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What Drives Changes in Economic Thought? Why economists
study what they do — and how the crisis might change it
Were economists caught by surprise by the financial crisis because the
profession’s models and dominant schools of thought are misguided?
If so, how did it come to be that way? Will the financial crisis change
things? Rather than a fundamental shift in economic thought, many
economists seem to hope for a humbler view of what economics can
teach us about the world.

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.


John A. Weinberg


Tobacco Stimulus

Aaron Steelman

Virginia and North Carolina are among the states using money from their
1998 settlement with tobacco companies to spur economic development.


Kathy Constant


Flexible Workforce: The role of temporary employment in
recession and recovery
Many economists see temp employment as a buffer during recessions
and a harbinger of direct hiring during recoveries. How strong is the
current preference for temp workers — and does that preference have
long-term implications?

Renee Courtois Haltom
Betty Joyce Nash
David A. Price
Jessie Romero

Charles Gerena
Becky Johnsen
Ann Macheras
Sonya Ravindranath Waddell


Benefits and Burdens of Expanded Military Bases
Many military bases in the Fifth District are expanding as a result
of the 2005 Base Realignment and Closure Plan, scheduled for
completion by mid-September. Economic benefits may loom in the
long run, but the influx may cause short-term pain as communities
cope with crowded schools and congested roads.


1 President’s Message/Don’t I Buy Food or Gasoline?
2 Upfront/Regional News at a Glance
6 Federal Reserve/Stigma and the Discount Window
9 Policy Update/A Pinch of Basel?
10 Jargon Alert/Market Failure
1 1 Research Spotlight/The Price of Avoiding Minor Financial Loss
28 Interview/Joel Slemrod
34 Economic History/Virginia and the Final Frontier
37 Around the Fed/The Decision to Export
39 Book Review/Bourgeois Dignity
40 District Digest/Economic Trends Across the Region
48 Opinion/The Financial Crisis and the Practice of Economics


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The views expressed in Region Focus
are those of the contributors and not
necessarily those of the Federal Reserve Bank
of Richmond or the Federal
Reserve System.
ISSN 1093-1767

Don’t I Buy Food or Gasoline?
ecent increases in commodity and energy prices
mean that Americans are paying more at the
grocery store and at the gas pump — at the same
time that many families are still trying to regain their
footing after the recession. In this environment, it is understandable to ask why many economists, including those
within the Federal Reserve System, frequently seem
to focus on “core” inflation, which excludes often volatile
food and energy prices, rather than on “headline”
inflation, which does include those items that are so
important to households. In fact, from time to time I get
asked, don’t I buy food or gasoline?
The answer is yes, indeed, I do. And I, as well as others
within the Federal Reserve System, pay attention to the
prices of those goods — both when we purchase them and
also when we consider monetary policy. In fact, the Fed’s
mandate is to ensure the long-term stability of the overall
price level, which means that headline inflation is our
ultimate concern.
But in the short term, we must be careful that the tools
of monetary policy — which have a lagged effect on the
economy — are not applied in reaction to temporary price
changes. The level of core inflation is not a goal in and of
itself; rather, it is a means to the end of determining the
most appropriate policies for the long run.
That said, core inflation is not a perfect predictor of
underlying inflation trends, and its correlation with overall
inflation may depend on how it is measured. Moreover,
recent research suggests that looking only at core inflation
may understate the decline in purchasing power actually
experienced by households during previous periods.
The two most common measures of inflation are the
consumer price index (CPI) and the personal consumption
expenditures (PCE) price index. I tend to prefer the PCE
measure, which is based on data from the CPI but includes
different weighting methods that make it more consistent
over time. Since 2000, the PCE has also been the preferred
measure used by the Federal Open Market Committee
Because inflation numbers often run hot or cold for
several months at a time, the Richmond Fed looks closely at
year-over-year headline PCE inflation to evaluate economic
conditions in the Fifth District and the nation. Headline
inflation is also an important component of the longer-term
economic forecast each Reserve Bank president prepares
prior to FOMC meetings. That does not mean, however,
that core projections aren’t useful too. All members of the
Committee evaluate those measures as well, especially when
looking at more near-term conditions.
Currently, inflation forecasts are consistent with our


price stability mandate, and the
market’s expectations reflect
that commitment. But as I
noted in my last column in
Region Focus, signs that the
recovery is strengthening may
mean that we will need to exit
from our current accommodative monetary policy in the
near future. And upward pressure on energy and commodity
prices must be monitored carefully. Monetary policymakers
cannot influence the relative price of oil, of course, but we
can and must keep a close eye on whether distributors begin
passing along higher input prices to consumers. If headline
changes prove to be more persistent than previously
expected, we must be vigilant that they not become embedded in expectations.
The lesson to be drawn from this discussion is that no
single measure of inflation is “wrong.” The Fed’s mandate
means that we should choose the best tools available to
determine the appropriate policies to achieve long-term
stability of the overall price level. In short, we are committed
to fostering an economic environment in which households
and businesses can make the investment and savings
decisions that will promote their well-being and the
well-being of the nation’s economy as a whole. That means
taking into account the prices of all goods — including food
and energy — when considering the likely path of inflation
and which policies we should pursue as a result of that


Region Focus | First Quarter | 2011



Regional News at a Glance

The Hipp

1914 Theater Comes to Life in Richmond
The Hippodrome Theater will open this spring in Jackson Ward, a historic neighborhood in
Richmond. The event caps a decade’s worth of planning and investment and construction.
In a city that already boasts several downtown
live-music venues, the Hippodrome stands apart.
“The Hipp” is located in a National Historic Landmark.
Jackson Ward has been a predominantly black community since the early 20th century, and became nationally
recognized for its economic and cultural vibrance. In
particular, 2nd Street boasted a number of theaters,
earning the community the nickname “Harlem of the
In 1914, the Hippodrome Theater opened to the
community, presenting both vaudeville acts and films.
The theater was part of the “Chitlin’ Circuit,” a group of
venues in the eastern and southern United States where

The Hippodrome’s new marquee brightens 2nd Street on the
evening of Mayor Jones’ State of the City address.

black entertainers could perform when racial segregation was prevalent. After its heyday in the 1930s and
1940s, the Hippodrome showcased popular acts such as
Ray Charles, Ella Fitzgerald, Ethel Waters, and James
In 1945, the building caught fire, and it was rebuilt as
a movie theater. In 1970, the Hippodrome became a
church, and was rarely used after 1982. The historic
venue was not completely forgotten, however.
Richmond developer Ronald Stallings inherited the
property from his father. His dream has been to reopen
the Hipp as an elegant nightclub, a venue for rhythm
and blues, jazz, and soul artists. Stallings is the president
of Walker Row Partnership, which has renovated or
redeveloped dozens of properties in Jackson Ward. Its
mission is to provide Jackson Ward with places to “work,
shop, live, and play,” all in keeping with “New Urbanism,”
an urban design movement that promotes walkable
mixed-use communities.
After years of planning, Stallings secured financing
for the ambitious project in October 2009. Construction took a year and was completed in February. The
complex includes a theater, two restaurants, retail
space, and 29 apartments. The project cost about $12
million, with $8 million of that going toward the theater
renovation. The project received $600,000 from the
city and federal funds.
In early February, Richmond Mayor Dwight Jones
delivered his second State of the City address in the
newly transformed theater. For Jones, whose address
promoted “creating healthy and sustainable communities,” it was an ideal setting.

Snow Job


Winter Can Cost, but Also Benefit


veryone loves a snow day, except the people paying
for the cleanup: taxpayers. Through the end of
February, North Carolina had spent $55 million clearing
snow and ice from state roads. The annual budget for
snow removal is $30 million, more than enough in a typical year. But when big storms hit, as they have the last
two winters, the state has to pull money from projects


Region Focus | First Quarter | 2011

such as pothole repair or tree trimming, according
to Julia Merchant, spokesperson for the state’s
Department of Transportation. Those choices are
tough, especially when money is already tight. The
South Carolina Legislature passed a special bill this year
that exempts school districts from making up all of the
snow days; the districts can’t afford them.

States pay for snowplows, salt for the roads, and
overtime pay for the plow drivers. Virginia stocked
up on 48,000 tons of sand and 281,000 tons of salt
this winter. But the budgets don’t come close to the
total cost of a major storm.
The economic impact of a one-day shutdown
includes lost wages, slow retail sales, and less tax
revenue. The total can be in the hundreds of millions of dollars, according to a study of 16 states by
IHS Global Insight for the American Highway
Users Alliance. In Maryland and Virginia, IHS estimates the impact at $183.5 million and $260 million,
respectively. The federal government loses $71 million per day when it closes, as it did for an
unprecedented four straight days during last year’s
“snow-pocalypse.” And those estimates don’t
include property damage, crop loss, car crashes,
repairing power lines, or flight delays, all of which
add billions to the cost of winter storms.
When government offices are closed, people
can’t file for unemployment benefits. A major storm
that hit Alabama, Georgia, North Carolina, and
South Carolina in January contributed to the
biggest drop in unemployment filings in nearly one
year, but when offices reopened the following week
claims increased by 51,000. Bad weather may not
affect the unemployment rate, since workers who
were paid during any part of the survey period are

A snowplow clears the Cherohala Skyway
in western North Carolina.

counted as employed. But it does affect the number
of hours people work, particularly in the construction industry.
Not everyone loses money when it snows.
“When weather is in the news, it is very good for
business,” says Scott Bernhardt, Chief Operating
Office of Planalytics, a company that models
the economic impact of weather for retailers,
manufacturers, and utilities, among others.
Snowplow manufacturers and salt suppliers do well
during a snowy winter, but some retail stores also
benefit. “People grocery shop like crazy. People
order pizzas. Convenience stores sell out of just
about everything,” Bernhardt says. Still, most of the
lost sales due to a storm don’t get made up, particularly in regions where snow is uncommon,
according to Bernhardt: “When snow falls in the
South, it’s a net loss.”

Urban Growth

D.C. Population Reverses 60-Year Decline
n the 20th century, New Deal policies and
World War II added to the federal payroll and
propelled the District of Columbia’s population
to its peak of 802,000 people in 1950. After that,
D.C.’s population declined for decades — until the
most recent census, when D.C. grew by nearly
30,000 people, or roughly 5 percent.
“The overall numbers have a story to tell us
about exactly how much the population has
increased and how rapidly,” says Harriet Tregoning,
the director of the D.C. Office of Planning. “We
haven’t seen growth like this since World War II
and this hasn’t been a time of remarkable mobility.”
The population in 2010 reached 601,723. Fully



12,000 of those people came in the past two years,
10,000 in 2009 alone. Though the data explaining
the growth have yet to be published, the rebound
likely reflects multiple factors: government growth
following the terrorist attacks of Sept. 11, 2001, as
well as a general trend of young people and empty
nesters moving into cities. From 2007 through
2009, some 4,685 people aged 25 to 34 moved into
Washington along with 5,798 people aged 60 to 64,
according to American Community Survey (ACS)
data released late last year.
“This follows the anecdotal information we’re
getting,” Tregoning says. “There are particular areas
where we’re getting growth, particularly Capital

Region Focus | First Quarter | 2011



D.C. Population Rebound





1960 1970


1990 2000 2010

SOURCE: U.S. Census Bureau

Riverfront and Columbia Heights.” The riverfront neighborhood is in the southeast on the Anacostia River, south
of Capitol Hill, and Columbia Heights lies in the northwest quadrant of the city. Across from the Columbia
Heights Metro station, Target and Best Buy anchor a retail
complex. Transportation and vibrant neighborhoods are
what Tregoning calls the “pull” factors, elements that now
attract residents. “We have so many neighborhoods that
are now interesting to people and good transit; they’re
increasingly served by neighborhood retail,” she says.
The city’s demographic composition has changed as
well. ACS data indicate that the white population was estimated at nearly 39 percent in 2009, up from 34.5 percent in
2006, while the black population fell from 55 percent to 53.2
percent during the same period. (In 1980, black residents

comprised roughly 70 percent of the city’s population.)
The Hispanic population remained about the same —
rising from 8.2 percent in 2006 to 8.8 percent in 2009.
D.C. also grew the natural way — more births. Births
have increased annually from about 7,600 in 2000 to more
than 9,000 in 2009, with a natural increase (births minus
deaths) of about 27,000 since 2000. D.C. also attracted
more than 24,000 new residents from outside the United
States since 2000. Possibly because of the city’s continued
job growth, it also attracted domestic migration. Between
2008 and 2009, about 4,450 more people moved to the
area from other states than moved away, according to the
D.C. Planning Department.
The job mix in D.C. remains almost one-third federal
— 29 percent of its 728,300 jobs — and that may have
attracted people to the area. The private sector comprises
two-thirds of jobs, and D.C. government and transportation-related jobs make up the rest.
While the District of Columbia’s population has
increased, the U.S. population as a whole grew more
slowly than during any decade since the Depression, 9.7
percent. The recession slowed immigration and birth
rates, demographers say, and that may continue for the
short term.

Art in the Office

Businesses Learn Creativity
hen times are tough, business owners need to get
creative. At least three programs in the Fifth
District boost problem-solving abilities through art-based
activities: the Innovation Institute in Charlotte and Fun
Days and Creative Meetings in Richmond.
At Art Works Studios and Galleries in Richmond,
Fun Days classes serve to reinvigorate organizations.
Co-owner Glenda Kotchish says the sessions provide a
creative environment where teams can interact. Kotchish,
a former computer system consultant and lifelong artist,
understands the power of the combined analytical
and creative sides of the brain. The Fun Days host small
groups, tailored to each organization; past programs
include crafting album covers while listening to music,
painting a group mural, and assembling handmade books.
The Visual Arts Center of Richmond offers Creative
Meetings. According to director of education Aimee



Region Focus | First Quarter | 2011

Joyaux, the program was created in response to recent
buzz about creativity in the office. “Richmond has a thriving art community and a thriving business community, but
there has not been a lot of overlap between the two,” she
says. A former student is Jana McQuaid, director of graduate studies at Virginia Commonwealth University’s
School of Business. McQuaid participated alongside
members of groups from both nonprofit and for-profit
sectors, and she says the class encouraged her to reorganize her professional life to encourage creative thinking.
“Our team was working on a new procedure for processing applications,” says McQuaid. “Previously I might
have created a draft template and asked for everyone to
submit individual written comments. Instead, this time
we all met as a group with a large board and Post-It notes.
We posted everyone’s ideas and we were able to really
feed off of one another’s comments, coming up with a

process that is much better than submitting feedback in
The Innovation Institute in Charlotte puts executives
from multiple industries under the instruction of painters,
sculptors, photographers, or printmakers. Barbara
Spradling, the Institute’s Director and a retired bank executive, says that artists take risks. That means they fail,
sometimes regularly, while corporations traditionally do
not support failure. Consequently, artists have much to
offer the business world, and in turn the business world
pays artists to host creative classes, making this a “very
symbiotic relationship.”
Spradling reports that the recession increased enroll-

ment in these courses as many business leaders increasingly encourage innovation. Art Works and the Visual Arts
Center indicate similar success. Each has attracted wellknown clients: Members of the Virginia Senate have had
their own “Fun Days;” Creative Meeting has hosted
Capitol One and Wells Fargo; and the Innovation Institute
sent representatives to California to teach classes to
Motorola employees.
The term “starving artist” was coined for those who
depend upon their creativity as a livelihood. As more companies enlist artists to help stimulate innovation, creativity
could become more lucrative.

Coins for the Commonwealth

Alternative Currency Proposal Fails



resolution to study the possibility of an alternative currency for Virginia
may have stalled out, but it’s an idea that’s also being introduced in
other state legislatures.
Virginia delegate Robert Marshall, a Republican who represents parts
of Prince William and Loudoun counties, recommended to the General
Assembly that the Commonwealth adopt its own currency of gold and
silver. The resolution went to a subcommittee, which voted to take no
action, meaning that it will not come before the full legislature for a vote.
In his resolution, Marshall argued that the Federal Reserve’s monetary
policies could lead to economic instability, including runaway prices. But
it’s unlikely that the United States would face the kind of drastic hyperinflation that would imperil the U.S. economy, says Randall Parker, an
economist at East Carolina University whose work has specialized in the
causes and consequences of the Great Depression. “I don’t think that
hyperinflation on the order of magnitude that would cease to have the
dollar as a functioning medium of exchange is very likely at all.” For that to
happen, Parker says, inflation would have to reach Zimbabwe- or Serbialike levels. Inflation hit 500 billion percent before Zimbabwe abandoned
its currency. The Federal Reserve and professional forecasting groups project inflation in the United States between 1 percent and 2 percent for the
next several years.
Marshall joins legislators in about nine other states who have made
similar proposals. Bobby Franklin in Georgia introduced an act that would
require the use of pre-1965 silver coins and silver and gold “American Eagle”
coins to pay all debts to and for the state. John Dougall in Utah says he will
propose allowing residents to mint gold and silver coins in their homes that

These one- and 10-dollar notes were issued in 1862. Virginia
issued a total of $5.3 million in currency during the Civil War.

would be accepted as part of his proposed new currency.
The last time states issued their own currencies was during the Civil
War, when Virginia and other Confederate states, including North and South
Carolina, needed to fund wartime operations. Several Indian Territory
nations, allied with the South, also had their own currencies. The
Confederacy printed money to pay for the war because they were cut off
from foreign trading partners and bullion deposits in the North. They had
no gold or silver. By the midpoint of the war, Southern currency was a mix
of state-issued notes, Confederate notes, and private bank issues (not to
mention a healthy supply of counterfeits) — all of which were worthless
when the war ended. But today, a Civil War-era 100-dollar Virginia note can
be worth as much as $5,000 to collectors.
Collectors may be interested in another of Marshall’s proposals. His bill
authorizing the State Treasurer to mint gold, silver, and platinum commemorative coins passed both chambers and is on its way to the governor.

Region Focus | First Quarter | 2011


Stigma and the Discount Window

is usually discussed in the context of primary credit, which is
available to healthy financial institutions. This is the Fed’s
principal means of adding liquidity to the banking system.
At the height of the financial crisis in October 2008, the
Fed granted a weekly average of $111 billion in primary
credit, a record (the previous record was about $12 billion
for the week of Sept. 11, 2001).
It is difficult to prove that stigma exists. Stigma would
manifest itself through banks not borrowing from the Fed.
However, it would be difficult to distinguish that from the
fact that financial institutions usually have viable funding
alternatives that are cheaper.
Banks rely most heavily on other banks for short-term
funding through the federal funds market. Banks have to
keep a certain amount of cash, known as reserves, on hand
according to the Fed’s reserve requirements, equal to 10 percent of total deposits in most cases. But since a bank’s
depositors withdraw their funds at will, the amount of
reserves on hand fluctuates from day to day. There’s an
opportunity cost for holding “excess” reserves — banks
could lend those funds out and earn interest — so banks
generally try to minimize the amount they hold. (The Fed
started paying interest on reserves in late 2008, which
lessens that opportunity cost some.)
That’s where the fed funds market comes in. Banks that
have an excess supply of funds become lenders, and banks
that need to fill a sudden shortfall become borrowers. Banks
have existing legal agreements in place, and simply call each
other up when they want to trade
funds. That’s why it wouldn’t be difficult for other financial institutions to
identify discount window borrowing,
says Becky Snider, who oversees the
Richmond Fed’s discount window.
“If an institution suddenly disappears
from the fed funds market, other
banks might assume, particularly if
Richmond posts a large borrowing in
that period, that they went to the
The Fed would much prefer that
banks obtain funds from this private
source. But banks are rational, and
one would expect them to go
to whichever funding source is
cheapest. Prior to 2003, that was the
discount window. The Fed kept the
In its early days, the discount window was a
discount rate below the target fed
Borrowing From Dad
physical window located within each regional
funds rate and limited arbitrage by
Three types of loans are offered Federal Reserve Bank, as shown in this 1960s
scrutinizing the banks that borrowed.
through the discount window. Stigma photo of the window inside the New York Fed.

ne of the primary ways central banks can stabilize
the financial system in times of distress is by acting
as the “lender of last resort” to financial institutions when funding dries up. Banks that face a liquidity
shortage may be unable to provide depositors with the
funds they wish to withdraw. At an extreme, the bank could
fail. Banks facing shortages can go the Fed’s discount
window, and that can help avoid unnecessary failures.
Yet banks aren’t always willing to take the Fed up on this
offer. During the recent financial crisis, for example, the Fed
did everything it could to encourage bank borrowing, from
easing lending terms to publicly urging banks to take loans if
needed. But borrowing remained low in late 2007 despite
severe liquidity shortages in the financial system.
A common explanation for the reluctance of banks to
borrow from the Fed is a “stigma” attached to the discount
window. This stigma is based on the notion that only a bank
in financial trouble would go to the Fed over other, cheaper
sources of funds. Banks are believed to fear that regulators,
investors, or other banks will assume the worst if the bank is
discovered to have borrowed from the Fed. There can be
perfectly benign reasons for accessing the discount window:
a bank that receives a large withdrawal too late in the day to
locate a private lender, for example. The problem is that
such stigma, if present, may hamper the Fed’s ability to
provide liquidity in a crisis.
Other institutions will not necessarily know when a bank
borrows from the discount window. Banks may sometimes
be able to figure out the identities of
specific borrowers, but only the total
amount of borrowing from each
regional Federal Reserve district is
made public; those data are published
weekly in the Fed’s H.4.1 release.
That’s about to change. The DoddFrank financial reform legislation
passed in the summer of 2010 requires
the Fed to publicize the names of all
banks that borrow from the discount
window and the total amount borrowed, two years after that borrowing
takes place. It is too soon to tell
whether the certainty that discount
window loans will be made public will
further dissuade banks from borrowing in times of need.


Region Focus | First Quarter | 2011



The Fed required all discount window borrowers to show
that they had sought loans on the fed funds market first, and
banks had to provide information on what business activities the loans would be funding. Perhaps as a result of the
Fed’s scrutiny, going to the discount window became associated with an inability to obtain funds from other banks.
“In my banking days, I always described it as being like
borrowing from my father,” said Fed Governor Elizabeth
Duke in an early 2010 speech. Duke had a long career as a
banker before being appointed to the Board of Governors in
2008. “I was always sure that at some point I would have to
answer uncomfortable questions.”

Evidence of Stigma
Since stigma is latent during times of more or less normal
market functioning, when there are plenty of funding alternatives to the discount window, economic research that
attempts to measure the quantitative impact of stigma has
focused on unique events in financial markets. One example
was around the turn of the millennium, when businesses of
all types were worried that the date turnover would trigger a
glitch in computer systems. As a preventative measure, many
banks chose to hold extra reserves. The Fed met the added
demand for liquidity by creating the Y2K Special Lending
Facility. The SLF was specifically designed to sidestep stigma: Borrowers did not need to approach the fed funds
market first, they weren’t restricted in how the fund were
used, and they didn’t have to pay the funds back right away.
The Fed encouraged banks to use the SLF without a fear
that it would trigger fears of insolvency or intensified oversight on the part of the Fed.
Nonetheless, lending patterns through the SLF provided
strong evidence of stigma, economist Craig Furfine of
Northwestern University found in 2001. He applied an algorithm to confidential fed funds data to identify the total
volume of fed funds loans compared to those through SLF.
The results were striking: During one particular week in late
1999, SLF borrowing was $236 million, while borrowing
through the fed funds market at rates higher than the SLF
rate exceeded $1.5 billion, more than 6.5 times larger, he
found. Banks were willing to pay a sometimes hefty premium for the ability to obtain funds from anyone but the Fed.
Stigma hadn’t been given theoretical treatment until a
2010 model developed by Richmond Fed economists
Huberto Ennis and John Weinberg. They show that it can be
rational for banks to borrow elsewhere at higher rates if
costly repercussions result from going to the discount window. In their model, a bank’s ability to repay an overnight
fed funds loan depends in part on its ability to resell the
assets in its portfolio to investors. One reason a bank may go
to the discount window is if other banks, perceiving those
assets are distressed, refuse to lend at a reasonably low rate.
Meanwhile, a bank’s potential investors are unable to distinguish the reason for borrowing, but if they observe discount
window borrowing, they can infer with a reasonably high
probability that the cause was poor asset quality. Thus,

borrowing from the discount window conveys a signal of
financial distress to investors, and associated banks are able
to resell their assets only at a discount.

Changes to Reduce Stigma
In 2003, the Fed made dramatic changes to its discount window practice in part to mitigate stigma. The discount rate
was changed to a constant one-percentage point spread
above the target fed funds rate, which removed the arbitrage
opportunity between the discount and fed funds rates. This
allowed the Fed to ease up on the regulatory scrutiny that
accompanied discount window borrowing. Nowadays,
provided a bank is in good financial condition and can post
adequate collateral, discount window funds are lent on a “no
questions asked” basis. To mark the change, the Fed publicly
urged banks and other regulators to view occasional discount window borrowing as appropriate and unworrisome.
Nevertheless, evidence of stigma persists. Furfine revisited the issue after the switch. Though the Fed sets a target
level for the fed funds rate and is generally able to achieve it
through open market operations, the actual fed funds rate
can fluctuate. In principle, fed funds transactions can trade
at any rate, including above the discount rate. During the
first three months of 2003, Furfine found, an average of
more than 57 times more activity occurred in the fed funds
market at rates equal to or higher than the discount rate.
Since discount window borrowing is rare in normal times,
markets are likely to view a bank’s sudden willingness to
borrow as a sign of weakness when the broader market is
experiencing distress, argued Governor Duke in her
February 2010 speech. “When uncertainty about the health
of individual institutions or the industry as a whole increases, stigma intensifies as the market tries to identify the
weaker players. The dilemma facing the Fed is that when
discount window borrowing is most needed to keep credit
flowing, it is most stigmatized.”
Indeed, borrowing remained low as the financial crisis
unfolded in the second half of 2007. The Fed reduced the
spread between the discount and fed funds rates to one half
of a percentage point in August 2007, and discount loan
terms were extended from overnight to 30 days (eventually
the rates and terms were loosened further). But few banks
responded. Four of the nation’s largest banks borrowed a
combined total of more than $2 billion, but they stated publicly that is was a symbolic move meant to encourage small
institutions facing liquidity shortages to borrow.
The Fed responded in December 2007 by creating an
entirely new lending facility to get liquidity to the financial
system. Like SLF, the Term Auction Facility (TAF) was
designed specifically to get around the stigma problem.
The key difference was that TAF funds were administered
through auction. It worked like this: The Fed announced
that it would lend a fixed amount of funds, and an unlimited
number of banks could bid for up to 10 percent of
that amount (a cap set to ensure the funds were evenly
distributed). Funds were given to the highest bidders at the

Region Focus | First Quarter | 2011


Fed Lending During the Financial Crisis
Banks proved much more willing to borrow from the Term Auction Facility,
which was specifically designed to sidestep the stigma problem that is
believed to afflict the discount window.


Term Auction Facility
Discount Window

Aug. 2007

Aug. 2008

Aug. 2009

Aug. 2010 Apr. 2011

SOURCE: Federal Reserve Board of Goverors H.4.1 Release (Factors Affecting
Reserve Balances)

“stop out” rate — the rate whose associated bid exhausted
the funds. Thus, the TAF guaranteed multiple borrowers,
which reduced the likelihood that any one borrower would
be identified and penalized by the market.
Despite the fact that discount window and TAF funds
were in principle identical — even precisely the same institutions were eligible — TAF lending quickly dwarfed that of
the discount window (see figure). During the 28 months that
TAF was operational, more than 4,200 individual loans were
granted through 60 auctions, providing more than $3.8 trillion in funds. The amount offered at each auction varied
from $20 billion when the program was first launched to
more than $150 billion during the worst days of the crisis.
There is no evidence that the market initially attached
any stigma to TAF when it was launched, writes a group of
researchers in a 2011 Federal Reserve Bank of New York
Staff Report. They document that financial institutions
were willing to pay an average premium of 37 basis points,
and 150 after the failure of investment bank Lehman
Brothers to borrow from TAF rather than the discount
window. The fact that banks were repeatedly willing to pay
more for TAF funds is interpreted by the authors as strong,
quantitative evidence of stigma.
If one interprets all of that premium as being the result of
stigma, then stigma cost banks an average of $5.5 million in
interest per TAF auction during the summer of 2008, a
period when the TAF rate was consistently above the
discount rate — and $75 million in interest for the auction
immediately following the failure of Lehman. It appears
stigma has the potential to be quite costly for banks in times
of greater liquidity needs.

What Will Happen After Dodd-Frank?
An outstanding question is how the financial crisis will
affect stigma. Will it worsen it by forever associating Fed

loans with financial turbulence? Or lessen it by making
central bank loans more common, as is the case in other
Adding a twist of uncertainty is the requirement under
the Dodd-Frank law that discount window loans be published with a two-year lag. It is possible that the effects of
publication will be different for stigma during “normal”
times versus stigma during times of financial distress. There
appears to be a clear difference between the two. As
Governor Duke and the New York Fed’s TAF study each
suggest, financial turmoil seems to worsen stigma as uncertainty rises and banks struggle to identify weaker
counterparties. Will loans being made public two years after
the fact affect banks’ willingness to borrow in a crisis?
We may not know until the next financial panic.
Dodd-Frank was not the only recent mandate for the Fed
to reveal discount window borrowing. Lawsuits filed under
the Freedom of Information Act by the news organizations
Bloomberg and Fox News sought to require the Fed to disclose discount window borrowing that occurred during the
financial crisis — during April and May 2008 (around the
failure of Bear Stearns), and from August 2007 through
November 2008, respectively.
The Fed denied the requests under the argument that
disclosure would dissuade banks from accessing the discount window. The U.S. Court of Appeals for the Second
Circuit ruled against the Fed in the Bloomberg case, and in
March of 2011, the Supreme Court denied the Fed’s petition
to hear that case. The Fed subsequently released the data.
The lawsuits are the first of their kind leading to publication
of discount window data, according to Alan Meltzer, a Fed
historian at Carnegie Mellon University.
As for more normal times, whether stigma deters borrowing can come down to the culture of an individual bank,
says Snider of the Richmond Fed. “There are two different
groups: For some banks, no matter what, they will never
come to the discount widow. Then you’ve got a group to
which it appears to make sense, especially late in the day and
when conditions are advantageous. To them, if we’re going
to publish the data in two years, that doesn’t seem like a big
deal.” Still, she says, the Richmond Fed made efforts to
make sure that each of the hundreds of depository institutions in the Fifth District which potentially have access to
the discount window were aware of the coming change.
Ultimately, Snider says, “what banks should remember is
that if a bank borrows from the discount window, that
means it met the Fed’s criteria for primary credit: It is a
fundamentally healthy institution.”

Armantier, Olivier, Eric Ghysels, Asani Sarkar, and Jeffrey Shrader.
“Stigma in Financial Markets: Evidence from Liquidity Auctions
and Discount Window Borrowing During the Crisis.” Federal
Reserve Bank of New York Staff Report No. 483, January 2011.
Ennis, Huberto, and John Weinberg. “Over-the-Counter Loans,


Region Focus | First Quarter | 2011

Adverse Selection, and Stigma in the Interbank Market.”
Richmond Fed Working Paper No. 10-07, April 2010.
Furfine, Craig. “Standing Facilities and Interbank Borrowing:
Evidence from the Fed’s New Discount Window. International
Finance, November 2003, vol. 6, no. 3, pp. 329-347.

A Pinch of Basel?

n Dec. 16, 2010, the Basel Committee on Banking
Supervision — a group of senior officials of central
banks and bank supervisory agencies from 26
countries and the Hong Kong Special Administrative
Region — released a final draft of its framework of banking
regulatory reforms. That framework, known as Basel III,
is a response to the 2007-2008 financial crisis, and is
expected to be adopted by bank regulators worldwide,
including in the United States.
The reforms set out by Basel III are wide-ranging, but at
the center are increased capital requirements. Capital
requirements are intended to act as a buffer, ensuring that
financial institutions are able to withstand some level of
losses; they are typically expressed as a ratio of capital to
assets, or to some risk-adjusted measure of assets. Of course,
banks also maintain capital reserves for self-interested
reasons — for instance, to maintain the confidence of
investors. It is widely believed, however, that many of the
risks created by low capital levels are felt not by the bank,
but by the financial system as a whole (including government
programs such as deposit insurance), thus warranting regulation of minimum capital levels.
Today, U.S. regulators generally require a 4 percent capital ratio for “Tier 1” capital (mainly shareholders’ equity and
retained profits net of accumulated losses) and an 8 percent
capital ratio overall. Under Basel III, these requirements
will become more stringent. The framework calls for the
minimum Tier 1 ratio to go up to 4.5 percent in 2013, continuing to increase to 5.5 percent in 2014 and 6 percent in 2015.
The minimum total capital requirement will remain at 8 percent, but it will be supplemented under Basel III by a
“capital conservation buffer” of common shareholder equity
that will kick in at 0.625 percent in 2016 and rise to 2.5 percent in 2019. Banks that do not meet the buffer requirement
would be restricted in their ability to pay dividends and
bonuses and to buy back their shares.
Thus, roughly speaking, the total Tier 1 ratio will effectively double from 4 percent to 8.5 percent (6 percent plus
2.5 percent), and the minimum total capital ratio will
increase from 8 percent to 10.5 percent. Additionally, the
framework contemplates a “countercyclical capital buffer,”
also based on common equity. The buffer would vary from
0 to 2.5 percent at the discretion of national regulators. The
concept is that regulators would require this additional
buffer during an expansion, and would reduce it during a
downturn to maintain the availability of credit.
The framework states that systemically important banks
— banks of such a size that they may be considered too big
to fail — “should have loss-absorbing capacity beyond the
minimum standards.” Basel III does not specify what addi-


tional standards should apply to systemically important
banks, instead indicating only that “the work on this issue is
ongoing.” (Systemic risks to the financial system are also
newly addressed within U.S. law by the Dodd-Frank Wall
Street Reform and Consumer Protection Act, which provides for regulation of systemically important bank holding
companies and nonbank financial institutions.)
No congressional action is needed for the Basel III
framework to take effect in the United States. To meet the
implementation date of Jan. 1, 2013, the Federal Reserve
System and the other bank regulatory agencies are expected
to issue a proposed notice of rulemaking this year for rules
incorporating the Basel III capital requirements into U.S.
regulations. It is likely that regulators will invite comments
from the public on the proposed rules before they become
final. It’s also worth noting that the Basel III reforms are not
binding: Countries have discretion to disregard or not fully
implement certain provisions.
What will be the macroeconomic effects of the increased
capital requirements? That is the trillion-dollar question.
A 2007 literature review by David VanHoose of Baylor
University, published in the Atlantic Economic Journal, concludes that heightened capital requirements are likely to lead
to reductions in bank lending. In the short run, banks facing
increased capital requirements may be reluctant to issue new
equity to bring their capital ratio into line with those requirements, given the costliness of raising equity capital. Thus,
they will tend to respond on the asset side, slowing the
growth of their assets, rather than on the capital side.
Another potential unintended consequence of higher
capital requirements is the risk of regulatory arbitrage. If
capital requirements create a modest cost disadvantage for
banks, then an increasing share of lending activity could
move to vehicles outside the bank regulatory system, such as
private equity funds or securitization.
No one yet knows whether the increased capital requirements of Basel III are sufficiently high to produce
appreciable macroeconomic effects or regulatory arbitrage,
or whether the minimum capital ratios could be set even
higher without such effects. Given the lengthy phasing-in of
the requirements, regulators will have the opportunity to
assess the extent of those effects in coming years.
“There’s a lot of uncertainty about what the right amount
of capital is,” says Richmond Fed economist Huberto Ennis.
“It depends on the costs and benefits of having additional
capital. Incrementally, how costly would it be to ask for
15 percent capital? We don’t know. As far as I can tell, it’s
people making calls based on soft information and hunches.
We know capital is good, we know it may be costly.
The question is, what’s the right amount?”

Region Focus | First Quarter | 2011


Market Failure
basic economic principle is that free markets
produce outcomes in which resources are generally
allocated efficiently. By “efficient,” economists mean
that all the mutually beneficial trades which are possible
have been exhausted. Free markets accomplish this feat by
coordinating willing buyers and sellers through prices.
Sound too good to be true? It can be. There are special
circumstances that economists call “market failures” in
which a freely functioning market is unable to produce an
efficient outcome. When there are market failures, government intervention may be justified to correct the failure
and, ideally, drive the outcome closer to efficiency.
Economic theory has identified a limited number of market flaws that can lead to market failure. One is when a good’s
consumption or production comes with externalities.
Consider a factory that produces smog with each unit of output. The smog harms nearby households
and businesses. But if producers can pollute for free, the production costs faced by
the producer are lower than the true costs
to society. The price of the good will be
artificially low, and too much of the good,
and its associated pollution, will be produced.
A “public good” can also be an example
of a market failure. Sometimes it is not
possible to exclude nonpayers from consumption of a good or service. A local
fireworks display is a common example. It
would be hard to exclude anyone in the
surrounding area that chooses not to pay,
so few people have incentive to fork over
the entrance fee. As a result, a private party
will be less likely to put on the show at all, even though many
people would derive value from it. In the case of public
goods, the government may step in to provide the service,
inducing everyone to pay through taxation. This is why one
often sees city governments at the helm of local Fourth of
July celebrations.
Though market failures may at first blush appear to be
about fairness — the smog producer harms its neighbors, or
people free ride on the fireworks display — this occasional
feature is not what concerns economists. The primary cost
associated with market failure is that an inefficiently high
or low amount of the good in question is produced. That
causes resources to be directed to places other than where
they are most highly valued. Society as a whole is richer
when resources go to their highest-value uses.
In fact, plenty of market outcomes that reasonable
people may view as undesirable or unfair are not market



Region Focus | First Quarter | 2011

failures at all. Take, for example, a market-oriented economy
that produces income inequality. If a person becomes very
rich by inventing a product that a lot of people value highly,
that may be a perfectly efficient outcome even if no poorer
person benefits in the slightest. A society that spends an
exorbitant amount of money on gambling or unhealthy
foods reflects that people place different values on how to
spend their time and money. Distasteful to some people,
perhaps — but not a market failure.
One must also be careful about alleging market failure —
especially if that allegation is used to justify government
intervention — in instances where markets are not truly
free. The recent financial crisis is an example. Financial
markets are heavily regulated, which necessarily alters the
incentives that market participants would face in a truly
free market. Most financial markets are far from being truly
“free” markets. It is important to separate
the effects of market failure, if any, from the
unintended side effects of the regulations.
As for correcting market failures, a good
rule of thumb is that successful methods
replicate market behavior as closely as
possible. For example, in the case of the
smog-producing factory, the government
could simply place a ban on smog production, but that would deprive consumers of
the benefit of the good that was being produced. A more efficient arrangement would
be for the government to assign property
rights to the surrounding air. This would
force the producer to “internalize” the
externality by compensating its neighbors
for the right to pollute their air, raising
production costs.
Private producers have often found ways to correct market flaws in order to produce efficient outcomes. When there
are externalities, private parties have sometimes been able to
divvy up property rights with no government intervention
whatsoever. Private entrepreneurs have also found ways to
exclude nonpayers to profitably produce roads (through tolls)
and radio signals (through scrambled signals) even though
both are commonly cited examples of public goods.
In addition, government interventions can themselves
reduce efficiency through unintended consequences, distortionary taxes, special interests, or simply errors in judgment.
That’s why not all market failures warrant policy action.
When considering policy intervention to correct a market
failure, the relevant question is whether the costs associated
with government action are likely to be greater than those of
the initial market failure.



The Price of Avoiding Minor Financial Loss

homes. Second, consumers may prefer to smooth costs over
uch economic research has focused on how
the long-run rather than risk suddenly having to pay a signifpeople avoid or embrace financial risk. Justin
icant amount. Third, some individuals could have significant
Sydnor, a microeconomist at Case Western
borrowing constraints, making them unable to cover sudden
Reserve University, focuses in a recent paper on the
financial loss. Fourth, homeowners could be “influenced or
phenomenon that, as he puts it, many consumers “appear
pressured to take the more expensive lower deductible
to pay a large amount to insure against very modest financontracts by the company’s sales agents, who earn partial
cial losses.” He cites the demand for extended warranties,
commissions.” Fifth, the selection of deductibles offered
mobile phone insurance, and low insurance deductibles as
by the provider may influence the consumer. “People
evidence that many consumers are highly averse to risk.
have a tendency to avoid picking the extreme options from
In particular, Sydnor finds that there is “a surprising level
a menu and may be reluctant
of risk aversion over modest
to pick the highest or lower
stakes” in the market for home“(Over)insuring Modest Risks.”
owners’ insurance.
Justin Sydnor. American Economic Journal:
Sydnor. Finally, consumers may
Sydnor analyzes data from
have other personal reasons to
a random sample of 50,000
Applied Economics, October 2010,
avoid risk. For example, previous
standard homeowners’ policies
vol. 2, issue 4, pp. 177-199.
research has concluded that
issued by a large insurance
consumers want to avoid the
provider. The policies were all
psychological pain of sudden financial loss.
issued in a single unnamed western state in the past decade.
Sydnor also looks at the extent to which consumers’
In choosing coverage, customers had a choice of four availchoices of deductibles affected profitability. In view of his
able deductibles that they would pay in the case of loss or
findings that consumers pay more for low-deductible
damage: $1,000, $500, $250, $100. As usual in insurance
policies than the expected value of the additional coverage,
markets, choosing lower deductibles meant higher premione might assume the low-deductible policies are more
ums. Sydnor finds that a plurality of customers, 48 percent,
profitable to the insurance provider, but this is not the case.
chose the $500 deductible; 35 percent chose $250; 17 percent
The insurance provider earned roughly similar profits from
chose $1,000; and less than 1 percent chose $100. He then
both groups. Sydnor argues that this is partly because lowquantifies the average difference between the cost and value
deductible customers have higher claim rates than those
of the different deductibles by comparing the additional
with high deductibles. In short, it appears that the prices
costs and claim rates of the lower deductibles. He calculates
charged by insurance companies may be consistent with a
that “those who held lower deductibles paid [five times]
competitive equilibrium.
more than the expected value for that extra insurance.”
Thus, while some individual consumers could save money
Sydnor also analyzes the decisionmaking processes
by switching to higher deductible plans, if all consumers
behind these purchases. In studying the participants, he
finds that customers who have held policies for longer “were
changed their behavior, the insurance company would have
actually more likely to hold one of the lower deductibles.”
a difficult time distinguishing more and less risky customers.
He speculates that such decisions by this segment of homeThis might force the provider to raise insurance costs or to
owners may be due to “consumer inertia,” where despite
create a new higher deductible.
rising insurance costs, individuals fail to adjust their initial
As a result, Sydnor does not recommend government
choices. “It is likely that the observed choice of lower
policy changes to “correct” consumer behavior. “In partideductibles partially reflects inertia and not solely an active
cular, a given individual might benefit from [altering the
choice reflecting risk preferences.” He predicts that this
biases] that caused him to avoid purchasing [a more approphenomenon would apply to the U.S. homeowners’ insurpriate deductible], but a policy aimed at changing all
ance market as a whole and calculates that by switching to
consumers’ behavior is unlikely (at least in home insurance)
the highest available deductible, U.S. homeowners could
to improve the equilibrium for the consumer.”And while
save around $4.8 billion annually.
Sydnor looked at only homeowners’ insurance policies, he
Sydnor concludes that those in his sample “overinsure[d]
concludes that similar research could usefully be applied to
modest risks when making home insurance purchases” and
other insurance markets as well. “Doing so may open up new
proposes six potential explanations for this phenomenon.
insights about behaviors,” he suggests, “and may generate
The first, and the most obvious, according to Sydnor, is that
policy prescriptions in areas such as health insurance and
consumers may simply misjudge the level of risk to their


Region Focus | First Quarter | 2011



or those on the inside, it is hard to ignore the sense that the
economics profession is in a state of intellectual crisis.

The sense is not unanimous, mind you, or probably even
the majority view. But there is the uncomfortable fact that
the profession was largely surprised by the largest economic
event in several generations. Some have taken it as a sign
that economists are, decidedly, studying the wrong things.
The specific complaints are varied: Economists were so

generally can’t conduct controlled experiments. An exception is the experiments conducted by the likes of Nobel
Prize-winning economist Vernon Smith, but those typically
deal with how people interact in different market settings
and often do not have broad applicable policy implications.
As a practical matter, one can’t raise taxes on one segment of

Why economists study what they do — and how the crisis might change it
focused on unrealistic, highly mathematical models that
they missed the problems developing before their very eyes.
They were so complacent with the idea that markets
usually get things right that they ignored a housing bubble
and securitization mess in the process. Overall, critics say,
policymakers shouldn’t listen to a profession so lacking in
consensus and out of touch with reality.
Did the research and beliefs of economists leave them
ill-equipped to foresee the possibility of a major financial
crisis? And if so, what drove the profession to such a myopic

Is Economics a Science?
The recent criticisms are interesting in historical perspective because states of intellectual crisis tend to spur new
theories in the sciences. One might expect the evolution of
thought to be slow and steady, but physicist Thomas Kuhn
paints a more dramatic picture in his 1962 book The Structure
of Scientific Revolutions: It is a “series of peaceful interludes
punctuated by intellectually violent revolutions.”
What triggers a revolution, he writes, is that researchers
identify something at odds with the dominant theory. One
of three outcomes occur: The dominant paradigm explains it
satisfactorily; the field determines it is something we are
unable to study with existing tools, putting it off for future
generations; or a new candidate paradigm emerges. But after
a revolution, only one end is possible: The worldviews
cannot coexist; one replaces the other.
Evolution is a bit choppier in economics than natural
sciences. It is much harder to disprove theories of human
behavior than the mechanistic functionings of, say, physics
or chemistry. People are subject to change, and economists


Region Focus | First Quarter | 2011

the population to analyze effects on the taxed and untaxed
— not even in the name of science. Instead, economics
experiments take place in models, or systems of equations
designed to simulate real-world behavior.
Science-like tools such as statistics and equations weren’t
always a part of economics. Most people recognize Scottish
philosopher Adam Smith as the “father” of economics, who
delivered some of the most basic economic principles. But
economics as a technique was invented by economist David
Ricardo, writes economic historian Mark Blaug in his book
Economic Theory in Retrospect, one of the leading texts on the
history of economic thought. Ricardo is most famous for
showing in 1817 that two nations can benefit mutually from
trade even if one is better than the other at producing every
single good. This idea of comparative advantage is perhaps
one of the least intuitive concepts in all of economics,
which Ricardo made profoundly clear through a simple
story problem involving two countries that produce the
same two goods.
His approach was deductive reasoning: drawing specific
conclusions based on a much more general, simplified example, the benefit of which is that it can be solved through
logic. Not everyone agreed with that approach. Twentieth
century economist Joseph Schumpeter coined the phrase
“Ricardian vice” as the faulty practice of using overly simplistic assumptions to guide real-world policy. Nonetheless,
the value of objective reasoning caught on and distinguished
economics from other “moral” sciences like sociology and
Math became a big part of economics after the “marginal
revolution” of the late 1800s. Previously, the “classical” economists — as they are now generally dubbed — spent their



time studying the aggregate economy. But a desire to understand market-level issues, like why an egg costs more than a
cup of tea, narrowed their attention to the margin: the last
unit bought, sold, traded, or produced. The new nucleus of
study was incentives, opportunity costs, and marginal
choices. The marginal revolution was the birth of neoclassical economics, which looks a lot like the microeconomics of
today. Calculus was required to study incremental decisionmaking at the margin, and math became a permanent
mainstay in economics.
The use of math in this context fit well with Ricardo’s
logical technique for analyzing policy problems. The combination enabled economists to make objective policy
prescriptions free of moral or ideological axes to grind.
Anyone could plainly see the assumptions behind an economic model; one could accept or reject the policy

wages would eventually adjust to bring supply and demand
back in balance. More than a decade of severe unemployment seemed to prove that prediction false.
They were looking in the wrong place, Keynes said. The
Depression was a shortfall in demand at the aggregate level.
While the neoclassicals might have been more concerned
with the specific source of the shock through the lens of
individual decisionmaking, to Keynes that wasn’t the point —
in fact, people can randomly and without cause shift demand
due to “animal spirits,” he said. The policy implication was
simple: The government can avoid recessions by stepping in
to consume when flesh-and-blood consumers refuse.
For decades, circumstance seemed to confirm Keynes’s
theory, and that kept it in favor. Unemployment virtually
disappeared after military spending was ramped up for
World War II. (Those who are rightfully concerned about

implications on their merit. The notion that economics
could, and should, be objective was how it became thought
of as a science. Marginalism, for its part, refocused the discipline’s purpose: Economics was about how people behave as
they allocate scarce resources to make their lives better.
With its new branding as an independent science, economics also became more academic and less accessible to
laypeople. Gone were the days of amateur economists like
Smith and the brilliant but virtually untrained Ricardo. It is
no surprise that many of today’s leading economics journals
were established around the turn of the 20th century.

9 percent or 10 percent unemployment over the past few
years will understand how monumental it seemed when
unemployment that topped 15 percent or 20 percent for the
better part of a decade simply evaporated and never
returned.) The 1950s were mild and the 1960s boomed. By
the late 1960s, many economists believed the government
could “fine tune” the economy to keep it at full employment.
Booms and busts were a thing of the past.
Keynesianism seemed to work, but other factors also
kept it dominant, says UCLA economist Lee Ohanian.
Keynesianism was a fertile area of study, so that’s what
received the attention of economists. The General Theory was
nontechnical, even a tad rambling. Economists got much
better at econometrics in the 1940s and 1950s, and that
created the opportunity to develop Keynes’s broad ideas
into a full-fledged Keynesian toolkit for the economy,
Ohanian says.
Economists at universities, the Federal Reserve, and
other agencies spent much of the 1950s and 1960s constructing enormous models of the economy that included
hundreds of equations, each representing supply and
demand behavior in some specific sector. Chances are,
Ohanian says, if you ask economists who received their
Ph.D. in the 1960s the topic of their dissertation, it was one
of those equations. With the new models economists could
tweak a policy variable and calculate the precise expected
results on employment, consumption, wages, and a variety
of other variables of interest. “These econometric developments elevated Keynesianism to a quantitative enterprise.”

Upheaval in Economics
A recurring theme in economics since the marginal revolution has been that major economic events — especially
when they are painful — are the primary catalysts for new
modes of thought.
No economic event was larger, or more painful, than the
Great Depression. As revolutions go, marginalism was
adopted at a glacial pace — five or six decades from first
inklings to the formal codification of supply and demand in
1890 — compared to the upheaval that followed when John
Maynard Keynes published the General Theory of Employment,
Interest and Money in 1936. In the history of economics, the
Keynesian revolution comes closest to being one of Kuhn’s
dramatic paradigm shifts in thought. His theory made its
way into economics textbooks after a decade, and visibly
into policy within five or six years. The reign of his ideas
lasted decades.
No existing theory could explain the Depression.
Neoclassicals could explain unemployment: If real wages
were held above market-clearing levels by any number of situations — monopolies, tariffs, or price rigidity in general —
unemployment would result. But they could not explain protracted unemployment. They predicted that prices and

A Model Breaks Down
Between an economy that conformed and conveniently
timed econometric advances, “Keynes’ idea was in the right
place at the right time,” Ohanian says. He explores in a
recent paper with UCLA colleague Matthew Luzzetti the

Region Focus | First Quarter | 2011


Right Place, Right Time
The Phillips curve was a truly revolutionary idea: It appears in some form in
virtually all macroeconomic research. It was also possibly in the right place at
the right time, according to University of Chicago economist Harald Uhlig.
If Phillips had plotted the relationship between inflation and unemployment today instead of in 1958 he’d have seen little of obvious interest — or,
potentially, publishable certainty.


Phillips Curve (1948-1959)













Phillips Curve (1948-2010)






SOURCE: Both inflation and unemployment data from the Bureau of Labor Statistics.
Charts originally appear in “Economics and Reality,” Harald Uhlig, NBER working paper
no. 16416, September 2010.

reasons behind the rise of Keynesianism — and its eventual
decline. “What’s interesting is that after 1970 the economy
evolved in ways that were as pathological to the Keynesian
model as the Great Depression was to the market clearing
models of the 1920s,” he says. “It was really a case of what
goes around comes around. And I think a lot of science proceeds that way.”
The first problem was the breakdown in the Phillips
curve. The Phillips curve is the famous inverse relationship
between inflation and unemployment identified in 1958 and
quickly enveloped in the Keynesian rubric: In practice, it
was believed, policymakers could orchestrate lower unemployment by producing inflation, which would cause
producers to think that demand for their goods had
increased, causing them to hire more workers. When inflation later flared up, they could employ tighter monetary or
fiscal policy, which would slow the economy a bit but would
stabilize prices. In short, government officials could effectively fine-tune the economy as needed.
It worked well for about a decade. But in the late 1960s
some countries experienced rising inflation with little or no
improvement in unemployment. Through much of the
1970s, both inflation and unemployment rose at once —
stagflation. The Phillips curve’s menu of choices suddenly
seemed unavailable.
Economists jumped at the chance to explain the puzzle,
much like Keynes had done 40 years earlier. Robert Lucas
offered the famous “Lucas critique” in the 1970s: People
simply caught on to the government’s strategy. In general,


Region Focus | First Quarter | 2011

Lucas said, people’s past behavior is a poor guide for future
policy because that strategy will, in fact, change the very
behavior it is based on, neutralizing systematic attempts to
manipulate the economy. This was a decidedly antiKeynesian proposition. (The Phillips curve may be another
example of an idea that was in the right place at the right
time. See chart.) Lucas and others helped launch the “rational expectations” movement, which provided a formal model
for how people’s expectations affect macroeconomic outcomes. No longer satisfied with the notion of mysterious
animal spirits, economists took a closer look at the causes of
shifts in demand. Further econometric advances allowed
them to develop specific theories — called “microfoundations” — about what caused consumption and other
aggregates to change at the individual and firm level.
There were other gradual shifts that led economists away
from Keynes. The Lucas critique also applied to the complex
systems of equations economists had spent two decades
developing. The equations were based on past behavior;
there was no reason to expect them to be stable. Sure
enough, a series of studies starting in the early 1970s showed
that simple statistical models which included no theory
whatsoever were often better at forecasting the economy
than the complex models the profession had spent two
decades producing.
But it was that real-world events blatantly conflicted with
the theory that really caused the profession to move on from
Keynes. “[T]he inflation and the stagflation of the 1970s did
more to persuade economists that there was something
wrong with Keynesian economics — that you needed supply-side policies and all that — than all the empirical
evidence on the econometric studies against Keynesian economics,” Blaug said in a 1998 interview with Challenge
magazine. “Sometimes you have to be hit over the head with
a hammer before you give up a beloved theory.”

Math as Not Just a Servant, But a Master?
As MIT economist Olivier Blanchard describes it, if
Keynesianism was a revolution, macroeconomics since
rational expectations has been a drawn-out battle with gradual movement toward peace.
Two, not one, replacement paradigms emerged, both
emphasizing microfoundations. First, the new classicals,
whose models included fewer market imperfections, were
able to incorporate a “general equilibrium” view that demonstrated how separate markets affect each other as they might
in the actual macroeconomy. Their brand of macroeconomics looked more like microeconomics, with a focus on the
power of markets to allocate resources most efficiently.
Second were the new Keynesians, who wanted to tweak, not
replace, the Keynesian models by using microfoundations to
explain aggregate imperfections that the government might
be able to fix via judicious monetary and fiscal policy. The
models generally were unable to study more than one market
at a time, a “partial equilibrium” perspective.
This is the famous “freshwater” and “saltwater” divide

that has caused much controversy (and occasional name calling) within the economics profession. The monikers
describe the geographic locations where the economists in
those camps have tended to be located. Saltwater economists (centered at universities around the two coasts) have
been accused of assuming policymaker omniscience and
ignoring the bad incentives that government intervention
can create, while freshwater economists (centered at universities around the Great Lakes) have been accused of
operating with blind faith in the unfailing power of markets
to self-regulate.
Those caricatures still exist, but for the most part the
camps have converged over time to create a hybrid of general equilibrium, microfoundational models that include
imperfections and a potential role for government intervention. “The new tools developed by the new classicals came to
dominate. The facts emphasized by the new Keynesians
forced imperfections back into the benchmark model,”
wrote Blanchard in 2008. The Economist magazine described
the convergence in vision as “brackish” macroeconomics.
Even more striking has been the convergence in methodology. Because of advancements in econometrics and
computer power, economists today can combine the
strengths of various theories better than before. What models today have in common is not so much any one school of
thought, but the type of mathematical tools that are used —
so, in a way, mathematics is the new reigning paradigm of
economics. The quintessential example are DSGE models,
which stands for “dynamic stochastic general equilibrium” (a
fancy way of saying they include decisions made over time
and under uncertainty, and that the decisions made by policymakers, consumers, and firms affect each other).
DSGE models are the dominant workhorse in macroeconomics today, especially at policy institutions like the Fed.
They consist of a small handful of equations that tell economists how much households are likely to consume and work,
and how much firms are likely to produce and invest, as the
result of some policy or shock the economist imposes. Such
models are used to ask specific hypothetical questions, the
results of which are interpreted with a good amount of judgment (see page 17). But they’re solved using math so complex
that one of the biggest constraints on their size is sheer
computer memory.
One result of increasing reliance on math — critics pejoratively refer to it as “formalism,” or math for math’s sake —
is that the profession has become very specialized.
Economic historian Robert Whaples of Wake Forest
University puts this is in characteristically economic terms:
“Fixed costs of switching fields of study may be higher in
economics than in other sciences, especially social sciences,
because you do have to learn a lot of rigorous techniques.”
Increasing specialization may be one reason the crisis
caught economists by surprise. To truly see the complex web
of securitizations — that, when unwound, was the crisis —
one would have needed knowledge about multiple fields like
financial and real estate economics, argues University of

Even the most inclusive models cannot be
used as a “theory of everything,” to borrow
a phrase from physics, that merges a large
number of fields and sounds an alarm
when events like crises are imminent.
Chicago economist Raghuram Rajan in a recent blog posting. “[Y]ou had to know something about each of these
areas, just like it takes a good general practitioner to recognize an exotic disease. Because the profession rewards only
careful, well-supported, but necessarily narrow analysis, few
economists try to span sub-fields,” he writes.
Fed Chairman Ben Bernanke argues that even economists who warned of instability saw only very limited
portions compared to what actually transpired. “[T]hose few
who issued early warnings generally identified only isolated
weaknesses in the system, not anything approaching the full
set of complex linkages and mechanisms that amplified
the initial shocks and ultimately resulted in a devastating
global crisis and recession,” Bernanke said in a September
2010 speech on implications of the crisis for the field of
There are limits to how much that interdisciplinary
perspective can be modeled quantitatively. Even the most
inclusive models cannot be used as a “theory of everything,”
to borrow a phrase from physics, that merges a large number
of fields and sounds an alarm when events like crises are
imminent. Even if computers and math could handle such a
feat, the result would risk taking historical relationships for
granted, much like the Keynesian equations of the 1950s and
1960s. “We’ve got hundreds of millions of people interacting,” says Whaples. “They’re real people, and they’re
complex in their behaviors, their motivations, and their
interactions. And there are some really smart ones out there
who have seen how the system works and that there’s a little
way they can make it work to their advantage,” he says. “You
will never be able to model the economy the way my physicist friends want you to.”
Even if such a model existed, forecasting crises is, to most
economists, a nonstarter. Markets tend to uncover information on crises and turning points before economists can
forecast them with models.
But the professional rewards for taking a qualitative interdisciplinary perspective are also lower. Using prose instead
of math is less likely to get an economist published and is
harder to garner attention. Rajan would know; he warned of
instabilities with surprising accuracy in a 2005 Federal
Reserve conference, when he was chief economist at the
International Monetary Fund, and even with his stature he
was largely dismissed by the economics profession, including his own colleagues, the IMF said in a recent report. But
even with the benefit of hindsight, it is hard to see how it
could be any other way: Those who spend their careers predicting unlikely events like large crises and crashes are
destined to be wrong a lot of the time. Many economists

Region Focus | First Quarter | 2011


quite rationally stick to chipping away at outstanding
research questions.
Arguably, it is regulators who should have been aware of
the hidden risks, but the financial system appears to have
innovated out of their view. Almost no one appreciated its
susceptibility to bank-like runs, Bernanke argued. He
described the crisis as a flaw in the administration of economic knowledge — for example, the design of regulations
in the public sector, and the design of risk-management systems in the private sector — not so much in the science or
theory of economics. The flurry of regulatory overhauls
since the crisis — which, economists argue, should emphasize information gathering and better, not simply more,
regulation — are intended to fix that problem.
In fact, Ohanian predicts the crisis will change regulatory economics more than theories of macroeconomic
issues like business cycles and growth. “I think what will
come out of the last couple of years is a focus, ironically,
more on the ‘micro’ side of macroeconomics, meaning how
should you pursue regulation of financial institutions, how
do we deal with the problem of too-big-to-fail, what type of
accounting standards should be used, how should we move
things off the balance sheet back onto the balance sheet,” he
says. “I think we learned a lot that bad policies are ones that
create bad incentives.”

A Caveat, Not a Revolution
For better or for worse, most economists don’t seem to predict wholesale changes in what economists study. In
addition to forecasting, theory is used to understand how
the world works. While there are features that models will
inevitably be made to include in order to better study the
crisis, like a stronger role for the financial intermediation
sector that was the epicenter, many aspects of the crisis were
already well-represented in models. Economists had been
formally modeling financial market characteristics like runs,
illiquidity, risk, and leverage for years, Bernanke said in his
speech. It’s that they — and regulators and indeed many
market participants — weren’t aware of the specific corners
where some of those potential problems existed. Once those
corners were revealed, Bernanke said, existing models proved
exceedingly helpful in determining how to treat them.
The methodological consensus that Blanchard described
may have been damaged somewhat by the crisis. Many
people viewed dominant methods like DSGE modeling as
increasingly useful tools and believed that efforts should be
devoted to refining them. But those models couldn’t fully
make “sense out of the 2008 financial crisis” says Harald
Uhlig, chair of the department of economics at the
University of Chicago. Many “Ph.D. students and
researchers alike these days want to contribute to the new
debates that have emerged rather than fixing these models.
That could be a good thing, if alternative, quantitatively
useful models eventually emerge,” he says, but it would be a
shame if the value of existing models is forgotten in the


Region Focus | First Quarter | 2011

Instead of a revolution, many see the profession, policymakers, and the public adopting a much humbler view of
what economics can tell us about the world. For one thing,
the economy is dynamic — what economists believe to be
true can change. Economists just got complacent, argues
John Quiggin of the University of Queensland in Australia.
The “Great Moderation” of the last 30 years, in which
recessions were generally mild, made economists and policymakers a bit too comfortable with their apparent past
success, he says. We also saw this in the 1920s and late 1960s,
he says, in the events that ushered Keynesianism into and
out of fashion. “You heard that we had it under control, or as
controllable as it might be. Those claims have been proven
false, so I guess we have to accept that our knowledge about
the macroeconomy is fairly provisional.”
Quiggin organized a session at the 2011 annual meeting of
the American Economics Association, the professional
organization of economists, titled, “What’s wrong (and
right) with economics.” Part of his impression from the session was that with economic recovery apparently under way,
complacency is probably on its way back. While he concedes
that “we may just be too close to the action to see what new
ideas are emerging,” he argues that it appears “there was a lot
more soul-searching on the part of the Keynesian establishment and a lot more creative stuff happening than there is
this time.”
It may partially be the quantitative nature of modern
economics that causes it to be mistaken for the certainty and
precision that natural sciences can offer, George Mason
University economist Russ Roberts wrote recently on his
blog, Café Hayek. He argues macroeconomics should be
viewed more like biology than physics. “We do not expect a
biologist to forecast how many squirrels will be alive in 10
years if we increase the number of trees in the United States
by 20 percent. A biologist would laugh at you. But that is
what people ask of economists all the time.”
But the economics profession is relied upon to provide
clear policy guidance. The ability to provide it can affect
how much attention a theory gets, Ohanian says. “During
any kind of crisis or recession there are always many calls
from many quarters for government to ‘do something.’ It’s
really inconceivable that policymakers might say, ‘You know
what, we don’t see that there’s anything we can do that we’re
convinced is going to make things considerably better, so
we’re going to sit in the sidelines,’” Ohanian says.
That means there are rewards of influence to those willing to overstate the certainty of their predictions, says David
Colander of Middlebury College, a long-time critic of
excess formalism in economics. “A lot of economists don’t
do that, but unfortunately they’re not the ones who get
reported in the newspaper and whose views get discussed,”
he says. “My complaint about economics is that too often
some groups of economists let other people think that we
fully understand things that I don’t think we do. The honest
economic scientist should be willing to say, ‘Scientifically we
continued on page 38

Does Math Make Fed Policy?
One doesn’t often hear the complaint that economics is too
heavy on math and theory coming from within policymaking bodies such as the Fed. A cynic could argue that’s a
matter of self-preservation. But those on the inside say it’s
because math and theory have an important, though measured, role in policy.
Economic models are used to run hypothetical policy
experiments — analogous to what physicists do in a lab —
the results of which provide some input on the likely path of
important indicators like GDP, consumption, or employment in response to the question being asked.
How can models that rely on often unrealistic, simplified
assumptions possibly be useful for real-world policy? With a
fair amount of judgment. Briefings for Fed policy meetings
entail many hours of discussion; if they were just about the
output of models, they would be over quickly.
But judgment doesn’t enter in where one might expect.
The math that solves a model isn’t much of a topic for
debate since the tools are common and economists are generally confident in the algebraic abilities of their colleagues.
The real action is in the base assumptions: the nature of constraints and trading opportunities facing consumers,
producers, and policymakers in the simulated economy
being represented by a model.
Economists ask whether the assumptions behind the
model pass the “smell” test, and where a bit of homegrown
judgment can fill in holes. That judgment is enlightened by
real-world data; anecdotal insights from the Fed’s business
contacts (including labor and production decisions they
face); bank examiners; discussions with other policymakers;
and still other models, including types that rely more on
mere data and less on theory and math. Those alternative
sources help form opinions about which assumptions, and
thus which models, are most likely to reflect how the economy currently functions in the unique situation being
considered. When multiple models with believable assumptions start to produce comparable quantitative results, then
economists become more confident in their predictions.
Why the need for simplifying assumptions at all? The
U.S. economy consists of hundreds of millions of people,
each with unique circumstances and motivations.
Economists will never be able to capture that complexity in
a single model. Yet if we thought there were no commonalities between people or across businesses, or that they made
decisions randomly, there would not be much to study or
explain. So right away economists have to assume some basic
rules to get behind the “whys” of human behavior.
That’s why many models — particularly ones that include
the “microfoundations” of human behavior that are required
to evaluate the effects of policy on individuals — get more
mathematical as they include more real-world complexity.
Math is the only language that is unambiguous. It is the
only way to be clear to one’s colleagues what complex

behaviors are being assumed, which is how they understand
what drives the model’s results and decide whether that is
In 2001, economist Robert Lucas described working with
Edward C. Prescott in the early 1970s on research that
applied the rational expectations concept that would eventually win him a Nobel Prize. (Prescott would also become a
Nobel Prize winner for related ideas.) The two economists
were struggling to crack how labor markets are likely to
respond to monetary policy. Lucas said:
Some days, perhaps weeks, later I arrived at the office
around 9 and found a note from Ed in my mailbox. The full
text was as follows:
ÒBob, This is the way labor markets work:
v(s,y,) = max {_,R(s,y) + min[_,§v(s«,y,_)Ä (s«,s)ds«]}. EdÓ
The normal response to such note, I suppose, would have
been to go upstairs to EdÕs office and ask for some kind of
explanation. But theoretical economists are not normal, and
we do not ask for words that ÒexplainÓ what equations mean.
We ask for equations that explain what words mean.
From there, any difference of opinion between Lucas and
Prescott could only lie in what either believed reasonable to
assume about labor markets — not what “might” be true
through the lens of ideology or bias. If they could agree on
the structure of labor markets — agreement made possible
by the clarity math provides — they could agree on the output of the model.
Because the public does not converse in this way, the
nature of the often subtle debates between research economists rarely translates well to the public. For instance, the
public discussion of many policies of the last few years, from
quantitative easing to fiscal stimulus, was littered with estimates from economists of various stripes about the likely
impacts on jobs and GDP, but with relatively little discussion of what each was assuming en route to their
It’s no wonder it can appear to outsiders as if economists
could be laid end to end and still never reach a conclusion, as
George Bernard Shaw allegedly quipped. Economists disagree on many policies, but would agree much more than
laypeople might assume if they could first agree on starting
assumptions, which, admittedly, is very difficult to do.
In that light, it is easy to see why new techniques are
readily added to policymakers’ broad toolkit, but new theories take much longer to be embraced. Policymakers tend to
wait until an idea is well-established before using it as the
basis for policy. In many ways, economist David Colander of
Middlebury College says, actual policy today reflects innovations of a generation ago. “The younger people are pushing
… new models. But the policy that is used really reflects …
some Friedman, some Keynes, a whole variety of ideas,” he
says. “There’s judgment.”

Region Focus | First Quarter | 2011


Virginia and North Carolina are among the states using money from their
1998 settlement with tobacco companies to spur economic development

ell before the federal government doled out
billions of dollars to push the economy out of
the 2007-2009 recession, states created their
own stimulus programs using money from an unlikely
source: cigarette manufacturers.
In 1998, the attorneys general of 46 states and the District
of Columbia signed a master settlement agreement (MSA) to
resolve lawsuits against America’s four largest tobacco companies. As of April 2010, the firms have paid out more than
$74 billion as part of that agreement, with the Fifth District
receiving about $7 billion.
The money was intended to compensate for costs associated with smoking-related illnesses and to fund programs
that improve public health and reduce tobacco use. But the
MSA didn’t dictate how the payments should be used. As a
result, many states have used the windfall for a variety of
purposes, from buying laptops for classrooms to plugging
budget holes.
Those with communities that relied on tobacco farming
and production to generate economic activity have used the
money to offset job losses that have resulted from declines
in smoking, some of which may be attributed to the MSA’s
restrictions on cigarette marketing. In the Fifth District,
Virginia and North Carolina lawmakers devoted a significant portion of their tobacco settlement payments to
stimulating development and job growth, especially in rural
communities with a history of agriculture and relatively high


As with the federal stimulus program, however, it’s difficult to separate the effects of the payments from other
things happening in the economy or to know what would
have happened in these communities without the influx of
outside funds. Since 2000, there have been two recessions
and a significant expansion in between, not to mention the
repercussions of globalization and technology-driven
increases in productivity.
In addition, any jobs generated from investing tobacco
settlement payments in economic development projects
must be weighed against the costs. Will a project require
the expansion of local public goods like roads and police?
Will it result in the displacement or substitution of existing
An important step in such a cost-benefit analysis is tracking where the money goes. “Good public policy requires that
the details of incentive packages be disclosed and that the
effectiveness of incentives be measured,” noted Daniel
Gorin, an economist at the Federal Reserve Board of
Governors, in a 2008 overview of economic development
incentives. “Policymakers can then be held accountable for
their decisions on the basis of evidence rather than politics.”
The following charts summarize tobacco settlement
payments to the Fifth District and the spending of those
funds in North Carolina and Virginia, both by county and by
category. A spreadsheet with more detailed information can
be downloaded from the Richmond Fed’s public website:

Tobacco Master Settlement Payments to Fifth District, 1999-2010
aryland and North Carolina have been the largest
beneficiaries of MSA payments in the Fifth District,
each receiving about $1.7 billion between 1999 and 2010.
Each state has prioritized its spending quite differently, the



1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010





SOURCE: Tobacco Project website, National Association of Attorneys General


Region Focus | First Quarter | 2011



former supporting health care and the latter emphasizing
economic development.
Nearly all of Maryland’s payments support statewide and
local efforts to reduce cancer mortality and tobacco use,
as well as fund substance abuse programs and the state’s
Medicaid program. The rest are devoted to a program that
helps southern counties transition out of their 300-year-old
tradition of tobacco farming.
As part of that program, Maryland farmers were offered
an annual payment of $1 for every pound of tobacco they
grew in 1998 for 10 years, in return for growing something
else. More than 90 percent of farmers accepted the voluntary buyout. Other parts of the program continue to fund
regional agricultural development and land preservation.
In contrast, North Carolina sends half of its tobacco
settlement payments to the Golden LEAF Foundation, a

nonprofit organization dedicated to fostering development
in economically distressed and tobacco-dependent communities. Another quarter of the payments assist tobacco
producers and related businesses, while the remaining
quarter support tobacco use prevention and cessation,
obesity prevention, prescription drug assistance, and other
health-related programs.
Virginia also splits its MSA payments three ways. Fifty
percent of the payments are devoted to assisting tobacco
farmers and fostering economic development, 41.5 percent
support the state’s Medicaid program and various healthcare
initiatives, and 8.5 percent are spent by a foundation that
combats youth smoking and childhood obesity.
Many states have securitized the stream of income from
their future MSA payments so they could have the budgetary certainty of a lump-sum payment. Tobacco-control
advocates, however, have criticized the practice. States have
frequently used the one-time infusion of money to plug
budget holes or finance major capital investments in the
short term, not to fund health care programs over the long
term as critics say the MSA originally intended.
The Fifth District’s experience with securitization of

MSA payments has been a mixed bag in this regard. South
Carolina was among the first states to take this route in
2001, issuing bonds that raised $934 million. About threequarters of the bond proceeds went into a special trust fund
to finance a variety of health care initiatives, including a
prescription drug benefit for seniors and antismoking
programs. The remainder compensated individuals for
losses in tobacco production as well as funding water and
wastewater system projects, car tax relief, and grants to local
The same year, the District of Columbia sold $525 million
in bonds against a portion of its future payments to reduce
its debt and fund capital projects. A second bond issue of
$245 million in 2006 financed other capital projects.
West Virginia securitized all of its future tobacco
settlement payments in 2007, raising $807 million to help
balance the books of the state’s teacher retirement system.
Initially, it had directed half of its payments into a trust
fund to cover the future health-related costs of tobacco use
and half for the state’s health and human resources department, primarily to replace a portion of state funding for

Expenditures of Tobacco Master Settlement Agreement Funds by County, 2000-2010
Virginia has favored the southern and southwestern counenoir County in eastern North Carolina is known as the
ties where farmers produce most of the state’s tobacco,
home of the state’s first governor and attracts visitors
while North Carolina has spread its investments to economevery year to its Civil War battlefields and drag strip. So why
ically-challenged rural counties in general, not just
did $106 million in tobacco settlement payments flow into
tobacco-growing centers.
this rural county during the last 10 years?
A single project accounts for 95 percent
of this money: the North Carolina Global
TransPark, a 2,500-acre site that the state envisions as an air cargo airport surrounded by
just-in-time manufacturing facilities. The airport has been developed and one anchor
tenant, Spirit AeroSystems, was secured, thanks
to a $100 million grant from the Golden LEAF
Foundation to finance the construction of its
manufacturing facility.
A single project also accounts for
Pittsylvania County receiving the largest
amount of payments — $92 million — in
Virginia. About $26 million has been awarded
to the county and the city of Danville to develop the Institute for Advanced Learning and
Research into a high-tech hub for southern and
Southwest Virginia. The institute partners with
Virginia Tech to conduct research and development in horticulture and forestry, motorsports,
and other areas, as well as commercialize technologies in those fields.
Aside from these outliers, Virginia and
Virginia Tobacco Indemnification and Community Revitalization Commission, Virginia Foundation for Health
North Carolina have invested their tobacco set- SOURCES:
Youth, Golden LEAF Foundation, North Carolina Tobacco Trust Fund Commission, and North Carolina Healthy and
tlement payments over a wide geographic area. Wellness Trust Fund Commission


Region Focus | First Quarter | 2011


Expenditures of Tobacco Master Settlement Agreement Funds by Category of Spending, 2000-2010
Noneconomic Development Spending
(Total = $455.2 million)





Economic Development Spending
(Total = $494.6 million)

Higher Ed.
Development Construction & Workforce Education
& Expansion Projects Development






Higher Ed.
Development Construction & Workforce Education
& Expansion Projects Development


Noneconomic Development Spending
(Total = $642.8 million)

Economic Development Spending
(Total = $621.8 million)

Smoking Tobacco Farmers
& Producers General Fund



Smoking Tobacco Farmers
& Producers General Fund


NOTES: Data represents grants awarded and program funds committed by a state-designated organization during the specified fiscal year. It does not include nongrant or
non-program expenditures, such as an organization’s administrative and marketing expenses, or direct compensation to tobacco farmers. Actual disbursements may occur in subsequent years, and end up being smaller than the original grants due to grantees discontinuing the funded program or the organization cutting off funding. Data for Virginia includes
the 40 percent of the state’s MSA payment set aside for the general fund from 2000 to 2004 and for the Virginia Health Care Fund from 2005 to 2010.
SOURCES: Virginia Tobacco Indemnification and Community Revitalization Commission, Virginia Foundation for Healthy Youth, Golden LEAF Foundation, North Carolina Tobacco Trust
Fund Commission, and North Carolina Health and Wellness Trust Fund Commission

hen tobacco settlement payments are used to develop
certain sectors of a regional economy or support
specific businesses, states are placing bets on economic
winners. Lawmakers, along with the assortment of commissions they have created to spend the money, may try to
reinvigorate declining industries or jump-start new ones.
The problem is that empirical research hasn’t been able
to conclusively prove whether such “industrial policy” in
general pays off significantly. “The standard justifications
given … by state and local officials, politicians, and many academics are, at best, poorly supported by the evidence,”
noted Alan Peters and Peter Fisher, both professors of urban
and regional planning at the University of Iowa, in a 2004
journal article. Consequently, Peters, Fisher, and other
researchers of economic development incentives advocate
improving education, simplifying the taxation and regulation of businesses, and doing other things to encourage
economic growth rather than trying to choose winners.
Virginia and North Carolina have tried both approaches
with the tobacco settlement funds they have devoted to economic development. From 2000 to 2010, the states awarded
$35 million in grants for K-12 education, funding after-school



Region Focus | First Quarter | 2011

programs for at-risk youth and purchases of laptops, iPod
Touches and other technology for classrooms. A larger
chunk of money — $247 million — went into higher education and workforce development. In many cases, the money
paid for new equipment at community colleges so that students can be trained to use the latest technology.
The biggest portion of Virginia and North Carolina’s
economic development dollars — about $561 million —
funded business development and expansion on the local,
regional, and statewide level. Often, the money helped existing businesses to acquire capital equipment or financed
improvements to business parks and municipal infrastructure to attract new businesses. Targeted industries included
biotechnology, manufacturing, and tourism.
Budget pressures, however, have competed with efforts
to spur economic development. More than $233 million in
tobacco settlement payments have been directed by North
Carolina lawmakers into the state’s general fund during
the last 10 years. About $273 million of Virginia’s payments
went into the state’s general fund, largely because 40 percent
of payments were automatically counted as general revenue
from 2000 to 2004.

The role of temporary employment in recession and recovery

andra Youngblood’s temporary staffing service took
its first hit in 2008, when her clients started laying
off temps. “So as not to affect their permanent staff,”
she says. She runs Youngblood Staffing with her husband;
the home office is in Wilmington, N.C., with branches in
Whiteville, Lumberton, and Fayetteville. The staffing
company was lucky, she says, because they were able to cut
expenses to the bone and save their own employees’ jobs.
“We did not have to close offices.”
Things got better. By the middle of April 2010, “The skies
opened and we tripled our business in a month and we have
not slowed down.”
This pattern of boom and bust has become typical of the
temporary help services industry. Starting with the 19901991 recession, the drop-offs and subsequent spikes in temp
employment have intensified with each downturn. Temp
employment turns negative months before total nonfarm
employment — 12 months before, in the case of the last
recession — and then starts increasing before an employment uptick. As a result, economists see temp employment
as a buffer during recessions and a harbinger of direct hiring
during recoveries.
Temporary jobs accounted for 26 percent of the new
private-sector jobs created in 2010, compared to 7.1 percent
in the same period following the 2001 recession. The industry has added an average of 25,000 jobs each month for the
last year, the most of any sector. With unemployment still
around 9 percent more than 18 months after the recession
officially ended, some observers are wondering if, not when,
companies will start hiring new employees directly. But
although temporary employment is increasing more rapidly
than employment overall, it remains a small share of the
total. Even at the industry’s peak in 2000, it accounted for
just 2 percent of total employment, and today it is 1.7 percent. But just how temporary is the current preference for
temp workers — and does that preference have long-term


The Macro Level
The temp industry grew from 1 million to 2.7 million
workers in the 1990s, and its growth is cited as a factor in the
decade’s historically low unemployment and inflation rates.
At least in the short term, some economists view the
relationship between unemployment and inflation as a
trade-off: Low unemployment and strong economic growth
may lead to upward pressure on wages and “overheating” in
the economy generally, which lead in turn to higher prices.
But the wide availability of temp workers may have reduced
the wage pressures that typically accompany a tight labor

market, as suggested by Lawrence Katz of Harvard
University and Alan Krueger of Princeton University in a
1999 paper. Looking at state-level data, they found that
wages rose more slowly in states with a higher share of temporary employment: An 0.25 percent increase in temporary
employment was associated with 0.2 percent slower wage
At any given time, there is a certain rate of “natural” or
“frictional” unemployment caused by the fact that it takes
time to match workers with open jobs. Katz and Krueger
note that temporary employment may smooth this friction
by making matching more efficient. A worker can sign on
with a temp agency instead of spending time searching for
an open position, and a company can contract with a temp
agency instead of spending time recruiting workers. And
although a worker may be in a temp job involuntarily, preferring to find a permanent job, at least that worker is no longer
unemployed. For these reasons, the rise in temporary
employment between 1979 and 1993 may have lowered the
natural unemployment rate by as much as 0.25 percent,
according to a 1999 paper by Maria Ward Otoo of the
Federal Reserve Board of Governors.
During a downturn, temps lose their jobs first. During
the 2001 recession, temporary workers accounted for 26 percent of net job losses, although they made up only 2 percent
of the workforce prior to the recession. Between December
2007 and December 2008, temp employment dropped by
more than 484,000 jobs, about 19 percent, while total
employment fell by 2.3 percent, according to the Bureau of
Labor Statistics (BLS). The trough was in June 2009, when
temp employment fell to its lowest rate since 1995, but since
then it has increased every month, except for a regular seasonal downturn in January.

Temping’s Appeal
Such flexibility is what the temp industry was designed for:
Companies use temps to respond to changes in demand
without incurring the costs of hiring and firing. It is
expensive to recruit, train, and provide benefits for new
employees. If demand falls, the “adjustment costs” of laying
off workers, such as mandatory advance notice of layoffs or
severance packages, can equal as much as a full year of payroll. Firms may also use temporary workers to screen
potential new employees or to fill in for sick employees.
Unemployment insurance taxes are another major
expense. Companies are “experience rated” according to the
number of workers they lay off who then claim benefits;
more layoffs bring higher taxes. But temp workers are
employed by the staffing agency, which means the agency,

Region Focus | First Quarter | 2011


Temporary Employment, GDP, Nonfarm
Employment, and Unemployment



Nonfarm Employment
Temporary Employment
Unemployment Rate
NOTES: Data are seasonally adjusted. GDP in real 2005 dollars. Shaded areas
represent recessions.
SOURCES: Bureau of Economic Analysis, Bureau of Labor Statistics, Haver Analytics

not the company where the work was performed, gets the
There are some disadvantages to using temporary
workers. They can be less productive, perhaps because they
are not motivated by the prospect of future raises or promotions, according to Chicago Fed economist Yukako Ono.
Companies also pay a fee to the staffing firm, which varies
depending on the number of workers, skill level, and contract length, among other factors. The total “bill rate” covers
the worker’s wage plus a markup for expenses such
as workers’ compensation and payroll taxes, operating
expenses, and a profit margin.
That markup may not translate into higher wages for the
employee. Temp workers in high-skill, high-demand fields,
such as nursing, may earn more per hour than a similar
permanent employee. But the majority of temporary positions are in low-skill fields such as clerical or light industrial
work, where average hourly pay ranges from 75 percent to 85
percent of the national average wage for the same position,
according to the BLS. Benefits also tend to be worse for
temps than for regular employees, except in high-end fields.
Although many temp firms offer health insurance, the
policies are often bare bones and the worker is responsible
for most of the cost, so the share of workers opting for coverage is low, according to Bryan Pena of Staffing Industry
Analysts, an industry consulting group.
The uncertainty of temp work may make workers more
likely to be depressed or anxious, according to researchers at
McGill University. Anecdotally, temp workers report feeling
like “second-class citizens” in the workplace, and miss feeling connected to an employer and their coworkers. Others
prefer the flexibility, however, and view temp work as an
opportunity to quickly learn new skills. But the majority of
temp workers accept temporary jobs for economic reasons,
either because it was the only job they could find or because


Region Focus | First Quarter | 2011

they hope the placement will translate into a permanent
position. In the last few years, the industry also has emphasized its role as a bridge to traditional employment. Surveys
conducted by the American Staffing Association (ASA)
report that about half of temporary workers are eventually
hired directly by the company where they were placed as a
temp or with another firm.
Results are mixed for the less-skilled and low-wage
workers who make up the bulk of the industry. Temporary
work employs a significant portion of participants in
government employment and training programs; after the
1996 welfare reform in the United States, 15 percent to 40
percent of former welfare recipients found work in temporary jobs. A 2009 study followed welfare-to-work clients
who were randomly placed in either temporary or directhire jobs. The workers placed in direct-hire jobs were more
likely to be employed and had substantially higher earnings
over a two-year period, but placement in a temporary job
had no long-term positive effects on the probability of
remaining employed or on earnings. “Placing them in a temporary job was about equivalent to no placement at all,” says
David Autor of MIT, who conducted the study with Susan
Houseman of the Upjohn Institute for Employment
Research. Still, when unemployment is high, a temporary
job is better than no job. “You make more as a temp worker
than you do when you’re unemployed,” Autor says. “Being
employed is a positive thing.”
The number of people looking for jobs right now means
that competition is stiff even for temp jobs. Just ask Zachary
Basham, 23, of Nellysford, Va. As a recent college graduate,
he secured a temp job at a law firm reviewing claims. “It was
my first job out of college and I was simply looking for a
place to start.” But he was let go after a week, along with
several others, with no explanation or warning. He returned
to doing maintenance on a golf course, but is currently
unemployed except for his volunteer work in an alumni
office at a private school. He’s registered with several temp
agencies but has had no calls.

Harbinger of Hiring?
Temporary employment is broadly viewed by economists
and policymakers as a leading indicator of permanent job
creation — a sign that companies are trying out new workers
and positions in anticipation of increased demand. But persistently high unemployment combined with the rapid
growth of temp jobs has some observers worried that this
recession is different.
Data proving the relationship between temporary and
permanent employment are hard to come by. An analysis of
BLS data by the American Staffing Association shows that,
in the past, temp employment has led overall employment
by about six months during normal economic times, and by
three months when the economy is coming out of a recession. The ASA study doesn’t include data from the current
recession, which was both deeper and longer than the ones
before it.

Economists and other researchers don’t think that a
“perma-temp” workforce is likely. “I don’t see what would
make us think this is some kind of brand-new paradigm. It
seems a perfectly plausible response to a period of sustained
uncertainty,” Autor says. A large and permanent increase in
temporary employment would mean that something dramatic had changed in the economy to change the costs of
direct versus temporary hiring, he explains. “In general that
would be an indicator of some type of deeper ailment. I
don’t think that’s going to happen.” Instead, the magnitude
of the initial downturn may mean that there is a longer lag
between temporary and permanent hiring on the upturn.
“It’s been a long deep recession and faltering recovery. It’s
natural that employers would not be hiring like gangbusters,” says Autor.
The “absorptive capacity” of the temp industry has
increased with each of the last three recessions, which could
be a factor in the jobless recoveries that have followed. Erica
Groshen, an economist at the New York Fed, suggests that
perhaps one-third of the current job loss is due to cyclical
change, resulting from decreased demand, and two-thirds to
structural change, meaning that the jobs that have been lost

aren’t coming back in the same industries or locations. Temp
work may facilitate structural change by enabling companies
to use a downturn as an opportunity to reorganize production processes and trim payrolls. It may also make companies
more likely to shed jobs via permanent layoffs, rather than
laying off workers temporarily and then recalling them if
things pick up, as Groshen explains in a 2003 article with fellow New York Fed economist Simon Potter.
Currently, consumers are spending more freely, business
investment is picking up, and GDP is generally projected to
grow 4 percent in 2011. And employers are adding to payrolls, albeit slowly. Hiring is likely to come around once
employers trust the recovery, says Michael Doyle, vice president and general manager of the Southeast division of
Manpower, one of the nation’s largest temporary staffing
firms. He is also seeing an increase in the number of people
moving from temporary to direct-hire jobs. “I think [firms]
cut beyond, maybe 2 percent to 3 percent more than they
should have, and they’re now hiring temps back rather than
full-time employees.” That said, for some companies, a leaner staff that uses the flexibility of temps may become their
continued on page 38

How Temping Grew
In 1956, about 20,000 employees worked in temporary help
services, mostly in factories and offices. Though temp use
has spread across job sectors in the last 20 years, about
80 percent of temp labor is still low-skill, low-paying light
industrial and clerical work. The remaining 20 percent
includes professional jobs such as engineering, information
technology, and health care specialties.
Many factors played a role in the rapid growth of the
temporary sector, which expanded by 11 percent annually
between 1979 and 1995. About 20 percent of the increase can
be explained by the decline of employment at will, according
to MIT economist David Autor.
Employment at will traditionally assumed that employers
and employees can unilaterally end a relationship when and
why they choose, unless otherwise stated by contract. The
doctrine was recognized throughout the United States in the
middle of the 20th century. Between 1973 and 1995, however,
the courts of 46 states found exceptions that limited
employers’ discretion to let workers go. The direct and indirect costs to employers of legal action in the wake of those
decisions are hard to quantify. But Autor’s results found
rapid growth of temp employment after a state’s courts
adopted an exception to employment at will, about 10 percent in the year of the ruling. The paper notes that
temporary help continued to expand after 1992, several years
after adoption of the most recent exception, suggesting
other factors are involved as well.
As advances such as just-in-time delivery caught on, firms
incorporated the idea of just-in-time labor into employment
practices. Temp agencies also got good at matching people

to jobs, using technology and expanded footprint to reach
across geographical areas. The agencies added client services such as training and consulting, which has contributed to
growth in the sector. As the concept of the variable workforce has taken hold, Michael Doyle of Manpower observes
that this has become an integral part of company strategy,
especially for large corporations
Today, the $70 billion temp employment industry consists of about 23,000 agencies. Almost half are small, with
fewer than 100 full-time employees. At the other end of the
spectrum are companies like Manpower, which operates in
82 countries and has 4 percent market share in the United
States. During and after the recession, buyers have been
negotiating lower fees, and the industry has consolidated.
Weaker firms have been acquired by larger firms that, in
some cases, cut rates to knock out the competition, according to Brian Pena of Staffing Industry Analysts.
Temp agencies face many of the same pressures as their
client firms — particularly unemployment insurance taxes.
Sandra Youngblood, of Youngblood Staffing, headquartered
in Wilmington, N.C., says she’s careful to serve only workers
she can place elsewhere, in the event of layoffs. She recently
turned down a chance to place 60 seasonal employees. “Back
in the day, we would have jumped all over that,” she says.
“But knowing that in July those people are going to be gone,
I don’t see where I could place them.” She, too, worries
about the rising rates. The jobs recovery may have started
first in the temp agencies, but even they still face tough decisions when it comes to hiring.

Region Focus | First Quarter | 2011




Liaison Officer Ted Kientz (at left) shows Army Chief of Staff General
George William Casey around the newly built U.S. Army Forces and
Reserve Commands combined headquarters at Fort Bragg, N.C.


Region Focus | First Quarter | 2011

Though communities may benefit long term, an influx
may mean short-term pain in the form of crowded schools
and congested roads. The region near Fort Bragg will need
to educate the expected 6,000 new students that may crowd
classrooms and overwork teachers. Moreover, Fort Bragg’s
expected 41,000 new people will crowd area roads.

Bragg, Aberdeen, and Lee: Gateways to Growth
Growth inside military gates can mean growth outside the
gates. Jobs may expand in construction, retail, health care,
and hospitality. But the economic effects are likely to be
larger in locations where there’s already a healthy mix of professional positions in scientific research and development
and engineering.
Nowhere is that truer than in Maryland, a state where the
pre-BRAC military in 2008 generated $16 billion in direct
spending in the state, according to Richard Clinch, an economist at the University of Baltimore who has studied
the economic role of Maryland’s military installations.
“Maryland is lucky in that it has been able to attract, because
of its proximity to Washington, high value-added services
for the U.S. Department of Defense,” Clinch says.
The 73,000-acre APG will gain between about 8,000 and
9,000 positions, 5 percent of which are military. People are
starting to move in. Many of those are transfers from
Fort Monmouth in New Jersey, which is slated to close.
Commercial and residential real estate are selling in Harford
County, home of Aberdeen Proving Ground. “About 60 percent of the Fort Monmouth workforce has relocated due to
this BRAC,” says Denise Carnaggio, deputy director of the
county’s office of economic development. She also reports
strong demand for Class A office space.
The positions at APG will average $80,000 annually and
will include jobs in engineering, electronics, systems, computers, and budget, among others. Incoming organizations
include communications, electronics management and
research, vehicle technology research, and medical and
chemical defense R&D. APG’s expansion is its biggest since
World War II, with a dozen missions arriving from eight
states, including some from elsewhere in Maryland and
Military spending stimulates personal income growth in
states with higher manufacturing and retail shares, and in
those that already receive a large share of military prime
contracts, according to a March 2009 paper by Michael
Owyang of the St. Louis Fed and Sarah Zubairy of Duke
University. The benefits of military spending are unlikely to
be as great in isolated areas, where there may be only trooprelated activities. In those cases, the military bases may be


he stars will soon align over Fort Bragg, N.C., and
when they do, only the Pentagon will have more
generals. That’ll be sometime this year when two
Army commands relocate to brand-new Fort Bragg headquarters, part of a total of about $1.3 billion in construction. Likewise, Fort Lee’s 6,000 acres in central Virginia
are humming with $1.2 billion worth of new and expanded
training and logistics schools and facilities for all military
branches. Communications and intelligence operations are
expanding big-time at Fort Meade and the Aberdeen
Proving Ground (APG), among others of Maryland’s 17
military sites.
These expansions result from the 2005 Base Realignment
and Closing plan, or BRAC, which reshuffles 33 major sites
and closes 22 others. (See adjacent map.) It’s a $35 billion
nationwide effort, due for completion by mid-September.
Economic studies project mostly positive economic effects
from the added commerce the expansions will bring. Base
closures typically bring the opposite: job loss, the severity of
which varies with the strength and diversity of a community’s
nonmilitary economy.
Military installations can benefit communities, especially
posts that import the equivalent of a corporate headquarters,
with highly paid jobs — engineers, scientists, professionals,
and high-level managers. Those locales see more of a
boost than ones with bases that only process and train
troops. Already, 40 new defense contractors have set up
shop in Harford County, Md., in anticipation of APG’s
economic boon.

District of Columbia

Northern Virginia


1. Bolling Air Force Base
2. Naval District Washington
3. Potomac Annex

5. DFAS Arlington
6. Marine Corps Advanced Amphibious Assault

15 . Fort Meade
16 . Naval Station Annapolis

7. Fort Belvoir
8. Marine Corps Base Quantico
9. Naval Surface Warfare Center Dahlgren

17 . Army Research Laboratory Adelphi
18 . Naval Surface Warfare Center Indian Head
19 . Andrews Air Force Base

4 . Walter Reed Army Medical Center

20 .
21 .
25 .

10. Arlington Service Center
11. Headquarters Battalion
Headquarters Marine Corps Henderson Hall
12. Various Leased Space

West Virginia
13. Fairmont U.S. Army National Guard
Reserve Center
14. Bias U. S. Army Reserve Center Huntington




24 25 23 15
4 11
5 1 2 3
12 19 20
18 7

Naval Air Facility Washington
Martin State Airport Air Guard Station
Fort Detrick
Navy Reserve Center Adelphi
National Naval Medical Center Bethesda
Naval Surface Weapons Station Carderock
Aberdeen Proving Ground
Defense Finance and Accounting
Service Patuxent River
28. Naval Air Station Patuxent River
29. PFC Flair U.S. Army Reserve Center Frederick



West Virginia




Central and
Southeastern Virginia



35 36
38 37



39 40

North Carolina



30 . Richmond International Airport
Air Guard Station
31 . Defense Supply Center Richmond
32 . Naval Weapons Station Yorktown
33 . Fort Lee
34. Fort Eustis
35 . Langley Air Force Base
36. Fort Monroe
37. Naval Amphibious Base Little Creek
38. Naval Support Activity Norfolk
39. Naval Medical Center Portsmouth
40. Naval Shipyard Norfolk
41. Naval Station Norfolk
42. Naval Air Station Oceana


South Carolina




North Carolina
43 .
45 .
47 .

Navy Rese rve Center Asheville
Charlotte/Douglas International Airport
Pope Air Force Base
Seymore Johnson Air Base
Fort Bragg
Marine Corps Base Camp Lejeune
Niven U.S. Army Reserve Center Albermarle
Marine Corps Air Station Cherry Point



South Carolina
52 .

Defense Finance and Accounting Service Charleston
Naval Weapons Station Charleston
South Naval Facilities Engineering Command
Marine Corps Air Station Beaufort
Fort Jackson
Shaw Air Force Base
McEntire Air Guard Station

Gaining jobs

SOURCE: 2005 Defense Base Realignment and Closure Commission Final Report

Region Focus | First Quarter | 2011


more self-contained. George Mason University economist
Stephen Fuller notes that in such areas, “It’s easier to keep
everything on post. The spillover is only some retail spending. There isn’t a whole lot that goes back into the local
economy.” Fuller studied the effects of BRAC on jurisdictions in Northern Virginia concerned about the effects of a
possible influx of new residents, especially in less-populated
Forts Bragg and Lee will be home to high-level commands, and though they are located in less-populated
locales, the regions have already benefited. For example, the
initial large-scale construction may have buffered the Fort
Lee area near Petersburg, Va., from the recession. The construction remains under way as the BRAC effort goes full
throttle toward its deadline. “All that construction worked
to our advantage,” says Dennis Morris of the Crater
Planning District Commission, an organization of 11 jurisdictions. A procurement organization helped small
businesses identify subcontractors who then met with the
prime contractors. About 65 percent of the prime contracts
were awarded to Virginia firms, and subcontractors in the
region received 851 contracts. “The bottom line is we fared
well in the region on getting our share of those prime contracts or subcontracts,” he says. “Our rural areas did very
well as a supplier for, let’s say, brick for the new barracks.”
Fort Lee will double in size, to approximately 44,500
people, divided roughly evenly between employees (military,
civilian, and contract) and family members. Its biggest
impact may be in total wages and salaries. The Virginia
Employment Commission has estimated, beginning in 2008,
those could average $1.2 billion per year through 2011,
though the projections could be off because many are opting
to commute, for now, if they live within a couple of hours’
drive, from Tidewater or Northern Virginia.
Fort Lee, long the source of logistics training and supply
— “the right stuff at the right place at the right time” — will
now handle more training, including schools of transportation, ordnance, and culinary arts, among others, for all
military branches. There will also be about 700 to 900 people
employed by the Defense Contract Management Agency, the
procurement headquarters for all the branches. To house
students, there’s a 1,000 room hotel under construction. In
short, Fort Lee will train every branch of service in jobs and
missions that support soldiers. The fort trains people in
“everything from a young man’s personal hygiene needs, that
is, how to take a field shower and do their laundry, to
explosives and ordnance, including repairing a weapon,”
says Scott Brown, chief of Fort Lee’s BRAC synchronization
Many operations at Fort Lee involve high-level management — the Quartermaster, Ordnance, Transportation
schools for the Army, the Air Force Transportation
Management School, and the Defense Commissary Agency
headquarters. In many ways, these resemble corporate headquarters. And those managerial jobs pack a bigger economic


Region Focus | First Quarter | 2011

Fort Bragg’s new $300 million, 700,000-square-foot
headquarters will do likewise. The complex will house the
U.S. Army Forces Command, FORSCOM, and the U.S.
Army Reserve Command, USARC. Overall, Bragg is
expected to grow to 58,336 military personnel, from preBRAC levels of 49,247.
The two commands alone are likely to bring nearly
3,000 active-duty, civilian, and contractor jobs, with higher
than average salaries for the Sandhills region. Average
military and civilian salaries for FORSCOM positions pay
$75,000. At USARC, the average is $93,000 for military
salaries and $78,000 for civilian. Roughly a third of the
civilian employees in this group are expected to relocate to
Bragg from other bases; the rest will be hired locally or
move for a job. An estimated 1,000 military contractors
are expected to set up shop in the area to be close to key
Military-related population growth includes active-duty
soldiers, civilians employed by the Army, private contractor
employees, and Army dependents. The number also includes
people who may move to the region to get a job off the base.
Fayetteville issued $300 million in new permits — everything from luxury apartments to four-star hotel projects —
in 2010, according to Fayetteville City Manager Dale Iman.
While this flurry of activity is welcome, the costs to state
and local governments can create fiscal challenges in the
short term, economist Clinch says. “The problem with any
introduction of a huge economic activity is that the capital
costs have to be paid for but the revenue comes later.”

Education Station
That’s happening with roads and schools in the 11-county
Sandhills Region of North Carolina and in Aberdeen’s
Harford County, and probably any locale where military
posts are growing.
Take schools near Fort Bragg, for instance. “Our counties
are struggling to figure that out,” says Greg Taylor, executive
director of the task force. Schools in counties likely to
be affected, Cumberland, Harnett, and Hoke, are estimated to
need nearly $220 million in capital construction, $68.4 million
of that is related to military growth. The county has used
bonds to pay for four new schools in the past couple of years.
But it’s still not clear whether funding from the state will keep
up with Cumberland County’s growth, according to Theresa
Perry, assistant superintendent.
Districts are entitled to impact aid from the federal government because military installations pay no taxes, but the
program isn’t fully funded. And if the school district lies outside of the county where the base is located, the per-student
aid is half.
Business growth will occur in the wake of Fort Bragg’s
expansion, Taylor says, “but that money comes after the fact.
You can’t tell the kids, wait five years and we’ll build you a
school; the funding to fix the problem comes later.” In
counties where the tax base includes a healthy mix of
commercial and residential properties, there’s less to worry

about. But in largely residential, or bedroom, counties, there
may be problems.
Schools in Prince George County aren’t hurting, though
— at least, not yet. Bobby Browder is superintendent.
“Projections of student population were much higher
but a majority of individuals planning on moving didn’t
move.” For example, the Transportation Command
from Fort Eustis in Newport News will move, but the
majority of employees have not. “From what we can discern,
they are commuting,” he says, along with transferred
personnel from locations in Northern Virginia. “Because
they couldn’t sell their homes, they’ve bought hybrids and
they commute.”
Browder’s happy that growth hasn’t materialized all at
once because Prince George is only now receiving its impactaid funds for the 2007-2008 school year. With the recession,
school funding everywhere has been cut, so the impact aid
becomes even more important. To date, the district has
received $3.5 million in impact aid.

The Military Road
Transportation remains a hot issue. The National Academy
of Sciences studied funding of traffic improvements following the BRAC report. Short-term strategies include quick
fixes — toll lanes or lane widening. The report cited fundamental flaws in the BRAC decisions concerning the ability
of local infrastructure to handle added traffic. The report
also cited the Defense Department’s inability to fund road
improvements, and poor communication between installations and local transportation authorities.
To ease projected congestion on Interstate 95, a partnership between Amtrak and Fort Lee puts troops on trains,
right on base, for weekly training exercises at Fort A.P. Hill,
in Northern Virginia.
Workers broke ground on a spur, a portion of Interstate
295 that will link Fort Bragg to Interstate 95. Other improvements to ease ingress and egress from the base may take years
and lots of money. Case in point: State and federal funding
sources can’t cover the tab for appropriate projects — $344
million — to widen roads and provide direct interstate access
to Bragg, the biggest post in the nation. In 2008, more than
400 military convoys with troops and heavy equipment traversed Fayetteville, N.C.’s city streets on their way to Bragg.

Although military spending doesn’t always offset costs
for communities, they are
Military Spending and GDP
never unwelcome, says Randy
Defense accounted for more than a
Parker, an economist at East
Carolina University. “The peothird of GDP in World War II, and by
ple in the town in which these
1947, it had fallen to about 7 percent.
bases are centered are not
The Korean War, the Cold War, and
unhappy campers,” he says.
later, the Vietnam War drove
“The people are happy to
accept any type of growth that
defense’s share of the GDP into doucomes their way.”
ble digits. That was in the 1950s and
He points to the large
1960s. By 1979, military spending fell
number of military retirees
to less than 6 percent of GDP. It rose
in the 11-county region near
Fort Bragg. “I don’t know
above 7 percent in the mid-1980s, but
that this will bring factory
by 2000, the so-called “peace divijobs and so forth, but
dend,” took spending below 4 percent
it fosters some economic
of GDP. Bases were closed or
growth in restaurant jobs,
primarily in service and retail
realigned in 1988, 1991, 1993, and 1995,
as spending declined. Since 2001,
But a possible military
defense spending has grown to
drawdown presents future
almost 5 percent of GDP.
risks. Some regions are just
now recovering from previous
— From “How is the Rise in Defense Spending
base withdrawals, and, of
Affecting the Tenth District Economy?” by
Chad Wilkerson and Megan Williams, Federal
course, APG’s economic gain
Reserve Bank of Kansas City Economic Review,
is New Jersey’s loss, at least in
Second Quarter 2008
the short term.
“When you link your fortunes to military growth, then
you also link your fortunes to military shrinkage,” Parker
says. “It is a somewhat risky strategy, since you’re putting
your eggs in one basket.”
When the stars are rising, that’s great, but when spending
shrinks, local military economies may falter. Northrop
Grumman, the defense contractor, has attributed its hundreds of recent layoffs in the district to a slowdown in
defense spending.
Still, national security is likely to remain a major budget
item for the foreseeable future even if peace breaks out
all over.

Gonzales, Oscar. “Economic Development Assistance for
Communities Affected by Employment Changes Due to Military
Base Closures (BRAC).” Congressional Research Service Report
for Congress, June 2009.

Owyang, Michael, and Sarah Zubairy. “Who Benefits from
Increased Federal Spending? A State Level Analysis.”
Federal Reserve Bank of St. Louis Working Paper, June 2010.

Region Focus | First Quarter | 2011


Joel Slemrod

Editor’s Note: This is an abbreviated version of RF’s conversation with Joel Slemrod.
For the full interview, go to our website:


RF: In a 2005 paper, you described your “Beautiful Tax
Reform.” Could you briefly discuss the system that
you laid out in that paper? Relatedly, do you think it is
possible to divorce normative concerns from positive
concerns when thinking about tax policy, or will equity
issues always arise?
Slemrod: Let me take the second question first. Although
this paper does lay out a framework for my preferred tax system, it also argues that one’s preferred tax policy is inevitably
a mixture of what one thinks about how the economy works
— for example, behavioral responses to tax rates — and also
value judgments, which aren’t subject to economic analysis
and probably are very hard to persuade others to adopt. So I
thought that I could make a bigger contribution to this
edited volume (which included papers from many people saying what tax system they would prefer), if I stated explicitly
how my own preferred tax reform depends on both my views
on how the economy works and on what my values are. So my
answer to the second question is no — what tax policy is
best will always depend on both positive and normative
Let’s now come back to the first question. In the paper, I
made the point that the simplest tax system isn’t necessarily


Region Focus | First Quarter | 2011

the best, in part because of the trade-off between what one
might call efficiency and equity. Consider that the simplest
tax system is probably what one might call a lump-sum tax,
where everyone pays basically a fixed amount. It wouldn’t be
trivial to enforce, but it certainly would be a lot simpler than
what we’ve got now. However, I think most people, maybe
not everybody but most people, would find that objectionable because they think the tax burden ought to be related to
a household’s well-being, whether that be assessed by
income or wealth or consumption or some other measure.
So that’s why I wouldn’t favor replacing our graduated
income tax system with a lump-sum tax or a value-added tax
— because the distribution of the tax burden is not progressive enough for me, and that, I emphasize, is “for me.”
If your values were such that you were happy with an approximately proportional tax burden, where the tax burden is
approximately proportional to lifetime income, there’s a lot
to be said for just relying on a value-added tax. But I’m not
willing to do that, so I’m sticking with a tax system that
relies heavily, maybe not entirely, but heavily on a graduated
income tax.
The rest of the paper talks about fairly standard ways to
clean up the income tax, because I think a lot of the exceptions to a straightforward tax levied on income — a lot of the
credits and deductions, for instance — are examples of the


The recent recession and relatively sluggish recovery
have prompted much discussion about what policymakers can — and cannot — do to stimulate economic
activity and foster a healthy financial system. Much of
that discussion has focused on monetary and regulatory
policy, of course. But fiscal policy can play an important
role as well in such periods.
Joel Slemrod, an economist at the University of
Michigan, has spent his career working in the field of
public finance. His research has spanned a number of
areas, including how sensitive businesses and individuals are to tax rates within and across countries, and how
that sensitivity affects their location decisions; the
degree to which households, especially high-income
households, alter their behavior due to tax policies; conditions that may affect people’s savings behavior; and
the level of noncompliance with tax laws in the United
States and abroad.
Slemrod, who directs the Office of Tax Policy
Research at Michigan, also has held numerous appointments in Washington, D.C., with such institutions as
the U.S. Department of Treasury and the President’s
Council of Economic Advisers. Aaron Steelman interviewed Slemrod in the fall of 2010.

RF: What does our recent experigovernment favoring particular
One’s preferred tax policy is
ence tell us about the effecpeople or particular activities that
result in inefficiency. So, for examtiveness of tax rebates in stimuinevitably a mixture of what one lating economic activity in a
ple, I would get rid of the itemized
deduction for state and local propthinks about how the economy recessionary period?
erty taxes; I would get rid of the
works — for example,
preferential tax treatment of
Slemrod: Actually, we have had
employer-provided health insurthree tax rebate policies enacted in
behavioral responses to tax rates the last decade — 2001, 2008, and
ance; and I would clean up the
implicit subsidy to owner- occupied
then again in 2009. I have done a
— and also value judgments.
housing, and although I don’t have a
fair amount of research on this topic
clean solution for how to do that,
with Matthew Shapiro, my colwe know how to move things in the right direction. Then in
league here at Michigan. The research methodology is based
the paper I talk a little bit about how the process of filing
on posing the following questions to a sample of people:
taxes could be simplified, so that a large fraction of
What did the tax rebates lead you to do? Did they lead you
Americans wouldn’t need to file a tax return at all. Other
mostly to increase spending, mostly to increase saving, or
countries do this, including 15 OECD countries, and we
mostly to pay down debt?
could do it, too, regardless of how hard the Internal Revenue
When we focused on 2008 and 2009, in both cases we
Service (IRS) now says it would be. And, finally, I talk a little
found that only a small fraction of people said it led them to
bit about cleaning up how corporate income is taxed in the
mostly increase their spending. In 2008, less than a quarter
United States. Almost no economist thinks we have a very
of people said that and in 2009, only about 13 percent said
rational system. The most obvious problem is that income is
that. So we concluded that the stimulus to spending that
taxed first at the corporate level and then at the personal
works through the marginal propensity to spend would actulevel, but the underlying issues are that the rate of tax on
ally be quite modest as a fraction of the total tax cut.
corporate income is different than on other income and the
Because these tax cuts were pretty large, the dollar stimulus
tax base is capricious, depending on things like the financial
was not trivial, but certainly relative to the tax cut, the stimpolicy of the corporation; I discuss some ideas about how to
ulus probably was fairly modest. Our surveys tell us two
clean that up.
other interesting things: One, contrary to conventional
wisdom, we found no evidence that low-income people
RF: You mentioned the way we currently tax employerwould be more likely to spend the money they received from
the tax cuts. Second, we found that, with the 2009 tax cuts,
provided health insurance. What do you think are the
which were delivered in the form of reduced employer withbenefits as well as deficiencies with that policy?
holding, people actually had a lower marginal propensity to
spend, which was contrary to what a lot of economists had
Slemrod: Well, it certainly reduces the after-tax price of
opined when the delivery mechanism for the tax cuts —
health insurance for people. The problem is that it reduces
rebate payments versus reduced withholding — was being
the price below the true social cost, so that people acting in
discussed in early 2009.
their own family’s interest, are, at the margin, buying insurance where the value to them is actually less than the true
RF: We often hear the claim that taxpayers vote with
cost. In a word, we are subsidizing high-deductible, low cotheir feet, leaving relatively high-tax states for relapay insurance policies and, given the upward trend we are
seeing in the fraction of our gross national product that goes
tively low-tax states. What does your work on the estate
to health care, I think we ought to be moving toward reductax tell us about that claim? And what do you think of it
ing or eliminating such subsidies. Not only that, it’s a very
more generally?
unattractive sort of subsidy, because the subsidy rate is
dependent on the household’s marginal tax rate, so the subSlemrod: I think there’s substantial evidence that people
sidy rate is highest for the highest-income people. And I just
and businesses, when they consider where to locate, think
don’t think that even people who would argue for a subsidy
about the financial implications of where they’re going,
would favor such regressivity if they were designing a subsidy
including the kind of taxes and the tax rates they would face.
scheme from scratch. The reason to be wary about
There’s also a lot of evidence that they think about the other
abandoning the subsidy is that it supports the system of
side of the government budget too, that is, what government
employer-provided health insurance, which spreads risks
provides. For example, there is evidence that, other things
across employees and offsets the problem of adverse selecequal, some people will migrate to where welfare benefits
tion that can plague health insurance markets; before we
are higher. It’s also very clear that people don’t migrate simeliminate the subsidy entirely, we need to have other policies
ply to where the taxes are the lowest, because if you look at
in place to prevent a collapse of efficient markets for health
the United States, the states with the lowest taxes ( and, coninsurance.
sequently, relatively low levels of public services) are not

Region Focus | First Quarter | 2011


attracting masses of people. I have one article, now several
years old, which looks at one aspect of this issue: whether
differences in the estate tax rates of American states affect
migration. It uses a fairly simple research design that analyzes data about the state of residence at death of people
whose wealth is high enough that they would be subject to
estate taxes. We looked to see whether, over time, when
state estate tax rates change, if deaths of high wealth people
go up when estate tax rates go down, and vice versa. And we
do, in fact, find that to be true. That’s consistent with the
fact that, other things equal, at the margin, some rich people
will move when they’re getting on in years to places where
the estate tax is lower. Another possibility is that they just
manage their affairs so that their legal residence is in a state
with a relatively low tax rate. One or the other, or some combination of the two, appears to happen, although the
magnitude is not very large.
RF: This is a broad question: But does Atlas, in fact,
Slemrod: You’re referring to the book I edited titled
Does Atlas Shrug? The Economic Consequences of Taxing the Rich.
It seems like that this issue never goes away in policy
debates. The book is a collection of articles by different
economists and lawyers who don’t all come to the same
conclusion. My own view, based in part on the research
discussed in this book, is that certainly high-income
people notice taxes, and they react to taxes in ways that
lower their exposure to taxes. The evidence for taxes substantially affecting what one might call “real” behavior,
such as labor supply or savings, is not as strong as the
evidence regarding another class of behaviors we might
label “avoidance.”
There are a lot of examples of high-income people
taking avoidance steps to reduce their exposure to taxes.
For instance, when tax rates are known in advance to change
from one year to the next, we see high-income people shifting their taxable income into the lower tax rate year. If the
relative tax on corporate income versus individual income
diverges a lot, there’s evidence that high-income people will
change the form of their business, from a corporation subject to the corporate income tax to a business not subject.
Thus, my overall conclusion is that Atlas does shrug, but not
in the way that some might think.
Now, that being said, the public economics field has
moved toward the view that if you’re trying to measure the
efficiency cost of state income taxation, the best summary
measure of that is not the elasticity of labor supply — it’s the
elasticity of taxable income. Taxable income is certainly
affected by labor supply, but also by all the other things
people might do to lower their taxable incomes, such as
avoidance, evasion, increasing tax deductible activities, and
so on. So I don’t mean to say that these other sorts of
“avoidance” responses are not relevant for policy. They
absolutely are.


Region Focus | First Quarter | 2011

RF: How large of a problem is tax evasion in the United
States? That is, what is the magnitude of tax evasion and
what could be done to decrease that number in a way
that is not socially harmful?
Slemrod: The most comprehensive attempts to assess the
magnitude and nature of tax evasion have been done in the
United States by the IRS. For obvious reasons this is not an
easy question to answer, even with a careful, comprehensive
study. So, with some margin of error, the IRS thinks that for
the income tax and other taxes that the IRS oversees, the
rate of noncompliance is about 13 or 14 percent — about 13
or 14 percent of what should be paid is not paid.
What should be done about it? First, note that just
because there’s a 13 or 14 percent noncompliance rate does
not mean that we have vastly too little enforcement. For
sure the optimal noncompliance rate is certainly not zero,
just the way the optimal burglary rate is not zero — it would
just require too many resources to completely eradicate
either of these things. What would I do? The most effective
way to reduce noncompliance is to have third-party reporting. In the United States for most wages and salaries, your
employer sends a report to the IRS stating how much you
have been paid, and now their computers are good enough
that if you don’t report those wages and salaries, there’s a
very high likelihood that you are going to get a computer
notice from the IRS asking you why. Thus, the chance of getting away with understating your wage and salary taxable
income is very low and, consequently, the IRS has estimated
that the rate of noncompliance for wages and salaries is
1 percent, while the rate of noncompliance for self-employment income is 57 percent. The former is subject to
withholding and information reporting, and the latter is
subject to neither. So one thing we should consider doing is
extending information reporting further. Most other countries have it for interest and dividends; many countries have
withholding for those kinds of payments, as well. We should
pursue, as the IRS has been doing recently, informationexchange agreements with other countries, because it’s
become quite clear that a lot of the noncompliance of highincome people involves offshore accounts or transactions,
and transparent information exchange among countries
reduces the attractiveness of noncompliance.
I and a co-author just recently completed a study using
these data from the IRS about the distribution of noncompliance by income class, which suggests that the rate of
noncompliance goes up with income class, except at the very
highest levels of income. No one had a good sense of the distributional pattern of noncompliance until this analysis.
One commonly hears that “the poor evade but the rich
avoid,” the idea being that high-income people don’t need to
do illegal things because they have plenty of legal ways to
reduce their taxes. But our analysis suggests that this is not
true — the rate of noncompliance does generally go up with
income class, except, again, at the very highest levels. Now,
all of these studies are fraught with problems. It might be,

for example, that the kind of evasion
that really high-income people engage
in is very difficult for the IRS, even
with a very intensive audit, to discover.
The IRS is certainly aware that even an
intensive audit isn’t going to uncover
all noncompliance, and it’s going to
uncover some kinds more than others.
They try to make up for this by estimating multiplicative factors that
adjust for the fraction of noncompliance they think they have missed.

Joel Slemrod
➤ Present Position
Paul W. McCracken Collegiate
Professor of Business Economics and
Public Policy, Professor of Economics,
and Director of the Office of Tax Policy
Research, University of Michigan

what is a policymaker who, otherwise would prefer to use that
instrument to reduce consumption in an effort to improve
public health, to do?

Slemrod: Goods vary quite a bit in
their price elasticity, that is, their
➤ Previous Faculty Appointment
responsiveness to tax-inclusive
University of Minnesota (1979-1987)
prices. The evidence suggests that
the consumption of cigarettes is
➤ Other Positions and Professional
relatively price inelastic. So while
you could potentially see an alliance
Member of the Advisory Board, Tax
Policy Center of the Urban Institute
RF: Many developing countries
between people who care about
and Brookings Institution (2002have much higher rates of tax
public health issues and people
Present); Member of the Congressional
in the government who care
evasion. Is this simply because their
Budget Office Panel of Economic
about raising revenue, those two
collection systems are less ineffiAdvisers (1996-2004); Contractor,
constituencies differ in their
cient? Or might there be cultural
Office of Tax Analysis, U.S. Department
“preferred” elasticity. If cigarette
reasons such as the populace
of the Treasury (1983-1984 and 1986purchases were inelastic to a taxmay have less trust in their
1988); Senior Staff Economist, Council
induced price increase, this would
government and feel less obliged
of Economic Advisers (1984-1985)
disappoint people who want to
to support it?
reduce smoking, but it is going to
➤ Education
raise more revenue than if demand
Slemrod: Well, I think the first aspect
A.B. (1973), Princeton University; Ph.D.
(1980), Harvard University
were highly price elastic.
— variation in tax enforcement effecMy own work has addressed
tiveness — is certainly a big part of it. In
➤ Selected Publications
how the possibility of tax avoidance
countries where the tax administration
Co-author (with Jon Bakija) of Taxing
affects the impact of raising state
is severely constrained for resources
Ourselves: A Citizen's Guide to the Great
cigarette taxes. Consider what
and the enforcement is very weak, the
Debate Over Tax Reform (4th edition,
happens when there are ways to
return to evasion is high. People don’t
2008); editor or co-editor of numerous
avoid a state’s cigarette taxes withwant to be perceived as suckers in
books including Does Atlas Shrug? The
out actually smoking less — for
countries like that, where they see
Economic Consequences of Taxing the Rich
example, traveling across the boreverybody else getting away with it.
(2000) and Why People Pay Taxes: Tax
der to buy cigarettes in a state
Whether part of the story is that
Compliance and Enforcement (1992); and
which has much lower taxes, or in
people evade more when they don’t
author of articles in such journals as the
the modern version, going on the
trust their government, including
American Economic Review, Quarterly
Journal of Economics, Journal of Political
Internet and buying apparently taxregarding spending their money wisely,
Economy, Journal of Public Economics, and
free cigarettes. Then the state faces
is an interesting question, and a lot of
National Tax Journal
a tricky dilemma. If it tries to raise
social scientists argue that it is imporrates, it’s not going to get as much
tant. My own view is that we don’t yet
revenue as it otherwise would. And for a lot of people the
have a lot of hard evidence on the question. There is a posieffective price has not gone up, because it just drives them to
tive cross-country correlation between the fraction of
the Internet. My research on cigarettes suggests that the
people who say they don’t trust their government and measelasticity of taxed sales in a given state has gone up over
ures of tax evasion, but that doesn’t compellingly tell us that
recent years, as these tax-free alternatives, for example
the lack of trust causes the higher rates of tax evasion. What
through the Internet, have become more widely available.
causes what is tough to nail down. For example, you can’t
And I say “apparently tax-free” because, although it is quite
really do a field experiment, where you go into one part of a
easy to buy untaxed cigarettes over the Internet, technically,
country and change how people feel about the government,
if I did that, I am supposed to remit tax liability to the state
and don’t do that it in another part, and then compare
where I live. The tax applies depending on where you smoke
changes in tax evasion rates. Trust in government could be
them, not where you buy them. But everyone knows that
very important, but it is just very hard for social scientists to
almost nobody actually remits these taxes.
pin down its behavioral implications.
On this topic, there is a wonderful piece of work by an
economist from the University of Illinois at Chicago named
RF: Are there certain goods for which consumption
David Merriman who had his students collect discarded
seems relatively unaffected by higher taxes? For
cigarette packs all over the Chicago area. You can tell from
instance, certain “sin goods” such as cigarettes? If so,

Region Focus | First Quarter | 2011


the stamp on the pack where it was purchased. And sure
enough, there are a lot of packs apparently consumed in
Chicago that were purchased in Indiana, where the taxes are
lower, and the fraction increases as you move closer to the
Indiana border.
RF: What does your research tell us about the effects of
tax policy on foreign direct investment (FDI)?
Slemrod: My own research and research done by others suggest that a host country’s tax policy does have a significant
effect on the amount and the type of FDI it attracts. My
own research has tried to differentiate two aspects of why a
low-tax rate may make a country more attractive for FDI.
One is that it just lowers the effective tax on income.
The other aspect is that, with a low tax rate, once there is
activity in the country, most multinationals have the incentive to shift their taxable income into your country. They
have many ways of doing this — such as establishing subsidiaries in low-tax countries. From a policy point of view, I
feel quite differently about these two aspects. I have no
problem with a country levying a low effective tax rate on
income to try to attract real investment. I have a bigger
problem with a country inviting, even encouraging, multinationals to shift income from higher-tax countries into their
country, because to me this is parasitic on the treasuries of
these other countries and isn’t productive at all from a
global point of view. In fact, I think this is welfare reducing
because the higher-tax countries expend resources to try to
keep the revenue from leaving and the companies expend
resources to camouflage the income shifting. In the news
recently is a country that has been quite successful at both of
these aspects. For a long time Ireland has had a 12.5 percent
corporate tax rate. This means there is a relatively low-tax
rate on income from investment in Ireland. But I think the
bigger issue is that this provides a tremendous incentive for,
say, U.S. car companies to build maybe only a single plant in
Ireland, and then shift the taxable income earned in its hightax locations into Ireland and thus lower their worldwide tax
burden. That’s a “beggar-thy-neighbor” policy of Ireland.
RF: The savings rate is affected by many things but
one possible factor that many people may not have
considered is the threat of a catastrophic war. What
does your research tell us about this question?
Slemrod: Congratulations for waiting about an hour to ask
me about one of my quirky papers! I have studied a few
issues people seem fascinated by, and this is one of them. I
have three articles that try to estimate whether, when
people seriously think there’s a chance of a nuclear conflagration, this belief affects their saving behavior. In short, do
people believe we ought “to eat, drink, and be merry, for
tomorrow we die?” To test this hypothesis I looked at aggregate saving over time in the United States, across countries,
and micro data within the United States, and in all three


Region Focus | First Quarter | 2011

cases found that when people think, or profess to think,
there’s a chance of a nuclear war, their saving rate goes down,
just as economic theory would predict.
RF: You mentioned you have published other supposedly
quirky papers that have garnered a lot of attention.
Slemrod: Yes, my co-author, Wojciech Kopczuk of
Columbia University, and I actually won an “Ig Nobel” prize
from a publication called the Annals of Improbable Research.
We won it for a serious economics paper that was eventually
published in the Review of Economics and Statistics entitled
“Dying to Save Taxes: Evidence from Estate Tax Returns on
the Death Elasticity.”
We looked at estate tax return data from the history of
the U.S. estate tax and found that when the estate tax was
going to change — go up or down — in an anticipated way,
then the distribution of deaths around that date was not
symmetric. When the tax rate was going to increase, more
people died before the rate rose, and when the tax rate was
going to be lowered, people held on and more people died
after the decrease. Since we wrote the paper, the general
“death elasticity” finding has been replicated using data from
episodes in Australia and Sweden when they ended their
estate taxes. Those studies found evidence that people
delayed their death to save their heirs’ money, in some cases,
millions and millions of dollars. We wrote this paper before
the 2001 U.S. tax changes, which phased down the estate tax
over the subsequent decade and which eliminated it completely for 2010, only to reinstate it in 2011. So there now are
two recent episodes to further investigate our hypothesis.
Between 2009 and 2010, some people should have been
hanging on to “get” the zero estate tax rate. And now, right
now (November 2010), the morbid part of the hypothesis
applies, because someone who is going to leave a huge estate
— well, they’ve got four weeks to get on with it estate-tax-free.
RF: Are there papers you have been working on recently
that you would like to discuss?
Slemrod: I am working on a paper about the effect of
public disclosure of income tax returns. The issue is, what
would be the impact if there was public disclosure of income
tax liability and taxable income, as there is in several countries today and there was in the United States in the 1920s
and again in the 1930s? In Norway, for instance, you can go
online and see anybody’s taxable income, income tax liability, taxable wealth, and wealth tax liability. The people who
think this is a good idea argue that it dampens noncompliance, because if your neighbor sees that you have reported
$10,000 of income and has reason to think it should be
$100,000, he might provide that information to the tax
authority. The ongoing research is, as far as I know, the first
empirical study on the impact of disclosure.
It uses data from Japan, which had disclosure from
1949 until 2004 for both individuals and corporations.

We examine what happened when disclosure ended, and
take advantage of the fact that disclosure was required only
for people and corporations with taxable income and tax liability over some threshold. So we look at the distribution of
taxable income reports and observe that it tightly fits a
Pareto distribution until you get very near the threshold,
where there are noticeably fewer reports than would be
expected under a Pareto distribution. This is completely
consistent with the notion that both individuals and corporations near the threshold are understating their income in
order to avoid disclosure. Also, in Japan — this is wellknown among accountants, apparently — there were
so-called “39 companies,” referring to the fact that the disclosure threshold level for disclosure was 40 million yen.
These “39 companies” arranged their affairs so they wouldn’t
have to publicly disclose their income. That’s the first half of
the paper: that a nontrivial amount of individuals and corporations apparently take actions to avoid disclosure.
In the second part of the paper, we look at whether we
can see a disruption in corporations’ reporting of taxable
income in their financial statements when disclosure ended.
Remember, in 2004, everybody could see what your taxable
income was, but in 2005 nobody could see, other than
Japan’s version of the IRS. Did we suddenly see taxable
income and tax payments go down, because they didn’t feel
this pressure of public disclosure? And the answer seems to
be that no, we didn’t see that. This might be so because in
Japan there is a very high degree of conformity between the
tax return measure of income and the financial statement
measure of income, which means there’s already quite a lot
of information in the public domain about taxable income
for big public companies, so disclosure was not that big a
deal — when it ended, there wasn’t a big response. But for
smaller companies whose income was near the disclosure
threshold, which were mostly private companies, the public
tax disclosure was the only information out there, so it mattered more for them.
Something else that I have been thinking about lately is
what I call “policy notches” — where a very small change in
behavior can lead to a large change in tax liability. A good
example is fuel economy policy. The “Gas Guzzler” tax is
notched. So when the fuel economy of a car (but not a truck
or SUV) changes from 16.4 to 16.5 miles per gallon, there’s a
several-hundred dollar reduction in the tax, throughout the
whole range of the tax. The same is true in the Canadian
system. Do automobile manufacturers respond to those
notches? Do they make sure that the fuel economy measure
on which the tax is based is just over the notch to get the
lower tax?
A former graduate student of mine, Jim Sallee, who’s now
at the Harris School of Public Policy Studies at Chicago, and
I have written a paper called “Car Notches” that reports
pretty convincing evidence that car manufacturers are well
aware of these notches and are re-engineering their cars to
take advantage of it. Unfortunately, a notched policy like
this is inefficient because it induces auto manufacturers to

spend a lot of effort and resources re-engineering some of
their cars that are near the notch just barely over it and provides no incentive at all to do the same on cars that aren’t
near the notch. That just isn’t an efficient way to encourage
fuel economy.
RF: Which economists have been most influential in
shaping your research agenda and your thinking about
economic policy issues?
Slemrod: I was incredibly lucky to go to graduate school at
Harvard at a time when some of the really great contributors
to my field were on the faculty. My advisor was Marty
Feldstein, who was teaching one half of the two-semester
public finance sequence. Richard Musgrave, who had written probably the most influential book on public finance
while he was teaching at Michigan in the late 1950s, about 15
years before I got to graduate school, taught the other half.
Marty was a leader in the new public finance, taking seriously rigorous normative models of optimal taxation and
applying frontier empirical methods to estimating the
impact of taxation on behavior, and he had a tremendous
influence on how I think about research. But I was tremendously influenced by Dick Musgrave and his views about the
importance of the normative issues that inform economic
models. The most stimulating economic intellectual experience I have ever had was the weekly public finance seminar
at Harvard, when — metaphorically speaking — Marty
would sit in one corner of the room, Dick Musgrave would
sit in the other corner, and we graduate students, who at the
time included tremendously smart people like Larry
Summers and Alan Auerbach, would be in the middle. Marty
and Dick would — generally very respectfully, but always
forcefully — give their often contrary perspectives on the
issues of the day. That experience was very important and
formative for me.
My first job as an assistant professor was at the University
of Minnesota. I never became a rational expectations guy
like many others there, but one thing I respected tremendously about the faculty there was that they took economics
very seriously. It wasn’t a game. It was important, and it
needed to be rigorously based, whether they were talking
about theory or empirical work; I hope I picked up some of
that seriousness. I also have had long-time colleagues and
collaborators who have been incredibly important to me.
One is Shlomo Yitzhaki, an Israeli economist who I worked
with continually for 20 years on one project or another, and
who convinced me that aspects of taxation that were then at
the periphery of the standard models, such as avoidance,
evasion, and enforcement, were actually central to the economics of taxation. Another big influence on my research
career was Roger Gordon, who was my colleague at
Michigan and was the reason I came here. The serious and
eclectic intellectual environment in the economics department at the University of Michigan, and the great graduate
students here, keep me stimulated and motivated.

Region Focus | First Quarter | 2011


Virginia and the Final Frontier
Federal space centers
and proximity to
customers have
helped to attract
private space firms

Apollo astronauts practiced for lunar
missions at NASA Langley’s Lunar
Landing Research Facility. This 1969
photo of the facility shows its model
Lunar Excursion Module, or LEM.
The LEM was suspended from cables
to enable the astronauts to simulate
piloting on the moon. A Langley
worker is standing beneath the craft.


n a Saturday morning a little
more than a half-century ago,
Oct. 24, 1959, some 20,000
visitors swarmed Langley Research
Center in Hampton, Va. The occasion
was an open house to give the public
a look inside the National Aeronautics and Space Administration, or
NASA, which had been hurriedly
created by Congress and President
Eisenhower in mid-1958 in response
to the orbiting of the Russian Sputnik
America’s early efforts at chasing
Sputnik had not gone well. An attempt
by the U.S. Navy to launch a satellite in
late 1957, two months after Sputnik,
failed when the rocket exploded spectacularly on the launch pad. Now
Americans looked expectantly to
NASA to put the United States in
front of the space race.
At the center of attention inside
Langley’s open house were spacecraft
and rockets: Among them were a
model of a German V-2 rocket engine;
a rocket known as “Little Joe” that
would soon be used to launch a sevenpound Rhesus monkey into space and
back again; and a mock-up of the
Mercury space capsule, which was to
carry an American into orbit. At an
exhibit on Project Mercury, an engineer told attendees, “The possibility of
venturing into space has shifted quite
recently from the fantasy of science
fiction into the realm of actuality.
Today, space flight is considered well
within the range of man’s capabilities.”
The visitors were led to understand
that they were in one of the birthplaces of the American-manned space
program — and they were. Two and
a half years later, the Langley-run
Mercury program would send John
Glenn around the Earth. Langley
managed the project, trained Glenn
and the program’s six other astronauts,
carried out aerodynamic and structural tests, and created the ground-


Region Focus | First Quarter | 2011

tracking system, among other things.
Soon afterward, Langley would
make crucial contributions to the
Apollo program: Its Lunar Landing
Research Facility trained the Apollo
astronauts in piloting spacecraft near
the moon’s surface and in moon walking. In the overall design of the Apollo
missions, a Langley engineer, John
Houbolt, argued as a voice in the
wilderness for a plan of lunar-orbit
rendezvous — that is, the docking of
two spacecraft in lunar orbit after one
of them had landed on the surface —
and ultimately convinced other NASA
centers of its superiority. Langley then
built a rendezvous and docking simulator in an airplane hangar to train the
astronauts in the technique.
Today, the 788-acre center employs
some 3,800 workers in the Hampton
Roads area — divided roughly 50-50
between civil service employees and
contract employees — who work on
projects ranging from wind tunnel
tests to next-generation escape systems for saving astronauts in case of
launch failure.
In recent years, policymakers in
Virginia have been seeking to build on
the presence of Langley and other
federal and private space centers with
the aim of expanding the state’s space
industry — and, with it, the highpaying skilled jobs that the industry
brings. To that end, the Virginia
General Assembly has enacted legislation to promote the industry’s
development: The Spaceport Liability
and Immunity Act of 2007, which
protects space transportation companies from liability for the injury or
death of a spacebound passenger if
the company has given warning of the
risks, and the Zero G Zero Tax Act
of 2008, which exempts human
space launches and some cargo space
launches from state income taxes.
While such measures may make the
state more attractive for investors, the



history of Langley and other players in the Virginia space
sector highlight the powerful role of nonpolicy factors —
and sometimes sheer serendipity — in bringing space activities to the state. The stories of a cross-section of Virginia’s
space organizations, public and private, suggest that the
state does have a number of advantages that have seeded
development in the past and that will likely continue doing
so, including its proximity to the nation’s capital and its
strong public university system.

NASA Lands in Virginia
The months between Sputnik and the creation of NASA
saw a melee among defense agencies for control of the space
program. (An Air Force publicist invented the term “aerospace” to reinforce the idea that aeronautics and space were
inseparable.) Eisenhower opted for a civilian program that
would exist in tandem with, and somewhat overlap,
Pentagon missile programs. NASA’s facilities would be
plucked here and there from the military: the Army’s missile
program in Huntsville, Ala., headed by Wernher von Braun,
the German missile designer and future director of the
Saturn V moon-rocket program; the Army’s Jet Propulsion
Laboratory near Pasadena, Calif.; the Navy’s Vanguard
rocket program; and part of an Air Force test range at Cape
Canaveral, Fla. NASA also inherited five centers from its
predecessor, an aircraft research agency known as the
National Advisory Committee for Aeronautics (NACA).
As it happened, two of those centers were in Virginia:
One was Langley, and the other was Wallops Flight Facility,
located on Virginia’s Delmarva Peninsula and nearby
Wallops Island. (Congress established another NASA center
in the Fifth District, Goddard Space Flight Center in
Beltsville, Md., a year after NASA’s founding.)
Langley had been founded in 1920 as the first civil aeronautical research agency in the United States. Its site in
Hampton, originally farmland, was chosen on the basis that
it was a reasonable distance from Washington and yet was
isolated enough for safe and secure flight testing. “Since
then, we’ve been involved in advancing the science of flight,”
Langley director Lesa Roe says. “Literally every aircraft
today contains some technology that we developed at
Roe hopes that Langley’s capabilities will find customers
in the private space industry. “We have met with the SpaceX
folks [the launch vehicle and spacecraft company run by
PayPal co-founder Elon Musk] and others,” she says. “If they
need to use our facilities, we can put agreements in place so
they can come and test in our wind tunnels or have access
to our expertise in materials or aero sciences or systems
analysis. We’re eager and willing to do that.”
Wallops Flight Facility was built later than Langley, in
1944, as the Pilotless Aircraft Research Station; NACA
staffed it with Langley employees to conduct research for
the war effort. Rocketry was part of its research from the
outset — to aid its aircraft work.
“In the early years, under NACA, it made sense to try out

a bunch of different aerodynamic shapes,” says Wallops
director William Wrobel. “They didn’t have wind tunnels.
To get the high speeds, they put these shapes on rockets.”
Wallops today consists of an airfield for aircraft-related
research on the peninsula and six launch pads and related
facilities on the island. The center launches 15 to 20 rockets
per year, ranging from targets for the Navy to suborbital
science projects and satellites, and has 1,100 full-time
Located alongside the NASA launch facility is the MidAtlantic Regional Spaceport, or MARS, operated by Virginia
and Maryland in an effort to bring space business to the
region. On land leased from NASA, it offers two launch pads
to commercial customers. It is one of seven nonfederal
spaceports that the Federal Aviation Administration has
licensed. Its biggest deal so far is an agreement with Orbital
Sciences Corp., based in Dulles, Va., for eight launches of
Orbital’s Taurus II launch vehicle between 2011 and 2015 to
carry supplies to the International Space Station.

A Private Space Sector Thrives
One of the biggest private-sector players in Virginia’s space
industry started as an Arizona company. Motorola believed
in the 1990s that there was a mass market for premiumpriced satellite phone service with worldwide coverage.
It started Iridium to serve this market and, with other
investors, put $5 billion into it. Iridium orbited 66 communications satellites (plus in-orbit spares) to service the
hundreds of thousands of customers that it assumed would
beat a path to its door.
Iridium opened for business in late 1998 — and filed for
bankruptcy less than a year later. Its satellite system worked
splendidly, but it never had more than a small fraction of the
number of subscribers it needed to break even. In late 2000,
as Iridium was preparing to shut down and de-orbit its satellites, a group of private investors scooped up Iridium for a
comparative pittance, $25 million, with the intention of
offering the service to specialized markets. They had
encouragement from the U.S. government, which, for strategic reasons, didn’t want to see Iridium fail.
The new owners quickly moved the headquarters to
Arlington, Va. (since moved to Tysons Corner) to be closer to
Iridium’s most important customer, Uncle Sam. In addition,
the company had always maintained a significant part of its
operations in Leesburg, namely, its Satellite Network
Operations Center, operated under contract by Boeing to
control the satellites.
In the past decade, Iridium’s customer base has shifted
more to private customers. “Although [the Department of
Defense] is still our single largest customer, representing 23
percent of revenues, commercial is now the larger part of
our business and is growing at a faster rate,” says Don
Thoma, Iridium’s executive vice president of marketing.
One thing, however, has been a constant in Iridium’s
strategy: It still seeks niches, not the mass market. “Iridium
fills a need for customers who operate in locations or

Region Focus | First Quarter | 2011


situations where there really are no reliable communications
alternatives,” Thoma says. “Iridium complements cell
phones by providing voice and data communications to the
rest of the globe, where cell towers can’t reach. We offer a
reliable option, for example, for ships in the middle of the
ocean, planes flying over the North Pole, and first responders in the middle of a natural disaster.”
Iridium, now a profitable public company, derives a competitive advantage from its large satellite fleet (or
“constellation,” to use the industry’s term). The approach of
Iridium’s main competitors is to provide coverage of the
Earth with just a few satellites placed in high orbit, around
22,000 miles up — known as geostationary orbit, because
each satellite stays in a fixed position in relation to points on
the ground. Iridium, in contrast, keeps its satellites in low
Earth orbit, roughly 483 miles up, thus requiring the large
constellation. Iridium’s way is more costly, but the shorter
distance eliminates the transmission delay that comes with
geostationary satellites and hinders phone communications.
The shorter distance also means Iridium’s phones can have
smaller, less bulky antennas. In satellite phones, as in other
electronics, customers like things small.
Another space-industry company that values Virginia’s
proximity to the federal government is Dulles-based
GeoEye, which owns and operates three Earth-imaging
satellites, and sells high-resolution images to the National
Geospatial-Intelligence Agency (NGA), as well as to private
customers. NGA, in turn, disseminates the imagery to U.S.
intelligence agencies and military services. “It’s nice that we
can drive to the agencies, to Capitol Hill, to the Pentagon,”
says Uyen Dinh, senior director for government affairs at
The company is in Dulles because it started as a division
of Orbital Sciences there before being spun off in 1997. Now
the company has more than 230 employees in Virginia and
$270 million in 2009 revenue. Two-thirds of its revenues
come from the U.S. government.
Another customer is Google, which uses images from
GeoEye, as well as other providers, for display in Google
Earth and Google Maps. The government allows GeoEye to
sell imagery to private customers such as Google at halfmeter resolution, while the images that GeoEye delivers to
the government are much more detailed.
The company is positioning itself to sell sophisticated
analysis of Earth images in addition to the images themselves. Part of that strategy is GeoEye’s acquisition
in December of McLean-based SPADAC, which uses
human analysts and software to perform “predictive
analytics” of geographic images for terrorist attacks or other

“As a market begins to mature, strategically you want to
move further up the value chain and offer more comprehensive services to your clients,” says Chris Tully, the firm’s
senior vice president of sales. “We don’t want to be simply a
pixel provider.”
For affluent customers who prefer to look at Earth from
space for themselves, there is Vienna, Va.-based Space
Adventures, Ltd., which charges $50 million per passenger
for orbital missions of 10 to 12 days in a Soyuz spacecraft and
the International Space Station. Since 2001, seven clients
have flown on eight orbital missions (one client, exMicrosoft executive Charles Simonyi, has gone up twice).
The company’s latest offering is a trip around the moon on a
Soyuz spacecraft. One of the two available seats has already
been reserved. Ticket price: $150 million.
Space Adventures is based in Virginia because its founder,
a Coloradoan, Eric Anderson, had studied aerospace engineering as an undergraduate at the University of Virginia and
decided to stay in the state. He had dreamed of being an
astronaut until he learned during a summer internship at
NASA that his eyesight would disqualify him from the
agency’s astronaut corps. So he shifted his dream to starting
a business that would put private citizens in space.
Two years after graduation, Anderson founded Space
Adventures in his Arlington townhouse in 1998. He had no
way to put people into space, so he offered terrestrial adventures in astronaut training — zero-gravity flights,
high-gravity training in a centrifuge — and flights to the
edge of space in a Russian MiG-25 fighter jet. By 2001, he
had managed to engineer an agreement with the Russian
Federal Space Agency and Rocket and Space Corporation
Energia, a Russian manufacturer of spacecraft components,
for the orbital flights.
Of course, the market for the Soyuz missions is limited
because the ticket price is so high. “We estimate that for
orbital space flights, there’s probably less than 10,000
people in the world who could afford them,” says Space
Adventures president Tom Shelley. “But within that very
narrow market, there’s a pretty strong interest. We have a
large number of people in our pipeline who’ve stated they
want to do this. The biggest limiter for them is time because
it takes a good deal of commitment of time.” (Founder
Anderson is now chairman of the company.)
The exploitation of space in Virginia has come far since
the Saturday-morning preview at Langley in 1959. Economic
incentives will play a role in the industry’s development.
Yet if history is any indication, an even greater role will be
played by proximity to sophisticated customers and a
pool of highly skilled engineers to act as employees and

Hansen, James R. Spaceflight Revolution: NASA Langley Research
Center From Sputnik to Apollo. Washington, D.C.: National
Aeronautics and Space Administration, 1995.


Region Focus | First Quarter | 2011

McDougall, Walter A. … The Heavens and the Earth: A Political
History of the Space Age. New York: Basic Books, 1985.

The Decision to Export

“Understanding Exports From the Plant Up.” George
Alessandria and Horag Choi, Federal Reserve Bank of
Philadelphia Business Review, Fourth Quarter 2010, pp. 1-11.

elling to foreign markets isn’t easy, but it often can boost
local job growth along with an exporter’s sales figures.
That’s why states send their governors on trade missions
and offer various incentives to encourage exporting.
But does exporting itself beget success, or are successful
companies in a better position to become exporters? George
Alessandria at the Philadelphia Fed and Horag Choi at
Monash University address this question in a recent paper.
Using data from manufacturers in the United States,
Canada, and Chile, the economists determined the distinguishing features of exporters — they are bigger, more
productive, and more profitable than nonexporters. Then
they modeled the decision of a plant to export or sell domestically to explain these characteristics. Their conclusion was
that the process of exporting does not necessarily transform
less productive firms into superstars.
“Our simple model shows that causation may run from
superstar to exporting,” notes Alessandria and Choi.
“Indeed, future exporters tend to be more productive and to
grow faster even before they enter export markets.”


“The Effect of Falling Home Prices on Small Business
Borrowing.” Mark E. Schweitzer and Scott A. Shane, Federal
Reserve Bank of Cleveland Economic Commentary 2010-18,
December 2010.

t has been widely reported that the housing market’s
downturn has sharply affected residential construction.
A recent analysis by the Cleveland Fed suggests that
reduced lending to small businesses should not be overlooked in the process — and that, in fact, the two issues
are in some ways connected.
One reason for reduced lending is that many business
owners have seen the equity in their homes dry up. At focus
groups convened by the Federal Reserve last summer, businesses owners reported that the reduced value of their
homes made it difficult to provide collateral for loans.
“Other participants said that the reduced value of homes
has made home equity borrowing as a source of business
capital more difficult to come by, also contributing to the
difficulty many small businesses face in obtaining sufficient
capital to finance their operations,” notes Mark Schweitzer,
the Cleveland Fed’s director of research, and Scott Shane, a
professor at Case Western Reserve University.
To support this anecdotal evidence, Schweitzer and
Shane analyzed survey data. They found that in 2007


between one-fifth and one-quarter of business owners had
obtained a loan against the equity in their homes or used
their primary residences as collateral for business purposes.
They also found that the use of home equity lines rapidly
expanded during the last decade as home prices increased.
And when prices fell, home equity borrowing declined
sharply. However, it isn’t clear how much of these changes
were due to other factors such as changes in the availability
of home equity lines.
Finally, as the authors point out, not all small businesses
owners are equally affected by declines in home prices.
Those more likely to leverage their residences include “companies in the real estate and construction industries, those
located in the states with the largest increases in home
prices during the boom, younger and smaller businesses,
companies with lesser financial prospects, and those not
planning to borrow from banks.”
Still, there is enough of a correlation between home values
and small businesses’ access to capital to inform policymakers. “Returning small business owners to prerecession
levels of credit access will require an increase in home prices
or a weaning of small business owners from the use of home
equity as a source of financing,” writes the report’s authors.
“How Do Sudden Large Losses in Wealth Affect Labor Force
Participation?” Eric French and David Benson, Federal Reserve
Bank of Chicago, Chicago Fed Letter 282, January 2011.

nother frequently reported effect of the housing market downturn is that workers are delaying retirement to
replace large and sudden losses in household wealth.
Chicago Fed economists Eric French and David Benson
decided to find out whether declines in home values (as well
as drops in some stock prices) have significantly affected the
U.S. labor market.
“On the surface, labor force participation statistics for
older individuals seem consistent with anecdotes about
delayed retirements,” note French and Benson. While labor
force participation for most age groups has been falling, it
has been rising for those aged 55 to 64.
But this upward trend dates back to the early 1990s. So,
other factors, such as longer life spans and changes in pensions and Social Security rules, may have encouraged
delayed retirements as well.
French and Benson estimated the wealth losses of older
workers approaching retirement and plugged those data into
an equation that relates changes in wealth to changes in the
labor supply. The result: The labor force participation rate for
workers aged 51 to 65 would be 2.9 percentage points lower if
asset prices hadn’t declined between 2006 and 2010.


Region Focus | First Quarter | 2011




continued from page 16

don’t know, we’re dealing with unfamiliar territory here.’ ”
Unfortunately, he says, it would take a discipline-wide
commitment to turn that around. The AEA recently considered adopting a code of ethics to induce economists to
disclose any paid consultancies that could potentially sway
their research conclusions. A better move, Colander says,
would be for economists to have a culture that discourages
people from purporting undue certainty in their predictions
and explanations.
If there’s a bottom line to recent criticisms of what economists study, Whaples says, it is that the fundamental
dispute dates back at least a century. The consensus vacillates between those who say markets don’t work well and
that we need to put regulations on them, and those who
point out the unintended side effects of government
intervention and the fact that smart people will exploit

regulations. “That basic argument goes back and forth,
around in a circle, forever,” Whaples says. “When we haven’t
had any crises for a while, the ‘markets work’ group will get
stronger. And when we have a crisis the ‘markets don’t work
so well’ group will get stronger.”
Nobody can say which is right, he says; there are valid
points to be made on both sides. “But there’s always going to
be that middle ground. The problem is, it’s kind of wide.”
The crisis may have helped narrow the question some: In
what situations do markets work, and how does policy affect
how markets function?
Economics is about the journey, not the destination;
economists will never be “done” understanding the economy and human behavior. But the constant drive toward
better understanding can only be a good thing for future
economic thought.

Bernanke, Ben S. “Implications of the Financial Crisis for
Economics.” Speech at the Conference co-sponsored by the
Center for Economic Policy Studies and the Bendheim Center
for Finance, Princeton University, Sept. 24, 2010.
Blanchard, Olivier. “The State of Macro.” NBER Working Paper
No. 14259, August 2008.
Blaug, Mark. Economic Theory in Retrospect, Fifth Edition.
Cambridge: Cambridge University Press, 1997.
Luzzetti, Matthew, and Lee Ohanian. “The General Theory of
Employment, Interest, and Money after 75 Years: The Importance



of Being in the Right Place at the Right Time.” NBER Working
Paper No. 16631, December 2010.
Putterman, Louis. Dollars & Change: Economics in Context.
New Haven: Yale University Press, 2001.
Rajan, Raghurham. “Why Did Economists Not Spot the Crisis?”
Feb. 5, 2011 post on the University of Chicago Booth School of
Business’ “Fault Lines” blog.
Uhlig, Harald. “Economics and Reality.” NBER Working Paper
No. 16416, September 2010.

continued from page 23

new normal. “I don’t know — I’m waiting to see,” he says.
Temp work is an important part of the flexibility that is
one of the U.S. economy’s great strengths. “In the long run,
this flexibility helps make our country more competitive, it

increases living standards, it lowers prices for goods,”
Groshen says. “But in the short run, there can be high costs
to the workers involved — the costs are very concentrated,
while the benefits are diffuse.”

Autor, David, and Susan Houseman. “Do Temporary-Help Jobs
Improve Labor Market Outcomes for Low-Skilled Workers?
Evidence from ‘Work First.’ ” American Economic Journal: Applied
Economics, July 2010, vol. 2, issue 3, pp. 96-128.

Peck, Jamie, and Nik Theodore. “Flexible Recession: The
Temporary Staffing Industry and Mediated Work in the
United States.” Cambridge Journal of Economics, March 2007,
vol. 31, issue 2, pp. 171-192.

Groshen, Erica, and Simon Potter. “Has Structural Change
Contributed to a Jobless Recovery?” Federal Reserve Bank of
New York Current Issues in Economics and Finance, August 2003,
vol. 9, no. 8.

Otoo, Maria Ward. “Temporary Employment and the Natural
Rateof Unemployment.” July 1999, Board of Governors of the
Federal Reserve Working Paper, no. 99-66.

Katz, Lawrence, and Alan Krueger. “The High-Pressure U.S. Labor
Market of the 1990s.” Brookings Papers on Economic Activity, 1999,
vol. 30, no. 1, pp. 1-88.


Region Focus | First Quarter | 2011

Riches From Respect

wo centuries ago the world’s economy stood at the
present level of Bangladesh,” observes Deirdre
McCloskey at the outset of Bourgeois Dignity.
McCloskey, an economist at the University of Illinois at
Chicago, who holds appointments in the university’s
history, English, and communication departments, seeks
in her latest book to explain the unprecedented worldwide,
long-term economic ascent that began in Holland in the
1600s and in Britain in the 1700s, bringing — by her
estimate — at least a sixteenfold increase in real income
per person during that time.
In doing so, she replaces traditional explanations for this
growth with one based on a change in rhetoric and attitudes,
which she calls the Bourgeois Revaluation: a reappraisal of
the status of bourgeois commercial activities such as trading
and inventing. Starting in Holland and then in Britain, she
argues, people throughout society, including within the
aristocracy, no longer sneered at these activities — no longer
saw them as vulgar — but instead saw them, and the
bourgeoisie that carried them out, as having merit. The
bourgeoisie had long had some degree of liberty: Now it had
From dignity to economic growth, the transmission belt
implied by McCloskey’s story is that talented yeomen who
would have otherwise pursued traditional occupations such
as farming or soldiering were drawn instead to the newly
respected pursuits of trade and industrial innovation.
Gentlemen and aristocrats were perhaps drawn to organizing ventures and investing.
McCloskey’s thesis is intuitively appealing. In our own
time, it is reasonably obvious that social prestige is commonly a factor in occupational choice and employer choice. Why
not in the time of the Industrial Revolution too?
The conversational narrative style of Bourgeois Dignity is
appealing, as well. At times, it feels as if she is writing for a
favorite niece. (“I wish you would pay attention,” she playfully chides the reader at one point.) Along the way, there are
quick digressions on such varied subjects as the persecution
of British mathematician Alan Turing under antigay laws,
the animated film Ratatouille, and space telescopes.
But setting out an attractive and stylishly told thesis is
one thing; proving it is another. Here is where the book
becomes frustrating. To be sure, hers is inherently a difficult


thesis to support using the conventional tools of economics:
It is challenging to find reliable time series for ordinary
economic aggregates going back 400 years, let alone proxies
for intangibles like dignity.
Her approach in this book is negative, considering and
rejecting a series of alternative explanations for modern economic growth. If none of these adequately accounts for the
sixteenfold-plus increase, she holds, that failure supports
her theory as the residual. Among the explanations she finds
lacking are foreign conquest and imperialism, foreign trade,
science (as distinct from commercial innovation), savings, a
rise in greed, economies of scale, natural resources, and railroads, canals, and improved roads. For McCloskey, none of
these could have had more than a small part in the growth;
each had too small an effect, started too early to explain the
rising tide, or occurred in too many other places without a
corresponding effect on growth.
Responding to institutional theorists, such as Douglass
North, she agrees that property rights and the rule of law
were necessary for growth, but argues that they evidently
were not sufficient, since both of these predate the period
when growth started in Holland and Britain. “And what then
of secure Italian or for that matter Byzantine or Islamic or
Chinese property rights?” she asks.
McCloskey’s approach seems unsatisfying in some
respects, however. First, even if none of the traditional
factors fully accounts for the growth, what about the interaction of them? She gives too little consideration to this
possibility. Second, her treatments of some of the traditional explanations are somewhat cursory and derisive.
Rightly or wrongly, she gives the impression that she has not
presented those theories in their strongest form before
attempting to knock them down.
Her positive argument for her theory is set out briefly
here in about 35 pages. (She promises that a follow-up
volume, The Bourgeois Revaluation: How Innovation Became
Virtuous, 1600-1848, will make the case in more detail.) It is
primarily based on canvassing rhetorical sources of the
period and showing the use of pro-bourgeois rhetoric. Yet it
is hard to make the case based on rhetoric alone: The
rhetoric of the period, as she is careful to note, is divided on
the subject. Moreover, her rhetorical methodology does not
here meet the standard to which she holds the theories she
criticizes. “The assertion is without quantitative oomph,”
she says of one opposing argument, “ and is not science, until
it is actually measured.”
Then, too, the causation could run in the other direction:
Rising prosperity might have led to a rise in pro-bourgeois
rhetoric. Her next volume undoubtedly will set out a more
comprehensive case for her theory of bourgeois dignity in
economic growth.

Region Focus | First Quarter | 2011



Economic Trends Across the Region

Long-Term Industry and Occupation Outlook
in the Fifth District

he Bureau of Labor Statistics (BLS) publishes
projections biennially for the various occupations
that produce all of the goods and services in our
economy — from the bricklayer to the computer programmer. The occupational employment projections offer a view
into expected changes in the number of people employed
in each profession over a 10-year time horizon. (There are
approximately 750 occupations in the classification system
used by BLS and other federal agencies, known as the Standard Occupational Classification system, or SOC.) The
current projection period covers 2008 to 2018. In contrast
to forecasts of near-term economic activity, the long-term
projections for growth in occupations convey valuable
insight on growth or decline in occupations over a period
of time that is sufficient to allow for planning and strategic decisionmaking.
The development of long-term employment projections
dates back nearly 60 years, to shortly after the end of World
War II, and their original purpose was to provide career
information for veterans returning to civilian life. Today,
occupational employment projections provide valuable
information that serves an even broader set of customers in
three important areas: career advice and planning, curriculum planning for education and training institutions, and
alignment of economic development planning with the
workforce. Employment changes across occupations matter
a great deal to guidance counselors in middle schools and
high schools as they offer career advice to help students
match their interests to potential opportunities, while also
considering the availability of future job openings. Likewise,
postsecondary institutions, whether four-year colleges and
universities, community colleges, or technical institutes, use
the projections as a valuable component to plan for the
appropriate courses and majors or technical training that
will serve the needs of their students over time. Finally,
economic development agencies use the projections to set
realistic targets for the types of industries they want to
attract and promote in their region, so that the workforce
needed by companies will match the availability of specific


How the Projections Are Derived
The methodology and the timing of the projections have
evolved over the years to the current two-year cycle.
Development of the national projections involves several
related steps, starting with estimates of the total labor force
for the projection year. Census estimates of the size and
demographic composition of the population are combined


Region Focus | First Quarter | 2011

with projected labor force participation rates to obtain an
estimate of the labor force in 2018.
In turn, the labor force projections feed a model of the
U.S. economy to derive estimates of growth in the aggregate
economy. Growth in the economy stems from demand for
goods and services on the part of households, businesses, the
government, and other countries. Together, these sources of
demand, referred to as “final demand,” generate growth
across many industry sectors within the economy. While
some industry sectors expand output in direct response to
final demand, others grow because they supply inputs to
expanding industries. The resulting projections of industry
output imply a level of industry employment, taking into
account other factors, such as expectations of productivity
Finally, detailed occupational employment for each
industry is estimated by applying an industry-occupation
matrix, often called a staffing matrix, to the projected industry employment. The staffing matrix assigns industry
employment to all of the occupations that are used in a
particular industry; it is based on the BLS’ Occupation
Employment Statistics (OES) survey, which collects data
from employers on a triennial cycle. Throughout the entire
estimation process, a number of assumptions are made
regarding the path of the economy over the 10-year horizon,
the effect of demographic changes on the rate of labor force
participation, and technological advances in production.
To be sure, output by industry can move at a different
pace and even in the opposite direction from employment by
industry, reflecting the type of technological progress that
allows for more output to be produced with fewer workers.
This is an important distinction because growth, as measured
by greater output, may not create additional job opportunities in every case. For this reason, careful estimates of future
industrial production and employment, based on appropriate
assumptions regarding technological developments and
expected productivity growth, form the foundation for accurate projections of employment by occupation.
The information gained from the occupational employment projections differs in a meaningful way from the
projections by industry. While industry-level projections tell
us what firms will produce, the occupation-level projections
tell us how labor will be combined to do the work. In addition, the occupational projections summarize the net
employment change for a particular occupation across
various industries. For example, we know the demand for
computer systems analysts will grow, but the projections
also tell us that the management, scientific, and technical

Projected Occupational Employment Composition in 2018 —
Fifth District States
consulting services industry will increase the
number of analysts they employ, while wired
SC Total
Major Occupation Groups
telecommunications carriers will reduce their
Transportation and material moving
use of computer systems analysts by 2018. This
Installation, maintenance, and repair
type of information allows a job seeker to tailor
Construction and extraction
his job search to a particular industry where
Farming, fishing, and forestry
chances of success are higher.
Office and administrative support
Sales and related
State workforce agencies and labor market
information departments use the national proProfessional and related
jections from the BLS to prepare their own state
Management, business, and financial
and local area industry and occupational
NOTE: State total does not include all Fifth District jurisdictions. At press time, the District of Columbia has
employment projections. Clearly, the more geonot yet published 2008-2018 statistics and West Virginia did not publish group level data.
SOURCES: Bureau of Labor Statistics, Individual State Labor Market Information Offices
graphically focused projections provide great
value to the customers of the information —
students of all ages, guidance and career counselors, postsechealth care services, nursing and residential care facilities,
ondary education institutions, and economic developers —
and social assistance, while South Carolina registered
who are all involved in planning at a more local level. To the
the fastest growth expected for hospitals. In addition to
extent that the industry mix of the state or region differs
their high percentage growth rates, many of the health carefrom the industry composition of the nation, the occuparelated industries will also provide the largest gain in the
tional employment projections will reveal different trends in
absolute number of jobs over the 10-year period. Other
demand for occupations at the local level. So, what do the
high-growth industries common to these four states include
industry and occupational employment projections reveal
data centers and informational technology, as well as profesfor the states in the Fifth District?
sional, scientific, and technical services. In contrast to the
other states, West Virginia’s projected fastest-growing
industry over this period is the construction of buildings.
Industry-Level Employment Projections
Overall employment is expected to grow in the Fifth
Most of the states in the Fifth District publish their longDistrict states for which we have data, but only Virginia’s is
term projections for employment by industry at the same
expected to grow at an average annual rate that exceeds the
time that they publish the occupational employment projecnational growth rate of 1 percent.
tions. For the top 10 fastest-growing industries in Maryland,
West Virginia, Virginia, and South Carolina, some common
trends emerged. Health care and social assistance industries
Projections for Occupational Employment
are expected to show the fastest rates of job growth from
The long-term industry employment projections are inter2008-2018 for the Fifth District states and for the nation.
esting in themselves, but also are critical as input to the
These industries include ambulatory health care services,
projections of occupational employment. Shifts in the
hospitals, nursing and residential care facilities, and social
industrial structure of the economy translate into changes in
assistance. (Industry-level projections for 2008-2018 were
demand for many occupations and, over time, even the
not available from North Carolina and the District of
emergence of new occupations. The occupational employColumbia at press time.)
ment projections reveal how people are employed in the
Virginia projected the fastest job growth in ambulatory
base year and how the composition of employment will
change over the 10-year horizon.
For the nation as a whole, professional and service
Fastest-Growing Occupations — Fifth District States
occupations already accounted for 40 percent of
Financial examiners
occupational employment in 2008 (the base year). By
Biochemists and biophysicists
2018, the share of these broad occupation groups is
Survey researchers
expected to increase to 43 percent. On the other
hand, sales and office and administrative support
Veterinary technologists and technicians
occupations, which together accounted for more than
Medical scientists, except epidemiologists
26 percent of employment in 2008, will likely make up
Home health aides
a smaller share of employment in 2018, due to the
Personal and home care aides
application of technology that reduces the number of
Mathematical scientists, all other
sales personnel and office clerks required to support a
Network systems and data communications
business. Likewise, the share of production workers is
Biomedical engineers
expected to decline, from 6.7 percent in 2008 to 5.9
percent in 2018, as manufacturing continues to impleAverage Annual Growth Rate (Percent), 2008-2018
ment technology that changes the quantity and the
NOTE: Does not include Washington, D.C.
SOURCES: Bureau of Labor Statistics, Individual State Labor Market Information Offices
mix of workers.

Region Focus | First Quarter | 2011



Occupations with Largest Gain — Fifth District States

Personal and home care aides
Management analysts


Nursing aides, orderlies, and attendants


Accountants and auditors


Office clerks, general
Customer service representatives


Retail salespersons


Home health aides
Combined food preparation and serving
workers, including fast food
Registered nurses










Employment Change, 2008-2018
NOTE: Does not include Washington, D.C.
SOURCES: Bureau of Labor Statistics, Individual State Labor Market Information Offices

Across the Fifth District, there is some variation in the
projected composition of employment by occupation in
2018. Maryland and Virginia’s employment in professional
and related occupations will exceed the national average,
with shares of 24.4 percent and 23.9 percent, respectively,
versus 21.8 percent for the nation. South Carolina expects a
higher share of production workers relative to the other
Fifth District states and the nation, but it will also have a
higher share of service and sales related occupations as well
(see table on page 41).
Changing demand for occupations is best explored by a
closer look at some of the 750 occupations for which longterm projections are available. It is helpful to consider the
rate of change in employment by occupation, as well as the
change in the number of jobs by occupation. The fastestgrowing occupations do not necessarily create the greatest
number of jobs, although their growth is important in terms
of the needs of particular industries and the educational programs that generate the pipeline of future workers. Also,
some of the fastest-growing occupations are also the most
highly compensated. In contrast, some of the greatest job
gains will be created in occupations with a modest growth
rate (due to the high number of workers in those occupations), such as cashiers and food preparation, which will
grow fairly steadily to match population growth, or registered nurses, whose numbers will grow to serve the rising
share of older age groups within the population.
Within the Fifth District, biomedical engineers was the
fastest-growing occupation, ranking first for every state,
with an average annual growth of 5.9 percent expected
between 2008 and 2018 in the District, compared to growth
of 5.6 percent nationally. (See chart on page 41.) Together,
Virginia, Maryland, and North Carolina account for 95 percent of the demand for biomedical engineers in the Fifth
District in 2018, although every District state registers a
growth rate of at least 5 percent. Moreover, the median
salary for biomedical engineers in the United States was
$77,400 in 2008, making this a highly compensated occupation. Advances in technology and innovations in medicine
will drive the high growth for biomedical engineers over the
coming decade.


Region Focus | First Quarter | 2011

Other occupations with high rates of expected growth in
the Fifth District include network systems and data communications analysts, mathematical scientists, personal home
care aides, and home health aides, rounding out the top five
growth occupations. The fastest-growing occupations derive
directly from the fast-growing industries projected for the
Fifth District, where health care, data processing, and professional and technical services topped the list.
By comparison, the largest absolute gain in employment
by occupation is in registered nurses, an occupation that is
projected to grow by 61,241 in the Fifth District, far outnumbering other occupations in terms of total jobs created.
(See adjacent chart.) Although employment of registered
nurses is expected to grow in percentage terms at only a moderate rate of 2.2 percent, the growth in the number of
registered nurses implies a greater need for education and
training programs in Fifth District community colleges and
four-year colleges and universities. Registered nurses also
earn relatively high salaries, with the national median of
$62,450 in 2008. Clearly, for individuals with an interest in
nursing, the opportunities are abundant and the wage compensation is significant, especially compared to other
occupations that require a similar education background.
In general, however, many of the occupations with the
greatest gains in employment in the Fifth District are not at
the higher end of the compensation scale. Other occupations that stand to gain large numbers from 2008 to 2018
include food preparers, home health aides, retail sales
persons, and customer service representatives.
Many occupations will experience an outright decline in
the number employed and perhaps a sharp contraction in
their rate of growth. In the Fifth District, these occupations
are employed primarily in industries that have been experiencing structural decline over the past few decades. The
textile and apparel industries, as well as furniture manufacturing, have been particularly pressured by foreign
competition, but also by labor-saving technological
progress. Occupations such as sewing machine operators
and other operators of textile-related machinery will experience a continued decline in employment from 2008 to 2018.
Most of the declining occupations are concentrated in the
production group, both within the Fifth District and nationally. At a local level, communities struggle to provide
employment opportunities to individuals who have lost
their jobs through these structural changes. Workforce
development agencies can use the occupational employment projections to help steer displaced workers in perhaps
a more appropriate direction for retraining in occupations
that have solid growth prospects.

Education and Training Requirements
As an important component of the occupational employment projections, the BLS assigns an education or training
category to each occupation to indicate the most significant
source of postsecondary education or training among
workers who have become fully qualified in that occupation.

The education-related categories include first professional
degree, doctoral degree, master’s degree, bachelor’s degree
plus work experience, bachelor’s degree, associate degree,
and postsecondary vocational award. The postsecondary
vocational award refers to certificates or awards that can be
earned in as long as a year or as short as a few weeks. The
other education categories match the definitions used in the
Census Bureau’s educational attainment data or other
sources of education statistics.
The work-related training categories include work in a
related occupation, which mainly applies to supervisors or
managers, and on-the-job training, which varies in length
and accompanying instruction. Short-term on-the-job training applies to occupations in which the skills needed to be
fully qualified can be acquired during one month or less of
on-the-job experience and a short demonstration of job
duties. Moderate-term on-the-job training involves a period
of one to 12 months of on-the-job experience combined with
informal training to be considered fully qualified in the
occupation. Finally, long-term on-the-job training requires
more than 12 months of on-the-job experience and formal
classroom instruction and may take the form of formal or
informal apprenticeships that last several years.
Employment in occupations that involve some level of
postsecondary award or degree made up about a third of
national employment in 2008, but higher education will
become increasingly important as nearly half of all new jobs
expected to be created from 2008 to 2018 fall in this category.
The same trend holds true for the Fifth District, where education at the level of a postsecondary award or degree will
account for a third of expected employment in 2018, but
nearly half of the growth in employment over the 10-year
period (see the following charts). Indeed, a bachelor’s degree
will be the most significant source of education or training
for 22 percent of the new jobs created from 2008 to 2018.
Most of the fastest-growing jobs in the Fifth District
require at least a bachelor’s degree and include such occupa-

Fifth District — Education and Training Requirements for
Employment Change, 2008-2018
First professional
degree 1.7%
Doctoral degree 1.5%

Short-term on-the-job
training 29.5%

Master’s degree 2.8%
Bachelors or higher
degree, plus work

Bachelor’s degree

Moderate-term on-the-job
training 10.4%
Long-term on-the-job
training 4.6%

Associate degree
vocational award
Work experience in a
related occupation

NOTE: Does not include Washington, D.C.
SOURCES: Bureau of Labor Statistics, Individual State Labor Market Information Offices

tions as biomedical engineers, network systems and data
communications analysts, and financial examiners. The
occupation predicted to grow the most in absolute terms in
the Fifth District, registered nurses, requires at least an associate’s degree to be fully qualified. Nonetheless, there will
still be many jobs that require only short-term on-the-job
training, as this category will account for 36 percent of
projected employment in the Fifth District in 2018 and 30
percent of employment growth from 2008 to 2018.
As noted earlier, jobs requiring a higher level of education
and training earn a higher median wage. Nationally, jobs
requiring a bachelor’s degree paid a median wage of $57,770
in 2008, while jobs that required only short-term on-the-job
training paid $21,320. Several occupations predicted to gain
in great numbers in the Fifth District fall in the category of
short-term on-the-job training, including food preparers and
servers, home health aides, and retail salespersons.


Fifth District — Education and Training Requirements
for Projected Employment (2018)
First professional
degree 1.2%
Doctoral degree 0.9%
Master’s degree 1.7%
Bachelor’s or higher
degree, plus work
experience 4.6%
Short-term on-the-job
training 35.5%

Bachelor’s degree
Associate degree
vocational award
Work experience in a
related occupation

Moderate-term on-the-job
training 15.2%
Long-term on-the-job
training 6.4%

NOTE: Does not include Washington, D.C.
SOURCES: Bureau of Labor Statistics, Individual State Labor Market Information Offices

As a faster pace of job gains likely takes hold this year, the
labor market will quickly reveal which occupations are in
highest demand. It is equally important, however, to look
further ahead to understand the longer-term changes in our
economy as they relate to the demand for specific occupations. Projections from the BLS provide 10-year industry
and occupation projections at the national level, while the
individual efforts of state labor market information agencies
produce state- and local-level projections.
In combination with information on education and training requirements, the occupational projections provide
powerful information for individuals entering the labor market or considering a career change, as well as the counselors,
advisers, and educational institutions who serve them. In
addition, the long-term occupational employment projections provide a view of future labor demand so that local
economic developers and providers of education and training can synchronize their efforts more effectively.

Region Focus | First Quarter | 2011


State Data, Q3:10












Q/Q Percent Change
Y/Y Percent Change













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







Professional/Business Services Employment (000s) 149.3
Q/Q Percent Change
Y/Y Percent Change






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







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

























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







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







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







Nonfarm Employment (000s)

Unemployment Rate (%)
Real Personal Income ($Mil)
Q/Q Percent Change
Y/Y Percent Change


Region Focus | First Quarter | 2011

Nonfarm Employment

Unemployment Rate

Real Personal Income

Change From Prior Year

First Quarter 2000 - Third Quarter 2010

Change From Prior Year

First Quarter 2000 - Third Quarter 2010

First Quarter 2000 - Third Quarter 2010




00 01 02 03 04 05 06 07 08 09


00 01 02 03 04 05 06 07 08 09

Fifth District


00 01 02 03 04 05 06 07 08 09

United States

Nonfarm Employment
Metropolitan Areas

Unemployment Rate
Metropolitan Areas

Building Permits

Change From Prior Year

Change From Prior Year

First Quarter 2000 - Third Quarter 2010

First Quarter 2000 - Third Quarter 2010

First Quarter 2000 - Third Quarter 2010


Change From Prior Year


00 01 02 03 04 05 06 07 08 09


00 01 02 03 04 05 06 07 08 09





Manufacturing Composite Index

First Quarter 2000 - Third Quarter 2010

First Quarter 2000 - Third Quarter 2010







First Quarter 2000 - Third Quarter 2010




00 01 02 03 04 05 06 07 08 09


United States

Change From Prior Year



Fifth District


House Prices



00 01 02 03 04 05 06 07 08 09


Services Revenues Index



00 01 02 03 04 05 06 07 08 09


00 01 02 03 04 05 06 07 08 09
Fifth District


United States



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
2) Building permits and house prices are not seasonally adjusted; 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,
Employment: CES Survey, Bureau of Labor Statistics, U.S. Department of Labor,
Building permits: U.S. Census Bureau,
House prices: Federal Housing Finance Agency,

Region Focus | First Quarter | 2011


Metropolitan Area Data, Q3:10
Washington, DC
Nonfarm Employment (000s)
Q/Q Percent Change
Y/Y Percent Change

Hagerstown-Martinsburg, MD-WV










Asheville, NC

Charlotte, NC

Durham, NC




Unemployment Rate (%)




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




Raleigh, NC

Wilmington, NC




Unemployment Rate (%)




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




Unemployment Rate (%)
Building Permits
Q/Q Percent Change
Y/Y Percent Change

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

Greensboro-High Point, NC
Nonfarm Employment (000s)
Q/Q Percent Change
Y/Y Percent Change


Baltimore, MD

Region Focus | First Quarter | 2011

Winston-Salem, NC

Charleston, SC

Columbia, SC




Unemployment Rate (%)




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




Greenville, SC

Richmond, VA

Roanoke, VA










Virginia Beach-Norfolk, VA

Charleston, WV










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

Nonfarm Employment (000s)
Q/Q Percent Change
Y/Y Percent Change
Unemployment Rate (%)
Building Permits
Q/Q Percent Change
Y/Y Percent Change

Nonfarm Employment (000s)
Q/Q Percent Change
Y/Y Percent Change
Unemployment Rate (%)
Building Permits
Q/Q Percent Change
Y/Y Percent Change

Huntington, WV

For more information, contact Sonya Ravindranath Waddell at (804) 697-2694 or e-mail

Region Focus | First Quarter | 2011


Should the Financial Crisis and Historic Recession
of 2007-2009 Change the Practice of Economics?

and institutions to function so poorly. Both of these narraf course it should, and it will. As our cover story
tives occupy places in the mainstream of financial
in this issue of Region Focus makes clear, the
economics. One is that financial fragility results from
economics profession has always learned from
externalities in the distribution of risk in markets. These
events. And events of the magnitude and uniqueness as
externalities have to do with the effects of one firm’s
those seen in the period we’ve just come through can have
performance — especially when it incurs large losses — on
a profound impact on how scholars and policy analysts
another’s condition. Because firms don’t take these external
frame and approach questions. For instance, the discipline
effects into account, they take on more risk than they otheris still learning about and adapting its work in response to
wise would. This results also in the mispricing of risk. This
the Great Depression, as debates continue regarding its
narrative is really just a version of a concept — externalities
causes, the effectiveness of policy responses, and how it
— which has been a part of mainstream economic thought
compares to other significant contractions throughout
since at least the late 1890s when
history and around the world.
Alfred Marshall formally identified
But I think those who foreOf particular interest in the the issue and then his student
see wholesale change in economic
science are likely to be disappointed.
wake of the financial crisis is Arthur Pigou further developed the
idea and its potential implications
The events of the last few years are
not cause to throw out the prevailthe profession’s approach to for public policy. There is an active
body of theoretical research articuing paradigm in economic research
the study of financial
lating the conditions under which
— the notion that resource allocasuch systemic externalities might
tion can be understood in the
markets and institutions.
arise, although empirical validation
context of individual optimization,
has proved a challenge.
with the reconciliation of conflictAn alternative, although not mutually exclusive narrative,
ing goals being achieved through the equilibrium of a market
suggests that the mispricing of risk and the associated
mechanism. That itself is a pretty big tent, and it contains
tendency of firms to take on too much risk is the result of
within it many lines of research and ideas that may prove
government policy. In particular, if market participants
useful in making sense of our extraordinary recent past.
believe that the government will protect firms or their
Of particular interest in the wake of the financial crisis is
creditors from severe losses in the event of a financial crisis,
the profession’s approach to the study of financial markets
then they will tend to underweight risk in making their
and institutions. A caricatured depiction of the discipline’s
investment decisions. Just like externalities, this will lead to
approach to financial market behavior would be to say that
the underpricing of risk. This moral hazard view of financial
economists put too much weight on the efficient markets
market dysfunction has also been a part of mainstream
hypothesis and therefore missed indicators of dysfunction
research for a long time.
in markets. But the efficient markets hypothesis — roughly
So economists were working out ideas about financial
stated, that well-functioning markets do a good job of incorinstability well before the crisis. Unfortunately, that work
porating relevant information about fundamentals into asset
had not yet gotten us to the point of being able to quantify
prices — is really just a benchmark against which to measure
the effects of either externalities or moral hazard. The
observed financial market performance. One important line
events of the last few years will have a powerful influence on
of research in the mainstream of financial economics is to
how these and related lines of research continue, and should
take apparent deviations from market efficiency — evidence
help us better understand the relative importance of alternaof mispriced assets — seriously, and to seek to understand
tive financial market imperfections.
the frictions that cause observed behavior to differ from the
There are two narratives about the financial crisis that
John A. Weinberg is senior vice president and director of
represent different views about which forces caused markets
research at the Federal Reserve Bank of Richmond.



Region Focus | First Quarter | 2011

International Housing Policy
As the United States debates how to reform housing finance
policy, some useful insights can be drawn from other developed
nations — many of which direct far fewer resources toward
subsidizing housing finance.

Bruce Yandle of Clemson University
discusses environmental policy, the deficit,
and his experience making the transition
from business to academic economics.

Economic History

Development Economics
Despite decades of effort and billions of dollars donated in
foreign aid each year, 1.5 billion people still live in extreme
poverty, on less than $1.25 per day. What do economists know
about why some countries thrive economically while others
struggle to develop? What should rich countries and international institutions be doing to help?

For more than 180 years, railroads have
played a vital role in the economic development of the Fifth District and the United
States. Pioneering carriers, such as the
Baltimore and Ohio Railroad, overcame
many obstacles to increase productivity and
expand trade throughout the region and

Disaster Relief


Is it unwise to target donations in the wake of a disaster? Some
economists say such donations may pour money into affected
regions inefficiently and divert money from other needy areas.
Donations may be more effective when organizations with
broader missions can direct funds as needed.

Does success in high-profile athletic events
at universities lead to an increase in applicants and alumni donations?

Visit us online:
• To view each issue’s articles
and Web-exclusive content
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our online issue posting

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

Change Service Requested

Please send subscription changes or address corrections to Research Publications or call (800) 322-0565.

• “A Regional Look at the Role of
House Prices and Labor Market
Conditions in Mortgage Default”
by Sonya Ravindranath Waddell,
Anne Davlin, and Edward Simpson Prescott

• “Housing and the Great Recession:
A VAR Accounting Exercise”
by Samuel E. Henly and
Alexander L. Wolman

• “Optimal Contracts for Housing
Services Purchases”
by Borys Grochulski

• “Mortgage Reform and Growing
Exposure of the Federal Housing
Administration’s Mortgage Mutual
Insurance Fund” by Brent C Smith

You can access Economic Quarterly and more at: