Full text of Econ Focus (Federal Reserve Bank of Richmond) : Fall 2008, Volume 12, Number 4

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

FALL 2008

THE

FEDERAL

RESERVE

BANK

OF

RICHMOND

VOLUME 12
NUMBER 4
FALL 2008

COVER STORY
12

House Bias: The economic consequences of
subsidized homeownership
Over the past 60 years, various public policies have been aimed
at increasing the number of homeowners in America. Yet economists
worry that the subsidies to this sort of investment have led to
some undesirable consequences. Has the United States invested too
much in homeownership?

Our mission is to provide
authoritative information
and analysis about the
Fifth Federal Reserve District
economy and the Federal
Reserve System. The Fifth
District consists of the
District of Columbia,
Maryland, North Carolina,
South Carolina, Virginia,
and most of West Virginia.
The material appearing in
Region Focus is collected and
developed by the Research
Department of the Federal
Reserve Bank of Richmond.

FEATURES
16

Up in the Air: Carbon policies weigh environmental
and economic risks

DIRECTOR OF RESEARCH

John A. Weinberg
EDITOR

Aaron Steelman

One of the most interesting debates in environmental economics
pits supporters of a carbon tax against those who prefer a cap-andtrade policy. As the economists ponder, a coalition of Northeastern
states is embarking on an experiment to create a market for
carbon permits.
20

Immigrant Entrepreneurs: Talent, technology, and jobs
A quarter of venture-capital backed firms in the United States were
founded by immigrants. Many of these are high-tech and engineering
companies. The modern U.S. economy seems to be driven in large part
by businesses started by newcomers.

SENIOR EDITOR

Stephen Slivinski
MANAGING EDITOR

Kathy Constant
STA F F W R I T E R

Betty Joyce Nash
E D I TO R I A L A S S O C I AT E

Julia Ralston Forneris
R E G I O N A L A N A LY S T S

Matthew Martin
Sonya Ravindranath Waddell
CONTRIBUTORS

Khalid Abdalla
Matthew Conner
DESIGN

Beatley Gravitt Communications
C I RC U L AT I O N

DEPARTMENTS

1 President’s Message/Thornton, Bagehot, and the Modern Central Bank
2 Federal Reserve/Dollarization Explained
6 Jargon Alert/Principal-Agent Problem
7 Research Spotlight/Microbanks
8 Policy Update/Bidding Begins for Maryland “Racinos”
9 Around the Fed/Lending During the Volcker Disinflation
10 Short Takes/News from the District
23 Interview/Joseph Gyourko
28 Economic History/The North Carolina Gold Rush
31 Book Review/The Price of Everything
32 District/State Economic Conditions
40 Opinion/Why the Great Depression Matters

Shannell McCall
Published quarterly by
the Federal Reserve Bank
of Richmond
P.O. Box 27622
Richmond, VA23261
www.richmondfed.org

Subscriptions and additional
copies: Available free of charge
by calling the Public Affairs
Division at (804) 697-8109.
Reprints: Text may be reprinted
with the disclaimer in italics
below. Permission from the
editor is required before
reprinting photos, charts, and
tables. Credit Region Focus and
send the editor a copy of the
publication in which the
reprinted material appears.
The views expressed in Region Focus
are those of the contributors and not
Dnecessarily those of the Federal Reserve
Bank of Richmond or the Federal
Reserve System.
ISSN 1093-1767

COVER PHOTOGRAPHY: GETTY IMAGES

PRESIDENT’SMESSAGE
Henry Thornton, Walter Bagehot, and the Modern Central Bank
n the last issue of Region
Focus, I discussed some of
the problems that could
result from Federal Reserve
support to troubled financial
institutions. In particular, I
argued that such support, if not
done properly, could encourage
institutions to take on risks that
they otherwise would avoid.
This, of course, is the issue of
moral hazard, and it should
remain in the forefront of the
minds of policymakers as the economy recovers from the
current financial upheaval.
But that raises an interesting issue: How can central
banks assist distressed financial institutions without inducing undesirable future behavior by those institutions?
In short, how can the Fed act effectively as the lender of last
resort?
There is no precise answer to those questions. When the
Fed intervenes in the market, its actions often have effects
that could not have been perfectly forecast. Policymakers
rely on economic science to guide their decisions, but
policymaking itself is not an exact science. Instead, it is a
complicated exercise that often requires people to act on
incomplete information, using the best data and theory
available to form decisions.
Such theory is often new work done by leading contemporary economists. But not always. There are times when
policymakers can learn much from the writings of the classical economists. I think that the current situation is such
an instance.
Writing in the 19th century, Henry Thornton and later
Walter Bagehot offered thoughtful advice as to how the
Bank of England could act effectively as the lender of
last resort. As my former colleague Thomas Humphrey
has written, the Thornton-Bagehot framework stressed six
key points:

I

• Protecting the aggregate money stock, not
individual institutions.
• Letting insolvent institutions fail.
• Accommodating only sound institutions.
• Charging penalty rates.
• Requiring good collateral.
• Preannouncing these conditions well in advance
of any crisis so that the market would know what
to expect.

This, I believe, is a good place for modern central
bankers to start when they think about how to lend to troubled institutions. If the Fed is going to make funds available,
it should do so with the primary goal of protecting sound
institutions and the financial industry as a whole. It should
not attempt to save every institution. The optimal level of
failure in any industry is not zero, and that includes the
financial industry.
This is often a fine line to walk. There are cases where it
is difficult to know in advance how much collateral damage
would result if an institution were to fail. But if the rules
of the game are spelled out clearly and the market believes
the Fed will stick to those rules, then banks will have a
strong incentive to avoid putting themselves in situations
where they must come to the Fed to borrow at abovemarket rates. Moreover, banks will seek to protect themselves against a sudden loss of access to liquidity, promoting
efficiency and stability in the financial system.
We are going through what is, in many ways, an unprecedented period in American economic and financial history.
Economists and policymakers — and I count myself among
both groups — do not know exactly why the financial sector
has encountered such disruptions recently, although many
plausible hypotheses have been proposed. More to the
point, however, we do not know exactly how to most effectively help that sector get through this period. The best we
can do is to rely on sound theory, data, and judgment to not
only restore the health of the financial sector but also to
avoid similar upheaval in the future. In this case, I believe
that means drawing upon some longstanding principles
about central bank policy. They do not provide all the
answers, but they do provide a framework that should
prove very useful to the Fed and other central banks around
the world.

JEFFREY M. LACKER
PRESIDENT
FEDERAL RESERVE BANK OF RICHMOND

Fa l l 2 0 0 8 • R e g i o n Fo c u s

1

FEDERALRESERVE
Dollarization Explained
BY ST E P H E N S L I V I N S K I

In some developing
countries, monetary
stability might best
be achieved by
officially adopting
a stable foreign
currency.

Argentina instituted a “currency
board” system in 1991, but
never adopted a policy of full
dollarization. Argentine pesos
like those pictured are still
in circulation today.

2

R e g i o n Fo c u s • Fa l l 2 0 0 8

o understand the power of
currency to decide the fate of
nations — developing nations,
in particular — Manuel Hinds,
the former finance minister of El
Salvador, says it helps to know the
fable of Dema Gogo.
Gogo is the president of a fictional,
poor developing nation. Shortly after
he assumes office, he has a conversation with the devil, who passes along
an idea he got from a recently
deceased macroeconomist: Create
your own currency, make it the legal
tender, and force citizens to relinquish
their dollars in exchange for the new
currency. This appeals to Gogo since it
would allow the government to create
as much money as it wants and still
receive interest from placing the
newly acquired dollars in a
U.S. savings account. It’s
called
seigniorage,
says the devil. A perfect solution, it
seems, for a new
ruler who wants to
finance all the public works projects he
was sure would
secure his continued
incumbency. He even
gives the currency the
name “gogo.”
But as is always the
case with Faustian
bargains, there are
unexpected consequences.
Oversupply of the currency creates
inflation. That’s a nice thing for
exporters who can sell to overseas
consumers in exchange for more-valuable dollars but bad for laborers who
have begun to protest the increased
prices of imports.
So the devil suggests devaluing the
currency by raising the official
exchange rate of the dollar from one
to two gogos. That protects the

T

government’s reserve of dollars from
falling lower due to increased demand
by citizens for the sounder currency.
But it also scares international
investors afraid of another devaluation
and suddenly the country faces higher
interest rates in international capital
markets.
The vicious spiral continues. More
political pressure from labor unions
spurs the president to order the printing of more gogos to pay wages. Then
his advisors tell him that he has lost
all credibility with foreign creditors
and many voters. Soon, the president
finds himself running from an angry
mob of citizens and during the pursuit
falls off a cliff to his death.
This fable provides insight to the
very real havoc created by political
control over monetary policy in the
developing world, particularly in Latin
America. As a response to those economically dangerous impulses, some
economists have suggested that a way
for these economies to break out of
the trap is to hitch their currency to
the U.S. dollar — an action known as
“dollarization.” Yet there are a variety
of ways of achieving this, and the
distinctions between them could
have important consequences for
economic growth.

The How and Why
of Dollarization
The term “dollarization” describes a
shift away from a country’s domestic
currencies toward a foreign currency
— typically the U.S. dollar, but not
always — as a store of value, unit of
account, and medium of exchange.
Official dollarization occurs when a
country explicitly makes a foreign currency the preferred legal tender.
There are a few countries that have
taken this direct route. The two
biggest economies in this category are
El Salvador and Ecuador. The former

Dollarization also reverses the
has been dollarized since 2001,
isolation that results from having
the latter since 2000. Panama
The main benefit of official
an unstable currency: The newly
dollarized in 1904. There are four
dollarized economy will soon find
other smaller countries that have
dollarization would come
itself more integrated with interfully dollarized: the Marshall
national capital markets. And the
Islands, Micronesia, Palau, and the
from the monetary stability
ability of businesses to make longBritish Virgin Islands. Puerto
term plans becomes more viable
Rico, the Northern Mariana
that follows from the divorce
with the stability of the newfound
Islands, American Samoa, Guam,
currency.
and the U.S. Virgin Islands are dolof politics and
There are trade benefits, too,
larized, too, as a result of being
which are especially important to
U.S. territories.
monetary policy.
developing countries for which
But the shift toward a foreign
exports compose a large share of
currency can occur in countries in
the economy. Dollarization reduces the transaction cost of
which it is not considered legal tender. In fact, this form of
exchanging one currency for another. This may not seem like
“unofficial” dollarization in which citizens prefer other cura big problem, but it certainly can have real effects. Take
rencies in domestic transactions or as a means to safeguard
trade between Canada and the United States, for instance.
the value of their bank savings is more common than the
Various studies have concluded that Canadian provinces
official form.
tend to trade more with each other than with states in the
While data on the scope of unofficial dollarization worldUnited States to which they are closer geographically. Even
wide are hard to come by, the most recent figures from
with lower trade barriers between the two countries since
economist Edgar Feige of the University of WisconsinNAFTA, it appears that the transaction cost of trading out
Madison are illustrative. The countries with the highest
currencies has been a contributor to lower trade volume
degree of unofficial dollarization — the amount of foreign
than one would otherwise expect.
currency in circulation in each country as fraction of the
But there is another side of this coin, so to speak. From
effective money supply — were Bolivia, Nicaragua, Uruguay,
the perspective of policymakers, there are indeed downsides
Croatia, and Russia (see table on page 4).
to getting rid of the government’s control over monetary
The holders of foreign currency in these economies are
policy. It eliminates the ability of a central bank to serve as a
investing in a hedge against the (often very high) inflation of
lender of last resort and pursue other actions that can protheir domestic currency. So the main benefit of official dolvide stability to the macroeconomy in the face of aggregate
larization — especially when coupled with an elimination of
supply or demand shocks. The government would also lose
the central bank functions of the government — would
the revenue generated by seigniorage.
come from the monetary stability that follows from the
Others have argued that the incentives of the anchor
divorce of politics and monetary policy. The transaction
country could be altered by widespread dollarization of
costs from shifting to such an arrangement could also be low
developing economies. Because the anchor country presumin the countries listed here since so many citizens already use
ably already has a central bank with the ability to adjust to
the sounder currency.
economic shocks, the policymakers there might have to conThere are other ways of dollarizing an economy. Instead
sider how their actions will affect the smaller countries that
of eliminating the central bank function, a government can
rely on their monetary stability This won’t be a problem if
replace it with a “currency board.” This board would be
the anchor country is likely to experience the same sorts of
responsible only for maintaining a specific exchange rate
simultaneous shocks as the dollarized country. But if the dolbetween the domestic currency and the foreign currency of
larized countries are subject to idiosyncratic shocks that are
choice. Another solution would be to keep the country’s
foreign to the anchor country, there may be international
central bank in its old form and task it with the exchange
pressure on the latter to take a policy stance that benefits
rate stability role. These forms of “soft” dollarization, howthe former.
ever, could tempt policymakers to use the monetary tools
Dollarization could also deal a blow to “national pride” in
that are still available to them and weaken the currency
a country that adopts it. Few politicians are likely to want to
again. (As we’ll see later, that’s the problem that afflicted
admit that their country’s currency is troubled. Indeed, such
Argentina.)
a concern among policymakers in the developing world is
The textbook version of any of these forms of dollarizaoften pointed to by economists like Nobel laureate Robert
tion would lead to a more hospitable environment for
Mundell as a reason for why more countries don’t dollarize.
economic growth. In a predollarized scenario, the risk
Perhaps most fundamentally, dollarization will achieve its
premiums — and, therefore, interest rates — charged by
desired goal only if the anchor country pursues wise moneoverseas lenders would be high. In a dollarized scenario,
tary policies that result in price stability. For instance, that
lower real interest rates for those borrowing from internahas generally been the case in the United States for more
tional capital markets follow when the risk premiums fall.

Fa l l 2 0 0 8 • R e g i o n Fo c u s

3

Unofficial Dollarization
Index: Reported Ratios of
Dollar Holdings in Foreign
Economies (2003-2004)

grated with international financial markets, particularly after banking laws were
liberalized in 1970.
Juan Luis Moreno-Villalaz explained it
this way in a 1999 article, authored when
he was an advisor to the Ministry of
Country
Economy and Finance in Panama:
Argentina
68.8
“Panama’s monetary system operates as if
Armenia
45.3
it were a competitive macroeconomy,
Belarus
58.9
since monetary equilibrium is the result
of private-sector decisions without govBolivia
83.5
ernment intervention or distortions.”
Bulgaria
55.6
Not all dollarization experiments have
Costa Rica
47.5
begun as peacefully as Panama’s. An
Croatia
72.7
example of a more recently dollarized
Czech
25.9
economy is Ecuador, which adopted
the U.S. dollar as the official currency
Estonia
17.4
in 2000.
Hungary
20.6
Ecuador’s economic growth was stagKyrgyzstan
41.4
nating in the 1990s because of a heavy
Latvia
48.7
government presence in the economy.
Lithuania
31.5
Policymakers attempted and failed to
open the country to international trade
Mexico
25.8
and capital markets. Meanwhile, political
Nicaragua
76.4
unrest began to build as the large concenPeru
57.5
tration of business involved in oil
Poland
18.0
exporting took a hit when oil prices fell,
Romania
36.1
taking sections of the economy down
with it. A collapse of the banking system
Russia
72.6
followed in the late 1990s around the time
Turkey
46.7
that the atmospheric phenomenon
Ukraine
44.9
El Niño had a devastating impact on
Uruguay
74.1
production and infrastructure. Runaway
Venezuela
18.0
inflation, the result of an overly permisSuccessful Dollarization
sive and politicized central bank prior to
in the Real World
SOURCE: Edgar L. Fiege, University of
the crisis, was also a factor.
Wisconsin-Madison
So, dollarization was adopted as part
To see how a small country can function
of the solution, along with the privatizaas a dollarized economy, you don’t have to
tion of some state-owned enterprises, and liberalization in
look any farther south than Panama, which adopted the U.S.
labor markets. But it was done in the midst of a political cridollar as the official domestic note in 1904. (Panama does
sis that accompanied the economic downturn. Ecuador had
circulate a domestic coin — the “balboa” — but it is fully
gone through four presidents between 1996 and 1998. When
convertible at a rate of one coin for one U.S. dollar.)
the sitting president, Jamil Mahuad, announced the dollarThe dollarization of Panama did not occur in a political
ization policy in January 2000, he was deposed days later.
vacuum. The U.S. government had a specific interest in
His successor, Vice President Gustavo Noboa, stuck to the
building a canal there as the 20th century dawned and was
policy and by 2003, his last year in office, the inflation rate
encouraging the Panamanian government to declare indewas 7.9 percent — down from close to 100 percent in 2000
pendence from Colombia. When it did so in 1904 and new
— making it the first year since 1972 to see a single-digit
independent governmental institutions were established, no
inflation rate.
central bank was created and the U.S. dollar became the de
facto official currency.
The absence of a central bank, however, does not mean
The Perils of Soft Dollarization
there are no options for the private banking system looking
The Ecuador example shows how dollarization can follow
for a lender of last resort in an economic tumult.
massive economic dislocation and political unrest. Yet it also
Panamanian banks have established lines of credit with forhints at how the form that dollarization takes can affect the
eign banks that have branches in Panama and can draw on
outcome. The Ecuadorian government opted for a soft form
those in a liquidity crunch. In fact, Panama is very well-inteof dollarization — it retained the central bank and allowed
than two decades, but there have also
been missteps along the way, such as in
the 1970s, when inflation reached double
digits. Under such circumstances, it’s
unclear that dollarization is preferable to
maintaining an independent currency
and central bank.
Still, from the perspective of most of
the citizens who hold the currency, only
the last of these concerns is likely to be
seen as an actual downside. And there
have been solutions proposed to overcome some of these shortcomings
perceived by policymakers. Take the loss
of seigniorage, for example. The anchor
countries could easily share the seigniorage revenue with the countries that adopt
its currency. Such a revenue-sharing
arrangement existed between the British
government and some of its colonies
before the 1950s. There also exists a
seigniorage-sharing agreement between
the European Central Bank and the
countries that have adopted the euro.
Still, the opposition among policymakers in developing countries to
dollarization is probably the most robust
barrier to such policy changes. Exploring
the successful experiments with dollarization in Latin America can help us
understand the circumstances under
which a developing country might adopt
such a policy.

4

R e g i o n Fo c u s • Fa l l 2 0 0 8

it to function as a lender of last resort. Today, some
observers suggest that the future of dollarization remains
uncertain in the face of recent stresses to that country’s
banking system.
A country that most vividly illustrates the perils of soft
dollarization is Argentina. President Carlos Menem came to
office in 1989 during a period of economic stagnation. The
next year, the inflation rate topped 20,000 percent.
Dollarization of the economy began in 1991 and was
relatively painless since most citizens preferred dollars anyway, and had large holdings of them. (Dollar notes were
estimated to exceed domestic currency notes and bank
deposits combined.)
The form that dollarization took here was soft too. The
mechanism used was widely called a “currency board.” It was
tasked with overseeing the convertibility of the currency
and offered anyone who wanted to trade in their pesos for
dollars a 1-to-1 exchange rate. It was a credible commitment
because the board was required to hold dollars in reserve as
means to make good on the exchange and was presumably
bound by the expectation that they would not embark on a
discretionary monetary policy.
This arrangement was in some ways a concession to the
sovereignty concern. At the time, pesos were still in circulation and considered legal tender, but the convertibility of
them to dollars made the U.S. currency the de facto medium
of exchange. Yet it was indeed successful in reducing inflation to single digits by 1993.
But the currency board deviated from the textbook
definition. There were some loopholes in the reserve
requirements. The Argentina currency board was able to
hold a certain percentage of government-issued bonds
instead of foreign currency. And the government was quite
eager to run up debt in the years after the currency board
was created.
International investment in the region slowed after international shocks, like the East Asian and Russian currency
crises, and local ones, like the devaluation of the Brazilian
currency. A recession resulted, but that alone wasn’t
enough to threaten the currency board structure. Instead,
Argentina’s government had trouble paying interest on the

international and internal debt it had racked up over the preceding decades. In addition, skepticism of the government’s
commitment to convertibility spooked the markets and
began a “silent run” on bank deposits.
By this time, the government was led by officials who
were known to be less fond of the currency board structure.
By the middle of 2001, the government was well on its way
to devaluing the peso by violating the convertibility rule.
They also announced a separate set of exchange rates for
various export transactions. Thus, the currency board
ceased to be a rules-based institution that bound the hands
of policymakers.
Advocates of hard dollarization argue that Argentina
would be in better shape if the discretionary power of the
currency board was taken away completely. They arguably
have a point: When the Argentine peso faced inflationary
pressure from speculators in 1995, the government was able
to reduce that pressure by threatening to shift to
hard dollarization and to get rid of the peso
altogether. By threatening a less discretionary policy, they were able to protect
their currency.
Over time the allure of monetary
sovereignty and political pressure prevailed. Economist Kurt Schuler,
currently with the U.S. Treasury
Department, has tallied up the costs to
these sorts of political preferences and discovered that they are steep. Between 1971 and
2000, developing countries without central banks had
about as much inflation as developed countries with central
banks. Presumably the latter learned very important lessons
from the period of high inflation in the 1970s. But developing countries with central banks have far less success:
Average annual inflation was about 10 times higher in those
countries.
Sometimes truth and fiction look disturbingly similar.
The story of Dema Gogo provides us with insight on monetary experiments in the developing world. Unfortunately, for
many of those countries the fable continues to be closer to
reality than myth.
RF

READINGS
ˇ
Bogetic´, Zeljko.
“Official Dollarization: Current Experiences and
Issues.” Cato Journal, Fall 2000, vol. 20, no. 2, pp. 179-223.
Feige, Edgar L., and James W. Dean. “Dollarization and Euroization
in Transition Countries: Currency Substitution, Asset Substitution,
Network Externalities, and Irreversibility,” in Monetary Unions and
Hard Pegs, eds. Volbert Alexander, Jacques Mélitz, and George M.
von Furstenberg. New York: Oxford University Press: 2004,
pp. 303-321.

Hinds, Manuel. Playing Monopoly with the Devil: Dollarization and
Domestic Currencies in Developing Countries. New Haven, CT: Yale
University Press, 2006.
Salvatore, Dominick, James W. Dean, and Thomas D. Willett, eds.
The Dollarization Debate. New York: Oxford University Press, 2003.

Fa l l 2 0 0 8 • R e g i o n Fo c u s

5

JARGONALERT
Principal-Agent Problem
magine a firm hires a new employee. His job includes
examining the competing bids from the firm’s suppliers and preparing reports on the merits of each. How
does the firm know the employee will handle this task dutifully? It may be easier to simply make up facts than to
thoroughly research the bids. Or the employee may favor
one supplier over another for reasons completely unrelated
to the merit of the proposal — because of a family connection, for instance.
This is an example of what economists call the “principalagent problem.” In this scenario, the employer is the
“principal” and the employee is the “agent.”
The interests of agents are not perfectly
aligned with those of the principals. Yet the
principals can only imperfectly monitor the
actions of the agents. This means that
agents can advance their own interests at
the expense of those of the principals.
An employer can respond to the agency
problem by increasing the monitoring of
employees. This could be achieved through,
among other things, enhanced management scrutiny of employee work. But this
requires a significant investment of the
employer’s time and resources.
So economists have long pondered lesscostly incentive plans that would align the
interests of employees with those of
employers. The main way of doing that is to
tie employee compensation to the performance of the firm
or a specific metric of that firm’s success or productivity.
One popular policy among publicly listed firms is the
granting of stock options to employees, often upper management. These stock options are a part of an employee’s
compensation and they rise in value as the firm’s stock rises
in value. This ties the financial well-being of the stock
option recipient directly to that of the firm.
However, stock options can create their own set of
perverse incentives. In recent years, some firms have been
scandalized by the practice of “backdating.” Firms that offer
stock options to employees are required to disclose to the
government the date at which the stock option was offered.
This is used to determine the fair market value of the option.
Listing a date that is earlier than the actual date the option
was offered could inflate the value of that form of compensation. Yet, stock options are still widely used by publicly
listed firms — indeed, analysis has shown that they are an
effective way of overcoming the agency problem and
accompany increases in a firm’s value — although there is

I

6

R e g i o n Fo c u s • Fa l l 2 0 0 8

more care paid to their disclosure procedures today.
The link between an individual employee’s effort and the
performance of the company’s stock can be tenuous. A more
direct way to deal with the agency problem is performancebased pay. Year-end bonuses are a common form of this sort
of pay system. Another type of performance-based pay is
one when workers are paid a “piece rate” in which they are
compensated per unit of work. For example, vegetable or
fruit pickers might be paid by the number of pounds picked.
The piece rate system can work well for jobs or industries
where the productivity of a worker can be clearly tied to
some unit of final production.
The attempts of firms to ameliorate the
agency problem could also have effects
beyond the walls of the individual firms
themselves. In 1984, economists Carl
Shapiro and future Nobel Prize-winning
economist Joseph E. Stiglitz constructed a
model in which a particular solution to the
principal-agent problem could increase
unemployment.
In the Shapiro-Stiglitz model, employers pay workers an above-market wage
called an “efficiency wage” so as to prevent
workers from shirking — that is, slacking
off. The cost to an employee of getting
fired — the lost wages — would be higher,
thereby inducing an employee not to shirk.
Yet, if one firm pays efficiency wages,
then all firms will likely face an incentive to pay efficiency
wages to compete for workers. This would temporarily
remove the incentive to avoid shirking since losing a job
at one firm wouldn’t necessarily entail a pay cut at an
alternative job. However, if all firms pay efficiency wages,
then wages will be above the market-clearing level, resulting
in involuntary unemployment. This decreases the chances
that a fired worker will find a replacement job and
encourages the employee not to shirk. So, in the end,
efficiency wages serve their goal of mitigating the principalagent problem but at the cost of bringing about higher
unemployment.
There are other proposals to align the incentives of workers with employers. One is the use of “seniority wages,”
when workers are initially hired at a rate lower than their
marginal productivity, but see their wages rise as they
demonstrate their value to a company. The type of arrangement that helps solve the principal-agent problem will be
largely determined by a firm’s production processes, and
thus can vary widely across industries.
RF

ILLUSTRATION: TIMOTHY COOK

BY K H A L I D A B DA L L A

RESEARCHSPOTLIGHT
Microbanks: Subsidy Dependent or Self-Sufficient?
BY M AT T H E W C O N N E R

researchers used a financial self-sufficiency ratio, a measure
he goal of “microbanks” is to reduce poverty by proof a bank’s ability to generate enough revenue to cover its
viding short-term, low-principal loans that serve to
costs. The ratio is derived from revenue divided by the sum
increase access to credit which might otherwise be
of adjusted financial expenses, adjusted net losses from
closed to those in the developing world. The literature conloans, and adjusted operating expenses.
cerning microlending ranges from unabashed praise to
Village banking serves the poorest customers, with an
harsh criticism.
average loan size of approximately $149, but it also reaches a
Some see the trend as one of the greatest forms of
large number of borrowers. The troubled financial positions
humanitarianism in recent years — Muhammad Yunus,
of the clientele causes the average interest rate of villagefounder of the Grameen Bank of Bangladesh, one of the
based loans to be the highest of the three types studied.
pioneer microbanking programs, recently received the
These banking operations also face the highest average
Nobel Peace Prize. Others see microlending as little more
costs, since the small loan amounts
than a glorified welfare program.
generate small incremental paySubsidies appear to play a very
“Financial Performance and Outreach:
ments compared to the operating
large role in the sustainability of
A Global Analysis of Leading
costs associated with managing
nearly all microbanks. This is due
such a vast number of outstanding
to the fact that microbanks face
Microbanks” by Robert Cull, Asli
loans. According to the survey, the
two large problems. One, they
Demirgüç-Kunt, and Jonathan Morduch.
average return on assets for villend primarily to people who can
Economic Journal, February 2007,
lage-based lending was negative.
offer no collateral. Two, they
The banks that employ the
attempt to generate profit while
vol. 117, pp. 107-133.
group lending technique follow
granting relatively small loans.
the same guidelines as the village
Even the Grameen Bank of
banks but on a smaller scale. Group banks have an average
Bangladesh, which has reported profits nearly since its
loan amount of $430.98 and also charge slightly lower interinception, may not be as self-sufficient as once thought.
est rates, given that their clients are financially better off and
According to economist Jonathan Morduch of New York
are more likely to fully repay loans. Operating costs are also
University, when Grameen's accounts are followed over
lower than village-based lending because of the larger loan
time, he finds that “categories and expenses are moved
amounts and smaller outreach, but these banks also show a
around to ensure that Grameen posts a modest profit.”
negative return on assets.
In addition, he also notes the fact that the subsidy rate (as
Individual-based lenders are the only group that reported
a percentage of total loan portfolio), while falling over recent
profit not enhanced by subsidies and grants, but they also
years, still rests at approximately 9 percent. In a comprehenexhibited the lowest amount of outreach. The average loan
sive survey of microfinance firms targeting the poorest
amount for these banking operations is approximately
borrowers, research showed that these banks were generat$1,220, which reduces average costs and allows for a slightly
ing only enough revenue to cover 70 percent of their
positive return on assets.
full costs.
Working with customers who can handle such large loans
However, microbanking is a very complex industry with
and are obviously not the “poorest of the poor” seems to
many variations in how each institution lends money and the
veer from the primary targets of microbanking. There
mechanisms used to encourage repayment. In a recent
appears to be a viable trade-off between profits and outarticle, Morduch and economists Robert Cull and Asli
reach, with the more profitable banks possibly experiencing
Demirgüç-Kunt of the World Bank performed a global
what the authors refer to as “mission drift,” or a shift toward
analysis of leading microbanks. They split microbanks into
prioritizing revenue over the reduction of poverty.
three categories depending on lending type: 1) village lendThis situation presents a conundrum. It seems that the
ing in which there is large-scale joint liability for repayment
surest way to be a successful microbank is to act more like a
2) group lending where the focus is on self-formed groups of
traditional bank. The authors note that there are “examples
borrowers (solidarity groups) that assume joint liability for
of institutions that have managed to achieve profitability
repayment and 3) individual lending that centers around a
together with notable outreach to the poor — achieving
more traditional bilateral relationship between bank and
the ultimate promise of microfinance. But they are, so far,
customer.
the exceptions.”
RF
To assess the profitability of these microbanks, the

T

Fa l l 2 0 0 8 • R e g i o n Fo c u s

7

POLICYUPDATE
Bidding Begins for Maryland “Racinos”
BY B E T T Y J OYC E N A S H

aryland voters have decided to go ahead and take
a chance. In the fall of 2008, they approved an
amendment allowing slot machines. Up to 15,000
video lottery machines at five locations could bring $660
million annually for the first eight years to the state education trust fund (48.5 percent of gross revenue) when fully
implemented by 2013. The amendment’s supporters billed
the slots revenue as a way to invest in education and also
perk up the state’s foundering horse industry.
But revenue projections vary. To collect the estimated net
$660 million, the state must capture all the money
Marylanders now spend at slot machines in neighboring
states, plus generate dollars from new gambling at a rate of
150 percent above current levels, according to an analysis by
the Maryland Institute for Policy Analysis and Research.
Maryland will get about $90 million, earmarked for education, just from the sale of licenses to slot operators as early
as 2010, with about $150 million coming in the following
year. “It’s going to cost you to bid for one of these licenses,”
says Michael Hopkins, executive director of the Maryland
Racing Commission. Bids are due Feb. 1, 2009. Magna
Entertainment Corp., the biggest racetrack owner in
North America and parent of the Maryland Jockey Club,
plans to bid for machines at its property Laurel Park, home
of the Pimlico Race Course and the Preakness Stakes. But
not all machines will be installed at tracks — there will be a
slots operation in downtown Baltimore and one at Rocky
Gap State Park in Allegany County in the state’s western
panhandle.
The money may help the state budget deficit. It won’t be
a long-term solution to fiscal problems, though. Even gambling states like Nevada are currently in fiscal distress.
The statewide referendum amended the constitution to
allow slots, and any expansion of gambling will require
another amendment. In addition to wagering at horse
tracks, there are currently three off-track betting locations
in Maryland. Slot machines will be installed in five geographically dispersed locations. Previously the law allowed
only nonprofits to operate slot machines. Some of these can
be found on the Eastern Shore in the halls of charitable veterans’ organizations.
Laurel Park is on track for 4,750 machines in Anne
Arundel County within two miles of Route 295. Ocean
Downs in Worcester County may get 2,500. (Some Ocean
City businesses weren’t too happy about that — they’re
worried people will spend money on slots rather than
T-shirts and restaurants.) Other sites include the 3,750
machines in Baltimore City, Cecil County with 2,500
machines within two miles of Interstate 95, and 1,500

M

8

R e g i o n Fo c u s • Fa l l 2 0 0 8

machines in Allegany County.
Maryland’s horse industry wanted slot machines because
slots gambling in West Virginia, Delaware, and Pennsylvania
helps fund larger purses and that means more and better
quality horses compete at those tracks. That attracts racers
and breeders away from Maryland.
Racing days in Maryland have fallen from 306 days 15
years ago to 185 days in 2007, according to an August 2007
report by the Maryland Department of Labor, Licensing and
Regulation. The horse racing industry nationwide is in
decline because of growing competition for dollars from
other entertainment.
Of gross slots revenue, no more than 33 percent is slated
for the operators, 7 percent will enhance race purses and
provide funds for the breeding industry (up to $100 million
annually), and 5.5 percent will go to localities to defray costs
(such as increased police presence) associated with the slot
machines.
There will also be 1.5 percent for small, minority, and
women-owned business investment accounts, 2 percent to
the state lottery for administrative costs, and another
2.5 percent for racetrack renewal. The rest is promised
to education. A “problem gambling fund” will also receive
$6.4 million annually. The money will, in part, pay for a study
to assess the level of pathological gambling in the state.
The horse industry occupies a special niche in Maryland,
but represents only 0.4 percent of the state’s $250 billion
overall economic activity, according to economist Robert
Carpenter of the University of Maryland, Baltimore County
and the Baltimore office of the Federal Reserve Bank of
Richmond.
Earmarks from slots for purses and breeders and racetracks amount to an industry subsidy, say some critics.
“Saving a dying industry just doesn’t make sense,” says
Donald Norris, chair of the department of public policy at
the University of Maryland, Baltimore County. Slot machines
may also compete with existing forms of state-sanctioned
gambling and potentially lower revenue in other ways.
While slots money should not directly affect the state’s
general fund — they are transfers between gamblers and earmarked funds, such as the education trust fund — lottery
sales are expected to decline by 10 percent with slots competition, according to Norris. Some people also will
substitute slot play for shopping, lowering tax revenue for
this source.
Norris explains that the social costs of the new slot
machines could reach $228 million annually. Those include
increases in crime, bankruptcy, cost related to gambling
addiction, divorce, among others.
RF

AROUNDTHEFED
Lending During the Volcker Disinflation
BY M AT T H E W C O N N E R

“The Effect of Monetary Tightening on Local Banks.” Rocco
Huang. Federal Reserve Bank of Philadelphia Working Paper
08-20, September 2008.

eginning in 1979, the Federal Reserve under Paul
Volcker instituted an anti-inflationary policy that
focused on a drastic tightening of the money supply. At
the time, the banking system in the United States was fragmented geographically due to restrictions on local banks
that prohibited them from opening branches across county
lines. Bank holding companies, however, were able to have
subsidiaries in numerous counties. In theory, this should
have made them more resilient in the face of monetary
tightening because they could move capital between regions
with differing demand for loans.
This paper presents new empirical evidence that suggests
Fed policy did, in fact, affect isolated local banks more
intensely than banks with operations spread across county
lines. The study covers the period between 1977 and 1986, a
time frame that includes tight as well as expansionary monetary policy stances by the Fed. The results of the analysis
were consistent with theory: “Other things being equal,
local banks’ loan supply exhibits stronger sensitivity to monetary policy, compared with that of nonlocal banks.” In a
contractionary environment, the lending of local banks grew
much more slowly relative to bank holding companies with
branches than they did under an expansionary policy.
Huang reports that this historical experience suggests
that the banking sector’s increasing consolidation and
multicounty nature, accompanied by a decline in market
share of local banks, might have contributed to the stability
in the financial sector and could, therefore, help the Fed to
better focus on price stability.

B

“Can Smart Cards Reduce Payments Fraud and Identity
Theft?” Richard J. Sullivan. Federal Reserve Bank of Kansas
City Economic Review, Third Quarter, 2008, pp. 35-62.

ith the advent of electronic monetary transactions,
the potential for identity theft and payment fraud
has increased. Payments can sometimes be authorized by
asking the purchaser to verify personal information such
as an address or a phone number. But this presents an
obvious flaw as this information can be obtained by a
criminal who can then impersonate the cardholder.
Sullivan describes a safer alternative to these payment
systems: “smart cards” that use less personal information
for purchase verification and don’t require a magnetic
strip. Smart cards require a user to provide a personal

W

identification number (PIN) but they also contain a computer chip that stores a digital signature. After the customer
enters the PIN, the terminal in which the card has been
scanned can verify it against the encrypted information on
the card.
This sort of smart card has not been deployed in the
United States and Sullivan offers a possible explanation as to
why. In his view, offering differing security standards can
be seen by vendors as a way to gain advantage over their
competitors. This could reduce the willingness of these
parties to participate in developing a consistent industrywide security standard. “Even if the societal benefits justify
their cost, payment smart cards with strong authorization
security may be adopted slowly,” Sullivan concludes.
“How Economic News Moves Markets.” Leonardo Bartolini,
Linda Goldberg, and Adam Sacarny. Federal Reserve Bank of
New York Current Issues in Economics and Finance, August
2008, vol. 14, no. 6.

conomic data releases from the U.S. government and
private agencies can have effects on the movements of
the financial markets. The intensity of the response to
these reports, however, seems to vary. The authors of this
study compared the reactions of the markets to the release
of 13 scheduled announcements of data from government
and private sources between 1998 and 2007. Their focus is
on the occasions that actually produce “news,” which is
defined by the authors as “the surprise element, or the
difference between the actual value announced for an indicator and market participants’ prior expectations of what
that value would be.”
The results show that two government releases — the
nonfarm payrolls and advance Gross Domestic Product
reports — and the Institute for Supply Management’s
“Manufacturing Report on Business” tend to affect prices of
bond yields, equity prices, and exchange rates in significant
and systematic ways. All other releases studied tended to
generate erratic or insignificant effects.
The most significant effect tends to be on bond yields.
According to the authors’ regression results, a 1 percent surprise increase in nonfarm payrolls, for instance, raises the
yield on two-year Treasuries by 78 basis points on average.
The yield on 10-year Treasuries sees an average basis point
increase of closer to 60 basis points. The authors conclude
that the observations in the data set confirm the intuition
that markets react to surprise news of stronger economic
growth in a way consistent with an expectation that stronger
growth implies higher potential inflation in the future. RF

E

Fa l l 2 0 0 8 • R e g i o n Fo c u s

9

SHORTTAKES
DOCTORS ON THE SUPPLY SIDE

Virginia Adds Fourth Med School
new medical school is under construction in Roanoke.
The school is expected to add jobs, spill economic
benefits over into the city’s growing health sciences cluster,
and alleviate doctor shortages in the rural southwest corner
of the state. Nationwide, about 10 new med schools are in
the planning or construction stage, along with expansions.
The effort is designed to ease a looming national
doctor shortfall predicted by the Association of American
Medical Colleges (AAMC). That’s a change from the late
1990s when the AAMC’s analysts predicted a national surplus of 145,000 doctors. Newer information indicates that
retiring doctors and a growing population mean there
will be too-few doctors even if medical schools increase
enrollment by the stated goal of 30 percent over 2002 levels
by 2015.
While there’s no guarantee that new doctors will fan out
over rural Virginia, “where you educate and train has a major
impact on where you practice,” says Edward Salsberg, director of the AAMC’s Center for Workforce Studies. Of
Virginia’s 18,510 active physicians, 23 percent completed
medical studies in the state, according to the AAMC’s 2007
State Physician Workforce Data Book. Virginia ranks 30th
among the 50 states in the percentage of doctors who
practice in the same state where they studied.
The new medical school will help, says Dr. Cynda
Johnson, dean of the new Virginia Tech Carilion School of
Medicine. Affiliated with the for-profit health care firm
Carilion, the school will be private. Carilion has trained resident physicians for 25 years. Over the years, about 170
graduates of its Family Medicine program have stayed in
Southwest Virginia, she says. “They often choose to stay if
they have a good experience.”
Virginia Polytechnic Institute and State University is also
a partner in the venture. Virginia Tech will own the building,
for which the state has agreed to pay $59 million. The first
class of 42 students will arrive in 2010.
Even with the AAMC goal of increasing med school
enrollment, there’s likely to be a shortage. “Demand will far
outstrip supply even with our recommended increase,”
Salsberg says. “We have to look at a redesign of services with
nonphysician clinicians, redesigning and improving delivery.
Increasing supply is not the solution; it’s only part of the
solution.”
Despite the push for more doctors, simply increasing
supply may not improve care, according to authors of the
Dartmouth Atlas of Health Care 2008. Supplies of medical
services (specialists, equipment, or the number of hospital
beds, for instance) influence how often they are used, according to the Dartmouth report, but “higher spending and

A

10

R e g i o n Fo c u s • Fa l l 2 0 0 8

greater use of supply-sensitive care is not associated with
better care.”
Researchers counted doctors who had cared for Medicare
recipients with chronic diseases over their final two years of
life. For example, patients at the University of California at
Los Angeles medical center had more than twice the physician visits that patients at the Mayo Clinic did, but earned no
better marks on established quality measures. The report
concludes that the variation is grounded in the “assumption
among both physicians and patients that more medical care
means better care; the marked variations in supply that
emerge in an unplanned marketplace; and a fee-for-service
payment system that rewards providers for staying busy.”
However, access to services is associated with better outcomes, according to Salsberg, and increased supply will
provide greater access.
Virginia now has four medical schools. The University of
Virginia School of Medicine in Charlottesville and Virginia
Commonwealth University’s Medical College of Virginia in
Richmond are public. Eastern Virginia Medical School in
Norfolk is a public-private venture, while the Virginia College
of Osteopathic Medicine, located in Blacksburg, is private.
— BETTY JOYCE
NASH
MONSOON
SEASON
MONSOON SEASON

State and Local Governments
Curtail Spending
yrtle Beach, S.C., has delayed a boardwalk project
and a plan to add a performing arts center to its convention hall. “We do not see it meeting the same time lines
envisioned 6 to 12 months ago,” says Myrtle Beach City
Manager Tom Leath, referring to the project. Blame uncertainty in the bond markets.
Forty-three state governments, including all Fifth
District states except West Virginia, are coping with economic turmoil that has reduced personal income and
consumption tax revenues. Those declines are hurting local
governments nationwide because of declining property
values and taxes, with the fallout extending to school
budgets. For instance, in Chesterfield County, Va., school
officials need to cut more than $38 million from the FY
2009-2010 budget of about $603 million.
And it’s only the beginning, says Scott Pattison, executive
director of the National Association of State Budget
Officers (NASBO).
At press time, Maryland, North Carolina, and Virginia
were projecting fiscal 2010 budget gaps of $1.3 billion, $2.7
billion, and $1.8 billion, respectively. That budget year begins
in July 2009.
“I think you’ll see more significant cuts in the next year or

M

two,” Pattison says. By law, most states can’t run deficits, so
states raise taxes, cut expenses, or use reserve rainy day
funds to balance budgets.
Virginia Gov. Tim Kaine proposed a 30-cent cigarette tax
hike, likely to cause a stir because the home turf of Philip
Morris’ parent company, Altria, is Richmond. He’s also proposed education and Medicaid cuts. Kaine’s proposal would
cut the Virginia Department of Transportation’s work force
by about 1,000.
All that and no raises, for those who keep their jobs. The
governor’s proposal also includes cuts of 15 percent in next
year’s projected budget totals, except for community colleges (10 percent) and public safety agencies (7 percent).
And for the second year in a row, the state may dip into its
rainy day fund to the tune of $490 million, the biggest withdrawal in history, if approved.
But West Virginia is all “green grass and high tides” right
now, according to budget director Mike McKown. Coal and
natural gas severance tax revenue has driven collections
through November of 2008 to $72 million ahead of estimates. He doesn’t expect the surplus to last, however, and
plans a conservative estimate for FY 2010. For now, though,
there are no hiring freezes, job or budget cuts.
North Carolina faces a nearly 6 percent shortfall ($1.2 billion) in the current fiscal year, with most agencies being
forced to cut spending by 5 percent. Gov. Mike Easley
also wants agencies to submit plans for 3 percent, 5 percent,
and 7 percent cuts for the coming years because of revenue
uncertainty. South Carolina has cut its budget by more than
$1 billion since lawmakers approved the budget in June.
Revenue projections fell by more than 11 percent.
Pattison expects personal income tax collections to
“trough” in 2009. “It’s hard to predict refunds,” he says.
States, at least, have no credit problems for now, but are paying higher interest rates on bond issues. And, even though
retail investment remains strong in the bond market, institutional investment has not. “People are concerned that
institutions won’t get in on purchasing bonds soon enough,”
he notes. And that will affect future bond issues.
— MATTHEW CONNER AND BETTY JOYCE NASH
OPEN FOR BUSINESS

Taxpayers Subsidize Firm’s Expansion
in Virginia
ontinental AG will close its manufacturing facility in
South Carolina, and take its 318 jobs to its gasoline
injector plant in Newport News, Va.
The announcement comes at an uncertain time for the
future of the Big Three U.S. automakers. Yet even more
uncertain is the fate of many suppliers to the car makers,
particularly in the wake of a bruising year for car sales by
American manufacturers. A Continental spokeswoman in
Michigan, Michele Tinson, notes the move was mainly a
consideration of the new realities in the auto industry. The

C

expansion in Newport News will put the firm under one
roof, eliminate redundancies, and help the firm leverage
expertise to cut manufacturing costs, according to a
Continental press release.
The German-based company’s decision is part of a larger
consolidation and cost-cutting trend occurring in the auto
industry worldwide. “There’s going to be a big restructuring
because of the trouble that the auto firms are undergoing,”
says Doug Woodward, professor of economics at the Moore
School of Business at the University of South Carolina. “And
it’s not just the domestics. Foreign plants are revamping.
The BMW plant located in Spartanburg is expanding still,
but they are laying off workers. Michelin is still here, but
these are tough times for them.” South Carolina’s unemployment rate is the third-highest in the nation, 8.4 percent
in November 2008.
When Virginia Gov. Tim Kaine announced the move,
he noted the state will give the firm $3 million in relocation
assistance. Two $1.5 million “performance grants” will go
Continental’s way after the firm closes up shop in South
Carolina. The city of Newport News offered $3.5 million in
tax rebates. As is often the case in corporate relocations,
economic development agencies of both states vied for the
jobs. The competition between Virginia and South Carolina
“was very close,” according to Florence Kingston, director of
development for Newport News.
But it’s possible that the subsidies were unnecessary,
according to a study that surveyed foreign-owned firms
published in a 2004 issue of the Journal of World Business.
The journal queried 26 foreign-owned firms that set up
shop in North Carolina. The answers the executives gave to
questions about location decisions suggest there are far
more important considerations than taxpayer-funded
handouts.
Most foreign-owned companies in North Carolina see
government incentives as a minor factor in their location
decisions, according to Dennis A. Rondinelli, Glaxo distinguished professor of management at the University of North
Carolina-Chapel Hill’s Kenan-Flagler Business School and
co-author of the study. In news accounts, he has said that
executives have consistently emphasized that the primary
criteria are locational assets: good transportation access,
skilled labor force, quality of life, good education and
training facilities, and ability to train work force for their
industry.
Meanwhile, Newport News experienced what might
be called an investment boom this year. Canon Inc.
announced in May its intent to build a new $625 million
facility and initiate a $20 million expansion of its Gloucester
recycling plant. At least 1,000 new jobs are expected over
the next five years. In October, Northrop Grumman teamed
up with French firm AREVA to announce a joint venture
that will build reactor parts at an area factory. Each venture
was promised over $20 million in a variety of grants and tax
abatements by state and local governments.
— BETTY JOYCE NASH AND STEPHEN SLIVINSKI

Fa l l 2 0 0 8 • R e g i o n Fo c u s

11

The economic consequences of subsidizing homeownership
BY ST E P H E N S L I V I N S K I

sk most people in America today whether buying
a home is better than renting one, and you’ll likely
get a response that equates renting with stuffing
money down a garbage disposal. The idea of homeownership today is not one that simply evokes the comfort or
pride of living in a place of one’s own. Instead, it’s become
part of a common investment philosophy.
But if you ask Edmund Phelps, the Nobel Prize-winning
economist from Columbia University, he’ll proudly declare
that he doesn’t own a home. And to him, that’s not a bad
thing. “It used to be that the business of America was
business,” said Phelps in August 2008 to Bloomberg News.
“Now the business of America is homeownership.” In fact,
many economists will tell you that the American love affair
with homeownership has some consequences that you won’t
normally hear discussed.
Yet, despite the warning of some experts, the federal
government continues to play a role as matchmaker in
this affair. Policymakers have been promoting homeownership as a goal for most Americans since the Great
Depression. Even in the late 20th century, when the number
of American homeowners was at historic highs already, the
policy initiatives continued to expand. In 1995, when the
homeownership rate as measured by the U.S. Census

A

12

Region Focus •

Fa l l 2 0 0 8

Bureau was about 65 percent, President Bill Clinton made it
an explicit goal of his administration to boost it to 67.5
percent by the year 2000. So he enlisted his secretary of
housing and urban development, Henry Cisneros, to
spearhead a “National Homeownership Strategy.” The
policies that resulted encouraged a loosening of lending
standards.
The race to encourage homeownership is a bipartisan
one. President George W. Bush, while not committing
himself to a specific number, proposed raising the
homeownership rate for minority families through a government-led “Homeownership Challenge.” The goal was to
lower “barriers” to homeownership by using federal money
to help low-income families make their downpayments and
encourage “below-market-rate” investments.
For most of the country’s history, however, the odds were
that you did not own the home you lived in unless you were
a farmer. Nor is it clear that owning a home is in the best
interest of some who hold a mortgage today.
The homeownership rate is about 68 percent now.
Perhaps the best policy question is no longer why the homeownership rate in the United States is so low. A question that
economists might ponder instead is: Why should we want
the homeownership rate to be so high?

The Suburbanization of America
To understand how the ranks of homeowners grew, we
need to understand the spread of homeownership in
20th century America. It is largely a tale of how the
urban and economic landscape changed and the rise of
suburbanization.
The suburbs began to crop up in the 1890s, around the
same time that streetcars became a viable way for people to
commute between the outer edge of metropolitan areas and
the city center. Through the turn of the century and into the
1920s, the outer fringes of the city became a high-population
growth area. Yet even in those days owning a home was still
largely a rural phenomenon. The nonfarm homeownership
rate in 1920 was 41 percent, but the homeownership, rate of
farmers was 58 percent.
The Great Depression didn’t alter metropolitan settlement trends in any fundamental way, although it did reduce
the number of people who owned homes. But after World
War II, the rush to the suburbs and, consequently, the
upward shift in homeownership, was dramatic. Whereas it
took about 40 years after the turn of the 20th century for
the overall homeownership rate to crawl upward by 2 percentage points, it took only the 20 years between 1930 to
1950 for the rate to jump 7 percentage points, from 48
percent to 55 percent.
Harvard University economist Edward Glaeser suggests
this illustrates what is now practically an Iron Law of
housing economics: People who live in urban areas are
usually renters, and those who live in suburbs are usually
owners. “If you’re trying to explain the differences in homeownership between cities in the United States, the physical
structure of the homes is the overwhelming variable,”
says Glaeser. Or, to put it another way, the people who live in
detached single-family homes tend to own them — and
most of those sorts of housing units are concentrated in
suburban areas.
Homeownership rates in the Fifth District illustrate the
same general trend. Since the 1950s, the ownership rate in an
urban area like Washington, D.C., has been substantially
lower than the national average. Meanwhile, other states in
the Fifth District tended to have a higher-than-average
homeownership level. The 1950s housing boom spurred a
very dramatic rise in South Carolina particularly. And the
fact that the most rural state in the District — West Virginia
— also has the highest homeownership rate fits the pattern.
A subplot in the suburbanization tale is the growth of
mortgage lending. In the decades prior to the Great
Depression, mortgage lending to home buyers wasn’t a
booming industry. In 1910, only a third of the nonfarm
owner-occupied home purchases were mortgaged. Those
mortgages that did exist originated with local savings
and loan institutions which mainly did business in their
immediate geographic area.
The homeownership boom of the post-war years was
preceded by specific public policies geared toward making
the market for housing credit national in scope. President

Franklin Roosevelt’s New Deal legislation in the 1930s
insured mortgages through the Federal Housing
Administration (FHA) which allowed savings and loans
to take on a little more mortgage risk in their lending portfolios. The Federal Home Loan Bank system provided
short-term credit with subsidized interest rates to mortgage
lending institutions. The creation of the Federal National
Mortgage Association — known today as Fannie Mae —
allowed lenders to sell their mortgages to the federal
government and instantly replenish their capital which
could be in turn loaned to someone else.
By the 1960s, suburbanization and the policies that
accompanied its growth had changed American politics
and culture. Many presidential speeches since then have
included some kind of nod to the perceived importance of
owning a home and have been often accompanied by a
variety of new policies. By the late 20th century, owning
a home was equated in the popular imagination as an important life goal.
Today, the consequences of these trends are not something most people would like to ponder over their burgers at
a suburban backyard cookout. But the consensus among
economists now is that the policies geared to encouraging
people to own homes have had very real economic costs.

Subsidizing the Homeowner
The favoritism showered upon home purchases by the
government for at least the past 60 years has, in the aggregate, made it cheaper for people to borrow to invest in
homes rather than other items. Thus, it should be no
surprise that people will spend more time and money pursuing homeownership — and that’s what has economists
concerned. “There probably are effects on the homeownership rate that come from the fact that, on average, it’s less
expensive to be a homeowner than it would be in the
absence of current policies,” says economist James Poterba
of the Massachusetts Institute of Technology, the current
head of the National Bureau of Economic Research.
A major element in the subsidization of homeownership
is the ability of mortgage holders to write off their interest
payments when they file their income taxes. This isn’t a new
policy or one originally aimed at mortgage holders. The
deductibility of interest was, until 1986, a key feature of the
income tax since its inception in 1913 — anyone who had to
make interest payments on any sort of debt was able to
deduct these expenses. Although it may have been an accidental subsidy of sorts it had real consequences. Economists
Harvey Rosen of Princeton University and Kenneth Rosen
of the University of California-Berkeley conclude that about
one-quarter of the growth in the proportion of homeowners
between World War II and 1980 was driven by this favorable
tax treatment of mortgages.
Some economists quibble with this analysis. New
research by Glaeser suggests that the decision to buy or rent
may not really be influenced by the deduction. His study, coauthored with Harvard colleague Jesse Shapiro, suggests

Fa l l 2 0 0 8 • R e g i o n Fo c u s

13

The Post-War Homeownership Boom
The Downsides of Widespread Homeownership

100
90

HOMEOWNER RATE (PERCENT)

80
70
60
50
40
30
20
10
0
1900

1910

1920

MD
SOURCE: U.S. Census Bureau

1930

1940

VA

1950

D.C.

1960

1970

WV

1980

NC

1990

2000

SC

2007

U.S.

that the families who might be on the fence about buying a
house are the least likely to take advantage of the deduction.
“The bulk of the benefits,” says Glaeser, “go to fairly rich
people who aren’t particularly close to the margin between
owning and not owning. These are people who are overwhelmingly in single-family detached houses, and they
would be likely to own that house with or without the home
mortgage interest deduction.”
But that doesn’t mean that he thinks the subsidy is inconsequential. Instead, Glaeser says the deduction encourages
people who were already planning to buy a home to add
more things to their housing purchase wish-list. “It mainly
serves to induce prosperous people to buy bigger homes and
pay more for those homes,” suggests Glaeser.
Other government subsidies are less obvious, but they
also have the effect of actively steering more investment
capital toward the housing market. Government loan
guarantees through the FHA can generally lower the cost of
having a mortgage — after all, if a banker knows the government will pay him back if a loan goes sour, he’ll be less
worried about the risks of lending and can charge a safe
borrower a lower-risk premium (i.e., interest rate) or expand
his lending portfolio to include higher-risk borrowers.
Then there are the benefits bestowed by the federal
government for decades upon the government-sponsored
enterprises (GSEs) Fannie Mae and the Federal Home Loan
Mortgage Corporation, known more commonly as Freddie
Mac. These include explicit benefits (like certain
exemptions from the securities exchange laws that bind
ordinary banks) and implicit ones (like the widely expected
claim that the institutions had a credit lifeline financed by
the U.S. Treasury — a perception that was reinforced when
Fannie Mae and Freddie Mac were placed under conservatorship by the federal government in September). The
ability of these GSEs to buy mortgages from banks and
turn them into tradable securities also creates an incentive
for banks to issue more mortgages. The Congressional
Budget Office estimates that the combination of these
subsidies has resulted in mortgage interest rates for
borrowers that were up to a quarter percentage point
lower relative to what they would have been otherwise.

14

R e g i o n Fo c u s • Fa l l 2 0 0 8

Whether subsidies to homeowners encourage more home
purchases or instead simply lead people to buy bigger
houses may not matter much. What really matters is that
both result in similar economic effects. As Poterba explains:
“The general pattern has been that we have invested more in
housing relative to other kinds of capital goods than we
would in an economy in which the tax system and credit
institutions did not tilt the playing field at all.” Simply put,
Americans may have overinvested in housing.
This has been a worry of economists for a while. It’s a
concern based on what they see when they compare the
rates of return — profit per dollar invested — for a variety of
capital types. Most studies look at two broad categories:
housing capital and nonhousing fixed capital. The latter
consists of investments in manufacturing plants, machinery,
and other sorts of investments that produce goods.
Economic theory suggests that the rates of return for each
form of capital should equalize over time. That’s because
market forces would, all things being equal, allocate capital
in such a way as to deplete the profit potential in this fixed
set of investment options.
For instance, if an investor in one sector saw a higher rate
of return elsewhere he would move his money into that
other sector. But if enough people followed suit, the profits
in the newly popular sector would drop. (Imagine a suburban
strip mall with eight ice cream stores. You can see how difficult it would be for each of them to make the profit that they
would if they were the only ice cream store in town.) As the
investment flows away from the old sector, however, the
rates of return there will rise again. At some point — what
economists call “equilibrium” — the rates of return for both
categories of capital would be the same.
But there is another element of housing that is unique:
Buying a home is an investment made by people in a structure and in a community where they live. Perhaps there are
other unmeasured benefits of housing investment above and
beyond the simple rate of return. Some economists have
suggested that housing investment creates a positive benefit
(or “externality”) for the people who live in a community
composed predominantly of homeowners. Renters, as the
logic goes, don’t have much long-term interest in the
property they inhabit. Homeowners, on the other hand,
want the neighborhoods they live in to look good so you
would expect them to pay more attention to how nice their
property looks.
Some economists, like Ed Glaeser, have found that the
main positive externality of home investment is the number
of well-tended gardens in communities with a larger number
of owners. This benefit could be expected to increase the
aesthetic value of the community and could increase the
attractiveness of the community to potential residents.
The most comprehensive studies — such as a 1998 paper
published by the Federal Reserve Bank of Dallas — seek to
include a measure of these sorts of externalities in their rate
of return calculations. Yet, even then the conclusions

suggest that Americans have overinvested in housing,
relative to other nonhousing capital investment, since at
least 1929.
“When you observe that the measurable rates of return
are different across the sectors,” said the Dallas Fed study
author, Lori Taylor of Texas A&M University, “you either
have to conclude that there are substantial unmeasured
returns across the sectors or you have to conclude that society would be better off with a reallocation of resources.”
These unmeasured benefits would have to be very large — at
least $3,600 per homeowner in America — for the investment imbalance to be explained. And even if you assume
that the positive externalities are this large, there may be
vastly better ways for the government to encourage the good
behavior.
If the goal is for better-looking communities, why subsidize the purchase of the home? asks Glaeser. Instead, why
not target the real cause of the community beautification?
“You can target that,” he says, “with a limited gardening
subsidy, for instance. Give people who plant a garden a subsidy to buy mulch and leave it at that.”
Instead, the current policies produce an economy in
which housing investment is generally higher than it would
be if government didn’t favor it. And every dollar that is
invested in housing stock is a dollar not invested in a more
productive use elsewhere. That results in a net reduction in
overall economic efficiency.
Nor is it clear that using a home purchase as a primary
vehicle for a family’s investment is sound financial advice.
Robert Shiller, an economist at Yale University and an expert
on national housing markets, has estimated that “from 1890
through 1990, the return on residential real estate was just
about zero after inflation.” Throw in the costs of maintenance of the property and it’s easy to see how renting could
certainly be cheaper than owning, even if you include the tax
advantages. Yet the opportunity cost of those home investments — the foregone investment opportunities elsewhere
— go largely unseen.
The costs of owning a home go beyond the financial commitments too. Being tied down to a house tends to make
people less likely to leave an area in which employment
prospects are deteriorating. After all, terminating a lease is
much less costly and time-consuming than foreclosing on a

house or selling a home, even if the owner breaks even on
the transaction. Economists predict this would lead to a
decline in “labor mobility,” the ability for people to move to
where the jobs are.
A seminal study by British economist Andrew Oswald of
the University of Warwick traced the link between unemployment and homeownership. Oswald looked at the United
States, the United Kingdom, France, Italy, and Sweden
between 1960 and 1996 and discovered that, on average, a 10
percentage point increase in homeownership tended to
correlate with a 2 percentage point increase in the unemployment rate.
Recent studies of European data discover that you don’t
see these sorts of correlations in areas with higher concentrations of renters. Renters are simply more able and willing
to move away when their community hits the economic
skids. In addition, workers who aren’t likely to move from a
specific location might create frictions in the markets for
labor skills. It’s a cost to the economy when people live in an
area in which their skills are no longer valued. But there is
a potential personal cost too: The overall welfare of that
worker may suffer.
Homeownership also tends to contribute to adverse political incentives. Incumbent homeowners have an interest in
keeping their property values high and have been shown
statistically to have a bias in favor of land-use regulations.
These restrictions limit the number of houses that can be
built in any geographic area and, consequently, keep
housing inventory low and property values artificially
inflated.
None of this means that economists think the United
States should become a nation of renters. Nor is it likely that
would happen anyway. Getting rid of the government
subsidies to home purchases probably wouldn’t dent the
homeownership rate much as long as people continue
to prefer living in the suburbs (albeit it in slightly smaller
homes) and the United States remains a wealthy
country. Instead, the take-home message for policymakers, as Glaeser suggests, is that they should not aim
to “increase homeownership at all costs.” Unfortunately,
it may have taken major adversity in the financial
and housing markets for this alternative storyline to be
considered seriously.
RF

READINGS
Frame, W. Scott, and Larry D. Wall. “Financing Housing through
Government-Sponsored Enterprises.” Federal Reserve Bank of
Atlanta Economic Review, First Quarter 2002, pp. 29-43.

Oswald, Andrew J. “The Missing Piece of the Unemployment
Puzzle.” Inaugural Lecture, University of Warwick, November
1997.

Glaeser, Edward L., and Jesse M. Shapiro. “The Benefits of the
Home Mortgage Interest Deduction.” Tax Policy and the Economy,
2003, vol. 17, pp. 37-82.

Rosen, Harvey S., and Kenneth T. Rosen. “Federal Taxes and
Homeownership: Evidence from Time Series.” Journal of Political
Economy, February 1980, vol. 88, no. 1, pp. 59-75.

Mills, Edwin S. “Has the United States Overinvested in Housing?”
AREUEA Journal, Spring 1987, vol. 15, no. 1, pp. 601-616.

Taylor, Lori T. “Does the United States Still Overinvest in
Housing?” Federal Reserve Bank of Dallas, Economic Review,
Second Quarter 1998, pp. 10-18.

Fa l l 2 0 0 8 • R e g i o n Fo c u s

15

Carbon Policies Weigh Environmental and Economic Risks
arbon controls are on the congressional drawing
board for political, economic, scientific, and public
opinion reasons. The Intergovernmental Panel on
Climate Change’s 2007 report turned some heads with its
findings, key congressional committees have seized the
issue, and public interest is growing after a dramatic 2005
storm season and volatile oil prices. Last, but not least,
the Supreme Court ruled that the Environmental Protection Agency can regulate greenhouse gases under the Clean
Air Act.
But by how much, how soon, and at what cost? It’s easier
said than done. Emissions targets may or may not ensure
appropriate atmospheric concentrations or sufficiently limit
long-term damage because climate response is loaded with
uncertainty. Hypothetical scenarios would either stabilize
emissions at 2008 levels by 2050 or cut them to half of 1990
levels by that time, at a cost that ranges from below 0.5 percent to 1 percent annually of gross domestic product.
Solutions hinge on the idea that all people and businesses need an incentive, a price on energy-intensive goods, says
Ian Parry, an economist at Resources for the Future.
“Whereas any other policy, one that’s just focused on the
power or transportation sector, won’t exploit all the opportunities for emissions reductions and is therefore more
costly.”
That could be accomplished through a per-ton tax on carbon or emissions limits (a cap) coupled with “emissions
allowances” that participants may buy, sell, or trade among
themselves. Risks abound with each policy: It’s risky to do
nothing, a tax risks uneven environmental outcomes
because it doesn’t limit emissions, and “cap-and-trade” plans
can cause firms to face uncertainty because the price of carbon would fluctuate according to the market.
While experts and policymakers weigh alternatives, at
least economic incentives have influenced the big ideas on
the table this go around.

C

States Cut Carbs
Cap-and-trade policies already have a track record in cleaning up pollution. Best remembered is the ongoing U.S. acid
rain program, which has reduced sulfur dioxide (SO2) emissions 22 percent below mandated levels at a cost of about $1
billion a year, well under estimates of an annual $3 billion to
$25 billion. The ongoing nitrous oxide (NOx) trading plan
covers 19 states, the District of Columbia, and portions of
two other states.
A group of 10 states from Maryland to Maine auctioned
in September the first set (about 12.6 million) of carbon

16

R e g i o n Fo c u s • Fa l l 2 0 0 8

allowances in advance of a 2009 annual cap
on power plant emissions. Known as the Regional
Greenhouse Gas Initiative, (RGGI) the plan limits carbon
emissions at 188 million tons until 2015, when the cap will be
reduced by 2.5 percent per year until 2019. The first RGGI
allowances sold for $3.07 apiece at auction in September. Its
second auction was in December.
Latest data — 2006 emissions of 164.5 million tons
during a mild winter — suggest it may be a piece of cake for
some utilities to meet this goal. The initiative, which
Maryland joined in 2007, covers 233 coal, oil, and gas-fired
power plants located in the RGGI region. That includes
Dominion, based in Richmond, Va., the biggest power producer in New England. (Dominion participated in the
auction, but spokesman Jim Norvelle says they prefer a
national cap-and-trade plan over regional approaches.)
Critics have faulted the RGGI cap for not being aggressive enough. However, greenhouse gas buildup is a long-term
problem, and allowances can be adjusted if necessary.
You have to start somewhere, according to Matthias
Ruth, director of the Center for Integrative Environmental
Research at the University of Maryland. He’s studied effects
of climate change on Maryland, Boston, and New Zealand,
too. “It’s so new everyone was worried,” he says. “The last
thing you want to do is have an overly ambitious and
un-doable target.”
As to the distribution of allowances, RGGI’s plan
requires at least a quarter be auctioned; most states, including Maryland, plan to auction 100 percent. In a
cap-and-trade program, an auction reveals emissions prices
through bidding and can raise money that could offset less
efficient taxes such as those on capital or payrolls.
In most cap-and-trade programs, allowances have been
given away, except in 2004 and 2005 when Virginia
auctioned nitrogen allowances, and netted $10.5 million.
The RGGI auction raised $38.6 million, some of which will
pay for energy conservation and alternatives. That may not
be the most efficient use of the money, Parry notes, because
“the government is picking winners, saying this is a better
way to reduce emissions; we know better than the market.”
It would be more equitable and efficient if the money were
used to, say, lower personal income taxes in those states.
The RGGI states might be the first, but may not be the
last to cap greenhouse gas emissions and trade allowances
regionally in the absence of a national plan. Seven Western
states, including California, plus four Canadian provinces
have formed the Western States Initiative, which will
create a regional cap-and-trade system similar to RGGI’s.

PHOTOGRAPHY: GETTY IMAGES

BY B E T T Y J OYC E N A S H

Six Midwestern states and Florida also are studying variations on the RGGI theme. California in 2006 passed a
law to return that state to 1990 emissions levels by 2020, a 25
percent cutback. Proposals to achieve that are in flux and
include a light rail system, alternative energy incentives,
and more.
These regional blueprints turn pollution allowances into
a marketable asset. Participants meet emissions targets any
way they can — with pollution-control technologies or by
spending allowances — rather than using methods prescribed by government. The quantity is fixed and the price is
determined by the market. To limit swings in the market, a
price ceiling or floor could reduce price uncertainty —
RGGI’s floor was set at $1.86 per allowance. The hope is that
such tweaks will become unnecessary over time in a smooth
trading market.
Economist Richard Newell of Duke University says such
flexibility will “achieve some degree of cost containment
while at the same time providing some certainty about emissions reductions.” Another tweak would be to inject more
allowances into the system if costs get too high, he notes.

An allowance reserve would create a stash that could be
released when and if prices rose above a certain level. Newell
thinks it’s worth exploring these options to create a flexible
“hybrid” plan.
Participants also could be allowed to bank permits for
the future and to use those or borrowed permits when
demand pushes allowance prices up, say, during a cold winter
or hot summer. Because climate change extends into the distant future and emissions contribute to the global
atmosphere, it may make sense to cut deeply when it’s economically feasible and let up when it’s not. “But then there’s
the problem of whether it’s credible to let firms borrow a lot
of allowances in the early years of a program,” Parry says.
“For political reasons, it might reduce the credibility.”
A European cap-and-trade program got a rocky start in
2005 because its administrators lacked accurate emissions
data on the downstream users on which the caps were
imposed. “They put the system in place and then required
the accurate inventories and then, all of a sudden, when they
collected the inventories, it turns out the emissions were different from what [they] were anticipating,” Parry says.

Join the Club
In the 1920s economist Arthur Pigou identified the concept of
using taxes, now called “Pigovian” taxes, to compensate for
negative side effects — externalities — of actions that harm
third parties. Firms use the atmosphere as a depository for carbon but don’t pay for it the way trash haulers, for instance, pay
to dump loads into a landfill, having already passed along that
cost to customers.
That’s a kind of market failure, one of two that greenhouse
gases represent. There’s also no incentive for firms to research
and develop new technologies to improve the situation. So it’s
necessary to price the privilege of sending pollutants into the
atmosphere, says John Whitehead, an economist at
Appalachian State University and co-author of an environmental economics blog. “When they see the cost, it creates an
incentive to cut back pollution,” he says. And whether it’s a carbon tax or a permit generated by a cap-and-trade plan doesn’t
matter. “In business terms, whether they’re paying in the form
of a tax or paying another business to buy their permit, it doesn’t matter, $100 is $100.”
While a carbon tax or cap-and-trade plan may have similar
outcomes, under certain conditions cap-and-trade plans aren’t
considered “Pigovian.” The permits (either auctioned or handed out for free) are considered property in this created market.
Along with the permit goes the right to buy or sell, and perhaps
borrow or bank them. The theoretical framework for the capand-trade plans was conceived by Ronald Coase, a Nobel
laureate, who suggested that if it doesn’t cost parties too much
to bargain, then they’ll achieve an efficient distribution of ownership rights. So if a firm can make more money selling permits
(“rights”) than by using them to emit pollution, it must be

because that firm can better reduce pollution on its own at a
lower cost than the permit buyer can.
Ideally a carbon price would be “harmonized” across sectors
and countries. Yet the dynamic, gradual, and compounding
effects of climate change make it tough to quantify the total
costs to society, and the range of estimates is all over the map.
Based on 100 peer-reviewed estimates, the Intergovernmental Panel on Climate Change Working Group calculates that social costs in 2005 average $12 per ton, but costs
range from -$3 per ton to $95 per ton. Economist William
Nordhaus of Yale University has developed models that suggest
carbon taxes in 2010 could vary by policy scenario from $2 per
ton of carbon to $200 per ton. Nordhaus favors an “internationally harmonized” carbon tax to achieve reductions or a
well-designed universal cap-and-trade program. A regulatory
approach, such as current policies that set emissions standards
for vehicles and ban light bulbs, is inefficient.
The cap-and-trade versus carbon tax debate has been discussed widely in economics literature, government reports, the
popular press, and on the Internet. In 2006 Harvard University
economist Greg Mankiw founded an informal group, the Pigou
Club, composed of economists who say a carbon tax offers the
most effective solution to limiting global warming effects.
That’s especially true if the additional money the tax generates
is used efficiently by cutting taxes that depress work effort.
Club members include some pretty big names in economics as
well as other big names, too, like Al Gore, who has endorsed a
revenue-neutral carbon tax. However if a carbon cap-and-trade
program sells rather than gives allowances away, the differences
all but disappear.
— BETTY JOYCE NASH

Fa l l 2 0 0 8 • R e g i o n Fo c u s

17

Emissions were lower than expected and the cap wasn’t
effective, so prices collapsed. Now, however, source inventories are more accurate, and the goal is to cut greenhouse gas
emissions by 20 percent by 2020. Carbon trades at between
$20 and $40 per ton today. Ideally, the United States would
impose the program on a fewer number of entities — fossil
fuel suppliers — rather than downstream users because
there is more accurate data on those sources.

Path Dependence
Economist Charles Komanoff has spent years advocating an
alternative: a carbon tax. He is co-director of the nonprofit
Carbon Tax Center. Critics of carbon taxes say the political
process is not the best way to set a carbon price. But while
auctions and trades discover the price of carbon, he notes,
that price would be an indirect result of the political process,
too, because politics establishes the cap. Even with the
trade-off between emissions and financial uncertainty, “we
take the position, and economists support this, that all in all
there’s more certainty going forward under a carbon tax
than under cap and trade.” But the quantity limits lead most
environmentalists to back cap-and-trade plans — something

Komanoff refers to as a sort of “path dependence.” Taxes
are unpalatable and the cap-and-trade idea may be an easier
political sell. Matthias Ruth says he’s even had executives
tell him not to even say the word “tax” because they
“stop listening.”
Not everyone feels that way. A carbon tax is transparent,
and the money stream would be steady and predictable. And
lawmakers could use the tax to reduce other taxes or even
rebate money back to taxpayers, the way Alaska pays its citizens a dividend of oil revenues. British Columbia levied a
$10 per-ton tax on carbon in 2008. The revenue goes to cut
taxes on the bottom two income tax brackets and tax credits for the poor.
But if carbon allowances get auctioned, then the difference between the two systems narrows to a split hair. Gilbert
Metcalf, an economist at Tufts University, notes that even if
Congress sets a hard cap, it could be changed. “If abatement
costs turn out to be unexpectedly high, the resulting high
permit prices will create political pressure for Congress to
relax the quantity constraint.” Metcalf, in a paper, argues for
a gradually rising carbon tax with revenues directed to an
earned income tax credit tied to payroll tax collections.

Can Offsets Cut Carbon Emissions?
Carbon “offsets” are being watched closely to see whether
they significantly reduce additional emissions. These offsets
take the form of certified credits available through a
middleman who trades them on behalf of projects that
destroy, displace, or sequester carbon. Governments or
companies buy and sell offsets to comply with caps on carbon dioxide — or anyone could buy them for his own carbon
use. (There are six primary greenhouse gases, but offsets are
measured in metric tons of carbon dioxide equivalents.)
The wide range of offset opportunities includes renewable
energy, forest management, or landfill-gas capture projects.
Such a project in Greenville, S.C., made a list of 11 offset projects endorsed by the Environmental Defense Fund.
Enerdyne Properties developed a project that captures
gases created by decomposing trash, one of which happens
to be methane, also the chief constituent of natural gas. It is
then turned into electricity. “If it’s not collected and used
and burned, it’s a greenhouse gas that would otherwise go
into the environment,” says William Brinker, whose father
started the firm in 1993. “We’re preventing the release of the
methane and using it to provide reasonable electricity to
consumers.” Some 6,000 metric tons of methane emissions
may be prevented annually over the next 10 years, the equivalent of taking 23,000 passenger cars off the road every year,
according to estimates.
While offsets have been around for years, they were
codified in the Kyoto Protocol climate change agreement
adopted in 1997 that became effective in 2005. The treaty
binds 37 industrial nations to targets that cut greenhouse gas
emissions to below 1990 levels between 2008 and 2012.

18

R e g i o n Fo c u s • Fa l l 2 0 0 8

So far, 183 countries have ratified the protocol. The United
States has not.
Some industrialized countries meet targets using capand-trade systems that cover power plants and major
greenhouse-gas emitting industries. Targets may also be met
with offsets called “clean development mechanisms”
(CDMs). The CDMs generate certified emission reductions
(CERs) that represent avoided emissions which can be
bought and sold. The European Trading Scheme offers the
biggest global demand for CERs. Offset contracts are also
traded on the Chicago Climate Exchange.
But offsets have been criticized for not cutting emissions
in some cases. A working paper by Michael Wara and David
Victor of Stanford Law School argues that many CDMs do
not represent real reductions in emissions. In one example,
firms made more money from selling the credits generated
by capturing a toxic byproduct of a refrigerant gas than by
producing the gas. This “perverse incentive” actually
encouraged refrigerant production for the waste that generated the emissions credits. Payments in this case overall
will cost 4.7 billion euros while estimated abatement costs
are probably less than 100 million euros, according to Wara
and Victor.
Still, offsets remain big business. The World Bank estimates that the global carbon market — the buying and
selling of greenhouse gas emissions — reached $64 billion in
2007, double that of 2006, largely because of high carbon
prices in European Union countries. But the recession will
reduce emissions and credit carbon prices as industrial output declines.
— B E T T Y J OYC E N A S H

While economists agree that it’s a sound idea to use market
approaches to solve the problem, not all such policies will perform the same — that devil still lurks in details. Newell, the
Duke economist, and co-author Carolyn Fischer have found
that while emissions pricing offers incentives for fossil fuel
producers to cut emissions, consumers to conserve, and for
renewable energy producers to expand production and invest
in knowledge, an “optimal” policy portfolio will also subsidize
research and development. In theory, an efficient price would
encourage private firms to research and develop alternatives,
since they bear the burden of reducing emissions. But in practice, a price may not work that way. High prices that risk
significant cuts in economic activity aren’t likely to get
through the political process. Also, there could be a steep
learning curve in producing and using new technology.
By their calculations, there will be lower costs and better
market penetration of renewable energy sources with the
subsidies to R&D — the emissions price necessary to get to
a 4.8 percent reduction would fall by 36 percent, to $4.50 per
ton from $7 per ton.
What kind of money are we talking about? The
Congressional Budget Office estimates that revenue from a
cap-and-trade program could range anywhere from $50
billion to $300 billion a year (in 2006 dollars) by 2020.
Talk about uncertainty.
But what will happen to the money? With a big war going
on and the economy dragging its feet, you have to worry
about how Congress would use it, says John Whitehead, an
environmental economist at Appalachian State University.
Cutting taxes on labor and capital would help the most.
That could keep down the overall cost of the carbon control
program, Parry says. But it won’t work that way unless
legislation spells out the automatic reductions in other
taxes. Otherwise, the money would be up for grabs by
special interests.

So What?
China surpassed the United States in 2007 as the biggest
emitter of greenhouse gases, of which carbon is the chief
component. (Methane is more harmful, but represented
only 8.6 percent of emissions in 2006.) But the U.S. share of

State Emissions by Sector (2005)
MILLION METRIC TONS OF CARBON DIOXIDE

Hybrid Plans

180
160
140
120
100
80
60
40
20
0

MD
Transportation

NC
Industrial

SC

VA

WV

Residential

Electric Power

Commercial

NOTE: Total emissions for Washington, D.C., were roughly 4 million metric tons.
SOURCE: Energy Information Administration

accumulated greenhouse gases is 30 percent to China’s 8 percent. Electric power plants supply the biggest single U.S.
source of carbon at 40 percent, and coal produces about 83
percent of that electricity. Transportation accounts for
about a third of carbon emissions.
It’s not out of line to ask whether a cap and trade or carbon tax plan could significantly slow global warming because
it wraps the globe, not just the nation. How about the slashand-burn forestry elsewhere that accounts for 20 percent of
global carbon? How about smoggy Chinese cities, smokestacks, and the burgeoning car culture?
“The ultimate aim would be that over 10 to 15 years we’d
have an emissions trading scheme over most of the largescale emitters in the world,” Parry says. And a policy, a
carbon tax or cap-and-trade plan or hybrid of the two, could
influence other nations’ efforts to innovate and restrict
greenhouse gas emissions.
The European Union carbon trading experience has been
instructive for the United States, which has better data,
especially on power plant fuel consumption. Although
there’s no shortage of projections, there are still more questions than answers that only experience can provide.
What price will achieve various emissions targets? How will
demand respond to the prices? How easy will it be to
substitute alternate fuels? The RGGI regional laboratory,
meanwhile, is aiming to find out.
RF

READINGS
Congressional Budget Office. “Policy Options for Reducing CO2
Emissions.” February 2008.
Kopp, Raymond J., and William A. Pizer, “Assessing U.S. Climate
Policy Options.” Resources for the Future, November 2007.
Metcalf, Gilbert E. “Designing a Carbon Tax to Reduce U.S.
Greenhouse Gas Emissions.” NBER Working Paper No. 14375,
October 2008.
Murray, Brian C., Richard G. Newell, and William A. Pizer.
“Balancing Cost and Emissions Certainty: An Allowance Reserve
for Cap-and-Trade.” NBER Working Paper No. 14258, August 2008.

Nordhaus, William D. “After Kyoto: Alternative Mechanisms to
Control Global Warming.” American Economic Review, May 2006,
vol. 96, no. 2, pp. 31-34.
Ruth, Matthias, Dana Coelho, and Daria Karetnikov. “The U.S.
Economic Impacts of Climate Change and the Costs of Inaction.”
Report by the Center for Integrative Environmental Research at
the University of Maryland, October 2007.
Stavins, Robert N. “A U.S. Cap-and-Trade System to Address
Global Climate Change.” Discussion Paper 2007-13, Brookings
Institution, October 2007.

Fa l l 2 0 0 8 • R e g i o n Fo c u s

19

BY B E T T Y J OYC E N A S H

inh duc Phan and Vivek Wadhwa arrived on opposite U.S. coasts five years apart under radically different circumstances. Yet they share the common
history of growing businesses. Phan has built a construction firm, while Wadhwa has co-founded two software
firms, and now works as an executive-in-residence at Duke
University’s Pratt School of Engineering. Both believe that
the United States contains rich entrepreneurial soil.
The nation’s foreign born have reached a record high, in
total numbers. And they have fanned out to most of the 50
states, many in regions unaccustomed to immigrants. Of the
foreign born, 29 percent lived in the South in 2003. These
demographic changes have been fraught with controversy
and confusion about the role of immigrants, legal and illegal,
in the labor market (see Region Focus, summer 2006). And
that’s too bad because it may have obscured the yields from
this cross-border pollination — the birth of businesses that
produce not only jobs, but also the new technology that
speeds growth.
Entrepreneurship isn’t only about money, says Wadhwa,
who is from India. He arrived in the United States in 1980
after studies in Australia. “You are creating an economic system of innovation.” Another bonus — the children of these
newcomers inherit entrepreneurial aptitude. Phan landed at
Camp Pendleton in 1975 courtesy of the U.S. military after
the fall of Saigon. He preached entrepreneurship to his offspring yet did not practice it. He finally leapt. “If I taught my
kids how to listen to me and then I chickened out, what kind
of a father is that?”
Institutions such as bankruptcy laws that allow for failure, generally widespread access to credit, and intellectual
property protection can encourage entrepreneurship.
Wadhwa says simply: “America is still the place where everyone wants to be … because you’re allowed to fail over here.”

T

areas: science, technology, engineering, and math. Tech manufacturers were even more likely — 40 percent — to have an
immigrant founder.
In a separate study, Wadhwa enlisted the help of students
at Duke’s Master of Engineering Management Program
where he teaches. They called small- to midsized tech firms
to ask founders’ nationalities. Results mirrored NVCA’s.
Immigrant entrepreneurs founded 25 percent of U.S. engineering and tech firms established in the past decade. Those
companies generated $52 billion in revenue and employed
nearly half a million. “We’re talking about high-tech, highgrowth companies which have been giving America its big
advantage,” he says. California (39 percent), New Jersey (38
percent), and Michigan (33 percent) headed the list of states
with the greatest representation of immigrant tech firms.
Virginia wasn’t far behind at nearly 30 percent. Maryland
(nearly 20 percent) and North Carolina (14 percent) also
ranked near the top.
Maybe these numbers shouldn’t surprise us. After all, 13
percent of the U.S. working population is foreign-born, and
25 percent of all scientists and engineers (half at the doctorate level) were born outside the United States.
Neither Wadhwa nor the NVCA are subtle about the
studies’ agendas. They want to demonstrate limitations of
immigration rules, like the 65,000 cap on visas that allow
U.S. firms to hire expert foreign workers for a limited time.
A dearth of visas and a million immigrants waiting for green
cards, they say, will hurt in the long run. “The United States
is stuck in massive brain drain,” says Wadhwa. Frustrated,
talented techs may take their education credentials, earned
in the United States, and go home. And in fact, there is evidence that the Chinese contribution to U.S. patent activity
has leveled off, and the Indian contribution has declined,
according to Harvard Business School economist William
Kerr, after increasing dramatically in the 1990s.

The Tide of STEMS
Recent studies have examined the extent and influence of
immigrant-founded businesses in the United States. A
November 2008 study for the Small Business
Administration puts the immigrant share of business owners
at 12.5 percent, with total income of $67 billion.
A study published in 2006 by the National Venture
Capital Association (NVCA) calculated that immigrants
formed a quarter of venture-backed public firms, with a total
market capitalization of more than $500 billion. The
research included whoppers like Intel, Yahoo, eBay, Sun
Microsystems, and Google. Most companies were in STEM

20

Region Focus •

Fa l l 2 0 0 8

The Knowledge Channel
So what? Don’t inventors maintain two-way ties with the
home countries anyway and communicate within a worldwide professional circuit? Not exactly. Kerr studies
cross-border tech transfer, and says it’s hard to document
spillovers. When highly educated, productive immigrants
depart, it matters where they work, he notes. And multinational companies make some of these decisions. If
U.S.-educated talent in Beijing research and develop
products for Microsoft, Kerr says, it’s not a clear picture as
to whether the United States loses out. At least part of that

PHOTOGRAPHY: BETTY JOYCE NASH

knowledge and money flows back to the United States. But
what if a “hotshot” Indian graduate can’t work here, returns
to India, and “never picks up the phone or comes back to the
United States?” he asks. “We could have benefited from the
job growth and innovation.”
The question gets more complicated by the idiosyncrasies of research. Bright ideas spread quickly. Kerr says
researchers are 30 percent more likely to exchange new ideas
through “ethnic knowledge” channels for about five years,
and by the time the notion is a decade old, the “ethnic
effect” has dissipated — the idea is everywhere.
It’s clear that foreign output and productivity benefit via
the ethnic channel. Kerr has found that a 10 percent growth
in immigrants’ research in the United States improves immigrants’ home country output and productivity by 1 percent
to 3 percent. These effects are particularly strong for China
and the computer industry.
Research also depends on colleagues in the office, down
the hall, down the block, and across town. “I am influenced
more by research that happens here [at Harvard] or at MIT
than I am from someone at Chicago — we meet in the hall
or have lunch,” Kerr says. “For myself, it probably hurts me
if some of the very best potential researchers I could collaborate with are going back to their home countries.” And
restrictive immigration rules are not the only reason that
immigrants leave. “There was the early 2000 tech recession
and the financial troubles now — that will lead to foreign
opportunities improving relative to U.S. opportunities.”
With regard to the expert visa (called H-1B) problem, it’s
tough to solve for many reasons, not least of which is lack of
data. “We don’t know who leaves; we don’t have a group to
compare them against,” Kerr says. His research has confirmed that the policy has substantial impact for U.S. Indian
and Chinese innovation rates, not surprising because they
get the visas. Raising the cap increases overall U.S. innovation primarily through the new immigrants themselves.
“This faster innovation growth is not very dramatic — 1 percent to 2 percent in the most affected cities compared to the
least affected cities, but it may add up over the course of
many years,” he says.
Immigration policy debates continue, along with
research about economic contributions. Economists have
found that an immigrant college graduate is twice as likely to
patent as a native counterpart, according to research by
Jennifer Hunt and co-author Marjolaine Gauthier-Loiselle
in a National Bureau of Economic Research working paper.
That’s because more immigrants than natives have science
and engineering degrees.
As economies like China and India leap ahead economically, it gets easier to make money there. The rate at which
its scientists and engineers return home may accelerate as
entrepreneurial infrastructure improves, and that could dull
the United States’ competitive edge.
Praveen Kalakuntla graduated from Duke’s engineering
management program in December, and will join colleagues
back home in India once he observes “how processes and

people work here in the United States.” Kalakuntla plans to
use his expertise to further green technology, and says the
Indian government provides support in the form of land,
special economic zones, and tax rebates for businesses.
“People in India at least now are not afraid to take the risk in
something that might be better for the world.” But he would
consider locating a branch in the United States.
Longtime entrepreneur and Cuban immigrant Al Guerra
of Kelvin International Corp. heads the Hampton Roads
Hispanic Chamber of Commerce. Nearly all of Guerra’s
cryogenic (ultralow temperature) equipment customers are
overseas. Guerra immigrated alone at age 10 in 1961 as
Castro took over. His father, also a businessman, a car dealer in Havana, left first, and his mother and brother traveled
separately later. The reunited family settled in Boston,
Guerra became an engineer, and later worked at Jefferson
Labs, investing in the business on the side. He moved up as
far as he could, but says that Hispanics with high-tech skills
can encounter a glass ceiling. So he left to run Kelvin
International full-time. “Don’t forget, most immigrants have
the risk gene already built in,” he says. Guerra confirms that
many immigrants he meets through his work with the
Hispanic Chamber start businesses to escape discrimination
or advance a stalled career. Often, ethnic groups cluster
within a field because of language, culture, and knowledge
affinities.

From “Sojourn to Settlement”
While STEM businesses have reshaped and boosted the
economy in the past decade, traditional service or manufacturing startups remain common paths for newcomers. A
family member may immigrate and open a restaurant, and
later bring in friends and relatives who learn the ropes and
open another. Ditto for motels, convenience stores, nail
salons, dry cleaners, and other service niches dominated by
specific ethnic groups.
Relatives are preferred employees because of trust.
Laura Zarrugh, a cultural anthropologist at James Madison
University, documented immigrant business formation around Harrisonburg, Va. Entrepreneurship isn’t so

La Milpa in Richmond, Va., includes a restaurant, market, crafts, bakery,
and a catering service. The business was started by Martin Gonzalez in
1995. He immigrated to Richmond from Mexico City in 1988.

Fa l l 2 0 0 8 • R e g i o n Fo c u s

21

Immigrant Business Owners as Percentage
of State and U.S. Total
(U.S. Total: 12.5 Percent)
18
16
14
12
10
8
6
4
2
0

D.C.

MD

NC

SC

PERCENT OF STATE TOTAL
NOTE: Percent of U.S. total for D.C. = 0.1
SOURCE: U.S. Census Bureau, 2000

VA

WV

PERCENT OF U.S. TOTAL

surprising for Latinos since a quarter of Mexico’s work force
is self-employed. In the United States, Latinos are less likely
to own a business than whites or Asian Americans, but there
is evidence that Latino business numbers are rising. In 20032004, Zarrugh identified 48 operating, registered, and
licensed Latino businesses in Harrisonburg, up from one
business in 1989, but more probably exist in the informal
economy. The small town in rural Virginia reflects nationwide Latino self-employment. Latinos represented 3 percent
of total self-employment in 1979 and 8.5 percent in 2003,
helping them move from sojourn to settlement.
Martin Gonzalez arrived in Richmond in 1988. The
Mexico City native knew people who had already immigrated to Richmond. As he progressed through nighttime
English language classes at Crestview Elementary, he
worked construction, washed dishes, and waited tables.
Then he went to J. Sargeant Reynolds Community College.
Along the way, he developed a fresh idea that gave him “good
results right away.” It was a Mexican store — food, crafts,
groceries. Another Mexican immigrant financed the business. A decade later, he’s got his own enterprise. La Milpa
offers to its 80 percent Mexican clientele a bakery and
catering, restaurant, market and Mexican crafts. Gonzalez
says it’s been the chance of a lifetime “to prove all the
knowledge I have.”

Money and Moxie
The entrepreneur who doesn’t have to worry about startup
money is rare — immigrant or native. It’s hard if not impossible to go to a bank touting an idea with no collateral. But

venture capital, especially in the tech centers in Silicon
Valley, Chicago, Boston, and to a lesser extent, Research
Triangle Park in North Carolina, has until recently flowed
into tech ventures. “If you have a good idea, it’s not hard to
get financing,” Wadhwa says, but it depends on where you
are. The National Venture Capital Association reports six
Initial Public Offerings of venture-backed firms through
third-quarter 2008, the lowest number over three quarters
since 1977.
Traditional businesses can be tougher to get off the
ground, with many people relying on personal savings, says
Phan. It’s how he started. Now his firm has grown to three
divisions, employing from 30 to 60 people. But he now tells
fellow Asians in his role as the director of the Virginia Asian
Chamber of Commerce that savings is old time. “We need to
teach them to learn how to use a credit line, how to use
money in the market.”
Charito Kruvant, a Bolivian native raised in Argentina,
started Creative Associates International in Washington,
D.C., with savings and an initial credit line of $50,000 that
her husband had to co-sign. It was the 1970s. Today, the firm
works in 17 countries helping people cope and recover from
the effects of conflict, among other efforts. Today, the firm’s
credit line is $18 million.
Most immigrant entrepreneurs Laura Zarrugh studied
in Harrisonburg used savings and money from second
jobs to get going. Many got loans from parents or siblings
or (less often) friends. Only four obtained startup
capital from banks or small business loans. Those who
obtained such loans did so with the help of American
associates, a realtor in one case and a boss in another. Lack
of formal credit history makes it hard for entrepreneurs
generally and immigrants especially to get money from
financial institutions.
Money issues aside, Wadhwa thinks we take for granted
the “potent force” of the American dream — work hard and
make it big. “In almost every country in the world, this is not
the case.”
Likewise, as Phan shows the younger generation how to
manage and keep a business going, he urges them to become
joiners, to live in the larger community because, in his
words, “I probably love this country because I saw the other
side of the coin.”
RF

READINGS
Anderson, Stuart, and Michaela Platzer. “American Made: The
Impact of Immigrant Entrepreneurs and Professionals on U.S.
Competitiveness.” National Venture Capital Association,
November 2006.
Fairlie, Robert W.. “Self-Employed Business Ownership Rates in
the United States: 1979-2003.” The U.S. Small Business Association
Office of Advocacy, December 2004.
Hunt, Jennifer, and Marjolaine Gauthier-Loiselle. “How Much
Does Immigration Boost Innovation?” National Bureau of
Economic Research Working Paper no. 14312, September 2008.

22

Region Focus •

Fa l l 2 0 0 8

Kerr, William R. “Ethnic Scientific Communities and
International Technology Diffusion.” Review of Economics and
Statistics, August 2008, vol. 90, no. 3, pp. 518-537.
Wadhwa, Vivek, Ben Rissing, AnnaLee Saxenian, and Gary Gereffi.
“America’s New Immigrant Entrepreneurs: Part 1.” Duke Science,
Technology & Innovation Paper No. 23, January 2007.
Zarrugh, Laura H. “From Workers to Owners: Latino
Entrepreneurs in Harrisonburg, Virginia.” Human Organization,
Fall 2007, vol. 66, no. 3, pp. 240-248.

INTERVIEW
Joseph Gyourko

PHOTOGRAPHY: TOMMY LEONARDI

Editor’s Note: This is an abbreviated version of RF’s conversation with Joseph Gyourko. For the full interview, go to our Web
site: www.richmondfed.org/publications.
The boom and subsequent decline of the U.S. housing
market has many economists and the general public asking: What happened? Joseph Gyourko, a professor of
real estate at the University of Pennsylvania’s Wharton
School of Business, has spent a lot of time examining
that issue. In part, he says, the run-up was caused by
irrational, speculative behavior by private lenders and
borrowers. But there were other causes, too, such as
land-use regulation that limited building in some cities
and thus drove up prices. Gyourko argues that in areas
where it is relatively easy to build, the correction will
likely persist until prices are again driven by fundamentals — meaning, by production costs. In those areas
where regulation has effectively capped the supply of
housing, such as New York City, prices will be determined almost solely by demand, which has fallen
recently as numerous Wall Street firms have encountered troubles.
Gyourko also has looked at the problems Fannie Mae
and Freddie Mac have experienced. He argues that the
implicit subsidy those companies received came with a
costly catch — to provide risky loans to marginal applicants in the name of “affordable housing.” While the
provision of affordable housing may be a laudable policy
goal, it should be done transparently, with the budgetary costs clear to everyone. Ultimately, Gyourko argues,
Fannie and Freddie should be shrunk and privatized.
As an urban economist, Gyourko has studied
what drives economic growth and vitality. In today’s
economic environment the most important factor is
human capital. Cities with innovative, high-skilled work
forces will continue to thrive while many of the giant
industrial cities will face a steady, if slow, decline.
Gyourko joined the Wharton faculty in 1984, after
earning his Ph.D. that same year at the University of
Chicago. He has served as co-editor of Real Estate
Economics, been a visiting scholar at the Philadelphia
Fed and a nonresident senior fellow at the Brookings
Institution, and since 2006 been a research associate
with the National Bureau of Economic Research
(NBER). He currently is director of Wharton’s
Zell/Lurie Real Estate Center and co-author with
Edward Glaeser of the recently published Rethinking
Federal Housing Policy: How to Make Housing Plentiful
and Affordable. Aaron Steelman interviewed Gyourko at
his office at Penn on Sept. 25, 2008.

RF: Is the expansion of homeownership, in your view, a
desirable public-policy goal?
Gyourko: I think there are benefits to homeownership.
That said, expanding it the way we have done is clearly not
worth enduring systemic risk. So, given how we did it and
what we got, the answer is no.
This is how I think we should consider the issue: When
you become an equity owner, you have a stake in your community. You have a stronger incentive to make the
community better than if you were transient. That is the
standard economic argument in favor of potentially subsidizing homeownership. But there is no evidence in the
literature that relies on truly experimental or exogenous
variation which shows there is any benefit. We all believe
there is but it is very hard to find. You can identify correlations of being a homeowner and better outcomes for
children, of being a homeowner and being more publicspirited in terms of becoming informed about public issues.
But it’s hard to show causality. Yes, I think economists
believe there are positive externalities to being a homeowner. But there is no way that those positive externalities

Fa l l 2 0 0 8 • R e g i o n Fo c u s

23

justify the extent we have intervened in the market through the
huge subsidies that have gone to
Fannie Mae and Freddie Mac and
created systemic risk.

Supply-side restrictions are a
big reason why housing prices
are so high in some markets.

RF: What do you think of the
home mortgage interest deduction?
Gyourko: It’s a political sacred cow. But I don’t think it has
done much good and I am not in favor of it. Ed Glaeser has
done some work that shows its effect on the homeownership rate is very small. Consider my own case. My decision to
buy a house is not affected at all by the home mortgage
interest deduction. I have two children who go to public
schools in a nice area. And to go to those public schools, you
have to own a home because there is not much rental stock.
So that’s a big reason why I am a homeowner, not because I
can deduct the mortgage interest.
What the policy does affect, though, is the type of homes
people own. I probably own a bigger home than I would
otherwise. But it’s not at all clear to me why you would want
to subsidize middle- and upper-income households. I don’t
think it is affecting the homeownership rate much and it is a
subsidy to the relatively better off.
RF: How much, if at all, does homeownership contribute to frictions in the labor market — that is,
lessening mobility for new and perhaps more suitable
employment options?
Gyourko: We are a little unclear on sharp estimates. But Ed
Glaeser and I did some work in 2005 which shows that
cheap housing in general is really attractive to the poor in
declining areas. The argument goes as follows: If you are a
low-skilled worker, your wage is pretty much the same in
Detroit as it is in, say, Charlotte. However, prices in declining areas like Detroit can fall dramatically below
construction costs but not in Charlotte. So you might
actually be relatively better off in Detroit, even though
your employment opportunities are less, because you can
consume a lot of great housing at a cheap price.
More broadly, some work I recently did that is now out in
the NBER Working Papers series shows that if you go
negative in terms of your home equity, your two-year
mobility rate falls by half. Why? Mainly, I think, because
those people are capital constrained. Also, I think there is
some loss aversion that is going on. But it’s clear that there
are large mobility effects if you have negative equity in your
home. I think they are much smaller if you do not have
negative equity.
We do know that there are big differences in mobility
between renters and owners. But, again, that is not necessarily causal. I am an owner and I am much less mobile than my
research assistant who is a renter. But that’s because he is
young and doesn’t have kids, whereas I want to stay in the

24

R e g i o n Fo c u s • Fa l l 2 0 0 8

same place. I don’t want to move
my kids out of school. People
who want to stay in one place do
tend to own a home, but it’s not
necessarily the home that locks
them in.

RF: I have read that the nonprime mortgage market
reached nearly 40 percent in recent years. What do you
think is a more stable long-run figure?
Gyourko: Actually, the nonprime market reached 50 percent in 2006. That includes subprime, Alt-A, home equity,
and FHA/VA. The sum of those four reached 50 percent of
mortgage volume issued in 2006. In a typical year, it would
range somewhere between 10 percent and 20 percent.
It skyrocketed. I think the 10 percent to 20 percent range is
more normal.
RF: What do you think caused that increase?
Gyourko: There were a couple of factors. First, a long
period of rising prices led both borrowers and lenders to
believe that, with relatively little risk, you could have very
high leverage and very low rates. That, combined with the
very large fees that these loans generated, led to an increase
in market share. Second, I believe the government strongly
encouraged it. Fannie and Freddie provided important
liquidity for this market.
Why did they do that? I doubt that it was because they
thought it was in their shareholders’ interests. They probably thought these were risky loans. They had Congress
telling them that their implicit subsidy comes with this mandate to provide affordable housing, and this was one of the
ways that they did it. Our political system very much
encouraged them to provide liquidity and extend these risky
loans to very marginal buyers.
RF: What would you view as a desirable endpoint, from
a policy perspective, with regard to Fannie Mae and
Freddie Mac?
Gyourko: I would like to see them shrunk, privatized, and
spun off. That means the affordable housing component of
their reason for being has to be taken over by somebody else,
because I don’t think we should do away with all affordable
housing programs.
But I do think those programs ought to be brought onbudget and placed in the Department of Housing and
Urban Development or a similar entity and made an explicit
cost to the government. The way to get these programs
managed properly is to have them truly transparent, and
then we can decide which ones we think are worth it and
which ones are not. I think the reason these programs got so
big was that they were off-budget, and politicians could
nudge Fannie and Freddie management because there was

no cost in terms of actual budgetary expenditures, even
though there was obviously a very large cost in terms of risk.
RF: Could you discuss your work with Ed Glaeser on
land-use regulation and the price of real estate in urban
areas?
Gyourko: Glaeser took a leave from Harvard and visited
Penn for a year. We started talking and one of the things we
noted was that the dispersion in house prices across markets
is going way up over time. However, the high land price areas
are relatively few and they are almost all on the coasts of the
United States. The question is: Why is that the case? One
answer would be, if you only believe in horizontal development, you have an ocean as a natural barrier to growth. But
you can also build up, and New York was the classic case.
Another reason might be income. The reason prices are
higher in New York, Boston, San Francisco, and Los Angeles
is that incomes are higher. And then you get another boost
for San Francisco and Los Angeles because the climates are
great. People are willing to pay for that.
But supply is an important factor. It became clear that
unless you have differences in supply, you could not explain
why prices were very high in those markets. There has been
very little new construction. And the reason why is that
there have been restraints on growth. Developers would like
to build but they can’t because of regulation. We have now
convinced ourselves, and I hope others, that supply-side
restrictions play a big role in how those markets have
changed and are a big reason why their prices are so high.
The existing residents of those areas have been very
successful at limiting growth.
RF: Why would you see such behavior among residents
in only a select group of cities, though?
Gyourko: We don’t know. As economists, our first thought
is that the people of New York and San Francisco are just
protecting capital gains. But let’s assume that the people of
Richmond and Atlanta are not stupid, and obviously they are
not. They could figure this out, too, and place restrictions on
growth. But they haven’t. Clearly there is something else
going on. It could be social. It’s a huge research question.
RF: Do you see the trend of tremendous growth in
house prices on the coasts continuing?
Gyourko: In the long run, that trend will continue. But in
the short run, they are going to fall. New York’s housing
supply is inelastic so the prices are determined by
demand. When Wall Street is booming, housing prices are
going to rise. When it is having trouble, like now, housing
prices are going to fall, I think substantially. But in the long
run — let’s say 10 years or more — prices are going to continue to rise. They are attractive places to live — they have a
lot of amenities — and they have high human capital.

So as long as people want to live there and they are fundamentally productive, prices will go up in the long run if you
restrict supply.
RF: Have you looked at Houston? If so, how has its
regulatory policies (or lack thereof) affected development compared to other Sun Belt cities?
Gyourko: In terms of growth, there’s not much difference.
Atlanta, Dallas, and Houston have all grown well above the
national average in terms of population expansion. And if
you are growing in population, it means you are building
homes. The correlation between the change in population
and the change in housing units is almost one. So they are all
growing at fairly similar rates.
What differentiates Houston is that it is more of a
hodgepodge, because it is unique in its relative lack of zoning policies. So you get one type of development right next
to a completely different type. Personally, I don’t like that. I
think there actually are negative externalities to that type of
growth.
While Glaeser and I have argued that the social costs of
development congestion are not nearly as high as the price
increases associated with excessive limitations,
I am not a believer in no zoning and no regulation. There
really are some social costs, and I think Houston probably
goes too far. It doesn’t internalize some of those costs. You
should think about traffic flows. You should think about pollution spillovers. It is reasonable to try to internalize the
costs of those things. It is quite legitimate for government to
congregate certain types of activities in select areas. That’s a
far step from, say, having huge minimum lot size requirements, so that only the super rich could live in an area.
In short, I think cities are better off with some
regulation, much less than New York, but probably more
than Houston.
RF: Some people have argued that the housing markets
in cities like Buffalo, Cleveland, and Detroit are ripe for
a rebound as jobs become more mobile, due to telecommuting, and people look for more affordable housing.
Do you think there is some truth to those arguments or
do you think they tend to be too optimistic?
Gyourko: I think it is highly unlikely that we will see a
rebound in those cities’ housing markets. Again, what
drives modern growth in the modern era — ever since manufacturing deurbanized — is skills. You need high-skilled
people, and there is no reason for those people to go to
Buffalo. They can go to Charlotte, Atlanta, or Dallas,
where the climates are better and there tend to be more
amenities.
Now, is it possible that one of those slumping cities will
have the next Bill Gates in it, just by serendipity, and that he
sprouts a huge new industry there? Yes, it’s possible. But it
would require a lot of luck.

Fa l l 2 0 0 8 • R e g i o n Fo c u s

25

RF: You have talked a lot about how people value amenities when choosing a place to live. Older industrial cities
tend to still have good medical facilities, nice museums,
and world-class orchestras, all of which arose during
their industrial heydays. Why aren’t those attractive to
residents?
Gyourko: They are important. Those things help to explain
why urban decline is so long and so slow. This wealth that
they accumulated when they were great industrial towns is
very durable. It has thrown off things that have lasted a long,
long time. The Cleveland Clinic is still with us, it is still one
of the great medical centers in the world, and that’s not
going to go away. But the rest of the place will slowly decline
because very little of our economy is tied to having cheap
water access, which means that the business value of being
on the Great Lakes has declined sharply.
RF: Many cities have helped fund sports stadiums, with
public officials arguing that such facilities will improve
the business and residential climates in such areas.
For instance, this argument was used in Washington,
D.C., when the new baseball stadium was built in
Anacostia. Is there much evidence to support such
claims?
Gyourko: The bulk of the evidence is that, in a purely fiscal
sense, these things don’t work. The numbers don’t add up. So
to justify them, you have to make different arguments.
When Ed Rendell, the former mayor of Philadelphia and
now the governor of Pennsylvania, argued in support of subsidies for stadiums for the Phillies and the Eagles he said
that there are valuable social spillovers. There’s a feeling of
community that is generated by having nice stadiums where
fans can go and have a good time. I think that is the only
argument that is plausible.
I personally don’t like these subsidies. Consider the
Eagles. The National Football League operates a type of
monopoly. There is not free entry. So when you subsidize
stadiums, you are providing a subsidy to players and
management. I see no reason why the median taxpayer in
this town should subsidize Jeffrey Lurie, the owner, or
multimillion dollar players. I didn’t favor such subsidies.
I don’t favor them. And I have never seen any hard, good
evidence, which is replicable, that shows they are positive in
a fiscal sense.
Rendell made a noneconomic argument. I don’t think it’s
a compelling argument. But it is a far stronger argument
than claiming that there will be a net revenue gain by subsidizing stadium construction. One of the reasons that the
economic argument is weak is that people have a relatively
fixed budget for leisure. People who don’t go to the football
stadium and spend money there are likely to spend those
funds elsewhere, say, at the movies. But they are not likely to
spend money both at the game and at the movies. They are
choosing between available options.

26

Region Focus •

Fa l l 2 0 0 8

RF: But what if the city council decides that it wants to
revitalize a certain part of the city and that building a
stadium would help do that?
Gyourko: Yes, that has been a justification for some
stadium subsidies. But when people say that they want to
improve an area, I suspect that what they really want to do
as a society is to help the people living in that area. A much
cheaper and more efficient way to do that is to directly give
them money. So when you think about the subsidy for the
Washington Nationals’ new ballpark in Anacostia, think
about the money that was spent on that. Then take that
same sum, divide it by the number of poor people living
around the stadium, and that’s the size of the check you
could have given them. If you really want to help them, that’s
the way to do it.
RF: How accurately do households factor in commuting
costs when purchasing houses in the suburbs or exurbs?
Gyourko: I haven’t seen economists address that question.
But I think people understand quite well what the trade-offs
are. And, increasingly, people who work in the downtown
core do not live in the exurbs. Remember, the reason you
have exurbs is that businesses follow people out there. So
those people’s commuting costs are often much lower than
you might think.
I will give you an example: the Philadelphia metro area.
The largest office node is not downtown Philadelphia. It’s
the King of Prussia office node northwest of the city. It has
10 million more square feet of office space than downtown
Philadelphia. People live around there and have pretty short
commutes. So employment has suburbanized and that’s why
commuting times are not as severe as a lot of people believe.
I think people understand how much they are going to
have to drive. The real question is: Do we pay too little for
gasoline? The answer is almost certainly yes, at least until
recently. The true social cost of driving was higher than the
price we were paying at the pump.
RF: What do you think of “Best Places to Live” studies?
Gyourko: I am not a big fan of the popular ones because
they don’t do it through revealed choice. Quality of life
should be measured by how much you are willing to pay to
live in an area. Instead, a lot of these indices put places near
the top of the list with cheap housing. As an economist,
I know that housing must be expensive somewhere because
it is really attractive or really productive. High prices signal
high quality of life, not low prices. The classic urban spatial
equilibrium models say that housing prices are the fees you
pay to access the amenities and productivities of an area.
I built some indices in the early 1990s based on that
assumption. I think most of the business community gets
this backward, because they like low prices, not unsurprisingly. From their point of view, Green Bay looks really

attractive. Do you really think the
quality of life is higher there? My
argument would be no, because
people are not willing to bid up
the price.
RF: You have a recent working
paper titled, “Do Political Parties
Matter? Evidence from U.S.
Cities.” Can you talk about that a
little?

Joseph Gyourko
➤ Present Position

Martin Bucksbaum Professor of Real
Estate and Finance, The Wharton
School, University of Pennsylvania
➤ Education
A.B. (1978), Duke University; Ph.D.
(1984), University of Chicago
➤ Selected Publications
Co-author of Rethinking Federal Housing
Policy: How to Make Housing Plentiful and
Affordable (2008); author or co-author of
numerous papers in such journals as the
American Economic Review, Journal of
Political Economy, Quarterly Journal of
Economics, Journal of Law & Economics,
and Journal of Urban Economics

Gyourko: That paper is forthcoming in the Quarterly Journal of
Economics. There is a big political
economy literature out there which
says that at the federal and state levels, political parties matter. That is,
partisanship is important because
the policy outcomes are quite different if, say, the Republicans are in control rather than the
Democrats. My colleague Fernando Ferreira and I thought
that this probably isn’t true at the local level. We suspected
that the reason is that there is much more competition at
the local government level. For instance, if I don’t like
policy at the federal level, what am I going to do? I could
move to Canada. But that’s very costly. It’s also usually
costly to move to another state. But if I don’t like the policies of my hometown of Swarthmore, it’s pretty cheap to go
next door. So we thought that competition would restrain
partisanship.
We spent a couple of years collecting data on mayoral
elections: which party won and by how much. In this paper,
we looked at close elections and compared local fiscal policy
outcomes — how big was the government, what they spent
their money on, things like that. The reason we relied on
close elections is that it doesn’t appear that the populace of
those jurisdictions have extreme preferences. And so it
becomes possible to test whether a politician is able to
impose his views in favor of either smaller or bigger government. It turned out that it didn’t matter whether a
Republican or a Democrat won a close election. They do
basically the same thing.
This, in my view, is basically a validation of Anthony
Downs’ median voter theory. At the local level — perhaps
not at the federal or state level — what really matters are the
preferences of the median voter. It’s not the preferences of
the politicians who get elected. The politicians are driven by
the competitive forces of their environment to do what the
median voter wants. Mobility is so high and there are so
many competitive districts within a metropolitan area
where people can move to, that the politicians must respond
to the median voter’s wishes. A politician might be ideological but he can’t act on it.
To give you an example, in Swarthmore there are a bunch
of single-family homes owned by relatively high-income

people who are willing to tax themselves a lot to get good public
schools. That’s the median voter.
Any politician who said he was
going to cut taxes and not fund
schools would get run out of town
on a rail. He might believe that
personally, but he would never
declare it publicly.
RF: Are there any issues that you
are working on currently which
you think are important that we
haven’t discussed?

Gyourko: Ed Glaeser, Albert Saiz,
and I have this paper, “Housing
Supply and Housing Bubbles,” that
just came out in the Journal of Urban
Economics. Basically, it shows that in
inelastically supplied housing markets, volatility really is
higher. It’s true not just on the blackboard, it also shows up
in real-world data. Inelastically supplied housing markets
have much bigger housing booms and busts, which is a bit
foreboding right now. When fundamentals change, price
could adjust or quantity could adjust. But quantity can’t
adjust in an inelastic market. All of the adjustment from the
change in fundamentals is in prices. They can really boom in
good times and really bust in bad times. So as we think about
this housing debacle, one of the ways to at least lower
volatility in the next downturn — and there will be another
one — is to think about increasing the elasticity in these
markets.
The other thing in that paper which I think is interesting
really goes back to work by Sherwin Rosen and Jennifer
Roback. In a free market, prices are pinned down by production costs. And those production costs are physical
construction costs, land and land assembly costs, and entrepreneurial profit. In that paper, we compute each of those
costs for each market. You can build an 1,800 square foot
home in any market in the United States for less than
$200,000 in today’s dollars.
If you look prior to 2003, throughout the Sun Belt, in any
unconstrained market where you think supply elasticity is
high, actual prices never deviate by more than 10 percent.
It appears to work really well. Then, after 2003, in Florida,
Phoenix, Las Vegas, the Inland Empire of California, prices
started to deviate considerably. That appears to be the
beginning of the real mispricing of housing. Those markets
start to look like they are inelastic in supply, but the
number of permits never went down. As an old Chicago
School guy, it’s the closest I have ever come to saying we
simply mispriced this asset. Theory tells us that prices
should be pinned down by the sum of those three factors,
and for 20 years they were. To me, this also suggests where
prices are going back to in those markets.
RF

Fa l l 2 0 0 8

• Region Focus

27

ECONOMICHISTORY
Gold Among the ’Heels
BY B E T T Y J OYC E N A S H

This illustration of the Gold Hill mining
works appeared in Harper’s New
Monthly Magazine in 1857, 15 years after
gold was first discovered in the district.
The area was most prosperous and
profitable between 1853 and 1858. In 1854,
miners struck a new deposit. The Randolph
mine plumbed 800 feet, and yielded more
gold than any mine east of the Mississippi.

28

R e g i o n Fo c u s • Fa l l 2 0 0 8

hen people say the streets
of Charlotte are paved
with gold, they’re not
speaking metaphorically. They may
very well be flecked with gold underneath the asphalt.
Eleven years after the Constitution
was ratified and 50 years before
the Forty-niners rushed to California,
a Cabarrus County, N.C., farm boy
picked from a creek a shiny rock that
his father used as a doorstop for
three years. At least, that’s the story.
It brought $3.50 from a Fayetteville
jeweler but was worth $3,600. The
rock turned out to be a 17-pound
gold nugget, and there was more
where that came from — the Reed
Gold Mine.
News of North Carolina gold set
off a half century of discoveries in the
South, from Virginia to Alabama.
The gold turned corn and cotton farmers into spare-time surface miners, and
eventually brought people from
mining regions of England, Wales,
Italy, Germany, Austria, and Poland,
not to mention put money directly
into the pockets of the cash-poor
citizens of this new nation. As surface
mines played out and evolved into
deep mining enterprises, private
interests organized investors, business
plans, large-scale machinery, and
mining
expertise
to create full-time
corporations. These
industrial enterprises
attracted money from
the North and abroad.
The state also, in 1827,
granted the first corporate charters to
mining firms, giving
investors some legal
protection.
The North Carolina gold rush pales in

W

comparison to California’s, which
produced gold estimated at $200
million (in that era’s dollars). North
Carolina’s output totaled about $17.5
million between 1799 and 1860,
excluding gold that was bartered or
shipped abroad. (The price of gold
hovered around $20 per ounce
throughout the 19th century.)
In contrast to the wild California
migration from around the globe to
stake claims, the North Carolina rush
seems subdued. But from 1804 until
1828, all domestic gold coined at the
U.S. Mint in Philadelphia came from
the Tarheel state. At the time,
however, precious little came back
home to circulate.

Grains of Gold
New World explorers searched for
gold to no avail. While rumors of
riches abounded in the Colonial era,
there’s no record of its discovery. But
the Europeans who undertook those
expeditions were on royal missions,
and most gold discovered would have
become royal property. “Thus, there
had never been a gold rush,” writes
Bruce Roberts in his book, The
Carolina Gold Rush. “What sense was
there in rushing in to get something
the king’s men would appropriate?”
North Carolina gold lay in what’s
known to geologists as the Carolina
slate belt, a swath that extends
through the Piedmont region from
Virginia to Mississippi. But mines also
were found in the western and eastern
parts of the state, according to retired
historian Richard Knapp, who coauthored Gold Mining in North Carolina
with Brent Glass, who now directs the
Smithsonian’s National Museum of
American History.
U.S. Mint deposits don’t reflect the
total amount of gold produced
because miners spent gold with local

ILLUSTRATION: LOC, LC-USZ62-61829

News of gold
discoveries pulled in
experts, captains of
industry, money, and
miners to the sleepy
backwater that was
early 19th century
North Carolina.

merchants, shipped it to Europe, and used it to make
jewelry and decorate guns besides sending it to be coined. At
the country stores, a pennyweight of gold was worth almost
a dollar, according to Bruce Roberts.
North Carolinians needed that cash. Production in those
early years had been erratic, and annual shipments to the
Mint in Philadelphia were negligible, partly because the gold
particles served as currency. Gold was highly valued, according to Knapp and Glass, because there wasn’t much currency
to be had. By 1819, only $5 circulated for each citizen in the
nation. The North Carolina state geologist of the era,
Denison Olmsted, wrote: “Almost every man carries with
him a goose quill or two of it [gold], and a small pair of scales
in a box like a spectacle case … I saw a pint of whiskey paid
for by the weighing of 3 1/2 grains of gold.”
As cotton fortunes rose and fell, eras of price decline
inspired farmers to spend more time finding gold. Most
mines remained inefficient and production sporadic, but
several gained prominence and, by the 1830s, the gold mines
were becoming big business.

40 years later it was a prospector’s paradise with a mine on
every farm,” writes Roberts.
But turning gold nuggets into coins presented almost as
much of a problem as mining it. The trip to Philadelphia
over rutted roads offered little but danger and an expense of
5 cents to 10 cents a mile. If a mine owner preferred to stay
home so he could mine more gold, he could ship his product,
but risked theft and expense that way, too. And if he cashed
the gold out at a local bank or business, he would pay a commission of 6 percent or more.
Legislative efforts prevailed when, in 1835, President
Andrew Jackson signed legislation authorizing branch mints
in Charlotte (population 730), the center of gold production.
The legislation also brought mints to Dahlonega, Ga., and
New Orleans.
Even though the U.S. Mint didn’t open the Charlotte
branch until 1838, a private enterprise had been minting
coins in the town of Rutherfordton in the foothills for seven
years.

The Bechtler Mint
Easy Pickings
At first, farmers found gold in streambeds, what was called
“placer,” “branch,” or “deposit” mining. Farmers diverted
water to wash pans or troughs of gravel. (Gold is 19 times
heavier than water, eight times heavier than sand, and three
times heavier than iron, so it sank to the bottom. Gold particles are also attracted by amalgamation with other metals.)
Miners worked for a share, typically 87 cents to 90 cents per
day, according to Roberts, although it’s hard to believe the
hired help didn’t stuff their own pockets first. The amount,
comparable to the era's farm labor wages, varied day by day,
mine by mine, according to the gold that laborers found.
By the 1820s surface gold had begun to play out. William
Thornton, the architect who had designed the U.S. Capitol
building, had researched gold prospects in 1806, and
returned to Washington, D.C., to form the N.C. Gold Mine
Co. His venture fizzled, but he contributed the insight that
more gold might lay underground.
The gold mining industry began in earnest in 1825 when a
Stanly County farmer named Barringer investigated a rock
outcropping. He struck a vein of gold mixed with quartz,
and in one day had extracted $1,200 to $1,500 worth of gold.
Before the mines lost their glitter, half the state’s counties had at least one, with the most found in Mecklenburg.
That county’s mines included those with colorful names like
Queen of Sheba, King Solomon, and the famous Rudisill
mine at the intersection of Mint and Summit streets in
Charlotte. Count Vincent de Rivafinoli managed the
Mecklenburg Gold Mining Co. that employed about 600
people. By 1830, the Charlotte-based Miners’ and Farmers’
Journal began publishing. Articles about gold mines were
picked up in other weekly newspapers, and the news of
North Carolina gold put the state on the map.
“Mecklenburg County may have been a ‘hornet’s nest’ to
Cornwallis and a ‘trifling place’ to George Washington but

A German gunsmith, Christopher Bechtler, Sr., immigrated
from a gold-mining region in Germany when news of North
Carolina’s gold reached Europe. He settled near gold finds in
the South Mountain geological belt, opened shop in 1831,
and minted the first American gold dollar. The U.S. Mint did
not begin coining gold dollars until 1849. (The Charlotte
Mint produced only gold coins — totaling approximately $5
million over the life of the mint — in three denominations.)
Bechtler’s books, according to Roberts, show that he coined
more than $2.2 million from 1831 to 1840.
By this time, the deep mining that required equipment,
labor, and know-how had taken root. Shafts were
sunk to as much as 900 feet deep in the Gold Hill Mines,
perhaps the most developed hard-rock mine in
North Carolina, according to Knapp and Glass. In 1857,
Harper’s New Monthly Magazine published an illustrated
account of life in this mining town in Rowan County
near Salisbury, N.C. The author, writing under the pseudonym Porte Crayon, describes his descent into the mine’s
mouth:
This was a square opening lined with heavy timber, and
partly occupied by an enormous pump used to clear the
mines of water and worked by steam …The ladders were
about twenty inches wide, with one side set against the
timber lining of the shaft, so that the climber had to
manage his elbows to keep from throwing the weight of
the body on the other side … Heated and reeling with
fatigue, they at length halted at the two hundred and
seventy foot gallery. Here they reposed for a few minutes, and then leaving the shaft walked some distance
into the horizontal opening … The miners were congregated here, awaiting the explosion of a number of blasts
in the main gallery … They were soon enveloped in an
atmosphere of sulphurous smoke.

Fa l l 2 0 0 8 • R e g i o n Fo c u s

29

Gold Hill today is a 70-acre park privately owned by the
nonprofit Gold Hill Foundation, which also owns the
mineral rights over 400 acres. From documents and clippings, Vivian Hopkins, who lives near Gold Hill, has pieced
together the history of the gold heyday. The first discoveries
were in 1823 and 1824, she says, with copper and silver running through the veins as well as gold. The mine’s two main
shafts, Barnhardt and Randolph, plumbed depths of 500
and 800 feet, respectively. By the early 1840s, the mine
had become a conglomerate of 23 mines in the Gold Hill
region. The lively town developed the usual businesses of
the day: a general store, shoemaker, livery stables, and
wagon makers.
Gold Hill investors traded stock on a New York
exchange; mine experts oversaw three daily shifts. While the
gold mining industry never replaced farming, authors Knapp
and Glass write that it “offers impressive evidence of industrialization that struck a balance between industry and
agriculture, a balance that persisted in other, more successful industries that fueled the state’s economy well into the
end of the twentieth century.”

The Panics of 1837 and 1857
The North Carolina gold rush erupted in an era when state
banks issued their own notes, and attempts at national banking had foundered. Silver coins that had been produced at
Philadelphia were being hoarded by state and private banks
to back their paper currency. The effects of the gold finds in
North Carolina on the financial system apparently have
been little researched, yet the claim is made that North
Carolina gold made a big difference in the amount of gold
available to the federal government, Knapp says.
Even after the California Gold Rush, the mines at Gold
Hill thrived, Hopkins says, noting it wasn’t until 1857 that
Harper’s Weekly published its accounts of Gold Hill. Up to the
Panic of 1857, which brought a chain of failures of banks and
businesses, many gold mines were bought by Northern
interests, Knapp says. But by 1860, even before the Civil War
forced operations to cease, gold mining began its decline.
“The Panic of 1857 had an effect — it was harder for companies after that depression to raise capital, and they were
competing with companies in California, which probably
offered better chances,” he says. Mining engineers and
experts migrated to California, and gold in the North
Carolina mines was getting more expensive to extract
because deep mines typically hit water. There’s an old
saying that when the pumping starts, the mining ends,
Knapp says, adding that there were more engineering

problems than there was gold to be had.
But one flamboyant promoter of the era, Walter George
Newman, enticed Wall Street investors by salting the
mine at Gold Hill with gold nuggets. Newman went out of
business and died penniless.
The North Carolina Militia put the Charlotte branch
mint under state control in 1861, with its coins and bullion
turned over to the Confederate states. It never reopened but
served as a hospital and headquarters during the war. The
structure was rebuilt, altered, moved, and today houses the
Mint Museum of Art, where the exhibits include gold coins.
While the gold mines never had the long-term impact of
the textile or tobacco industries, the deep mines nevertheless were the first industry to attract significant outside
capital and form corporations. Farmers’ mining efforts,
and later deep mine enterprises, brought an organization
of work routines and expertise critical to industrial
development.
An overlooked contribution of the gold mines in the
state’s industrial evolution was its public relations value.
News of gold pulled in experts, captains of industry, money,
and miners to the sleepy backwater. They came from the
North and abroad, especially England. And the wealth generated by the gold industry played a part in the development
of Charlotte as a banking center. Consider Robert Miller
who bought Charlotte’s Rudisill gold mine in 1878 along with
several partners. Miller was an original board member of the
Commercial National Bank, Bank of America’s predecessor.
In the Depression, there was a resurgence of creek and
deep mining especially after President Franklin Roosevelt
fixed the price of gold to $35 an ounce, its first significant
increase in many years. “It got people interested in gold as a
source of income,” Knapp says. Although workmen did find
a nugget while constructing a new building for First Union
National Bank in Charlotte in 1969, the easily gotten gold
was no doubt exhausted.
Gold seekers today can walk portions of a restored mine
tunnel and pan for gold at the state’s historic site where
the Cabarrus County boy found that first chunk, the
Reed Gold Mine. And prospectors still pore over geological
maps. In 2008 the Gold Summit Corp. of Nevada investigated the potential for gold on sites in North Carolina
and South Carolina, showing that the fascination with el
dorado never dies. The results proved too weak to pursue,
according to a press release, but “the partners remain interested in evaluating more of the higher-priority gold
anomalies in the broader districts if suitable option
terms can be negotiated.”
RF

READINGS
Crayon, Porte. “North Carolina Illustrated, The Gold Region,”
Harper’s New Monthly Magazine, August 1857, vol. 15, no. 87,
pp. 289-300.
Knapp, Richard, and Brent Glass. Gold Mining in North Carolina.
Raleigh, N.C.: Division of Archives and History N.C. Dept. of
Cultural Resources, 1999.

30

R e g i o n Fo c u s • Fa l l 2 0 0 8

Roberts, Bruce. The Carolina Gold Rush. Charlotte, N.C.: McNally
and Loftin, 1971.

BOOKREVIEW
Bringing Life to the Dismal Science
THE PRICE OF EVERYTHING:
A PARABLE OF POSSIBILITY AND PROSPERITY
BY RUSSELL ROBERTS
PRINCETON: PRINCETON UNIVERSITY PRESS, 2008, 203 PAGES
REVIEWED BY AARON STEELMAN

t the beginning of the appendix to his new novel,
economist Russell Roberts of George Mason
University writes: “This book is my attempt to give
the beginner and the expert a better understanding of the
role prices play in our lives — how they create harmony
between the competing desires of consumers and entrepreneurs, and how they steer resources and knowledge to
transform and sustain our standard of living.”
As you might suspect, then, The Price of Everything is no
ordinary novel. Yes, it has a plot, but it is secondary — a
device to get across some core economic points. This means
that the book is long on dialogue and some readers might be
tempted to say short on character development. But
through these extended conversations, you not only learn
economics, you also find out what makes the main characters tick. This is especially true of Ruth Lieber, an economist
whose zest for her job and life in all its facets makes her the
real star of The Price of Everything.
The story, though, does not center around Ruth. Instead,
the main character is Ramon Fernandez, a standout tennis
player at Stanford University. Ramon came to Miami from
Cuba with his mother, Celia, when Ramon was just 5 years
old. Ramon’s father, Jose, had been a star baseball player, a
national hero, whose athletic gifts had garnered him special
favor with the Cuban government and meant that his family
lived in relative opulence.
But shortly after Jose’s death, the favors that his family
had received began to disappear. The
Fernandez clan was no longer useful to the
Castro regime — at least not for now. Those
favors might reappear if Ramon turned out
to be a great athlete like his father. But Celia
wanted more for her son. She wanted him to
be able to choose the life he wanted to live,
and so they fled to Florida, where Celia
worked cleaning houses and Ramon became
a tennis prodigy. After their defection from
Cuba, all official memory of Jose was
destroyed.
The book opens with Ramon and his
girlfriend Amy making dinner when an
earthquake hits the San Francisco Bay area.
They drive to Home Depot to buy flash-

A

lights but find that the store is sold out. So they go instead to
“Big Box,” a new chain that is described as a combination
“Home Depot, Sam’s Club, and Borders.” Big Box has an
ample supply of flashlights, milk, and other items people
want following a natural disaster. But there’s a catch: The
store has doubled its prices in response to increased
demand. This outrages Ramon who believes the store is taking advantage of people in a crisis, especially poor people
like his mother back in Florida. He later determines to stage
a protest against Big Box — whose CEO happens to be one
of Stanford’s biggest donors — that ends in chaos. Not to be
deterred, he plans to use his opportunity as commencement
speaker to rail against the injustices of Big Box and other
companies that, in his mind, put profits over people.
In the intervening weeks before graduation, though,
Ramon gets to know Ruth, who is teaching one last class
before retirement. Amy is one of her students, and she tells
Ramon of the excitement that Ruth brings to the classroom.
Ruth believes that, while not perfect, the market is the institution best suited to meeting the myriad desires of people,
rich, poor, and in between. She hopes to demonstrate to her
students that the actions of the market may seem unruly, and
at times unfair, but that order emerges naturally. One of her
favorite phrases is that the fruits of the market are “the result
of human action but not the result of human design,” echoing
the Scottish Enlightenment thinkers of the 18th century.
Ruth explains to Ramon why Big Box’s decision to double
prices may have seemed hard-hearted but that it also probably was the best way to allocate goods in the time of a
disaster. Ramon remains skeptical — and suspicious. Is Ruth
Lieber simply a shill for Big Box, someone who doesn’t want
to see him bring embarrassment to the chain at commencement? Several conversations later, he remains unsure of “the
virtues of unmanaged, uncoordinated, unorganized, undesigned action.” But he’s also
less sure of his own original position — and
he certainly no longer doubts Ruth’s
sincerity.
Ramon and Amy graduate, get married,
and after winning several Grand Slam championships, Ramon has plans to move his
family to his homeland, which is now a
democracy in the post-Castro era. He
visits Ruth one last time, who is now elderly
and living in retirement on the Northern
California coast. It’s a touching scene and a
fitting end to a book that shows that a
market-based economy is neither boring
nor heartless.
RF

Fa l l 2 0 0 8 • R e g i o n Fo c u s

31

DISTRICT ECONOMIC OVERVIEW
BY S O N YA R AV I N D R A N AT H WA D D E L L

ifth District economic conditions weakened over the second
quarter of 2008 as employment
activity dropped, the housing market
contracted further, and mortgage
delinquency and foreclosure rates
rose. Nonetheless, in most indicators,
the Fifth District continued to outperform the nation.

F

Labor Markets Soften
Although Fifth District labor markets
stagnated somewhat in the second
quarter, they performed above the
nation. Payroll employment was flat in
the second quarter as employers
reported a net gain of 300 jobs (0.0
percent). Over the same period, the
nation shed 218,000 jobs for a 0.2 percent payroll decline. Since the second
quarter of 2007, the Fifth District
noted 0.8 percent payroll growth while
national employment grew 0.1 percent. Over the year, employment gains
were particularly solid in education
and health services (3.1 percent),
leisure and hospitality (2.0 percent),
government (1.5 percent), and professional and business services (1.4
percent). The steepest losses were in
the goods-producing industries as
manufacturing shed 27,600 jobs (2.2
percent) and mining and construction
shed 13,600 jobs (1.6 percent), most of
which were in construction.

The Richmond Fed’s service and
manufacturing sector surveys reported
a weakening in employment as more
firms noted reductions in hiring
activity. Contacts in retail reported
the steepest contraction in employment in recent months. Further
evidence of weakness in Fifth District
labor markets can be seen in the 0.5
percentage point rise in the unemployment rate over the second quarter.
Still, at 4.9 percent, the jobless rate
remained below the national mark of
5.3 percent.

Housing Market Conditions
Weaken Slightly
Recent assessments of the Fifth
District housing market indicated
some weakening in the second quarter.
New residential construction fell off
as residential permitting activity and
housing starts declined in the quarter.
Permit levels dropped 0.5 percent over
the second quarter and 33.3 percent
over the preceding year. Meanwhile, at
the national level, permitting activity
rose 27.0 percent in the second quarter, after three months of decline, and
fell 28.8 percent over the year.
Although second-quarter permit levels
grew in the District of Columbia,
Maryland, and South Carolina, all jurisdictions in the Fifth District have seen
continued year-over-year declines in

Economic Indicators
2nd Qtr. 2008
Nonfarm Employment (000)
Fifth District
U.S.
Real Personal Income ($bil)
Fifth District
U.S.
Building Permits (000)
Fifth District
U.S.
Unemployment Rate (%)
Fifth District
U.S.

32

1st Qtr. 2008

Percent Change
(Year Ago)

14,005
137,699

14,005
137,917

0.8
0.1

956.9
9,995.0

948.3
9,920.8

1.4
1.5

35.9
287.9

36.1
226.7

-33.3
-28.8

4.9%
5.3%

4.4%
4.9%

R e g i o n Fo c u s • Fa l l 2 0 0 8

permitting activity for at least two
years. Overall, Fifth District housing
starts also fell 9.1 percent in the second
quarter and 28.2 percent over the
preceding year.
Some weakening in Fifth District
housing activity was also evident in
reports on home sales and house
prices. Existing home sales fell 4.6
percent in the second quarter and
23.1 percent over the year. House
prices grew 0.5 percent in the second
quarter after a 0.1 percent decline
in the previous quarter. District
house prices, therefore, outperformed
national prices, which fell 1.4 percent
in the quarter.
Half of the jurisdictions in the Fifth
District saw a decline, as District of
Columbia house prices fell 1.8 percent,
Maryland prices fell 2.2 percent, and
Virginia prices fell 1.9 percent. On the
other hand, North Carolina house
prices rose 0.6 percent, South
Carolina prices rose 0.4 percent, and
West Virginia prices rose 0.7 percent.

Mortgage Delinquency and
Foreclosure Rates Rise
Most measures of conventional and
subprime mortgage delinquency and
foreclosure in the Fifth District hit
record or near-record highs in the
second quarter.
Nonetheless, rates remained below
those at the national level. Mortgage
delinquencies in the Fifth District
rose to 5.8 percent over the quarter as
both conventional and subprime
mortgages hit record-high delinquency rates at 3.5 percent and 19.3 percent,
respectively.
The subprime delinquency rate was
higher than the 18.2 percent national
mark, although overall delinquencies
and conventional mortgage delinquencies in the United States outpaced
Fifth District rates. The District foreclosure rate hit a record-high 0.7
percent in the second quarter
although it, too, was lower than the 1.1
percent U.S. foreclosure rate.

Nonfarm Employment

Unemployment Rate

Real Personal Income

Change From Prior Year

First Quarter 1998 - Second Quarter 2008

Change From Prior Year

First Quarter 1998 - Second Quarter 2008

First Quarter 1998 - Second Quarter 2008

4%

7%

8%

6%

6%

7%
3%
2%

5%
4%

5%

1%

3%
0%

2%
4%
1%

-1%

0%
3%

-2%
98 99 00 01

02

03 04 05 06 07

08

-1%
98 99 00 01

02

03 04 05 06 07

Fifth District

08

98 99 00 01

02

03 04 05 06 07

Nonfarm Employment
Metropolitan Areas

Unemployment Rate
Metropolitan Areas

Building Permits

Change From Prior Year

Change From Prior Year

First Quarter 1998 - Second Quarter 2008

First Quarter 1998 - Second Quarter 2008

First Quarter 1998 - Second Quarter 2008

7%
6%
5%
4%
3%
2%
1%
0
-1%
-2%
-3%

Change From Prior Year

7%

30%

6%

20%

5%

10%

4%

0%

3%

-10%

2%

-20%

1%
98 99 00 01

02

Charlotte

03 04 05 06 07
Baltimore

08

98 99 00 01

Washington

02

Charlotte

03 04 05 06 07
Baltimore

FRB—Richmond
Manufacturing Composite Index

First Quarter 1998 - Second Quarter 2008

First Quarter 1998 - Second Quarter 2008

30

30

20

20

08

-30%
98 99 00 01

Washington

FRB—Richmond
Services Revenues Index
40

08

United States

02

03 04 05 06 07

Fifth District

08

United States

House Prices
Change From Prior Year
First Quarter 1998 - Second Quarter 2008

15%
13%
11%
9%
7%
5%
3%
1%
-1%
-3%

10

10
0
0
-10
-10
-20
-20
-30

-30
98 99 00 01

02

03 04 05 06 07

08

98 99 00 01

02

03 04 05 06 07

08

98 99 00 01

02

Fifth District

03 04 05 06 07

08

United States

NOTES:

SOURCES:

1) FRB-Richmond survey indexes are diffusion indexes representing the percentage of responding firms
reporting increase minus the percentage reporting decrease.
The manufacturing composite index is a weighted average of the shipments, new orders, and
employment indexes.
2) Metropolitan area data, building permits, and house prices are not seasonally adjusted (nsa); all other
series are seasonally adjusted.

Real Personal Income: Bureau of Economic Analysis/Haver Analytics.
Unemployment rate: LAUS Program, Bureau of Labor Statistics, U.S. Department of Labor,
http://stats.bls.gov.
Employment: CES Survey, Bureau of Labor Statistics, U.S. Department of Labor, http://stats.bls.gov.
Building permits: U.S. Census Bureau, http://www.census.gov.
House prices: Federal Housing Finance Agency, http://www.ofheo.gov.

For more information, contact Sonya Ravindranath Waddell at (804) 697-2694 or e-mail sonya.waddell@rich.frb.org

Fa l l 2 0 0 8 • R e g i o n Fo c u s

33

STATE ECONOMIC CONDITIONS
BY S O N YA R AV I N D R A N AT H WA D D E L L

District of Columbia
conomic conditions in the District of Columbia were
mixed in the second quarter of 2008. Conditions in
the labor market varied as payroll employment grew, but
the unemployment rate edged up. Meanwhile, despite
the continued drop in house prices, new residential construction picked up in the second quarter. High mortgage
delinquency and foreclosure rates remained a drag on
households.

E

U.S. and D.C. Employment Growth Since Jan. 2001
Index = Jan. 2001 = 100
110

he Maryland economy showed signs of slowing in the
second quarter of 2008. The housing market softened
further with depreciating house prices and declining home
sales. In addition, households were hurt by a jump in unemployment and continued rises in mortgage delinquency and
foreclosure rates.
Conflicting reports from the two employment surveys
provided a mixed picture for Maryland’s labor market. The
state added 3,500 jobs (0.1 percent) to its economy in the
second quarter. Job growth was entirely in the service
sector with the education and health services and government sectors posting the most significant gains of 3,200 jobs
and 3,500 jobs, respectively. Meanwhile, the unemployment
rate grew to 3.9 percent — a 0.4 percentage point jump from
the first quarter. The second quarter marked the largest
increase in the number of unemployed persons in the state
(11,400) since the first quarter of 1992.
The housing market in Maryland showed clear signs of
weakening. House prices fell 2.2 percent in the second
quarter for the largest drop since the second quarter of 1982.
The drop in house prices over the past year (4.0 percent)

104
102
100
98
96
01

02

03

05

04

06

District of Columbia

07

08
United States

SOURCE: Nonfarm Payroll Employment, BLS/Haver Analytics

Recent assessments of the District of Columbia labor
market varied. On the one hand, payroll employment grew
0.2 percent in the second quarter as firms added 1,700 jobs
to the economy. In addition, the 10,100 net job gain since
the second quarter of 2007 was the largest year-over-year
payroll addition since the first quarter of 2005. On the other
hand, the unemployment rate ticked up to 6.3 percent from
6.1 percent in the first quarter — its highest mark since the
third quarter of 2005. In addition, the jobless rate was above
the national rate (5.3 percent) and ranked the highest of all
Fifth District jurisdictions.
Housing market conditions in the District of Columbia
were similarly mixed in the second quarter. House prices —
as measured by the House Price Index — fell 1.8 percent in
the second quarter, after dropping 1.9 percent in the first
quarter and 0.8 percent in the final quarter of 2007. This
was the first time since 1993 that house prices depreciated
for three consecutive quarters. In addition, the pace of
existing home sales fell 5.3 percent for the fifth straight
quarter of decline. Nonetheless, new residential construction seemed to pick up in the second quarter as both permit
levels and housing starts grew after two quarters of decline.
The contraction in house prices affected mortgage delinquency and foreclosure rates in the jurisdiction, which

R e g i o n Fo c u s • Fa l l 2 0 0 8

U.S. and MD Employment Growth Since Jan. 2001
Index = Jan. 2001 = 100
108
106
INDEX LEVELS

106
INDEX LEVELS

U Maryland

T

108

34

increased across the board. The percentage of mortgages
with payments past due rose to 5.1 percent in the second
quarter, pushed up by increases in the percentage of
mortgages with payments more than 90 days past due,
which jumped to 1.3 percent — the highest rate since the
third quarter of 1988. Meanwhile, the foreclosure rate
jumped to its highest rate in almost a decade (0.7 percent).
Still, real personal income grew 0.4 percent for the second
quarter in a row and per-capita personal income grew 0.3
percent to end the quarter at $52,780 per person.

104
102
100
98
96
01

02

03

04

05

06
Maryland

SOURCE: Nonfarm Payroll Employment, BLS/Haver Analytics

07

08
United States

marked the steepest year-over-year drop in the history of the
series. In addition, existing home sales fell 5.3 percent in the
second quarter. Although residential permitting activity
grew 6.7 percent over the quarter, housing starts dropped
2.5 percent.
Softening in the housing market was reflected in
increased mortgage delinquencies, which at 6.1 percent hit
their highest rate since the third quarter of 2001. More
starkly, the percentage of mortgage payments more than
90 days past due was at a historic high (1.8 percent) in the
second quarter. The percentage of seriously delinquent
mortgages (either more than 90 days past due or in foreclosure) also hit a record of 3.5 percent. Nonetheless, Maryland
households were sustained by 0.4 percent growth in
both real personal income and per-capita income in the
second quarter.

h

North Carolina

T

he economy of North Carolina lost some traction in the
second quarter of 2008. The labor market contracted
as the economy shed jobs and unemployment shot up.
Real estate conditions softened as new residential construction fell off, as did the pace of existing home sales.
Meanwhile, mortgage delinquency and foreclosure rates
continued to rise.

U.S. and NC Employment Growth Since Jan. 2001
Index = Jan. 2001 = 100
106

INDEX LEVELS

104
102
100
98
96
94
01

02

03

04

05

06

North Carolina

07

08
United States

SOURCE: Nonfarm Payroll Employment, BLS/Haver Analytics

The labor market in North Carolina contracted in the
second quarter. Payroll employment fell 0.3 percent as the
state shed 13,100 jobs. All sectors of the economy shed
workers except for the education and health services sector
and the leisure and hospitality sector. The biggest losses
were in manufacturing (8,000 jobs); trade, transportation,
and utilities (5,800 jobs); and professional and business
services (4,400 jobs). The second-quarter unemployment

rate jumped 0.7 percentage point to 5.7 percent for the
highest joblessness in the Tarheel State since the first
quarter of 2004.
Conditions in the North Carolina housing market also
weakened in the second quarter. New residential construction dropped off as permitting activity fell 3.5 percent and
housing starts dropped 12.0 percent. This quarter marked
the steepest year-over-year decline in permitting activity
(32.7 percent) since the fourth quarter of 1981 and the steepest year-over-year decrease in housing starts (27.8 percent)
since the first quarter of 1982. In addition, the pace of existing home sales fell 9.7 percent for the fifth straight quarter
of decline. Although house prices rose 0.6 percent in the
second quarter, it marked the smallest quarterly growth
since the third quarter of 2003.
Mortgage delinquency rates also rose in the second
quarter, illustrating heightened challenges facing North
Carolina households. The mortgage delinquency rate
jumped to 6.2 percent for the largest recorded secondquarter delinquency rate in the state. The delinquency rate
on mortgages with payments more than 90 days past due hit
a record high of 1.5 percent. Still, household balance sheets
were buttressed by 1.3 percent growth in real personal
income, and 0.7 percent growth in per-capita income.
Per-capita income in North Carolina ended the second
quarter of 2008 at $28,471 per person.

o South Carolina
R

ecent assessments of the South Carolina economy were
mixed. The housing market advanced at a reasonable
pace, with a slow appreciation of house prices and some
growth in new residential construction. Nonetheless, payroll employment stagnated, the unemployment rate edged
up further, and high mortgage delinquency and foreclosure
rates remained a cause for concern.
South Carolina labor markets softened in recent months.
Payrolls were virtually stagnant as the state shed 100 jobs
in the second quarter. The biggest losses were in the construction and manufacturing sectors that shed 8,400 jobs
and 3,000 jobs, respectively. Offsetting these losses, the
biggest gains in employment were in the leisure and
hospitality, and government sectors, which added 4,700 and
4,800 jobs, respectively. The unemployment rate was 6.2
percent in the second quarter — up from 5.8 percent in the
first quarter and above the national 5.3 percent mark.
The housing market improved at a measured pace in the
second quarter of 2008. House prices appreciated 0.4 percent in the second quarter and 3.3 percent over the year.
Residential permitting activity grew 14.2 percent after three

Fa l l 2 0 0 8 • R e g i o n Fo c u s

35

Index = Jan. 2001 = 100
108
106

INDEX LEVELS

104
102
100
98
96
01

02

03

04

05

06

South Carolina

07

08
United States

SOURCE: Nonfarm Payroll Employment, BLS/Haver Analytics

quarters of decline. Housing starts increased 4.7 percent in
the quarter. Still, existing home sales were down 8.5 percent
in the quarter and 23.9 percent over the year — the steepest
year-over-year drop since the fourth quarter of 1989.
Despite the firming of housing conditions, the mortgage
delinquency rate rose to 6.4 percent of all mortgages in the
second quarter — the highest second-quarter delinquency
rate since 2003. In addition, the percentage of mortgages
with payments more than 90 days past due hit a record high
of 1.5 percent in the second quarter. Furthermore, the foreclosure rate moved up to 0.8 percent — one of the highest
rates ever seen in South Carolina. Nonetheless, household
finances were buoyed by a 1.5 percent increase in real
personal income — the steepest increase of all District jurisdictions. In addition, per-capita personal income rose 1.0
percent to end the quarter at $32,159 per person.

u Virginia
he Virginia economy exhibited some mixed conditions
in the second quarter of 2008. Labor market indicators
varied and, although the housing market generally struggled,
existing home sales increased.
The two employment surveys provided a mixed picture
for the Virginia labor market. State firms added 6,800 jobs
to the economy in the second quarter, for 0.2 percent payroll
growth. Only three industries reported employment
declines: construction (1,300 jobs); trade, transportation,
and utilities (1,300 jobs); and leisure and hospitality (3,100
jobs). Nonetheless, unemployment edged up 0.3 percentage
point to 3.8 percent in the quarter.
The housing market remained soft in the second quarter
of 2008. House prices declined 1.9 percent for the fourth
consecutive quarter with the largest drop in prices since the
third quarter of 1982. In addition, since the second quarter

T

36

R e g i o n Fo c u s • Fa l l 2 0 0 8

of 2007, house prices fell 2.6 percent — the largest year-overyear decline on record. Residential permit levels were also
down 10.9 percent in the second quarter while housing
starts fell 8.6 percent. Existing home sales, however, rose
10.5 percent over the quarter, although sales still declined 8.1
percent over the year.
The weakening housing market appeared to take its toll
on households as mortgage delinquencies rose to 4.9 percent — its highest mark since the fourth quarter of 2001.
The percentage of mortgages with payments more than 90
days past due reached a record high of 1.3 percent, as did the
foreclosure rate at 0.7 percent. Nonetheless, households
were sustained by a growth in real personal income of 0.6
percent in the second quarter. Per-capita income also rose
0.4 percent to end the quarter at $35,305 per person.

U.S. and VA Employment Growth Since Jan. 2001
Index = Jan. 2001 = 100
108
106
INDEX LEVELS

U.S. and SC Employment Growth Since Jan. 2001

104
102
100
98
96
01

02

03

04

05

06
Virginia

07

08
United States

SOURCE: Nonfarm Payroll Employment, BLS/Haver Analytics

w West Virginia

conomic conditions in West Virginia were generally
downbeat in the second quarter of 2008. Despite a slight
appreciation in house prices, the housing market softened.
Meanwhile, the unemployment rate jumped up while mortgage delinquency and foreclosure rates continued to rise.
The business and household surveys offered contradictory reports on the labor market. Payroll employment
grew 0.2 percent (1,600 jobs) over the second quarter and
0.4 percent (3,100 jobs) over the year. Meanwhile, however,
the unemployment rate grew 0.6 percentage point to end
the quarter at 5.2 percent. West Virginia added 5,300 people
to the ranks of unemployed in the second quarter — the
steepest quarterly increase since the first quarter of 1983.
The housing market lost some traction in recent months,
although house prices held up better than in other parts of
the Fifth District and the country. Residential permitting
activity continued its decline in the second quarter, falling

E

1.2 percent, while housing starts contracted 32.0 percent.
Existing home sales, meanwhile, dropped 12.2 percent for
the largest decline since the last quarter of 1999.
Nonetheless, the House Price Index grew 0.7 percent in the
second quarter for the fourth straight quarter of house price
appreciation.
In addition to troubles in the housing market, mortgage
delinquencies continued to rise. The mortgage delinquency
rate was 7.3 percent in the second quarter — the highest rate
in the Fifth District. The delinquency rate on mortgages
with payments more than 90 days past due hit its highest
second-quarter mark on record (1.6 percent), as did the
foreclosure rate (0.7 percent). Still, both real personal
income and per-capita income rose 1.3 percent in the second
quarter. Per-capita income ended the quarter at $25,319
per person.
RF

U.S. and WV Employment Growth Since Jan. 2001
Index = Jan. 2001 = 100
106

INDEX LEVELS

104
102
100
98
96
94
01

02

03

04

05

06

07

West Virginia

08
United States

SOURCE: Nonfarm Payroll Employment, BLS/Haver Analytics

Behind the Numbers: Retail Sales

Monthly Retail Sales and Food Services

2008

2007

2005

2006

2004

2003

2001

2002

2000

1998

1999

1997

1995

1996

1994

1993

YEAR-OVER-YEAR PERCENT CHANGE

30
Headlines across the United States have been
20
reporting the end of consumer spending as we
know it — or, at least, as we have known it.
10
According to the most recent Census Bureau
0
data, U.S. retail sales and food services fell 2.8
percent in October for a record 4.1 percent drop
-10
since October 2007. The other oft-cited retail
-20
sales data, the International Council of Shopping
Centers (ICSC)-Goldman Sachs index reported a
-30
0.9 percent decline in retail sales over the year
ending in October 2008 — the steepest yearRetail Sales and Food Services
Motor Vehicles and Parts Dealers
over-year decline in an October over the 39-year
SOURCE: Department of Commerce, Bureau of the Census/Haver Analytics
history of the index.
(seasonally adjusted data)
The two surveys sample different populations
food services sales still declined 2.2 percent in October, but
using different methodology. The ICSC-Goldman Sachs
moved up 1.0 percent over the year. Sales of other big-ticket
index covers comparable store sales at major chains around
items also pulled down overall retail sales; for example, sales of
the country and accounts for more than 10,000 individual
furniture, home furnishings, and electronics all together
stores. The Census data use a stratified random sampling
dropped 2.4 percent over the month and 9.7 percent over
method to select about 5,000 retail and food
the year.
services firms whose sales are weighted and benchmarked to
Retail sales in the Fifth District were also sluggish in
represent the complete universe of more than 3 million retail
October, according to Richmond Fed survey reports. The
and food services firms. One significant difference between
index for sales revenues — which is equal to the percentage
the two surveys is that the ICSC-Goldman Sachs measure
of the 105 responding firms that reported an increase in
excludes both restaurant and vehicle demand, which are
revenues minus the percentage that reported a decrease —
included in the Census measure.
was -18 in October. Meanwhile, the index for big-ticket
In fact, a measurable portion of the slump in retail sales
sales was -36 and the index for shopper traffic was -32. All
and food services reported by the Census in the past two
three of these indexes, however, have been moving around in
months came from sales of motor vehicles and auto parts,
negative territory for at least 10 months.
which dropped 5.5 percent in October and 23.4 percent over
the year. Excluding the vehicles and parts dealers, retail and
— SONYA RAVINDRANATH WADDELL

Fa l l 2 0 0 8 • R e g i o n Fo c u s

37

State Data, Q2:08
DC

MD

NC

SC

VA

WV

702.5
0.2
1.5

2,633.8
0.1
1.1

4,174.1
-0.3
0.9

1,957.8
0.0
0.7

3,776.9
0.2
0.5

759.9
0.2
0.4

1.6
2.1
-3.9

128.7
-1.6
-2.5

523.4
-1.5
-2.6

246.7
-0.4
-1.7

275.6
0.9
-1.6

57.5
-0.7
-3.0

Professional/Business Services Employment (000’s) 155.6
Q/Q Percent Change
-0.3
Y/Y Percent Change
1.0

403.4
0.2
2.0

503.7
-0.9
1.1

229.8
2.7
1.5

651.3
0.4
1.2

62.0
1.1
2.0

Government Employment (000’s)
Q/Q Percent Change
Y/Y Percent Change

233.3
0.0
1.0

485.8
0.7
1.6

702.0
-0.1
1.2

345.8
1.4
2.9

694.4
0.4
1.5

146.0
0.7
0.4

Civilian Labor Force (000’s)
Q/Q Percent Change
Y/Y Percent Change

330.9
-0.1
1.8

3,011.3
0.6
1.3

4,559.4
0.4
0.9

2,144.3
0.3
0.7

4,122.1
0.6
1.9

815.8
0.4
0.9

6.3
6.1
5.7

3.9
3.5
3.5

5.7
5.0
4.7

6.2
5.8
5.7

3.8
3.5
3.0

5.2
4.6
4.5

31,129.8
0.4
2.2

224,104.3
0.4
0.6

262,754.1
1.3
1.7

118,449.8
1.5
2.2

274,495.2
0.6
1.1

45,943.4
1.3
2.2

Building Permits
Q/Q Percent Change
Y/Y Percent Change

189
23.5
-62.3

3,909
6.7
-37.8

15,559
-3.5
-32.7

8,066
14.2
-32.9

7,344
-10.9
-32.0

839
-1.2
-27.5

House Price Index (1980=100)
Q/Q Percent Change
Y/Y Percent Change

634.5
-1.8
-3.4

518.5
-2.2
-4.0

348.6
0.6
3.6

330.2
0.4
3.3

463.1
-1.9
-2.6

238.1
0.7
3.4

Sales of Existing Housing Units (000’s)
Q/Q Percent Change
Y/Y Percent Change

7.2
-5.3
-28.0

64.4
-5.3
-30.0

164.0
-9.7
-29.1

86.4
-8.5
-23.9

113.2
-10.5
-8.1

26.0
-12.2
-13.3

Nonfarm Employment (000’s)
Q/Q Percent Change
Y/Y Percent Change
Manufacturing Employment (000’s)
Q/Q Percent Change
Y/Y Percent Change

Unemployment Rate (%)
Q1:08
Q2:07
Real Personal Income ($Mil)
Q/Q Percent Change
Y/Y Percent Change

NOTES:
Nonfarm Payroll Employment, thousands of jobs, seasonally adjusted (SA) except in MSAs; Bureau of Labor Statistics (BLS)/Haver Analytics, Manufacturing Employment, thousands of jobs, SA in all but DC and SC; BLS/Haver Analytics, Professional/Business
Services Employment, thousands of jobs, SA in all but SC; BLS/Haver Analytics, Government Employment, thousands of jobs, SA; BLS/Haver Analytics, Civilian Labor Force, thousands of persons, SA; BLS/Haver Analytics, Unemployment Rate, percent, SA
except in MSA’s; BLS/Haver Analytics, Building Permits, number of permits, NSA; U.S. Census Bureau/Haver Analytics, Sales of Existing Housing Units, thousands of units, SA; National Association of Realtors®

38

R e g i o n Fo c u s • Fa l l 2 0 0 8

Metropolitan Area Data, Q2:08
Nonfarm Employment (000’s)
Q/Q Percent Change
Y/Y Percent Change
Unemployment Rate (%)
Q1:08
Q2:07
Building Permits
Q/Q Percent Change
Y/Y Percent Change

Washington, DC MSA

Baltimore, MD MSA

Charlotte, NC MSA

2,446.1
1.5
1.1

1,332.3
1.9
0.6

876.5
1.7
1.9

3.5
3.4
2.9

4.0
3.9
3.6

5.8
5.4
4.6

3,705
-15.6
-49.3

1,252
1.6
-23.8

3,897
8.8
-38.3

Raleigh, NC MSA
Nonfarm Employment (000’s)
Q/Q Percent Change
Y/Y Percent Change
Unemployment Rate (%)
Q1:08
Q2:07
Building Permits
Q/Q Percent Change
Y/Y Percent Change

Unemployment Rate (%)
Q1:08
Q2:07
Building Permits
Q/Q Percent Change
Y/Y Percent Change

Columbia, SC MSA

531.4
1.7
3.3

303.3
1.8
0.8

370.9
0.6
0.9

4.5
4.1
3.5

4.8
4.7
4.1

5.3
5.1
4.8

3,170
1.7
-24.8

1,309
-1.8
-40.4

1,252
20.8
-45.9

Norfolk, VA MSA
Nonfarm Employment (000)
Q/Q Percent Change
Y/Y Percent Change

Charleston, SC MSA

Richmond, VA MSA

Charleston, WV MSA

790.9
3.0
1.3

641.1
1.6
0.9

151.5
1.6
0.0

3.9
4.1
3.0
1,733
27.1
10.1

4.0
3.9
2.9
1,185
-29.1
-44.5

4.5
4.6
4.1
56
43.6
-20.0

For more information, contact Sonya Ravindranath Waddell at (804) 697-2694 or e-mail sonya.waddell@rich.frb.org

Fa l l 2 0 0 8 • R e g i o n Fo c u s

39

OPINION
Why the Great Depression Matters
BY ST E P H E N S L I V I N S K I

The best example of this line of inquiry is the work of
conomic analysis is, at its core, a form of storytelling.
economists Harold Cole and Lee Ohanian, both of the
When you strip away the math and the jargon, what
University of California at Los Angeles. They start by lookyou’re left with is a tale about how people respond
ing at some fundamental economic data.
to the world around them and how their actions influence
For instance, the ability of the economy to produce goods
everything else. And economists do indeed have a variety
more efficiently — illustrated by the substantial increase in
of stories they like to tell. Yet the one that seems to be
“productivity” after 1933 — should have increased economic
told most — and nowadays with increasing frequency —
output midway through the decade. But it didn’t. Wages and
is the one about the Great Depression.
prices should have gone down as a result of the reduced outThis story, while consisting of the same basic facts, can
put, but that didn’t happen either. “These data contrast
have a different tone depending upon who tells it. Some say
sharply with neoclassical theory, which predicts a strong
that between 1929 and 1933, a sudden decline in expectations
recovery [from the Great Depression] with low real wages,”
about the future of economic growth led to a collapse in
write Cole and Ohanian in their 2004 article in the Journal of
consumer and investor demand that could not be quickly
Political Economy.
corrected by the market.
This school of thought suggests that government policy
They suggest that what was hindering the labor adjustprovides a way around this shortcoming. The policies that
ment process was President Roosevelt’s New Deal labor and
supporters of this thesis propose
industrial policies. The National
are aimed at increasing weak
Industrial Recovery Act of 1933
Perhaps the most important (NIRA) actually had the effect of
demand in a variety of ways, particularly through government spending
limiting entry of competitors into
lesson to take from the
and employment programs. This
the market, mainly in manufacturGreat Depression is that
would serve, in the former case, to
ing. It also allowed incumbent
prop up demand and, in the latter,
firms to set minimum prices in
policymakers should follow
prop up employment and wages.
exchange for raising worker wages.
the Hippocratic Oath:
A competing explanation comes
When the Supreme Court ruled
from the neoclassical school of
that the NIRA was unconstituFirst, do no harm.
thought. Proponents of this view
tional in 1935, the National Labor
argue that what the economy really
Relations Act of that year carried
suffered from wasn’t an inherent weakness. Instead, it was
on several of the NIRA goals directed at limiting competiimpaired by the shock of policy missteps, particularly those
tion in the labor market and, consequently, inflating wages.
of the Federal Reserve which severely contracted the money
So, in short, the New Deal policies artificially inflated prices
supply and choked off economic activity. The neoclassical
and wages. That kept the market’s self-correcting forces
economists think that over time the economy can right itself
from working and made it tougher for the economy to
in the absence of shocks without widespread government
recover from the Great Depression.
direction. Instead, the remedy is to reverse the misguided
While there is still debate about whether this is a robust
policies that weigh the economy down.
explanation of what prolonged the Great Depression, it
Both schools acknowledge that policy has the power to
helps us understand the assumptions economists use when
shape economic growth. Yet the forms those policies take
they describe the Great Depression. Those who argue that
are important. Those that are aimed at “fixing” a perceived
federal policies during that era helped bring the United
shortcoming of the market are by nature intended to keep
States out of the economic doldrums have to assume that
the market from the opportunity to correct itself on its own.
policymakers, all of whom are fallible and under pressure
Still other policies can be geared to helping the market corfrom a variety of interest groups, were able or willing to craft
rect itself by assisting the mechanisms of self-correction.
sensible policy under economic and political duress. This is
This could include the lowering of barriers to competition.
a tall order, even for the best-intentioned policymaker.
So, one way to arbitrate this dispute would be to deterSo, perhaps the most important lesson to take from all
mine whether the activist fixes succeeded in helping achieve
the competing renditions of the Great Depression story is
a higher growth path for the economy. That begs a question:
that policymakers should follow the Hippocratic Oath:
Why did the Great Depression last as long as it did? After
First, do no harm. And more often than not, that means
all, by 1939 — 10 years after the start of the downturn —
avoiding the temptation to intervene and, thus, intruding on
employment and output were well below their 1929 levels.
the market’s self-correction mechanisms.
RF

E

40

R e g i o n Fo c u s • Fa l l 2 0 0 8

NEXTISSUE
The Economics of Corporate Bankruptcy

Federal Reserve

An important aspect of capitalism is the restructuring or
closing of troubled businesses. Yet it’s important to distinguish
between firms that are merely financially distressed and those
that are no longer viable. Bankruptcy law has arisen in the
United States to provide an orderly process of allowing courts
to make these distinctions. We’ll examine the costs and benefits of the current corporate bankruptcy system and discuss
how the creative destruction that is so vital to economic
growth is hindered or aided by these institutions.

We’ll chronicle the history of the Fed’s
role as the lender of last resort.

Jargon Alert
Everyone has heard the term “national debt”
used by economists, policymakers, and
journalists. But what exactly is included in
that measurement and what isn’t?

Interview

Minor League Ballparks
Since 2005, five minor league ballparks have been built in the
Fifth District. There are proposals to build others in North
Carolina, Virginia, and Maryland. We’ll consider the economics
of these facilities. Should they receive subsidies? Do they
promote economic growth? And, financially, how do they differ
from major league stadiums?

The Future of Media in Rural Communities
Newspapers, particularly those in rural areas, are generally
shrinking in size and coverage, and some are even going out of
business. Other media outlets, including the Internet and
public radio, have picked up some of the slack. We’ll explore
the new business model for gathering information and how that
is affecting the way rural communities get their news.

We talk to George Selgin, of West Virginia
University and a proponent of “free banking,” about what the world would be like if
the Federal Reserve didn’t control the
money supply.

Visit us online:
www.richmondfed.org
• To view each issue’s articles
and web-exclusive content
• To add your name to our
mailing list
• To request an e-mail alert of
our online issue posting

Look for our expanded REGIONAL section with more
metropolitan statistical area data and a more in-depth
look at trends and issues in the Fifth District.

Economic Briefs are new web-exclusive articles designed
to bring the work of our economists to a broader audience.
The articles are based on research published in academic
journals, Economic Quarterly, and the Working Papers
series, as well as on research conducted to inform the
Fed’s monetary and banking polices.
Recent topics include:
08-01, October 2008
“Inflation Expectations: Their Sources and Effects”
Shocks to the macroeconomy can affect the public’s
expectations about inflation, unless the Federal
Reserve has gained credibility for pursuing and
maintaining price stability.
08-02, November 2008
“What Income Inequality Measures Can
(and Cannot) Tell Us”
In recent decades, income inequality has increased.
But this doesn’t mean that those with lower
incomes are relatively worse off.
08-03, December 2008
“Turmoil in the Student Loan Market”
Recent credit market problems and federal
legislation lowering lender revenues have
diminished the availability of some types of
student loans. Nevertheless, new sources of
funding have become available, changing the
structure of the market while helping to meet
the demand for student loans.

Federal Reserve Bank
of Richmond
P.O. Box 27622
Richmond, VA 23261

PRST STD
U.S. POSTAGE PAID
RICHMOND VA
PERMIT NO. 2

Change Service Requested

Please send address label with subscription changes or address corrections to Public Affairs or call (804) 697-8109.