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What Causes Recoveries? How good policy and good luck
can trigger the upward side of the business cycle
As economies recover from recessions the transition often can be
slow and unpredictable. Yet economists have studied this process
less than one might expect. Many factors play important roles in
determining the recovery process, including prudent monetary
policy, clean balance sheets, consumer and business confidence,
and exogenous shocks.

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


Aaron Steelman

Debts and Defaults: The growing market — and tab — for
student loans


Student loan debt has increased greatly in recent years, as have the
default rates on that debt. Rising tuition rates, federal subsidies, and
securitization contributed to the increase, but new regulations may lead
to significant changes for both lenders and borrowers.

Kathy Constant

Renee Courtois Haltom
Betty Joyce Nash
David A. Price


Caretaking the Culture: Art museums strive for
financial stability


The Virginia Museum of Fine Arts recently unveiled the biggest
expansion in its history, designed to turn the 75-year-old museum into
a public gathering place. Although it’s a challenge for museums to
charge visitors in a way that fully pays the bills, ensuring widespread
accessibility to patrons is an important part of their mission.

Triangulating the Recession: Knowledge jobs lend resistance,
but not immunity, to downturn
The Triangle region of North Carolina may not be recession-proof,
but it’s surely cushioned by its mix of high-skilled jobs in fields such
as the life sciences, pharmaceuticals, and math-intensive professions.


1 President’s Message/Questions Surrounding the Fed’s ‘Exit Strategy’
2 Upfront/Regional News at a Glance
6 Federal Reserve/The CRA and the Subprime Crisis
10 Jargon Alert/Information Asymmetry
1 1 Research Spotlight/Do Natural Resources Support Economic Growth?
12 Policy Update/Fed Launches Round Two of ‘Quantitative Easing’
13 Around the Fed/The Double Whammy of Foreclosures
26 Interview/David Feldman
31 Book Review/Stumbling on Wins
32 Economic History/The Queen’s Private Navy
36 District Digest/Economic Trends Across the Region
44 Opinion/How Many Kinds of Unemployment?


Jessie Romero
Charles Gerena
Becky Johnsen
Richard Kaglic
Sonya Ravindranath Waddell

BIG (Beatley Gravitt, Inc.)
Published quarterly by
the Federal Reserve Bank
of Richmond
P.O. Box 27622
Richmond, VA 23261
Subscriptions and additional
copies: Available free of
charge through our Web site at
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Publications at (800) 322-0565.
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with the disclaimer in italics
below. Permission from the editor
is required before reprinting
photos, charts, and tables. Credit
Region Focus and send the editor a
copy of the publication in which
the reprinted material appears.
The views expressed in Region Focus
are those of the contributors and not
necessarily those of the Federal Reserve Bank
of Richmond or the Federal
Reserve System.
ISSN 1093-1767

Questions Surrounding the Fed’s ‘Exit Strategy’
he U.S. economy, despite officially in recovery from
the most severe recession since the end of the
Great Depression, still shows signs of weakness in
the labor market: Nearly 10 percent of Americans are out
of work and face very real difficulties. As a result of the
relatively sluggish pace of this recovery and because of the
low rates of inflation we have been experiencing, the
Federal Reserve has continued to pursue accommodative
monetary policies. The target for the federal funds rate
remains between 0 and 0.25 percent, and in November the
Fed decided to expand its balance sheet (which was already
more than $2 trillion) by another $600 billion by the end
of the second quarter of 2011 through the purchase of longterm Treasury securities. These actions reflected the view
that the risk of further economic weakening outweighed
the risk of inflation.
Currently, the outlook for inflation remains good. Prices,
measured broadly, rose only about 1 percent over the last
year, less than half of the rate during the years preceding the
recession. Moreover, it appears that market participants
believe that inflation will remain relatively low — around
2 percent on an annual basis over the next five years.
Nevertheless, the Fed remains steadfast in its commitment
to maintaining price stability. Doing so requires varying the
degree of monetary accommodation as overall economic
conditions vary over the business cycle. As the economic
recovery picks up, there will come a time when monetary
policy will need to be less accommodative. In short, the
Fed must consider an “exit strategy” and be prepared to
implement it when growth has become strong and well
Decisionmaking regarding monetary policy is always
an inexact process. The Fed — meaning both the Board
of Governors and the 12 Reserve Banks — employs sophisticated models as well as more “on the ground” anecdotal
information to assess the likely path of the economy and
which policies to pursue as a result of that evaluation.
But the task at hand is particularly tricky. The Fed must be
careful not to tighten too quickly, a course that could potentially stifle the recovery. At the same time, it must not be too
loose for too long and potentially stoke inflation. In other
words, it’s not a question of whether the Fed should change
course — but of when and how.
I don’t have a rigid timeline about the “when” part of that
issue. That will depend upon how the economy behaves in
coming months. Most private forecasters are predicting that
growth will be roughly 4 percent in 2011. My own view is in
line with that.
As for the “how,” the central question has to do with
sequencing. The Fed has a few options for withdrawing


monetary accommodation. It
could first raise the interest
rate on reserves that commercial banks hold at the Reserve
Banks, and then reduce the size
of the balance sheet through
asset sales. This would put
upward pressure on other
short-term interest rates since
banks would not be willing to
supply short-term funds to the
money markets at rates significantly below what they can
receive by holding reserves with the Fed. Commercial banks’
reserve balances would remain elevated, however, due to the
delay in asset sales, and this would put downward pressure on
interest rates.
An alternative is to begin selling assets before raising
short-term interest rates. This approach would eliminate
more rapidly the distortions caused by the Fed’s intervention
in mortgage-backed security markets, and would have the
advantage of providing more confidence to market participants in projecting the effects of raising the interest rate on
reserves, when the time comes.
My colleagues on the Federal Open Market Committee
have discussed the merits of these alternative approaches to
withdrawing monetary accommodation, but no decisions
have been made. There is a consensus, however, that keeping
the federal funds rate near zero indefinitely is not tenable —
it will have to rise over time.
Evidence that the economy appears to be picking up
pace brings with it weighty questions about how the Fed
should respond, just as the financial crisis did. Happily,
the questions we now face involve analysis of the pace of
recovery rather than the pace of decline. My colleagues and
I will give these questions the same careful scrutiny that we
did when the economy faced the shocks that led to the
recession of 2007-09.


Region Focus | Fourth Quarter | 2010



Regional News at a Glance

Sunbelt Hockey

All-Star Location is a Coup for ‘Caniacs’


The National Hockey League’s puck stopped in Raleigh last January, when it held its 2011
All-Star Celebration at the home arena of the Carolina Hurricanes. Hosting the sold-out
event was something of a coup for Triangle hockey fans, a.k.a. the Caniacs.
The All-Star game wasn’t the first time the Triangle
has served as a hockey magnet. The Hurricanes hosted
the Stanley Cup Final in 2002 and 2006, as well as the
NHL Entry Draft in 2004. The Hurricanes won the
Cup in 2006, a sweet victory in light of the cancellation
of the NHL 2004-2005 season due to a labor dispute.
“Fifteen years ago, we had zero hockey presence,” says
Scott DuPree, vice president for sports marketing for
the Greater Raleigh Convention and Visitors’ Bureau.
“Now we have thousands of fans; the arena draws big.”
So big, it drew the All-Star game. The All-Star game
and events were about “recognizing a market that’s
already been successful,” says Mike Sundheim, the
Hurricanes’ director of media relations. The team in
2009 and 2002 was in the playoffs in addition to its
Stanley Cup win in 2006. “Nothing builds fan base like
a championship.”
The NHL began its expansion into the South in the

The Hurricanes celebrate after a 4-3 overtime victory
over the Atlanta Thrashers in January 2011.


Region Focus | Fourth Quarter | 2010

1990s — the Hurricanes moved from Hartford, Conn.
The NHL sought a national footprint to win television
contracts as the population shifted to the Sunbelt. It
was assumed Northern fans would follow Southern
teams, according to Larry DeGaris, associate professor
of sports marketing at the University of Indianapolis.
It hasn’t worked quite that way. The NHL has a threeyear contract with Comcast’s Versus cable channel, not
a major network. Some teams struggle to fill seats,
especially during the economic slowdown as corporate
demand for luxury seats declined. Today, the Southeast
Division includes the Washington Capitals, Carolina
Hurricanes, Florida Panthers, Tampa Bay Lightning,
and Atlanta Thrashers.
Another problem: When Rangers fans from New
York move, for example, to South Florida, they’re still
Rangers fans, DeGaris says. “They can’t go to the
[Rangers] games, but they can watch them on television, so they can still be fans, and even participate in
the fantasy leagues.” But simply because teams have
been slow to catch on doesn’t mean they’re not feasible.
“You look at population growth and where the trends
are, if you’re looking to the future, any strategy has to
include the Sunbelt.” He points out the proliferation of
minor league hockey teams, though those tend to come
and go.
Southern teams’ attendance lags that of stalwarts
like the Detroit Red Wings, of course, DeGaris notes.
But the Hurricanes have averaged between 85 percent
and 93 percent of capacity since 2006-2007, except
2009-2010, when attendance fell to 81.6 percent,
primarily because of the recession, Sundheim says.
Hockey in the South may take time to a build fan
base, and some sports bloggers even speculate that
attendance numbers are bloated because of giveaways
and promotions. But many variables drive attendance
and DeGaris believes fan interest is growing. “Hockey
is a great live event,” he says. “It’s like auto racing — it’s
visceral, you can smell the ice shavings, the Zamboni.”

Trimming Costs

NC Health Plan Penalizes Obese State Workers


n July, the North Carolina State Health Plan will increase
insurance premiums for state employees with a Body Mass
Index (BMI) of 40 or higher. The plan covers more than 600,000
state employees, retirees, and teachers.
BMI is the ratio of an adult’s weight to height that roughly
correlates to the percentage of fat compared to total weight.
A person with a BMI of 30 or above may be considered obese,
but whether the BMI presents a health risk for an individual
would need to be determined by a variety of health assessments, according to the Centers for Disease Control. People
who are obese are considered at greater risk for chronic disease,
including heart disease, stroke, diabetes, and some types of
In the past decade, obesity often has been labeled an “American epidemic.” According to the CDC’s Behavioral Risk Factor
Surveillance System (BRFSS), the national median percentage of
adults who are obese jumped from 15.9 percent in 1995 to 26.9
percent in 2009. The BRFSS generates a wide variety of health
information through monthly telephone surveys conducted by
state health departments with technical help from the CDC.
Data are aggregated for each state by the CDC.
In the Fifth District, three jurisdictions fall below the
national average in their percentages of obese adults: the District of Columbia at 20.1 percent, Virginia at 25.5 percent, and
Maryland at 26.8 percent. States above the national average in
the Fifth District are South Carolina at 30.1 percent, West
Virginia at 31.7 percent, and North Carolina at 30.1 percent. In
the Carolinas, percentages of obesity have almost doubled
since 1995.
North Carolina implemented its new policy, called the Wellness Initiative, to cut rising insurance costs and improve workers’
health. The state Legislature in 2009 rescued the health plan
with $250 million to pay bills; the plan is slated for more money
from the general fund in the coming year. Currently, state
employees of any BMI can choose between two insurance policies with different co-pays, co-insurance, and deductibles. Starting in July, however, all members will be enrolled in one plan,
which has higher co-pays and co-insurance; only members who
have a BMI lower than 40 can enroll in the alternate plan. Moreover, in July 2012, the BMI requirement will be lowered to 35.
This plan also restricts the insurance options for employees
who use tobacco and are not actively trying to quit.
North Carolina is doing so because tobacco use and obesity
cause the largest number of preventable deaths in the state,
according to the state’s Web site.

Obesity Trends* Among U.S. Adults

*BMI ≥ 30, or approximately 30 lbs. overweight for a 5'4'' person
SOURCE: Behavioral Risk Factor Surveillance System (BRFSS), CDC, 2009

But not all health experts believe the add-on will help.
Dr. Eric Finkelstein, deputy director for health services and
systems research at Duke-National University of Singapore,
doubts that this policy will significantly affect rates of obesity
among state employees, but may instead have other benefits.
“Few people are going to change their lifestyle over this, in my
opinion,” Finkelstein says. “They will just pay the additional fee.
However, it will help the state health plan because they are
essentially charging more money for obese people so it helps
defray the associated costs.”
Finkelstein in October 2010 published a study in the Journal
of Occupational and Environmental Medicine that quantified
the per-capita cost of obesity among full-time employees at
$16,900 for obese women with a BMI over 40 and $15,500 for
obese men of the same BMI range. This study concluded that
the aggregate cost to employers was $73.1 billion a year. The
costs were incurred as a result of employee medical costs,
health-related absenteeism, and “presenteeism,” where workers
report to work yet produce less due to poor health.
Finkelstein has an alternative to combat obesity in the workplace. “I would put incentive strategies in place that encourage
people to make healthy choices, like rewards or subsidies for
program participation, and I would strongly encourage those
choices.” Even so, Finkelstein predicts that other states will soon
adopt similar policies to those in North Carolina. He also foresees private employers instituting penalties for obesity.

Region Focus | Fourth Quarter | 2010


Coal Conversion

Gas Price Spikes Inspire Technology


$3 billion coal-to-gasoline plant is slated for Mingo County, W.Va.,
over objections from environmental groups. The plant will be built by
New York-based TransGas Development Systems.
Adam Victor, the company president, says the plant was inspired by
Hurricane Katrina’s impact on Gulf Coast refineries. “We saw prices for fuel
go up four times in one day, and started looking for ways to mitigate our
fuel costs,” he says.
The firm decided on coal to liquids after exploring other technologies:
ethanol, biomass, biodiesel, and wood gasification. The predecessor technology was used in Germany to make synthetic fuel from coal in the World
War II until the Allies began bombing the synfuels plants in late 1944 and
early 1945.
The TransGas plant is designed to convert coal from the region, an
estimated 3 million tons annually, into 756,000 gallons per day of premiumgrade gasoline. The process produces methanol, then cleanses it to make a
sulfur-free gasoline, according to Victor. The plant expects to employ 3,000
people during construction, starting in June 2011, and 250 thereafter. The
plant is likely to be fully operational by June 2015. Victor says the firm plans
an IPO on the London Stock Exchange in the second quarter of 2011.
At issue are potential emissions such as carbon dioxide and the plant’s
classification as a minor source of pollution, a status requiring less scrutiny.
The permit is under appeal. Carbon emissions are widely considered a contributor to global warming, and recently finalized carbon regulations by the
U.S. Environmental Protection Agency are under way. New emissions standards for cars and trucks were issued in March 2010, effective over the 2012

to 2016 period. New permitting rules for stationary sources, effective Jan. 2,
2011, will require “best available control technology” for major sources of
greenhouse gases. By July 1, 2011, a second phase will affect new and modified sources.
The TransGas project has obtained its permit to build and operate the
plant from the West Virginia Department of Environmental Protection and
will not be subject to the new rule. Though the permit is under appeal, the
project will go forward but revisions to the permit could delay its start,
according to Ronald Potesta, of the Charleston, W.Va., engineering firm that
prepared the TransGas permit application.
TransGas chose its location partly because of supportive infrastructure,
such as the King Coal Highway. The current development along the highway
includes the Mingo Hybrid Energy Park, where the coal-to-gas plant will
locate. The first 10-mile section of the highway will be completed by July
2011, with another five miles expected to be finished by fall 2012. The 15
miles of road is a public-private project, costing about $125 million. Coal
company preparation of the roadbed, as part of strip mine reclamation,
has reduced the projected taxpayer cost by an estimated $270 million,
according to Mike Whitt of the Mingo County Redevelopment Authority.
The highway is a 94-mile section of Interstate 73 that ultimately will span
the distance from Sault Ste. Marie, Mich., to Myrtle Beach, S.C.
Officials in southern West Virginia hope the highway will invigorate the
region’s economy. In 2006, mining employed 9.6 percent of workers in the
region compared to 20 percent in 1970 and 1980.

Home Economics

Birth Rates Dip Again in 2009
n his studies of the economics of the family, economist
Gary Becker has described children as a consumption
good. If he’s right, it might make sense during a recession
for people to put off the baby and the new refrigerator.
The moribund economy may have pushed down the
United States’ crude birth rate, but demographers caution
against putting too much stock in the preliminary numbers.
The United States remains on track to maintain population, though births fell from 13.9 births per 1,000 people to
13.5. That was a 2.6 percent decline compared to 2008,
which in turn had fallen by 1.6 percent over the previous
peak birth year, 2007.
The U.S. birth rate is among the highest of developed
countries, but fertility in some European countries had
begun to rise. In 2009, most of those nations’ rates stayed
the same or declined slightly. “Although the drop in fertility



Region Focus | Fourth Quarter | 2010

has not been across the board, there are many developed
countries in Europe and Asia that are experiencing
fertility declines similar to that of the United States,” says
demographer Mark Mather of the Population Reference
Bureau (PRB).
Rising wages for female workers and other labor market
trends, along with widely available contraceptives, have led
to lower fertility rates over the past 30 years. Rates recently
had begun to climb in some countries, such as France.
Possible explanations for U.S. declines include increased
unemployment that may have slowed immigration or
spurred immigrants to leave the United States; the fertility
rate for Hispanic women fell by 3 percent in 2008.
The total fertility rate — the average number of children a woman would bear, given current birth rates, over
a lifetime — in the United States fell slightly in 2009,

Total Fertility Rate* for Low Birth Rate Countries
1999 to 2009
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
United Kingdom
United States**

*Total Fertility Rate: average number of children a woman would bear over a
lifetime, given current fertility rates
SOURCE: Population Reference Bureau

from 2.086 births per thousand in 2008 to 2.043 in 2009.
Birth rates had risen to 2.123 in 2007. Birth rates in lowfertility rate countries also fell. In Spain, for example,
where rates had climbed from 1.173 in 1995 to 1.458 in
2008, the total fertility rate in 2009 slipped to 1.400,
according to the PRB. That’s despite the government’s
$3,000 per child cash-for-kids program, slated for termi-

nation in January 2011. Rates also fell slightly in Germany,
France, and the United Kingdom.
A new working paper examines the effects of housing
wealth on birth rates. Economists Michael Lovenheim
of Cornell University and Kevin Mumford of Purdue
University used differences in the timing and size of
the housing market boom and decline, over time, across
different states. The study finds that for homeowners
a $10,000 increase in real housing wealth causes a 0.07
percent increase in fertility. The authors found few effects
of housing price growth at the MSA level on the fertility of
renters. “That increases in housing wealth are strongly
associated with increases in fertility is consistent with some
recent work showing a positive income effect on birth,” the
authors write. Estimates suggest that recent housing market
variations could have “sizeable demographic effects that are
driven by the positive effect of housing wealth on fertility.”
Their results were published in a Stanford Institute for
Economic Policy Research discussion paper.

New Life for Failed Banks

‘Shelf Charters’ Let Investors Become Bankers
ank failures are increasing nationwide, but the Fifth
District has fared better compared to other areas of
the country. From the beginning of 2008 through the end
of 2010, 15 banks in the District (which includes five states
and Washington, D.C.) were “resolved” by regulators and
the Federal Deposit Insurance Corporation (FDIC). In
nearby Georgia and Florida, 51 and 45 banks failed,
respectively; eight other states also had double-digit
failures. Two of the banks that closed in the Fifth District
were acquired not by other established banks, the traditional approach, but instead by approved investor groups
participating in a new preliminary charter process.
When a bank fails, the best outcome is acquisition
by another institution, which costs the FDIC’s deposit
insurance fund less and is also less disruptive to the bank’s
customers. The FDIC maintains a database of potential
bidders on failed banks, and once it becomes certain that a
bank will be closed, the agency “markets” the bank via a
confidential e-mail to potential buyers. (The failing bank is
not identified in the e-mail; interested bidders later receive
a link to a secure Web site with more details.)


Previously, only groups with deposit insurance — i.e.,
existing banks — were eligible to bid. But to keep pace with
the anticipated number of failures, in the fall of 2008 the
(continued on page 35)





K Bank
Ideal Federal Savings Bank
Bay National Bank

Randallstown, MD
Baltimore, MD
Baltimore, MD


M&T Bank
No Acquirer
Bay Bank, FSB*

Nov 2010
July 2010
July 2010

Waterfield Bank
Bradford Bank
Suburban FSB
Cooperative Bank
Cape Fear Bank

Germantown, MD
Baltimore, MD
Crofton, MD
Wilmington, NC
Wilmington, NC


No Acquirer
M&T Bank
Bank of Essex
First Bank
First Federal Savings
and Loan Association

Mar 2010
Aug 2009
Jan 2009
Jun 2009
Apr 2009

Williamsburg First
National Bank
First National Bank
of the South
Woodlands Bank
Beach First National Bank
Imperial Savings
and Loan Association
Greater Atlantic Bank

Kingstree, SC


First Citizens Bank
and Trust Company, Inc.
NAFH National Bank*

Jul 2010

Fifth District Failed Banks


Spartanburg, SC


Bluffton, SC
Myrtle Beach, SC
Martinsville, VA


Reston, VA


Bank of the Ozarks
Bank of North Carolina
River Community Bank,

Northfork, WV


The Citizens Savings Bank

Jul 2010
Jul 2010
Apr 2010
Aug 2010
Dec 2009
Sep 2008

*Formed by Hovde Private Equity Advisors LLC and North American Financial Holdings, respectively

SOURCE: Federal Deposit Insurance Corporation

Region Focus | Fourth Quarter | 2010


The CRA and the Subprime Crisis
The Community
Reinvestment Act
didn’t cause it,
but there are still
for improvement

or more than 30 years, the Fed
and the other bank regulators
have been responsible for
evaluating the extent to which banks
meet the lending needs of their
communities. The Community Reinvestment Act, or CRA, sets this
obligation, and regulators can hold up
the expansion plans of banks that fail
to perform well, so there is strong
incentive for them to comply. Since
the CRA may push banks into what
are perceived to be riskier lending
areas, onlookers ranging from thinktank analysts to policymakers have
wondered whether it played a large
role in fueling the subprime lending
boom and bust. Some critics even say
the crisis is proof that the CRA
should be abolished, while others
argue it played at most a small part in
the housing boom and bust of the
past decade.
The CRA was originally designed
to attack the urban decay that took off
after World War II. Policymakers
viewed the deterioration of urban


The Community Reinvestment Act was created to prohibit redlining, shown in
this Philadelphia area map. Banks literally drew a line around certain
low-income, often ethnic, neighborhoods and placed limits on lending to them.


Region Focus | Fourth Quarter | 2010

cores as partly the result of
constrained credit to resident homeowners and businesses. Sometimes
this was the result of explicit discrimination through “redlining,” which
most CRA historians trace back to a
1930s effort by the federal Home
Owners’ Loan Corporation (HOLC), a
New Deal-era organization created to
prop the real estate industry.
The HOLC was asked to assess real
estate lending risks of 239 U.S. cities.
Officials drew color-coded maps
based on perceived risks and assigned
the color red to the riskiest areas,
defined in part as having a high
concentration of African-Americans.
Although the government retreated
from explicitly racial policies after a
Supreme Court decision in the late
1940s striking down racial deed
covenants, banks mimicked the
practice and continued to profile
neighborhoods into the 1970s. They
applied stricter lending terms to the
(typically) minority borrowers within
those neighborhoods, or refused to
lend at all.
Discrimination wasn’t the only
cause of constrained credit; market
frictions also existed. Borrower risk
was harder to assess in the late 1970s
when the Act was created, particularly
in unpioneered markets. Relatively
fewer home sales in underserved areas
made real estate appraisals difficult.
By the same token, borrowers in
lower-income markets tend to have
sparser credit history from which to
assess risk. The first bank to enter an
underserved market had significant
work to do to investigate the risks and
prospects of borrowers, but once the
inroads were made, information
proved difficult to keep proprietary.
This led to the “first mover” problem
in which no bank had sufficient incentive to extend loans or even establish a
branch in underserved areas.



Thus the CRA was created to induce banks to extend
loans that they presumably would not have otherwise. This
was rationalized by the government support banks receive
through deposit insurance and access to the Fed’s discount
window. Government and ultimately taxpayer support
seemed to imply an obligation to meet the credit needs of
entire communities, not just the safest lending risks.
The CRA also fit the spirit of the day. Lawmakers passed
the CRA in 1977 amidst a chain of similar laws aimed toward
strengthening access to credit services for poorer populations and minorities. Those included the Fair Housing Act of
1968 and the Equal Credit Opportunity Act of 1974, both of
which focused explicitly on racial discrimination. The CRA’s
main provisions omit mention of race, instead focusing
more broadly on low-to-moderate (LMI) income communities. The Act states that financial institutions have an
“affirmative obligation” to meet the credit needs of the local
communities in which they are chartered. In practice, banks
are rated on three categories of activity — lending to borrowers in LMI communities, investment in community
development, and financial services, ranging from the availability of ATMs to financial education — and how that
activity is distributed across neighborhoods and borrowers
of different income thresholds. The weights applied to each
of those categories vary by bank asset size, but lending —
consumer, homeowner, small-business loans, among other
types of credit — is weighted highest.
There are no explicit lending quotas under the CRA, but
regulators can hold up the merger or expansion plans of a
bank that fails to achieve a passing rating of “Satisfactory” or
“Outstanding.” CRA ratings began to be published in 1989,
and advocacy groups began to use the newly available data to
protest the plans of banks that did not perform well on CRA
exams through the public comment process and merger
hearings. This intensified the imperative to perform well on
CRA exams, especially after restrictions on interstate
branching were lifted in the mid-1990s and bank merger
applications surged. Banks responded by ramping up their
CRA programs.
The CRA’s passage in 1977 was not without controversy.
Opponents voiced arguments that aren’t much different
from those of the CRA’s critics today: It would distort markets, unduly burden financial institutions, and encourage,
if not mandate, unsound lending. The latter argument has
escalated following the subprime mortgage lending boom
and bust. Many economists, both supporters and opponents
of the CRA, argue that it did not play a large role in the
crisis. At the same time, most regulators and community
development practitioners agree that its current form is
somewhat outdated in the modern financial system.

Does the CRA Lead to Unsound Lending?
The role of the banking system is to allocate credit to its
most productive uses. The modern banking system is generally based on the premise that banks can accomplish this
goal most efficiently if they are able to make loans which are

most profitable to them within the bounds of safety and
soundness regulations. Accordingly, the 1977 CRA language
emphasized that all CRA-related loans should comply with
normal safety and soundness standards. Rather than inducing banks to extend unduly risky loans, the CRA was
couched as a way to force banks to look harder to identify
profitable lending opportunities in LMI areas that they otherwise might have avoided. If constrained credit was the
result of discrimination and market frictions — as opposed
to heightened credit risk in LMI areas — then in theory the
CRA could increase LMI lending without sacrificing safety
or profitability.
Most studies have found that the CRA had a net positive
effect on lending to LMI communities, though some mixed
results have stemmed from the difficulty of controlling for
the myriad other factors that affect lending. For instance,
lending to LMI populations has certainly increased faster
than higher income lending, but this could also reflect coincident factors such as fair lending laws and a stronger
cultural norm against discrimination.
A 2003 study by economists Robert Avery, Paul Calem,
and Glenn Canner of the Federal Reserve Board looked at
census tracts, or geographic areas, just above and just below
the LMI threshold of 80 percent of median family income.
At the 1990 census, tracts just below the threshold had lower
homeownership and higher vacancy rates than households
just above the threshold. By 2000 there was very little difference between them. The CRA would have focused on
households just below the threshold, so the authors conclude that at least part of the improvement in LMI
households most likely resulted from the CRA.
It is also likely that the CRA resulted in loosened lending
standards in some cases. Critics point to at least one significant change that may have had this effect. The original CRA
framework consisted of 12 criteria that granted banks credit
for attempts to locate LMI lending opportunities. Critics
and advocacy groups argued that banks could skirt the
CRA’s intent by showing they had investigated loan opportunities without actually making loans. In general,
practitioners also thought CRA procedures were too vague
to be applied consistently. In 1995, CRA regulations were
revised with a focus on measurable lending outcomes, and
part of the current assessment criteria includes the extent to
which banks use “innovative or flexible” lending practices to
extend loans. This specificity made CRA examination and
compliance much less costly, and, as the Avery, Calem and
Canner study shows, LMI lending increased in the same
time period.
But the change came with an unintended side effect,
according to former Fed governor Lawrence Lindsey, who
oversaw CRA regulation during his tenure. Eventually LMI
markets became better served, but the new “soft quotas” did
not change. “In fact, it would be a real CRA black eye for a
bank to reduce the number of loans it was making in a particular area,” Lindsey wrote in a 2009 manuscript on the
CRA published jointly by the Boston and San Francisco

Region Focus | Fourth Quarter | 2010


U.S. Homeownership and Housing Policy
Many policies historically have explicitly or implicitly supported homeownership.


pendent mortgage companies not subject to
the CRA, after controlling for borrower,
loan, and neighborhood characteristics.
Interestingly, the performance of loans
made by CRA lenders relative to non-CRA
lenders — a statistical output called an odds
ratio — is actually better within banks’
assessment areas than outside of them. This
may reflect that loans in CRA assessment
areas face an additional level of scrutiny by
regulators through CRA exams’ on-site
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
reviews and file checks, the authors suggest.
Creation of Federal Housing Administration
Announcement of National Homeownership Strategy/
Creation of “soft quotas’’ under CRA
Creation of Fannie Mae
Slicing the data in a number of ways
Homeownership data from Decennial Census
Creation of Freddie Mac
suggests that the CRA does not bear large
(decade frequency)
Passage of Community Reinvestment Act
Homeownership data from Current Population Survey
Changes to mortgage interest tax deduction
responsibility for the subprime crisis, even
(annual frequency, starting in 1965)
Passage of affordable housing mandate of GSEs
if it encourages lower lending standards in
some cases. “There are undoubtedly some
SOURCE: U.S. Census Bureau
legitimate criticisms of the CRA regulations in this regard, but responsibility for the credit cycle is
Feds. “[G]iven that the most creditworthy borrowers had
much wider and includes the behavior of borrowers and
already received loans, a somewhat less creditworthy group
lenders, regulatory breakdown, and political machinations
had to take their place. As time went on, lending standards
of both parties,” Lindsey writes.
had to be relaxed to avoid any ‘backsliding’ on an instituPerhaps more important is that the spirit of the CRA is
tion’s CRA obligations.”
reflective of America’s long-standing policy stance in favor
But the 1995 changes came more than a decade before
of homeownership. Such policies have spanned decades and
most of the financial crisis seeds were sown. There have
political parties (see chart). The government has insured
been no substantive changes to CRA regulations since the
mortgages through the Federal Housing Administration,
mid-1990s to cause a major change in LMI lending trends,
created a vibrant secondary market for mortgages through
yet the subprime crisis is rooted mainly in mortgages
Government Sponsored Enterprises (GSEs) Fannie Mae and
extended between 2004 and 2007. That implies other
Freddie Mac — in the early 1990s committing those
factors caused the more recent boom in subprime lending
agencies to an affordable housing mandate — and offered a
and deterioration of lending standards. One probable factor
variety of tax benefits reducing the cost of homeownership.
is that it became increasingly profitable for all types of mortMost recently, U.S. homeownership took an upward leap
gage lenders, even those not subject to the CRA, to sell
after 1995 when President Clinton adopted the National
mortgages on the secondary market during the recent boom.
Homeownership Strategy, the first comprehensive national
After good credit risks were met, it appears lenders may
initiative explicitly designed to push homeownership to
have lowered lending standards in order to continue particirecord levels. One of the Strategy’s many features was an
pating in this booming and profitable market.
explicit commitment to reducing lending standards for
Data, too, suggest institutions covered by the CRA were
borrowers who would otherwise not qualify for mortgages.
not a large enough part of the subprime market to conHomeownership went from around 64 percent, where it
tribute significantly to the crisis. A 2008 Federal Reserve
had more or less hovered for decades, to a peak of about
Board of Governors study analyzed 2006 data made public
69 percent in 2004 and 2005.
through the Home Mortgage Disclosure Act (HMDA).
As Lindsey notes, many factors affect homeownership
During the 2005-2006 peak in subprime lending, half the
rather than any one initiative. However, taken together
volume of higher-priced mortgages, which researchers often
these policies may have conveyed ongoing government supinterpret to reflect subprime borrowers, was originated by
port of the housing market and reduced the propensity of
nonbank mortgage companies not covered by the CRA.
lenders, markets, and regulators to question loosened lendOnly 6 percent of all higher-priced loans in 2006 were made
ing standards and investment in housing. As a result of the
by CRA-covered institutions or affiliates to LMI borrowers
recent fallout, many policymakers, though certainly not all,
or neighborhoods in their CRA assessment areas, the
now say that the “American Dream” of homeownership is not
researchers found.
the right choice for everyone despite its benefits to many.
Those loans performed better than loans made by nonbanks, research suggests. A study of California data during
the boom by San Francisco Fed researchers Elizabeth
Re-asking the Question
Laderman and Carolina Reid found that mortgages exThere are better-founded criticisms of the CRA than its role
tended in a lender’s CRA assessment area were significantly
in the subprime lending crisis. It has become clear that
less likely to be in foreclosure than those extended by indethe CRA in its current form has not kept up with the fast-



Region Focus | Fourth Quarter | 2010

changing financial system. Many argue that the CRA’s
geographic focus is misplaced in an increasingly boundaryless electronic banking system. The share of consumer loans
outstanding, for example, that are held by CRA-regulated
commercial banks has declined by 40 percent in the last
three decades (until the financial crisis, when it recovered
some), so the CRA misses a lot of the action. And should
lending continue to receive the majority of the weight on
CRA exams? The subprime crisis proved that more lending
is not always better. Other financial services such as tailored
savings vehicles and consumer education could be a better
way to support LMI communities.
As academics and regulators consider how to reposition
the CRA to fit today’s financial landscape, many are also asking again what problem the CRA is intended to solve. Is it
meant to correct market frictions? To supplement antidiscrimination laws by altering banks’ incentives? To help solve
a social problem? The answers to these questions matter for
whether and how CRA regulations are updated, broadened,
or eliminated.
There is little doubt that the market frictions that appear
to have constrained LMI lending are lower today than even
15 years ago. That may partially be a testament to the CRA
itself. Banks have become much more skilled at mining profitable lending opportunities in LMI areas. Technological
progress and credit-scoring innovations have made it cheaper for banks to assess risks and tailor safe lending products to
borrowers who may otherwise be perceived as too risky to
consider. Many experts believe the CRA initially helped
push banks into lending areas they may have otherwise
ignored, eroding some of the information barriers that previously existed. More recently, banks have formed creative
partnerships with community organizations in order to
identify profitable development and lending opportunities.
These inroads have helped dispel the notion that LMI
lending cannot be profitable. A 2000 Board of Governors
study commissioned by Congress surveyed large banks about
their CRA activity. The 143 responding banks — representing about half the assets of the banking industry at the time
— reported that 77 percent of CRA-related mortgages were

at least marginally profitable, compared to 94 percent of the
portfolio as a whole (including CRA-related mortgages).
To the extent that market barriers are lower today, the
CRA in effect acts as a tool for redistribution. Banks pay an
implicit tax for that redistribution equal to the considerable
compliance costs and any foregone profits from induced
lending. Historically, this has been justified, at least for CRA
supporters, as a quid pro quo in exchange for government and
ultimately taxpayer support of the banking system. (This
argument also is one reason why nonbank lenders are
currently excluded from the CRA.) The stability that government support buys for the financial system is intended as
a public good, but banks undoubtedly benefit. Economists
asked whether banks adequately pay for this benefit in the
late 1990s when lawmakers were considering the repeal of
the Glass-Steagall Act, says economist Lawrence J. White
of New York University’s Stern School of Business.
Government support amounts to a subsidy, argued one side,
while the other pointed out the considerable regulatory
burden associated with being a bank.
“Banks are subject to extensive regulation at least partly
because they are special, because they have deposit insurance,
because they have access to the Fed,” White says. “Do banks
benefit from being generally the only provider of financial
services who get to offer this insurance to their customers?
Yes, of course. But there are lots of other costs that are
involved in being a depository institution that sop up much,
if not all, of the gain,” he says.
Even if banks still aren’t judged to be adequately repaying
taxpayers for that service, White says, why not make the
tax explicit and therefore more efficient? “If that’s the
desire, levy a tax that would go into a CRA fund. Let’s be
clear and transparent, rather than levy the tax through this
vague, opaque process” -- that is, latent redistribution
through the CRA.
One positive outcome of the subprime crisis is that the
discussions casting undue blame on the CRA seem also to
have led policymakers to revisit the law and its possible
flaws, bringing immediacy to the resolution of these
important issues.

Avery, Robert, Raphael Bostic, and Glenn Canner.
“CRA Special Lending Programs,” Federal Reserve Bulletin,
November 2000, vol. 86, pp. 711-731.
Avery, Robert, Paul Calem, and Glenn Canner. “The Effects of
the Community Reinvestment Act on Local Communities,”
paper presented at “Sustainable Community Development:
What Works, What Doesn’t and Why,” conference sponsored
by the Board of Governors of the Federal Reserve System,
March 27-28, 2003.
Chakrabarti, Pabral, David Erickson, Ren S. Essene, et al. eds.
Revisiting the CRA: Perspectives on the Future of the Community

Reinvestment Act, Federal Reserve Banks of Boston and
San Francisco, February 2009.
Laderman, Elizabeth, and Carolina Reid. “Lending in Low- and
Moderate-Income Neighborhoods in California: The
Performance of CRA Lending During the Subprime
Meltdown.” Federal Reserve Bank of San Francisco
Community Development Working Paper No. 2008-05,
November 2008.
Lindsey, Lawrence B. “The CRA as a Means to Provide Public
Goods.” In Revisiting the CRA: Perspectives on the Future of the
Community Reinvestment Act, pp. 160-166.

Region Focus | Fourth Quarter | 2010


Information Asymmetry
n economics, a standard assumption is that market
participants have — and base their decisions on —
“perfect information.” However, in real life, this is not
the case; consumers cannot possess all available knowledge
concerning all transactions. Even though the assumption
of perfect information is widely used, economists have
developed methods for studying the behavior of markets
with imperfect information. One important kind of imperfection is information asymmetry.
Information asymmetry exists when one party, typically
the buyer, has less perfect information than the other. If
the price of a good or service does not accurately reflect its
quality and the buyer does not possess as much information
regarding the product as the seller, this can place the buyer
at a disadvantage. The term “information asymmetry” was
popularized by George Akerlof in his 1970
paper “The Market for Lemons.” This
concept was applied further by Michael
Spence and Joseph Stiglitz, who, with
Akerlof, shared the 2001 Nobel Prize for
their work.
Information asymmetry is applicable
to many common transactions; a few
examples are fixing a car, selecting
a college, and obtaining a home mortgage. In each of these instances, the
typical consumer weighs the opportunity
cost of gathering more information
against the potential costs associated with
accepting some level of ignorance about the product.
Consider the case of hiring a mechanic. As all car owners
know, it would require a substantial investment of time at a
trade school or working at a garage to understand a car as
well as the average mechanic, so most people do not attempt
to make their own repairs. In a worst-case scenario, a dishonest mechanic could overcharge the client and fail to repair
the car, resulting in an accident or further damage to the car.
However, most consumers seem to agree that this is an
unlikely situation, and instead accept the more likely scenario that they may simply be overcharged. As a result,
information asymmetry often exists between the average
consumer and a mechanic. The consumer does not become
fully informed because it would be difficult to do so, and the
costs of possibly making a poor decision are acceptably low.
Another significant transaction many people enter into is
selecting a college. In this instance, information asymmetry
between the buyer, who pays the tuition, and the seller, the
college, is largely nonexistent. Here, information is readily
available to prospective students and parents. Institutions
send comprehensive brochures to students, and a wealth of



Region Focus | Fourth Quarter | 2010

independent reviews and ranking systems are available
on the Internet. Also, the cost of not investigating
college choices is particularly high. If a student selects a
college that is not a good fit, this may result in a costly and
time-consuming transfer to another institution, or years of
tuition that could have been better spent elsewhere. In a
worst-case scenario, the student may be forced to drop out
of college and be unable, for a variety of reasons, to return
or attend another. As a result, information asymmetry is
largely nonexistent in this market. The consumer seeks to
become informed because information is easily accessible,
and not doing so creates a large risk that the transaction will
fail — a risk that entails significant costs.
Granted, there are limitations to this example; there is
information accessible to the consumer only once the
student has enrolled in college. It may
turn out a school is not a good fit for
even a well-informed applicant for
reasons that could not have been reasonably predicted. Nonetheless, even in this
case, the consumer did everything
possible to obtain information equal to
that of the college’s admissions officer,
reducing the possibility of information
asymmetry between the two parties.
The final example involves one of the
most important purchases most people
make: obtaining a home mortgage. As
recent issues in the mortgage market
demonstrate, there was widespread information asymmetry
between many borrowers and their lenders. Even though the
terms of a mortgage contract generally are quite explicit,
many home buyers find those contracts, especially their most
important features, difficult to understand. The costs of not
thoroughly understanding the mortgage agreement are large,
and may result in years of high-interest payments or even
foreclosure. So, the consumer has to make a choice: whether
to seek outside help in understanding the contract or simply
to trust the mortgage provider. That choice often determines
the level of information asymmetry in this market.
These examples illustrate the degree to which information asymmetry is prevalent in many common transactions.
In some cases, there are high opportunity costs to spending
the time and money to gather information about a purchase,
so consumers do not bother with detailed investigations.
In other cases, the risks of agreeing to less-than-optimal
terms could be highly consequential for a consumer,
prompting the consumer to conduct thorough research.
Rational consumers must balance these two factors when
making decisions in the marketplace.



Do Natural Resources Support Economic Growth?

accepting the hypothesis of high volatility.”
he management of natural resources is important
Nonetheless, Frankel identifies five other channels that
for all countries, but perhaps especially so for
he perceives as plausible reasons for the natural resource
developing countries. From rare earth minerals to
curse. The first three are the high volatility of commodity
oil to diamonds, certain countries have been endowed with
prices, the crowding out of the manufacturing sector as a
resources that theoretically should bestow wealth and
result of resource specialization, and the fact that “mineral
trading leverage. Nonetheless, many countries that possess
riches can lead to civil war.” The final two are that endowthese riches still suffer from poor economic conditions.
ments of natural resources can lead to poor institutions, and
This phenomenon was labeled the “natural resource curse”
the Dutch Disease, which suggests that a commodity boom
by economist Richard Auty in 1993. Since then, researchers
can lead to real appreciation of the domestic currency and
have done considerable work on this topic.
increased government spending.
Among the most recent
Once the boom dies down it is
of these articles, Harvard
“The Natural Resource Curse:
difficult to readjust from appreciUniversity Economist Jeffrey
A Survey.” Jeffrey A. Frankel.
ation and high spending.
Frankel consolidates the oftenFrankel cites policies that
times opposing conclusions on
National Bureau of Economic Research
national governments have tried
the resource curse into a single
Working Paper no. 15836, March 2010.
to combat the resource curse,
survey. In his essay, Frankel cites
including marketing boards,
potential causes of the natural
taxation of commodity production, producer subsidies,
resource curse, as well as examples of both poor and prudent
other government stockpiles, price controls for consumers
policy decisions to counteract the phenomenon. Finally,
and international cartels.
Frankel proposes various policies that have never been
Frankel proposes that some institutions may succeed in
implemented, but according to much of the existing
a variety of ways and offers three examples that should
literature, should be effective.
effectively share risk. These are price-setting in contracts
According to Frankel, the term “natural resource curse” is
with foreign companies, hedging in commodity futures
relatively self-explanatory, that “… the possession of oil,
markets, and denomination of debt in terms of commodity
natural gas, or other valuable mineral deposits or natural
price. He also promotes two means of effective monetary
resources does not necessarily confer economic success.”
policy: managed floating and alternative nominal anchors.
He admits that the term seems counterintuitive, but points
Finally, Frankel points to several historical examples
to one particular natural resource to help illustrate the term:
where governments were successful in mitigating harms
“… it is best to view oil abundance as a double-edged sword,
associated with the resource curse. First, he cites reserve
with both benefits and dangers.”
accumulation by central banks. Next, he discusses Chile’s
Frankel then identifies the six “channels” which suggest
rules for the budget deficit, and then Sao Tome and
that “possession of natural resources … can confer negative
Principe’s sovereign wealth funds. He then points to Alaska’s
effects on a country, along with the benefits.” He begins with
practice of lump-sum distribution in booms. His final two
one channel that has been much debated among economists,
examples are the process of reducing net private capital
the downward long-term trend in commodity prices.
inflows during booms and the effort to impose external
Frankel frames the debate as one between “Malthusianism,”
checks. Frankel demonstrates that there are several ways to
the idea that population growth comes at the cost of diminfall victim to the natural resource curse, but also that a
ishing stores of natural resources, versus “cornucopianism,”
variety of institutions are at a government’s disposal.
the belief that resources are renewable or replaceable.
Frankel avoids generalizations by addressing different
In the end, Frankel concludes that both sides have their
channels and institutions in existence by various resourceshortcomings. “Malthusians do not pay enough attention to
rich nations. Frankel has a cautiously optimistic conclusion
the tendency for technological progress to ride to the rescue.
about the natural resource curse. “Needless to say, policies and
On the other hand, the fact that the Malthusian forecast has
institutions are influenced by local circumstances, country
repeatedly been proven false in the past does not in itself
by country. But with innovative thinking, there is no reason
imply the Panglossian forecast that this will always happen
why resource-rich countries need fall prey to the curse.”
in the future.” Because of this, Frankel does not believe that
Essentially, through understanding the potential externalities
there is conclusive evidence for this to be a factor in the
of resource wealth, countries can implement effective policies
natural resource curse. “[I] largely rejected the hypothesis
to escape the resource curse, he concludes.
of a long-term negative trend in world prices, while


Region Focus | Fourth Quarter | 2010


Fed Launches Round Two of ‘Quantitative Easing’

ongoing, stated intention to keep interest rates low for a
hat can monetary policy do to stimulate the
long time to come. Long-term rates are partially a function
economy when interest rates are as low as they
of what financial markets expect future short-term rates to
can effectively go? Typical recession protocol
be. The Fed has said in its policy statements that it is likely
would have the central bank lowering interest rates in an
to keep rates unusually low for an “extended period,” and
effort to boost investment and consumption, and therethrough QE2 the Fed is quite literally putting its money
fore economic activity and employment. But the Fed’s main
where its mouth is.
policy tool, the federal funds rate, has been at the so-called
As with any policy move, QE2 comes with risks. Perhaps
zero bound since December 2008. For the past two years
the largest concern raised by critics is that QE2 could
the Fed has had to rely on alternative tools to ease lending
be inflationary. The Fed pays for the asset purchases by
conditions in an effort to stimulate the economy.
crediting the seller banks’ accounts with the Fed. If banks
For years, the zero bound was only a hypothetical
decided to lend those funds out, the money supply would
curiosity in the United States, though Japan in the 1990s
increase, which tends to produce inflation, all else equal. But
provided a real-world case study of the zero bound in action.
several Fed officials have argued
Then, as now, economists centered on
that there’s little reason to expect
“quantitative easing” as a policy
QE2 is designed to be a
banks to suddenly lend the new
option. The phrase has traditionally
reserves; there are already plenty
referred to when the central bank
complement to the Fed’s
of excess reserves floating
infuses the banking system with
ongoing, stated intention
throughout the banking system
excess reserves. Under normal policy
that banks have thus far declined
conditions, the Fed would carefully
to keep interest rates low
to lend. This might dampen the
tweak the supply of reserves to
for a long time to come.
probability of increased inflation.
achieve the target federal funds — the
Also, the Fed has tools — namely,
rate at which banks lend those
the ability to pay interest on reserves — to very quickly
reserves to each other — through the forces of supply and
induce banks to hold on to excess reserves rather than lend
demand. But if the target rate is zero, the Fed can instead
them. Given these factors, Chairman Ben Bernanke argued
flush the banking system with excess reserves in hopes that
in a recent 60 Minutes appearance that the risks of inaction
banks will lend those reserves and, as a result, stimulate the
are far greater than the risk of inflation.
As noted, the magnitude of the effect of QE2 on longThe first round of quantitative easing started between
November 2008 and March 2010 when the Fed purchased
term rates is uncertain. A New York Fed study found that the
$1.75 trillion in agency mortgage-backed securities and
first round of asset purchases led to “economically meaninglonger-term treasuries. The economy remained weak by the
ful and long-lasting” reductions in various types of long-term
end of 2010, however, with very high unemployment. To prointerest rates, while economists James Hamilton and Jing
vide additional stimulus, the Fed announced its second
(Cynthia) Wu of the University of California-San Diego
round of purchases after its Nov. 3, 2010, policy meeting.
found a smaller but still negative effect. Explaining the
This round has come to be known colloquially as “QE2.”
uncertainty, at least partially, is that the first round of
The Fed plans to purchase another $600 billion — just
purchases took place in the tumultuous aftermath of the
longer-term treasuries this time — by the middle of 2011, or
financial crisis, making it hard to single out the effects the
about $75 billion per month. This is intended to lower
asset purchases had.
longer-term interest rates in the economy through two
Much of the strain of the financial crisis has since eased,
primary channels. First, the purchases are ostensibly large
so the effects of this round of easing on long-term rates may
enough to affect the overall market price for longer-term
ultimately be easier to estimate. The effect on employment
Treasury bonds, equivalently pushing down their interest
will be harder to discern. Would-be employers continue to
rates, as well as rates on assets that are close substitutes. In
grapple with a number of complications, not least of which
this way, the manner in which QE2 affects the economy —
is uncertainty surrounding the future course of the economy
through indirect influence on overall market interest rates
and, potentially, other policies both related and unrelated to
— is not largely different from normal monetary policy
the weak economy. For that reason, the Fed will keep an eye
when the Fed is not facing the zero bound.
on the program — and potentially adjust the scale of asset
Second, QE2 is designed to be a complement to the Fed’s
purchases as economic conditions change.



Region Focus | Fourth Quarter | 2010

The Double Whammy of Foreclosures

“The Impact of Foreclosures on the Housing Market.” Daniel
Hartley, Federal Reserve Bank of Cleveland Economic
Commentary 2010-15, October 2010.

f a foreclosure notice is tacked onto the door of your
neighbor’s house, there’s a good chance the value of your
house will be affected as well. There are two reasons for
this, and research by Cleveland Fed economist Daniel
Hartley suggests that local housing markets may determine
which one is more important for owners, lenders, and
policymakers to address.
One way that foreclosures can decrease property values is
by suddenly increasing the supply of available homes in a
given market. This supply shock may lower prices and/or
increase the time that houses remain on sale. At the same
time, the people who lose their homes may not be in the
market for another house. They are less creditworthy and
prohibited for several years from getting certain mortgages
like FHA loans.
“This means that the former homeowner will most likely
rent or move in with family for a number of years,” notes
Hartley. “This is important because unless the foreclosed
home is converted to a rental property, the foreclosure will
result in an additional home on the market, but no addition
to the pool of potential buyers.”
Another way that foreclosures reduce neighboring home
prices is by making a community less desirable. A foreclosed
home may not be maintained as well as surrounding
properties or sit unoccupied, attracting criminal activity.
This is known as a “disamenity,” the opposite of amenities
like good schools that boost a neighborhood’s home values.
But which mechanism is more important, the supply
shock or the disamenity effect of foreclosures? Hartley
tackled this question by studying a decade’s worth of
housing transactions and foreclosures in Chicago. He found
that in neighborhoods with a low vacancy rate, foreclosures
lowered property values by way of the supply effect while
the disamenity effect was near zero. The opposite was true
in neighborhoods with high vacancy rates — foreclosures
lowered prices by way of the disamenity effect and the
supply effect was almost nonexistent.
Hartley’s finding suggests different policies might be
necessary to stem the negative effects of the foreclosure
wave. “In low-vacancy-rate neighborhoods … the best
strategy may be to meter out the foreclosed properties at a
rate slow enough to avoid flooding the market,” he notes.
“In contrast, in high-vacancy-rate neighborhoods … the most
important issue is making sure that properties are kept up
and do not sit vacant.”


“Improving Survey Measures of Household Inflation
Expectations.” Wändi Bruine de Bruin et al., Federal
Reserve Bank of New York Current Issues in Economics and
Finance, vol. 16, no. 7, August/September 2010.

hether you decide to go shopping or keep your savings in the bank is likely dependent on what you
expect the value of your money to be in the future. That’s
one reason why many economists — especially those at the
Federal Reserve — try to estimate inflation expectations.
One approach is to find out what people think about
future prices through consumer surveys. Four years ago, the
New York Fed joined researchers at the Cleveland Fed and
other institutions to analyze and hopefully improve existing
surveys of consumers’ inflation and wage expectations.
Details of the project were published by the New York Fed.
The survey, administered since November 2007, has,
among other things, confirmed earlier findings of differences in inflation expectations across demographic groups.
Furthermore, it has revealed a decline in the uncertainty of
consumers’ expectations since mid-2008 and a persistent
expectation that real wages will decline. The researchers
plan future work to help predict “how consumers respond to
specific price changes and other new information as well as
to economic and financial developments.”


“The State of State and Local Government Finance.” Ronald
C. Fisher, Federal Reserve Bank of St. Louis Regional
Economic Development, October 2010, vol. 6, no. 1, pp. 4-22.

he public sector was hit hard by the recent recession
and will face major challenges in managing its
budgets during the next decade. “In the short run, taxes may
be increased to restore fiscal stability as the economy
recovers,” noted Ronald Fisher, an economist at Michigan
State University, during his keynote address at an April
2010 conference co-hosted by the St. Louis Fed. His
remarks were published in a special issue of one of the
Bank’s journals, Regional Economic Development.
Fisher continued: “Of course, tax increases alone will not
be enough. Several options have been widely discussed,
including redesigning corrections systems, reconsidering
public employee pension and benefit plans, broadening tax
bases, building more substantial fiscal reserves … and even
reorganizing local government structure.”
As for the long run, municipalities and states may have to
reconsider how they spend money on things such as health
care, education, and criminal justice as well as how to reform
their sales and income tax systems.


Region Focus | Fourth Quarter | 2010



n the 1870s, the English economist W. Stanley Jevons
studied a century and a half of trade data and
concluded that recessions of the English economy were
caused by the cycles of solar activity. He was “perfectly
convinced,” he wrote, that recessions “depend upon
meteorological variations of the like period, which again
depend, in all probability upon cosmical variations of which
we have evidence in the frequency of sunspots, auroras,
and magnetic perturbations.”
Regrettably, astronomers revised their estimates of
solar cycles, and Jevons’s theory did not survive the revision.
An American economist, Henry Moore of Columbia
University, fine-tuned Jevons’s theory in 1923, giving a
predominant role in recessions to the cycles of Venus in
the Earth’s skies. This theory, too, failed to outlast extended
contact with the data.
The discipline of economics has come a long way
since then in its ability to account for recessions.
Macroeconomists today consider the interaction of variables such as inventories, wages, interest rates, investments,
and, of course, profits. They also look at “exogenous”
variables — factors hitting the system from outside — such
as technological changes, fuel-price shocks, and changes in
tax policy. The literature on recessions is voluminous;
indeed, if all the articles about recessions in the EconLit
database were laid end-to-end, they would reach all the way
to … well, they would reach awfully far.
Economists have had less to say about recoveries,
however. “Most of macroeconomics presumes that the economy reverts [to growth] following a shock all by itself,” wrote
University of Chicago economist John Cochrane in the 1994
edition of the NBER Macroeconomics Annual. “For this
reason, we usually focus on the shocks that start recessions
and their propagation mechanisms, but almost never … on
policies and shocks that end recessions.”
Cochrane’s observation a decade and a half ago still
holds true today. When economists speak of recoveries, they
typically characterize them simply as a resumption of the
natural state of the economy: growth.




Region Focus | Fourth Quarter | 2010

Monetary Policy
Do economists have anything more to say about the causes
of recoveries, and the factors determining their strength?
Is good policy simply a matter of taking away the cause of
the recession? Are all recoveries the result of wise monetary,
fiscal, or regulatory interventions? What are the nonpolicy
forces, if any, that spark recoveries? Even though these questions have not been studied by economists as much as one
might expect, there is enough literature and historical precedent to supply some tentative answers.
A leading paper on the subject by Christina and David
Romer of the University of California at Berkeley — aptly
titled “What Ends Recessions?” — examined the eight
recessions that had occurred in the United States between
1950 and the paper’s publication in 1994. (Christina Romer
was chair of the President’s Council of Economic Advisers
from January 2009 to September 2010.) The Romers looked
at measures of fiscal policy and monetary policy and ran
several regressions comparing the economy’s actual behavior
with the GDP figures that would have resulted if policymakers had followed a hypothetical baseline policy. The
results indicated that monetary policy had a potent,
“crucial” effect on recoveries; for each one-percentage-point
fall in the real federal funds rate, the researchers concluded,
real GDP increased between 1.5 percent and 3.0 percent on
average during the first year of recoveries. Conversely, the
monetary tightening that typically occurred before the peak
of the cycle had persistent effects that reduced growth
during the recovery.
With regard to discretionary fiscal policy, in contrast, the
results indicated slight effects on GDP except during the
1973-1975 recession. The Romers thus attributed to discretionary fiscal policy “at most a small role in recoveries.” They
found a greater role for automatic fiscal stabilizers, such as
the decreases that take place in tax collections during a
recession as incomes fall, and the increases in payouts of welfare and unemployment benefits; these automatic changes
in fiscal policy added an average of 0.6 to 0.9 percentage
points to GDP growth during the first year of recoveries.

The researchers did not attempt
to measure the effects of nonpolicy
factors on recoveries. Instead, they
lumped the effects of nonpolicy factors together as a residual value and
found that such factors appeared to
have “little effect on growth.”

Clean Balance Sheets

sponsive to accommodative monetary policy as their focus turns to
de-leveraging rather than borrowing for new housing assets or
durable goods.”
Countries, of course, have
their own balance sheets, which
could hamper a recovery if
national debt is excessive, according to macroeconomic forecaster
and analyst Allen Sinai of Decision Economics. “You can
have a credit crunch in terms of the ability of the government to finance its operations through Treasury issues
and/or the ability of the private sector to obtain financing,
because foreign investors don’t want to invest in a country
where the credit risk is high, the currency is going down, and
there’s a big overhang of debt,” says Sinai. “It’s a risk of us
tumbling back down into a downturn, as may happen to
some of those countries that have had to impose fiscal austerity because of the nature of their sovereign problem.”
For the quickest and strongest recovery, Sinai says,
“We need to be in a situation where we’re not financially
compromised — either households, companies, financial
intermediaries, or government.”

When economists speak of
recoveries, they typically
characterize them simply as a
resumption of the natural state
of the economy: growth.

Other economists who have studied
recoveries, however, believe that factors apart from monetary policy and automatic fiscal stabilizers — including both
policy and nonpolicy factors — play important roles in
determining the recovery process. High among these are
balance sheets: those of companies, consumers, and the government. When it comes to igniting a recovery, clean
balance sheets are like kindling; overburdened ones are like
asbestos blankets.
George Perry and Charles Schultze of the Brookings
Institution, in a 1993 article in the Brookings Papers on
Economic Activity, looked at the recovery following the recession of 1990-1991 and concluded that recovery was being
inhibited in part by the balance-sheet problems of highly
leveraged businesses. They noted that when interest payments become high in relation to cash flow, the firm tends to
become less willing to invest. Even if the spirit is willing,
moreover, the flesh becomes weak: On account of their
balance sheets, highly leveraged firms that do seek to
continue to expand must contend with impaired access to
additional credit at attractive interest rates.
Although the ratio of corporate debt to GDP had peaked
in early 1991 and declined since then, Perry and Schultze
argued that the decline was primarily due to falling
interest rates — and that firms with already debt-heavy
balance sheets might well be apprehensive of those rates
bouncing back up. Those apprehensions, in turn, would
curtail investment on the part of those firms and thus slow
any recovery.
Benjamin Friedman of Harvard, commenting on Perry
and Schultze’s article, noted that during the six-year period
leading up to the 1990-1991 recession, more than half of the
net value of bonds issued by U.S. nonfinancial companies
essentially paid down equity. Such debt burdens, Friedman
argued, “would impair the economy’s ability to mount a
sustained recovery after the recession ended.”
The balance sheets of consumers are even more significant, argues an unpublished 2010 paper by Steven Gjerstad
and Vernon Smith of Chapman University. Gjerstad and
Smith surveyed post-war recoveries and concluded that new
residential construction is the primary transmission channel
for monetary policy during both downturns and recoveries
— and thus, if households’ balance sheets impair their
ability to spend, monetary easing will have at most a minor
effect. “When household balance sheets are damaged in the
aftermath of a serious housing bubble and collapse,”
Gjerstad and Smith conclude, “households remain unre-

A second factor with a major role in the recovery process is
confidence — what John Maynard Keynes called “animal
spirits.” When Harvard’s Lawrence Summers was director of
President Obama’s National Economic Council, he argued
in a speech that “panic and fear” are major obstacles to
recovery. “Businesses, consumers, and investors need to feel
both that recovery can be sustained and that the economy is
returning to a long-run sustainable path,” Summers maintained. “I cannot overstate the importance of confidence.”
For Summers, building confidence requires fiscal and
monetary discipline. Federal policymakers, he argued, can
contribute to confidence by eschewing any policy that might
“call into question our national commitment to sound
money, noninflationary growth, and sustainable devolution
of government debt.” In addition, Summers suggested,
policymakers can build confidence by resolving policy
issues as quickly as possible to minimize periods of policy
Confidence can be built, but it can also be torn down.
If political leaders can build confidence — and thus potentially spur investment — by expressing support for policies
that businesses and investors perceive as helpful (and then
consistently carrying those policies out), they can also
destroy confidence with words that appear to be a prelude
to adverse policy. The Panic of 1907 and its aftermath illustrate the role of language in building confidence — or
undermining it. Robert Bruner, dean of the Darden School
of Business at the University of Virginia and co-author of the
2007 book The Panic of 1907: Lessons Learned from the Market’s
Perfect Storm, says that the panic led President Theodore

Region Focus | Fourth Quarter | 2010


Roosevelt to rein in his populist rhetoric and to seek instead
to reassure the business community.
“ ‘Malefactors of great wealth’ is a phrase of Teddy
Roosevelt’s that echoes down through the decades,” Bruner
says. “This and other phrases and speeches reached an
intensity in late 1906 and early 1907 that truly threatened
the investing public. The president in the first 10 days of the
panic itself finally caught on that perhaps he had overdone
the attack on wealth and Wall Street, and began to issue
public statements to the effect that ‘we trust in the wisdom
of financial leaders to set things right.’ But once the genie
was out of the bottle, it proved very difficult for the utterances of the President to simply restore the faith of the
public in the ability of the private market to achieve the
outcomes they hoped for.”
Or as the late Walter Wriston, formerly chief executive
officer of Citicorp (now Citigroup), phrased it, “Money goes
where it is wanted and stays where it is well-treated.”
Consumer spending, like business spending, is influenced
by confidence. Christopher Carroll of Johns Hopkins
University found in a 1992 study that consumer pessimism
about unemployment leads — not surprisingly — to less
consumption. Using regressions that incorporated data from
the U.S. Commerce Department National Income and
Product Accounts and the University of Michigan’s Survey
of Consumers, Carroll found that an expectation of rising
unemployment rates leads consumers to prefer an increase
in savings and to avoid an increase in debt. A level of indebtedness that consumers find acceptable during boom times
may amount to recovery-killing “debt overhang” in recessionary times, Carroll found — if consumers lack confidence
in the future.

Good Shocks
A third factor with a significant role in recovery is positive
exogenous shocks to the economy. Just as negative exogenous shocks, such as the sharp sudden increases in fuel
prices of 1973, can push economic activity downward,
good exogenous shocks can help GDP recover. Such shocks
could include a surge in foreign investment or an increase in
skilled immigration that fills critical needs. Peace, such as
the end of the Cold War in the 1990s, can also constitute a
good shock.
The fact that these shocks are commonly labeled
“exogenous” doesn’t mean that policymakers must simply
wait around for them to happen, however. When economists call such shocks “exogenous,” they are speaking a bit
casually, since the applicability of the term depends on how
one defines the system. These shocks may be outside the
influence of fiscal and monetary policy (although even that
is arguable), but they are not necessarily beyond the influence of policymaking in general. Foreign investment, for
instance, is affected by, among other things, tax policy and
currency-repatriation policy.
Moreover, where policy cannot influence whether an
event happens, it may still influence the effects of the event:


Region Focus | Fourth Quarter | 2010

Even a natural disaster — the classic example of an exogenous event — might or might not be exogenous from the
standpoint of a macroeconomic model since the effects of a
natural disaster are influenced by policy factors such as
building codes and investments in forecasting systems.
Perhaps the ultimate good shock is technological innovation. That was the thesis of Harvard University’s Joseph
Schumpeter, who held, starting in a series of articles in the
1910s, that the growth phase of business cycles is brought
about by entrepreneurial innovation; successful innovators
spur economic activity not only through their own efforts,
but also by inspiring imitators, all of which creates a surge of
Schumpeter regarded the growth of railroads, and the
investment and development they generated, as a clear case
of this process during his lifetime. A modern-day example is
the aftermath of the 1990-1991 recession, which initially
was followed by a weak recovery; in the years immediately
following the trough, growth was at less than half the rate of
the recoveries of the 1960s and 1980s. Only with the
Internet boom of the mid-1990s — driven by the commercialization of the World Wide Web — did the recovery catch
up to historical norms.

What Happened to Joe Palooka?
Historically, recessions during the post-World War II era
were followed by rapid GDP growth. The fastest growth,
moreover, occurred after the deepest recessions. Princeton
University’s Alan Blinder, writing in 1984 about the Reagan
recovery, called this regularity the “Joe Palooka effect” in
reference to an inflatable punching bag with an image of the
cartoon boxer Joe Palooka on it. “Because he was weighted
at the bottom, he snapped right back when you punched
him to the floor,” Blinder explained. “And the harder you hit
him, the faster he came bouncing back.”
Mr. Palooka hasn’t been taking punches like he used to;
the recovery from 1990-1991 recession was the first of three
disappointingly slow recoveries. Growth during the first two
years after the 1990-1991 and 2001 recessions were just 2.1
percent and 2.2 percent respectively — far shallower than
the same periods during recoveries of the 1950s through the
1980s, which often brought growth rates higher than 6 percent. Growth following the 2007-2009 recession also has
been relatively weak and by some measures appears to be
slowing further. The 1990-1991 recession also saw the advent
of the so-called “jobless” recovery, as employment did not
grow substantially during the year after the recession’s end
— a pattern that, too, repeated itself after the 2001 and
2007-2009 recessions
Hypotheses abound. Sinai of Decision Economics
suggested in an American Economic Review article in May
2010 that businesses may have become reluctant to hire,
even during a recovery, on account of both the increasing
cost of labor (when benefits and payroll taxes are factored in)
and the proliferating substitutes for traditional hiring,
continued on page 35

The growing market — and tab — for student loans

fter the financial crisis, consumers curtailed their
credit card debt. However, as the economy has
recovered, another form of debt has grabbed attention: student loans. In June 2010, for the first time in
history, total student loan debt, at more than $850 billion,
exceeded credit card debt, estimated at less than $830
billion. The statistic was first reported by Mark
Kantrowitz, publisher of, a leading resource on
student financial aid. The finding was one in a series of
sobering statistics concerning student loan debt.
Last year, the U.S. Department of Education released its
2007-2008 National Postsecondary Student Aid Study (NPSAS).
The NPSAS data show that the average loan debt of fouryear undergraduate borrowers was $20,200 at public
institutions, $27,650 at private nonprofit institutions, and
$33,050 at private for-profit institutions. This represents
increases of 20 percent, 29 percent, and 23 percent,
respectively, since 2004. In total, the data showed that
about two-thirds of graduates from four-year institutions
had student loan debt.
Despite increases in public awareness and federal support, students seem less able to manage these debts.
Although student loan debt is not dischargeable through
bankruptcy under current law, a number of borrowers stop
making payments regardless. In early September 2010,
Secretary of Education Arne Duncan announced that the
2008 national cohort default rate on student loans increased
to 7 percent, the highest rate since 1997. Defaults increased
from 5.9 to 6 percent for public institutions, from 3.7 to 4
percent for private institutions, and from 11 to 11.6 percent
for for-profit schools. The high default rates at for-profit
institutions in particular have sparked a debate in Congress
to regulate these institutions.
The official cohort default rate counts only people who
default within two years of beginning repayment. (A cohort
is composed of borrowers who enter repayment within the
same fiscal year.) Because many people default in later years,
the actual number of defaults is much greater. Beginning in
2012, the official rate will cover a three-year window, and
preliminary data put the rate nearly 70 percent higher.
These figures point to a growing problem with postsecondary student debt on a national scale. In the Fifth
District, students in Washington, D.C., graduated with an
average debt of $29,793 per student, versus the national
average of $23,200. (The data are based on where the student attends college, not on home state; Washington, D.C.,
has only one public university.) In West Virginia, 73 percent
of students graduating from college had debt, compared



with 67 percent nationally. According to the NPSAS,
however, the rest of the District had both lower average
student debt levels and a lower proportion of students with
debt in 2008 (the most recent data available).

The Federal Loan Market
Most student loans are provided by the Department of
Education. The Higher Education Act of 1965 established
the Guaranteed Student Loan Program (now called the
Federal Family Education Loan Program, or FFELP) to
encourage college attendance. Through FFELP, a student
borrows from a private lender, but the government guarantees the loan against default and guarantees the lender a
“competitive” rate of return, enabling the student to borrow
more cheaply. In 1993, the Department of Education also
began lending directly to students via the Federal Direct
Loan Program (FDLP). Schools could participate in FFELP
or FDLP, and within five years, 35 percent of new loan origination was through the direct lending program. By 2006,
though, that number dropped to 20 percent, which many
attributed to aggressive marketing and incentives offered to
schools by lenders. (The federal government also issues Pell
grants, which do not have to be repaid, to students with
demonstrated financial need. The maximum award in 20102011 was $5,500, depending on the student’s eligibility.)
When the financial crisis hit in 2007, many lenders
exited the market, or failed entirely, because they could not
raise capital by selling student loan asset-backed securities
(SLABs). Government caps on interest rates also prevented
them from covering higher lending costs. To ensure
students’ access to credit, the Federal Reserve allowed
financial institutions to use SLABs as collateral, and
Congress allowed the Department of Education to buy
loans from lenders. Many schools reapplied to the direct
lending program, and FDLP increased more than 50 percent
by the end of 2008. At the end of fiscal year 2009, the
Department of Education was guaranteeing $457 billion in
loans, offered by 2,900 different private lenders. The department’s direct loan portfolio was $153 billion, up from
$110 billion in FY 2008.
A provision of the recent health care act eliminated the
guarantee system and required all institutions to switch to
direct lending programs as of July 1, 2010. By issuing all
federal loans itself, rather than guaranteeing the loans of
third-party lenders, the government estimates it will save
more than $60 billion over 10 years, which has been pledged
to expanding need-based grants and debt relief efforts.
Critics of the legislation are concerned about limiting

Region Focus | Fourth Quarter | 2010


students’ choice in borrowing and the potential loss of
thousands of jobs in the loan industry.

Alternative Loans
Students face a complicated array of federal loan options.
The primary types are subsidized Stafford loans, where the
government pays the interest while the student is in school,
and unsubsidized Stafford loans, where interest payments
can be added to the principal and deferred until graduation.
The loans have different limits based on whether the
student is an undergraduate or graduate, dependent or independent, and the student’s year in school. Dependent
undergraduates can borrow up to $31,000 in aggregate, and
independent students can borrow up to $57,500. (Generally,
dependent students are unmarried undergraduates who rely
on their parents for financial support.) With the cost of
attendance averaging $12,283 per year at public institutions
and $31,233 at private institutions, some students have
turned to “private” student loans to make up the difference.
Financial aid experts counsel students to take out federal
loans, which have fixed interest rates and more flexible
repayment terms, before turning to private lenders. (The
private loan market has also faced allegations of predatory
lending and collusion with college aid offices). Still, private
lending made up more than 20 percent of all new student
lending for much of the last decade, and private loans make
up 20 percent of current loans outstanding.
While private loans can close the gap between federal aid
and college tuition, one-fifth of private borrowers haven’t
exhausted their federal eligibility, and more than 10 percent
haven’t applied at all for federal loans. Reasons may include
the complicated Free Application for Federal Student Aid
(FAFSA), confusion about loan options and limits, or a perception that only students with financial need can borrow.
Private lenders also advertise low introductory rates, instant
credit approval, and easy application processes.

The rapid increase in private lending has been followed
by an even greater decrease. Sallie Mae, the largest private
lender in the United States, reported a 68 percent drop in
originations from 2007 to 2010, and private lending overall
has decreased by nearly a third. The drop is largely due to the
lack of demand for SLABs, but also reflects stricter underwriting standards.
The future of the private loan market is uncertain. New
regulations, including greater oversight and more lenient
bankruptcy discharge rules, may make student lending less
attractive. (Because the only thing students have to offer as
collateral is their future earnings, the rules are designed to
protect the lender’s claim on that collateral. Pending legislation would make it easier for borrowers to discharge private
loans, although federal loans would be unaffected.) But there
are signs of recovery in the securities market, and the end of
FFELP may spur lenders to seek out new business in the
private market. For students, federal lending and need-based
grants are still well below the cost of attending college,
and even the newly simplified FAFSA form still has more
than 100 questions on it.

What’s Behind the Increase?
Several factors are driving the increase in student borrowing.
On the demand side, increased emphasis on the importance
of higher education has coincided with an increase in college
costs: More students want to attend college, and they need
more money to do it. In the last 10 years, prices for undergraduate tuition and fees have risen between 34 percent and
46 percent at public institutions and 31 percent at private
institutions (adjusted for inflation). College costs have outpaced overall inflation, and room and board has increased
more for students living on campus than off campus, which
suggests that college costs have also outpaced the cost of
living. Still, a $20,000-plus debt may be a rational investment. A report by Georgetown University’s Center on

Demand for Graduate School Rises, as Does Its Costs
Rising student debt is not isolated to undergraduate education. Prospective graduate students face many challenges,
such as increased competition for admission and higher
costs, which may threaten their ability to enter and then
remain in a graduate program.
According to a report by the Council of Graduate
Schools, applications for admission grew by 8.3 percent
between 2008 and 2009; enrollment grew by 5.5 percent.
A 2010 report released by the U.S. Department of
Education’s National Center for Education Statistics
revealed that from 2000 to 2008, the average total price
of attendance for graduate school, adjusted for inflation,
increased by 52 percent, from $14,900 to $22,700
annually. Perhaps not surprisingly, law and medical programs were the most expensive, at $44,900 and $43,100


Region Focus | Fourth Quarter | 2010

And the growing price of graduate education shows in
students’ borrowing habits. In 2000, 30 percent of graduate
students took out loans; the average annual loan was
$13,500. In 2008, almost 43 percent of students took out
loans, the average being $18,500. For professional school
students, these figures were much higher. In 2008, almost
82 percent of law and medical students took out loans, with
the average topping $30,000.
A 2010 report published by the Census Bureau stated
that in 2008, those with advanced degrees earned
about $25,000 more than bachelor's degree recipients and
over $50,000 more than high school graduates. So, while
a postsecondary education usually bolsters earnings,
financing that education raises difficult choices for many
students not just at the undergraduate level, but also at
the graduate level.

The rise in student debt poses several challenges to the
increasing number of students striving for a degree. Student
debt can linger for decades, preventing graduates from making important decisions such as buying a house, getting
married, or having children. Parents who co-sign their children’s loans also share this burden, and it may prevent them
from making their own life decisions, such as retiring.
For borrowers who fall into delinquency, their lenders can
exact several harsh penalties. In addition to harmed credit
scores and higher payments, further financial aid is denied,
academic transcripts may be withheld, tax refunds may be
withheld to repay the student loan, and federal payments
like Social Security may be reduced. The longer a borrower
remains delinquent, the less likely he or she will be to resume
control of the debt.
There are strategies that borrowers can use to delay or
reduce their payments, but they require thorough research
and strict adherence to the terms set by the lenders.
Although it is possible to defer payments by obtaining additional schooling or through economic hardship, the interest
on unsubsidized loans continues to accrue — and if a


Education and the Workforce estimates that 63 percent of
jobs will require a four-year degree by 2018, and the College
Board calculates that four-year college graduates earn on
average almost $20,000 more per year than high school
Some economists, including Andrew Gillen of the Center
for College Affordability and Productivity, a nonprofit
research organization in Washington, D.C., argue that
tuition hikes are an effect, rather than a cause, of increased
student borrowing. In a 2008 policy paper titled “A Tuition
Bubble? Lessons from the Housing Bubble,” Gillen details a
vicious cycle. Because the government views postsecondary
education as a public good, it provides subsidies (relatively
cheap and plentiful student loans) to pay for it. The subsidies
increase the ability of more students to pay for school, which
leads universities to raise their prices, which then leads
the government to provide greater subsidies, and so on.
Normally, the price would settle at a point where the
ability and willingness of students to pay for an education
matches the ability and willingness of a school to supply that
education. But because the subsidy artificially increases the
ability of students to pay, and because the supply of higher
education is relatively inelastic, the normal laws of supply
and demand may be distorted.

Average Cumulative Loan Debt for Bachelor’s Degree
Recipients Upon Graduation

Public Four Year

Private Four Year

For Profit

NOTE: Includes U.S. citizens and residents. Plus, loans from friends and family, and
credit card debt are not included.
SOURCE: NPSAS 2003-2004, NPSAS 2007-2008

student takes out additional loans to remain in school, the
ultimate burden only grows larger. And in the case of forbearances, which are similar to deferring payments but are
available to those who are in default, interest on all
loans continues to accrue. In the end, interest can turn a
seemingly manageable loan into a significant liability.
To minimize payments, two often cited options are the
federal Income Based Repayment (IBR) Plan, which caps
the required monthly payment based on the borrower’s
income, and the Public Service Loan Forgiveness (PSLF)
Program, which forgives a portion of the balance for borrowers employed in some public service jobs. The federal
government also offers partial loan repayment for service in
the military or sponsored volunteer efforts for a few years.
IBR and PSLF were both enacted within the last few
years, and IBR is set to expand in 2014. The effect of these
programs and the change to federal direct lending on
students’ borrowing habits will not be seen for several years.
Additionally, the current data include students who started
school — and thus started borrowing — prior to the financial crisis, so it is uncertain how the decrease in private
lending will affect total debt levels. Despite public concern
about how much students are borrowing, the recession may
mean that many students starting college now may have
little choice but to increasingly turn to the loan market.
The consequences of accumulating student debt illustrate how important it is for borrowers to understand the
terms of their student loans. And as tuition and incidental
schooling costs increase, the next wave of hopeful college
applicants must decide whether student loans are a strategy
that leads to worthwhile investments in education — or to
cumbersome obligations.

2007-2008 National Postsecondary Student Aid Study.
U.S. Department of Education, National Center for Education
Statistics. Online:

Integrated Postsecondary Education Data System.
U.S. Department of Education, National Center for Education
Statistics. Online:

Gillen, Andrew. “A Tuition Bubble? Lessons from the Housing
Bubble.” Center for College Affordability and Productivity, 2008.

Kantrowitz, Mark. “Total College Debt Now Exceeds Total
Credit Card Debt.” Fastweb, Aug. 11, 2010.

Region Focus | Fourth Quarter | 2010


he Virginia Museum of Fine Arts
(VMFA) opened in Richmond
75 years ago during the Depression.
So it’s fitting that the museum unveiled
the biggest expansion in its history —
$150 million and 165,000 square feet — on the
heels of the recent recession.

the Culture
Art museums
strive for
financial stability



Art museums provide valuable services. Museums not
only enhance a community, they also protect and restore
inherited artifacts, interpret and accumulate current
creative work, and pass treasures forward to future generations. In short, they take care of the culture.
But it’s a challenge to quantify or charge for this value in
a way that pays the bills. Art museums rely on gifts and
contributions as well as earned income, endowment
income, and some government funding. Most museums
struggle to fund daily operations as they make the tough
trade-offs required to pursue missions.
The VMFA’s dramatic new wing, with its 40-foot glass
wall overlooking The Boulevard, exhibits its 21st century

The heart of the Virginia Museum of Fine Arts’ expansion
is its new wing, which includes public gathering spaces
such as a three-story glass atrium.


Region Focus | Fourth Quarter | 2010

purpose: wide-open public
access. An atrium unites the
museum’s existing wings and
opens onto a library, shop, café,
and the galleries. General
admission is always free —
and the museum is open 365
days a year, including Thursday
and Friday nights until 9 p.m. “Accessibility is part of the
answer to how we can make this work,” says VMFA director
Alex Nyerges. “We need to make art museums part of the
fabric of our daily lives.”
Paradoxically, the VMFA wants to increase revenue by
making as many attractions as possible free.

Museums and the Market
Art museums don’t respond in the usual way to the forces of
supply and demand that underpin markets for most commercial goods. Though the market for buying and selling art
functions just fine, museums aren’t in the business of selling
art for profit: They show and preserve the art and educate
the public, a money-losing proposition almost by definition.
As such, the services provided by museums are often considered public goods that may not adequately be produced by
the for-profit sector. For most museums, then, viability
means some combination of private contributions and public funds. This is why most museums are private nonprofits,
about 71 percent; most of the rest are publicly owned and
managed by various levels of government, according to an
Institute for Museum and Library Services (IMLS) survey of
more than 1,000 institutions in 2008. Only 0.2 percent of
museums in the United States are for-profits.
American museums grew from the generosity of private
benefactors. These cultural capitalists amassed wealth in the
19th century, and funneled cash into culture — including
libraries, museums, and schools. The VMFA got its start
from just such a man, John Barton Payne, during a museumbuilding wave between the world wars when more than 30
museums went up nationwide. A native Virginian, Chicago
lawyer, judge, and public servant, Payne pledged his own art
collection in 1919 to a future state museum dedicated to
the arts. In 1932, the state accepted Payne’s cash gift of
$100,000, conditional on matching funds. Though the state
then had no discretionary money, Gov. John Garland Pollard
raised private funds, and received 30 percent of the amount
from a federal Works Progress Administration grant. In
1934, the General Assembly legislated state maintenance of
the building and staff salaries, while the Board of Trustees
was deemed responsible for art objects and endowments.
Payne died in 1935; the museum opened in 1936. In fiscal year
1936-1937, the state appropriated about $32,000 for the
museum — roughly $503,000 in today’s dollars. The
museum has been sustained since by the public, business

leaders, collectors, and other benefactors, including the late
Paul Mellon, its longest-serving trustee at 40 years.
Though a steady stream of state funding may be unusual
for an art museum, Virginia is not the only Fifth District
state to provide substantial funding for its flagship museum;
so does North Carolina. Both museums opened new wings
in 2010. And though funding fluctuates, each receives
roughly a quarter of its operating funds from the state.
Those funds help sustain ordinary operations that don’t
attract attention from benefactors, such as maintenance,
security, and management of the art collection. Energy costs
are substantial, for instance, because the building requires a
controlled atmosphere at all times to protect the integrity of
the collection even when the building is unoccupied.

Multiple Missions
Art museums are places for people to learn, formally or
informally. Art museums advance scholarship about the art
and artists in the collection. As such, notes Massachusetts
Institute of Technology economist Peter Temin, part of what
museums do is provide education.
Museums can also stimulate spending, especially when
shows attract people from out of the area. For instance, the
Picasso exhibit this winter at the VMFA will be the show’s
only East Coast stop, and people from all over Virginia and
other states are likely to be among the projected 200,000
Another of the VMFA’s missions is sharing art. Selections
from the VMFA’s collection will circulate in 2011 among
museums in cities large and small throughout Virginia, in
two separate anniversary shows, to commemorate the
museum’s founding.
Most people don’t realize the complexity of what goes on
behind the scenes at an art museum. For example, the seemingly simple process of shipping art to share it with another
museum requires an enclosed, climate-controlled loading
dock big enough for a tractor trailer. Sturdy wood trunks
and special packing foam protect artworks. A meticulous
array of instructions, and sometimes a courier, accompany
the pieces.
Requests for loans must meet specific criteria before the
museum agrees to lend. “We are stewards and it’s our
responsibility to make sure this gets passed on to future
generations,” says chief conservator and deputy director
for collections management Stephen Bonadies. (Monet’s

Region Focus | Fourth Quarter | 2010


in Waltham, Mass., recently
considered selling part of its
The Association of Art Museum Directors surveys its members each year. Survey results include responses through
collection to help solve financalendar year 2009, with varying response rates, with the latest showing 149 member responses. In 2010, AAMD
cial problems — but did not.
members included a museum in Canada, Puerto Rico, and three in Mexico.
University in Nashville, Tenn.,
got court permission to sell
one-half interest in Alfred
Stieglitz photographs to the
Crystal Bridges Museum of
American Art, scheduled to
open later this year in
Earned Income
Bentonville, Ark. “Such choices
are very difficult in times like
SOURCE: Association of Art Museum Directors’ State of North America’s Art Museums Survey
these,” Temin says, of the recent
Admission fees may help art museums, but they don’t
Field of Poppies is among the VMFA’s most frequently lent
constitute much of a revenue stream. No recent data exist
to quantify the proportion of revenues earned overall
The public also rarely views the museum’s behind-thefrom admissions; at the time of a 2001 survey by AAMD,
scenes restoration efforts, such as recent work on a bed that
however, the average admission was $2.25.
dates from about 1905. The bed is one of three from the
Free admission makes economic sense, according to
workshop of French designer Louis Majorelle; the entire
Harvard University economist Martin Feldstein, who edited
bedroom suite was donated by longtime patrons Frances
Lewis and her late husband, Sydney, founders of Best
The Economics of Art Museums, published in 1991. While a
Products. The project required the services of an outside Art
private museum full of Rembrandts or Renoirs might charge
Nouveau expert.
high entry fees, a nonprofit won’t do it because “the decline in
The VMFA currently sends half of its restoration
attendance would be contrary to the museum’s basic mission.
projects elsewhere, but aims to build its conservation
“Even a modest admission charge might deny someone
department so it can perform more work in-house and also
who wished to see the collection the opportunity to do so
serve other museums. “We could double the department
even though his or her seeing it would impose no cost,”
and probably save money because we farm out so much to
Feldstein writes. That would remain true up until the point
consultants,” Nyerges says.
at which an exhibit or a museum became congested.
Attendance is one index of effectiveness, and at most
museums, it runs counter to the business cycle. When times
Creative Financing
are tough, more people visit. But private and public funding
Temin and others have pointed out that museums typically
decline in a downturn, as governments struggle to balance
can’t raise money in ways a private business might: by selling
budgets and contributions dwindle along with endowment
assets — in this case, valuable art. Founders and future
donors needed a guarantee, in those early years, that gifts
Art museum funding breaks down this way, on average:
would be used for stated purposes. The potential for the
13.1 percent comes from government, 23.3 percent from
breaking of such agreements may be less acute today,
private sources, 46.1 percent from earned income, and 17.5
according to Temin, given that museums are now staffed by
percent from investments, according to an IMLS survey
professionals with greater training than in the early years;
based on fiscal 2006 data, the latest available.
various laws ensure that donors’ wishes are honored. Selling
Museums are also subsidized indirectly through forgone
art is frowned upon. “Assets are the reason museums exist
taxes on property and income, estate tax deductions
and the collections are essentially held in public trust by the
for charitable contributions, and nontaxation of endowmuseum,” says Janet Landay, the executive director of the
ment income. Federal insurance guarantees also protect
Association of Art Museum Directors (AAMD), a nationaccredited museums against catastrophic damage when art
wide organization of about 198 art museum directors.
is loaned.
“The field has made it a key principle in our professional
The recession crimped art museums’ income, according
practices that you cannot sell artwork to cover any expenses.
to the latest AAMD survey. In 2009, 23 percent of responWhat sometimes gets confusing is the fact that museums
dents reported increases in overall revenue relative to the
sell art regularly, but use the money to upgrade the collecprevious year, up from 15 percent in 2008. That compares
tion. It’s restricted accession money. It’s a line that you really
to 58 percent in 2006 and 55 percent in 2007. Less than
can’t cross.”
one-fifth of respondents, 16 percent, reported increases in
During the Depression, though, some museums fell back
corporate support in 2009, with three-fifths reporting
on collections to save the institutions. Brandeis University

Revenue by Category


Region Focus | Fourth Quarter | 2010

declines, the same as in 2008. (Business
By the Numbers: ‘Tiffany: Color and Light’
activity peaked in December 2007, the
official start of the recession.)
Endowment income fell during the recession after rising in 2005 and 2006. By 2008,
Exhibition Design & Production
only 8 percent of respondents reported
Administration/Loan Fee
increases in endowment income; in 2009,
Shipping & Insurance
Corporate, Individual
79 percent of museum respondents said
endowment income fell. Earned income also
Education & Publications
has fallen.
Public funding also can be precarious.
The VMFA’s state funding has fluctuated
SOURCE: Virginia Museum of Fine Arts
over the last decade. In 2003 the museum
received $7.5 million and in 2009, the state
is cultivating clientele with free jazz, free exhibits, and a
contribution totaled about $8.79 million, both figures in
variety of events, some with fees, most without. “Art After
2010 dollars.
Hours,” formerly a fee event with music and food and
The VMFA is striving to vary and build income streams.
dancing, now costs nothing. The new atrium serves as a
Currently the VMFA’s annual operating budget is about $37
Main Street, of sorts, branching off into galleries, the café,
million, with about 27 percent coming from the state.
and shops. “This is a very calculated and directed plan aimed
Endowment, earned income, contributed income, and
at increasing revenue,” Nyerges says. The aim is a steady flow
special events need to provide the remaining 73 percent.
of visitors who can find a variety of entertainment options
“The goal is to have four diverse sources of support so we’re
while visiting VMFA, not only the exhibits. “It allows us to
not relying on any one particular source and amount,”
bring in more people to the building and, while they are here,
Nyerges says. In the recession, endowments went down,
they may see the South African or the quilt exhibition.”
giving went down, and state budget appropriations went
Membership and attendance at VMFA have varied over
down. Earned income includes membership fees, tuition for
the years. In fiscal year 2000, attendance reached 669,000;
classes, ticket revenues, education programs, parking deck
that included more than 250,000 visitors to an exhibit of
revenues, facility use fees, publications sales, photo sales,
Egyptian art. By September 2009, membership had dropped
and revenues from the gift shop.
to 7,100, largely due to construction started in 2005 and the
Mega shows like the Picasso exhibit are no panacea for
10-month closure prior to the re-opening in May 2010.
revenues. The Picasso show is likely to cost “just shy of $5
But by late November, VMFA had about grown to 20,000
million,” Nyerges says. Though these big shows may attract
members. And the museum logged about 265,000 visitors in
crowds, they can be break-even efforts. For instance, the
the first seven months after unveiling its transformation into
VMFA hosted a major collection of work by master
a kind of town hall.
glassmaker Louis Comfort Tiffany from May to August 2010,
“The notion of a hall of relics, dusty and quiet, is obvithe only American museum to feature the exhibition. Yet the
ously a 19th century creation,” Nyerges says. People can be
show barely broke even. And costs of shows and the day-toinspired by beautiful works but also challenged and
day functions of the museum aren’t likely to get cheaper, only
educated through exhibits like the recent display of South
more expensive. Special shows are, like many of the VMFA’s
African photographs depicting apartheid-era events. Art
galleries, underwritten by patron or corporate support.
museums today bring people together to learn, enjoy, and
The plan is to build traffic, popularity, and attendance.
have fun to make their lives better while museums, behind
Art museums today are about bringing people together, says
the scenes, continue as keepers of the culture.
Nyerges. In its aim to become a gathering spot, the museum
Feldstein, Martin, ed. The Economics of Art Museums. Chicago:
University of Chicago Press, 1991.
Manjarrez, Carlos, Carole Rosenstein, Celeste Colgan, and Erica
Pastore. “Exhibiting Public Value: Government Funding for
Museums in the United States.” Washington, D.C.: Institute of
Museum and Library Services, 2008.

Skinner, Sarah J., Robert Ekelund Jr., and John Jackson. “Art
Museums and Attendance, Public Funding, and the Business Cycle.”
American Journal of Economics and Sociology, April 2009, vol. 68, no. 2,
pp. 491-516.
Temin, Peter. “An Economic History of American Art Museums.”
In Martin Feldstein (ed.), The Economics of Art Museums. Chicago:
University of Chicago Press, 1991, pp. 179-193.

Region Focus | Fourth Quarter | 2010



Knowledge jobs lend resistance, but not immunity to downturn

onventional wisdom has it that the Research
Triangle area enters recessions late and exits them
early, says Brenda Steen, of Apex, N.C. Steen
directs the Chamber of Commerce in Apex, a bedroom
community near Raleigh known as the “peak” of the
Triangle. “My heart goes out to people in Florida and other
places where things are worse; 2008 and 2009 were really
scary and depressing.”
The Research Triangle is a prosperous region bounded by
three major universities in north central North Carolina —
North Carolina State in Raleigh, Duke University in
Durham, and the University of North Carolina at Chapel
Hill. The area is home to jobs that require extensive education, and it’s also got a healthy set of public employers at the
state schools and the capital in Raleigh. By many measures,
the region’s job mix helped buffer residents from the effects
of the most recent recession but it couldn’t protect them
Steen can’t help having a keen awareness of the local business climate in her job at the Apex Chamber. It’s where
people stop for information; she also gets resumes from job
hunters. Membership declined by 25 percent over the recession — small businesses, when polled, said they couldn’t
afford the dues. Area churches held resume-writing workshops in late 2008, as well as gatherings to get people out of
the house and give them somewhere to go. Steen’s husband
lost his job in a layoff. And in October 2008 Sony Ericsson
relocated its headquarters to Atlanta and laid off between
800 and 900 people. And there were even more layoffs.
By the end of 2009, the Durham area had shed 7,800 jobs
since the recession started, and the larger Raleigh-Cary area,
27,500. The Triangle treaded water as the broader North
Carolina economy “went kerplunk,” says Bo Carson of
the Research Triangle Regional Partnership (RTRP), the
region’s economic development organization.
Positive signs now loom: Over the first half of 2010, both
the Raleigh and Durham metros added jobs: 1,200 and
4,800 respectively. In May, RTRP announced a record $2
billion in 2009 investments for the region, expected to
bring 11,000 jobs; in 2010, the group reported another
$1.27 billion for the year.
The Triangle may not be recession-proof, but it’s surely
cushioned by its mix of high-skilled jobs in fields such as the
life sciences, pharmaceuticals, and math-intensive professions.


center draws researchers and patients from around the
world. Just outside the city limits sits the 7,000-acre
Research Triangle Park. Spawned by the state more than a
half-century ago to leverage university research, it’s now
studded with private and public enterprises. In Raleigh,
North Carolina State University has its main campus and its
own research park, Centennial Campus. The Triangle’s third
point is the sprawling University of North Carolina in
Chapel Hill and its health center.
The Triangle ranks 19th among the top 20 metro areas in
the United States, as measured by the number of degrees its
universities and colleges produce, nearly 19,000 in 2006,
according to a staff report by economists Jaison R. Abel and
Richard Deitz from the New York Fed. In North Carolina,
roughly a quarter of people over age 25 have a bachelor’s
degree, but the percentage jumps to between 40 percent
and 42 percent in the Triangle. In the Raleigh-Cary and the
Durham-Chapel Hill MSAs, about 19 percent and 14 percent respectively have postgraduate degrees compared to
8.5 percent statewide.
The region ranks even higher, sixth, in its academic
research and development expenditures, about $1.4 billion
in 2006, according to Abel and Deitz. Duke and its medical
center, for example, garnered grants worth $2.6 billion
between Dec. 1, 2007 and Oct. 31, 2010, according to Karl
Bates, director of research communications.
Abel and Deitz investigated the relationship between
academic research and development and the amount and
types of human capital in metro areas. Because college graduates are mobile, they may not enter the labor market where
they attended college. The researchers found only a “small
positive relationship between a metropolitan area’s production and stock of human capital.” The authors suggest that
migration redistributes educated workers, defined in the
paper as graduates with at least a bachelor’s degree. That’s
because most metro areas in the United States, 62 percent,
produce more graduates than they can employ. The remaining 38 percent employ more graduates than they produce.
Even so, universities do influence demand for human capital
through R&D spillovers that help create firms and shape
job formation. Abel and Deitz note that research efforts
ultimately “tilt the structure of local labor markets toward
occupations requiring innovation and technical training.”
All this human capital is associated with more growth as well
as higher wages and income.

Degree Production
The Triangle region spreads across eight counties, with
about 1.7 million residents in the combined statistical area.
Duke anchors Durham, an old tobacco town, whose medical


Region Focus | Fourth Quarter | 2010

Triangle Employment
During the recession, the Triangle’s unemployment rate
stayed below two digits, but barely. The rate peaked at 9.6

Employment by Sector

Raleigh-Cary MSA

Durham-Chapel Hill MSA
Total Government
Trade, Transportation & Utilities
Professional & Business Services
Education & Health Services
Professional & Business Services
Leisure & Hospitality
Mining, Logging & Construction
Financial Activities
Other Services

Total Government
Education & Health Services
Professional & Business Services
Trade, Transportation & Utilities
Leisure & Hospitality
Other Services
Financial Activities
Mining, Logging & Construction


10 20 30 40 50 60 70 80 90 100




10 20 30 40 50 60 70 80 90 100

SOURCE: N.C. Employment Security Commission

percent in the Raleigh-Cary MSA compared to 11.8 percent
statewide; the Durham MSA’s peaked at 8.6 percent. The
unemployment rate at the end of September 2010 was
6.7 percent in the Durham MSA, down from 7.9 percent a
year earlier, and 7.7 percent in Raleigh-Cary, down from
8.8 percent a year earlier.
Given the recession’s depth and breadth, even in the
Triangle, it may take a while for firms to swell payrolls
enough to make a dent in unemployment numbers. As in the
recoveries of 1990 and 2001, hiring may lag as firms invest in
equipment, not people, to increase productivity.
Public employers in the Triangle have provided relative
stability, but that might not last, given the state’s $3 billion
projected deficit, says Jason Jolley, senior research director
of the Center for Competitive Economies at the University
of North Carolina.
Jolley believes recovery will be slow in the Triangle.
Government and universities may be stabilizing influences
in the Triangle, he says, but they are likely to face cuts.
“We’ve had furloughs, we haven’t had raises in two or three
years, and so there’s not the spending associated with these
institutions as there has been in the past.”
In both the Durham-Chapel Hill and Raleigh-Cary
MSAs, the government sector has grown in the past decade,
from 18 percent of employment to 21 percent in Durham and
16 percent to 18 percent in Raleigh. The share of jobs in education and health services also has grown: from 14 percent to
19 percent in the Durham-Chapel Hill MSA and 9 percent
to 12 percent in Raleigh-Cary over the same period.
The information technology job sector has shrunk over
the past decade, from about 2 percent of employment to
1 percent in the Durham-Chapel Hill MSA (that is, from
5,400 people in 1999 to 3,900 in 2009); the sector went from
4 percent to 3 percent in Raleigh-Cary (from 17,100 in 1999
to 16,900 in 2009). The Triangle has shed jobs at companies
such as Sony Ericsson. Electronics company Aviat Networks
laid off 200 in the Triangle, consolidating its business in
Silicon Valley.
Many remaining tech employers are cautious, a vestige of
the 2001 recession. “I think tech companies remember very
well the pullback and are constantly worrying about overexpanding,” says economist Mike Walden of North Carolina

State. “So they are using more ‘just-in-time’ and part-time
labor to avoid heavy commitments to labor costs.”
Corporate downsizing is also emptying office spaces. For
instance, Blue Cross and Blue Shield of North Carolina and
GlaxoSmithKline plan to shrink footprints in the region,
with consequences unclear for the labor market.
Add to that the increased demands on counties for social
services, with less tax revenue, and the picture further dims.
Unemployment has declined, but that’s because of labor
force dropouts, Jolley says. And then there are the underemployed. “Like the college students who have graduated
and have to keep working at the bar on Franklin Street.”
Economic conditions remain soft, though upbeat stories
are threaded through the statistics. In Apex, you may need
to wait in line at a restaurant on a Friday night, Steen says,
adding that congested traffic at Target is a good sign. These
reports, though, exist amid still-vacant commercial buildings and halted housing developments.
More people are moving to Triangle area. While state-tostate migration stagnated for the United States as a whole,
the number of people moving into Raleigh-Cary went up by
3.2 percent from July 1, 2008 through July 1, 2009 as the
recession ebbed; the Durham-Chapel Hill population grew
by 2.1 percent over the same period.
Demand for labor will rise when demand for firms’
products and services does. Carson cites examples such as
IBM’s new cloud computing center, for which they are
hiring 600 people. And the region’s life sciences cluster
attracts more and more contract pharmaceutical research.
He says that promised jobs are in the pipeline — those
knowledge-based jobs that made the Triangle famous. They
seem to have at least provided resistance to the region
during the recession.
Some people have created their own jobs — a coffee
service, a brewery, a ladies’ boutique, coaching, painting,
house- and window-cleaning businesses. “I’m not sure where
the funding is coming from,” Steen says. Some may have
borrowed from their retirement accounts, she speculates,
while others may have been able to convince banks to loan.
And after a six-month stint commuting to a Washington,
D.C.-based think tank, she reports that her husband found
work at Pfizer.

Region Focus | Fourth Quarter | 2010


David Feldman


RF: Much of your early work was in international trade
and finance. How did you become interested in the
economics of higher education?
Feldman: My very first paycheck as a tenured member of
the faculty here was reduced in the 1990 statewide pay cut
that the governor authorized. So my first interaction with
being a state employee was having my contract be signed for
one thing, and then having my paycheck be for less, because
the governor just arbitrarily cut state salaries. That was my
introduction to higher education finance and the beginning
of my interest in it.
I didn’t become a researcher in it right away. But 1990 was
a state budget crisis, and that stimulated all sorts of discussions around here about the appropriate role of the state in
funding higher education. Over the following decade, what
we observed was that state support for universities here
followed a downward roller coaster trend. When times were
good, the state share would rise back up, but it never quite
got to the level of the last peak. And then the next budget


Region Focus | Fourth Quarter | 2010

crisis would come, and state support would fall, and times
would get good, and it would come back up, but
not quite as much. When I came, the state supplied over
70 percent of our operating funds, and I think it’s now down
to something in the 30s. That’s a rather startling change in a
little over 20 years.
My co-author, Bob Archibald, made the switch before
me; he had started thinking seriously about financial aid. We
actually began our co-authorship not on higher education
issues, but on trade issues. But once he had begun writing
with me, he then began interesting me further in the higher
education side of things. We just got talking, and the rest is
RF: In the 26 years from 1980 to 2006, the real price of
education has increased more than 100 percent. Some
consider rising tuition to be evidence of irresponsibility
on the part of university administrations. But you found
that during the past half-century, the trend in the real
price of higher education has been very similar to that of
the services of highly educated professionals, such as
physicians and lawyers, including a sharp acceleration in
real prices starting around 1980. How do you account
for that acceleration?


As tuition at both public and private universities has
increased sharply in the past quarter-century — far
faster than the general rate of inflation — the question
of how to pay for undergraduate education has
become increasingly angst-ridden for students and
their parents.
How did higher education become so expensive?
The question calls for systematic economic analysis.
David Feldman and his collaborator Robert Archibald,
both economists at the College of William & Mary,
have sought to provide that analysis in a series of
articles and in a recent book from Oxford University
Press, Why Does College Cost So Much?
Feldman has been at William & Mary since arriving
in 1989 from Colgate University as a visiting professor,
a job that he took to be closer to his wife, then a medical
resident at Virginia Commonwealth University Medical
Center in Richmond. His early work focused on
issues in international trade, macroeconomics, and
economic history, often combining insights from all
three areas. His research with Archibald on the
economics of higher education likewise draws upon a
number of subfields, including labor economics, in
addition to the microeconomics of university admissions. David A. Price interviewed Feldman in his office
at William & Mary in December 2010.

the kind of services that they
Feldman: The acceleration starts
had been. So you see, in many of
around 1980. What we find, which
Basically, for the first 75 years
the medical specialties, legal
won’t come as a surprise to any labor
specialties, education — all edueconomist in the country, is that the of the 20th century, the supply
cation, in fact, not just higher
acceleration in college costs was
education — these industries
timed almost perfectly to the end of
of highly educated
have seen their cost structure just
what Claudia Goldin and Bob Margo
people — or changes in the
called the “Great Compression” —
the period in which the income dissupply of highly educated
RF: Presumably salaries are a
tribution in the United States
became compressed in the middle.
very high share of the overall
people — had outpaced
That was a period, basically 1940 to
costs of a university.
1980, when the United States was as
changes in demand.
middle class a country as it has ever
Feldman: Indeed. Some people
been. The gap between the 90th perhave pointed out that faculty
centile of the income distribution
salaries have not risen astronomiand the 10th percentile was as narrow as it had ever been.
cally. But often these people look only at salaries, not at
In fact, in the 1970s, that gap continued to narrow, until by
salaries plus benefits. Faculty compensation has increased
the middle of that decade it was as low as it had been in the
considerably since 1980 when you add salaries and benefits
20th century. But starting in the late 1970s and early 1980s,
a number of things came together to cause the costs of
To some extent a faculty member is not a perfect cog; you
colleges and universities — as well as of all industries that
can’t just take a faculty member in the English department
use a significant amount of highly educated labor — to start
and put him or her to work in investment banking, of course.
to accelerate compared to other things.
But there is a shared labor market, the labor for highly
We don’t have anything in particular to add to the story
educated people. And ultimately changes in the return to
that labor economists have developed, but we find the most
higher education filter through to all degree categories.
persuasive explanation is Claudia Goldin and Lawrence
Katz’s race between technology and educational attainment.
RF: Don’t government subsidies of tuition, such as subBasically, for the first 75 years of the 20th century, the supply
sidized student loans, play a role in rising tuition?
of highly educated people — or changes in the supply of
highly educated people — had outpaced changes in demand.
Feldman: Oh, they certainly could, and it is the common
Due to capital-skill complementarity, the demand for
wisdom. But two things need to be clarified here. First, even
highly educated people had been steadily rising over the
if it led to a higher list price, it might lead to a lower net price
course of the century, but for much of the century, the
for students. Second, the whole notion that “it’s all econ 101”
supply increased even faster.
relies on the idea that the supply of higher education is
This was the period in which we had the push for uniupward sloping — that in order to get more places available,
versal high school completion and a skyrocketing increase in
universities have to get a higher price for it. Actually, the
the number of people coming out of colleges and universibulk of the evidence suggests that this industry is pretty
ties. But in the mid- to late-1970s, attainment stagnated.
much a constant-returns-to-scale industry, so the long-run
We peaked with the number of people getting high school
supply curve is essentially flat. The way we put it in the
degrees at around 75 or 80 percent, and male college complebook, if you have a university of size 5,000 on one side of the
tion rates stagnated. Female college completion rates
river and there’s a demand for 5,000 more places for stucontinued to rise, but increasing numbers of collegedents, you can build a university on a vacant piece of land on
educated women weren’t going into the labor force. In the
the other side of the river, that duplicates everything that
same period, the demand for highly educated people continuniversity 1 did, and do that largely without changing the
ued to rise, as it always had, and if anything, the computer
cost structure. You could provide the same education for
revolution of the past 40 years has accentuated that trend.
5,000 more students on the other side of the river simply by
So the earnings of people with a college degree, relative
duplicating the plan.
to people with a high school degree, just took off. That’s mirIf you look back over the last 50 years, that’s largely
rored for people with advanced degrees, the kind of terminal
what’s happened. The numbers of students who are being
degrees that college professors, and doctors and lawyers,
put through American universities dwarfs the number 40
have. Any business in which a substantial fraction of its
years ago. And this increased number of places that we have
employee base is highly educated is going to feel these cost
available for college students has not meant that we’ve slid
pressures. Some businesses can more easily shed those
along an upward sloping supply curve. We have been able to
people in favor of machinery or other things, but many of
build totally new universities and university systems without
the personal services industries cannot do that and remain
affecting cost per student at any given university. So what

Region Focus | Fourth Quarter | 2010


we’re actually concerned with is the reasons why that flat
supply curve itself is drifting upward over time. That’s the
force for rising costs, this flat supply curve drifting up over
time. What we suggest is that the prime impact of government subsidies is not to raise tuition, but to increase the
number of places available.
RF: Wouldn’t you expect technology to bring productivity gains to higher education? Why hasn’t this
Feldman: Actually, it has. If you look around a university
campus today, you will see many things that look quite different than the way they looked 30 years ago. Technology has
had an impact on higher education that’s basically the same
as the impact it’s had everywhere else. A simple example is
secretaries and typists. If you look around a college campus,
what you will see is that the number of secretaries and typists in comparison to when I was a student in the 1970s is
way down. When I was a graduate student at Duke, we had
two or three departmental secretaries, and a small army of
typists. Those typists typed my tests, they typed my papers,
they did all my typing for me. We more effectively do much
of our own work that once was done by this army of typists.
It’s something you observe everywhere in this economy.
The number of people whose job categorization is keyboard
worker or typist has just gone through the floor. It’s in
higher education, it’s everywhere. That’s the substitution of
relatively low-cost technology for relatively high-cost labor.
But what we argue is that this is not the dominant way
that technology affects higher education. The primary
impact of technological change in higher education is less on
reducing our costs and more on improving or changing what
we do. To a certain extent, colleges and universities are first
adopters. We tend to be first adopters of new technologies
out there, and we don’t do that because of its cost-reducing
impact. We do it because it’s what our faculty needs in order
to do their research. It’s what our students need in order to
become fully conversant in the new techniques that are
reshaping the work world that they’re going to move into.
A lot of people tend to think that the impact of technology is only in the natural sciences, and this is quite wrong.
It may be more important in a dollars and cents sense in
physics and chemistry, but new techniques have changed the
way the economics department teaches. Our students
have to be quite conversant in Stata and SAS and other
econometric packages. People in architecture have to be fluent in computer-assisted design; people in history
departments often have to be familiar with computerized
database analysis that would have been impossible 30 or 40
years ago. So the kinds of techniques that we adopt aren’t
necessarily adopted with an eye to lowering the cost of what
we provide.
RF: Is it difficult to assess the role of technology in the
cost structure because it has changed the product?


Region Focus | Fourth Quarter | 2010

Feldman: Correct — we’re not measuring the same thing.
It’s not as though our output is a pound of potatoes. It’s
almost impossible to measure the value of the output except
retrospectively, many years in the future, looking back at
whether or not we succeeded in preparing students for what
they need to know.
Our traditional measures of productivity are way too
crude to handle many things, like personal services. Not only
that, we’re a multiproduct firm: We produce research, we
produce public service, we produce graduates at the undergrad and grad level.
RF: There’s a popular perception, at least, that workers
in the for-profit sector are working harder today than
they were 20 or 30 years ago, and that this trend has
passed academia by. Do you think that’s true?
Feldman: There may be something to it if you go back 60
years. But over the last 20 or 30 years, no. I don’t think that’s
a very accurate thing to say. There is no good data that support the often politicized perception that faculty members
don’t do any work — that faculty members teach six to nine
hours a week, and twiddle their thumbs for the rest of the day.
If you want to look at evidence, you need to go to the
Bureau of Labor Statistics, for instance, and look at the
establishment survey, or other data sources, on the average
workweek for the economy as a whole. If you actually go and
look at data on the average workweek, over the last 30 years,
it has fallen: from about 38 to 39 hours per week to 34 to 35
hours per week, among workers in general. So the idea that
the higher education sector is inherently full of lazy, unmotivated people and the private sector is full of dedicated
people working ever longer hours doesn’t seem to be borne
out at all in the actual national data.
The data we have suggest that as the nation has become
more affluent over long stretches of time, 40 to 50 years,
people have taken part of that affluence in the form of
higher leisure, so shorter workweeks. Those are the facts.
RF: Does the institution of tenure reduce faculty
Feldman: Tenure is a very complicated subject. I think a lot
of people think about tenure using the quaint old story
about academic freedom. But I think most economists
actually look at tenure as an economic institution. It’s a way
of solving a set of incentive problems that are out there. One
of the problems is that you have faculty members who are
being asked by universities to specialize in something that’s
fairly narrow. One thing that gives the faculty member the
incentive to do what the university wants, which is risky specialized research ventures, is the security that if the world
turns against them 10 years from now — they’re looking at
problem Y, and problem Y stops being important or gets
solved — the faculty member isn’t just dismissed while
they’re trying to retool to solve problem X. So in a sense,

what the institution of tenure does is
that it helps faculty members to
invest in risky ventures that are of
value to the university.
Does tenure raise costs? I think it
actually reduces costs. Tenure is compensation in a nonmonetary form as
opposed to in a monetary form.
Other things equal, if you give a
person job security, part of that is in
lieu of a higher salary.

David Feldman
➤ Present Position
Professor of Economics,
College of William & Mary
➤ Previous Faculty Appointment
Colgate University, 1984-1989
➤ Education
A.B. (1978), Kenyon College; Ph.D.
(1982), Duke University

that are farther away.
If you were to go back 40 or 50
years, for instance, and look at a particular geographic area, the number
of schools that effectively had that
market was fairly small. Each of
those schools today has much less
market power within that market.
Two things tended to lock students
into their more local network: One
was transportation and the other was
information. Transportation and
information are now both very cheap
in comparison to what they were 40
or 50 years ago. What that means is
that people have the luxury of taking
a wider view. And when they do that,
it means that any given school,
instead of having two or three or four
other competitors, now has 20, 30,
40 other competitors.

➤ Selected Publications
RF: You write about the decline in
Co-author of Why Does College Cost So
what is called “state effort” —
Much? with Robert Archibald, as well as
appropriations per $1,000 in
articles in such journals as
personal income — in support of
of Higher Education,
state universities. You found that
Education, Review of
on average, state effort has gone
International Economics, Economic Inquiry,
down 40 percent from its peak in
and Southern Economic Journal
the 1970s. Yet state budgets generally have soared during that time.
Why has higher education’s share of state spending been
shrinking so much?
RF: Students can look at universities farther away …

Feldman: That’s a complicated issue as well. And a lot of
people have weighed in on it. Clearly the first place to look
is at what states are actually spending their money on. Those
categories are ones like corrections, Medicaid, roads, and
K-12 education. These are things that are muscling higher
education out of the budget.
Over the past 35 years, states have shown that they are far
more willing to endure the political problems that come
with allowing tuition to go up than they are willing to endure
the political problems that come from raising taxes.
Increasing taxes: anathema. Increasing tuition: bad, but not
as anathema as raising taxes. And unlike things like the
prisons, you can’t charge the prisoners for their rent. But you
can charge the college students for their education. So states
have found it more palatable to allow universities to cover
more and more of their increasing costs by direct charges to
families, rather than cough up additional state revenues in
order to keep those charges down.
This is not a Virginia issue, this is nationwide. The
pattern of declining state effort is nationwide.
RF: Has undergraduate education become a more
national market than it was a generation ago?
Feldman: Much more so, yes. At the average university —
this is true at public universities, it’s true at private universities — if you look at the percentage of the student body
that comes from within the state, it’s gone down. The
percentage of out-of-state students has gone up. Or if you
look at it differently, if you look at the number of students
who come from with a certain radius, not just within state,
but just miles, schools now have to compete with schools

Feldman: I’ve got a 17-year-old who’s doing that as we speak!
RF: … and universities can look at students who are
farther away. What has this meant?
Feldman: One of the things that it does is create better
matching. Students can find a finer match for what they
want than they could in years past, when both information
and transportation were much more expensive.
But there are other aspects. One of the things that we’ve
observed is that the nationalization of the market has led to
increased prosperity of the elite. Instead of Harvard, Yale,
and Princeton competing for the best of the Northeast, we
have Harvard, Yale, and Princeton, oh, and Stanford, competing for the best of the nation. So what we have observed
at our most elite universities is that their selectivity has gone
up over time. There’s debate about what’s happened to selectivity at the rest, but there’s not a whole lot of debate about
selectivity at the elite. The elite are now more selective
than they have ever been. So there’s a concentration of
talent that has occurred as the best students who used to go
to largely regional universities now can aspire to Harvard,
Yale, Princeton, and the better small liberal arts programs.
RF: Now that higher education is a national market, do
you see it becoming a more global market?
Feldman: It has become global. And many of the same
forces that I’ve just been talking about in the national
market are also driving the internationalization. Somebody
from Shanghai or Bogota can aspire to go to school at the
University of Kansas, or Yale, for two reasons: The cost of

Region Focus | Fourth Quarter | 2010


transportation has gone down, and the cost of information
has gone down, so they, too, can look beyond the national
university system of their country. At the same time, the
American university system has for many years been the gold
Likewise, the demand for education — it may be an
investment, but it’s an investment where there’s a big cost.
In the United States, it can be financed by borrowing. It’s
much less easy for somebody in the developing world to
access capital markets and borrow for an education. As
incomes have increased in various parts of the developing
world, a class of people has developed who can actually
finance that education in advance, in cash. So clearly, the
development of the oil economy in many parts of the world,
the development of an elite in many parts of the world, have
led to families with enough income and assets that they can
buy an American education by writing a check. This is a
group of people that is adding to the pool of aspirants who
want to get in. So we’re already there.
The U.S. higher education system is still the most
welcoming to outsiders. We speak English! How many
foreigners in China are going to choose to go to a Germanspeaking university in Germany? There are some; I’ve met
them, actually. But the numbers who have the German language skills, or the Italian language skills, or the French
language skills, are very small in comparison to the numbers
who have English language skills. So the demand for coming
to the United States and Great Britain is quite high.
RF: Do you think there are other countries that offer a
better model than ours for structuring the system of
higher education here?
Feldman: I don’t know that I want to make a complete
declarative statement, yes or no. Different systems of higher
education have different advantages and disadvantages. On
balance, I think ours works better than most other systems
do, for many reasons. Here’s one that I really like to highlight: We have a system of higher education that is the best
in the world at giving people second and third chances. I
don’t think that’s a benefit to be underestimated. There are
an awful lot of people in this world who don’t grow up until
they’re 25, and in the United States it’s very easy for them
to go back to school. In Germany, if you are not college
material when you’re 11, then you don’t get tracked into the
“gymnasium.” It’s very, very difficult for you to move into the
elite in German society.
Ours is a much more individual-based system. Somebody
who was a hamburger flipper at McDonald’s who says,
“This is a dead end, I don’t want to do this the rest of my
life,” simply takes the savings that they’ve squirreled away
and goes to a two-year community college and gets the skills,
and then decides whether or not to transfer those skills to a
local university and get their four-year degree. We have a lot
more flexibility in our system than in most other systems
in the world, and I think that’s of great value.


Region Focus | Fourth Quarter | 2010

RF: Let’s talk about international trade in general for a
moment. As you know, international trade as a share of
GDP declined far more sharply during the latest recession than in past recessions. What is going on there?
Feldman: I wish I could tell you! I don’t know. This is not
your garden-variety recession. This is not an inventorydriven process; this is driven by financial market meltdowns
and financial market uncertainty. And I would venture to
speculate that a recession driven by those two things
probably affects trans-border contracts and trading more
than it does internal ones — for many reasons, one of them
having to do with risk. If you increase the risk of foreign
investment, if you increase the risk of contracting with
foreigners with products in their currency, for instance, and
there is a real risk of significant ruptures in currency values,
what you do is you create home-market bias. You make the
risk of dealing internally within your own borders low
compared to the risk of dealing externally with foreigners.
So I would imagine that one of the things that you would
observe is that an increasing home bias would tend to diminish the relative importance of trade and economic activity.
That’s just a guess.
RF: Who were your main influences in your development as an economist?
Feldman: On the personal side of things, when I was a
young professor at Colgate, we hired a guy from the
University of Pennsylvania named Robert Margo, one of the
premier economic historians in the country. I was just
learning the business, and he was the one who essentially
helped me to understand how to think about research
questions, how to pose an interesting question, how to
think about managing a question, how to think about
modeling and forming questions that a reasonable person
could test.
In parallel to that, the other influence is my thesis
adviser, Ed Tower. Tower’s influence was to show me the
value of probing deeply. Most thesis advisers are not handson. It’s, “Hey, come back in three months time when you’ve
got three-quarters of it to show me.” That wouldn’t have
worked for me. And fortunately, that’s not how Ed Tower
worked. Ed Tower wanted to talk to you at breakfast every
week. “So what are you thinking about?” And we would have
a conversation. And he would ask questions, and push,
basically until you would give up and say “uncle.” That would
teach you exactly what you didn’t know, and where your
modeling, where your intellectual apparatus was just not
grappling with the problem. So those are two personal influences who helped me to understand what it means to be a
professional economist.
Editor’s Note: Our originally scheduled interview with
Joel Slemrod of the University of Michigan will appear in the
next issue.

Calling the Shots
2010, 256 PAGES

n Stumbling on Wins, David J. Berri and Martin B. Schmidt,
economists at Southern Utah University and the College
of William and Mary, respectively, examine why
“experts” in sports so often make decisions that lose both
money and games. Drawing on behavioral economics, which
suggests that the rational decisionmaker of standard economic theory represents an incomplete depiction of
actual human behavior, Berri and Schmidt argue that we
often are reluctant to accept information that contradicts
our current world view, even if it means repeating the same
mistake again and again. And we often misinterpret the information we do have, or overestimate its predictive power.
The solution, they maintain, is “useful” numbers —
numbers that are actually connected to outcomes (wins) and
numbers that are consistent over time (for instance,
numbers that will tell you something about a player’s
performance from year to year). In their 2007 book Wages of
Wins, written with Stacey L. Brook, now at the University of
Iowa, Berri and Schmidt developed a metric called “Wins
Produced” (WP) to evaluate basketball players. WP uses
regression analysis to measure the effect of individual player
box score statistics on team wins. The authors find that a
player’s contribution to wins depends primarily on shooting
efficiency, rebounds, turnovers, and steals. In Stumbling on
Wins, the authors extend the WP framework to analyze
fourth-down play calling in football (coaches play it safe too
often); the value of hockey goalies (less than the goalies
would like to believe); and whether coaching matters in basketball (not much, apparently, unless the coach is Phil
Jackson), among other things.
The factors that make a player valuable to his team
should, in general, be the factors that determine his salary.
Berri and Schmidt find that the most important determinant of pay in the National Basketball Association (NBA) is
points scored: Five more points per game equals an extra
$1.4 million per year. The problem is that a player can score
more points simply by taking a lot more shots, and ignoring
other aspects of his game — to the detriment of the team as
a whole.


Case in point: the New York Knicks of the mid-2000s.
New general manager Isiah Thomas spent millions acquiring
a roster of high-scoring free agents. But despite having the
biggest payrolls in the league, the Thomas-era teams also had
some of the worst records. In a chapter of the book that may
surprise many sports fans who have vilified Thomas, Berri
and Schmidt conclude that he simply showed the same preference for high scorers as the rest of the league — but had
more money to spend on them. “It’s not clear that other general managers would have made different choices given the
budget Isiah had at his disposal,” Berri and Schmidt write.
Berri and Schmidt also examine a long-debated question:
Are black quarterbacks in the National Football League
(NFL) underpaid? Comparing quarterbacks using “Wins
Produced per 100 Plays” (WP100) instead of the NFL’s
Quarterback Rating — which they deem “complicated, and
furthermore, incomplete and inaccurate” — the authors find
persistent bias in the evaluation of black quarterbacks. On
average, black quarterbacks produce more wins than white
quarterbacks; they are also much more likely to run with the
ball than to throw it, and therein lies the rub. Regressing
salary on various performance measures, Berri and Schmidt
find that the number of passing yards has the most explanatory power for salary, while rushing yards are not significant.
Because white quarterbacks on average are paid more than
black quarterbacks, the authors conclude that the black
players are “doing something extra that helps
their respective teams win games, but this extra effort is
Decisionmakers also have difficulty evaluating the
performance of future players (as fans of the Portland Trail
Blazers, the team that picked Sam Bowie ahead of Michael
Jordan, know all too well). Draft day decisions illustrate a
key aspect of decisionmaking. More data make us feel like
we’re making better, more informed decisions — but the
human brain can process only so much information, a
concept economists call “bounded rationality.” So we sometimes don’t focus on the most useful information.
In both the NFL and the NBA, Berri and Schmidt
find that a player’s productivity (as measured by Wins
Produced) doesn’t have much to do with his draft position.
Quarterbacks get picked one round earlier if they’re an inch
taller or score higher on an IQ test. A college basketball player who plays in the Final Four of the NCAA tournament can
improve his draft position by a full 12 spots — if he declares
for the draft that same year. If he returns to school,
the effect on his draft position (and, thus, potentially
millions of dollars) is lost the following season. Although
continued on page 34

Region Focus | Fourth Quarter | 2010


The Queen’s Private Navy

This portrait of Queen Elizabeth I, with
her hand resting on a globe, suggests her
ambition to make England a world power.
Privateers helped her do so — and also
defended England against the attempted
invasion by the Spanish Armada
in 1588, depicted behind her.


hen Elizabeth I became
queen in 1558, following
the death of her sister,
Queen Mary I, she found that she had
inherited a mess: England’s navy had
shrunk to a dangerously small number
of ships, the country was vulnerable
to attack by the powerful Spanish
empire, and the treasury had little
money with which to build up the
fleet or to do anything else. England
also lacked the flow of wealth that
Spain enjoyed from overseas colonies;
by this time, Spanish conquistadors
had already defeated the Aztecs of
Mexico and the Incas of Peru and had
been hauling away the incredible
riches of those regions. England, in
short, was outmatched militarily and
Elizabeth’s solution was to turn to
the marketplace: She allowed private
enterprises to form
pirate expeditions, in
essence, to capture
Spanish shipping and
bring home its treasures.
Many of these plundering enterprises were
joint-stock companies in
which members of
society — including
merchants, gentry, and
even Elizabeth herself —
purchased shares. The
returns from the enterprises enriched the
Crown and stimulated
the English economy.
Even more significantly, in the long
run, Elizabeth’s policy built up the
human capital that would enable
England in the following century to
establish itself successfully in North
Historians today distinguish lawful
“privateers” — captains and crews
attacking foreign ships with the
permission of a sovereign — from


Region Focus | Fourth Quarter | 2010

pirates, who were mere robbers. With
regard to the anti-Spanish voyages in
Elizabethan England, however, this
distinction is not always easy to draw.
In theory, they were privateers: They
were required to hold licenses, known
as “letters of reprisal,” and to comply
with other restrictions on the raiding
of foreign commerce. In practice,
however, the official responsible for
oversight of privateers, the Lord High
Admiral, was notoriously corrupt and
was lax in enforcing the rules if the
price was right. Thus the privateers
often were privateers in name only.

Tons of Silver
Perhaps the most famed of the queen’s
privateers was Francis Drake, who
began a 14-year run of extraordinary
exploits in 1573 with raids against the
Spanish in present-day Panama. Aided
by local Cimaroons — former African
slaves who had escaped from their
Spanish owners, and who were glad to
make common cause with Spain’s
enemies — Drake and his men traveled overland across the Isthmus and
ambushed a Spanish caravan; its 190
mules were carrying tons of silver
ingots and another £100,000 or
so in gold coins. Although converting
money values across centuries is a
highly imprecise science, research by
economic historians suggests a conversion factor of roughly 134; in other
words, Drake’s £100,000 haul in gold
coins alone would be worth approximately £13.4 million ($21 million) today.
Drake’s next great, and highly profitable, adventure began on Dec. 13,
1577, with his departure from
Plymouth, England, for raids on
Spanish ports and shipping around
South America. His 100-foot flagship,
the Golden Hind (that is, the golden
deer), was joined by four other vessels.
They reached the Atlantic coast of
South America in two months, and
then took another seven months to


How Elizabeth’s
England, rewarded
investors, and
led the way to the
English New World

follow the coast southward and to traverse the Strait of
Magellan near the continent’s southern tip. By that time,
three of the four ships traveling with the Golden Hind had
been abandoned, and the fourth had returned to England
after becoming separated from Drake.
Drake nonetheless kept going, attacking Spanish ships as
he followed the coast of Chile, ultimately capturing a large
Spanish treasure ship, the Nuestra Señora de la Concepción, on
March 1, 1579. The ship had ample artillery with which to
fend off an attacker, but Drake was able to employ the
element of surprise — English privateers had been unknown
in the Pacific. The Golden Hind hid its guns and slowed to
give the appearance that it was merely another merchant
ship, then attacked when the Nuestra Señora came within
hailing distance. Drake’s crew required six days to transfer
the ship’s riches, including 80 pounds of gold and 26 tons
of silver.
Anticipating that the Spanish might be waiting for him
on his return trip, Drake decided instead to cross the Pacific
and return home via a western route. He first sailed northward to upper California, which he claimed for Elizabeth
and named New Albion. (The Spanish had visited the area
before him, however.) He spent a month in the San
Francisco Bay in the summer of 1579, then made his
way around the world. It was the first circumnavigation
of the globe by an Englishman. Moreover, because
Ferdinand Magellan had died during his 1519-1522 journey,
Drake was the first commander of any nation to complete
the voyage.
Following Drake’s arrival in England on Sept. 26, 1580,
not quite three years after he left, Elizabeth gave him a
knighthood. He was also a hero to the shareholders, who
reportedly received a 4,600 percent return on their investments — that is, for every £1 they put in, they received £47
after expenses. Three and a half centuries later, John
Maynard Keynes would credit the voyage with cleaning up
Elizabeth’s balance sheet and helping to finance the great
British trading companies:
Indeed, the booty brought back by Drake in the Golden
Hind may fairly be considered the fountain and origin
of British foreign investment. Elizabeth paid off out of
the proceeds the whole of her foreign debt and invested a part of the balance (about £42,000) in the Levant
Company; largely out of the profits of the Levant
Company there was formed the East India Company,
the profits of which during the seventeenth and
eighteenth centuries were the main foundation of
England's foreign connections; and so on.

Drake’s next two voyages were explicitly both commercial and military, seeking Spanish treasure for investors while
also carrying out Elizabeth’s orders to attack strategic targets. First was his 1585-1586 raid on Spanish interests in the
Caribbean. His fleet plundered the port city of Santo
Domingo, the colonial capital, located in the present-day

Dominican Republic, and ransomed the town of Cartagena
on the Caribbean coast of present-day Colombia. The
following year, Drake led a 23-ship fleet in successfully
attacking the port of Cadiz in the Spanish homeland,
destroying some 37 Spanish naval and merchant ships, as
well as plundering Spanish merchant ships in the area.

Single-Handed Victory
Among the English sailors taking part in the Cadiz raid was
a 27-year-old named Christopher Newport. From there,
Newport would rise quickly in the world of privateering;
sailing under Drake was apparently a good credential.
Within a few years, in 1589, Newport was second in command of the Margaret, a privateer ship financed by several
London merchants. The following year, he was captain of
the Little John, which sailed with several other ships to the
Caribbean to patrol for Spanish vessels.
During an attack on two ships carrying treasure from
Mexico to Havana, the privateers encountered tough resistance and Newport lost his right arm. To make matters worse,
the battle ended without any treasure — one of the Spanish
ships sank and the other escaped.
Despite this rocky start to Newport’s career as a captain,
he would spend 13 years privateering successfully in the
Caribbean. His most renowned voyage during those years
came in 1592, when he commanded a fleet of four ships that
plundered Spanish towns on the island of Hispaniola and in
Honduras. Two of the ships then returned to England
with the loot, while the other two — including Newport’s
flagship, the Golden Dragon, stayed behind to seek further
They joined forces with another English privateer fleet;
in keeping with the practice of the time, the leaders of the
two fleets would have negotiated “consortship” agreements
defining their responsibilities and the division of the
fruits of their joint labors. On August 3, the combined fleets
spotted and captured an enormous treasure ship, the
Madre de Dios. It was the greatest plunder of the century,
freighted with £500,000 worth of gems, silks, and spices.
When Newport brought it back to port in England, he had
made his name as the nation’s foremost mariner of the
Caribbean. The fortunate shareholders in the voyage
included the queen.
Newport’s Caribbean journeys continued. Near the end
of Elizabeth’s reign in 1603, John Chamberlain, a gossipy
Londoner, reported to a friend:
Here is fresh news out of Spain of one Newport, a
seaman, that with two ships hath taken five frigates
laden with treasure coming from Cartagena and
Nombre de Dios [a Panamanian port] towards the
Havana; if all be true that is reported, it will prove the
greatest prize that I ever heard of, for they that are
most modest talk of two millions at least. The King of
Spain hath sent out eight men-of-war to waylay and
intercept him. …

Region Focus | Fourth Quarter | 2010


Newport, like his fellow privateers, did not face a loss of
social status from his predatory occupation. On the contrary, he married into a wealthy family and even served on
the vestry of his church. Privateering was an activity, rare for
the England of the era, that involved social classes from the
highest to the lowest ranks. In 1596, Newport bought a share
in a privateer company himself.

Privateering as State Policy
The financial benefits that Elizabeth and her nation
received from privateering are obvious. An ambassador to
England from Venice later opined, “Nothing is thought to
have enriched the English more or done so much to allow
many individuals to amass the wealth they are known
to possess as the wars with the Spanish in the time of
Queen Elizabeth.” Kenneth R. Andrews, then an economic
historian at the University of Hull, estimated in 1964 that
privateering during her reign amounted to between 10 percent and 15 percent of England’s total imports. One Julius
Caesar — not the Roman emperor, but an admiralty judge
who would later serve as Elizabeth’s Chancellor of the
Exchequer — wrote in 1590 that Elizabeth’s own gains from
privateering up to that point had amounted to more than
£200,000, or roughly £26.8 million ($42 million) in today’s
At the same time, Elizabeth’s policy weakened the
Spanish: Not only did they lose treasure, their merchant
fleet suffered the capture of more than 1,000 ships. Gary
Anderson and Adam Gifford, Jr., economists at California
State University, Northridge, argued in a 1991 article that
privateering acted as a substitute for a standing national

navy, and in fact was a form of private production of naval
In addition to the financial and military benefits of privateering, it made a crucial contribution to England’s future
through its effect of building up human capital. As England
lacked any settlements in the New World during Elizabeth’s
time other than the short-lived Roanoke colony, it would
have been far-fetched to predict that England would ever
have a significant presence there — let alone that it would
someday dominate most of the East Coast of North
America (including the area that comprises the present-day
Fifth District of the Federal Reserve System). Any reasonable observer would have assumed that the New World
would continue to be dominated by Spain and, to a
much lesser degree, by France. An unintended consequence
of privateering was that it enabled England, at no cost to
the Crown, to develop a cadre of captains and sailors with
experience in crossing the Atlantic and navigating the
It is thus unsurprising that when the first Jamestown
colonists set out on the River Thames in late December of
1606, at least two of their three ships were commanded by
former privateers. Newport was the admiral of the voyage
and the commander of the flagship, the Susan Constant.
Bartholomew Gosnold, another former privateer, captained
the Godspeed. (The background of John Ratcliffe, captain of
the third ship, the Discovery, is unknown.) Still another
ex-privateer, George Somers, would lead the expedition that
rescued the Jamestown colony in May of 1610 after the
so-called Starving Time. The Elizabethan privateering
companies created the path to an English New World. RF

Anderson, Gary M., and Adam Gifford, Jr. “Privateering and the
Private Production of Naval Power,” Cato Journal, Spring/Summer
1991, vol. 11, no. 1, pp. 99-122.
Andrews, Kenneth R., Elizabethan Privateering: English Privateering
During the Spanish War, 1585-1603. Cambridge, England: Cambridge
University Press, 1964.

Cordingly, David, Under the Black Flag: The Romance and the Reality
of Life Among the Pirates. New York: Random House, 1995.
Rabb, Theodore K., Enterprise & Empire: Merchant and Gentry
Investment in the Expansion of England, 1575-1630. Cambridge, Mass.:
Harvard University Press, 1967.

Andrews, Kenneth R. “Christopher Newport of Limehouse,
Mariner.” William and Mary Quarterly, Jan. 1954, 3d ser., vol. 11,
no. 1, pp. 28-41.



continued from page 31

managers would better serve their teams by focusing on
the factors of Wins Produced, when faced with lots of
information they tend to focus on what’s easiest to see at the
Berri and Schmidt draw some compelling conclusions
about why the experts get it wrong, but they are not without
their critics. Since Wages of Wins was published, other
statisticians and basketball experts have argued that they


Region Focus | Fourth Quarter | 2010

disregard key factors in their models and overstate
their results. In response, Berri and Schmidt write that the
criticism stems from the fact that “Wins Produced is not
consistent with popular perceptions. Given the problems
with popular perceptions, though, this result shouldn’t be
a surprise.” Whether or not you agree with them, you
may think twice before celebrating your favorite team’s new
draft pick.



continued from page 5

Office of the Comptroller of the Currency (OCC)
announced that it would begin issuing “shelf charters,” conditional approval granted to investors seeking a national
bank charter. With a shelf charter, the investors complete
the preliminary paperwork to become a bank, but the charter remains on hold (“on the shelf ”) until the investors are in
a position to acquire a specific bank. At the same time as the
OCC rule change, the FDIC announced that it would open
the bidding to groups that did not currently have, but were
pursuing, a national bank charter, thereby allowing investors
with shelf charters to bid. Similarly, the Office of Thrift
Supervision (OTS), which regulates savings banks, reinstituted a “pre-clearance” process, further expanding the pool
of bidders.
Although some believe that private equity ownership of
banks poses new risks, Kevin Mukri, spokesman for the
OCC, emphasizes that shelf charters are “not a loophole for
private investors. They can’t go off and do their own thing —
they have to become a national bank. They have to become
subject to all the national rules and regulations.” (A national
bank is one that is chartered and regulated by the OCC
rather than by the state.)
So far, three investor groups have gone on to submit bids
and earn final approval from either the OCC or the OTS and
the FDIC. Being eligible to submit a bid doesn’t assure its
success. Regulators review the management, funding, and
business plans of would-be banks, and preliminary approval



isn’t a guarantee of final approval. Two of the three successful bids were for banks in the Fifth District. Bay National
Bank in Baltimore was acquired by the Washington, D.C.
firm Hovde Private Equity Advisors LLC. First National
Bank of the South, based in Spartanburg, S.C., was purchased by North American Financial Holdings, which also
picked up two banks in Georgia and Florida.
Both Bay National and First National were fairly young
banks, established in 2000, and they expanded rapidly, making real estate loans during the boom years of the 2000s. It’s
a business model that was replicated across the nation, and
whose effects reverberate more than a year after the end of
the recession. In 2010, 157 banks failed in the United States,
up from 140 in 2009 and 25 in 2008, bringing the total to 322
since the beginning of 2008. In contrast, between 1995
(roughly the end of the Savings and Loan crisis) and 2007,
just 58 banks failed.
Tony Plath, a finance professor at the University of North
Carolina-Charlotte, expects the number of failures to bottom out in 2011, although he projects that the industry may
yet lose another 500 banks. The FDIC currently has about
850 banks on its confidential “watch list.” Given the small
number of shelf charters, they may not be a major new
source of bank acquisitions. As the supply of failed banks
continues to increase, however, the industry may have to
turn to new sources of demand.

continued from page 16

such as information technology, robotics, and the use of
modern telecommunications technology to interact with
technologically skilled workers in low-wage markets.
Diagnosing the reasons behind the new shape of
American recoveries — if, indeed, the last several recoveries
represent a long-term change — remains a challenge for the
economics discipline. Chicago’s Cochrane notes that it is an
unsolved puzzle. “In the early 20th century, we had frequent
deep recessions, but we bounced out of them quickly,” he
says. “Now we seem to be bouncing out of them slower and

slower. Europe certainly got to a position in the 1970s and
1980s where it would get stuck without ever bouncing out,
usually for various policy reasons. Maybe that’s what’s going
on now in the United States, too. That would be depressing.”
It surely would. On the other hand, anyone old enough to
have survived the stagflation of the 1970s and the recessions
of the early 1980s knows that thoughtful policy changes can
bring a powerful recovery even in exceptionally tough
times. Joe Palooka may be woozy, but the ring doctor hasn’t
stopped the fight yet.

Blinder, Alan. “The Joe Palooka Effect,” Boston Globe,
Nov. 13, 1984, p. 48.

Different? Are They All Different?” Brookings Papers on Economic
Activity 1993, no. 1, pp. 145-211.

Carroll, Christopher D. “The Buffer-Stock Theory of Saving: Some
Macroeconomic Evidence.” Brookings Papers on Economic Activity,
1992, no. 2, pp. 61-156.

Romer, Christina D., and David H. Romer. “What Ends
Recessions?” In Fischer, Stanley, and Julio J. Rotemberg (eds.),
NBER Macroeconomics Annual 1994. Cambridge, Mass.: MIT Press,

Cochrane, John. “Comment.” In Fischer, Stanley and
Julio J. Rotemberg (eds.), NBER Macroeconomics Annual 1994.
Cambridge, Mass.: MIT Press, 1994.
Perry, George L., and Charles L. Schultze. “Was This Recession

Sinai, Allen. “The Business Cycle in a Changing Economy:
Conceptualization, Measurement, Dating.” American Economic
Review, May 2010, vol. 100, no. 2, pp. 25-29.

Region Focus | Fourth Quarter | 2010



Economic Trends Across the Region

How The Recession Affects State and Local Tax Shortfalls —
and How Those Shortfalls Affect the Recovery

n Sept. 20, 2010, the National Bureau of Economic
Research declared an official end to the worst
recession in the United States since the Great
Depression, pegging the trough at June 2009. But the pace
of recovery since that time has hardly been gratifying: GDP
growth has averaged less than 3 percent in those five
quarters as compared to an average of nearly 7.5 percent
in the six quarters following the trough of the 1982
recession. Moreover, the Census Bureau’s latest annual
report on income, poverty, and health insurance coverage
in the United States, also released in September, estimated
that the number of Americans living in poverty in 2009
was higher than at any point in the 51-year history of the
series. So while it is welcome news that the economy is
growing again, the Census report provided a timely
reminder that struggles continue for many Americans.
Much of the burden of providing vital services — such as
job training, health care, and transportation services — to
those who have been adversely affected by the downturn
often falls on state and local governments. Yet state and local
governments have been battered by the recession as well.
Tax revenue collections fell well short of planned levels
when the recession was at its worst, and governments
faced increasing demand for their services, rendering those
revenue declines even more problematic.
While the primary cause of these revenue shortfalls is the
severity of the most recent recession, another factor is that
governments have increasingly moved to funding long-term
and relatively predictable expenditure outlays with cyclical
(and often volatile) revenue streams. As a result of this
mismatch, budgets appear to have become much more
vulnerable to downturns in the business cycle. The problems
associated with this imbalance will likely grow worse before
they get better. The deep recession and slow recovery have



GDP and State Tax Revenues

State tax collections
Real GDP

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
SOURCE: U.S. Census Bureau and Bureau of Economic Analysis


Region Focus | Fourth Quarter | 2010


left taxpayers and policymakers with little appetite for new
“revenue enhancements.” As households struggle to rebuild
their own balance sheets, it appears the last thing they feel
obligated to do is rebuild the government’s, and elected
officials have acted accordingly.
This essay examines the effect that the 2007-2009
recession has had on states’ fiscal positions and, in turn, how
those fiscal positions are affecting the nascent economic
recovery, particularly in the Fifth District. The emphasis is
on the five states that make up the region: Maryland, North
Carolina, South Carolina, Virginia, and West Virginia.

The Recession’s Effect on State Tax Revenues
The immediate problem faced by state and local governments is predominantly a revenue-side phenomenon. This is
not to say that expenditures played no role in the yawning
budget gaps that emerged during the recession. But it was
not a rise in expenditures that threw governments’ budgets
out of balance; it was a sudden and unexpected fall in
revenues. Since nearly all states (including each of the five
Fifth District states) are required to balance their budgets,
this is a problem.
State and local tax revenue collections are directly related to economic activity. When the economy picks up, firms
boost output and hire more workers. When job growth is
sustained, those workers are confident enough to increase
purchases of goods, services, and new homes. With 43 of the
50 states imposing individual income taxes and all states
levying sales taxes in some form, governments see increased
revenues from those sources. They will also see increases in
real estate transfer taxes and property taxes as housing
activity and home prices increase. When the economy
contracts, these trends reverse.
While predicting the directional response of tax revenue
collections to changes in economic activity is easy, forecasting the magnitude of that response is far more challenging.
And it has become more so over the course of the past two
decades. Historically, changes in economic growth were
accompanied by similar changes in general revenue tax collections. At times, tax collections would change a little faster
or a little slower than GDP, but the relationship remained
fairly tight.
That tight relationship appeared to break down during
the recession that ended in November 2001. During that
recession, which was very shallow by most measures, state
level tax collections decreased far more than economic
output (see chart). In a 2008 working paper, Federal Reserve

Tax Revenues by State

Bank of Chicago economists Rick Mattoon and Leslie
McGranahan suggest that much of this break can be
explained by states’ increasing reliance on individual income
taxes (and the rising importance of capital gains in state
income tax collections) to fund expenditures. Nationwide,
the average percentage of total state tax revenues derived
from individual income taxes had increased from a little
more than 10 percent in the early 1960s to more than 35
percent prior to the recession in 2001. This nationwide
trend was evident to varying degrees in each state in the
Fifth District.
Given the 2001 experience, one could surmise that a
significant economic recession would have dire consequences for state governments. The most recent downturn,
with its roughly 8.5 million job losses and considerable
declines in capital gains, illustrated just that. On aggregate,
states saw revenues fall off precipitously in the fourth quarter of 2008 and experienced double-digit declines
(year-over-year) in the first three calendar quarters of 2009.
And few state governments were able to escape the carnage.
According to the Center for Budget Policies and Priorities,
only five states saw year-over-year increases in tax collections in fiscal 2009, when the fiscal crisis intensified
dramatically. Meanwhile, 14 states experienced declines in
excess of 10 percent. So the shortfalls in state tax revenue
collections were both severe and widespread across the
Three of the 14 states that experienced those sharp
decreases in tax collections — North Carolina, South
Carolina, and Virginia — are in the Fifth District. Generally
speaking, states in the Northeast, the Midwest, and the
West are more likely to rely on personal income taxes to pay
for general expenditures, while states in the South lean more
heavily on sales taxes. That generality does not always
hold in the Fifth District, however (see chart). Virginia,
Maryland, and North Carolina relied more heavily on individual income taxes heading into the most recent downturn,
while South Carolina and West Virginia relied most heavily
on sales taxes. (Even though South Carolina and West
Virginia derive a greater share of their tax revenues from
sales taxes than do the other three states, they saw the relative share of individual income taxes roughly triple over the
past 50 years.)
Given Virginia’s heavy reliance on individual income
taxes, it is not surprising that its tax collections had the
biggest decline among Fifth District states (-12.5 percent)
when the national recession was at its worst in fiscal 2009.
Yet South Carolina, which relies more on sales taxes, saw a
significant drop as well (-10.5 percent). Even though South
Carolina is less reliant on individual income taxes than
Virginia (34 percent versus 52 percent), job losses in the
state during the downturn were more severe. Total nonfarm
employment in South Carolina fell about 7 percent as a
result of the recession, whereas in Virginia job losses were
closer to 4 percent.
Local government tax collections held up well when



Individual Income






SOURCE: U.S. Census Bureau

compared to state tax collections. As mentioned above, state
level tax collections turned negative in year-ago comparisons
in the fourth quarter of 2008 and remain well below
prerecession peaks. As of the first quarter of 2010, local
government tax collections had not yet turned negative,
although their growth rate had slowed materially.
The primary factor behind the relatively better performance of local tax collections lies in local tax structures.
Nationwide, states derive roughly 80 percent of total tax
revenues from sales and individual income taxes, on average.
By contrast, local governments derive a little more than 20
percent of total taxes from these two sources and rely heavily on property taxes as a source of revenue. In fact, property
taxes made up 71 percent of local government tax collections
in the year prior to the latest recession. Unlike sales and
individual income taxes, which are highly cyclical, the
property tax base is a less volatile and more reliable funding
source. Property taxes are not a major revenue source for
states, typically accounting for 2 percent or less of total state
tax collections annually. The one exception in the Fifth
District is Maryland, where property taxes account for
about 4 percent of total collections.

Budget Gaps
The sudden drop in states’ tax collections nationwide left
most with substantial gaps between actual and previously
forecasted revenues. The tendency of demand for government services to increase during recessions only
compounded the problem. Reports by the National
Governors Association (NGA) and the National Association
of State Budget Officers (NASBO) track the progression of
states’ difficulties as the economy entered the 2007-2009
recession. They reported in the spring 2007 edition of their
The Fiscal Survey of States that only three states had to make
downward adjustments to their enacted fiscal 2007 budgets,
with the total cuts amounting to approximately
$170 million. By the spring of 2008, the number of states
forced to cut enacted budgets increased to 13 for total cuts of
$5.2 billion. By the spring of 2009, 42 states cut their
enacted budgets by a combined $46.2 billion. All told, states
will have faced budget gaps amounting to nearly $300 billion
between fiscal 2009 and fiscal 2012. Federal to state transfers
provided by the American Recovery and Reinvestment Act

Region Focus | Fourth Quarter | 2010


to GDP growth in three of the four quarters during
(ARRA) will offset roughly $135 billion of that, but very litfiscal 2010, with the reduction shaving 0.3 percent off headtle of those funds will be available beyond fiscal 2011.
line growth, on average. State and local government
Although fiscal 2009 (which ran from July 1, 2008
spending made a slight positive contribution to GDP
through June 30, 2009) covered the worst of the economic
growth in the second quarter of 2010, as those states
downturn, the problems with state’s fiscal conditions conwith fiscal years ending on June 3 released their remaining
tinued through fiscal 2010 and will likely persist much
budgeted expenditures.
longer. In fiscal 2010, each of the five Fifth District states
State and local budget cuts are also affecting employhad to cut expenditures after their budgets had already been
ment. State and local governments employed nearly 20
enacted, with those cuts ranging from $120 million in West
million workers in the U.S. That is about 15 percent of total
Virginia to more than $1 billion in Virginia, according to
payroll employment in the nation, more than the manufacNGA and NASBO.
turing and construction industries combined. As a result of
The problems at the state level have had, and will
the fiscal duress, state and local governments have been cutcontinue to have, adverse effects at the local level. For local
ting jobs and more are likely to follow. Payroll employment
governments, having a more stable tax base only partially
in the state and local government has been declining since
shields them from the deep fiscal duress that states are
the recession started in December of 2007. Through the
under. Since tax collections account for just 36 percent of
third quarter of 2010, the sector had shed about 300,000
their total revenues, local governments rely heavily on state
jobs, or roughly 1.5 percent of total sector employment.
governments to help them pay the bills. In fact, local governCompared to the private sector, which lost about 6 percent
ments get roughly 30 percent of their total revenues from
of payroll employment, this does not look all that bad.
the states. In the most recently completed fiscal year (2010),
While the private sector showed modest increases in payroll
NASBO reported that 22 states reduced local aid to help
employment over the first three quarters of 2010, however,
close budget gaps; among them were Maryland, South
state and local government employment continued to
Carolina, and Virginia.
move lower. This trend is likely to persist for several more
In more normal times, local governments receive very
little funding from the federal government. But these are
In the Fifth District, state and local government employnot normal times. A large share of ARRA funds were sent
ment currently accounts for about 16 percent of total
directly to local governments as states pulled back on their
nonfarm employment. South Carolina, West Virginia, and
contributions. With the ARRA funds set to run their
North Carolina exceed the district-wide and nationwide
course by the end of fiscal 2011, states will inevitably
averages while Virginia and Maryland have
cut transfers to local governments. Thus,
slightly lower averages. To date, cuts in Fifth
local governments still face considerable
District state and local government jobs have
challenges in coming years.
Localities generally did
not kept pace with national declines. This
better than states in
scenario is unlikely to persist given the severe
Effect of Budget Cuts on GDP
maintaining their tax
revenue declines in Fifth District states.
and Employment
revenues during the
An important common thread in both levTo this point, we have only examined state
recession. On average,
els of government is the preponderance of
and local government in terms of revenues.
states derive roughly 80
education jobs. Combined employment in
But those revenues pay for the plethora of
percent of total tax
education accounts for more than one half of
services provided by state and local governrevenues from sales and
all government jobs at the state and local
ments. And a slowdown in government
individual income taxes.
levels. Governments are reluctant to reduce
spending will detract from an already modest
In contrast, local governfunding for education, even in moderately
economic recovery, at least in the short run.
ments rely mainly on
tough economic times. Nonetheless, the
Moreover, the cuts will be more painful in
property taxes. In fact,
severe drop in revenues has led to declines in
some areas than in others. In particular,
property taxes made up
education funding and education jobs.
rural areas are likely to suffer more than
71 percent of local
Overall, state and local educational employmetropolitan areas, for reasons which will be
government tax collecment is down between 1 percent and 1.5
addressed in a moment.
tions in the year prior to
percent since its peak in mid-2008, with the
State and local government spending,
the recession. Unlike
majority of that decline at the local level. It is
through the provision of services such as
sales and individual
unlikely that state educational institutions
education, police protection, and health care,
income taxes, which are
can maintain current staffing levels with such
as well as their investments in roads, bridges,
highly cyclical, the
severe declines in revenue, even with
and schools, accounts for nearly 12.5 percent
property tax base is a less
increased enrollment and an ability to hike
of GDP in the United States. Cuts in those
volatile and more reliable
services and investment have already been a
funding source.
The cutbacks in education and other state
drag on GDP growth. State and local govern-


ment spending made a negative contribution


Region Focus | Fourth Quarter | 2010

and local government spending are likely to


states are obligated to pay for current expenaffect rural areas disproportionately. In a
ditures with current revenues, few are
2010 essay for the Federal Reserve Bank of
States in the Northeast,
obligated to properly fund their longer-term
Kansas City, Alison Felix and Jason
the Midwest, and the
expenditure obligations. Unfortunately, few
Henderson show that state government
West are more likely to
transfers account for a far greater share of
rely on personal income
rural governments’ total revenue compared
taxes to pay for general
to their metropolitan counterparts.
expenditures, while states
Likewise, state and local governments
State and local governments are facing their
in the South lean more
account for a larger percentage of total paymost challenging fiscal positions since at least
heavily on sales taxes.
roll employment in rural counties, and an
the Great Depression. While certainly diffieven larger share of personal income.
cult to predict ahead of time, the fiscal crisis
Inasmuch as West Virginia and the Carolinas
is understandable when considering the leshave the largest rural populations of Fifth District states,
sons of the 2001 recession and the severity of the most
these problems have particular significance.
recent economic downturn, especially the job losses. An
inability to pay for key services has already affected economic growth in many areas through cuts to services,
Longer-Term Liabilities
investments, and employment (which continues to trend
While the general purview of this essay is state and local
downward). Governments need to find better ways to match
government deficits, their efforts to eradicate those deficits,
their long-term and fairly predictable expenditure plans
and what impact those efforts may have on the recovery,
with similarly reliable funding sources to minimize the gaps
there is a large, longer-term problem looming on the horizon
that are otherwise bound to form during an economic downfor many states and it would be remiss to ignore the subject
turn. This will help limit the effect of downturns on
completely. And that problem is an alarming underfunding
government services. Moreover, policymakers will have to
of state and local governments’ retirement and other postfind a way to provide the services and produce the investemployment benefits. Recent research by the Center for
ments that enhance long-term economic growth while also
Retirement Research suggests that the total liabilities of
meeting the needs of their most vulnerable citizens more
state and local government post-employment benefits
efficiently. Given the magnitudes of the budget shortfalls
amount to approximately $4.9 trillion, of which $2.2 trillion
following the most recent recession, it is unlikely that govis unfunded. Moreover, as state and local governments
ernments will be able to tax their way out of the crisis. States
continue to struggle with yawning gaps between general
will probably have to rely on a combination of “revenue
fund revenue collections and general fund expenditures,
enhancements” and spending cuts to get their fiscal houses
many have slowed their contributions to their alreadyback in order.
underfunded retirement funds. While 49 of the 50 U.S.

Our regional economists share
their insights on local and
national business conditions
with trade associations,
civic organizations,
and other groups.

The Regional View will feature:
• A podcast that highlights the economist’s key insights
• An audio slideshow of the presentation, edited for length
• A PDF of the slideshow used by the presenter

The first editions of The Regional View focused on presentations by economists Andy Bauer,
Rick Kaglic, and Ann Macheras given in West Virginia, South Carolina, and Virginia, respectively.
To hear their talks, or to subscribe to the podcast, go to
Region Focus | Fourth Quarter | 2010


State Data, Q2:10


















Professional/Business Services Employment (000s) 151.1
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







Unemployment Rate (%)













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







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













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

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

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

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


Region Focus | Fourth Quarter | 2010

Nonfarm Employment

Unemployment Rate

Real Personal Income

Change From Prior Year

First Quarter 2000 - Second Quarter 2010

Change From Prior Year

First Quarter 2000 - Second Quarter 2010

First Quarter 2000 - Second 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 - Second Quarter 2010

First Quarter 2000 - Second Quarter 2010

First Quarter 2000 - Second 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 - Second Quarter 2010

First Quarter 2000 - Second Quarter 2010

First Quarter 2000 - Second 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 | Fourth Quarter | 2010


Metropolitan Area Data, Q2:10
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 | Fourth Quarter | 2010

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




Unemployment Rate (%)




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




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

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 | Fourth Quarter | 2010



How Many Kinds of Unemployment?

offered as support for the idea that policies to boost
he persistently high level of unemployment in the
aggregate demand will be effective in bringing down the
United States has stimulated a spirited debate about
unemployment rate. If, on the other hand, structural factors
its causes. This debate has focused largely on the
are more important, stimulative policy may make relatively
importance of structural factors — the possibility that
little difference in the near term.
demand for labor is rising in the economy, but not in those
The third part of the textbook taxonomy — frictional
occupations, industrial sectors, or geographic locations
unemployment — doesn’t play much of a role in the popular
where the unemployed are predominantly looking for work.
debate. But even though its meaning in the textbook
Those who think such structural causes are important
definitions is fairly narrow, there is an important sense in
point to the historically high proportion of long-term
which all unemployment is frictional. The definition of an
unemployed (those out of work for more than 26 weeks)
unemployed person is someone who does not have a job but
and to the upturn in reported job vacancies. Those on the
is actively searching for one. The fact that searching can take
other side of the argument point to the fact that the sharp
time — that is, the fact that there are frictions that get
decline in and continued low levels of economic activity
in the way of unemployed workers finding available
have been pretty widespread, which is seemingly inconsisvacancies — is integral to the very
tent with the notion that the
existence of unemployment.
economy is dealing with the costs
As growth quickens, the
At the same time, I’m not so sure
of shifting resources from
responsiveness of unemployment
the distinction between structural
depressed to robust sectors or
could be revealing about the
and cyclical unemployment is as
geographic locations. They tend
importance of structural and
clear as the recent debates make it
to argue, instead, that unemployseem. There are always differences
ment is high (and aggregate
cyclical factors.
in the growth paths of different
production low) because of a shortindustries and regions, bringing about reallocation of labor
fall of the aggregate demand for goods and services.
that takes time and entails some unemployment. This shiftThis debate drew me back to the textbooks from the
ing of economic activity is an important part of the
introductory macroeconomics courses I have taken or
dynamics that drive the business cycle, making it hard to
taught in my life. These textbooks typically had (and still
fully distinguish what’s structural and what’s cyclical.
have) sections on the types of unemployment, which are
Thinking about unemployment as a search issue — which
identified as a three-part taxonomy — structural, cyclical,
I think is the most useful way to frame the discussion —
and frictional. Structural unemployment, as in the current
leads one to consider variations in unemployment over time
debate, refers to the effects of shifts in economic activity
in terms of changes in the rate at which people enter the
between different parts of the economy — either because of
search process, mainly through the loss of jobs, and the rate
changing relative demands or changing technology, or both.
at which people exit the search process, mainly through
Cyclical unemployment is identified as the joblessness that
finding jobs. These transition rates vary over time for a
results from a downturn in the economy, often thought of as
variety of reasons, both structural and cyclical. While many
resulting from falling aggregate demand. Finally, frictional
things remain uncertain, what seems clear is that the low
unemployment captures the fact that some people are
rate at which people exit from unemployment is at the heart
always “in between” — between their last job and their next
of the current sluggish behavior of the job market.
job, or in some cases, between their last job and leaving the
The economy has been growing, though the recovery has
labor force.
been slow and unemployment has come down very little
I wonder how useful this taxonomy really is. An unemfrom its peak. As the pace of growth likely quickens in 2011,
ployed person’s current predicament is made no easier
the responsiveness of unemployment could be revealing
whether it is the result of structural, cyclical, or frictional
about the relative importance of structural and cyclical
forces. On the other hand, if there are structural factors at
factors in the current business cycle. That information
play that could help that individual make longer-term plans
would be useful to the writers of future textbooks and to
— like training or relocation decisions — this information
future policy analysts, but surely less so to those now waiting
could be useful. Of course, the recent debate about
for improvements in the labor market.
structural versus cyclical factors is driven largely by peoples’
thinking about policy responses — in particular how responsive unemployment might be to stimulative fiscal or
John A. Weinberg is senior vice president and director
monetary policy. An emphasis on cyclical factors often is
of research at the Federal Reserve Bank of Richmond.



Region Focus | Fourth Quarter | 2010



What Drives Economic Thought?

Federal Reserve

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? Studying how economic thought evolves helps us understand the value of what economists research today — and
how economic predictions should, and should not, be used in

Economists have long speculated about
the presence of market stigma that may
dissuade banks from borrowing from the
Fed’s discount window. What evidence of
stigma exists, and how will new requirements that the Fed publish the names of
borrowers — a provision of the DoddFrank legislation — affect discount window
activity? The article will be the first in a
series on regulatory reform.

Temporary Employment and the
“Jobless Recovery”
Temporary employment is on the rise and accounted for more
than a quarter of new private-sector jobs in 2010. Is this a sign
that companies are getting ready to start hiring full-time
workers? Or does it signal the beginning of a longer-term trend
toward continued high levels of temporary hiring by firms?

Military Multipliers?
Military installations are welcoming an influx of personnel
and families as the result of the 2005 Base Realignment and
Closure decisions. Among others, Forts Lee in Virginia, Meade in
Maryland, and Bragg in North Carolina will expand dramatically.
That growth may bring benefits, yet it will also bring costs.

Jargon Alert
A “market failure” is commonly identified as
when freely functioning markets fail to
allocate resources according to economists’
standard definition of efficiency. Market
failures may imply a role for government
policy, but they are far rarer than the term’s
frequent usage might imply.

Economic History
Cape Canaveral may get the headlines,
but the Fifth District is home to a large
part of the space industry that touches
everyone’s lives: communication satellites.
What are the roots of the Fifth District’s
space industry?

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

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

Recent Economic Research from the Richmond Fed
Working Papers Series

Economists at the Federal Reserve Bank of Richmond conduct research on a wide
variety of monetary, banking, and macroeconomic issues. Before that research makes
its way into academic journals or our own publications, though, it is often posted on
the Bank’s Web site so that other economists can have early access to the findings.
Recent offerings from the Richmond Fed’s Working Papers series include:

Optimal Bonuses and Deferred Pay for Bank Employees:
Implications of Hidden Actions with Persistent Effects
in Time
Arantxa Jarque and Edward S. Prescott, October 2010

Debt Dilution and Sovereign Default Risk
Juan Carlos Hatchondo, Leonardo Martinez, and Cesar Sosa Padilla,
May 2010

Time to Produce and Emerging Market Crises
Felipe Schwartzman, October 2010

Over-the-Counter Loans, Adverse Selection,
and Stigma in the Interbank Market
Huberto M. Ennis and John A. Weinberg, April 2010

On the Optimality of Ramsey Taxes
in Mirrlees Economies
Borys Grochulski, October 2010

Assessing the Effectiveness of the Paulson “Teaser Freezer”
Plan: Evidence from the ABX Index
Eliana Balla, Robert E. Carpenter, and Breck L. Robinson, April 2010

The Cyclical Price of Labor When Wages Are Smoothed
Marianna Kudlyak, August 2010

Quantifying the Impact of Financial Development on
Economic Development
Jeremy Greenwood, Juan M. Sanchez, and Cheng Wang, April 2010

The Role of Non-Owner-Occupied Homes in the
Current Housing and Foreclosure Cycle
Breck L. Robinson and Richard M. Todd, June 2010
Housing Default: Theory Works and So Does Policy
Allen C. Goodman and Brent C. Smith, May 2010
Learning About Informational Rigidities from Sectoral
Data and Diffusion Indices
Pierre-Daniel G. Sarte, May 2010

Quantitative Properties of Sovereign Default Models:
Solution Methods Matter
Juan Carlos Hatchondo, Leonardo Martinez, and Horacio Sapriza,
March 2010


On-the-Job Search and the Cyclical Dynamics of the
Labor Market
Michael U. Krause and Thomas A. Lubik, June 2010

How Large Has the Federal Financial Safety Net Become?
Nadezhda Malysheva and John R. Walter, March 2010
Residential Mortgage Default: The Roles of House Price
Volatility, Euphoria and the Borrower’s Put Option
Wayne R. Archer and Brent C. Smith, March 2010

Inventories, Inflation Dynamics, and the New Keynesian
Phillips Curve
Thomas A. Lubik and Wing Leong Teo, February 2010

You can access these papers and more at: