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Federal Reserve Bank of Philadelphia SEPTEMBER OCTOBER 1977 THE ECONOMICS OF COMMUTING IN A HIGHER COST WORLD Also: The World Business Cycle: Is It Here To Stay? BUSINESS REVIEW SEPTEMBER/OCTOBER 1977 S E P T E M B E R / O C T O B E R 19 7 7 THE ECONOMICS OF COMMUTING IN A HIGHER COST WORLD Nonna A . Noto ... Where people live and work depends on the costs of housing and commutation. Energy policy, if it affects these costs, will have an impact on regional development. THE WORLD BUSINESS CYCLE: IS IT HERE TO STAY? Narim an B e hra vesh Federal Reserve Bank of Philadelphia 100 North Sixth Street (on Independence Mall) Philadelphia, Pennsylvania 19106 The BUSINESS REVIEW is published by the Department of Research every other month. It is edited by John J. Mulhern, and artwork is directed by Ronald B. Williams. The REVIEW is available without charge. Please send subscription orders, changes of address, and requests for additional copies to the Department of Public Services at the above address or telephone (215) 5746115. Editorial communications should be sent to the Department of Research at the same address, or telephone (215) 574-6418. The Federal Reserve Bank of Philadelphia is part of the Federal Reserve System—a System which includes twelve regional ... The 1973 recession hit the industrialized nations at about the same time, but that’s not a sign that business cycles around the world have fallen into step. banks located throughout the nation as well as the Board of Governors in Washington. The Federal Reserve System was estab lished by Congress in 1913 primarily to manage the nation’s monetary affairs. Sup porting functions include clearing checks, providing coin and currency to the banking system, acting as banker for the Federal government, supervising commercial banks, and enforcing consumer credit pro tection laws. In keeping with the Federal Reserve Act, the System is an agency of the Congress, independent administratively of the Executive Branch, and insulated from partisan political pressures. The Federal Reserve is self-supporting and regularly makes payments to the United States Treasury from its operating surpluses. FEDERAL RESERVE BANK OF PHILADELPHIA The Economics of Commuting in a Higher Cost World By Nonna A. Noto* Another reason for reexamining commuta tion is the effect it has had on large cities. As access to suburbs has become easier, city dwellers have left thousands of residences in the urban centers as well as the roads, utilities, and sewage systems already in place. Their departure has contributed to loss of cohesive neighborhoods, a transpor tation system unbalanced by rush-hour traffic, and a host of other undesirable developments on the urban scene. These conditions have led policymakers and other public figures to call for measures to change the present patterns of commuta tion. The proposals have ranged all the way from improving mass transit to rehabilitat ing urban homes and taxing petroleum at a rate that would make the operation of gasguzzlers prohibitively expensive for most people. These commutation patterns, how ever, are not accidental. They didn’t just happen, for no reason at all. Instead, they came about because people made decisions about where to live and where to work. And Every workday morning, 50 million Ameri cans climb into their cars and head for jobs in offices and factories. Commut ing, chiefly by car, became a way of life after World War II—so much so that it and its costs sometimes were taken for granted. Now, however, commuting patterns and the residential dispersion patterns that go with them are being reevaluated. One reason is the higher cost of petroleum-based energy and the desire to conserve it. The mayor of one of A m er i ca ’s largest cities recently pointed out that if the average length of home-to-work trips were reduced only one mile each way, total travel per year would be reduced by 25 billion vehicle miles— a saving of 1 million barrels of oil per wee k. 1 *Nonna A. Noto, who joined the bank staff in 1974, holds a Ph. D. from Stanford University. She special izes in urban economics and public finance. 'Thomas Bradley, “America’s Cities,’’ in John J. Mulhern, ed., The Future of American Cities [Philadelphia; Federal Reserve Bank of Philadelphia, 1976), p. 6. 3 BUSINESS REVIEW SEPTEMBER/OCTOBER 1977 those decisions were based in part upon the cost of both housing and transportation. Thus an understanding of the economic forces that have determined the cost struc ture of homesites and worksites in the past may help us understand what the future may hold for our cities, suburbs, and regions. COMMUTING COSTS AFFECT WHERE PEOPLE LIVE Commuting—the regular journey from home to work and back again—makes it possible for people to live and work in the communities of their choice, even if those communities are at a distance from one another. That’s the benefit of commuting. But commuting has costs, in both money and time. And at some point the prospective homebuyer has to trade off the benefits against the costs. Costs of Commuting: Money and Time. The principal direct costs associated with commuting are out-of-pocket money costs and travel time. For example, bridge and BOX 1 highway tolls, car operating costs, and parking fees—the main monetary costs associated with commuting by car—are determined primarily by the mileage trav eled and the kind of vehicle used. They would be the same for any individual mak ing the same trip with the same kind of vehicle. Although the time spent commuting can be measured with a device as impersonal as a clock, the value of that time depends on how much it would be worth to an individ ual to spend his time doing something else. Thus the value of commuting time is an individual matter and is likely to vary with income, family size, sex, and age [Box 1). People do not value their commuting time as highly as their time on the job.2 Perhaps Estimates suggest that people value their commut ing time at about 40 percent of their wage rate. See Gary Becker, “A Theory of the Allocation of Time,” The Economic Journal 75 (1965), pp. 493-517; Michael E. Beesley, "The Value of Time Spent in Traveling: Som' New Evidence,” Economica 23 (1965), pp. 174-185. WOMEN AND COMMUTING Sex seems to make a difference in commuting. Women, on average, live closer to their work than men. Part of the reason may be that women's wages are lower than men’s* while the value of their time spent in the household is higher. With relatively lower wages, women have less of an income incentive to undertake a long commute. And the family may prefer having them home earlier to having the extra income they might gain by longer commutes. Many working women either are single or have few children at home. As members of small households with low demand for housing space, they have less incentive to undertake a long commute to save on housing costs. If, in addition, a woman works near another member of her household, she and the other member—with higher combined commuting costs than the single earner family—would tend to live closer to the common workplace. Finally, women are less likely than men to own or drive a car. Consequently, their commutations may be limited to routes and distances accessible by walking or serviced by mass transit. Lower benefits and higher costs point toward a shorter commute for women. Thus accessibil ity to affordable residences may be especially important to businesses that depend heavily upon female workers.t *Nationwide in 1976, median hourly earnings for women were only $2.90 compared with $4.67 for men. U.S. Department of Labor, Bureau of Labor Statistics, “Weekly and Hourly Earnings Data from the Current Population Survey,” Special Labor Force Report 195, 1977, p. 9. fFor further discussion of the relationship between household characteristics and commuting patterns see John F. Kain, “The Journey-to-Work as a Determinant of Residential Location,” Regional Science A ssociatio n Papers 9 (1962), pp. 146-147; and “A Contribution to the Urban Transportation Debate: An Econometric Model of LJrban Residential and Travel Behavior,” Review of Economics and S ta tistic s 46 (1964), pp. 62-63. FEDERAL RESERVE BANK OF PHILADELPHIA dwellings.3 Residential development in metropolitan Philadelphia, for example, fol lows this pattern—a decrease in the density of residential construction with increasing distance from Center City (Figure 1). Thus the cost of commuting—or, alterna tively, the benefit of accessibility—is re flected in the pattern of land values. These values tend to be lower the farther commu ters travel from concentrations of economic activity. And these lower land values are mirrored in decreasing density of residen tial construction as roads lead outward from the skyscrapers of the central city to the farms of the distant suburbs. The Tradeoff: A Long Commute vs. High Housing Costs. In choosing residential loca tions, then, many consumers trade off com muting costs against housing prices. A cen tral location saves on commuting but costs more per unit of housing, while an outlying location saves on housing but costs more in commuting. Who is more likely to commute the greater distance? People who want large lots and big houses are more likely to, because the total saving on housing will be larger the more land and housing space purchased. Thus a household with several children is a better candidate to choose an outlying loca tion than a young single worker. And an outlying location is likely to offer a greater house saving incentive to a high-income family that intends to purchase a large property than to a low-income family that wants at most a two-bedroom apartment. But because the value of time is related to income, the high-income individual is likely this is because it is not easy to substitute nonwork time for work and wages, or because working is more unpleasant than commuting, or because commuting incorpo rates leisure activities such as listening to the radio and enjoying the scenery. Still, people do place sufficient value on their time to be willing to pay tolls for faster trips. And thus it seems that the time spent traveling is an important cost to many com muters. Longer Commutes, Lower Land Prices. With these substantial costs involved, why are people willing to commute long distances and long hours? There’s no single answer to this question, because different people have different reasons for commut ing. For some it may be the attraction of clean air and a garden plot. For others it may be proximity to schools and other institu tions. But for many people, the chief reason for undertaking a long commute may be to get more for their housing dollar. This housing dollar buys a structure, a neighborhood, and land. The price of land is lower at greater distances from the business centers, because individuals or firms must absorb higher transportation costs to reach the business centers from more distant loca tions. And where land prices are lower, so are prices per square foot of housing of a given grade. Thus lower land cost is the key to lower suburban housing prices. The price of land, in turn, influences the density of construction. Nearer the busi ness center, where land values are higher, each dwelling unit will tend to use less land, and housing will tend to be built upward rather than outward. A larger per centage of the dwelling units will be in highrise apartments or attached rowhouses. At greater distances from the hub, land values are lower and so houses tend to come with bigger lots. A larger percentage of the hous ing units will be duplexes, small multi-unit complexes, or fully detached single-family 3For further discussion of the transportation costland value tradeoff see William Alonso, Location and Land Use (Cambridge: Harvard University Press, 1964); Edwin S. Mills, “An Aggregate Model of Resource Allocation in a Metropolitan Area,” Ameri can Economic Review 57 (1967), pp. 197-221; Richard F. Muth, Cities and Housing (Chicago: University of Chicago Press, 1969); and Lowdon Wingo, Transporta tion and Urban Land (Washington: Resources for the Future, 1961). 5 BUSINESS REVIEW SEPTEMBER/OCTOBER 1977 FIGURE 1 HOUSING DENSITY FALLS WITH INCREASING DISTANCE FROM CENTER CITY PHILADELPHIA (Housing Units per Residential Acre, 1970) SOURCES: Philadelphia City Planning Commission; U.S. Department of Commerce, Bureau of the Census; Delaware Valley Regional Planning Commission. 6 FEDERAL RESERVE BANK OF PHILADELPHIA these neighborhoods and by the smaller size and poorer condition of their houses. This pattern of lower grade and thus cheaper housing in the older central cities is evident, for example, in the 1970 census figures for the Philadelphia metropolitan area. The $8,400 median value for owneroccupied houses in the central city of Camden compares with a $17,100 value for the remainder of Camden County. Chester City’s median house value of $10,100 con trasts with the $18,300 figure for the remainder of Delaware County. There are some exceptions, however, in the City of Philadelphia itself. The median house values of $29,900 for Center City and of $18,900 for the newly developed Far Northeast approach the figures for the sur rounding suburban areas. But the median value of housing in the neighborhoods immediately surrounding Center City Philadelphia is equal to or less than the figures for the cities of Camden and Chester (Figure 2). Thus, as a result of the uneven distribu tion of housing prices, employers of lowskilled and low-paid workers may find that they can reduce their labor costs by setting up shop near the relatively inexpensive housing stock of a central city. But employ ers that depend heavily on higher paid managerial, professional, and technical workers may be able to reduce their labor bills by locating near the more attractive suburban housing. ... And With Commuting Distances. The proximity of housing to a worksite influ ences the number of workers available to an employer at that site for a given wage. Because the road networks of the older metropolitan areas radiate outward like the spokes of a wheel, some suburban busi ness locations may be quite inaccessible to all but those workers who live on or close to one spoke. As long as suburbs remain low in their density of development, labor scarcity may force the suburban employer to pay higher wages than the central-city to be torn between the attraction of a central location that conserves commuting time and an outlying location that offers a large house and yard at considerable savings. Behind this choice lies the tradeoff of higher housing costs against higher commuting costs. Thus commuting costs affect where we live—directly, in transportation outlays, and indirectly, by their impact on the price of land. And because commuting imposes costs on employers, those costs also affect where we work. COMMUTING COSTS AFFECT WHERE PEOPLE WORK Commuting costs and housing costs can influence the location of businesses as well as of residences because these costs affect wages. The wages employers must offer to attract labor to a given location reflect, in part, what their employees must pay to get to work and what they must pay for hous ing. Because of the variation in the price of housing in different parts of the metropoli tan area and because the transportation network makes some locations more acces sible than others, workers may find it more costly to work at some sites than at others. As a consequence, they may be willing to take jobs at some locations only if the wages employers offer there are enough higher than wages elsewhere to compensate for the higher housing and commuting costs. Employers, in turn, may find that their labor costs differ at different sites in the same metropolitan area. Labor Costs Rise and Fall With Housing Costs ... Just as workers may require higher wages if commuting costs are high, they may be willing to settle for lower wages if their cost of living is reduced by having low-priced housing in the vicinity of the worksite. And in many cases, despite the tendency for land values to be lower at greater distances out, total housing prices may be lowest in the older industrial neigh borhoods of the central cities. This fact is explained in part by the characteristics of 7 SEPTEMBER/OCTOBER 1977 BUSINESS REVIEW FIGURE 2 MEDIAN HOUSING PRICES ARE LOWER IN THE OLDER CENTRAL CITIES THAN IN THE SURROUNDING SUBURBS (Thousands of Dollars, 1970) SOURCES: Philadelphia City Planning Commission; U.S. Department of Commerce, Bureau of the Census. 8 FEDERAL RESERVE BANK OF PHILADELPHIA employer even in the absence of higher commuting costs and housing prices. But the construction of highways in outlying areas has improved the competitive posi tion of suburban locations as employment sites. And the rise in auto ownership by individuals has increased the number of people available to employers at noncentral locations (Box 2). By influencing the wage at which people are willing to work, the cost of commut ing—including the price of housing and its accessibility to a job site—affects the num ber of workers willing to commute for a given wage. The availability of labor at a site, in turn, influences the wage that will be paid there. Setting up in locations near suitable housing may help businesses save on labor costs, since lower commut ing costs can result in lower wages. Thus, in short, our pattern of residential and business location has depended in an important way on the costs associated with commuting—the cost of housing and the cost of transportation. But as those costs change, especially with respect to one another, so will people’s responses to them. BOX 2 REVERSE COMMUTING Suburban businesses can look to city residents as well as suburbanites in their search for workers. In 1970, 12 percent of Philadelphia’s resident labor force was reverse commuting from the city to the neighboring suburbs each day. These workers may be traveling the other way, but they appear to be responding to the same economic forces that affect suburbs-to-city commuters. Reverse commuters tend to earn more than their neighbors who both live and work in the City of Philadelphia (though not as much as those who live in the suburbs and work in the city). In 1969, 21 percent of Philadelphia’s reverse commuters earned over $10,000. While 24 percent of suburban resident-workers earned this much, only 15 percent of city resident-workers did so. Suburbs-to-city commuters had the highest income, with 44 percent earning over $10,000.* Some wages may be higher in the suburbs, in part, because the suburban jobs are more highly skilled or because there is a shortage of workers at suburban locations. But although these people make more money by reverse commuting than they would working in the city, they don’t seem to make enough more to compete in the suburban housing market. Reverse commuters may be taking advantage of the cheaper housing available in the city. To the extent that zoning and the economic pressures of the suburban real estate market discour age the construction of small units, people who can afford only small dwellings cannot benefit from the lower unit price of suburban housing. Their cheapest housing alternative still may be the small rowhouse in the central city. So, if the city is accessible, they may continue to live there even though they work outside the city limits. Reverse commuters actually may face lower commuting costs. If they travel in the direction of lighter traffic, they should be able to travel longer distances in any given length of commuting time, with lower commuting costs per mile. The faster average commuting speed may make a suburban job even more accessible than a downtown job for someone who lives near the outskirts of the city. Thus a central-city rather than a suburban residence may mean a saving in travel time as well as in housing costs for some city dwellers who work in the suburbs. "U.S. Department of Commerce, Bureau of the Census. Census of Population: 1970. Subject Reports. Final Report PC(2)-6D, Journey to Work (Washington, D.C.: Government Printing Office, 1972). Philadelphia suburban counties include Bucks, Montgomery, Chester, and Delaware in Pennsylvania, and Burlington, Camden, and Gloucester in New Jersey. 9 SEPTEMBER/OCTOBER 1977 BUSINESS REVIEW creases the demand for central-city neigh borhoods as upper-income and middleincome residential sites. Well-paid workers, whose time has a relatively high opportunity cost, have a strong incentive to reduce their commuting time; and they are in a financial position to bid for the expen sive locations accessible to their worksites. Further, the demographic trend toward reduced family size—by shifting demand to smaller houses—diminishes the house savings to be gained from a longer trip to the suburbs. Finally, Federal subsidies for urban renewal and redevelopment, along with the increased cost of new housing, help make the rehabilitation of older struc tures more attractive economically. In short, higher future commuting costs are likely to reinforce present trends towards denser concentration of economic activity, with people living nearer their work both in the suburbs and in the city. The current concern with energy conserva tion, however, could lead to transportation policies that substantially alter the time and money costs of commuting and hence the trend toward greater density. For exam ple, policies that favored rail systems as an alternative to automotive commuting might save energy. But energy savings would not be the only outcome. Building a rail system to the outer suburbs would tend to increase the spread of development by reducing average travel time and making those sub urbs more easily accessible. Thus it would work against the tendency to greater den sity and might discourage inner-city reha bilitation efforts. The moral of the story is that policy actions aimed at reducing commuting costs through energy conservation have wide spread side effects, especially in the areas where people do the most commuting. This impact is regional in scope, and thus there’s a case to be made for coordinating energy conservation policies which affect commut ing with policies for improving conditions overall in the nation’s metropolitan areas. WHAT THE FUTURE HOLDS: GREATER DENSITY FOR CITIES AND SUBURBS? Our present commutation patterns devel oped in the days of relatively cheap gasoline and easily accessible suburban housing. Now, however, the price of auto fuel has increased; and as the nearby suburbs fill up, people who want large lots must look further and further afield to find them. These conditions mean that people will be paying more in money and in time to con tinue commuting. As the price goes up, commuters tend to make certain adjust ments. And these adjustments are likely to be in the direction of greater density for both cities and suburbs, with people living closer to where they work. The increased demand for suburban loca tions by firms and their employees as well as by central-city commuters has raised the relative price of suburban land. The trend of rising land costs combined with the in creased demand for smaller housing units has produced a powerful economic force for higher density construction in the suburbs. These developments have increased the variety of nearby housing available to peo ple working in the suburbs as well as the size of the nearby work force available to employers. The increasing costs of trans portation and housing suggest that this movement toward increased residential density in the suburbs is likely to continue. Other recent trends have combined with the rising cost of energy to decrease the benefits and increase the costs of the suburbs-to-city commute for some workers. The resulting increase in demand for cen trally located residences has provided a financial incentive for the conversion of a few downtown neighborhoods, such as the Society Hill and Art Museum neighbor hoods of Center City Philadelphia, from low-income to middle-income and upperincome areas. These trends are expected to continue as the growth in downtown employment of professional and managerial workers in 10 FEDERAL RESERVE BANK OF PHILADELPHIA The World Business Cycle: Is It Here To Stay? B y N arim an Behravesh* During the boom years of the 1960s and early 1970s, the U.S. was not overly con cerned with the possibility that economic fluctuations would spill across national boundaries.1But since the 1973 oil embargo, the business cycles of the major industrial ized nations have appeared to be moving more nearly in step than they were before. This apparent synchronization has promp ted speculation that inflation and recession are world problems that no longer can be dealt with by notional stabilization poli cies. If indeed we have entered a period of synchronized business cycles, we have a new argument for more closely coordinated economic policies, at least among the larger economies of the industrialized world. Some might go further and argue for a supranational policymaking agency or a world central bank. If the evidence for a world business cycle is not conclusive, however, then the case for closely linked policymaking is less convincing. And so the questions: Is the post-1973 cycle different from what came before? And, depending on the answer to that one, what impact did national policy initiatives and other devel opments have on business cycles during this period? *The author, who joined the Philadelphia Fed's Department of Research in 1974, received his training at the University of Pennsylvania. He specializes in econometrics and macroeconomics. ’In the early 1950s, some attention was given, espe cially by European economists, to cycles induced by fluctuations in international trade. 11 BUSINESS REVIEW SEPTEMBER/OCTOBER 1977 IS THE POST-1973 CYCLE DIFFERENT? FIGURE 1 COINCIDENT INDICATORS SHOW NATIONAL ECONOMIES MOVING AT Business cycles are complex phenomena, and so they’re not easy to study. Since 1920, the National Bureau of Economic Research has analyzed U.S. business cycles and has developed coincident indicators that trace the path of business cycles.2 Recently, the NBER also has developed coincident busi ness cycle indicators for Canada, France, Germany, Italy, Japan, and the U.K. Look ing at the coincident business cycle indica tor for each country should tell us if the post-1973 business cycle is different from the pre-1973 cycle for each and all of the seven countries. But policymakers gener ally are more concerned with movements in the unemployment rate and the rate of infla tion over the business cycle than with changes in the coincident indicators. There fore, we shall be looking also at the unem ployment rate and the percentage change in the consumer price index (CPI) for each of these nations to help put their recent busi ness cycles into perspective. Coincident Business Cycle Indicators. Coincident indicators for each country are composite indexes of such economic mea sures as gross national product adjusted for inflation, industrial production, retail sales adjusted for inflation, and the unemploy ment rate. Figure 1 plots the coincident indicators for each of the seven countries. The overall rise in each country’s index shows how fast that country’s economy is growing. The Japanese economy, for exam ple, has grown the fastest, the British econ omy the slowest. The larger peaks and valleys on these plots coincide with large economic fluctua tions. Prolonged dips correspond to reces sions; steady upward movements corre spond to economic expansions. The low points in the U.S. graph match the reces- 2This terminology has been developed by the National Bureau of Economic Research. 12 FEDERAL RESERVE BANK OF PHILADELPHIA sions of 1958, 1960-61, 1969-70, and 197375. It’s apparent from Figure 1 that fluctua tions in the Canadian economy roughly parallel those in the United States, whereas the same can’t be said for the other econo mies. It’s apparent also that these seven countries moved into the 1973-75 economic slowdown almost in step. But aside from these two items, the graphs show that the national economies have not been moving together. The Appendix presents further evidence that confirms the lack of coinci dence for business cycles before 1973.;i Although most of these countries started their recessionary descents at roughly the same time, both the timing and the pace of their recoveries have been quite different. Canada has recovered fairly rapidly and strongly (that is, Canada’s coincident busi ness cycle index is well above its 1973 level). By early 1977, France, Germany, and the U.S. had barely recovered from the recession, whereas Italy, Japan, and the U.K. had not yet recovered. The British recovery continues weak. Thus, although these seven countries suf fered through recessions at roughly the same time, they seem to be recovering at their own individual paces. The Unemployment Rate. Much the same can be said for the national unemploymentrate histories. Looking at changes in unem ployment rates gives us a basis for compar ing business cycles in these countries. Figure 2 shows that all the unemployment rates rose during the recent recession, but it shows that they rose by different amounts. In Japan, whose graph is nearly flat, the unemployment rate has risen only slightly during slowdowns. Italy’s unemployment rate shows a little more variation but in recent years has been relatively unrespon sive to changing economic conditions. The United Kingdom has seen its unemploy ment rate rising, on average, since 1958; but this rate has dropped during periods when the British economy has shown some strength (in 1960, 1965, and 1973). Sim ilarly, France’s unemployment rate has moved up fairly steadily in the past 15 years. Germany has managed to hold its rate steady for years at a time; but between these long stretches, the unemployment rate has responded to economic slowdowns. Only the U.S. and Canadian rates have moved in tandem since 1958, and these have fluctuated more widely than the rates in the other five countries. In short, because of structural differences in these economies, their responses to busi ness cycles have been and continue to be different. The Consumer Price Index. Unlike the coincident indicators and unemployment, the CPI shows roughly the same pattern for each country (Figure 3). From 1958 to 1972 the rates of inflation for these countries showed secular increases but were gener ally stable, with the exception of France at the end of the Fourth Republic in 1958. Since 1958, the rates of inflation in Can ada, Germany, and the U.S. have been lower than the rates in the other four countries. The rates of inflation in Italy, Japan, and the U.K. are the most volatile among these nations. But the rates of inflation in all countries have moved up and down in response to business cycles. Usually, price increases have slowed down during or soon after recessions. For each of these nations in the 1973-76 period, the rate of inflation was 2 to 3 times as high as the rate of inflation in the 1958-72 period. These price-level rises were particu larly dramatic for Italy, Japan, and the U.K. The recession in each country has slowed the pace of inflation, but not enough in most countries to bring the rate down to 1972 levels. In Italy, inflation accelerated again 3There is some evidence that four of these countries (the U.S., the U.K., Italy, and Germany) experienced growth slowdowns in the early 1970s. But the com bined effect of these slowdowns had a very small impact on world economic growth. 13 BUSINESS REVIEW SEPTEMBER/OCTOBER 1977 FIGURE 2 NATIONAL UN EM PLO YM ENT PATTERNS OUT OF SYNC Unemployment Rate (percent) 8 CANADA 6 4 6 4 GERMANY 2 ITALY 4 2 4 JAPAN 2 8 6 UNITED STATE S 4 5 4 3 FRANCE 2 1 6 4 UNITED KINGDOM 2 1958 1960 1962 1964 1966 1968 SOURCE: Organization for Economic Cooperation and Development. 14 1970 1972 1974 1976 FEDERAL RESERVE BANK OF PHILADELPHIA FIGURE 3 Cons um er Price Index (percent) IN FLA TIO N R A T E S : S A M E DIRECTION BU T D IF F ER E N T M A G N IT U D E S trialized economies in the recent recession? Can these factors recur? And have they changed the structure of the world economy so that business cycle coincidences are more likely? To answer these questions, it’s necessary to explore the roles that economic policy and other factors played during this time. in early 1976. Thus, even before 1973, inflation rates moved more in unison than either the coin cident indicators or the unemployment rates. Nevertheless, even these rates show considerable differences. These three measures—the coincident indicators, the unemployment rate, and the CPI—give us a picture in which one feature stands out: the simultaneity of recession’s onset in the industralized countries in 1973. That’s the point that needs to be explained. Monetary and Fiscal Policy. To determine what role, if any, monetary and fiscal policy played in the recent recession, let’s look at money-supply growth rates and govern ment budget deficits for each of these coun tries. Figure 4 plots money-supply growth rates for the seven countries. The pattern of these WHY WAS THE 1973-75 RECESSION SYNCHRONIZED? What factors contributed to the nearly simultaneous downturn of the large indus 15 B U SIN E SS REVIEW SEPTEMBER/OCTOBER 1977 FIGURE 4 M O NEY-SU PPLY GROWTH: UP HERE, DOWN THERE Annual Rate (percent) CANADA 10 FRANCE GERMANY ITALY JAPAN UNITED KINGDOM UNITED STA TE S 1960 1965 1970 SOURCE: International Financial Statistics. rates is quite different for each country. U.S. growth rates, for example, have been smoother and lower than the rest, whereas the money-growth rates for Canada have been relatively high and have fluctuated more. The upward trends in money-growth patterns that we see in some of these coun tries may explain in part the upward trends in the rates of inflation. Between 1970 and 1973, many of these countries experienced fairly rapid money-growth rates. This prob ably set the stage for the rapid rates of inflation experienced in 1973 to 1975, but it goes only part way toward explaining why these rates were as high as they were. Money-supply growth rates in each of these countries slowed down in 1973 and 1974. But the magnitude of the decline dif fered from country to country, and the tim ing w a s n ’t exactly in phase. The slowdown in money-growth rates may have helped to retard economic activity in each country that suffered a downturn. 16 FEDERAL RESERVE BANK OF PHILADELPHIA Figure 5 plots the government budget deficits for each country. Here again, the picture is an eclectic one.4France, Germany, Japan, and the U.S. had budgets that were nearly in balance up until 1974, while Italy and the U.K. have been running increas ingly large deficits since 1970. Each coun try’s deficit has increased during reces sions, and all seven countries registered unusually large deficits during the last recession. Most economists would agree that government deficits can he inflationary and that whether they are or not depends on how they are financed. Some would argue further that inflation leads to belt tightening by consumers and businesses and, therefore, to recession. Except perhaps in Italy and the U.K., however, the recent large deficits materialized only after infla tion rates had started their upward spirals and after the economic downturns had begun. If anything can be concluded from this sequence of events, it’s that the national recessions drove governments into deficit by reducing their tax revenues and increas ing their expenditures for unemployment insurance and social security. It doesn’t appear that the deficits caused the reces sions. Thus we can attribute only part of the severity and the coincidence of the recent recessions to monetary and fiscal policy. We have to look elsewhere for the key to the 1973-75 slowdown. felt by all countries at roughly the same time. The immediate result was a reduction in the productive capacity and an increase in the rate of inflation of each country.5 Given its timing and effects, the embargo can be blamed, in large part, for the coinci dence and the severity of the 1973-75 reces sions. Similarly, along with price increases for other raw materials, the swift rise in oil prices caused by the embargo was a main contributor to high rates of inflation during 1974 and 1975. The impact of the move from fixed to more flexible exchange rates is a little more con troversial. Some economists believe that this shift may have had a destabilizing effect on the world economy. But most econ omists would agree that in a world with flexible exchange rates, economic fluctua tions will not spill over national boundaries as readily as they might in a world with fixed exchange rates.6 The effect of this change on the world economy has yet to be assessed fully. Therefore it is premature to say because of the change to flexible rates that we do or do not have a world business cycle. ONE POLICY OR MANY? On balance, the evidence available sug gests that we have not entered an era of internationally coordinated business cycles. Except in the case of the most recent slowdown, if there has been business-cycle coincidence among the major industrialized countries, it has been very weak. Further more, changes in economic activity, employment, and even prices have been far from uniform across national boundary lines. Other Factors. The Arab oil embargo and the shift from fixed to relatively flexible exchange rates may shed light on the issue at hand. The embargo and the subsequent oil price increases were severe shocks to the indus trialized nations, and their impacts were ’Because of the oil shortage, fewer oil-dependent goods could be produced; and because of higher oil prices, more of the economy’s scarce resources were drawn into oil importing and away from other produc tive activities. 4The government budget deficit (or surplus) mea sured at full employment is a better indicator of fiscal policy, but it is not available for most of these coun tries. HSee J. M. Westerfield, “Would Fixed Exchange Rates Control Inflation?” Business Review, Federal Reserve Bank of Philadelphia (July/August 1976), pp. 3-10. 17 BUSINESS REVIEW SEPTEMBER/OCTOBER 1977 FIGURE 5 R ECESSIO N Deficits PLU N G ES GOVERNMENTS RED-INK O PE R A T IO N S 18 INTO FEDERAL RESERVE BANK OF PHILADELPHIA that business cycles in these same coun tries would be in step with one another even in the absence of outside shocks. There’s enough evidence to suggest inter national vulnerability to external shocks. But as yet, there’s little evidence to sup port the view that business cycles are closely linked worldwide. Thus it may be prudent for the industrial ized nations to be prepared to bail one another out in case their economies suffer external shocks. But individual nations still are in a position to use traditional stabilization policies in trying to cope with the movements of their own national busi ness cycles. Although monetary policy and fiscal pol icy initiatives may have had some influence on the 1973-75 recession, they can’t take all the blame for the timing or severity of that recession, both of which were caused in large part by the oil embargo. In the absence of shocks of this kind, widespread coinci dent slowdowns probably will not be com mon occurrences in the future. It’s one thing to say that industrial nations, because of their increased depen dence on imported energy and raw materials, are more vulnerable than they used to be to shocks such as the oil embargo. It’s entirely different to suggest 19 BUSINESS REVIEW SEPTEMBER/OCTOBER 1977 APPENDIX In the text of this article, the conclusions regarding the noncoincidence of the pre-1973 cycles were arrived at by eyeballing the data. Since eyeballing is not an entirely satisfactory method, this appendix presents two more precise measures of the interrelations among the indi vidual business cycles. cyclical indicators for the countries being considered. The weights to be used for such a calculation are the gross national products of each country. Two such weighted averages, com puted by the National Bureau of Economic Research, are presented in Figure A.l. The first composite index is for six countries excluding the U.S. This index shows virtually no fluctua tions until 1973. Thus, until then, the business One way to test for a world business cycle is to compute a weighted average of the coincident FIGURE A.l COMPOSITE INDEXES SHOW NO BIG DIPS BEFORE 1973 20 FEDERAL RESERVE BANK OF PHILADELPHIA FIGURE A.2 COINCIDENT CYCLICAL INDICATORS SHOW SIGNIFICANT COHERENCE FOR U S. AND CANADA ONLY FRANCE GERMANY ITALY JAPAN UNITED KINGDOM UNITED STATES s w O z < os u . Key Correlation 1.0 (Coherence) Z < — < 0.0 82 1 .5 Cycle Length (Years) SOURCE: National Bureau of Economic Research cycles in the six countries did not coincide.* The seven-country index, which includes the U.S., shows some fluctuations at U.S. business cycles. This happens because the weight given to the U.S. in this composite index is by far the largest. Another way to measure the interrelation among business cycles is to look at the correla tion of the coincident indicators across business cycles. This measure, known in time series anal ysis as coherence, differentiates between the correlations of two variables for economic cycles which last from half a year to ten years (Figure A.2). For example, if the coherence of two varia bles has a peak for 5-year to 10-year cycles, then it can be assumed that these two variables are correlated across business cycles. But if coher ence has a peak for cycles from 6 months to 2 years in length, the two variables are correlated for very short-term fluctuations and generally don’t move together in business cycles. Usually, coherence of 0.5 or more can be considered evidence of interrelation between two variables. But a high coherence says nothing about causality; it indicates only that two varia bles are related to one another in some way.t The coherence of one pair of countries, the U.S. *The same kind of picture emerges from the weight ed averages of the industrial production or gross national product of these countries. tCoherence may be a poor measure of such interrela tions because the effects of other variables are not held constant. Thus partial coherence may be a better mea sure. 21 BUSINESS REVIEW SEPTEMBER/OCTOBER 1977 and Canada, has a peak at business cycles (7 to 10 years). But for the remaining countries, the interrelation across cycles generally is weak— confirming our observation that from 1955 to 1973 there was no world business cycle. V W V W V W W W W W W V W y W W W W ^ W ^ A W % ft^ ^ W V W ^ W W W W W ^ W W W W W ^ ■ W ■ The Philadelphia Fed’s Department of Research occasionally publishes RESEARCH PA PERS written by staff economists. These PAPERS deal with local, national, and international economics and finance. Most of them are relatively technical and are intended for professional researchers. The entire current series is listed on page 23. All PAPERS in print, except those that have been reissued in other series, are available from this bank. To order copies, mark which ones are desired, detach the order form, place it in an envelope, and send it to RESEARCH PAPERS, Department of Research, Federal Reserve Bank of Philadelphia, 100 North Sixth Street, Philadelphia, PA 19106. Your copies will be sent to the address on your mailing label. 22 FEDERAL RESERVE BANK OF PHILADELPHIA nw w ORDER FORM w w print. 14. Anthony M. Santomero, On the Role of Transaction Costs and the Rates of Return on the Demand Deposit Decision. Out of print. □ 15. Nariman Behravesh, Spectral Estimation of Dynamic Econometric Models with Serially Correlated Errors. □ 16. Janice M. Westerfield, Empirical Proper ties of Foreign Exchange Rates under Fixed and Floating Rate Regimes. □ 17. John J. Seater, A Model of Vacancy Con tacts by Job Searchers. | | 18. Nonna A. Noto, The Effect of the Local Public Sector on Residential Property Values in San Mateo County, California. □ 19. Ronald D. Watson, The Marginal Cost of Funds Concept in Banking. □ 20. Ira P. Kaminow, Economic Stabilization Under Fixed and Flexible Exchange Rates. □ 21. Anthony M. Santomero and John J. Seater, The Inflation-Unemployment Trade-Off: A Critique of the Literature. □ 22. Janice M. Westerfield, The Forward Exchange Market: Risk and Return in a Portfolio Context. □ 23. James M. O’Brien, On the Incidence of Selective Credit and Related Policies in a Multi-Asset Framework. □ 24. Timothy Hannan, The Optimal Control of Heroin Addiction. □ 25. Donald J. Mullineaux, The Stability of the Demand for Money: Some Adaptive Regression Tests on Monthly Data. □ 26. Donald J. Mullineaux, More on the Rationality of the Livingston Price Expectations Data. □ 27. Anthony M. Rufolo, Efficient Local T a xa tion and Local Public Goods. [~1 28. Donald J. Mullineaux, Inflation Expec tations and Money Growth in the United States. □ 29. Anthony M. Santomero and Joseph D. Vinso, Estimating the Probability of Failure for the Banking System. □ 1. Anita A. Summers and Barbara L. Wolfe, Intradistrict Distribution of School R e s o u r c e s to the D i s a d v a n t a g e d : Evidence for the Courts (Philadelphia School Project.) □ 2. Donald J. Mullineaux, Branching Restric tions and Commercial Bank Costs, reissued in the Journal of Business 49 (1976), pp. 402-407. □ 3. Donald J. Mullineaux, Economies of Scale of Financial Institutions: A Comment, reissued in the Journal of Monetary Economics 1 (1975), pp. 233-240. □ 4. Ira. P. Kaminow, Required Reserve Ratios, Policy Instruments, and Money Stock Control, reissued in the Journal of Monetary Economics 3 (1977), forthcom ing. □ 5. James M. O’Brien, The Information Value o f D e m a nd E qu a t i o n Residuals: A Further Analysis. □ 6. Anita A. Summers and Barbara L. Wolfe, Equality of Educational Opportunity Quantified: A Production Function Approach (Philadelphia School Project). [~~1 7. Cynthia A. Classman, Pennsylvania Bank Merger Survey: Summary of Results. □ 8. Anita A. Summers and Barbara L. Wolfe, Manual on Procedure for Using Census Data to Estimate Bl ock I nco me (Philadelphia School Project). □ 9. Anita A. Summers and Barbara L. Wolfe, B l o ck I n c o m e Estimates, City of Philadelphia: 1960 and 1970 (Phila delphia School Project). □ 10. Anthony M. Santomero and Ronald D. Watson, Determining an Optimal Capital Standard for the Banking Industry. □ 11. John J. Seater, A Unified Model of Con sumption, Labor, and Job Search. □ 12. John J. Seater, Utility Maximization. Aggregate Labor Force Behavior, and the Phillips Curve. □ 13. Donald J. Mullineaux, Economies of Scale and Organizational Efficiency in Bank ing: A Profit-Function Approach. Out of □ 23 on Independence M all 100 North Sixth Street Philadelphia, Pa. 19106
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