The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
SECOND QUARTER 2016
FEDERALRESERVE
RESERVEBANK
BANKOF
OFRICHMOND
RICHMOND
FEDERAL
Tomorrow’s
Lenders?
Online nonbank lenders are
growing fast, but questions remain
Do State Tax Cuts
Attract Business?
Overseeing
the Fed
Interview with
Josh Lerner
VOLUME 20
NUMBER 2
SECOND QUARTER 2016
COVER STORY
10
Tomorrow’s Lenders?
Online nonbank lenders have experienced tremendous growth.
What promises, and perils, do they hold for the financial system?
Econ Focus is the
economics magazine of the
Federal Reserve Bank of
Richmond. It covers economic
issues affecting the Fifth Federal
Reserve District and
the nation and is published
on a quarterly basis by the
Bank’s Research Department.
The Fifth District consists of the
District of Columbia,
Maryland, North Carolina,
South Carolina, Virginia,
and most of West Virginia.
DIRECTOR OF RESEARCH
Kartik Athreya
EDITORIAL ADVISER
Aaron Steelman
EDITOR
FEATURES
14
How Much Do State Business Taxes Matter?
States hope to attract businesses by cutting their taxes, but it’s
not clear how well it works
18
Social Security: An American Evolution
The story of our biggest government program is not just about
politics. It’s also about the influence of a diverse group of
economists
Renee Haltom
SENIOR EDITOR
David A. Price
MANAGING EDITOR/DESIGN LEAD
Kathy Constant
STAFF WRITERS
Helen Fessenden
Jessie Romero
Tim Sablik
EDITORIAL ASSOCIATE
Lisa Kenney
CONTRIBUTORS
Charles Gerena
Richard Kaglic
Eric LaRose
Michael Stanley
DESIGN
DEPARTMENTS
1 President’s Message/Minority Unemployment and the FOMC
2 Upfront/Regional News at a Glance
3 Policy Update/New Rules for Nest Egg Advisers
4 Federal Reserve/Who’s the Boss in Monetary Policy?
7 Around the Fed/Will Poor Countries Catch Up?
8 Jargon Alert/Helicopter Money
9 Research Spotlight/Was China Behind a Manufacturing Decline?
23 Economic History/Winston-Salem Out of the Ashes
26 Interview/Josh Lerner
31 Book Review/The Economics of the Global Response to HIV/AIDS
32 District Digest/Education and Vulnerability to Economic
Shocks in the Carolinas
40 Opinion/The Payoff from the Earned Income Tax Credit
Janin/Cliff Design, Inc.
Published quarterly by
the Federal Reserve Bank
of Richmond
P.O. Box 27622
Richmond, VA 23261
www.richmondfed.org
www.twitter.com/
RichFedResearch
Subscriptions and additional
copies: Available free of
charge through our website at
www.richmondfed.org/publications or by calling Research
Publications at (800) 322-0565.
Reprints: Text may be reprinted
with the disclaimer in italics
below. Permission from the editor
is required before reprinting
photos, charts, and tables. Credit
Econ Focus and send the editor a
copy of the publication in which
the reprinted material appears.
The views expressed in Econ Focus
are those of the contributors and not
necessarily those of the Federal Reserve Bank
of Richmond or the Federal Reserve System.
ISSN 2327-0241 (Print)
ISSN 2327-025x (Online)
PRESIDENT’SMESSAGE
Minority Unemployment and the FOMC
T
he Federal Reserve is getting critics’ attention
these days due to the debate over when and how
rapidly it should raise its benchmark interest rate.
Some have pointed to the fact that minority unemployment tends to be substantially higher than unemployment
of whites, and they argue that these populations will be
hurt the most if the Fed tightens monetary policy. To see
these differences, we need to go back no further than the
October jobs report, which estimated white unemployment at 4.3 percent, compared to 8.6 percent for blacks and
5.7 percent for Latinos.
This is a long-standing challenge. Narayana Kocherlakota,
the former president of the Minneapolis Fed, has noted
that for more than 40 years black unemployment has been
roughly 1.9 times greater than the overall rate. In response
to these disparities, some observers, such as AFL-CIO
chief economist William Spriggs, have called for the Fed to
continue keeping policy rates near zero to bring joblessness
among minorities down and closer to the rate of whites.
This, they argue, would be a better definition of “maximum
employment” — half of the Fed’s monetary policy mandate
— than one based on just aggregate numbers. As an example,
some point to the late 1990s and early 2000s: While aggregate unemployment fell below 4 percent, black unemployment dropped to an all-time low of 7.6 percent and real wage
growth of blacks averaged 2 percent annually, compared to
1.7 percent for whites.
These historic disparities merit a serious discussion. But
in this case, the proposed cure may well be worse than the
disease. What the critics’ argument overlooks is the risk
that is posed if the Fed overshoots and runs the economy
so “hot” that inflation pressures rise quickly. If this were
to happen, the Fed would need to respond by raising rates
to counteract those pressures. But when it’s lifting rates
rapidly, it can be difficult to calibrate the proper response.
Rising inflation expectations may also require a more
forceful Fed response. And history has shown that the Fed
has sometimes gone too far in those situations, pushing the
economy into recession.
A case in point was the early 1980s, under the chairmanship of Paul Volcker. In response to the spike of inflation
of the late 1970s, the Fed aggressively sought to shrink the
growth of the monetary base and allowed interest rates to
rise. By December 1980, the effective federal funds rate
reached almost 20 percent. These drastic measures eventually tamped down inflation, but they also led to a recession.
And as was the case in previous recessions, minorities
suffered far more than whites in the downturn. Whereas
national unemployment climbed to more than 10 percent
in 1983, it rose to almost 22 percent for blacks.
Once inflation stabilized
in the early 1980s, the Fed
sought to avoid a repeat of
this scenario by seeking to
anchor inflation expectations and act pre-emptively
when necessary. One of the
best-known examples was
our decision to raise interest rates in 1994-1995, when
headline inflation appeared
calm and the economy had
recently come out of a downturn. Despite that tightening, economic growth remained
robust and unemployment dropped further.
More fundamentally, however, this debate is about what
monetary policy can accomplish. Over time it can achieve
price stability, which, in turn, can promote growth and
employment by providing a steady environment that facilitates longer-term investment decisions. By contrast, the
policy tools that are well-suited to target specific distributional outcomes are primarily fiscal, such as public spending
on education, infrastructure, and workforce development
— and these policies are outside the Fed’s purview. Fiscal
policy decisions are not just more powerful to achieve these
ends; it is far more appropriate that they are made by elected
officials, because the democratic process reflects the public’s
trade-offs and priorities.
In short, if we want to consider the effect of monetary
policy on disadvantaged populations, we need to realize it
cuts both ways. There may be greater short-term benefits
from expansionary policy for those Americans, but they
would also face greater long-term risk from those same policies. In light of this risk, it’s not obvious that the Fed should
tilt policy one way or the other. The underlying reality is that
monetary policy is a blunt instrument — just one short-term
interest rate — and as such, it’s ill-designed to address a multiplicity of distributional issues.
EF
JEFFREY M. LACKER
PRESIDENT
FEDERAL RESERVE BANK OF RICHMOND
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
1
UPFRONT
Regional News at a Glance
BY L I S A K E N N E Y
MARYLAND — Baltimore-based Under Armour will open a 1.3 million-squarefoot distribution facility in Baltimore County in the location of the former
Sparrows Point steel mill. (See “Red Skies and Blue Collars,” Econ Focus, First
Quarter 2013.) The facility will focus on Under Armour’s e-commerce business,
which the company said grew 44 percent in the second quarter of 2016. Under
Armour said the facility will employ about 1,000 people and will be the company’s
fourth distribution center in the United States. It is expected to open in the
summer of 2018.
NORTH CAROLINA — In August, the state Supreme Court ruled that
Carthage, N.C., had unlawfully charged residential homebuilders “impact fees” for
water and sewer systems in developments. In Carthage, the approval of land for
subdivisions led to immediate charges for water and sewer expansion even if the
builder never connected to the system. If the fees were not paid, Carthage would
refuse building permits. The court ruled that state law “clearly fails to empower
the Town to impose impact fees for future services.”
SOUTH CAROLINA — The aerospace industry contributed $19 billion to the
state’s economy in 2016, a $2 billion increase from 2014, according to an economic
impact study sponsored by the South Carolina Council on Competitiveness.
The study, conducted by University of South Carolina economist Joseph Von
Nessen, found that the aerospace cluster contributed 100,000 jobs, paying an
average salary of $70,000, 69 percent higher than the state average. The study said
aerospace companies with fewer than 500 employees plan to grow their workforce
by 31 percent by the end of 2017.
VIRGINIA — Sales of Virginia wine reached a record high this year, according
to figures from the Virginia Wine Marketing Office, with 6.6 million bottles sold
in FY 2016. This is a 6 percent increase over FY 2015 and a 34 percent jump since
2010. Sales at the state’s 285 wineries — Virginia ranks fifth nationally in number
of wineries and grape production — grew 7.3 percent. The sale of Virginia cider
also increased, up 52 percent over FY 2015. In 2012, the wine and cider industries
contributed an estimated $750 million annually to the state economy.
WASHINGTON, D.C. — In an attempt to streamline regulatory processes for
D.C. businesses, the Department of Consumer and Regulatory Affairs launched
in August the D.C. Business Center, a website that allows businesses to apply for
a basic license, renew a license, and submit documentation and payments, among
other tasks. The site uses a licensing wizard to tell prospective business owners
what licenses and supporting documentation are required to start their business in
the District. The site focuses on the kinds of basic licenses most frequently issued,
such as those for restaurants, single-family rentals, and contractors.
WEST VIRGINIA — Towns hit hard by coal industry layoffs will receive help
in the form of federal grants aimed at stimulating economic development. The
POWER Initiative involves 10 federal agencies granting $38.8 million to 29
economic and workforce development projects spread among several Appalachian
states, including West Virginia. Fifteen of the selected projects are in West
Virginia, including two that span multiple states. Officials estimate the grants will
create or retain 3,400 jobs.
2
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
POLICYUPDATE
New Rules for Nest Egg Advisers
BY C H A R L E S G E R E N A
T
he shift from traditional pensions to defined
These tougher standards are aimed at ensuring that investcontribution plans and IRAs has put more people in
ment advice is impartial and in the best interest of customcharge of their nest eggs. In response, IRA holders
ers. For example, currently brokers are only required to
have turned to broker-dealers, insurance companies, pension
recommend products that are “suitable” for an investor’s
consultants, and other firms for help.
needs or risk tolerance, even when there are conflicts of
Often, these advisers charge hefty fees over the life of the
interest at play.
investment, and their staffs may receive commissions and
Second, fiduciaries will be obligated to acknowledge their
other forms of compensation for recommending investment
status and the status of their employees. They will also have
vehicles that may not give clients the biggest bang for their
to disclose material conflicts of interest and document their
buck. As a result, savers may be earning 1 percentage point
adherence to the standards of conduct.
less annually than they would have otherwise, according to
There has been a lot of discussion about how the DOL’s
a 2015 estimate from the President’s Council of Economic
rules will affect the retirement investment industry. What
Advisers.
about the broker who volunteers to provide general inforTo address this potential misalignment of incentives,
mation on saving for retirement at a Rotary Club meeting?
new rules from the U.S. Department of Labor (DOL),
Such communications may be considered “educational” and
which go into full effect in January 2018, impose stricter
not a recommendation.
standards of conduct on a broader array of retirement
As for their impact on individuals planning for their
investment advisers. “We are putting in place a fungolden years, the rules may prompt some retirement
damental protection into the
investment advisers to move their
American retirement landclients from commission-based
scape,” said Labor Secretary
accounts to accounts that charge
The net effects of the DOL’s
Thomas Perez when the rules
an ongoing flat fee based on the
were announced in April 2016.
rules … will certainly ripple through size of assets invested. This has
“A consumer’s best interest
already been happening. In 2014,
the financial services industry.
must now come before an advis35 percent of the average adviser’s
er’s financial interest.”
assets under management were in
Conflicts of interest are comaccounts that charged a flat fee,
mon in a market economy. For example, a real estate agent
according to PriceMetrix, up from 26 percent in 2011. The
hired by a young couple looking for a cheap fixer-upper may
problem is such fee-based accounts may turn out to be more
instead steer them toward a newer, more expensive house he
expensive for savers who are in it for the long haul and rarely
is trying to sell for another client. Or, a physician may send a
make changes to their portfolios.
patient for follow-up bloodwork at a diagnostic lab that she
Worse, savers with only small accounts may be dropped
has a financial interest in.
as clients by investment advisers. A recent report by
“Societies rely on various devices to manage these conMorningstar predicted that many of these people will turn
flicts,” wrote Joel Demski, an emeritus professor at the
to lower-cost ways to manage their retirement savings, such
University of Florida and accounting researcher, in a 2003
as index-based funds and online investment services (known
article in the Journal of Economic Perspectives. “Some activities
as “robo-advisers”) that use algorithms to create an investare prohibited, such as an auditor engaged with an explicit
ment portfolio automatically.
pay-for-performance contract, while at other times, we rely
The net effects of the DOL’s rules, for the companies
on disclosure of relationships.”
that provide advice and for the clients they serve, are
The DOL’s new rules take both of these approaches.
unknown. But they will certainly ripple through the financial
First, if a bank, broker-dealer, or insurer is paid for recomservices industry.
mending an investment, the firm is considered a “fiduciary
It’s no wonder that a multitude of industry particiinvestment adviser.” Such firms can continue to benefit
pants and groups — including the Securities Industry
from commissions, revenue sharing arrangements, and
and Financial Markets Association and the National
other forms of compensation as long as the pay is deemed
Association of Insurance and Financial Advisors — have
“reasonable.”
filed lawsuits to block implementation of the DOL’s new
In addition, they must adhere to standards of conduct
rules. In addition, a bill introduced by Rep. Jeb Hensarling,
defined under the Employee Retirement Income Security
R-Texas, in September 2016, the Financial CHOICE Act,
Act of 1974 for pension and health plan administrators.
would reverse the rules.
EF
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
3
FEDERALRESERVE
Who’s the Boss?
How Congress holds monetary policymakers accountable
BY R E N E E H A LT O M A N D J E S S I E R O M E R O
I
n 1956, Federal Reserve Chairman William McChesney
Martin Jr. stood before the Senate Committee on
Banking and Currency to have his reappointment to
the Board of Governors confirmed. Sen. Paul Douglas,
D-Ill., went to great lengths to remind Martin who was in
charge: “Mr. Martin, I have had typed out this little sentence
which is a quotation from you: ‘The Federal Reserve Board is
an agency of the Congress,’” he said. “I will furnish you with
Scotch tape and ask you to place it on your mirror where you
can see it as you shave each morning.” In 2013, Chairman
Ben Bernanke was asked if he had any advice for incoming
chair Janet Yellen. “The first thing to agree to,” he replied,
“is that Congress is our boss.”
In fact, though, Congress does not dictate or audit monetary policy decisions. Instead, lawmakers establish general
goals for monetary policy and evaluate its effectiveness over
time — a structure designed by Congress itself to keep monetary policy free of political pressure.
In recent years, the Fed has come under intense scrutiny
as a result of its unconventional policy responses to the
financial crisis of 2007-2008 and the ensuing recession.
While many observers credit the Fed with protecting the
U.S. economy from an even worse outcome, others believe
the central bank has displayed a troubling lack of transparency and accountability. These critics have proposed a
number of reforms to increase congressional oversight of the
Fed. But how does Congress currently hold the Fed accountable? And what is the right balance between monetary policy
independence and accountability? As with so many relationships, the answer is: It’s complicated.
A Balancing Act
Both research and history have shown that when monetary
policy is divorced from politics — and thus, for instance,
from the pressure that might be exerted by politicians hoping to stimulate the economy before an election — monetary
policymakers have more credibility in maintaining low and
stable inflation and are better able to focus on that longterm goal. At the same time, monetary policy decisions
have far-reaching consequences; thus, the public reasonably
expects the Fed to be accountable to elected officials.
Policymakers have attempted to resolve the tension
between independence and oversight by giving the Fed
independence in the use of its policy instruments — that is,
allowing the Fed to set interest rates or apply other monetary policy tools without congressional input or approval
— while allowing Congress to determine monetary policy
objectives and review the Fed’s performance over time. In
4
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
economics parlance, the Fed has “instrument independence”
but not “goal independence.”
This does not mean that the Fed has always acted independently; the Fed’s relationship with the legislative and
executive branches has evolved over the past century. But
especially since the early 1950s, the Fed has increasingly
asserted its independence from Congress and the president.
At the same time, in more recent decades, the Fed has
made a number of changes to be more transparent. Some of
those changes have been dictated by law, such as requiring
the Fed’s monetary policymaking body, the Federal Open
Market Committee (FOMC), to report to Congress twice
per year; others have been initiated by the Fed itself, such as
issuing a detailed statement after each FOMC meeting and
holding press conferences four times per year.
What’s the right amount of independence? That’s a question economists are still trying to answer. Although the consensus is that independence is beneficial, researchers have
not yet pinned down precisely which aspects of independent
governance structures — other than the absence of overt,
frequent demands from elected leaders — contribute to better policy outcomes. In addition, macroeconomic outcomes
depend on many factors: It’s difficult for researchers to disentangle whether those outcomes result from different economic circumstances, policy strategies, mandates, or political
environments. That makes it hard to say whether or not the
current amount of congressional oversight is effective, not
to mention if a change in oversight would be more effective.
The Big Club Behind the Door
Congress has both implicit and explicit tools for ensuring
the Fed is meeting the goals lawmakers have established.
For example, the Senate has the ability to approve — or
delay approving — presidential nominations of many of the
Fed’s leaders, including the Fed chairman and the governors
who compose the majority of the FOMC. Especially when
there is a strong partisan divide, senators have been able to
signal their dissatisfaction with monetary policy by delaying
the approval of Fed leaders. In 1996, for example, Sen. Tom
Harkin, D-Iowa, held up Alan Greenspan’s confirmation for
a second term as chairman for months to protest what he
and some other Democrats viewed as Greenspan’s focus on
inflation at the expense of economic growth.
Congressional hearings are another form of oversight.
The Federal Reserve Reform Act of 1977 required the
Board of Governors — in practice, the chairman — to
appear before Congress twice per year. (Fed governors and
regional Bank presidents also testify before congressional
committees occasionally, on an array of topics.) The nature
of those hearings has changed over time. In the late 1970s,
when both inflation and unemployment were high, committee members were relatively quick to challenge rhetorically
the Fed’s independence and decisionmaking, according to
research by Cheryl Schonhardt-Bailey of the London School
of Economics and Political Science and Andrew Bailey of
the Bank of England. But during the period known as the
Great Moderation, from the mid-1980s to the mid-2000s,
committee members increasingly used the hearings to talk
about topics other than the Fed, such as the United States’
international competitiveness, education policy, and the
activities of Fannie Mae and Freddie Mac — perhaps to use
the Fed chairman as expert support for their positions in
other policy debates.
The ultimate source of Congress’ authority is its ability
to amend the Federal Reserve Act, the law governing the
Fed. Lawmakers have amended the Act many times over
the past century, including some major changes to the conduct of monetary policy. (See box.) In addition, lawmakers
can try to steer the central bank via proposed legislation
(even if members know it won’t pass), public statements,
and even implicit threats.
These measures add up to what Stanford University
political scientist Barry Weingast has dubbed “the big club
behind the door,” meaning that the threat of punishment
— whether directly via amendments to the Act or through
more indirect means — should, in theory, push the Fed to
understand and comply with congressional wishes. In this
view, the absence of visible struggle suggests congressional
dominance rather than congressional impotence. This view
also suggests that overt efforts to reform the Fed aren’t actually about trying to improve the Fed’s performance, since the
Fed already has plenty of incentive to keep Congress happy.
So what are reform attempts actually about?
Assigning Responsibility
Economists and others traditionally have been concerned
that members of Congress might favor accommodative monetary policy to boost employment and output in the short run
— but according to one theory, individual lawmakers might
not have much incentive to try to influence the Fed. In the
seminal 1974 book Congress: The Electoral Connection, political
scientist David Mayhew of Yale University modeled politicians as “single-minded seekers of reelection,” meaning they
are motivated to pursue activities for which they can take
credit in the eyes of voters. But because Fed policies affect
many regions and many aspects of the economy, no single
legislator can credibly claim to have directly influenced
them. So self-interested lawmakers actually should not have
much interest in monetary policy.
Alternatively, the same electoral incentives could spur
politicians to use the central bank as a scapegoat if the economy turns sour or if interest rates get uncomfortably high
— whether or not those outcomes are actually the result of
monetary policy missteps.
Milestones in Monetary Policy Governance
• The Banking Act of 1935 created the modern Federal Open
Market Committee, a body of board members and a rotating subset of Reserve Bank presidents. The Act effectively
removed monetary policy as the exclusive purview of Reserve
Bank presidents and centralized it in the FOMC.
• The Treasury-Fed Accord of 1951 allowed the Fed to pursue
independent monetary policy, ending a period of low interest
rates at the Treasury’s behest to ease war financing.
• The Federal Reserve Reform Act of 1977 established the
Fed’s dual monetary policy mandate and required the Board
of Governors to testify before Congress twice per year. The
Humphrey-Hawkins Act of 1978 required the Board also to
submit written reports.
• The Dodd-Frank Act of 2010 significantly expanded the Fed’s
supervisory powers over financial institutions while limiting the
Fed’s emergency lending authority. The Act also directed the
Government Accountability Office to audit the Fed’s governance structure and its lending programs during the financial
crisis and required the Fed to disclose the details of discount
window loans.
In recent work, Sarah Binder of George Washington
University and the Brookings Institution and Mark Spindel
of Potomac River Capital examined congressional scrutiny
of the Fed by measuring the number of bills introduced to
the House and Senate between 1947 and 2014. They found
that lawmakers did appear to be motivated by economic
conditions: The number of bills introduced spiked with the
onset of recessions. Consistent with Schonhardt-Bailey and
Bailey’s results, Congress was notably quiet with respect to
the Fed during the Great Moderation. (Binder and Spindel’s
research will be published in their forthcoming book,
Monetary Politics: Congress and the Federal Reserve, 1913-2016.)
Binder and Spindel also found differences between the
two political parties. Democrats were more likely to introduce legislation when unemployment spiked, although this
subsided somewhat after employment was officially added to
the Fed’s mandate in 1977. Republicans showed little interest in the Fed until the “stagflation” of the 1970s, perhaps
reflecting their greater concern with inflation, which had
been relatively low and stable since the end of World War II.
Some periods spur both parties to action. During
the recession induced by the Fed under Chairman Paul
Volcker in the early 1980s to bring inflation down from the
double-digit levels it had reached, Democrats introduced
bills increasing the number of presidential appointees on
the board, which would have weakened the influence of
Reserve Bank presidents and of the chairman. Republicans
pushed for monetary policy audits and for synchronizing
the chairman’s terms with presidential administrations,
“likely a GOP rebuke,” Binder and Spindel have written,
“to the independent-minded Volcker,” whose recession
probably contributed to Republican losses in the House of
Representatives in the 1982 midterm elections.
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
5
Under Pressure
Does the Fed respond to political scrutiny? The evidence is
mixed. Between 1973 and 2008, Binder and Spindel found
little evidence that the Fed attempted to appease Congress
by lowering interest rates when legislative activity targeting
the Fed increased. But other research suggests the Fed has
factored political threats into its policymaking.
While economists generally believe that a mistaken
understanding of the forces driving inflation, and of the
relationship between inflation and employment, was at the
heart of the Great Inflation and the stagflation of the 1970s,
political pressure also may have played a part. In a 2016 article in the Journal of Money, Credit and Banking, Gregory Hess
of Wabash College and Cameron Shelton of Claremont
McKenna College concluded that during the 1970s, the
Fed lowered the federal funds rate more than warranted by
economic conditions in response to bills that threatened the
Fed’s power.
Research by Charles Weise of Gettysburg College also
finds evidence of political motivations. In a 2012 American
Economic Journal: Macroeconomics article, Weise reviewed
FOMC meeting transcripts from 1969-1982 for statements
referencing the political implications of monetary policy.
He concluded that monetary policy was about 25 basis points
lower than it would have been, given economic variables,
during periods when the chairman expressed feeling pressure
for loose policy and 25 basis points higher when there was
pressure for tight policy. Even Volcker — arguably the most
famous inflation hawk of all time — urged the committee when
he was its vice chairman to back away from policy that would
be appropriate “if we were living really in an apolitical climate.”
Sometimes, Weise notes, political pressure might actually
motivate the Fed not to comply with Congress’ wishes. By
1982, Congress and the president were pushing for easier monetary policy. But some FOMC members believed a change in
policy would be “politically suspect” and damage the Fed’s
credibility. (Later that summer, inflation began to ease off and
the Fed finally lowered the target for the federal funds rate.)
Congress also has pressured the Fed to use monetary policy tools for nonmonetary purposes. “What would Congress
have to do to indicate that it wishes the Board to change its
policy and give greater support to the housing market?” asked
Sen. William Proxmire, D-Wis., in a 1968 hearing. Proxmire
went on to imply that Congress would change the law if it had
to. In that case, the Fed complied voluntarily by purchasing
debt issued by federal housing agencies rather than risking
new legislation that could have permanent effects.
The Fed also was very cognizant of Congress as it moved
toward adopting an explicit inflation target, as Binder and
Spindel document. Bernanke wanted the Board to announce
a target when he first joined the Board in 2002, but other
FOMC members were concerned that Congress might
perceive the Fed as straying from its dual mandate. In
2009, Bernanke received explicit advice from Rep. Barney
Frank, D-Mass., that such a move in the middle of the Great
Recession would seem politically tone deaf. In the end, the
2 percent target wasn’t adopted until 2012, when employment had somewhat recovered.
Gathering Steam
Binder describes the relationship between Congress and
the Fed as interdependent. “Congress doesn’t want to be
responsible for monetary policy,” she says. “It needs someone to blame when things go wrong. But the Fed’s independence is contingent on keeping Congress on its side.”
That’s been a difficult task in recent years, with both political parties expressing dissatisfaction with various aspects of
the Fed’s response to the financial crisis and Great Recession.
Reform proposals have been wide-ranging, including subjecting monetary policy to government audits; requiring
the FOMC to follow a monetary policy rule; restricting the
Fed’s emergency lending powers; and changing the appointment process for Reserve Bank presidents. Some also have
proposed going back to the drawing board altogether and
appointing a longer-term commission to study monetary
policy reforms.
Some of these proposals have garnered bipartisan support,
potentially increasing the likelihood of legislative action. In
both 2012 and 2014, more than 300 House members from
both sides of the aisle voted in favor of “audit the Fed” legislation that would enable the Government Accountability
Office to audit the Fed’s monetary policy decisions. The bills
didn’t make it out of the House, and a stand-alone vote in the
Senate in January 2016 failed to reach cloture, but the fact
that the issue came to a vote nearly 40 years after Congress
explicitly prohibited such audits sent a clear signal that such
scrutiny was back on the table.
To be sure, there is still room for the Fed to continue to
increase its transparency and accountability. But given the
uncertainty surrounding the appropriate balance between
independence and accountability, it’s not clear that more
direct oversight would necessarily improve the Fed’s performance. And there might be other costs. “As Congress gets
more willing to attack the Fed, does that put the Fed in a
weaker position to protect itself from congressional incursions
that may have policy implications?” Binder asks. “If we think
there’s economic value to the Fed’s reputation and credibility,
then these attacks on the Fed do have consequences.”
EF
Readings
6
Binder, Sarah, and Mark Spindel. Monetary Politics: Congress and
the Federal Reserve, 1913-2016. Manuscript, September 2016.
Schonhardt-Bailey, Cheryl. Deliberating American Monetary Policy:
A Textual Analysis. Cambridge, Mass.: MIT Press, 2013.
Meyer, Laurence H. “The Politics of Monetary Policy: Balancing
Independence and Accountability.” Remarks at the University of
Wisconsin, LaCrosse, Wis., Oct. 24, 2000.
Weise, Charles L. “Political Pressures on Monetary Policy
During the U.S. Great Inflation.” American Economic Journal:
Macroeconomics, April 2012, vol. 4, no. 2, pp. 33-64.
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
AROUNDTHEFED
Will Poor Countries Catch Up?
BY E R I C L a RO S E
“Relative Income Traps.” Maria A. Arias and Yi Wen,
Federal Reserve Bank of St. Louis Review, vol. 98, no. 1,
First Quarter 2016.
A
bsolute poverty has declined dramatically around the
world over the past quarter-century. For some observers, this trend validates neoclassical convergence theory,
which posits that capital flows and technology spillover to
low- and middle-income nations will cause their income
levels to catch up to those of developed nations. In absolute
terms, it is true that many developing economies have been
consistently experiencing income growth. Thus, it would
seem they are escaping low- and middle-income levels and
converging to American living standards.
Or are they? Most of the literature has focused on absolute notions of convergence, but a recent paper by two
St. Louis Fed economists redefines this concept in relative
terms. They find that most developing countries have not
seen their income levels, as measured by real per capita
GDP, increase as a percentage of U.S. levels. The researchers conclude that, excluding the Asian Tigers, the probability of developing countries remaining behind the United
States is close to 100 percent in the long run.
The researchers believe prevailing explanations, which
emphasize the importance of institutions and barriers to
technology diffusion, inadequately account for this apparent
contradiction to convergence theory. Instead, they argue
that developing countries should follow the Asian Tigers’
example by enacting policies that increase domestic market
size in order to support industry.
“Changes in Labor Participation and Household
Income.” Robert Hall and Nicolas Petrosky-Nadeau,
Federal Reserve Bank of San Francisco Economic Letter
No. 2016-02, Feb. 1, 2016.
A
notable economic trend so far this century has been
the decline in the U.S. labor force participation rate
(LFPR) for all individuals over age 16, which had an unusually steep drop from 67.2 percent to 62.4 percent between
2004 and 2013. Economists propose various explanations
such as an aging population and a changing welfare system.
In a recent San Francisco Economic Letter, economists
Robert Hall and Nicolas Petrosky-Nadeau propose an additional factor — “the changing relationship between household income and the decision to participate in the labor
force.” Using data from the Census Bureau’s Survey of Income
and Program Participation (SIPP), they develop a probability model to analyze changes over time in the likelihood
that an individual with certain demographic characteristics
will participate in the labor market.
As might be expected, their model shows a much lower
LFPR for low-income households than for high-income
ones. Surprisingly, however, the researchers find that
the recent drop in the LFPR among prime working-age
individuals (aged 25 to 54) has been led by higher-income
households; households in the poorest income quartile
“added 0.7 percentage point to the total participation rate
between 2004 and 2013,” whereas households in the highest and second-highest income quartiles subtracted 1.6 and
2.1 percentage points, respectively. Likewise, high-income
households have led the drastic 9.6 percentage point drop
in the LFPR among workers aged 16 to 24.
Also, SIPP data seem to contradict arguments that an
aging population largely explains this decline. Workers 55
and older saw a 3.1 percentage point increase in their LFPR
between 2004 and 2013.
“The Limited Macroeconomic Effects of Unemployment Benefit Extensions.” Gabriel Chodorow-Reich
and Loukas Karabarbounis, Federal Reserve Bank of
Minneapolis Working Paper No. 733, April 2016.
I
n 2008, Congress authorized emergency unemployment
compensation in response to high unemployment rates.
Combined with state-level extended benefits, the measure
caused the duration of unemployment insurance (UI) benefits to increase from 26 weeks to an unprecedented 99
weeks in some states. Many opponents of these extensions
predicted that they would delay economic recovery by effectively subsidizing unemployment; others argued that such
benefits would help the unemployed maintain their previous
consumption levels, thus accelerating economic recovery by
increasing total consumer spending.
A recent working paper by two researchers from the
Minneapolis Fed attempts to determine the macroeconomic
effects of these UI extensions. Most states normally offer 26
weeks of UI as regular benefits and provide extended benefits
based on state unemployment rates. Because unemployment
rates are measured in real time for these purposes, they are
prone to measurement errors. The researchers exploit these
measurement errors to isolate the effects of benefit extensions.
Overall, they find results “inconsistent with either large
negative or positive effects of benefit extensions on macroeconomic aggregates including unemployment,” concluding
that UI extensions “increased the unemployment rate by
at most 0.3 percentage point” during the Great Recession.
These conclusions are consistent with previous literature.
(See “Expanding Unemployment Insurance,” Econ Focus,
Second Quarter 2014.)
EF
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
7
JARGONALERT
Helicopter Money
S
ince the global financial crisis, central bankers around
the world have considered and sometimes used a
number of unusual policy tools, including quantitative
easing (QE) and negative interest rates, in an attempt to
stimulate economies and fight deflationary pressures. Now
some economists and policymakers are thinking about adding another item to this toolbox: helicopter money.
No, the use of helicopter money wouldn’t involve money
actually falling from the sky. But it would involve a much
more direct method of getting money into the hands of
citizens than central banks have used before. Under traditional expansionary monetary policy, the Fed attempts to
stimulate the economy indirectly by lowering the interest
rates faced by banks, causing them to
borrow and make more loans. In turn,
the interest rates faced by businesses
and consumers decrease, providing economic stimulus. In contrast, helicopter
money would consist of the central bank
creating money and then distributing it
directly to the public through fiscal transfer payments — for instance, by financing
a government spending increase or tax
cut or, more drastically, by mailing a
check directly to each household.
The idea of helicopter money stems
from a 1969 essay by Milton Friedman,
who envisioned a hypothetical scenario in which a helicopter drops $1,000 on a community in a one-time event that
doubles every individual’s cash balances. In the long run,
Friedman concluded, this event would do nothing more than
double the nominal price level. But in the short run, Friedman
believed the “helicopter drop” could increase real output,
since prices would take time to adjust and firms might initially
mistake inflation for real price increases.
Economic events over the past quarter-century have
caused the idea to be taken more seriously as a possible tool to
increase both output and inflation. In the mid-1990s, Japan
began experiencing deflation, and in a famous 2002 speech,
Ben Bernanke mentioned helicopter money as a possible last
resort for the Fed to fight deflation should it ever reach the
United States. Over the past few years, more figures have publicly discussed the idea as near-zero interest rates have weakened the ability of conventional monetary policy to further
stimulate aggregate demand. Although a close aide to Japan’s
prime minister has opposed it, many experts speculate that
the Bank of Japan may pursue this policy in the coming years.
In addition to lowered interest rates, the Great Recession
saw the use of QE, in which central banks use newly created
money to buy assets from financial institutions. Conceptually,
8
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
helicopter money is quite similar — some supporters call it
“QE for the people.” Many believe that QE failed, however;
they argue that banks did not increase lending to consumers
in response to this massive liquidity increase, blunting its
effects. In contrast, helicopter money could get around this
problem by eliminating the middleman and putting money
right in the hands of consumers, possibly providing stronger stimulus than QE. As Columbia University economist
Michael Woodford put it, “the fact people get an immediate
transfer should lead them to believe that they can afford to
spend more.”
The primary argument against the use of helicopter money
is perhaps as much about politics as economics. Helicopter
money is essentially a merging of fiscal and
monetary policy, because new money is
being created by central banks but distributed in the form of fiscal transfers. Central
banks lack the authority to cut taxes or
increase government spending. In this
regard, helicopter money could threaten
the independence of central banks by
giving politicians some control over the
money supply and the ability to finance
increased government spending by printing money rather than with present or
future tax hikes. Even if helicopter money
were promised as a one-time occurrence,
politicians could always come back for seconds. Any short-run
benefits of helicopter money could be greatly outweighed by
the long-run harm of reduced monetary independence, which
most economists strongly agree makes monetary policy less
effective over time and creates inflationary pressures.
Additionally, helicopter money’s effects may be hard to
predict because its success depends largely on its ability to
shape consumer behavior and inflation expectations. If consumers see such a policy as a sign of desperation, they may
actually lose faith in the ability of central banks to conduct
effective monetary policy, leading them to save the money
instead of spending it — making helicopter money a failure.
On the other hand, helicopter money, through its effects
on expectations, could end up raising inflation well beyond
annual 2 percent inflation targets.
Some politicians and economists in Europe and Japan are
pushing to make Friedman’s thought experiment a reality,
and time will tell whether the European Central Bank and
the Bank of Japan heed their advice. But in the United
States, at least, it’s doubtful that the Fed will begin coordinating policy with Congress anytime soon — in June, Fed
Chair Janet Yellen said it might be considered only in a “very
abnormal, extreme situation.”
EF
ILLUSTRATION: TIMOTHY COOK
BY E R I C L a RO S E
RESEARCH SPOTLIGHT
Was China Behind a Manufacturing Decline?
S
BY E R I C L a RO S E
ince 2000, the number of Americans employed in
relationship between the imposition of PNTR and manufacmanufacturing has decreased by nearly 30 percent,
turing employment. Although their identification strategy
falling from roughly 17.3 million to 12.3 million. In the
does not allow for an exact estimate of the share of the manpast few years, many politicians and pundits have blamed
ufacturing employment decline accounted for by PNTR,
this decline on trade liberalization and new free trade agreePierce and Schott conclude that “moving an industry from
ments, particularly with China.
an NTR gap at the 25th percentile (0.23) to the 75th (0.40)
While economists express virtually unanimous agreement
of the observed distribution” produces an economically sigthat the aggregate benefits of freer trade outweigh the aggrenificant employment loss.
gate costs, trade can still adversely affect certain groups.
To strengthen these findings, the article examines other
Indeed, numerous studies have found that manufacturing
trends contemporary with the PNTR implementation that
workers are hurt by increased import competition resulting
have been proposed as sources of this employment loss, such
from free trade agreements. In a July 2016 American Economic
as policy changes in China, declines in unionization, and
Review article, Justin Pierce of the Federal Reserve Board of
the bursting of the tech bubble. In response, the authors
Governors and Peter Schott of Yale University build upon
implement several control variables and still find a statistithis literature by examining whether one specific policy procally and economically significant negative impact of PNTR
moting freer trade with China
on manufacturing employment.
has indeed hurt American manAdditionally, they examine man“The Surprisingly Swift Decline of
ufacturing employment.
ufacturing employment during
U.S. Manufacturing Employment.”
The authors focus on the
this period in the European
By Justin R. Pierce and Peter K. Schott.
establishment of Permanent
Union, which had granted the
Normal
Trade
Relations
equivalent of PNTR to China
American Economic Review, July 2016,
(PNTR) between the United
back in 1980, two decades earlier
vol. 106, no. 7, pp. 1632-1662.
States and China, passed in
than the United States. They
2000 and effective in 2001. The
find comparatively little man1930 Smoot-Hawley Tariff Act had set high “non-NTR” tariff
ufacturing employment loss in the EU, providing further
rates for nonmarket economies such as China, but in 1980,
evidence against alternative explanations to PNTR.
China began receiving annual waivers allowing it the normal
What explains the contribution of PNTR to this
NTR rates. Such waivers were not considered inevitable but
employment decline? The paper proposes four possible
rather subject to frequent congressional votes and threats
mechanisms. First, the reduced uncertainty created by
to end China’s NTR status. By permanently setting tariffs
PNTR may have encouraged firms to buy goods from
at relatively low NTR levels, the establishment of PNTR in
Chinese rather than American manufacturers. Second,
2000 thus eliminated a major source of uncertainty for firms
PNTR may have led to production offshoring. Third, lower
seeking trade with and investment in China. Since PNTR’s
expected future tariffs may have led to the substitution of
implementation coincided with the decline in manufacturing
capital for labor among domestic firms and a shifting away
employment, the authors investigate the causal effect of this
from labor-intensive product lines, since the United States
specific policy on employment from 2001 to 2007.
has a comparative advantage in capital whereas China has
Pierce and Schott define an industry’s “NTR gap” as the
one in labor. Finally, offshoring by one portion of a supply
difference between its non-NTR tariff rate and its NTR
chain due to PNTR may lead to offshoring of other porrate for Chinese imports — that is, the difference between
tions of the same chain.
the industry’s rates before and after 1980. Industries with
Evidence indicates that all four of these mechanisms can
larger NTR gaps are more affected by this policy change
partly account for the effect of PNTR on manufacturing
and thus might be expected to have a larger response to it.
employment. Thus, industries with larger NTR gaps experiThe authors use data from the Bureau of Economic Analysis
enced not only lower employment levels but also “increased
to calculate industry-level NTR gaps and from the Census
imports from China, and higher entry by U.S. importers and
Bureau’s Longitudinal Business Database to gather employforeign-owned Chinese exporters” as well as “shifts toward
ment and industry data from individual firms.
less labor-intensive production.” Overall, these effects point
Using this annual data from 1990 to 2007, the authors
to the strong role played by trade policy uncertainty in firm
estimate an equation examining whether higher NTR gaps
behavior; with the previously high uncertainty over future
lead to larger employment losses following PNTR’s impletariff rates nearly eliminated by PNTR, firms have stronger
mentation. They find a negative and statistically significant
incentive to establish trade relationships with China. EF
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
9
Tomorrow’s Lenders?
Online nonbank lenders have experienced tremendous
growth. What promises, and perils, do they hold for the
financial system?
BY TIM SABLIK
T
rue to its name, Prosper reported a good year in 2015. It originated $3.7 billion in consumer loans,
more than half its total since it began operations in 2006. Prosper isn’t a bank, though. It’s one
of a growing number of new alternative lenders that are part of the broader “fintech” movement
bringing a Silicon Valley startup spirit to the world of consumer and small-business finance.
Like most of its peers, Prosper boasts sleek web and mobile platforms and promises to connect
borrowers quickly with the funds they need at a competitive and transparent price. And judging
by the growth in this sector over the last two years, consumers have been increasingly taking these
lenders up on that offer. According to an April study by the University of Cambridge’s Centre
for Alternative Finance and the University of Chicago’s Polsky Center for Entrepreneurship and
Innovation, online lenders more than tripled their lending volume between 2014 and 2015, from
$11.7 billion to $36.5 billion. The bulk of this lending has been to consumers. (See chart).
This growth has been driven by both supply and demand factors. On the demand side, consumers and small-business owners are attracted to the ease of use and variety of options offered by
alternative lenders. On the supply side, these firms claim to gain a cost and speed advantage over
traditional lenders by forgoing physical branches and using advanced algorithms to instantly analyze
huge swaths of new consumer data. Additionally, alternative lenders present a new opportunity for
investors hoping for higher returns in a low interest rate environment.
But with expansion has come questions. Do these firms enjoy an advantage over traditional firms
because of new methods and technology or because they have avoided costly financial regulations and
oversight? As this sector has grown and evolved, financial regulators like the Office of the Comptroller
of the Currency (OCC), the Treasury Department, the Federal Deposit Insurance Corporation
(FDIC), and the Fed have begun asking in earnest: What opportunities and risks do these firms present for consumers, traditional lenders, and the financial system as a whole?
A Marketplace for Loans
Alternative lenders began with a simple, and old, idea: connect savers with borrowers. The challenge
lies in convincing savers to lend money to strangers when the latter know more about their likelihood
of repaying than the former. Traditionally, banks have served as middlemen for these transactions.
Savers make deposits that become the bank’s liabilities. The deposits are federally insured, alleviating
the need to worry about repayment. Banks use those deposits to fund loans, taking on the burden of
assessing borrowers’ risk so that savers don’t have to. Banks then earn a profit on the spread between
the interest they charge borrowers and the risk-free interest they pay depositors.
Many of the new online lenders connect savers and borrowers in a more direct way. Borrowers
that come to Prosper or rivals like Lending Club are offered loan terms based on their credit
history and other factors. Once approved to appear on the platform, these loans are listed on
the site and investors can choose to invest in portions of any number of loans. Those savers earn
a return based on the performance and riskiness of the loan, while the lending firm earns a fee
from matching the two parties and facilitating the transaction. This peer-to-peer or marketplace
lending draws on the power of the crowd, similar to funding websites like Kickstarter that pool
hundreds of individual small-dollar donors to fund a big project.
Not all alternative lenders follow the same model, though. “Balance sheet” lenders like OnDeck,
10
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
Filling the Gaps
By analyzing new sources of consumer data, these firms
may be able to reach new consumers and businesses that
have been underserved by traditional financial firms. At
least, that’s the hope.
Market Volume of U.S. Alternative Lenders
40
35
30
$BILLIONS
a leading alternative lender to small businesses, are much
closer to traditional banks. They hold a significant portion
of their loans on their own balance sheet and earn revenue
from the performance of those loans. Investors hold stock in
OnDeck rather than investing in individual loans.
While they have been billed as disruptors to banks, the
similarities of some of these online platforms to traditional
players somewhat belies that image. In fact, many alternative lenders depend on traditional institutions to originate
their loans. Borrowers that apply for a loan from Lending
Club, for example, actually receive a loan from a brick and
mortar bank (WebBank in Salt Lake City, Utah, which partners with several online lenders). By having a bank originate
the loan, marketplace lenders can piggyback on its charter
without obtaining one of their own. The bank then sells the
loan to the alternative lender after a few days, which in turn
securitizes the loan for sale to its investors.
Still, online lenders have innovated on the traditional
underwriting model by looking at more than just credit
scores. Alternative lenders say they analyze borrowers’ social
media accounts, educational histories, and online commerce
sales at Amazon or eBay to glean more information not
captured by traditional metrics. In theory, this information
leads to a more accurate risk assessment of borrowers, allowing alternative lenders to price riskier loans more profitably
and lower-risk loans more competitively than traditional
lenders. Additionally, since individual investors rather than
the firm bear the risk of the loans, marketplace lenders can
hold less capital against their loans compared to traditional
banks, further reducing their operating costs and passing
those savings on to borrowers.
In recent years, online lenders have attracted funding
from large institutional investors. For example, in 2010,
Lending Club’s investor base was entirely composed of individuals. By 2015, that number had shrunk to just 20 percent,
with institutional investors and individuals acting through
an investment vehicle or managed account making up the
rest. Low loan losses and interest rates have attracted investors seeking solid returns, according to a 2015 report on the
sector by Goldman Sachs.
This increase in investor participation is in part thanks
to provisions in the Jumpstart Our Business Startups Act of
2012. “More people are eligible to invest in startups now in a
broader way,” says E.J. Reedy, a senior fellow at the University
of Chicago’s Polsky Center. “At the same time, you’ve got
consumers that are more used to dealing with online platforms
and are not as tied to a traditional bank branch. And you also
have advances in algorithms and other technologies to provide scoring on loan applications. All of these things coming
together have allowed for this kind of surge to happen.”
25
20
15
10
5
0
2013
Other
2014
Business Lending
2015
Consumer Lending
NOTES: “Other” category includes marketplace real estate lending, various forms of crowdfunding,
and invoice trading.
SOURCE: “Breaking New Ground,” University of Cambridge Centre of Alternative Finance and
University of Chicago’s Polsky Center for Entrepreneurship and Innovation.
But for the most part, the typical borrower at an alternative lender looks a lot like the typical borrower at a traditional bank. For example, 80 percent of Prosper’s loans are
to borrowers with high credit scores, according to a 2016
study by the Treasury Department. What is drawing these
individuals to online lenders rather than banks? According
to surveys, borrowers rate the speed and ease of use of these
new lenders relative to traditional banks very highly. This is
particularly true among younger borrowers, who, according
to a 2015 survey by Morgan Stanley Research, were most
likely to have used or heard of alternative lenders. Price
seems to be another draw. Morgan Stanley found that as
much as 85 percent of marketplace loans to consumers are
being used to refinance some form of existing debt, suggesting that borrowers are able to get better rates refinancing
their debt with these new lenders.
Indeed, many alternative lenders have built their businesses on being able to identify low-risk borrowers better
than traditional lenders. SoFi began in 2011 as a platform for
alumni of Stanford University’s Graduate School of Business
to make loans to current students of the program. Today, its
main service is providing student loan refinancing options to
recent graduates from any accredited university or graduate
program. Loans from the Department of Education carry
the same terms for all students. SoFi advertises better rates
for students who are employed with a steady income and
who can demonstrate good financial history.
While having additional options is certainly beneficial
to creditworthy borrowers, what about those who have historically fallen through the cracks? A growing number of
startups are targeting these borrowers as well. LendUp, a San
Francisco-based firm, recently raised funding to provide credit
cards to less creditworthy borrowers. Additionally, alternative
lenders have targeted small-businesses owners who have had
trouble obtaining credit from banks. Traditionally, small businesses have relied on local community banks for loans, but
the number of community banks has been falling steadily for
decades. (See “Who Wants to Start a Bank?” Econ Focus, First
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
11
Reasons for Borrower Dissatisfaction
Treasury’s 2016 study, rates on consumer loans from
online lenders can range anywhere from 6 percent to
36 percent annually based on the borrower’s credit
Long wait for credit decision
rating, compared to about 10 percent to 12 percent
annually for a bank loan or credit card. Small-business
Difficult application process
loans at online lenders ranged anywhere from 7 percent to a whopping 98 percent annually in one case.
Unfavorable repayment terms
Concerns over high interest rates at online lendHigh Interest Rate
ers mirror criticisms that have dogged other alternative suppliers of credit, such as payday lenders.
0
10
20
30
40
50
60
70
80
A number of states have adopted usury laws capPercentage of Business Borrowers Dissatisfied with Lender
ping allowable interest rates in order to limit these
Large bank
Online lender
Small bank
practices, though online lenders have found a way
around these restrictions through their partnerships
NOTE: Survey respondents could select multiple reasons.
with brick and mortar banks. National and state
SOURCE: “2015 Small Business Credit Survey,” Federal Reserve Banks of New York, Atlanta, Boston, Cleveland,
Philadelphia, Richmond, and St. Louis.
banks that make loans to borrowers in other states
only need to abide by their home state’s usury laws.
Quarter 2016.) Both small and large banks have pulled back
By partnering with a bank headquartered in a state with no
from making smaller loans in general since they carry the same
usury limit (such as Utah), platform lenders can effectively
costs as larger loans but fewer profits.
make loans at any interest rate across the country.
“The problem is that those are the loans that most small
Some have argued that this violates the spirit of state
businesses want,” says Karen Mills, a senior fellow at Harvard
usury laws. Last year, the U.S. Court of Appeals for the 2nd
Business School and the former administrator for the Small
Circuit ruled in Madden v. Midland Funding that once a bank
Business Administration under President Barack Obama.
sells a loan (in this case, a credit card balance) to a nonbank,
Part of the recent tightening of credit by traditional
that nonbank does not enjoy the same exemption from
lenders was driven by uncertainty immediately following
out-of-state interest rate caps as the originating bank. This
the financial crisis of 2007-2008. But while banks slowly
ruling calls into question the “valid when made” doctrine,
loosened lending standards during the recovery, the July
which holds that a transaction between two parties that is
survey of senior loan officers on bank lending practices conconsidered not usurious when made cannot later become
ducted by the Federal Reserve Board of Governors shows
usurious. The implication of this decision is that alternative
tightening again for large- and small-business lending. In
lenders that buy loans originated by banks could be subject
a 2014 paper on the state of small-business lending with
to the usury laws of the borrower’s home state rather than
Brayden McCarthy (now a vice president at online lending
the bank’s. In June, the U.S. Supreme Court declined to
marketplace Fundera), Mills argued that this retrenchment
hear the case.
reflects structural impediments on traditional lenders. And
The debate over interest rate caps highlights their inherin addition to the costs to banks for making smaller loans,
ent tension. On the one hand, those laws are intended to
there are costs to businesses for going the traditional route.
protect borrowers with fewer options for credit from being
“The theory is you sit down with your banker and go over
exploited. On the other hand, preventing lenders from
what kind of loan you need, and that’s how you get the loan
charging rates commensurate with a borrower’s risk may disthat’s right for you,” says Mills. “The problem is that it’s a very
suade them from lending to risky borrowers at all, denying
cumbersome process that requires big time commitments
credit access to the people usury laws are intended to help.
for the small-business owner.” Moreover, a business owner
“To say that an expensive loan is inherently predatory,
may have to go through that process multiple times to get the
I don’t think that’s accurate,” says Brian Knight, a senior
funds they need. According to the Fed’s 2015 Small Business
research fellow at George Mason University’s market-oriCredit Survey, only about half of businesses that applied for a
ented think tank the Mercatus Center and previously head
loan from a bank received all the money they applied for.
of the FinTech program at the Milken Institute in Santa
Monica, Calif. “Some borrowers represent a sufficient risk
Balancing Access and Protection
that to get someone to lend to them, the rate is going to
While creditworthy borrowers have enjoyed savings by refineed to be higher. And the way to improve that cost is to
nancing debt through alternative lenders, others have been
facilitate competition so that prices can come down to an
less satisfied with the rates they’ve received. Of the 20 perefficient market level. At the same time, we want to make
cent of firms in the Fed’s Small Business Credit Survey that
sure that people have all the information they need to make
applied for loans from online lenders, more than 70 percent
an informed decision and ensure that there is no fraud.”
were approved for some credit. But those approved firms
Alternative lenders must already comply with federal
were on the whole unsatisfied with the high interest rates and
and state consumer protection laws, such as the Truth in
repayment terms of their loans. (See chart.) According to the
Lending Act, which requires lenders to fully disclose the
Lack of transparency
12
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
terms of loans to borrowers. And several business groups
and online lenders came together last year to develop and
endorse a Small Business Borrowers’ Bill of Rights, which
asserts that small-business owners have the right to clear and
transparent loan terms and fair collection practices.
“The goal is to have thoughtful parameters around this
market that do not get in the way of the innovation that has
been helpful in filling the gap that traditional lenders have
not been able to meet,” says Mills.
Oversight and Systemic Risk
Questions about consumer and business protections raises
another question: Who oversees online lenders? But, Knight
quips, the more appropriate question may be, “who doesn’t
oversee them?”
Banking regulators like the OCC, the Fed, and the
FDIC have an interest because of those firms’ relationships with banks. Online lenders must also register the
securities they issue to investors with the Securities and
Exchange Commission (SEC). And the Consumer Financial
Protection Bureau (CFPB) has said it is accepting consumer
complaints against online lenders.
Still, “there is a perception that some of these companies
have been moving faster than regulators can keep up with,”
says Reedy. “We’ve definitely seen regulators in the last
year move to clarify what the rules are.” In addition to the
Treasury, the OCC and FDIC have sought comments on
and released reports about online lenders. The Fed, particularly the San Francisco Fed given its proximity to many of
these startups, has also been studying them.
So far, financial regulators have largely taken a “wait and
see” approach, though in August the FDIC announced a
proposal to begin subjecting banks that partner with online
lenders to greater scrutiny. This may be in response to
concerns that some of the practices of online lenders could
threaten the broader financial system through their bank
partnerships. Some commentators have highlighted similarities in the way online lenders offload risk from their balance
sheets to investors and the securitization practices that lay
at the heart of the 2007-2008 financial crisis.
But it doesn’t appear that the risks are entirely the same
— at least not yet. Despite its impressive growth, the online
lending market represents only a small fraction of the trillions of dollars in outstanding consumer debt. Moreover, the
capital at risk in these ventures has been supplied by investors willingly undertaking risk rather than by traditional
depositors whose deposits enjoy a taxpayer guarantee, says
Knight. Those investors have an incentive to be on guard for
excessive risk-taking by the lenders, and they seem to have
been active in trying to discipline bad actors so far, he adds.
Investors hammered Lending Club earlier this year when it
was revealed that its CEO had investments that constituted
a conflict of interest and that it had wrongfully altered some
loan applications. Lending Club responded quickly, firing its
CEO and working to rebuild investor trust.
“I think the difference between now and 2007 is that
there seems to be a lot more market discipline,” says Knight.
“Now that’s not to say that if things keep growing that people won’t get complacent. That’s always a possibility. But I
don’t necessarily see that happening right now.”
Disruptors or Partners?
Lending Club is not the only alternative lender to have
suffered a shakeup in recent months. Other major firms in
the sector also reported losses over the summer as investors
either pulled out or demanded higher returns on new loans
to compensate them for risks that now seem higher than
they initially believed. Financial commentators have also
long warned that the underwriting models of these alternative lenders that rely on different consumer data have not
been tested in a rising interest rate environment or during a
downswing in the credit cycle. Recent troubles while interest rates and loan delinquencies are still relatively low has
led many critics to sound the death knell for online lenders.
As the alternative lending space continues to evolve
rapidly, it is too early to tell what form it will finally take.
One possibility, says Mills, is that startups and traditional
banks will increasingly find common ground for partnerships. Banks may find it cost-effective to outsource some
of their technology needs to nimbler firms unencumbered
by decades of legacy banking infrastructure. For example,
in 2015, JPMorgan Chase decided to partner with OnDeck
rather than develop a new online platform for small-business
lending. For their part, online lenders gain access to banks’
existing customer bases.
“It’s very difficult for new players to find customers,
particularly small businesses, because small-business owners are hard to reach — they are busy,” says Mills. “Banks
already have those customers. But for customers who want
small-dollar loans, it’s not cost effective for banks to serve
them. So it seems like a good overlapping of needs.”
Through partnerships, online lenders may yet reshape
traditional finance — even if it’s not quite the sweeping
overhaul some had envisioned.
EF
Readings
“2015 Small Business Credit Survey: Report on Employer Firms.”
Federal Reserve Banks of New York, Atlanta, Boston, Cleveland,
Philadelphia, Richmond, and St. Louis, March 2016.
Mills, Karen Gordon, and Brayden McCarthy. “The State of
Small Business Lending: Credit Access during the Recovery and
How Technology May Change the Game.” Harvard Business
School Working Paper No. 15-004, July 22, 2014.
“Opportunities and Challenges in Online Marketplace Lending.”
U.S. Department of the Treasury, May 10, 2016.
Wardrop, Robert, et al. “Breaking New Ground: The Americas
Alternative Finance Benchmarking Report.” Report from the
University of Cambridge Centre for Alternative Finance and the
University of Chicago’s Polsky Center for Entrepreneurship and
Innovation, April 2016.
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
13
4% Do
How Much
35
3
35%
5%
5
%
State Business
Taxes 7.
Matter?
40%
8.93%
States hope to attract businesses by cutting
their taxes, but it’s not clear how well it works
%
8.70%
8.93%
8%25%
2
BY ERIC LaROSE
O
n Jan. 1, 2016, North Carolina lowered its top state
corporate income tax rate to 4 percent. One of the
highest-taxed states in the South prior to a comprehensive tax reform package signed by Gov. Pat McCrory in
2013, North Carolina now has the lowest top state corporate
income tax rate of the 44 states with such taxes.
“North Carolina’s tax reform was one of the three
biggest state tax reforms in the last 30 years,” says Scott
Drenkard, director of state projects at the Tax Foundation, a
free-market-oriented tax policy research organization. But it’s
hardly an isolated example; over the past several years, states
across the country have been cutting taxes on businesses in an
effort to foster economic growth. Within the Fifth District
alone, West Virginia slashed its top marginal corporate net
income tax rate from 9 percent to 6.5 percent between 2006
and 2014. And Virginia Gov. Terry McAuliffe recently proposed cuts for his own state, claiming that it needs to remain
competitive with its southern neighbor.
The Carolina Comeback?
The economic argument behind lowering state taxes on
businesses is relatively simple: Everything else equal, lower
tax rates in a state reduce the costs of doing business and
consequently should make it more attractive for corporations to locate and expand there. North Carolina and
Kansas are the two states that have perhaps embraced this
philosophy the most since the end of the Great Recession.
McCrory, for instance, echoed the view of many North
Carolina lawmakers when he said that cutting business taxes
would “help North Carolina compete for new businesses
while growing existing ones.” Likewise, Kansas Gov. Sam
Brownback argued that “pro-growth tax policy” would be
a “shot of adrenaline into the heart of” his state’s economy.
Most businesses don’t actually pay taxes via the corporate income tax. More than 90 percent of firms, including
S-corporations, sole proprietorships, and partnerships — what
14
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
most people consider “small businesses,” as well as some larger
companies — are classified as pass-through entities, meaning
their owners pay individual income taxes on their businesses’
profits; the corporate income tax only applies to profits on
C-corporations, a category including most “big businesses.”
For this reason, personal income taxes are also de facto business taxes, so state-level business tax reforms often target
both personal and corporate income taxes.
North Carolina made cuts to both its personal and corporate income tax rates, lowering taxes for all businesses. But it
also eliminated an income tax exemption on the first $50,000
of net income for pass-through entities, a policy change that
helped to create a more consistent business tax structure in
the state even while dramatically lowering tax rates.
By most measures, North Carolina has had one of the
stronger-performing state economies over the past few years
and has experienced significant improvement in its performance relative to the rest of the nation. “At the beginning
of the recovery, North Carolina’s GDP growth rate was 36th
among the 50 states,” says Michael Walden, an economist at
North Carolina State University. “By 2015, it ranked 10th.”
Last year, North Carolina’s real personal income grew
about 3.9 percent, compared to the national average of less
than 3.4 percent. The state’s unemployment rate, well above
the national average from 2008 through 2013, equaled the
national rate of 4.9 percent in June. Looking at all these figures plus statistics on housing, corporate equity, and other
factors, a March 2016 Bloomberg News article concluded that
the state “has gained the most economic ground over the
past three years of any U.S. state.”
Many give North Carolina’s 2013 tax reforms much of
the credit for this performance, arguing that they drastically
improved the state’s business climate and encouraged more
businesses to locate there. Prior to 2013, North Carolina
had the highest top personal and corporate income tax rates
in the Southeast. In response to these reforms, Drenkard
notes, the state has had the biggest-ever improvement in the
Tax Foundation’s annual state business tax climate rankings.
“We used to rate North Carolina 44th in the country, which
really stood out like a sore thumb in the South, and now we
rank the state 15th,” he says.
Trouble in Kansas
Some states slashing business taxes haven’t been as lucky as
North Carolina. Kansas also implemented major business tax
reforms starting in 2013. While these reforms didn’t directly
lower its top marginal corporate income tax rate of 7 percent,
they did lower personal income taxes and, most importantly,
completely eliminated the income tax on pass-through corporations. This policy change has meant that small businesses
and S-corporations in Kansas no longer pay any income tax,
even as larger C-corporations still face the state’s relatively
high 7 percent top marginal rate. The governor’s office predicted that this would create more than 20,000 jobs in the
state by 2020 and initiate an economic boom.
Instead, Kansas has seen extremely poor economic performance. The state’s GDP shrunk during three of the four
quarters of 2015, technically putting the state in a recession
under one common definition of the term, and Kansas lost
about 5,400 total jobs between February 2015 and February
2016. Between 2013, when the tax reforms went into effect,
and the end of 2015, Kansas saw personal income growth
of less than 4 percent, compared to over 6 percent from
2010 through 2012. This situation prompted Federal Funds
Information for States, an organization tracking the impact
of federal policies on state budgets, to rank the state’s economy as the sixth worst in the nation.
Part of Kansas’ troubles certainly results from recent
declines in agricultural prices. But Kansas still lags behind its
Great Plains neighbors such as Nebraska, which shares very
similar demographic, geographic, and economic characteristics. Additionally, over 85 percent of recent job growth in
the Kansas City metropolitan area has occurred in Missouri
instead of Kansas. “It’s difficult to identify the role Kansas’
tax reforms have played in its weak economy, but it’s very
hard to argue that they’ve had the positive effects proponents predicted they would,” says Peter Fisher, an economist
at the University of Iowa and the Iowa Policy Project, a
left-leaning think tank analyzing tax and budget issues.
What explains this huge difference between the experiences of Kansas and North Carolina? Some argue that North
Carolina’s tax changes were better for growth because they
applied to and encouraged all forms of business activity. In
this view, lowering overall business tax rates but eliminating
the small-business exemption and other loopholes created
both a more equitable and lighter tax burden. By leaving the
corporate income tax unchanged but eliminating income
tax on pass-through entities, Kansas effectively gave preferential treatment and exemptions to a certain category of
businesses, argues Drenkard, creating perverse incentives in
the process; since 2013, a large number of Kansas firms have
reorganized themselves as pass-through entities to escape
paying taxes on profits. This trend suggests that the tax
changes have likely encouraged companies to change their
corporate statuses more than they actually stimulated additional small-business activity.
As a general rule, economists and tax experts prefer a simple business tax structure with lower overall rates to one with
higher rates but riddled with loopholes, deductions, and incentives. Jason Furman, a former senior fellow at the Brookings
Institution, summed up the rationale behind this principle of
tax neutrality: “Generally the tax system should strive to be
neutral so that decisions are made on their economic merits
and not for tax reasons.” Fisher agrees that “revenue-neutral
reform that eliminates tax preferences and incentives while
lowering rates would be sensible policy, though it is not clear
that it would have much effect on growth.”
A Changing Consensus
Although there seems to be wide agreement among economists who have studied the issue that North Carolina-style
tax reforms are preferable to Kansas-style ones, at least in
terms of the incentives they create, the economics profession still remains divided over the true impact of broadly
reducing statewide business taxes, as North Carolina did —
even after grappling with this question for decades and conducting hundreds of studies on the matter. There has long
been reason to believe that corporate income tax cuts probably have more of an effect on business activity than personal
income tax cuts. A 1989 article in the Southern Economic
Journal observed that when large corporations expand, they
usually consider several potential sites, and tax rates may
play some role in their decision. In contrast, smaller businesses usually form or expand where their owners already
live; it is quite unusual for an individual to move to another
state specifically to start a small business, let alone allow tax
rates to influence where they move. “Among taxes that could
have an impact on state economic growth, first and foremost
would be the corporate income tax,” says North Carolina
State’s Walden. A 2015 working paper by Xavier Giroud of
the Massachusetts Institute of Technology and Joshua Rauh
of Stanford University found that C-corporations are indeed
more responsive, in terms of both employment and business
creation, to corporate income tax cuts than are pass-through
entities to personal income tax cuts.
Up through the 1980s, there existed a general consensus that, because state taxes were fairly small compared to
federal taxes and other business costs, a state’s corporate
tax rates had no statistically significant effect on its wages,
employment, or economic growth. This consensus in turn
implied that personal income tax cuts failed to expand the
business of tax-through entities too. In fact, economists
believed that business tax cuts, at least at the state level,
were mostly a zero-sum game, in a similar manner to targeted tax incentives. (See sidebar on next page.)
Since the mid-1980s, this consensus has broken down; a
number of papers have found that state business tax cuts do
have statistically significant positive economic effects, even
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
15
as other studies continue to find otherwise. For several
decades, research on the topic faced several challenges,
making it difficult to isolate the effects of state tax changes
— for example, states often adjust tax rates in response to
changing economic conditions, making it tricky to separate the effects of the tax change from those of the economic environment that led to the change. Some say the
breakdown of this consensus has resulted from the use of
increasingly sophisticated statistical techniques and methodologies allowing researchers to get around these problems. In an influential 1998 article in the Journal of Political
Economy, University of Minnesota economist Thomas
Holmes examined the effects of right-to-work laws on state
economies by looking only at counties along state borders
between states with and without such laws. This approach
controlled for many economic factors in addition to policy
changes between states, allowing Holmes to focus on causal
effects of state policies. Since then, many economists have
used this approach to examine other policies such as state
corporate and personal tax rates. In a 2015 working paper,
Alexander Ljungqvist of New York University and Michael
Smolyansky of the Federal Reserve Board of Governors
examined counties along borders between states that
either increased or decreased their corporate income tax
rates. The authors found an interesting asymmetric result:
State corporate tax increases led to “significant reductions
in employment and income,” but decreases failed to boost
economic activity.
There is disagreement among economists over whether
cuts in state business taxes have any effect on a state’s economic performance, but they mostly agree that if they do,
the impact is at most quite small. Syracuse University economist Michael Wasylenko conducted a literature review
on the topic and summed up the majority view: “Taxes do
not appear to have a substantial effect on economic activity
among states,” except in hypothetical scenarios where one
state’s business tax rates are exceptionally high compared to
those of its neighbors and other similar states.
Targeted Tax Incentives
In addition to cuts in overall state-level business taxes, state
and local governments frequently use targeted tax incentives,
which, as the name implies, are tax breaks designed to entice
specific businesses to relocate to a region. For instance, in
2005, Texas state officials offered Samsung more than $200
million in property tax rebates to get the company to locate
near Austin. Currently, several Southwestern states are
offering similar incentives to Facebook as the corporation
looks to open new data centers. Although it’s nearly impossible to keep track of the total amount spent nationwide on
these incentives, a 2012 New York Times report estimated
this figure at more than $80 billion per year.
Politicians hope that offering these incentives to businesses will sway their decisions about where to locate, thus
providing jobs and other benefits for their respective states.
If tax incentives do actually influence the location decision
of a firm, then they create obvious and tangible benefits for
the communities in which they locate. But most evidence
suggests that, most of the time, targeted tax incentives do
not sway location decisions; one report from the Institute on
Taxation and Economic Policy concluded that “as many as 9
out of 10 hiring and investment decisions subsidized with tax
incentives would have occurred even if the incentive did not
exist.” This fact implies that states are essentially giving “free
money” to large corporations.
Along these lines, many have likened these policies to subsidies or corporate welfare programs rather than to traditional
tax cuts. Targeted tax incentives “do not improve conditions
for business development but instead seek out specific businesses and cut them deals so they will develop,” argues Scott
Drenkard of the Tax Foundation.
Even if tax incentives were widely effective in persuading
firms to locate in certain communities, they would still be
16
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
hard to justify economically. Targeted tax incentives are
a clear example of a zero-sum game — one community’s
gain is an equally large total loss for everywhere else. In this
case, the jobs and wages a community receives due to the
incentive are balanced out by the fact that these jobs are
taken from other locations in which businesses would have
located instead.
Additionally, the positive benefits enjoyed by these certain
communities may be only temporary. Companies receiving tax breaks to move to a municipality are always free to
relocate or shut down when economic conditions change.
During the Great Recession, General Motors closed over 50
of its properties for which it had received state and local tax
breaks to build. Economist Jeffrey Dorfman of the University
of Georgia has noted that in such instances, communities
are often made worse off than they would have been if the
company had never located there to begin with, since they
are still stuck paying for now-unneeded infrastructure built to
accommodate these businesses.
For these reasons, the use of targeted tax incentives is
overwhelmingly opposed by economists and even groups
such as the Tax Foundation that advocate for lower tax rates
across the board. Economists at the Minneapolis Fed have
even called for a federal ban on state and local tax incentives,
arguing that this would save taxpayer money without inflicting overall economic harm, since businesses would still have
to locate somewhere.
Despite the economic inefficiency of targeted tax incentives, they will likely remain popular policy. Nevertheless,
state governments would probably see much better results
from creating a better climate for all businesses than from
giving handouts to specific ones.
— E r i c L a R o se
Small Costs, Small Benefits
Top Marginal Corporate Income Tax Rates in
Fifth District States
TOP MARGINAL CORPORATE INCOME
TAX RATE (PERCENT)
50
The most direct explanation for the fairly modest
45
effects of state business tax cuts is what many econ9.2
8.25
40
6.5
6
omists have believed for decades: State-level personal
5
4
35
and corporate income taxes are too small to be of
35
35
35
35
35
35
30
much consequence to businesses. According to the
25
Iowa Policy Project, total state and local business
20
taxes constitute less than 2 percent of average total
15
business costs across every state. Moreover, taxes
10
on business income comprise only about 10 percent
5
of the total amount paid in such taxes. In his liter0
D.C.
VA
MD
NC
SC
WV
ature review, Wasylenko estimated that a 1 percent
State
decrease in total state taxes paid by businesses would
State
Federal
eventually increase that state’s GDP by about oneSOURCE: Federation of Tax Administrators
fifth of a percent. In practice, this means that, for
instance, a 25 percent reduction in a state’s business
income tax rates would only increase its GDP by one-half of
government imposes a 35 percent top corporate income tax
a percent — hardly the economic boom often hoped for by
rate on C-corporations, more than any other government
policymakers in such instances.
within the Organisation for Economic Co-operation and
While supporters of tax cuts often say that by spurring
Development. Similarly, pass-through entities are taxed at
economic activity they expand the tax base and partially pay
up to a rate of 39.6 percent.
for themselves, they almost always lead to a net reduction
Thus, federal tax rates dwarf their equivalent state rates
in tax revenue. Since 49 states are required to balance their
and minimize the relative impact of variations between
budgets, this means either lower spending or tax hikes in
state tax regimes. (See chart.) A large corporation that
other areas as well. As a result of Kansas’ tax reforms, its tax
moves from, say, North Carolina to Louisiana doubles the
revenues have plummeted; at the end of the 2016 fiscal year
top state corporate income tax rate it pays. But because it
in June, the state had over a $100 million budget shortfall,
pays the same federal rate, it increases the total top rate it
with tax collections for May alone nearly $75 million less
pays by barely 10 percent. For this reason and others, many
than expected. (North Carolina has not faced similar issues,
economists have advocated heavy reductions in the federal
partly due to heavy population growth and the elimination of
corporate income tax to promote economic activity even
certain tax exemptions.)
as most of the profession remains skeptical of large positive
Many studies have found that increased state spending
effects of state tax cuts. (See “Taxing the Behemoths,” Econ
on items such as infrastructure and education does positively
Focus, Third Quarter 2013.)
influence state economies, much more so than state tax cuts.
Still, in this age of political polarization, large-scale fedIf state tax cuts force budget cuts as well, then the effects
eral reforms may be economically desirable but are probably
may essentially cancel each other out. A 1990 article in the
politically unrealistic. “We haven’t seen real federal tax
Review of Economics and Statistics found that tax increases had
reform since 1986,” Drenkard explains, “and the states are
negative economic repercussions only when the increased
taking a front seat on this and trying to do what they can.”
revenue was used to fund transfer payments such as unemployment insurance or state welfare programs; likewise, tax
Can States Do Anything?
cuts could be harmful if they forced cuts on health care,
Economists debate the role of other state policies, such as
education, and infrastructure. Fisher argues that many studright-to-work laws and regulatory environments, in creaties on state tax rates find statistically significant results only
ing better business environments that foster growth. And
because they hold state spending constant instead of taking
there does seem to be significant agreement that states
into account the inevitable impact of tax cuts on budgets.
can increase the productivity of their future workforce by
It’s possible that Kansas, which has cut millions of dollars
improving their education systems, possibly through greater
in funding for higher education and been forced to delay
funding. “The single biggest improvement that states can
numerous road improvement projects, may actually be made
make to improve their economies in the long run would be
worse off by its tax cuts.
to improve K-12 education performance,” Walden argues.
Of course, businesses pay federal as well as state taxes.
“You’ll hear that from almost any economist you talk to.”
A C-corporation faces a top state-level corporate income
But some of the most important factors affecting state
tax rate between 5 percent and 8 percent in most states,
economic performance are probably outside the scope and
with Iowa having the highest rate at 12 percent. Likewise,
influence of any policy originating in state capitals, at least
a small-business owner usually pays a top state-level perin the short run. A state’s growth rate has been found to be
sonal income tax rate of 3 percent to 7 percent and no more
heavily shaped by its demographic makeup and economic
than 13.3 percent (in California). In contrast, the federal
continued on page 22
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
17
SOCIAL SECURITY:
AN AMERICAN EVOLUTION
The story of our biggest government program is not just about politics.
It’s also about the influence of a diverse group of economists
BY HELEN FESSENDEN
I
da May Fuller, a retired secretary in rural Vermont,
was running errands in the town of Rutland one day in
November 1939 when she decided to make a detour. She
stopped by the local office of the recently established Social
Security Administration to ask whether she might be eligible
for benefits. “It wasn’t that I expected anything, mind you,”
she explained later. “But I knew I had been paying for something called Social Security and I wanted to ask the people
in Rutland about it.”
After Fuller filed her claim, the Treasury Department
grouped it into the batch of the very first 1,000 payments
to be sent out. Hers was at the top of the list, which is how
she became the first American to receive a monthly Social
Security check. Dated Jan. 31, 1940, it totaled $22.54 — about
a fifth of average monthly wages back then.
What started as a modest check to a Vermont secretary
has become the largest government program on the books.
In 2015, it provided about $897 billion in payments to 60
million beneficiaries, covering seniors, dependent survivors,
and those on disability — about 5 percent of U.S. gross
domestic product. It is the most important source of cash
support for low-income seniors and consistently ranks as
one of the most popular government programs.
Still, Social Security has been getting fresh scrutiny. Some
lawmakers are urging action to address long-standing gaps,
especially for widows and single mothers without long work
histories, who are more likely to fall into poverty in old age.
At the same time, the financing challenges stemming from
declining fertility and baby boomer retirements are becoming more acute: Fewer workers will be available in coming
decades to support more retirees. Whereas four workers
supported each recipient in 1965, that ratio will fall to an
estimated 2 to 1 in 2030. Due to these pressures, government
forecasts project the Social Security Trust Fund (the accumulation of past surpluses, invested in U.S. Treasuries) will
start to be drawn down in 2020 and then be depleted in 2034.
This means that, absent a policy fix, anyone who becomes
eligible that year or after would get substantially reduced
benefits, by about a fifth.
What did Social Security achieve, and why did it evolve
the way it did? In part, the program’s history has been
shaped by the usual give-and-take of political bargaining.
But it also reflects the application of research by some of
the most influential American economists as the modern
postwar welfare state grew — and then came under strain.
Among the most seminal figures are Robert Ball, whose
18
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
four-decade government career profoundly shaped the program; Alan Greenspan, who led the bipartisan commission
in the early 1980s that pulled Social Security back from insolvency; and two of the most famous postwar Keynesians, Paul
Samuelson of the Massachusetts Institute of Technology
and James Tobin of Yale, both Nobel laureates. In more
recent decades, another influential scholar has been Martin
Feldstein, the Harvard economist who has been among the
most prominent backers of a more market-based approach
to reform. In very different ways, each left an imprint that
is visible today in the debates about the program’s future.
‘The Hazards and Vicissitudes of Life’
Most Americans today wouldn’t recognize the program as
it was laid out in the 1935 Social Security Act. It covered
only about half of all workers, and until 1939, it didn’t
even offer benefits to spouses, widows, or children who
lost a wage-earning parent. Benefit payments, relative to
wages, were more modest than today’s average replacement
rate of around 40 percent. But other core principles have
remained intact. One has been “pay as you go” financing
through payroll taxes, split between employer and employee
— a feature that President Franklin Roosevelt sought so
that the program would neither add to the deficit nor be
subject to the vagaries of congressional appropriators. (In
fact, monthly payments weren’t initially scheduled to start
until 1942, so that reserves could be built up; responding
to public pressure, Congress decided in 1939 to start disbursing checks early.) Another principle has been that the
expected benefit is tied to career earnings and, in turn, to
the amount of payroll taxes paid. However, Roosevelt also
pushed a progressive payment formula so that lower-income
seniors got a larger share of their wages than their better-off
counterparts. In short, Social Security was a fusion of two
approaches. It was a transfer program in that there was some
redistribution of income from current workers to retirees
along progressive lines. But it was also an insurance program
in that the government applied the funds to protect against
old-age risks such as outliving savings.
More broadly, the 1935 Act was part of a bigger shift
— a global evolution toward old-age insurance that began
in the 19th century. In the United States, the earliest of
such schemes was a Civil War benefit for disabled Union
veterans and family survivors. These benefits evolved into a
broad Republican political strategy in the decades following
the war, so much so that by 1900, around three-quarters of
surviving soldiers got disability benefits. Financed mostly
by tariff revenue, the program was one of the biggest items
in the federal budget. Meanwhile, other industrializing
nations, starting with Germany, began developing public
insurance policies to help their aging citizens who could no
longer work or rely on extended family support, something
that often fell away as workers moved to cities. Last but not
least, life expectancy was growing, so much so that by the
1930s, a 65-year-old American man could expect to live to 77,
while a 65-year-old woman typically lived to 79.
The convergence of urbanization, industrialization, and
longevity meant that older Americans in the early 20th
century were increasingly likely to fall into poverty once
they could no longer work. This trend became acute during
the Depression, when the poverty rate of those over 65
rose to 78 percent, compared to about a third of all households. After the Civil War generation passed on, some U.S.
states developed their own old-age insurance programs but
these tended to be limited. To the New Dealers, then, a
federal effort to combat old-age poverty and smooth out
wage-volatility risk was a core goal. “We can never insure
one hundred percent of the population against one hundred percent of the hazards and vicissitudes of life,” said
Roosevelt at the bill’s signing. “But we have tried to frame
a law which will give some measure of protection … against
the loss of a job and against poverty-ridden old age.”
The Age of Expansion
The Great Depression provided the political catalyst for
Social Security, but its theoretical framework can be traced
to a group of scholars known as institutional economists,
starting around World War I. This approach, technocratic
in bent and tied to the Progressive movement, heavily
influenced the labor movement and the New Dealers, and
two well-known institutional economists, Edwin Witte and
Arthur Altmeyer, helped draft the 1935 Act. It also happened
to make an imprint on the studies of a young Robert Ball
as he pursued a master’s degree in economics at Wesleyan
University in the mid-1930s.
After working in mid-level positions in the Social Security
Administration during World War II, Ball’s first major role
came in 1947 when he was appointed as staff director to
a government panel to assess whether benefits — which
remained modest and grew very slowly in the 1940s —
should be enhanced. The panel’s 1949 report helped persuade Congress to substantially hike benefits so they moved
above subsistence and to expand eligibility to more workers.
Starting in 1950, Congress approved a series of benefit hikes
as well as the inclusion of domestic, agricultural, and selfemployed workers — all initiatives Ball continued to push
as he took on more senior positions. The introduction of
disability benefits followed in 1956. In effect, Social Security
was supplanting the traditional patchwork of state old-age
programs, becoming the universal program known today
as old-age and survivors’ insurance. Amid strong wage and
population growth, by the end of the 1950s, the government
From the start, Social Security was a fusion
of two approaches: a transfer of income from
young to old, and insurance against old-age risks.
had authorized four major increases in payments, effectively
doubling average monthly benefits and expanding covered
jobs to most of the work force, while lifting the payroll tax by
only 2 percentage points and the taxable income base from
$3,000 to $4,800. By 1959, the poverty rate for the elderly
had dropped to 35 percent compared to about 18 percent
of the working-age population. In 1961, early retirement (at
age 62) was extended to men. And after Ball took over as
commissioner in 1962, the program saw further expansion
through more generous disability benefits.
Throughout the program’s growth, Ball held certain
concepts constant. First, he maintained that benefits
should provide enough assistance that they keep the retiree
above poverty, but they shouldn’t be so generous that they
are the only source of support — otherwise, workers might
not save enough themselves. Second, he believed in universal coverage not only as a way to achieve poverty reduction,
but also to give the program the broadest political support
possible. Finally, he argued that benefits should remain
tied to average wages in some way so that workers would
view Social Security as an “earned” benefit rather than a
handout.
“The thing that has appealed to me most … is that it supplies a continuing income to groups who without it would be
most susceptible to poverty,” Ball said in 1973, when he retired
as commissioner. “Yet it does this through their own effort —
the protection grows out of the work they do.”
‘The Greatest Ponzi Game’
As Social Security began transforming American retirement
in the postwar years, economists began analyzing the ways
that social insurance more broadly could coexist with a
market economy. One of the most influential was Paul
Samuelson, who famously developed a model in the 1950s to
explain how old-age insurance could be financed across generations. As he described it in a 1958 paper, two “overlapping
generations” coexist in an economy: working adults and the
nonworking elderly. In their working years, people are able
to save more, while in old age they tend to consume more
and save less. But under a program such as Social Security, a
retiree can receive far more in benefits than he or she has paid
in, because those payments are financed by taxes drawn from
an ever-growing economy and an ever-growing population of
workers (in effect, expanding the transfer component). As
long as the rate of return on tax revenue is compounded each
year, Samuelson explained, the amount drawn from the wages
of current workers is always greater than the taxes paid by preceding generations. “Social Security is squarely based on what
has been called the eighth wonder of the world — compound
interest,” he wrote in 1967. “A growing nation is the greatest
Ponzi game ever contrived.”
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
19
James Tobin, like Samuelson, was keenly interested in
social insurance schemes. Starting in the 1950s, he complemented Samuelson’s work by analyzing, among other
things, how people price risk in their investment choices,
how demographics and productivity impact Social Security
forecasts, and whether payroll taxes diminish the propensity
to save. Both in his academic and public work, he argued
that a universal, inflation-indexed old-age insurance system
was economically efficient if run well: It prevented adverse
selection while providing stronger guarantees against a
greater range of risks. Those risks included outliving your
private savings and pensions (since we don’t know when
we’ll die), surviving a spouse who had provided support, or
seeing inflation erode the value of personal assets. (Tobin
would also note that the richer and more stable an economy,
the lower those risks will be in the aggregate.) Finally, as he
saw it, because the government made a political decision in
the New Deal to protect people against extreme indigence,
even if they didn’t save during their working years, the commitment must go both ways — and that meant mandatory
participation through payroll taxes.
“Since we know as a country and a government that we
will bail such people out,” he explained in a 1990 speech,
“we have a right to insist that they save at least the minimal
amounts that would be necessary to prevent the government
from having to intervene in that way.”
Years of Retrenchment
Two developments in the 1970s upended core assumptions
of the postwar social insurance models. One was that population and economic growth began to slow down from the
boom years, which meant the expectation of sufficient compounded rates of return might no longer apply to later generations. The other was that inflation was increasing far more
quickly than before — and policymakers had a poor grasp of
how to contain it. Without a way to control inflation and
a way to peg Social Security benefits to prices, retirement
security would quickly erode.
These were the challenges Ball had to grapple with late
in his career as Social Security commissioner. Starting in the
late 1960s, Congress approved ad hoc benefit increases that
often exceeded inflation. In total, from 1940 to 1974, nominal benefits rose by 391 percent, whereas inflation increased
by only 252 percent. A key objective for lawmakers was to
find a way to adjust benefits automatically for inflation, so
they didn’t have to keep revisiting the issue. Congress passed
in 1972 the first-ever legislation pegging benefits to the consumer price index. But policymakers soon discovered that
their formula accidently made benefits far more expensive
than intended because it erroneously adjusted them for
inflation twice. By 1975, two years after Ball stepped down as
commissioner, Social Security began to run deficits, and in
1977 Congress passed amendments to bring benefits closer
to real wage growth. Those reforms helped, but they failed
to restore fiscal balance, in part because of stagflation’s
extreme effects on wages and inflation.
20
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
In 1981, the Social Security Administration projected
that the trust fund had only two years left before it would
be fully depleted, forcing benefit cuts. The Reagan administration first floated a proposal to cut benefits, including sharp reductions for early retirees, which the Senate
unanimously rejected. The administration then decided to
convene a bipartisan panel of experts and key lawmakers to
find a more palatable alternative. The commission’s leader:
Alan Greenspan, who had served as chair of the Council of
Economic Advisers in the Ford administration.
The Grand Bargain
Greenspan had spent most of his career as a forecaster, not
an academic, and he had published little on specific fiscal
programs. But for decades, he had warned about the general
risk of unsustainable growth of government spending. In a
1971 paper, for example, he warned that an inevitable fiscal
squeeze would lead to a rationing of government benefits,
including Social Security, and cause “polarization of societal
groups.” Later, in his 2007 memoir, he would write that his
own preference for any Social Security reform had always
been a private-account approach that would invest some of
the payroll tax into the stock market.
On the panel, however, Greenspan took on a pragmatic
role. With help from Ball, who had been tapped for his technical expertise, Greenspan convinced the group to first agree
on the numbers so that they could define the solvency crisis
before doing anything else. After hard bargaining throughout 1982, all agreed that they could sign off on limited concessions as long as they were distributed equally. The final
report in early 1983 won Republican support by temporarily
freezing the inflation adjustment and cutting benefits for
future retirees by lifting the full retirement age from 65 to
67 — but very slowly and incrementally and not starting until
2000 (effectively masking some of the costs of reform). The
plan brought along Democrats by making adjustments on
the revenue side, including taxing Social Security benefits for
the first time. The bipartisan weight behind the report galvanized Congress to act within months. But deadline pressure
may also have had something to do with it. By the time the
final legislation passed in April, the trust fund was estimated
to be only four months away from depletion.
In his memoir, Greenspan called the episode a “virtuoso
demonstration of how to get things done in Washington.”
The episode also built his credentials as an effective leader,
four years before Reagan tapped him as chairman of the
Federal Reserve Board. The 1983 legislation brought the
trust fund back into balance two years later, and to this
day many experts see the mix of benefit cuts and higher
taxes as a template for any future fix. Talk of curbing the
growth of future Social Security benefits came up again in
2011, for example, during unsuccessful bipartisan talks on
a budget “grand bargain.” Most recently, the Bipartisan
Policy Center, a nonprofit led by former lawmakers from
both parties, has called for a similar balance between benefit cuts and tax hikes as part of a comprehensive plan on
The Social Security Funding Gap
Social Security revenue and outlays as a percentage of gross domestic product (GDP).
5
4
Trust Fund savings are expected
to be exhausted by 2034.
3
2
Historical
1
Projected
0
Dedicated Revenue
Scheduled Benefits
NOTES: “Scheduled benefits” represent what Social Security recipients would be owed under the
current formula. “Dedicated revenue” represents what Social Security receipts would be if taxes or
policy are unchanged. Both are based on long-term demographic and economic forecasts by the
Social Security Administation.
SOURCE: U.S. Social Security Administration, as adapted by the Bipartisan Policy Center in its Report
of the Commission on Retirement Security and Personal Savings (July 2016).
Bush administration. After a few months of debate, however, it died in the Senate. Lawmakers couldn’t agree on how
to fill the financing gap, and no one in either party wanted
to consider actually cutting benefits. Further complicating
the math, the budget surplus was gone. Three years later, the
financial7 crisis and stock market crash greatly reduced the
public’s 6appetite for retirement investment risk.
The 5idea of adding a personal-account component to
Social Security is now considered a political long shot in
4
Washington,
even as other nations — including Australia,
New Zealand,
Mexico, and Sweden — have been expanding
3
experiments
in
partial privatization in recent years. That
2
said, Feldstein and others have had more success in pushing
10 slow20the growth
30
40
50
60 time.
70
for ideas1 that0 would
of benefits
over
One proposal
isLarge
to lift
the fullSmall
retirement
age
by lender
up to three
0
bank
Online
bank
more years, reflecting the increase in life expectancy since
the 1983 reform. Seniors would still be eligible for early
Dedicated Revenue
Scheduled Benefits
retirement at age 62 (which yields lower benefits), but they
would receive more if they opted to wait longer before applying for full benefits. As Feldstein has pointed out, the change
in full retirement age has coincided with a higher labor force
participation rate among seniors in recent decades — which
means more are paying into Social Security. The idea of
boosting the full retirement age has recently gotten more
attention from a broader array of economists and experts,
including the Bipartisan Policy Center’s proposal.
80
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
2020
2025
2030
2035
2040
2045
2050
2055
2060
2065
2070
2075
2080
2085
2090
The 1983 reform ensured solvency through the early decades
of the 21st century. But Ball, Tobin, Greenspan, and many
other economists also realized at the time that the lower
birthrates of the modern era, and the onset of baby boomer
retirements, would mean that fewer workers had to support
a growing population of retirees in the generations thereafter. (See chart.) By the 1990s, the implications of the demographic crunch were becoming evident with each Social
Security Trustee Report. At the same time, the robust stock
market led many Americans to expect higher returns on their
investments in general. And as the budget surplus emerged
in the late 1990s on the heels of the boom, some policymakers asked whether part of that money might finance a “down
payment” on a Social Security reform in the direction of privatization. Indeed, starting in the 1980s, some nations began
limited experiments in privatized pension financing. The
idea was that personal saving and investment should take
on a greater role in retirement security, reducing the need
of the government to raise taxes or cut spending to fund the
pensions of an ever-growing population.
Martin Feldstein, who headed the Council of Economic
Advisers under Reagan, was a leading advocate of this route.
The option of raising Social Security taxes, he warned, would
push the marginal tax rates so high that they would reduce the
incentive to work. But if one compared the stock market’s
historic rate of return — which he calculated at about 7 percent a year — to the implicit rate of return as measured by the
growth of the tax base (about 2.5 percent), a long-run solution
that diverted some of the payroll tax into “personal” accounts
could make up the financing gap. These accounts, by investing
in diversified stock funds akin to 401(k)s, would yield higher
returns than they would as payroll tax dollars, he concluded.
The challenge, as Feldstein acknowledged, was that there
was a still a tough trade-off for policymakers. Any revenue
diverted from taxes meant current benefits would have to be
trimmed, and the scheme would require an ongoing series of
benefit cuts as the retiree population grew. Still, he argued,
total benefits would rise over time due to the higher projected returns on personal accounts.
Other economists took issue with some of those assumptions. For example, Peter Diamond of MIT and Peter Orszag,
then of the Brookings Institution, noted that the effective rate
of return on Social Security had to be discounted in any case
for the substantial “legacy debt” that the trust fund had to pay
off for the first wave of recipients, who got far more than they
paid in. Furthermore, the program’s lower return reflected its
far lower risk compared to stock-market investment. Other
economists questioned the premise that stock-market returns
would be as high and consistent as Feldstein assumed.
As the political tides shifted, this approach, in an altered
fashion, got its chance for a real-life test in 2005 from the
6
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
2020
2025
2030
2035
2040
2045
2050
2055
2060
2065
2070
2075
2080
2085
2090
Getting Personal
7
PERCENTAGE OF GDP
retirement security. The political challenge of addressing
solvency is so daunting, however, that no overhaul has
come close to passage since 1983.
A Changing Safety Net
What is the extent of Social Security’s current solvency
challenge? Each year, the trustees of the Social Security
Administration release the official report on the program.
This year’s report calculated that if the program is to be
restored back to full solvency over 75 years, it would have to
make up a “payroll deficit” of 2.66 percent; that deficit, in
effect, is the difference between expected revenue from taxable income and expected outlays. This means that either payroll tax rates can go up or that the tax base could be broadened
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
21
by raising the cap on taxable income, now set at $118,500.
Those who favor the latter route argue that the spike in higher
incomes relative to median wages over the last 30 years has
left a larger share of high earners undertaxed when it comes
to Social Security earnings. But others say that, for any deal
to include higher taxes, benefit cuts of some sort will have to
be included. Whatever form an overhaul might take, most
economists agree that if the right steps are taken soon, the
program can be brought back to long-term solvency without
drastic changes or sharp benefit cuts starting in the 2030s.
Scholars are also trying to apply new lessons from the
Great Recession as a test case of the program’s function as a
safety net. Broadly speaking, the program’s initial purpose of
protecting seniors against life’s “vicissitudes” has been borne
out by research, across booms and busts, in an economy that
is far different from the one in Roosevelt’s day. A 2012 report
by the Center for Retirement Research at Boston College,
for example, concluded that early benefit claiming played an
important role as an income guarantee during the worst of the
downturn. It found a 5 percentage point spike in early benefit
claiming from 2007 to 2009, and that it was closely correlated
to movements in the unemployment rate. Taking a longer
view, economists Gary Engelhardt of Syracuse University
and Jonathan Gruber of MIT have noted a strong correlation
between the historic expansion of Social Security benefits
and the concurrent fall in the elderly poverty rate — indeed,
explaining the entire decline in the elderly poverty rate
between 1967 and 2000. (That rate dropped to around 10
percent in the 1990s, and it has stayed there since.)
As for Ida May Fuller, she received checks until she died
at age 100 in 1975. The payments came to about $23,000
over those 35 years, and she said they were enough to cover
most of her basic expenses in later years after she moved in
with a niece. But Fuller, a Republican, was always a skeptic
about Roosevelt, and the program’s expansion during her
years in retirement didn’t sit with her well.
“Every time they raise [benefits], they raise the amount
taken away from the working people who pay into it,” she
told a reporter in 1970. “And it’s just getting to be too much
of a burden.”
EF
Readings
Berkowitz, Edward D. Robert Ball and the Politics of Social Security.
Madison: University of Wisconsin Press, 2003.
Engelhardt, Gary V., and Jonathan Gruber. “Social Security and
the Evolution of Elderly Poverty.” National Bureau of Economic
Research Working Paper No. 10466, May 2004.
Feldstein, Martin. “Structural Reform of Social Security.” Journal
of Economic Perspectives, Spring 2005, vol. 19, no. 2, pp. 33-55.
Samuelson, Paul A. “An Exact Consumption-Loan Model of
Interest with or without the Social Contrivance of Money.”
Journal of Political Economy, December 1958, vol. 66, no. 6,
pp. 467-482.
Tobin, James. ”Social Security, Public Debt and Economic
Growth.” In James Tobin (ed.), Full Employment and Growth:
Further Keynesian Essays on Policy. Brookfield, Vt.: Edward Elgar,
1996, pp. 254-285.
How Much Do State Business Taxes Matter? continued from page 17
structure, among other things, and there are clearly regions
that are prospering in spite of high taxes and other policies
generally considered “anti-business.” The booms in cities
such as San Francisco and New York, which are located in
high-tax states, suggest that other factors are outweighing
the regulatory and tax burdens coming out of Albany or
Sacramento. For instance, a 2010 book edited by Harvard
economist Edward Glaeser suggested that agglomeration
benefits may have risen in recent years, making it more
attractive for, say, a high-tech startup to locate in Silicon
Valley than in Nevada, a much lower-taxed state with a
much smaller concentration of similar firms.
And perhaps most importantly, state economies generally
tend to fluctuate along with the national economy. “Changes
in the national GDP growth rate account for 70 percent of the
change in North Carolina’s GDP growth rate,” notes Walden.
“The single most important determinant of economic growth
in North Carolina is economic growth in the nation.”
EF
Readings
Alms, James, and Janet Rogers. “Do State Fiscal Policies Affect
State Economic Growth?” Public Finance Review, July 2011,
vol. 39, no. 4, pp. 483-526.
Fisher, Peter S. “Corporate Taxes and State Economic Growth.”
Iowa Policy Project, April 2013.
Gale, William G., Aaron Krupkin, and Kim Rueben. “The
Relationship Between Taxes and Growth at the State Level: New
Evidence.” National Tax Journal, December 2015, vol. 68, no. 4,
pp. 919-942.
22
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
Giroud, Xavier, and Joshua Rauh. “State Taxation and the
Reallocation of Business Activity: Evidence from EstablishmentLevel Data.” National Bureau of Economic Research Working
Paper No. 21534, September 2015.
Ljungqvist, Alexander, and Michael Smolyansky. “To Cut or
Not to Cut? On the Impact of Corporate Taxes on Employment
and Income.” Federal Reserve Board of Governors Finance and
Economics Discussion Series No. 2016-006, Dec. 11, 2015.
Walczak, Jared, Scott Drenkard, and Joseph Henchman. “2016 State
Business Tax Climate Index.” Tax Foundation, November 2015.
ECONOMICHISTORY
Out of the Ashes
Winston-Salem is transforming its economy from tobacco to medical research
BY T I M S A B L I K
D
owntown Winston-Salem, N.C., used to be the
heart of tobacco manufacturing in America.
Factories and warehouses belonging to R.J.
Reynolds, once the largest tobacco company in the world,
dominated the cityscape. Today, instead of cigarette
machines and factory workers, many of those buildings
house medical lab equipment and researchers from Wake
Forest University’s School of Medicine, Forsyth Technical
Community College, and Winston-Salem State University,
as well as more than 60 companies.
The activity downtown is a welcome change for residents
after turbulent times. For most of the 20th century, locals
had grown accustomed to decade after decade of growth.
But for the first time in 1980, the city’s population declined.
Then the real bad news began. McLean Trucking, the
fifth-largest trucking company in the country and employer
of some 10,000 people in Winston-Salem, declared bankruptcy in 1986. Piedmont Airlines, renowned for bringing
a bit of the city’s Southern hospitality to fliers across the
country, was acquired by USAir in 1988; the new owners
promptly shifted over 5,000 jobs from Winston-Salem to
other locations. That same year, AT&T closed an office
in the city that at its height had employed about 13,000
people. But the worst dagger to the city came in 1987, when
Reynolds’ new management moved the company headquarters to Atlanta.
“City leaders had counted on these companies to provide
their growth,” says Gayle Anderson, president and CEO of
the Winston-Salem Chamber of Commerce. “All of a sudden, that wasn’t going to happen anymore.”
The Rise of Camel City
Like much of the South, neighboring Winston and Salem,
N.C., owed their initial growth largely to two plants: cotton
and tobacco.
“King Cotton” came first, with Salem’s first textile mill
opening in 1836. At the turn of the 20th century, Pleasant H.
and John Wesley Hanes started the clothing company that
would go on to become a globally recognized brand. Winston,
established after Salem in 1849, gravitated toward tobacco. In
fact, the Hanes brothers initially came to Winston in 1872 to
make their fortunes in the tobacco industry. But the true heir
to “King Tobacco” would arrive two years later.
Richard Joshua Reynolds was drawn to Winston by the
newly constructed North Western North Carolina Railway
spur connecting the town to Greensboro, N.C. The Forsyth
County soil was also perfect for growing North Carolina’s
popular bright-leaf tobacco. The son of a Virginia tobacco
farmer and manufacturer, Reynolds established his first
“little red factory,” which was no larger than a tennis court,
next to the railroad track and began producing his own blend
of chewing tobacco.
By the time Winston and Salem merged in 1913, Reynolds
had established himself as the dominant tobacco maker
in town. That year, he introduced Camel cigarettes to
the country. They were an instant hit. In the first year
alone, Reynolds produced more than 1 million Camels. By
1921, his company was making billions of them, and they
accounted for half of the cigarettes smoked in the United
States, earning Winston-Salem the nickname “Camel City.”
America’s entry into World War I was good for Reynolds
and Hanes, which supplied cigarettes and undershirts for
soldiers. Winston-Salem was importing and exporting so
many goods and materials that it was declared a “port of
entry” by Congress in 1916 — the farthest inland port up to
that time and the eighth largest in the country.
People flocked to Winston-Salem as its businesses roared
into the 1920s. Between 1910 and 1920, its population more
than doubled from about 22,000 to 48,000, making it briefly
the largest city in North Carolina. While not a “company
town” per se, one didn’t have to look far to see Reynolds’
influence on Winston-Salem. From the 22-story R.J. Reynolds
Tobacco Building (recognizable to anyone familiar with the
Empire State Building, since the architects used a scaled-up
version of the same design for the iconic New York skyscraper), to the smokestacks of the Bailey Power Plant
emblazoned with the company name, to the Reynolda House
Museum of American Art, Reynolds’ name is everywhere. As
a number of local histories recount, not much happened in
the city without the approval of Reynolds executives.
Residents didn’t resent this relationship, however.
Reynolds offered well-paying jobs with good benefits, and
company executives gave generously to build their community. A fund established by the family of Bowman Gray, the
company’s third president, helped create a medical school at
Wake Forest University, and members of the Reynolds family persuaded the university to move to Winston-Salem in
1956. Two years later, Reynolds became the largest tobacco
company in the world, and its success spurred the growth of
supporting businesses like McLean Trucking and Wachovia
Bank, which handled Reynolds’ accounts. Then, things
started to unravel.
Up in Smoke
Signs of trouble came slowly at first. Studies linking cigarette
smoking to lung cancer began trickling in during the 1940s
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
23
downtown Winston-Salem closed. It was a bleak epilogue
to a rapid exodus of employers that had left the community
stunned. “We knew we had to do something different,” says
Anderson. “The question then became: What?”
Winston-Salem’s skyline preserves the past as it looks to the future. The
Bailey Power Plant, which once fueled factories for R.J. Reynolds Tobacco
Co., is being renovated as part of a new research and innovation district.
and 1950s. In 1964, the Surgeon General issued its first report
warning that smokers faced a much higher risk of developing
lung cancer and other lung diseases than nonsmokers. While
Reynolds and other tobacco manufacturers fought these
charges, the company was also facing increasing competition
from within the industry. In 1972, Phillip Morris unseated
Reynolds as the top cigarette maker in the world (though
Reynolds managed to hold on to its number-one position in
America for about another decade).
In response to these pressures, the company sought to
diversify. R.J. Reynolds Tobacco Co. became R.J. Reynolds
Industries and began acquiring various beverage and food
makers. In 1975, it also started work on a new, modern tobacco factory in northern Forsyth County dubbed
“Tobaccoville.” In the end, both moves would end up working against Winston-Salem residents.
When Tobaccoville opened in 1986, Reynolds shifted its
workforce from the older facilities in downtown WinstonSalem to the new factories, abandoning earlier plans of revitalizing the downtown factories as the company’s finances
continued to decline. Although Reynolds executives originally intended to simply move existing employees to the
new facilities, they quickly realized they had a problem.
Tobaccoville had been built to take advantage of the latest computerized machinery to minimize costs, but most
Reynolds employees did not have the training to operate it.
At the same time that new technology threatened to make
the local workforce obsolete, changes within the company
further weakened local ties. As part of its diversification
effort, Reynolds had acquired Nabisco Brands Inc. in 1985
and the two companies merged into RJR Nabisco. Nabisco’s
chief executive, F. Ross Johnson, quickly maneuvered to the
top of the new company. An outsider originally from Canada,
Johnson saw little reason to keep RJR Nabisco in “bucolic”
Winston-Salem, as he called it. Within days of becoming
CEO, he persuaded the board to move the company headquarters to Atlanta and organized a leveraged buyout of
the company in 1988, which was the subject of the Bryan
Burrough and John Helyar book Barbarians at the Gate.
On June 29, 1990, the last operating Reynolds factory in
24
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
Winston-Salem is hardly the first American city to grapple
with the loss of its defining industry. From an economic
perspective, cities develop because there is some benefit to
firms and people from being in that location. A successful
firm like Reynolds can attract other businesses, either in the
same industry or across industries, that mutually benefit from
being near one another. These benefits include sharing a pool
of specialized labor, sharing access to raw materials or transportation infrastructure, and sharing knowledge. Economists
refer to these advantages as “agglomeration economies.”
But what happens to a city when the industries that produced these agglomeration economies decline or disappear?
It’s possible that new firms will move in, be successful, and
start the cycle of growth all over again. That could take
decades, though, if it happens at all. This has led many
leaders of declining cities to ask: Are there policies that can
expedite the development of new clusters of growth?
One option is to attempt to spur agglomeration economies from knowledge spillovers from the education sector
to the business sector. Firms that operate in a research field
may be drawn to locate near prominent research universities
in order to benefit from collaboration with researchers and
to gain access to a skilled workforce of graduates. But first,
some believe, they need a common collaborative space to
work in.
The plan to build such a space in Winston-Salem began
in the late 1980s. Douglas Maynard, chairman of the radiology department at Wake Forest University’s Bowman Gray
School of Medicine, was interested in bringing the latest medical imaging technology to the school. But Maynard needed
engineering expertise to help train medical students in the use
of the new devices. Wake Forest did not have an engineering
program, and it was unclear how soon they would be able to
develop one. The original plan Maynard pitched to local leaders was to create a research park where Wake Forest could
collaborate with other universities in the Piedmont Triad area
(comprised of Winston-Salem, Greensboro, and High Point).
“It was going to be Research Triangle Park West,” says
Anderson, who was involved with the project from the
beginning in her role at the Chamber of Commerce.
The Research Triangle shared among universities in
Durham, Raleigh, and Chapel Hill was the blueprint for a
successful collaborative space between education and business. But after talking with a consultant, Vernon George,
project organizers quickly realized that trying to copy that
model wouldn’t work for them. George told them that
most of the intellectual capital in Winston-Salem was in the
School of Medicine. Positioning the research park outside of
town, far away from the campus, would make it less likely to
succeed, he believed.
PHOTOGRAPHY: COURTESY OF WAKE FOREST INNOVATION QUARTER
Doing Something Different
The Innovation Quarter Takes Shape
The Piedmont Triad Community Research Center opened
in 1994 in an old Reynolds building in downtown WinstonSalem. It initially housed the Bowman Gray School of
Medicine’s department of physiology and pharmacology and
researchers from Winston-Salem State University. The park
proceeded slowly from there. The first planned expansion
into the historic Reynolds Factory No. 256 went up in flames
— literally — when the building burned down during renovation work.
But organizers didn’t give up. In 2002, the CEO of Wake
Forest University Health Sciences, Richard Dean, announced
plans for a much larger park encompassing roughly 200 acres
in downtown Winston-Salem. This space would accommodate more science programs from the medical school and
private research companies, as well as new residential homes
and retailers. This larger vision was facilitated by additional
building donations from Reynolds. The first buildings of this
new expansion opened in 2006. The park continued to grow,
housing more departments from the School of Medicine and
a growing number of private firms. For example, Inmar Inc.,
a data analytics firm, moved its headquarters and about 900
employees to the park in 2014. The prior year, the park was
renamed Wake Forest Innovation Quarter, reflecting both
its more local focus and evolving goals.
“The difference now is the word ‘community,’ ” says Eric
Tomlinson, the president of the Wake Forest Innovation
Quarter and chief innovation officer of Wake Forest
Baptist Medical Center. Rather than building a park just
for researchers, Tomlinson says organizers began looking at
how to make the Quarter part of “a district for innovation,
where people will work, live, learn, and play.”
Project organizers hired Wexford Science and
Technology, a development firm based in Baltimore that
partners with universities to design and build such mixed-use
spaces. Daniel Cramer, executive vice president at Wexford,
says that the Winston-Salem project posed unusual challenges. The buildings that Reynolds had donated were on
the National Register of Historic Places, which meant that
efforts to redevelop them qualified for federal and state historic tax credits. While this made the project more affordable, it also meant that architects could not simply demolish
the buildings and start from scratch. They had to find a way
to fit modern research, residential, and retail spaces in the
shells of turn-of-the-century tobacco factories.
Many of the buildings housed very specialized, and
oddly shaped, equipment. The latest project involves
converting a power plant, the iconic Bailey, into a place
for shopping and entertainment — not something the
structure was originally designed for.
“The buildings don’t lay out quite the way you would want
them to, but they are all fabulous buildings,” says Cramer.
Preparing the Workforce of the Future
Winston-Salem is not the only city that has attempted to
pivot its local economy from manufacturing to health care
research. But will the local workforce be able to take advantage of this new economy?
A 2003 working paper by Edward Glaeser of Harvard
University and Albert Saiz of the Massachusetts Institute of
Technology found that cities with high levels of human capital are more likely to grow and adapt to economic shocks.
(See also “Education and Vulnerability to Economic Shocks
in the Carolinas,” p. 32.) But as Reynolds’ experience with
Tobaccoville highlighted, the skills of workers in WinstonSalem have not always lined up well with the changing needs
of employers.
“There are maybe 1,000 technical jobs posted today that
are going vacant because we don’t have enough people in the
community with those skills,” says Anderson. Educators like
Wake Forest and Forsyth Technical Community College
can provide training but only if workers seek it out. Much
of the local workforce is older, Anderson says, making them
less inclined to return to school and acquire new skills. And
because of the long history of steady, well-paying factory jobs
with Reynolds, “there is still a mentality here that you can
graduate from high school and get a really good job,” she says.
While the more technical jobs in the Quarter don’t
directly replace the manufacturing jobs lost in WinstonSalem, Anderson says the Chamber of Commerce estimates
that most of the roughly 3,000 jobs in the Innovation
Quarter have been filled by locals. And there are more developments to come. In October, organizers for the Quarter
announced plans for a new building containing affordable
apartments, retail space, and parking.
Meanwhile, Anderson is already thinking about the next
big project: repurposing an old Reynolds manufacturing
center three miles north of the Innovation Quarter called
Whitaker Park. Its proximity to Smith Reynolds Airport,
a small general aviation airfield, could be attractive to businesses that outgrow the Innovation Quarter or to new firms
drawn to Winston-Salem. Just as the tobacco boom didn’t
last forever, Anderson knows that the health care sector may
not grow forever either.
“That’s why I ask my board all the time, ‘what’s the
next big thing?’ ” says Anderson. “Because if you’re not
thinking about that, it’s going to come up from behind and
smack you!”
EF
Readings
Bricker, Michael. Winston-Salem: A Twin City History.
Charleston, S.C.: The History Press, 2008.
Elliott, Frank. From Tobacco to Technology: Reshaping WinstonSalem for the 21st Century. Winston-Salem, N.C.: Winston-Salem
Chamber of Commerce, 2016.
Glaeser, Edward L., and Albert Saiz. “The Rise of the Skilled
City.” National Bureau of Economic Research Working Paper
No. 10191, December 2003.
Tursi, Frank V. Winston-Salem: A History. Winston-Salem, N.C.:
John F. Blair, Publisher, 1994.
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
25
INTERVIEW
Josh Lerner
Editor’s Note: This is an abbreviated version of EF’s conversation with Josh Lerner. For additional content, go to our website:
www.richmondfed.org/publications
26
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
EF: How did you become interested in economics
in general and in the study of entrepreneurship and
private-firm finance in particular?
Lerner: I have a slightly unusual background in the sense
that I didn’t study any economics to speak of in college. I
went through a program where you could piece together
whatever assorted subjects you wanted to. And in the course
of that, which included physics, history of science and technology, and a bunch of other topics, I got interested in the
whole area around new firm creation and entrepreneurship.
In my first job out of college in the 1980s, I was a research
assistant at the Brookings Institution. There was all the talk
then about Japan as number one. It seems like a thousand
years ago, doesn’t it? Congress had recently enacted the
Bayh-Dole Act, which at least purportedly freed the universities to do more in terms of technology transfer. There was a
lot of interest in commercialization of science, spinoffs, and
so forth. I got sucked into these issues and have never been
able to escape since, showing a distinct lack of imagination!
I came to realize that we were clueless not only about
how the policies in this arena ought to be designed, but even
on questions of how the basic private sector mechanisms
worked. Then I met a fellow named Lewis Branscomb, who
led the program at the Kennedy School in science, technology, and public policy. He was interested in promoting
more study of questions about innovation and the like. As it
turned out, Lew was highly persuasive in convincing me to
come up to Harvard. He worked out a very nice arrangement
PHOTOGRAPHY: EVGENIA ELISEEVA
Joseph Schumpeter, best known for his observation that
“Creative Destruction is the essential fact about capitalism,” viewed the entrepreneur as a critical figure of
economics; he argued that entrepreneurs and entrepreneurship merited close empirical study by economists.
Such research, he suggested in the mid-1940s, “may
result in a new wing being added to the economist’s
house.”
The profession was slow to take Schumpeter’s advice.
Since the surge in high-tech entrepreneurship in the
1990s, however, a growing number of economists have
been drawn to the project of building that wing. One of
the leading researchers on entrepreneurship and entrepreneurial finance during this time has been Harvard
Business School economist Josh Lerner. Along with
bringing empirical economic research to bear on entrepreneurship, venture capital, and angel investment,
he has pursued research interests in private equity
organizations and innovation. In 1993, he introduced
the school’s first course on venture capital and private
equity, which he still teaches.
In addition to his appointment at Harvard, he is
co-director of the Productivity, Innovation, and
Entrepreneurship Program at the National Bureau
of Economic Research and is editor of its journal,
Innovation Policy and the Economy. He is also the founder
and director of the Private Capital Research Institute, a
nonprofit devoted to increasing access to private data
on venture capital and private equity and encouraging economic research on those sources of capital.
He is the author or co-author of 11 books on venture
capital, private equity, and innovation, most recently
The Architecture of Innovation: The Economics of Creative
Organizations.
David A. Price interviewed Lerner at Harvard
Business School in July 2016.
where I was officially studying
no debt or just a little bank line
in the economics department
of credit. The only big financial
Fees in private equity and venture
and largely funded by the dean
decision is whether we’re going
capital are remarkably sticky. The
of the business school. I guess
to take the thing public or sell
compensation structures don’t look
even at that point, the business
out to some corporate acquirer.
that different in today’s era of
school was encountering a lot
With private equity, given the
$10 billion-plus funds than they did
of demand for entrepreneurcomplexity of the balance sheets
ship and venture capital. I came
of these companies — they often
back in an era of $10 million funds.
with a pretty clear sense that I
have multiple layers of debt,
wanted to work in this wacky
which they juggle over time —
area of how innovative businesses got funded.
there’s so much more of the financial engineering taking
At the time, Zvi Griliches was there, the father of doing
place. The role of the private equity guys is in many cases
measurement with patents. I fell under Zvi’s spell, and
much more that of a financial counselor.
even though this was a little removed from his own work, I
That’s not to say they don’t also positively shape the operarealized that I could apply a lot of his ideas to this setting.
tions of the companies themselves. I’ve done some work with
This was particularly important given that you’re dealing
Steve Davis, John Haltiwanger, Kyle Handley, Ron Jarmin,
with small privately held companies, where traditional
and Javier Miranda where we have looked at exactly how primetrics are not necessarily going to be useful. You could
vate equity groups change the companies in which they invest.
understand how intellectual property contributes to firm
We see evidence of a significant boost in terms of productivvalue and use it as a metric for how firms are evolving and
ity for the private equity-backed firms relative to their peers.
other such questions.
But it’s typically not the venture-type scenario of saying “let’s
I’ve been pretty much in this same orbit here 25 years
figure out the business model.” It’s more figuring out ways to
later. My theory is that 20 years from now, entrepreneurrun the business more efficiently.
ship’s status at business schools will be like finance’s today.
Entrepreneurship began as a real academic backwater. We’re
EF: Of the roles that you identify for private equity
still seen by many as a slightly obscure area today, but I think
general partners, which are the ones where they create
that it’s likely to have more centrality over time.
the most value?
EF: Much of your work has been in the area of private
finance, especially venture capital and private equity.
From an economist’s perspective, how do private equity
general partners create value?
Lerner: Private equity is different from venture capital in
the sense that most of the companies are considerably more
mature at the time they’re getting financing. There’s a middle ground of growth deals that look like half venture capital
and half private equity, but the typical kind of company getting funded by a classic buyout group is a real business with
real profits, a real management team, and so on.
So you see several differences. One is that, for the young
companies, it’s almost standard that at a certain point the
CEO is going to be replaced. It’s a rare CEO who can grow
a business from one to 100 employees and then grow it from
100 to 10,000 employees. The skill sets in those realms are
quite different. In many cases, you see people who have been
happily early-stage CEOs for multiple go-arounds: They know
that after the company gets to 100 or 200 employees their
time will have come, and they’ll move on to another early-stage
opportunity. With the buyout or private equity-backed companies, replacing management does happen, but it’s a much
more unpleasant and unexpected kind of event.
Another difference is that so much more of the decisionmaking and the guidance that the private equity guys are
doing relates to financial strategy, as opposed to pure operating strategy. With your typical startup company, there’s
Lerner: There’s been more work done on this in the buyout
realm. One of the advantages of buyouts is that because
you’ve got such detailed financial information, you can see
often the way in which value is created: How much is real
operational improvements, how much of it is the market
timing, and how much of it is the financial engineering or
the use of debt? A number of papers have done this to try to
divide the share of value being created into these three broad
buckets. If you asked the private equity guys, many would
say, “Oh, 90 percent of it is us going in and adding value to
the operations of companies.” If you look at the academic
evidence, you’d probably say the operational improvements
are a lot closer to 30 percent than 90 percent. Not to say that
it doesn’t happen, but it’s only one of a number of levers that
the private equity groups are pulling to create value.
EF: Turning to venture capital — is geography becoming less important in the venture capital industry? The
conventional wisdom, at least, is that technology is making remote work and long-distance interaction easier in
general. Has that been true here?
Lerner: If you looked before the dot-com bust in 2000, you
saw a lot of venture capitalists who were of the mentality
that “if it’s not within a 60-minute drive of my office, it’s not
worth funding.” There was heavy localization within Silicon
Valley: Most of the large U.S. groups really focused on the
companies there.
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
27
Josh Lerner
But if you look today, you see the
percent. But given the economies
➤ Present Positions
large groups have offices in India and
of scale of running a larger fund, it
Chair, Entrepreneurial Management
China and, in many cases, some footmeans the profits per partner can be
Unit and Jacob H. Schiff Professor of
print in Europe as well. So it’s become
staggering. If you look at the history
Investment Banking, Harvard Business
much more of a global market. Not
of financial intermediation, you see
School
only have the destinations of the
in general that as more competition
Co-Director, Productivity, Innovation,
investments changed, but the share of
has arrived, prices have come down. I
and Entrepreneurship Program,
venture capital financing that’s comanticipate venture capital and private
National Bureau of Economic Research
ing from the United States has shrunk
equity will follow that pattern, but
➤ Education
relative to where it was in 2000. So
it’s been surprising how leisurely the
Ph.D. (1992), Harvard University
that would be consistent with the
adjustment process has been.
B.A. (1982), Yale University
“death-of-distance” kind of argument.
Another area that has gotten a lot
On the other hand, it seems that
of
interest is the questions around
➤ Selected Publications
the power of focal points is still
persistence.
There’s a fair amount
“The Globalization of Angel
quite strong. I had a Chinese venof
evidence
historically that both
Investments: Evidence across
ture capitalist here today; his fund is
private
equity
and venture capital
Countries,” Journal of Financial Economics,
forthcoming (with co-authors); “Private
a relatively young fund, but they’ve
have been characterized by a lot
Equity, Jobs, and Productivity,” American
nonetheless already set up an office in
of persistence: If you’re in the top
Economic Review, 2014 (with co-authors);
Silicon Valley (as well as their home
quartile of funds for one fund, your
“Assessing the Contribution of Venture
base in China). For many of the comnext fund is disproportionately
Capital to Innovation,” RAND Journal of
panies that they’re funding, even if
likely to be in the top quartile as
Economics, 2000 (with Samuel Kortum);
it’s Chinese entrepreneurs founding
well. Similarly at the low end. But
numerous other articles in such journals
the companies, they want to be in
there seems to be a variety of evias the Journal of Finance, Quarterly Journal
Silicon Valley from day one.
dence that the industry has become
of Economics, and Journal of Political
Even looking at the newer marless persistent. Persistence seems to
Economy; and numerous books
kets, the locations of venture activbe disappearing.
ities tend to be lumpy, with a large
role for a few places like Tel Aviv, Cambridge in England,
EF: Do you have a view yet of whether the equity crowdand more recently Singapore, Shanghai, and Bangalore.
funding arrangements legalized by the JOBS Act will
A relatively small handful of markets are hubs of venture
have a major effect on startup finance?
activity. For all the globalization that’s taking place, it
still seems to be very much a geographically lumpy kind of
Lerner: When we look over the last 10 years or so, one of the
business.
really interesting phenomena has been the growth of what I
call “personalized” entrepreneurial finance. By that, I mean
EF: What can economics tell us about the future of the
we’re seeing a whole set of models where, instead of having an
venture capital and private equity industries?
institution act as the gatekeeper, you see individuals funding
young companies directly. Crowdfunding is one example.
Lerner: One area where I think economics can add some
We’ve also seen the rise of individual angels and angel groups.
insight, one that’s particularly controversial today, is the
So there’s a whole range of things going on, much of which is
questions around fees. For instance, fees for private equity
enabled by the Internet.
funds have been intensely controversial for many of the state
I myself am a little bit in the skeptical camp on
pension funds.
crowdfunding per se. A lot of my doubts have to do with
One argument would be to say it doesn’t really matter
the inherent contradictions between the entrepreneurial
how much you pay if you’re getting returns that are in excess
process and disclosure requirements. When you think
of risk-adjusted market returns. (It should be noted that
about what have been the guiding principles of securimany pensions do not get these excess returns!) But even so,
ties regulation, a big part has been based on disclosure:
if you’re a trustee of a public pension, you have a role of being
“Sunlight is the best disinfectant.” But if you think from
a custodian of employees’ money. And if fees are excessive,
the perspective of an entrepreneur, it’s very important to
however you define this, that may be a problem even if you’re
keep information close to the chest rather than tipping off
getting attractive returns.
competitors early as to your business model. When Google
An interesting thing is that fees in private equity and
filed to go public, people were shocked by how profitable
venture capital are remarkably sticky. The compensathe search business was for them. Yet at that point, they
tion structures don’t look that different in today’s era of
had already established themselves and had an insurmount$10 billion-plus funds than they did back in an era of
able lead that Yahoo and the others haven’t been able
$10 million funds. They’ve come down somewhat, so instead
to catch up to. The natural tendency is to say, “Let’s just
of 2 percent committed capital, it’s more likely to be 1.5
make everyone disclose everything,” but the very process
28
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
of disclosing things is likely to destroy a lot of the competitive advantage that the entrepreneurs might have. That’s a
tough conundrum to solve.
Moreover, when you look at attempts to create entrepreneurial finance models with crowdfunding-type flavors
to them, the outcomes have not been great. For instance,
there was an effort in Europe during the 1990s to create a
whole series of small capitalization models where riskier
young companies could list and so forth with relatively lax
regulations. They ended up with a phenomenon where the
bad drove out the good. All it took was a few scammers to
come in and undertake “pump and dump” schemes, and the
interest in those markets declined precipitously. And I think
some of the same danger lurks here.
I’m much more enthusiastic about models like the
AngelList syndicates, which is essentially using a model
where the people on the platform see information about the
companies and decide whether to fund them or not. But it’s
restricted to sophisticated investors. You’re aware of which
of the other sophisticated investors are investing in which
companies, which can help shape decisions. So you’re using
the crowd, but there’s also a minimum level of skill and
knowledge required to play.
EF: You’ve written that attitudes toward entrepreneurship are shaped by culture and religion. Research
doesn’t seem to tell us much about the roles of social
forces like these in entrepreneurship. Is that because
researchers don’t see them as policy relevant or are they
simply too difficult to measure?
Lerner: I think a lot of it comes down to the difficulty of
measurement. Peers influence what we think about and what
our priorities are. But it’s hard to show, partly because, by
and large, we can’t randomly assign people to be in particular
places. It tends to be that we choose places to work where
we get exposed to certain kind of peers, but that may tell us a
lot more about ourselves rather than about the effects of our
peers.
Ulrike Malmendier and I tried to find a setting where one
could look at this question where there was an element of
randomization. We ended up looking at the impact of how
students spent their first year at Harvard Business School. In
particular, what we have here is a system where people spend
the first year with a section of 90 people and they take all of
their classes together. These sections tend to be powerful
connecting devices for people, still binding them together
when they come back for their 25th reunion. So we can ask,
does having in one’s section fewer or more entrepreneurial
peers — people who were entrepreneurs prior to business
school — end up affecting the willingness of people who
didn’t have an entrepreneurial background to start a new
venture themselves after school?
When we ran the analysis, we were shocked because we
got exactly what we thought was the wrong answer: Having
more entrepreneurial peers makes people less likely to start
businesses. When we broke it down, however, we discovered that the individuals who had lots of entrepreneurial
peers were less likely to start unsuccessful businesses but
were as likely or lightly more likely to start successful businesses. So it seemed that having the entrepreneurial peers
was scaring people away from doing ideas that subsequently
turned out to be unsuccessful, but if anything, encouraging
people to go out and start businesses that proved to be
successful. That suggested that peers really do matter, but
in perhaps a more complicated way than we would initially
anticipate.
EF: What do you think are the most important open
questions in the study of entrepreneurship?
Lerner: The list of really interesting open questions is a long
one, but for me, three areas stand out. One would be understanding the nature of the teams during the entrepreneurial
process. I think a lot of the initial work focused on the
founder: What was his or her impact in terms of motivation,
prior jobs and schooling, and so forth? But when we look at
the evidence, we know that ultimately the founders are often
a group and there is what economists call a “joint production
function.”
Venture capitalists often say that they’d rather hire three
entrepreneurs from separate companies than three entrepreneurs from the same company, because of their diversity of
views. But no one’s ever really proved that, to my knowledge,
or answered many other questions about how teams work
together in startups.
The second one would be related to innovation. A lot of
the debate has been focused on firm size and innovation:
Do smaller firms innovate more? Probably, but the more
one looks at this, the more inconclusive the results are. To
me, it’s more interesting to ask the question of what kind of
innovation is being done: What is the nature of innovation
by entrepreneurial companies as opposed to more established firms? And how does that end up affecting the overall
evolution of firms and industries?
A third question I would highlight, which we’ve already
hinted at a bit, is about the changing sources of funding
available. For instance, among venture-backed firms today,
the average company going public was 12 years old at the
time of IPO last year. Historically, it was around four or
five years old. And so you’ve got all these companies that are
privately held sitting there raising money but staying private.
They’re getting funded not just by venture capitalists, but
also by sovereign wealth funds and family offices and even
mutual funds. What’s the ultimate implication of this trend?
Is being private, sheltered from financial markets, actually
good because a lot of people do more long-run things? Or do
these arrangements simply allow management to perpetuate
poor decisions?
EF: You’ve done a lot of work with Jean Tirole looking
at the incentives behind the creation of open-source
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
29
software. What are the main reasons why developers
and companies participate in open-source projects? Is
it altruism?
say something about how the effect of private equity has
changed? For instance, was the deleterious effect of the
leverage in buyouts greater during the crisis period, or were
the firms actually able to weather the crisis better because
the private equity investors had more tools in place? We’re
also looking at the performance of private equity groups of
different experience, sizes, and past success, in terms of the
social consequences of the investments.
Another project that my colleague Victoria Ivashina and
I are working on relates to the division of fees and profits
within investment partnerships. As I mentioned before,
the overall level of rewards that these groups get have been
controversial, but no one has previously looked at how the
partners divide these among themselves, and what the consequences of these decisions for the partnerships and their
investors are.
Lerner: We’ve argued that open source — like the Linux or
Android operating systems — poses a puzzle. Why would
a group of people organize themselves into a project and
basically volunteer to develop code that is ultimately going
to make a lot of money for Google, Red Hat, and IBM? We
argue that there’s a combination of short-term and longterm incentives at work.
Short term, often programmers just want to fix a bug or
want to use the program to do something that it can’t quite
do. So one motivation is simply problem solving.
On the other hand, there can also be some tangible
longer-term benefits to individuals from participating in
these projects. Part of the benefits stem from the fact that
taking part in these projects can be fun; there’s a lot of ego
gratification associated with becoming a project leader. In
addition, we suggest that career concerns can play a role. If
you’re a programmer at a small university in Iowa, even if
you’re a great one, it’s hard for you to “show off your chops”
as to how good you are. One of the attractions of open
source is you choose a project that fits with your own skills,
go out, and work on it. If you are a useful contributor, often
you’ll be invited to take on more leadership in the endeavor.
Many of the most successful open-source projects have people who are participating partially for the ego gratification
but also for the career benefits of being seen as a good programmer; this may impress employers and may lead to offers
from venture capitalists and the like.
EF: What do you think are the biggest pluses and
minuses of doing economic research in the setting of a
business school?
Lerner: There’s no one right answer here. If you’re doing
highly theoretical work or esoteric advanced empirical work,
you might argue there’s less of a return to being at a business
school. For those researchers, the “tax” of needing to put more
attention into teaching might be seen as not really worth it.
But for people who are interested in areas where there are a
lot of benefits from interacting with practitioners — whether
it’s access to data or deeply understanding what the phenomena are — there can be substantial benefits from being in a
business school setting. In general, the ability to identify and
get close to practitioners is easier in a business school setting,
where alumni often seek to be actively engaged.
The fact that you’re at a business school obviously doesn’t
mean you’ll get any data you want. But it really does help get
in the door to be able to tell your story and make a pitch as to
why cooperating would be helpful. For instance, for a recent
working paper on angel investment groups around the world,
we relied a lot on my contacts with Harvard Business School
alumni and Antoinette Schoar’s network with the MIT Sloan
alumni. The alumni were very helpful in both identifying who
had the kind of data we were looking for and then advocating
within those groups to work with us. So I think there are a
lot of pluses in terms of the connectivity. In general, I think
the explosion of research using private data — typically from
corporations as opposed to governmental sources — may
mean business school faculty will be doing a larger share of
cutting-edge research in the years to come.
EF
EF: What are you working on now?
Lerner: One of my projects is trying to extend our work on
the impact of private equity investment. As I mentioned, my
co-authors and I looked at the years up to 2005 and showed
that in general there was a positive impact of private equity
investment in terms of productivity. The firms backed by
private equity seemed to lose jobs at the factories that were
open at the time the private equity group came on board,
but they also were more likely to open up new facilities that
netted out much of the negative effect associated with the
job losses.
The question we’re asking now is, “what happened after
2005?” The industry had a fantastic boom in 2006 and
2007, there was the crash in 2008 and 2009, followed by
long drought, and now there is a strong recovery. Can we
u
30
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
BOOKREVIEW
The HIV/AIDS Challenge
THE ECONOMICS OF THE GLOBAL
RESPONSE TO HIV/AIDS
BY MARKUS HAACKER
OXFORD: OXFORD UNIVERSITY
PRESS, 2016, 290 PAGES
REVIEWED BY HELEN FESSENDEN
T
he international response to HIV/AIDS ranks
among one of the great public health stories in
recent decades. Today’s landscape is far different
from the mid-1990s, when the successful application of
combined antiretroviral therapies in wealthy nations was
darkened by the news that the virus was rapidly spreading
in countries too poor to afford such treatments. By 1996,
20 million people worldwide were living with HIV, with a
large share in sub-Saharan Africa. By 2002, that number had
spiked to 30 million. As Markus Haacker points out in his
new book, The Economics of the Global Response to HIV/AIDS,
the epidemic’s impact has been so massive that it accounts
for eight out of the 10 worst declines in life expectancy at a
country level since 1950.
Thanks to billions of dollars in aid and an effective
coordinated global response over the last 15 years, the rate
of infections has dramatically slowed, and people who are
infected can now expect to live close to a full life. But paradoxically, this success in health policy has led to an economic
challenge for the nations that have been hard hit: how to
pay for prevention and treatment in the long run. Haacker
is well-positioned to address this, as a scholar who has spent
years at the World Bank and the International Monetary
Fund researching the economics of the HIV/AIDS crisis.
His book lucidly explains what research has and has not been
able to answer in this respect. And he usefully places this
research in a global context rather than focusing on one or
two countries, as work in this area often does.
AIDS policy researchers generally see 2001 as a tipping
point when the international community scrambled to craft
a coordinated response, leading to the expansion of efforts
under the auspices of organizations such as UNAIDS and
the Global Fund to Fight AIDS, Tuberculosis, and Malaria.
The United States also began contributing as a major player
in 2003, with the President’s Emergency Plan For AIDS
Relief, or PEPFAR. Those extra resources helped build a
two-pronged approach. On the prevention side, promotion
of condom use and male circumcision — as well as the
targeting of certain high-risk groups — began cutting into
HIV incidence rates. On the intervention and treatment
side, drug companies agreed to cut prices of antiretroviral
therapies in targeted countries so that they could be distributed to patients, including pregnant or nursing women
who risked infecting their children, thereby reducing the
chance of transmission.
By 2015, 16 million were receiving these drugs worldwide, and the average annual mortality rate dropped from
6.4 percent in 2004 to 3.2 percent in 2014. In South Africa,
an infected patient can now expect a close to normal life
span; in Botswana, the average HIV-related drop in life
expectancy was once almost 20 years, and now it is five. The
rate of HIV incidence, meanwhile, has greatly slowed; the
total number of infected patients worldwide was 37 million
in 2014.
This progress stands as a rebuke of sorts to the widespread
pessimism of the 1990s. But the extent of the economic
impact is still up for debate. Haacker emphasizes the need
for more research on the macroeconomic effects, especially
to answer some of the puzzles of the past 15 years. For example, some of the worst-hit nations — such as Kenya and
Botswana — have maintained high per capita GDP growth
rates despite the fact that both have a high share of citizens
with HIV/AIDS. He also notes that most studies to date
have not found a link between the spread of HIV/AIDS and
an increase in poverty, although there is a stronger correlation
with inequality.
An even more pressing concern for economists, in
Haacker’s view, is how to measure the cost-effectiveness of
all of these strategies. Now that infected populations can
live close to normal life spans, the cost of lifetime treatment needs to be accounted for as it would for any other
chronic disease. The global budget for HIV/AIDS programs is now about $20 billion, $11 billion of which comes
through external aid. Since prevention and treatment have
become a long-term concern, an effective strategy can
be sustained only if costs are controlled. In recent years,
policymakers have been more explicit about using an
investment framework, comparing expected rates of return
on different approaches, to make allocation decisions. The
challenge is that it takes decades to assess the impact of a
strategy: An individual can move through different highrisk groups or try different prevention techniques over his
or her adult life. That said, Haacker notes, some prevention measures — such as male circumcision and increased
condom use — are so cost-effective and reliable that it
makes sense to apply them as broadly as possible.
For any reader interested in the intersection between
health and economics, Haacker’s work is a comprehensive
guide to one of the greatest public health challenges in history. It’s also a valuable reminder that economics is just as
important as medical science in crafting long-term strategies
for managing chronic disease in large populations — something that policymakers everywhere will have to keep in
mind as nations age in coming decades.
EF
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
31
DISTRICTDIGEST
Economic Trends Across the Region
Education and Vulnerability to Economic Shocks in the Carolinas
BY R I C H A R D K AG L I C
T
he role of technological disruption in the economy
and its effect (actual and potential) on workers is a
lively topic of discussion among labor market economists. Certainly, the steady — some would say accelerating
— march of information technology and robotics into the
workplace, coupled with lingering anxieties from the Great
Recession, has heightened workers’ insecurities about their
own place in the economy of the future. Technological
changes, combined with other economic forces, dramatically altered the economic landscape of the Carolinas
over the course of a generation. During this evolution, the
region’s economy evolved to look less like it did in the 1990s
(overly reliant on manufacturing) and more like the national
economy of today.
Still, the region and its workers appear more exposed to
economic disruptions than with the nation as a whole. In
some measure, this vulnerability can be viewed as a human
capital development challenge. The states need to do a
better job of training workers for today’s economy as well as
preparing them for the disruptions that will inevitably come
in the future, whether those disruptions are technological or
cyclical in their origin.
manufacturing industries, such as textiles and vehicle production. The reasons for manufacturing’s migration south
are many — the spreading use of air conditioning, lower
labor costs, and relatedly, low unionization rates, to name
just a few.
Thus, North Carolina and South Carolina both developed hard-earned reputations as “manufacturing states.”
As recently as 1990, manufacturing firms employed
nearly 1.2 million workers in the two states. Moreover,
the Carolinas’ employment base had become more
manufacturing-intensive than some traditional industrial
giants such as Michigan, Ohio, and Wisconsin. In 1990,
manufacturing accounted for a little more than 30 percent
of private payroll employment in the two states combined,
whereas it accounted for between 25 percent and 27 percent
of jobs in Michigan, Ohio, and Wisconsin.
But in the lead-up to the new century, employment in
some of the region’s important manufacturing industries
came under pressure from (among other factors) changing
consumer demands and technological advances. These technological advances were not limited to improvements in
capital equipment, such as robotics and automation. They
also included efficiencies gained from so-called process
Technological Disruptions and
technologies — such as improved logistics, outsourcing (and
Changing Industry Structure
“off-shoring”), and global sourcing business models. The
In the Carolinas, the region’s experience with economic
result was that the two states saw manufacturing jobs eroddisruptions (cyclical and technological) in its manufacturing
ing during the 1990s and falling throughout the first decade
industries is relatively recent when compared to similar
of the new millennium leading into the Great Recession. In
travails in the New England and Midwestern regions of the
fact, manufacturing employment in the two-state region fell
United States. Indeed, for many years, the Southeastern
by more than 406,000 between 1990 and 2007, or by more
United States generally, and the Carolinas specifically,
than 34 percent. And manufacturing’s share of total private
successfully lured some of those other regions’ mainstay
employment fell to 16 percent (from 31 percent) and actually
ended up below the comparable share in each of
the Midwestern states noted above (Michigan,
Manufacturing Employment vs. Total Private
Ohio, and Wisconsin).
Employment in the Carolinas
During this period of industrial restructur160
ing, many argued that the loss of manufactur(Index, Jan. 1990 = 100)
140
ing jobs would doom the states’ economies.
120
It didn’t. While manufacturing jobs were on
100
the decline, innovative businesses and people
in the two states were creating jobs in other
80
industries, many of which would have been
60
hard to predict 10 years earlier. Firms brought
40
new and innovative goods and services to
20
consumer and business markets. And they
0
created jobs, lots of them. Between 1990 and
1990
1995
2000
2005
2010
2015
2007, total private employment in the two
states plowed forward even as technology was
All Private
Manufacturing
depressing manufacturing employment. (See
SOURCE: Author’s calculations based on Bureau of Labor Statistics data
chart.)
32
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
In fact, job growth in the Carolinas outLocation Quotients in the Carolinas by Industry Employment
paced the nationwide average. Between 1990
and 2007, total private employment in the
Construction
Carolinas increased by slightly more than
Manufacturing
30 percent compared to 27 percent for the
United States as a whole, with the vast majorTrade, transp., utilities
ity of those new jobs created in services rather
Information
than goods-producing industries. Whereas
Finance,
insurance,
goods-producing industries (mostly manufacreal estate
turing and construction, with a little natural
Prof. & business services
resource extraction thrown in) accounted for
Education & health
more than 37 percent of private-sector jobs
in the Carolinas in 1990, they accounted for
Leisure & hospitality
just 23 percent in 2007. Meanwhile, some key
Other services
services industries — professional and business services, education and health services,
Government
and leisure and hospitality — accounted for
0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80
just 28 percent of jobs in the two states in
1990 but accounted for more than 41 percent
1990
2007
2015
of employment 17 years later. As a result, the
NOTE: LQ values greater than 1.0 indicate higher concentration of employment in that industry in the
employment base of the Carolinas just prior
Carolinas relative to the nation as a whole.
to the Great Recession looked dramatically
SOURCE: Bureau of Labor Statistics
different than it did in 1990.
Of course, the Carolinas economy was not
the only area going through this type of industrial restructurin the Carolinas for 1990, the region’s dependence on
ing at the time. The entire national economy was changing
goods-producing industries at that time is readily apparent.
as well. In the United States, manufacturers reduced their
(See chart.) The manufacturing LQ of 1.55 indicates that
payrolls by nearly 4.1 million workers between 1990 and
the region was 55 percent more concentrated in manufac2007, or a little more than 23 percent. And manufacturing’s
turing employment than the nation, while the construction
share of private-sector employment in the United States
LQ of 1.17 shows that the region was 17 percent more condeclined from 19 percent to just under 12 percent.
centrated in construction employment. In contrast, each
of the service-providing industries had employment LQs
Measuring a Changing Jobs Base
well below 1.00 in 1990, suggesting that the region was
One statistical tool that analysts use to assess the structure
much less concentrated in those particular service-providing
of a region’s economy is the location quotient, or LQ. LQs
industries.
can be derived using many different economic data — such
A dramatically different picture of the Carolinas job
as income, output, or demographic data. Here, it will be
base emerges when one takes a look at those same location
helpful to look at LQs constructed from payroll employquotients just prior to the Great Recession. An interesting
ment data.
point is that as the years passed, all of the employment LQs
An LQ based on employment is derived by comparing
for the Carolinas converged toward 1.00, or in other words,
employment shares in the region to the corresponding
toward the national average. In those industries in which
shares in the nation as a whole, specifically by dividing the
the region was more heavily concentrated than the nation
former by the latter. For example, in 1990, manufacturing’s
— manufacturing and construction — the LQs moved down
share of total payroll employment (private sector and pubtoward 1.00, while in those industries for which the region
lic sector) in the Carolinas was 25.2 percent, while manufacwas less heavily concentrated than the national average — all
turing accounted for just 16.2 percent of the nation’s total
of the service-providing industries — the employment LQs
employment. Thus the region’s manufacturing employment
moved up toward 1.00. So at the end of the day, while the
LQ in 1990 was 1.55 (25.2/16.2). The key point to remember
Carolinas economy was transforming to look less and less
when using employment LQs is that an LQ equal to 1.00
like its former self, it started to look more and more like the
means that the region’s share of employment in an industry
national economy.
is equal to the national average. If the LQ is less than 1.00,
the industry is less concentrated in the region than it is in
Structural vs. Cyclical
the nation; an LQ greater than 1.00 indicates that employWhile aggregated data suggest that the Carolinas have weathment in that industry is more heavily concentrated in the
ered manufacturing job losses over the long term, it appears
region than it is for the nation as a whole.
that private-sector employment in the region remains more
In the LQs for employment by industry concentration
volatile and susceptible to economic disruptions in the short
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
33
Carolinas Per Capita Income Relative to U.S. Average
92
(Index, U.S. = 100)
90
88
86
84
82
80
1990
1995
2000
2005
2010
SOURCE: Census Bureau, Bureau of Economic Analysis
term. As the Carolinas economy became less reliant on the
highly cyclical manufacturing and construction industries,
more closely resembling the economic structure of the
nation, one might assume that the Carolinas economy would
closely track the nation’s through the business cycle. But
that has not been the case.
Prior recessions had been particularly unkind to North
Carolina and South Carolina. During the recessions of 1991
and 2001, the Carolinas economy fared worse than the
nation as a whole in terms of job losses. During the recession
in the early 1990s, job losses in the United States amounted
to 1.9 percent of private-sector employment, while in the
Carolinas job losses amounted to 2.3 percent in the same
time frame. And then, in the downturn in the early part of
the 21st century, job losses in the Carolinas amounted to
4.7 percent of private-sector jobs during what was a relatively
mild recession by most measures. In contrast, the United
States shed 3.0 percent of its private-sector jobs during the
same economic contraction.
How did the region fare during the Great Recession? Not
well. In spite of reduced reliance on highly cyclical industries
(manufacturing and construction), and despite assuming an
economic profile that more closely resembles the nation’s,
the region once again suffered disproportionate job losses.
During the labor market downturn that resulted from the
Great Recession (roughly the period between January 2008
and February 2010), the U.S. economy lost approximately
8.8 million private-sector jobs, representing a 7.6 percent
decline in just over two years.
As bad as the employment numbers looked for the nation
as a whole during the Great Recession, corresponding data
for the region looked even worse. Combined, North Carolina
and South Carolina lost nearly 500,000 private-sector jobs,
or an astounding 9.8 percent. Looking at state rankings puts
the severity of the region’s job losses in perspective: Of the
48 U.S. states (outside of the Carolinas) and the District of
Columbia, there were only six jurisdictions that exceeded
the 9.8 percent decline that was experienced in the region.
Moreover, three of those jurisdictions (Arizona, Florida, and
Nevada) were particularly hard-hit by the sharp downturn in
34
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
the housing market, a phenomenon that was far
less pronounced in the Carolinas.
So while the Carolinas economy remains on
a higher-trajectory growth path in the long run,
it continues to be more susceptible to economic
disruptions in the short run, as evidenced by the
deeper plunges into recession.
In addition to employment figures, another
telling statistic is per capita personal income
relative to the nation. Per capita personal
income is a function of total income in a state
and its population, or total income divided by
2015
population. And when one looks at per capita
income in the Carolinas against the rest of
the nation, the trends do not look favorable.
In 1990, per capita personal income in the
Carolinas was roughly 86 percent of the national average.
(See chart.) During the 1990s, the region started narrowing
the gap with the national average, and by the late 1990s,
the region’s per capita income relative to the nation had
increased to roughly 90 percent. By 2015, however, it was
down to roughly 83 percent. (It is worthwhile to note that
during the 1990s, manufacturing employment in the region
was already on a slow downward path.)
The Role of Manufacturing’s Decline
The popular press has often pointed to the loss of manufacturing jobs as a contributing factor to the region’s relative
decline in income, arguing that manufacturing jobs being
lost were better paying than the service-sector jobs that
were replacing them. While that argument does have some
merit, it does not account for two relevant facts. First, as
noted earlier, manufacturing job losses were not unique
to the Carolinas; they were occurring across the nation.
Moreover, average manufacturing wages in the region
tended to be lower than nationwide norms. Second, as the
Carolinas economy evolved since 1990, its job base transformed to more closely resemble the nationwide averages.
Thus, making the argument that the region was losing
ground to the nation because of changes to its industry
structure becomes more difficult when those changes
result in the region’s jobs base looking more, not less, like
the national average.
So while it is true that the region has lost much of its manufacturing jobs base, that phenomenon alone cannot entirely
explain the Carolinas’ continued susceptibility to economic
disruptions, nor can it wholly account for the region’s relatively weak showings in per capita income relative to the
nation. Consequently, it makes sense to look not only at the
jobs that are being created in the Carolinas, but also at the
workforce that the region is developing.
How do states prepare themselves not only to survive economic disruptions (cyclical, technological, or otherwise), but
also to embrace them and thrive with them? A logical place
to start is by enhancing workers’ economic survival skills.
And that begins with education and, more broadly, human
capital development. It also happens
to be a place where data show that the
Carolinas have room to improve.
Educational Attainment
Educational Attainment by Age Group
NC
U.S.
Total
Percent
Total
SC
Percent
Total
Percent
Population 25-64
168,714,683
5,247,099
2,525,878
From a societal standpoint, more
highly skilled workers portend more
High school graduate or higher 149,121,771
88.4 4,623,496
88.1 2,225,714
88.1
economic growth potential for a
region. On an individual level, comBachelor’s degree or higher
53,932,881
32.0 1,622,020
30.9
698,394
27.6
pletion of postsecondary education
SOURCE: Bureau of the Census, 2015 American Community Survey, 1-year estimate
or skills training leads to higher lifetime earnings potential. It is well
documented that workers with a bachelor’s degree or
tendencies. As noted above, higher educational attainment
higher, on average, will earn considerably more income
results in greater labor force participation rates, lower unemover their lifetimes than workers who have completed no
ployment rates, and higher average incomes, on balance. In
more than a high school diploma. And that earnings gap
both North Carolina and South Carolina in 2015, labor force
is widening.
participation rates were lower than the nationwide average,
But perhaps more important to the individual worker
unemployment rates were higher, and average incomes were
is the flexibility that higher skills attainment provides,
lower.
especially during periods of economic disruption. At no
These educational attainment statistics go a long way
time in recent history was that more evident than during
toward explaining the relatively higher susceptibility to ecothe Great Recession. During the worst of that downturn,
nomic disruptions that the region has experienced. The less
while the nation’s unemployment rate hit 10 percent, it did
educated a worker is, the more likely he or she is to become
not rise above 5 percent for those workers with at least a
unemployed in times of economic turmoil.
bachelor’s degree. The upshot here: The higher your educaIn addition, the relatively poor performance in per capita
tional attainment, the more opportunities you will have for
personal income makes sense as well. Compared to nationemployment and the more likely you are to stay employed
wide averages, both states have a smaller share of their total
even in times of significant economic disruption.
population actively participating in the economy (lower
So then, how well positioned are workers in the Carolinas,
labor force participation rates). Of those who are participatfrom an educational attainment standpoint, to survive and
ing, a smaller share are actually employed (higher unemploythrive in periods of economic duress, technological disrupment rates). And those who are working earn lower wages,
tions, or both? Unfortunately, the preponderance of evidence
on average, than their national counterparts.
suggests that the Carolinas are somewhat behind nationwide averages. Whether looking at high school graduation
Conclusion
rates, college enrollment rates, or percentages of population
The economies of North Carolina and South Carolina have
with postsecondary degrees, the data show that both North
gone through a painful adjustment process since the early
Carolina and South Carolina fall below nationwide average
1990s as a combination of changing consumer preferences,
levels of attainment. For example, in the United States overtechnological advances, and cyclical disruptions dramatiall, 32.0 percent of the population between the ages of 25 and
cally reduced the number of manufacturing jobs. Over this
64 had attained a bachelor’s degree; the comparable percenttime frame, the states have largely moved on in impressive
ages in the Carolinas were 30.9 percent for North Carolina
fashion with payroll employment growth in both states
and 27.6 percent for South Carolina. (See table.)
exceeding the nationwide average. And manufacturing jobs
Perhaps of more importance is the seeming underperare growing once again, albeit slowly. However, over the
formance in measurements of the states’ STEM (science,
course of recent business cycles, employment growth in
technology, engineering, and mathematics) readiness. With
the region has remained more volatile than in the nation
more technology being integrated into nearly all job descripas a whole
tions, there is virtually universal agreement on the need
Moreover, the jobs being created (manufacturing and
to improve education in the so-called STEM subjects. In
otherwise) are very different than they were just a decade
2011, the American Physical Society derived a measure of
ago. Most require a greater understanding of information
STEM readiness by state using available metrics for student
technology and automation as well as education beyond high
achievement and enrollment as well as teacher qualificaschool. Those jobs that do not require such skills are often
tion scores, a measure that it called SERI (Science and
low paying or prime candidates to be replaced by technology
Engineering Readiness Index). Here again, the Carolinas fell
one day. So long as the region lags behind the nation in most
below the nationwide average.
measures of educational attainment, its workers are likely to
Given their lower level of educational attainment,
remain more susceptible to economic disruptions, technothe Carolinas exhibit some rather predictable economic
logical or otherwise.
EF
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
35
State Data, Q4:15
DC
MD
NC
SC
VA
WV
Nonfarm Employment (000s)
768.2
2,680.3
4,268.7
2,027.2
3,893.2
761.2
Q/Q Percent Change
0.2
0.6
0.4
0.8
0.8
0.1
Y/Y Percent Change
1.1
1.6
2.1
2.7
2.6
-1.4
Manufacturing Employment (000s)
1.1
105.8
459.1
237.5
234.1
47.1
Q/Q Percent Change
-2.9
1.7
-0.5
0.6
0.3
-1.1
Y/Y Percent Change
0.0
2.1
1.0
1.8
1.0
-1.3
Professional/Business Services Employment (000s) 162.2
434.0
600.5
271.2
709.7
67.0
Q/Q Percent Change
0.3
0.7
1.4
2.9
1.7
0.6
Y/Y Percent Change
2.2
1.8
4.0
3.7
3.9
-2.0
Government Employment (000s)
238.8
503.2
718.8
362.3
710.7
152.3
Q/Q Percent Change
0.2
0.2
-0.4
0.5
-0.3
0.7
Y/Y Percent Change
1.0
-0.1
0.4
1.2
0.0
-0.5
Civilian Labor Force (000s)
390.4
3,157.7
4,777.2
2,260.8
4,236.7
782.9
Q/Q Percent Change
0.3
0.2
0.3
0.3
0.3
-0.2
Y/Y Percent Change
1.7
0.8
1.8
1.0
0.0
0.1
Unemployment Rate (%)
6.6
5.0
5.6
5.5
4.2
6.3
Q3:15
6.7
5.1
5.7
5.6
4.2
6.7
Q4:14
7.6
5.5
5.8
6.6
4.9
6.4
Real Personal Income ($Bil)
45.4
310.6
378.9
174.1
403.2
61.9
Q/Q Percent Change
0.5
1.0
0.9
1.2
0.7
-0.2
Y/Y Percent Change
5.3
3.5
4.0
4.8
3.9
0.8
Building Permits
1,508
3,472
12,549
6,287
7,253
591
Q/Q Percent Change
51.1
-22.3
-4.5
-25.6
-17.5
-26.8
Y/Y Percent Change
119.8
-8.1
-0.6
-3.9
5.2
10.3
House Price Index (1980=100)
774.0
438.8
329.8
335.7
426.6
227.8
Q/Q Percent Change
2.1
0.5
0.6
1.0
0.7
0.3
Y/Y Percent Change
7.8
2.4
4.9
5.6
2.5
2.7
NOTES:
SOURCES:
1) FRB-Richmond survey indexes are diffusion indexes representing the percentage of responding
firms reporting increase minus the percentage reporting decrease. The manufacturing composite
index is a weighted average of the shipments, new orders, and employment indexes.
2) Building permits and house prices are not seasonally adjusted; all other series are seasonally
adjusted.
3) Manufacturing employment for DC is not seasonally adjusted
Real Personal Income: Bureau of Economic Analysis/Haver Analytics.
Unemployment Rate: LAUS Program, Bureau of Labor Statistics, U.S. Department of Labor/Haver
Analytics
Employment: CES Survey, Bureau of Labor Statistics, U.S. Department of Labor/Haver Analytics
Building Permits: U.S. Census Bureau/Haver Analytics
House Prices: Federal Housing Finance Agency/Haver Analytics
For more information, contact Michael Stanley at (804) 697-8437 or e-mail michael.stanley@rich.frb.org
36
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
Nonfarm Employment
Unemployment Rate
Real Personal Income
Change From Prior Year
Fourth Quarter 2004 - Fourth Quarter 2015
Change From Prior Year
Fourth Quarter 2004 - Fourth Quarter 2015
Fourth Quarter 2004 - Fourth Quarter 2015
4%
3%
2%
1%
0%
-1%
-2%
-3%
-4%
-5%
-6%
10%
9%
8%
7%
6%
5%
4%
05 06 07 08 09 10
11
12
13 14
15
3%
05 06 07 08 09 10
11
12
13 14
Fifth District
15
8%
7%
6%
5%
4%
3%
2%
1%
0%
-1%
-2%
-3%
-4%
-5%
05 06 07 08 09 10
11
12
13 14
15
United States
Nonfarm Employment
Major Metro Areas
Unemployment Rate
Major Metro Areas
Building Permits
Change From Prior Year
Fourth Quarter 2004 - Fourth Quarter 2015
Fourth Quarter 2004 - Fourth Quarter 2015
Change From Prior Year
Fourth Quarter 2004 - Fourth Quarter 2015
7%
6%
5%
4%
3%
2%
1%
0%
-1%
-2%
-3%
-4%
-5%
-6%
-7%
-8%
05 06 07 08 09 10
Charlotte
11
Baltimore
12
13 14
15
13%
12%
11%
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
Washington
40%
30%
20%
10%
0%
-10%
-20%
-30%
-40%
05 06 07 08 09 10
Charlotte
11
Baltimore
12
13 14
15
FRB—Richmond
Manufacturing Composite Index
Fourth Quarter 2004 - Fourth Quarter 2015
Fourth Quarter 2004 - Fourth Quarter 2015
20
10
10
0
-10
-20
-30
-40
-50
0
-10
-20
-30
05 06 07 08 09 10
11
12
13 14
15
11
12
13 14
15
United States
House Prices
Change From Prior Year
Fourth Quarter 2004 - Fourth Quarter 2015
16%
14%
12%
10%
8%
6%
4%
2%
0%
-2%
-4%
-6%
-8%
40
30
20
05 06 07 08 09 10
Fifth District
Washington
FRB—Richmond
Services Revenues Index
30
-50%
05 06 07 08 09 10
11
12
13 14
15
05 06 07 08 09 10
Fifth District
11
12
13 14
15
United States
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
37
Metropolitan Area Data, Q4:15
Washington, DC
Baltimore, MD
Hagerstown-Martinsburg, MD-WV
Nonfarm Employment (000s)
2,622.7
1,383.6
104.8
Q/Q Percent Change
1.2
1.0
1.4
Y/Y Percent Change
2.4
1.1
-2.0
Unemployment Rate (%)
4.3
5.2
5.0
Q3:15
4.3
5.2
5.4
Q4:14
4.9
5.8
5.8
Building Permits
6,039
1,266
196
Q/Q Percent Change
-0.7
-37.7
-16.2
Y/Y Percent Change
21.6
-25.3
-40.8
Asheville, NC
Charlotte, NC
Durham, NC
Nonfarm Employment (000s)
185.8
1,126.6
298.9
Q/Q Percent Change
2.1
2.3
1.6
Y/Y Percent Change
3.0
3.1
1.3
Unemployment Rate (%)
4.5
5.3
5.0
Q3:15
4.6
5.4
5.0
Q4:14
4.7
5.7
4.9
Building Permits
438
5,003
1,107
Q/Q Percent Change
-14.5
10.7
-5.6
Y/Y Percent Change
36.9
22.5
4.9
Greensboro-High Point, NC
Raleigh, NC
Wilmington, NC
Nonfarm Employment (000s)
361.0
594.7
120.4
Q/Q Percent Change
2.2
1.7
-0.6
Y/Y Percent Change
1.9
3.6
2.1
Unemployment Rate (%)
5.8
4.7
5.5
Q3:15
5.9
4.7
5.5
Q4:14
6.1
4.8
5.5
Building Permits
604
2,447
321
Q/Q Percent Change
-14.6
-14.3
-29.1
Y/Y Percent Change
-12.1
-18.9
-48.3
NOTE:
Nonfarm employment and building permits are not seasonally adjusted. Unemployment rates are seasonally adjusted.
38
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
Winston-Salem, NC
Charleston, SC
Columbia, SC
Nonfarm Employment (000s)
259.4
337.7
392.5
Q/Q Percent Change
1.3
0.6
2.2
Y/Y Percent Change
1.0
3.1
2.2
Unemployment Rate (%)
5.4
4.7
5.2
Q3:15
5.5
4.8
5.2
Q4:14
5.5
5.8
6.0
Building Permits
289
1,384
934
Q/Q Percent Change
17.3
-29.3
-29.6
Y/Y Percent Change
-18.4
-0.8
5.8
Greenville, SC
Richmond, VA
Roanoke, VA
Nonfarm Employment (000s)
409.3
669.6
163.7
Q/Q Percent Change
1.7
2.5
1.6
Y/Y Percent Change
3.2
4.3
1.3
Unemployment Rate (%)
4.8
4.3
4.1
Q3:15
5.0
4.4
4.2
Q4:14
6.0
5.2
4.9
Building Permits
998
1,398
N/A
Q/Q Percent Change
-41.8
-4.0
N/A
Y/Y Percent Change
-22.9
69.7
N/A
Virginia Beach-Norfolk, VA
Charleston, WV
Huntington, WV
Nonfarm Employment (000s)
771.2
123.4
142.5
Q/Q Percent Change
-0.1
0.6
2.1
Y/Y Percent Change
1.3
-2.3
-1.0
Unemployment Rate (%)
4.7
6.0
6.1
Q3:15
4.7
6.4
6.2
Q4:14
5.4
6.2
6.2
Building Permits
1,216
58
36
Q/Q Percent Change
-33.4
-6.5
0.0
Y/Y Percent Change
-24.7
1,060.0
0.0
For more information, contact Michael Stanley at (804) 697-8437 or e-mail michael.stanley@rich.frb.org
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
39
OPINION
The Payoff from the Earned Income Tax Credit
BY K A RT I K AT H R E YA
O
ne of the largest federal antipoverty programs —
the Earned Income Tax Credit (EITC) — appears
not well-known to many Americans, including
many of those it targets. The EITC provides low- and
moderate-income workers a subsidy in the form of a credit
that’s “refundable” in the sense that if the worker’s tax bill
is less than the credit, he or she receives a refund check
from the Internal Revenue Service. The EITC resulted in
$66.7 billion in income tax credits to 27.5 million families
in 2014, an average of about $2,400 per family. As you
would expect, EITC recipients are generally low-income
workers: In 2010, Nicole Simpson of Colgate University;
Devin Reilly, currently at the consulting firm Analysis
Group; and I looked at the characteristics of recipients
and found that their mean household income was a little
more than $15,000.
The EITC rewards employment, since only those with
earnings are eligible to receive it. It is attractive because
it is simple to administer and gives recipients complete
flexibility in deciding how to use the money they receive.
But does the EITC work? Before trying to answer that,
it’s useful to think through the incentives and disincentives that the EITC sets in motion. As a credit on earned
income, the EITC basically raises a worker’s effective wage.
But this doesn’t necessarily mean recipients will choose to
work more. When hourly wages go up, individuals may
choose to seek more work — either by getting a job, or,
if they already have one, by taking on more hours. This is
what economists refer to as the “substitution” effect —
workers substituting paid work for nonmarket activities,
such as caring for their children or parents. On the other
hand, being able to earn more per hour allows workers to
make any given level of purchases through fewer working
hours. This is called an “income” effect, and it works in the
opposite direction.
There is another force at work that can partially thwart
the EITC from achieving its goals. The program limits
eligibility by reducing the recipient’s credit once his or her
income crosses a certain threshold. In this “phase-out zone,”
a further increase in income causes a decrease in the amount
of the EITC. This, in turn, creates a disincentive for workers
in this zone to increase their hours worked.
Whether the incentives or disincentives to work
dominate is an empirical question, and recent research
offers some answers. The EITC does not appear to
strongly affect men’s work hours one way or the other.
And because of the income effect, the EITC seems to
lead some married women to leave work. Nada Eissa
of Georgetown University and Hilary Hoynes of the
University of California, Berkeley studied the response of
40
E CO N F O C U S | S E CO N D Q U A RT E R | 2 0 1 6
married couples to the EITC expansions that took place
between 1984 and 1996. They found that, while the expansions slightly increased the labor force participation of
married men, they reduced the labor force participation
of married women by more than a full percentage point.
The success story for the EITC, in terms of increasing
entry into the workforce, has been that of single parents,
mothers especially. Indeed, researchers have found that
the EITC was the main reason that the employment rates
of single women with children went up in the 1990s.
The EITC has other benefits for single women, including those who are not EITC eligible. Simulations by Gizem
Kosar of the New York Fed in 2014 found that the presence
of the EITC in the economy encourages women to gain
work experience. As a result, the wages of single women are
5 percent higher in such an economy than in an economy
without the EITC.
The EITC also serves as a form of insurance against wage
fluctuations, both routine ones and ones that occur during
economic downturns. In work that Nicole Simpson, Devin
Reilly, and I did in 2014, we found that the EITC may substantially reduce the volatility of a recipient’s spending. And
strikingly, EITC income appears to have broader effects on
family well-being: Recent work has found that for single
mothers with a high school education or less, an increase
of $1,000 in their EITC is associated with a 6.7 percent to
10.8 percent reduction in low birth weight newborns.
Like every transfer program, the EITC comes with limitations. For instance, some of the money paid to recipients
may end up, indirectly, in the pockets of their employers
in the sense that EITC payments may enable employers to
set wages a little lower. Jesse Rothstein of the University
of California, Berkeley has estimated that an average of 30
cents of every dollar of EITC money received by low-skill
single mothers ends up in the pockets of their employers in
this way. In addition, the EITC cannot help those who’ve
suffered a job loss or are unable to find employment — it is
a credit only for earned income, after all. Lastly, by making
low-skilled jobs pay more, in effect, the EITC may discourage skill acquisition. If at all substantial, this effect is something for policymakers to keep firmly in mind.
On balance, the EITC appears to play a valuable role in
combating poverty and helping low-income individuals —
single mothers especially — transition into the workforce,
and it may serve as an important buffer against risks. But
further research is vital for a full understanding of both its
limitations and its benefits.
EF
Kartik Athreya is executive vice president and director
of research at the Federal Reserve Bank of Richmond.
NEXTISSUE
Millennial Finance
Many millennials entered the workforce in the midst of the
Great Recession and the collapse of the housing market.
Observers worry that these forces, coupled with other burdens
like mounting student debt, are stunting millennials’ financial
development. Econ Focus looks at research on the economic
challenges of workers in the millennial generation.
Women at Work
The share of women participating in the U.S. labor force has
been dropping since 2000. But in most developed economies
around the world, the rate has been rising since the early 1990s.
Why is the U.S. labor market for women different — and can
policymakers do anything to change it?
Life Expectancy in America
For most people and in most developed countries, life expectancy
has increased steadily for decades. But in the United States,
growth in life expectancy has stalled — and might actually have
reversed for some groups.
Jargon Alert
In economics, the life-cycle hypothesis
states that people save money while they
are young so that they can draw down their
savings as they age. On its face, it seems
like an obvious insight. But as a number of
economists over the years have shown, this
simple idea has profound implications for
the economy as a whole.
The Profession
Even after they’ve officially retired, some
economists never truly leave economics
behind. Conferences, adjunct positions,
and writing projects are ways that these
economists keep themselves involved.
Interview
Jonathan Parker of MIT on whether
households smooth their consumption
over time as economic theory predicts,
why the incomes of wealthy households
have become more sensitive to the business
cycle, and the macroeconomic effects of
fiscal policy choices during recessions.
Visit us online:
www.richmondfed.org
• To view each issue’s articles
and Web-exclusive content
• To view related Web links of
additional readings and
references
• To subscribe to our magazine
• To request an email alert of
our online issue postings
Federal Reserve Bank
of Richmond
P.O. Box 27622
Richmond, VA 23261
Change Service Requested
To subscribe or make subscription changes, please email us at research.publications@rich.frb.org or call 800-322-0565.
The Richmond Fed’s 2015 Annual Report
Annual Report Essay Assesses
Prospects for Long-Term Growth
A “New Normal”?
THE PROSPECTS FOR LONG-TERM GROWTH IN THE UNITED STATES
FEDERAL RESERVE BANK OF RICHMOND
An essay in the Richmond Fed’s 2015 Annual Report challenges the
idea that the U.S. economy will be stuck in slow-growth mode for
many years. Economic growth following the Great Recession has
been well below the post-World War II pace, a performance that
some observers have called the “new normal.” The pessimists argue,
among other things, that innovation has slowed and is unlikely to
improve and that demographic trends do not bode well for fiscal
policy. The authors of the Richmond Fed essay concede that these
issues are significant, but they contend that continued innovation
and sound public policy could yield substantial improvements
in economic performance. That scenario might be difficult for
U.S. citizens to imagine right now, they conclude, “but how many
Americans in 1930 would have thought that the rest of the 20th
century would have produced such massive gains for such a huge
swath of the population?”
2014 ANNUAL REPORT
FEDERAL RESERVE BANK OF RICHMOND
2013
FEDER AL R ESERVE BANK OF RICHMOND
ANNUAL R EPORT
Previous annual report essays include:
Living Wills: A Tool for Curbing Too Big to Fail
Living Wills: A Tool for
Curbing “Too Big to Fail”
With contingency planning,
regulators can make the
financial system more stable—
and avoid future bailouts
Should the Fed Have a Financial
Stability Mandate ?
Lessons from the Fed’s f irst 100 Years
Should the Fed Have a Financial Stability Mandate?
Lessons from the Fed’s first 100 Years
The Annual Report is available on the Bank’s website at www.richmondfed.org/publications/research/annual_report/
@FedFRASER