditors at least as much
as they would obtain under a Chapter
7 filing, but, as noted above, this is
typically not very much. Creditors
cannot reject the terms of a plan if
the borrower has pledged his or her
entire disposable income over the next
three to five years for debt payments.
Disposable income here means income
after taxes, basic living expenses, and
tuition. Upon completion of the plan,
the remaining unsecured debts are
discharged. In practice, unsecured
creditors typically receive a fraction of
the outstanding principal (see below).
General unsecured creditors received
about $815 million from Chapter 13
plans during the 2001 fiscal year.12
Debt Management Plans Are
Not the Same as Chapter 13. While
debt management plans are similar in
many ways to a Chapter 13 bankruptcy
filing, there are several important differences.13 Borrowers who participate
in a debt management plan should be
able to improve their credit history
more quickly than if they default or
file for bankruptcy. This should mean
they are able to gain access to new
credit more rapidly.14 Unlike most
Chapter 13 plans, debt management
plans expect the borrower to repay the
entire principal owed. A number of
protections afforded in bankruptcy are
absent in a debt management plan.
For example, participation in a debt
management plan does not protect
the borrower from legal action by his
or her creditors. Nor are creditors
compelled to accept a proposed debt
management plan.
Debt management plans also do
not address secured credit. If consumSee the article by Ed Flynn, Gordon Burke,
and Karen Bakewell.
12
See the 1999 and 2004 articles by David
Lander.
13
There is no direct test for this, but the Visa
study (discussed later) is suggestive.
14
www.philadelphiafed.org
ers have important assets, financed
by secured loans, which they are also
having trouble paying, a bankruptcy
filing may be the better option. In
this situation, a borrower who enters a
debt management plan might increase
the risk of losing the house because
he or she has pledged income to pay
unsecured debts that would probably
be discharged in bankruptcy. In short,
while debt management plans are
useful for many distressed borrowers,
Do borrowers who
seek out credit
counseling perform
better because of
the counseling or
because they are
somehow different
from borrowers
who don’t seek
counseling?
they are not suitable for all borrowers
in trouble, and they are not simply a
substitute for a Chapter 13 filing.
Why Do Creditors Agree to Participate in Debt Management Plans?
From the creditor’s standpoint, the net
benefit of agreeing to a debt management plan depends on what they think
the borrower will do in the absence
of the plan. If the creditor thinks a
borrower will otherwise stop paying
altogether or enter bankruptcy, the
creditor might recover more if it agrees
to a debt management plan than if it
refuses. But if the creditor thinks a
borrower would otherwise continue to
pay, agreeing to a debt management
plan would likely reduce the payments
the creditor will receive. After all,
longer repayment terms, lower interest charges and fees, plus fair share
payments come at the expense of the
creditor.
What’s more, creditors’ expectations depend significantly on what
they expect a borrower’s other creditors will do. As explained earlier, if
it is likely that another creditor will
push a borrower into bankruptcy, every
creditor has less incentive to offer
concessions or to refrain from collections activity.
WHAT DO CREDIT
COUNSELORS ACCOMPLISH?
Once again, it’s important to
recognize the very difficult problem
of selection: Do borrowers who seek
out credit counseling perform better
because of the counseling or because
they are somehow different from borrowers who don’t seek counseling? It is
at least possible that any measured differences between these groups is due to
a selection effect (perhaps only highly
motivated borrowers seek out counseling) rather than a treatment effect (the
counseling itself helps borrowers to
manage their debts).
Debt Management Plans. According to data from NFCC members,
a typical debt management plan
included $16,000 in unsecured debts,
roughly 40 percent of the annual
income of the participating borrowers.15 Despite this remarkable degree
of leverage, about one-quarter of plan
participants remain in the plans until
all their debts are paid off. In many
other cases, borrowers pay down some
of their debts and exit the plans to
manage the remainder on their own.
Still, approximately one-half of debt
management plans fail after about six
months. In some instances, borrowers have pledged more cash flow than
they can afford. In others, one or more
creditors refuse to accept the terms
15
These borrowers had an average total indebtedness of $51,000 including mortgages, medical
debt, and tax liens.
Business Review Q4 2005 13
of a plan and take actions (such as
garnishment) that push the borrower
into bankruptcy.
Anecdotal evidence suggests the
completion rate of debt management
plans is a bit higher than for Chapter 13 plans (which is only about 33
percent). But the criterion for success
is different under debt management
plans, where the entire principal is
expected to be repaid. Even in successful Chapter 13 plans, unsecured
creditors receive only about 35 percent
of the original principal.16 Chapter 13
plans are also costly to administer. The
average attorney’s and trustee’s fees for
a Chapter 13 case in 2003 were $1,500,
or about 14 percent of the amount
repaid.17
A 1999 study conducted by Visa
provides some insights into the success
or failure of debt management plans.
Borrowers who dropped out were more
likely to be unemployed or to lose their
jobs. Similarly, borrowers with lower
income were less likely to complete
their plans. Almost a third of borrowers who dropped out of a debt management plan had filed for bankruptcy.
Compared to a separate survey of
borrowers who filed for bankruptcy,
participants in debt management
plans appear to enjoy better access to
unsecured and secured credit. Those
successfully completing a debt management plan were more likely to hold a
credit card than those who could not.
Borrowers who successfully completed
a debt management plan were more
likely to buy a house than those who
did not complete the plan.
Visa asked borrowers why they
sought credit counseling. Respondents
were three times as likely to mention
a desire to get out of debt, or concerns
about being overextended, than to cite
creditors’ collection tactics or the desire to avoid a bankruptcy filing.18 This
may suggest that borrowers who enter
into debt management plans are different from other distressed borrowers. To
rule out such a possibility, researchers
typically devise studies that randomly
assign participants into treatment and
The statistics on debt management plans
are from the articles by David Lander and
statistics provided by the NFCC. The statistics
on Chapter 13 plans are from the report by the
Congressional Budget Office and the articles
by Jean Braucher; Scott Norberg; and William
Whitford.
18
But when asked, “What was the last straw?”
borrowers cited collection tactics four times as
often as any other factor.
See the 2005 article by Gordon Bermant.
These amounts do not include filing fees.
20
16
17
14 Q4 2005 Business Review
ganizations, the chain’s net losses were
17 percent lower.
Consumer Financial Education.
There is some evidence of significant
effects for the counseling programs
offered by NFCC member organizations. In one study, only 7 percent of
consumers counseled filed for bankruptcy, compared with 25 percent in a
comparable control group. In another
study, economists Gregory Elliehausen,
Christopher Lundquist, and Michael
Staten examined the effect of budget
Is there any evidence that creditors do better
with accounts in debt management plans than
with accounts held by borrowers with similar
observable characteristics?
control groups and then examine differences in outcomes between these
groups.19
Is there any evidence that creditors do better with accounts in debt
management plans than with accounts
held by borrowers with similar observable characteristics? Creditors obviously believe they do, or they would not
be willing to participate in the plans.
Ralph Spurgeon describes the results
of comparison between two sets of
cardholders at a large store chain: One
group enrolled in debt management
plans, and the other group did not.20
The chain lost money on both groups
of accounts, but it lost 32 percent less
on the accounts in debt management
plans. Taking into account fair share
payments to the credit counseling or-
19
counseling (not debt management
plans) on borrower credit quality, as
measured by data contained in credit
bureau files for about 6,000 borrowers
just before and three years after the
counseling session (that is, in 1997
and in 2000). Improvements among
this group were compared to changes
in the creditworthiness of a comparable control group—comparable in
the sense that individuals with similar
credit scores were drawn from the
same geographic areas as those who
were counseled.21
The authors report significant
improvements in a wide variety of
measures of creditworthiness among
borrowers who sought credit counseling. Relative to the control group,
counseled borrowers increased their
credit scores and decreased their
total indebtedness and the number
of accounts with balances. They also
experienced a significant decline in
the number of delinquent accounts.
The samples were selected to exhibit comparable distributions of credit scores.
21
Borrowers who received counseling were
identified from the files of five NFCC member
counseling organizations.
There is now at least one study of this sort
for debt management plans underway. See the
article by Ladwig.
www.philadelphiafed.org
The effects were the largest among
borrowers with the lowest credit scores
around the time they sought out credit
counseling.
There remains the concern that
the borrowers who sought out credit
counseling are somehow different from
other borrowers. In their analysis,
Elliehausen, Lundquist, and Staten try
to control for this by first attempting to
predict, using data contained in credit
bureau files, which borrowers would
seek out counseling. That makes this
study superior to most other studies,
but we still cannot be entirely sure the
authors’ technique has fully controlled
for selection bias.
A REVOLUTION IN THE
CREDIT COUNSELING
INDUSTRY?
Around 1990, there were about
200 nonprofit credit counseling
organizations in the U.S. It took 30
years to reach that number. But this
process of gradual increase changed
dramatically in the 1990s. After 1994,
at least 1,200 new organizations began
counseling borrowers; three-quarters of
these became active after 1999.22 This
new breed has been very successful,
taking market share away from NFCC
member organizations. Several of the
new organizations are the largest in
the field, managing roughly $7 billion
in outstanding debts.23
The new breed is different from
the previous generation of counseling
agencies. For example, they are more
automated, and they invest much more
heavily in advertising. They also focus
almost exclusively on debt management plans. They offer little budget
counseling or financial education.
They rely more on borrowers, and
less on creditors, for their revenues.
They do this by charging borrowers significantly higher fees than the
traditional counseling agencies. It can
cost a borrower $1,000 or more in
fees to complete a debt management
plan with some of the new counseling
organizations.24
Some members of the new breed
have been accused of engaging in egregious trade practices, similar to those
attributed to the for-profit debt counseling organizations of the 1950s and
1960s.25 Some organizations apply the
first month of debt payments to plan
fees rather than payments to creditors,
but they don’t disclose this information
to borrowers. As a result, these borrowers fall further behind with their
creditors. Other counseling organizations charge borrowers large upfront
fees. Some deduct significant fees ($50
or more) from borrowers’ monthly
debt payments. Some counselors don’t
include all unsecured creditors in the
plan, increasing the risk of legal action
against the borrower and ensuring the
failure of the plan. The completion
rate on plans administered by some of
the largest of the new counseling organizations is rather low—only 2 percent
in one instance.26
Why the Influx of New Counseling Organizations? Several factors
explain the influx of new organizations
into the counseling industry. For one,
demand for these services has increased significantly. Consider the case
24
By way of contrast, the average set-up fee
among NFCC organizations is $25, and the
average monthly maintenance fee is $15.
of general purpose credit cards issued
by banks. In the 11 years between 1992
and 2003, the number of bankcard
holders increased by nearly 33 million.
Among this group, the share that was
seriously delinquent rose gradually
until 1999 and then rose rapidly as
the U.S. entered into recession. The
combination of these two trends has
contributed to a tripling of the number
of delinquent cardholders (Figure 1).27
This also corresponds with a period
of rapid increase in bankruptcy filings
and in active debt management plans
relative to the population (Figure 2).
The recent decline in the use of debt
management plans may be due in part
to rising house prices (and low interest
rates), which have helped many consumers to pay down their unsecured
debts using home equity loans.28
A second factor is that barriers to
entry into the credit counseling business have fallen, at least temporarily.
There are a number of reasons for this.
For one, nonprofit credit counseling
organizations are lightly regulated at
the state and local level, and there is
no federal regulation that directly addresses this industry.29 Another is that
27
A similar pattern is observed when comparing the 1992 and 2001 editions of the Survey of
Consumer Finances (SCF). According to the
SCF, the number of families with bankcards
increased by 19 million. The share of families 60
or more days late on a debt payment increased
from 6 to 7 percent. Taking into account the
increase in households over this period, it appears that about 1.9 million more families were
having trouble paying their debts in 2001 than
in 1992.
28
Another factor was the declining market
share of NFCC members—the figure includes
only debt management plans administered by
those organizations.
The Federal Trade Commission can sue
counseling organizations that engage in unfair
or deceptive trade practices, but its jurisdiction does not include nonprofit organizations.
That means the FTC must also convince a
court that these institutions are “organized to
carry on business for its own profit or that of its
members.”
29
Not all of these survive—there are currently
about 870 active nonprofit credit counseling
organizations.
22
This number is calculated from the 2005
report by the U.S. Senate Subcommittee on
Investigations (hereafter Senate Report).
23
www.philadelphiafed.org
While it is difficult to measure the frequency
of such practices, a number of examples can be
found in the Senate Report, the testimony of
Howard Beales of the FTC, and the report by
Deanne Loonin and Travis Plunkett.
25
26
See the March 30, 2005, FTC press release.
Business Review Q4 2005 15
FIGURE 1
Delinquent Bank Cardholders (thousands)
2,500
2,000
1,500
1,000
500
0
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
Sources: Author’s calculations based on data from the Statistical Abstract of the United
Sources: States, The Nilson Report, and TransUnion’s Trendata.
Note: Delinquency refers to cardholders who are 90 or more days late on their payments.
FIGURE 2
Bankruptcy & Debt Management Plans per
Thousand of Population 16 and Older
6
5
4
3
2
advances in technology (call centers,
the Internet, data processing, and electronic payments) reduced the upfront
cost of setting up debt management
plans and the ongoing cost of administering them. But these technologies
also require significant investment,
and that is one reason newer counseling organizations seek the business of
borrowers around the country rather
than in a particular local market, as
was common with the older counseling
organizations.
Another reason barriers to entry
were at least initially low is the amount
of trust established between credit
counselors and creditors over the
previous 30 years. Creditors expected
counselors to properly screen borrowers
and were willing to provide generous
fair share payments. At least initially,
creditors treated the new organizations
much as they did the older ones.30 The
success of the existing institutions also
invited entry. If fair share payments
could be used to subsidize education
and budget counseling, profits could
be earned by organizations willing to
focus on just debt management plans,
assuming they are successful in attracting borrowers.
The Relationship with Creditors. Credit counselors no longer enjoy
the same relationship with creditors.
One reason is that the out-of-pocket
costs for debt management plans have
become quite large. The share of large
credit card portfolios that consist of
accounts in debt management plans
is now about 2 to 3 percent. About a
quarter of the collections budget of
1
0
1980
1982
1984
1986
1988
DMP
1990
1992
Chapter 7
1994
1996
1998
2000
2002
Chapter 13
Sources: Author’s calculations using data from NFCC and the Administrative Office of the U.S. Courts.
Note: Data on debt management plans refer only to NFCC member organizations
16 Q4 2005 Business Review
This may be due in part to antitrust concerns.
In 1994, several independent credit counseling
organizations sued Discover Card and NFCC,
alleging an illegal restraint of trade, because
Discover would make fair share payments only
to NFCC members. The suit was eventually
settled.
30
www.philadelphiafed.org
major credit card lenders is spent on
fair share payments.31
While it has always been difficult
to quantify the benefit to creditors
of participating in debt management
plans, creditors suspect the benefits
to them may have fallen. With the
entry of the new breed, creditors are
convinced that at least some consumers that would otherwise pay their
unsecured debts are simply seeking
more advantageous terms.
At the same time, creditors began
to reduce their fair share payments
from the 12 to 15 percent typical of 20
years ago to half this amount, or even
lower, today. Among NFCC members,
fair share payments currently average
about 6 percent of payments made to
creditors. Revenue compression has
contributed to consolidation among
NFCC members and the near failure
of others.32 In contrast, the new breed
is less affected because they rely more
on fees paid by the borrowers and are
more willing to raise those fees.
In addition, creditors have reduced the concessions (such as lower
interest rates) they offer to borrowers
enrolled in debt management plans,
making them more difficult to complete.33 This has a significant effect on
borrowers, since balances take longer
to pay off when the interest rates are
higher. As a result, borrowers pay
down less debt over the typical threeto five-year length of a debt management plan. In addition, borrowers are
more likely to become discouraged and
drop out of the plan altogether.
31
See the article by Linda Punch and the Senate
Report.
See the report by Deanne Loonin and Travis
Plunkett and the article by Jane Adler.
32
See the 1999 press release by the Consumer
Federation of America. It also documents the
decline in fair share contribution ratios among a
number of large banks.
33
www.philadelphiafed.org
COUNSELORS, CREDITORS,
AND REGULATORS RESPOND
More recently, there are signs
that established credit counselors and
creditors are responding to the influx
of counseling organizations. For example, the NFCC has established new
standards for its member organizations,
including accreditation of counselors,
licensing and bonding requirements,
annual audits of accounts, educational
and counseling requirements, and
disclosure of financing sources and
Large creditors are
concentrating their
fair share payments
on a smaller number
of counseling
organizations—ones
that can demonstrate
their effectiveness.
fees. In addition, the NFCC prohibits the payment of bonuses to credit
counselors, charging consumers fees
in advance of providing services, and
“prescreening” consumers to be solicited for debt management plans.
Credit counselors are seeking
alternative funding sources for their financial education and budget counseling efforts. They are also participating
in studies to demonstrate the efficacy
of these programs. NFCC members are
also making significant investments in
IT to improve their productivity.
Creditor Action. Lenders are
changing their relationship with
counseling organizations. For example,
they now play a more active role in
determining which consumers should
be eligible for debt management
plans. Some creditors make fair share
payments only to counseling organizations that meet specific standards, for
example, by limiting fees charged to
borrowers.
Creditors are adopting backloaded fair share payments and other
pay-for-performance formulas. For
example, when a borrower starts a debt
management plan, the creditor may
return only 2 percent to the counseling organization. If the borrower
remains current on the plan for a year,
the creditor may return an additional
7 percent of plan payments to the
counseling organization. Other lenders
are replacing fair share contributions
altogether with charitable contributions made to nonprofit counseling
organizations that apply for support.34
In short, large creditors are concentrating their fair share payments on a
smaller number of counseling organizations—ones that can demonstrate
their effectiveness. These changes are
relatively new, so creditors and credit
counselors continue to hone the measures of effectiveness used to determine
fair share payments.
Legislation. The most significant
changes affecting the credit counseling industry are those contained in
the recently enacted bankruptcy law.35
The Bankruptcy Abuse Prevention
and Consumer Protection Act of 2005
limits access to Chapter 7 for some
high-income borrowers, leaving them
to consider either a workout under
Chapter 13 or a debt management plan
negotiated by a credit counseling organization. The act also lengthens from
six to eight the number of years before
a borrower can obtain another Chapter
7 discharge.
In addition, borrowers are now required to obtain credit counseling from
an approved nonprofit organization before filing for bankruptcy. To obtain a
For examples, see the Senate Report and
the articles by David Breitkopf and Burney
Simpson.
34
35
Public Law No. 109-8. For a summary, see
the January-March 2005 issue of the Federal
Reserve Bank of Philadelphia’s Banking Legislation and Policy.
Business Review Q4 2005 17
discharge of their debts in bankruptcy,
borrowers must first complete a course
in personal financial management.
The NFCC estimated its members
would provide 780,000 pre-filing counseling sessions and 535,000 pre-discharge education sessions in the first
year after the law took effect (October
17, 2005). This will require an increase
of more than 1,000 counselors.36
The law specifies minimum
standards to be used by U.S. trustees
or the courts to determine whether a
nonprofit credit counseling organization is approved for the purposes of
the mandatory counseling requirement. Assuming these standards are
sufficiently rigorous, such a certification process could make it easier for
consumers to identify reputable credit
counselors. The law also requires the
Executive Office for U.S. trustees to
develop standards for the required consumer financial education programs
and to evaluate the effectiveness of
those efforts.37
This law includes a provision
designed to encourage unsecured
creditors to accept debt management
plans proposed by credit counselors. If
such a plan would repay 60 percent of
the original principal (under current
practice these plans return 100 percent
of the principal), and the creditor
refuses to participate, a borrower filing
for bankruptcy can petition the court
to reduce the outstanding debt by up
to 20 percent. The likely effect of this
provision is unclear. If a borrower is
able to file under Chapter 7, most or
all of his or her unsecured debts will
be discharged anyway. Most Chapter
13 repayment plans offer unsecured
creditors some portion of the original
principal, but it is typically small and
even less is usually repaid. A 20 percent reduction in such amounts may be
insufficient to influence the decisions
of unsecured creditors.
There are a number of other legislative proposals at the federal level. A
2003 bill, the Debt Counseling, Debt
Consolidation, and Debt Settlement
Practices Act (H.R. 3331), would
make explicit that credit counseling
organizations, irrespective of their
nonprofit status, can be sued for unfair
and deceptive trade practices. There
are also proposals to revise the 1996
Credit Repair Organizations Act with
credit counselors in mind. That law
currently does not apply to nonprofit
organizations. A recent federal court
case, however, makes clear that the
act will apply to tax-exempt charities
that are, in fact, operated as for-profit
organizations.38
The National Consumer Law
Center, together with the Consumer
Federation of America, has proposed
a model state law to regulate credit
counselors. The National Conference of Commissioners on Uniform
State Laws is also working on a draft
Uniform Consumer Debt Counseling
Act that would, among other things,
regulate fees charged to consumers for
debt management plans and require
that counselors spend at least as much
on education as they do on advertising.
Regulatory Action. Since
2003, the Internal Revenue Service
has initiated investigations into the
nonprofit status of 59 credit counseling organizations, which collectively
account for approximately 50 percent
of the industry’s revenues. It has since
revoked the tax-exempt status of six
organizations and denied applications
for nonprofit status to 20 others.39 Also
in 2003, the FTC sued a number of
the newer counseling organizations
for engaging in unfair and deceptive
trade practices and operating as forprofit enterprises. In 2005, the FTC
concluded a number of settlements,
effectively shutting some of these
organizations down. Others have announced changes in their organization
and business practices.40
CONCLUSION
In the U.S., credit counseling
organizations are playing an increasingly important role in the functioning
of the market for unsecured consumer
credit. Credit counselors make it possible for some borrowers to repay their
unsecured debts. This, in turn, offers
borrowers the chance to re-establish
access to credit more rapidly than if
they file for bankruptcy.
Credit counselors are also important providers of consumer financial
education and budget counseling,
which, until recently, was indirectly
subsidized through fair share payments
made by creditors. If these programs
are indeed effective, but creditors
are now less willing to fund them,
perhaps the public should. In other
words, these activities may represent
an important public good. A lender
may well benefit when its customers become more sophisticated about
credit, but the lender does not enjoy
all the benefits. Some of the benefits
are enjoyed by the customer and his or
See the September 2005 press release from the
NFCC.
36
39
A list of approved counseling organizations
can be found at www.usdoj.gov/ust/bapcpa/
ccde/index.htm. There is also a list of organizations approved to provide instruction in
personal financial management.
37
18 Q4 2005 Business Review
See Zimmerman v. Cambridge Credit Corp et
al., 1st Circuit, No. 04-2039 (2005). A key test,
according to the decision, is whether the organization is generating income for itself or others.
See the article by Caroline Mayer.
38
40
See the testimony of IRS Commissioner
Everson, the March 2005 press releases from the
FTC, and the Senate Report.
www.philadelphiafed.org
her other creditors. Thus, lenders may
have an inadequate incentive to fund
such efforts. While customers may
benefit from receiving budget counseling and financial education, they are
presumably unable to afford it at their
time of greatest need.
There is evidence that credit
counseling organizations are effective
in helping some consumers regain access to credit and better manage their
finances. But it is difficult to interpret
these results. Are they due to selection
or treatment effects? Relatively little
formal research has been done, and
there remains a lot more to do.
In recent years, changes in technology and in the market for consumer
credit have induced major changes in
what had been a quiet life for nonprofit
credit counseling organizations. There
has been a dramatic increase in the
number of counseling organizations
and in the observable costs of debt
management plans among unsecured
creditors. Creditors are not so sure they
are benefiting from the increased use
of debt management plans.
Creditors and traditional counseling organizations are beginning to
respond to these new conditions, but it
is too early to tell how effective these
changes will be. There is also growing
interest, both at the state and federal
levels, in additional regulation of credit
counselors. The idea is to make it easier for consumers to make an informed
choice among credit counselors.
But distressed borrowers must also
decide between their different options.
Is it better to file for bankruptcy than
to participate in a debt management
plan? If so, is it better to file under
Chapter 7 or Chapter 13? How well do
borrowers understand these options?
What organizations are in the best
position, and have the right incentives,
to educate consumers about these
options? More generally, how can we
quantify the effect of credit counselors’ activities on consumers’ access
to unsecured credit and the price
they pay for it? These are just a few of
many important questions that require
further study. BR
California Department of Corporations.
Study of the Consumer Credit Counseling
Industry and Recommendations to the Legislature Regarding the Establishment of Fees
for Debt Management Plans and Debt Settlement Plans. Sacramento, CA: California
Department of Corporations, 2003.
Everson, Mark. Prepared Statement, in
Non-Profit Credit Counseling Organizations, Hearings before the Subcommittee
on Oversight of the House Committee on
Ways and Means, 108th Congress, 1st Session (November 20, 2003).
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Beales, Howard. Prepared Statement of the
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Underestimating Advertising:
Innovation and Unpriced Entertainment
BY LEONARD NAKAMURA
A
lthough advertising is often the object of much
disrespect, it nonetheless plays a significant
role in the economy. For one thing, it helps
consumers find out about new products, and
new products have been rising in economic importance.
Therefore, this relationship between new products and
advertising makes it worthwhile to revisit the economics
of advertising. In this article, Len Nakamura discusses
advertising’s role as a productive economic activity as
well as its value as a long-term investment and its role
in subsidizing entertainment, such as TV and radio
broadcasts.
It’s easy to disrespect advertising.
Ads interrupt football games, impede
news reports, and slow Internet searches. It should be no surprise, then, if
the social usefulness of advertising
is underestimated. Even economists,
usually so mindful of the benefits of
free markets, have often been unaware
of the multiple benefits advertising
provides.
Consider its role in new product
development, the source of so much
economic progress. If potential users
Len Nakamura
is an economic
advisor in
the Research
Department of
the Philadelphia
Fed.
www.philadelphiafed.org
don’t find out about new products so
that they can buy them, firms will
have little incentive to create them.
That’s where advertising comes in: It
helps consumers learn more quickly
about the existence and properties of
new products, so they can buy them,
thereby making themselves, as well
as the firms that made the products,
better off.
Advertising thus helps firms and
users benefit more from creativity.
Larger returns increase the expected
rewards to creativity, encouraging new
product development and productivity
gains. Since new products have been
rising in economic importance, this
nexus between new products and advertising makes it worthwhile to revisit
the economics of advertising. Advertising — although widely disrespected
— can be an unusually productive
economic activity. Two other aspects
of advertising are often overlooked: its
value as a long-term investment and its
role in subsidizing entertainment such
as TV and radio broadcasts.
ADVERTISING: HOW IT WORKS
AND HOW WE VIEW IT
Advertising has been derided as
being, on its face, a creator of wasteful
monopoly. In this view, advertising
creates an artificial monopoly that, in
turn, compensates the maker of the
advertised product for the expense
of advertising. Consumers would be
better off without advertising. The
additional price paid for the advertised
product may waste economic resources
if it does nothing to enhance the product. The British economist Nicholas
Kaldor worried about this aspect of
advertising in his seminal article. Can
advertising do anything to enhance a
product? It is only words and images,
smoke and mirrors.
Advertising Reduces Search
Costs. Is it so obvious that words
really do nothing? Perhaps advertising makes a product more valuable to
consumers. To see how it can do so, we
begin by recognizing that advertising is
a form of communication, of transmitting information. The systematic study
of information transmission dates
from University of Chicago economist
George Stigler’s classic 1961 article
on information. In that article, he
directly addressed advertising, arguing
that it can be defined as communicating with consumers about products.
Stigler focused on the simple case
of consumers who know a product
exists but not where to buy it, and who
might have to expend time and energy
Business Review Q4 2005 21
to locate it. In this case, advertising
that lets consumers know where to
buy a product (or its price) can lower
the consumers’ search costs. A bird in
hand being worth more than one in
the bush, advertising raises the price a
consumer will pay at a given location.
Advertising New Products.
Another type of informative advertising tells consumers about the qualities
of new products. New products are
protected from competition by patents
and copyrights, but these protections
do not inform consumers about the
existence of the new products and
their attributes. This is the job of
advertising; advertising helps consumers adopt new products faster, speeding
profits for the new product’s developers. Since the developer’s monopoly is
only temporary, speed is crucial. For
example, the now-familiar silhouette
iPod dancers have been used to help
create awareness of the Apple iPod and
induce millions of new consumers to
participate in the legal downloading of
music. In turn, Apple reaped large rewards for this more convenient method
of obtaining music.
Persuasion to Change Consumer Preferences. Advertising of
well-known products that doesn’t
provide price or seller locations does
not appear to be informative. Consumers know that beers and colas exist.
How then does advertising create
value? One answer is that advertising
persuades. The industrial economist
Richard Caves wrote in 1967, “[Advertising] seeks to change our preference
patterns and create wants which our
private introspection would deny….
Where advertising departs from its
function of informing us and seeks
to persuade or deceive us, it tends to
become a waste of resources.”
In this view, persuasion is seen
as a distortion of desire. Consumers
don’t know their true desires in the
wake of advertising or possibly didn’t
22 Q4 2005 Business Review
know their true desires before the
advertising. But can we use the tools
of economic analysis to study consumers who have a distorted view of their
wants, either before or after a change
in preferences? Economists Avinash
Dixit and Victor Norman in their
1978 article argued that we should not
include distorted preferences in welfare
analysis, but they note that we can
analyze how the consumer is affected if
we use either criterion consistently: the
New products
are protected
from competition
by patents and
copyrights, but these
protections do not
inform consumers
about the existence of
the new products and
their attributes.
consumer’s pre-advertising preferences
or post-advertising preferences.
To understand what this means,
consider an alternative mechanism for
a change in preferences. For example,
a hot summer may boost consumers’ purchases of air conditioners. We
judge the new quantities as being right
for the consumer, given that the hot
summer has occurred — we don’t use
the purchases from a cool summer
to argue that consumers have been
fooled. With persuasive advertising,
however, demand has changed, but
without anything concrete to point
to as the cause of the change. In this
view, consumers have been fooled. But
if consumers can be fooled, they can
also wise up — they can be “unfooled.”
For any specific piece of advertising,
you don’t know which has occurred.
So what to do?
Dixit and Norman argued that
if you obtain the same results using
either criterion, you have a convincing
analysis. And once you consider both,
they argue that under either standard,
most persuasive advertising is likely
to be excessive from society’s point of
view. They point out that if advertising raises the consumer’s demand
for a product, two effects raise the
advertiser’s profit. One is that consumers are willing to buy more of a product
at any given price, making themselves
and the advertiser better off. To this
extent, consumers’ and advertisers’
interests are aligned, and advertising
may be a good thing.
But a second effect is that advertising may either raise or lower the
price of the product. If the price rises,
all consumers of this good pay more for
each unit of the good; the advertiser
is made better off without any corresponding benefit to consumers. To that
extent, the advertiser has an incentive
to spend money on advertising without
benefit to consumers; advertising is
a pure cost – what economists call a
deadweight loss. Furthermore, Dixit
and Norman show that as long as this
second incentive exists, firms with
market power will spend too much
on advertising. They show that as
advertising approaches the level that
maximizes the advertiser’s profit, the
last dollar spent is entirely this pure
cost. This analysis does not imply that
society would be better off banning
advertising, but it does imply that in
these cases, we would certainly be
better off with a little less advertising.
One way of getting advertisers to reduce their spending would be to apply
a small tax to advertising expenditures.
On the other hand, it is possible
that the price to consumers could fall
as a result of advertising, for example,
if having a larger market could result
in lower per unit costs. In this case,
consumers are better off, according to
www.philadelphiafed.org
the post-advertising tastes, although it
is possible they could still be worse off
under pre-advertising tastes.
This analysis is valid whether
we choose the consumer’s preferences before or after the advertising
as the valid criterion, but it assumes
that advertising has no impact on the
product’s true value to the consumer.
The last dollar of advertising gets the
consumer to buy a tiny bit more of a
product, so that the marginal benefit
to the consumer is, at best, very small
and fully offset by what the consumer
is paying for the product. But what if
advertising affects the true value of
customers, e.g., suppose advertising is
informative. Then the last advertising dollar reaches a consumer who
wouldn’t otherwise buy the advertised
product, and this transmission of information can potentially have a large
benefit.
Thus, when advertising is informative, the last consumer is made
better off from the last dollar of expenditure.
Advertising to Change the Product and Not Preferences. Stigler and
Gary Becker argue that as a general
methodological principle, economists
should think first of changes in tastes
as reflecting a change in the product
itself, rather than as a distortion of
consumer preferences. In this view,
advertising can make any product a
new product. As a consequence, advertising generally has large benefits for
consumers. Is this argument reasonable? Can this “new product” view of
advertising be extended to examples
that appear to be persuasion?
One easy example is that an
existing product might be advertised
because a new use has been found for
it. For example, aspirin acts as a blood
thinner to reduce the risk of heart
attacks. This raises the demand for
aspirin because of information gleaned
from studies of aspirin.
www.philadelphiafed.org
A less scientific example of a new
use for an existing product is fast food.
Fast food was once seen mainly as a
summertime treat, but McDonald’s
pioneered the idea that fast food could
be eaten in the winter, as a cheap
break from the routine of home cooking. In the late 1960s, McDonald’s
used advertising on Macy’s Thanksgiving Day parade and the Super Bowl to
Advertising may act
like a Post-it® note to
remind us of products
we have forgotten to
buy recently.
suggest to consumers that they didn’t
need to wait until summer to enjoy a
Big Mac. In the wake of the advertisements, winter sales rose dramatically
– and seasonal patterns were permanently affected. Similarly, consumers
once thought long-distance phone
calls were too expensive for chatting.
As long-distance prices fell, AT&T’s
“Reach Out and Touch Someone”
commercials, which urged consumers
to call their relatives and friends long
distance on Sundays, changed consumer phone habits permanently.
Commercials may provide information through images that are an
indirect or highly abbreviated form
of communication. For example, an
Apple iPod permits a consumer to
carry around a lot of songs, effectively
freeing the listener from having to
carry a stack of CDs and a comparatively bulky player, and to move freely
without the music skipping. All of this
freedom is suggested by the hip/silly
motions of the iPod silhouette dancers;
this image would then lead a potential
buyer of an iPod to engage in additional investigation before actually buying
an iPod.
Also, the fact that a product exists
doesn’t mean we remember to buy it.
In that case, advertising may act like a
Post-it® note to remind us of products
we have forgotten to buy recently.
After all, habit is a tricky business. As
consumers, we value both familiarity
and variety. But because we have limited memory, it is hard to keep these in
balance. We replace items we like with
new items as we seek variety, but we
may forget how much pleasure we got
from the old item, until an advertisement reminds us to go back to it.
As TV viewers, we may be excessively irritated by advertising and see
it as being uninformative because it
isn’t informing us. Most of the time, we
aren’t in the market for the car being
advertised or have already decided
what beer or vacation we prefer. The
advertising is directed at someone else,
someone more open to the subject
of that product (who, we may feel,
is a weak-willed victim of persuasive
advertising). In this case, all the ad
in question does is get in the way of
our entertainment. If each person is
enlightened by only 1 percent of all
ads, the gains to advertiser and shopper may outweigh the costs. Advertiser and shopper would be better off if
somehow advertising became less scattershot. But that doesn’t mean that,
given the technology at hand, advertising isn’t informative in its impact.
Different observers will inevitably
have different perceptions about the
extent to which advertising is persuasive or informative. Nevertheless, as
the importance of new products rises,
the informative component of advertising is likely to rise with it, leading
more people to believe in advertising’s
social benefit.1
See my 2003 article on evidence for the growing — and substantial — amount of economic
activity devoted to creating new products.
1
Business Review Q4 2005 23
INFORMATIVE ADVERTISING:
HOW VALUABLE?
Let’s look a bit more closely at
informative advertising. It is not like
the normal economic products for
which we can rely on Adam Smith’s
Invisible Hand to assure us that the
market provides the right amount of
economic activity in producing and
consuming them. Usually, the Invisible Hand theory applies to products
that competitors are free to duplicate
and whose price, therefore, accurately
reflects the cost of reproducing them.
Economists Gene Grossman
and Carl Shapiro looked at this more
complex product — advertising — and
asked whether producers have the
right incentives to produce informative
advertising when there is more than
one advertised product. They showed
that there are two opposing forces: Information about products makes consumers better off (“consumer surplus”)
but at the expense of other producers
(“business stealing”).
Consumer Surplus. Information
about a product increases the likelihood that a consumer will purchase
a good that has more value to him
than the goods he is replacing. The
average new consumer reached by an
ad would be willing to pay more for a
product than the producer is asking,
even though the producer is making an additional profit because of
market power. To this extent, too little
advertising is provided. The consumers who have not been reached by
advertising would be better off if they
could pay the advertiser to reach them,
because they would gain more than
the payment would cost them, but such
payments are difficult to arrange.
Business Stealing. Advertising
typically induces some consumers to
switch from one firm with market
power to another, thereby depriving
the first firm of some monopoly profit.
So some of the profit the second firm
24 Q4 2005 Business Review
receives from the new consumption
is “stolen” from the old producer. To
this extent, producers have too much
incentive to advertise. Put another
way, the first firm would be better off
if it could bribe the second firm not
to advertise. But, again, this trade is
difficult to arrange and moreover may
violate anti-trust laws.
In addition to these two effects,
however, when advertising includes
entertainment as a byproduct, consum-
the cost of advertising. They saved
resource costs while offering advertisers greater diversity in their ability to
reach target audiences.
Stigler discussed the use of entertainment to attract buyers to information. He argued that the assimilation
of information is not easy or pleasant
and that buyers will assimilate it more
easily in an enjoyable form – just as air
conditioning a store makes shopping
more enjoyable. Consumers are more
The rise of TV broadcasting in the 1950s also
depended on advertising.
ers derive an additional benefit. This
makes it more likely that advertising
is actually undersupplied. Moreover,
because all new products need to be
advertised, the additional costs of advertising may limit the creation of new
products. So if we take advertisement
into consideration, the arguments for
subsidizing new products are likely
stronger.
ENTERTAINMENT AS A
BYPRODUCT OF ADVERTISING
Consider the advertising-fuelled
rise of radio. Radio was a crucial
development in the 20th century and
took hold beginning around 1923.
Radio broadcasts helped jazz burst out
on a national and international scale,
suddenly changing the course of world
music and defining the decade of the
1920s as the Jazz Age. Other examples
of radio’s impact were FDR’s fireside
chats, baseball play-by-play, and the
CBS symphony orchestra’s performances.
The rise of TV broadcasting in
the 1950s also depended on advertising, and much of the rise of the
Internet was spurred by advertising.
Of course, the compliment went both
ways. These innovations lowered
likely to buy products whose information is broadcast in the most easily
absorbed form.
Zero: An Uncomfortable Price
for Economics. Entertainment that’s
a byproduct of advertising may fly
beneath the radar of economics, however, because it has zero price and so
zero sales in nominal terms. How can
a good have a zero price if it is valued
by consumers? This can happen if
the good is sold along with another;
that is, it is a joint product. When
entertainment and the advertised item
form a joint product, they are much
like honey and pollination as the joint
product of bees. If farmers are willing
to pay a lot for pollination services, the
supply of honey will soar and the price
of honey could fall to zero if honey
went into excess supply.2 Similarly,
entertainment and news may be free:
Just as the price of honey might fall to
2
When honey prices are high enough, beekeepers may have to pay farmers to situate their
hives in their orchards. Thus, pollination services may have a positive price in certain circumstances, such as when farmers pay beekeepers
to pollinate their fields; in other circumstances,
pollen becomes an input into beekeeping and
pollination has a negative price.
www.philadelphiafed.org
zero, advertising can make the price of
an entertainment fall to zero.
The price of entertainment
subsidized by advertising could also
be zero because it is difficult to collect
payments from the consumer. That
is, the entertainment producer might
prefer to charge consumers a positive price, but the cost of collecting
the price might make that infeasible.
For example, broadcast radio and
TV function by sending signals off
into the ether, where radios and TVs
receive them for free. Nowadays these
broadcasts can be sent encrypted, as
they are with satellite and cable TV, to
collect fees from the consumers. But
back when radio and TV were first invented, the electronic devices capable
of such coding and decoding were far
in the future. So the technology made
it necessary to have the broadcasts
supported by advertising, rather than
by direct sale.
WHAT IS FREE
ENTERTAINMENT WORTH
TO CONSUMERS?
How important have expenditures
on entertainment been? Neil Borden’s
pioneering 1942 book on the economics of advertising introduced the
notion that news and entertainment
media are subsidized by advertisement
and empirically estimated the size of
the subsidy.
First, let’s look at the heyday
of radio. In 1935, total advertising
expenditures on radio were $80 million, according to Borden, roughly 0.1
percent of GDP. Roughly half of that
went to entertainment — payments to
live talent, transcriptions of shows, and
leases of phonograph records. Economically, this is small potatoes. Culturally,
however, it was a revolution.
One piece of evidence for radio’s
revolutionary impact is the expenditures it displaced. As broadcast professional music substituted for music cre-
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ated in the home, sales of pianos and
other home instruments fell. Economist F. M. Scherer shows that the
timing of the decline of expenditures
on home instruments coincided with
the rise of radio sales: The explosion of
radio sales from 1923 to 1925 coincided with a steep drop in piano sales,
particularly player pianos.3 In 1923,
344,000 pianos were produced in the
U.S.; by 1929, the number had fallen to
121,000, a nominal sales decline of $67
million (U.S. Census of Manufactures,
1925 and 1931). And this is just one
of the many areas affected. No doubt
the ability to hear the CBS orchestra
or Louis Armstrong on the radio raised
the recreation enjoyed by consumers.
What about the rise of television?
In a very nice study, Roger Noll and
his co-authors present quantitative
evidence on the monetary value of the
rise of TV. How can we find out what
consumers would pay for an item they
receive for free? The answer Noll and
his co-authors found was that some
potential TV consumers could not
receive broadcast for free, and they
argued that the amount these viewers
were willing to pay was a window into
the value of TV for all consumers.
In sparsely populated areas of rural
America, broadcasters did not find it
worthwhile to send signals over the air;
the cost of the transmitters could not
be justified. A commercial solution
that became available in the 1960s was
community cable TV. The amount
consumers who were not served by
broadcast TV were willing to pay for
receiving the broadcasts via cable
is a clear measure of the monetary
value of the usually free broadcasts. It
At the same time, the quality of phonographs
was improving dramatically. Moreover, there
was clearly a complementarity between radios
and phonographs, as exposure to music over the
radio encouraged sales of phonograph records.
3
turned out that, by 1969, 80 percent
of households in areas served were
willing to pay $5 a month for no-frills
cable access to regular broadcast TV.
Noll and his co-authors argued that
consumers who did have access to TV
broadcasts would have been willing to
pay at least the same amount to receive
the broadcasts, if they had had to.
Five dollars a month, spread across 80
percent of all U.S. households, would
have amounted to $3 billion, or about
0.4 percent of household income.
But this estimate is actually on
the low side. When Noll and his
co-authors did a careful job of estimating the total amount that consumers
would have been willing to pay, they
came up with a much larger number:
5.1 percent of household income in
1969. They arrived at this number by
using variations in cable TV charges,
characteristics of the households, and
the availability of partial broadcast TV
in some areas, to tease out exactly how
much each of the three broadcast network channels was worth to consumers. (At the time, there were only three
broadcast channels: CBS, NBC, and
ABC.) The fact that in some areas one
or two channels were available over
the air enabled them to put a price on
each additional channel, based on the
reasoning that each additional channel
available over the air should lower the
demand for cable. However, the precise
number (5.1 percent) depends on the
exact type of equation used.
This raises the question: Is such a
large number plausible? One measure
of the impact on consumers is what
they did with their time. Families
stayed home in huge numbers to watch
broadcast TV (Figure 1); by 1970,
Americans were spending 22 hours
a week watching. This is a striking
shift in consumers’ use of leisure time
— plausibly one-fourth of weekly
leisure time after we eliminate work
(including household production ac-
Business Review Q4 2005 25
FIGURE 1
Cable and Broadcast TV
Weekly Viewing Hours
35
30
weekly hours
25
20
15
10
5
0
1950
1955
1960
weekly TV hrs.
1965
1970
cable
1975
1980
1985
1990
1995
2000
broadcast
Note: These data splice together data on annual viewing hours for 1984 to 2000 from Veronis
Suhler Stevenson published in the 1994, 1999, and 2003 U.S. Statistical Abstract, with average
viewing per day data for 1984 and earlier from A.C. Nielsen from the U.S. Statistical Abstract,
1985 and earlier. The two series do not agree in 1984; the former gives 1,520 hours per year,
which is 29.2 hours per week, while the latter gives 7 hours per day, or 49 hours per week. I forced
the Nielsen data to equal the Veronis Suhler Stevenson data in 1984.
tivities), commuting, and sleep hours.4
Clearly, free television outcompeted a
lot of alternatives, both free and costly,
for consumers’ limited time. To get
Time diary data from the American Time
Use Survey show that in 2004, Americans 15
and older spent 2.6 hours per day (18 hours
per week) watching television as their primary
activity. This does not count time when the
television set is on but something else — such as
eating or household chores — is the primary activity. Unfortunately, the time-use survey does
not publish data on TV watching as a secondary
activity. Even if we take the time-use survey
as a better measure, the implication is still that
watching television is a major leisure activity of
American adults.
4
26 Q4 2005 Business Review
a better feeling for expenditures on
leisure-time activities, consider those
recreational and personal care activities that consumers pay for—which
includes services such as movies, cable
TV, beauty salons, golfing, and spectator sports, and goods such as books,
electronic equipment, and toiletries.
Consumers spent about 8 percent
of their income in the late 1960s on
these leisure-time goods and services,
according to the U.S. Bureau of Economic Analysis. TV by then had become the dominant form of leisure, so
perhaps a consumer value of 5 percent
of income for TV is not implausible,
although it may be an overestimate.5
Do we see this shift in consumer
expenditures on alternative forms of
recreation, the way we saw the decline
in player pianos? Economists would
have expected expenditures on recreational services, as a luxury good, to be
rising as a proportion of expenditures,
since per capita real incomes were
rising and households could afford
more luxuries. Instead, real recreational services fell as a proportion
of expenditures in the 1950s (Figure
2). As happened with radio, consumers substituted TV for other forms of
priced entertainment.
Thus, free entertainment and
news played an important role in
making consumers better off. We have
already pointed out that corporations may be better off over sustained
periods of time because of advertising. How might these factors figure
into our calculations of the value of
economic activity? Should they affect
how we look at profitability and U.S.
output? I will argue that the answer is
yes.
ACCOUNTING FOR
ADVERTISING
Let’s consider how advertising
appears in the national accounts. To
take the elements of the analysis step
by step, let’s start by thinking about
advertising without entertainment,
and let’s consider short-run advertising, whose impact is simply to raise
sales in the same period in which the
advertising is purchased. When a mail
order company sends out a catalog of
clothing items, the costs of the catalog
Personal care and recreation does not include,
for example, hotels, restaurants, foreign travel,
air travel, cars and gasoline, household services,
or religious and social welfare activities.
5
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FIGURE 2
Recreation Services as Proportion of
Personal Consumption Expenditures
With and Without Subsidy
Percent
5.00
4.50
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
1951
1954
1957
1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
Real Recreation Services including Subsidy
Real Recreation Services without Subsidy
Advertising Subsidy to Real Recreation Services
Source: U.S. Bureau of Economic Analysis and author’s calculations from Nakamura (2004).
are paid for by the sales the company
rings up from it. The costs of designing, printing, and mailing the catalog
(the inputs) show up as income to
those who created the advertising,
while the catalog itself (the output) is
simply considered part of the sweaters
and other clothing sold. Thus, the advertising shows up nowhere in output,
except as an ingredient of the items
sold, just as the cost of the warehouse
where the sweaters were stored is an
ingredient.
The same thing holds true for
advertising with entertainment. When
a “Seinfeld” rerun appears on TV, its
cost and its entertainment value are
considered just like the postage in a
direct mail solicitation — from the
perspective of the national accounts,
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the entertainment’s only value is to sell
the advertised product.
Entertainment. How should our
official national income measures
account for the benefit gained from
entertainment that is a byproduct of
advertising? If we are to accurately
measure economic growth in the U.S.,
we should include the contributions
of radio and TV broadcasts to consumption. Normally, entertainment
is included in personal consumption
expenditures according to its total
sales. But the total sales of radio and
TV broadcasts are zero, despite their
quantity being positive, because their
price is zero to the consumer.
But when these zero-price products became available, consumers
were very much better off than they
had been, as has been documented.
How might we show a sensible, positive value for consumers? One way to
measure the contribution would be to
argue that the free entertainment services paid for by advertisers, e.g., Jerry
Seinfeld’s salary for TV performances,
would have been paid for by consumers. After all, these entertainment
services are bid away from alternative
paid entertainment venues (e.g., Jerry
Seinfeld’s forgone Las Vegas revenue).
If the economy is reasonably efficient,
Jerry Seinfeld’s TV performances are
more valuable to consumers than his
potential Las Vegas performances, so
the measure is a reasonable minimum.
If we value this entertainment
at cost, taking Seinfeld’s salary as
this cost, we are taking an approach
parallel to that of other zero-priced
products, such as government-supplied
education. That is, in the national
accounts we value public education at
its cost.
Suppose that radio and TV entertainment services paid for by advertisers amount to 20 percent of recreational services paid for by consumers,
as they did for much of the 1960s and
1970s. Then we can estimate that the
effect of these services is to increase
the total real quantity of recreational
services 20 percent. So real expenditures go up 20 percent. Nominal
expenditures are unchanged (since
these services are being supplied at
zero price). The net effect is to reduce
the price of recreational services. This
makes sense: The consumer has obtained 20 percent more services without spending any more. The effect of
this calculation for radio and television
is shown in Figure 2, where we have
mapped out the part of ad expenditures on radio and television that go to
providing consumer entertainment.
Note what has happened here. A
dollar of advertising shows up in more
than a dollar’s worth of output. It
Business Review Q4 2005 27
shows up in the value of the advertised
product as a dollar’s worth of extra
value for the consumer and the advertiser. How sizable is this extra value?
In my 2004 working paper, I have
made some rough estimates of the part
of advertising that goes into consumer
entertainment. There I have estimated
that for each dollar spent on broadcast
television advertising, some 60 cents of
free entertainment is produced — raising recreation output without raising
costs. Because broadcast TV and radio
advertising expenditures amount to
about $60 billion, entertainment is
boosted by $36 billion. Advertising
has become an unusually productive
economic activity. According to my
rough estimates, if we add in contributions to all media, advertising adds
close to $70 billion in entertainment
consumption to U.S. output.6
Advertising in Corporate Income and Expense Accounting. Let’s
briefly go over the issue of how to best
incorporate advertising in corporate
income and expense accounting, an
issue I’ve already addressed in more detail in my 2003 article on intangibles.
Currently, advertising expenditure
is typically expensed; that is, the total
cost is recognized immediately and
subtracted from income. This is the
correct treatment of advertising to the
extent that profits are recouped during
the same period in which expenses are
laid out. For example, a department
There are two ways in which advertising
should be included in the national income accounts but is not. One is that the entertainment
subsidized by advertising should be included
in personal consumption expenditures. The
other is that some proportion of advertising
expenditures should be considered investment.
Until this proportion is estimated and included
in investment, gross investment in advertising
will be underestimated in the national income
accounts, where it is all treated as if it were
short-lived. See my 2003 paper for additional
discussion.
6
28 Q4 2005 Business Review
store or an auto dealership advertising a Thanksgiving weekend sale will
garner all the value from this advertising in that weekend, and it is properly
expensed. A going-out-of-business
sale is the pure type of an advertising
expense that has no long-run value.
The principle here can be illustrated by considering a $10 million
machine that lasts 10 years and creates
$2 million worth of value each year.
One way to account for it would be to
expense it in the first year of production. The firm would show a loss of $8
million in the first year, and a profit
Unfortunately, it is not
easy to analyze how
advertising can have
very long-lived value.
of $2 million in all the others. The
alternative is to capitalize the investment and expense it over the 10 years
of its useful life. The firm’s expenditure
would show up as a $10 million capital
item, whose value depreciates $1 million each year. Only the depreciation
would show up on the income and
expense statement. If we do this, the
firm shows $1 million in profit each
year. Accountants have decided that
this latter approach makes more sense
for physical investments, since, in fact,
the firm is not doing poorly the first
year and suddenly improving for the
rest of the decade but is making a nice
profit each year.
So if Apple spends $150 to
manufacture an iPod and $50 to
advertise it, then sells it for $200, its
profit is zero — provided the advertising has not created a durable asset,
such as brand loyalty, for Apple. But
if the advertising makes it possible
for Apple to continue to sell iPods for
nine more years without continuing
to advertise, the advertising should
be expensed over the 10 years that
Apple sells the product. Advertising
that confers a long-term advantage in
the marketplace should be capitalized
and depreciated, which spreads out the
expense over the useful life of the advertising. For example, some products,
such as prescription drugs, have strong
temporary monopolies, and advertising
for them may properly be depreciated
over the patent’s lifetime. Other products, such as breakfast cereals and cola
beverages, build brand loyalty that can
last for many years.
A practical difficulty is that it may
be hard to know in advance how longlived advertising is going to be. How
long will iPod be a successful product?
Will the consumers who are led to buy
a product continue to think that it’s a
good product – or will a new product
offer greater value?
Many articles have explored the
longevity of advertising and obtained
different results. What most of the
studies have shown is that not all
advertising is long-lived, but they also
suggest that at least some advertising
is long-lived. The general practice of
expensing advertising of new products
will result in profits being understated
in the short run and overstated in the
long run. This problem is similar to
that associated with the expensing of
research and development.
Unfortunately, it is not easy to
analyze how advertising can have very
long-lived value. Even when one can
build up such a picture, it is difficult
to analyze with certainty how much
of a company’s or an industry’s longlived market power is due to advertising. While a few studies, such as
Aviv Nevo’s study of the ready-to-eat
breakfast cereal industry, have very
carefully attacked the question of how
long-lived market power and profitability can survive, there are not enough
www.philadelphiafed.org
such studies to form a coherent picture
of long-lived advertising power.
One avenue that needs greater
pursuit is the relationship between
advertising and new products. To the
extent that new products create permanent gains in consumption, advertising may be said to have a permanent
asset value to society. This is a line of
research where much empirical work
remains to be done.
CONCLUSION
What do we make of advertising? One view is that advertising is
wasteful, annoying, and distorting.
There may well be a significant part
of advertising that fits this view. But
there is a very large, and growing, portion of advertising that is informative
and constitutes a social benefit, as is
the case with most economic activity.
Moreover, we have identified a part of
advertising – the part that subsidizes
entertainment – that contributes to
consumer welfare but has not been
counted in output. When we add up
advertising’s contributions, they appear
to be substantial. Two cheers for advertising — or maybe four? BR
Nakamura, Leonard. “Advertising,
Intangible Assets, and Unpriced
Entertainment,” paper presented
at SSHRC Conference on Price
Measurement, Vancouver, BC, 2004.
Scherer, F. M. Quarter Notes and
Banknotes. Princeton, NJ: Princeton
University Press, 2004.
REFERENCES
Borden, Neil. The Economic Effects of
Advertising. Chicago: Irwin, 1942.
Caves, Richard. American Industry:
Structure, Conduct, Performance, 2nd ed.,
Englewood Cliffs, NJ: Prentice-Hall, 1967.
Dixit, Avinash, and Victor Norman,
“Advertising and Welfare,” Bell Journal of
Economics 9,1, Spring 1978, pp. 1-17.
Grossman, Gene M., and Carl Shapiro.
“Informative Advertising with
Differentiated Products,” Review of
Economic Studies 51, January 1984, pp.
63-81.
Kaldor, Nicholas. “Economic Aspects of
Advertising,” Review of Economic Studies
18, 1, 1950-51, pp. 1-27.
www.philadelphiafed.org
Nakamura, Leonard. “A Trillion Dollars a
Year in Intangible Investment and the New
Economy,” in John Hand and Baruch Lev,
eds., Intangible Assets: Values, Measures,
and Risks. Oxford: Oxford University,
2003.
Stigler, George J. “The Economics of
Information,” Journal of Political Economy
69, June 1961, pp. 213-25.
Stigler, George J., and Gary S. Becker,
“De Gustibus Non Est Disputandum,”
American Economic Review 67, March
1977, pp. 76-90.
Nevo, Aviv. “Measuring Market Power
in the Ready-to-Eat Cereal Industry,”
Econometrica 69, 2001, pp. 307-42.
Noll, Roger G., Morton J. Peck, and John J.
McGowan. Economic Aspects of Television
Regulation. Brookings Institution,
Washington D.C., 1973.
Business Review Q4 2005 29
After the Baby Boom:
Population Trends and the Labor Force of the Future
BY TIMOTHY SCHILLER
O
ver the past 40 years, the baby boom
generation’s participation in the workforce
and women’s increased presence in the
workplace have had a large effect on the
American labor force and the nation’s economic growth.
But as the baby boomers start to retire in large numbers
and women’s participation in the workforce levels off,
what effect will this have on the U.S. labor force and
the nation’s economy? More specifically, how will these
factors affect the economies of the Third District states?
In this article, Tim Schiller describes the issues associated
with these and other demographic shifts and their impact
on the local and national economies.
The U.S. economy has grown at
an annual rate of around 3.4 percent,
adjusted for inflation, over the past 50
years. An important factor in achieving that pace of economic growth has
been an increase of about 1.7 percent
annually in the supply of workers. This
relatively rapid growth in the labor
supply has been the result of two factors: the entry of the baby boom generation into the labor force, and the increasing participation of women in the
labor force. Those two factors are now
Tim Schiller
is a senior
economic analyst
in the Research
Department of the
Philadelphia Fed.
30 Q4 2005 Business Review
poised to fade, and labor force growth
will ebb as a large cohort of workers
reaches retirement age and as women
no longer swell the ranks of the labor
force. For output growth to continue
at its pace of the past half-century in
the face of slower labor force growth,
workers’ productivity will have to grow
more rapidly.
A slower-growing, aging labor
force will make it difficult to meet
the need for workers in some major
industries and occupations in the nation and in the Third Federal Reserve
District. The issues associated with
these demographic shifts are likely to
be more acute in the tri-state region
than in the nation because the region’s
population is older, the labor force is
projected to grow more slowly, and the
occupational and industrial mix in the
region is more heavily concentrated
in those jobs for which demand is projected to grow and the supply of workers is likely to be tight. Alternatively,
the region’s favorable mix of industries
and occupations—it’s concentration in
education and health care—could give
the region an advantage in attracting more workers to meet the growing
need.
THE FUTURE SUPPLY OF
WORKERS
To project the supply of labor, we
need to understand the factors that
influence the number of workers in the
economy. The basic factor is the size
of the working age population, which
includes all those 16 years of age and
older. They are not all in the labor
force, however. Only a percentage of
the working age population is working
or available for work, and this percentage is called the labor force participation rate. It differs by age, sex, race,
and ethnicity. So projections of the
overall population are only the starting
point for estimating the labor force.
To estimate the size of the total labor
force, we also need population projections by age, sex, race, and ethnicity
and projections of their labor force
participation rates.1
The Slowing of Labor Force
Growth. The Bureau of Labor
Statistics (BLS) projects a slowing of
growth in the labor force, from a rate
of 1.7 percent per year between 1950
and 2000 to just under 0.8 percent
Labor force participation rates also vary over
the business cycle, typically falling during
recessions and rising during expansions, but in
this article the focus is on long-term trends in
participation rates.
1
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per year between 2000 and 2050. (For
the BLS’s projection methodology, see
Projecting Population and Employment.)
The slower growth projected for the
labor force reflects both a decline in
population growth and a decrease in
overall labor force participation.
The BLS takes its population
projections from the Census Bureau.
And the Census Bureau projects that
overall population growth will gradually slow from an annual rate of around
1.2 percent from 1990 to 2000, to less
than 1 percent in this decade, then to
less than 0.7 percent by the middle of
this century. The Census Bureau projects that the fertility rate (the number
of children born per woman during her
lifetime) will increase slightly during
the first half of the century, the death
rate (the number of deaths as a percent
of the total population) will increase,
and the annual number of immigrants
during the projection period will be
similar to the current rate of around
1 million. The combined result of
these projected changes is a projected
slowing in population growth over the
projection period, 2000 to 2050.
To these population factors, the
Bureau of Labor Statistics adds its own
projection of labor force participation
to estimate the future growth of the
labor force, and this projection is also
for slower growth or a leveling off in
the participation rate.
Three factors account for the projected slowing of labor force growth.
In order of significance these are: 1)
slower growth in the age group with
the highest labor force participation; 2)
an end to the increase in women’s labor force participation; 3) a decline in
the number of immigrants in relation
to the total population and labor force.
Typically, labor force participation
begins at age 16 and declines significantly around the usual retirement age
of 64. Although there are indications
that more workers will remain in the
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labor force past normal retirement age
in the future, the population in the
16 to 64 age group supplies the bulk
of the labor force, and it is expected
to continue to do so. In the current
decade and in the years after 2030, the
16 to 64 age group will grow at about
the same rate as the overall population. However, from 2010 to 2030 the
increase in this group will be between
0.2 and 0.3 percent, much lower than
total population growth, because the
baby boomers will be moving out of
this age group (Figure 1). As they do
so, their labor force participation will
declining participation among women
of all ages by 2030.
As noted earlier, immigrants will
make up a declining proportion of the
population and labor force. This will
affect labor force growth in two ways.
First, immigrants will add proportionally less to the overall labor force in
the future. Second, immigrants tend
to have higher labor force participation
rates than the rest of the population,
so their relative decline in the labor
force will result in an even greater
decline in the overall labor force participation rate.
The aging of the baby boomers will also
contribute to the second factor tending to
reduce the growth rate of the labor force: a
reversal in the growth of women’s labor force
participation rate.
decline, reducing the growth rate in
the overall labor force.
The aging of the baby boomers
will also contribute to the second
factor tending to reduce the growth
rate of the labor force: a reversal in the
growth of women’s labor force participation rate.2 Women’s labor force
participation rate increased from 34
percent in 1950 to 60 percent in 2000.
It is projected to rise to 62 percent in
2012, then decline to 57 percent by
2050 (Figure 2). A large part of the
decline will be the result of the aging
of baby boom women and the fact that
women typically retire at earlier ages
than men. This will act as a brake on
the growth of the overall participation rate for women. But not all of the
decline in women’s participation rate
is due to the aging of the population.
The Bureau of Labor Statistics projects
Men’s participation rate has been declining for
more than 50 years, and projections show it will
continue to do so.
2
An Older and More Diverse
Labor Force. During the next several
decades, demographic changes will
influence the composition of the labor
force in two ways: it will become older
as we have already indicated, and it
will become more diverse with respect
to race and ethnicity.
As the baby boomers entered the
labor force in the 1970s and 1980s,
the percentage of young workers went
up and the percentage of older workers went down. As the boomers age,
the percentage of older workers will
increase. The percentage of the labor
force that is 55 and older will rise from
around 13 percent in 2000 to around
20 percent in 2030. Then, as the
boomers retire, the percentage of older
workers will decline somewhat, to
around 19 percent in 2050 (Figure 3).
Besides the aging population’s
effect on raising the median age of the
work force, the average retirement age
will likely rise in the future. The BLS
projections take this possibility into ac-
Business Review Q4 2005 31
Projecting Population and Employment
T
he U. S. Bureau of Labor Statistics (BLS)
publishes 10-year projections of the labor
force and employment every two years.
The latest projections were published in
2004 and cover the period from 2002
to 2012.a The Bureau also occasionally
publishes longer term projections of the labor force, but
not employment. The latest, published in 2002, extends
to 2050.b
The starting point for employment projections is
projected population growth. The BLS uses the Census Bureau’s middle-series projection. This projection is
a
See the article by Michael Horrigan and the ones by Mitra Toosi.
b
See the articles by Mitra Toosi.
derived by combining the mid-range forecast of the birth
rate, death rate, and international immigration among
the various age and race cohorts that make up the total
population.c The middle series assumptions for the total
population are that the birth rate will remain close to its
present level, the death rate will increase, and international immigration will decrease over time relative to the
size of the U.S. population. Immigration is still expected
to add significantly to the total population, but because
the number of immigrants is projected to be constant,
based on current law and recent net immigration patterns, immigrants are expected to contribute less to both
population growth and total population in the future.
(box continues on next page)
c
See the article by Frederick Hollman and co-authors.
FIGURE
Components of Population Change 1995-2025
Percent of 1995 population
20
15
10
5
0
-5
-10
-15
PA
Natural Increase
NJ
International Migration
DE
US*
State-State Migration
*State-to-state migration does not affect the total U.S. population.
Source: U.S. Census Bureau
32 Q4 2005 Business Review
www.philadelphiafed.org
Projecting Population and Employment
In projections of state populations the Census Bureau
takes into account likely state-to-state migration and
international immigration in addition to the natural
increase in the state’s population (the birth rate minus
the death rate). Through 2025, each of these factors is
projected to affect population growth in different ways for
the three states of the region: Pennsylvania, New Jersey,
and Delaware (see the accompanying chart).d
Each of the three states is expected to gain proportionately less from natural increase than the nation. In
Pennsylvania, the natural increase in the population is
expected to be slight. The state is expected to experience
little international immigration and net outward migration to other states. New Jersey’s natural increase and
net international migration is projected to be the highest among the three states. The projections suggest the
state will continue to have a higher rate of international
immigration than the nation. Some of the international
migration is expected to be offset by high levels of outmigration from New Jersey to other states. Among the
three states in the region, only Delaware is projected to
gain population from all three sources: natural increase,
international immigration, and state-to-state migration.
For employment by industry and occupation, the BLS
projections are based on a combination of a projection
of the total number of available workers and a projection
of the economy’s growth during the projection period.e
In other words, the employment projection assumes the
economy will grow at a steady trend rate with all available
workers employed. For the 10 years from 2002 to 2012,
the BLS projects real GDP will increase at an average
annual rate of 3.0 percent, slightly below the 3.2 percent
average annual rate of the previous 10 years.f
d
The latest projections of state population, based on the 2000 census,
extend to 2030, but they do not include details of the components of
population change. However, the previous projection, based on the
1990 census, does include details of these components, but it extends
only to 2025.
count by projecting a rising labor force
participation rate for the 55- to 64year-old age group in the short term.3
In fact, recent data indicate that labor
force participation among both men
and women age 55 and older has risen.4
The major reasons for this are related to
retirement financing. The minimum age
to receive full Social Security benefits
is rising, and some workers will delay
retirement until they qualify for full
benefits. Furthermore, there is a trend
away from reliance on defined benefit
plans to more participation in defined
contribution plans, which are more
See the article by Sophie Korczyk and the 2004
article by Mitra Toosi.
3
4
See the article by Katharine Bradbury.
www.philadelphiafed.org
e
f
See the article by Michael Horrigan.
See the article by Betty Su.
financially rewarding to those who work
beyond normal retirement age.5
There is also some evidence that
baby boomers are more interested than
earlier generations in continuing to
work in some manner during “retirement.” Surveys in recent years indicate
that more people currently employed
plan to work beyond age 65 than did
Defined contribution plans are those in which
employees making periodic payments to retirement funds (such as 401k’s) through payroll
deductions. Their retirement income depends
on the investment return to the fund. Defined
payment plans are those in which the employer
promises a fixed retirement payment to employees based on salary and years of employment. A
growing number of firms are placing limits on
the retirement pay earned under defined benefit
plans; in response, workers are turning to defined
contribution plans to boost prospective retirement income.
5
workers in previous generations.6
Changing demographics will affect
not only the median age of the labor
force but also the racial and ethnic
composition. Because projected immigration is expected to be made up
largely of Asians and Hispanics, and
because these and other minority racial
and ethnic groups have greater birth
rates than other population groups,
most minority ethnic and racial groups
will increase their share of the population and the labor force (Figure 4).7 In
See the article by Christopher Reynolds, and
the 2003 publication from AARP.
6
For example, the birth rate (number of births
per 1,000 persons) for Hispanics is 22.6, for
blacks it is 16.1, and for non-Hispanic whites it
is 11.7 (National Center for Health Statistics,
2003).
7
Business Review Q4 2005 33
addition, their labor force participation
is projected to rise.
FIGURE 1
Projected Annual Growth Rates of
U.S. Population and Labor Force
Percent
1.2
1.0
0.8
0.6
0.4
0.2
0.0
2000-2010
2010-2020
Total Population
2020-2030
2030-2040
Population 16-64 Yrs. Old
2040-2050
Labor Force
Source: Bureau of Labor Statistics
FIGURE 2
Labor Force Participation Rate*
Percent*
100
Actual
90
Projected
80
70
60
50
40
30
20
10
0
1950
1960
1970
1980
1990
Men
* Of population 16 years and older
Source: Bureau of Labor Statistics
34 Q4 2005 Business Review
2000
Women
2010
2020
Total
2030
2040
2050
THE FUTURE DEMAND
FOR WORKERS
A smoothly functioning economy
requires a match between the skills of
available workers and the job requirements of the industries and by occupations that need workers. These
job requirements will change as the
demand for different products and services changes, and as the technologies
that workers use evolve. So, in addition
to projections of the labor force, the
Bureau of Labor Statistics also projects
employment by industry and occupation.
Labor economists classify employment in two ways: by industry and by
occupation. Every worker is counted
in both of these classifications. In
industry classifications, every worker
is assigned to an industry according to
the kind of good or service produced
by the firm in which he or she is employed. In occupational classifications,
every worker is assigned to an occupation according to the kind of work
he or she does. (See Major Industrial
and Occupational Classifications for
examples of the major categories of
industries and occupations.) For some
jobs, the occupational classification
is closely associated with an industry. For example, most physicians are
self-employed or work for firms that
directly provide health-care services,
so most are counted in the health-care
industry. However, some might be
employed in other types of firms—a
manufacturing firm, for example—and
would therefore be counted as working in the manufacturing industry.
Regardless of the industry in which
they work, all physicians are counted
as health-care practitioners within the
professional occupations category.
For other jobs, the occupational
classification is not so closely associ-
www.philadelphiafed.org
FIGURE 3
Labor Force
Thousands
Percent
25.0
250,000
Projected
Actual
200,000
20.0
150,000
15.0
100,000
10.0
50,000
5.0
0
1950
1960
1970
1980
1990
2000
Labor Force
2010
2020
2030
2040
2050
Percent 55 and Older
Source: Bureau of Labor Statistics
FIGURE 4
Racial and Ethnic Composition
Of the Labor Force
Percent of Total
80
0.0
ated with an industry. For example, all
computer programmers are counted in
the computer and mathematical science
occupations group of the professional
occupations category. But many work
for banks, part of the financial industry,
as well as in many other industries such
as manufacturing and education, and
they are counted as working in those
industries.8
Growth in Service Industries
and Professional and Nonprofessional
Service Occupations. In general,
demand for workers in professional
and service occupations is expected to
increase. Among occupational categories, the BLS projects that employment in the two largest—professional
and related occupations, and service
occupations—will grow the fastest in
percentage and absolute terms to 2012
(Figure 5). Together, these occupations
will account for more than half the
total job growth to 2012.9 Among the
industry categories, job growth from
2002 to 2012 will be concentrated in
services.10 The services industries with
the strongest projected employment
growth—both in absolute and percentage terms—are education and health
services, and professional and business
services (Figure 6).
A major factor in future demand
for workers by industry and occupation
70
60
50
A potential source of confusion is the use of
the word “service” as both an industry and occupational classification. There are many service
industries, such as professional and business
services, education and health services, etc., in
which there are workers in many occupations.
Jobs in these industries have a large range of
educational requirements and pay. Service occupations, however, are more narrowly defined.
The largest service occupations are health-care
aides, policemen and firemen, food preparation
workers, and building and grounds maintenance workers. Most of the jobs in the service
occupations are at the lower end of the scale of
educational requirements and pay.
8
40
30
20
10
0
Non-Hispanic White
Hispanic
Black
2000
Source: Bureau of Labor Statistics
2050
Asian and Other
9
See the article by Daniel Hecker.
10
www.philadelphiafed.org
See the article by Jay Berman.
Business Review Q4 2005 35
Major Industrial and Occupational Classifications
Industries are categorized according to the output of establishments. Occupations are categorized according to the jobs
that individuals perform. People in most occupations can work in one of several industries, and every industry employs
persons in many occupations.
Industry
Types of Firms (major categories)
Mining
Oil and gas extraction, mining
Utilities
Electric utilities, natural gas utilities, water systems, sewage systems
Construction
Building, utility, highway and bridge construction, specialty contractors
Manufacturing
Food, textile, paper, chemicals, metals, metal products, machinery, computer, electrical equipment,
transportation equipment, furniture
Trade
Wholesale, retail
Transportation
Air, water, and land transportation, warehousing, pipelines
Information
Publishing, motion pictures and sound recording, broadcasting, Internet, telecommunications,
data processing
Finance
Banks, savings institutions, credit unions, securities firms, insurance, commodities firms
Real Estate and Rental
Real estate lessors, real estate agencies, rental and leasing services
Professional Services
Legal, accounting, architectural, engineering, computer, management, scientific, advertising,
and marketing services
Administrative
Employment services, business support services, travel services, waste management
Education
Elementary and secondary schools, colleges and universities, trade schools
Health and Social Care
Offices of physicians and dentists, outpatient care centers, medical laboratories, home health-care
services, hospitals, nursing and residential care facilities, social services, child day care services
Arts, Entertainment
Performing arts companies, spectator sports, amusement and gambling facilities
Accommodation
Travel accommodations, food service and drinking places
Other Services
Auto repair, equipment repair, personal and laundry services
Occupation
Types of Jobs (major categories)
Management, Business
Executives and managers, accountants, business analysts, purchasing agents, human resource
specialists, financial specialists
Professional
Computer and mathematical occupations, architects, engineers, scientists, social workers, lawyers,
teachers, librarians, artists, performing artists, athletes, physicians, pharmacists,
health-care technologists, nurses
Service
Health-care aides, law enforcement and protective occupations, food preparers and servers,
building maintenance workers, personal care workers
Sales
Retail sales workers, rental clerks, real estate agents, sales agents
Office, Administrative
Financial clerks, records clerks, couriers and dispatchers, secretaries, office support workers
Farming, Fishing
Farm, fishing, and logging workers
Construction, Extraction
Construction trades, miners, oil and gas drilling workers
Installation, Maintenance
Electricians, mechanics, equipment repairers
Production
Manufacturing production workers, machinists, printers, woodworkers, power plant operators
Transportation
Aircraft pilots, motor vehicle drivers, railroad workers, water transport workers,
material moving workers
36 Q4 2005 Business Review
www.philadelphiafed.org
FIGURE 5
Occupations with Greater than Average
Projected Growth
Percent change, 2002 - 2012
25
20
Average of all occupations
15
10
5
0
Professional
Service
Management &
Business
Construction &
Extraction
Source: Bureau of Labor Statistics
FIGURE 6
Industries with Greater than Average
Projected Growth
Percent change, 2002 - 2012
35.0
30.0
25.0
20.0
Average of all industries
15.0
10.0
5.0
0.0
Educaton &
Health Services
Professional &
Business
Services
Source: Bureau of Labor Statistics
www.philadelphiafed.org
Transportation
Information
Leisure &
Hospitality
Other Services
Construction
is the aging of the nation’s population.
An aging population will increase
demand for health services, so demand
for workers in this industry will grow.
By occupation, the bulk of workers in this industry will be medical
practitioners (for example, physicians,
pharmacists, and nurses), part of the
professional occupations category, and
nonprofessional service occupations
(for example, health-care aides and assistants). Other occupations that will
be in demand to serve an aging population will be personal care workers
(within the services occupations) and
social workers (within the professional
occupations). These two occupations
can be found in a variety of industries
and in government agencies.
The other major factor in future
demand for workers by industry and
occupation is changing technology.
The increasing capabilities of computer
and telecommunications technologies
will increase the demand for workers
in the information services industry,
which includes firms that create computer software and provide Internet
services, for example. Furthermore,
continuing advances in the automation of business functions will increase
demand for workers in computer-related occupations in all industries. The
automation of manual work has been
at least partially responsible for the
decline in manufacturing employment
over the past several decades, and it
is increasingly affecting nonmanufacturing work, as well. In fact, automation is one of the reasons that office
and administrative occupations are
projected to have the slowest growth
among occupational categories except
for production (mainly manufacturing)
and agricultural occupations.
Employment growth in the professional and business services industries
is also projected to be strong, and this
will drive growth in management and
business occupations. Firms provid-
Business Review Q4 2005 37
FIGURE 7
Occupational Job Openings Projections
(Number of Openings, 2002 - 2012)*
Service
59
Office & Administrative
79
Professional
45
Sales
72
Production
90
55
Management & Business
63
Transportation
Construction & Extraction
57
Installation & Repair
Farming, Fishing, Forestry
63
90
Thousands 0
5000
Growth
10,000
15,000
Replacement
*Ranked by number of replacement openings. Numbers at
end of bars are replacement openings as percent of total openings.
Source: Bureau of Labor Statistics
ing employment services, including
temporary staffing firms, and those
providing business consulting on management, human resource administration, marketing, and scientific and
technical matters are expected to grow.
Here again, technological change is
an influence, as advances in telecommunications and the standardization of
information technology have increased
38 Q4 2005 Business Review
the outsourcing of business functions,
which these service industries provide.
The BLS also projects growth in
the educational services industry. The
BLS projects rising enrollments in
post-secondary institutions as the children of the baby boomers reach college
age and as workers of all ages demand
more training throughout their careers. This is another instance of the
influence of technological change on
labor demand: the anticipated need
for more job training, and the educators to provide it, is at least partly a
result of workers’ need to keep pace
with advances in the technology used
in the workplace. Although the BLS
projects flat enrollments for preschool
through secondary levels, it projects
that increases in hours of operation
and reductions in class size will necessitate higher employment. Because the
bulk of educational services is provided
through state and local governments,
the projected increase in demand for
education will underpin growth in
government employment.
Replacement Needs May Differ
from Growth. As baby boomers retire,
the need to replace them will be more
pressing in occupations in which large
proportions of current workers are
members of the baby boom generation.11 Thus, the occupations with the
greatest percentage or number of
additional jobs may not be the occupations with the largest number of job
openings. Among broad occupational
categories, service, office, professional,
and sales occupations will have the
largest replacement needs (Figure 7).12
Some specific occupational categories, such as truck drivers, teachers,
physicians, nurses, and managers and
administrators, have large numbers of
baby boomers, and these occupations
will face large replacement needs as
baby boomers retire. So job seekers in
the future will have opportunities in
industries and occupations that are not
growing but that will have large numbers of job openings due to replacement needs.
11
See the article by Arlene Dohm.
Other industries with large numbers of baby
boomers — mainly, manufacturing and farming
— have had declining employment. So the need
to replace workers in those industries will not
be as great.
12
www.philadelphiafed.org
FIGURE 8
Projected Annual Population Growth
2000-2030
Percent
1.2
1.0
0.8
0.6
0.4
0.2
0.0
-0.2
US
DE
Total
NJ
PA
16-64
Source: Bureau of the Census
THE FUTURE LABOR FORCE
IN THE REGION
Just as slower population growth
will set an upper limit on labor force
growth for the nation in the decades
ahead, it will also limit labor force
growth in the three states of the Third
Federal Reserve District: Pennsylvania,
New Jersey, and Delaware. The industries and occupations projected to have
strong growth in the nation—services
and professions—are also projected to
have strong growth in the three states.
Slower Population and Labor
Force Growth in the Region. As
mentioned earlier, national population
growth is projected to slow from about
1.3 percent per year from 1970 to 2000
to a bit less than 1 percent per year
from 2000 to 2030 (the latest year for
which we have state projections). Population growth in Pennsylvania, New
Jersey, and Delaware is also projected
www.philadelphiafed.org
to be slower from 2000 to 2030 than it
was in the preceding 30 years. Pennsylvania and New Jersey are projected
to have slower population growth over
the projection period than the nation,
and growth in Delaware is projected to
match the national growth rate.
In the region as in the nation, the
16 to 64 age group is projected to grow
more slowly than the total population
from 2000 to 2030 (Figure 8). This age
group will increase in New Jersey and
Delaware, but at a slower rate than in
the nation. In Pennsylvania, the 16 to
64 age group is projected to decrease
from 2000 to 2030.
Future Industry and Occupational Employment in the Region.
The service industries are projected to
have the most rapid growth in employment in the region, as they are in the
nation (Figure 9).13 The region already
has a relatively high concentration of
employment in education and healthcare industries, and these are projected
to have high growth rates. Occupational projections for the region are
also much like those for the nation,
with likely gains in high-skill health
occupations and both high-skill and
low-skill service occupations (Figure
10).
The pattern of industry and occupational employment projections is
very similar for Pennsylvania and New
Jersey. Total growth is projected to
be lower for Pennsylvania than New
Jersey, but the top industry categories
are the same for both states: professional and business services and education and health (though the order in
the two states is reversed). As in the
U.S., occupations in professional and
business services will be the fastest
growing.
Projections for Delaware are different. Education and health services
are not top industry categories. The
top category is transportation and
warehousing, where employment is
projected to grow as major national
retailers establish distribution facilities
in the state. In terms of occupations,
management and business will grow
fastest; professional jobs are only the
fourth fastest growing.
In the Third Federal Reserve
District, the largest metropolitan area
is Philadelphia-Camden-Wilmington,
which consists of 11 counties in Pennsylvania, New Jersey, Delaware, and
Maryland. There are no forecasts of
industry or occupational employment
growth for this entire metropolitan
area. However, the Delaware Valley
Regional Planning Commission has
forecast annual employment growth
13
In both Pennsylvania and New Jersey employment in agricultural industries and occupations
is projected to have large percentage increases,
but the number of current jobs and the absolute
increases are very small in both states.
Business Review Q4 2005 39
for the Pennsylvania-New Jersey portion of around 0.6 percent from 2000
to 2030. This is a considerably slower
rate than the nearly 1 percent annual
growth from 1970 to 2000.
It is important to keep in mind
that both the industry and occupational employment projections are
based on demand, while the labor force
projections are based on supply, determined by population growth and labor
force participation. As noted earlier,
many of the workers in the industries
and occupations with growing demand
are close to retirement age now. This
is especially the case for the education
and health-care industries. Projected
increases in demand for these industries and projected increases in the
number of workers retiring from them
will make it difficult to replace and increase the number of workers available
to meet the growing demand.
This issue is especially important
for our region because the education
and health-care industries are a larger
part of the regional economy than they
are in the nation. Like the national
projections, the state employment projections assume the jobs required for
economic growth will be filled, with a
limit set by the projected population.
With slow growth projected for the
regional population, it is possible that
education and health-care employers
in the region will face more difficult
times ahead in meeting their staffing
needs. Conversely, it is possible that
the region will be able to attract more
workers than is currently anticipated
precisely because it is a center for
these industries with growing demand
and therefore growing employment
opportunities. So besides presenting
a challenge to the region, the demographic factors that will influence the
labor markets in the years ahead also
present the region with an opportunity
to build on its strengths.
40 Q4 2005 Business Review
FIGURE 9
Industries with Fastest
Projected Growth
Pennsylvania
Annual Percent Increase, 2002 - 2012
1.40
1.20
1.00
0.80
Average of all
industries
0.60
0.40
0.20
0.00
Professional &
Business
Services
Educaton &
Health Services
Other Services
Transportation
Information
Leisure &
Hospitality
Construction
New Jersey
Annual Percent Increase, 2002 - 2012
3.00
2.50
2.00
1.50
Average of all industries
1.00
0.50
0.00
Educaton &
Health Services
Professional &
Business
Services
Other Services
Construction
Leisure &
Hospitality
Retail Trade
Transportation
Delaware
Annual Percent Increase, 2002 - 2012
3.50
3.00
2.50
2.00
Average of all industries
1.50
1.00
0.50
0.00
Transportation
Professional &
Business
Services
Leisure &
Hospitality
Other Services
Construction
Educaton &
Health Services
Information
www.philadelphiafed.org
FIGURE 10
Occupations with Fastest Projected Growth
Pennsylvania
Annual Percent Increase, 2002 - 2012
1.40
1.20
1.00
Average of all occupations
0.80
0.60
0.40
0.20
0.00
Professional
Service
Management & Business
Construction & Extraction
New Jersey
Annual Percent Increase, 2002 - 2012
2.00
1.80
1.60
Average of all occupations
1.40
1.20
1.00
0.80
0.60
0.40
0.20
0.00
Professional
Service
Management & Business
Construction & Extraction
Delaware
Annual Percent Increase, 2002 - 2012
2.00
Average of all occupations
1.80
1.60
1.40
1.20
1.00
0.80
ISSUES RAISED BY AN OLDER,
SLOWER-GROWING LABOR
FORCE
An older, slower-growing labor
force will raise issues for employers in
the years ahead. The major issues are
determining job tasks and responsibilities for older workers (job content), administering compensation and benefits
for this group, ensuring the continuity
of expertise within firms when older
workers retire, and improving labor
productivity as the pool of available
workers expands less rapidly. Business
and nonprofit employers are beginning
to recognize these issues and take steps
to deal with them.
With slower growth in the labor
force, employers will need to consider
labor-saving changes in production
methods and more on-the-job training in order to get the most production from their employees. In addition
to training new employees, training
programs will also have to focus on
retraining older workers as technology
and job tasks change. This retraining
is already taking place for nurses and
engineers, professions in which the
average age of workers has been rising
more quickly than others.14 Companies
in industries that face large worker replacement needs, such as health care,
aerospace, education, and utilities, are
stepping up training programs.15
Another issue is retaining expert
knowledge within firms as their most
experienced workers leave. To deal
with this issue, firms have begun to
set up mechanisms by which older
workers share their knowledge and
skills with their younger co-workers.16 Another way many firms are
tapping older workers’ expertise is by
0.60
0.40
0.20
0.00
Management & Business
Service
Construction & Extraction
14
See the 2004 publication from AARP.
15
See the article by Alison Maitland.
Professional
See the article by Dorothy Leonard and
Walter Swap, and the one by Anne Fisher.
16
www.philadelphiafed.org
Business Review Q4 2005 41
rehiring retirees, often on a part-time
or contract basis.17 Firms that rely
heavily on intellectual capital are also
stepping up programs to assess their
critical knowledge, record interviews
with their expert staff, document all
essential information, and—in some
cases—redesign production processes
to eliminate the amount of expert
knowledge workers need to have.18
An older work force is likely to
desire a different mix of employee benefits and working arrangements than
what has been typical.19 For example,
older workers are more likely to require
family-friendly employment arrangements that will allow them to care for
aging spouses and elderly parents, for
whom nonresidential institutional care
is not as widely available as daycare
is for workers’ children. According
to some analysts of labor issues, older
workers might also be more interested
in telecommuting, to spare themselves
the inconvenience of commuting.
Changes in job content to reduce the
physical demands of a job are one
way some companies are attempting
to preserve workers’ ability to remain
productive as they age. Another agerelated concern is job safety because
older workers tend to take longer to
recover from accidents than younger
workers.
See online article 996 from the Wharton
School.
17
18
Retirement issues are paramount
for older workers, of course. They
might be more interested in compensation packages that permit a shift of
salaries into pensions, to make up for
shortfalls in retirement financing, and
to payments for health-care expenses,
which tend to increase with age.
to implement some of the working
arrangements and employment agreements that are important to older
workers.21
They also might be more interested
in phased retirement arrangements
(also referred to as partial retirement)
in which they can reduce their hours
of work and earn part of their salary and receive part of their pension.
Currently, phased retirement plans are
mainly available only to workers who
have reached normal retirement age
and not to older workers generally. To
make phased retirement more widely
available to older workers, both private
retirement arrangements and tax rules
regarding pensions and health-care
coverage would require revisions.20
But many firms, including some of the
nation’s largest, have already begun
SUMMARY
The aging of the baby boom
generation will prompt changes in
both the supply of and the demand
for workers among different industries
and occupations, leading to potential
shortages of workers in health care and
education. As the baby boom generation grows older, the average age of the
labor force will increase, its growth will
slow, and its composition will become
more diverse. These challenges are
likely to loom especially large in the
region. All the issues associated with
an older, slower growing population
and labor force are likely to be more
acute in the region. This is because,
compared with the nation, the region’s
population is older, its labor force is
projected to grow more slowly, and the
occupational and employment mix
in the region is more heavily concentrated in those jobs for which demand
is projected to grow and the supply of
workers is likely to be less ample, especially education and health care.
But the region is already a center
of education and health-care industries
and occupations, in which demand is
projected to be strong. So this favorable job mix could enable the region
to attract more workers than currently
anticipated. BR
See the article by Rudolph Penner, Pamela
Perun, and Eugene Steurele.
21
See the 2004 publication from AARP and the
article by Milt Freudenheim.
Older workers are
more likely to require
family-friendly
employment
arrangements that will
allow them to care for
aging spouses and
elderly parents.
See the book by David DeLong.
See the AARP’s 2004 publication; the article
by Lynn Karoly and Constantijin Panis; and
online article 1123 from the Wharton School.
19
42 Q4 2005 Business Review
20
www.philadelphiafed.org
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AARP. Staying Ahead of the Curve 2004:
Employer Best Practices for Mature Workers.
Washington, DC: AARP, 2004.
AARP. Staying Ahead of the Curve 2003:
The AARP Working in Retirement Study.
Washington, DC: AARP, 2003.
Berman, Jay M. “Industry Output and
Employment Projections to 2012,” Monthly
Labor Review, February 2004, pp. 58-79.
Bradbury, Katharine. “Additional Slack in
the Economy: The Poor Recovery in Labor
Force Participation During This Business
Cycle,” Public Policy Briefs, Federal Reserve
Bank of Boston, 2005.
DeLong, David W. Lost Knowledge: Confronting the Threat of an Aging Workforce.
Oxford: Oxford University Press, 2004.
Dohm, Arlene. “Gauging the Labor Force
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Fisher, Anne. “How to Battle the Coming
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121-128.
Freudenheim, Milt. “More Help Wanted:
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Hecker, Daniel E. “Occupational Employment Projections to 2012,” Monthly Labor
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Hollman, Frederick W., Tammany J.
Mulder, and Jeffrey E. Kallan. “Population
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Horrigan, Michael. “Employment Projections to 2012: Concepts and Context,”
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Karoly, Lynn A., and Constantijn W. A.
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2004, p. 2.
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Reynolds, Christopher. “Retirement Goes
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2004, pp. 12-13.
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http://knowledge.wharton.upenn.edu/
index.cfm?fa=printArtcile&ID=1123,
February 18, 2005.
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Penner, Rudolph G., Pamela Perun, C.
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Review Q4 2005 43
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