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Winter 07 Full Coverv7

2/28/07

WINTER

4:42 PM

Page 1

2007

THE

FEDERAL

RESERVE

BANK

Stock Options
Economics Meets Accounting

• Interview with Robert Fogel
• How Richmond Won a Reserve Bank
• 1970s Inflation: Bad Luck or Bad Policy?
• Milton Friedman Remembered

OF

RICHMOND

Winter 07 Full Coverv7

2/28/07

4:42 PM

Page 2

COVER STORY

16

Options on the Outs: The popularity of employee stock
options is expected to wane with the adoption of a new
accounting rule
Stock options can align employee and shareholder interests. But they
aren’t free to issue, despite the way firms have been allowed to report
them – until now.

FEATURES

23

Phoning It In: Telecommuting hasn’t become the
commonplace work alternative its advocates anticipated
Still, the flexibility it offers has helped a significant number of
companies and employees.
28

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.
DIRECTOR OF RESEARCH

John A. Weinberg

Opt In or Opt Out? Automatic enrollment increases
401(k) participation

EDITOR

Rational people should sign up for retirement plans in roughly the
same numbers regardless of whether the default is opt in or opt out.
But they don’t. Insights from behavioral economics help explain the
success of automatic enrollment.
32

Bringing in the Unbanked: Banks are increasingly turning
their attention to Hispanics without bank accounts

Aaron Steelman
SENIOR EDITOR

Doug Campbell
MANAGING EDITOR

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

Charles Gerena
Betty Joyce Nash
Vanessa Sumo
E D I TO R I A L A S S O C I AT E

If banks want their business, they must convince the unbanked that
the actual benefits of opening an account are larger, and the costs
smaller, than perceived.

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

36

Midlife Medicare: The case for reform heats up

Andrea Holmes
Matthew Martin
Ray Owens
CONTRIBUTORS

Health care markets have a host of fundamental economic problems.
Fixing Medicare will require facing those problems head on.
40

Bad Luck or Bad Policy? Why inflation rose and fell, and
what this means for monetary policy
The Fed generally gets credit for taming inflation during the
1980s. But some argue that falling prices were largely the result
of good fortune.

DEPARTMENTS

1 President’s Message/Policy Trumps Luck
2 Federal Reserve/A Division of Power
8 Jargon Alert/Pareto Efficiency
9 Research Spotlight/The Next Age of Globalization
10 Policy Update/Fed to Begin Paying Interest on Reserves
11 Around the Fed/Banks of All Sizes
12 Short Takes
44 Interview/Robert Fogel
50 Economic History/Rooftops and Retail
54 Book Review/Off the Books: The Underground Economy of the Urban Poor
56 District/State Economic Conditions
64 Opinion/Milton Friedman and Liberty

P H O T O : G E T T Y I M A G E S /A R T V I L L E B A 0 1 3

VOLUME 11
NUMBER 1
WINTER 2007

Clayton Broga
Joan Coogan
Robert L. Hetzel
Megan Martorana
Christian Pascasio
William Perkins
John R. Walter
Patricia Wescott
DESIGN

Ailsa Long
C I RC U L AT I O N

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

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

PRESIDENT’SMESSAGE
Policy Trumps Luck
n economic circles, the
1970s are known for the
period’s runaway inflation.
As the story goes, Federal
Reserve policymakers made
all the wrong moves in attempting to rein in prices. It took
the decisive actions of Fed
Chairman Paul Volcker, who was
willing to raise interest rates
sharply in order to finally arrest
inflation’s rise in the early 1980s,
ushering in the period known

I

as the Great Moderation.
It’s a good story, but it is not unchallenged. As Vanessa
Sumo’s article in this issue of Region Focus, “Bad Luck or
Bad Policy?” describes, some economists have argued that
both the Great Inflation of the 1970s and the Great
Moderation of the 1980s and onward resulted not so much
from unwise and then shrewd monetary policy, but rather
from luck — first bad and then good. According to this argument, in the 1970s, the United States suffered two energy
shocks, in 1973 and 1979, which sent the price of many goods
skyrocketing; the Fed may not have made all the right
moves, but it was essentially powerless to prevent inflation
from rising. Then, in the 1980s, oil prices stabilized and
subsequently fell. And in the 1990s, labor productivity
increased, thanks largely to advances in technology such
as computer power. This provided an environment in which
the economy could grow relatively rapidly and inflation
could fall steadily until it reached a level more in line with
historical norms. In that light, some claim that the low inflation and the two relatively short and mild recessions we’ve
experienced since then have had little to do with actions
of the Federal Open Market Committee (FOMC). All this
happened almost by accident, incidental to monetary policy.
Our article concludes that there is likely a role for both
luck and policy in this story. There can be no question that
the U.S. economy encountered problems as a result of the
energy shocks of the 1970s, and that this complicated the
mission facing the Federal Reserve. Likewise, subsequent
productivity improvements have been a great boon to the
economy and arguably made the Fed’s job easier. But in both
cases, the Fed was far from powerless. Fundamentally, it
retained the power to achieve low and stable inflation. But
before discussing the core issue of monetary policy more
fully, let me turn to another significant development that
has affected the U.S. economy recently: the productivity
improvements that have resulted from financial innovation.
Something of a revolution in unsecured credit began
in the 1980s and picked up steam in the 1990s. The same

period saw advances in mortgage and home equity lending.
Thanks to falling costs of computing and telecommunications, creditors became able to evaluate borrowers more
efficiently and effectively. Thus, credit became more widely
available, and on better terms, to more borrowers. Financial
innovations also encompassed the world of high finance,
with a host of new products coming to the wider market —
derivative contracts, swaps, and securities backed by all
sorts of assets.
What did all these innovations accomplish? They helped
households smooth consumption and, by extension, contributed to economic growth by reducing the volatility of
consumption relative to income and expense shocks.
Moreover, financial innovation seems to have played a role
in launching and sustaining the Great Moderation.
But as with our previous lessons, we must be careful not
to draw overly broad conclusions. Yes, the fruits of financial
innovation can be seen at the macroeconomic level in the
form of reduced real volatility. Certainly, such “lucky” economic shocks make a difference in output. But the full story
still must include a prominent place for monetary policy.
Through its policy actions, only the FOMC can fundamentally control inflation — and in so doing, it can also foster an
environment in which growth can occur.
During the 1970s, the economy and prices seemed to be
at the mercy of energy shocks. But in my view, the damage
need not have been nearly so great. Monetary policy during
the 1970s was excessively loose. The resulting surge in overall inflation raised expectations of yet further inflation. The
Fed accommodated energy price increases and let them pass
through to the prices of other goods and services. Had we
seen a more aggressive approach to confronting inflation, it
is reasonable to believe that we would have achieved both
lower inflation and faster economic growth.
In the debate over “luck vs. policy,” place me firmly in the
“policy” camp. Financial innovations and productivity
improvements are important to economic growth. But
these gains can easily be compromised by poor monetary
policy. By keeping inflation low and stable, good monetary
policy avoids the need for sharp movements in interest rates
that can add to volatility in real economic activity. The
improved economic performance of the last two and a half
decades demonstrate the importance of the Fed’s pursuit of
price stability.

JEFFREY M. LACKER
PRESIDENT
FEDERAL RESERVE BANK OF RICHMOND

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

1

FEDERALRESERVE
A Division of Power
BY C H A R L E S G E R E N A

During an intense
four months in
1914, America’s
central bank took
shape. How
Richmond won a
Reserve bank

A

pril 2 had a special meaning
for Richmonders in the years
following the Civil War. It was
that date in 1865 when Southern
soldiers fled the Confederate capital
as Union troops approached, setting
fire to tobacco warehouses and bridges
during their retreat. The ensuing conflagration and looting that followed
the next morning left smoldering piles
of rubble where newspaper offices,
banks, and hotels once stood.
Almost a half century later, the
date would bring a feeling of vindication to a city that spent decades
recovering from that devastating fire
and the economic upheavals of the
Reconstruction era. On April 2, 1914,
it was announced that Richmond
would become one of 12 cities to serve
as a base of operations for the Federal
Reserve System.
The Fed’s formation culminated
years of debate over what kind of
central bank the United States needed
to avert liquidity problems and bank
failures in the future. Should the Fed
be governed by the private sector in
association with government officials
or by political appointees? Should
the Reserve banks have a high level
of autonomy or be mere branches

of a powerful central authority? For
various economic and political reasons, Congress decided on a regional
approach with the Federal Reserve
Act of Dec. 23, 1913.
That was only half the battle. For
the next three months, the Reserve
Bank Organization Committee made
some tough choices on the number of
Reserve banks, the boundaries of the
districts that the banks would serve,
and the headquarters city for each
district. The latter task attracted
formal petitions from 37 cities,
including Baltimore; Washington,
D.C.; Charlotte; Columbia, S.C.;
and Richmond.
Every contender had its merits, its
fierce supporters, its political levers.
While Richmond was smaller in
population compared with Baltimore
or Washington, the city loomed large in
the eyes of Southern businessmen.
This was reflected in the flow of capital
at the time. Richmond’s national
banks loaned $33.5 million to borrowers
in 13 Southern states as of January 1914,
more than any other community
in the country — except New Y
ork —
and four times greater than Baltimore
and Washington combined. This
historical connection likely gave the
River City an edge in gaining a
Reserve bank.

The Richmond Fed
opened the doors to its
first headquarters at
1109 East Main Street
in November 1914, less than
a year after the city’s
business leaders began their
bid for a Reserve bank.

2

R e g i o n F o c u s • Wi n t e r 2 0 0 7

The Reserve Act designated who
would serve on the organization committee: Treasury Secretary William
McAdoo, Agriculture Secretary David
Houston, and Comptroller of the
Currency John Williams. (Williams
wasn’t confirmed by the U.S. Senate
until mid-January so he missed the
early stages of the committee’s work.)
While all eyes focused on these men,
the initial preparation of a districting
plan fell to a group of experts led by
Henry Parker Willis, an economist

PHOTOGRAPHY: VALENTINE MUSEUM/RICHMOND FED ARCHIVES

The Conflict

who helped Congress craft the Reserve
Act and would later serve as secretary
for the first Federal Reserve Board.
The committee’s mandate was clear
but the path to meeting that mandate
was not. The only criteria were a few
paragraphs in the enabling legislation.
For example, each Reserve bank
district had to open with at least
$4 million in paid-in capital from its
member banks. That may not sound
like much by today’s standards, but
the average resources of state and
national banks in 1915 amounted to
just $916,000 per institution. The
Reserve Act required member banks to
pay 6 percent of their resources into
the new central bank, or $54,960
per institution based on the average
capitalization at that time. So, it would
take about 73 banks of average size to
put a Reserve bank over the $4 million
threshold.
That made drawing district lines
tricky. Banking resources were
concentrated in the Northeast, necessitating the division of the region into
several smaller districts to prevent any
one Reserve bank from commanding
too much capital at the expense of
other banks. The reverse was true on
the West Coast — economic activity
was spread out so the district boundaries had to be drawn as broadly as
possible to ensure that each bank was
large enough to serve its constituents.
In addition, there had to be at
least eight Reserve bank districts, but
no more than a dozen. Here, the tension between a centralized and a
regional system of central banking
reasserted itself.
Prominent bankers in large cities
wanted the minimum number of districts, with New Yorkers advocating a
Reserve bank in their city that controlled most of the Northeast and
seven other banks with less power and
geographic scope. They felt a dominant New York Fed was necessary in
order to win the respect of the financial community abroad.
Businessmen in smaller and more
rural communities who wanted their
interests served by the nation’s new
central bank had the opposite view.

They wanted as many Reserve banks as
possible, evenly distributed throughout
the country and roughly the same size.
Advocates of this approach also included populists like William Jennings
Bryan; Treasury Secretary McAdoo,
who feared a dominant New Y
ork Fed
would overshadow the other Reserve
banks; and Henry Willis, who felt each
Reserve bank needed to be strong and
self-supporting.
Also, a regionally balanced central
bank would be better positioned to
address seasonal imbalances between
supply and demand in regional capital
markets. According to University of
Idaho economists Jon Miller and
Ismail Genc, rediscounting commercial paper was the primary tool of
monetary policy, given the rigidities of
using the gold standard to regulate the
money supply. “At times of high loan
demand, regional Reserve banks could
accept commercial paper owned by
member banks as collateral for loans
to them to expand the reserve base,”
they wrote in a 2002 article.
Ultimately, neither side of the
debate got everything they wanted.
Twelve districts were drawn and the
capital paid into the Federal Reserve
System was divided as evenly as possible, but the New York Fed still ended
up with more capital than the four
smallest Reserve banks combined.
The New York Fed wasn’t as large as its
supporters wanted — that would have
resulted in one bank commanding
about half of the system’s total capitalization — but it still ended up being
the largest and the most influential. Its
vaults have held gold reserves for foreign countries since 1924, its president
assumed a permanent spot on the
Federal Open Market Committee in
1943, and its domestic trading desk has
conducted the Fed’s open market
operations since the 1920s.
Finally, the Reserve Act required
that “districts shall be apportioned
with due regard to the convenience
and customary course of business.”
Railroad and telegraph lines had to
connect each Reserve bank city with
the communities it served so that
checks could be delivered for clearing,

member banks could present their
collateral in person for loans of
reserves, and bank employees could
keep abreast of credit conditions.
At the Reserve Bank Organization
Committee’s first official meeting
on Dec. 26, 1913, McAdoo and
Agriculture Secretary Houston
decided to focus on three factors when
choosing a Reserve bank location: geographical convenience to member
banks, the industrial and commercial
development needs of communities
within a district, and the established
custom and trend of business.
“In laying out the districts and
establishing the headquarters for
Reserve banks, every effort will be
made to disturb as little as possible
existing conditions, and to promote
business convenience and normal
movements of trade and commerce,”
noted McAdoo and Houston in a
statement released the next day.
“While the committee appreciates the
local pride and sentiment which are
prompting many cities to urge their
claims, [it must arrive] at sound conclusions through consideration of
fundamental and vital factors.”

The Prize
Even before the organization committee officially began its work, cities
began petitioning for a Reserve bank.
“Reserve cities are springing up all over
the United States,” Houston lamented
to President Woodrow Wilson in a
letter sent three days after the committee’s initial meeting. “Certainly nobody
could have imagined that so many
[cities] had strategic locations.”
Winning a Reserve bank was seen
as good for business, though its
precise economic impact was unclear.
According to David Hammes, an economist at the University of Hawaii at
Hilo, the responsibilities of the Federal
Reserve System weren’t fully known.
“Nobody knew what was being created,
not even the people on the committee,”
Hammes says. Some businessmen
confused the role of the Reserve banks
with commercial lenders.
Hammes adds, Uncle Sam didn’t
have the local presence and economic

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

3

impact that it has today. Therefore,
the creation of a regionally oriented
central bank represented one of
the first federal projects of national
scope, promising to bring some form
of government employment to communities, though the magnitude was
still to be determined.
Finally, having a Reserve bank nearby would provide a convenient source
of coin and currency, check handling,
and other services to commercial
banks. Among other things, this was
expected to benefit firms involved in
correspondent banking, which encompasses a variety of services that one
bank provides to another bank, such as
payments processing and foreign
currency settlement.
During the selection process,
McAdoo pointed out that the location of a Reserve bank in a city
wouldn’t be as important to their economic development as many assumed.
In retrospect, it is possible that access
to the Fed’s efficient check clearing
and discount window services indirectly helped businesses in the
immediate vicinity of a Reserve bank.
However, it is equally possible that
the Reserve bank cities were already
progressing more than other locales,
which is why they were chosen.
In Richmond’s case, its selection as
a Reserve bank site was credited for
elevating its status as a regional financial center. The city also had a lot
going for it economically in the early
20th century.
Despite the turmoil of the Civil
War and Reconstruction, Richmond
remained a center of trade and finance
in the “Old South.” James Dooley, a
wealthy railroad executive, described
the city in this manner in a letter to
Comptroller Williams. “Richmond is
still to all intents and purposes the capital of that great division of the United
States which lies between the Atlantic
Ocean and the Mississippi, south of
the Mason and Dixon’s line,” Dooley
wrote. “She is the capital city of their
business, the capital city of their banking, the capital city of their affections.”
Washington and Baltimore both had
commercial ties to the South and

4

R e g i o n F o c u s • Wi n t e r 2 0 0 7

retained many of its cultural traditions.
But Richmond was more closely identified with the region.
Also, goods and capital in the
South Atlantic tended to flow from
south to north. Therefore, a Reserve
bank in Richmond would be able to
accommodate those regional flows
and still be within reach of the
Northeast’s economic centers.

The Campaign
Even with these advantages,
Richmond initially wasn’t a contender
for a Reserve bank, according to a
book by Henry Willis in 1923 on
the central bank’s history. “In none
of the preliminary surveys of the
situation was the establishment of a
bank at Richmond, Va., ever seriously
considered,” he wrote.
Willis himself considered a
Richmond Fed “unnecessary” since
Reserve banks in Atlanta and
Philadelphia would be accessible to
most of the Southeast and MidAtlantic. “He thought he had the
Eastern Seaboard covered,” Hammes
notes, so having a Reserve bank in
Richmond “didn’t solve an economic
problem.”
Others believed that if the East
was to be divided into multiple
Reserve bank districts, Baltimore or
Washington were better suited for a
bank headquarters.
The Maryland Bankers Association
and other trade groups supported
Baltimore for several reasons. The port
town handled a large volume of foreign
trade, plus it was a center of domestic
trade in the South Atlantic region.
Supporters argued that the extent of
Baltimore’s trade within the region
wasn’t fully reflected in clearinghouse
data since a “tremendous volume” of
transactions was handled by jobbing
houses and manufacturing plants.
Bankers and businessmen in nearby
states said they had close financial ties
to Baltimore and wanted to expand
them. John Mayo, a Kentuckian who
helped develop the state’s coal and timber resources, was one of them.
“Baltimore has lent us money for the
development of our resources when we

could not get it anywhere else and when
New Y turned us down,” he said in a
ork
Baltimore Sun article. “If our paper is to
be rediscounted, we want it held in a
city in which we feel at home...”
The Washington Clearing House
Association and other organizations
believed their hometown deserved a
Reserve bank because of the city’s
prominence as the seat of the federal
government. Also, the bank would be
near the Treasury Department and the
Federal Reserve Board that was designated to manage the new central bank.
“If one of such banks be located in
Washington directly under the vision
of the Federal Reserve Board, that
supervisory authority can watch … the
work that is being carried on, note
how the bank serves the purpose for
which it is intended, and decide from
personal contact and observation what
rules and regulations are needed to
bring all such banks to a high state
of efficiency,” noted Henry McKee
of the Clearing House Association in
his testimony to the Reserve Bank
Organization Committee.
Oliver Sands, a prominent Richmond banker, initiated that city’s
lobbying efforts on Dec. 29, 1913, less
than a week after the Reserve Act was
enacted. He called a meeting of local
banks eligible for Federal Reserve
membership to discuss the idea of
having a district headquarters in
Richmond. Later that day, the Business
Men’s Club met to discuss the matter.
Both groups agreed to pursue a
Reserve bank, calling on representatives from the private and public
sector to form a joint “Committee on
Locating a Federal Reserve in
Richmond.” The committee coalesced
two days later, with Sands serving as
the chairman.
A corps of stenographers and
administrative assistants worked from
a conference room at the Business
Men’s Club to gather information and
send promotional literature to communities throughout the South Atlantic.
Teams of volunteers also toured
the region to convince local bankers.
George Seay, who worked for the joint
committee as a consultant and would

later serve as the first leader of the
Richmond Fed, gave several talks during an 11-day tour of the Carolinas.
Richmond managed to win over
many Carolinians, including the president of the North Carolina Bankers
Association and the former mayor of
Charleston, S.C. The support wasn’t
unanimous, however. Some Tar Heels
wanted a Reserve bank in Charlotte,
while others in the Palmetto State preferred Columbia. Eventually, both
cities mounted their own campaigns.
West Virginians were torn. Many
bankers in the Mountain State felt
more closely aligned with their neighbors in Ohio and Pennsylvania than
with Virginia and other South Atlantic
states. Wheeling, W.Va., bankers
wanted to be included in a Reserve
bank district along with Pittsburgh, a
city that it had economic ties with. In
January 1914, a poll of state and national banks in West Virginia revealed a
preference for a Reserve bank in
Pittsburgh or Cincinnati; Baltimore
was also a popular option, while
Richmond was the first choice of only
17 bankers.
Meanwhile, McAdoo and Houston
had to act quickly. The Reserve banks
were to be open for business by Nov.
16, 1914, less than a year after the
Reserve Act was enacted. So, during
six weeks in January and February, the
gentlemen and a small entourage visited 18 cities on a highly publicized
fact-finding mission, starting in New
York City and ending in Cleveland.
During their cross-country travels, a
stenographer recorded more than
5,000 pages of testimony from more
than 300 witnesses.
Representatives from Virginia and
the Carolinas traveled to the nation’s
capital on Jan. 15 to present
Richmond’s case. Several hundred
strong, the group greatly outnumbered other delegations from
Baltimore, Charlotte, and Columbia
which crowded into Williams’ office
at the Treasury Department during
three days of hearings in Washington.
(Williams, who was the assistant
Treasury secretary at the time, did not
stay for the hearings since he wasn’t

yet confirmed as Comptroller of the
Currency.)
Seay presented his brief, prepared in
just 18 days, outlining why Richmond
should have a Reserve bank. The thoroughness of the stat-heavy brief, as well
as of follow-up documents submitted
about a month later, reportedly
impressed McAdoo and Houston.
Backers of a Reserve bank in Charlotte
and Columbia were also apparently
swayed by Seay’s arguments, which
were published in a bound volume and

widely circulated. Those cities’ campaigns fizzled in the face of growing
support for Richmond.

The Fallout
Comptroller Williams joined McAdoo
and Houston to work on the committee’s plans for the rest of February and
all of March. On April 2, 1914, they
announced the fruits of their labor.
At the close of business that day,
a crowd gathered at the Richmond
offices of John L.Williams, a prominent

Popularity Contest
When the Reserve Bank Organization Committee wanted to take the pulse of the
banking industry in 1914, there were no toll-free numbers that bankers could call or
Web-based surveys they could answer. Instead, the Treasury Department mailed card
ballots to each of the 7,471 national banks that had formally accepted the terms of
membership in the new central bank system. The ballot asked for a first, second,
and third choice for the location of a Reserve bank that bankers preferred to be
associated with. “The ballots were gathered prior to designation of any district boundaries, so banks were unconstrained in their choice of cities,” noted University of Hawaii
at Hilo economist David Hammes in a September 2001 article in The Region, published
by the Minneapolis Fed. “Comments by committee members in the various cities indicate that they had access to the results of the balloting prior to both the completion of
their tour and their deliberations,” which ended on April 2, 1914, with their announcement of the Reserve bank district boundaries and headquarters cities.
In a statement released eight days later in defense of its decisions, the committee
members noted that bankers in North Carolina and South Carolina didn’t want to be
aligned with a Reserve bank located to their south or west. Instead, Carolinians
preferred Richmond, which was the obvious favorite of Virginian bankers.
Not surprisingly, bankers polled in the District of Columbia and Maryland wanted
a Reserve bank in Washington and Baltimore, respectively. But the committee
members chose not to locate a bank in one of those cities, in part, because either
would have been too close to the Philadelphia headquarters of the Third District. In
addition, “the industrial and banking relations of the greater part of the district were
more intimate with Richmond than with either Washington or Baltimore,” they wrote
in their statement.
South Carolina’s capital city, Columbia, was the first choice of 28 national banks in
the Palmetto State versus 11 for Richmond. But when the votes were added up, the
latter city came out on top by garnering more second-choice votes: 27 for Richmond
versus five for Columbia. Richmond also received far more first- and second-choice
votes than Baltimore, Washington, or Charlotte from banks in North Carolina and
Virginia. Baltimore did garner the most second-choice votes in West Virginia, placing
it behind Pittsburgh in the final tally.
The views of West Virginia’s bankers were especially divided, according to the
committee’s statement. So, the Northern Panhandle counties of Marshall, Ohio,
Brooke, and Hancock were placed in the Fourth District, where they had business ties
to the cities of Cincinnati and Pittsburgh. Those who had wanted to be associated with
a Reserve bank in either of those cities, however, were still disappointed because the
district’s headquarters was located in Cleveland. (Pittsburgh and Cincinnati were later
chosen as branch locations for the Fourth District.) The rest of West Virginia ended up
in the Fifth District.
— CHARLES GERENA

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

5

banker, to await news from his son, the
comptroller. Richmond’s mayor and
Virginia’s governor anxiously waited
with local bankers and businessmen to
hear the announcement.
E.L. Bemiss, comptroller Williams’
brother-in-law, kept his ear to the
phone “and conversation fell to a
whisper,” according to a news report
in the Richmond Times-Dispatch. Three
men stood by a map of the United
States to trace the boundaries of the
Reserve bank districts as they were
announced.
Finally, the call came from
Comptroller Williams at 6:30 p.m.
Bemiss relayed every word as
Williams announced the 12 Reserve
bank districts and boundaries one by
one. “There was a dramatic and
intense moment as the list of Reserve
Bank cities and their regions came
over the wire,” the Times-Dispatch
described. “When Richmond’s name
was called, bank presidents grasped
hands and held them while they
cheered together. Soon messenger
boys were struggling into the crowded
rooms with telegrams of congratulations from all sections of the country.”
Richmonders celebrated as if they
had gained a major league baseball
team or the Summer Olympics. The
next evening, the upscale Jefferson
Hotel hosted a mass meeting and

buffet dinner sponsored by the local
chamber of commerce.
Elsewhere, though, the selection
of Richmond and other Reserve bank
cities wasn’t as well received. New
York, Chicago, St. Louis, and San
Francisco were obvious choices for
Reserve banks. They were centers of
business and finance, had large populations, and were designated under
the National Bank Act of 1864 as
cities where national banks had to
maintain reserves equal to a percentage of their deposits. Other choices
were less obvious and subject to question. Baltimore and Washington,
D.C., were clearly disappointed. So,
too, were New Orleans and Denver.
City leaders in both towns thought
that they were deserving of a Reserve
bank. Denver, in particular, questioned the wisdom of placing a
Reserve bank in Kansas City, giving
Missouri two banks.
The Reserve Bank Organization
Committee offered a general explanation of how it drew district lines and
selected headquarters cities, from the
ability of a Reserve bank to assist businesses in its district to the district’s
economic track record and future
prospects. Still, accusations flew of
committee members playing politics.
Several Reserve bank cities had ties
to high-level members of the

Poll of National Banks, Top-Five Preferences for Reserve
Bank Cities by State
MD

1st & 2nd
Choice Votes

Baltimore
Philadelphia
Washington
New York
Pittsburgh
VA

97
25
25
15
6

1st & 2nd
Choice Votes

Richmond
Baltimore
Washington
New York
Philadelphia

104
58
45
7
7

NC

1st & 2nd
Choice Votes

Richmond
Charlotte
Baltimore
Washington
Philadelphia
WV
Pittsburgh
Baltimore
Cincinnati
Richmond
Washington

57
26
23
7
3

1st & 2nd
Choice Votes
54
53
39
28
13

SC
Richmond
Columbia
Baltimore
Washington
Charlotte
D.C.*

6

R e g i o n F o c u s • Wi n t e r 2 0 0 7

38
33
6
3
3
1st & 2nd
Choice Votes

Washington
Baltimore
New York
Philadelphia

*Only four cities in total received votes from national banks in the District of Columbia.
SOURCE: Reserve Bank Organization Committee, 1914

1st & 2nd
Choice Votes

12
10
1
1

Democratic Party, which was reinvigorated after taking control of Congress
in 1910 and the White House in 1912.
For example, Rep. Carter Glass, chairman of the House banking and finance
committee, President Wilson, and
Williams had strong Virginia connections and played pivotal roles in the
formation of the Federal Reserve
System. Glass, in particular, played a
major role in crafting the Reserve Act
and ushering it through Congress.
For several days, lawmakers on
Capitol Hill debated the validity
of the organization committee’s
choices. Glass gave an impassioned
speech on April 8, 1914, defending
Richmond’s selection and the
committee’s motives.
“The business of the national banks
in Virginia, including Richmond, is
far ahead of the business of the
national banks of Maryland, including
Baltimore, or any other of the five
states embraced in [the Fifth
District],” he argued. As of Jan. 13, the
capital and surplus of Virginia’s national banks amounted to $32.9 million,
compared with $31.3 million in
Maryland, $18 million in West Virginia,
$13.3 million in North Carolina, $12.6
million in the District of Columbia,
and $10 million in South Carolina.
The organization committee eventually answered its critics by issuing
another statement on April 10.
Committee members argued that they
wanted to choose cities which were
growing in importance. Richmond’s
national banks were the largest source
of loans, outside of New York, for
businesses in the South. Also, they held
more deposits from the region’s banks
than Baltimore or Washington, even
though the latter were among the cities
where banks had to park their reserves.
To provide further justification for
its decisions, the committee released
the results of a nationwide poll of
7,471 national banks. The poll was
likely taken because many bankers
had opposed the creation of the Fed, so
the committee members wanted to be
sure they felt included in the process.
The organization committee
closely followed the preferences

expressed by those surveyed — 11 out
of the 12 cities that garnered the most
support were selected as Reserve bank
cities. Cleveland got the nod instead of
Cincinnati or Pittsburgh, both of
which were the preference of banks in
the Fourth District.
Unmoved by the organization
committee’s assertions of objectivity,
protests continued over Richmond’s
selection. The mayor of Baltimore and
Maryland’s governor led a massive
demonstration at a downtown theater
on the evening of April 15. More than
3,000 people attended, lining up in the
pouring rain from the time the doors
were opened until well after the
meeting’s start.
While other rivals eventually
accepted the Reserve bank plan,
Baltimore didn’t back down. On
April 29, the Regional Reserve Bank
Committee of Baltimore asked the
organization committee to reconsider
and delay the formation of the
Richmond Fed pending an appeal to
the Federal Reserve Board. When the
organization committee refused to do
either, Baltimoreans crafted a detailed
brief and sent it directly to the
newly appointed Reserve Board on
Sept. 11, 1914.
The brief argued, among other
things, that Baltimore was a natural
point of trade and its total banking
resources far exceeded Richmond
when taking into account the capital
of the city’s trust companies and
mutual savings banks. In a formal
rebuttal, George Seay pointed out that
trusts were unlikely to join the Federal
Reserve while mutual savings banks
couldn’t join, so their resources
shouldn’t have been counted. (This

might have skewed the results of the
poll as well since only Federal Reserve
member banks were sent ballots.)
Despite these efforts, Baltimore
lost its bid for a Reserve bank when
the U.S. attorney general ruled in April
1916 that the Federal Reserve Board
didn’t have the authority to tinker
with the locations of Reserve banks.
Less than two years later the city did
get a branch office that has grown into
the eighth-largest check processor for
the Federal Reserve System, handling
620 million checks in 2005.

The Legacy
Were the organization committee’s
decisions politically motivated? “The
key role played by Virginians in devising, legislating, and … implementing
the new system no doubt provided
encouragement” to Richmond’s
boosters, wrote James Parthemos,
former director of research at the
Richmond Fed, in a 1991 article for
the bank’s Economic Review.
However, Parthemos didn’t think
politics played a decisive role. “That
the Richmond leaders were not prepared to count on political favoritism
is indicated by their retention at some
early stage of two of the nation’s
highly regarded professional banking
consultants to evaluate the case
for locating a Reserve bank in
Richmond,” he noted.
If the organization committee was
politically motivated, then the choices
for Reserve bank cities initially
suggested by Henry Willis in a confidential report to the committee would
have differed significantly from the
committee’s final plan, assuming that
Willis wasn’t merely telling the

committee what it wanted to hear. In
fact, there were only two differences
— Willis selected Portland and
Cincinnati, while the committee
chose Richmond and Dallas.
Several researchers have found
that the organization committee’s
decisions were likely based on
economics, not just politics. For
example, economist Michael McAvoy
at the State University of New York at
Oneonta compared a decisionmaking
model based on economic factors with
a model based on political preferences.
He determined that the former was a
better predictor of what the committee members agreed upon.
“The [organization committee]
selected the proper 12 FRB locations
based upon bankers’ preferences, city
population, [banking system] capital
growth, and population growth,”
McAvoy described in a July 2006
article. “Given these objective criteria,
the [committee] likely maximized
social welfare rather than its own.”
People have continued to push for
some changes — a branch of the
Richmond Fed opened in Charlotte in
December 1927 after years of lobbying
led by a local banker, while bankers
and local government officials in
Washington tried and failed to get a
branch for their city in the 1970s. And,
economists Miller and Genc, among
others, have proposed reevaluating the
district boundaries to better reflect
regional economic relationships.
Still, as the saying goes, the proof
of the pudding is in the eating. The
operational structure of the Federal
Reserve System has persisted through
two World Wars, 17 recessions, and
RF
16 U.S. presidents.

READINGS
Hammes, David. “Locating Federal Reserve Districts and
Headquarters Cities.” The Region, September 2001, pp. 24-27
and 55-65.

Miller, Jon R., and Ismail Genc. “A Regional Analysis of
Federal Reserve Districts.” The Annals of Regional Science,
February 2002, vol. 36, no. 1, pp. 123-138.

Johnson, Roger T. Historical Beginnings … The Federal Reserve.
Federal Reserve Bank of Boston, December 1999.

Parthemos, James. “A Reserve Bank for Richmond.”
Federal Reserve Bank of Richmond Economic Review,
January/February 1991, vol. 77, no. 1, pp. 24-33.

McAvoy, Michael R. “How Were the Federal Reserve Bank
Locations Selected?” Explorations in Economic History,
July 2006, vol. 43, no. 3, pp. 505-526.

Willis, Henry Parker. The Federal Reserve System. Legislation, Organization, Operation. New York: The Ronald Press Company, 1923.

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

7

JARGONALERT
Pareto Efficiency

I

magine you and a friend are walking down the street
and a $100 bill magically appears. You would likely
share the money evenly, each taking $50, deeming this
the fairest division. According to Pareto efficiency, however,
any allocation of the $100 would be optimal — including the
distribution you would likely prefer: keeping all $100 for
yourself.
Pareto efficiency says that an allocation is efficient if an
action makes some individual better off and no individual
worse off. The concept was developed by Vilfredo Pareto, an
Italian economist and sociologist known for his application
of mathematics to economic analysis, and particularly for his
Manual of Political Economy (1906).
Pareto used this work to develop
his theory of pure economics,
analyze “ophelimity,” his own
term indicating the power of
giving satisfaction, and introduce indifference curves. In
doing so, he laid the foundation
of modern welfare economics.
Because the two individuals
in the opening example will
not lose any of the money they
originally held, they cannot end
up worse off than they started.
Any additional amount of
money that they receive will
make them better off. If one
individual keeps all $100, the
other will be as well off as he
was before the money appeared. Whether the money is
split evenly or one individual keeps more than the other,
Pareto efficiency is achieved.
Consider another example: the sale of a used car. The
seller may value the car at $10,000, while the buyer is
willing to pay $15,000 for it. A deal in which the car is sold
for $12,500 would be Pareto efficient because both the
seller and the buyer are better off as a result of the trade. In
this case, they are better off by the same amount: $2,500.
However, any price between $10,000 and $15,000 is Pareto
efficient because the seller receives more value in money
than the value he places on the car, and the buyer values the
car more than the money he pays for it.
Pareto efficiency has applications in game theory,
multicriteria decisionmaking, engineering, and many of
the social sciences. It is a central principle in economics.
In general, an economic allocation problem has several
possible Pareto efficient outcomes. In the marketplace, the

8

R e g i o n F o c u s • Wi n t e r 2 0 0 7

competitive equilibrium is typically included among them.
A major drawback of Pareto efficiency, some ethicists claim,
is that it does not suggest which of the Pareto efficient
outcomes is best.
Furthermore, the concept does not require an equitable
distribution of wealth, nor does it necessarily suggest taking
remedial steps to correct for existing inequality. If the
incomes of the wealthy increase while the incomes of everyone else remain stable, such a change is Pareto efficient.
Martin Feldstein, an economist at Harvard University and
president of the National Bureau of Economic Research,
explains that some see this as unfair. Such critics, while conceding that the outcome is Pareto
efficient, might complain: “I don’t
have fewer material goods, but I
have the extra pain of living in a
more unequal world.” In short,
they are concerned about not only
a person’s absolute position but
also his relative position, and
argue that, as a result, Paretian
analysis has little to offer.
Feldstein rejects this argument
and maintains that Pareto efficiency is a good guiding principle
for economists, even if some
actions that promote Pareto
efficiency lead to increases
in income inequality. Instead,
Feldstein argues that we should
focus on poverty, and to do this
we should not stifle changes that would increase the total
economic pie just because they would also produce
outcomes that would initially increase inequality.
In general, rich societies can more effectively deal with
such problems than poor ones. For instance, would you
rather live in a country that has almost perfect income
equality but is desperately poor or one that has quite a bit
of income inequality but is rich enough to help out its most
unfortunate citizens? Most people would choose the latter.
That said, Pareto efficiency may not be the only
benchmark that a society may wish to use in choosing
between alternative public policies. It can be a very helpful
guide — and, indeed, has enriched economic analysis a
great deal — but as Pareto himself wrote, “Political economy
does not have to take morality into account. But one who
extols some practical measure ought to take into account not
only the economic consequences, but also the moral,
RF
religious, political, etc., consequences.”

ILLUSTRATION: TIMOTHY COOK

BY M E G A N M A RTO R A N A

RESEARCHSPOTLIGHT
The Next Age of Globalization
BY C L AY T O N B R O G A

B

not. As a result, upskilling the work force will not necessarily
y now “offshoring” has become almost a household
slow the movement of jobs overseas. Instead, the key deterterm in the United States. Jobs that used to be
minant of a job’s offshoring vulnerability is whether it is
performed on these shores increasingly are shifting
impersonal or personal, not low- or high-end. Typists,
overseas — to China, India, and numerous spots in Latin
security analysts, manufacturing workers, accountants, and
America. It is a simple matter of cost savings: Companies
computer programmers are open to offshoring; taxi-drivers,
take advantage of cheaper labor by substituting foreign
airline pilots, construction workers, teachers, and nurses are
workers for U.S. workers.
likely not.
The loss of U.S. manufacturing and service jobs due to offThe economic effect of offshoring is impossible to ignore.
shoring is highly visible, leading many to call for trade
Blinder predicts 28 million to 42 million current U.S. service
restrictions. But despite the political uproar, the economic
sector jobs could logically be threatened by foreign competitheory behind offshoring remains sound. Ultimately, both
foreign nations and the United States ought to benefit from
tion. At the same time, he warns against attempts to halt
trade, whether in goods or labor. Low-cost nations gain jobs
offshoring. Efforts to protect American industries will not
while U.S. consumers gain lower prices. The United States
only fail, they will also be costly to the world economy. He
can then build on its comparative advantage in high-value
says that “the world gained enormously from the first two
products and services, perhaps
industrial revolutions, and it is
boosting productivity and growing
likely to do so from the third — so
“Offshoring: The Next Industrial
the overall economy.
long as it makes the necessary ecoOf course, such a transition can
nomic and social adjustments.”
Revolution?” By Alan S. Blinder.
be painful, and it is by no means
Blinder believes rich countries
Foreign Affairs, March-April 2006,
immediate. In “Offshoring: The
must “reorganize the nature of
Next Industrial Revolution?”
work to exploit their big advanvol. 85, no. 2, pp. 113-28.
tage in nontradable services.” This
Princeton University economist
will mean reconsidering the way
and former Federal Reserve
the U.S. work force is trained. On balance, he argues that a
Governor Alan Blinder takes a fresh look at offshoring and
greater focus on education is probably welcome, especially if
forecasts its future effects on the U.S. labor market. His main
a more educated labor work force is also more flexible and
contribution is to argue that highly educated workers are not
can cope more readily with occupational change. But since
necessarily the answer to survival in the 21st century. Rather,
the distinction between personal services and impersonal
the United States needs an education system that produces a
services does not necessarily correspond to skill level, “prowork force geared to “personal service” jobs.
viding more education cannot be the whole answer.”
In the first Industrial Revolution, the U.S. work force
But there’s a catch: Blinder is also a believer in “Baumol’s
shifted from agriculture to manufacturing. The second
disease,” which implies that achieving productivity improveIndustrial Revolution was characterized by U.S. jobs shifting
ments in many personal services is difficult to impossible.
from manufacturing toward services, though manufacturing
That’s bad news for a nation pegging its future to personal
remains an important part of the American economy. During
services. It means prices of personal services will rise relative
these periods, only items “that could be put in a box” were
to other prices. “When you add to that the likelihood that
considered tradable. Today, however, many things that were
the demand for many of the increasingly costly personal servconsidered nontradable are becoming tradable as a result of
ices is destined to shrink relative to the demand for
improving technology and transportation. Blinder believes
ever-cheaper impersonal services and manufactured goods,
this marks the early stages of a third Industrial Revolution.
rich countries are likely to have some major readjustments to
While this observation is not particularly unique, Blinder
make,” Blinder says.
provides some novel ideas about how the United States ought
But the United States need not despair, he says. The more
to respond. The traditional remedy for coping with offfluid domestic labor market is likely to adjust faster to the
shoring has been “more education and a general ‘upskilling’ of
demands of the third Industrial Revolution than European
the work force.” The United States’ comparative advantage is
increasingly in services, generally requiring highly skilled
markets. And personal service jobs bring less alienation and
workers. But Blinder argues that the jobs threatened by
greater job satisfaction than impersonal ones. That said, big
offshoring today cannot be divided conventionally between
changes are afoot, Blinder concludes: “Offshoring will likely
jobs that require high levels of education and jobs that do
RF
prove to be much more than just business as usual.”

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

9

POLICYUPDATE
Fed to Begin Paying Interest on Reserves
BY J O H N WA LT E R A N D PAT R I C I A W E S C O T T

O

n Oct. 13, 2006, legislation was enacted granting
and redirect their efforts to more useful projects.
the Federal Reserve System a new power: to pay
When the Fed begins paying interest on required reserves,
interest on balances held by depository instituand especially if it decides to pay interest on excess reserves,
tions at Federal Reserve banks, even balances in excess of
the payoff from investments in personnel to monitor reserve
reserve requirements. Holding reserves at the Fed is mandabalances will diminish. Currently, with no interest payments
tory for insured U.S. depository institutions, which include
on required and excess reserves, the payoff is equal to the difbanks, credit unions, and savings institutions. The amount
ference between market interest rates and zero, so the payoff
that institutions must set aside (either as balances at the Fed
is the market rate. Once the Fed pays interest, the payoff will
or as vault cash) varies but in most cases is about 10 percent
be the difference between the market rate and the rate the
of total deposits.
Fed pays, which is likely to be fairly small, on a risk-adjusted
Reserve requirements can help foster the implementation
basis. With a smaller payoff, depository institutions will
of monetary policy because they create a predictable demand
decrease their spending on monitoring their excess reserves.
for reserves. Paying interest on
Payments system risk could be
reserves is not a new idea.
moderated by the payment of
Once the Fed pays interest on
In fact, the Federal Reserve has
interest on reserves, especially if
long promoted it, and the Nobel
interest is paid on excess reserves
reserves, depository institutions will
Prize-winning economist Milton
and such reserves increase. The
have less need to expend resources
Friedman advocated the idea more
Federal Reserve and depository
than 40 years ago. The provisions
institutions face the risk that a
minimizing their balances.
will take effect on Oct. 1, 2011.
depository will have insufficient
Proponents argue that the
funds on hand to make a required
legislation could lead to a number of improvements. First,
payment. In such a case the defaulting institution’s troubles
depository institutions today expend considerable resources
could lead to financial difficulties for other institutions.
to minimize their required and excess reserve balances. They
With little or no excess reserves, institutions at times rely on
do so because the Fed does not pay interest on such balances.
expected funds from other institutions in order to complete
Thus, every dollar held on deposit at the Fed as reserves is
their own payments; so the default of one institution can
one less dollar that can be employed elsewhere to earn intercreate problems for others. Paying interest on excess
est. There will be fiscal costs to paying interests on reserves.
reserves would encourage depository institutions to hold
However, since the Fed will earn interest on any new, excess
excess reserves. Any additional reserves reduce the chance
reserves, it can at least partially offset these costs.
of defaults since depositories will have a larger buffer against
Depository institutions spend significant time and
payments demands.
money to shift funds away from liabilities on which the Fed
The Fed’s job of implementing monetary policy could be
imposes reserve requirements and into liabilities on which
eased somewhat by paying interest on reserves. The Fed
it does not. Sophisticated, and costly to establish, bank
conducts monetary policy through its ability to influence
sweep programs move customer funds from deposits that
short-term interest rates. More specifically, it attempts to
are subject to reserve requirements.
maintain the federal funds rate — the interest rate
In addition, banks incur personnel and software costs to
depository institutions charge when lending reserves to
closely monitor reserve holdings, trying to ensure that only
one another — at a varying target rate that is determined by
the required minimum is held. Such monitoring is complithe Federal Reserve to keep inflation in check while
cated and costly because reserve balances serve a dual role:
allowing for sustainable economic growth. Observers argue
1) meeting reserve requirements and 2) providing the chanthat the fed funds rate is likely to be less volatile if the Fed
nel for interbank payments. Banks want to hold no more
pays interest on reserves. As a result, the Federal Reserve
than necessary to satisfy these two needs because they earn
will have an easier time hitting its target. Of course, as with
no interest on reserves.
any new policy, the magnitude of these anticipated benefits
Once the Fed pays interest on reserves, depository
RF
is uncertain.
institutions will have less need to expend resources minimizing their balances. The upshot may be that a more
John Walter is a research economist and Patricia Wescott
efficient economy is produced. Depository institutions can
is a research analyst with the Federal Reserve Bank of
spend fewer resources to keep tabs on reserve requirements
Richmond.
10

R e g i o n F o c u s • Wi n t e r 2 0 0 7

AROUNDTHEFED
Banks of All Sizes
BY D O U G C A M P B E L L

“Changes in the Size Distribution of U.S. Banks: 1960 - 2005.”
Hubert P. Janicki and Edward Simpson Prescott, Federal
Reserve Bank of Richmond Economic Quarterly, Fall 2006,
vol. 92, no. 4, pp. 291-316.

“How Resilient Is the Modern Economy to Energy Price
Shocks?” Rajeev Dhawan and Karsten Jeske, Federal Reserve
Bank of Atlanta Economic Review, Third Quarter 2006, vol.
91, no. 3, pp. 21-32.

t’s no secret that the U.S. banking industry has experienced significant consolidation over the past few
decades. Amid rapid consolidation, the number of banks
operating in the country since 1960 has fallen from 13,000
to about 6,500. The conventional wisdom is that there is
no end in sight to this trend, with the big banks getting
bigger and midsized banks all but disappearing, to create a
“barbell” industry shape. In a new article, researchers at the
Federal Reserve Bank of Richmond call into question
elements of the conventional wisdom. Hubert Janicki and
Edward S. Prescott document the decline in bank numbers
and draw several new findings. Among them: The pace of
new bank openings has been relatively constant over time.
Entry averages about 1.5 percent of total operating banks.
The authors also document striking changes in bank
growth starting in 1980, about the time when deregulation
started. They find that before this point, bank growth was
consistent with “Gibrat’s Law,” which states that firm
growth is independent of firm size. After 1980, they find that
Gibrat’s Law no longer holds; instead, the largest banks grow
the fastest, though that has slowed down recently.
The authors forecast that the number of U.S. banks is
likely to continue dropping, but soon may level off. This
prediction is based primarily on observations from the
(admittedly brief) period from 2000 to 2005. “If the present
trends continue, the transition in banking that began in the
1980s is slowing down and coming to an end,” the authors
write. And despite the prediction of a “barbell” banking
industry structure — with many big and small banks, but
very few midsized ones — the projected remaining 5,000
banks probably won’t have such a shape. Instead, Prescott
and Janicki see “more midsized banks than large banks” –
much as it is now shaped.
All of this helps lay the factual foundation for a theory of
how many banks there will be in the future, and how many
of those will be big, medium, or small in size. Such a theory
can establish the costs and benefits of past limits on bank
size and evaluate policies that affect bank size distribution.
“A theory of the changes in bank size distribution needs
an explanation of why the size dynamics changed and by
how much,” the authors conclude. “The natural place
to start is with an understanding of how removals to
growth and size limits change the growth rates of different
size banks.”

ne of the longer-running debates in modern economics centers on whether business cycle fluctuations
are more likely to be triggered by energy price shocks or
productivity shocks. On one side, Dhawan and Jeske argue,
are the empiricists who claim that energy price shocks are
the primary cause, while on the other are economists whose
“dynamic stochastic general equilibrium” models suggest
that we should look at shocks to total factor productivity
(TFP) instead.
In a new paper, the authors reconcile the two arguments
by building a model that takes into account energy use in the
production function. They find that big changes in energy
prices can have business cycle effects if they also affect the
underlying productivity trend. That appears to have been the
case from 1970 to 1985. But since then, it is harder to identify
how productivity has been affected by energy price shocks.
But the economy is not recession-proof. “While the
economy is more resilient to energy price shocks than
before 1985, it is still subject to fluctuations in TFP unrelated
to energy price hikes.”

I

O

“The Relocation Decisions of Working Couples.” Jonathan F.
Pingle, Federal Reserve Board of Governors Finance and
Economics Discussion Series Working Paper 2006-33,
August 2006.

he United States has about 33 million households with
both spouses working outside of the home. This poses a
problem. If one spouse gets a job offer in another city,
acceptance tends to be contingent on whether the other
spouse can likewise find gainful employment. Increasingly,
couples move only when one spouse gets a big enough raise
to more than offset the other spouse’s lost earnings.
Jonathan Pingle, an economist with the Federal Reserve
Board of Governors, finds that early-career location
decisions are especially important. “[C]ities attracting
young, high income couples will likely keep them — cities
like Washington, San Francisco, or Seattle,” Pingle writes.
“As migration continues to decline, this could sort the most
productive labor away from cities that cannot find ways
of attracting the young and the educated before they marry,
form dual-worker households, or have children — after
which relocation becomes difficult even if one of the
spouses gets a good job offer elsewhere.”
RF

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11

SHORTTAKES
UPDATE ON FINANCIAL TURNAROUND

Albemarle First Boosts New Owner

T

he fall 2006 issue of Region Focus went to press just
before an announcement that was pertinent to the
article, “The Life and Times of Albemarle First.” In October,
Winchester, Va.-based Premier Community Bankshares
reported third-quarter earnings of $2 million. What was
notable about those results was the contribution made by
Albemarle First, which Premier had acquired July 1.
As readers of the article may recall, Charlottesville-based
Albemarle First had struggled in its early years to overcome
lending problems and a check-kiting scheme. But more
recently a financial turnaround seemed to be taking hold,
amid a concerted effort by new management and staff. (A
new executive team was put in place in early 2002, starting
with the appointment of CEO Tom Boyd.) Premier’s thirdquarter announcement appears to support the conclusion
that the turnaround was complete: Albemarle First provided
profits of $455,000, the highest quarterly total in the
acquired bank’s history.
On Jan. 29, Premier announced it was being acquired
by Charleston, W.Va.-based United Bankshares, pending
regulatory and shareholder approvals.
— DOUG CAMPBELL
BEST PRACTICES

West Virginia Encourages IT Investment
in Health Care Industry

T

echnological advances have revolutionized the diagnosis and treatment of illness. Yet the revolution in
information technology, ranging from electronic recordkeeping to wireless communications, hasn’t had as big an
impact on the health care industry. Doctors still lug around
thick folders stuffed with records and x-rays, making it
difficult for different practices to share information on the
same patient. Verbal and written orders from doctors can be
misinterpreted, leading to deadly medical errors in hospitals.
West Virginia is among states trying to change the status
quo. Since March 2006, it has facilitated the development of
a statewide health information network, which was recommended by a task force created by Gov. Joe Manchin in 2005
and touted in the governor’s last three State of the State
addresses.
David Campbell, chief executive officer of the nonprofit
Community Health Network of West Virginia, believes this
network would support the use of electronic medical
records (EMR) and the free flow of information between
doctors, hospitals, and insurance companies. “The government won’t build and operate the system, but it does have a
public interest in encouraging its development,” Campbell

12

R e g i o n F o c u s • Wi n t e r 2 0 0 7

says. Banking and other industries have used information
technology to make their operations more efficient and
improve the quality of services. “We haven’t done that in
health care.”
Information technology may improve the quality of
patient care. Devon Herrick, a senior fellow at the National
Center for Policy Analysis, says software could check for
contra-indications when a doctor writes a prescription. More
important, “massive data mining of EMR systems will, in the
long term, help establish best practices and evidence-based
treatments,” Herrick adds. “By adopting best practices and
coordinating care, quality will hopefully be better.”
Such quality improvements could yield cost savings for
providers. Better patient safety would reduce the costs
incurred to correct medical mistakes. Fewer duplicative
tests would be ordered because medical records would be
more accessible.
Health care insurers could save money as well, adds Sallie
Hunt, an official at the West Virginia Health Care Authority
involved in the creation of the state’s health information
network. For example, electronic prescribing of medications
would enable insurers to better manage their costs through
the use of formularies, preferred lists of drug products that
have been deemed to be the most cost-effective. A doctor
could use a wireless handheld device to select drug options
presented for patients based on their insurance coverage.
So why aren’t health care professionals lining up to buy
wireless routers? Some blame the fee-for-service system of
health care reimbursement. Third parties pay the same price
for medical services regardless of how efficiently they are
provided.
“Doctors are not being paid for high-quality care coordination. Rather, they are being paid by the task,” Herrick
notes. “When more people begin paying for medical bills
directly, such as from a [health savings account], they will
begin to demand timely access to their medical information
and will want efficient care.”
However, even under the current fee-for-service regime,
a doctor could cut costs and boost profits by implementing
IT. The problem is it takes time for providers to learn about
new technologies and implement them in order to achieve
the maximum cost savings. Doctors are always working
under a time crunch, so the opportunity cost of the
transition may not outweigh the savings, which are in the
long run and may not seem as significant or certain. There
are also privacy concerns. Once patient records are put
into electronic form, arguably they become more vulnerable
to being accessed by unauthorized persons.
Finally, it’s not cheap to implement information technology. In a survey of physician groups and individual practices,
Robert Miller and Ida Sim at the University of California at
San Francisco found that the upfront costs for deploying an
EMR system ranges from $16,000 to $36,000 per physician.

THE CONVERSION QUESTION

Credit Unions Weigh Costs and Benefits
of Converting to Banks

S

ince 1995, the first year they were allowed to do so,
29 member-owned credit unions have turned into either
mutual holding companies or stockholder-owned banks,
either through direct conversion or through mergers. In the
Fifth District, four credit unions have made the switch. It’s
usually a two-step process beginning with a membershipwide vote first on whether to convert to a depositor-owned,
mutual savings bank, then concluding with another vote on
conversion to a stockholder-owned bank. Also required are
approvals from regulators.
Generally, conversions are instigated by management
and pitched as the best means for the institutions to survive. Lafayette Federal Credit Union of Kensington, Md.,
was one of the most recent credit unions to undertake the
process for conversion. The effort has recently stalled
amid concerns about the voting process for conversion of
the 16,000-member institution. But before Lafayette
Federal withdrew its conversion plan, CEO Michael
Hearne explained why he favored the effort. “The name of
the game is grow or die. It’s increasingly expensive to do
business and the only way you pay for additional expenses
is to bring in additional revenue, and the only way you do

M ILLIONS

2000

IN

1500
1000
500
0

OF

9
8
7
6
5
4
3
2
1
0

2500

N O.

3000

C ONVERSIONS

Credit Union Conversions, 1995-2006

D OLLARS

These expenses include equipment purchases and installation, conversion of existing paper-based information into
digital form, and training personnel. They don’t include the
revenue that is lost during the transition period due to
productivity declines.
Hospitals and large physician groups are better able to
absorb these costs than smaller groups and individual practices, plus they have the management expertise and
organizational scale to make other changes necessary to realizing the full benefits of information technology. For
example, the Carolinas HealthCare System began installing
wireless access points throughout its 14 hospitals in North
Carolina and South Carolina in 2004. This investment will
enable doctors to instantly access patient orders, lab results,
and other information.
Should states or Uncle Sam help foot the bill for IT
investment in the health care industry? A 2002 Institute of
Medicine report called for government funding of largescale demonstration projects to test the implementation of
health information networks. But, Miller and Sim believe
that governments don’t need to directly fund networks or
subsidize IT purchases by health care professionals.
“Our study suggests that most practices can secure capital
for purchasing the technology,” the researchers note in
their March/April 2004 article in Health Affairs. “Policy
funds could be better used for rewarding quality improvement, for example, than for replacing available sources
of capital.”
— CHARLES GERENA

95 96 97 98 99 00 01 02 03 04 05 06
Y EAR

Assets

Conversions

SOURCE: Filene Research Institute

that is to increase volume,” he said. “It’s much easier to
grow as a thrift than a credit union.”
The first U.S. credit union opened in 1909 in New
Hampshire. In the early days, credit unions were founded to
serve members of a specific organization with small
consumer loans. They developed under the premise that
their members’ common interests and bonds could serve
as a substitute for collateral, explains Richmond Fed
economist John Walter. In 1932, the average size of a
U.S. credit union was just 187 members. “With this knowledge in hand, the credit union loan committee could make
a low-risk and, therefore, low-interest loan to a credit union
member,” Walter writes in a recent article.
This distinguishing characteristic no longer exists so
strongly. Today’s credit unions can span numerous employers and geographic areas, diminishing old “common bond”
insights into lending. At the same time, however, they have
gained mortgage lending powers and expanded their
business lending.
Most important, as nonprofits, credit unions still maintain their exemption from federal income taxes unlike
banks. That tax-exempt status bothers community bankers,
who complain that credit unions present unfair competition
because they can use their tax-bill savings to undercut
bank prices.
So why would credit unions, with their built-in tax
advantage, want to convert? One reason may be that some
of their original competitive advantages have eroded.
Creditworthiness is more easily identified by all financial
services players nowadays thanks to innovations in the financial marketplace. Also, even as credit unions have grown to
close to 90 million members, they remain smaller in comparison to commercial banks. About half of all U.S. credit unions
have less than $10 million in assets, while only 1 percent of all
banks are that small, Walter writes. Many credit unions are
looking for growth opportunities, but as they are currently
organized, those opportunities are limited.
James Wilcox, an economist at the University of
California at Berkeley, has studied credit union conversions.
Credit unions have to use retained earnings as their only
source for meeting capital requirements, unlike banks which

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

13

RAISE THE ROOF

Tunnel Clearance Could Open Access to
Southern West Virginia

T

wenty-eight rail tunnels, four in Virginia and 24 in West
Virginia, are getting taller. Starting this summer, the
tunnels will be modified to accommodate double-stacked
railcars that move goods inland, mainly to Chicago and
other Midwest cities, from Hampton Roads port terminals.
The project aims to lower costs while speeding the transport
of goods.
The price tag for tunnel clearances alone is estimated at
$151 million. At least one tunnel, Big Four # 2 near Welch,
W.Va., will be “daylighted,” meaning its top will be blasted off.
It’s a big project, with Norfolk Southern Corporation getting
taxpayer help to realize economic benefits sooner rather than
later. The improvement wasn’t at the top of the railroad’s
to-do list, from a shareholder perspective, says Mark Burton,

14

R e g i o n F o c u s • Wi n t e r 2 0 0 7

Raising tunnels to accommodate double-stacked containers
on trains will move cargo more cheaply and efficiently from
Hampton Roads ports to Chicago.

director of transportation economics at the University of
Tennessee’s Center for Transportation Research.
Burton says railroads are under pressure to increase earnings. “That has really squeezed the level of investment to
something below what the railroads would have liked to
have seen.” Any savings for Norfolk Southern probably will
go to keep rates competitive, thus benefiting shippers who
could always land at another deep water port and load onto
rival rails, Burton notes. CSX, for example, already double
stacks on routes from its Charleston, S.C., terminal. “This
puts them on equal footing with CSX,” he says.
Federal funding is estimated at $95 million and Virginia
will pay $22.5 million toward the clearance and construction
of an intermodal terminal in the Roanoke region. West
Virginia is likely to fund most of a terminal proposed for
Prichard, W.Va., near the Ohio River.
Construction will begin this summer on the tunnel clearance portion of the project, slated for completion in 2009.
The entire effort, which includes a terminal and construction work in Ohio, too, is called the Heartland Corridor.
Double-stacked containers from ships load directly onto
railcars at Norfolk, the most efficient way to move containers between Norfolk and Chicago, says Robin Chapman,
Norfolk Southern spokesman. Stacked trains currently travel the long way around to Chicago, avoiding West Virginia,
Southwest Virginia, and low tunnels altogether. The more
direct route clips 233 miles and a day’s travel time off the trip
to Chicago. The shortcut runs through Roanoke, Va., and
Southern West Virginia by way of Columbus, Ohio, a distance of 1,031 miles compared to 1,264 miles.
Double stacking cuts costs nearly in half, Burton says.
“Single-stack shipments are sometimes competitive with
trucking prices and sometimes not,” he says. “Double stacks
always generate profit.”
West Virginia could win big economically from the
increased container traffic, especially if plans for an intermodal terminal in Prichard, W.Va., materialize. Intermodal
terminals where trucks, trains, and even barges come
together serve as inland ports, giving manufacturers easy,
direct access to coastal ports for overseas markets. “What the
intermodal terminals do is bring to the regions where they’re
located the capability for companies in that region to connect
more directly to the international markets,” Chapman says.

PHOTOGRAPHY: NORFOLK SOUTHERN CORPORATION

can raise capital in many different ways. Wilcox says that
credit unions that offer superior rates and services probably
shouldn’t be converting; they can better serve members as
credit unions. But he adds that credit unions which offer
similar rates and services to banks make for good conversion
candidates. “What members ought to figure out is that they
own this thing and then whether it’s better to cash out now
or keep the cash coming,” Wilcox says.
However, conversions can be controversial. Usually the
controversy stems from how the equity is divided up after
conversion. Typically, credit union members are offered the
opportunity to buy shares of the new bank before those
shares are sold to the public. By law, shares can’t be distributed to members in exchange for their claims to retained
earnings. Meanwhile, fewer than one out of 10 members end
up purchasing shares of the converted institution.
That number would increase, Wilcox thinks, if the rules
were changed for how credit union equity is disbursed. He
proposes that both credit union depositors and borrowers
be compensated for their “lifetime contributions” to the
institution. At the very least, it would be a fairer system than
the present. “Life is messy, and half a loaf or two-thirds a loaf
is better than none,” Wilcox says.
In late December, Lafayette Federal’s board and management thought it had overcome equity concerns in winning a
membershipwide election to convert to a mutual savings
bank. But given the balloting problems, the Lafayette
Federal board said it would terminate the conversion plan
and anticipated “no immediate changes in our operations.”
Hearne, Lafayette’s CEO, says the board tried to allay
equity issues by pledging, in the event of such a conversion,
to not accept stock grants, options, or any payments and buy
stock under same considerations as other members. “I don’t
know what else could have been done to say that this
shouldn’t be an issue,” Hearne says. “But that’s the most
visceral issue here. I understand why.”
— DOUG CAMPBELL

Direct access means business, says Patrick Donovan,
executive director of the West Virginia Public Port
Authority. “What that does is give Southern West Virginia,
Kentucky, and Ohio global reach other than the river system. When you look at our proximity to Midwest markets
out of West Virginia, it’s pretty impressive.”
For the state to retain and recruit firms, the intermodal
terminal is critical. Container traffic over the deep draft
ports — such as Norfolk and New York — has grown by
double-digit percentages in all but one of the last 10 years,
Burton notes. “The huge growth and importance of container traffic is directly tied to international traffic,” he says.
“The reason global markets work, the reason we’re wearing
so many Chinese tennis shoes, is that international shipping
by container has become remarkably cheap.”
Currently, any manufacturer in West Virginia faces a
$400 to $600 disadvantage per container. “So firms that
want to use containers don’t locate there,” Burton says.
Norfolk Southern provided the state with $1 million for
preliminary engineering of the Prichard site.
Consumers may benefit as well. Take beer, a product that
ranks high on the inbound commodities list, says Burton.
“Somebody who likes to drink German beer would be able to
buy it more affordably.”
— BETTY JOYCE NASH
WEST VIRGINIA’S MEDICAID MODIFICATION

New Program to Encourage Personal
Responsibility for Health Care Decisions

W

est Virginia is testing a first-of-its-kind program: providing incentives for the state’s poorest people to
accept more personal responsibility for their health. The
pilot program has begun with three counties — Clay,
Upshur, and Lincoln — asking patients to sign “member
agreements” that give access to services not usually covered
by Medicaid. Members with diabetes or weight problems,
for example, could attend nutritional seminars or meetings
with dieticians. On the flip side, beneficiaries who don’t sign
the agreements face limits on the number of prescriptions
they receive and don’t get access to extra benefits.
As with most states, West Virginia’s funding of Medicaid
— the nationwide health care program that covers medical
services for the poor — constantly strains the budget. But the
pilot program is not being pursued as a short-term cost fix; it
is a long-term effort to improve the health and well-being of
West Virginia’s poorest residents, officials say. By extension,
over time it is hoped the program contains costs. (Other states
are modifying Medicaid coverage, too. Kentucky, for example,
is restricting the number of prescriptions some beneficiaries
can receive. But West Virginia’s program is the first to provide
incentives toward improving health.)
The idea was approved by the federal government in the
summer and started in late 2006. Initially, the target population is the young and healthy poor, a demographic that at
present isn’t a drag on Medicaid expenditures but which

could be if future lifestyle choices make them unhealthy.
“We want these people to make healthier decisions and
we want to partner with them to make these healthier decisions,” says Shannon Riley, spokeswoman for the West
Virginia Bureau for Medical Services. “If we can eliminate
lifestyle-induced diseases in this young and healthy population, that significantly slows the growth of our [Medicaid]
program in the future.”
While private insurers and even public health departments have been trying for some time to build incentives for
patients to take more interest in their health, Medicaid has
never been the ground for such efforts. The federal
government pays for about 57 percent of the $275 billion
nationwide program, with states covering the rest.
Robert Helms, a resident scholar on health care policy
with the American Enterprise Institute, says the West
Virginia program is a good first step. The program is in keeping with recommendations of the Medicaid Commission’s
2006 report, to which Helms contributed, to give states
more control and flexibility in administering Medicaid.
In a roundabout way, West Virginia’s “Mountain Health
Choices” program helps ease the classic health care problem
of those receiving a service not directly paying for it, which
creates all the wrong incentives. Recipients agree to keep
doctor appointments, only use the emergency room in case
of real emergencies, and comply with prescription medications, among other responsibilities.
“I’m very supportive of what they’re trying to do, with
the principle of trying to help more people be more responsible,” Helms says. “It’s moving in the right direction. And
the cost benefits may even be secondary to improving the
quality of these people’s health, preventing them from
becoming serious Medicaid patients in the first place.”
While patients who sign up for the program are eligible
for enhanced services, those who don’t are relegated to
another plan. The “Basic Plan” limits prescriptions to four
per month, for example, while the “Enhanced Plan” has no
limit. This difference has given rise to some criticism. A short
article in the Aug. 24 edition of the New England Journal of
Medicine questioned whether some Medicaid patients, especially children beholden to their parents’ actions, would be
denied necessary medical services under the plan.
But Riley, the West Virginia spokeswoman, says the program is not about withholding care as much as it is about
rewarding patients who take steps to improve their health.
All Medicaid beneficiaries have the opportunity to sign up
for the enhanced plan each year. “Honestly, it’s kind of
insulting to insinuate that poor people can’t make good decisions,” Riley says.
In the next year, the state aims to add new features to the
program, offering more programs not typically covered
under Medicaid, though details still have to be worked out
and approved by the federal regulator, the Centers for
Medicare and Medicaid Services. The idea is to expand the
program statewide, eventually covering a majority of the
state’s 380,000 Medicaid beneficiaries.
— DOUG CAMPBELL

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

15

The popularity of employee stock options is expected to wane with the adoption
of a new accounting rule

A

pril 27, 2004, was a good day at
RF Micro Devices Inc. On
that date, the Greensboro,
N.C., company reported its first full
year in the black since 2001. “We
turned the corner on profitability,”
CEO Bob Bruggeworth said in the
day’s press release.
RF Micro Devices was founded in
1991 by a small band of local engineers
and then built into a multinational
firm with offices in Silicon Valley and
China. The cellular phone components market in which it competes is a
growing but tough business. Turning
the corner on profitability was welcome news indeed.
But there was no big move in RF
Micro’s stock price following the positive earnings report. As is the case

16

R e g i o n F o c u s • Wi n t e r 2 0 0 7

with most financial announcements, it
would have taken a big surprise for the
stock price to have been affected. In
fact, the market was already taking
into account something that RF
Micro wasn’t announcing that day —
looked at another way, the reported
$30 million profit was actually a loss of
$25 million.
This news wouldn’t officially come
until two months later in RF Micro’s
annual report, filed with the Securities
and Exchange Commission. The reason for the difference between the
announced net income of $30 million
and the “pro forma” loss could be
found on page 28 of form 10-K in
a footnote headed “Stock-Based
Compensation.” It showed that in RF
Micro’s latest fiscal year, the value of

stock options (and to a lesser extent,
certain outright stock awards) granted
to employees was costing the firm
about $62 million. Deducting that
amount from earnings (plus adding in
credit for a few other items) pushed
the firm into the red.
It wasn’t the first time RF Micro
had reported a profit when in an alternate — some would say “economic” —
reality, it had lost money. The same
thing happened in 2001. And in every
other year of its existence, the firm’s
profits were actually lower than
reported because of stock option
grants, and its losses likewise larger.
This is not to say that RF Micro
was engaged in fraudulent behavior, or
even doing anything unusual for that
matter. Until this year, practically

PHOTOGRAPHY: GETTY IMAGES

BY DOUG CAMPBELL

every publicly traded firm in the country reported the cost of expensing
employee stock options in footnotes.
Scores would have reported losses
instead of profits if employee options
had been expensed. (In 1999, for
instance, the number of U.S. technology firms reporting losses would have
doubled if options had been deducted
from profits.) RF Micro Devices just
happens to be a good example of how
this process worked — and perhaps of
how managers tend to make decisions
based on accounting numbers instead
of economic ones.
To many, stock options in the 21st
century have become synonymous
with corporate greed. But that’s hyperbole which ignores some of the
positive things that options can do —
like align shareholder and employee
interests by motivating workers to
boost their company’s performance
and drive stock prices upward, for
starters. Stock options help companies like RF Micro grow faster than
they otherwise could have.
At the same time, many managers and boards until recently
were seemingly blind to the true
costs of stock options, an anomaly
that economists are striving to
explain. And this unawareness had
a number of negative implications
for investors. Misjudging options
as much cheaper than cash, managers were more likely to lavish them
on employees. Meanwhile, option
grants to top executives grew so widespread that the average CEO today
makes about 262 times the average
employee. Perhaps the executives are
worth every dollar, or perhaps this is
what happens when a big chunk of
compensation gets accounted for as
virtually free. Finally, the recent scandal over the practice of “backdating”
employee stock options may have
some of its roots in the relatively painless way firms were allowed to account
for options.
Today, granting options is no longer
painless: 2006 is the first year that
public companies are being required to
subtract the cost of stock options
from their income. The change, which

was years in the making, came about
in large part because of clamoring
for corporate governance reforms.
Accounting scandals at Enron and
WorldCom gave the Financial
Accounting Standards Board (FASB)
support for a long-proposed rule to
make stock option expensing mandatory, instead of something that since
1995 was relegated to footnotes in
annual company filings. (And before
1995, usually not reported at all.)
Across the nation, this one small
accounting change is affecting the
use of employee stock options in a
significant way.

Stock Option Basics
Employee stock options represent the
right to buy a share of stock at a
specified price — called the exercise

The price that the firm
would fetch in the market
for this asset would be its
economic value. Anything
less, and shareholders
arguably are being ill-served.
or strike price — before a specified
date. Unlike standard, short-lived “call
options,” employee options usually
cannot be sold to outside investors
(see sidebar, Google). Also, they tend
to have lengthier terms, sometimes of
up to 10 years, and usually include
vesting periods.
Here is how it works. A firm issues
an option to an employee. The option
usually has an exercise price identical
to the price of the firm’s stock on the
day the option is issued. So if the stock
is trading at $10 on that day, the
exercise price is also set at $10. If the
option vests in four years, then the
employee will have the right to buy a
share of stock four years later at $10,
no matter what the firm’s stock price is
at that future time. If the firm’s stock

price has doubled to $20, an employee
can buy that $20 share for just $10,
then immediately turn around and sell
it at the market price, pocketing the
$10 difference as profit.
The vesting period is the key to
an option’s utility in retaining and
motivating employees. The idea is
that workers will perform at a higher
level so as to raise the stock price,
knowing that a higher price is in their
direct interest. At the same time,
other shareholders benefit — a seeming resolution to the age-old agency
problem, aligning incentives of both
the owners and the agents. (As an
added bonus, the tax treatment for
stock options is less expensive
compared with cash payments and
stock grants.)
Employee stock options were still
something of a rarity in 1972 when
a new rule was established to
require that companies treat
options as an expense as measured by their “intrinsic value” —
which is the difference between
the stock price when issued and
the exercise price. Thus, the
intrinsic value sets a lower bound
on the exercise price, and hence
its valuation. If the exercise price
is set at the trading price of a
stock on the day it is issued, then
no expense is recorded. For example, a company whose stock was
trading at $10 would issue options
with strike prices of $10 on that day so
as to avoid the expense. Because of
this, virtually all employee options
issued after 1972 were “at the money,”
or with identical exercise and trading
prices on the day they were issued.
Another way to view it is that firms
were essentially allowed to ignore the
cost of employee stock options.
In 1995, as option grants grew more
popular, the FASB issued a new rule
that firms must also, at the very least,
report the “fair value” of employee
options in footnotes to their regulatory filings. (The FASB had wanted
this information to appear in the main
income statement, but firms lobbied
to prevent this from happening.) Fair
value is calculated by using formulas

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

17

that involve estimating the number of
granted options which will vest and
the expected volatility of the firm’s
stock price until the exercise date,
among other factors that are impossible to nail down with precision.
“Fair value” aims to derive the
underlying economic value of granting
options. Unlike an accounting valuation, an economic valuation seeks to
reflect the “opportunity cost” of a
firm’s decision about how to deploy its
assets. In the case of a stock option,
the relevant question is: What else
could be done with it? A firm could sell
it to an outside investor, for example.
The price that the firm would fetch in

the market for this asset would be its
economic value. Anything less, and
shareholders arguably are being illserved.
Consider the easiest way that firms
could account for stock options —
they could buy them from third parties and then give them to employees.
True, this would trigger an upfront,
one-time expense. As Robert Bliss, a
former senior economist with the
Chicago Fed now at Wake Forest
University put it: “That this form of
employee stock option is not widely
adopted reveals something of the
motive behind their current usage —
to transfer value to the employee

without the appearance of an actual
expenditure.”
Wayne Guay, an accounting professor at the University of Pennsylvania,
acknowledges that valuing employee
options is tricky. But that’s the nature
of accounting, he says. Placing a dollar
value on things like “goodwill” and
pension plans likewise is fraught with
assumptions and possible impreciseness. Moreover, just about every single
number in a financial statement is an
estimate, from cash on hand to inventory. “Of the list of things that are
currently reflected in the income
statement, valuing employee stock
options does not strike me as one of

Internet search and information firm Google recently introduced a novel kind of stock option, one that employees can sell
to outside investors. Historically, most employee stock options
have been nontransferable, though firms like Microsoft have in
the past offered one-time programs for employees to sell
options.
Google’s plan is thought of as the first to be rolled out on
an ongoing basis, with a regular market in which financial
institutions and other investors can offer to buy employee
options. The company pitched the idea as a way to increase
the value of employee stock options — or at least the value
that employees place on them. The higher perceived value of
“sellable” employee options results from the fact that employees nowadays tend to exercise their options almost
immediately after they vest. (Google had its initial public
offering in 2004, and since then many of its
employee options have vested and been exercised.) But profits from options in many cases
would have been greater if the employee had
waited for the firm’s stock price to rise. By selling vested options to optimization-minded investors and
financial institutions instead of exercising immediately,
employees are likely to pocket bigger profits.
The program “makes the value of [employee] options more
tangible,” said Allan Brown, director of Recognition and HR
Systems on Google’s blog. “By showing employees what financial institutions are willing to pay for their options, it is made
clear that the value of their options is greater than just the
intrinsic value.” (By intrinsic value, Brown meant the difference between the exercise price and the current market price.)
Google’s plan is an example of how many firms continue to
believe in the power of stock options, even as expensing them
has made more apparent the economic cost of issuing them. In
fact, Google predicts that its cost of issuing options will rise
with the plan because it will increase the expected life of the

18

R e g i o n F o c u s • W im m e r 2 0 0 7
Su nt
6

options. The plan will convert all post-IPO options to transferable ones, along with all newly issued options. It is to go into
effect in the spring of 2007 and will not be available to senior
executives. Google says it awards options to all new employees
and then annually to many others.
Google’s timing in introducing transferable options has
ties to the new requirement of stock option expensing.
Google said that one of its aims was to close the gap between
the amount of stock option expense that the company has to
subtract from earnings and the amount which employees
perceive their options are worth. The amount that has to be
deducted from earnings is based on options-pricing formulas,
with Google using the standard Black-Scholes-Merton (BSM)
pricing model.
In a statement about accounting for transferable options,
Google explained: “Because traditional employee
stock options are not transferable, there is a
disconnect between their value as determined
using BSM — which, under the new accounting
rules, we recognize as stock-based compensation as the options vest — and the value employees ascribe to
their options on the date of grant. The [transferable stock
option] program diminishes this disconnect.”
Carl Luft, a finance professor at DePaul University who has
studied stock options, says that Google’s effort means it’s possible that market-determined prices for employee options will
someday be the way that firms value such options in their
financial statements. This would help end the debate over the
best way to value options and complaints that current formulas are imprecise, even though the prices are likely to come out
pretty close to each other. “My guess is that the market price
will converge with one of the theoretical pricing models pretty quick,” Luft says. “And that will provide a hard number that
can be used in reporting rather than the number that is sub— DOUG CAMPBELL
ject to criticism.”

LOGO: COURTESY OF GOOGLE

Google to Introduce Transferable Options

Pushback
Haubrich actually is more agnostic
about how to deal with stock options
than his quote implies. He notes
that former Federal Reserve Chairman
Alan Greenspan was a moderate
proponent of expensing options, in
part because he was doubtful that
markets actually do fully see their true
costs. What’s more, even if the market
cannot be fooled by stock options,
there is ample evidence that boards
and managers can.
Consider the voluminous comments the standards board received
from corporations in advance of
adopting the expensing rule. “We continue to believe that, because no
corporate assets have been consumed
nor liabilities created, the issuance of a
stock option conceptually does not
result in an expense to the corporation,” said Rajeev Bhalla, former
controller for Bethesda, Md.-based
Lockheed Martin. Or reflect on the
words of Billie Rawot of Clevelandbased Eaton Corp.: “Employee stock
options do not represent an expense
to the company that should be recorded in the income statement.”
Though not all firms denied the
very existence of a “cost” in issuing
employee stock options, many argued
in letters to the standards board that
the new rule greatly overstated their

Grant-Date Values of Employee
Stock Options in the S&P 500
250

M ILLIONS

200
150

IN

competing approaches to measuring
option costs are based on the same
basic information,” Hubbard and
Calomiris wrote.
Moreover, the evidence suggests
that the footnoted valuations are
actually quite effective and informative.
A number of studies have concluded
that the market properly takes notice of
these footnotes and assigns market
values accordingly. Summing up the
economic argument against an official
expensing of options, Cleveland Fed
economist Joseph Haubrich said: “Why
should it matter if this information
is reported on one line rather than
another? Put differently, if the market
already values these options, there
would be little benefit to counting
them as an expense.”

D OLLARS

the most difficult things that we currently estimate,” Guay says.
Still, managers complain more
about valuing options than other
items. They note that although it
usually takes at least several years for
employees to see any economic gain —
and gains may never materialize at all
— firms have to begin expensing the
options immediately. Likewise, they
argue that valuations are at best
estimates. What’s more, the formulas
used for valuing employee options
were originally developed for
standard-issue options. The difference
is important because employees tend
to exercise options immediately after
they’re vested, even if they are not
optimally priced at that time, which
is contrary to what the standard
formulas say they should do.
In addition, some firms dispute
the very necessity of expensing
options. They point out that granting
options doesn’t affect cash flows, the
fundamental measure by which
shares are valued. Also, small and
young firms in particular claim that
expensing options will make their
reported earnings lower, which in turn
would raise their cost of financing,
perhaps then choking off future
investment and innovation.
In a 2004 paper, economists
R. Glenn Hubbard and Charles
Calomiris of Columbia University
argued that “the noise produced in
accounting earnings by the decisions
by the [Financial Accounting
Standards Board] about ‘true earnings’
are ill-advised.” Better, Hubbard and
Calomiris said, would be to leave the
valuation of options to Wall Street
professionals, whose sophisticated,
informed analyses play a central role in
setting stock prices at the margin.
Yes, Hubbard and Calomiris agree,
options represent a bona fide expense
that needs to be disclosed. But the
myriad different ways that they can be
valued mean that investors may end up
not comparing apples to apples when
looking at numbers across different
companies. “The primary role for
regulation should be in the area of
disclosure, which will ensure that

100
50
0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

SOURCE: Hall and Murphy, 2003

expense. This complaint was at the
heart of doomsday scenarios raised by
the likes of Christine Copple of
Washington,
D.C.-based
ASM
Resources: “The most talented scientists and researchers are much more
likely to depart the United States for
other nations. We must maintain our
competitive edge in attracting the
world’s top scientists.” In other words,
Copple was saying that ASM would
have to pare back on its option grants
if it had to expense them — even
though it was already doing so in the
footnotes.
As a result of these kinds of
perceptions, U.S. firms were nearly
unanimous in their support of maintaining the status quo of keeping
option expenses in footnotes. But
did this make sense? How could
firms simultaneously argue that
a) footnotes provide adequate information about stock option expenses
and b) incorporating this same information into their main income
statements would be harmful? As
economist Haubrich notes, “Only if,
for some reason, the government both
wants to subsidize ... firms and finds
that the cheapest way to do so is to
ignore the option expense, does this
story make sense.”
Perhaps something else is
going on. To understand what,
RF Micro Devices serves as a useful
illustration.

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

19

Grants Galore
From almost the moment it was
founded, RF Micro Devices relied on
stock options as a major part of its
compensation program. Like at a lot
of young, high-tech firms, RF Micro’s
leadership reasoned that the upside to
investing in the company was large.
Meanwhile, cash on hand was small.
Granting options provided employees
with the promise of a big future payoff, while costing little in terms of
impact on the income statement —
thanks to accounting conventions of
the day.
In RF Micro’s fiscal 2000, subtracting the cost of employee stock
options from earnings (along with a
few other adjustments) would have
dropped profits 36 percent, from $50
million to about $32 million. Dean
Priddy, RF Micro Devices’ chief financial officer and the fifth employee to
be hired at the firm, in an interview
did not specifically address whether all
those options would have been granted if they had to be expensed. But he
did say: “I see why some management
teams would like it to be more of a
footnote.”
In 1998, the adjusted price of RF
Micro shares was just more than $1.
By early 2000, it was topping $90.
Options outstanding during 2000,
meanwhile, had exercise prices ranging between 4 cents and $175, with a
weighted average strike price of
$17.22. For a couple of years, employees holding options to buy RF Micro
stock were on the brink of striking it
rich. “If [the stock price] appreciates,
then the investor is going to be happy.
And the employee, too, is going to
draw some economic benefit,”
Priddy says.
Then in the winter of 2000, RF
Micro shares began to plunge, following the general southward trend of
the technology sector. With shares
quickly dipping to about $5, almost
all the outstanding options granted to
employees became worthless. And
RF Micro stock remained mired
south of $10 a share for the next few
years. With the 2006 adoption of the
new accounting rule regarding

20

R e g i o n F o c u s • Wi n t e r 2 0 0 7

expensing options, those worthless
options would suddenly be costing
RF Micro a chunk of profits.
For that reason, RF Micro in 2005
was one of about 900 firms nationwide that accelerated its stock option
vesting schedule. By speeding up the
vesting period, firms essentially erased
them off the books so that they
wouldn’t need to expense them in
their income statements when the
time came. There was nothing necessarily sinister about the practice,
although for firms that intend to keep
on using employee stock options — or
substitute some other sort of compensation in lieu of options — it may
mean that reported 2005 expenses
appear abnormally low and likely to
jump up the following year.
In RF Micro’s case, all of the accelerated-vesting options were “out of
the money,” meaning the exercise
price was above the trading price
at the time. The company vested
10.2 million shares, and in its fiscal
2005 annual report said the move cost
it $22.1 million. But again, this charge
appeared only in the footnotes,
instead of in the main report if they
had carried over to the next year.
“That was a legitimate way to avoid
the expense on those particular
options,” says Priddy. “We decided it
would be a prudent thing to do.”
One earnings bullet was dodged,
but the new accounting rule loomed.
How would RF Micro Devices
respond? First, it has begun duly
reporting its options expenses in the
regular income statement. But it also
began doing something else — providing its own version of how investors
might view the firm’s financial reports.
It’s called “non-GAAP” results. GAAP
stands for Generally Accepted
Accounting Principles, and the nonGAAP numbers take out expenses for
stock options, as well as some onetime charges. For the firm’s second
quarter this year, the GAAP results
showed a loss of $20 million while the
non-GAAP results showed a profit of
$23.7 million.
“To the extent that [stock-option
expense] are in the GAAP results, it

does stand out,” Priddy says. “We’re
less concerned about where it shows
up than being able to show the investment community what we believe our
core operating results are. That gets to
the non-GAAP presentation.”

Broad-Based Options
Whether RF Micro Devices provides
two versions of financial results or 200
ultimately doesn’t matter. The important thing is that a) the market gets the
information it needs to properly value
the firm and b) the firm’s managers
and board members recognize the true
economic cost of granting options as
they go about making decisions about
how to deploy the company’s assets.
The problem with stock options centers more on the latter point.
Kevin Murphy, an economist at the
University of Southern California
(USC), believes that scores of firms
had a blind spot with regards to
options, thanks in part to their previous disclosure location in the
footnotes, and he has evidence to back
that assertion up.
Murphy, along with Harvard
University economist Brian Hall,
found an enormous spike in the value
of option grants during the 1990s. In
1992, the average grant-date value of
employee stock options among firms
in the S&P 500 was $22 million; by
2000, it was $238 million. But the big
story in that growth was who was
receiving the options — rank-and-file
employees. By 2002, about 90 percent
of stock options were granted to
employees below the top-executive
level.
The thing is, the utility of options
among such lower-level employees is
limited. Options would seem useful in
attracting entrepreneurial, risk-taking
workers. But usually only the
performance of employees with a lot of
responsibility and decisionmaking
opportunities can directly affect company stock prices. When options are so
liberally given, they can create a freerider problem, with many employees
benefiting from stock price gains that
occurred largely because of the actions
of others. Also, as a retention tool,

options can backfire in times of bear
markets, as employees ditch their firms
in search of companies offering other
compensation packages.
Therein lies the big question:
Taking for granted that all of these
problems with granting options to
lower- and mid-level employees are
true, what reason would rational,
incentive-minded boards and managers have in lavishing options across
the payroll? The only plausible answer
is that they regard them as free, or at
least as costing less than cash.
“The conclusion that these ... firms
will be hurt [by the new rule requiring
expensing of options] and not
benefited is based on the incorrect
assumption that these options are
free, or cost very little,” Murphy says.
“But there’s an inherent fallacy in
that logic. My own view is that
companies are always helped when
they make decisions based on the
economic cost.”
How is it that boards and managers
don’t seem to recognize the economic
costs of options while the market
does? The leading hypothesis is that
managers don’t pay attention to
economic numbers because their
compensation is based on accounting
numbers. Equally, managers perceive
that hitting their accounting number
targets is key to keeping their stock
prices steady and rising. “There’s a lot
of literature out there that seems to
suggest that managers care a whole lot
about accounting treatments for
various types of things even though
the market sees through it,” says
Guay, the University of Pennsylvania
accounting professor. “This whole
notion of meeting or beating forecasts
has evolved into this complex game of
signaling that didn’t evolve out of any
economic significance.”
Economists Hall and Murphy have
looked beyond stock options and
found other evidence that managers
often respond to accounting concerns
in ways that seem irrational, citing
the 1993 rule change imposing a
charge for anticipated post-retirement health care liabilities. Firms
predicted that stock prices would fall

because of the impact on income, but
prices remained the same because the
market was already valuing this
economic liability — and yet companies still cut back on their retiree
medical benefits. Such seeming
irrationality remains hard to explain,
but it’s worth noting that, despite
such cases, firms generally behave in
ways that are consistent with mainstream economic theory.

Backdating
The historical practice of making
options essentially free in accounting
terms may be at the heart of one of
the more recent scandals engulfing
corporate America — options backdating.
Backdating is the term given to the
practice of retroactively matching
strike prices of stock options so that
they correspond to a particularly low
price for the company’s stock. The
result is that employees with backdated
options
have
greater
opportunity to enhance their profit
from exercising them. Backdating is
not necessarily illegal, so long as
shareholders are properly informed
and earnings are properly adjusted —
but in practice few firms seem to have
met those requirements.
The vast majority of firms that
have announced they expect to restate earnings to reflect backdating of
options are in the technology
sector, many based in Silicon Valley.
Among the more than 100 of those
firms is only one in the Fifth District
— ePlus Inc., a computer products
reseller based in Herndon, Va.,
according to a Wall Street Journal
compilation of reports on firms that
have disclosed government investigations. The company in August said
it would have to account for $3 million in stock option compensation
expenses from April 1997 through
March 31, 2006, and that further
expenses arising from an internal
investigation “will be significant.”
Erik Lie, a finance professor at the
University of Iowa, is one of the leading researchers of the backdating
phenomenon. Lie estimates that at

least 2,000 firms have engaged in
backdating over the years.
Backdating is much less likely to
happen today for two reasons. The
first is due to a 2002 requirement
by the SEC that option grants be
reported within two business days.
Firms that want to dabble in backdating today have to engage in
outright fraud rather than play around
the edges of legality as before. “Now
you have to come up with one more lie
about how you made the grant,”

Views on Stock Options and
Reaction to FAS No. 123(R) from
Around the Fifth District
“The concept behind using stock options is
that it aligns employees’ interests with those
of our shareholders. As they work to increase
the value of the firm, employees in turn are
rewarded with the growing value of their
stock option grants.”
—LINDA BREWTON, MANAGER,
INVESTOR RELATIONS, RED HAT INC., DURHAM, N.C.
“Stock options align well with Sonoco’s shareholder interests and provide a good vehicle
for employee stock ownership, and until
recently had an advantageous accounting
treatment ... With the anticipation of FAS
No. 123(R) several years ago, Sonoco began to
shift more of its incentives at the senior level
from stock options to long-term incentive
plans based on restricted stock.”
—ROGER SCHRUM, DIRECTOR,
CORPORATE COMMUNICATIONS, SONOCO PRODUCTS CO.,
HARTSVILLE, S.C.
Since the adoption of FAS No. 123(R), “The
substantial majority of employees receiving
awards have received restricted stock instead
of stock options.”
—KATHARINE KENNY, ASSISTANT VICE PRESIDENT,
INVESTOR RELATIONS, CARMAX INC., RICHMOND, VA.
“We are very concerned that the cost of
expensing employee stock options would
restrict the ability of companies to offer this
important benefit in the future ... In addition,
we are concerned with the impact the
proposal would have on small businesses.”
—STEVEN ANDERSON, CEO,
NATIONAL RESTAURANT ASSOCIATION, WASHINGTON, D.C.

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

21

Lie says. “That may help curb backdating.”
Second, some analysts argue that
expensing options serves as a deterrent to backdating. If firms had to
immediately recognize the cost of
granting options, then there likely
would have been more scrutiny over
the practice of backdating and
its accompanying costs. Rebecca
McEnally, a director with the CFA
Institute, a Charlottesville, Va.-based
nonprofit financial markets organization, says the requirement that firms
expense options is one of several
important changes that will ease the
problem. “Both preparers of financial
statements and auditors pay too little
attention to the numbers that are
reported in the footnotes,” McEnally
says. “If it’s not expensed, it looks like
a free good at the time, even though it
is costly to investors.”

Future Options
But what place will garden-variety
employee stock options hold in the
future? The evidence so far is that
companies are paring back their
employee option grants. Murphy, the
USC economist, says his recent surveys have found that while in 2001,
firms were granting 2.6 percent of
their compensation in the form of
stock options, in 2005 it was down to
1.3 percent. “There’s a tremendous
amount of evidence that managers
and directors respond to changes in
accounting rules,” Murphy says.

In other words, now that there is
both an economic and accounting cost
to be reported, employee stock options
seem unlikely to be offered in the volume they were in years past. When it
became obvious that stock option
expensing would become the norm,
many firms began cutting back on their
use. Perhaps the most famous firm to
swear off options is Microsoft. Since
2003, the Redmond, Wash., company
has only made outright stock grants to
workers. In firms where stock options
continue to be issued, Murphy and
Hall believe, they are “likely to be
reduced and concentrated among
those executives and key technical
employees who can plausibly affect
company stock prices.” That category
would include young and small firms, as
well as possibly struggling firms for
which employee loyalty and high performance is particularly important.
Of course, for firms that believe
stock prices already reflected the cost
of options, then reporting them
should not matter much, says the
Cleveland Fed’s Haubrich. “So if
options are the proper compensation
tool, their use should continue.”
In Greensboro, RF Micro Devices
remains a believer in stock options.
Last year, the firm’s shareholders
approved a plan that canceled 9.4 million old options and awarded half
as many new ones. The old options
were worthless, with strike prices
as high as $87.50 at a time when
RF Micro shares were trading well

below $10. The newly issued shares
(one awarded for every two canceled
shares) came with much more friendly
exercise prices of $6.06 and vesting
over two years.
Thus, options remained a part of
RF Micro’s compensation program.
The firm continues to believe in the
utility of stock options, so much so
that to this day, every new domestic
employee at RF Micro Devices gets an
award of stock options upon hiring.
The firm has 2,000 domestic employees, so this is no trifling matter. It
speaks to management’s philosophy
about employee impact. As CFO
Priddy says, “We believe that every
single employee has the ability to
improve the long-term operating
results for the company, whether it’s
someone working in wafer fabrication
to help improve the product, or if it’s a
person in customer service. To us, all
of our employees are valuable assets,
and we believe these employees recognize the value of our stock options.”
In a way, one can think of RF Micro
Devices’ enduring faith in stock options
as a natural experiment: How much can
a firm rely on stock options to motivate
employees in a time when granting
them now carries immediate and perhaps more obvious costs? Priddy is
optimistic. “It’s something we certainly
continue to plan on doing. I really don’t
know if this company as we know it
today would be here without stock
options,” he says. “That’s how powerful
an incentive tool I believe they are.”RF

READINGS
Bliss, Robert. “Common Sense about Executive Stock Options.”
Federal Reserve Bank of Chicago, Chicago Fed Letter no. 188,
April 2003.

Guay, Wayne, S.P. Kothari, and Richard Sloan. “Accounting for
Employee Stock Options.” American Economic Review, May 2003,
vol. 93, no. 2, pp. 405-409.

Bulow, Jeremy, and John B. Shoven. “Accounting for Stock
Options.” Journal of Economic Perspectives, Fall 2005, vol. 19,
no. 4, pp. 115-134.

Hall, Brian, and Kevin Murphy. “The Trouble with Stock
Options.” National Bureau of Economic Research Working
Paper no. 9784, June 2003.

Calomiris, Charles, and R. Glenn Hubbard. “Options Pricing and
Accounting Practice.” American Enterprise Institute Working
Paper no. 103, January 2004.

Haubrich, Joseph. “Expensing Stock Options.” Federal Reserve
Bank of Cleveland Economic Commentary, November 2003.

Deshmukh, Sanjay, Keith M. Howe, and Carl Luft. “Executive
Stock Options: To Expense or Not?” Financial Management,
Spring 2006, vol. 35, no. 1, pp. 87-106.

22

R e g i o n F o c u s • Wi n t e r 2 0 0 7

Lie, Erik. “On the Timing of CEO Stock Option Awards.”
Management Science, May 2005, vol. 51, no. 5, pp. 802-812.

Phoning

It In

Telecommuting hasn’t become the commonplace work alternative its advocates
anticipated. Still, the flexibility it offers has helped a significant number of
companies and employees

T

hree years ago, Malcolm
McLeod didn’t know how
much longer he could endure
his daily commute. The 60-year-old
environmental engineer remembers
leaving his home in Caroline County,
Va., at 4:30 a.m. every morning so he
could drive to the nearest Virginia
Railway Express station, catch a train,
and get to his office in Washington,
D.C., two and a half hours later. In the
evenings, he would leave work at 4:15
p.m. and get home well after 6.
Sure, McLeod could have moved,
but he preferred a less urban environment and wanted to remain in the
farmhouse he had purchased and
renovated 30 years ago. He also could
have retired or looked for employment
closer to where he lived, but he had
already put in several decades at the
U.S. Army Corps of Engineers and
generally found his job rewarding. The
agency didn’t want McLeod to leave,
either — he manages the decommissioning of three nuclear plants built
more than 40 years ago by the Army
Corps, plants he knows inside and out
since he helped engineer them.
So, several days a week McLeod
trades his desk in D.C. for one of the
workstations at the Fredericksburg

Regional Telework Center, located in
an old shopping center off Interstate
95 and just nine miles from his house.
“Depending on how many stoplights I
hit along Route 17, it takes me about 10
to 15 minutes to get to the center,” he
describes. For McLeod, working from
the center part-time has been a
lifestyle change. “I would have seriously
considered retirement unless I was
able to do this.”
The Fredericksburg center is one
of 14 locations operated by the
General Services Administration for
federal employees like McLeod who
don’t drive to their place of employment every day. Instead, they
“telecommute” or “telework,” using
communications technology to perform their jobs remotely on a regular
basis, usually from home or a location
that’s nearby. The government agencies pay a daily rate of $25 to $49 for
every employee based at a telework
center, as well as foot the bill for longdistance calls.
From the outside, the Fredericksburg center looks like any other plain
storefront. Inside is a microcosm of
the typical office environment, accessible 24 hours a day, seven days a week
with the swipe of a card at the front

door. Thirty workstations are scattered
around the open floor plan, each with
a telephone and a desktop computer
networked to the outside world.
Telecommuters have access to a
conference room for meetings and
locked cabinets for storing confidential
paperwork.
McLeod and the other regulars at
the center get to use a reserved workstation. Some personalize their space
like Mary Ann Delaney, a national
account manager for military construction at the Army Corps. Delaney, who
has worked at the center since 1994
and spends three days a week here,
likes to display pictures of her dog.
“It is completely seamless,”
Delaney says, using a word that
McLeod also used to describe his current work arrangement. “I deal with
people in Europe, I deal with people at
the home office, [and] I deal with people at the Pentagon. It’s amazing.”
Despite these and other success stories, the Fredericksburg center was
pretty quiet on a fall Tuesday morning.
Typically, it’s booked at 60 percent of
capacity on Tuesdays, notes Jennifer
Alcott, who manages this facility
and two others in Woodbridge and
Stafford in Northern Virginia. Overall,

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

ILLUSTRATION: PHOTOSPIN AND AILSA LONG

BY CHARLES GERENA

23

Winning Converts
Those who have studied telecommuting or advocated its adoption say that
the ranks of telecommuters have
grown over the long term, with a
leveling off occurring after 2000.
But don’t try to pin them down to
exact numbers.
“Firms do not need to report teleworkers to anyone, nor do individuals
need to do so,” says Diane Bailey, a
professor of management science and
engineering at Stanford University who
has studied telecommuting. “Additionally, definitional problems about who
to count … make counting difficult.”
Instead of braving the congested roads of Northern
Virginia, Juliet McBride and Malcolm McLeod
telecommute from the Fredericksburg Regional
Telework Center.

24

R e g i o n F o c u s • Wi n t e r 2 0 0 7

A variety of government surveys
include data on people who work from
home, from the U.S. Census Bureau’s
American Housing Survey to the
Department of Transportation’s
National Household Travel Survey.
Nonprofits like the International
Telework Association and Council
(ITAC) have done surveys too. The
problem is some of them count a person as a telecommuter if he works
outside of the office full-time, while
other surveys also count people who
telecommute irregularly, work offhours at home, or are home-based
entrepreneurs or consultants who
rarely spend time in a traditional office.
With these limitations in mind,
the most recent estimates from the
Bureau of Labor Statistics and ITAC
place the number of people who
telecommute at least once a week at
21 million to 22 million, or 15 percent
to 16 percent of the total work force.
These numbers are higher than
estimates calculated in the 1990s,
but still less than what some experts
had projected.
Lawmakers have been trying to
encourage broader use of telecommuting to reduce energy consumption and
improve air quality. Reducing traffic in
metro areas also has become a way to
increase transportation capacity without building more roads, which can be
politically difficult to accomplish, and
to improve quality of life. In both
cases, growth would be encouraged
in communities.
Therein lies a problem with using
telecommuting and other alternatives
like mass transit and carpooling to reduce traffic. If
congestion eases in a metro
area, more people want to
live there. A similar phenomenon occurs when new roads
are built — traffic problems
are relieved in the short run,
but this induces more people
to drive, clogging the roads
with traffic once again.
“You just bring more
people into urban areas.
The physical number of
people would be the same,

or perhaps larger,” notes economist
Elena Safirova. Based on her research
at Resources for the Future, a
Washington, D.C.-based think tank,
Safirova says that telecommuting
programs cannot be relied upon to
sustain the reductions in congestion
they initially achieve.
In addition, studies on the transportation impact of telecommuting
have found reductions only in daily
trips and vehicle miles traveled on an
individual basis. “Thus, although an
individual telecommuter may experience a sharp reduction in [vehicle
miles traveled], total benefits depend
on how many people are telecommuting and how often they are doing so,”
wrote Safirova and Margaret Walls in a
2004 paper.
Even as the technology has
emerged to allow people to work
remotely and independently, embracing telecommuting still requires a
major shift in thinking for both
employers and their employees. The
benefits have to outweigh the costs to
make it worth the change.

The Future of Human Resources
Management?
Advocates point to several potential
benefits of telecommuting for
employers. Number one on their list
is that it increases productivity.
By allowing employees to telecommute, companies can reduce
absenteeism and tardiness. Instead of
trying to come to the office when an
overturned tractor trailer has shut
down the interstate, employees can
stay home and work. Or, when they
have a doctor’s appointment or a
school emergency close to home,
telecommuters don’t have to take as
much time off.
Another way telecommuting could
benefit companies is to help match
jobs with workers. “Employers [that
offer telecommuting] have access
to a wider work force than they
would if they relied on only the local
work force,” Safirova explains. “Some
people don’t want to live in large
cities,” but they might work for
companies in those locations.

PHOTOGRAPHY: CHARLES GERENA

the utilization rate of the 14 telework
centers is about 55 percent, amounting to 469 federal and nonfederal
employees.
This trend mirrors what has
happened in the private sector —
telecommuting hasn’t been widely
adopted despite efforts to encourage
its use since the 1970s, frustrating its
proponents. While this arrangement
gives businesses and workers greater
flexibility, the benefits accrue to only
a particular type of employee doing a
certain kind of work in certain industries. Just because people can do a
variety of jobs from a laptop on their
kitchen table doesn’t mean that
telecommuting is automatically the
most economically rational choice
for everyone.

Similarly, the flexibility provided
by telecommuting can help a company
retain employees, especially in tight
labor markets. Take ORC Macro
International, for example. The
management consulting firm’s division
in Bethesda, Md., started offering
telecommuting in the late 1990s to
hang on to its data collection and
dissemination workers who were
moving away.
“These people were going to be
hard to replace,” recalls Guy Garnett,
the division’s vice president of network systems and services. “They
knew how we work and the projects,
so they were more valuable than a new
hire.” One employee was married to a
member of the military who was
posted to Bosnia. When she decided
to go with him, the company allowed
her to telecommute from six time
zones away.
Today, ORC’s Bethesda employees
telecommute from Massachusetts,
Pennsylvania, and even Eastern
Europe. Last April, Vladimer
Shioshvili started telecommuting
from Georgia — the former Soviet
Republic, not the Peach State — to be
closer to his family. The senior programmer/analyst works from a small
room in his girlfriend’s apartment,
outfitted with a computer desk and
chair, a laptop provided by the
company, and a printer, along with a
view of the busy streets below.
“It can get a little loud sometimes,”
Shioshvili says, and it took awhile
to get used to the eight-hour time
difference. But there have been no
problems with his intercontinental
telecommute so far, other than an
occasional dropped call.
Finally, telecommuting promises to
reduce a company’s need for office
space. Jennifer Alcott, the Fredericksburg telework center manager, points
to the U.S. Patent and Trademark
Office as an example. According to
Alcott, the PTO will have to hire
about 3,000 examiners within the
next few years. This influx of new
hires will require doubling the size
of its campus in Alexandria. To
lessen that expense, the agency is

expanding its 10-year-old telecommuting program.

Don’t Move My Cheese
Despite these and other fruitful implementations of telecommuting, there
are many managers who remain
unconvinced. They need hard evidence that increased productivity and
cost savings will compensate for the
startup and ongoing expenses of a
telecommuting program.
Claims of improved productivity

have been based largely on case studies
of individual companies and surveys,
both of which are subjective measures
that have their limitations.
“You can measure the productivity
impacts of telecommuting as well
as you can measure [white-collar]
productivity generally,” says Patricia
Mokhtarian, director of the Telecommunications and Travel Behavior
Research Program at the University of
California at Davis. “It is pretty hard
to quantify,” though it can be done in

Government Sweetens the Telecommuting Pot
Since the Arab oil embargo in 1973 and
1974, government officials on the federal
level have been nudging private companies
to offer telecommuting as a way to reduce
energy consumption. Later, Clean Air Act
mandates forced states to take a hard look
at ways to get cars off the road, including
having more people work from home. In
both cases, the results of their efforts have
been mixed.
Congestion and air-quality concerns
are what drove local governments in the
Washington, D.C., region to include
telecommuting as part of their regional
transportation planning. “We were designated as a severe non-attainment area for
nitrogen oxides and volatile organic
compounds by the EPA,” says Nicholas
Ramfos, who manages the telecommuting initiatives of the Metropolitan
Washington Council of Governments. In
order to receive federal transportation
funding, the region had to show it was
taking steps to reduce those pollutants.
Government programs support
telecommuting for another reason — to
open doors to employment for those who
have difficulty finding and keeping a job.
These include the homebound (i.e.,
stay-at-home parents, the physically
handicapped, and the elderly), spouses of
military personnel who are subject to
relocation at any time, and residents of
isolated rural areas.
Since 2001, Telework!Va has provided
incentives for Virginia businesses to establish or expand telecommuting programs.
The state-funded program offers a maxi-

mum of $3,500 per employee for up to 10
employees to help cover program expenses over a two-year period. Reimbursable
costs include leasing office equipment for
home use, renting space at a telework center, and consulting and technical services.
So far, two dozen companies in the
Northern Virginia, Richmond, and
Hampton Roads regions have received
$302,000 in grants, the majority going to
firms closest to the nation’s capital. That is
just a fraction of the $3.2 million budgeted
for the program by the General Assembly.
Through its Telework Partnership with
Employers program, Maryland had
offered state-funded grants of up to
$15,000 to pay for a consultant to assess a
company’s potential for telecommuting,
then develop and implement a program.
Russ Ulrich, who coordinates air-quality
outreach programs at the Baltimore
Metropolitan Council, says that most of
the money set aside by lawmakers for the
eight-year-old program has been spent.
Still, telecommuting was slow to catch on
in the Baltimore metro region.
“There was a lot of skepticism, especially for those businesses that had
never heard of teleworking and had no
firsthand experience with it,” Ulrich
notes. “The idea of working remotely
wasn’t fully understood.” Even though
the regional economy is changing, it still
has a “blue-collar mentality.” Employers
expect their workers to show up at their
place of business, and for many of the
region’s top industries, telecommuting
— CHARLES GERENA
simply is not feasible.

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

25

some industries like telemarketing
and sales.
Furthermore, actual improvements
in the productivity of telecommuters
may be limited to those who are
already disciplined, hard workers.
Relatively unproductive workers don’t
magically become “Employees of the
Month” if they are allowed to telecommute. These employees need
monitoring, which telecommuting
makes more difficult. Productivity
gains are also constrained when people
telecommute only part-time.
Cost savings from reducing office
space have been documented. The
caveat, in this case, is that the
company must achieve a critical mass
of teleworkers in order to realize
those savings. “You’ve got to have
enough people out of the office for
enough days during the week that you
can reconfigure your office space,”

A Small Slice of the Work Force
Among the 82 federal agencies surveyed in 2004,
only 4 percent of their 1.8 million employees
telecommuted at least once a week.
1,818,397 Total Workers

Not Eligible
to
Telecommute
59%

Eligible
to
Telecommute
41%

752,337 Workers Eligible to Telecommute
Telecommuters
19%
NonTelecommuters
81%

140,694 Workers Telecommuting
Telecommute
Less Than Once
Per Week
50%

Telecommute
1+ Days
Per Week
50%

SOURCE: “The Status of Telework in the Federal Government,”
U.S. Office of Personnel Management, December 2005

26

R e g i o n F o c u s • Wi n t e r 2 0 0 7

says Harriett West, a senior manager
at Clifton Gunderson. She has tried to
develop a telecommuting specialty
practice at the accounting and business consulting firm since 2001, but
hasn’t had many takers.
While the benefits of telecommuting seem unclear, many managers are
concerned about what might be lost if
employees are allowed to work from
anywhere. Some say it would be harder
to ensure that telecommuters are
doing their jobs. Others don’t want to
lose the fruits of collaboration.
Mokhtarian says academic studies
have demonstrated the value of having
workers physically present. While
information technology is supposed to
make working remotely as good as
being in the office, managers lose the
body language, the ease of getting people together, and the side conversations
that convey a lot of meaning and information. “In many cases, there is a
legitimacy to the idea that we need to
be face to face,” she adds.
There is also the monetary cost
of creating a virtual office. While
42 percent of adults have broadband
Internet access at home, the company
or the worker has to be willing to pay
for connecting those households without it. In addition, telecommuters
need the proper equipment in place,
from fax machines to PCs with secure
network access. “For some federal
agencies and contractors, security
for remote access is a huge concern,”
says Nicholas Ramfos, director of
the commuter program at the
Metropolitan Washington Council of
Governments.
Such costs vary from company to
company, but a telework study done
for the Virginia Department of
Transportation in 2001 arrived at
some general estimates. For a program with a minimum of 50
participants telecommuting at least
twice a week, startup costs were
pegged at $6,000 for home-based
telecommuters and $9,500 for those
who work at a telecenter. The annual
recurring costs ranged from $2,500 to
$3,500 per person. (The General
Services Administration’s cost esti-

mate for home-based telecommuters
also falls within this range.)
Finally, legal issues have to be
addressed. Most states — including
Virginia, West Virginia, and the
Carolinas — reserve the right to tax a
company’s income if it has workers
telecommuting from those states.
Then, there are liability questions:
What is the employer’s obligation to
ensure that the telecommuter’s home
office adheres to workplace safety
standards? Do union contract
requirements apply to employees
who work at home? Each question
can be addressed in the telecommuting agreement signed by the
employer and employee, but every
additional provision adds costs to the
arrangement and undermines its
flexibility.

The Employee Perspective
Managers aren’t the only ones who
weigh the potential benefits and costs
of telecommuting. For employees, the
advantages of working from home
have to be worth the effort.
The main promise of telecommuting for individuals is the flexibility it
offers for balancing work and family
duties. In her 2002 review of previous
telecommuting research, Diane Bailey
found that women, dual-career
couples, and families with younger
children often cite this benefit.
Additionally, Bailey says telecommuters benefit from greater autonomy
and the time and cost savings of working from home.
Still, telecommuting may not yield
significant benefits for everyone. For
example, some people don’t mind
having a long journey to work. One
study done by Patricia Mokhtarian in
2000 found that people actually derive
some benefit from a commute of moderate length — among 1,300 workers
surveyed in the San Francisco Bay
Area, the average commute desired
was 16 minutes.
Why? Workers may need the
journey between home and work to
prepare for the workday ahead or
to unwind before walking through
the front door. “This is the time

Reality Check
Like videoconferencing, telecommuting isn’t right for every company,
every job, or every person.
Service firms that focus on the
creation, distribution, or use of information are a natural fit for
telecommuting. This includes call
centers, computer software firms,
marketing organizations, and corporate support operations like payroll
and human resources. Also, occupations where most of the work occurs
outside of the office anyway are better
suited for telecommuting, such as sales
and auditing.
In contrast, workers at manufacturing plants, mines,

If the Telework Exchange and other nonprofit groups promoting telecommuting
had their way, there would be more
bumper stickers like this one on cars.

and building maintenance firms have
to do their jobs on-site. In general,
most of the production work force will
probably never telecommute. Neither
will those occupations where face-toface interaction is essential to the job.
Herman Miller, which offers workspace consulting services in addition
to producing office furniture, outlined
in a 2001 white paper what it considers
to be the ideal telecommuting job:
“Work that can be performed off-site
is generally explicit enough to be
achieved without further explanation

or direction, paced and controlled by
the worker, conducted over the
phone,” and involves soft skills like
reading and planning. A Department
of Labor report published in 2000
noted that telecommuting works best
for jobs that demand a high degree
of privacy and concentration, are
predictable, and information-based.
Rita Mace Walston, general manager of a nonprofit advocacy group
called the Telework Consortium, adds
that people who are newcomers to
their job, the industry, or the world of
work in general may need a
little seasoning in the office before
they are ready to telecommute.
In general, the best telecommuters are self-directed and
self-disciplined. These are
traits that Vladimer Shioshvili
possesses, and they help
make telecommuting from
Eastern Europe work for
him and his employer, ORC Macro
International.
“I can motivate myself, most of the
time,” he says, although keeping
himself on task can sometimes be a
challenge when there are distractions
in his apartment. He continues to
work late once in a while, putting in
more than eight hours a day like he
used to back in Bethesda.
To stay in the loop, Shioshvili uses
a messenger service, e-mail, and
phone conversations in addition
to instant messaging. Also, because
the company has several dozen
telecommuters,
project
teams
hold biweekly conference calls to
supplement physical meetings.
“Sometimes, it doesn’t feel like I’m
RF
that far away.”

PHOTOGRAPHY: COURTESY OF TELEWORK EXCHANGE

to decompress and change roles. It is a
transition period between one role in
your life and another,” economist Elena
Safirova notes.
Some workers believe they are
judged by how much “face time” they
have with management. Therefore,
their chances of promotion would be
hurt if they become less visible by
telecommuting. Among 1,320 executives surveyed by recruitment firm
Korn/Ferry International in late
2006, about 61 percent thought
telecommuters are less likely to
advance in their careers compared to
employees working in traditional
office settings.
“Even though workplace technology has made big leaps forward
compared to 20 or 30 years
ago, the general mentality of
the workplace is still the same:
out of sight, out of mind,”
Safirova says.
In fact, this could be more
perception
than
reality.
Consultant Harriett West says
workers allowed to telecommute are
usually the ones that management
thinks are the most trustworthy and
productive. Korn/Ferry’s survey confirms her assessment: 78 percent of
respondents said telecommuters are
either equally or more productive
than their office-bound colleagues.
Finally, some telecommuters may
have trouble stepping away from
their desk at the end of what otherwise would be the normal workday.
“If you wake up at 2 o’clock in the
morning with an idea, the work is
right here,” West explains. “Some
people need more of a barrier
between work and home.”
READINGS

Bailey, Diane E., and Nancy B. Kurland. “A Review of Telework
Research: Findings, New Directions, and Lessons For the Study
of Modern Work.” Journal of Organizational Behavior, June 2002,
vol. 23, no. 4, pp. 383-400.
Telework: The New Workplace of the 21st Century. U.S. Department
of Labor, 2000.
Walls, Margaret, and Elena Safirova. “A Review of the Literature
on Telecommuting and Its Implications for Vehicle Travel and

Emissions.” Resources for the Future Discussion Paper 04-44,
December 2004.
Washington Metropolitan Telework Demonstration Project, August
1997-April 1999: Final Report. Metropolitan Washington Council
of Governments, July 1999.
Westfall, Ralph D. “Does Telecommuting Really Increase
Productivity?” Communications of the ACM, August 2004,
pp. 93-96.

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

27

Opt in or
Opt out?
Automatic enrollment
increases 401(k) participation
BY BET TY JOYCE NASH

28

R e g i o n F o c u s • Wi n t e r 2 0 0 7

which what you get depends very
much on what you as an individual do
while you’re working,” says Brigitte
Madrian, a Harvard University economist who has studied plan designs and
savings outcomes.
But 401(k) decisions require a chain
of financial moves that many workers
avoid. About one-fifth of eligible
employees don’t even take the first
step — signing up.
To remedy this, automatic enrollment in 401(k) plans is gaining
traction among employers. Instead of
having to sign up, employees are
enrolled by default but retain the
right to opt out. Participation results
among firms that have tried it have
risen as high as 90 percent, in some
cases. It’s especially effective for
increasing participation of women
and minorities.
Traditional neoclassical economics
can’t explain the success of automatic
enrollment. Why would it improve
enrollment when the choices are the
same? Rational people should participate in roughly the same numbers
regardless of whether the default is
opt in or opt out. In explaining this

paradox, economists are turning to
behavioral economics.

Human Nature and
Economic Man
Basic neoclassical economic theory
suggests that people weigh costs and
benefits, making decisions that are in
their best interest. They save and
spend according to need over a lifetime. Some people, for example, may
count on that rich uncle, or other
savings vehicles, especially home
equity. And 401(k) plan contributions
are deducted before taxes, a great
benefit to higher-income earners, but
not so much for low-wage workers. So,
for some people it could be rational to
forego contributions to a 401(k) plan,
especially since tax rates and/or brackets may be higher at retirement than
now. (For low- and moderate-income
people, some research shows that a
401(k) plan may raise lifetime taxes
and lower lifetime expenditures.)
Still, surveys indicate that retirement preparation may be inadequate
to sustain retirement. The Center for
Retirement Research at Boston
College reports that 35 percent of

PHOTOGRAPHY: PHOTODISC AND PHOTOSPIN

P

lanning for retirement is
something we would expect
“rational economic actors” to
take great care in doing. But the
Federal Reserve’s 2004 Survey of
Consumer Finances shows the typical
household approaching retirement
with less than $30,000 in financial
assets outside of employer-sponsored
plans. And people aren’t saving enough
in those plans. This is not the sort of
behavior one would expect from
forward-looking human beings.
Society could be headed for an
expensive ride if the workers of today
don’t squirrel away money — early and
often. Life expectancy can leave, on
average, about 20 years in retirement,
and someone will have to pay for it.
With guaranteed company pensions
becoming less common and the arithmetic problems of Social Security well
publicized, today’s workers need a
retirement lifeline. The risk and
responsibilities of retirement rest on
individuals’ shoulders.
“Companies are moving away from
defined benefit plans [guaranteed
pensions] and moving toward
[defined] contributions, the 401(k), in

households aged 55 to 64 have no pension, only Social Security. With 401(k)
becoming the new pension, policy
experts worry that this group of insufficient savers could grow. Mainstream
economics hasn’t fully explained nor
found the cure for low savings.
The life-cycle theory, for example,
assumes that people increase savings
as they age. But economists Lawrence
Summers of Harvard University and
Christopher Carroll, now with Johns
Hopkins University, suggested in a
1989 paper that consumption, rather
than being smoothed over the life
cycle, instead tracks income. And it
would seem that aging baby boomers
would be beefing up the national
savings rate, but the rate continues
its decline.
“Unfortunately, many years of concentrated attention on this issue by
policymakers and economists have
failed to uncover a silver bullet for
increasing household saving,” Fed
Chairman Ben Bernanke said recently
in a speech. While no silver bullet,
automatic enrollment in 401(k) plans
may be a step in the right direction.
Whereas neoclassical economics
generally models humans as wholly
rational beings, behavioral economics
assumes some flaws. Incorporating
psychological insights, behavioral economics finds human decisions
sometimes fraught with error and systematic bias: People have trouble
making long-term decisions and place
more weight on present circumstances
than those in the future.
Behavioral economists Richard
Thaler and Shlomo Benartzi observed
in 1981 that actual household behavior
veers from the life-cycle theory for
many reasons. People might calculate
needs incorrectly, and have trouble
delaying gratification. For example,
people born between 1931 and 1941
who saved with old-fashioned pension,
Social Security, and home equity —
vehicles requiring precious little
willpower — tend to be adequately
prepared in retirement, according to
economists Alan Gustman and
Thomas Steinmeier of Dartmouth
College and Texas Tech University,

respectively. But workers today need
to act: calculate future expenses, save,
and invest for adequate asset accumulation. That is a tall order for people
who place enormous weight on current consumption, and an especially
tall order for people with little or no
financial knowledge.
Those decisions require selfcontrol and savvy as well as the ability
to act rather than procrastinate. As
Thaler and Benartzi write, “determining the appropriate savings rate is
difficult, even for someone with economics training.”
Thaler and others have identified
the human tendency to postpone
unpleasant tasks such as saving or
dieting rather than spending or eating.
Using such human characteristics
to advantage, automatic enrollment
can increase savings somewhat painlessly. Thaler and Benartzi point out:
“Standard economic theory would predict that this change would have
virtually no effect on saving behavior.
The costs of actively joining the
plan (typically filling out a short
form) are trivial compared with the
potential benefits of the tax-free
accumulation of wealth.” Yet automatic enrollment has clearly added
workers to 401(k) plans.

Benefit vs. Contribution
Guaranteed income streams, also
known as defined benefits, have been
drying up. Employers over the last 25
years instead have offered 401(k) plans
as an alternative. Only about one in
five employees today is covered by traditional pensions compared to the
nearly two-thirds so covered in 1983.
Moreover, one in four workers were
offered both a pension and participation in a 401(k) plan in 1983, but by
2004 that number had fallen to 17 percent. Overall, 63 percent of workers in
2004 had access to a 401(k) plan.
But 401(k) plan participation isn’t
what it could be, especially if compared with the traditional pension
that usually covered every employee at
a firm. About one in five eligible
employees fail to sign on to 401(k)
plans, with younger workers less likely

than older workers to join. Of participants, only about 11 percent
contribute the legal maximum. Many,
about half of U.S. workers, don’t kick
in enough to maximize the amount
that some employers match, either,
essentially refusing “free money.” In
some cases, a lot of free money.
David Wray of the Profit
Sharing/401(k) Council of America
(PSCA) says surveys of his members
indicate automatic enrollment can
raise participation from its current
70 percent to 75 percent to more than
95 percent. At white-collar firms with
educated employees, “We had one
company, a consulting company,
automatically enrolled with 98 percent
participation,” he notes. Such high
enrollment rates are more likely to
occur in smaller firms, because many
large firms still offer guaranteed
pensions, which typically means that
their 401(k) participation rates are
lower than smaller firms.
By 1998, Internal Revenue Service
rulings cleared the way to promote
automatic enrollment into 401(k)
plans, giving employees the choice to
opt out rather than opt in. “The presumption was very much, ‘We will set
up these plans, the people who need
them will use them, and if we set up
financial education they will make
smart choices and everything will be
hunky dory,’” Madrian says. That
worked fine for some, yet many are
uncomfortable with financial choices.
Researchers like Madrian have found
that firms can affect savings outcomes
significantly with automatic enrollment, sensible asset allocation, and
escalating contributions.

Opt Out
The Pension Protection Act (August
2006) clarified points about employers’
liability for investments, among other
murky areas, giving auto-enrollment a
leg up. Mark Iwry, who is a nonresident senior fellow at the Brookings
Institution, was the benefits tax counsel at the Department of the Treasury
when the concept surfaced.
He recalls asking, “Why do we like
defined benefits so much? And if

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

29

they’re not going to be around, let’s
transplant those organs into 401(k)s.”
Automatic enrollment fit the bill. The
policy would cover more moderateand low-income workers and ease the
pain of the disappearing pension.
Automatic enrollment for sure
works, and it’s largely because of the
human tendency to procrastinate, say
behavioral economists. People not
only put off signing on to their 401(k)
plans, they procrastinate when it
comes to changing allocations and
contribution levels. Economists
Madrian, David Laibson, and Andrew
Metrick found 401(k) participation
rates at three firms exceeded 85 percent under automatic enrollment.
Before, participation ranged from 26
percent to 43 percent after six months
at the three firms and 57 percent to 69
percent after three years.
“Even though they could opt out,
few did,” Madrian notes. “The traditional way companies have gone about
offering contribution plans have not
worked well for those individuals who
don’t feel comfortable making financial decisions. And there are very small
things companies can do that can have
a huge impact on outcomes we
observe, either for good or bad.”

Default Rates, Allocations
But even automatic enrollment isn’t a
retirement savings panacea. Human
inertia exerts so much power that
most people don’t ramp up contribution rates over time nor do they tweak

401( K ) PARTICIPATION R ATE (P ERCENT )

Automatic Enrollment and 401(k)
Participation: Evidence From
Recent Hires of a Fortune 500 Firm
100
90
80
70
60
50
40
30
20
10
0

85.9

37.4

Before Auto-Enrollment

After Auto-Enrollment

SOURCE: Madrian and Shea, 2001

30

R e g i o n F o c u s • Wi n t e r 2 0 0 7

investments to suit their stage in the
life cycle.
In a 2001 paper, “The Power of
Inertia
in
401(k)
Suggestion:
Participation and Savings Behavior,”
Madrian and Shea point to about a
48 percentage point increase in participation among new hires and an
11 percentage point increase overall at
a large health services firm 15 months
after enrollment. Among women, participation rose from 36 percent to 86
percent; for Hispanics, from 19 percent
to 75 percent; and for those earning less
than $20,000, from 13 percent to 80
percent.
Automatic enrollment succeeds in
enrolling lower-income and minority
workers because “these are the groups
who have the lowest comfort level
with financial matters,” she says.
“They have less education, less personal experience. They also have a lower
sense of urgency.”
Because employees are passive
when it comes to participation, plans
need to be designed with behavioral
traits in mind, Madrian and her coauthors James Choi, David Laibson,
and Andrew Metrick also noted in
another paper, “The Path of Least
Resistance in 401(k) Plans.”
Money tends to stick where it lands.
In that study, 65 percent to 87 percent
of participants stayed with the company specified default (2 percent to 3
percent) and remain in default funds,
typically conservative. That percentage
slowly declined, but even after two
years, 40 percent to 54 percent still
clung to the default. The fear is that
auto-enrollment, as useful as it has
become, may drag down retirement
savings if default contribution rates are
too low. Some employees might otherwise have selected higher contribution
rates. The benefits of higher participation rates could be offset by low
contribution rates and default allocations if they are too conservative.
“Employers can exert a strong
influence on savings and investment.
They could adopt automatic enrollment with aggressive defaults. Also
they could automatically roll over balances of terminated employees,

choose a higher match threshold to
motivate higher savings rates, and they
could offer well-thought-out investment options,” Madrian notes.

Choice is Hard
Decisionmaking can be tough.
Information may be so abundant that
people feel paralyzed to act. (An example: In one study, sales fell sharply
when customers had 24 jars of jam to
choose from instead of only six.)
Less is often more when it comes to
information: People use information
when it isn’t too costly for them in
terms of time and money, say Julie
Agnew and Lisa Szykman of the
College of William and Mary. They
examined how similarity of plan choices, as well as display of choices, “lead
to varying degrees of information
overload and the probability of opting
for the default.”
The authors controlled for the
financial aptitude of participants and
found that people who were less
sophisticated financially opted for the
default more often — 20 percent compared to 2 percent — than people who
possessed more knowledge about
financial matters. Fewer investment
choices eased the pain of too much
information but only for those with
above-average financial knowledge.
Even changing the way information
was presented, by making it easily
comparable, or reducing choices didn’t
ease “information overload” for those
who weren’t financially grounded.
“The results of this paper support the
move away from offering ‘one-sizefits-all’ defaults,” write the authors.

The Buy-In: Automatic
Enrollment
The PSCA’s David Wray, who surveys
his 1,200 members (with a total of 5
million employees) annually about
profit sharing and 401(k) plans, found
in 2005 that nearly 17 percent of the
1,106 firms responding offer automatic
enrollment for new hires, up from 10.5
percent in 2004 and 8.4 percent in
2003. Among the larger companies,
with at least 5,000 employees, 34 percent offer automatic enrollment.

Benefits giant Hewitt Associates’
2005 biennial survey of more than 450
firms found one in five automatically
enrolled employees in 401(k) plans
compared to 14 percent in 2003. One
in four firms provided automatic
rebalancing of accounts. Nearly 20
percent of companies either offer or
planned to offer escalation features.
Many firms in the Fifth District
offer or plan to offer automatic enrollment, according to Amy Reynolds of
Mercer Human Resources Consulting.
The Pension Protection Act will definitely increase auto-enrollment, she
predicts. “For employers who might
have been on the fence, the [Pension
Protection Act] has endorsed automatic enrollment,” she says. “Now it is
part of any conversation we have with
plan redesign.”
Scott Barton, who manages the
retirement plan for plumbing wholesaler Ferguson Enterprises, based in
Newport News, Va., says automatic
enrollment has been a feature since he
was hired in April 2006. The default
contribution rate is 2 percent, allocated to the guaranteed income fund.
While he isn’t sure about participation
rates before automatic enrollment,
currently they are about 89 percent.
And automatic escalation is a possibility down the road.
Blue Cross Blue Shield of North
Carolina began automatic enrollment

last year for its work force of about
4,100, the majority of whom are
women. While participation rates
were good, about 70 percent, now
more than 90 percent of employees
are part of the 401(k) plan.
Larger firms have tended to move
more quickly to automatic enrollment. For example, Michelin North
America employs more than 7,600
people in South Carolina. Michelin
started automatic 401(k) sign-up for
employees at 3 percent in January
2005. Since then, fewer than 1 percent
of new hires have opted out, according to Lynn Mann, public relations
director.
Thaler and Benartzi developed a
plan whose name uses the human
tendency to procrastinate. It’s called
“Save More Tomorrow.” Everyone
wants to save tomorrow, just don’t ask
them to do it today. The plan extends
the idea of automatic enrollment
by escalating contributions as
employees’ wages rise. Because the
plan links the savings to employee
raises, they don’t feel the pain
of reduced take-home pay. In its
first implementation, more than
80 percent of those offered the plan
signed up, increasing savings rates
from 3.5 percent to 9.4 percent. After
two more years those employees were
saving 13.6 percent, nearly four times
the previous level.

As automatic enrollment sets in,
escalating contributions are the next
step, and both are poised for growth,
says Wray of the PSCA. An added
bonus for firms to use automatic
enrollment and escalating contributions lies in the “nondiscrimination”
testing required by federal pension
laws. Savings rates between top
earners and others in the firm can’t
differ by more than 2 percent. Because
automatic escalation affects low- as
well as high-income earners, the new
Pension Protection Act eliminates discrimination testing if employers use
the tool. That may be incentive
enough, Barton says, for his company
to implement the idea.
Automatic enrollment’s success at
adding people to 401(k) rolls hasn’t
been widely criticized, according to
Madrian. “The criticisms have been
more along the lines of the extent to
which it is ‘paternalistic’ and whether
that is appropriate.” Richard Thaler has
dubbed it “libertarian paternalism.”
And even mainstream economists
such as Eugene Fama of the University
of Chicago, well known for his work
in the “efficient markets” tradition,
acknowledge the role of the behavioralists in raising participation with
automatic enrollment. While he’s not
well versed in the literature, he says
“hearsay suggests that they have
RF
it right.”

READINGS
Agnew, Julie R., and Lisa R. Szykman. “Asset Allocation and
Information Overload: The Influence of Information Display,
Asset Choice, and Investor Experience.” Journal of Behavioral
Finance, 2005, vol. 6, no. 2, pp. 57-70.

Gokhale, Jagadeesh, Laurence J. Kotlikoff, and Todd Neumann.
“Does Participating in a 401(k) Raise Your Lifetime Taxes?”
National Bureau of Economic Research Working Paper no. 8341,
May 2001.

Choi, James J., David Laibson, and Brigitte C. Madrian. “$100
Bills on the Sidewalk: Suboptimal Saving in 401(k) Plans.”
National Bureau of Economic Research Working Paper no. 11554,
August 2005.

Madrian, Brigitte, and Dennis Shea. “The Power of Suggestion:
Inertia in 401(k) Participation and Savings Behavior.” Quarterly
Journal of Economics, November 2001, vol. 116 no. 4, pp. 1149-87.

Choi, James J., David Laibson, Brigitte C. Madrian, and Andrew
Metrick. “For Better or For Worse: Default Effects and 401(k)
Savings Behavior.” National Bureau of Economic Research
Working Paper no. 8651, December 2001.
__. “Defined Contribution Pensions: Plan Rules, Participant
Decisions, and the Path of Least Resistance.” National Bureau of
Economic Research Working Paper no. 8655, April 2002.

Munnell, Alicia H., and Annika Sunden. “401(k) Plans Are Still
Coming Up Short.” Center for Retirement Research Issue Brief
no. 43, March 2006.
Thaler, Richard H., and Shlomo Benartzi. “Save More Tomorrow:
Using Behavioral Economics to Increase Employee Saving.”
Journal of Political Economy, February 2004, vol. 112, no.1,
pp. 164-187.

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

31

Bringing in the

U n banked

Banks are
increasingly
turning their
attention to
Hispanics without
bank accounts

elenovelas,
or
Spanishlanguage soap operas, are
wildly
popular
among
Hispanics. They typically tell the story
of a poor but beautiful girl who falls
in love with a rich, handsome young
man, and the story unfolds with every
design imaginable to keep them apart,
usually plotted by the fellow’s scheming family and ex-fiancé. Telenovelas
have such a fervent following that
when BB&T Corp. decided to produce
a set of tapes for its Hispanic banking
customers, it made sense to follow
this genre.
Except that the heroine of BB&T’s
telenovela series, Beatriz Bienvenido
Torres, or “Bibi,” is far from being love
struck. Bibi, a long-time resident of
the United States and a BB&T Bank
employee, is a trusted friend of recent
immigrants Juan and Maria Perez. The
series is about the couple’s adventures
of living in a new country and how Bibi
is always on hand to give them advice
— from how to call 911 to how to get a
mortgage. The tapes are distributed
through nonprofit organizations such
as Latino advocacy groups and are
available at the bank’s branches.
BB&T is just one of the many banks
that aim to bring the “unbanked”—
those who do not have bank accounts
— into the fold. Who are the
unbanked? About 46 percent of blacks
and 34 percent of Hispanics born in

T

32

R e g i o n F o c u s • Wi n t e r 2 0 0 7

the United States are unbanked
compared with 14 percent of whites,
according to a Kansas City Fed report.
Among immigrants, 53 percent of
Mexicans and 37 percent of other
Latin American immigrants are
unbanked, compared with 20 percent
of immigrants from Asia and 17 percent from Europe.
People who forego bank accounts
— regardless of whether they are
white, black, Hispanic or any other
ethnic group — generally have low
incomes. There simply isn’t much left
over for savings at the end of each
month, and the cost of a bounced
check sometimes doesn’t make a bank
account worthwhile. For these people,
payday lenders and similar organizations present an attractive option.
But there are factors that set
unbanked Hispanics apart from the
rest. In particular, many are recent
immigrants, a significant number are
undocumented, lacking in English proficiency, and they come from countries
where banking systems have not been
terribly stable.
Hispanics have been getting a lot of
attention from banks in recent years
because of their rising presence: They
are the largest and fastest-growing
minority group in the United States,
now outnumbering blacks. When the
U.S. population topped 300 million in
October, 36 million of the most recent

100 million additions were Hispanics.
In short, this is a big market, and
banks would be missing a tremendous
opportunity if they ignored it. A 2004
Federal Deposit Insurance Corp.
(FDIC) report notes,“More than half
of all U.S. retail banking growth in
financial services during the next two
decades will originate from the growing Hispanic market.”
The possible benefits are plentiful
for the unbanked too. Safety is important since the unbanked often carry
around large amounts of cash, making
them vulnerable to theft. And as they
develop roots in the United States over
time, their financial needs will likely
expand. “What is being understood
today is that most people who come to
this country end up staying. [They]
have a long-term interest in the country. Sooner or later they’re going to
want to buy that house … to buy that
car, and at some point they will need a
bank to do that,” says Dan Tatar, an
economist with the Community
Affairs Office at the Richmond Fed.
As Hispanics weigh the perceived
costs and benefits of banking, they
may sensibly decide to shy away from
banks. If banks want their business,
then they must convince the unbanked
that the actual benefits are larger, and
the costs smaller, than perceived,
and that there are gains from this
trade. Understanding the reasons why

PHOTOGRAPHY: GETTY IMAGES

B Y VA N E S S A S U M O

Share of Immigrant Heads of
Households with Bank Accounts
Canada
Germany
India
O RIGIN

Remittances and check cashing are
two of the most essential financial
transactions that Hispanics, especially
immigrants, regularly make. Although
banks usually offer these services at
much lower fees, most immigrants still
rely on alternative financial institutions like check cashing outlets and
money transfer operators.
The reasons go beyond socioeconomic and demographic characteristics
such as age, education, ethnicity, and
income. A recent report by the
Chicago Fed and the Brookings
Institution notes that immigrants are
less likely to have checking and savings accounts compared with the
native born, even after taking these
factors into account. The length of
time spent in the United States, language barriers, legal status, and
experience with financial institutions
in their home countries play important roles as well.
Lack of documentation is the most
oft-cited reason why immigrants are
discouraged from opening accounts.
Many immigrants mistakenly believe
that a Social Security Number,
generally available to U.S. citizens and
foreign nationals with work permits,
is required. Undocumented immigrants are also concerned that banks
will share their information with
immigration officials, or that they
wouldn’t be able to access their funds
if they are deported. This is a real fear
among undocumented immigrants and
a potentially high barrier to overcome,
because it could mean the difference
between staying and working in the
United States (and sending money
back home) and being forced to leave
the country.
But current rules on opening an
account at financial institutions do
not require a Social Security Number
for non-U.S. citizens. They require that
banks set up a customer identification

in several Latin American countries
many years ago. “If the bank would go
bankrupt then they would lose everything they have deposited,” says Rey.
Hispanics’ reasons for preferring
alternative financial institutions may
also have to do with what they
perceive as difficulties with a bank’s
products and services. With remittances, for instance, money transfer
operators (MTOs) like Western Union
and MoneyGram are still the carrier of
choice. Although the cost of transferring money through MTOs is usually
higher than through banks (especially
if one has a bank account), costs are
not the only factor in deciding how to
send remittances. Remitters may prefer MTOs over banks because of their
convenient locations, both on the
sending and receiving ends. Large
MTOs employ a vast network of
distribution points, from banks to
their own outlets to grocery stores
to pharmacies. Many wire transfer
services do not require identification
for transactions less than $1,000.
Hispanic immigrants may also
be unaware of the requirements
for obtaining a loan and hence
believe that they will be denied more
sophisticated banking products like

OF

Understanding the Unbanked

program that would, among other
things, collect and verify information
about customers opening an account.
For non-U.S. citizens without a
Social Security Number, the rules
suggest immigrants can provide a
similar identification number issued by
their home government. For instance,
many banks and credit unions accept as
proof of identification Mexico’s
Matricula Consular, one of the few
documents that illegal immigrants can
obtain in the United States.
It is possible, however, that this
may not be enough to assuage the
fears of undocumented immigrants.
Because the acceptance of foreign
government-issued ID has become
entangled in the debate over immigration policy, there may be concerns that
the rules will suddenly change and
turn against them. The rules at the
moment, however, don’t require banks
to verify the immigration status of
foreign account holders, and it is not
even possible for banks to do that.
These fears may be related to many
Hispanics’ inherent distrust of banks,
especially those who are new to the
United States and do not hold the
banking system in their countries in
high regard. “There is a poor acceptance of financial institutions in Latin
America,” says Luis Pastor, CEO of
the Latino Community Credit Union
based in Durham, N.C. For instance,
Pastor estimates that about 60 percent of Mexicans and 80 percent
of Hondurans do not have bank
accounts. If a poor person’s parents
and grandparents in Mexico never
used banks, then he tends to be less
inclined to use one.
There have been many incidents
that have fueled Hispanics’ distrust of
banks. Mexico’s banking crisis in the
mid-1990s, for instance, “further
damaged the reputational capital of
Mexico’s banking system and heightened suspicions that banks generally
were unreliable,” according to a World
Bank paper. Manuel Rey, director of
Banco de la Gente, a Charlotte-based
bank catering to the Hispanic market,
explains that the lack of deposit
insurance was characteristic of banks

C OUNTRIES

Hispanics are relatively unbanked is an
important first step. But equally important is understanding that even BB&T’s
Bibi may find it difficult to overcome
Hispanics’ aversion to banks.

Philippines
Korea
Cuba
Vietnam
China
El Salvador
Mexico
0

10

20

30

40

50

60

70

80

P ERCENT

Checking Account

Savings Account

SOURCE: “Financial Access for Immigrants: Lessons from Diverse
Perspectives,” Federal Reserve Bank of Chicago and the Brookings
Institution, May 2006

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

33

mortgages if they applied for them.
Their fears may not be unfounded.
Relatively few banks make loans based
on a foreign national’s Individual
Taxpayer Identification Number
(ITIN) — in this case, a Social Security
Number is usually required — although
that number is growing. Banks may be
reluctant to lend to undocumented
borrowers because ITIN mortgage
loans will likely be difficult to sell in
the secondary market.
But probably the most cited factor
in many studies on the unbanked is
that bank accounts can be expensive
to maintain. The problem lies in
having to carefully manage their bank
balances. If they mistakenly overdraw
their account, they can be charged
expensive overdraft or bounced check
fees. Because the unbanked often
live from paycheck to paycheck, they
may be more vulnerable to such
charges. Overdraft fees and the stress
of balancing one’s account may
outweigh the benefit of free check
cashing and other payment services
at the bank, so that it becomes a
rational decision for the unbanked
not to open an account.

Mind The Gap
Financial education is one of the first
things that banks emphasize in bringing the unbanked into the financial
mainstream. This may be especially
true for areas with many recent
Hispanic immigrants.

34

R e g i o n F o c u s • Wi n t e r 2 0 0 7

BB&T’s Bibi telenovelas, now on
their ninth installment, aim for the
same goal. Far from just promoting the
bank’s products and services, the
episodes dwell on topics that can help
Hispanic families ease their transition
to life in a new country, such as what to
do in the event of a storm (many of
BB&T’s branches are in the coastal
areas), advice on how to find a job, and
how a small family business can deal
with a wayward debtor. In the end, the
idea is that BB&T will be well served
by nurturing a progressive Hispanic
community within its footprint, with
the hope that those there will become
long-term clients. Jorge Moller, the
bank’s multicultural markets manager,
expects that about half of their net
new growth in the next five years will
come from the Hispanic segment. To
date, BB&T has given out about half a
million tapes over the last four years.
Luring unbanked Hispanics by
offering services that are essential to
them like check cashing and remittances is another bank strategy. The
hope is that by getting them in
the door, banks will then be able to
gradually move them up the financial
ladder, from savings and checking
accounts to more sophisticated financial products like education, housing,
and small business loans.
It sometimes starts by getting
people who use check cashing services
to open bank accounts, which for some
may take awhile. “The guys who work at
the branch spend several visits until
they develop their trust. [Customers]
may come and cash their check six
times before they give us a shot with an
account,” says Rey. But the patience
pays off. “One of the things we found is
that once they open an account, they
can be very loyal. Once they know that
the money is there and nobody is stealing the money and that the bank is still
open, then they stay with you. They
develop a relationship,” says Rey.
Banks also bundle their payments
and money transfer services with their
checking accounts, allowing them
to give attractive rates on products
like remittances. Bank of America’s
SafeSend, for instance, provides free

PHOTOGRAPHY: COURTESY OF BB&T

Reaching the unbanked: Audio series like these teach
immigrants about life in the United States, including
its banking system.

Although the largest concentration of Hispanics is in California and
Texas, many are now moving into
areas that previously saw very little
immigration. The Pew Hispanic
Center reports that the Hispanic population is growing faster in the
Southern states, including the
Carolinas, than anywhere else in the
United States. North Carolina, for
instance, is one of 13 states that have
at least half a million Hispanic residents, and the community’s population
grew almost fourfold over the period
1990 to 2000.
Because Hispanics in the South are
predominantly foreign born, these
communities may have a greater need
for financial literacy programs, cash
remittance services, and bilingual
tellers. Banks there “face the challenge
of integrating this growing Hispanic
population into the mainstream of the
financial services industry,” notes an
FDIC report.
For the Latino Community Credit
Union (LCCU), this task was particularly challenging since 75 percent of its
members had never opened a bank
account. The LCCU’s financial
education group, which is an entirely
separate department from its marketing arm, gives classes in Spanish on
various topics like how to manage a
checking account, how to save and
develop a budget, how to use a credit
card, how to build a credit history, and
how to buy a car and a home. These
courses go beyond just giving information about the credit union’s products.
They also encourage participants to
think about their families’ goals and
help them create a financial plan
(including tips on how to pinch a few
pennies) to take them there.
Complete with caps and gowns,
members and nonmembers who
graduate from these classes walk away
armed not only with the tools to build
their financial future but also with
increased trust in the banking system.
More than 9,000 participants have
graduated from these classes since
2001. “Some invest in marketing.
We invest in education. These are
different topics,” says Pastor.

money transfers to Mexico if customers
open a checking account. Banks and
credit unions can also participate in the
Federal Reserve’s Directo a México, a
low-fee money transmission service
launched in 2004, which requires the
sender as well as the recipient in
Mexico to open bank accounts.
The acceptance of consulate IDs
and ITINs as identification has provided opportunities for many
unbanked Hispanics not just to open
savings or checking accounts but also
to obtain loans. Even so, one other
barrier to obtaining loans is the lack of
a credit history, and banks do offer
products with which customers can
establish credit, such as a secured
credit card and a CD secured loan.
These products give customers a
chance to demonstrate, over a certain
period, their ability to take out a loan
and pay it on time, which is then
promptly reported to the credit
bureau. Once their credit is established, they may be eligible for loans
such as ITIN mortgages, which some
banks are beginning to offer and are
available to immigrants without a
Social Security Number.
As Hispanics climb up the financial ladder, they may also be interested
in taking out small business loans.
“Hispanics are very entrepreneurial,”
says Jorge Figueredo, executive vice
president of Security One Bank in
Fairfax County, Va., which caters in
part to small- and medium-sized
Hispanic businesses in that area. In

Fairfax County alone, there are about
7,302 Hispanic-owned businesses,
according to the 2002 U.S. Census
Survey. This represents almost 8 percent of all businesses in Fairfax
County, and about 38 percent of all
Hispanic-owned firms in Virginia.
In all, banks have made significant
strides toward earning the trust and
business of the Hispanic community.

Room for Improvement
The catch is that it is difficult to say
exactly how successful efforts have
been to move the unbanked into the
banking system. “No one really has any
actual figures on any of these issues,
what they have is a gut feeling of how
they’re doing,” says Manuel Orozco,
executive director of the Remittances
and Rural Development project at
Inter-American Dialogue, a policy
analysis group.
But Orozco thinks that some banks
are still not doing enough. Despite all
the hype about Hispanic banking, he
senses a lack of interest and a lack of
understanding of this market, especially among the bigger banks, which
could lead to frustrated efforts to
bring in unbanked Hispanics.
Perhaps what some banks are doing
wrong is that they have relied too much
on peddling the product without really
understanding the root cause of why
the unbanked choose to stay away.
Earning their trust is one hurdle. But,
as John Caskey, an economist at
Swarthmore College, points out, the

biggest problem for the unbanked is the
stress of living without any financial
savings, of being one hiccup away from
another crisis. Bank accounts are costly
for people who don’t earn enough to
put away in an account, as they require
extremely careful management to avoid
a multitude of fees.
In this sense, Caskey thinks that
“focusing on the bank account itself is a
little bit like focusing on the symptom
rather than the underlying cause.” If the
unbanked could somehow be persuaded to set aside even a little bit each
month, then having a bank account
could not only lower the cost of their
check cashing and other payments
transactions, but also, more importantly, add some stability to their lives.
Seen this way, the challenge looks
harder for banks than may have been
thought, because how can you encourage unbanked Hispanics — many of
whom live on low incomes — to consume less and save more? It may not be
as easy as installing Mexican artwork,
adding a few more chairs to accommodate other family members, or even
hiring bilingual tellers.
Banks that provide the kind of
financial education that motivates
unbanked Hispanics to become homeowners and entrepreneurs, to save for
retirement, and insure themselves
against financial risks may be on the
right path. But even those banks realize that big payoffs will take time.
Banking the unbanked is a long-term
RF
investment.

READINGS
Bair, Sheila. “Improving Access to the U.S. Banking System Among
Recent Latin American Immigrants.” University of MassachusettsAmherst and The Multilateral Investment Fund, 2003.

Kochhar, Rakesh, Robert Suro, and Sonya Tafoya. “The New
Latino South: The Context and Consequences of Rapid
Population Growth.” Pew Hispanic Center, July 2005.

“Banks Are Still Sizing Up Opportunities in the Growing
Hispanic Market.” FDIC Outlook, Winter 2004.

Orozco, Manuel. “Between a Rock and a Hard Place: Migrant
Remittance Senders, Banking Access and Alternative Products.”
Inter-American Dialogue Draft Report, October 2006.

Caskey, John. “Bringing Unbanked Households Into the Banking
System.” The Brookings Institution Center on Urban and
Metropolitan Policy and Harvard University Joint Center for
Housing Studies, January 2002.
Contreras, Patrick, and Eric Robbins. “Strategies for Banking the
Unbanked: How Banks are Overcoming Entrance Barriers.”
Federal Reserve Bank of Kansas Financial Industry Perspectives.
January 2006.

Paulson, Anna, Audrey Singer, Robin Newberger, and Jeremy
Smith. “Financial Access for Immigrants: Lessons from Diverse
Perspectives.” Federal Reserve Bank of Chicago and the
Brookings Institution, May 2006.
Prescott, Edward S., and Daniel Tatar. “Means of Payment, the
Unbanked, and EFT ’99.” Federal Reserve Bank of Richmond
Economic Quarterly, Fall 1999, vol. 85, no. 4, pp. 49-70.

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

35

Midlife Med care
The case for reform heats up
BY BET TY JOYCE NASH

ike the boomer birth cohort
that threatens its existence,
midlife Medicare needs an
overhaul. But it will take more than a
facelift and weight loss for the plan
to function through the biggest
challenge of its 42 years — seeing the
post-World War II generation through
old age.
Consider that one in every five
West Virginians use Medicare, the
biggest percentage of beneficiaries in
the nation, a reflection of that state’s
aging population. Nationwide, the
average is one in seven.
Medicare is the nation’s public
health pledge, placed into the Social
Security program as the centerpiece of
President Lyndon Johnson’s Great
Society along with its sister Medicaid,
to ease medical expense for the elderly.
(Medicaid pays for poor peoples’
medical care and long-term care.)
At last count, some 37 million use
Medicare, along with 6 million disabled people. About 7.5 million of
those are “dual eligibles” — they use
both Medicare and Medicaid.
The first of the boomers will arrive
at Medicare’s door in 2010, at a time
when there will be 3.6 workers per
beneficiary (compared with four
today) forking out to keep the system
going. By 2030, when the last boomer
turns 65, only 2.3 workers will be
paying in. Policymakers may have to
consider major changes sooner rather
than later.

L

Challenge and Opportunity
Medicare is plagued by some of the
same inefficiencies that dog the health
care system overall. Competitive markets can match prices to costs pretty
well, but health care markets are
imperfect, a result mainly of the thirdparty payment system, whether under

36

R e g i o n F o c u s • Wi n t e r 2 0 0 7

government or private insurance.
Health care markets have problems
with information asymmetries (when
one party in a transaction knows more
than the other), moral hazard (when
people use more of something than
they otherwise would because they’re
not paying the bill), and adverse selection (when the price of insurance or
care doesn’t depend on how sick you
are; the sickest, who are the most
costly to treat, get a relatively better
deal), among others.
Current projections indicate that
by 2050, Medicare may balloon to
account for 9 percent of the nation’s
total of goods and services, compared
with 2.7 percent in 2005, according to
the 2006 report of the Trustees of
Social Security and Medicare trust
funds. Funding problems have been
discussed for decades, especially during recent debates over the Medicare
Prescription Drug, Improvement, and
Modernization Act (MMA), which
passed in 2003.
Medicare’s hospital fund (paid for
through a 2.9 percent payroll tax
shared equally by employers and
employees) in 2005 spent $183 billion
on income of $199 billion. By 2010
expenses will overtake income,
exhausting trust fund reserves in 2018,
according to trustees’ projections. By
then the fund won’t generate enough
to pay benefits. (That’s two years earlier than the trustees reported in 2005.)
Medicare’s supplemental program,
Part B, which pays for doctors, outpatient work, lab work, supplies, and
home health, is funded through premiums (25 percent) deducted from Social
Security payments, and general tax
revenues (75 percent). Only continued
hikes in premiums and general revenue
contributions will sustain the fund
under current design. Many Medicare

beneficiaries also pay for “Medigap”
coverage, private insurance that helps
cover co-pays and services Medicare
doesn’t cover.
It’s worth noting that nearly all
elderly beneficiaries on Medicaid are
also on Medicare, and about 40 percent of the disabled who are on
Medicaid are also on Medicare.
Together they make up a big share of
the Medicare population, particularly
among the sickest, according to
Leighton Ku of the Center on Budget
and Policy Priorities. States share
the funding of Medicaid with the
federal government, while Medicare
is mostly a federal program.
The two programs are inextricably
linked. For example, poor people use
Medicaid to pay Medicare premiums.
Because Medicaid sneezes when
Medicare catches a cold, any fixes to
Medicare need to be well thought out.

Now Hear This
By 2008, arguments over Medicare
funding will intensify. That’s because
the MMA triggers a presidential warning when trustee forecasts say general
revenues will finance 45 percent or
more of total Medicare spending in
any of the next seven fiscal years. Two
warnings trigger legal obligation for
the president to submit legislation to
Congress.
OK, so here’s the first warning, says
the 2006 report. And according to
trustee and economist Tom Saving,
“Unless things are dramatically different, we’ll do it again in 2007.” If so, in
January 2008, the president would
submit a plan to Congress, forcing
debate. (However, Congress doesn’t
have to act.)
Politically palatable solutions are
scarce, owing to philosophical differences about the extent of government

responsibility for health care. Some
people consider keeping current benefits intact a moral obligation, others
favor trimming benefits, and others
want people in charge of their own
medical accounts so they’ll have an
incentive to monitor spending.
Mainstream economists, for the most
part, think such “consumer-directed”
care will introduce competition and
efficiency. The MMA calls for trying
out that savings account idea in 2007.

More Money, More Life
Medicare spending grows each year,
but its average per-capita spending
growth between 1969 and 2003 (9 percent) was less than for private
insurance (10 percent), according to
Centers for Medicaid and Medicare
Services (CMS). ( Joseph Antos, a
health care economist who serves
as a Commissioner of the Maryland
Health Services Cost Review
Commission, has disputed this estimate, pointing out that private firms
expanded coverage over that span. In
1970 private insurance paid 60 percent
of hospital and doctor services, but
85 percent in 1999.)
Overall, health care costs rose
about 7 percent in 2005. Cutting-edge
cures and life-prolonging drugs push
up costs. Just as longer lives create payment problems for Social Security,
ditto for health care. People can
expect to live 18 years in retirement,
much longer than expected when the
plan was unveiled in 1965. Somebody
will have to pay for those extra years of
health care. For instance, implanting
defibrillators for cardiac arrhythmia, if
expanded to half of the elderly with
new cases of heart attacks, would
mean about 374,000 annual procedures in 2015 and cost $14 billion,
adding up to $132,000 per additional
year of life, according to the RAND
Corporation’s “Future Health and
Medical Care Spending of the Elderly.”
Reducing chronic illness among
Medicare beneficiaries could save
money, but only slightly. Overall,
RAND’s “Future Elderly Model”
found that people will live better and
live longer, but the innovations

increase rather than decrease costs.
Obesity may be a different story.
Researchers found that starting at age
70, an obese person will cost Medicare
about $149,000 over a lifetime, the
highest level of any group, 20 percent
higher than for the next closest group,
the overweight, and 35 percent higher
than normal weight people. Medicare
could spend $38,000 more over the
lifetime of an obese 70-year old than a
beneficiary of similar age and normal
weight. If obesity is responsible for the
health differences, then preventing or
curing it would save Medicare money,
according to the RAND report.

Competitive Edge
Politicians of every stripe, accompanied by health care policy experts, are
searching for a way to get seniors
through old age without dragging
down the economy and discouraging
young workers in the bargain.
Trimming costs and adding
payers, such as through more and
higher-paid immigrants, may help.
And worker productivity is expected
to increase, so the necessary tax rate
need not rise appreciably if productivity increases slightly more than
historical rates, according to health
economist Mark Pauly of the
University of Pennsylvania.
The source of Medicare’s malady
may lie in the third-party insurance
payment system itself. If you don’t pay
for services out of your own wallet,
then you tend not to pay attention to
the bill. Was the proper service
rendered, how much did it cost, and
are those prices true? If you bought a
television set over the holidays, you
probably surfed the Internet and
combed newspaper ads for the best
price. But few people do that with
medical costs — unless they’re uninsured or self-insured — because few
pay out of pocket for services. That
leads to vast inefficiencies in health
care even in the private sector.
“One of the biggest problems with
Medicare and health care even is customers don’t care what it costs. If the
buyers don’t care when they go in, the
sellers aren’t going to care,” says econ-

omist Saving, who in addition to serving as a trustee on the Social Security
and Medicare Trust Funds teaches at
Texas A&M University. He points out
a case of cheating in 2000 with some
providers improperly coding conditions so they would be reimbursed at a
higher level. After a policing effort,
costs came in below forecasts. “The
real problem is that the prices are all
fiction,” he says. In a true market, with
winners and losers, accurate pricing
emerges through competition, but
Medicare sets prices administratively.
Inefficiencies abound in the entire
health care system, not just in
Medicare, and they include lack of
accountability and care coordination,
technology that may not be worth the
cost, and little incentive for cost-effectiveness. Paying providers the same
rate regardless of the quality of care
doesn’t do anybody any good.
Moreover, “perverse payment system
incentives, lack of information, and
fragmented delivery systems are barriers to full accountability,” according to
a 2006 Medicare Payment Advisory
Commission (MedPAC) report to
Congress. Under Medicare’s fee-forservice system, “doing more pays
more, regardless of the quality or efficacy of what is done.”
A wide range of proposals could
“fix” Medicare, Saving suggests, but he
warns that “anything will be a benefit
reduction.” Which might not be such
a bad thing, he says. “If the benefit
reduction is big enough, customers
might start caring what things cost.”
Raising the eligibility age, which has
been suggested, is unlikely to help
because younger enrollees are responsible for a relatively small percentage
of total Medicare expenditures. This is
in contrast to Social Security. Raising
the age at which people would begin
receiving benefits from that program
could help its potential fiscal imbalance. This is one of many reasons why
some economists believe Medicare is a
tougher problem to fix than Social
Security.
Cost sharing shows promise.
According to the 15-year RAND
Health Insurance Experiment, hefty

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

37

deductibles reduce spending through
careful use of services. Saving says a
$5,000 deductible would protect
people from catastrophe while dramatically reducing the necessary
transfers from general revenues. Plus,
the money would stimulate competition. “In reality if you looked at 79
million retired people — $5,000 times
79 million — the providers would be
competing for that money.”
Other Medicare fixes range from
enticing more private payers into the
market for competition’s sake, including incentives for disease prevention,
benefit cutting, or means testing,
among other policy combinations.
Means testing is coming. The
MMA will vary premiums and benefits
by income, setting higher premiums
for well-off seniors. In a 2004 paper,

economist Pauly proposed “a strategy
in which future Medicare beneficiaries
with higher incomes will pay for costincreasing but quality-improving new
technology, possibly with prefunding
that begins before retirement.”
Further regulation, especially
clamping down on prices, may produce
undesirable results. Reducing payments
to providers is an idea economists
don’t like because economic theory
suggests it can induce shortages, which
has happened with Medicaid, says
Robert Helms, director of health policy
studies at the American Enterprise
Institute. Or it can also cause a jump in
service, as providers make up for lost
revenue. Such changes would likely be
more noticeable in regions with high
percentages of Medicare enrollees,
like West Virginia.

“[There are] lots of ways physicians
can skimp on the service, and some are
subtle,” he notes. “Just cutting the rates
is a short-term and misguided policy.
You have to get to a situation where
everyone has an incentive, patient and
provider, to worry about cost and quality and cost-effectiveness.”
In an effort to keep rural doctors
from becoming scarcer than they
already are, Medicare is paying them a
bonus, part of the MMA of 2003. That’s
good news for rural states like West
Virginia. In addition to its aging population, with more deaths than births,
the state is overwhelmingly rural.
Forty-five of its 55 counties are rural.
Clamping down on prices often
backfires. In the 1990s, a supplemental Medicare + Choice plan was done in
by “top down price setting and com-

Rural Density
Fifth District counties with the biggest percentage of Medicare
enrollees tend to be rural, a designation that varies according to
federal agency and program.
Some 19 percent of West Virginians use Medicare, compared
with 14 percent nationwide, reflecting the fact that 45 of the state’s
55 counties are rural. A bulging pocket of elderly live in southern
West Virginia’s McDowell County, where the decline in coal mining
has hurt the local economy. About 27 percent of the county’s 25,343
people are Medicare beneficiaries.

Other Fifth District counties with high percentages of Medicare
enrollees include growing retirement locales such as Polk County,
N.C., near Asheville, and coastal Georgetown County, S.C., as well as
the Chesapeake Bay area’s Kent County, Md., and Lancaster County, Va.
Also noteworthy: North Carolina and South Carolina exceed the
national average for Medicare enrollees who are disabled, with
percentages of 19 and 20 respectively compared with 15 percent,
the U.S. average. About 23 percent of West Virginia’s Medicare
enrollees are disabled.
Kent County, MD
24% of 19,701 residents

Percent of Citizens Receiving Medicare
0.1% - 12.1%
12.2% - 17%

McDowell County, WV
27.3% of 25,343 residents

17.1% - 21.9%
22% - 35.8%

Lancaster County, VA
32.1% of 11,550 residents

35.9% or above

Polk County, NC
24.9% of 18,788 residents

NOTE: County figures are from 2003. State figures are from 2005.
SOURCES: Centers for Medicare and Medicaid Services, and the U.S. Census

38

R e g i o n F o c u s • Wi n t e r 2 0 0 7

Georgetown County, SC
23.6% of 45,043 residents

plex regulation,” health economist
Antos writes. Providers can always get
creative and expand services to counter
price controls, according to Antos,
who has written extensively about
using markets to strengthen Medicare.
“Tighter controls that also restrict
the use of services could prevent
that, but such restrictions would
have adverse consequences for the
health of beneficiaries,” he writes. In
2002, Medicare cut doctors’ fees by
5.4 percent, which prompted service
disruptions in some geographic areas
and didn’t save money. Payments
increased by nearly $3 billion, thanks
to extra service volume, a 7.9 percent
increase in 2002 compared to a
3.5 percent increase in 2000 and 2001.
“It would be difficult to argue that such
a sharp increase in volume last year was
justified solely on clinical grounds.”

Medicare Woos Private Payers
Medicare Advantage, a transformation
of the old Medicare + Choice plan,
aims to reinvigorate private plan participation (through various financial
incentives) and competition after
many insurers left the program. Their
defection was a response to restricted
payment rate growth in high-cost
areas. Private plans have been an
option since 1982, with enrollment
peaking at 17 percent of enrollees in
1999 and declining to 12 percent by
2004, according to MedPAC.
Medicare Advantage lets participants choose private plans in lieu of the
traditional fee for service plan. Under
some plans, participants may receive
more benefits than Medicare offers,
and they’ll pay more in premiums.
Medicare pays plans a capitated (per
person) rate that amounted to $55 billion in 2005, or 17 percent of total

Medicare spending, according to
MedPAC. Plans bid and the bids are
compared with county-level benchmarks to determine payment. If the
plan bids above benchmark, then that’s
the payment and participants pay the
difference. But if the bid is under
benchmark, then the Medicare program keeps 25 percent of the difference,
and 75 percent is rebated to the plan,
which is obligated to return it to the
enrollees in the form of lower cost sharing. Enrollment is now about 7 million
of the 46 million beneficiaries.
Among plan advantages is the
emphasis on coordination of care, says
Teresa DeCaro, acting deputy director
of the Medicare Advantage Group
at CMS. Medicare’s fee-for-service
program has no incentive to manage
care among providers, she notes. “In a
capitated arrangement, the plan is
only profitable if the costs incurred
match or beat expected costs,” she
says. “They’re always looking to
arrange services and put cost-effective
administrative structures in place so
beneficiaries are receiving the best
mix of services to keep them out of
hospitals and nursing homes, the kinds
of things that are really expensive to
do. That’s where all the dollars are.”
In addition to reviving competitive
alternatives, the MMA introduced
Medical Savings Accounts in 2007.
Medicare pays for a high-deductible
plan for enrollees, establishing an
account with the designated funds.
The money and its earnings are
tax free as long as it’s used for health
care. After meeting the deductible, the
health plan covers the medical services.
Unused amounts are rolled over even
if the enrollee opts into a different
plan. This provides an incentive
for relatively healthy people to be

discriminating when choosing care
while the catastrophic limits protect
very sick people from facing huge bills.
Antos has floated a Medicare reform
that uses as a model the Federal
Employees Health Benefits Program
(which includes retirees as well as active
employees). Beneficiaries would choose
from competitive plans including
a Medicare fee-for-service plan. A
common objection to market-based
Medicare reforms is that insurers will
choose only healthy people, what’s
known as risk selection. Antos suggests
more compensation for sicker enrollees
to provide incentives (as well as oversight for corrective action if necessary).
For example, the federal employee
health program subsidizes enrollee premiums. Because of the high subsidy, a
recent study found small differences in
the average age of enrollees in low- and
high-cost plans. Currently, consumerdriven plans, typically low-premium but
high-deductible plans, account for
about 3 percent of the private health
insurance market.
Competition will improve efficiency, the theory goes. But a careful,
cost-conscious health care consumer is
the critical link to competition. And
with new choice in Medicare plans and
Medical Savings Accounts, that’s the
aim, according to DeCaro.
“The presumption is that beneficiaries are more engaged, more aware of
the costs of health care,” she says.
“Therefore they’re more inquisitive
and more interested in good information about health care choices.”
Informed health care consumers?
Efficient health care markets? No
matter what, soon we will likely see
the end of Medicare as we know it.
Come 2008, some of these proposals
RF
could become policy.

READINGS
Antos, Joseph. “Can Medicare and Medicaid Promote More
Efficient Health Care?” Testimony before the Federal Trade
Commission/Department of Justice, Sept. 30, 2003.
Goldman, D.P., et al. “Future Health and Medical Care Spending
of the Elderly.” The RAND Corporation, 2005.
The Medicare Payment Advisory Commission. “Report to the

Congress: Issues in a Modernized Medicare Program, “ June 2005.
__. “Report to the Congress: Increasing the Value of Medicare,”
June 2006.
Van de Water, Paul N., and Joni Lavery. “Medicare Finances:
Findings of the 2006 Trustees Report.” National Academy of
Social Insurance, Medicare Brief, May 2006.

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

39

Bad Luck
Bad Policy?
Why inflation rose and fell, and what this means for monetary policy

W

ars have often fueled
inflation. Throughout history, printing money was
a handy way for governments and
empires to fund war-related expenses
without raising taxes. However, with
too much money chasing too few
goods, price levels would then shoot
up. In 1970s America, though, wars
were not the stuff that fueled inflation. Indeed, economist Brad DeLong
of the University of California at
Berkeley calls the Great Inflation of
the 1970s, “America’s only peacetime
outburst of inflation.”
No matter which measure is used,
inflation was high and volatile in the
late 1960s to the early 1980s. There
were three different inflation cycles
during this period, and each peak of
the cycle was higher than the last.
By the first quarter of 1980, inflation
had risen more than 14 percent over
the previous year. However, after
hitting that high point, inflation
rapidly declined and has remained
remarkably low and stable over the last
two decades. How can we explain this
unmistakable shift?
It is tempting to assign blame or
praise to the members of the Federal
Reserve’s Open Market Committee,
who were at the helm of the central
bank during these various episodes.
Much credit, for instance, has been
given to Paul Volcker and Alan
Greenspan for driving down inflation
during their tenure. But couldn’t they
have also been lucky? Similarly, weren’t
Arthur Burns and G. William Miller

40

R e g i o n F o c u s • Wi n t e r 2 0 0 7

just hit by a string of bad luck? After
all, the twin oil shocks of the 1970s
must have had a devastating effect on
the economy.
Whether the rise and fall of inflation is thanks to luck or policy is an
important question because the
answer tells us to what extent monetary policy matters for economic
stability or if we are simply helpless to
the vagaries of the business cycle.
“Do we think that we’ve learned some
lessons from the 1960s and 1970s, so
that [the Fed] should keep doing what
they’ve been doing? Or do we think that
we just got lucky? If so, that doesn’t tell
us much about future Federal Reserve
policy,” says Mark Watson, an economist at Princeton University and a
visiting scholar at the Richmond Fed.
The answer is far from settled, but it
could be a good measure of both.

Policy Mistakes and Triumphs
The story that policy rather than luck
is responsible for the rise and fall of
inflation is, according to Chicago Fed
economist Francois Velde, “an optimistic story that relies on errors made
and lessons well learned.” Learning
from policy mistakes of the past is a
crucial point for this view because it
provides a reason why policymakers
engineered a decisive break in their
response to inflation in the early 1980s.
The story begins with the memory
of the Great Depression of the 1930s.
DeLong believes that “the truest
cause” of the 1970s inflation was the
shadow cast decades later by this

extraordinary economic downturn.
The Great Depression may have led to
the Great Inflation because that event
cultivated a strong aversion to unemployment, convincing policymakers
that any level of unemployment was
too high.
At the same time, work by some of
the best economists of the 1960s
reassured policymakers that lower
unemployment could be successfully
purchased by allowing only moderate
increases in inflation. For instance,
estimates by Nobel Prize winners
Robert Solow and Paul Samuelson of
the trade-off between inflation and
unemployment for the United States
(the Phillips Curve) suggested that a
modest 4.5 percent increase in prices
each year would be enough to bring
down the unemployment rate from
5.5 percent to 3 percent.
Against this backdrop, the Fed,
under William McChesney Martin Jr.,
proceeded with what it thought
would be a successful experiment of
stimulating the economy through
expansionary monetary policy without
accelerating inflation. But as Velde
notes, unemployment indeed fell by
1969 — but to only about 4 percent
and at a high price tag of 6 percent
inflation, not exactly the terms that it
had bargained for.
By the time the 1970s rolled in and
Burns was appointed as the new head
of the Fed, inflation had started to
escalate to worrying levels. At this
point, it was becoming clear that the
trade-off promised by the Phillips

ILLUSTRATION: AILSA LONG

B Y VA N E S S A S U M O

Curve could no longer be fulfilled.
Once people came to anticipate more
inflation, any surprise expansionary
attempts by the Fed would only result
in higher inflation but without a
substantial decrease in unemployment
below its “natural rate.” However,
neither Burns nor the political leadership at that time were willing to lower
inflation for fear of the extremely
high cost it would entail in terms of
the loss of jobs.
The triumphant moment arrived
when Paul Volcker took control of the
Federal Reserve at the end of the
decade, armed not only with the
political mandate to purge inflation
but also with a bagful of hard lessons
from policy mistakes committed in
the recent past. An important lesson
learned was that people form their
expectations about inflation based on
how they anticipate policymakers
will react to it. In fact, policymakers
themselves could alter the terms of the
trade-off between inflation and unemployment. For instance, because
people are well aware of policymakers’
temptation to stimulate the economy
with surprise inflation, central bankers
must find a credible way to resist this
temptation in order to effectively
carry out monetary policy.
But how can we assert that the rise
and fall in inflation was indeed due to a
shift from bad to good policies, as
sketched in the story above? Two
studies, one by Richard Clarida
of Columbia University, Jordi Gali
of Pompeu Fabra University in
Barcelona, and Mark Gertler of New
York University, and another one written more recently by Richmond Fed
economist Thomas Lubik and Frank
Schorfheide of the University of
Pennsylvania, look for evidence that
policy has changed over the relevant
period in a way that explains the
dramatic movement in inflation.
Both papers look at the responsiveness of the Fed’s interest rate policy
to changes in inflation during the
pre-Volcker period on the one hand
and the Volcker and Greenspan period
on the other. The idea is as
follows. Central bank behavior is

captured well by a policy rule by
which the Fed sets the federal funds
rate, its monetary policy instrument,
in response to deviations of current or
expected inflation and output from
some desired level. If the Fed wishes
to successfully bring down inflation,
a helpful measure would be to raise
the fed funds rate by more than the
increase in inflation, such that the
real short-term rate rises and real
spending falls. But if the fed funds
rate changes by only a fraction of
the change in anticipated inflation,
then the Fed will effectively stimulate
the economy through lower real shortterm rates, which leads to further rises
in inflation.
Such a policy that accommodates
inflation, or a passive interest rate
policy, is particularly bad because it
not only prevents the Fed from
stabilizing inflation, but it also can
actually turn monetary policy into a
source of economic instability. This
can happen because passive policy
leaves open the possibility that the
economy be subjected to “sunspot”
shocks, which are unrelated to economic fundamentals but matter
anyway because people think they do.
For instance, sunspot fluctuations
can occur when individuals correctly
anticipate that the Fed will react too
feebly to an inflationary shock. This
anticipation is then built into future
inflation, to which real interest rates
decline, and the initial expectations
are validated. Because of this, inflation
can wander off the path it would
otherwise follow. The same fate holds
for fundamental shocks, such as
productivity shocks, that hit the
economy. Under a passive policy
regime these can affect the economy
in unpredictable ways. Thus, if a good
or active policy is not in place, monetary policy itself could potentially
lead to the type of volatile macroeconomic outcomes that we witnessed
back in the 1970s. The work of
Clarida, Gali, and Gertler, as well as
that of Lubik and Schorfheide largely
confirm this story.
Clarida, Gali, and Gertler were
probably the first to “add precision

to the conventional wisdom” that
monetary policy was relatively well
managed during the time of Volcker
and Greenspan but much less so 15
years prior to Volcker. They confirm
their suspicions that monetary policy
was passive during the pre-Volcker
period, whereas they find that during
the Volcker and Greenspan era, the
nominal interest rate was almost three
times more sensitive to changes in
expected inflation. “[Not] until Volcker
took office did controlling inflation
become the organizing focus of monetary policy,” wrote Clarida, Gali, and
Gertler. Hence, good policy had saved
the day.
Lubik and Schorfheide revisit the
findings of Clarida, Gali, and Gertler,
and add even more precision to
the latter’s work by devising a more
sophisticated method to estimate the
dynamics of the economy. Their estimation results likewise allow them to
ascertain whether there was a shift
from bad to good policy by looking at
the responsiveness of the nominal
interest rate to inflation during the
pre-Volcker and post-1982 periods.
Like Clarida, Gali, and Gertler, they
find that after the Volcker policy shift,
monetary policy was much more
aggressive in fighting inflation than in
the 1970s. In addition, their method
allows them to be more precise about
the role of sunspot shocks and fundamental shocks during the period of
passive policy, which had opened the
door to erratic and undesirable paths
of inflation and output in the 1970s.
These papers have prompted many
responses, particularly to explain why
rational policymakers would choose to
follow the inferior policy that they did
in the 1960s and 1970s. In the response
offered by Giorgio Primiceri of
Northwestern University, rational
policymakers form their rules based
on what they believe is optimal at that
time, given the information they
observe and what they know about
how the economy works. In other
words, policymakers were simply
doing the best they could. “Alan
Greenspan in the 1960s would have
behaved very similarly to the chairman

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

41

[then], just because Alan Greenspan in
the 1960s would not have known what
he knows now,” says Primiceri.
One reason why episodes of high
inflation can occur is if policymakers
believe that the natural rate of unemployment is lower than it actually is.
Their policies would then tend to be
too expansionary, thus leading to
higher inflation. However, this is not
enough to explain why rational policymakers would let inflation remain high
for such a long time. According to
Primiceri, policymakers in the 1960s
were under the spell of overoptimism,
a condition that was encouraged by
looking at the turbulent inflation data
from the 1950s, which offered the false
hope that inflation was quickly “mean
reverting.” Because they observed that
inflation was moving up and down,
they were convinced that if inflation
went up, it would not be long before it
would come back down again.
But what prolonged the rise in
inflation was when this overoptimism
turned into overpessimism in the
1970s. Policymakers thought that the
sacrifice ratio, or the cost of bringing
down inflation in terms of unemployment, was going to be very high. For
example, in a 1978 article, Arthur
Okun computed the sacrifice ratio
based on the estimated trade-off
between inflation and unemployment
in the literature at that time to be at 10
to one. That is, in order to bring
inflation down by 1 percent, GDP
must contract by 10 percent, a very
painful proposition. Things started to
change only in the beginning of the
1980s, when the cost of inflation was

42

R e g i o n F o c u s • Wi n t e r 2 0 0 7

finally deemed by all quarters as
simply too high.

As Luck Would Have It
Not everyone believes in the optimistic story of bad policy turned good.
For instance, the oil price shocks of
1973 and 1979 are considered one of
the prime suspects in the terrible
inflation of the 1970s. In that case,
it may have been bad luck rather
than bad policy that was driving
the surge and persistence in inflation.
But economists have at least three
problems with this argument. First,
inflation was already building up prior
to each burst in oil prices, not the
other way around. Second, it is not
clear that these shocks affected wages,
something that would have left a lasting impact on the course of inflation.
Third, an oil price shock alone may
not be enough to set off a sustained
rise in inflation without the help of
an expansionary monetary policy.
Still, fewer and more manageable
shocks during the 1980s and beyond
have made this period a relatively
peaceful one. The decline in the
volatility of output growth, due to
this dose of good fortune, may have
moderated inflation since the 1980s
and made a central banker’s job of
taming inflation much easier. Such
lucky shocks can come in the form of
smaller ones like the absence of oil
supply disruptions and the productivity resurgence of the 1990s, or more
permanent changes in the structure of
the economy. These include new ways
to manage inventory that have allowed
firms to smooth production, as well as

improvements in banking and finance
that have made it easier for consumers
and businesses to hedge risks and
soften their liquidity constraints.
But instead of trying to pick out
what exact piece of bad or good luck
there is to blame or be thankful for,
more recent work has focused on
analyzing how the volatility of such
shocks has changed over time. If the
rise and fall in inflation is indeed due
to a change in the economy’s fortunes,
and not because of a policy shift, then
the volatility of these shocks should
have diminished in the 1980s and
beyond.
Indeed, Princeton University economist Christopher Sims and Tao Zha
of the Atlanta Fed find that, unlike the
conclusions of the policy camp, the
Fed’s monetary policy rule did not
change over time. Instead, what best
characterizes the rise and fall of
inflation in their view is “stable monetary policy reactions to a changing
array of major disturbances.” In other
words, the differences in the two
regimes can be traced to the change in
the volatility of the shocks affecting
these two periods. Sims and Zha point
to the oil price shocks and the financing of the Vietnam War in the 1960s
and 1970 as the source of this macroeconomic turmoil, and that shocks on
such a scale have not recurred since.
On the surface, it is difficult to
square how different economists can
come to strikingly different conclusions – one says that a change in policy
is responsible for the dramatic turn
in inflation and the other says it is all
about luck. The divergence lies in the

PHOTOGRAPHY: LIBRARY OF CONGRESS/LC-DIG-PPMSCA-03433 AND PHOTOSPIN

In the 1970s, the U.S. economy experienced significant shocks, such as sharp rises in energy prices in 1973 and 1979. At the same time, the
Federal Reserve pursued monetary policies that many considered unwise. Economists debate whether the high and erratic inflation of
the period could have been contained if the Fed had acted differently or if the shocks to the economy were too much to overcome.

methods that they use to get their
results. For instance, Primiceri has
two papers that argue in favor of each
corner of the ring (although he says
that his “policy” explanation is his
favorite one). In his “luck” study, he
uses a statistical model that imposes
minimal assumptions and very little
structure, and so allows the data in its
most undisturbed form to weave its
own conclusion. He and others like
Sims and Zha who have used this
approach tend to find results in
favor of the luck side. On the other
hand, those who take on more economic assumptions in their model,
for instance, on how policymakers
behave and make decisions, will tend
to lean toward the policy side.
Similarly, Lubik’s response to
Sims and Zha’s conclusions is that
finding a change in the volatility
of the underlying shocks to the
economy can actually correspond
to more than one economic structure
or to more than one view of how
shocks are transmitted throughout
the economy. Thus, we cannot be certain that the bad luck-good luck story
is the right explanation of what is
observed in the data.

A Table for Two
Lubik and Schorfheide are able to
measure the importance of sunspot

shocks and fundamental shocks as
well as to observe how exactly these
disturbances could have led to the economic turmoil under a passive policy
regime in the 1970s. They find that
although sunspot fluctuations can
explain a sizeable amount (about onethird) of the volatility in inflation,
they do not do a good job of explaining
the volatility in output growth. “It
leaves the door open for an alternative
explanation,” says Lubik, “that [output
growth volatility] may have been due
to bad luck.”
Thus, luck may play a bigger role in
the dynamics of output growth. But if
the behavior of output somehow
affects inflation, then a bit of luck, not
just policy, will also find its way to
explaining the changes in prices. In
the 1980s and 1990s, monetary policy
was more aggressive, but at the same
time, real shocks such as the adoption
of information technology had a favorable impact on output growth and
inflation. Thus, the fall in inflation in
the last two decades could be
explained by a combination of a lot of
good policy and a bit of good luck
caused by stable output growth.
“I would put 70 percent on good policy and 30 percent on good luck,” says
Lubik.
Similarly, James Stock of Harvard
University and Mark Watson of

Princeton University find that
monetary policy has played an
important role in determining the
path of inflation, but doubt whether
it was instrumental for bringing
about that happy period of stable
output in the last two decades. “My
view is that the Fed gets to take full
credit for taming inflation; whether it
gets credit for taming the business
cycle is another question,” says
Watson.
In theory, the causation can run the
other way. Monetary policy can ease
output growth volatility as it works on
inflation. But if at the same time the
shocks to the economy have become
smaller or if firms have become better
at smoothing shocks, then these spells
of good luck could be mostly responsible for the stability in output growth.
Stock and Watson think that this is
the story of the 1980s and beyond and
hence conclude that monetary policy
played, at best, a modest role in this
period of moderation in output
growth volatility.
Thus, there could be a role for both
luck and policy, with policy getting
the edge for inflation and luck for
output growth. However, most are in
agreement that the Fed should take
much recognition for restoring price
stability — and responsibility for
RF
maintaining it.

READINGS
Clarida, Richard, Jordi Gali, and Mark Gertler. “Monetary Policy
Rules and Macroeconomic Stability: Evidence and Some Theory.”
Quarterly Journal of Economics, February 2000, vol. 115, no. 1,
pp. 147-180.
DeLong, J. Bradford. “America’s Peacetime Inflation: The 1970s.”
In Romer, Christina, and David Romer (eds.), Reducing Inflation:
Motivation and Strategy. Chicago: University of Chicago Press, 1997.
Lubik, Thomas, and Frank Schorfheide. “Computing Sunspot
Equilibria in Linear Rational Expectations Models.” Journal of
Economic Dynamics and Control, November 2003, vol. 28, no.2,
pp. 273-285.
__. “Testing for Indeterminacy: An Application to U.S. Monetary
Policy.” American Economic Review, March 2004, vol. 94, no.1,
pp. 190-217.
Okun, Arthur. “Efficient Disinflationary Policies.” American
Economic Review, 1978, vol. 68, no. 2, pp. 348-352.

Primiceri, Giorgio. “Time Varying Structural Vector
Autoregressions and Monetary Policy.” Review of Economic Studies,
July 2005, vol. 72, no. 3, pp. 821-852.
__. “Why Inflation Rose and Fell: Policymakers’ Beliefs and
U.S. Postwar Stabilization Policy.” Quarterly Journal of Economics,
August 2006, vol. 121, no.3, pp. 867-901.
Sims, Christopher, and Tao Zha. “Were There Regime Switches
in U.S. Monetary Policy?” American Economic Review, March 2006,
vol. 96, no.1, pp. 54-81.
Stock, James, and Mark Watson. “Has the Business Cycle
Changed? Evidence and Explanations.” Prepared for the Federal
Reserve Bank of Kansas City Symposium, Monetary Policy and
Uncertainty, August 2003, Jackson Hole, Wyoming.
Velde, Francois. “Poor Hand or Poor Play? The rise and fall of
inflation in the U.S.” Federal Reserve Bank of Chicago Economic
Perspectives, 1st Quarter 2004, vol. 28, pp. 34-51.

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

43

INTERVIEW
Robert Fogel
In the early 1960s, few economic historians engaged
in rigorous quantitative work. Robert Fogel and the
“Cliometric Revolution” he led changed that. Fogel

RF: I understand that your initial academic interests
were in the physical sciences. How did you become
interested in economics, especially economic history?

began to use large and often unique datasets to test
some long-held conclusions — work that produced
some surprising and controversial results. For
instance, it was long believed that the railroads had
fundamentally changed the American economy.
Fogel asked what the economy would have looked
like in their absence and argued that, while important,
the effect of rail service had been greatly overstated.

Fogel then turned to one of the biggest issues in all
of American history — antebellum slavery. In 1974,
he and Stanley Engerman published Time on the Cross.
They argued that on the eve of the Civil War, slavery
was far from a dying institution. Compared to
Northern agriculture, slave-based agriculture was
relatively efficient. Moreover, slave labor was being
put to productive uses in the manufacturing sector.
Fogel and Engerman were certainly not justifying the
South’s “peculiar institution” — they were simply
trying to understand and explain how that system
functioned economically. Nevertheless, the book
drew considerable criticism. Many of its conclusions,

Fogel: I became interested in the physical sciences while
attending Stuyvesant High School, which was exceptional in
that area. I learned a lot of physics, a lot of chemistry. I had
excellent courses in calculus. So that opened the world of
science to me. I was most interested in physical chemistry and
thought I would major in that in college, but my father said
that it wasn’t very practical and persuaded me to go into
electrical engineering. I found a lot of those classes boring
because they covered material I already had in high school,
so it wasn’t very interesting and my attention started to drift
elsewhere. In 1945 and 1946, there was a lot of talk about
whether we were re-entering the Great Depression and the
widely held view was that we could not have full employment
in a capitalist society. So those debates started to shift my
interests to the social sciences and economics in particular.
RF: The 20th century has been a period of remarkable
progress. Yet, as you have written, in the era immediately
following World War II, many economists did not
expect the American economy to do as well as it has.
Similarly, economists generally believed that the future
for many developing countries was going to be significantly bleaker than it turned out — that population
growth was going to be a major problem and that it was
quite unlikely that we would see such rapid progress
among the “Asian Tigers,” for instance. What do you
think accounts for those overly pessimistic forecasts?

however, have stood the test of time and it has
become a classic work in economic history. More
recently, Fogel has turned to questions of economic
demography, including why life spans have increased
so significantly in the developed world.

Fogel started his teaching career at Johns Hopkins
University, where he received his Ph.D. in 1963. He
subsequently taught at the University of Rochester,
the University of Chicago, and Harvard University,
before returning to the Chicago faculty in 1981. Fogel
was awarded the Nobel Prize along with another
economic historian, Douglass North, in 1993. Aaron
Steelman interviewed Fogel at his office in Chicago
on November 13, 2006.

44

R e g i o n F o c u s • Wi n t e r 2 0 0 7

Fogel: A lot of it was the difficulty of escaping from the
impact of the Great Depression and the influence of
Keynesianism, one reading of which seemed to suggest that
whatever had propelled capitalist economies during the
19th century and early part of the 20th century — major
technical advances, the settlement of the frontier — had run
out of steam. This view was common at Harvard, Princeton,
and most of the other Ivy League schools. But it was hotly
contested by people such as Arthur Burns and Wesley
Mitchell who were centered around the National Bureau of
Economic Research and Columbia. So it never firmly took
hold there or at Chicago.
But, in general, the profession had become pretty
pessimistic about the future and feared that depressions
would occur with some frequency. Simon Kuznets, for
instance, was the least ideological economist I have ever
known, but even he was very cautious about the economy’s

RF: How has the practice
of doing economic history
changed over the course of
your career? For instance, how
have improvements in the
processing of huge datasets
affected the research programs of economic historians?
Fogel: Prior to the mid-1950s,
there were no high-speed computers and even the best in
those days were not as good as
my current laptop. When they said “create a loop,” they were
not talking metaphorically. They gave you a peg board
and you literally wired a loop.
If you were interested in doing empirical research,
especially from micro data, the work was incredibly timeintensive. First, data retrieval was very hard. We used to have
to go into archives with paper and pencil and record
information by hand. Second, once you had assembled the
data, it took a long time to write and run the computer
programs and to input the data by punch cards. So, as the
technology improved, you no longer needed to place such
a high burden on theory. You could take several competing
theories, test them relatively quickly, and find out which one
was the most promising. Over time, this led us to increase
our ambitions. In the work I did on the aging of the Union
Army recruits, we could do careful longitudinal studies with
a lot of medical information from the military wartime
records and, for those who survived the war, from the
pension records. That would have been impossible just a
couple of decades before.
RF: You were one of the pioneers in using rigorous
quantitative methods to examine questions in economic
history. How was this approach received initially?
Fogel: Our teachers were very encouraging. They felt that
what we were doing was new and important. Often, they did

not have the same focus, but they thought that our
techniques were appropriate. And those, like Kuznets, who
were very empirically oriented, were, of course, supportive
of the work. We did run into problems with some of the
younger people, though. I remember going to one meeting
of the British Economic History Society. Some young
economic historians there said, “If you succeed, we will
be unemployed.” So they felt we were a threat, but they
were wrong because the “oldfashioned” analytical history is
always relevant. We did not
want to replace that. We were
providing an additional dimension. Happily, I think that
strife has largely ended. The
people who were at war with
quantifiers will now say, “If
quantification will help, by all
means, count.” They no longer
think we are barbarians.
To do economic history well,
you need to understand the
social context in which people
were acting, and a lot of that is
qualitative, not quantitative.
You have to understand from
where the data have come —
and whether the data are real.
That’s old-fashioned history.
I will give you an example. Bill Parker, who was an economic historian at Yale and one of the earlier cliometricians,
was interested in the annual growth of cotton farming in the
19th century. He found a pamphlet produced by the
Department of Agriculture that gave data for cotton
production by county between census years. So he went to
see the head of the department’s statistical division, showed
him the pamphlet, and asked if he had the raw data that
were used to put it together. The fellow said he did not have
the data but the man who wrote the pamphlet was still alive,
occasionally came into the office, and the next time he did
he would call Bill, who was working in Washington that year.
So Bill eventually spoke to him and asked him how he
collected the data. He said: “Well, I had the 1870 and 1880
census data. I had a big map of all the counties with information on elevation and other soil properties. I looked at
the map and I looked at the census and I put those balloons
where I thought they ought to be.”
So that happens. Some of the data are manufactured.
Just because something is in print doesn’t mean it can be
trusted. You have to go back and find out how those data
were generated.
Also, there are all kinds of mistakes that are made in the
census. When we go back to the original manuscripts, we
find errors, with a column being shifted over a slot, or simple
arithmetical problems, which means the numbers are not
internally consistent. Those data might be useful for setting

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

PHOTOGRAPHY: ANDREW CAMPBELL

future late into the 1940s. By then, he began to believe that
we had entered a new era of economic growth and maybe the
Great Depression was the exception, not the norm.
When I was beginning my graduate work at Columbia in
1956-1957, James Angell, who taught the monetary course
and the basic macro graduate course, said that you still
couldn’t rule out the possibility that the economy was being
kept afloat by wars. First, you had World War II and then
you had the Korean War. So that
uncertainty was still prevalent
in the mid- to late-1950s, but
I think it was beginning to shift
as we started to see more technological change and export-led
growth.

45

upper or lower bounds. Or, in certain cases, the effect of a
bad number on your overall result will be so small that you
can use it. But you have to be very careful.

the past. The life expectancy 350 years ago was about
30 years at birth while it’s about 78 years now in the United
States and England. We’re taller than we were by about
10 inches and the median weight is about 50 percent greater.
RF: It seems that the United States has reached a point
Our immune systems function much better and our
in its development that would have been remarkable to
endocrine systems work better. Also, if you have a health
people just 50 years ago. For instance, food is so plentiproblem, we have interventions that are very effective. So,
ful and cheap that we seem to be
the advances in public health and
more concerned about obesity
in medical technology have
What we currently call
than malnutrition among those
allowed us to improve the quality
in the lower part of the income
of life. Of course, health care is
the poverty line is so high
distribution. How large, in your
more expensive too. But that’s a
opinion, are the changes that we
trade-off that a rich country can
that only the top 6 percent
see in the way people live today
afford to make.
or 7 percent of the people
and what significance does that
have for the way we should look
RF: Per-capita income grew very
who were alive in 1900
at the process of economic
rapidly during the 19th century,
growth?
yet life expectancy did not seem
would be above it.
to be greatly affected until the
Fogel: First of all, we are much
20th century. How would you
richer than we used to be. What we currently call the poverexplain that? Is it simply, or at least mostly, a matter of
ty line is so high that only the top 6 percent or 7 percent of
significant innovations, especially in the pharmaceutical
the people who were alive in 1900 would be above it. That, by
and medical industries, during the 20th century?
the way, is also true when you compare us to other developed
countries.
Fogel: Part of it is that technological advances tend to build
England is a rich country but we are 50 percent richer,
on each other. For instance, we did not get really good conand we do things that seem wasteful to the English.
trol over the techniques for purifying drinking water until
My wife came down with pneumonia in 2001 in London.
about World War I, but we needed everything that was done
She was treated at one of the city’s top hospitals, Guy’s and
up to that point to figure out how to do it. Then there was a
St. Thomas’ Hospital, which is directly across from
diffusion process. Some cities implemented systems quickly
Parliament. Everything there was in wards, whereas in the
but others didn’t because it was very costly. There is a very
United States rooms are typically private or semi-private.
interesting article by David Cutler and Grant Miller looking
Americans today are used to having a phone beside their
at the arguments in different cities for and against spending
bed and 40 channels of television to watch while they are
money on water-purification projects. It often took cities
recuperating from an illness. That is unusual, even in other
many years to finally go ahead and fund those projects.
rich countries. Also, the way the diagnosis of her ailment was
We have looked at the relative importance of such largeconducted was different from the typical procedure used in
scale public health programs and it appears that they did a
the United States. The doctors and nurses were very good
great deal to expand life expectancy. Then there are issues
but they never X-rayed her. They just listened to her lungs
regarding the preparation and distribution of food products.
and came to the conclusion that she had pneumonia. If she
In 1900, about a third of cows in the United States had
had been in the United States, the doctors typically would
bovine tuberculosis. Even when dairies started to pasteurize
have X-rayed her as a precautionary measure. So we make all
the milk, it wasn’t very effective. There were a lot of consorts of investments that the British are not willing to make.
taminants that made it into the milk. So we probably didn’t
They spend $1,193 per person per year on health care, while
get a safe milk supply until the 1930s. Poultry is another
we spend $3,724.
example. Kids now think that chicken is something that is
We can do that because food, clothing, and shelter,
manufactured in some plant. They don’t realize that it was
which used to be 80 percent of a family’s expenditures,
once a living animal. When I went shopping with my mothnow account for only 35 percent. And a large part of the
er and you wanted a chicken, the butcher would go in the
food expenditures actually go toward services rather than
back room and bring out a live chicken. My mother would
on consuming nutrients — for instance, when you eat at a
feel its breast and say, “No, I don’t want that one. Bring me
restaurant or when you buy food at a supermarket that is
another one.” When she would finally choose one, the
highly processed. So we have become much richer over time
butcher would break its neck, chop its head off, and bring
and also compared to the rest of the world.
it back to us plucked and singed. That process introduced
I think there is a synergy between technological improvepossibilities for contamination. Now, the purity of the food
ments and physiological improvements. As you suggested
supply is very good — so good that when a problem slips
in the question, we are not the same people that we were in
through, it makes national headlines.

46

R e g i o n F o c u s • Wi n t e r 2 0 0 7

The people who have benefited the most from these
innovations have been the poor. Those at the top of the
income distribution were always eating the best food available. They also were living in houses that were separated
from the rest so they didn’t have to worry about their
wells being contaminated by seepage from the neighboring
buildings. So the major beneficiaries of these public-works
projects and technological changes have been the poor, who
now have access to safe food and water, which is relatively
cheap. But the wealthy also have benefited since the odds
of cross-contamination are now low.
RF: Could you please describe what you mean when you
use the term the “Fourth Great Awakening”? And how
does this concept differ from, say, Ronald Inglehart’s
idea of “post-materialism”?

each person rather than having to fight over who was getting
to watch their favorite program on the lone set. What is
available to the mass public is so much greater than what was
available not so long ago. Going to the opera used to be
considered an elite activity. What is new is that even a
person with modest income can rent a DVD of an opera.
So people’s discretionary time has increased dramatically
and they are able to pursue interests that they could have
only dreamed of in the past. That, I think, marks a whole
new age for many Americans.
RF: Culture was a subject that interested many of the
classical economists but fell out of favor for a while and
now has experienced somewhat of a rebirth. In your
opinion, how important of a role does culture play in a
country’s economic development? And from a purely
methodological standpoint, how do you measure that?

Fogel: Inglehart is one of many writers who have dealt with
Fogel: It’s true that
post-consumerism. The basic idea is that once a society
reaches a certain level of material
wealth, people really take many
material things for granted and
begin to search for other things —
® Present Position
nonmaterial things — to enrich their
Charles R. Walgreen Distinguished
lives. The example I like the most is
Service Professor of American
that in 1870, the head of the houseInstitutions, Graduate School of
hold used to have to work about
Business, University of Chicago
2,000 hours to provide the annual
® Previous Faculty Appointments
food supply for the family. Now, that
Johns Hopkins University (1958-1959),
person has to work only about
University of Rochester (1960-1964 and
240 hours. And with the price of
1968-1975), University of Chicago (1964food still declining, that figure will
1975), and Harvard University (1975-1981)
soon be closer to 160 hours.
® Education
Here is another example: We now
B.A., Cornell University (1948); A.M.,
take electricity for granted, but to
Columbia University (1960); Ph.D., Johns
make electricity widely available,
Hopkins University (1963)
you have to build up a huge physical
® Selected Publications
structure that produces and distribAuthor or co-author of several books,
utes it. I’m old enough to remember
including Railroads and American Economic
when not all parts of New York had
Growth: Essays in Econometric History
electricity. They had metered gas
(1964); Time on the Cross: The Economics of
as the form of lighting. You would
American Negro Slavery (1974); Without
put a quarter into the meter and
Consent or Contract: The Rise and Fall of
get 24 hours of gas or something
American Slavery (1989); The Fourth Great
Awakening and the Future of Egalitarianism
like that. In fact, when I was an
(2000); and The Escape from Hunger and
undergraduate, I read that about
Premature Death, 1700-2100: Europe,
two-thirds of the houses in the 1930s
America, and the Third World (2004)
did not have electricity. I didn’t real® Awards and Offices
ize how new electricity was, and we
did not finish providing electricity
Co-winner of the Nobel Prize in
Economic Sciences (1993); Fellow,
to the rural areas until the 1960s.
American Academy of Arts and Sciences;
Well, my kids don’t remember
Member, National Academy of Sciences;
a time when you did not have
Past President of the American
televisions. In fact, TV sets were so
Economic Association and the
cheap when they were growing up
Economic History Association
that you could afford to have one for

Robert Fogel

the impact of culture is difficult to
measure. But if you assembled a
group of economic historians and
development economists in a room,
I think there would be nearly unanimous agreement that there are some
cultures that are pro-growth and
some that are anti-growth. I’m writing an article for Daedalus in which
I forecast global growth rates, with
a special emphasis on the European
Union (the original 15 members), the
United States, China, India, and
about half a dozen Southeast Asian
countries. In it, I argue that China’s
per-capita income will grow about
8 percent per year until about 2040,
while India’s will grow about 6 percent, even though India’s growth
rate is currently higher than that.
The reasons I give are largely
cultural. There are too many people
in India — some call them “rural
romantics” — who would be willing
to pay a price of two or three points
in the growth rate in order to preserve certain traditional values. Also,
there are more ethnic minorities in
India than there are in China. Over
90 percent of China’s population is
Han Chinese and although the
central government worries about
the Western provinces, which are
mostly Muslim, that problem is
more economic than political. In
fact, China is subsidizing those
provinces in order to reduce the gap
between them and the coastal areas.

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

47

I think that there are too many cultural issues in India for
them to be quite as focused as China in pursuing highgrowth policies.
This is analogous in a sense to the European countries:
They are willing to make similar sacrifices in their growth
rates in order to preserve what they see as important
cultural values, such as equality. There are similar forces at
work in the United States. For instance, I believe that the
Green Party, if it ever achieved much political success, might
sacrifice economic growth in order to achieve other ends.
It is possible for rich countries to achieve both — to get
rapid economic growth while enacting reforms to
ameliorate the social problems they see as so important.
RF: You have made contributions to a very large number
of topics in economic history, but it seems clear that
your work on slavery in the antebellum United States —
especially Time on the Cross — has garnered the most
attention. How did you become interested in the topic
and how, if at all, have your views changed since that
book was published?
Fogel: First of all, we did not initially believe what we were
finding. The debate over the economics of slavery was an old
one. It went well back into the 19th century. But the view
that dominated was the Republican view of slavery, which
was a political view, not an economic one. It included
the proposition that slavery was so
bad economically that it even made
the slave owners worse off. That
view appears in the work of
Frederick Law Olmsted, when he
said that a slave owner with
50 slaves was poorer than the average policeman in New York City.
When you think of each slave as
having the value of a Rolls-Royce in
today’s dollars, imagine how far off
Olmsted’s argument seems to be.
It was only ideology that could
produce this type of argument.
The abolitionists, especially the fundamentalists, knew
that slavery was wrong, that it was a sin. So that’s all there
was to it — there was no discussion beyond how to get rid
of it. William Lloyd Garrison believed in immediate
emancipation gradually carried out. Salmon Chase — who
was the governor of Ohio, Secretary of the Treasury, and
later a Supreme Court justice — was the most brilliant abolitionist politician. Chase’s reaction to Garrison was that
Garrison wanted to wear sackcloth and eat burnt ashes,
while Chase wanted to build coalitions broad enough to
bring the system down, even though that involved compromising some principles. So the abolitionists were similar to
the Religious Right. They believed they were in direct
contact with God. Many of the famous abolitionists at one
point or another walked into the woods and had a spiritual

48

R e g i o n F o c u s • Wi n t e r 2 0 0 7

encounter. They were not people who could be said to be
big believers in the Chicago School of economics.
So when the cliometricans started out, it was widely
believed that a system as evil as slavery could not be
economically efficient. But there had been some economists
who had measured the profitability of slavery and found that
it was a profitable enterprise. Slave owners made at least the
market rate of return. But few doubted that it was less
efficient than free labor in the North; there really wasn’t
another side to the argument. When we first performed a
back of the envelope calculation, it turned out that slave
farms were 6 percent more efficient than free farms.
Stan Engerman and I found that result silly so we
decided to do a more careful study. We thought that we
would then find that slavery was something like 90 percent
as efficient as Northern labor. That was a smaller gap than
we originally thought it would be, but it still was the less
efficient of the two systems. However, the more refined
calculations produced a different result. It showed that
slave agriculture was 36 percent more efficient than free
agriculture. So we had a problem at that point — our results
did not conform to what we had predicted or what theory
might suggest — so we did what economists do when faced
with such a dilemma: We applied to the National Science
Foundation and got a grant to study the issue in more depth.
W. W. Norton put out a new edition of Time on the Cross
in 1989, in which Stan and I wrote an epilogue. The long and
short of it was that we were all
sucked in by the political argument.
But when you started looking at the
numbers, the Republican account
just did not hold up. So it was very
shocking. We got into deep arguments with friends. My wife and
I were close friends with Peter
Temin and his wife, but the slavery
debate led to some discord between
Peter and me. So our wives brought
us together and said, “You can argue
as much as you want in your offices,
but once you cross the threshold of
either house, forget it.” I think, on the whole, we managed
not to undermine personal relationships, even though the
sometimes-bitter debate that followed the book’s publication could have done that. Also, I felt very uncomfortable
thinking of slaves as a commodity. It was very hard to talk
about it in class. I always felt a sense of embarrassment and
felt the need to make it clear that I was not in favor of
slavery. The fact that slavery was efficient did not mean that
it was good.
RF: I notice that you are close to publishing a collection
of interviews with economists. Whom did you speak
with for that book and what insights do you expect will
emerge about the changing nature of economics during
the 20th century?

Fogel: My wife and I are writing a small book called Simon
Kuznets and the Empirical Tradition in Economics. For the book,
we did many interviews. Some of the people we talked with
knew Simon well personally, while some of them had little
connection to him but were intellectual leaders in economics.
We are using some of this material in the book, but there
was also a lot of interesting material that simply did not fit.
So we decided that we would collect these interviews and
publish them separately in a book that is tentatively titled
The Transformation of Economics, 1914-1980: Interviews with
Economists. For instance, we have about eight hours of interviews with Milton and Rose Friedman. Milton had worked
closely with Simon, co-authoring an important book titled
Income from Independent Professional Practice, part of which
also served as Milton’s dissertation. The interviews with the
Friedmans are wide-ranging and provide a superb history of
the economy and of the discipline. There is some overlap
with the material in their autobiography, Two Lucky People,
but most of the discussions break new ground.
RF: There’s a large gap in your academic CV from 1948,
when you finished your undergraduate degree, to the
mid-1950s, when you enrolled in graduate school. What
were you doing during that period?
Fogel: When I graduated from college, I had two job offers.
One was from my father, to join him in the meat-packing
business. That would have been quite lucrative. The other
was as an activist for a left-wing youth organization. I chose
the latter and worked as an activist from 1948 to 1956. At the
time I was making that decision, my father told me: “If you
really believe in that cause, come work with me. You will
make a much higher wage and you could give your extra
income to hire several people instead of just yourself.”
I thought, well, that makes some sense. But I was convinced
that this was a way to get me to change my views or at least
lessen my commitment to an ideological cause that I found
very important. Yes, the first year, I might give all of
my extra money to the movement, but every year I would
probably give less, and finally reach the point when I was
giving nothing at all. I feared I would be co-opted. I thought
this was my father’s way of indoctrinating me.
So I went to work as an activist. At first, I thought what
I was doing was important. But over time, I started to
become disillusioned. The Marxists had predicted a depression in 1947-1948. That didn’t happen, so they said, it will
happen the next year. But it never came. So by the early
1950s, I began seriously reconsidering my position. I had
been drawn to Marxism because I thought of it as a science.
But it was pretty clear that its “scientific” predictions were
wildly off the mark. I was ready to leave the movement, but
then McCarthyism started to heat up and that led me to
hesitate. I stayed a few more years to fight against
McCarthyism. But by 1955 and 1956, the horrors that had
occurred under Stalin, which we had all heard about but didn’t
really believe, were confirmed by Khrushchev. That was the

breaking point in a sense. I began to rethink my views and
especially my involvement with Marxism. So I decided that
I needed to receive more serious training in economics and
the social sciences generally and went to Columbia.
RF: Did the failures of Marxism to accurately analyze the
economic situation in the United States influence you to
pursue work that was heavily data driven and empirical?
Fogel: There is no doubt about that. As I said, Marxism was
sold as a science, but it became clear that it was not. It was
more of an ideology than anything else. My early experiences
made me very skeptical of ideologues of any persuasion. I’m
willing to be surprised, to accept seemingly radical ideas, but
there better be data to back up those claims, and Marxism
could not provide that type of evidence.
RF: Which economists have influenced you the most?
Fogel: Well, obviously Simon Kuznets would be at the top of
the list. The older I get, the more I realize the extent to
which my whole outlook on economics was shaped by him.
George Stigler had a big influence on me, first as a student at
Columbia and then as a colleague at Chicago. I took his
price theory course at Columbia. He was an extremely smart
man, a great teacher, and had a great wit. I never got heavily
involved in monetary economics, but I was certainly
influenced by Milton’s empiricism. Robert Solow also had a
huge influence on me. He provided a framework for looking
at growth that was extremely useful in my work. Tom
Schelling was another strong influence on me. You couldn’t
be at Harvard without being impressed by him. He has one
of the most probing, original minds I have ever encountered.
I would say, though, that the biggest influence on me
has been my graduate students, many of whom I have
collaborated with very closely. The story I am about to tell is
already in print, but it’s worth recounting. It’s about a casual
lunch that several of us had at the Quadrangle Club. Harry
Johnson, Al Harberger, Zvi Griliches, and I were there.
During the conversation, Mike Mussa’s name came up, and
we each said that Mike knew as much about our field as
we did. He had processed all this information and theory
that he had taken from his classes and synthesized it in a
remarkable fashion. But none of us was willing to say that we
each knew as much as all four people at that lunch.
On the slavery issue, Claudia Goldin did some really
insightful work as a graduate student. Dora Costa’s dissertation, which in book form won the Paul A. Samuelson Award,
has had a major influence on the study of changes in the
process of aging over the course of the 20th century.
Some people are able to carry out their work on their
own, but not the type of research I have done or am doing
currently. One person can master only so many skills, and for
my work you really need to have collaboration with others.
I have been very fortunate to have had such a great group of
RF
colleagues and students.

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

49

ECONOMICHISTORY
Rooftops and Retail
BY C H A R L E S G E R E N A

Roland Park’s
developers built this
shopping center in
the 1890s as a
convenient place for
Baltimore’s early
suburbanites to shop.

50

R e g i o n F o c u s • Wi n t e r 2 0 0 7

ne can imagine how the first
residents of Roland Park felt
when they moved to this former suburb of Baltimore in the late
1800s. The community has since been
incorporated into the city, but it
retains the atmosphere of an urban
refuge. Its winding streets and rolling
hills defy the grid patterns that characterize the city’s downtown.
Different, too, is the neighborhood’s commercial development. Built
in the late 1890s, the local shopping
center is a two-story building with a
steep gabled roof, narrow leaded-glass
windows, and ornamental half-timbers, which blends in with the
surrounding Tudor-style architecture.
Storefronts that at various times
housed a drugstore and a tea room are
now occupied by two bank branches, a
delicatessen, a French bistro, an
antique shop, and professional offices.
“This was a new thing” for suburban residents. “They didn’t have to go
downtown for every single item,” says
Robert Hearn, a 17-year resident of
Roland Park and a former professor at
the Johns Hopkins Institute for Policy
Studies. Hearn researched the community’s history for the Roland Park
Civic League.
Throughout the history of retailing, new formats have emerged to
reflect changes in societal preferences,
from the arcades in European cities to

O

the regional malls that dominate
America’s suburbs. Roland Park’s
shopping center illustrates how retail
development has mirrored the decentralization of cities that started in the
Northeast and Midwest and spread
throughout the United States.
“Some would argue that … it is part
of the American psyche to be against
cities because that is where evil lives
and graft and corruption. It is the rural
ideal,” notes Michael Beyard, an urban
planner and economist at the Urban
Land Institute. Beyard contends that
government subsidies helped support
decentralization and suburbanization,
although these trends had already
been occurring as a result of rising
incomes and other factors.

Mean Streets
When most people think about suburbanization, they tend to picture the
spic-and-span, cookie-cutter homes
that began transforming America’s
landscape in the 1950s. In fact, the
impetus to leave cities and settle the
outlying countryside existed long
before the days of Ozzie and Harriet.
“Suburbanization has been occurring for as long as we have had cities,”
notes Brian Berry, a geographer at the
University of Texas at Dallas. He has
studied urban development for more
than 40 years.
Even though American cities were
newer and generally smaller than their
European counterparts during the
19th century, they became more
densely developed as industry took
root and European immigrants settled
them. Streets were narrow, lot sizes
were small, and houses were close to
the curb. This pattern of development
occurred as much out of necessity as
to reap the advantages of economies
of scale and agglomeration.
Cities formed near sources of
raw materials or around hubs for long-

PHOTOGRAPHY: ROLAND PARK ROADS & MAINTENANCE CORP. FILES

As the population
has decentralized,
retail development
has moved out of
cities into the
suburbs

distance transportation, such as a railroad station or a port along a major
waterway. But local travel was typically limited to as far as a horse or one’s
own two feet could carry a person. “As
cities grew, more and more people had
to crowd into that limited radius,”
Berry says. “Competition for land
increased and land prices went up,”
forcing urban development to occur
vertically, not horizontally.
Crowding led to public health and
safety issues in cities. Diseases like
cholera and typhoid fever spread easily,
water and sewer systems proved inadequate, and fires occasionally engulfed
entire blocks. In the eyes of many, the
desire to have more elbow room and
better living conditions began to outweigh the benefits of city living.
The same economic and social
forces that have shaped people’s preferences for housing have also led to
changes in retailing. “Merchandising
outside city walls began in the Middle
Ages, when traders often established
markets … beyond the gates to avoid
the taxes and congestion of the urban
core,” wrote Columbia University

historian Kenneth Jackson in a 1996
journal article. Later, enclosed shopping spaces were created to provide
a cleaner environment sheltered
from the elements, from London’s
Burlington Arcade (completed in 1819)
to Milan’s Galleria ( built in 1867).

First Wave
The upper middle class and the wealthy
led the initial decentralization and suburbanization of the United States
during the 19th century. “Social change
usually begins at the top of society,”
noted Jackson in his 1985 book,
Crabgrass Frontier: The Suburbanization of
the United States. “In the United States,
affluent families had the flexibility and
the financial resources to move to the
urban edges first.”
This trend runs counter to what
the rest of the world has experienced.
In France and other European countries, the wealthy concentrated in
cities. The suburbs were regarded as
undesirable because they housed the
urban outcasts who couldn’t afford to
live in the city.
“In many cases … the density created

so much competition in the housing
market that it was very expensive to
live there,” notes Samuel Staley, director of urban and land use policy at the
Reason Foundation. So, shanty towns
emerged as an affordable alternative
for the poor and working class, built
on the outskirts of the city where land
was cheaper but close to where the
jobs were.
Prosperous Americans often maintained urban residences but they
regularly spent their weekends outside
the city and summered there to escape
the sweltering heat. The task for
developers was to make the suburbs
attractive for year-round living.
In order for residents to easily
return to the city, railroad suburbs were
located near a train station. Later,
developers built homes at the end of
horse-drawn and electric-powered
trolleys, earning their communities
the nickname of streetcar suburbs.
Along the East Coast, suburbanization started north and west of cities,
according to ULI’s Michael Beyard.
Since they were often located on the
fall line, this quadrant was typically at

Raleigh’s First Shopping Center
Opening in 1949, the regional shopping center at Cameron
Village was, by some accounts, the first large-scale retail
facility of its kind built in the Southeast. It was one of the
components of a 158-acre planned community built two
miles northwest of downtown Raleigh.
At the time, many planned suburban developments
had only small neighborhood shopping centers, says
Richard Longstreth, an architectural historian at George
Washington University. Levittown, Pa., and Lakewood,
Calif., were two notable exceptions. “They had the scale
to warrant a regional shopping center,” Longstreth says.
In contrast, the Southeast didn’t have the density and
growth in population that the Northeast, Midwest, and
the West Coast had, so there wasn’t need for large-scale
development.
Cameron Village was developed on rural land, but within the city limits of Raleigh. Also, the city had been rapidly
growing since the early 1900s and drew shoppers from
throughout eastern North Carolina.
Developer J.W. “Willie” York modeled Cameron
Village’s shopping center after Kansas City’s Country Club
Plaza, notable for its large-scale, tightly managed development, and distinctive, automobile-oriented design. York

met the plaza’s creator, J.C. Nichols, at the annual meeting
of the Home Builders Association in 1946.
Y
ork’s center opened with three stores and one restaurant. Within eight years, it expanded to 55 stores, attracting
Sears and a number of downtown retailers. (The center now
boasts more than 90 storefronts.) Eventually, the shoppers
who had traveled to Fayetteville Street, Raleigh’s downtown
shopping district, chose Cameron Village for its variety of
retail offerings and parking for 2,000 cars.
They were also attracted to Cameron Village’s upscale
atmosphere. Store signs were white metal, mounted to the
building and backlit, not neon or hanging from hooks.
Large canopies protected people from bad weather.
G. Smedes Y
ork, Willie’s son and chairman of the family
business that still manages Cameron Village, says the
shopping center was built to be convenient for people
living in Raleigh’s suburbs. It was oriented to fashion
consumers and other specialty segments.
Today, Cameron Village has reinvented itself as a
lifestyle center. Its former owner, Atlanta-based Branch
Properties, invested $16 million to remove the canopies,
build a town square, and give each storefront a distinctive
facade to resemble an urban streetscape.
— CHARLES GERENA

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

51

a higher elevation, making it less prone
to flooding. Also, the prevailing winds
came from the northwest, blowing
pollution from urban factories toward
the ocean and away from residents.
Roland Park, one of the earliest
suburban developments, fits this
description. Built on a series of ridges
overlooking Baltimore, the community
was marketed to the upper class and
upper middle class who lived in toney
neighborhoods like Mount Vernon.
“There was the worry of disease and
pestilence in the city,” describes local
historian Robert Hearn. “And, it was
cooler out here. … There wasn’t airconditioning” in residences. Finally,
people wanted something different. “If
you had big trees and lived up on a hill,
that was better than living downtown
where everything was brick and stone.”
The community’s landscape, part
of which was laid out by the firm of
Central Park designer Frederick Law
Olmsted, appealed to potential suburbanites. They also were attracted to its
clean water supply, drawn from artesian wells, and its sewer system, built
underground versus the open system
used in Baltimore.
The first planned developments
outside of cities had to provide some
of the amenities that urban dwellers
were accustomed to. The one thing
they didn’t re-create was a business
district. Stores and factories were next
to houses out of necessity in the city,
and that was something suburban residents didn’t want to deal with again.
“At the time, commerce was considered something that detracted from
land values,” says Richard Longstreth,
an architectural historian at George
Washington University who has
researched the retail decentralization
of metro areas.
That’s why commercial activity in
Roland Park was confined to a single
“business block.” It would contain
“only those businesses which are necessary for the comfort of our
residents,” noted Edward Bouton,
general manager of the development
company, in an 1891 letter to a member
of the company’s board. Saloons and
other businesses were banned.

52

R e g i o n F o c u s • Wi n t e r 2 0 0 7

Roland Park’s business block is
widely referred to as the nation’s
first shopping center, though some
would argue that later developments
near Chicago and Kansas City were
more representative of the genre.
According to Longstreth, the development proved that a collection of retail
locations managed by a single owner
could add value to a residential suburb.
The facility resembled a large country
house rather than a commercial building, plus it was set back from the street
and had a landscaped front yard.
Not much retail development
occurred outside of cities at first. Only
a few, small shopping centers like
Roland Park’s were built through the
turn of the 20th century. Aside from
the desire to keep commercial activity
out of residential areas, suburbs didn’t
have the customer base to support
larger-scale, regionally oriented retail.
They weren’t densely populated, nor
was it easy for people to travel long
distances.
Instead, the earliest shopping
centers focused on being a convenient
source of necessities for the neighborhood’s residents, complementing
rather than competing with downtown
shopping districts. If suburbanites
wanted the latest fashions and a broad
selection of specialty goods, they
made a special trip back to the city to
browse its stately department stores
and specialty retailers.
Roland Park’s developers facilitated such a journey — they built an
elevated railway line that could get residents to City Hall in downtown
Baltimore in about 30 minutes. In fact,
one of the stops on the line was at the
shopping center.
Department store operators
opened a few suburban locations, but
their focus continued to be their flagship stores in downtown shopping
districts. Business historian Daniel
Raff at the University of Pennsylvania
says cities provided the foot traffic
needed to create sufficient turnover of
their broad inventories.
“The profitability of the company
depends on how rapidly the stores
sell their inventory and replace it

with more merchandise,” Raff
describes. For a store in the middle of
Herald Square in New York, “there is a
large enough population of heterogeneous tastes [that] it will be sooner
rather than later [when] someone is
going to want that special thing.”

For the Masses
As white-collar and working-class
Americans became more affluent in
the early 20th century, Reason’s Sam
Staley notes, they, too, started seeking
housing alternatives. They gradually
moved from the crowded tenements
of central cities to less dense townhouses to single-family, detached
homes with small lots.
Meanwhile, the challenges of city
living multiplied. Progressive Era
reforms to eliminate poor living conditions, while providing some benefits
to residents, often resulted in higher
housing costs. A second wave of
European immigration and the “Great
Migration” of Southern blacks seeking
a better life added to the competition
for housing. The introduction of the
mass-produced automobile in 1908 led
to urban congestion and pollution, as
well as provided a means for people to
venture farther away from cities.
Suburban retail growth picked up in
the 1920s, with the development of
more ambitious shopping centers containing 10 or more stores and parking
for automobiles. “The accelerated rise
of controlled residential development
just before and particularly after World
War I spawned the creation of [a larger] shopping center,” wrote historian
Richard Longstreth in a 1997 journal
article. “These complexes provided
numerous goods and services either
not available nearby or scattered in less
compelling, unplanned nodes along
traffic arteries.”
Residential and retail decentralization slowed during the Great
Depression and World War II, then
the exodus from cities accelerated
from a trickle to an outpour. Several
factors opened suburbia to the masses
in post-war America.
First, the establishment of the
interstate highway system during the

late 1950s and 1960s greatly improved
travel compared to the patchwork of
state and locally funded roads, encouraging people to use their cars more
often and travel farther.
Second, advances in construction
enabled the mass production of
affordable single-family, detached
homes to meet the demand for residential development that had built up
in previous decades. The first large residential subdivisions were filled with
small, similarly designed homes that
were criticized for being “little boxes,”
geographer Brian Berry describes, but
they were viewed by many as a better
alternative to the cramped, expensive
quarters in central cities. The land surrounding cities was a good place to
build these subdivisions because it was
usually relatively cheap and unencumbered by land-use regulations.
Finally, efforts by the federal government to encourage home construction
and ownership helped support the postwar development boom. These
included loans backed by the Federal
Housing Administration to both developers and prospective home buyers,
and federally guaranteed mortgages for
veterans provided under the GI Bill.
Once suburbanization kicked into
high gear, communities outside of
cities became dense enough to support
retail development on a larger scale.
The increased mobility of suburbanites also enabled retailers to draw from
a wider geographic radius.
Initially, department stores and
other retailers opened additional
branches to serve growing suburban
markets, maintaining their presence in
downtowns because they thought

cities would continue to thrive,
according to Longstreth. Instead,
cities became less desirable locations
for retail development as they lost
population.
As populations continued to
decentralize, retailers sought to locate
near each other to attract a critical
mass of customers. Regional shopping
centers emerged and enclosed regional
malls followed, offering a wider selection of more specialized merchandise
in an attractive environment that
competed with downtown shopping
districts. They also offered something
that was hard to find in land-locked
cities — a generous supply of parking.
By the 1950s, suburban shopping
centers reportedly surpassed urban
downtowns in total retail sales.

Back to the Future
Retail development has become closely tied to residential development and
the lag between the two has narrowed.
Malls need lots of room for large
anchor tenants, parking lots for cars,
and space for future expansion. So,
rather than risk waiting too long for a
suburban community to fill in, some
retail developers follow the first wave
of residential growth to communities
where they think more growth will
occur in the future.
Today, suburbs have matured into
centers of industry and commerce in
their own right, extending the boundaries of metropolitan areas far beyond
their central cities. They have reinvented the urban aesthetic to reflect
today’s economic and social realities.
Such changes can be seen in the
Baltimore metro region. Roland Park’s

shopping center continues to offer
convenience, but residents also travel
outside of the city limits to satisfy
their retail needs. There’s Towson
Town Center, a super-regional mall
with 195 stores just five miles north of
Roland Park in Baltimore County.
Outlet shoppers have Arundel Mills,
only 19 miles to the south.
Suburbs have achieved the economic vitality of cities, Sam Staley
notes, but without the skyscrapers.
Reflecting this evolutionary step,
some suburban retail developers are
trying to re-create the feel of a downtown shopping district in the form of
lifestyle centers. Rather than provide
a climate-controlled shopping oasis
separated from the surrounding
neighborhood, these centers are open
to the elements and offer sit-down
restaurants and specialty retailers
situated in an attractive streetscape.
Two such malls have opened in or near
Richmond, Va., in the past few years.
Going forward, retailers will continue to evolve. In some cases, that will
mean “power centers” anchored by
big-box retailers. In other cases, it will
mean infill development and redevelopment in cities that are managing to
attract new residents — Canton
Crossing, a 65-acre, mixed-use development on Baltimore’s waterfront,
will include street-level retail and
restaurants to serve office workers and
condo tenants in the complex.
“Retail development is responding
to a complex set of values, needs,
and preferences,” Staley says. “It is a
metaphor for the way our communities are changing. In some ways, it is a
RF
leading indicator.”

READINGS
Gillette, Howard Jr. “The Evolution of the Planned Shopping
Center in Suburb and City.” Journal of the American Planning
Association, Autumn 1985, vol. 51, no. 4, pp. 449-60.
Jackson, Kenneth T. “All the World’s a Mall: Reflections on the
Social and Economic Consequences of the American Shopping
Center.” American Historical Review, October 1996, vol. 101,
no. 4, pp. 1111-1121.

Longstreth, Richard. “The Diffusion of the Community Shopping
Center Concept During the Interwar Decades.” Journal of the
Society of Architectural Historians, September 1997, vol. 56, no. 3,
pp. 268-293.
Waesche, James F. Crowning Gravelly Hill: A History of Roland ParkGuilford-Homeland District. Baltimore: Maclay & Associates, 1987.

__. Crabgrass Frontier: The Suburbanization of the United States.
New York: Oxford University Press, 1985.

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

53

BOOKREVIEW
Underground in America
OFF THE BOOKS — THE UNDERGROUND ECONOMY OF
THE URBAN POOR
BY SUDHIR ALLADI VENKATESH
CAMBRIDGE, MASS.: HARVARD UNIVERSITY PRESS, 2006
448 PAGES
REVIEWED BY DOUG CAMPBELL

I

t’s been almost two decades since Peruvian economists
Hernando de Soto and Enrique Ghersi published
The Other Path, considered by many to be the seminal
work on the underground economy. De Soto and Ghersi
described how entrepreneurial Peruvians, in response to the
rise of the radical “Shining Path” movement and burdensome regulations that made doing business according to the
letter of the law very hard, cultivated an alternative marketplace. They worked as vendors, home builders, and drove
most of the buses in Lima.
Eventually, this “informal” economy was estimated
to encompass 38 percent of gross domestic product (GDP).
Such entrepreneurialism showed the
inconsequence of the government’s centrally planned, overregulated economy,
ultimately weakening the ideology and
guerrilla movement behind it.
Now comes what’s being hailed as the
next landmark narrative on the underground economy. This time, the author is
an American of South Asian descent, a
sociologist made semi-famous in Chapter
Three of Freakonomics, the surprise bestseller by economist Steven Levitt and
journalist Stephen Dubner, as the enterprising grad student who got his mitts on
the ledger of a Chicago drug dealer.
In his first book, American Project: The
Rise and Fall of a Modern Ghetto, Sudhir
Alladi Venkatesh, now an associate professor at Columbia,
focused on Chicago’s failed subsidized urban housing. In his
latest, Off the Books: The Underground Economy of the Urban Poor,
Venkatesh looks at a single urban neighborhood — a South
Side quarter that the author pseudonymously calls “Maquis
Park” — and delivers an authoritative account of the current
underground economy at work in a major American city.
Though they are not burdened by hurdles as severe as the
Peruvian entrepreneurs chronicled in The Other Path, the
residents of urban Maquis Park, nonetheless, face their own
barriers to entry in the formal economy. The neighborhood’s
physical infrastructure is eviscerated, basic public services

54

R e g i o n F o c u s • Wi n t e r 2 0 0 7

are often substandard, human capital is generally low,
and official joblessness is rampant. So the people of
Maquis Park build their own economy.
This is no ivory tower view. Venkatesh spent parts of
eight years, from 1995 to 2003, “hanging out” in Maquis
Park. He thinks that his South Asian lineage was an asset;
the black residents didn’t view him as white or black, but
more of a mediator who could be occasionally called upon to
settle a transactional dispute. This role helped him get close
to his sources. The result is a close-up study of inner-city life
that rings authentic.
There is Leroy, the auto mechanic who gets paid for oil
changes with trades — a used microwave, sometimes cell
phones. “Soccer Mom” Baby “Bird” earns a living as a
prostitute, while her neighbor Eunice cleans offices for
minimum wage and supplements by selling home-cooked
soul food. Even the clergy get wrapped up in the underground economy. Sometimes the pastors negotiate conflicts
between pimps and prostitutes; other times they help settle
contracts between underground traders. They serve as
liaisons between the police and street
gangs. They also receive direct benefits for
their roles, with cash donations often
following the recovery of stolen property,
for example. “Like their flock, pastors
must also contend with the complexities
of life where the underground may be the
only available resource,” Venkatesh writes.
To be sure, there is no shortage of
“legitimate” business. It’s just that many
of these licit trades get mixed up with
illicit ones. The diner owner also vends
pirated CDs at the register. The hair
stylist subleases a back room to sex
workers. They do it for survival because
they see no other way. Here’s Eunice, the
office cleaner who also doesn’t report
income on food she sells: “Oh, the Lord sees that. Yes, I do
live an illegal life in the eyes of God. But he also sees I ain’t
selling no drugs. I take care of my grandchildren. All that
money? It goes to my babies, keeps them in school. I mean,
you always going to take care of your children.”
The underground economy of Maquis Park is not a
political statement. It is, as Eunice describes, a matter of economic necessity. And it is a fairly robust, if not at first obvious,
sort of activity. “Beneath the closed storefronts, burned-out
buildings, potholed boulevards, and empty lots, there is an
intricate, fertile web of exchange, tied together by people with
tremendous human capital and craftsmanship,” Venkatesh

In such cases, the underground economy of Maquis Park
works, but it’s safe to say residents would eagerly give it up
for the certainty of the official economy. Venkatesh is
mostly sympathetic to his sources, and he devotes many
passages to their resourcefulness. But he has no illusions
about their plight. The further Maquis Park residents
Simply put, it is nearly impossible for residents in
burrow into the “shady” economy, the less likely they are to
Maquis Park to avoid underground economic activity:
build credit and human capital that would propel them into
it is an ever-present threat on the streets, in parks,
the official economy.
and other public places; and for the working and poor
Unlike Peru of the 1980s, the regular economy of the
families, it is always a temptation, given the hardships
United States is a far more desirable place to be. The
of living near the poverty line. Recall that, at any
tragedy is that some Americans find it hard to move into
point in time, nearly half of the community is out of
that world. The informal economy can be more lucrative
the labor force, so poverty by itself will force people
and the barriers to entry often lower. One might not find
to seek work outside the mainstream.
the underground economy worthy of celebration, but its
Five main types of players operate in Maquis Park, and
existence is imperative to understand. Not only is the
Venkatesh devotes a chapter to each of them: the domesAmerican underground economy significant in size — some
tics, the entrepreneurs, the street hustlers, the clergy, and,
estimates put it at roughly 10 percent of official GDP —
finally, the gangs. The aptly named Big Cat is leader of the
studying it can tell us much
dominant Maquis Park street gang,
about how markets, both legal
the Black Kings, through whom
and illegal, work.
seemingly all underground transacNot only is the American
How accurately Off the Books
tions eventually pass.
renders these events remains
underground economy signifiBig Cat is keenly aware of his
somewhat unclear. This is a
shady status. He yearns to rise in
cant in size, studying it can tell
minor quibble, but because
social standing, to be so successful
Venkatesh has changed names
in the underground economy as to
us much about how markets,
of people and locations, his
be catapulted up to the legitimate
reporting is impossible to
one. “He believed the black urban
verify. In a footnote, Venkatesh
both legal and illegal, work.
poor must use the underground to
explains
that
Columbia
amass the necessary political and
University guidelines require
economic capital to improve their
that “risks to human subjects” are minimized, a practice
social standing and become influential actors in the wider
that has become standard at research universities around
city.” Recognizing that his own welfare depends on his relathe country. There is otherwise no reason to doubt that
tionship with the community, Big Cat even backs off on some
all the people and places he describes are genuine, but
of his most profitable drug-dealing operations. But he is
readers are justified in approaching the text with a
doomed from the start. It’s not giving anything away to note
healthy amount of skepticism.
that Big Cat never realized his goal. News of his death opens
Off the Books undoubtedly will show up on social science
Chapter One; his funeral serves as the book’s conclusion.
syllabuses in campuses across the country. Many econoThe portrait that emerges of Maquis Park is one of
mists already have placed it on their recommended reading
shaky, tense alliances, risk, and the ever-looming possibility
lists. Venkatesh’s work is not quite an academic text, yet it
of death. Bargaining is a way of life between the groups —
is much more than a simple community snapshot. He may
not just bargaining over goods and services but bargaining
get a bit ham-fisted in repeating his theme: that activities in
to keep the underground economy afloat. Marlene, the
the underground and over-ground economy are inextricably
nanny and sometimes community watchdog, meets with
intertwined. But it’s an important point. Off the Books
Big Cat and Pastor Wilkins to hammer out a sort of
lucidly describes the urban underground in all its interpeace pact. Their agreement allows unfettered drug and
locking alliances and complicated angles. Perhaps next we
prostitution activity in their park while children are in
school or in the late-night hours. But when kids are playing,
can begin to deal with the problem at a level equivalent to
illicit activity is to cease.
RF
its complexity.
writes. Y Maquis Park is brimming with homeless hustlers
es,
and barely-scraping-by merchants. But every single one of
them is working to make ends meet. They operate in the
shadow economy because the official one is both harder to
access and provides insufficient income. Venkatesh explains:

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

55

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

T

he Fifth District’s economy
expanded at a more modest
pace in the third quarter,
as the continued deceleration in housing activity was joined by further
weakening in the retail sector.
News from District labor markets
remained generally upbeat though,
with a steady increase recorded in
third-quarter payrolls. Also, thirdquarter readings from manufacturing
and services establishments were
mostly positive across the board.

Labor Markets Expand
Fifth District labor market conditions
remained generally solid outside of a
slowdown in retail hiring. Compared
to the second quarter, districtwide
payrolls advanced 1.1 percent in the
third quarter. Demand for bilingual
employees was strong, as evidenced by
a Richmond, Va., agent who noted
that further strengthening in the area’s
economy had helped boost demand
for employees fluent in Spanish,
especially in the transportation and
health care industries.

Housing Activity Slows
Residential real estate activity
slowed further in the third quarter,
with the National Association of
Realtors reporting a 1.5 percent
decline in Fifth District home sales.
Consistent with the latest data,
District realtors noted that new construction and home sales had softened
further across most markets.
Illustrating this, a District of Columbia
agent described that area’s housing
market as “horrible,” and added that
sales were down 25 percent from a year
earlier. Keeping with the downshift in
sales volume, dwindling demand continued to draw down the pace of home
price appreciation in many areas.
Third-quarter District home prices
were only 5.4 percent higher compared
to a quarter earlier, the lowest quarterly
growth rate since early 2003.

The Fifth District’s economy
expanded at a more modest
pace in the third quarter.
According to the Bureau of Labor
Statistics, another large inflow of new
entrants to the labor force was
recorded in the third quarter, pushing
the District’s unemployment rate up
0.2 percentage point to 4.5 percent,
slightly below the 4.8 percent rate
posted a year ago.

Services Revenues Strong
News from Fifth District serviceproviding firms remained upbeat, with
third-quarter measures of employment
and wage growth expanding at

Economic Indicators
3rd 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.

56

2nd Qtr. 2006

Percent Change
(Year Ago)

13,673
135,595

13,636
135,128

1.7
1.4

910.7
9,490.0

904.1
9,416.0

2.6
3.8

54.2
437.9

64.2
529.5

-15.1
-23.9

4.5%
4.7%

4.3%
4.6%

R e g i o n F o c u s • Wi n t e r 2 0 0 7

a healthy clip over the period and
revenue growth outpacing that of mid2006. Contacts at professional,
scientific, and technical firms indicated
that demand strengthened late in the
third quarter. An executive at a financial
services firm in Baltimore, Md., attributed his clients’ bullishness in part to
the recent drops in energy prices.
Activity at Fifth District retail firms
contracted further, however, with
contacts reporting a continued deceleration in third-quarter sales activity.
Executives at two building supply
chains noted that sales growth at
District stores eased as new
residential construction softened.
The pace of sales also cooled at furniture and home accessories stores
in central Virginia, according to an
industry contact in Richmond, Va.
In labor markets, retailers continued to trim employee levels and wages
over the period. District contacts from
both service-providing and retail businesses noted that price growth
moderated from July to September.

Manufacturing Rebounds
The Fifth District’s manufacturing
sector rebounded strongly in the third
quarter, following a drop-off in momentum during the second quarter.
Indicators that were generally lackluster at midyear, such as growth in
factory shipments and new orders, had
picked up considerably by September.
In response to the pickup, District
manufacturers added employees and
extended hours, as evidenced by the
length of the average workweek and
factory employment activity, both
of which expanded strongly. Among
industries, contacts in electronic,
plastics, and printing and publishing
reported the strongest growth in
demand over the period. Manufacturers reported that raw materials
and finished goods price growth moderated to a degree from July to September,
but they anticipated a somewhat faster
rate of increase moving forward. RF

Nonfarm Employment

Unemployment Rate

Real Personal Income

Change From Prior Year

First Quarter 1993 - Third Quarter 2006

Change From Prior Year

First Quarter 1993 - Third Quarter 2006

First Quarter 1993 - Third Quarter 2006

5%

8%

8%

7%

6%

7%

4%
3%

5%
6%

2%
1%

4%
3%

5%

2%

0%

1%

4%
-1%

0%

-2%

3%
93

95

97

99

01

03

05

93

95

97

99

01

03

-1%

05

Fifth District

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 - Third Quarter 2006

First Quarter 1995 - Third Quarter 2006

Change From Prior Year

First Quarter 1993 - Third Quarter 2006

9%

30%

8%

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

20%

7%
10%
6%
0%
5%
-10%

4%

-20%

3%
2%
93

95

97

99

Charlotte

01

Baltimore

03

05

-30%
93

Washington

95

97

99

Charlotte

01

03

Baltimore

95

05

Washington

FRB—Richmond
Services Revenues Index

99

01

03

Fifth District

FRB—Richmond
Manufacturing Composite Index

First Quarter 1996 - Third Quarter 2006

97

First Quarter 1996 - Third Quarter 2006

05

United States

House Prices
Change From Prior Year
First Quarter 2001 - Third Quarter 2006

40

40

16%

30

30

14%

20

20

12%
10%

10

10

0

0

-10

-10

-20

-20

2%

-30

-30

0%

8%
6%

96

98

00

02

04

06

4%

96

98

00

02

04

06

01

02

03

Fifth District

04

05

06

United States

NOTES:

SOURCES:

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

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

For more information, contact Matthew Martin at 704-358-2116 or e-mail Matthew.Martin@rich.frb.org.
Wi n t e r 2 0 0 7 • R e g i o n F o c u s

57

STATE ECONOMIC CONDITIONS
BY M AT T H E W M A RT I N

T

he District of Columbia’s economy has slowed of late
and most labor market measures of economic performance have been moving sideways. There has been very little
in the way of payroll job gains so far this year, while the
household survey indicates that the labor force contracted
again in the third quarter. The decline in housing activity
has been modest compared to neighboring states, but existing home sales in the third quarter were lower than both
previous quarter and year earlier totals.
Employment statistics indicate a continuation of modest
growth in the third quarter for the District of Columbia.
The number of payroll jobs actually contracted by a small

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

108
106
104
102
100
98
96
94
01

02

03

04
U.S.

05

06

D.C.

SOURCES: Bureau of Labor Statistics and Haver Analytics

margin compared to the previous quarter, though the number of jobs is 1.5 percent higher than a year ago. Most of
these gains occurred at the very end of last year and there
has been little increase so far in 2006. The District of
Columbia’s large government sector has not added many
new positions over the past year, but there is also some
softness evident in the outsized professional and business
services sector.
Periods of slower growth are not uncommon for the
District of Columbia. During the most recent recession, for
example, job growth actually accelerated, but was then
followed by a period similar to that seen recently. In the
nation’s capital, outright declines in employment are rare;
however, the number of people actually living there has
declined at times. This may be one reason the household
survey reported another sharp drop in the labor force in the
third quarter. Over the past year the labor force has declined
2 percent, possibly reflecting population declines within the
District of Columbia. However, the area has long had more
jobs than laborers, given the large number of commuters.
As is the case in neighboring states, residential real estate
activity has declined recently. Existing home sales fell 5.6
percent in the third quarter and have fallen 15 percent since

58

R e g i o n F o c u s • Wi n t e r 2 0 0 7

the third quarter of last year. Even though these declines are
sharp, they are still smaller than those in both Maryland and
Virginia. Residential permit issuance actually rose in the
third quarter, though the numbers tend to be volatile from
quarter to quarter.

U Maryland
aryland’s economy continues to grow at a steady pace,
despite a continued pullback in the state’s housing
market. Payroll job growth has slowed to just over 1 percent
annually, but Maryland possesses the second-lowest unemployment rate in the District. The state’s job market
remained relatively strong through the last recession. Both
new home building and existing home sales dropped sharply
in the third quarter, but there is little evidence of a broader
impact from housing on the state’s economy.
Labor market indicators for Maryland are broadly positive.
The third-quarter average unemployment rate of 4.1 percent
is 0.3 percent above the second quarter, but the increase
reflected more of a jump in the labor force growth rather than
a decline in employment. As it stands, the unemployment rate
is still marginally lower than a year earlier and is the secondlowest rate among all jurisdictions in the District. Job growth
from the establishment survey has been steady, with gains of
1.1 percent at an annual rate in the third quarter equal to the
rate of increase since the third quarter of last year.
Maryland’s job performance has outpaced the national
labor market in the last several years. Since the beginning of
2001, the number of persons employed in the state has
increased 5 percent against slightly more than half that
amount for the United States as a whole. The difference is
entirely due to the lack of job losses during the recession and
weak recovery early in the decade. Since 2004, however, job
growth has been faster nationally.
Other than Virginia, no other state in the District has
seen as sharp a pullback in residential housing as Maryland.

M

MD and U.S. Employment Growth Since Jan. 2001
106

Payroll Employment, Index
Jan. 2001 = 100

District of Columbia

104
102
100
98
96
94
01

02

03

04

U.S.

05
MD

SOURCES: Bureau of Labor Statistics and Haver Analytics

06

NC and U.S. Employment Growth Since Jan. 2001
106

Payroll Employment, Index
Jan. 2001 = 100

The decline in activity has been notable for both new residential construction and sales of existing homes. In the third
quarter, permit issuance was 15.8 percent below the year-ago
level compared to a 19.4 percent drop in existing home sales.
The decline in activity has slowed house price appreciation,
though the 7.6 percent increase at an annual rate in the third
quarter was the second-largest gain among all jurisdictions
in the District. Prices are also 13.3 percent higher than a year
earlier, on average, suggesting that further slowing might
be forthcoming.

104
102
100
98
96
94
01

02

03

04

U.S.

05

06

NC

SOURCES: Bureau of Labor Statistics and Haver Analytics

h

T

North Carolina

he North Carolina economy is performing well, though
the pace of expansion appears to have moderated in the
second half of the year. Labor market data are generally positive even though the rate of job growth slowed in the third
quarter. The state is likely to see fewer new jobs for all of
2006 compared to the previous year despite fewer manufacturing job cuts. By contrast, housing markets in the state
have shown considerably more strength than those in every
other jurisdiction in the District, including a substantial
increase in third-quarter existing homes sales.
Labor market data for the third quarter were generally
positive, though various indicators present something of a
mixed picture. Payroll employment slowed in the third quarter to 1.1 percent, down from 1.9 percent in the second quarter.
However, compared to a year earlier, growth remained robust,
with a 1.9 percent increase that was nearly identical to the
second-quarter rate. Additionally, the household survey was
more optimistic, with large gains in both employment and the
labor force. Growth in the latter was stronger, causing the
state’s unemployment rate to average 4.8 percent in the third
quarter, up 0.3 percent from the prior period.
Despite good job growth throughout 2006, North
Carolina remains a trailing state by at least one measure.
Current employment levels in the state are only fractionally
higher than levels at the beginning of 2001, about the time
national employment reached a prerecession peak. Even
South Carolina has surpassed the previous employment
peak by a larger margin, despite having a higher unemployment rate from the household survey. Unlike the
establishment survey data shown in the chart, North
Carolina’s household survey shows much stronger growth
over the same period, outpaced only by Virginia over the
same period within the District. While differences between
what the two surveys measure account for much of the difference in measured employment, the growing disparity in
the two measures suggests future data revisions. The establishment data will be revised early next year as part of an
annual process. In North Carolina’s case the revision will

likely improve the employment picture by increasing payroll
employment figures from a year ago.
Although there is some slowing in residential real estate
markets, there has not yet been an overall pullback across the
state. New building construction peaked earlier in the year
and has since slowed. Third-quarter permits were sharply
lower than second-quarter levels and 7.5 percent below than
a year earlier. However, existing home sales have held up well,
rising 5.3 percent in the third quarter at an annual rate and
they remain nearly 10 percent higher than a year ago.

o South Carolina
S

olid employment growth so far this year and more
resilient real estate markets than most have improved
the economic outlook for South Carolina. Admittedly, the
state has more room for improvement than others in the
District, especially with an unemployment rate that remains
above 6 percent. However, that figure is now more than half
a percentage point lower than a year ago amid job growth in
excess of 2.5 percent over the past 12 months. As with North
Carolina, the manufacturing sector remains the primary
weight on economic growth, though at least job losses have
slowed so far in 2006.
Employment growth slowed to 1.1 percent in the third
quarter, down from 3.4 percent in the second. However,
there was little change in the rate of growth over the past
year, which actually ticked slightly higher to 2.8 percent. At
6.4 percent, however, the unemployment rate is the highest
in the District, even though payroll job growth has actually
been better than average since the last recession.
Employment in South Carolina is now nearly 4 percent
higher than it was in early 2001, outperforming the national
economy. Most of the difference between the two is due to
net job growth in 2006. As job growth has accelerated,
the labor force has expanded more quickly, keeping the
unemployment rate elevated.
Labor force growth has slowed, allowing the unemployment rate to slowly trend lower compared to both the

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

59

Payroll Employment, Index
Jan. 2001 = 100

106
104
102
100
98
96
94
01

02

03

04

U.S.

05

06

SC

SOURCES: Bureau of Labor Statistics and Haver Analytics

second quarter and a year earlier. In the second quarter,
South Carolina had the fastest rate of labor force growth in
the District at 3.4 percent. A slight drop in the third quarter
still leaves the labor force 1.6 percent larger than a year ago.
Like the rest of the District, new home construction
slowed considerably in the third quarter, with new permit
issuance down 9.9 percent compared to a year ago. Unlike
North Carolina, however, existing home sales also declined
in the third quarter yet remained marginally higher than a
year earlier. As might be expected, the pullback was sharper
in the state’s coastal areas, which comprise a significant
share of total state activity. The moderating real estate market also slowed house price appreciation, though the house
price index rose a respectable 6.5 percent at an annual rate in
the third quarter.

growth since the recession, helping the state easily outperform the nation as a whole. As it now stands, employment in
the state grew 6 percent since early 2001.
The sharp pullback in the state’s residential real estate
market remains the one sector that is under pressure. The
decline in existing home sales has been particularly sharp
and the 24.4 percent fall in sales since last year is the fastest
rate of decline in the District. The fall in permit issuance has
been even larger, falling 32.2 percent since the third quarter
of last year. Not surprisingly, house price appreciation has
slowed, but so far it remains positive. The 2.7 percent
increase in the third-quarter house price index stands in
sharp contrast to the 21 percent increase posted in the third
quarter of 2005. So far, however, weaker results in real estate
seem to have only a limited impact on the rest of the economy,
with even construction employment still expanding at a
robust pace thanks to healthy commercial construction.

VA and U.S. Employment Growth Since Jan. 2001
108

Payroll Employment, Index
Jan. 2001 = 100

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

106
104
102
100
98
96
94
01

02

03

04

U.S.

u Virginia
irginia remains a model of steady, mature growth while
also possessing the lowest unemployment rate in the
District. Employment growth has slowed this year, but with
an unemployment rate hovering near 3 percent and modest
labor force growth, some slowing was inevitable. Activity in
the state’s residential real estate market has declined sharply
so far this year, with both existing and new home sales sharply
lower than last year. Price growth has also slowed, though
broader impacts on the economy are not evident at this point.
The pace of job growth in the third quarter was similar
to the second quarter, with a nearly equal pace of growth
posted over the past year as well. At 1.5 percent, Virginia’s job
growth is not the fastest in the District, but the unemployment rate was a District low 3.2 percent in the third quarter,
leaving little room for a faster expansion. Even the state’s
labor force has grown by 1.5 percent over the past year, suggesting a balanced economy that is adding jobs as workers
become available to fill them.
The chart shows the strength of Virginia’s labor market
over time. Employment in the state fell less than that seen
nationally during the last recession, with a faster pace of

V

60

R e g i o n F o c u s • Wi n t e r 2 0 0 7

05

06

VA

SOURCES: Bureau of Labor Statistics and Haver Analytics

w

West Virginia

est Virginia’s economy continues to expand with
some encouraging signs in some sectors. Job growth
slowed in the third quarter and residential real estate
activity contracted sharply, but the state is still benefiting
from elevated energy prices and a newfound stability in
manufacturing employment. Both new residential construction and existing home sales contracted sharply in the third
quarter, but house price growth accelerated compared to
the prior period.
Labor market conditions remained generally positive for
West Virginia in the third quarter. Quarterly payroll job
growth slowed to 0.8 percent at an annual rate, in part due
to a sizable drop in government employment. However,
employment in the state’s mining sector expanded again
and is now as high as it has been at any point in more than
10 years. The manufacturing sector managed to add a few
jobs, bringing at least temporary stability to a sector that
has been contracting throughout the current expansion.

W

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

Monthly volatility in the household survey data limits the
inference value of the reported figures, but a three-month
moving average of the unemployment rate is currently
higher than a year earlier by about 0.3 percent.
West Virginia’s labor market actually came through the
last recession in better shape than the national market. Since
then, however, job growth in the state has slowed and the
advantage over the national economy has eroded. As a result,
employment in the state is 3.1 percent higher than it was at
the start of 2001, marginally above the 2.6 percent growth
seen nationally over the same period.
Residential real estate markets generally showed further
signs of slowing, with existing home sales down 11.5 percent
in the third quarter. Comparisons to a year earlier were even
less favorable, with a decline in sales of 19.4 percent. Permit
issuance has also fallen sharply and is now 21.2 percent lower
than a year ago. Despite these figures, house price appreciation accelerated in the third quarter to 8.2 percent, up from
1.8 percent in the second quarter.

Payroll Employment, Index
Jan. 2001 = 100

106
104
102
100
98
96
01

02

03

04

U.S.

05

06

WV

SOURCES: Bureau of Labor Statistics and Haver Analytics

Measures of labor market activity from the household
survey have been volatile recently, but suggest strong growth
in the state’s labor force. The unemployment rate jumped a
full percentage point to 5.6 percent in the third quarter, but
the increase owed more to a 3.2 percent increase in the labor
force than the 1 percent decline in household employment.

Behind the Numbers: Updating GDP

3Q 2006

2Q 2006

1Q 2006

4Q 2005

3Q 2005

2Q 2005

1Q 2005

4Q 2004

3Q 2004

PERCENT ANNUAL CHANGE

In late October, the Commerce Department announced
of GDP appears. So why does the government release
that the “advance” estimate of third-quarter gross domestic
these historically inaccurate advance reports if it knows the
product (GDP) rose at an annual rate of 1.6 percent. It was
numbers will inevitably move up or down?
“a more moderate rate of growth” than seen in the first
One reason is that the advance and preliminary reports
half of 2006, Commerce Secretary Carlos Gutierrez said in
are often close to the mark. According to a BEA study, early
a statement.
estimates “consistently indicate
GDP Revisions
In response, some economic
whether growth is positive or
analysts said they were worried Despite quarterly revisions, final GDP results are usually close
negative, whether growth is
about a slowdown. But in to early estimates.
accelerating or decelerating,
November, the department’s
whether growth is high or low
6
“preliminary” estimate for GDP
relative to trend, and where the
5
growth was revised upward to 2.2
economy is in relation to the
percent, close to the 2.6 percent
business cycle.” The chart pro4
pace of the previous quarter, and
vides visual confirmation of this
3
analysts were reassured. Then in
finding. In the past two years,
late December came the final
revisions to GDP growth haven’t
2
report on third-quarter GDP —
significantly deviated from the
an even 2 percent. Markets were
overall trend.
1
mostly unrattled, however, with
Another reason is that eco0
the Dow Jones dropping for the
nomic analysts know that
day but by only 0.34 percent.
revisions are coming and hedge
Early GDP results are always
their own forecasts accordingly,
Advanced
Preliminary
Final
subject to change. They are
taking the advance and prelimi“based on partial and incomplete
nary GDP figures as just that —
NOTE: Estimates are in chained 2000 dollars.
SOURCE: Bureau of Economic Analysis
source data,” according to the
early indicators. “We recognize
Bureau of Economic Analysis
that none of these statistics are
(BEA). For example, only two months of data are usually
as precise as we’d like them to be,” says Roy Webb, a senior
available for most data sources 30 days after the close of a
economist at the Richmond Fed. “We accept them for what
quarter, at which time the government’s “advance” estimate
they are and make allowances.”
— DOUG CAMPBELL

winter 2007 • Region Focus

61

State Data, Q3:06
DC

MD

NC

SC

VA

WV

690.1
-0.6
1.5

2,588.9
1.1
1.1

3,991.3
1.1
1.9

1,910.3
1.1
2.8

3,737.3
1.4
1.5

755.3
0.8
1.0

Manufacturing Employment (000)

2.2

138.0

558.5

256.6

297.5

61.5

Q/Q Percent Change

13.1

-0.7

-1.9

-5.4

-0.9

0.2

Y/Y Percent Change

6.5

-1.6

-1.1

-1.4

0.6

0.2

Professional/Business Services Employment (000) 151.4
Q/Q Percent Change
-0.1
2.1
Y/Y Percent Change

394.3
3.8
2.2

455.8
2.9
2.3

210.7
4.0
2.0

626.3
3.7
2.6

59.4
3.9
1.0

233.3
2.6

464.7
-3.2

682.0
0.6

338.0
5.0

672.8
1.9

142.7
-1.7

-0.1

-0.3

3.0

2.8

1.2

-0.7

289.8

3,005.7

4,446.7

2,117.6

4,008.4

821.4

-3.3
-2.0

1.8
2.0

4.5
2.3

-0.7
1.6

0.7
1.5

3.2
2.1

5.8

4.1

4.8

6.4

3.2

5.6

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

Government Employment (000)
Q/Q Percent Change
Y/Y Percent Change
Civilian Labor Force (000)
Q/Q Percent Change
Y/Y Percent Change
Unemployment Rate (%)
Q2:06

5.5

3.8

4.5

6.6

3.1

4.6

Q3:05

6.3

4.2

5.4

6.8

3.6

5.2

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

28.5
2.0
2.0

217.0
3.1
2.6

248.2
3.1
2.7

111.4
3.2
3.4

261.9
2.7
2.4

43.7
3.8
3.0

Building Permits
Q/Q Percent Change

232

6,423

23,868

12,034

10,357

1,205

9.4
27.5

-70.2
-15.8

-45.2
-7.5

-31.6
-9.9

-61.2
-32.3

-13.1
-21.2

644.61
4.0
11.3

533.27
7.6
13.2

326.43
6.5
8.4

309.64
5.5
7.8

463.42
2.7
9.9

231.09
8.2
6.3

10.2
-5.6

110.0
-5.3

242.6
5.3

119.2
-2.7

136.0
-5.6

-11.5

-15.0

-19.4

9.7

0.7

-24.4

-19.4

Y/Y Percent Change
House Price Index (1980=100)
Q/Q Percent Change
Y/Y Percent Change
Sales of Existing Housing Units (000)
Q/Q Percent Change
Y/Y Percent Change

31.6

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

62

R e g i o n F o c u s • Wi n t e r 2 0 0 7

Metropolitan Area Data, Q3:06
Washington, DC MSA

Baltimore, MD MSA

Charlotte, NC MSA

3,003.2
1.3
2.4

1,304.1
-0.4
1.2

808.9
0.1
2.3

3.2
3.0
3.4

4.5
4.0
4.4

4.7
4.5
5.2

Building Permits

6,522

1,785

6,442

Q/Q Percent Change

-49.6

-61.6

-17.5

Y/Y Percent Change

-16.6

-28.3

5.7

Nonfarm Employment (000)
Q/Q Percent Change
Y/Y Percent Change
Unemployment Rate (%)
Q2:06
Q3:05

Raleigh, NC MSA

Charleston, SC MSA

Columbia, SC MSA

276.3
-1.6

289.5
-4.3

361.5
-0.3

Y/Y Percent Change

2.7

2.9

3.3

Unemployment Rate (%)
Q2:06
Q3:05

3.9
3.7
4.3

5.4
5.1
5.7

5.7
5.6
6.0

832
-70.1
-29.8

1,984
-41.0
-24.2

1,822
-35.0
-1.3

Nonfarm Employment (000)
Q/Q Percent Change

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

Norfolk, VA MSA

Richmond, VA MSA

Charleston, WV MSA

780.3

622.3

152.2

Y/Y Percent Change

0.2
1.7

-2.4
1.1

2.9
1.9

Unemployment Rate (%)
Q2:06
Q3:05

3.7
3.5
4.1

3.4

4.8

3.2
3.7

4.4
4.6

1,600
-54.8
-38.0

1,831
-68.7
-31.3

69
-60.4
-15.9

Nonfarm Employment (000)
Q/Q Percent Change

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

For more information, contact Matthew Martin at 704-358-2116 or e-mail Matthew.Martin@rich.frb.org.

Wi n t e r 2 0 0 7 • R e g i o n F o c u s

63

OPINION
Milton Friedman and Liberty
BY RO B E RT L . H E T Z E L

L

iberty was a fundamental ethical value for Milton
Friedman, the Nobel Prize-winning economist who
died late last year. Unlike some other classical liberals, however, he did not defend liberty as an absolute right.
Rather, he viewed it as a necessary condition for a peaceful
and prosperous social order. Central to the functioning of
such a society were free markets and limited government.
In 1946, when Friedman began teaching at the University
of Chicago, the prevailing intellectual consensus was strongly
opposed to markets. For Friedman, free markets depended
upon property rights broadly construed: Everyone should
have the ability to bring his physical and human capital into
competition with anyone else. As Friedman explained, markets decentralize the allocation of resources through the
information and incentives provided by the price system. The
self-interest of producers assures that the market provides
the goods that individuals choose to consume and also that
resources are allocated efficiently across competing uses.
Critics of a market-based economy argued that it cannot
create a caring society. Such a society depends upon individual acts of kindness and the caring of voluntarily formed
groups — family, fraternal, and religious organizations. It
would appear logical to add government to this list by placing economic activity under the control of a benevolent
government. Surely, replacing the selfish motives of market
actors with the selfless motives of government employees
would create a more compassionate society.
Friedman followed F.A. Hayek in challenging this logic.
The price system economizes on the information needed by
individual actors to make decisions optimal for the entire
economy. Because the central planner cannot possess all the
knowledge required to make a complex economy function,
only a free-market economy can create wealth. Moreover,
government, by its very nature, is not voluntary; it is
coercive. Invariably, supposedly benevolent, egalitarian
governments institute policies that primarily benefit those
who exercise power, not the masses, as promised. Friedman
compared as “controlled experiments” East Germany with
West Germany and North Korea with South Korea. In
Friedman’s view, government needed to wield some coercive
power to carry out basic tasks such as national defense, but
that power should be held sharply in check.
Free markets were also criticized for not exhibiting the
competition necessary for their survival. A decade of high
unemployment during the Great Depression followed by
high employment during wartime led to the widespread
belief that the price system had failed and that only government could provide a remedy. For the public, free enterprise
crashed when the banks crashed in the Depression.

64

R e g i o n F o c u s • Wi n t e r 2 0 0 7

Friedman challenged this view on two levels. First, he and
Anna Schwartz explained the Great Depression as a failure of
monetary policy, not the market system. Second, Friedman
spent his life illustrating the usefulness of the competitive
market model for understanding economic phenomena —
both in the classroom and through books, magazine columns,
and television appearances aimed at the general public.
Friedman demonstrated that government intervention in
the marketplace frequently produced unintended and counterproductive results. For example, he criticized the wage and
price controls imposed by President Nixon on Aug. 15, 1971,
predicting correctly that they would lead to shortages.
Friedman also relentlessly demonstrated the relationship
between high money growth and inflation, arguing that
“inflation is always and everywhere a monetary phenomenon.”
As a result, when monetary policy became inflationary again
toward the end of the 1970s, the public no longer believed that
private greed created inflation. Fed Chairman Paul Volcker
then had the public and political support necessary to
implement a policy of disinflation. Without Friedman’s
continual advocacy of policies to restrain money growth, the
United States might have continued to suffer from periodic
bouts of inflation and controls that would have destabilized
the economy and eroded limitations on government power.
When I was an undergraduate at the University of
Chicago in 1964, I heard a speech by a famous political
scientist, Hans Morgenthau, who argued that because modern economies are so complicated they require extensive
government planning and control. Many years later,
I recounted this story to Friedman, who laughed and replied
that Morgenthau had accused him of fighting the wars of the
19th century. Friedman willingly accepted the comparison to
the 19th century English economists who had defended free
trade during the Corn Law debates.
Friedman can rightly be compared to the Enlightenment
philosophers of the 18th century, such as Jefferson and
Voltaire, as well. He believed that individuals could identify
common ground and through reasoned discourse come to
agreement — and spent his life engaged in such discussions.
If the 21st century is to be an age of human progress rather
than conflict between people with different religious and
ideological views, it will be because of efforts made by individuals such as Milton Friedman who believed that the
world can be a place of reason and prosperity rather than
RF
conflict and hardship.
Robert L. Hetzel is a senior economist and policy advisor at
the Federal Reserve Bank of Richmond. He was a student of
Milton Friedman’s at the University of Chicago.

Winter 07 Full Coverv7

2/28/07

4:42 PM

Page 3

NEXTISSUE

E 11
R1
R 2007

School Choice

Interview

The theory of school choice says that market competition
aligns the incentives of school administrators with parents. As a
result, schools perform better and kids learn more. But more
than 50 years after Milton Friedman popularized the idea,
only a few cities have turned it into practice. Results from
school-choice programs in Milwaukee, Washington, D.C., and
North Carolina are beginning to move the discussion from the
theoretical to the practical.

We talk with Kip Viscusi of Vanderbilt
University about the economic study of
the law.

Prediction Markets
Markets are good at predictions, usually proving quite accurate
on the outcomes of everything from sporting events to national
elections. That’s in part because markets are excellent collectors of information, especially compared with more centralized
means of gathering intelligence. More and more firms are turning to markets for guidance, and someday even public policy
may be based on market predictions.

Economic History
The Fifth District has a long history of
black-owned financial institutions with a
similar goal — to provide financial services
to people who wouldn’t have access to
them otherwise. But do those institutions
provide the same type of benefits to consumers in today’s more competitive, open
marketplace?

Jargon Alert
Opportunities to buy an asset and then sell
it almost immediately for a higher price —
what economists call “arbitrage” — do exist.
But they disappear quickly.

Jobs Bank
In the 1980s, automakers thought creating a “jobs bank” for
displaced workers would yield benefits for all. Employees
would get to stay on the payroll until they found another job or
retired, and the companies would keep a skilled pool of labor
on call for speedy redeployment. But with more people in the
jobs bank than expected, the program has proved costly to the
Big Three and the effects on workers have been mixed.

Conservation Economics
How do you encourage landowners to keep open space?
Tradable development rights provide incentives to participate
in conservation efforts.

Visit us online:
www.richmondfed.org
• To view each issue’s articles
and web-exclusive content
• To add your name to our
mailing list
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our online issue posting
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weekly update

Winter 07 Full Coverv7

2/28/07

4:42 PM

Page 4

Region Focus 2006
WINTER 2006, VOL. 10, NO. 1

One Family’s Story

Economic History
The Sea Island Hurricane
of 1893

Interview
Tyler Cowen
George Mason University

Cover Story
The Road Ahead
Can Congestion Pricing
Ease Gridlock?

Economic History
Heritage Tourism

Interview
Raymond Sauer
Clemson University

Cover Story

On the Job

Switching Over

The Economics of
Workplace Safety

FALL 2006, VOL. 10, NO. 4

Cover Story

Urban Poverty

SPRING 2006, VOL. 10, NO. 2

Cover Story

SUMMER 2006, VOL. 10, NO. 3

Highlighting Business Ac tivity in the Fifth Distric t

Electricity Moves to
Retail Competition

Economic History
Immigration through the
Port of Baltimore

Interview
Guillermo Calvo
Inter-American
Development Bank
and the University of
Maryland

Economic History
How North Carolina
Became a Banking Giant

Interview
Martin Baily
Institute for International
Economics

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