Full text of Econ Focus (Federal Reserve Bank of Richmond) : Summer 2006, Volume 10, Number 3

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Summer 06 Full CoversFINAL

SUMMER

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2006

THE

FEDERAL

RESERVE

BANK

OF

RICHMOND

The Economics of Workplace Safety
Volcker Disinflation • The (Illegal) Immigrant Effect
• Interview with Guillermo Calvo

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COVER STORY

14

$afety First
When markets work, it pays for companies to have safer
workplaces, including Fifth District coalfields
Coalfields
Despite some high-profile accidents, the American workplace has
become safer over the past 100 years. Financial incentives can have
a positive influence.

FEATURES

19

The (Illegal) Immigrant Effect: The economic impact of
unauthorized migrants isn’t as big as you might think
Immigrant labor lowers wages for less-skilled native-born Americans,
but it also lowers prices for consumers. The biggest economic
beneficiaries of immigration are immigrants themselves.

VOLUME 10
NUMBER 3
SUMMER 2006

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

24

Shortfall: Commodity producers are expanding capacity to
meet growing demand, but lags in supply are putting pressure
on Fifth District manufacturers
Economic theory says that rising prices should entice firms into the
market, eventually raising supply and easing prices. In reality, it can
be a relatively slow process.

Aaron Steelman

MANAGING EDITOR

Kathy Constant
STA F F W R I T E R S

Charles Gerena
Betty Joyce Nash
Vanessa Sumo

Married people often are wealthier and healthier than their single
counterparts — but marriage is not the only reason.

E D I TO R I A L A S S O C I AT E

30

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

Productivity Postponed: The late 20th century
centurywitnessed
witnessed
huge leaps in information technology innovation, but gains
in productivity were slow to follow

Andrea Holmes
Ray Owens
CONTRIBUTORS

As companies invested more in IT products, it took workers awhile to
to
figure
how
best
these
new
technologies.
figure
outout
how
to to
best
useuse
these
new
technologies.
34

Meet the New Grundy: Public works, private education revive
Appalachian town
The rebuilding and relocating of flood-prone Grundy, Va., is costing
taxpayers $130 million. The hope is that the public works will leverage
growing private investment.
37

Bypassing Banks: Prosper.com aims to directly link individual
borrowers with lenders using an eBay-type model
The American banking system serves most consumers well. But a new
Web site hopes to fill a niche in the lending market.

CO V E R P H OTO G R A P H Y: G E T T Y I M AG E S

EDITOR

Doug Campbell

Love, Money, and Marriage: Should public policy encourage
people to tie the knot?

1 President’s Message/Banking on Credibility
2 Federal Reserve/From Stagflation to the Great Moderation
6 Jargon Alert/Rational Expectations
7 Research Spotlight/Upended
8 Policy Update/Breaking Down Barriers
9 Around the Fed/Market Power?
10 Short Takes
41 Economic History/Baltimore Immigration
44 Interview/Guillermo Calvo
49 Book Review/Adam Smith’s Lost Legacy
52 District/State Economic Conditions
60 Opinion/Banking and Commerce

John A. Weinberg

SENIOR EDITOR

27

DEPARTMENTS

DIRECTOR OF RESEARCH

Clayton Broga
Joan Coogan
Andrew Foerster
Thomas M. Humphrey
Christian Pascasio
Andrea Waddle
John R. Walter
DESIGN

Ailsa Long
C I RC U L AT I O N

Nichole Armstead
Walter Love
Shannell McCall
Published quarterly by
the Federal Reserve Bank
of Richmond
P.O. Box 27622
Richmond, VA 23261
www.richmondfed.org

Subscriptions and additional
copies: Available free of charge
by calling the Public Affairs
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Reprints: Text may be reprinted
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below. Permission from the
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reprinting photos, charts, and
tables. Credit Region Focus and
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publication in which the
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The views expressed in Region Focus
are those of the contributors and not
necessarily those of the Federal Reserve
Bank of Richmond or the Federal
Reserve System.
ISSN 1093-1767

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PRESIDENT’SMESSAGE
Banking on Credibility
his issue of Region Focus
comes at a time when
inflation is on many
people’s minds. The prices of
some commodities have been
shattering records, putting pressure on companies that use
those products to increase what
they charge their customers.
Consumer prices, excluding food
and energy, rose at an annual rate
of 3.1 percent in the first five
months of 2006, compared with
2.2 percent for all of the previous year. During such periods,
attention turns to the Fed to see what policy steps it will take.
And with the spotlight so intense, the Fed understands that
maintaining its credibility is of the utmost importance.
A central bank’s monetary policy is considered credible if
the public perceives that it is committed to keeping inflation
low and stable. Without credibility, it would be difficult for
the central bank to anchor the public’s expectations of
future inflation, which complicates monetary policymaking.
A central bank ultimately would like its policy to affect the
real interest rate through changes in the nominal target rate,
the difference between the two being expectations of future
inflation. But if inflation expectations are volatile, it will be
harder to pin down what the policy rate should be.
Inflation expectations tend to be self-fulfilling in the
sense that the anticipation of much higher prices in the
future puts upward pressure on current prices. If a central
bank’s record in fighting off higher prices is weak, shocks
that hit the economy can easily unhinge inflation expectations and push the inflation rate upward. By contrast, if a
central bank’s credibility is well-established, people are less
jittery about every piece of news that can affect future
inflation, making it easier for the central bank to pursue
price stability.
The notion that credibility is critical to monetary policy
follows from the recognition that people are rational when
forming their expectations. They understand a central bank’s
preferences for low, stable inflation and will use this knowledge to predict future monetary policy moves. Because the
Fed failed to adequately take forward-looking expectations
into account during the “go-stop” monetary policy of the
1960s and 1970s, its attempts to exploit the perceived tradeoff between output and employment were futile.
Each time the Fed stimulated the economy in the
go phase of the policy cycle, it would wait too long before
tightening policy in the stop phase. By this time, higher
inflation expectations had already crept into the public’s
pricing decisions. After several go-stop cycles, inflation rose

T

to its highest level in three decades. Attempts by the Fed to
“fine-tune” the economy had failed.
This inflationary phase ended when the Fed, under the
guidance of Paul Volcker, tightened policy until inflation was
brought under control and inflationary expectations were
anchored at low levels. In October 1979, Volcker introduced
a dramatic policy shift that eventually resulted in the fed
funds rate rising to nearly 20 percent. This aggressive tightening came at the cost of a sharp recession in early 1980
and another that began in mid-1981 and lasted until well
into 1982. But the Fed understood that its credibility was at
stake. In order to return the economy to more stable times,
the Fed needed to send a strong and unwavering signal of
its commitment to fight inflation.
In the ensuing years, the Volcker Fed remained watchful in
preserving its hard-won credibility, recognizing that it can
easily be lost. Former Richmond Fed economist Marvin
Goodfriend has observed that although inflation was only
about 4 percent in 1983 to 1984, the long bond rate, an
indicator of inflation expectations, was trading significantly
higher. Knowing that it should not take such signals for
granted, the Fed pre-empted this threat by raising the
fed funds rate to about 11 percent. Since that time, there
have been several “inflation scares” in which rising bond
yields warned of potentially higher inflation. But each time,
under Volcker and his successor Alan Greenspan, the Fed
responded to pre-empt the threat.
The success of the Volcker and Greenspan Feds at keeping
inflation expectations in check paved the way for the “Great
Moderation,” a long and sustained period of output and
inflation stability. As a result, it is widely acknowledged
that maintaining price stability is the best contribution a
central bank can make to ensuring sustained growth in
incomes and employment. But even after 25 years of relatively
sound policy, the Fed understands that in a low inflation
environment, as much as in a high one, it must remain vigilant.
Signs of rising inflation have surfaced this year. How serious
those signs are remains unclear — productivity growth is
strong and the cost of labor relative to output has barely moved
since a year ago. Even so, preserving its credibility requires
reacting appropriately to keep inflation low and stable. The Fed
has spent much effort establishing a reputation for making
price stability its primary objective. That has been a long and
hard-fought battle, one that we must continue to wage.

JEFFREY M. LACKER
PRESIDENT
FEDERAL RESERVE BANK OF RICHMOND

Summer 2006 • Region Focus

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FEDERALRESERVE
From Stagflation to the Great Moderation
How former
Federal Reserve
Chairman
Paul Volcker
tamed inflation
and changed
monetary
policymaking as
we know it

The Fed’s decisive moves to
control inflation, beginning
in 1979, drew the attention of
the public and media, which
had grown skeptical of the
central bank’s resolve in
pursuing price stability.

2

Region Focus • Summer 2006

W

hen Paul Volcker returned
early from an International Monetary Fund
meeting in Belgrade on Oct. 2, 1979,
everyone sensed that something was
afoot. Volcker, the newly installed
Chairman of the Federal Reserve
Board of Governors, had called for a
special meeting on Oct. 6, which was
10 days ahead of the regularly scheduled Federal Open Market Committee
(FOMC) gathering. Average inflation
had rocketed to 10.6 percent in the
first eight months of 1979 from 7.6
percent in 1978. In September, inflation soared to a high of 11.9 percent
over the previous year.
Worried about those trends,
Volcker believed that the Fed had to
change its policies, sharply and decisively. He opened that fateful meeting
with this observation: “We wouldn’t be
here today if we didn’t have a problem.”
More than a quarter of a century
ago, the Federal Reserve took a dramatic turn in monetary policy that

sent interest rates soaring to their
highest levels on record and triggered
two recessions. But the move also
finally arrested inflation’s insidious
rise and set the stage for a long period
of prosperity in the United States.
The “Incredible Volcker Disinflation,” as economists Marvin
Goodfriend of Carnegie Mellon
University (and former senior economist at the Richmond Fed) and
Robert King of Boston University
(and a visiting scholar at the
Richmond Fed) hail this period, was
“incredible” because the Fed was able
to successfully bring down inflation
from a high of 13.5 percent in 1980 to
less than 4 percent in just a few years,
and to keep it low for the next two
and a half decades. This was a remarkable feat at a time when inflation
seemed so well-entrenched in the
economy and the costs of reducing it
were deemed very large.
But Goodfriend and King also call
this period “incredible” because the
“imperfect credibility of monetary
policy” complicated attempts to disinflate the economy. Stubbornness of
inflationary expectations frustrated
the Fed’s efforts to bring down inflation permanently, even after Volcker’s
policy shift in October 1979. The
public’s deep skepticism of whether
policymakers were serious about taming inflation and whether they would
stay the course made it extremely
difficult for the Fed to earn the credibility that was necessary to effectively
rein in prices.
One of the Fed’s missions is to
conduct monetary policy in the pursuit of maximum sustainable growth.
In many ways, The Reform of
October 1979, as it has also come to
be known, has led to the recognition
that the Fed can best achieve this goal
through its principal mission: keeping
prices stable.

PHOTOGRAPHY: GETTY IMAGES

BY VA N E S S A S U M O

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Great Expectations
Setting policy in the presence of high
and volatile inflation expectations is
like navigating a ship in a fog — it is
difficult for a central bank to see
where it is headed, whether it has
been tightening or loosening too
much or too little, and so runs the risk
of destabilizing the economy. An
environment with stable inflation
expectations, on the other hand,
makes it easier to bring about changes
in real interest rates and thus carry
out monetary policy effectively.
The Fed that Volcker inherited was
utterly lacking in credibility. At the
time, the notion that an expansionary monetary policy could
permanently reduce unemployment was widely accepted and led
many to believe that running some
inflation was worthwhile. In time,
the public would come to expect
that the Fed would each time
loosen money in order to stimulate
the economy. But there was little
understanding of how such expectations could feed into future wages and
prices. Hence, there was little appreciation about the importance of
anchoring inflation expectations.
This led to a “go-stop” fashion of
monetary policy. In the “go” phase of
the policy cycle, inflation would rise
slowly as the Fed stimulated output
and employment. By the time inflation reached worrying levels, higher
inflation expectations had already
seeped into the public’s pricing decisions. Thus, an aggressive increase in
the interest rate would have been
needed to trounce inflation, but as
Goodfriend points out, “There was a
relatively narrow window of broad
public support for the Fed to tighten
monetary policy in the stop phase of
the cycle.”
This window opened when rising
inflation started to become a concern,
but closed quickly when unemployment began to rise. “The tolerance for
rising inflation and the sensitivity to
recession meant that go-stop cycles
became more inflationary over time,”
explains Goodfriend. As a result, the
public began to lose confidence in

the Fed. The perception that taming
inflation would always take a backseat
to efforts to combat a potential recession created the reputation that the
Fed could not credibly commit to
price stability.

The Monetary Policy Experiment
Inflation began its ascent in the
mid-1960s. From a low of 2.6 percent
a year from 1964 to 1968, inflation
rose to an average of 5 percent from
1969 to 1973, and 8 percent from 1974
to 1978. By 1979, it had reached a high
of 11.3 percent.

The Fed that Volcker
inherited was utterly
lacking in credibility.
Even before he took over the
Federal Reserve chairmanship from
G. William Miller, Volcker was a wellknown inflation hawk. In an April 1979
FOMC meeting as president of the
Federal Reserve Bank of New York, he
remarked, “[Inflation] clearly remains
our problem. In any longer-range or
indeed shorter-range perspective, the
inflationary momentum has been
increasing. In terms of economic stability in the future, that is what is
likely to give us the most problems
and create the biggest recession.”
In part because of these credentials, President Carter appointed
Volcker as Chairman, ushering out
Miller after only 18 (widely perceived
as ineffective) months on the job. But
in August 1979 when he was finally
sworn in, Volcker held back. In order
to assure public support for taking a
drastic measure to fight inflation, he
would need to wait for a moment of
crisis to arrive.
That happened sooner than
expected. During the September 1979
FOMC meeting, the committee proposed a small increase in the federal
funds rate (the overnight rate at which
banks borrow reserves from each

other) to 11.5 percent. There were
eight assents and four dissents, but
three of these dissents actually came
from hawks who were disappointed at
the relatively small change and
favored more tightening. When the
Board of Governors met afterward to
decide on the discount rate (the rate
at which the Fed lends to financial
institutions), a half percentage step up
was passed with a 4-to-3 vote, this
time with all three dissents on the
dovish side.
But because only the vote on the
discount rate was immediately made
known to the public, markets interpreted the strong dovish dissents as
a signal that the Fed would forestall any further increases in the
interest rate. Moreover, the markets
believed that Volcker’s ability to
fight inflation was in question since
it appeared that he was facing
increasing opposition within the
Fed. The vote also seemed to
confirm the widely held idea that the
Fed would stop fighting inflation if it
meant triggering a recession. Some
analysts speculate that events may
have unfolded differently had the markets known that three of the four
dissents on the fed funds rate vote
were actually by hawks who wanted
more tightening instead of less.
Nevertheless, the public’s belief
that the Fed would take a softer
stance on inflation roiled commodity
markets. Daily futures prices for precious metals such as gold and silver
rose sharply and turned disturbingly
volatile as speculators rushed to
hedge their positions against inflation. The mania spread to most other
commodities as well.
After commodity futures prices
spiked on Oct. 2, rumors surfaced
that a support program for the flagging dollar was on its way, sending
traders skidding the other way, only
to learn later in the day that the
rumor was unfounded. At this point,
Volcker knew that the need for
a dramatic monetary policy shift
had arrived.
Calling for a special FOMC meeting, Volcker was determined to push

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1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987

P ERCENT

The cleverness of this simple plan,
ment, pushed to the foreground by
a strong program to deal with the
apart from the huge publicity that it
Milton Friedman’s monetarist ideas.
situation. At the meeting on Oct. 6,
created, was in taking off the Fed’s
Friedman pointed out that adjusthe presented the committee with
hands the responsibility of where the
ments in inflationary expectations
two possibilities for attacking inflafed funds rate may go. What tipped
would break the perceived trade-off
tion: the traditional method that
the decision in favor of changing
between inflation and unemployment
would involve targeting a significant
operating procedures, according
if monetary policy continued to
increase in the fed funds rate;
to economists Athanasios Orphanides
exploit this relationship. Moreover,
or, a radical change in operating
of the Federal Reserve Board of
insights from rational expectations
procedures.
Governors and David Lindsey, formertheory taught that forward-looking
The Fed has at its disposal two
ly of the Board, and Robert Rasche of
agents cannot be “fooled,” so their
main approaches for conducting open
the St. Louis Fed, was “the practical
expectations and corresponding
market operations: It can target the
observation that a monetary authority
actions reflect how they perceive
price of balances — the federal funds
monetary policy is conducted.
rate — that banks hold at the Federal
deliberately setting the funds rate
Friedman also argued that because
Reserve. Or it can target the quantity
would be unlikely to select the level
inflation is mainly a monetary pheof those balances. The operational
that it expected to induce that targeted
nomenon — caused by excessive
shift that Volcker was proposing would
money stock, because the implied
increases in the money supply — the
mean the Fed would stop directly tarvolatility of the funds rate would
cost of reducing inflation in terms of
geting the prices of reserve balances
be more than the authority could
lost output would be much less severe
and instead aim at a specific level of
stomach.” Because there was always a
than was previously thought. These
“nonborrowed reserves.” Under the
strong reluctance to let the funds rate
ideas encouraged the Volcker Fed to
plan, the Fed would target a level of
rise too high, adopting the new rule
proceed with its decision to drastibalances that would fall short of
would allow the Fed to fix its gaze on
cally alter its policy.
demand at the prevailing fed funds
keeping the amount of money and
The Fed hoped that this dramatic
rate, thus causing banks to bid up the
credit in check while letting the fed
shift would send a firm signal of
rate — accomplishing the same monefunds rate attain the necessary level.
its resolve to fight inflation and its
tary policy goal but in a different way.
intention to return the economy to
However, and advantageously, this
Rise of the Monetarists
more stable times. The question,
approach would mean allowing a much
Taming inflation expectations was a
however, was whether the Fed could
wider range where the fed funds rate
central objective in this policy experistick to this policy. Volcker
could settle.
himself had hinted that he
In speaking about these
The Fed Funds Rate and Inflation
intended to use the new opertwo alternatives, Volcker
The Fed aggressively raised interest rates in the early 1980s
ating procedure for only
mentioned that changing
to control inflation, which had reached double digits.
three or four months. But it
operating procedures had
would take much longer than
occurred to him in the past:
20
that to deliver a permanent
“My feeling was that by put18
decline in inflation.
ting even more emphasis on
16
The first test of the
meeting the money supply
14
Volcker
Fed’s determination
targets and changing operat12
to stabilize prices came on
ing techniques … and thereby
10
what Goodfriend identifies
changing psychology a bit, we
8
as the “inflation scare” of
might actually get more bang
6
December 1979 to February
for the buck … I overstate it,
4
1980. During this period, the
but the traditional method of
2
10-year bond rate, an indicamaking small moves has in
0
tor of inflation expectations,
some sense, though not
soared from 10.5 percent to
completely, run out of psyFed funds rate
Inflation
12 percent. The inflation rate
chological gas.” The two
in February over the previous
possibilities were put to a vote
NOTES: The blue line represents the monthly effective federal funds rate from
year was around 14.2 percent.
and the outcome was unaniJanuary 1967 to December 1987. The red line represents the monthly year-on-year
percentage change in the consumer price index. The shaded areas indicate recessions
At the same time, there were
mous — switch to the new
as determined by the National Bureau of Economic Research; December 1969 to
indications that the economy
operating procedures. The
November 1970, November 1973 to March 1975, January 1980 to July 1980, and
was weakening, which once
Committee widened the fed
July 1981 to November 1982.
SOURCES: St. Louis Fed’s Federal Reserve Economic Data (FRED) and the
again put the Fed in a bind.
funds rate band from 0.5 to
Bureau of Labor Statistics
But the Fed forged ahead
4 percentage points.
4

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Page 5

with its tightening stance, and within
two weeks of the March 1980 FOMC
meeting, the fed funds rate shot up to
19 percent.
This aggressive tightening, however, would only restrain inflation
temporarily, partly because the Fed
felt compelled to ease the burden it
had created by allowing interest rates
to go so high. After credit controls
(annual ceilings on both direct lending and loan guarantees in federal
programs) that President Carter put
in place plunged the economy into an
even deeper recession, the Fed loosened policy, effectively moving the
fed funds rate down to 9 percent by
July 1980.
By the fall of that same year the
fed funds rate and the 10-year bond
rate were around 13.25 percent and
10.5 percent, respectively, roughly
where they had stood the year before.
This seemed to suggest that efforts to
stabilize inflation in the past year had
not been so successful, perhaps
because the familiar pattern of gostop policy that had plagued the Fed’s
credibility had not yet been convincingly shaken off.

Staying the Course
The Fed tightened monetary policy
again, just as the economy was recovering from the short 1980 recession
and the threat of increasing energy
prices due to skirmishes in the
Middle East. The fed funds rate rose
to a near record high of more than
20 percent in December of that
same year. Though the FOMC knew
it was risking another recession,
Volcker reiterated the importance of
staying the course in a February 1981
meeting, “We see the risks of the

alternative of a sour economy and
an outright recession this year. So,
maybe there’s a little tendency to
shrink back on what we want to do
on the inflation side. I don’t want to
shrink back very far; that is my general
bias for all the reasons we have stated
in our rhetoric but don’t always carry
through on.”
Still, nothing could stop long-term
inflation expectations from climbing
higher, as they did when the 10-year
bond rate peaked to more than 15
percent in October 1981. Average
inflation for 1981 was running high at
10.4 percent. This second inflation
scare, say Goodfriend and King, was
a pivotal moment in U.S. monetary
history “because it convinced the
Fed that the cost of a deliberate
disinflation in 1981-82 was acceptable
in light of the recurring recessions
that would be needed to deal with
inflation scares in the future.”
And true enough, despite evidence that the economy was faltering
and moving into another recession,
the Fed was unwavering in its pursuit
of stable prices. In the July 1981
FOMC meeting, Volcker once again
reminded everyone of the ultimate
objective. “I haven’t much doubt in
my mind that it’s appropriate in substance to take the risk of more
softness in the economy in the short
run than one might ideally like in
order to capitalize on the antiinflationary momentum to the
extent it exists,” Volcker said. “That
is much more likely to give a more
satisfactory economic as well as
inflationary outlook.”
Finally in October 1982, Volcker
announced the end of the new operating procedures that were put in place

three years earlier. Inflation had
begun to weaken in the spring of 1982
and by that fall, inflation had slipped
to around 5 percent, the long rates
dropped by 2 percentage points since
that summer, and the fed funds rate
fell to around 9 percent from more
than 14 percent in July.
The Volcker Fed reverted to managing the fed funds rate more closely
(targeting the price of balances
instead of the quantity) and began
taking a more accommodative stance
in its treatment of the money supply.
The recession ended in November
1982. Still, the Fed did not give into
complacency and held the fed funds
rate in the 8 percent to 9 percent
range through the first half of 1983,
even as inflation moved down to
less than 4 percent by the end of
that year, largely because long-term
interest rates were still hovering over
10 percent.
The battle was not yet completely
won at this point, for there were still
some inflation scares that would test
the Fed’s mettle. Nevertheless, the
hardest work had been done.
Volcker’s monetary policy experiment established the credibility
that the Fed sorely needed to
stabilize inflationary expectations. A
time of unprecedented low inflation
and steady economic activity has
ensued in the decades since the
Volcker disinflation, a period which
has sometimes been called the
“Great Moderation.” Most observers
agree that improved monetary policy
since Volcker deserves much of the
credit for this era of stability.
Without a doubt, Alan Greenspan
and Ben Bernanke have benefited
greatly from this legacy.
RF

READINGS
Federal Open Market Committee Transcripts, 1979-1982.
Washington, D.C.: Board of Governors of the Federal
Reserve System.

Goodfriend, Marvin. “The Monetary Policy Debate Since October
1979: Lessons for Theory and Practice.” Federal Reserve Bank of
St. Louis Review, March/April, vol. 87, no. 2, part 2, pp. 243-262.

Goodfriend, Marvin, and Robert King. “The Incredible Volcker
Disinflation.” National Bureau of Economic Research Working
Paper no. 11562, August 2005.

Lindsey, David, Athanasios Orphanides, and Robert Rasche.
“The Reform of October 1979: How It Happened And Why.”
Federal Reserve Bank of St. Louis Review, March/April, vol. 87,
no. 2, part 2, pp. 187-235.

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JARGONALERT
Rational Expectations
any economic decisions in life depend upon predictions or expectations about the future. A new college
graduate’s choice of a career often depends on how
he thinks earnings in certain fields will change over coming
years. Investors choose stocks based upon their views of likely
changes in returns. A farmer decides how much corn to plant
according to his expectations of future prices.
In each of these examples, the effect of expectations on current behavior is clear. However, in each case, future prices
depend upon the actions of a large group of individuals making
current decisions. Earnings in a field will depend
upon how many college graduates choose that
occupation and how much demand exists for
those skills; the price of a stock will depend
upon how many shares are available and
whether investors want to buy or sell them;
and the price of corn will depend upon how
much corn farmers have harvested and
how much households wish to consume.
The rational expectations hypothesis is
important for studying forward-looking
decisions and markets. It rests on the
premise that any discrepancies between
expectations and outcomes are not “systematic.” In other words, people do not
make the same mistakes over and over,
constantly misjudging future events. Rational expectations theory does not assume that people have perfect foresight, but it
does assume that decisionmakers understand how future prices
will be determined — for instance, the more corn is harvested,
the lower the price will tend to be — and do the best job possible forecasting the future with the information available to
them now.
Since the idea of rational expectations depends on systematic discrepancies between outcomes and expectations, events
that are “surprises” can have large effects. For instance, farmers
understand that droughts are possible but infrequent. As a
result, when a drought occurs, they are unlikely to have predicted its effects on supply and, hence, prices for the current season.
This is a surprise for which rational expectations theory can
account. What rational expectations does not allow, however, is
for farmers to systematically misjudge the frequency of
droughts and their effects on crop yields and prices. That is, one
would expect farmers to understand that if a drought occurs,
yields will be low and prices will be high.
The same is true when it comes to investors. Certain stocks
may be undervalued at certain points in time. But overall,
investors are unlikely to consistently underestimate the future
prices of equities. If there were such a discrepancy, savvy

M

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Region Focus • Summer 2006

investors would realize that their expectations were too low, buy
more stock, and drive up prices.
Rational expectations can also help explain people’s
consumption patterns. Consider a person in mid-career who has
been laid off, but expects to find a new job in the next few
months. Should this person, whose income has just dropped significantly, make an equal cut in his immediate consumption?
Economists would argue there may be no need for a big cut,
because he can use debt or savings for a short while, then repay
the debt or replenish savings once he is employed again.
People tend to be forward-looking
when it comes to public policy changes
as well. For instance, temporary tax cuts
intended to stimulate the economy may in
fact be met with only slight increases
of consumption, as people expect future
tax rates to return to their previous
higher level to raise revenue.
In addition to fiscal policy, rational
expectations theory has significant implications for monetary policy. Many
economists used to believe that there was
an exploitable trade-off between unemployment and inflation: The Fed could cut
interest rates, stimulate the economy, and
lower unemployment without having to
worry about runaway inflation. But this policy only worked until
people figured out that inflation and expansionary policy go
hand in hand. As a result, rational expectations suggested the
Fed simply keep inflation low and not try to exploit possible
trade-offs.
However, the Fed could have a short-term trade-off by unexpectedly letting inflation rise or fall. Alas, this policy would
reduce the Fed’s credibility, causing people to expect higher
inflation. What’s more, people would raise their expectations of
a “policy surprise,” making actions, and therefore results, more
volatile in the future. Along these lines, Robert Lucas developed
the “policy ineffectiveness proposition,” which states that
expected policy shifts will have little effect on the economy, as
people will rationally adjust their behavior to limit the effect of
the policy.
There exist some challengers to rational expectations theory.
Behavioral economists, for example, tend to view people as relatively myopic. Still, rational expectations theory today
occupies a central place in how most economists think about
how people look to the future. For policy institutions such as
the Fed, rational expectations theory suggests it is wise to be
predictable with policy changes and to not try to manipulate the
economy through policy surprises.
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RESEARCHSPOTLIGHT
Upended
BY VA N E S S A S U M O

Y

way. Looking at the spread — or the slope — of the yield
ield-curve watching has become somewhat of a
curve alone may not capture all the information that is
pastime for forecasting enthusiasts. The fascination
useful for forecasting future output.
is understandable. The yield curve, or a comparison
In a recent paper, economists Andrew Ang of Columbia
of interest rates on government bonds of different maturiUniversity, Monika Piazzesi of the University of Chicago,
ties, has been an impressively reliable indicator of future
and Min Wei of the Federal Reserve Board of Governors
economic growth. And lately, the shape of the yield curve has
attempt to disentangle and condense the information
been notably flat, leading many to wonder if it might just tip
embodied in the yield curve by choosing a small number of
over and whether that could portend a recession.
variables that have the most explanatory power for predictThe curve begins on the left with the shortest-maturity
ing GDP growth. They find that, first, the yield spread and,
bonds and ends on the right with the lengthiest, from
second, the level of the nominal short-term rate together
three months to 30. An inversion of the curve, or when the
capture almost all of the useful information contained in the
yield on a short-term bond is higher than that on a long-term
yield curve. In particular, they find that it is the nominal
bond, has correctly predicted every single recession in
short rate rather than the slope
the United States since 1950,
of the yield curve that provides
with the exception of one
the most predictive power.
“false” signal in 1966. It predict“What Does the Yield Curve Tell Us
These results lend support to
ed the recession in 1990 five
former Federal Reserve Bank
quarters earlier, and when the
about GDP Growth?” by Andrew Ang,
Chairman Alan Greenspan’s
yield curve inverted in 2000,
view on why today’s yield curve
a recession followed two quarMonika Piazzesi, and Min Wei.
should be interpreted carefully.
ters later. No wonder markets
recently took notice when the
Journal of Econometrics, March-April 2006, Like Ang, Piazzesi, and Wei,
Greenspan believes that it is
yield on the 2-year bond crawled
the short rate that underlies
above that of the 10-year bond
vol. 131, issues 1-2, pp. 359-403.
much of the yield curve’s
several times between late last
predictive ability. Specifically,
year and March. In early June
in testimony before the Joint Economic Committee in
the yield on the 10-year bond closed lower than the fed funds
November 2005, Greenspan noted that a flat or inverted
rate for the first time since April 2001.
curve could signal weaker economic growth ahead, but
Why is an inverted yield curve so alarming? An upward
that depends on how far the real fed funds rate is from
sloping yield curve is the result of investors’ expectations
its long-run level.
that interest rates will rise in the future. The yield curve
Another reason why some economists think that an
also slopes upward because investors demand a risk preinversion may not mean a recession involves the level of
mium for the uncertainty of holding a bond that matures
another interest rate — the long-term one. Even though the
further away in the future. Usually, a positively sloped curve
Fed has increased its target rate 17 times since June 2004,
indicates good times ahead. As the economy rapidly
inching it up from 1 percent to 5.25 percent, long-rates have
expands, markets expect future interest rates to rise
remained stubbornly low at around 4 percent to a little more
because of potentially higher inflation, which the Fed will
than 5 percent. Analysts point to low inflation expectations
stave off through rate hikes.
and increased demand for long-term bonds by foreign
An inverted yield curve, on the other hand, can be a
governments intervening in currency markets and by baby
harbinger of a recession. It suggests that investors anticipate
boomers preparing for retirement as some of the reasons
future yields to fall because they expect a slowdown to
why yields at the long end have remained subdued and
occur, which could eventually prod the Fed to stimulate the
the curve persistently flat. These are reasons that do not
economy through lower interest rates, as it has done at times
necessarily portend an economic downturn.
in the past. But an inverted curve also can be a measure of
Greenspan points out that even as the yield curve was flat
the sometimes inevitable effects of monetary policy. In
from 1992 to 1994, a long sustained period of economic
an effort to squeeze out inflation, the Fed can increase
expansion followed, not a recession. The yield curve is a
short-term rates high enough that a recession becomes likely.
powerful tool, but it may take a careful dissecting of levels
Some analysts argue that today’s flatness and periodic
and spreads to decipher what it’s trying to tell us.
RF
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POLICYUPDATE
Breaking Down Barriers
BY VA N E S S A S U M O

O

n Feb. 8, the curtain fell on the Public Utility
Holding Company Act of 1935 (PUHCA). The act
was passed at the height of the Great Depression
in response to the collapse of several electric and gas
holding companies.
According to critics, these firms had been charging their
utility subsidiaries high fees for service contracts and redirecting money to finance risky ventures — costs that were
passed on to consumers. The size and complexity of many of
these holding companies, usually spanning several states,
helped to obscure some of their practices and made them
difficult to regulate.
PUHCA granted powers to the Securities and Exchange
Commission (SEC) to break up these massive interstate
holding companies by forcing them to simplify their
structures. Utility holding companies were required to
shrink into single, integrated systems confined to particular
geographic areas. This limited merger possibilities to utility
companies that were physically interconnected or could
operate under a single, coordinated system. For instance, it
would have been virtually impossible for a utility in Illinois
to justify a merger with one in California.
The act also greatly restricted the types of businesses in
which holding companies could engage. An oil company was
not permitted to own and control utilities unless it gave up
its oil business, for example. The only way to avoid the SEC
oversight eye was to become an exempt holding company,
with the utility’s operations limited to a single state or
functioning predominantly as an operating utility.
The repeal of the PUHCA, which came as part of the
Energy Policy Act of 2005, broke down these old barriers
and opened the door to a variety of transactions. Utility
holding companies will now find it easier to merge or
acquire utilities in geographically distant locations. This was
the case when Duke Energy of North Carolina acquired
Cinergy of Ohio in April. In addition, Constellation Energy
of Maryland and Florida Power and Light hope to complete
their merger by the end of the year.
Nonutilities are likewise more free to acquire and control
utility companies. Although the SEC permitted Berkshire
Hathaway to acquire MidAmerican Energy Holdings in
2000 on the basis that it would have only one utility
company, Berkshire Hathaway can now venture into other
utilities, as it has done recently with its purchase of
PacifiCorp in March.
Supporters of the repeal, including the SEC itself,
the Federal Energy Regulatory Commission (FERC), and a
number of economists, felt that PUHCA no longer made
much sense in today’s environment. Before the repeal,
8

Region Focus • Summer 2006

changes in energy policy had been introduced that carved
out some exemptions for independent generating companies and foreign ownership of U.S. utilities. Moreover,
the SEC had begun permitting mergers between utility
companies that were only loosely interconnected.
In effect, the deregulation process had already been set in
motion. The development in accounting standards and
securities markets has also come a long way since 1935,
making the concern of inadequate financial reporting
that originally motivated the PUHCA largely unnecessary.
Today, audited financial statements must follow the rules set
by the Financial Accounting Standards Board, and securities
markets demand a tremendous degree of transparency from
companies wishing to raise money.
But those who opposed the repeal worry that there could
be a substantial weakening in regulation of utility holding
companies. Lynn Hargis, a lawyer with Public Citizen, a
nonprofit consumer advocacy organization, worries that
new players like investment banks would be more interested
in buying power plants and then flipping them than in
providing quality service. “Our power plants are important
basic public services. But these have now been left to the
market, and the market has only one thing on its mind that
is to make profits,” Hargis says.
Economist Paul Joskow at the Massachusetts Institute
of Technology, on the other hand, is not too concerned.
“In the current environment, when a hedge fund comes in
and seeks to acquire an operating company they will be
subject to significant scrutiny by the state,” Joskow says.
“And once investors become familiar with state regulation
they may decide that they don’t want to be in this business.” Thus, he thinks the main acquirer of utilities will be
other utilities. “There are too many utilities, and some are
better than others. If the repeal allows companies with
more expertise to expand their capabilities, then that’s a
good thing.”
Moreover, such mergers and acquisitions will still need
to be approved by state regulators and a host of federal
agencies. The repeal also hands over to FERC some of the
SEC’s previous responsibilities with respect to access to
books and records and for prescribing caps on prices
charged for non-power goods and services provided within
the utility holding company system.
So what about prices? Like Joskow, economist Richard
Gordon of Pennsylvania State University is relatively
optimistic about PUHCA’s repeal. “Anything that increases
the flexibility of the industry will in the long run lower
costs, and that’s going to be reflected in prices that
consumers pay,” he says.
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AROUNDTHEFED
Market Power?
BY D O U G C A M P B E L L

“Can Feedback from the Jumbo CD Market Improve Bank
Surveillance?” R. Alton Gilbert, Andrew P. Meyer, and Mark
D. Vaughan, Federal Reserve Bank of Richmond Economic
Quarterly, Spring 2006, vol. 92, no. 2, pp. 135-175.

“A Leaner, More Skilled U.S. Manufacturing Workforce.”
Richard Deitz and James Orr, Federal Reserve Bank of New
York, Current Issues in Economics and Finance, February/March
2006, vol. 12, no. 2.

ank examiners spend a lot of time on the road. They
drive around the country dropping in on financial institutions of all sizes, meeting with managers and inspecting the
books. It’s an expensive way to mind the banks, but necessary.
The other way that bank examiners keep tabs is through
a model which summarizes a depository institution’s financial condition. It’s useful so far as it goes, but in recent years
economists have been considering whether there might
be other, more effective ways of supervising banks that
complement on-site visits.
One of the leading candidates for how this might be
accomplished is through financial market information —
everything from stock prices to bond yields. Under one
proposal, large banks would have to issue a special debt
offering, with the idea that the market performance of this
debt issue would flag problem banks perhaps sooner than
traditional bank surveillance techniques.
In a new paper, economists in the supervisory units of the
Richmond and St. Louis Feds size up the surveillance properties of jumbo certificates of deposit (CDs). Jumbo CDs are
a cheap and stable source of funding for banks, and supply
ample data to mine. Equally, jumbo CDs are used by even the
smallest banks, which are the sort historically most likely to
fail and the ones that experience the widest time lags
between on-site examinations.
The authors build a model that aims to mimic surveillance practices used by bank supervisors. Then they
compare how jumbo CD signals fare as a predictor of bank
problems with the standard capital-adequacy model.
It turns out jumbo CDs aren’t so good at providing early
warnings about problem banks. Even though it costs almost
nothing to add jumbo CDs to a model of bank surveillance,
doing so produces little in the way of valuable information.
It may be that the jumbo CD results were less than fruitful because they were produced through a model that
tracked the healthy economic period of 1992 to 2005. This
could mean that other market data could produce meaningful information for different time periods. At the same time,
the findings on jumbo CDs suggest that no single source of
market information can replace existing bank monitoring
techniques. The authors conclude, “Our findings — when
viewed with other recent research — suggest the supervisory return from reliance on a single market signal through all
states of the world may have been overestimated.”

T

B

he U.S. manufacturing sector continues to shed jobs,
but a growing number of the remaining ones require
relatively high skills and, as such, they come with higher pay.
Manufacturing employment fell 9.3 percent in the United
States between 1983 and 2002. But economists at the New
York Fed found that during the same period, the percent of
high-skill manufacturing jobs rose 36.6 percent. Among the
biggest-gaining regions in this regard was the South Atlantic
(which includes the entire Fifth District); it saw a 63.4 percent gain in high-skill manufacturing jobs, countering the
region’s overall 8.8 percent loss of manufacturing positions.
These results are in keeping with economic theory.
Global trade has combined with technological advances to
lower demand for the least-skilled U.S. workers, whose jobs
can be done cheaper by workers overseas or by machines.
Meanwhile, high-skill jobs are being created in engineering
research and development, and export industries. As a
result, the authors conclude, “a manufacturing workforce is
emerging that is at once leaner and more skilled.”

“The Decline in Teen Labor Force Participation.” Daniel
Aaronson, Kyung-Hong Park, and Daniel Sullivan, Federal
Reserve Bank of Chicago Economic Perspectives, 1Q 2006,
pp. 2-18.

n the late 1970s, the labor force participation rate of
working-age teenagers (16 to 19 years old) peaked at about
59 percent. It’s been downhill almost ever since, including a
steep 7.5 percentage point fall between 2000 and 2003. Are
teens hanging out the mall and playing video games, or are
they devoting themselves to their studies as never before?
The answer may be important for the economy and
its future productivity. Investments in human capital — be
they in the labor market or in schooling — ought to increase
teens’ future earning power. The authors find that the longterm decline in teen labor force participation is
“a supply-side development,” triggered principally by “the
significant increase in the rewards from formal education.”
There remains a possibility that demand has also
dropped for teen labor, but the authors note that the recession ended four years ago and labor force participation
among 16- to 19-year-olds still hasn’t picked up. More to
the point, today’s teens simply aren’t looking for jobs.
They appear to be hitting the books instead.
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SHORTTAKES
costs, and a changing global environment, IP is scaling back
production in the United States. The company has announced
its intentions to explore selling an additional 6.8 million acres of
its domestic land, expecting proceeds of up to $10 billion from
its divestures.
While the land is “of the highest conservation value,” as
recent business deal has married a global paper company’s
The Conservation Fund’s Selzer labels it, it may not be entirely
profit-maximization goals with conservationists’ environsuitable for developers’ purposes. The swampiness of land
mental objectives. International Paper Co. (IP), one of the
located along rivers and estuaries can render it unsuitable for
world’s largest private landowners, sold 218,000 acres of forest
building, for example. Hence, the mixed quality of the land
land to The Conservation Fund and The Nature Conservancy
for development could have decreased competition from
in what was billed as the largest conservation deal the South has
commercial firms interested in bidding for it.
ever seen.
As part of the agreement, IP will continue to harvest timber
The two conservation groups will transfer much of the land
from the sold land until native
to respective state governplants regrow, which could be
ments within several years. The
another 20 to 50 years. This is a
remaining land will be recycled
large benefit that IP likely
back into the private market in
would not enjoy had they sold
the form of easements which
the land to developers.
require strict abidance to
In addition, IP says it has a
preservation rules.
genuine interest in environThe $300 million deal
mentalism. The company has
encompasses ecologically improhibited the harvest of
portant land stretching across
endangered forest land and
10 states, including more than
placed limits on the amount of
20,000 acres in Virginia and
timber that it harvests from any
116,000 in the Carolinas. In a
given area.
news release, The Conservation
“Coming to a compromise
Fund’s president Larry Selzer
like this hasn’t been done
forecasts that the preserved Linking pre-existing conserved areas, like South Carolina’s
before and could be a model for
land will protect the wildlife Waccamaw National Wildlife Refuge (pictured here), with
future transactions,” says IP
habitat, enhance air and water the land acquired from International Paper will better benefit
waterfowl and protect water quality.
spokeswoman Amy Sawyer. The
quality, and provide outdoor
U.S. Department of Agriculture projects some 44.2 million
recreation opportunities. Moreover, the deal links existing pubacres of privately owned U.S. forest land, particularly in the
lic and private conservation areas. The groups believe that
East, will be sold by 2030.
linking these forests and waterways will increase animals’ space
— CLAYTON BROGA
for mobility and further improve water quality.
The conservation groups obtained significant financial
GOING ONCE
backing from two private timber investment funds,
Conservation Forestry, LLC, and Forest Investment
Associates. Public reimbursement is a possible source of funding too. Virginia’s Department of Forestry has expressed
interest in purchasing some of the land sold by IP, Brian
est Virginia invested $24.8 million via online auctions in
Van Eerden of The Nature Conservancy told the Virginiana variety of state and local banks on May 16. The money,
Pilot. Funding for the North Carolina lands could flow from any
from $2.8 billion in state operational funds, went to banks
of the state’s three existing environmental trust funds. North
offering the best rates on six-month certificates of deposit.
Carolina lawmakers also are considering a $1 billion land-bond
Only banks with branches in the Mountain State were eligible
issue that could make its way on the November ballot. In South
to bid.
Carolina, such public funding is not unprecedented, as
“As everyone knows, banks are crying for deposits,” says Joe
Gov. Mark Sanford recently approved the borrowing of
Ellison, chief executive of the West Virginia Bankers
$32 million for a separate forest acquisition.
Association. “This gives smaller banks the opportunity to parThe deal is part of International Paper’s larger “transformaticipate and keep the money invested in West Virginia.”
tion plan” in which it is shedding vast swaths of domestic land.
That was the idea, according to Glenda Probst, executive
Citing North America’s mature markets, rising raw material
director of West Virginia’s State Board of Treasury
COMMON GROUND

Big Business and the
Environment Shake Hands

A

West Virginia Banks Bid
for State Deposits

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Region Focus • Summer 2006

PHOTOGRAPHY: KAREN BESHEARS

W

Page 11

ON THE HOME FRONT

Housing Markets Cool Off
in Some States but Not in Others
n the once-hot housing market of Northern Virginia, a slowdown is afoot. Residences in the cities of Alexandria,
Fairfax, and Falls Church, as well as the counties of Arlington
and Fairfax, were sold for only 97 percent of the list price in
May, compared with 101 percent a year ago (though it should be
noted that those asking prices were still higher than a year ago).
Sellers are reducing prices as people become more cautious
about buying a house. On average, a home for sale in this area
lingered for 51 days on the market in May, compared with just 15
days a year ago.
The country’s housing market has indeed begun to cool
down like many analysts predicted. More and more homes are
being offered but not enough buyers are willing to take up the
increase in supply. In April, the inventory of existing unsold
homes across the country rose to 3.38 million, the highest on
record. This suggests that the inflation in house prices may
start losing steam after the booming rates of the past two years.

I

Converging markets
Growth in house prices has slowed in the hotter markets, but is
still drifting upward in their less bubbly neighbors.
30
25
20
15
10

DC
West Virginia

Maryland
South Carolina

06Q1

05Q3

05Q4

05Q2

05Q1

04Q3

04Q4

04Q2

04Q1

0

03Q4

5

03Q3

Investments. The board approved $100 million for the auction
program. The next auction is in August.
“Since it was our initial auction we wanted to start small
and generate competition for the funds and increase
earnings,” she says. “From talking to other states and the
auction administrator we understand it takes time to get the
banks informed, registered, and trained. It takes awhile to get
full participation so we thought $25 million was a good
number.” The money is from state agencies with revenues
that are allowed to be invested and includes the state’s rainy
day funds. The fund does not include pension money.
The auction was efficient, according to Probst. “For us to
go out and meet with 10 or 15 different banks and negotiate
CDs would be much more time-consuming,” he says. The
treasurer’s office in 2005 took over the job of managing
the state investments. Operational funds previously were
invested outside the state. The online auction allowed the
state to receive the most competitive rates as well as keep
money in the state, and boost the local economy.
The highest bid was 5.16 percent, by United Bank Inc. of
Parkersburg, W.Va. The bank got $5 million. “I think that was
probably more than we could have negotiated on our own,”
Probst says. There is a $5 million ceiling per parent bank for
each auction “so that one large bank couldn’t come in and bid
on $25 million.”
Among smaller banks, Capon Valley of Wardensville, W.Va.,
which just reached $100 million in deposits, got $500,000 for
its 4.99 percent bid and Main Street Bank, with about $90
million in deposits, received $500,000 for a 5.15 percent bid.
West Virginia is the 11th state to offer online auctions for
deposit money. South Carolina began using the online auction
process in 2000, the second state to do so behind Ohio.
— BETTY JOYCE NASH

03Q2

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P ERCENT

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Virginia
North Carolina

NOTE: The chart shows year on year growth rates of house price indices for
each quarter.
SOURCE: Office of Federal Housing Enterprise Oversight

A closely watched indicator, the Office of Federal Housing
Enterprise Oversight’s quarterly index, shows that median
house prices in the United States increased by 12.5 percent in
the first quarter of 2006 over the previous year, easing
somewhat from the peak of 14.1 percent in the second quarter
of 2005.
But the slowing has been uneven throughout the country. In
the Fifth District, we see a tale of two housing markets — one
that has expanded rapidly in the past three years and the other
which has grown at a more modest pace. In particular, it seems
that the rates of appreciation in house prices between the
brisker and the more moderate markets in the Fifth District are
starting to converge, according to Ray Owens, a regional economist at the Richmond Fed. “Where house prices have gone up
the most, the cooling has been more pronounced. But where
prices have gone up the least, they continue to move somewhat
higher,” Owens says.
Median house prices in the rapidly growing markets of the
District of Columbia, Maryland, and Virginia rose by 13 percent
to 18 percent in the second quarter of 2004, peaked at
22 percent to 25 percent a year later, but have since slowed to
18 percent to 21 percent in the first quarter of 2006. While
house prices in these areas are still appreciating at high rates,
they have perceptibly cooled down.
On the other hand, price increases of homes in North
Carolina, South Carolina, and West Virginia have been drifting
upward, rising by 8 percent to 11 percent in the first quarter of
2006 from only 3 percent to 5 percent two years before.
A few years ago, the economies of these states were growing
sluggishly, partly because they had relied heavily on the manufacturing sector, which took a severe hit during the recession
five years ago. “More recently, [the] economies of the Carolinas

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are starting to rebound somewhat,” says Owens. He adds that
buying a home is still affordable for most people because house
prices have not appreciated as much.
— VANESSA SUMO
CAROLINA DREAMING

Newspapers Get New Owner
in the Carolinas

will be able to sell advertising in bundles. That’s a more appealing approach to retailers, who these days are more likely to be
regional or national chains. “No other media business is organized to gather mass amounts of news, only newspapers are, and
it’s a function that will continue,” Morton says. “Whether the
income comes from the newsprint product or the Internet, all
the money falls into one pocket.”
— DOUG CAMPBELL
BACK-TO-SCHOOL BONANZA OR BOONDOGGLE?

cClatchy Co. didn’t exist in the Carolinas as recently as
1990. But now, the California-based newspaper chain
owns the two largest dailies in North Carolina, the largest in
South Carolina, plus a handful of small to midsize papers across
both states.
For $4.5 billion, McClatchy picked up 32 newspapers from
Knight Ridder Inc. The purchase, which closed June 27,
included the Charlotte Observer in North Carolina and The State
of Columbia in South Carolina, adding to a Carolinas portfolio
that already included the Raleigh News & Observer and the
Beaufort (S.C.) Gazette. The company entered the Carolinas in
1990s with the buy of three South Carolina dailies. The News &
Observer was acquired in 1995.
Wall Street analysts were mostly positive about the deal,
though McClatchy’s stock price fell immediately after the
announcement. “The assets [McClatchy] is acquiring look very
similar to the company’s existing asset base,” wrote media analyst Paul Ginocchio with Deutche Bank. Union activity is
virtually nil at the acquired papers, which otherwise might
drive up labor costs, he added.
McClatchy quickly sold 12 of the Knight Ridder papers —
including the two Philadelphia dailies and two large papers in
northern California — deeming them misaligned with its highgrowth-market strategy. But the remaining 20 new papers still
make McClatchy the second-largest U.S. newspaper company,
trailing only Gannett Co., owner of USAToday and many others.
To be sure, newspaper readership is in decline. Substitutes
abound — from broadcast media to the ever-growing Internet
offerings. (In June, the News & Observer joined a growing
number of papers to dump daily stock listings, putting the bulk
of its quotes online instead.) The latest national circulation
report noted declines of 2.5 percent for dailies, continuing a
decades-long trend. Local U.S. newspapers saw advertising
spending drop 6.1 percent during the first three months of
2006, for example, while Internet advertising rose 19 percent.
But John Morton, a newspaper analyst in Silver Spring, Md.,
says that calling newspapers a dying industry “is a gross exaggeration.” Newspapers still earn about 19.2 percent operating
margins, the sort that “a lot of other businesses would love to
have half of,” Morton says.
For one thing, newspapers tend to be the most popular
online providers of local news, so those Internet advertising
gains are going directly to their pockets (though Web advertising still represents only about 5 percent of total revenues).
Readers continue to seek out journalism, it seems, but less so
in print.
With McClatchy’s holdings in the Carolinas, the company

M

12

Region Focus • Summer 2006

Virginia Joins Sales-Tax
Holiday Bandwagon

D

uring a contentious three months of budget negotiations
earlier this year, Virginia legislators did manage to agree
on one thing without much fuss. The state joined the rest of the
Fifth District in offering an annual reprieve from the sales tax
on selected goods.
Such “sales-tax holidays” have been popular throughout the
country since New York held one in 1997. The loss in tax revenue is relatively small compared with a state’s overall budget,
plus lawmakers say they are helping constituents save money.
But while major retailers like this tax policy, some supposed
benefits touted by its advocates aren’t as clear.
Starting this year, Virginia will have its sales-tax holiday
from the first Friday to the first Sunday of every August.
Consumers won’t have to pay the 5 percent general tax on
school supplies priced $20 and below, or on clothing and
footwear selling for $100 and below. In addition, retailers can
choose to pay the sales tax themselves on goods that aren’t
exempt and advertise them as tax-free.
Virginia officials believe the sales-tax holiday will help
retailers increase their sales and compete with stores across the
state’s border in West Virginia, Maryland, the District of
Columbia, and North Carolina, all of which have held similar
holidays during the summer and fall. (South Carolina has held a
sales-tax holiday since 2000, the longest record in the Fifth
District.) Judging from retailers’ past experiences, these taxfree events appear to rival the shopping sprees between
Thanksgiving and Christmas.
More generally, states push for sales-tax holidays as a way
to boost their economies. However, many tax policy analysts
and economists believe that the savings during the holiday
are too small to induce a significant amount of new
spending, except perhaps in communities which border
another state that isn’t having a holiday or has no sales tax
whatsoever, like Delaware. (In Virginia, for example, the
projected consumer savings from the three-day event will
total just $3.6 million.) Instead, the increased sales may
represent purchases that consumers decide to make during
the holiday instead of at other times of the year.
Retailers are tight-lipped about how much money they
make, so there is little data available to empirically support
either viewpoint. But anecdotal evidence abounds. Members of
the Consumer Electronics Association and the National Retail
Federation have reported increased sales of exempt items

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Page 13

during sales-tax holidays, but — unlike what some economists
say — not at the expense of other periods.
“If we said everything is 5 to 8 percent off today, consumers
would laugh at us,” says NRF spokesman J. Craig Shearman.
“But when we offer the same savings by way of a sales-tax holiday, they flock into the stores.”
Finally, advocates of sales-tax holidays say they want to help
families prepare their children for school, especially those on
low incomes for whom the sales tax is a relatively high burden.
The problem is consumers in higher-income brackets spend
more than those in the lower brackets. Also, richer people are
able to change the timing of their purchases, while poorer
people are less financially flexible and may not have the money
to “stock up” during holidays and maximize their savings. As a
result, the intended beneficiaries of a sales-tax holiday may end
up benefiting the least.
Also, the sales-tax holiday creates a disincentive for discounting goods. Some retailers reportedly cut prices of
nonexempt goods to take advantage of the marketing buzz
surrounding a holiday. But others may scale back their usual
markdowns on exempt items in anticipation of higher sales,
says David Brunori, who teaches state and local tax law at
George Washington University. “The sales tax is the draw,”
he explains.
Retailers may even increase prices on exempt goods to reap
greater profits. Brunori and a group of researchers at the
University of West Florida have found evidence of such
markups in New York and Florida during their holidays.
If the goal is helping low-income families, Brunori and
others suggest that state governments give tax rebates or direct
grants for low-income people to purchase school supplies,
clothing, and computer technology. Or governments could
eliminate the sales tax year-round, as New York did in April
2006 for clothing sold for $110 or less.
— CHARLES GERENA
BORDER WAR?

New Study Examines Relocations from
North Carolina to South Carolina

O

utsiders know Charlotte, N.C., as a thriving metro area.
With its financial services headquarters, big-league sports
teams, and bustling downtown, Charlotte is the very
embodiment of the New South.
But in recent years, the local headlines began to take their
toll on Ronnie Bryant, president of the Charlotte Regional
Partnership, the area’s economic development group. The
stories said Charlotte was fast losing jobs to just across the
border in South Carolina. In 2002, Wells Fargo Mortgage
moved 700 jobs to York County, S.C. In 2004, it was
CitiFinancial shifting 700 jobs to York County. Earlier this
year, Inspiration Networks, a religious cable TV network,
took its headquarters — and 200 jobs — to Lancaster
County, S.C.
People called it a “border war,” Bryant says. And the complaints mounted: Was the rivalry getting too hot? Did North

Carolina need to entice firms with better incentive packages?
“We wanted to step back and look at what was going on to get
some objective data to see if we really had a problem,”
Bryant says.
The partnership commissioned a study and the results
arrived in June. Since 2001, said the report, Mecklenburg
County — where Charlotte is located — lost an announced
3,150 jobs to South Carolina. To Bryant, this was exceedingly
good news: 3,150 jobs represents only about 0.5 percent of the
county’s job base. Meanwhile, since 2001 alone the county
picked up almost 63,000 new jobs from business expansion and
relocation, more than offsetting the border crossings. It was
hardly a bull rush of firms going south.
The report, prepared by Ticknor & Associates of Illinois,
also had a few cautions about the role of incentives. It said
that job movement to South Carolina was “decentralization”
and “a natural market force in every American region.”
(Witness the fast growth at the fringes of the Washington,
D.C. metro area, for example.) The costs are simply lower
in South Carolina, just outside the core of the Charlotte
metro area, providing all the incentive many firms need to
relocate operations.
The real drivers of these intra-regional moves aren’t South
Carolina business recruiters but consultants. Incentives are
at best a secondary draw. “I advocate incentives within a
competitive environment,” Bryant says. “But economic
developers would be the first to admit that the use of incentives
has gotten totally out of hand. To some extent, decentralization
is a natural occurrence, and we should not be influencing these
moves with incentives.”
Michael Luger, a management professor at the University of
North Carolina who studies economic development issues, says
land and utilities tend to be the biggest corporate expenses.
The importance of incentives in wooing companies depends on
which business they’re in. South Carolina’s incentives for
manufacturing firms are marginally more favorable than North
Carolina’s, Luger says, citing his own research. Meanwhile,
the overall land costs in South Carolina are lower, as is the
corporate income tax — but property tax rates are higher,
though South Carolina, unlike North Carolina, has abatement
programs. The bottom line, Luger says, is that not every firm is
worth trying to lure with incentives.
The 16-county Charlotte Regional Partnership, of course,
already encompasses four counties in South Carolina, including
the aforementioned York and Lancaster counties. An
economist might not be so concerned about which side of a
state boundary a company locates. What’s important is how the
overall economy is affected and whether resources are being
put to their most efficient use. But politicians and economic
development officials often take these narrow location issues
seriously.
“It’s an uneasy tension between North Carolina and
South Carolina and the Charlotte region,” Luger says. “They
recognize the importance of working together, but they also
recognize that they’re competing sometimes. I don’t think
that’s necessarily unhealthy.”
— DOUG CAMPBELL

Summer 2006 • Region Focus

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$AFETY FIRST

When markets work, it pays for
companies to have safer workplaces,
including the coalfields of Virginia
and West Virginia

oal mining is the heart of
Logan County, W.Va. When
the industry prospers, Logan
prospers. And when something bad
happens, everyone prays for a miracle.
On Thursday, Jan. 19, two crews of
miners were working in separate
sections of Alma Mine No. 1, not far
from the town of Logan. Around
5:30 p.m., an atmospheric monitoring
system detected high levels of
carbon monoxide about two miles
from the mine’s entrance. The source
of the toxic fumes was a fire on one of
the conveyor belts that carries coal out
of the mine.
According to initial reports, a dispatcher told everyone inside to get
out. Among the 12 men closest to the
fire, 10 managed to evacuate. Thick
smoke had replaced the fresh air they
were breathing, obscuring their view
and choking their lungs before they

C

14

Region Focus • Summer 2006

slipped on their portable oxygen
packs. The miners locked hands and
made their way through miles of passageways carved into the earth until
they met up with the other crew and
rode a diesel-powered railcar to the
mine’s entrance.
Amid the smoke and intense heat,
two men were somehow separated
from their crew. Family, friends, and
co-workers gathered at a nearby
church on Friday to await news of
the lost souls, recalling the heartwrenching scenes less than three
weeks earlier in Tallmansville near the
Sago mine explosion. It wasn’t until
Saturday when rescuers finally tamed
the fire enough to expand their search
and found two lifeless bodies.
Friction generated from a stuck or
misaligned conveyor belt could have
sparked the deadly fire. Or, an electrical problem in the motor that drives

the belt could have occurred.
Speculation on the fire’s cause will
continue until the federal Mine Safety
and Health Administration (MSHA)
and the West Virginia Office of
Miners’ Health, Safety and Training
complete their investigations. In the
meantime, federal prosecutors are also
investigating the accident for possible
criminal violations.
Coal mine workers in West
Virginia, Virginia, and other parts of
the country face an unpredictable,
challenging workplace. “By its very
nature, a mine is so dynamic. It never
sits still,” says Patrick Graham, director of safety and human resources
for Bluestone Coal Corporation
in Beckley, W.Va. Every time someone
tunnels into a mountain or blasts
through layers of dirt and rock
to reach a coal seam, miners’ work
conditions change geologically. If

PHOTOGRAPHY: BETH GORCZYCA/THE STATE JOURNAL

BY CHARLES GERENA

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Page 15

nothing changed, “there would be no
production.”
Graham believes coal mine operators control the conditions as best as
they can and minimize risks through
careful planning. But with West
Virginia losing 19 mine workers in
seven accidents between January and
May, it might seem logical to side with
union leaders, some lawmakers, and
other safety advocates who say companies put profits before people and
ought to invest more in safety.
Aracoma Coal, owner of the Alma
mine and a subsidiary of Richmond,
Va.-based Massey Energy, has been
cited for numerous violations related
to its fire suppression systems and
procedures to control the amount
of coal dust and other combustible
materials in the mine.
Despite these concerns, the
American workplace, including mines,
has become safer over the last 100
years. Textile workers no longer toil
behind locked doors in poorly ventilated workshops, while coal miners use
roof bolts instead of hastily placed
timbers to prop up underground
tunnels. The rate of work-related fatalities continues to improve, going from
5.2 deaths per 100,000 full-time workers in 1992 to 4.1 deaths in 2004. The
rate of nonfatal injuries and illnesses
also declined over the same period,
dropping from 8.9 incidents per 100
full-time workers to 4.8 incidents.
Safety advocates credit tougher regulation on the state and federal level,
especially since the creation of the U.S.
Occupational Safety and Health
Administration (OSHA) in 1970. Also,
companies are more aware of hazards
and the human toll of accidents.
Executives point to technological
advances that have made workplaces
both safer and more productive.
Firms are profit-maximizing entities. Managers usually base their
decisions on whether they benefit the
bottom line. What some economists
are quick to point out is that these very
same financial incentives can have a
positive influence on workplace safety.
An unsafe workplace is costly.
Accidents result in direct costs, from

the replacement of capital equipment
to higher workers’ compensation
premiums. They also have indirect
costs such as decreased productivity
and higher wages paid to employees.
Of course, people still get hurt or
killed more often than we would
prefer, and certain occupations like
coal mining, commercial fishing, and
truck driving have their inherent
dangers. Overall, government policies,
in combination with private-sector
initiatives, have improved workplace
safety by raising the financial toll of
poor safety practices and supporting
the development of better practices.

Boom Times and Red Hats
Safety was a significant problem in the
early days of the nation’s industrialization. Over time, the economy has
shifted from producing goods to
producing services and substituted
labor with capital. The result has been
fewer workers put at risk in relatively
dangerous occupations like manufacturing and fewer dangers associated
with manual labor.
For example, coal mine workers use
remote controls to operate massive
continuous mining machines that cut
into coal beds deep underground.
“[The mine worker] is standing back at
a considerable distance from where
the machine is operating,” describes
Chris Hamilton, senior vice president
of the West Virginia Coal Association,
a trade association representing mine
operators. “He is standing within a
safety zone, as opposed to being on the
machine … and being subjected to roof
falls, coal bed gases, or other environmental problems.”
While economic progress has
helped improve workplace safety, that
progress hasn’t been uninterrupted.
Workplace safety deteriorated during
the 1960s, according to Mark Aldrich,
former senior economist at OSHA and
a professor emeritus at Smith College.
Unions clamored for the federal
government to do something, which it
did by creating OSHA, but Aldrich
believes the real culprit was the business cycle. “It wasn’t that American
industry was getting worse. There was

a long boom beginning in the
Kennedy-Johnson years, and you could
see the injury rates pick up in manufacturing.”
As companies ramped up production, many new employees entered the
work force. “When the economy is
booming, labor turnover goes up,”
Aldrich explains. So, even the best
safety program becomes overwhelmed
by a flood of inexperienced new hires,
diluting the effectiveness of training.
Yet fatalities and accidents in the
coal mining industry fell to an all-time
low in 2005 despite recent growth in
demand. Production levels have been
fairly steady and payrolls have picked
up in the last few years, but neither has
accelerated at a pace that would
endanger safety, in Aldrich’s view.
What if the price of coal remains
high and mine operators keep facing
pressure to staff reopened sites? “That
is a recipe for trouble,” Aldrich says.
“The companies are going to hire people who don’t have much experience.
Unless they have really good safety
procedures,” the level of workplace
safety could decline.
Experienced workers are already
harder to find. Judy Steele Horne, a
certified mine safety instructor based
in Cedar Bluff, Va., says a lot of
seasoned miners couldn’t handle the
instability in the industry and retired
or moved. This has left fewer veterans
to call upon, forcing mine operators
to hire a lot of people who aren’t
accustomed to working together or at
a mine.
These inexperienced workers, also
known as “red hats,” must face the
rigors of the job and pressure from
companies eager to boost production. “They have to be fast learners,”
Horne adds.
The miners who died in the Alma
fire weren’t red hats, however. Don
Bragg had spent almost half of his
adult life in coal mining — nine and a
half years — while Ellery Hatfield was
a miner for 11 and a half years. Other
recent mining accidents have involved
experienced workers. Horne says that
when miners move to a new site, it is a
time of transition. Plus, there is peer

Summer 2006 • Region Focus

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Getting Safer

FATALITY R ATE P ER 100,000 W ORKERS

The annual fatality rate for American workers
declined 21 percent between 1992 and 2004,
despite occasional upticks.
5
4
3
2
1

2003
2004

2001
2002

1999
2000

1997
1998

1995
1996

1993
1994

1992

0

SOURCE: Bureau of Labor Statistics

pressure to perform, so workers may
put themselves in situations that compromise safety.

Accidents Have a Price
Beyond shifts in the overall economy,
a more significant influence on
workplace safety is the expense of
occupational injuries and fatalities to
individual firms. Companies will invest
more in equipment upgrades, better
training, and other safety improvements as long as these investments are
less than the cost of work-related accidents that are avoided.
For example, accidents result in lost
output. Production comes to a halt,
equipment has to be repaired or
replaced, and new workers have to be
hired and trained. The closure of the
Alma mine reportedly cost Massey
Energy $18.5 million in labor and lost
sales during the first quarter of 2006.
(Some areas of the mine are now open
except for the section damaged by
the fire.)
“Safety improves the regularity of
the production process,” notes Peter
Dorman, an economist at Evergreen
State College who authored a 1996
book on occupational safety.
Along these lines, reducing the
number of accidents may also increase
a company’s productivity. However,
some safety measures can slow down
the pace of production, such as the use
of manually operated machine guards
16

Region Focus • Summer 2006

on power saws and other equipment.
Therefore, the net effect of safety
investments on productivity varies
from company to company.
Patrick Graham says safety
improvements like coal dust controls
and automatic temporary roof
supports, which protect workers as
they install bolts to support the ceiling
of a mine tunnel, have benefited
Bluestone Coal. “You can’t have a productive, profitable mine if something is
unsafe,” he insists. “Either you move
that mountain safely or you’ve lost a
$1.5 million bulldozer.”
Premiums for workers’ compensation insurance are another cost
associated with work-related accidents.
Before states began introducing workers’ compensation in the 1910s, injured
workers could sue for damages. But
they had to prove that the employer’s
negligence was solely to blame, which
was difficult to do. Workers rarely won
their lawsuits and, when they did
succeed, only a few settlements were
large enough to cover lost wages and
medical expenses.
Now, companies must pay a fixed
percentage of an employee’s wage for
injuries or deaths in the workplace,
regardless of who is at fault. In addition,
they have to purchase insurance or selfinsure in order to cover future claims.
The premium is usually the payroll multiplied by a base rate calculated for the
firm’s industry and an “experience modification factor” based on the company’s
claim history. As a result, an unsafe work
environment should affect a company’s
bottom line, thus providing an incentive
to make conditions safer.

Hazard Pay
Perhaps the most noteworthy financial
impact of accidents is the higher salary
that relatively riskier companies may
have to offer. Economists like W. Kip
Viscusi at Harvard University believe
that the desire to avoid these additional labor costs is a strong incentive for
firms to invest more in workplace safety, while others question how often this
happens in real life.
The idea is that less desirable jobs,
including those with relatively high acci-

dent rates, pay better wages in order to
attract and retain workers. But there are
always risk-averse people who would
never set foot in an underground mine
regardless of the salary — they want
lower-paying, safer work. Therefore,
firms that are relatively more dangerous
theoretically have a choice. They can
spend more on safety, saving the money
they would have spent trying to entice
workers. Or they can continue paying a
risk premium, also known as a compensating wage differential.
“They are two sides to the same
coin,” notes Devra Golbe, an economist at Hunter College who
specializes in finance and industrial
organization. For each company,
“there is a balance that is struck”
between the wages and safety that it
offers in order to generate a given level
of profit.
In theory, labor markets should
match up companies that are offering
different combinations of wages and
safety with workers looking for similar
conditions. Those who care more
about maximizing their income should
end up in relatively riskier, higher-paying occupations, while those who want
to maximize their comfort and safety
should get what they want.
Research by Viscusi and others
shows that risk premiums do account
for differences between safe and
unsafe industries. For instance, the
average salary of a mining machine
operator was $20.31 an hour in 2004
compared with a shoe salesman’s salary
of $8.80 an hour, partly reflecting the
fact that the mining industry has a
higher number of occupational fatalities per capita than the retail sector.
The question is how well risk premiums reflect varying levels of safety
at companies within an industry, notes
Price Fishback, a University of
Arizona economist who has studied
workplace safety in coal mining and
other industries. “Can workers identify which are the safe and unsafe mines,
and do they see a premium for being in
an unsafe mine? There is still some
premium [paid by companies within
industries], but it’s harder to detect.”
The theory underlying risk

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premiums has other caveats. It
assumes that employees are fully aware
of workplace risks, can adequately
factor those risks into their decisionmaking, and have job mobility.
In fact, information asymmetries
exist in labor markets. For example,
OSHA regulations require chemical
producers to disseminate safety information to employers that use their
products in the workplace. In addition, companies must train their
employees on how to access and apply
this information. According to a 2002
article by researchers at Harvard
University’s Transparency Policy
Project, these rules have helped ill
workers figure out what chemicals
may have harmed them and secure
proper treatment and compensation.
But the descriptions for chemical
products are complex and hard to
understand and apply, limiting their
usefulness in accident prevention.
In addition to the challenges of
obtaining information on risks, people
don’t always evaluate that information
accurately. “Depending upon the way a
risk is perceived, you can respond in all
kinds of ways. People don’t process
information like computers,” notes
Mark Aldrich at Smith College. So,
while workers might be properly compensated for their perceived risks, how
well those perceptions meet reality is
an open question.
Even when people accurately
gauge the risks of the work they perform, they have to be able to act upon
that information. This isn’t always
easy to do, especially during times
of rising unemployment or for individuals with limited alternatives in
the job market.
“You make the best choices you
can, based on the opportunities you
have,” economist Devra Golbe notes.
“It may be that the alternatives are
poor and people have only relatively
risky, low-paying jobs to choose from
based on their education, where they
live, or other constraints.”
There is evidence that competition
for labor and job mobility was sufficient at the turn of the 20th century
for coal miners and other workers to

switch jobs when work conditions
proved too hazardous, according to
Fishback’s research. But rather than
improve safety, companies initially
paid some risk premium to their
employees instead. By the 1920s, high
turnover in certain sectors like coal
mining prompted companies to begin
improving work conditions.

All in a Day’s Work
Today, coal mining is a lot safer than it
used to be. But it’s still a risky enterprise that commands a wage premium,
making it attractive for small-town
residents in southwest Virginia and
West Virginia. Generations of miners
have developed a thick skin when it
comes to risks, so they likely accept
higher wages over greater safety.
This attitude was evident among
the students at a recent safety certification class taught by Lindell Goode, a
part-time instructor at Triangle Safety
Services in Pineville, W.Va. Workers
must take the course and pass a test
before setting foot in a mine, plus they
have to take an eight-hour refresher
class annually.
On day four of the five-day class,
Goode reviews proper blasting procedures for surface miners. As he
describes how to mix ammonium
nitrate pellets with diesel fuel to make
an explosive, several students asked
if they could do the same thing with
fertilizer from Wal-Mart.

“We need to have a demonstration
right here,” jokes one student, who
has been chewing the fat with his
classmates at the rear of the blue
cinderblock classroom. Goode jokes
right back that everyone is welcome to
experiment in their basement or
backyard. “No, I want to blow up a
mountain,” the guy replies.
Later, when Goode covers what can
happen to a miner’s lungs without
proper protection, the guys in the
back start muttering to one another.
Goode admits that he didn’t like to
wear a respirator either, but he also
didn’t want to be one of those retired
miners who can barely catch their
breath when they walk. “You can
either do it now, or pay for it later.”
With the training that miners
receive today, not to mention the
media blitz that usually follows an
accident, it would be hard for a red hat
to plead ignorance about the dangers
that lie head. It wasn’t always that way.
Most of what Don Cook knew about
coal mining came from his father and
grandfather, both of whom were miners. He didn’t have the information
that new miners receive today in
courses like the ones he teaches at
Triangle Safety.
When Cook started mining in the
1970s, the only thing new employees
had to do was visit the safety director’s
office. “The guy gave you a little book
and a brass tag for your belt that had

The Price of Danger
The premiums charged by BrickStreet Mutual Insurance, a private firm that took over
West Virginia’s workers’ compensation program in 2006, generally reflect industry
differences in workplace safety.

Timbering
Underground Coal Mining
Surface Coal Mining
Street and Road Construction
Chemical Manufacturing

Workers’ Comp
Premium, 2005*
$52.20
$39.86
$12.98
$10.89
$2.80

Nonfatal Injury/Illness
Rate, 2004**
14.8
9.3
3.2
4.6
2.1

* Per $100 in payroll
** Number of occupational injuries and illnesses per 100 full-time workers. It is the most recent data available
and was selected to closely match categories used by BrickStreet Mutual Insurance.
SOURCES: BrickStreet Mutual Insurance; West Virginia Bureau of Employment Programs

Summer 2006 • Region Focus

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your name and Social Security
Number,” he recalls. “He’d say, ‘Put
that on your belt so if you get killed,
we’ll be able to identify the body.’
[Then] he’d talk to you for about 30
minutes and … you’d go to work.”

Rules of the Road
Safety training is just one component of
the regulatory structure that state and
federal legislators have created to protect workers. A combination of
rigorous standards and strict enforcement are supposed to provide an
incentive for improving safety. In order
to avoid the wrath of agencies like
OSHA, companies are expected to
invest more in protecting their workers.
Many economists contend that
while OSHA inspections and interventions can jolt specific companies into
addressing safety problems, their ability to influence these firms diminishes
over time and their effect on the aggregate level of workplace injuries and
illnesses across all industries is limited.
One reason is the low probability of
being caught red-handed. Despite
efforts to increase the pace of inspections, it would take 117 years for
OSHA to check each workplace under
its jurisdiction at least once, according
to the AFL-CIO. The probability of
a follow-up visit to check on a
company’s compliance is also low.
Another reason is that many safety
regulations merely codify what are
already common practices that
address obvious hazards, notes the
University of Arizona’s Price Fishback.

“Where regulations are really helpful
is in identifying issues and preventing
things that are really hard to detect or
might not show up for several years.”
A separate federal entity handles
workplace safety in the coal mining
industry: the Mine Safety and Health
Administration. MSHA is a product of
legislation passed in 1977, five years after
a fire killed 91 workers at a silver mine in
Idaho. Increased government regulation
of mining followed other major mining
accidents in 1940 and 1968.
Most mine penalties are based on
six criteria outlined in the 1977 Mine
Act, including the size of the mine, its
financial condition, and its history of
violations and remediating those
problems. Still, “most fines are so
small that they are seen not as deterrents, but as the cost of doing
business,” argued Wes Addington, a
lawyer with the Appalachian Citizens
Law Center, in a New York Times article
(March 2, 2006).
Since the Sago incident in January,
there has been a concerted effort to
improve mining safety. Federal lawmakers have made several proposals
and West Virginia passed several new
regulations in a special session. But
some question how effective those
proposals would be in bettering working conditions.
Some businesspeople believe that
the best way to make workplaces safer
is to target proven “bad apples” for
government scrutiny instead of
inspecting everyone the same way.
Since 1997, OSHA has operated an

inspection program that targets companies which have reported 12 or more
injuries or illnesses resulting in days
away from work, restricted work activity, or job transfer for every 100
full-time workers.
Research by Golbe and economist
Randall Filer suggests that firms with
the thinnest operating margins and
in danger of bankruptcy have more
dangerous workplaces. This implies
that safety regulators should focus on
the companies closest to the financial
edge. Currently, financially troubled
mines can have a fine reduced if they
can prove that it would be a hardship.
Industry officials have also asked
for tax incentives or grants to help pay
for improvements beyond current
safety standards. But economists caution against subsidies that would not
yield benefits to safety in excess of
their cost to taxpayers or would add
another layer to an already complex
tax system.
Others have also called for greater
federal spending on basic research and
development. Generally, incremental
advancements over time can enable
companies to improve safety at a lower
direct cost without hurting productivity. “Very often, safety comes into
workplaces with new factories and
equipment,” Mark Aldrich notes.
Time appears to be the best ally of
occupational safety. As the human and
financial toll rises, politicians rally to
protect workers while companies realize
the bottom-line value of improving safety and pursue new technologies.
RF

READINGS
Aldrich, Mark. Safety First: Technology, Labor, and Business in the
Building of American Work Safety, 1870-1939. Baltimore: Johns
Hopkins University Press, 1997.
Conaway, Carrie. “Accidents Will Happen.” Federal Reserve Bank
of Boston Regional Review, vol. 13, no. 3, pp. 11-19.
Dorman, Peter. Markets and Mortality: Economics, Dangerous Work,
and the Value of Human Life. New York: Cambridge University
Press, 1996.
Filer, Randall K., and Devra L. Golbe. “Debt, Operating Margin,
and Investment in Workplace Safety.” Journal of Industrial
Economics, September 2003, vol. 51, no. 3, pp. 359-381.

18

Region Focus • Summer 2006

Fishback, Price V. “Operations of ‘Unfettered’ Labor Markets:
Exit and Voice in American Labor Markets at the Turn of the
Century.” Journal of Economic Literature, June 1998, vol. 36, no. 2,
pp. 722-765.
Vedder, Richard K. “Technology and a Safe Workplace.” Center
for the Study of American Business, Policy Study No. 156,
Washington University, August 2000.
Viscusi, W. Kip. Risk By Choice: Regulating Health and Safety in the
Workplace. Cambridge, Mass.: Harvard University Press, 1983.

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)
l
a
g
(Ille

The Immigrant Effect
A young boy watches his migrant worker mother
pick grape tomatoes in Rocky Point, N.C.

The economic impact of unauthorized migrants isn’t as big as you might think

J

avier, who does not give his last
name, says that he is 29 years
old and works in construction,
usually earning about $400 a week.
Two years ago he walked dozens of
miles through the desert, eventually
crossing the Mexican border into
Texas. Today he lives with two brothers
in Raleigh, N.C., where lately there is
an abundance of construction jobs.
Javier came to the United States, he
says, because “it was a necessity.” He
needed to earn a living and to this day
he regularly sends home what cash he
can to his family in Mexico.
He wants to stay in the United
States. “Everyone wants to stay here,”
he says. “Here, the life is much better.”
But he is unsure about whether this is
possible and whether he should even
be talking about his residency status
in public.

On the question of his legality,
Javier’s actions probably speak louder
than words. On this day he is one of
about 150 other people queued up at
the Consulate of Mexico in Raleigh,
which is housed in a two-story, brownbrick building at the edge of a strip
shopping center. This office opened
less than six years ago and its main job
is issuing “Matricula Consulars” to
Mexicans living in the United States.
Last year, the Raleigh consulate
handed out 23,553 of these documents,
which are photo identification cards
recognized by the Mexican government and informally accepted by
some U.S. employers as proof of
identity. But if you’re in the country
legally, there is no reason to have a
Matricula Consular.
By now Javier and his 12 million or
so unauthorized peers across the coun-

try need no introduction, especially in
Fifth District regions where the immigrant population has surged over the
past decade. Depending on your view,
he is either an essential part of the
U.S. labor market or a criminal who
is taking jobs from native-born
Americans. But a close look at the real
economic effects of illegal immigration reveals a more ambiguous answer.
The overall gains to the economy from
unauthorized migrants do not appear
to be huge, nor do the losses. Perhaps
the only thing that can be said with
certainty about immigration’s economic impact is in identifying its main
beneficiaries: They are the immigrants
themselves, people like Javier.

Influx
Immigration policy in the United
States in the late 20th century was

Summer 2006 • Region Focus

PHOTOGRAPHY: AP WIDE WORLD PHOTOS

BY DOUG CAMPBELL

19

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principally shaped by two acts. The
Immigration and Nationality Services
Act of 1965 did away with national
origin quotas in favor of setting
visa limits for immigrants from the
eastern and western hemispheres.
The Immigration Reform and Control
Act of 1986, which was envisioned as
a way to slow illegal immigration from
Mexico, granted amnesty to many illegal aliens while at the same time
criminalizing the hiring of undocumented workers.
Immigrants kept coming. The
foreign-born population grew from
9.6 million, or 4.7 percent of the total
population, in 1970 to 19.8 million
(8 percent of the total) in 1990 to
about 34 million (12 percent of the
total) today. Annual immigration

peaked in the late 1990s at about
1.5 million persons, according to the
Pew Hispanic Center, a nonprofit
research organization supported by
the Pew Charitable Trusts, then fell to
1.1 million in 2003.
A lot of these immigrants were
born in Latin America. In 1990, there
were 22.4 million Hispanics in the
United States, or just less than 10
percent of the total population. In
2004, according to Census estimates,
Hispanics reached 40.5 million, or
14.2 percent of the total population,
many of whom were born in the
United States.
The last few years saw a significant
change in the composition of immigrants. Since 1995, there have been
more illegal immigrants than legal

Immigration Growth Spurt
The Hispanic population, which was tiny just two decades ago, has now grown substantially.
Because of immigration, there are many counties in the Fifth District where Hispanics make
up more than 10 percent of the total population.

immigrants to the United States,
according to the Pew Hispanic
Center, with an estimated 700,000
undocumented migrants each year,
compared with closer to 610,000
legal immigrants.
As recently as the early 1990s, there
were an estimated 450,000 illegal
immigrants entering the country each
year. These were just the ones that
made it — border apprehensions averaged more than 1.4 million a year in
the late 1990s, though dropped to less
than 1 million in 2001 and 2002 before
turning up again recently.
Unauthorized migrants, the vast
majority of which are Hispanics, today
make up almost 5 percent of the labor
force, according to the Pew Hispanic
Center. In general, illegal immigrants
tend to have less education, fewer
language skills, and more limited
bargaining power with employers than
their legal counterparts. As a result,
they may depress wages for the leastskilled Americans, with whom they
compete for jobs, though by how
much remains in debate.

The Impact on Jobs and Wages

SOURCE: U.S. Census

20

Region Focus • Summer 2006

In April 2004, Sen. Lamar Alexander,
R-Tenn., posed a question to then-Fed
Chairman Alan Greenspan: “If we
have 8.4 million unemployed, according to our official statistics, and if
6 million illegal immigrants are working, are these 6 million taking the jobs
that 8.4 million want?” Greenspan did
not directly answer the question, but
most any economist would tell you the
answer is, in general, no.
For one thing, there isn’t a fixed
number of jobs in the economy; it can
contract and expand to meet supply
and demand. In fact, by their very presence, immigrants — both legal and
illegal — create demand for new jobs.
Additionally, some people argue that
immigrants are taking jobs that natives
don’t want. Washing dishes, harvesting
grapes, roofing houses, scrubbing hotel
rooms — these tasks are increasingly
performed by Hispanic workers, many
of whom (and despite their sometimes
dubious legal status) are more highly
prized by employers than native

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Page 21

workers. “Native-born workers aren’t
very happy in these jobs and so there
would be higher turnover with them,”
says Harry Holzer, a labor economist at
Georgetown University.
The North American Free Trade
Agreement chiefly covers trade of
goods. But there are plenty of economists who contend that the same free
trade principles behind that 1993 act
ought to apply with immigrant labor
because of the benefits to both parties.
In a trade arrangement, where production of, say, textiles is moved to a
lower-cost country, domestic capital
can be put to a more profitable use.
Likewise with immigration, low-skilled
jobs are filled with lower-cost workers,
allowing companies to produce goods
more cheaply.
The mistaken notion that both
legal and, increasingly, illegal immigrants are taking jobs one-for-one
from natives detracts attention from a
more plausible scenario: Illegal immigrants may be driving down the wages
of the least-skilled American workers.
Here is why: A large share of U.S.
immigrants are relatively less skilled.
Foreign-born U.S. working-age residents are far more likely to be high
school dropouts, for example, than
natives. About 32 percent of illegal
immigrants have less than a ninth
grade education, compared with 15
percent of legal immigrants and 2 percent of the native-born population.
Economic theory is fairly clear
on the impact of this sort of immigration: It should reduce the wages of
less-skilled native-born Americans.
Basically, the supply of low-skilled
labor is going up while the demand for
such labor is remaining flat, thus
tamping down wages for this segment
of the population.
There is agreement among
economists that this latest wave of
immigration has delivered this anticipated wage effect. The disagreement
is over its intensity.
Among the most influential observations on how the wage effect may
not be so significant are:
• Robert Topel, an economist at
the University of Chicago, said

in a 1997 paper that, “Most evidence suggests that the effects
of immigration on wages
have been minor,” principally
because the size of immigrant
labor was still too small to have
much effect.
• David Card, an economist at
the University of California at
Berkeley, in a 2001 study, found
only small impacts on local
unemployment and on nativeborn wages in areas where
there was a sudden inflow of
immigrants seeking jobs.
Another Card study in 2005
similarly finds “evidence that
immigrants have harmed the
opportunities of less educated
natives is scant.”
And the leading studies that point
to possibly significant effects are:
• A 1997 report by a panel of
demographers and economists
for the National Academy of
Sciences estimated that the
4 percent increase in labor
supply during the 1980s
(driven in large part by immigration) “could have reduced
the wages of all competing
native-born workers by about
1 or 2 percent.”
• Harvard University economists George Borjas and
Lawrence Katz give the upper
bound wage effect in a 2005

paper. They looked at the
effect of immigration on
native-born wages between
1980 and 2000 and saw a
3 percent decline for average
workers and as much as 8 percent for high school dropouts.
Granted, none of these studies distinguished between illegal and legal
immigration. But that’s because to
economists, the distinction isn’t all
that important. Immigrants represent
a new pool of labor, whether they’re
here legally or illegally.
Referring to his own studies, Borjas
(who migrated from Cuba as a child)
says it’s a simple function of supply
and demand. “You have more labor
coming in, in the short run, holding all
other things equal, it will create a
decline in the wage level,” Borjas says
in an interview. “It’s also a distributional impact. The wage of those
workers who supply the most labor
will fall relative to the wage of the
workers who don’t have a huge
increase in labor supply.”
Ethan Lewis, an economist at the
Philadelphia Fed who studies immigration, grants that some less-skilled
U.S. workers may see their wages drop
by a small amount. But he takes a bigpicture perspective. “For native-borns
in general,” Lewis says, the impact of
immigration (both legal and illegal) is
“positive. The reason, of course, is that
most Americans are not as unskilled as

Growth in the Hispanic Population
While the number of Hispanics living in the United States has almost doubled since 1990,
from 22.4 million to 40.5 million, growth in some Fifth District states has been even greater.
600,000
500,000

1990

400,000
300,000
200,000
100,000
0

DC

MD

NC

SC

VA

WV

SOURCES: U.S. Census; Pew Hispanic Center

Summer 2006 • Region Focus

21

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Hispanic immigrants. So mostly,
they’re tilting the wage structure
favorably for native-born workers who
tend to be more skilled.”
But this does not answer other
concerns about the costs imposed by
illegal immigrants. Do they drain
resources from hospitals, K-12 public
schools, and corrections facilities?
The Center for Immigration
Studies, a nonprofit group that wants
fewer immigrants, said that households headed by illegal immigrants in
2002 cost the federal government
about $26.3 billion but paid only $16
billion in taxes. That equates to each
illegal household costing the government $2,700 a year.
Jeff Passel, a demographer with the
Pew Hispanic Center, for one, is skeptical of that figure. He says that his
study of the New York metro area
found that while natives and legal
immigrants paid about 30 percent of
their income in taxes, enough illegals
were on the books that their overall
tax rate (even including those who are
paid off the books and thus don’t pay
taxes) worked out to 20 percent — not
as big a difference as conventional
wisdom or the Center for Immigration
Studies has it.
Another myth is that immigrants
arrive in the United States to collect
welfare payments; in reality, they are
not eligible for them. They come to
work, and about 90 percent of the
nation’s undocumented immigrants
are in fact working. What’s more, the
majority of them are paying payroll
taxes and contributing to Social
Security (an estimated $6 billion each
year), even though — because they are
illegal — they are ineligible to claim
these benefits.
Moreover, immigrants have many
other positive impacts on the economy.
If employers are able to keep wages
down by hiring illegal immigrants,
then presumably they pass on those
savings to consumers in the form of
lower prices for the goods and services
that rely most heavily on immigrant
labor. (The overall impact on the economy of these lower prices may not be
so great, however, with some oft-cited
22

Region Focus • Summer 2006

Size of Unauthorized
Population – 2004
Illegal immigrants increasingly are coming to Fifth District locations to settle.
DC
MD
NC
SC
VA
WV
U.S.

20,000-35,000
200,000-250,000
300,000
20,000-35,000
200,000-250,000
<10,000
11.5M

SOURCE: Pew Hispanic Center

studies putting the savings at about
one-tenth of 1 percent of Gross
Domestic Product.) In addition, illegal
immigrants themselves add to consumption, though by how much
depends on which study you consult,
and estimates vary.

New Immigrant Destinations
The impact of illegal immigration
is increasingly relevant in the
Fifth District. Today’s undocumented
immigrants are traveling far beyond
traditional destinations like California,
New York, Texas, and Florida. Passel
says a principal trend he sees today is
that illegal immigrants, while still
making California their top destination, are seeking out new places to
work and settle. The percentage of
illegal immigrants going from Mexico
to California has dropped from 33 percent to 22 percent in the past decade.
In 2004, about 300,000 illegal
immigrants came directly to what
Passel terms the “New Growth States,”
areas where immigrants have only
recently started moving to in large
numbers. Among these are North
Carolina, Virginia, and Maryland.
Arguably no state has experienced an
overall immigration impact as large as
North Carolina over the past 15 years.
Its Hispanic population since 1990 has
swelled more than sixfold to an estimated 600,000. Its growth rate of
Hispanics in the late 1990s was the
fastest in the nation.
Today, almost half of the state’s
Hispanic population is thought to be

unauthorized migrants. Earlier this
year, the North Carolina Bankers
Association, believing it was looking
at a largely untapped business opportunity, commissioned a study that
tried to peg the net economic impact
of Hispanic immigrants (both legal
and illegal) on North Carolina. The
authors estimated that the spending
by the state’s Hispanics had a $9.2 billion impact in 2004. In all, their
presence and work created 89,600
jobs in the North Carolina economy,
the study finds.
In addition, Hispanics were found
to pay about $756 million in taxes. (By
the authors’ estimate, 65 percent of
illegal immigrants nonetheless are
working “on the books,” and thus
getting taxes taken out of their paychecks. This estimate is in line with
other national studies.) The tax boost
almost entirely offset the costs of
illegal immigrants to the state budget.
Namely, costs for K-12 education,
health care (usually delivered in hospital emergency rooms), and jail, totaling
$817 million.
Jim Johnson, a University of North
Carolina business professor and a
study co-author, argues that immigrants, whether legal or illegal,
actually help improve the welfare of
native-borns. “Hispanics did a couple
of things,” Johnson says. “They were
filling newly created jobs and filling
vacancies as native-borns moved up in
the queue. Does that mean they’re
taking jobs that natives don’t want?
Yes.”
This line of reasoning in part gives
rise to the most provocative claims
the study makes: that Hispanic immigrants of all stripes virtually saved the
state’s construction industry. In 2005,
there were an estimated 111,630
Hispanics working in construction in
North Carolina, the study found,
accounting for almost half the state’s
total workers in that industry.
Johnson says that absent the legal and
illegal immigrant labor, the value of
North Carolina construction work
would have been cut by 29 percent
(ignoring labor substitution effects).
This is based on the assumption that

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the immigrants drove down wages by
about $1.9 billion, sometimes allowing (such as in the case of home
building) employers to keep their
prices to consumers lower and not
lose business to out-of-state firms
employing immigrant (or lower-cost)
labor themselves.
This claim is difficult to prove,
however. Borjas, for one, is skeptical.
“I have no idea what that means that
you ‘save an industry’ with immigrant
labor. It makes construction cheaper,
yes, which makes construction more
profitable as a business. But it doesn’t
save the industry. It just makes people
who employ immigrants laugh all the
way to the bank.”
Granted, in a competitive market
employers must eventually pass on
their cost savings to consumers. But
Borjas notes that this passing on
of cost savings is not immediate and
not complete. He asks rhetorically that
if all savings really were passed on
to consumers: “Why do employers
lobby for more immigration? Why
would they care? I think the answer
is obvious.”
Lewis, too, has doubts about the
precision of the North Carolina estimate. Though he agrees that the
state’s construction costs would go up
and output down in the absence of
immigrant labor, the 29 percent estimate is “probably a bit exaggerated.”
That’s because Hispanic workers
(whether documented or undocumented) probably aren’t responsible
for the full 29 percent of output even
if they represent 29 percent of
employment. Also, eventually equipment could be brought in to do some

of the work of the lost Hispanic
workers, Lewis says, though this
would take time and certainly cause a
short-term impact on the sector.

Eye of the Beholder
On balance, all these studies on the
economic impact of immigration,
even those that look directly at the
illegal sort, portray a mixed bag of
costs and benefits. Borjas, who
worries more than other economists
about illegal immigrants, believes that
immigrant labor on net is “a wash”
for the U.S. economy. There may be
important policy questions posed by
immigrants — from border security
to national identity — but these
mostly fall outside the purview of
economics.
And what about the impact of
illegal immigration on immigrants
themselves? Almost everything you
need to know is this: Studies have
found that immigrants earn between
double to 30 times their homeland
wages, depending on their occupation.
A study by University of California at
Davis economist Edward Taylor found
that Mexican immigrants left behind
homes where average per-capita
income was $1,372 per year.
This is why even those who know
they could be arrested upon arrival risk
their treacherous journeys across the
border. It may not be so much that
opportunity is so great here as it is that
back home is simply much worse. And
for the most part, immigrants find
opportunity here, no matter whether
they come with the proper papers or
not. Though about 15 percent of newly
arrived undocumented Mexican immi-

grants were without work during their
first six months here, unemployment
rates fall to 5.7 percent — close to
or better than native-born rates —
after that.
“The real question is why more
aren’t coming,” says the Pew Hispanic
Center’s Passel. “Especially with regard
to Mexico compared to California,
there’s a huge wage differential.”
These gains come despite the fact
that being illegal in the United States
exacerbates the difficulties immigrants encounter in trying to raise
their wages. Patricia Cortes, as a Ph.D.
candidate at M.I.T., found that a
10 percent increase in the share of
low-skilled (read, illegal) immigrants
in the work force lowers wages for
other low-skilled migrants by 8
percent, compared with a 0.6 percent
reduction for low-skilled natives.
Unauthorized migrant pay tends to
stay low, perhaps because these
workers lack bargaining power and
are unable to move up to higherpaying jobs strictly because of their
illegal status.
An illegal immigrant like Manuel,
who recently turned up at the
Mexican consulate in Raleigh, is
thinking principally about his own
short-term survival. He came to the
United States about one year ago and
now works as a landscaper, taking
home about $300 a week. Those earnings would place him below the
poverty line.
By mainstream American standards, it’s not exactly prosperity. But
to him, it’s all relative. “Everything
is nice here,” Manuel says. “Things
are good.”
RF

READINGS
Borjas, George J., and Lawrence Katz. “The Evolution of the
Mexican-Born Workforce in the United States.” National Bureau
of Economic Research Working Paper no. 11281, April 2005.

The National Academy of Sciences. “The New Americans:
Economic, Demographic and Fiscal Effects of Immigration.”
Washington, D.C.: National Academy Press, 1997.

Card, David. “Immigration Inflows, Native Outflows, and the
Local Labor Market Impacts of Higher Immigration.”
Journal of Labor Economics, January 2001, vol. 19, no. 1, pp. 22-64.

Passel, Jeffrey S. “Size and Characteristics of the Unauthorized
Migrant Population in the U.S.” Pew Hispanic Center,
March 7, 2006.

Lewis, Ethan. “How Do Local Labor Markets in the U.S. Adjust
to Immigration?” Federal Reserve Bank of Philadelphia
Business Review, First Quarter 2005, pp. 16-25.

Summer 2006 • Region Focus

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s h o r tfall
Commodity producers are expanding capacity to meet growing demand, but lags
in supply are putting pressure on Fifth District manufacturers. Will this round of
short-term pain spread to consumers?

G

lobalization has lowered
prices for a variety of goods,
making a trip to the local
big-box retailer a pleasure for valueoriented shoppers. It’s also made life
downright unpleasant for manufacturers like Martinsville, Va.-based Hooker
Furniture.
Aluminum prices weren’t high enough for Alcoa
to invest new capacity during the 1980s and 1990s.
Now, the company is starting to build new smelting
facilities like this one in Iceland.

24

Region Focus • Summer 2006

Increased competition from furniture makers in China and other Asian
nations has forced the 81-year-old
company to lower its own prices, says
Lewis Canter, vice president of manufacturing. “Furniture is more of a value
for the consumer today than it was
10 years ago,” he says. What makes
this price war all the more challenging
is that many of Hooker’s raw materials
— which account for a third of total
expenses — are more expensive and
the company hasn’t been able to pass
along most of these added costs to
customers.
“With the foreign competition in
the last few years, the price increases
have come fewer and farther between.
We have to make sure we don’t price
ourselves out of the market,” Canter
says. A small price increase last year and
a planned one this fall may cover about
half of the added expense for materials
like foam, a key component in leather
and fabric upholstered furniture.
Hooker Furniture isn’t the only
company in this predicament.
More than half of the 60 large
industrial manufacturers surveyed
by PricewaterhouseCoopers reported
higher material costs in the first
quarter of 2006, while 53 percent
reported that their own prices either
stayed the same or were lower.
Overseas competitors also pay more for
materials, but domestic manufacturing
executives complain that costs associated with health and pension benefits
and regulatory compliance are making

it difficult to compete with foreign
firms.
Many production inputs have
become a lot more expensive in the
last five years. For example, the price
of copper — used in everything from
water pipes to circuit boards — more
than doubled to $8,000 a ton between
May 2005 and May 2006. Copper had
traded for less than $3,000 a ton on
the London Metal Exchange during
the last two decades.
Supply interruptions, such as the
shutdown of natural gas production
after last year’s Gulf Coast hurricanes,
have led to price spikes. But several
demand-side forces have also pushed
up the cost of production inputs over
time. The rapid growth of China and
India has added to demand from
expanding economies around the
world. Additionally, many analysts
believe that hedge funds and institutional investors have been buying up
commodity contracts in lieu of more
traditional investments, thus driving
up their prices. Of course, hedge
funds may be doing this based on
their belief that there will be more
demand in the future.
Despite higher prices for many
commodities, supply continues to lag
behind demand. “The global community was really surprised by the huge
increase in demand from Asia for oil
and industrial metals over the last
three years,” says Earl Sweet, an assistant chief economist at Toronto-based
BMO Financial Group who tracks

PHOTOGRAPHY: GUDMUNDUR INGOLFSSON/COURTESY OF © BECHTEL CORPORATION

BY CHARLES GERENA

Page 25

Betting the Farm
Futures contracts are a good indicator
of how long the market expects
current conditions to last. They represent an obligation for the buyer to
accept delivery of a commodity for a
specified price at a future date.
While spot prices can rise dramatically, futures may not rise as much,
indicating that current market conditions are expected to be only temporary.
However, if futures are persistently
higher, then commodity suppliers
should have greater confidence in
making long-term investments in production capacity.
The Reuters/Jefferies CRB Index
averages the futures prices of 17 commodities in six broad categories,

Input Costs Up
Since 2004, more large manufacturers surveyed by
PricewaterhouseCoopers are reporting higher input
costs, while fewer have seen lower costs.
70
60
50
40
30
20
10
1Q06

4Q05

3Q05

2Q05

0
1Q05

Producers of various crude and intermediate goods are just beginning to
boost their capacity after decades of
putting their money elsewhere.
Jason Schenker, an economist with
Charlotte-based Wachovia, explains
how this situation happened.
After the end of the Cold War in
the 1980s, Russia dumped its metals
into world markets because it needed
money to finance its government.
Then, the Asian financial crisis in the
late 1990s and subsequent recessions
in the United States and elsewhere
reduced demand for materials. This
left many global inventories flush
with supply, keeping prices low and

“You couldn’t justify building the
plant,” Campbell recalls. “Now that
prices are up, it’s taking awhile to build
the facilities to produce the raw materials.” Alcoa is putting a new smelter
in Iceland and designing another one
for installation in Trinidad and Tobago.
It is also expanding its aluminum plants
in Australia, Jamaica, and South
America. “We’re looking to take advantage of the situation.”

4Q04

Going From Zero to 60

diminishing the potential return
on investment for new mines and
processing facilities. So, companies
directed their capital into real estate,
high-tech startups, and other investments that promised better returns.
Now, countries around the world
are expanding again. China’s rapid
industrialization has made a big splash
in the global marketplace, while North
American and European economies
are strong. This global surge in
demand has drawn down inventories
of production inputs like copper
and zinc to the point where supply
increases are finally practical, and
prices have spiked to reflect that need.
A good gauge of this trend is the
Producer Price Index, which measures
the average change over time in the
prices received by domestic firms.
The PPI for crude goods, such as
industrial metals and minerals,
increased 111 percent from December
2001 to December 2005. Meanwhile,
the PPI for intermediate goods that
are partially processed, such as cement
and lacquer, rose 27 percent over
that period.
The problem is that new supplies
don’t show up with the push of a
button. “It’s like turning an aircraft
carrier,” Schenker says.
While coal mining firms have been
reopening abandoned underground
mines and nonferrous metal exploration has been rising, discovering and
developing enough new mineral
reserves to meet demand takes years.
Also, it takes time to get financing,
obtain permits, buy equipment, and
hire workers, whether it’s for a new
mine or processing plant. Firms may
see high prices and strong demand
now, but favorable market conditions
have to last long enough to make it
worth investing in new capacity.
Paul Campbell, Jr. says this is what
happened at Alcoa while he was president of the aluminum producer’s
Southeast region. (He retired in 2005
and serves as a consultant based in
Charleston, S.C.) The company lagged
in creating new capacity during the
1980s and 1990s because the price of
aluminum wasn’t high enough.

3Q04

commodities. However, “investors
have been burned badly over many
decades of investing in commodities
and were slow to [take] the bait.
Now that they are, it’s going to take
several years to develop new supplies.”
Economic theory says that rising
prices should entice suppliers into
the market and encourage existing
suppliers to increase their output.
Eventually, the increased inflow of
goods should stabilize prices and
then drive them down. In reality,
commodity suppliers don’t leap into
action like firefighters responding to
an alarm. Each company’s response to
a price signal is different and depends
on several factors, chiefly the returns
that executives expect to make from
investments in production capacity.
So, when will commodity supplies
come back in alignment with
demand? Some economists expect
prices to become high enough to
decelerate economic growth and
accelerate the production of materials
in short supply by early 2007. Prices
of various industrial metals have
already reacted to this anticipated
market shift. They fell for five weeks
before recovering in mid-June.
In the meantime, higher costs for
production inputs will continue to
squeeze the margins of manufacturers
like Hooker Furniture. Whether household budgets will be squeezed further
is another question.

2Q04

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P ERCENT

RF Summer 2006v27

Increased costs compared with previous quarter
Decreased costs compared with previous quarter
Same as previous quarter
SOURCE: PricewaterhouseCoopers

Summer 2006 • Region Focus

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including energy and precious metals
(which comprise 35 percent of the
total). Judging from the index’s movements over the last four years,
producers appeared to have grounds
for optimism. The index was up 23 percent in 2002; 8.9 percent in 2003;
11.2 percent in 2004; and 16.9 percent
in 2005. Yet that didn’t seem to have
much of an effect on supply levels.
Several factors have raised the bar
for the return on investment necessary
for a company to justify increasing
its production. Higher oil prices have
added to production costs for makers
of asphalt, plastics, and other
petroleum-based products, costs which
can be hard to pass on to consumers.
Finding reserves of raw materials
is also challenging. Some are located
in areas of political instability, making
investors cautious about committing
their money to multiyear exploration
and development projects, according
to BMO’s Earl Sweet.
For instance, New Caledonia has
about one-fourth of the world’s known
nickel reserves, but efforts by the
island nation’s indigenous population
to break from French rule has periodically threatened mine development
and expansion. Labor unrest has
disrupted copper production in Chile
and Mexico.
Finding an optimal location for
a processing facility is difficult as well.
Kenneth Simonson, chief economist
of the Associated General Contractors
of America, says producers of construction aggregates prefer to build
their plants as close to a sufficient supply of raw materials as possible to save
on transportation costs. In addition,
they must have access to a plentiful
supply of electricity and water. But
companies can’t build just anywhere.
“For many kinds of manufacturing, it’s
really hard to get zoning and environ-

mental permits. Asphalt and cement
plants aren’t very appealing neighbors,” Simonson notes.

It’s Only a Matter of Time
Economists expect this supply lag to
correct itself. However, while prices
will likely fall from their current
heights, Sweet and other economists
don’t expect them to return to their
previous lows of the late 1990s,
either. Therefore, Sweet notes, producers should get an adequate return
on investment for expanding their
capacity. Higher futures prices for
copper and other minerals suggest
the market shares that assessment.
On the other hand, there are still
some significant question marks. Todd
Clark, an economist at the Federal
Reserve Bank of Kansas City, says
everyone is still trying to figure out the
impact of China’s and India’s increased
demand for nonrenewable resources.
“There is reason to be worried about
that and look hard at the issue,” he says.
Historically, technological advances
have led to better ways of extracting
natural resources and using them more
efficiently, but it’s not clear if they
would enable commodity producers to
meet future demand.
Until things straighten themselves
out, what will be the impact on
consumers? It may not be as big as
one might expect. Even if higher
commodity prices start trickling down
to consumers beyond the neighborhood gas station, Clark says the effect
on cost of living will be limited, since
the goods portion of the economy has
declined over time. Excluding food
and energy, goods represent only
25 percent of consumer spending.
Also, Clark says manufacturers
haven’t passed much of their increased
costs to consumers in the past, and he
doubts that trend has changed.

Previous research did uncover a
statistically significant relationship
between prices of less processed goods
and prices for more complete goods.
However, recent studies have suggested that this relationship weakened
during the 1980s and 1990s.
Indeed, global competition has
convinced many companies that their
customers won’t tolerate higher
prices to cover input costs. Instead,
they have chosen to sacrifice some of
their profit margins in the name of
protecting market share. Also, they
have tightened their belts by using
cheaper inputs, substituting capital
for labor, and hedging against price
increases with futures contracts.
Back at Hooker Furniture, Lewis
Canter looks for ways to improve
efficiency. For example, the company
trains its workers to reduce overspray
of finishes. Canter explains, “Furniture
is coming by real fast, so if your technique is sloppy, then you waste more.”
Some companies have shifted
their attention to niche markets with
less competition. Cheaper Asian
imports have lowered demand and
margins for Hooker’s bedroom,
home office, and home entertainment
offerings. So, the company closed
three plants in North Carolina and
focuses on producing high-end leather
chairs and sofas. It also sells more furniture imported from China, Mexico,
Honduras, and other countries.
Canter doesn’t see any relief from
input price pressures until oil markets
cool down. And, even then, Hooker
will continue to face pressures on the
output side. “Chinese furniture makers pay the same raw material costs as
we do, but their labor and overhead
costs are so much lower,” he remarks.
“We are trying to drive down overall
costs and determine where the biggest
opportunities are.”
RF

READINGS
Clark, Todd E. “Do Producer Prices Lead Consumer Prices?”
Federal Reserve Bank of Kansas City Economic Review,
Third Quarter 1995, pp. 25-39.
Mineral Commodity Summaries 2006. U.S. Geological Survey,
January 2006.

26

Region Focus • Summer 2006

Weinhagen, Jonathan. “Price Transmission within the PPI
for Intermediate Goods.” Monthly Labor Review, May 2005,
vol. 128, no. 5, pp. 41-49.

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Love, Money, and Marriage
There are many reasons why being married makes economic sense.
But do they make promoting marriage suitable for public policy?
ummer is wedding season, the
traditional time for bridal gowns
and ring shopping, multilayered
cakes, and festive receptions. And, of
course, the vows. But in truth, to the
disappointment of romantics everywhere, the institution of marriage in
the United States is past its prime.
Witness the U.S. marriage rate,
which is dropping like a rock. Since
1970, the number of marriages per
1,000 unmarried adult women has
declined 50 percent. Meanwhile, the
percentage of all adults who are married has slipped from 66.7 percent in
1970 to 55.1 percent in 2004. About
one out of three U.S. births is now to
an unmarried woman.
Social, scientific, and economic
factors seem to be driving these
trends. For many folks, the sexual revolution put to rest the notion that sex
had to happen within the boundaries
of marriage, and birth control likewise
reduced the inevitability of offspring.
Increasingly uncommon, too, is the
single-earner household, where men
go to work and women stay home.
Today’s woman also works outside the
home, and with that financial freedom
comes more choice in whether to
commit to a lifelong partner.
All of this may be just fine, except
for one thing — marriage, it turns out,
is associated with a lot of positive characteristics. Studies have shown married
people have better health, better sex
lives, and are said to be happier. And
here’s the trump card: Being married
means you have a greater chance of
being well-off. People who never marry
have 75 percent lower wealth than continuously married people, according to
one study. Or consider data from the
Census Bureau showing the median
income of married-parent families at
almost $66,000 and of lone-parent

S

families at about $25,000. Eight out of
10 “nonpoor” families are headed by
married couples; poor families are
headed by married partners only four
out of 10 times.
These facts give rise to marriage
as a public policy issue. Economics
has become a key component in
promoting pro-marriage policies —
everything from retooling welfare
eligibility rules to earmarking taxpayer funds for marital counseling.
“Poverty, crime, substance abuse, special education, foster care, child abuse
services, teen pregnancy — there is
hardly a single major domestic
program that state, local, and federal
agencies spend money on that is not
the result of social problems driven in
part by the decline of marriage,” says
the nonprofit National Fatherhood
Initiative. “This growing consensus on
the importance of marriage has led to
new efforts to generate public policies
that may help reduce rates of unmarried childbearing and divorce.”
But the emergence of marriage as a
public policy issue raises an important
question: How much of the “marriage
effect” is directly attributable to people’s marital status, and how much is
just a selection effect? Does marriage
make you economically well-off, or are
already economically well-off people
more likely to marry?

Marital Economics
Some of the economic advantages of
being married are obvious. Thanks to
economies of scale, two can live more
cheaply than one. There are fixed
costs to running a household. First,
there’s the house itself. Instead of paying two mortgages (or rents), a married
couple pays just one. The same is true
with things like utility bills. Finally,
there are smaller items like grocery

expenses, which tend to be lower on
a per-person basis for couples. Then
there are legal realities: If you’re
married, you get to take advantage of
your spouse’s possibly superior health
and other benefits, plus many other
legal privileges.
Contributing to the relative wealth
of married couples is the changing
dynamic of the “marriage market.”
Married partners tend to have similar
education levels. And unlike 40 years
ago when men still greatly outnumbered women in college, more women
are now seeking higher educations,
providing more opportunities for
on-campus relationships that may
last beyond graduation. Workplace
romances have increased, too, as
female labor force participation has
risen. These twin trends reflect how
it has become relatively easier
for high-income and high-education
people to meet up, helping to explain
why people with college degrees and
higher incomes are more likely
to marry.
Economist Gary Becker of the
University of Chicago pointed out
how wedded couples can develop
“marriage-specific capital,” in which
partners specialize in what they
do best, to the benefit of both.
Traditionally, this has meant men go
to the workplace and women raise the
children. Mostly because of this
arrangement, married men earn as
much as 40 percent more than single
men. This is what’s called the “marriage premium,” and, though there are
many factors that may contribute to it,
one of the biggest is thought to be
increased married male productivity
from labor specialization. Among
other things, married males may
spend more effort building human
capital which can translate into higher

Summer 2006 • Region Focus

ILLUSTRATION: AILSA LONG

BY DOUG CAMPBELL

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earning power, especially in today’s
economy. Cohabitating couples can
specialize, but their implicit lack of
commitment means that they don’t as
much as married couples, and hence
don’t reap the same economic returns.
(Importantly, Becker’s research also
finds that when women work, the
gains from specialization are reduced.
In a nation where 60 percent of households have two wage earners, this may
count as another reason why couples
don’t bother to marry.)
There are other benefits of married
life. Like a college degree, a marriage
certificate sends a sort of economic
signal. (A surprising fact: In any given
year, college graduates get married at a
clip three times greater than high
school dropouts.) Steven Nock, a
University of Virginia sociologist and
co-director of the Marriage Matters
project (a research effort funded by
the National Science Foundation),
says that in this way married couples
project “commitment, stability, and
maturity, among other things.” These
are the kind of attributes that
employers value and the sort of character traits not necessarily signaled by
cohabitating couples — though one
can also imagine some high-powered
jobs where employers would worry
that people with children wouldn’t be
able to commit as many hours to work
as their unmarried colleagues.

People Age 15 and Older
Who are Married
The percentage of people who are
married at any given time in the
United States has dropped since 1960.
80
70

P ERCENT

60
50
40
30

Men
Women

20
10
0
1960 1970 1980 1990 2000 2004
SOURCE: National Marriage Project

28

Region Focus • Summer 2006

Maybe most important is that
marriage is great for kids. In 1970,
10.8 percent of U.S. children lived
with single mothers. By 1998, the proportion was up to 23.3 percent.
Economists Isabel Sawhill and Adam
Thomas at the Brookings Institution
and Harvard University, respectively,
found that if the proportion had
remained at its 1970 level, the rate of
child poverty would have been 3.4
percentage points lower by 1998.
That’s almost 2.3 million children. In
their simulation model, among those
children whose (until then single)
mothers married, the poverty rate fell
by two-thirds. This happens both
because of the “two can live more
cheaply than one” rule of thumb as
well as from the labor specialization
of married couples. “Certainly if more
people were married, we would have a
lot less child poverty,” Sawhill says in
an interview.
Getting married is one thing, but
staying together is also economically
important. Divorce is harmful to children. The Center for Law and Social
Policy, a nonprofit organization
whose mission focuses on improving
the lives of poor people, found that
the primary custodial household’s
income falls 70 percent for children in
divorce’s immediate aftermath and
remains 40 percent lower compared
with intact households as long as six
years after divorce. The process of
divorce itself is expensive to
taxpayers, costing state and local
governments about $30,000. The
National Marriage Project, a research
effort at Rutgers University, says that
the 1.4 million divorces in 2002 cost
governments more than $30 billion
because of factors ranging from
higher use of food stamps to
increased Medicaid spending to
greater use of public housing.

Public or Private
Given the apparent link between marriage and economics, the question of
whether government intervention is
necessary in this most private of relationships deserves consideration. At
present, U.S. marriage policy is shaped

mostly by the tax code and the welfare
system.
The so-called “marriage tax” still
exists — filing jointly, a man and a
woman with high earnings may jump
into a higher tax rate than they would
if filing separately. Also, under the
welfare transfer system, single-parent
households may actually be eligible for
higher payments than married households when it comes to housing and
child care subsidies as well as cash
benefits. On the flip side, low-income
parents who marry may enjoy a sort of
“marriage subsidy” by collecting more
of the earned income tax credit than
they did as separate filers.
However, following passage of
1996 welfare reform, states were
given wider discretion in implementing rules, and many responded with
policies that aimed to keep couples
together. Since 2002, Nock says,
36 states have eliminated rules that
made welfare available only to singleparent families. Another 11 states
have partially made this change.
Indeed, there is no shortage of
proposals and programs that aim to
encourage more marriage. What we
have is a “seemingly endless array of
contemporary public and private
efforts to promote marriage, reduce
out-of-wedlock births, encourage
responsible fatherhood, and persuade
unmarried parents to marry,” Nock
writes.
In 2001, the Bush administration
launched its Healthy Marriage
Initiative, a project that urges unwed
parents to consider marriage for
the sake of their children. Another
program promotes healthy marriages
in local communities. At the state
level, South Carolina is one of 10 states
that since 2001 have introduced
major efforts that establish and fund
programs “designed to specifically
promote and strengthen marriage and
reduce divorce,” according to the
Center for Law and Social Policy.
Whether marriage promotion
programs like these can be effective
depends on what the real objective is:
1) increasing the number of married
people or 2) improving people’s

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Page 29

economic well-being. This second
objective may not hinge on being
married after all.

children, a selection effect. I think
there is something causal, but it isn’t all
causal.”

Selection Effect

The Real Issue

Much of the academic debate over
marriage centers on whether the positive economic effects seen in married
people are causal — that is, does getting married make people better off?
Or are better-off people the type who
get married, anyway? Economists writing for the conservative Heritage
Foundation say: “Moving from a single-parent to a married family is a
straightforward way to rise above the
poverty threshold.”
But pressed on this subject, many
scholars are ambivalent. “We’ll never
be able to totally untangle this issue,”
says University of Virginia’s Nock. “I
don’t think anybody fully understands
it.” Even the Institute for American
Values, in promoting its “Why
Marriage Matters” report, includes a
disclaimer about selection effects,
acknowledging that “reasonable
scholars” disagree over the causation/correlation effects of marriage
but concluding that, “the benefits of
marriage extend to poor and minority
communities.”
Sawhill, the Brookings economist, is
also torn. “You can’t explain away the
fact that there seems to be something
about marriage itself that is helpful to
children,” Sawhill says in an interview.
“I would never argue that all of the
differences between outcomes for
children in married families versus
single families is due to the fact that
there’s marriage in one case and not in
the other. Some of it is the fact that
people who marry tend to have other
characteristics that are good for

Some sociologists have argued that
poor people need no reminders about
the economic value of marriage. The
real issue for poor people is that marital status is low on their list of
concerns. Policymakers “are acting
upon the premise that not being married is what makes so many women
and children poor,” write Kathryn
Edin and Maria Kefalas, sociologists at
the University of Pennsylvania and
Saint Joseph’s University, respectively,
in their book, Promises I Can Keep: Why
Poor Women Put Motherhood Before
Marriage. “But poor women insist that
their poverty is part of what makes
marriage so difficult to sustain.”
Yes, married people tend to be
better off — on this there is little
disagreement. But to many social scientists, this misses the point. Instead of
encouraging marriage in the hopes of
lifting general welfare, there may be a
more direct approach in helping people
— regardless of marital status — take
on the most positive characteristics of
married people; namely, that they work
and provide stable environments for
raising children.
Andrew Cherlin, a sociologist at
Johns Hopkins University, says that,
reducing barriers to work can help all
sorts of households, be they headed by
married partners, cohabitating couples,
or single parents. That’s why Cherlin
generally favors universal preschool or
generous parental leave policies over
marriage promotion efforts.
“I don’t think policies should be
narrowly focused on marriage,”

Cherlin says. “Marriage is a good thing.
But I think promoting stability in
child-parent relationships, whatever
form they may take, is also a good
policy goal. A single mother who
doesn’t have to quit her job when her
child gets sick is a single mother who
is more able to maintain a household.”
Similarly, Brookings economist
Sawhill thinks that discouraging births
among teenage mothers is paramount.
The emphasis on marriage as an economic development program is OK,
she says. But, she adds, “That’s
tackling the problem a little late,
once a child is born outside of
marriage. It would be far preferable
if we prevented people from having
babies before they’re married in
the first place.” Instead of marriage
education, Sawhill favors programs
aimed at preventing teen pregnancy
with the aim of delaying unprotected
sex and unwanted births.
We come away from this analysis
with some question marks. Studies
clearly show that children are made
better off when they live in stable,
married households, though there are
differences of opinion over whether
this justifies pro-marriage policies.
The data also show that married
people make more money, but
whether that’s directly attributable
to tying the knot is unclear. Meanwhile,
marriage is far from dead. Most people
still get married — about 90 percent
of all American women by the age
of 45, in fact. And the pace of U.S.
divorces has fallen since 1980. Nobody
doubts that a nation of abundant,
healthy marriages is desirable. But if
the goal really is in reducing poverty,
then there may be more direct
remedies than matrimony.
RF

READINGS
Becker, Gary S. A Treatise on the Family. Cambridge, Mass.:
Harvard University Press, 1981.

“Marriage and Child Wellbeing.” Special Issue of The Future of
Children, Fall 2005, vol. 15, no. 2.

Conaway, Carrie. “Chances Aren’t.” Federal Reserve Bank of
Boston Regional Review, Quarter 3, 2002, pp. 24-30.

“The State of Our Unions: The Social Health of Marriage in
America.” The National Marriage Project, July 2005.

Edin, Kathryn, and Maria Kefalas. Promises I Can Keep: Why Poor
Women Put Motherhood Before Marriage. Berkeley: University of
California Press, 2005.

Sawhill, Isabel, and Adam Thomas. “For Richer or for Poorer:
Marriage as an Antipoverty Strategy.” Journal of Policy Analysis and
Management, Fall 2002, vol. 21, no. 4, pp. 587-599.

Summer 2006 • Region Focus

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Productivity
P O S T P O N E D
The late 20th century witnessed huge leaps in information technology
innovation, but gains in productivity were slow to follow. Economists,
including two with ties to the Richmond Fed, help explain why
B Y VA N E S S A S U M O

A

lmost every company has a
story to tell about how the
power of information technology, or IT, has transformed its
business. Dell, the world’s largest
personal computer manufacturer,
takes orders directly from customers
via the Internet, builds computers
exactly to their specifications, and
ships, all within 24 hours. Wal-Mart’s
Retail Link system shares actual sales,
forecasts, and inventory data from its
6,200 stores with 30,000 suppliers
worldwide, which allows the company
to respond effectively to customer
demand and minimize inventory costs.
On-board computers enable dispatchers and truck drivers to communicate,
and thus make decisions that keep big
rigs fully loaded and on the road.
An improvement in productivity, or
the ability to produce more goods and
services for the same amount of effort,
generates higher profits for the company and its owners and wages for its
workers, and therefore a better standard of living over time. Technological
progress is key to productivity growth
because it offers a better way of doing
things, of pushing out an economy’s
frontier of production possibilities.
Sometimes this progress is subtle —
for instance, when marginal improvements are made to existing
technologies — while in other cases, it
is stark. History counts several exam-

30

Region Focus • Summer 2006

ples of major innovations. The steam
engine, electricity, and the internal
combustion engine are just some of
the creations that have raised living
standards over the centuries.
Similarly, many believe that the
advancements in IT, triggered by the
invention of the microchip, have ushered in a period of fast productivity
growth in America. “Technological
innovation, and in particular the
spread of information technology, has
revolutionized the conduct of business
over the past decade and resulted in
rising rates of productivity growth,”
remarked former Federal Reserve
Bank Chairman Alan Greenspan in
December 2000. Average labor productivity, or the amount of output
produced for each hour worked, grew
by 2.6 percent a year for the nonfarm
business sector between 1995 and
2004, double the pace between 1973
and 1995, according to data from the
Bureau of Labor Statistics.
Labor productivity depends partly
on the amount of capital each worker
is equipped with — the more
machines per worker, the higher his
productivity. But labor productivity
also depends on something called
“total factor productivity,” or TFP, a
term which measures the growth in
output that is not due to changes in
either capital or labor. TFP is usually
associated with technological change

because it tries to capture the efficiency
with which labor and capital inputs are
used. For instance, TFP rose by 1.3 percent per year from 1995 to 2004,
accounting for half of the overall
growth in labor productivity. And like
the growth in labor productivity, TFP
has increased much faster than in the
two previous decades.
But it was not always so evident that
IT could be a driving force for productivity growth. A period of weak
productivity gains in the two decades
to the mid-1990s spurred many economists, including Andreas Hornstein of
the Richmond Fed and Per Krusell of
Princeton University (and also a
Richmond Fed visiting scholar) to
attempt to explain this period. They
find that after rising by 1.9 percent a
year from 1954 to 1973, labor productivity actually reversed to -0.2 percent a
year from 1973 to 1979 before recovering to positive territory of 1.1 percent a
year from 1979 to 1993 (although still
trailing the pre-1973 pace).
Changes in TFP were similar. This
was puzzling in the wake of widespread
introduction of robotics and microprocessor technologies. Why hadn’t
these innovations boosted productivity? One could not blame Nobel
laureate economist Robert Solow when
he famously observed in 1987, “You can
see the computer age everywhere but in
the productivity statistics.”

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Page 31

ing-by-doing will bring in additional
to overestimate the contribution of the
productivity gains.
new capital equipment to output
Perhaps a good way to understand this
Other studies have treaded along
growth, hence underestimating observproductivity paradox is to reach even
similar lines as those of Hornstein and
able productivity growth.”
further back in history. The invention
Krusell; that is, the idea that there is
This problem arises if new techof the dynamo (the electrical generasome delay in reaping the benefits of
nologies embodied in the latest
tor) and the course of electrification
investments in IT. Economists
equipment are introduced at a rapid
that followed beginning in 1880 had
Susanto Basu of Boston College, John
pace, forcing workers to learn faster
promised profound transformations
Fernald of the San Francisco Fed,
on the job. The 1970s offers a neat
to every factory, store, and home. But
Nicholas Oulton of the London
example. Faster and better computers
the realization of such a vision was
School of Economics, and Sylaja
flooded the market every year, such
hardly imminent at the turn of the
Srinivasan of the Bank of England find
that the quality-adjusted price of
20th century, according to Stanford
that in order to benefit from IT, there
their components (processor speed,
University economist Paul David.
must be “substantial investments in
memory, etc.) dropped dramatically.
Aside from the slow pace of electrilearning, reorganization, and the like,
Hornstein and Krusell find that prior
fication and the durability of the old
so that the payoff in terms of measto 1973, the price of producers’
manufacturing “group drive” system of
ured output may be long delayed.”
durable equipment was falling by 2.9
power transmission, machines had to
This study follows naturally from
percent a year, whereas after 1973 it
be fitted with electric motors (which
where Hornstein and Krusell left off.
was falling by an additional 0.6 permeant that old machines and new ones
Although TFP growth is initially
centage point per year. The cheaper
operated alongside one another), facunderestimated because such investprices encouraged firms to accumutory structures had to be radically
ments are not measured, it is
late more and more IT capital.
redesigned, and the stock of factory
actually overestimated once these
But in a world where a new
architects, electrical engineers, and
complementary investments become
machine cannot simply be plugged
workers familiar with the new
an increasingly important part of the
and played, the adoption of a new
machines needed to be built up. This
production process. Indeed, the
technology can temporarily reduce a
protracted adjustment made gains in
authors find that the surge in measworker’s productivity simply because
productivity slow to come.
ured TFP growth in the late 1990s in
the effective use of the new equipSimilarly in the 1970s, computer
ment is initially overestimated. The
technology did not manifest itself
the United States is positively correlated
evidence suggests this is what hapimmediately in a revolutionary way,
with high IT capital growth rates in
pened in the 1970s. As the pace of
and maybe this isn’t surprising. Some
the 1980s or early 1990s, but negatively
capital-embodied technical change
research shows that the transition to
correlated with the growth rate of IT
quickens, TFP growth will initially be
a new technological regime can
investment in the same period.
lower because only a fraction of the
actually slow productivity growth as
These investments are in intangible
new equipment is actually operable.
firms take time to learn how to use the
assets such as new organizational
Firms need time to learn how to best
new technology. This period of
designs, worker knowledge, and moniintegrate the new technology in their
“learning-by-doing” is one of the more
toring and incentive systems. Although
production plans and workers need to
intriguing explanations, proposed by
intangible, these assets are not invisible
update their skills. As this adjustment
Hornstein and Krusell, for the slowand so would likely show up in the marmoves forward, the process of learndown of measured TFP growth during
ket’s estimation of a firm’s value. No
the two decades to the
wonder that when Johnson
The use of personal computers became widespread in the 1980s, but may
mid-1990s.
& Johnson finally discovhave done little to boost workers’ productivity until years later.
“The idea is that new
ered its winning formula
machines require an investfor combining computerment in learning that is not
based flexible machinery
measured. Since a rise in
with a carefully designed
unmeasured
investment
work plan for manufacturspending leads to an undering adhesive bandages, it
estimated output growth,
ordered its factory winmeasured TFP growth is
dows painted black to
lower,” explains Hornstein.
prevent competitors from
“Another way of looking at it
running away with its valuis that if we assign the same
able blueprint.
experience level across all
Measured productivity
equipment, including the
growth can also understate
new ones, then we will tend
actual improvements in

Summer 2006 • Region Focus

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Dissecting the Slowdown

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productivity, according to Hornstein
and Krusell, if the quality component
of a final good or service is very high.
For instance, simply comparing the
number of cars produced today to 20
years ago does not reflect the significant quality changes that a typical car
has undergone. It would be more
appropriate to adjust a good or service
for its quality content, but that is often
difficult to do.
In addition, this understatement is
exacerbated the more capital-intensive the production of the quality
component of output is relative to
quantity. Computers, for example, are
a big part of how banks are able to
offer customers increasingly convenient ways of transacting. In that case, a
large portion of the increase in the
capital stock actually reduces TFP
growth because the output growth
that it generates goes unmeasured.
Hence, measured improvements in
TFP can slow during a period of rapid
technological change because IT capital goods are factored into the
equation — but the quality and con-

Labor Productivity and Total Factor
Productivity Growth
Despite the growing use of computers, productivity
growth slowed between 1973 and 1995 but finally
surged between 1995 and 2004.
3.0
2.5

P ERCENT

2.0
1.5
1.0
0.5
0.0
1959–1973

1973–1995

1995–2004

Labor Productivity
Total Factor Productivity
NOTES: Labor productivity growth is the average annual percentage change in output per hour for workers in the nonfarm
business sector. The growth in labor productivity partly depends
on total factor productivity growth, which is the average annual
percentage change in output that is not accounted for by
changes in either capital or labor. Average annual growth rates
are computed using a geometric average.
SOURCE: Bureau of Labor Statistics

32

Region Focus • Summer 2006

venience of these new services eludes
output statistics.
The late economist Zvi Griliches
emphasized the consequences of poor
measurement for the “unmeasurable
sectors” of the economy, mostly the
services industries. He showed that
despite heavy investments made in
computers and other informationprocessing equipment, more than
three-quarters of this investment went
into the unmeasurable sectors, thus
its productivity effects were largely
invisible in the data.
To make matters worse, the structure of the economy has changed
significantly whereas data improvements have come slowly. The share of
the services sector in total output, for
instance, has increased substantially
over the past half-century, weighing in
today at about three-quarters of GDP.
The services sector is singled out
by Hornstein and Krusell, as well as
others, as the most problematic in this
respect, because innovations from
these industries are trickier to identify
than the new products that come from
the goods sector. Until a few years ago,
bank output was measured by extrapolating from the number of bank
employees, which surely would not
capture the convenience and timesaving benefits from the rise of ATM
networks.
Much has changed, however.
Because of new and improved ways of
measuring services output in the U.S.
industry data, recent estimates by
economists Jack Triplett and Barry
Bosworth of the Brookings Institution
were able to uncover the robust
growth in productivity that had
always been there after all. Using the
new data, they find that the services
sector no longer lagged behind the
goods industries in terms of productivity growth. Labor productivity in
services increased by 2.6 percent a year
between 1995 and 2001, outpacing the
2.3 percent a year improvement in
labor productivity in the goods sector.
Still, unlike Hornstein and Krusell,
Triplett does not believe that measurement errors are the reason for the
slowdown in productivity growth

during the 1970s and 1980s. “That’s
still a big puzzle,” says Triplett. “I
suspect that it was a lot of different
things like the oil shock, regulation,
baby boomers entering labor force.”
Each of those may have had a small
effect, but taken together, the result
was significant.
Another view of the productivity
slowdown offered by Northwestern
University economist Robert Gordon,
in a comment to Hornstein and
Krusell’s paper, is that the slowdown
in productivity growth may be partly
due to the “new economy” of IT
simply falling short of some of the
remarkable inventions of the past.
It just did not have the potential to
spur a massive acceleration in TFP.
“The one big wave of American economic growth during 1915 to 1965,”
writes Gordon, “reflects the combined
influence of several central inventions
that, taken together, had a much more
profound impact on the way the
economy and society operated than
has the electronic computer.”

The Revival
After a long dismal period in the two
decades to 1995, productivity growth
began to surge to heights that would
be expected of an economy booming
with IT-stimulated innovations and
investments. Dale Jorgenson and Mun
Ho of Harvard University and New
York Fed economist Kevin Stiroh find
that average labor productivity grew
by 2.64 percent a year over the period
1995 to 2004 compared with 1.39 percent from 1973 to 1995, representing a
gain of 1.25 percent a year. Of this
difference, 0.62 percent a year was due
to capital deepening (the increase in
the amount of equipment used per
worker) and 0.72 percent was due to
faster TFP growth.
The remarkable contribution of
technological progress in IT production is reflected in the 30 percent
share of the IT-producing sector to the
increase in TFP growth over the two
periods, contributing far more than
the 3.9 percent share of IT equipment
and software in aggregate output. This
impressive productivity performance

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has played an important role in the
fall in IT prices and thus in boosting IT
investment. This has led to the wide
diffusion of IT capital across all sectors, reflected in the two-thirds share
of capital deepening attributed to IT.
But one thorny issue is whether
these gains have actually spilled
over to industries outside of the ITproducing sector. The services sector
comes to mind since these industries
are heavy users of IT capital, but some
also believe they have been afflicted
with “Baumol’s Disease” — a theory
developed by New York University
economist William Baumol which supposes that the inherent nature of
services causes them to languish in
terms of productivity improvements.
Triplett and Bosworth, who were
among the first to look at productivity
growth in the services sector, discover
evidence to the contrary. They find that
most of the acceleration in labor productivity growth after 1995, and all of
the acceleration in TFP growth, took
place in the services industries. This
lays to rest previous assertions that the
productivity growth of the 1990s was
fragile because no improvements in
productivity, particularly TFP, occurred
outside the electronics manufacturing
sector. Moreover, they find that fourfifths of the total contribution of IT to

aggregate labor productivity growth
between 1995 and 2001 is thanks to the
services industries.
Strong productivity growth continued after the late 1990s, even beyond
the end of the 1991 to 2000 expansion.
This has led to the consensus that the
resurgence was not cyclical, that it
would not fade away even as output
growth slowed down. Rather, it represents something more sustainable,
suggesting that the American economy could continue to expand, raising
standards of living.
Will this strong productivity
growth continue? “It depends on what
the innovations are going to be and in
what ways we can expand the variety of
products in an economy,” Hornstein
says. “I think there is still some potential there, for the application of IT and
for productivity growth.” Jorgenson,
Ho, and Stiroh anchor their projections
critically on factors such as the
evolution of semiconductor technology
and business investment patterns.
Nevertheless, they find “little evidence
to suggest that the technology-led productivity resurgence is over or that the
U.S. economy will revert to the slower
pace of productivity growth of the
1970s and 1980s.”
Gordon likewise predicts that productivity growth rates will stay firm,

similar to the growth rate of the late
’90s, but doubts that IT will be the
main driving force. “I tend to think we
have now exploited the low-hanging
fruit of the Internet revolution,” says
Gordon. Electricity and the internal
combustion engine were mega-inventions, in terms of their direct effects
and the importance of their spin-offs
and complements. On the other hand,
he considers the semiconductor, computer chip, and digitalization merely
“first-rate” inventions that likewise
spawned other first-rate inventions,
particularly the Internet. Beyond that,
he sees only a slew of second-rate innovations, a string of bit-by-bit technical
improvements instead of the revolution
that we enjoyed during the last decade.
A look back shows that IT has had
a profound impact on productivity
growth, even during periods when this
bond may not have seemed so strong.
But there is less of a consensus about
the role of IT in propelling productivity growth in the future, in part
because some puzzles still remain.
One lingering question is why IT did
not spur a similar productivity revival
in Europe when, after all, a computer
is the same anywhere in the world.
The tumultuous affair between technology and productivity looks certain
to continue.
RF

READINGS
Basu, Susanto, John Fernald, Nicholas Oulton, and Sylaja
Srinivasan. “The Case of the Missing Productivity Growth,
or Does Information Technology Explain Why Productivity
Accelerated in the United States but Not in the United
Kingdom?” National Bureau of Economic Research
Macroeconomics Annual, 2003, vol.18, pp. 9-82.
Brynjolfsson, Erik, Lorin Hitt, and Shinkyu Yang. “Intangible
Assets: Computers and Organizational Capital.” Brookings Papers
on Economic Activity: Macroeconomics, 2002, no.1, pp. 137-199.
David, Paul. “The Dynamo and the Computer: A Historical
Perspective on the Modern Productivity Paradox.”
American Economic Review, May 1990, vol. 80, no. 2, pp. 355-361.
Gordon, Robert. “Five Puzzles in the Behavior of Productivity,
Investment and Innovation.” National Bureau of Economic
Research Working Paper no. 10660, August 2004.
Griliches, Zvi. “Productivity, R&D, and the Data Constraint.”
American Economic Review, March 1994, vol. 84, no. 1, pp. 1-23.

Hornstein, Andreas. “Growth Accounting with Technological
Revolutions.” Federal Reserve Bank of Richmond Economic
Quarterly, Summer 1999, vol. 85, no.3, pp. 1- 22.
Hornstein, Andreas and Per Krusell. “Can Technology
Improvements Cause Productivity Slowdowns?” National Bureau
of Economic Research Macroeconomics Annual, 1996, vol. 11,
pp. 209-275.
___.“The IT Revolution: Is It Evident in the Productivity
Numbers?” Federal Reserve Bank of Richmond Economic
Quarterly, Fall 2000, vol. 86, no. 4, pp. 49-76.
Jorgenson, Dale, Mun Ho, and Kevin Stiroh. “Potential Growth
of the U.S. Economy: Will the U.S. Productivity Resurgence
Continue?” Business Economics, January 2006, vol. 41, no. 1,
pp. 7-16.
Triplett, Jack, and Barry Bosworth. Productivity in the U.S. Services
Sector: New Sources of Economic Growth. Brookings Institution
Press, 2004.

Summer 2006 • Region Focus

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Meet the

New Grundy

A new downtown
Grundy, Va., will move to
an elevated site across the
Levisa River. The old business
district suffered four major floods
during the 20th century because of
its precarious location at the intersection
of Slate Creek and the Levisa.

Public works, private education revive Appalachian town

T

he sign taped to the door of
the Comfort Inn in Grundy,
Va., warns guests to remove
muddy boots before entering. That
says a lot about the construction business in this coal mining mountain
town of about 1,200 where the Levisa
River and Slate Creek meet in southwest Virginia. There’s the new strip
mall going up by the motel, apartment
buildings under way, one with 88 units,
and construction of a second campus
for the new pharmacy school that
should be finished by August. The
10-year-old law school occupies a
renovated schoolhouse.
But all that’s nothing compared with
the empty 13 acres awaiting construction across the Levisa from the
flood-prone downtown. It’s hard to find
much flat land in one place, so a piece of
mountain was shaved off for more
space, leaving geological time visibly
stacked up behind the future Grundy.
34

Region Focus • Summer 2006

To demolish a town and literally
build a brand-new one on higher
ground is about as dramatic and rare as
flood solutions get. But that’s the plan
for Grundy.
Between the highway, a floodwall,
and the town site prep, the rebuilding
of Grundy is costing taxpayers at least
$130 million. The economic hope is
that the public works will lift the
region’s spirits and leverage growing
private investment. Along with the law
and pharmacy schools, Grundy’s got
a new Chinese restaurant and the
promise of a Wal-Mart.

Long-Term Investment
Nobody expects the public investments in Grundy to pay off overnight.
Maybe never, in any traditional economic sense. “The way I think it
would be justified would be that you’re
going to set it on a new path,” says
Brad Mills, an economist at Virginia

Tech. “Eliminating the risk is going to
create a better environment for investment and growth.”
While that may turn out to be
true, spending lofty sums on chronically flooded communities raises
economic questions, similar to those
being mulled in the wake of
Hurricane Katrina. Edward Glaeser,
an economist at Harvard University,
wrote in The Economists’ Voice on the
merits of rebuilding New Orleans:
“We could try to make good on the
idea that the government provides
insurance by rebuilding the city.
Alternatively, we could provide residents with checks or vouchers, and
let them make their own decisions
about how to spend that money —
including the decision about where to
locate, or relocate, themselves.” As
Glaeser points out, in the old days,
towns sprouted beside rivers, the
transport mode of the day. Such

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BY BET TY JOYCE NASH

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locations may no longer be desirable
or viable.
Of course, in many mountain communities like Grundy, the only flat land
around lies near rivers and streams —
and the major industry remains coal.
John Bock is project manager for
the U.S. Army Corps of Engineers’
Huntington, W.Va., district office. He
says flood control projects in southwest Virginia, eastern Kentucky, and
southern West Virginia yield benefits
that can’t necessarily be captured in
typical analyses. “Are we providing
direct protection for a coal mine? No.
But we are providing livable communities so people can work these coal
mines,” he says. “We still have to find
the most efficient way [to floodproof], but we’re going to do it.”
Private investment will develop
the new town across the river. The
U.S. Army Corps of Engineers will
build a floodwall, and the Virginia
Department of Transportation will
reroute U.S. Highway 460 on top of a
new earthen levee.
Grundy is the county seat of
Buchanan County, next to West
Virginia and Kentucky. The county
may have been built by coal, but it’s
also been burned by coal. “Coal is
booming right now, but we have to
look at the future,” says Grundy Town
Manager Chuck Crabtree. “In the
1970s nobody planned ahead.”
At least the coal jobs resurrected
by the current demand will buy time
for the town to develop its retail and
for the new universities to reach
capacity, Crabtree thinks. New retail
businesses plus the higher education
institutions surely will bring new people and help attract new employers.
During the coal boom, everybody
shopped downtown Grundy. In 1979,
the county was home to about 38,000
people with a personal income that
almost met the state and national
averages. But a decade later, the population had fallen to 32,000, and the
per-capita personal income slid to 66
percent of the state average and 70
percent of the national average. By
1999, the 27,500 people brought in 63
percent of the state average and 66

percent of the national average. Its
2004 population of about 25,143 again
was at 63 percent of the state average
and 69 percent of the national average.
And almost 6,000 people in the
county live below the federal poverty
level, about 23 percent, compared with
10 percent statewide and 16 percent in
Appalachian Virginia, according to
2000 data.
“We have gone from nearly 40,000
people down to about 25,000 people;
you’ve got to remember there were
no jobs,” Crabtree says. The largest
employers are the school system, the
government, and the hospital. “For a
young person to get a job he’s going to
have to go out and weed eat somebody’s yard.”

April 1977
Flora Rush did something most kids
don’t do anymore; she moved back to
Grundy after college in 1978. She had
just finished at Virginia Tech. Rush
is an extension agent today with
the Virginia Cooperative Extension
and works with entrepreneurs. She
returned, she says, because of the
community spirit that prevailed during the hard times after the flood.
“The people made the town, the people and the coal companies working
together.”
In April 1977, Grundy got the worst
— the 100-year “flood event.” Sixteen
inches of rain in three days filled
creeks and rivers and sent it all down
to Grundy. Before the river crested at

22 feet above flood stage, five feet of
water stood on Main Street. That
flood killed three people and slammed
228 homes and businesses to the tune
of $15 million.
Roger Powers, who is Grundy’s
mayor and owns several businesses,
remembers the flood of 1977; his
grandfather owned Jackson Hardware,
located in the 1930s-era downtown. “I
don’t think the town ever recovered;
several people just didn’t bother to fix
up their buildings and left mud in the
basements,” he says.
The flood of 1977 wasn’t the last
flood, but it was the one people still
talk about. (People talk about the
2002 flood for different reasons. It
inundated nearby Hurley, Va., and
muddied the county’s reputation, as
16 men were convicted in Operation
Big Coon Dog, a bribery scheme
involving federal disaster funds.)
It has taken almost 30 years, but
Grundy’s flood protection is under
way. Authorized 25 years ago by
special legislation covering floodprone counties in the coalfields,
Grundy’s solution is costly. The Corps
investigated floodwalls, diversion
tunnels, and upstream reservoirs
before deciding to move the town.
But the town didn’t have the required
25 percent cost share.
The Virginia Department of
Transportation was also looking to
upgrade U.S. 460 through Grundy and
continue it on to the Kentucky border.
The town, the Corps, and VDOT

West Virginia
Virginia

Kentucky
Grundy
Buchanan County

Vital Stats
Buchanan County, Va. – Home of Grundy
Population: 25,143 (estimated 2004) Median household income: $22,213 (1999 dollars)
Median age: 38.8 Single-family owner-occupied homes, median value: $55,400
SOURCES: U.S. Census; Bureau of Economic Analysis

Summer 2006 • Region Focus

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Coalfield Economic Development
the director of the Education
came up with this: A levee will run
Authority (VCEDA), the county
Opportunity Center at Southwest
underneath a portion of the new highIndustrial Development Authority, and
Virginia Community College to help
way, between the Levisa and
private money to renovate another old
adults get to college to break the cycle
downtown Grundy. The town was
school building, just like the law school.
of poverty. The mini-boom in coal is
allowed to use VDOT’s buyouts of
“We’ve already created some jobs;
making his job harder. “Now people
downtown properties as its cost share.
when we max out with 200 students
are saying, ‘I can go back into the coal
Businesses have either closed or
we will have created 60-some fullmine.’” Coal trucks once again travel
relocated, many to an empty new
time and some part-time jobs,” board
the highway, and coal-loaded rail cars
building owned by the town’s
Chairman Frank Kilgore says. Direct
wait by the river. Chunks of coal spew
Industrial Development Authority,
spending once the schools reach
from a chute at the Apollo Mine in
also headed by Crabtree. Many of the
capacity could reach about $5.5 milnearby Maxie.
businesses on the redevelopment site
lion by 2009, according to a study by
But, over the longer term, higher
will be new to Grundy. The town manthe Southwest Virginia Office of the
incomes are associated with educaager, after countless and fruitless calls,
Weldon Cooper Center for Public
tion. Hannah notes that it takes a
finally flew to Bentonville, Ark., to sell
Service of the University of Virginia.
smarter worker today, even in the coal
Grundy to Wal-Mart. It happened that
That includes retail sales, some taxes,
mines, where the skill levels required
founder Sam Walton’s son was at the
and visitors to the school,
meeting when Crabtree
among other expenditures.
pitched Grundy to the
Economic development
executives. The younger
projects are as scarce as flat
Walton
remembered
land in this region for obviGrundy because he and his
ous reasons, and so when
father had investigated the
the Buchanan County
town three times looking
Board of Supervisors asked
for possible sites.
Kilgore, its attorney, to find
It was a done deal once
projects, he suggested the
they found a private devellaw school. The VCEDA,
oper. The town will own the
funded by severance taxes,
site and lease it to the
has given $1.6 million to the
developer for 99 years. The
law school and $3.3 million
infrastructure
includes
to the pharmacy school,
9,600 feet of fiber-optic
The Appalachian School of Law in Grundy, Va., trains lawyers priaccording to Jonathan
conduit. “We have another
marily for solo and midsize practices in the Appalachian region. The
chain coming, and other school in June was fully accredited by the American Bar Association. Belcher of VCEDA. “The
model of private education
stores to be announced
has made a lot of sense. It’s a niche
here shortly; these are people who we
have increased. Education can raise
market there that is really working
could never, ever get to look at us
standards of living and draw jobs.
well,” says Belcher. “It’s not something
before,” Crabtree says. Wal-Mart will
The county snatched up a law
we could see work elsewhere.”
anchor the new town and perch on a
school waiting to happen in nearby
The law school has tapped into old
public parking garage. “Before we got
Wise County, which had backed off of
wealth, including old coal wealth. Its
Wal-Mart we could not give anything
the plan, and admitted its first students
endowment is at $3.5 million, says
in this town away,” he says of his
in 1997. Buoyed by the law school’s sucPresident Lucius Ellsworth. “We have
ardent pursuit of the retailer. “They
cess, the Appalachian School of
had good support from a number of
are successful, they know where the
Pharmacy opened in the fall of 2005
benefactors from the beginning — our
markets are, and where they go, retailwith 69 students, to meet a growing
first campaign goal of $7 million raised
ers follow them.”
need for pharmacists. (States in the
$11 million.” Most donors have ties to
Fifth District with the highest demand
the county.
for pharmacists include North
Appalachian Economics:
The Appalachian School of Law has
Carolina, West Virginia, Virginia, and
Education
attracted well-paid faculty members
the District of Columbia, according to
In a county where only about half,
from top schools such as Harvard. In
the Pharmacy Manpower Project.)
53 percent, of adults have high school
2002, a dean, a professor, and a student
Both colleges are private and nondiplomas and a sliver, 8 percent, hold
were murdered by a disgruntled stuprofit. Plans call for the pharmacy
bachelor’s degrees, compared with
dent. Ironically, the crime led to
school to add a forensics department.
82 percent and 30 percent, respectpublicity and actually increased the
The school has gotten a variety of pubively, statewide, education tops
continued on page 40
lic and private money from the Virginia
everybody’s wish list. Eddie Hannah is
36

Region Focus • Summer 2006

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BANKS
aims to directly link individual borrowers with lenders
using an eBay-type model. But will it work?
BY AARON STEELMAN

ou have just started a small
business. You have used
most of your savings to get
the company off the ground. But you
need a little more money to really get
things going. Where do you go? For
decades, people turned either to
family or friends or to a commercial
bank. But each of those options had
downsides. Borrowing from loved
ones can be fraught with problems,
leading to ended relationships
should the business turn sour. And
many people perceive, rightly or
wrongly, that borrowing from banks
can be a real hassle — there’s too
much paperwork and, at the end of
the day, the little guy is unlikely to
get the loan anyway. So why bother?
Filling this niche in the
marketplace is a new Web site:
Prosper.com. Launched in February
2006, Prosper wants to directly link
borrowers with lenders — that is,
individuals who need money with
individuals who have some to lend.
Chris Larsen, who co-founded the
online loan broker E-Loan, started
drawing up plans for Prosper a few
years ago. At the time, he thought
“the ultimate goal would be to have
an eBay for money.” Now about five
months since Prosper’s launch, it’s
possible to draw some tentative conclusions about how the site has been
working and what the future may
hold for it.

Y

Nuts and Bolts
Let’s say you want to borrow $5,000.
How do you go about it on Prosper?
The first thing you do is provide some
standard information to Prosper,
which the company will use to assign
you a credit score (in conjunction with
Experian, one of the largest credit
rating agencies). Credit scores range
from AA (the highest) down to HR
(high risk), the lowest. There is also a
NC (no credit) ranking. After you have
been assigned a credit ranking, you
will fill out a profile, describing why
you want the money and for what
purposes you intend to use it. Finally,
you will state the maximum interest
rate you are willing to pay.
Lenders will then bid on your loan.
On rare occasions, one lender may
decide to fund your entire loan
request. But more frequently, many
people will bid on the loan, so that you
may receive, say, a hundred $50 bids
from different lenders. This allows
lenders to diversify their portfolios.
Should your loan become fully funded,
you will pay Prosper a 1 percent
origination fee. In this case, $50. In
addition, you will pay the interest on
your loan to all of the people who
agree to lend you money. All loans are
extended on a three-year basis, and
they are only made if you receive the
full amount of money you requested.
For instance, if your loan attracts only
$4,500 in bids, your loan request has

failed and you have to go back to the
drawing board.
How about from the lender’s side?
Any individual can lend up to $25,000
at one time. The same is true with borrowers: The maximum that any
individual can request is $25,000.
(Some states do not permit loans this
large. Likewise, some states set caps
on the amount of interest that can be
charged. For instance, in states like
Pennsylvania, where the interest rate
ceiling is relatively low, you see very
few loans being made.) In order to bid
on a loan on Prosper, you first must
transfer money to the company, which
will handle the transactions for you. If
you successfully bid on a loan, Prosper
will assess a 0.5 percent annual servicing fee. Just as with any other type of
loan, there is a chance that borrowers
will default. Should this be the case,
Prosper will contract with a collection
agency to try to recoup your money.
The basic setup on Prosper is in
some ways similar to eBay but has
some important distinctions. For
instance, eBay is a one-to-one auction
platform. Someone puts up a good for
sale and it goes to the single highest
bidder. Larsen says that he didn’t think
that model would “work with money.
You had to have a one-to-many auction system, where multiple lenders
provide money to a single borrower.”
Also, as mentioned, Prosper handles
all the administration, effectively

Summer 2006 • Region Focus

COURTESY OF PROSPER.COM

bypassing

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acting as the middleman. That has
some benefits, Larsen says. “First, the
borrower and lender never have to
worry once they make a match.
Second, the borrower and lender can
remain completely anonymous if they
choose. Third, we have the complete
data about what actually happens so
we can reliably create an objective
ranking system.”

The Group System
On eBay, feedback plays a crucial role
in determining bids. Sellers with poor
feedback ratings often receive lower
prices for their items. But the feedback is subjective. It is based on the
buyer’s perception of how closely the
item matched the description and how
quickly it was sent. With Prosper, the
ratings seem much more clear-cut —
you either paid your loan on time or
you didn’t.
Eventually, Larsen hopes that individuals with particularly good records
will pool themselves into groups. For
instance, you might get a number of
real estate investors with AA or A
credit rankings who will form a group,
signaling to potential lenders that they
are good risks. Once that reputation is
established, members will have a
strong incentive to monitor the
behavior of other members, lest they
damage the reputation of the group
and drive up the loan rates that others
receive. This type of communitybased peer pressure, Larsen hopes, will

help Prosper, well, prosper.
“The big dilemma is how to get
diversification and familiarity working
together. That’s how the group system
came in,” says Larsen. “Even though
the money is coming from a broad set
of lenders, we want the borrowers to
always feel a strong sense of obligation
to the community to which they
belong.”
Jim Bruene, the editor of Online
Banking Report, who did a study of
Prosper about a month following its
opening, concurs. “For this thing to
work, there has to be some information that goes beyond the credit score
that lenders can rely on. I think
Prosper is hoping that the group
system does that. The problem is the
groups don’t really have much of a
track record now, but over time,
groups could become large enough and
credibly signal to lenders that their
members are good credit risks.”
Myron McCrensky is a group
leader. In other words, he started and
organizes one of Prosper’s groups, in
this case the “Business Owners
Cooperative.” McCrensky, who spent
most of his career working for the federal government, retired about seven
years ago and started a pet-care business in Alexandria, Va. He created an
account on Prosper about a month
after the site opened. He initially
intended to serve as a lender, but he
quickly decided that he wanted to
start a group for small business owners

Distribution of Loans on Prosper.com
Borrower’s
Credit Grade
AA
A
B
C
D
E
HR
NC

Average
Interest Rate

Average
Loan Amount

Successful
Loan Account

Percentage
Successful

9.37
10.88
13.96
16.81
20.64
23.55
25.13
21.41

$7,142
$6,859
$6,653
$4,982
$3,893
$3,496
$2,504
$2,322

174 of 654
161 of 611
206 of 804
328 of 1,508
287 of 2,106
310 of 4,307
333 of 12,937
31 of 448

27
26
26
22
14
7
3
7

NOTE: Data last updated on July 10, 2006
SOURCE: www.savagenumber.com

38

Region Focus • Summer 2006

in Virginia. Eventually, though, he
decided that he should expand the
geographic range of members and
now accepts applications from around
the country. For his efforts as group
leader, he receives a one-time payment
when a member’s loan gets funded. In
addition, when loan payments are
made, he receives a small amount of
income that he can share with other
members of his group. McCrensky
currently divides those proceeds on a
50-50 basis with the 120 or so members of his group.
McCrensky says he is fairly open
when considering applications. But he
has established a stricter set of guidelines recently. “I think the big fear that
people have about Prosper right now is
that it’s still possible for someone who
wants to defraud others to accomplish
that. There is still a lot of good faith
that has to go into making a loan.” So
in recent months, he has rejected a few
people. “There was one guy last week
who had belonged to another group
and the loan description he wrote —
why he needed the money — began to
change from one posting to another
and that, naturally, made me a bit
suspicious.”
His experience with Prosper has
made him skeptical about how well
the group system will actually work
in transmitting information to
potential borrowers. The reason: The
monitoring costs for group leaders
can be prohibitively high, if all you
are interested in doing is turning a
profit. “I think that I am fairly
hands-on, but it takes a lot of work
to adequately screen all of your
members, and you are not going to
be perfect. And for what a group
leader gets in terms of financial
rewards, the money is pretty nominal. It’s really a labor of love more
than anything.” The one way this can
work, McCrensky thinks, is for group
leaders to take on a lot of members,
increasing the number of loans and,
thus, fees received. “But, of course,
that also increases your monitoring
costs. So it’s not clear to me in
which direction the group system
will move.”

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Who Wants to Borrow and
Who Gets Funded?
Intuitively, it makes sense why a person with a D or E credit rating might
head to Prosper instead of his community bank. Indeed, many of these
people are not interested in getting
small businesses off the ground.
Instead, they are looking to make
consumer purchases, such as home
improvements or travel plans. A
large share are trying to borrow to
finance other debt they have accumulated, mostly high-interest credit
card debt.
But what about people with AA or
A ratings? “At the beginning, I think
there were some good deals out
there. There was some seed money
and you could get a 6 or 7 percent
loan, which was very competitive.
But now you go to Prosper and you
see the loans don’t appear to be as
competitive — they are 10, 11, or 12
percent,” says Bruene. “So now the
question is: Looking at it rationally,
why would you choose to get one of
these loans instead of taking a good
credit card deal?”
Overall, the number of loans
approved is relatively small. This is
true even for people with very good
credit ratings. As you drop down to
people with E and HR ratings, the
share approved becomes miniscule
— and this is off a pretty big base.
For instance, the number of loans
requested by people with HR ratings
is more than every credit rating combined. (Larsen says that at any one
time there are about 1,000 loan listings on Prosper. The listings last for
10 days, so there are always some
that are ending and others that are
beginning.)
So who is taking a shot on the
people looking for money on
Prosper? It runs the gamut. There
are some people who loan only to
those with AA and A credit ratings.
They figure that they are going to get
a relatively small return on their
money, but they like the safety of
lending to people with good track
records. Meanwhile, some lenders
“are willing to put up a lot of $50

loans to relatively high risk people at
high interest rates, hoping that, say,
80 percent of the people wind up
making good on their payments,”
McCrensky says.
Finally, there are some people
who see their activity as something
akin to providing a public good.
They may serve as both borrowers
and lenders. They borrow money
through Prosper and then wind up
loaning it out to activities they deem
worthwhile. Larsen says that he
remembers “one person with an AA
credit score who was borrowing on
Prosper and using the loan proceeds
for microlending in Africa.” Of
course, there are other people who
serve as both borrower and lender
with strictly pecuniary interests in
mind. They believe they can effectively use Prosper as an arbitrage
opportunity: borrow at, say, 10 percent and then loan at 20 percent,
pocketing the difference.
When asked if this type of
activity violates the community
standards of Prosper, Larsen is
agnostic. “I have definitely seen
that. I don’t endorse that. But I also
don’t want to prohibit it,” he says.
“We don’t want to squeeze too hard
by saying this type of borrowing is
OK, but this type isn’t. We have
looked at social networking sites
and those that have failed have
usually squeezed too hard early on.
The ones that have thrived have
operated on the assumption that
most users will act responsibly and
have made systems that filter out the
exceptions.”
If there is one guiding principle
for Larsen and his colleagues it is
this: “We have to make sure that
the market is safe, secure, and transparent.” That, more than anything
else, they believe, will determine
Prosper’s fate.

A Missing Market?
In a world with an extremely welldeveloped banking system why is
Prosper necessary? What type of
market opportunities currently exist
that Prosper can exploit? At the

most basic level, Larsen argues,
there are still large information
asymmetries. “I was involved in the
effort to increase the transparency
of credit scores. But for a long time
the lending side had all of this
information on potential borrowers,
while on the other side everyone
had a score, but you couldn’t find
out what it was,” he says. “One
side having fundamentally more
knowledge than the other can create
real inefficiencies. And I think that’s
still true to some extent today.”
In addition, Larsen thinks that
one side of the market — individual
lenders — currently has no place to
go. “It always seemed to us the element that was missing in consumer
finance markets was that people
with a little bit of money to lend
really didn’t have access to directly
compete with banks or with payday
lenders. We thought Prosper was one
way to remedy that. People who saw
an opportunity could now compete
in the capital markets.”
Consumer psychology — at least
among some segments of the population — may also make Prosper a
viable business opportunity. “For
instance, some people just inherently don’t want to work with banks,
others may have had bad experiences
with banks, and others may believe
that the paperwork needed to do
business with a bank is too burdensome, especially if they don’t have
standard W-2 forms to show to loan
officers,” Bruene says. Some of these
people might qualify for loans at
relatively good terms through banks,
he says. “But they just don’t like
those institutions and instead want
to borrow in a way that has more of a
community feel to it. So it’s like a
virtual credit union, in a sense.”
Which gets us to the personal
aspect of Prosper. All borrowers are
given the opportunity to compile a
personal history, explaining possible
credit problems in their past, why
they want the money now, and what
good they will do with it. Many borrowers feel this is information that
many banks simply ignore — but

Summer 2006 • Region Focus

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that may be vital in assessing their
creditworthiness. Apparently, many
lenders agree.
“The lenders are no fools,” says
McCrensky. “They are trying to
acquire every piece of information
available to them. Borrowers have to
convince lenders that they are a
good risk and have a good business
plan. They have to be able to write
seriously and provide a compelling
case. Otherwise, they probably won’t
get funded.”
The amount of personal information provided by lenders has
surprised Larsen. He expected more

people to go on the site anonymously, simply listing their credit
grade and the amount of money they
would like to borrow. Instead, most
people provide detailed stories and
even photos. “And I think those
people are probably getting better
bids,” says Larsen.
How long this will last, though, is
unclear, says Bruene. Already, there
have been a large number of blogs
that have grown up around Prosper.
Many of these blogs have analyzed
which loan solicitations have been
most successful and offer advice
on how to copy those approaches.

“So when that information becomes
widespread, lenders may realize they
are getting less meaningful data from
the profiles and discount that in the
future,” says Bruene. “In a few more
months, are those descriptions going
to have any value anymore?”
Getting back to the larger picture,
Bruene has his doubts about how successful Prosper will be. “In total, this
is not a market that is underserved.
There may be some pockets that are
underserved — in fact, I’m sure there
are — but whether Prosper can find
them and provide adequate service is
hard to say.”
RF

READINGS
Bruene, Jim. “Person-to-Person Lending: Does the eBay Model
Lend Itself to Consumer Credit?” Online Banking Report no.
127, March 13, 2006.
Cabral, Luis, and Ali Hortascu. “The Dynamics of Seller
Reputation: Theory and Evidence from eBay.” National Bureau
of Economic Research Working Paper no. 10363, March 2004.

Meet the New Grundy
continued from page 36
number of applications. In 2006, there
were 1,500 applications for 145 spaces.
Students who live and shop nearby
add to the liveliness of the community
and spend money, for example, at the
Internet café across the street. A few
students on a Sunday afternoon play
a quick football game out front.
Some students stay in the area after
graduation, and many settle in the
Appalachian region.
“I think the idea of the schools is
that the students will have a higher
propensity to remain in the region; it’s
increasing the human capital,” says
Brad Mills of Virginia Tech. “The idea
is that you create human capital, and
you’ll get an adequate skilled labor
market. Jobs do tend to cluster around
people . . . there definitely is evidence
of that.”
The school aims to train lawyers
for a solo or midsize practice, and
specializes in community service.
(For example, the students work in
elementary schools teaching conflict
40

Region Focus • Summer 2006

Manjoo, Farhad. “The Virtual Moneylender.” Salon.com, May 22,
2006.
Said, Carolyn. “Site Hooks Up Lenders, Borrowers: Prosper.com
Is an eBay-like Online Marketplace that Lets People Seek Out,
Bid on Loans.” San Francisco Chronicle, March 6, 2006, p. C1.

resolution.) Each law class starts with
about 140 students; about 100 stick
around to finish. Seventy percent of
the students come from the local fivestate Appalachian area, with 28 states
represented at the school.
Beth Maurer, a third-year student
from Asheville, N.C., chose the school
because it’s small and personal, like her
undergraduate college in West
Virginia. Plus she enjoys outdoor
recreation, and there’s plenty of that,
especially at the Breaks Interstate
Park on the Kentucky border. (There
are also few distractions to studying,
she adds.)
Associate Dean Stewart Harris,
like many faculty members, sought
the school because of the region and
the mission; he and his family moved
from the University of Florida, where
he taught law. “This is really an
unusual school, focused as it is on
community service, community leadership,” he notes. “We’ve been lucky
in recruiting top people.” There’s also
an emphasis on arbitration and
mediation, a growing need in legal
circles.

The University of Appalachia’s
School of Pharmacy also thinks
regionally, although its applicant pool
is rising. “We’ve got applicants from
30 states in this second go-round,”
says Kilgore. The school’s mission is
to improve health care in Appalachia
so those applicants get priority. “You
could fill your class with California
applicants if you wanted to, but that
wouldn’t help your region.”
Roger Powers, the mayor, says the
town’s population is slowly growing,
and that can only accelerate with the
town reconstruction project. The
schools, the flood control project, and
the new town are all finally coming
together. The law school alone probably brought in 39 or 40 jobs, plus
students. “A lot of people I know say,
‘A school in Grundy?’ Look at
Blacksburg [home to Virginia Tech],”
he says. In the 1950s, it was just another small Appalachian community.
Grundy’s sprucing up. “It’s like the
whole town is getting a facelift,” Flora
Rush says.
After all, they hope they’ve got
company coming.
RF

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ECONOMICHISTORY
On the Waterfront
BY B E T T Y J OYC E N A S H

t’s 8 a.m. at Fells Point in
Baltimore, and people are washing windows or unloading beer at
taverns in the salty breeze. If it weren’t
for rehabbed waterfront warehouses
and homes selling for upward of
$300,000, it could be 1817. Back then,
though, the waterfront reeked of
waste and runoff. Also missing from
the 2006 tableau are sailing ships with
cargoes of immigrants from war-weary
Europe or famished Ireland, some
with money in hand to buy farmland,
others redemptioners whose time
would be sold for the price of passage.
Those bakers, butchers, iron
workers, cabinetmakers, laborers,
retailers, shipbuilders, and financiers
built Baltimore, its turnpikes,
bridges, the B&O Railroad, and many,
many houses. The city grew from
13,503 people in 1790 to 212,418 in
1860 to become the nation’s third
largest, behind New York City and
Philadelphia. A quarter of Baltimore’s
residents that year were foreign born,
among them 15,536 Irish and 32,613
German, according to history professor
Dean Esslinger of Towson University.
He has written of Baltimore’s littleknown immigration history.
They were drawn by the same
forces that have always drawn immigrants — the opportunity to work and
improve their lots in life. Baltimore’s
influx never reached the likes of
Ellis Island in New York Harbor,
or its predecessor Castle Garden. But
by some estimates, as many as 2 million immigrants arrived through Fells
Point and later Locust Point between
the late 18th century and World War I,
forever branding the city’s character.
The earliest immigrants after the
English were primarily Irish and
German. Starving Irish, reports one
author, “arrived at Thompson’s Sign
of the Harp on Ann Street near
Thames in 1847.” Later came Italians

PHOTOGRAPHY: FROM THE COLLECTIONS OF THE B&O RAILROAD MUSEUM

I

and Russians, Ukrainians and Poles,
Greeks and Czechs, among others.
Immigration effects reverberated,
producing, for example, insurance
based on ethnic efforts to protect the
newcomers, or the German concept of
graduate school, unknown in the
United States before the 19th century.
Baltimore still absorbs immigrants.
The old ethnic neighborhoods, with a
church on every block, festivals, and
restaurants, exist alongside Spanish
Town, the most active Hispanic
enclave in the state, says Ellen von
Karajan, executive director of the
Preservation Society in Fells Point.
Among other projects, she is working
to save from the wrecking ball a Polish
sanctuary on the second floor of
the 1880s-era St. Stanislaus church.
“Baltimore has always been hospitable
to immigrants and still is,” she says.
“Immigrants are always city builders.
That is still going on.”

Two million
immigrants
entered the
United States via
Baltimore in the
19th century

West by Water
The Chesapeake Bay snakes inland
from the Atlantic to Baltimore,
the farthest west that immigrants
could venture via ship, farther west
than Philadelphia, farther west than
Charleston. The point of Fells Point

Immigrants wait for
a train at the
B&O Baltimore
facilities at the
Locust Point, Pier 9
or “Immigrant Pier.”

Summer 2006 • Region Focus

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hooks out into the Bay; the land
was settled by the Fells family,
Quakers from England.
Early on, the planter economy
needed only river landings to load supplies and product. But as the first
Germans drifted south from
Pennsylvania to western Maryland,
they brought wheat farming, establishing mills near the rivers and streams
that emptied into the Chesapeake.
Historian Dieter Cunz wrote: “The
grain farms of the west demanded an
intermediary, a port of deposit, an
urban center.” And demand for grain
in the sugar colonies of the West
Indies was growing.
By about 1800, there were a dozen
grain mills on a 14-mile stream on the
nearby Jones Falls, a stream that
stretches from northwest Baltimore
County to the harbor. Converted later
to textiles, there were some 350 mills
by the mid-19th century. Some made
canvas for the U.S. Navy sailing ships,
including the famous Constellation.
Baltimore gained from the War of
1812, and the city was feeling its economic oats. Fells Point had become
famous for the Baltimore Clipper
ships, many of which were privatized
for great profit during the war. (Some
126 privateers used Baltimore Harbor
during that war, seizing more than
500 British ships. Many investors
made fortunes on cargoes of wheat or
flour at wartime prices.)
Besides the growing maritime
industries of shipbuilding and
sailcloth-making, there were clothing
manufacturers. The spate of wars also
had stoked the chemical industry,
including powder mills. Government
pamphlets in boom times advertised
Maryland in Western Europe to
attract workers.
The National Road beckoned
immigrants to Baltimore. The road
was completed from the coast to the
Ohio River at Wheeling in 1818, and
immigrants flocked to Baltimore
knowing the path inland was cleared.
“From only a few hundred immigrants per year, the total of newcomers
climbed to nearly two thousand by the
end of the decade. In 1828, Baltimore
42

Region Focus • Summer 2006

further improved its position by establishing the nation’s first commercial
steam railroad,” writes Esslinger. Many
headed for the Midwest or even farther west. Before rails became reality,
canals to move goods inland were
under construction, providing work.
By 1867, the B&O Railroad joined with
the North German Lloyd Line and
offered one ticket from Bremerhaven,
Germany, to Baltimore and beyond.
“Baltimore was the favorite port
for Europeans and especially for
Germans during these decades, partly
because of the tobacco trade, partly
because of the close relations that
existed between Baltimore and
Bremen,” writes Cunz in his 1948 book
The Maryland Germans. Germans had a
taste for American tobacco. Ships
loaded with tobacco sailed down the
Chesapeake and returned “down the
mouth of the Weser packed full of
German emigrants.”
As early as 1783 a German Society
had been founded to care for the
mistreated and indigent. Immigration
dwindled during the Napoleonic wars,
but by 1817, the society was revived
as immigration gathered steam
and redemptioners suffered abuse
once more.
Here’s an often-told story: A ship
anchored in the Bay in a February
freeze in 1817 offered passengers’ labor
to would-be buyers with these words:
“These people have been fifteen weeks
on board and are short of provision.
Upon making the Capes, their bedding
having become filthy, was thrown
overboard. They are now actually
perishing from the cold and want of
provision.” In a move that speaks to
how influential the German Society
had become, it pressured the state
Legislature to pass laws drawn up by
the society to supervise the redemption system. Later, the society
collected $1.50 from each immigrant
to support the poor; the Hibernian
Society (Irish) did likewise.
Ethnic societies also established
employment bureaus, among other
services. For example, the German
Society’s Intelligence Bureau formed
in 1845 and found jobs for 3,500 immi-

grants by 1846. “Such effort and success could only have bolstered
Baltimore’s reputation as a favorable
port of entry when immigrants wrote
home to their friends and relatives,”
Esslinger writes.
Many newcomers — some estimate half — did stay to ply trades or
work in construction jobs in growing
Baltimore, especially in the transportation industry. Major turnpike,
rail, and canal projects, under way to
keep goods (and money) circulating,
required strong backs. For immigrants in bustling Baltimore, there
was construction galore on houses,
streets, bridges, and wharves. Esslinger
notes that some 2,000 houses a
year were going up in Baltimore by
mid-century.
With the multi-ethnic labor force,
though, tension sometimes erupted
over competition for jobs. For
example, Irish workers attacked
German-built sections of the C&O
Canal in 1839, according to reports.
Federal troops shot rioters, razed
worker shanties, and took prisoners.
Wages dropped to 87.5 cents a day
from $1.25, according to Baltimore:
The Building of an American City by
Sherry Olson. Free black workers
really felt the brunt of depressed
wages as white immigrants took
unskilled jobs as caulkers, or coal and
brick yard workers. In some yards,
the black caulkers’ $1.75 per day jobs
went to whites who worked for 50
cents less.
By the Civil War, immigration and
Baltimore’s economy had slowed. “Its
only growth sectors were closely tied
to its role as a strategic transportation center,” according to Olson. The
Union plopped troops on Baltimore’s
Federal Hill to ensure control of the
vital harbor.
Some businesses prospered, however, Olson wrote. “William Wilkens
was another enterprising German
immigrant of the ’40s. In the ’50s, he
had sent agents to the battlefields of
the Crimea, and now he followed the
Army of the Potomac to Richmond
and Petersburg, to clip the tails from
dead horses. At his curled hair factory

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on the Frederick Road, horsehair and
hog bristles were spread out like hay
over the hillsides to dry.”
The German community was active
politically, and many opposed slavery.
German newspapers editorialized
against the practice, making them
targets of attacks by nativists and
Southern sympathizers in this border
town.

From Bremerhaven to Baltimore
and Beyond
After the Civil War, Baltimore’s
economy rebounded. The steam
age accelerated manufacturing and
immigration, too, as it speeded transatlantic service and reliability. With
better connections, Baltimore became
even more attractive to German immigrants. In September 1865, Olson
reports that 18 first-class steamers
made regular trips to Havana and
Liverpool, the latter city being one of
the hubs of the Industrial Revolution.
In 1867, the B&O Railroad and the
North German Lloyd Line teamed up
to offer immigrants one ticket that
would take them from Bremerhaven
into the prairie states via steamer
and B&O passenger train. More than
10,000 immigrants entered through
the port in 1867 compared with fewer
than 4,000 in the previous year,
according to Esslinger.
But a casualty of the steamships
was Fells Point, as they docked at
Locust Point. Fells Point’s shipyards
folded and were replaced by the lumber, canning, and packing industries,
all of which needed workers.
Most immigrants coming through
Baltimore via the Lloyd’s Line in the
immediate post-war years hailed
from somewhere in what was then
the Austro-Hungarian empire,
including modern-day Germany. For

example, 12,000 arrived in 1868.
And so by the 1870s, Baltimore
exuded a German flavor and feeling.
Earlier generations of German immigrants had become entrenched, with
four German American banks, factories, breweries, German newspapers,
churches, clubs, halls, and opera
houses, as well as German housing
developments. And Germans ran their
own schools, many connected with
churches. “But the success of the
German educational institutions ironically produced their decline: by
popular demand, the city in 1872
added to its public schools a
network of ‘German-English’ schools,”
Cunz wrote.
The German American Society in
Baltimore is active today, with many
descendents carrying vivid memories
of forbearers’ tales. Ted Potthast grew
up in the furniture-making business
founded by his grandfather and three
great uncles, Potthast Brothers.
The first brother, Vincent, arrived
in Baltimore on the Lloyd’s Line in
1892, and Potthast relates the family
legend: Vincent got in a bar fight in
his hometown and, thinking he
had dealt a fatal blow, fled upriver to
Bremerhaven. Even as he was preparing to depart his native land, friends
arrived to report the victim simply
knocked out. Vincent emigrated
anyway. “He was a cabinetmaker, and
there was plenty of work,” Potthast
says. Germany was in a depression
and work there was scarce. Three
brothers joined Vincent and all
worked at the Knabe factory, a building of seven stories that covered a
city block, where the Orioles play
baseball today, Potthast says.
“In those days, the only entertainment was music and every family had a
piano, so pianos were selling like hot-

cakes,” he says. The brothers worked
in their off hours building their own
furniture business, replicating fine
Colonial furniture. Potthast Brothers
closed in 1975. Potthast Brothers furniture pieces remain in museums and
private collections nationwide.
Immigration through Baltimore
was largely managed through private
enterprise. For example, between
1868 and 1914 the steamship companies contracted with a woman named
Mrs. Koether to run a boarding house
on Locust Point. For each immigrant
she fed and housed, she received 75
cents a day, according to Esslinger.
The boarding house did not inspect
passengers, as stations in New York
did, because officials boarded ships at
the mouth of the bay and examined
passengers and papers before arrival
in Baltimore.
But by 1913, with immigrants
averaging some 40,000 a year, the
federal government constructed
three buildings to process immigrants.
World War I shut down immigration,
and Germans were viewed with special
suspicion, virtually ending Baltimore’s
role in reception. The structures
became military hospitals.
All but forgotten, Baltimore
immigration deserves recognition,
according to people who are raising
money for a memorial. But the
necessary $4.2 million is hard to
come by.
Brigitte Fessenden is working on
the project and is also president of the
German Society of Maryland. “This
memorial will not only honor and
commemorate those who came
before us, but also today’s immigrants
whose dreams and aspirations
are probably not so much different
from those of their predecessors,”
she notes.
RF

READINGS
Browne, Gary L. Baltimore in the Nation. Chapel Hill: University
of North Carolina Press, 1980.
Cunz, Dieter. The Maryland Germans. Princeton, N.J.: Princeton
University Press, 1948.

Esslinger, Dean R. “Immigration through the Port of Baltimore.”
In Stolarik, M. Mark (ed.) Forgotten Doors: The Other Ports of Entry
to the United States. Philadelphia: Balch Institute Press, 1988.
Olson, Sherry H. Baltimore: The Building of an American City.
Baltimore: Johns Hopkins University Press, 1997.

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INTERVIEW
Guillermo Calvo
Editor’s Note: This is an abbreviated version of RF’s
conversation with Guillermo Calvo. For the full interview,
go to our Web site: www.richmondfed.org
Why are some countries rich and others poor?
It’s perhaps the most important question in all of
economics. Although many economists have tried
to answer it and much progress has been made, there
are still many issues that are unclear. Latin America
provides a good case study. While a few countries,
such as Chile, have experienced steady rates of economic growth for many years, the region as a whole
still lags well behind the developed world in standards
of living. Moreover, other countries have continued to
suffer large financial shocks, which have introduced
volatility in their economic and political institutions.
Guillermo Calvo has spent much of his career looking
at problems facing developing countries, first as an
academic and later as a policymaker. Calvo, who
and the University of Pennsylvania, now teaches at
the University of Maryland and has written several
influential papers on a wide range of topics in macroeconomics. From 1988 to 1994, he was a senior adviser
in the research department at the International
Monetary Fund (IMF). During his time at the IMF,
he visited several countries of the former Soviet bloc,
examining what could be done to help ease their transition to more market-oriented systems. Since 2001,
Calvo, a native of Argentina, has served as chief economist at the Inter-American Development Bank (IDB),
where his focus has largely been on Latin America.
In addition to his teaching and policymaking
responsibilities, Calvo is president of the
International Economic Association.
Aaron Steelman interviewed Calvo at the IDB on
May 31, 2006.
44

Region Focus • Summer 2006

RF: This is a very broad question, but I think it will
help lay a foundation for the rest of the discussion. How
do developing economies differ from developed
economies? Are there some attributes of the latter that
are typically lacking in the former?
Calvo: You could make a very long list of differences, but
the ones that I think are most important and that have
captured my attention have to do with the financial sector.
There is often market incompleteness, which means that
many countries have to borrow in terms of foreign exchange
denominated bonds. There is also imperfection with
domestic capital markets. In particular, there is often poor
protection of credit, which makes people suspicious that
there will be a devaluation or confiscation. That can lead to
bank runs. So these two things seem to play a central role in
developing countries.
Now, one might wonder whether the institutions are so
different from developed countries or whether the shocks
are different, because the relative price changes are much
wider? If the United States were subject to those kind of
shocks, perhaps there would be the same type of political
pressure that we see in developing countries, and that would
affect the structure of institutions. It’s very difficult to tell.

PHOTOGRAPHY: LISA HELFERT

formerly held faculty positions at Columbia University

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RF: You have argued that there is no one correct choice
of exchange rate regimes for developing countries.
Could you please discuss why that choice should
depend, at least in part, on the characteristics of a
country’s economy?

Calvo: It catered to the domestic producers and it also
promised to lessen income inequality, which is a big problem
in Latin America. So it was popular for those reasons. The
period in which those policies were implemented also happened to be a period of relatively
high growth for the region. So if
you just look at the numbers and
don’t do any deep analysis, you
may reach the conclusion that
high growth was a result of
import substitution.
By the early 1980s, opinion
changed and the conventional
wisdom said that the model was
exhausted. I’m not so sure that
was the case. The region is very
sensitive to external credit conditions, and during the early 1980s
interest rates were going through
the roof. So this led to some very serious problems in Latin
America. But the simple-minded analysis concluded that the
model was exhausted, just as the simple-minded analysis
today says that the “Washington Consensus” is exhausted
because it, too, has experienced some problems. Our theory
is that there is a strong parallel between the two. While the
import-substitution model is not a system that I like, it may
be unfair to say that it simply had run its course and failed. It
was certainly vulnerable to shocks, to be sure, but any system
is vulnerable to shocks.

I think many analysts may
overestimate the policy
changes occurring in
Latin America. I don’t see
the region, in general, as
veering off course.

Calvo: Consider heavily dollarized economies. It’s very difficult
to have a floating exchange rate
because balance sheets are mismatched in terms of currency
denomination. Let’s take the
example of Bolivia. Eighty percent of deposits in the banking
sector are denominated in dollars.
Those loans go mostly to the private sector, denominated in
dollars, and therefore if you were
to devalue all of a sudden, you
would have a financial crisis. So I think the financial characteristics of an economy play a large role in determining its
exchange rate policy.
Now, in general, markets are seriously incomplete in
developing countries. You have structures that are not very
reliable and you have poorly functioning futures markets.
That makes it difficult for the policymaker. It’s very risky to
float. As a consequence, developing countries, whether they
like it or not, tend to peg. I’m not saying that pegging is optimal, but it’s a system that, at least in the short run, does not
interfere very much with the working of the economy and,
thus, it becomes appealing to the policymaker.
There are exceptions to this as you noted in the question.
Some developing countries have adopted floating exchange
rates with some success. But this is because they have
already developed the appropriate financial institutions.
RF: How important is the choice of an exchange rate
regime relative to other macroeconomic policy choices?

Calvo: My answer may sound a bit paradoxical. On the one
hand, as I have said, the choice of exchange rate policies is
heavily dependent on institutions; it is not much of an
independent policy variable. On the other hand, it is a very
critical variable. For countries to grow, at least for developing countries, exports are key. It’s very difficult to find an
example where exports are not the driving force. The
exchange rate can be thought as of a bridge between the
domestic and international economy. Exports have to go
over that bridge, and if exchange rates are highly volatile and
noncredible, coupled with incomplete futures markets,
the life of the exporter can be very difficult. That will have
negative effects on trade and, consequently, on growth.
RF: The import-substitution model was quite popular
in Latin America in the 1960s and 1970s. Why do you
think that was the case?

RF: You mentioned that income distribution is a
problem in Latin America. Could you please elaborate
on that? For instance, is it slowing economic growth in
the region?
Calvo: The World Bank has done work that shows some evidence of a link between inequality and slower economic
growth. I can imagine the mechanism: Inequality causes
political tension, which causes politicians to pursue policies
that cater to the poor by taxing capital, which induces capital flight, which lowers growth. Eventually, the situation gets
so bad that even left-of-center governments change policies
and adopt a more market-oriented approach. That works for
a while — you get increased growth but income distribution
deteriorates again. That’s the story and it seems to fit the
facts. If it’s true, then it’s a real trap. It’s not clear how you
get out of it.
RF: How can policymakers in developing countries
effectively signal that they are committed to economic
reform?
Calvo: I don’t think that there is a formula for that. I think
certain devices are useful, such as an independent central
bank. But that doesn’t mean it’s going to be a fail-safe solution because, in the final analysis, it can still be subject to

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political pressure if the economy becomes very bad.
International agreements, such as the Free Trade Area of the
Americas (FTAA), can also be useful. They can help establish credibility. But, again, the success of such agreements
depends on the political support that you can conjure up
at home, both in adopting them and then complying
with them.
RF: What is your opinion of central banks in developing
countries adopting inflation targets?

real opportunities that could be exploited even if trade with
the United States did not increase substantially. And, in that
context, it would be very useful to have a currency union.
Also, it goes beyond just trade. Latin America is a low
savings region, and in order to grow you need investment. So
if you are low savers, you need to attract foreign capital.
That requires creating an attractive environment. I think
the FTAA would have helped move the region in that
direction.

RF: You mentioned that a currency union would help
intra-regional trade. What’s your opinion of Latin
Calvo: When developing countries adopt an inflation target
America adopting a currency union more generally?
it’s usually because there is a lack of credibility. So they are
forced to stick to a system that is
Calvo: The jury is still out on how it
very rigid. That has some benefits,
has worked in Europe. We don’t
but it also makes it quite difficult to
know what is going to happen with
deal with shocks and, unfortunately,
➤ Present Position
Italy or Portugal, for example,
developing countries can experience
Chief Economist of the Inter-American
where officials have been lax in their
quite crippling shocks. For instance,
Development Bank and Distinguished
enforcement of rules established by
let’s say there is a financial shock and
University Professor of Economics at the
the European Commission. I have
you need to rescue the banking secUniversity of Maryland
been a fan of currency unions for
tor. The intense focus on controlling
➤ Previous Faculty Appointments
some time, but my enthusiasm for
inflation may make that very diffiUniversity of Pennsylvania (1986-1990)
them has cooled off recently. I am
cult. So an inflation target could
and Columbia University (1973-1986)
beginning to see many more potenpush the central bank toward
➤ Education
tial difficulties with them now.
pursuing policies that are counterPh.D., Yale University (1974)
A currency union requires
productive
and
ultimately
➤ Selected Publications
commitment among the policymakunsustainable from a political point
ers in the member countries. In a
of view. That’s why I cannot be too
Author or co-author of dozens of papers
region that has typically had a lot of
excited about inflation targets in
in such journals as the American Economic
Review, Journal of Political Economy,
political instability, politicians are
developing countries.
Quarterly Journal of Economics, Journal of
naturally inclined to give high
I should say that I’m also not a big
Monetary Economics, and Journal of
priority to domestic issues. They
supporter of the United States
Macroeconomics
want to make sure that they are
adopting an inflation target. There
popular at home so that their
have been cases, such as the period
➤ Awards and Offices
governments do not come under
immediately following the stock
President, International Economic
pressure from competing factions
market crash of 1987 and the collapse
Association; Fellow, American Academy of
or are toppled. This makes it
of Long Term Capital Management
Arts and Sciences; Fellow, Econometric
Society; Research Associate, National
difficult for many of them to crediin 1998, where the Fed pursued
Bureau of Economic Research
bly commit to the type of policies
policies that were good for the econthat are required by a currency
omy but that would have been
union. For instance, many will be unlikely to hit the fiscal
difficult to implement had it been committed to a rigid inflatargets if that means they will risk domestic unpopularity.
tion target.
So I think it is a bit premature for Latin America to
adopt a currency union. But this doesn’t mean that the
RF: How would you rate Latin America’s efforts at
region shouldn’t begin taking steps toward that goal. For
greater trade integration and openness?
instance, Europe did not adopt its currency union
overnight. It took many years, indeed decades, to
Calvo: The 1990s was a period of trade liberalization. It’s
establish how the system was going to work and then to
questionable whether that is sustainable. I am not particularimplement it.
ly optimistic. My hope was that something like the FTAA
would be ratified. Unfortunately, many countries seem to
RF: Many South American countries seem to be underhave given up on the FTAA and instead are pursuing bilateral
going an ideological shift. A number of leaders have
trade agreements with the United States. That’s not very tidy.
gained power running on an anti-Washington platform,
One of the benefits of something like the FTAA would be to
arguing that their countries should resist the type of
open up regional trade. There is not much trade going on
“neoliberal” policies favored by many in the developbetween Latin American countries now. So there are some

Guillermo Calvo

46

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ment community. How widespread is this sentiment?
And how large of an obstacle does it pose for economic
growth and stability in the region?
Calvo: I would say that it is more talk than action, at least
at the macro level. For instance, in Brazil, President Lula
said that he would not repay international loans, but now he
is making those payments, and implemented a fiscal
program that is even tighter than the one agreed with the
IMF. There are some exceptions. And in some countries, it
is too early to tell whether the rhetoric we have heard
will translate to big policy changes. But the majority of
countries are generally pursuing sound macroeconomic
policies, and I don’t anticipate that changing.
Now, it is true that there is a lot of talk in Latin America
about the “Washington Consensus” not working, and those
voices are joined by some prominent economists here in the
United States. My opinion is that the “Washington
Consensus” is really a misnomer. It is, for the most part, the
“Latin American Consensus” also. Most people agree that
the decalogue of policy proposals that are closely associated with it are reasonable and generally should be followed.
But it’s an incomplete list. For example, it does not
adequately address how to reform the financial sector. We
need to work on those problems, but that doesn’t mean the
decalogue is itself bad or counterproductive.
Also, I think it is important to mention the spread of
democracy during this period and the role it played. In
many parts of Latin America, democracy was a relatively
foreign concept. Then all of a sudden, the world opens up,
democracies are established, and politicians start making
promises to a populace that doesn’t understand democratic
politics and which takes those promises at face value. So
when the decalogue was proposed, some political leaders
both at home and abroad perhaps oversold what it would
mean for the region. When those things didn’t happen —
indeed, when there were severe financial crises — the populace became skeptical of liberalization. Unfortunately, it
also led to skepticism about democracy. The public associated democracy with economic liberalization — and, in
their minds, those things brought instability and financial
trouble. That’s not how things actually worked, but the
timing of events led them to believe it was true.
So I don’t want to downplay the opposition that does
exist to the “Washington Consensus.” But, as I said
before, I think that many analysts in the United States may
overestimate the policy changes that are occurring in Latin
America right now. I don’t see the region, in general, as
veering off course.
RF: How do you account for some rather dramatic
differences in economic performance within the
region? For instance, countries like Chile have been
relatively stable and grown relatively quickly, while
some of its neighbors have experienced significant and
persistent problems.

Calvo: Actually, we have a paper comparing Chile with
Argentina and how they responded to the crisis of 1998.
Chile suffered from that crisis, but the implications for
Chile were very different than they were for Argentina. In
Argentina, the system shut down almost completely. In
Chile, the growth rate went from about 6 percent to zero,
but then it bounced back. One of the major reasons has to
do with differences in financial systems and institutions.
Chile wasn’t dollarized, while Argentina was and that
caused a whole host of problems.
As for the broader question of Chile’s relative success in
the years leading up to the 1998 crisis and following it, I
think there are a number of factors at work. Chile, perhaps
more than the rest of the countries of South America,
liberalized its trade policies and generally pursued marketoriented reforms in the 1980s. On balance, these reforms
were beneficial to the economy. Also, Chile experienced
high rates of productivity growth. We are still uncertain
about all the causes of this productivity spurt — some of it
can probably be attributed to domestic policies, some of it
to positive shocks, such as exogenous technological
improvement — but whatever the causes, it’s clear that it
helped improve growth rates.
RF: Chile has a long history of American-trained
economists advising the government. How common is
that in other Latin American countries?
Calvo: I would say that is now commonplace. The one
exception may be Argentina, where many of the Americantrained economists have left the government. Also, the
economists who are active often have quite important roles
in the policymaking process in Latin America, much more
so than in the United States. In addition, I think it is more
common for Latin American politicians to cross party lines
in seeking out economists for government positions.

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RF: What is your opinion of Hernando de Soto’s The
Other Path? What lessons can policymakers in Latin
America take from that book?
Calvo: The main lesson is that regulations must be
simplified as much as possible in order to encourage the development of the formal sector and, thus, most likely enhance the
pace of technical progress. However, I am skeptical that a major
overhaul of government regulations will have a major effect in
the short or medium term. The reason is that the informal sector strongly relies on tax evasion and, unless you implement a
major tax moratorium — accompanied by substantially lowered
tax rates —firms are likely not to move to the formal sector,
even if all the red tape is eliminated. Moreover, a moratorium is
likely to have detrimental moral hazard implications.
RF: Roughly 15 years after the fall of the Soviet bloc,
what have we learned about the transition from
centrally planned to market economies? For instance, is
there an optimal way to sequence reforms?
Calvo: Optimal sequencing of reforms is a very complex issue
which transcends economics. My view is that it is essential for
politicians to get strong popular support. This enhances the
credibility of reforms. Without credibility, even well-designed
and good policy reforms may turn out to be counterproductive.
This makes it difficult to extrapolate reforms in the Soviet bloc
to other regions, for instance, like China. A sudden dismantling
of state-owned firms in China, following the Soviet bloc pattern,
would seriously impair growth and social cohesion in China.
RF: Debt forgiveness has gotten a lot of attention
recently. What is your opinion?
Calvo: I think it raises real problems. It is one thing for the
developed world to make transfers to poor countries. If they
want to do that, fine. But it’s quite another for those countries
to make loans to poor countries and then when those countries
get in trouble because of bad policies, simply forgive the debt.
In those cases, you are simply pretending that you are lending
money and, in the process, you are allowing policymakers to
behave in a way that is not good for them. It’s bad for the country that is making the loan and it’s bad for the country that is
receiving it. The moral hazard issues here are quite severe and I
don’t think they have been dealt with adequately.
RF: Could you comment on the “global savings glut”
hypothesis and its implications for the path of the U.S.
current account?
Calvo: In general, I am sympathetic to that argument. I think
it fits the fact well. Now what could be causing it? It’s possible
that it could be a consequence of some of the crises we had in
the 1990s. In particular, those crises might have induced Asian
countries to save more, giving them the ability to finance
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Region Focus • Summer 2006

tion be stable? I think it could be. I think we could go along in
this way for quite a while without there being a global crisis. My
concern is that if there were a hiccup in the financial markets,
it would not be the United States that would be most severely
hurt, as some have argued. Rather, I fear that emerging markets
would be hit hard. In the eyes of most investors, the United
States, despite its current account deficit, is still a very stable,
attractive place to put their money. If there were trouble,
I think they would turn to the United States as a haven.
RF: How has your academic work helped you as a policy
adviser?
Calvo: I think it has been very useful. The analysis we have to
do is often very complex and there will be many things that
you will not understand fully. But I have gone back time and
again to basic macroeconomic principles to develop a framework for looking at the policy questions I encounter. Also, the
work that sprang up from the rational expectations revolution
has helped me think about problems regarding credibility.
Even if I don’t take the rational expectations stories verbatim,
they provide a very simple but powerful way of understanding
how people think about the future and how to structure policy responses. You might not get every detail right, but at least
you will be working within a reasonable framework and set of
parameters. In contrast, if you do not have a strong grasp of
theory, I think you will eventually find yourself adrift.
RF: How would you compare your position now with
the Inter-American Development Bank to your
previous job at the International Monetary Fund?
Calvo: The two institutions are very different. For instance, the
IMF has a much larger staff of macroeconomists, and the politics of the institution were much more difficult to navigate.
Also, the events that occurred while I was at the IMF were
unique. I was there when the Soviet Union was falling apart.
This gave me a chance to travel to Eastern Europe and witness
the problems they were facing firsthand. In academia, you are
always trying to push your work to the frontiers of the field, but
when I was at the IMF I had to get back to basics and deal with
very simple but hard questions. For instance, what is the
demand for money when prices are not well-defined because of
prior across-the-board price controls as in the former Soviet
Union? Those type of issues can really focus your mind. That
said, for a number of reasons, it was hard to influence the direction of the IMF. Eventually, they did absorb some of the advice
that I gave. So the experience was ultimately mutually beneficial, but it was also very tricky.
The IDB focuses on a broader set of questions. It deals with
a lot of microeconomic questions — welfare programs, poverty,
and so on — while the IMF was much more interested in purely monetary issues. Also, from a personal perspective, the
number of macroeconomists is much smaller and, as a result,
I have a much greater ability to influence the Bank’s
approach to macro issues.
RF

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BOOKREVIEW
The Real Adam Smith
ADAM SMITH’S LOST LEGACY
BY GAVIN KENNEDY
NEW YORK: PALGRAVE MACMILLAN, 2005, 285 PAGES
REVIEWED BY THOMAS M. HUMPHREY

dam Smith was a great economist, arguably the most
influential of all time. But this does not mean, as some
would have it, that his Wealth of Nations, published in
1776, marks the birth of modern political economy. On the contrary, Smith’s book and the economics it contains owe much to
his own previous work. More important, they draw heavily
from the ideas of earlier English, Scottish, and French economists as well as from continental and Scottish philosophers
writing in the natural law and historical-empirical traditions.
Nevertheless, it was Smith who, more clearly and systematically than his predecessors, saw the economy as a unified
system of coordinated and interdependent markets across
which the play of free competition and individual self-interest
produces optimal resource allocation without the need for central planning or conscious design. From his Wealth of Nations
comes an economic growth model in which specialization and
division of labor, by spurring productivity and output, act to
expand the scope of the market, thus permitting further division of labor and further market expansion in an upward
cumulative spiral.
To Smith we owe a price-theoretic analysis in which flows
of labor and capital in response to excess or deficient rewards
in particular industries cause short-run market prices to
converge to their long-run natural equilibrium, or cost-ofproduction, levels. At this point, rewards
are equalized such that no further incentives exist for resources to move and the
resulting composition of output just
matches that demanded by consumers. His
celebrated theory of relative wages attributes wage differentials to agreeableness of
work, cost of acquiring skills, regularity of
employment, trust and responsibility
imposed, and probability of success in different occupations.
But it is to his free trade doctrine that
his name is most durably linked. He
showed that trade is a positive-sum game
in which all parties gain when they buy
goods from others more cheaply than they
can produce themselves. Smith applied
this idea to explode the protectionist
fallacies of the Mercantilists and to
demonstrate that free trade, by expanding

A

the extent of the market, promotes greater division of labor
and growth. These contributions, together with the following
additional insights, mark him as an exceptionally perceptive
and creative economist: (1) national wealth consists of
goods and services rather than the nation’s stock of
monetary metals; (2) gross domestic product resolves into its
distributive-share components of wages, profits, and rent
whose sum total is nothing less than aggregate effective
demand; and (3) capital formation and technological progress,
both of which support division of labor, are vital to growth.

Smith and Laissez Faire
In Adam Smith’s Lost Legacy, Gavin Kennedy, an economist at
Edinburgh Business School, touches on these contributions.
But his main concern is to dispel the myth that Smith was a
laissez faire zealot who believed that market failure is inconceivable and that government intervention is never needed.
Actually, Smith argued that a strict policy of complete laissez
faire is warranted only in the ideal state of natural liberty where
free competition and perfect factor mobility prevail in all
markets. Absent these conditions, market failure can occur
making restorative intervention desirable.
Far from glorifying businessmen, Smith saw them, often
operating in collaboration with the government, as the source
of anticompetitive trade restrictions. He described how
rent-seeking businessmen conspire to monopolize markets,
restrict output, raise prices, and lower wages. To this end they
lobby politicians to grant them exclusive privileges, legal
monopolies, protective tariffs, and the like. When the
politicians, their class interests more
aligned with the lobbyists than with other
groups, comply, businessmen are benefited
at the expense of the community at large.
A government wanting to improve the
welfare of all its citizens would break free
from the dictates of its business petitioners
and remove all restrictive practices. It
would act to restore competition, not
undermine it.
Kennedy further notes that far from
positing a minimum caretaker (“anarchy
plus the constable”) role for government,
Smith charged the state with such basic
tasks as providing national defense,
justice, enforcement of contracts, security
of life and property for its citizens, and
elementary education for its poor (albeit
on a fee-for-performance basis to induce
diligence in teaching, diligence that would

Summer 2006 • Region Focus

49

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Page 50

be lacking if teachers were paid a fixed stipend regardless of
results). Noting that the spillover social benefits of primary
schooling justify its public funding, Smith held that higher
education, in which the pupils themselves capture all the benefits such that their private incentives already are aligned with
the social good, merits no such funding.
The state, according to Smith, also had the duty to
construct and maintain public works infrastructure in the
form of roads, canals, bridges, tunnels, and harbors when
these projects prove too unprofitable for private firms to
undertake. Other state functions approved by Smith included
the post office, public health, standards of weights and measures, coinage, regulation of the small denomination bank note
issue, and imposition of interest rate ceilings so as to remove
lenders’ incentives to channel credit away from prudent borrowers toward riskier ones (prodigals and spendthrifts)
promising potentially higher returns.
Kennedy even finds Smith occasionally approving certain
state-granted monopoly privileges such as patents, copyrights,
and infant-industry protection in some cases, as well as supporting tariffs levied for retaliation and bargaining purposes,
not to mention navigation laws requiring British traders to
ship their goods in British vessels, thus assuring the navy a
plentiful reserve of sailors. Enough intervention, as one economist mischievously put it, to please a modern socialist.
What Kennedy overlooks, however, is that these were
isolated exceptions to laissez faire rather than a wholesale
rejection of it. Overall, Smith championed unfettered
markets, favoring only interventions that removed market
imperfections and promoted free competition. Indeed,
Kennedy fails to realize that most of the interventions
winning Smith’s approval — provision of defense, justice,
security of contract, and laws protecting the mobility of
labor, and the like — were designed to bolster free markets
rather than supplant them. Such reforms removed barriers
impeding the efficient functioning of markets and established
the necessary framework, institutional and legal, within
which laissez faire could flourish.
In general, however, Smith was skeptical of the ability and
willingness of the government to implement even these
beneficial reforms. This was particularly true of the British
government of his time, which he saw as corrupt, incompetent, and biased in favor of merchants and manufacturers.
Worse, state officials had the temerity to believe they could
do better for private individuals than those individuals,
guided by their own self-interest, could do for themselves.
Under these conditions, it was hardly surprising, Smith
thought, to find intervention creating more monopoly power
than it removed. Until the behavior of the government
improved, a policy of strict nonintervention, though not
theoretically the best, might in practice be the least harmful.

Order without Design
Having dispelled one myth, Kennedy seeks to dispel another,
namely that selfishness is the prime motivator of economic
behavior in Smith’s analysis. Not so, says Kennedy. Simplistic
50

Region Focus • Summer 2006

popularizers of Smith confuse selfishness, or sheer unadulterated greed, with enlightened self-interest. Smith did not
make that error. Smith realized that purely selfish traders
would be doomed to perpetual frustration. Seeking to capture
all the gains from exchange for themselves, they would set
their selling prices so high and their buying prices so low that
no trade would take place.
By contrast, self-interested, or Smithian, traders realize
that all parties must find trade advantageous, that is, must
share in the gains from exchange, if trade is to occur.
Consequently, they willingly settle for a price that leaves them
better off given that their trading partners are better off too.
They take the welfare of their trading partners into account
in their own utility functions. They do the same for people
less fortunate than themselves when they form voluntary
associations to help the poor. Sympathy with one’s fellow
man, as Smith pointed out in his Theory of Moral Sentiments,
published in 1759, is entirely consistent with enlightened selfinterest. Sympathy generates demand for justice. And justice
is vital to the working of a harmonious, peaceful social order
within which economic growth and opportunity for personal
advancement thrive.
Such mutual interdependence of individuals operating in
society is, Kennedy claims, the essence of Smith’s famous
analysis of man’s propensity to truck, barter, and exchange.
Indeed, Kennedy sees in Smith’s analysis the prototype of a
modern bargaining model, albeit with a difference. Unlike
most modern models (for instance, Nobel laureate John
Nash’s) that depict only the properties of the final equilibrium state, Smith’s model traces the dynamic adjustment
process by which equilibrium is reached. Smith’s bargainers
start off by asserting their all-or-nothing bid and ask prices,
both of which are unacceptable to the other side. The resulting disappointment triggers an iterative sequence of offers
and counteroffers leading to the set of mutually acceptable
prices where trade occurs. Cooperation — benefiting others
in order to benefit one’s self — is the name of the game for
Smith’s bargainers.

Conclusion
The book contains some surprises. Neither Smith’s notion of
the division of labor as limited by the extent of the market
nor his celebrated pin-factory illustration of that concept
originated with him. The former he borrowed from his
teacher Francis Hutcheson and the latter he took from
Denis Diderot’s Encyclopédie. Even the invisible hand
metaphor dates from Shakespeare’s Macbeth rather than
from the Wealth of Nations.
There is some speculation. Kennedy believes that Smith’s
deliberate, carefully calculated planning of his career proves
that he was a judicious decisionmaker rather than the bumbling, absent-minded professor of legend. Again, Kennedy
conjectures that Smith, in his last years, never published his
Lectures on Jurisprudence for fear of appearing unpatriotic. The
Lectures, championing as they did the kind of democratic
principles adopted by the United States, might have been

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Page 51

seen as supporting an enemy country that had just recently
won its war of independence from Britain. Against Kennedy’s
conjecture, however, is the fact that Smith in the Wealth of
Nations already had gone on record as favoring emancipation
of the American colonies on the grounds that they as well as
the mother country would benefit from such independence.
There also are some omissions. Kennedy says nothing of
Smith’s monetary theory. And he is silent about the tension
between the division of labor and Smith’s assumption of
small-firm competition that operates as an invisible hand
to harmonize self-interest with the common good. The
tension arises because division of labor implies increasing
returns to scale in production. These scale economies mean
that large firms, by permitting greater scope for division of
labor, possess a cost advantage over small firms and so drive
them from the market, contrary to Smith’s assumption.
Smith did not address this contradiction, nor did anyone else
until Alfred Marshall in 1890, Allyn Young in 1928, and
George Stigler in 1951 tried to resolve it in their works on
increasing returns, competition, and division of labor.

BOOKNOTE
COMMON SENSE ECONOMICS: WHAT EVERYONE SHOULD
KNOW ABOUT WEALTH AND PROSPERITY
BY JAMES D. GWARTNEY, RICHARD L. STROUP, AND DWIGHT R. LEE
NEW YORK: ST. MARTIN’S PRESS, 2005, 194 PAGES

n general, readers should be wary of books with titles that
promise to tell them, and everyone else, what they need to
know about a topic. This is an impossible task. First, there
is the choice of subject matter. What should be included? We
live in a complex world — one in which comprehensive answers
to questions are hard to find and new information is constantly
being discovered, often making what was true a year ago less
true or even wrong today. So where should the authors start?
Just as important, where should they end?
Second, different people will open the book with different
levels of knowledge. How do you successfully pitch a book to all
potential readers? Some will come away thinking the way the
information was presented was too basic, while others will think
it was too advanced. There is a real danger that, in the attempt
to satisfy everyone, you will ultimately satisfy no one.
Still, one can understand the temptation that publishers face
when marketing a book. They want people to buy it, after all,
and making big claims in the title will persuade some customers
to make a purchase. Happily, Common Sense Economics: What
Everyone Should Know about Wealth and Prosperity is an exception.
It actually delivers the goods — well, at least most of them.
Readers from various backgrounds will benefit from this book.
It does an excellent job of concisely laying out basic economic
principles and tying them to real-world applications at both the
macro and individual levels.
Gwartney, Stroup, and Lee, economists at Florida State

I

But these omissions do little to mar a fine book.
True, Kennedy says little that scholars Jacob Viner,
Andrew Skinner, D. P. O’Brien, Mark Blaug, and others
haven’t said before. Nevertheless, his book is a welcome
addition to the literature. Its numerous, short chapters
(some no longer than three or four pages) make it a
convenient companion to read simultaneously with
the Theory of Moral Sentiments and the Wealth of Nations.
Students and other first-time readers of Smith will want
to refer to it as perhaps the most accessible and accurate
account available today of what Smith really meant, as
opposed to what popularizers, pundits, and politicians
claim he meant. Kennedy’s book is a healthy antidote to these
bogus interpretations. Reading him is one way to retrieve
Smith’s purloined legacy.
RF
Thomas M. Humphrey, a retired long-time editor of the
Richmond Fed’s Economic Quarterly, has written extensively
on the history of economic thought.

University, Montana State
University, and the University of
Georgia, respectively, start out by
discussing the conceptual building blocks of modern economics,
each under a separate header,
such as “Incentives Matter” and
“Decisions Are Made at the
Margin.” They then consider how
countries become rich, explaining the importance of transparent
legal systems, efficient capital
markets, and monetary stability,
among other things. Next they argue that the government
should take a relatively hands-off approach to handling the
economy, comparing it to food — both are essential but when
consumed excessively can lead to serious problems. Most economists would agree with this general outlook, but some will
think the authors are too fervent in their denunciation of state
action.
The last section concerns personal finance. “Often, the
world of investment advice appears to be totally divorced from
the world of economics,” they write. “Yet the principles that
lead to financial security are largely the same ones underlying a
prosperous economy.” For instance, individuals, like countries,
should discover their comparative advantage and invest in
acquiring human capital. Finally, the authors include a helpful
glossary of economic terms.
While some readers will find the book disappointing, many
more, I believe, will find it a useful guide to better understanding the world around them. If so, the publishers can be forgiven
for the hyperbolic title.
— AARON STEELMAN

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Page 52

DISTRICT ECONOMIC OVERVIEW
BY A N D R E A H O L M E S

he Fifth District economy
expanded at a steady pace in
the first quarter of 2006.
Payroll employment advanced at a
healthy clip, and the unemployment
rate receded sharply in all District
jurisdictions. Brisk growth occurred
despite some moderation in activity
within services establishments and
residential real estate markets. Also
encouraging, manufacturers noted a
sharp turnaround, with nearly all
measures of output strengthening late
in the quarter.

was apparent across all District states,
with only South Carolina posting a
jobless rate above the national level of
4.7 percent.

Labor Markets on Track

Services Growth Moderates

In the first quarter, District payroll
employment was 1.8 percent higher
than a year earlier, outpacing the 1.5
percent growth rate nationwide. The
bulk of the increase could be traced
back to stronger activity in the trade,
transportation, and utilities sector and
in education and health services businesses. Perhaps reflecting gains in
those industries, some Fifth District
contacts reported offering substantially higher wages to nurses and truck
drivers in order to address shortages of
qualified applicants in some areas.
The District’s unemployment rate
edged down to 4.1 percent in the first
quarter, despite strong expansion of
the civilian labor force. Improvement

Momentum in the Fifth District’s
services sector wound down somewhat
as the first quarter drew to a close.
Retail establishments in particular
noted a deceleration in activity following hefty growth at the beginning of
the year. Among retailers, sales were
flat at grocery stores and grew less
rapidly at big-box establishments,
reportedly because higher gasoline
prices caused some customers to
trim their purchases. Shopper traffic
and big-ticket sales also declined
noticeably in the first quarter, with
Fifth District contacts noting automobile and light truck sales as
particularly sluggish. News from
District service providers was less

T

The Fifth District
economy expanded at
a steady pace in the
first quarter of 2006.

Economic Indicators
1st Qtr.
2006
Nonfarm Employment (000)
Fifth District
U.S.
Real Personal Income ($bil)
Fifth District
U.S.
Building Permits (000)
Fifth District
U.S.
Unemployment Rate (%)
Fifth District
U.S.

52

4th Qtr.
2005

Percent Change
(Year Ago)

13,579
134,722

13,513
134,161

1.8
1.5

901.6
9,354.8

892.1
9,272.3

2.0
2.1

63.9
492.3

56.5
480.0

10.3
4.9

4.1%
4.7%

4.7%
4.9%

Region Focus • Summer 2006

glum — revenues advanced, but at a
slower pace.

Residential Real Estate Slows
Residential real estate activity slowed
in the first quarter, with home sales
declining 5.6 percent compared to
modest growth in late 2005. Reports
from District real estate agents were
generally in line with the latest data.
One agent in Washington, D.C., said,
“It’s definitely a buyers’ market and they
[the buyers] are holding off.” Consistent
with the slowdown in demand across
the District, the pace of home price
appreciation also cooled in many areas.
First-quarter home prices in the District
were only 8.6 percent higher compared
to a quarter earlier, marking the first
period of single-digit appreciation in
two years.

Manufacturing Rebounds
District manufacturing conditions
rebounded strongly in the first quarter.
Indicators that were generally subdued
in January, such as factory shipments,
new orders, and employment, were
growing briskly by the end of the quarter. Highlighting the turnaround, the
March readings of the above measures
were the strongest in two years. Sizable
increases in capacity utilization, vendor
lead time, and employment were also
reported by District manufacturers
over the period. Among industries,
some of the largest gains were again
reported by producers of electronics
and electric equipment.
Manufacturers also reported that
the pace of growth in raw materials
and finished goods prices was more
measured in March, following a sharp
uptick earlier in the year. Some manufacturers, however, noted an increased
difficulty in passing higher costs to
their customers. A North Carolina
furniture manufacturer, for instance,
said that the higher fuel surcharges he
was facing on raw materials deliveries
were “eating into profits.”

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Page 53

Nonfarm Employment

Unemployment Rate

Real Personal Income

Change From Prior Year

First Quarter 1993 - First Quarter 2006

Change From Prior Year

First Quarter 1993 - First Quarter 2006

First Quarter 1993 - First Quarter 2006

4%

8%

8%

7%

6%

7%

3%

5%

2%
6%

4%

1%

3%

5%
0

2%

-1%

4%

1%

3%

-1%

0%

-2%
93

95

97

99

01

03

05

93

95

97

99

01

03

Fifth District

05

93

95

97

99

01

03

05

United States

Nonfarm Employment
Metropolitan Areas

Unemployment Rate
Metropolitan Areas

Building Permits

Change From Prior Year

First Quarter 1993 - First Quarter 2006

First Quarter 1995 - First Quarter 2006

Change From Prior Year

First Quarter 1993 - First Quarter 2006

8%
7%
6%
5%
4%
3%
2%
1%
0
-1%
-2%

30%

9%
8%

20%
7%
10%

6%
5%

0%

4%
-10%

3%
93

95

97

Charlotte

99

01

Baltimore

03

-20%

2%

05

93

Washington

95

97

99

Charlotte

FRB—Richmond
Services Revenues Index

01

Baltimore

03

95

05

FRB—Richmond
Manufacturing Composite Index

First Quarter 1996 - First Quarter 2006

First Quarter 1996 - First Quarter 2006

30

30

25%

20

20

10

10

0

0

-10

-10

-20

-20
00

02

04

06

-30

03

05

United States

First Quarter 2001 - First Quarter 2006

30%

98

01

Change From Prior Year

40

96

99

House Prices

40

-30

97

Fifth District

Washington

MD
NC
SC

VA
WV
DC

20%
15%
10%
5%
96

98

00

02

04

06

0%

01

02

03

04

05

NOTES:

SOURCES:

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

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

Summer 2006 • Region Focus

06

53

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Page 54

STATE ECONOMIC CONDITIONS
BY A N D R E A H O L M E S

District of Columbia
conomic activity in the District of Columbia continued
to gain momentum in early 2006. The first quarter saw
a pickup in payrolls as well as a decline in the jobless rate.
On the business front, venture capital investment was
robust, but the residential real estate market advanced at a
slower pace.

E

DC Unemployment Rates by County, Q1:06

Percent
3.4 or Lower
3.5 - 5.4
5.5 - 7.4
7.5 - 9.4
9.5 or Higher

District of Columbia payrolls expanded 3.2 percent in
the first quarter of 2006, the strongest quarterly gain
posted since 2001. Robust first-quarter job growth in nearly
all industry sectors, particularly professional and business
services, offset modest job losses at education and health
services and government establishments.
Indicators of household labor market conditions, such as
the unemployment rate, also showed improvement in the
first quarter. The jobless rate posted a 0.7 percentage point
drop to a seasonally adjusted 5.3 percent in early 2006.
Also positive, personal income continued to expand in
the first quarter. Compared to a year ago, incomes stood
2.4 percent higher in the District of Columbia.
Measures of private investment into District of
Columbia businesses were also encouraging. First-quarter
venture capital activity rebounded strongly, with the most
recent data showing a $29.3 million increase in venture
investment between January and March of this year,
exceeding the investment level for all of 2005.
The District of Columbia’s residential real estate market,
however, showed signs of cooling. First-quarter sales of existing homes were flat compared to the quarter earlier and 18.2
percent below last year’s level. The slowdown in demand was
reflected in slower home price growth. District of Columbia
recorded price acceleration of only 6.0 percent, marking the
first period of single-digit growth in nearly three years.
54

Region Focus • Summer 2006

U Maryland
aryland’s economy grew on pace in the first quarter.
The latest economic reports showed a rebound in job
numbers and continued strength in household finances.
Private investment into state businesses, however, expanded
at a somewhat slower clip, and residential real estate
activity was more restrained than in late 2005.
According to the Bureau of Labor Statistics, business
hiring in Maryland continued to accelerate in the first quarter. Payrolls expanded 1.4 percent, equal to 8,800 jobs. By
sector, the bulk of the job creation occurred on the services
side of the economy, with only information and leisure and
hospitality establishments reporting losses. Payrolls were
also boosted at goods-related businesses, with the exception
of factory jobs, which were trimmed in the first quarter.
Matching the pickup in hiring, first-quarter personal
income expanded 2.6 percent from a year earlier, and state
households reported a decline in the share of unemployed.
Maryland’s first-quarter jobless rate came in at 3.5 percent,
well below measures from the prior quarter and a year earlier.
Compared to the state, unemployment at the county
level was mixed, with the lowest rates recorded in the counties within the Baltimore-Washington Corridor. Baltimore
City posted a low 3.9 percent jobless rate, but the strength
of the measure is due in part to the city’s labor participation
rate, which is much lower than in the surrounding counties.
Maryland’s residential real estate market advanced at a
more conservative pace in early 2006. Sales of existing
housing units dropped 1.9 percent in the first quarter and
new permit growth fell 12.9 percent. Demand for housing,

M

MD Unemployment Rates by County, Q1:06

Percent
3.4 or Lower
3.5 - 5.4
5.5 - 7.4
7.5 - 9.4
9.5 or Higher

however, remained strong enough to boost prices by 13.3
percent in the first quarter, the largest quarterly jump
recorded districtwide.

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Page 55

First-quarter venture capital investment into Maryland,
another measure of business activity, failed to match the
fourth-quarter level but remained well above the year-ago
amount. Early 2006 inflows totaled $95.7 million, double the
level recorded a year earlier.

NC Unemployment Rates by County, Q1:06

h

Percent

North Carolina

conomic conditions in North Carolina advanced
steadily in the first quarter. Signals from labor markets
were generally upbeat, and indicators of business and
household conditions were positive across the board. Real
estate conditions were more muted, with a pullback in
demand cooling price acceleration.
North Carolina posted the strongest net employment
gain among District states in the first quarter, with jobs
increasing by 23,800. Goods-producing firms trimmed
payrolls, with the exception of construction establishments, which added more than 2,200 jobs. By comparison,
first-quarter employment growth was more widespread
at services companies, with losses recorded only in the
information and financial activities sectors.
Measures of activity at North Carolina households were
also encouraging. Reflecting strong payroll expansion,
personal income rose 0.9 percent in the first quarter,
matching activity recorded in the fourth quarter, and the
jobless rate declined significantly. The share of unemployed persons in the labor force fell 0.7 percentage point
to 4.5 percent, marking a return to the state’s prerecession
level. As shown in the map, areas of high unemployment
are still scattered throughout the state, but unlike South
Carolina and West Virginia, the jobless rate remains under
9.5 percent in each county.
The latest indicators of business activity in North
Carolina strengthened, with venture capital investment
coming in just over the $100 million mark in the first quarter. At $103 million, the first-quarter reading slightly
outpaced late 2005 measures but fell a little short of the
year-ago level. Compared to other District states, North
Carolina attracted the bulk of the first-quarter funding —
accounting for more than 35 percent of districtwide
inflows.
The most recent data suggested further moderation
in North Carolina’s residential real estate market.
First-quarter sales of existing housing units contracted
3.2 percent, marking the first quarterly decline since
late 2004. Moderating demand has also slowed the
rate of appreciation of North Carolina’s housing stock.
Home prices increased only 6.9 percent in the first
quarter after growth, peaking at 11.8 percent during the
previous period.

E

3.4 or Lower
3.5 - 5.4
5.5 - 7.4
7.5 - 9.4
9.5 or Higher

o South Carolina
A

long-awaited firming of economic conditions in South
Carolina appears to be underway. First-quarter
measures of labor market activity advanced steadily, and
financial conditions at South Carolina households and
businesses remained on track. Residential real estate
markets showed some signs of moderation, falling in line
with reports from most other District states.
South Carolina payrolls advanced 3.8 percent in the first
quarter, the strongest quarterly growth rate districtwide.
By sector, the strongest job gains were recorded at trade,
transportation, and utilities, education and health services,
and construction establishments. By comparison, the
largest loss occurred among professional and business
services firms, the state’s largest industry sector.
The upturn in job growth over the last year aided South
Carolina household finances, as personal income expanded
at a 2.0 percent annual rate in the first quarter. Steady
payroll expansion was also reflected in South Carolina’s
first-quarter unemployment rate, which edged 0.8 percentage point lower to 6.4 percent, the lowest reading in
approximately three years. Notwithstanding the firstquarter improvement, South Carolina still recorded the
highest jobless rate districtwide, with more than half of
the state’s counties posting unemployment rates in excess
of 7.5 percent.
News from South Carolina’s residential real estate
markets was somewhat less encouraging. First-quarter
existing home sales moderated 8.8 percent from the fourthquarter level, though new permit applications expanded
briskly. The abatement in sales slowed the rate of home
price appreciation, which moved up only 7.6 percent in
the first quarter, the lowest quarterly appreciation rate
recorded since mid-2004.

Summer 2006 • Region Focus

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Page 56

SC Unemployment Rates by County, Q1:06

Percent
3.4 or Lower
3.5 - 5.4
5.5 - 7.4
7.5 - 9.4
9.5 or Higher

Growth of Virginia’s residential real estate market was
also limited in early 2006. Compared to year-ago levels,
new building permit authorizations rolled in at a slightly
higher pace but first-quarter existing home sales declined
17.7 percent. Moderation in demand was also apparent when
viewed against data from the fourth quarter of 2005 — home
sales were down 10.4 percent.
The slowdown in demand further dampened the pace of
home price acceleration in Virginia. First-quarter home
prices were 11.2 percent higher compared to late-2005,
marking the third quarter of a deceleration in growth,
following the 25.3 percent peak reached in mid-2005.

VA Unemployment Rates by County, Q1:06
Percent

Other indicators from South Carolina’s business front
were more upbeat. Venture capital funding, for instance,
rebounded in the first quarter. Inflows totaling $9.7 million
were recorded, a significant increase from the flat activity
recorded in the last three out of four quarters.

3.4 or Lower
3.5 - 5.4
5.5 - 7.4
7.5 - 9.4
9.5 or Higher

u Virginia
irst-quarter measures of Virginia’s economy moved
forward at a steady pace compared to the previous
period. Employment and household conditions advanced
steadily, though indicators of activity at Virginia businesses
and within the residential real estate markets were less
robust.
Virginia firms boosted payrolls 1.1 percent the first three
months of 2006, following a 2.0 percent gain in late 2005.
The first-quarter addition of 5,733 new construction jobs
helped offset losses in Virginia’s other industry sectors,
including information and financial activities, where firstquarter payrolls were trimmed by more than 1,000 each.
Financial conditions at Virginia households also brightened. First-quarter personal income measures were generally
on track, with Virginia incomes rising 2.5 percent in the first
quarter of the year. Additionally, the overall pickup in hiring
at Virginia businesses was reflected in the first-quarter jobless rate, which declined 0.4 percentage point to 3.0 percent,
the lowest unemployment rate districtwide. As illustrated in
the chart, 85 percent of the Fifth District counties boasting
a jobless rate under 3.5 percent hail from Virginia.
First-quarter reports from state businesses were less favorable. Virginia recorded a decline in venture capital inflows,
tracking districtwide and national activity. In terms of
attracting capital, Virginia’s $55 million first-quarter influx
was nearly two-thirds less than the fourth-quarter amount
and marked the smallest quarterly inflow in nearly two years.

F

56

Region Focus • Summer 2006

w West Virginia
he most recent data suggest that West Virginia’s
economy remained generally on track in early 2006.
The state’s labor market tightened further, despite limited
first-quarter payroll growth. Outside of labor market
activity, household indicators were more upbeat than
measures of business activity, and signs of moderation
became more pronounced in the residential real estate
markets.
First-quarter payroll activity was generally flat in West
Virginia. Employment losses at natural resources and
mining, construction, education and health services, and
leisure and hospitality establishments dampened overall
growth, resulting in a net gain of only 67 jobs during the first
three months of the year.
Household financial conditions in West Virginia were
more upbeat. Personal income advanced 1.3 percent in early
2006, bringing total annual growth to 1.8 percent. By comparison, districtwide annual income growth was slightly
higher, amounting to 2.0 percent.
Also suggesting a rosier outlook for households,
West Virginia’s labor market continued to tighten in early

T

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WV Unemployment Rates by County, Q1:06

Percent
3.4 or Lower
3.5 - 5.4
5.5 - 7.4
7.5 - 9.4
9.5 or Higher

2006 despite the limited rise in payrolls. According to the
Bureau of Labor Statistic’s household employment survey,

the state’s jobless rate dropped one full percentage point to
3.9 percent, marking the lowest unemployment rate recorded over the 30-year history of the data series. As shown in
the chart, however, pockets of high unemployment are still
prevalent across the state. For example, at 9.5 percent,
Wirt County posted the highest nonseasonally adjusted
jobless rate statewide in the first quarter.
Compared to household activity, certain indicators of
business activity in West Virginia were less encouraging. For
example, first-quarter venture capital inflows were flat,
following a surge of $1.6 million in late-2005.
West Virginia’s latest home sales data also moderated.
According to the National Association of Realtors,
first-quarter home sales were 3.3 percent below the fourthquarter level and 7.4 percent below the year-ago level.
The pullback in West Virginia home sales appears to have
dampened home price growth. First-quarter prices increased
only 4.4 percent, the smallest quarterly gain in three years.

Behind the Numbers: Why So Many Indicators?
economists right now are skeptical that an inverted yield
Predicting the direction of the economy can look easy somecurve means we’re headed into recession, even though the
times. During much of the 1990s, for example, multiple
curve has predicted many downturns.
economic indicators were sending consistent signals. By the
Economists use time-series models to help them forecast
end of the decade, though, things were less certain. Many
future economic performance, plugging in an array of
economic forecasters were slow to see the technology crash
data from different indicators.
and the 2001 recession that
Up and Down: Output and Employment
But even after gleaning the
followed it.
Don’t Always Track Closely
computer-generated results, ecoThe difficulty in identifying
Percent Change
Percent Change
8
8
nomists usually take a closer look
economic turning points is the
7
7
at individual variables. “It may be
reason why economists watch an
6
6
that individual indicators are sugarray of indicators instead of rely5
5
gesting that something unusual is
ing on just one or two. For one
4
4
going on that might not be
thing, indicators don’t always
3
3
getting picked up in the mechanmove together closely. Recently,
2
2
1
1
ical forecasting process,” says,
for example, employment has
0
0
Matthew Martin, an economist
grown more slowly than output.
-1
-1
at the Richmond Fed’s Charlotte
And sometimes even indicators
GDP
-2
-2
Nonfarm Employment
branch.
that are supposed to be tracking
-3
-3
To deal with all this uncerthe same sector of the economy
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
tainty, economic forecasters
don’t tell the same story, such as
SOURCES: Bureau of Economic Analysis and Bureau of Labor Statistics
create multiple scenarios as a way
when the so-called “payroll” and
to highlight potential risks: What if home prices follow a
“household” employment surveys contradict each other.
different path than expected? What if energy prices begin to
Then there are cases when indicators behave differently
pass through to core price indexes? Granted, you might not
across business cycles. As mentioned above, employment
want to respond to every wiggle. But any one of these indihas recovered relatively slowly since the last recession. This
cators could make a difference, which is why all of them are
is in contrast to many previous recoveries. One explanation
analyzed. “More information is always better,” Martin says.
is that women are no longer entering the labor force at the
— DOUG CAMPBELL
same strong rate as in years past. Additionally, a lot of

Summer 2006 • Region Focus

57

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Page 58

State Data, Q1:06
DC

MD

NC

SC

VA

WV

690.7
3.2
1.5

2,575.9
1.4
1.5

3,961.1
2.4
1.8

1,889.3
3.8
1.9

3,710.8
1.1
2.1

751.1
0.0
1.2

2.1
14.0
-6.1

138.7
-2.1
-2.3

562.9
-0.9
-1.3

258.1
-0.4
-2.7

295.7
0.8
-0.7

61.5
0.7
-1.4

Professional/Business Services Employment (000) 152.1
Q/Q Percent Change
10.0
Y/Y Percent Change
3.1

388.5
1.1
2.2

450.3
0.7
2.4

201.6
-17.0
2.4

619.7
0.3
3.8

59.5
1.1
1.9

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

231.4
-1.7
-0.8

467.7
0.6
1.3

674.3
3.6
1.9

333.6
1.7
2.5

664.7
-0.3
1.2

144.1
1.0
0.1

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

293.5
0.3
-2.0

2,971.5
2.3
2.1

4,371.6
0.2
1.7

2,103.5
-0.1
2.0

3,976.7
1.6
2.0

808.9
2.2
1.8

Unemployment Rate (%)
Q4:05
Q1:05

5.3
6.0
7.0

3.5
4.0
4.2

4.5
5.2
5.1

6.4
7.2
6.6

3.0
3.4
3.4

3.9
4.9
4.8

Personal Income ($bil)
Q/Q Percent Change
Y/Y Percent Change

27.5
1.3
2.4

214.1
1.0
2.6

240.4
0.8
0.9

110.0
1.1
2.0

264.6
1.3
2.5

45.0
1.3
1.8

1,327
1,795.2
134.9

6,291
-12.9
-18.8

26,517
95.0
19.7

14,474
76.5
14.4

13,806
16.3
2.6

1,472
276.1
10.2

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

618.6
6.0
20.8

509.4
13.3
20.5

315.0
6.9
8.3

299.5
7.6
9.1

450.6
11.2
18.1

226.6
4.4
10.6

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

10.8
0.0
-18.2

126.4
-1.9
-6.5

231.6
-3.2
17.0

112.0
-8.8
7.3

154.4
-10.4
-17.7

35.2
-3.3
-7.4

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

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

NOTES:
Nonfarm Employment, thousands of jobs, seasonally adjusted (SA) Bureau of Labor Statistics (BLS)/Haver Analytics, Manufacturing, thousands of jobs, SA; BLS/Haver Analytics, Professional/Business Services, thousands of jobs, SA; BLS/Haver Analytics,
Government, thousands of jobs, SA; BLS/Haver Analytics, Civilian Labor Force, thousands of persons, SA; BLS/Haver Analytics, Unemployment Rate, percent, SA; BLS/Haver Analytics, Personal Income, billions of chained 2000$, Bureau of Economic
Analysis/Haver Analytics, Building Permits, number of permits, NSA; U.S. Census Bureau/Haver Analytics, House Price Index, 1980=100, NSA, Office of Federal Housing Enterprise Oversight/Haver Analytics, Sales of Existing Housing Units, thousands of units,
SA; National Association of Realtors®

58

Region Focus • Summer 2006

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Metropolitan Area Data, Q1:06
Nonfarm Employment (000)
Q/Q Percent Change
Y/Y Percent Change
Unemployment Rate (%)
Q4:05
Q1:05
Building Permits
Q/Q Percent Change
Y/Y Percent Change

Washington, DC MSA

Baltimore, MD MSA

Charlotte, NC MSA

2,937.4
-3.6
2.6

1,277.8
-8.4
1.7

800.1
-3.3
2.6

3.0
3.0
3.7

4.0
3.9
4.9

4.7
4.9
5.4

8,691
160.2
4.7

2,377
-20.7
13.2

6,148
85.5
29.9

Raleigh, NC MSA
Nonfarm Employment (000)
Q/Q Percent Change
Y/Y Percent Change
Unemployment Rate (%)
Q4:05
Q1:05
Building Permits
Q/Q Percent Change
Y/Y Percent Change

Unemployment Rate (%)
Q4:05
Q1:05
Building Permits
Q/Q Percent Change
Y/Y Percent Change

Columbia, SC MSA

274.2
1.0
2.5

285.6
2.8
4.4

359.1
-0.4
2.9

3.8
4.0
4.4

5.2
5.4
5.6

5.6
5.8
5.9

1,179
188.0
7.4

2,566
45.6
1.7

2,057
117.4
13.6

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

Charleston, SC MSA

Richmond, VA MSA

Charleston, WV MSA

757.9
-6.8
2.0

618.3
-3.7
2.0

147.7
-5.4
0.9

3.7
3.7
4.4

3.4
3.3
3.9

4.6
4.1
5.9

2,310
-47.9
-4.8

2,319
44.5
-17.8

84
57.4
23.5

For more information, contact Andrea Holmes at 804-697-8273 or e-mail Andrea.Holmes@rich.frb.org.

Summer 2006 • Region Focus

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OPINION
Mixing Banking and Commerce
BY J O H N R . WA LT E R

any U.S. firms include both commercial and nonbank financial units. For example, Ford Motor
Co. encompasses not only units that manufacture automobiles but also those, such as Ford Motor Credit,
that gather funding and make loans to individuals. Firms
that handle both commercial and financial activities appear
to reap significant benefits which create the appeal of
such combinations. One byproduct of a commercial firm’s
activities may be information about its customers’ financial
situation. The financial affiliate might then use this
information to inexpensively target products to particular
customers, benefiting both the financial firm and its
customers, an activity commonly know as cross-selling.
While finance-commerce combinations are widespread,
combinations between banks and commercial firms typically are prohibited. But the law does provide a loophole
that allows nonfinancial firms to engage in a limited range of
banking activities. It is through this well-traveled loophole
that retail giants Wal-Mart and Home Depot recently have
submitted applications to form or buy banks.
These applications have focused a great deal of attention
on the controversial combination of banking and commerce.
The merits of the specific Wal-Mart and Home Depot applications aside, this may be a good time to ask why
banking-commerce combinations are typically prohibited in
the first place.
The Bank Holding Company Act of 1956 prohibits
commercial firms from owning banks. This keeps manufacturers and operators of retail stores, for example, from
purchasing banks. The Gramm-Leach-Bliley Act, enacted in
1999, opened the opportunity for banks to be owned by
companies engaged in the financial activities of securities
dealing and insurance, but did not allow bank ownership to
nonfinancial commercial firms.
The Bank Holding Company Act, however, does allow
commercial companies to own industrial loan corporations
(ILCs), or industrial banks. These institutions are funded
with Federal Deposit Insurance Corp.-insured deposits but
typically do not offer checking accounts to businesses.
(Wal-Mart wants to create an industrial bank and Home
Depot wants to buy one.)
According to a Government Accountability Office study,
there were 57 industrial banks at the end of 2004. They held
$140 billion in assets, and about 3 percent of all insured
bank deposits. While many are owned by financial firms, a
number are owned by commercial firms such as the automotive company BMW and retailer Target Corporation.
Why are banking-commerce combinations controversial? Observers have at times raised concerns over conflicts
of interest that might arise if banks and commercial

M

60

Region Focus • Summer 2006

companies are owned by the same firm. They argue that
such concerns justify keeping banking and commerce
separate. While this argument takes several forms, the
most frequent is that a bank affiliated with a commercial
firm would tend to deny loans to the affiliate’s competitors.
Under this scenario, a bank with a commercial affiliate —
say, a restaurant — would not wish to provide funding to
competing restaurants. Helping the competitor would
tend to lower the profits of the affiliated restaurant.
On the other hand, if competition is reasonably strong —
and there is every reason to think that today’s banking
markets are quite competitive — denying loans to competitors only lowers overall profits of the consolidated
banking-restaurant firm. If there are alternative lenders
over which the affiliated bank has no price advantage, the
competing restaurant would receive a loan regardless at the
same interest rate the affiliated bank would offer. So, by
failing to make the loan, the bank loses any profit it might
have made on that loan, hurting the bank. And the affiliated
restaurant gains no advantage.
Consequently, concerns regarding conflicts of interest
are probably insufficient justification for maintaining the
current wall separating banking and commerce and denying
firms the opportunity to benefit from combinations.
Nevertheless, there remains a hazard that could justify the
continued presence of the wall, or at least require that
significant precautions be taken if the wall is removed.
The hazard is that a combined company can be expected
under certain circumstances to withdraw resources from its
bank to hide problems in its commercial subsidiary, damaging bank safety. A holding company owning a bank and a
commercial entity can be expected to choose this course
when it can hide its commercial subsidiary losses from
investors and analysts by shifting commercial subsidiary
losses to the affiliated bank. Since bank assets are often
considered more opaque to outsiders than nonbank assets,
such losses might be better hidden if shifted to the bank. If
commercial firm losses can be expected to be shifted to
insured banks, and perhaps on to the FDIC, there may be
reason to prevent combinations.
Potential loss-shifting presents real risks to the public.
Stepped-up oversight could potentially mitigate those risks
and, as a result, allow us to remove the wall between banking
and commerce. For now, though, combinations through the
industrial bank loophole raise legitimate concerns for bank
regulators, and deserve careful consideration before being
approved.
RF
John R. Walter is a research economist at the Federal
Reserve Bank of Richmond.

Summer 06 Full CoversFINAL

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Page 3

NEXTISSUE
Corporate Headquarters

Interview

In the competitive world of regional economic development,
there are few bigger prizes than landing a corporate headquarters. But how big is the economic impact of a headquarters,
and how do business executives make their location decisions?
We explore these questions and analyze the role of incentives
in attracting and retaining corporate headquarters.

We talk with Martin Baily, chairman of
the Council of Economic Advisers under
President Clinton and now a senior
fellow with the Institute for International
Economics.

Federal Reserve

Electricity Deregulation
Deregulation of retail power providers was supposed to
lower prices for consumers. But with rates in some recently
deregulated states rising instead of easing, there is a growing
perception that retail competition programs are failing.
Maryland, Virginia, and the District of Columbia have
already begun deregulation. How long will residents have to
wait until the intended benefits materialize?

How Charlotte, N.C., became one of the
nation’s leading banking centers.

Research Spotlight
Economists investigate the role culture
plays in economic growth.

Students and Credit Card Debt
The average college student carries a $2,200 credit card
balance, causing much consternation among some observers.
We look into whether youth debt is the problem it’s sometimes
cracked up to be, or a natural — and useful — tool for students
to smooth consumption as they transition from school to work.

Organic Food Market
Demand for organic foods is growing quickly, but domestic
farmers are meeting only a small share of it, with most goods
coming from abroad. Does it make economic sense for farmers
in the Fifth District and beyond to go organic?

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

Coming Soon: Check out our
new online weekly update
The Fall 2006 issue will be
published in October.

Summer 06 Full CoversFINAL

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Page 4

The Economics of Household Borrowing

T

hroughout American history,
credit typically has been seen as
a good thing, while debt has had
more negative connotations. Are
these perceptions valid? And are
today’s Americans “drowning” in
debt? Not necessarily, if you’re looking at the economics of borrowing.
From that vantage point, the story is
quite different.

In the Federal Reserve Bank of Richmond’s 2005 Annual Report
feature article, “Borrowing by U.S. Households,” the Bank’s
Director of Research John A. Weinberg looks at the recent history
of borrowing in the United States and suggests that the expansion of
credit has been beneficial to most people. Generally, households
make forward-looking borrowing decisions, which allow them to
smooth their consumption over time. Improved technology and
increased competition have driven down the average costs of
borrowing, making it easier for households to service their debt.
Not all consumers make wise borrowing decisions, however, and as
a result greater focus on financial education may be an appropriate
policy response.
The Annual Report also includes messages from the Bank’s president
and senior management, a report on the Fifth District economy, and
an overview of the Richmond Fed’s 2005 financial activity.
The 2005 Annual Report is available free of charge by contacting:
Public Affairs
Federal Reserve Bank of Richmond
P.O. Box 27622
Richmond, VA 23261
Phone: 804-697-8109
Email: Research.Publications@rich.frb.org
Or by accessing the Bank’s Web site at www.richmondfed.org/publications

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

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PERMIT NO. 2

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