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Winter 08 Full Cover_F1

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W II N T EE R 220000 8
W N T R
8

THE

PRIVATE
EQUITY
Public Mystery
Public Mystery

• Virtual Economics
• Payroll to Playoffs
• Central Bank Cooperation

FEDERAL

RESERVE

BANK

OF

RICHMOND

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VOLUME 12
NUMBER 1
WINTER 2008

COVER STORY

12

Going Private: Another private equity boom has passed, but
the underlying need for the industry has not
Private equity remains a largely misunderstood industry. Although
some buyouts and firms make splashy headlines, most equity deals are
relatively small but important. Now credit market turmoil is prompting questions about whether this is the end of an era for private equity.

FEATURES
18

Virtual Economics: Economists explore the research value
of virtual worlds
Virtual worlds like Second Life could prove fertile ground for the
study of economic policy, institutions, and crisis management. There
may even be an opportunity to perform “risky” virtual-world experiments that would be unethical and impractical in the real world.

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

John A. Weinberg

23
SENIOR EDITOR

Wanted: Brains to Train: Firms court and school a new breed
of skilled worker
Pipefitting is not a glamorous job, but workers to fill it are in high
demand. The skilled labor shortage has been aggravated as students
have been pushed to earn a bachelor’s degree instead of a technical
one. Companies in South Carolina are finding new ways of coping
with this shortage.
26

Stephen Slivinski
MANAGING EDITOR

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

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

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

From Payroll to Playoffs: Is revenue sharing the best way
to keep major league baseball competitive?

Matthew Martin
Ray Owens

Underlying the perceived inequity in baseball is the fear that higherrevenue teams will continue to monopolize all the talent. Sports
economists see things differently than the head honchos of major
league baseball.

CONTRIBUTORS

28

Building a Better Market: The right financial contracts and
intermediaries can give borrowers and lenders a helping hand
Mechanism design can help design rules of the game that minimize
the costs of limited information, while recognizing that people are
always looking out for their own self-interest.

DEPARTMENTS

1 President’s Message/Of Mortgages and Markets
2 Federal Reserve/Central Bank Cooperation
6 Jargon Alert/Ricardian Equivalence
7 Research Spotlight/Self-Control
8 Policy Update/Term Auction Facility
9 Around the Fed/Urban Flight
10 Short Takes/News from the District
32 Interview/Christopher Ruhm
36 Economic History/Rice to Riches
39 Book Review/Discover Your Inner Economist
40District/State Economic Conditions
48 Opinion/In Defense of Failure

P H O T O :: G E T T Y II M A G E SS
PHOTO GETTY MAGE

Nashat Moin
William Perkins
Ernie Siciliano
DESIGN

Beatley Gravitt Communications
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

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PRESIDENT’SMESSAGE
Of Mortgages and Markets

T

he tumult in the mortgage markets is on the
minds of everyone these
days. It’s certainly on the minds
of all of us here in the Federal
Reserve System.
Responding to the recent
uptick in mortgage foreclosures
and delinquencies is a priority
for all of the Federal Reserve
banks. One way we can do that
is by helping policymakers, journalists, and business leaders
put those trends into perspective.
The truth is that the vast majority of homeowners have
been able to make their monthly home payments on time,
including many that hold what are commonly known as subprime mortgages. Many foreclosures are concentrated in
specific regions, and significant portions of those were the
product of risky investments made for speculative purposes.
It’s also important to recognize that not all foreclosures
can or should be avoided. For a variety of reasons, some individuals end up with homes and mortgages that turn out to
be unsustainably large relative to their current financial
resources and their expected future earnings.
Yet it’s hard to overstate how devastating losing a home
can be to a family that was simply pursuing the dream of
sustainable home ownership. Thus, the Richmond Fed has
teamed up with the other banks of the Federal Reserve
System to embark on the Homeownership and Mortgage
Initiative.
One of our tasks in this Initiative is to lead an outreach
effort that can help prevent unnecessary foreclosures. Our
Community Affairs Office is collaborating with state
finance housing agencies, financial institutions, and
nonprofits to provide foreclosure prevention training
to Fifth District housing counselors. Our outreach efforts
have already contributed to the creation of a foreclosure
prevention task force in South Carolina and a 24-hour counseling hotline for North Carolina residents at risk of losing
their homes.
The widespread attention to home mortgage delinquencies has given rise to a push for new policy responses from
state legislatures and Congress. The risk with such
responses, however, is that the policy outcomes may be too
hasty and based on uninformed perceptions instead of
hard facts.
So, another element of the Richmond Fed’s contribution
to this effort is our research capability. In an effort to provide financial institutions and policymakers the detailed
analysis that can help craft evidence-based policy solutions,

we have taken the lead on coordinating a working group
consisting of some of the System’s top economists and
community development experts. Their task is to prepare
an overview of the current state of knowledge about housing
and mortgage markets. The System will then conduct
further research to fill the analytical gaps and better understand the effects of foreclosures on neighborhoods.
The Richmond Fed is also distributing mortgage data
and providing analysis to help Fifth District communities
identify where foreclosure “hotspots” exist and convening
discussions with policymakers and practitioners to understand the underlying causes of foreclosures. In the first
quarter of 2008, we have made presentations in the District
of Columbia, Virginia, and North Carolina.
We are also taking part in a process that will review and
propose updates to the Truth in Lending Act and related
statutes. Our hope is to restore some of the underwriting
safeguards and disclosure standards that have been eroded
in recent years.
There is no question that the U.S. economy is going
through a period of adjustment which is quite uncomfortable for some. Yet it’s important to remember that a
competitive market economy is, over the long run, better
for everyone. The cover story on private equity funds in this
issue of Region Focus is a good reminder of that. For all the
bad press they’ve received over the past year, private equity
funds serve a very important function: They help make the
allocation of capital in the economy more efficient.
By purchasing companies that are underperforming,
private equity funds are able to enhance a firm’s productivity
through restructuring. And despite the coverage of the
short-term layoffs that often occur after a private equity
takeover, what isn’t often reported is the large number
of new jobs that are eventually created by the newly
efficient firm. In short, private equity helps facilitate the
vibrant competition that is the key to innovation and healthy
economic growth.

JEFFREY M. LACKER
PRESIDENT
FEDERAL RESERVE BANK OF RICHMOND

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FEDERALRESERVE
Central Bank Cooperation
Central banks have
a long history of
working together,
but is there still
scope for future
cooperation?

They speak the same language: Bank
of England Governor Mervyn King,
left, talks with former Federal
Reserve Chairman Alan Greenspan,
center, and European Central Bank
President Jean-Claude Trichet, right,
at a G20 finance ministers and
central bank heads meeting
in November 2004.

2

R e g i o n F o c u s • Wi n t e r 2 0 0 8

n the midst of the credit market
turmoil last year, the world’s
major central banks got together
in a surprise move to help ease the
liquidity squeeze. Central banks were
compelled to act — not alone but in a
coordinated fashion — because of the
international nature of events in
the markets. Although critics of
this synchronized action say that it
does not address the underlying
reason why market participants fret
about lending, their move was considered far less controversial than past
episodes of central bank cooperation.
One well-known controversial
example was when Britain returned
to the gold standard after World
War I. Britain struggled for many
years to keep a
fixed rate of exchange between
gold and sterling.
Part of the problem was how to
address a weak
domestic economy and at the
same time maintain this peg.
If the Bank of
England eased
monetary policy
to shore up economic activity,
then it would
risk gold flowing
out of the country and complicate the task of
defending the peg. Fortunately for
Britain, New York Fed President
Benjamin Strong’s close friendship
with Bank of England Governor
Montagu Norman made Strong sympathetic to Britain’s economic woes.
Strong was instrumental in the
Fed’s decision to reduce interest rates
in the fall of 1927 supposedly to help
Britain. Lower interest rates in the

I

United States allowed Britain to avoid
raising its own interest rate, which
would have been counterproductive
for its slumping economy. At the same
time, the rate cut took some pressure
off of Britain’s gold peg, because a
wider difference between British and
U.S. interest rates encouraged gold
flows to Britain.
But the Fed’s action also meant
that credit conditions would be
looser in the United States. Indeed,
President Herbert Hoover would later
blame Strong and Fed policies at that
time for the stock market boom
and the eventual bust of 1929, and
subsequently the Great Depression.
Whether this instance of one central
bank helping out another actually
led to disastrous results is unclear.
(Others have argued that the
Fed’s decision to expand monetary
policy was taken mainly for domestic
reasons, because of concerns that a
rise in interest rates in Britain would
depress demand for U.S. exports.)
Central banks cooperate to achieve
common goals. This can be accomplished by sharing information,
jointly setting standards, collectively
intervening in a financial crisis, and
coordinating exchange rates and
monetary policy. However, cooperating can be complicated, especially if
central banks engage in a deeper form
of cooperation. For instance, coordinating exchange rates requires
following a policy that may be inconsistent with a country’s domestic
economic conditions. A central bank
will then have to weigh the costs of
giving up its independence and influence over the economy against the
benefits of cooperation.
But aside from this difficulty,
tightly linked capital markets and
favorable changes in the way central
banks conduct monetary policy have
cast some doubt on whether coopera-

PHOTOGRAPHY: AP IMAGES

BY VA N E S S A S U M O

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tion should continue in the future.
“If central banks are focused
on domestic price stability, and if
domestic financial stability is assured
by adequate governance and regulatory standards (albeit likely to be
internationally negotiated), what
further role is there for international
cooperation?” asked William White,
an economist at the Bank for
International Settlements (BIS) at
a 2005 BIS conference on central
bank cooperation. “Globalized”
financial and goods markets might
imply that coordination is not
only beneficial but also necessary
to manage spillovers of a country’s
policies on others. However,
if central banks keep their
domestic affairs in order, then
the rationale for international
cooperation is weaker.

Ways to Work Together
In October 1979, the Federal Reserve
announced an abrupt change in operating procedures to fight rapidly rising
inflation in the United States. Interest
rates shot up and were kept at very
high levels, even if that meant risking a
recession. The Fed’s efforts eventually
tamed inflation, but not without
affecting economies abroad. Latin
American countries, in particular, had
borrowed heavily from international
creditors at floating interest rates. So
when rates in the United States (and
Europe) went up, Latin American
countries struggled to pay their debt.
Moreover, demand for their exports
weakened as the United States and
other countries slipped into a recession, which crippled their ability to
earn much-needed foreign currency.
Latin America’s debt crisis was
worrying because some of the world’s
biggest banks had lent heavily to these
countries and were not sufficiently
capitalized to cover these exposures.
The situation had the potential to
destabilize the world’s financial system. So when the crisis erupted in
Mexico in August 1982, the Federal
Reserve and the Japanese and
European central banks moved swiftly
to offer a “bridge” loan of $1.85 billion

Page 3

to help Mexico until it reached an
agreement with the International
Monetary Fund to sort out its financial
problems. “We didn’t have to spend a
lot of time explaining to each other
the nature of the emergency,” wrote
Paul Volcker, chairman of the Federal
Reserve from 1979 to 1987, in a book
that he co-wrote on international
monetary affairs.

If central banks keep their
domestic affairs in order,
then the rationale
for international
cooperation is weaker.

Central banks have banded together
in similar ways in the past. They cooperated to lend support to Mexico in its
1982 financial crisis. In December
2007, central banks simultaneously
injected liquidity in the banking
system when banks became increasingly cautious in the interbank credit
market. Central banks have also
chosen to collectively intervene in
currency crises, such as the various
efforts to save the gold standard and
the Bretton Woods fixed exchange
rate system.
But cooperation does not always
involve a “rescue.” The experience in
Latin America in the early 1980s, for
instance, highlighted the need to set
capital adequacy standards for banks
worldwide. Banks serve an important
economic role and often take on a high
degree of leverage to carry out that
role. Banks also have privileged access
to central bank funds and their
deposits are federally insured.
Consequently, there is a strong need to
make sure that banks aren’t taking on
too much risk. A global convergence
of such standards is desirable because
the collapse of a number of financial
institutions could affect other intermediaries throughout the world. And
as banks increasingly compete interna-

tionally, it is important that they face
regulatory environments which aren’t
too different.
This common recognition drove
central banks and financial supervisors
of industrialized countries to write and
adopt the 1988 Basel Accord. It sets
forth guidelines to measure the minimum amount of capital that banks
ought to have in relation to the risk
they carry. Despite criticisms and
shortcomings, the Basel Accord is
widely viewed as having achieved
its purpose of promoting more
consistent regulation across countries. The implementation of the
second Basel Accord, which takes
into account the complexity of the
structure and practices of banking
and financial markets today, is now
under way.
But perhaps the easiest form of
cooperation is in sharing information that central bankers can use to
make policy. Indeed, this is what Beth
Simmons of Harvard University called
“shallow cooperation” at the BIS
conference. Its importance, however,
should not be understated. Providing
each other with quality and timely
economic and financial data allows
central bankers to compare, assess,
and discuss how changing conditions
can potentially affect the economy at
home. Simmons says that central
banks can also share information by
“showing one’s hand” — that is, by
communicating policy preferences
and policy choices which may soon be
implemented. And it also helps when
central bankers talk to each other
about their understanding of how the
economic world works, knowing that
without basic agreement, central
banks would be less effective at
improving their joint welfare.

From Shallow to Deep
Exchange rate and monetary policy
coordination is the most ambitious
form of collaboration, because it
imposes constraints on a monetary
authority’s autonomy. That it requires
the highest level of commitment is
probably why it is also most prone
to failure.

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When two countries fix their
exchange rates, central bankers essentially give up their power to guide the
economy using monetary policy. For
instance, if a central bank wished to
expand the money supply in response
to high unemployment, then it would
have to eventually sell foreign reserves
to maintain the exchange rate. But
that would reverse the expansion.
Similarly, if the United States experienced high inflation, then countries
which have a fixed exchange rate with
the dollar would be effectively importing that inflation. Central banks in the
other countries would have to (and in
fact, do) inflate their economies to
keep the exchange rate constant.
The fixed exchange rate regime
under the Bretton Woods agreement
is an example of this type of cooperation. Signed in 1944, the world’s
industrialized countries agreed to fix
their exchange rate to the dollar, while
the United States would peg the dollar
to gold. Fixing exchange rates was
thought to be an effective way of
imposing monetary discipline. No
central bank would be able to pursue
excessive monetary expansion without
breaking the peg. It was also believed
to be beneficial to international trade
as well as to prevent speculators from
destabilizing currencies. However, the
demands of such a regime eventually
put a strain on this cooperation,
particularly in the late 1960s, when
accelerating inflation in the United
States made it difficult for Germany
and other countries to maintain a
fixed exchange rate to the dollar.
The system eventually collapsed in
the early 1970s.
There were also attempts to actively
intervene in the exchange rate market
after the Bretton Woods era. One
rather notorious case involved the
efforts of some central banks to
weaken what was thought to be an
overvalued dollar in the 1980s.
America’s brittle economy and its
large and growing trade deficit was a
concern not only for the United States
but also for its trading partners.
Strong protectionist pressures to
discourage imports were building in

4

R e g i o n F o c u s • Wi n t e r 2 0 0 8

Congress at that time, and many
feared that lawmakers might give in to
such demands. To avoid this
possibility, U.S. Treasury Secretary
James Baker brought together finance
ministers and central bankers of the
group of five industrial countries
(G-5), which included the United
States, West Germany, Japan, France,
and the United Kingdom.
In a secret meeting at New York
City’s Plaza Hotel in September 1985,
the G-5 voiced concerns that the large
external imbalances and the threat of
protectionism “could lead to mutually
destructive retaliation with serious
damage to the world economy.”
They agreed that “exchange rates
should play a role in adjusting external
imbalances” and that they would
“stand ready to cooperate more closely
to encourage this [appreciation of
other currencies against the dollar]
when to do so would be helpful.”
A weaker dollar would improve the
U.S. trade balance and help lift the
economy out of a recession, which
would in turn increase demand in
the long run for other countries’
exports. Moreover, it would head
off the possibility of protectionist
measures that might trigger similar
policy responses from other countries.
A concerted effort followed to sell
dollars in the foreign exchange
market. The dollar fell sharply
throughout 1986.
Following the Plaza Accord,
Volcker was under pressure to lower
interest rates to prop up the domestic
economy. Indeed, the Reagan administration had made known its desire for
lower interest rates. But Volcker
hesitated to move in this direction for
fear of a runaway decline in the value
of the dollar. He finally agreed to
lower interest rates, but only if he
could get the German and Japanese
central banks to likewise lower their
rates, so that the difference between
the domestic and foreign return on
capital, which determines the flow
of funds and therefore the exchange
rate, would remain the same. The
central banks agreed and the coordination was carried out in March and

April of 1986. Such cooperation would
be highly unusual today.
However, the continued fall in the
value of the dollar started to worry
other countries, particularly Japan
with its export-driven economy. In a
meeting at the Louvre in Paris in
February 1987, finance ministers and
central bankers of the Plaza Accord
group (plus Canada) agreed that
“further substantial exchange rate
shifts among their currencies could
damage growth and adjustment
prospects in their countries.” Again,
there was concerted exchange rate
intervention, but this time in the
other direction. Central banks bought
dollars and sold local currency, which
effectively increased the domestic
supply of money. Some analysts say
that Japan’s monetary easing, following these controversial episodes of
cooperation, contributed to the
financial and real estate bubble that
plagued the country in the late 1980s.

Cooperation and Its Discontents
Arguments for coordination are often
made in reference to situations like a
world shock that hit all countries
(an oil price spike, for instance).
A central bank might respond by tightening monetary policy to prevent a
rise in the overall price level. Higher
interest rates would dampen demand
for domestic goods, and bring about
a stronger currency that would make
imports cheaper and keep prices low.
If a neighboring central bank,
however, follows a similar strategy,
then the exchange rate between the
two countries’ currencies will stay
more or less the same. If each of the
central banks responds with even
more tightening to get the desired
exchange rate appreciation, then they
would eventually succeed in bringing
down inflation, but only at a high cost
in terms of output. Had the two
countries coordinated their actions
and agreed not to tighten as much,
then inflation would be stabilized and
the reduction in output and employment would not be as high. Therefore,
countries would be better off if central
banks coordinated monetary policy.

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This argument for cooperation,
though, is incomplete. In a 1985 paper,
Harvard
University
economist
Kenneth Rogoff notes that such
monetary policy cooperation can also
be counterproductive if it exacerbates
the central banks’ credibility problem;
that is, the temptation to inflate the
economy in order to increase employment. When a central bank expands
monetary policy, interest rates fall
and the exchange rate depreciates.
A weaker currency makes imports
more expensive and causes price levels
to go up, which provides an automatic
check on a central bank that is also
concerned about inflation.
But if two countries coordinate
their monetary expansion, then the
exchange rate between their currencies will not change. This increases a
central bank’s incentive to give in
to the temptation of inflating the
economy because of the greater effect
on employment. However, because
workers anticipate this incentive to
inflate, they will demand higher wages.
The result is a higher long-run
inflation rate than if countries acted
unilaterally. Thus, cooperation can
only produce a better outcome if
central banks can credibly suppress
these inflationary impulses.
During the past few decades,
central banks of industrialized
countries have made substantial
progress in mitigating the commitment problem in monetary policy, says
Rogoff. Moreover, goods and financial
markets are now more tightly linked
than ever. Both factors seem to
suggest that countries could benefit
substantially from monetary policy
coordination.
However, Rogoff, in a 2002 paper
with economist Maurice Obstfeld of
the University of California, Berkeley,

Page 5

finds that on the contrary “this lack of
coordination may not always be a
big problem.” The argument for
cooperation in the face of world
shocks actually weakens when the
monetary authority can credibly commit to keeping prices stable, because
they can do so successfully without
imposing a large cost on output and
employment. When that happens,
the benefit of cooperation may be
much smaller.
With respect to country-specific
shocks, or shocks that hit one country
but not another, central bank cooperation may also be unnecessary as capital
markets become more integrated.
Central bankers may not need to be
called upon to sort out shocks of this
nature, since countries can borrow
from each other through financial
markets to smooth consumption when
times are tough. Hence, the case for
monetary policy cooperation may be
much weaker.

The Future of Cooperation
Although central bank cooperation
has gone through many ups and
downs over the last century, the
broader trend that economist Barry
Eichengreen of the University of
California, Berkeley, sees is that
cooperation has grown. Advances in
communication and transportation
technology have reduced the costs of
sharing information, and institutions
like the BIS have provided a venue to
regularly exchange information and
expertise concerning monetary policy.
Perhaps more important, cooperation has grown over time because
monetary policymakers now speak the
same language. “One can make compelling arguments that the rise of a
common monetary policy paradigm —
namely, the belief that independent

central banks should target low and
stable rates of inflation and pursue
other objectives to the extent that
they do not conflict with this core
mandate — is a key explanation for
their ability to cooperate,” said
Eichengreen at the BIS conference.
He cites the experience of monetary
policy coordination among the
European Union group of central
banks — the European System
of Central Banks (ESCB) — which
would have been more difficult had
they not agreed on the primary
objectives of low and stable inflation.
Eichengreen also notes the success
of central banks and regulators in
establishing and adopting capital
adequacy rules for banks, reflecting a
common recognition of a market-led
financial system.
But while central banks that understand each other may have a greater
ability to work together, Rogoff and
Obstfeld’s finding suggests that
countries may be just as well-off
if central banks don’t cooperate, as
long as they follow good policies to
ensure price and financial stability.
This is because in recent decades,
countries can increasingly depend
on their own abilities to fight inflation
without a costly impact on output,
and on internationally integrated
capital markets to insure themselves
against country-specific shocks.
Even so, the ability to follow sound
policies has been helped along by the
exchange of information and views
between central banks, and by harmonized standards — especially with
respect to financial stability — that
these monetary authorities helped to
establish. Thus, the future may be
brighter for these types of cooperation, but less so for exchange rate and
monetary policy coordination.
RF

READINGS
Bank for International Settlements (BIS). Fourth BIS Annual
Conference: Past and Future of Central Bank Cooperation,
June 27-29, 2005.

Rogoff, Kenneth. “Can International Monetary Policy
Cooperation be Counterproductive?” Journal of International
Economics, May 1985, vol. 18, issue 3-4, pp. 199-217.

Obstfeld, Maurice, and Kenneth Rogoff. “Global Implications of
Self-Oriented National Monetary Rules.” The Quarterly Journal of
Economics, May 2002, vol. 117, no. 2, pp. 503-535.

Volcker, Paul A., and Toyoo Gyohten. Changing Fortunes: The World’s
Money and the Threat to American Leadership. New Y
ork: Random
House, Inc., 1992.

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Page 6

JARGONALERT
Ricardian Equivalence

W

hen President Bush signed an “economic
stimulus” package in February 2008, the hope
was that getting hundreds of dollars to every
taxpayer in the form of a rebate could help boost the
economy. But the money to fund this plan has to come from
somewhere. Without reducing government spending, a tax
rebate would mean an increase in the budget deficit.
A government sometimes spends beyond its revenues in
an effort to rouse a slumping economy. Commissioning
roads and bridges, for instance, increases demand for
construction workers, services, and supplies. That translates
into higher incomes and purchases of other
goods and services that, in turn, put more
spending power in other people’s wallets.
The same argument applies to a policy of
cutting taxes or tax rebates. Lower taxes
mean that people can take home a bigger
chunk of their income, which might
encourage them to spend more.
But an alternative view in economics
— Ricardian equivalence — suggests that
such deficit spending is no free lunch.
Named by Robert Barro of Harvard
University (its main proponent) after
19th century economist David Ricardo,
the theory of Ricardian equivalence claims that people will
tend to save rather than consume the extra income arising
from such spending. This is because people understand that
whatever amount a government overspends today has to be
repaid in the future in the form of higher taxes, thus unraveling a government’s efforts to stimulate the economy.
If a tax cut today merely postpones a tax increase until
tomorrow, then there would be little reason for people to
loosen their purse strings now.
To understand this logic, suppose that a government has
a balanced budget and wants to inject billions of dollars
through a tax cut that would give every household $1,000.
If a government’s expenditures are already equal to its
revenues, it must finance this policy by borrowing money
and promising to pay back the principal and interest several
years from now. Recognizing that this will show up as a
future tax liability, forward-looking households will likely
put away the $1,000 in the bank and let it earn interest. The
proceeds of this saving should be just enough to pay for an
anticipated rise in taxes.
For this view to hold, a number of assumptions must be
satisfied. First, most consumers must be of the type to think
far ahead when deciding how much to consume and save, as
well as understand some notion of the implications of

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Ricardian equivalence. Critics say that might be a stretch.
After all, it is quite reasonable to assume that some people
are shortsighted and fail to recognize that taxpayers ultimately pay for a government’s debt.
Moreover, a person can hardly be blamed for not taking
into account a tax liability that may come only decades from
now. For instance, a government can issue a 30-year bond to
finance the deficit spending. Consumers may not care about
what happens that far in the future, especially if the liability
will likely fall on forthcoming generations. But Barro argues
that people leave bequests precisely because they care about
their children’s welfare, and so would not
want to consume more today at their
children’s expense. Thus consumers
think over a much longer, almost indefinite, horizon. If true, the Ricardian view
should hold.
But a borrowing constraint can
weaken Ricardian equivalence. If a person wishes to consume more today
knowing that his future income can pay
for his current purchases, then all he has
to do is borrow money from a bank. As
such, a tax cut would not alter his spending decisions because he can count on
borrowed funds to smoothen his consumption. However, if
for some reason he is unable to find a lender, then his consumption today is limited by the cash he has on hand. In this
case, he may be more inclined to spend the extra cash from
a tax cut.
This could be especially true for poorer people. A study
published in the American Economic Review by David
Johnson, Jonathan Parker, and Nicholas Souleles on the
impact of the 2001 tax rebates on household expenditures
finds that families with low levels of liquid assets and
income spent more of their rebates than the average household. In general, the authors find that a typical household
spent 20 percent to 40 percent of their rebates on nondurable goods during the three-month period they received
their checks. About two-thirds of the rebate was spent
during this period and the next three months. Ricardian
equivalence predicts that rebate spending should have been
close to zero.
However, the overall evidence is inconclusive. Indeed,
economists still call on the theory of Ricardian equivalence
to debate the effectiveness of the 2008 tax rebate. Many
seem to think that it is at least partially true. Government
deficit spending may stimulate the economy, but the impact
would be somewhat subdued in the Ricardian view.
RF

ILLUSTRATION: TIMOTHY COOK

BY VA N E S S A S U M O

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RESEARCHSPOTLIGHT
Self-Control
BY N A S H AT M O I N

very day we’re faced with temptations. Do you reach
A score of zero indicated no self-control problems. Out of
for a second slice of cake or do you refrain? Whether
the 1,520 respondents, two out of every three had no selfyou ultimately succumb to temptation is influenced
control problem according to the measures set forth by the
at least partly by how much self-control you have.
authors of the study.
Economic literature on self-control typically describes the
Y the researchers also found a significant group of
et
situation this way: While there is an ideal action that people
people whose problem was not overconsumption — only
would prefer to take — a decision arrived at after taking into
around 10 percent suffered from that problem. About
full account the long-term consequences of the intended
27 percent of the respondents stated they were likely to
action — there is often something that tempts them to
consume less than their stated ideal amount. The authors
deviate from this ideal. Those with a lack of self-control give
take this to mean “that there is a significant group who
in to the temptation and deviate from their ideal more often,
appear to have problems of underconsumption, at least for
and this can lead to suboptimal
consumption activities that also
economic outcomes.
involve time.”
“Measuring Self-Control.”
In theory, self-control probTo see if this bears itself out in
lems could hinder accumulation of
the actual real-world decisions of
By John Ameriks, Andrew Caplin,
wealth. People who can’t resist the
the participants, the authors comJohn Leahy, and Tom Tyler.
urge to consume will not put aside
pared the results of the survey to
money in savings. But there is
American Economic Review, June 2007,
each participant’s wealth profile.
limited empirical support for this
(The sample of survey particivol. 97, no. 3, pp. 966-972.
seemingly intuitive notion.
pants was far from representative.
In a recent paper, economists
A third of the participants had
John Ameriks, Andrew Caplin, and John Leahy team with
Ph.D. degrees. The median level of personal debt was zero
psychologist Tom Tyler to measure the effects of self-control
and net worth was $500,000.) What they found was a staproblems. They assume that people are fully aware of their
tistically significant and strong relationship between the
level of self-control and how it affects their decisions.
self-assessed measure of self-control and wealth. Those who
In their experiment, they offered 10 restaurant gift cerexpected to overconsume in the survey had accumulated on
tificates with an unlimited budget, each of which could be
average 20 percent less wealth in the real world than those
used once, over the course of two years. Then they asked the
with no self-control problems. Those who expected to
participants the following questions:
underconsume accumulated 25 percent more.
a) From your current perspective, how many of the 10
Among the more striking findings was that older responcertificates would you ideally like to use in year 1 as
dents tended to have more self-control. “This finding is
opposed to year 2?
certainly consistent with the common view that temptation
b) Some people might be tempted to depart from their
falls with age, and has important connections with actual
ideal. Which of the following best describes you:
consumption behavior over the life cycle.”
strongly/somewhat tempted to use more in year 1 as
Critics of the study might suggest that the best test of the
opposed to year 2, or not tempted at all?
authors’ theory is how the recipients of the gift certificates
c) If you were to give in to your temptation, how many
actually use them, not whether they say they are likely to use
certificates do you think you would use in year 1
them. Or they might question whether people are able to
as opposed to year 2?
accurately gauge how much self-control they really have.
d) Based on your most accurate forecast of how you
There’s also the possibility that people respond to different
think you would actually behave, how many of the
incentives when they are presented with an unearned gift
nights would you end up using in year 1 as
versus when they earn a paycheck. Yet, based on this study
opposed to year 2?
at least, there is some interesting evidence that whether
The measure of self-control used in the study represents
someone expects they’ll reach for that proverbial second
the difference between each participant’s stated ideal and
slice of chocolate cake could have some real implications in
their expected consumption levels, i.e., their response to (d)
their economic decisions.
RF
minus their response to (a). So, for instance, a positive
Nashat Moin is an assistant economist at the Federal
number indicates that the respondent will tend to consume
Reserve Bank of Richmond.
more (“overconsume”) than their stated ideal preference.

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POLICYUPDATE
A New Addition to the Fed’s Toolkit
BY D O U G C A M P B E L L

O

n Dec. 12, 2007, the Federal Reserve announced a
new tool in the ongoing effort to address financial
market disruptions. Under the Term Auction Facility program, the Fed provides credit directly to banks —
where the demand for liquidity has been highest.
The announcement was made jointly with four other
central banks. The Bank of Canada, the Bank of England,
the European Central Bank, and the Swiss National Bank
said they would also, in slightly different formats, pump
funds into their financial systems backed by a wide set of
collateral.
The introduction of the auction program came amid
serious strains in the financial markets. In announcing the
program, the Fed said it was “designed to address elevated
pressures in short-term funding markets.” Those pressures
were evident in the widened spread between two closely
watched rates — the one-month London Interbank Offered
Rate, or LIBOR, which is the rate at which major banks in
London are willing to lend Eurodollars to each other; and
the overnight indexed swap rate, or OIS, which can be interpreted as the average expected overnight rate over the
course of the next month. Because the OIS rate does not
tend to reflect credit and liquidity risk pressure as much as
LIBOR, the difference between the rates is useful in
showing how much such risks are bothering markets. At its
heart, the Term Auction Facility program is about getting
funds to banks in a time when credit is tight.
Open market operations are the main tool the Fed uses
to inject funds into financial markets. Each weekday morning, the trading desk at the New York Fed sends out an
electronic message inviting primary dealers — investment
banks that regularly trade government securities — to bid on
funds. Typically, the Fed buys securities under one-day or
two-week repurchase agreements. The awarded funds make
their way into the banking system via dealer accounts
at clearing banks. In this fashion, the Fed raises or lowers
reserve levels at banks. If it wants to lower the target federal
funds rate, the Fed auctions more funds, adding to reserves.
When there are more reserves, there are more funds for
banks to lend out, and so interest rates, specifically, the rates
on interbank short-term loans, should go down.
The Fed also supplies liquidity through the so-called
discount window. Banks can go to the discount window
at their regional Reserve Bank for short-term loans.
Historically, the discount rate is set at 1 percentage point
more than the target federal funds rate. But in August 2007,
as financial market turbulence picked up, the Federal
Reserve Board reduced the spread to half a percentage point
and in March lowered it further to a quarter point.

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The two things that make the Term Auction Facility
program different from the discount window are:
• Its anonymity, allowing banks to borrow directly from
the Fed without the perceived stigma associated with the
primary credit. Though discount window borrowings are
also anonymous, bank counterparties and other market
participants might be able to discern that a bank has come
to the window. Identifying borrowers is much more difficult
with the Term Auction Facility program.
• The control that the trading desk wields over the size of
the auction, meaning that there is little uncertainty about
the effects on bank reserve levels. By contrast, the potential
for large, unanticipated discount window borrowings is
something that could greatly complicate the New York Fed
trading desk’s task of offsetting any significant borrowings
in open market operations.
(The Term Auction Facility program is separate from
several other major credit and auction programs introduced
so far this year. The new Primary Dealer Credit Facility, for
example, is an overnight loan program in which borrowers
can put up a wider set of collateral than in traditional
repurchase agreements. Acceptable collateral for the dealer
program includes investment-grade corporate securities,
municipal securities, and mortgage-backed securities.)
Strictly speaking, the Term Auction Facility program is
not a tool to conduct monetary policy. No money is added or
withdrawn from circulation, and the Fed’s balance sheet
remains the same because it liquidates holdings in proportion to dollars lent through the auction. It’s much closer in
practice to discount window lending. In exchange for the
loaned funds, the Fed holds collateral from the banks. The
collateral is the same as “the wide variety of collateral that
can be used to secure loans at the discount window,” and
goes beyond the Treasury and government agency securities
required in open market operations.
The first auction was held on Dec. 17. Banks from every
Federal Reserve district submitted propositions. A total of
93 depository institutions bid about $60 billion, out of
which an aggregate $20 billion was awarded in 28-day loans.
The “stop-out” rate — the lowest accepted rate — was 4.65
percent, compared with the 4.25 percent target federal funds
rate at the time (and the 4.75 primary credit rate).
Though the lending rate is set by the market, the Fed sets
a floor. For the Dec. 17 auction, the minimum rate was 4.17.
On Feb. 25, when the target federal funds rate was 3 percent,
the minimum auction bid rate was 2.81. No maximum rate is
necessary — the final auction rate would not likely go much
above the discount window rate, since banks could go there
continued on page 38

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AROUNDTHEFED
Urban Flight
BY D O U G C A M P B E L L

“The Evolution of City Population Density in the United
States.” Kevin A. Bryan, Brian D. Minton, and Pierre-Daniel
G. Sarte. Federal Reserve Bank of Richmond Economic
Quarterly, Fall 2007, vol. 93, no. 4, pp. 341-360.

eople live in cities for many reasons — to be close to
their jobs, to culture, and to neighbors, among other
motivations. Economists tend to think of these reasons as
the positive externalities — or byproducts — of population
density. In theory, living close together helps people work
together. This in turn improves the productivity of their
endeavors. Dense cities have been termed the economic
“nucleus of an atom” because of their role in sparking
transfers of human capital. One study found that patents per
capita rise 20 percent as the employment density of a city
doubles. Of course, density also brings negative externalities, such as congestion and higher land prices.
In a new paper, economists with the Richmond Fed
lay some groundwork for studying the implications of population density in the early 21st century. With speedy
transportation options and hi-tech communication devices,
how important is population density to a city’s economic
growth? The authors build an electronic database containing
land area, population, and urban density for every U.S. city
with a population greater than 25,000. Such data has been
available in the past, but most of it was not in electronic
form. Then the authors use the data to estimate the distribution of city densities since 1940.
The results are clear and robust: “There has been a stark
decrease in density during the period studied. This deconcentration has been occurring continuously since at least
1940, in every area of the United States, and among both
new and old cities.” Since 1940, density in legal cities with
populations over 25,000 has fallen from 6,742 people per
square mile to 3,802, in large part because of increases in
city size (mostly through annexation). The leading theories
for why people live farther apart include decreased transportation costs, thanks to the automobile, and a desire
among some people to live in more homogenized environments, with lower tax rates and better schools.
The authors also believe that improved communication
technologies allow people to live farther apart without
giving up the positive externalities normally gained through
population density. “Falling urban densities suggest that,
over the past seven decades, the productivity benefits of
dense cities have been weakening,” they conclude.
The authors have made their data and replication
files available to the public at http://www.richmondfed.
org/research/research_economists/pierre-daniel_sarte.cfm.

P

“The Reaction of Consumer Spending and Debt to Tax
Rebates: Evidence from Consumer Credit Data.” Sumit
Agarwal, Chunlin Liu, and Nicholas S. Souleles. Federal
Reserve Bank of Philadelphia Working Paper 07-34,
November 2007.

etween July and September 2001, the U.S. government
disbursed $38 billion in tax rebates to working
Americans. The average amount was $500 per household.
Using a new panel dataset of credit card accounts, the
authors examine how consumers respond to what they term
“lumpy” boosts to their income.
The records indicate that consumers used their rebates
to pay down credit card balances, but then quickly ratcheted
up their spending. This runs counter to basic economic
intuition; if the rebates were anticipated, consumers should
not have significantly changed their spending habits at the
time they collected their checks. On the other hand, the evidence suggests that the rebates had precisely the effect on
consumption that politicians hoped for.
The authors conclude: “Because these results relied
exclusively on exogenous, randomized variation, they represent compelling evidence of a causal link from the rebate to
spending.”

B

“Hedge Funds, Financial Intermediation, and Systemic
Risk.” John Kambhu, Til Schuermann, and Kevin J. Stiroh.
Federal Reserve Bank of New York Economic Policy Review,
December 2007, vol. 13, no. 3, pp. 1-18.

s they’ve grown larger, hedge funds have come under
scrutiny for their potential to disrupt the economy.
Economists with the New York Fed explain why hedge funds
exacerbate market failures that make traditional methods to
reduce credit exposures less effective.
They begin with a concise definition for hedge funds as
“largely unregulated, private pools of capital.” Because they
are open only to accredited investors and large institutions,
they aren’t subject to much regulation and hedge fund
managers enjoy great latitude in their choice of investment
strategies.
Recent improvements in counterparty credit risk
management — specifically, the use of collateral to provide
a buffer against increased exposure — as well as the everpresent force of market discipline remain the most
appropriate checks on hedge funds, the authors conclude.
“While various market failures may make [counterparty
credit risk management] imperfect, it remains the best line
of defense against systemic risk,” they write.
RF

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SHORTTAKES
BASE BENEFICIARIES

New Soldiers to the Fayetteville Area
Offer an Economic Opportunity
hrough 2013, the region around Fayetteville, N.C.,
is expected to gain an extra 25,600 people beyond
previous forecasts. The growth spurt is attributable to a
confluence of three U.S. Department of Defense initiatives,
all targeted at Fort Bragg.
Fort Bragg is already the nation’s largest army base with
about 55,000 employees, but it will add 4,647 active-duty
military personnel, 1,893 military civilians, and 616 contractors. Another sort of army — thousands of construction
workers, retailers, health care professionals, additional contractors — will follow to support the increased population.
In all, it adds up to 25,600 new residents in the 11-county area
surrounding Fort Bragg, according to a preliminary study.
Fort Bragg’s biggest influx of people comes courtesy of
the Base Realignment and Closure Commission (BRAC)
process, which wrapped up in 2005. (Also boosting the
number of soldiers at Fort Bragg, though to a lesser degree,
are two other Army initiatives — the Army to Modular
Forces and the Grow the Army programs.) While many communities are adjusting to smaller or shuttered military bases,
the Fayetteville area is one of the beneficiaries of BRAC.
In fact, the adjacent Pope Air Force Base was slated to lose
about 4,000 jobs; even so, the region overall is gaining.
The size of the incoming population will require expansions of infrastructure and many public services, including
those to schools and health care facilities. An extra 4,145
children of soldiers are moving in, for example, forcing
communities to find or build classroom space.
But aside from the usual headaches associated with
“growth management,” the population shift to the
Fayetteville area has some obvious upsides. “We view it as a
major opportunity for economic transformation,” says
Wayne Freeman, president of Training & Development
Associates, the local firm that was tapped to conduct the
economic impact study.
Part of Freeman’s optimism stems from the caliber of jobs
moving to Fayetteville. Ten of the incoming soldiers are
generals. (When they arrive, Fort Bragg will have about 45
generals, more than anywhere in the country but the
Pentagon.) An expected 779 are field grade officers who
make between $102,000 and $142,000 a year (including
housing and food allowances). In addition, contractors
formerly located in the Atlanta area near Fort McPherson are
expected to relocate to Fayetteville to serve Army commands
now moving to Fort Bragg.
“We see a transformation of the economy and the work
force to meet the needs of the emerging industries associated
with defense, and less of a reliance on the declining indus-

T

10

R e g i o n F o c u s • Wi n t e r 2 0 0 8

In September 2007, the 82nd Combat Aviation Brigade ran
four miles to commemorate the 9/11 tragedy.

tries in the areas of textile, tobacco, and agriculture,” says
Paul Dordal, a retired Air Force general now serving as
executive director of the BRAC Regional Task Force at
Fort Bragg.
It’s an exaggeration to say that Fayetteville and its
surroundings constitute a boom town. The metro area
around Fayetteville comprises some 1 million people, so
adding another 25,000 won’t be so much a revolution as a
mini-makeover.
The Fayetteville housing market is a good example of how
the opportunities for new business may be limited.
Freeman’s study concludes that existing housing — including
several developments that recently broke ground in anticipation of the Fort Bragg influx — may be adequate to
accommodate the inbound residents. “We think housing is
going to be one of those instances where the market is prepared,” Freeman says. This expansion at Fort Bragg will
eliminate much of the slack in the market right now.”
— DOUG CAMPBELL

WELFARE MAKEOVER

verweight, depressed, and can’t find a job? Wake
County, N.C., is launching a pilot program in April that
aims to remove these and other obstacles to deliver poor but
motivated individuals and families to the middle-class ranks
within five years.
The program, called Middle Class Express, aims for a
holistic approach, says the county’s human services director
Ramon Rojano. Not only will this initiative provide job assistance, but also advice on how to save money, buy a home, and
plan a healthy lifestyle — the characteristics that typically
define the middle class. A personal coach will help partici-

O

PHOTOGRAPHY: COURTESY OF THE “PARAGLIDE,” FORT BRAGG’S NEWSPAPER

Riding the Express to the Middle Class

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pants develop a life plan as well as guide their progress over
five years.
While there’s no conclusive evidence that this comprehensive middle-class coaching will work, results from other
programs suggest that it should help, says Margery Turner,
the director of the Metropolitan Housing and Communities
Policy Center at the Urban Institute, a think tank based in
Washington, D.C. “It reflects our best understanding now of
the challenges that families face,” Turner says.
For instance, families may work hard to earn a living but
still pay bills late and lack decent health care. Families also
may be forced to move frequently, and so housing assistance
is a crucial component of success. Finding an affordable
home in a safe neighborhood allows a household to balance
its budget every month and stabilize family life.
Families can face big hurdles. “For folks with lower skills,
it’s not an easy path to the middle class,” says Susan Gewirtz,
program manager for the Center for Working Families at the
Baltimore, Md.-based Annie E. Casey Foundation. They
may need help finding and accessing public benefits like the
Earned Income Tax Credit. Or they may not know how to
save money, and so are vulnerable to expensive financial
services such as high-cost loans.
But Turner worries that middle-class status may not be
easy to reach within five years. Although families can
achieve much in that time, it’s a big step from a low-skilled
job to a higher-paying job that can propel families to the
middle class. “The gap in skills and experience is big,”
Turner says.
Obstacles like drug or alcohol addiction can block these
families, too, says Douglas Besharov, a scholar on social
welfare studies at the American Enterprise Institute.
“A program that’s trying to undo these behavioral problems
has a much bigger challenge than just trying to get people a
job or a little more job training,” he says. He thinks that the
success of such a program depends on the quality of the
people and resources invested.
One advantage for Wake County is that its human
services department handles not only social services but also
physical and mental health, job training, child support,
housing, and transportation services. Rojano says they are
the only county in North Carolina with this approach to
integrated human services. The program will use this structure to transform itself into a true one-stop guidance center.
After all, every family is unique. And that’s what makes
this comprehensive approach so attractive.
— VANESSA SUMO

BANDWIDTH BONANZA

Spectrum Auction Uses
Experimental Design
hen television broadcasters dump analog signals in
2009 to bring shows like “American Idol” to viewers
in high resolution, a precious portion of the airwaves will

W

be vacated. So what’s the best way to distribute this
reclaimed space? Auctions have long been the Federal
Communications Commission’s solution, but a University of
Virginia economist recently contributed research that
makes spectrum auctions even more efficient.
Wireless firms ponied up more than $19 billion in March
for licenses to use these frequencies, with AT&T and Verizon
coming out on top. The industry wants the licenses because
signals in this piece of the electromagnetic spectrum have a
valuable characteristic: They travel farther, faster, and
penetrate buildings more easily than those in the higherfrequency band currently used for mobile phones.
Spectrum is sold by band (frequency range) and geographic area. Since the airwaves belong to the public, it’s
important to distribute them as efficiently as possible
if they’re used by private firms. Auctions reveal spectrum
value. The widest portion, the “C” block, was auctioned in a
way that allowed participants to bid on a package rather
than on many individual licenses. The format was designed
by University of Virginia economist Charles Holt and a
colleague, Jacob Goeree of the California Institute of
Technology. The design was tested by university students in
an economics lab.
Although auctions can allocate spectrum effectively, it’s
hard for a firm to buy the mix of local licenses that would
establish or complete a national or regional footprint.
Customers like getting coverage over a wide area, and firms
like it, too, because they can operate efficiently and make
more money. If firms don’t win key parts of an area in the
auction, the licenses end up being worth less than they
otherwise would be.
“This is known as the ‘exposure problem,’ which, if
anticipated, can result in lower bids and inefficient allocations,” according to Holt.
This “package bid” design lets firms bid on license combinations. It also solves a “free riding” problem for
participating small, regional providers. Those firms might
wait for others (or free ride) to outbid a national company
on multiple licenses in a given area. But they might
lose out if they wait. Also, this new auction design provides
base prices for each license, according to the prior
round’s bids.
“Prices tell bidders how high they need to go to get into
the action and win a particular license,” according to Holt.
Careful auction design can also make a difference
because auctions raise money for the public. The auction’s
proceeds will be handed over to the U.S. Treasury by June 30,
and spent on public safety and digital television transition
efforts, according to the FCC.
This particular set of airwaves attracted more than
200 participants, including all the major players in communications. Google did not post a winning bid, but they still
provided a valuable contribution. They successfully pressed
the FCC for rules to force the industry to open
wireless networks to a wide variety of phone equipment and
Internet applications.
— BETTY JOYCE NASH

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Going Private
Another private equity boom has passed,
but the underlying need for the industry has not
BY VA N E S S A S U M O

I

n the mid-1980s, Meineke Discount Muffler had a problem. Automakers began
fitting their cars with stainless-steel mufflers with life spans of 12 years. Until

then, cars had been fitted with cold-rolled steel mufflers, which rusted after three
years. This innovation was worrying for the Charlotte, N.C.-based company
because a huge chunk of its business, about 65 percent in 1995, depended on

Meineke managers were determined to find new ways to
grow, but its parent company, an Australian multinational,
wasn’t too interested in investing in new plans. “They were
very forthright about it,” says Kenneth Walker, Meineke’s
president and chief executive. Meineke’s role in the parent
company’s portfolio was mainly to generate cash, which the
parent wanted to spend in other ways.
Meineke executives longed to be independent, a wish
that was fulfilled in August 2003 when two private equity
firms, Carousel Capital, located just down the street from
the Meineke headquarters, and The Halifax Group,
which has offices in Washington, D.C.; Dallas, Texas; and
Raleigh, N.C., helped management buy Meineke from its
parent company for $68.5 million. Meineke changed its
name to Meineke Car Care Center and was transformed into
an independent company with a more diverse service
offering, significantly improved marketing, and increased
sales and profits. Carousel and Halifax assisted Meineke to
get to that point in more ways than just injecting capital.
Less than two years after buying Meineke, Carousel and
Halifax sold their investment and another private equity
firm stepped in.

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Hundreds of deals involving private equity firms take
place in the country every year. For more than 25 years, the
private equity industry has been an important source of
funds for a number of groups: entrepreneurs starting a
business; families wishing to sell the business after the death
or retirement of a founder; firms with strong growth
prospects but in need of capital; companies in financial
distress; and publicly listed companies seeking to go private.
Private equity managers typically restructure the companies
they buy and sell them later, keeping a part of the profits and
giving the rest to investors.
Often, the deals take place with little publicity. Others
are more high-profile, like the infamous takeover of RJR
Nabisco in 1988 by Kohlberg Kravis Roberts & Co., one of
the world’s largest private equity firms. That deal inspired a
book and a movie, Barbarians at the Gate: The Fall of RJR
Nabisco, a title that suggests the kind of reputation which
private equity firms had then and have even today.
Private equity has burst into the limelight again in recent
years, primarily because of the large amounts of capital that
some groups have been able to raise, as well as the size of the
deals that have been made. In the 1980s, a $200 million to

PHOTOGRAPHY: GETTY IMAGES

short-lived mufflers.

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$300 million fund would have been
considered large. But today, that’s just
a fraction of the $21.7 billion fund
that Blackstone, another large private
equity firm, raised in 2007.
The large influx of money from
various investors, favorable credit
conditions, and the willingness to
form “club deals” allowed private
equity firms to splurge on buyouts of
some big-name companies. Chrysler,
Hilton Hotels, and Hertz are just a few
names. In the United States, the number of private equity-backed mergers
and acquisitions (M&As) with values
topping $1 billion jumped from eight
in 2002 to 102 in 2007, according to
Thomson Financial.
But private equity is not just about
the deals and the firms that make the
splashy headlines. About nine out of
10 private equity-backed M&A deals
worldwide were less than $1 billion in
the last three years, and seven out of
10 were under $250 million.
Critics are skeptical whether
private equity firms leave companies
better off in the long run. They cite
the quick flips, the sometimes ruthless, cost-cutting way private equity
firms go about getting results, and the
seemingly nonchalant way they spend
money. The current turmoil in the
credit markets, which will likely be

Page 13

painful for private equity firms in
terms of their ability to finance deals
and the returns that they can expect,
has prompted questions on whether
this is the end of private equity.
That seems doubtful as past waves
have shown. The private equity market
tends to be cyclical. Moreover, most
academic studies suggest that private
equity firms do enhance the performance of the companies they purchase.
The new owners, refining techniques
developed over many deals, introduce
strategies to make their companies
more efficient. If so, then why is this
industry so controversial? Part of the
problem is the veil of secrecy that surrounds it. “This is still in many
respect[s] a very mysterious business,”
said Harvard Business School’s Josh
Lerner at a private equity conference
organized last fall by the think tank
American Enterprise Institute (AEI).
“There is a lot which is not really
understood about it, and a lot of
what seems to be understood is
absolutely wrong.”

What is Private Equity?
The private equity market is one
way through which companies can
obtain funds. Investors provide capital
in exchange for ownership shares
in companies that are not traded in

public markets, hence the name
“private equity.” But instead of investing directly in private companies,
investors or the “limited partners” —
typically big groups like public and
corporate pension funds, financial
institutions, college endowments, and
sovereign wealth funds or very wealthy
individuals — place their money in the
hands of a team of professionals,
or the “general partners.” The general
partners then select and manage a
portfolio of companies on their behalf.
Private equity investing took off in
the early 1980s thanks in part to the
widespread adoption of this limited
partnership arrangement. The other
big boost came in 1978 from a ruling
that putting money in seemingly risky
private equity funds did not violate
the Employee Retirement Income
Security Act’s (ERISA) “prudent man”
requirement for investing private
pension funds, as long as these investments were part of a larger pool. As a
result, venture capital partnerships —
the predominant private equity
activity at that time — raised $50
million in the first six months of 1979
from pension plans governed by
ERISA, up from less than $5 million a
year between 1976 and 1978.
During the life of the partnership,
usually about 10 to 12 years, the
investors’ money is tied up and they
have little control over how it is
managed. It might seem that investors
would be better off without an intermediary. However, this would involve
identifying and monitoring each of
their investments. Effective private
equity investing requires considerable
skill in choosing and structuring
investments as well as in providing
business advice to acquired companies, expertise that firms presumably
have gained through participating in a
large number of deals. Thus, working
through a private equity firm can be
better than investing directly provided
the limited and general partners’ interests and incentives are well-aligned.
The compensation structure
provides this control — as well as a
lucrative way to reward general
partners for good performance. When

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Page 14

Heady Growth

14

R e g i o n F o c u s • Wi n t e r 2 0 0 8

2007

2005

2003

2001

1997

1999

1995

1993

1989

1991

1987

1985

1983

1981

PERCENT

sell later at a higher price.
a private equity firm sells a
The value of private equity deals surged to about a third
Companies typically go
portfolio company, the firm
of all merger and acquisition deals in 2007. However,
analysts say that private equity activity slowed in the last
through a process of what
returns the investors’ capital
few months of that year.
Harvard’s Lerner calls “intenand whatever remains is split
35
sive therapy.” This process can
between the general and limitbe painful as private equity
ed partners. Investors typically
30
firms work to weed out ineffitake 80 percent of the profit,
25
ciencies. But the hope is that
and the private equity firm gets
20
companies will emerge health20 percent or what the industry
15
ier, more profitable, and more
calls the firm’s “carried inter10
valuable. How do they do this?
est.” The bigger the profit, the
5
A report by consulting firm
larger the firm’s share of the
0
McKinsey & Company finds
pie, which is a powerful incenthat in the best-performing
tive to invest well. Limited
SOURCE: Thomson Financial
World
United States
deals, partners devoted more
partners also pay management
than half their time to a portfees equal to about 2 percent of
The issue of succession applies to
folio company during the first 100
the amount of capital they commit to
middle-market family firms and
days and met with top executives
a fund. But these fees are not based on
closely held private companies as well,
almost every day. Carousel Capital
performance and are intended to cover
which are typically bigger, welllikewise thinks this is a key factor in
basic expenses.
established companies with stable
determining the success of an investReputation is also a valuable incencash flows. The company may be sold
ment. “We’re a big believer that
tive. Private equity managers are eager
to the heirs of the founding family or a
investing relatively close to home is a
to establish a good record because that
new management team in partnership
good practice, because it promotes so
determines their ability to raise more
with a private equity firm that
much interaction between the
funds from investors and lenders in
organizes the funds for the sale.
investors and the management team,”
the future. Partnerships have a finite
Middle-market firms may also be
says Brian Bailey, one of Carousel’s
lifetime, and if a private equity firm
looking for capital to finance an
managing partners.
earned a low return on its last fund,
expansion or acquisition. Depending
Carousel prefers to invest in the
investors would seek other places to
on their size, these firms do have
Southeast so that the partners can
put their money.
access to debt markets, but that may
easily get to their companies and
From the portfolio companies’
not be sufficient to meet their financspend more time with management
perspective, private equity can be a
ing needs. And because they may have
when needed. Meineke’s Walker
good alternative, especially if they are
no desire to go public, private equity
talked with his primary contacts at
unable to raise capital from other
can be a good option.
both firms about once a month, if not
sources such as banks or the public
But perhaps the most familiar
once a week. Although few private
market. For instance, firms with highprivate equity transactions today are
equity firms are located just a few
growth prospects that are young
buyouts of public companies. Many
blocks from one of their portfolio
and untested might benefit from
people have probably heard of a levercompanies, he could sometimes meet
venture capital, which is a type of
aged buyout, which is a common way
up with a Carousel partner for lunch
private equity investment. America’s
of taking over a big public company
and talk business. “It was an informal
venture capitalists have financed wellusing a substantial amount of debt.
way to stay connected with one of the
known companies like Google, Apple
Public companies go private so they
partners,” says Walker.
Computer, and Intel.
can have a freer hand in making adjustPrivate equity firms are demanding
Smaller family firms may have
ments that will benefit the company,
bosses. “If you talk to managers who
opportunities to grow but are
without having to constantly worry
work with private equity partners on
resource-constrained. The founder
about short-run fluctuations in their
their board … ‘anxious vigilance’ can
may have to put in more of his own
stock prices, the costs of compliance
sometimes describe their world,” said
money, but he can only do that
imposed on public companies by the
economist Karen Wruck of Ohio State
for so long. “Their family and friends
Sarbanes-Oxley Act, and various presUniversity at the AEI conference.
network is only so big and so they need
sure groups. Of course, CEOs will still
General partners “vigorously exercise
to go to an outsider,” says Fred Russell,
have a boss: the private equity firm.
their governance rights,” said Wruck.
managing director and CEO of
Running the business becomes a much
Virginia Capital Partners, a small
more intense process, where private
private equity firm in Richmond. Also,
Inside a Deal
equity partners ask tough questions
as the founder of the firm ages, he may
Private equity firms buy shares in
and make managers understand how
want to retire and sell the business.
private companies that they hope to

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their decisions affect the value of the
company. It’s not so much that private
equity firms always know how to
run a specific business. Their knack is
in finding the right people and
organizing the company in such a way
that they let managers use their
expertise but hold them closely
accountable for the results. Private
equity firms can get very good at
employing the same principles over
and over again — applied many times
to different deals and companies.
Changing the capital structure of a
company through a leveraged buyout
is another way to align the incentives
of management and shareholders, but
private equity firms often get much
flak for using a lot of leverage.
Borrowing to finance a buyout allows
private equity firms to purchase companies with only a small amount of
equity capital, and shareholders to
receive very high returns. Say, for
example, a private equity firm buys
a company for $100 million, using
$30 million of its own equity capital
and $70 million in borrowed funds.
If the private equity firm later sells
it for $130 million, then, after repaying
the debt, the investors actually
double their money even though the
company’s value rose by only 30
percent. The gains flow mostly to
equity holders because debt holders
receive only a fixed rate of return.
Critics say, however, that piling on
debt makes a company more vulnerable to going bust and therefore poses a
risk to the economy.
But leveraging can be a powerful
tool in changing the way managers
behave. Economist Michael Jensen
of the Harvard Business School noted
almost two decades ago that a central
weakness of a public company is the
inherent conflict between owners and
managers of a firm over the control
and use of corporate resources.
In particular, managers of public
companies may be hesitant to
distribute the extra cash that is left
over (after all profitable investments
have been funded) to shareholders
in the form of dividends. Managers
want to hold on to this extra cash

Page 15

because it makes them less dependent
on the capital markets.
This may, however, lead to a
temptation to invest in wasteful
projects if they no longer need to
convince providers of capital each
time of the soundness of their investment plans. Borrowing, therefore,
can impose discipline on company
managers. Since interest is paid out
of a company’s cash flows, paying
off debt is in effect a substitute for
paying dividends. Debt can improve
the company’s performance because
managers must make sure that there
is enough cash to meet interest payments and because they are dissuaded
from squandering company funds.
A leveraged buyout also puts equity
in the hands of a smaller group
of investors, which mitigates the
problem of monitoring managers
when there are many dispersed shareholders. Moreover, buyouts usually
dictate that managers invest their own
money in a substantial stake in the
company, so they’re given a bigger
chance to participate in the success (or
the failure) of the company. CEOs of
portfolio companies tend to own a
larger share of the company than their
counterparts at public corporations,
and this can be a powerful incentive.
Leveraging is an important part of
the private equity firms’ tool box, but
it is no longer a strategy that is only
available to private equity firms. So,
even as firms apply financial and
governance techniques, they also focus
specifically on improving their portfolio companies’ operations, by building
industry expertise and bringing in
operations specialists and consulting
groups to help them identify points for
improvement. Some of these measures
include reducing costs, for which
private equity firms are sometimes
heavily criticized. But even as they cut
and tighten, buyout shops today also
look for opportunities to expand the
reach of their companies’ products in
this country or abroad.
While it is possible for public
companies to employ these same
techniques without having to go
private, it may be difficult to do in

Private Equity’s Impact on Jobs
There are other ways to measure the private
equity industry’s contributions apart from
financial returns. A 2007 Journal of Corporate
Finance paper surveys U.S., U.K., and other
country studies on the real effects of buyouts.
The summary finding is that buyouts
“enhance performance and have a salient
effect on work practices” of their portfolio
companies. For instance, plant productivity
increased substantially after a buyout.
However, much media attention has focused
on employment numbers. Critics, in particular, have often accused private equity firms of
enriching themselves while slashing jobs in
the process.
That private equity destroys jobs is not
completely untrue. “It’s not that it’s an inaccurate claim, but when you fill out the whole
picture, the story is much more mixed,” says
University of Chicago Graduate School of
Business economist Steven Davis, who
co-authored a large-scale study of the
employment impact of buyouts on U.S. establishments. “I don’t think the story fits with
the narrative that the critics have put forth,
nor does it really fit the sometimes glowing
testimonials from the private equity community itself,” says Davis in an interview.
The study, published in the January 2008
World Economic Forum report, follows target
businesses before and after the buyout transaction, and then compares them with other
establishments with no ties to private equity.
When broken down in terms of job creation
and destruction, target establishments are
cutting jobs at a faster rate than comparable
businesses, but target businesses create
jobs at a similar pace. This suggests that
private equity firms start out with some
“housecleaning” of businesses which seem to
be already in distress even before the buyout,
as the study finds.
But companies also expand their
businesses, and thus employment, when they
open new manufacturing plants, retail
locations, and other facilities. Thus, to
complete the picture, the authors look at jobs
create by private equity-backed companies at
these newly opened establishments. Private
equity emerges the winner: They find that
target firms create jobs at a much faster rate
than firms with no ties to private equity.
Overall, it appears that job losses are partly
offset by job gains from this expansion.
— VANESSA SUMO

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Page 16

practice, particularly with respect to
governance. In portfolio companies,
CEOs effectively have a boss. In a
public corporation, by contrast, CEOs
typically don’t have one. Jensen, who
also spoke at the AEI conference,
said that the board of directors of a
public corporation generally see
themselves as employees of the CEO.
This situation changes only in the
event of a crisis, but by that time,
too much inefficiency has already set
in. (Public-to-private transactions
account for about a quarter of all
buyouts worldwide in terms of dollar
value, according to a recent World
Economic Forum report. Most buyouts are acquisitions of private firms
and corporate divisions.)
In the end, whether the hard work
has paid off partly depends on the
private equity firms’ ability to “exit” an
investment well; that is, to find the
right buyer. An exit route can be
arranged through an initial public
offering (IPO) of the company,
accomplished by selling shares in
the public market or by selling the
business to another company or
private equity firm.
In Meineke’s case, the partners had
a five-year plan that they achieved
in less than two years, and everybody
around the table agreed that it
was time to move on. “Companies do
get to a certain point in their life
cycle where they would perhaps
benefit from another owner,” says
Bailey. Carousel and Halifax were
bought out by Allied Capital, a
private equity firm based in
Washington, D.C., together with
Meineke’s management. Carousel and
Halifax say they earned more
than their typical annualized target
return of 25 percent. “They were the
right partners at the right time,”
Walker says.

Measuring Performance
If you ask Walker, he’ll say that private
equity firms do create value. His big
idea was that the company could grow
quickly and profitably by buying other
franchise automotive brands while
taking advantage of the company’s

16

R e g i o n F o c u s • Wi n t e r 2 0 0 8

back-end resources, which include the
accounting, legal, and financial management departments. He was proven
correct. “It was private equity that
allowed us to do that,” says Walker. “It
just allowed us to be a more efficient
company.”
However, others are more doubtful
about the merits of private equity. The
quick flip is one tactic that doesn’t
come across favorably, with many
asking whether overleveraged companies have been sold too rapidly in the
public market. For instance, the
private equity groups that bought car
rental company Hertz in 2005
announced an IPO in just less than a
year, which prompted BusinessWeek
to call that move “rent-a-company.”
A 2006 NBER paper by Lerner and
Jerry Cao of Boston College finds
some evidence that leveraged buyouts
which went public after less than a year
performed much more poorly than
companies held longer. Such a strategy
would then seem futile since buyout
groups typically retain large ownership
stakes after the IPO and failure is too
costly for their reputation.
But Lerner and Cao also find,
overall, leveraged buyouts that later
offered shares to the public through
an IPO “consistently outperform
other IPOs and the stock market
as a whole.” Moreover, they find no
evidence that the returns of these
“reverse” leveraged buyouts deteriorated over time. This suggests that
private equity firms make their
portfolio companies more valuable,
even long after an IPO.
Another way to measure performance is by comparing the returns of
a private equity fund to one that
invests in a stock market index such
as the S&P 500. In other words, which
would do a better job of generating
higher returns — a private or a public
company? A well-cited 2005 Journal
of Finance study by University
of Chicago Graduate School of
Business economist Steven Kaplan
and Antoinette Schoar, an economist
at the Massachusetts Institute of
Technology, finds that the returns to
private equity funds — gross of fees

paid to the general partners — beat
the returns on investing in the S&P
500 (the analysis includes venture capital and buyout funds). Other studies
come to similar findings.
However, Kaplan and Schoar’s
study finds that the same returns to
private equity funds — net of fees —
were roughly equal to the returns on
the S&P 500. So, while their findings
suggest that private equity firms create value at the company level,
investors don’t seem to do better than
if they just put their money in a market index fund. It would then seem
bizarre that investors pour so much
money in this asset class given the
poor returns.
There may be other reasons why
investors put their money in private
equity funds. Investors might value
the option of participating in a
future fund if participating in the first
one gives them access to the next.
Investors know that in this business, a
firm can get better at what they do
over time. Certain investors like big
investment banks may also value
investing in private equity funds for
the relationship that comes along with
it, because they value the possibility
that private equity firms will call upon
their consultation or underwriting
services. Or, it could be that investors
have a hard time comparing funds’
returns to that of the market index.
But the best-performing funds
within this larger group do better than
the market index even after fees. There
seems to be persistence in fund
performance as well; that is, a good
private equity firm can consistently
generate good returns. This persistence is stronger than in other fund
types such as hedge funds and
mutual funds.

Feast, Famine, and the Future
As credit markets became more
cautious over the past several months,
many predicted a substantial slowdown and even the demise of what
they perceived was an overheated
private equity market. But the boomand-bust nature of the industry is
nothing new. “This is a story we have

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seen many times before,” said Lerner.
Money from investors flows into
private equity when returns are
perceived to be higher relative to other
types of investment. Together with
favorable credit conditions, which are
important to private equity because
the deals typically involve leveraging,
private equity firms can raise large
funds for their acquisitions. But more
capital available means more competition, which bids up the prices of
companies they buy. Moreover, when
the industry as a whole is doing well,
money also flows to inexperienced
groups who enter the market in the
hopes of replicating the success of the
industry’s best performers. Hence, as
the supply of capital goes up, returns
go down and investors pull out. Poor
performers leave the market, competition eases, returns go up, and the cycle
starts all over again.
The buyout boom of the late 1980s,
culminating in Kohlberg Kravis
Robert & Co.’s takeover of RJR
Nabisco, is in many ways comparable
to the heady growth in buyouts in the
last few years. Both episodes were
marked by large amounts of capital,
record-breaking deals, intense public
scrutiny, and the use of debt securities
that fueled aggressive deal-making
(the junk bonds of the 1980s and the
collateralized loan obligations of
recent years).
As in the earlier buyout wave, deal
volumes and returns on private equity
investment will likely drop as the

Page 17

current cycle turns. The difference,
however, is that the companies’ capital
structures are actually much safer
today, said Kaplan, who also spoke
at the AEI conference. Even with
the firms’ aggressive use of debt,
companies’ debt levels are lower and
there is more of a cushion to make
repayments. Thus, in the event of a
recession, portfolio companies will
probably not experience the large
number of defaults that was seen in
the early 1990s.
But even those who believe in the
merits of private equity worry that
some of the firms’ practices may be
weakening the very attributes that
have made them effective at what they
do. For instance, because the amount
of capital committed by investors has
increased tremendously in recent
years, the management fees collected
by the firm as a percentage of this
capital has likewise soared. Lerner
cited a study that shows partners’ pay
from “carried interest,” the performance motivator, is actually a relatively
small slice of their overall compensation and that much of the income
comes from fees. He thinks that this is
a concern because it might lead to pressure for firms “to just do the safe thing,
rather than doing the right thing.”
There are also worries about
private equity firms themselves going
public — as Blackstone famously did
in 2007 — because it could undermine
the incentive structure that has been
built into the limited partnership

arrangement. Private equity firms are
motivated to make deals work because
their reputations are on the line. Their
partnerships with investors have a
fixed lifetime, so if they want to
raise another fund, they must show
investors that their past funds have
performed well. Thus, replacing the
funding provided by a partnership
with permanent capital from issuing
public stocks removes this important
motivator.
As this relatively young industry
grows in size and influence, it is
perhaps inevitable that there are
increasing pressures for more regulation and transparency. Some are also
calling for private equity partners to
pay taxes on the carried interest based
on the income tax rate, rather than the
lower tax rate on capital gains.
But those who think that private
equity will fall under the heavy weight
of criticism and its perceived excesses
might be disappointed. The industry
has been remarkably successful and it
generally has a good story to tell.
Its influence extends even beyond the
firms that it operates. “If you have a
competitor who has private equity as a
significant owner and they are making
huge improvements, you had better
make similar improvements or you will
not be competitive,” said Wruck. The
message is clear: Companies that are
not backed by private equity firms will
be forced to shape up. Otherwise, they
may soon find themselves competing
against one that is.
RF

READINGS
American Enterprise Institute. “The History, Impact, and Future
of Private Equity: Ownership, Governance, and Firm
Performance.” Conference presentations. November 27-28, 2007.

Kaplan, Steven N., and Antoinette Schoar. “Private Equity
Performance: Returns, Persistence and Capital Flows.” Journal of
Finance, August 2005, vol. 60, no. 4, pp. 1791-1823.

Cao, Jerry, and Josh Lerner. “The Performance of Reverse
Leveraged Buyouts.” NBER Working Paper No. 12626,
October 2006.

Ljungqvist, Alexander, Matthew Richardson, and Daniel
Wolfenzon. “The Investment Behavior of Buyout Funds: Theory
and Evidence.” European Corporate Governance Institute Finance
Working Paper No. 174/2007, June 2007.

Cumming, Douglas, Donald S. Siegel, and Mike Wright.
“Equity, Leveraged Buyouts, and Corporate Governance.” Journal
of Corporate Finance, September 2007, vol. 13, no. 4, pp. 439-460.
Fenn, George W., Nellie Liang, and Stephen Prowse. “The
Economics of the Private Equity Market.” Federal Reserve Board
Staff Studies, December 1995, no. 168.
Jensen, Michael C. “Eclipse of the Public Corporation.”
Harvard Business Review, September-October 1989.

Phalippou, Ludovic, and Oliver Gottschalg. “Performance of
Private Equity Funds” (April 2007). American Finance Association
2008 New Orleans Meetings.
World Economic Forum. “Globalization of Alternative
Investments Working Papers Volume 1: The Global Economic
Impact of Private Equity 2008.”

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Page 18

Virtual Economics
Economists explore the research value of virtual worlds
BY D O U G C A M P B E L L

J

azmine Sciarri is a fashionable brunette who favors
flared miniskirts and colorful tops. Her background is
a bit of a mystery, though she has been known to dance
with hippies. Curiously, Jazmine seems to be fascinated
with banking. Wherever she goes, she looks for bankers.
She has many, many questions for them.
Before any bankers in the audience get too excited, let
it be known that Jazmine isn’t real. If you’ve read enough
stories about virtual-world gaming, by now you probably
have already figured out that Jazmine is a stand-in — or
avatar —for a flesh-and-blood person.
Most of the time, it might be logical to assume that
Jazmine’s creator was a 16-year-old boy clicking a mouse in
his parents’ basement. In this case, Jazmine was invented by
Courtney Nosal, an economic analyst with the Federal
Reserve Bank of Atlanta. Nosal is neither a brunette nor a

18

R e g i o n F o c u s • Wi n t e r 2 0 0 8

flower child (though for fun, she likes to visit a virtual island
of dancing hippies). But she does share Jazmine’s interest
in bankers.
Nosal wants to talk with people who have set up virtual
banks in the digital realm of Second Life, a popular Internet
site. How do they attract depositors, invest their money
(with the local Linden dollar currency), and make loans?
If they’re a lot like banks in the real world, all the better.
The Atlanta Fed is asking these questions because of the
light the answers may shed on real-world banking trends.
The effort is the brainchild of David Altig, the Atlanta Fed
research director, who thinks virtual worlds could prove
fertile ground for the study of economic policy, institutions,
and crisis management. There may even be an opportunity
to perform “risky” virtual-world experiments that would be
unethical and impractical in the real world.

PHOTOGRAPHY: COURTESY OF SECOND LIFE

Avatars in
Second Life aren’t real
people, but their
economic behavior is
of growing interest
to researchers.

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What if the Fed unexpectedly cut
the funds rate by 5 percentage points?
(Let’s see if that makes Jim Cramer
happy, Altig likes to joke.) Inside the
confines of a virtual world, where the
consequences are also virtual, perhaps
we can find out. “I’m not interested in
studying the economics of virtual
worlds,” Altig says. “I’m interested in
studying the real-world lessons that we
might learn from virtual worlds.”

Fantasy Facts
Virtual worlds can take on many
forms. They can be as simple as
Internet message boards, where
people use pseudonyms to post
political rants or riff on celebrity
gossip. They can be massive online
role-playing games such as World of
Warcraft, in which players assume new
identities and computerized bodies as
dwarves or paladins and together go
“questing” for gold and battle. Other
virtual worlds are less game-like and
more like pure social networks. There
is no win-or-lose-game in Second Life
except for the side matches that
residents organize themselves.
Online virtual worlds have existed
as long as the Internet. Early efforts
included 1991’s ImagiNation Network,
whose dial-up subscribers could play
games and interact with other players
in a variety of environments. Meridian
59, which launched in 1995, is credited
with sparking the explosion in virtualworld gaming as we know it today.
It allowed users to create avatars that
could be maneuvered about a landscape fighting monsters and chatting
with other players. From there,
environments such as Ultima Online,
EverQuest, and the 8-million-member-and-growing World of Warcraft
took hold.
With the caveat that estimates
vary, the population of role-playing
virtual worlds such as those described
above is about 30 million and growing.
The first economist to get widely
noticed for studying virtual worlds
was Edward Castronova of Indiana
University. His research began as a
lark. He decided to gather data
about EverQuest players by sending

Page 19

messages to two popular message
boards.
In the course of 48 hours,
Castronova logged 3,619 responses
and put together what he called the
“Norrath Economic Survey,” named
after the particular region of
EverQuest under study. He reported
population characteristics, microeconomic conditions, and macroeconomic indicators. Then he posted
the information as a working paper in
December 2001. It was an instant hit,
and Castronova’s phone began to ring
off the hook. A few years later,
besieged by requests to expand on the
subject, he wrote a book about his
economic studies in virtual worlds,
and now is recognized as a leading
authority on the subject. “It really just
started as a joke,” Castronova says
today. “But it continued from there.”
Castronova quickly concluded that
supply and demand operate in virtual
worlds the same as in the real world.
The “points” that players accumulate
can be in the form of gold coins, “gils,”
or other trinkets, depending on the
game. Players amass currency by
killing monsters, crafting apparel, and
smelting weapons, among other
activities. In World of Warcraft, for
example, one player may buy a shield
from another player. Though the
transaction is made in the local
currency — gold coins — buying and
selling of the coins also occurs outside
the game at Internet auction sites.
Players swap real currency for virtual
currency through an online retail site,
then have their avatars meet in some
prearranged virtual location to swap
the goods. (The difference between
real and virtual currency is a topic that
could fill the pages of a book, for how
is a Linden dollar any less currency
than a U.S. dollar if people use both as
units of exchange?)
The existence of such clear
economic behavior has convinced
Castronova that virtual worlds may —
but don’t always — provide venues for
economists to learn things about economic activity that they otherwise
couldn’t. Traditionally, economists
have relied on 1) theoretical models

that require perhaps imprecise
abstractions and assumptions about
human behavior 2) statistical regressions of past economic activity, which
may fall short because changing the
rules of the game will probably mean
changes in future behavior, rendering
the lessons from the past moot, and
3) experiments with groups of people
in random and control groups, which
tend to suffer because of the
small sample sizes and unrealistic
environments.
Virtual worlds are different. With
so many players acting in purposeful
ways toward common goals, collectively they can be thought of as
representations of human society.
It may not matter so much that the
synthetic version is a realm of elves
and warlocks, or of uncommonly
slim, attractive, and fashionable digitized humans who can also fly. Or
that people think of their avatars
differently than their regular selves
(a reported 25 percent of gamers
switch genders with their avatars, for
instance). True, there are differences —
barriers to entry are clearly lower in
virtual worlds, as are the opportunities
to cultivate economies of scale in
worlds with basically boundless
supplies of content.
What’s important is that the
societies which form in these virtual
worlds are — for all intents and
purposes — real. People talk, form
relationships, buy things, and sell
things. What’s more, these are
controlled environments, making
experimentation much easier.
“Given this level of control, an easy
yet breathtakingly powerful research
strategy almost immediately leaps to
mind,” Castronova wrote in a 2005
paper. “Build several synthetic
worlds in exactly the same way, except
for some difference in a variable of
interest … attract people into the
worlds, sit back, and watch what
happens.”

Not Quite Funny Money
At the Atlanta Fed, Altig cautiously
agrees with that assessment. He looks
at virtual worlds and sees different

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monetary systems and different
institutions and wonders: What if
different outcomes in prices and inflation in those worlds could be tied to
the existence of particular institutions
and the rules that govern those institutions? “The big payoff would be to
populate a world and observe the outcomes under different institutional,
banking, and payments arrangements,”Altig says.
At first glance, the world of Second
Life looks like a promising candidate
for such a project. It is one of the
fastest-growing, massively multiplayer
online sites, with more than 12 million
residents.
Unlike other popular Internet
realms, Second Life is not exactly a
game, per se. It’s basically an artificial
universe for people to meet, interact,
and possibly do business together.
(Plus, Second Lifers can fly, a fun
bonus.) Most of the environment is
created by players themselves — from
digital night clubs to shopping malls.
In all of these subenvironments,

Second Life residents can talk to
each other, either through instant
messaging, traditional e-mail, or
microphones that transmit players’
actual (though sometimes purposely
distorted) voices.
In Second Life, there is no stated
purpose that requires the accumulation of Linden dollars. But all the
same, players who want to buy virtual
property or don fancy hats must pay.
They can earn money by taking virtual
jobs, or by paying for Lindens with
real-world currency.
Some 4.3 billion Linden dollars
were in circulation as of February,
trading at about 265 Lindens per U.S.
dollar. Though real-to-virtual world
transactions occur across just about all
synthetic environments, Second Life
actually encourages the exchange of its
currency for U.S. dollars. (The emergence of the “gold farming” industry is
probably the most infamous example
of the crossover between real and synthetic economies — in China, many
businesses hire gamers to obtain gold

coins in World of Warcraft and then
sell them for real currency.) It keeps a
Lindex market board where traders
can see the going exchange rate. Real
banks — and many other commercial
enterprises, from Toyota to IBM —
have also set up sites in Second Life
and other places, but these tend to
be little different than existing
Internet offerings.
Among the most intriguing usercreated businesses that have sprouted
up in Second Life are banks — or at
least, virtual institutions that call
themselves banks. An estimated 100
self-identified banks were in operation
last year, most offering depositors
certain rates of return on their Linden
dollars, and some making loans to
Second Life residents for mortgages or
business ventures. These banks set up
ATMs around the digital world;
customers could deposit their money
there in hopes of collecting promised
interest payments and then withdraw
when they needed to make transactions with other players.

The Adventures of Deeter Gumbo
Deeter Gumbo, my Second Life avatar, is a klutz. And
painfully shy around attractive strangers, of which there is
no shortage in the virtual world. But for all his faults, he’s
good at making a quick buck. I mean “Linden dollar.”
I had never set foot in a virtual world before February.
I opened a Second Life account with a single mission — to
find a bank (or at least something calling itself a bank),
deposit some money, and make an investment in a business.
Here is the surprisingly short-lived story of how it happened:

I chose “city-chic male,” who sports a thick, curly head of
hair and a goatee.
Second Life then asks if you want to join as a “Premium”
resident, which gets you some land and more L$s for a
small monthly or quarterly fee ($9.95 per month for the
highest level). I decide to join with a free account, since this
way I would enter the world penniless and have to climb my
way out of poverty through good ‘ol American pluck.

8:05 a.m.: Opening an account in Second Life is a snap.
You first choose your avatar’s name — the first name is
whatever you want; I chose Deeter because, because …
Upon reflection, I have no idea. Perhaps it’s because I
always liked that Mike Meyers character of the same (if
differently spelled) name on Saturday Night Live. “Gumbo”
was picked from a drop-down menu of semi-ridiculous last
names that Second Life mandates you to use. Then it’s just
a matter of entering your birth date and e-mail address.
8:10 a.m.: Now to select my avatar’s body type. This is
something I’m told that can be changed anytime, but to get
started Second Life provides a small sample of selections.

20

8:15 a.m.: After downloading a software application Deeter
appears in what looks like a courtyard, a half dozen or so
other people standing around him in circles painted on the
virtual ground. This is the tutorial part of Second Life,
where you learn how to walk, fly — yes, fly! — talk with
other avatars, and pick up and wear items. Most of the
time, the only view I have of my avatar is from behind.
Despite my efforts, Deeter unfailingly bumps into walls,
even in wide-open alleys. And it takes 10 minutes to figure
out how to pick up a torch.
8:35 a.m.: A couple of knights give me a chain mail shirt.
This puzzles me, since I was led to understand that Second
Life wasn’t one of those go-to-battle role-playing sites,

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In Second Life, there is no deposit
insurance, no oversight, and quite a bit
of opacity in how the banks do
business. If bankers wanted to take
depositors’ money and run, they could
do so with little fear of repercussion —
other than the hit to their reputations
(which are very important in online
worlds) that would make it difficult for
them to conduct business as bankers
in the future.
Linden Lab, the company that owns
and operates Second Life, was forced
to reconsider the freewheeling banking
market in August 2007. Ginko
Financial, a Second Life bank offering
returns of 40 percent, suddenly
declared itself unable to repay depositors 200 million Lindens, or about
$750,000 at the time. The bank owner,
whose identity remains unknown, did
not say what caused the shutdown.
Many Second Lifers downplay the
significance of the crash, saying that
Ginko was an obvious fraud and aberration. All the same, Ginko’s failure
was just one of many reported banking

Page 21

troubles in Second Life. Bank runs
were rampant. So in January, Linden
Lab said it would prohibit “banks” or
any other entity from offering interest
on investments “without proof of an
applicable government registration
statement or financial institution
charter.” What this means is that now
only real banks can gather deposits
and make loans in Second Life. As of
February, none did. (Among the obstacles to virtual banking are real-world
money laundering laws that require
banks to know their customers, which
is difficult with anonymous avatars.)
“Usually, we don’t step in the middle of Resident-to-Resident conduct,”
the company said. “But these ‘banks’
have brought unique and substantial
risks to Second Life, and we feel
it’s our duty to step in. And Linden
Lab isn’t, and can’t start acting as, a
banking regulator.”

Jazmine’s Quest
In so much as Second Life banks
resemble real-world banks operating

but no matter. Then it’s off to change my appearance.
I decide to give myself an enormous rear end and tiny head.
Plus a square chin.
8:45 a.m.: After learning how to use the search box, I am
awarded the ceremonial “Key to Second Life.” I type in
“bank” in the search engine and teleport myself to a likely
suspect — SL Cap Exchange. About a half dozen avatars
are wandering about, several speaking to each other in
what looks like German. (Their dialogue appears in script
over their computerized bodies.)
8:50 a.m.: The exchange has an ATM but I realize I have
no Lindens to deposit. I teleport myself to the help island
and say to nobody in particular, “How can I make some
money?” A friendly guide sidles up to me and replies,
“Search for jobs.” So I type “jobs” into the search box, and
a list of hundreds of opportunities appears.
9 a.m.: I’m on Job Island, I think. A wall of flashing
billboards captures my attention. “Click Here for
Free L$s” says one sign, so I do. After a moment, I’m
wearing a digital sign that says “Click Me for L$s.”
Supposedly I will get Lindens if I can persuade others

in nearly regulation-free environments, the opportunities for economic research may be vast. Altig
frames the question: “The big thing is,
are these banks institutions that we
can map into something we recognize
in the real world and can therefore
draw conclusions based on things we
see happening in Second Life?”
That’s what Courtney Nosal — or
Jazmine — is trying to find out.
Plugging in the term “bank” to Second
Life’s search engine, she tracked down
more than 100 residents who, at one
point or another, claimed to be bankers
in the virtual world. Most were not
quite banks as we know them on
“earth.” They mostly exchanged U.S.
dollars (or other world currencies) for
Linden dollars. Some would take their
depositors’ Linden dollars, convert
them to U.S. dollars, and invest them in
real projects or stocks, hoping to make
good on their promised interest rates.
Nosal contacted them with
messages sent through her avatar,
identifying herself as a Fed researcher:

to click me. It’s unclear why anyone would want to do
so (and in fact, nobody does during the next hour). While
I’m trying to figure out what to do next, a stunning redhead approaches me and says “Hi.” Terrified, I scurry away.
Second Life, bah! This is just like my real life.
9:05 a.m.: “Use These Machines for Free L$s” beckons a
row of ATMs. Clicking on them, a Web page appears with
a list of surveys and offers that I can complete in exchange
for Lindens. At this point, I’m no longer really in a virtual
world, just the regular online world, where commerce
dominates. Dozens of sponsors — ranging from Red
Lobster to XM Satellite Radio — ask for a little personal
information in exchange for Linden dollars. I pick one,
enter as little information as possible, and then L$15
materializes on my person.
9:15 a.m.: Back at the SL Capital Exchange, I deposit
L$10 in the ATM, and then pull up a page of business
prospects. I choose “hoorenbeek,” ticker HBK, a “quality
clothing and accessories” firm, and invest L$4.20, for four
shares. That’s a total investment of 1.6 U.S. cents. Mission
accomplished. Now, I can just wait for my riches.
— DOUG CAMPBELL

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Jazmine Sciarri says: Hi, I’m from the
Federal Reserve and we are very interested
in the current banking atmosphere in SL.
I’m interviewing all of the bank CEOs,
and your participation would be highly
appreciated.
Jazmine received dozens of replies.
In follow-up messages, she revealed
her real name and outlined the Fed’s
reasons for conducting the study. She
queried about deposit levels, interest
rates, and bankers’ preferences on regulations. The goal at this early stage
was to delineate Second Life’s banking
industry. A fairly robust industry
might allow for the sort of experimentation that Altig envisions.
Early returns suggest that experimentation may have to wait. Since the
de facto ban on banking, the number
of self-identified bankers in Second
Life has dwindled to about 10, Nosal
learned. A representative sampling of
her findings:
• BCX Bank — still operating,
no deposits
• SLIB Bank—no longer taking
deposits, most clients are
shareholders
• Ginko — no response.
Among the bankers who endure, a
clear sentiment prevails — they want
regulation as a way to weed out scam
artists and knowledgeable bankers.
During runs, many bank CEOs ended
up paying depositors out of their own
pockets. “Most of them lost count of
how many runs there have been,”
Nosal says. “People have lost faith in
the banking system because there were
so many banks that were just scams.”
It’s a fundamental economic question: What is the minimal rule of law
needed to create and sustain a
thriving community? Can you do it
without regulation? To Altig, the early
evidence from Second Life confirms
what economists generally agree
upon today. “Some amount of
regulation appears to be necessary to

stabilize the banking system,” he says.

Fuzzy Line
Skeptics have a number of reasons to
question the value of virtual worlds for
economic research. There is the problem of selection bias — a majority of
online gamers are young and male.
Then there is the evidence that people
in virtual worlds behave differently
than they would in the real world; they
take more risks, for example. In real
life, a person likely wouldn’t plunge a
dagger into another person’s heart, but
in virtual worlds, a warlock wouldn’t
think twice about it.
But these are hardly insurmountable hurdles. Economists are
accustomed to adjusting for selection
bias and tweaking their models to fit
the expected behavior of agents.
Castronova, whose work helped call
attention to the research value of virtual worlds, is optimistic that much
more can be learned.
“Some people look at virtual worlds
as space that is ‘other,’ and others
see it as an extension of reality,”
Castronova says. “I believe it can be
both. If you change the rules of the
game, change the institutional structures where people live, their behavior
will be different. … Does that mean
our theories of economic and social
behavior are wrong? No. They just
manifest themselves differently in
different environments.” And in fact,
the different ways that behaviors
manifest themselves is what economists are hoping to see — because
perhaps they can learn what is causing
those different behaviors by pulling
different virtual-world levers.
Yet the research value of virtual
worlds like Second Life may already be
in jeopardy. As the line between the
real world and the virtual world blurs,
so, too, does the rationale for conducting virtual world experiments in
the first place. The worth of virtual-

world experimentation is the ability to
control the institutions, be they those
involved in the payments system or
central banks. The results from those
sort of experiments should be quite
clean. But if Second Life ends up with
nothing more than real-world, brickand-mortar banks setting up digital
ATMs, then how different is that from
existing Internet offerings?
Perhaps Second Life will evolve
into nothing more than a fancy Web
browser. And at that point, the
services in Second Life wouldn’t really
be any different than those that are
already provided in the real world.
“We have lots of real-world data, so if
all we get out of Second Life is more
real-world data, it’s not as significant,”
Altig says.
Which is not to say that economic
research with virtual worlds is dead
before it even started. The Atlanta
Fed’s effort is still in its infancy. Nosal
didn’t begin her Second Life work
until January, though Altig has been
thinking about the effort for a couple
of years now, back to the days when he
worked for the Cleveland Fed.
At the least, virtual worlds may
provide ample data for economists
to mull over. Analysts at the
Cleveland Fed — some of Altig’s former colleagues are hoping that Nosal
can gather enough data through
surveys of Second Life users to
produce meaningful research. In
theory, they could study much more
than banks for real-world lessons
about the economy. But they started
with banks because they seemed at
first like they might bear a close
resemblance to real-world banks.
“I think that something will
come of this. Whether it will be a
marginal addition to our knowledge
base or something more substantial is
a wide-open question,” Altig says.
“But it’s a question worth asking
and exploring.”
RF

READINGS
Bray, David A., and Benn R. Konsynski. “Virtual Worlds, Virtual
Economies, Virtual Institutions.” Emory University Working Paper
Series, May 2007.

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Castronova, Edward. “On the Research Value of Large Games:
Natural Experiments in Norrath and Camelot.” CESifo Working
Paper No. 1621, December 2005.

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Page 23

WANTED: Brains to Train
Firms court and school a new breed of skilled worker
BY B E T T Y J OYC E N A S H

Image Problem
Tech experts partly blame media for the dearth of skilled
labor. Few pipefitters or engineering technicians show up on
TV, they say, and so students aren’t lining up for those jobs.
Ambitious parents inadvertently add to the problem as they
press students to earn a bachelor’s degree instead of a
technical one. Some blame that on manufacturing phobia.

This skilled labor gap may reflect beliefs of previous
generations, say educators and corporate recruiters. As lowskilled manufacturing enterprises (like textiles) dwindled
in South Carolina, parents and guidance counselors channeled students to four-year colleges. While soft-skilled
liberal arts majors can’t qualify for technical jobs, their
flexible skills might allow them to weather a manufacturing
layoff better than a technician. Employers, notes labor economist Orgul Ozturk, read the college degree as a signal of a
general ability to learn.
Fallout from the labor shortage occupies Chris Lang day
in and day out in her work as dean for industrial and engineering technology at Trident Technical College in
Charleston. Certainly there is that fear of manufacturing
losses, she says. More than likely, though, students are uninformed about alternative careers. Firms get frustrated
because they can’t hire enough people, she says. Sometimes
they can’t even muster up enough students willing to train or
apprentice to be machinists or pipefitters, to name two
examples.
Wages, Lang insists, are not the problem.
“In South Carolina, students who graduate from technical programs often make more than people who have
graduated from college,” she says, adding that the focus on
the four-year degree has been at the expense of careers in
skilled trades. “If they [students] are never told about
these possibilities, they are just not going to know. “I think a
lot of it is the perception,” Lang says. If the parents don’t
work in a factory themselves, “they look down on that job.”

Instructor Ron Yancey of
Cheraw, S.C., left, trains
Northeastern Technical
College students on
specialized machine tools
used in products like cell
phones, computers,
and other electronic
components.

Wi n t e r 2 0 0 8 • R e g i o n F o c u s

PHOTOGRAPHY: ADVANCEMENT OFFICE, NORTHEASTERN TECHNICAL COLLEGE

J

ared Sherrow powered up his future even before he
graduated from high school. Sherrow opted for a new
earn-and-learn deal that is schooling him for a career
at Santee Cooper, the state-owned electric and water utility
in South Carolina.
“I really wasn’t interested in going to a four-year college,”
he says. “I was interested in going to tech, but I didn’t know
what I wanted to do.” Santee Cooper recruited Sherrow in
2007 to replenish its dwindling supply of plant technicians.
And Santee Cooper’s job crunch reverberates through
other industries, too, where trained and intelligent technicians appear endangered. Utilities and high-tech industrial
firms worry about who’ll run and fix the machines, weld the
seams, and fit the pipes. The South Carolina Employment
Security Commission projects that by 2014, jobs for
plumbers, pipefitters, steamfitters, and avionics technicians
will grow by 20 percent.
More than half of the nation’s aging utility workers will
be eligible to retire over the next decade, and that leaves
firms like Santee Cooper scrambling to lure high school
students like Sherrow.

23

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Page 24

Maybe the message is hitting
home: Automotive, machinist, heating
and air-conditioning technician enrollments bumped up at Trident in the fall
of 2007.
These jobs are not those of previous decades, but ones that require
more brain power, say people who
work in tech schools, like Cushman
Phillips. He directs training at
Orangeburg-Calhoun Tech in Orangeburg, S.C. “In today’s world, a computer-controlled system with thousands
of parts that all talk to each other —
the people who maintain and troubleshoot those are in high demand,” he
says. These are not jobs you can train a
monkey to do, he notes, because they

require a good head and a capable pair
of hands.

Stocking the Pond
Santee Cooper stocks its own pond.
Recruiting efforts, says senior employee relations representative Wendy
Cruce, will overcome what she calls a
“generational mindset.”
In 2007, the utility cranked up
“Power Associates,” the competitive
work and study scholarship Jared
Sherrow received. Technical education, they tell parents of qualified
students, can forge careers with Santee
Cooper.
“I think a lot of students and
parents don’t realize the value in these

technical careers,” Cruce says. “When
Jared finishes his program, there’s a
good chance he will be earning a lot
more than his high school friends right
off the bat.”
Expansion and retirements have
created chronic job openings at Santee
Cooper. But these jobs have changed
over the past 30 years. Auxiliary operators used to be trained on the job. Not
anymore — it’s too technical.
“They are on the floor, as well as the
unit operators who monitor everything on computers,” Cruce says.
Those positions, incidentally, bring in
$40,000 to $50,000 annually — to
start. By contrast, a teacher (with a
bachelor’s degree) starts at about

Plugging Holes in the Labor Market
Markets may manage the supply and demand of labor
over the long haul, but hiring decisions don’t happen in a
vacuum, so short-term labor imbalances may linger.
“These days, with the economy and jobs and technology changing so quickly, getting enough workers trained
is hard,” says Orgul Ozturk, who is from Turkey. She
teaches economics at the University of South Carolina.
“If the global world was truly global, there would be no
such shortage, at least not as severe,” she says. “Most
countries, like Turkey, have an excess of skilled labor.”
Immigration could move workers into vacant jobs if
policy allowed — there’s a worldwide labor surplus in less
developed countries. But U.S. immigration policies currently restrict a worldwide matchup of jobs to workers,
although special visas exist in some fields. (See the fall
2002 issue of Region Focus.)
Imperfect information about opportunities impedes
the flow of labor to some occupations. Many students
seem unaware of or uninterested in these opportunities,
and it’s hard to say why. People who seek qualified
candidates or study the problem suspect it may have
something to do with the obsession with the four-year
degree, information asymmetries, and even inadequate
high school math and science preparation.
But increasing the quantity and quality of specialized
labor over the long term is a tricky proposition, with
accurate labor forecasts difficult to come by. Even the
Bureau of Labor Statistics projects out to only 2016, with
caveats about the changing economy.
That’s because firms can alter, fairly quickly, the way
they do business. This rapid change makes forecasting
tough, according to Harvard University labor economist
Richard Freeman. “Projections of future demands for

24

R e g i o n F o c u s • Wi n t e r 2 0 0 8

skills lack the reliability to guide policies on skill development,” he writes in a 2006 National Bureau of Economic
Research paper. The paper examines claims that the
pending baby boomers’ exit from the work force
combined with the slow growth of U.S. labor will create a
mega-gap. He also addresses whether public policies
might sync supply with demand.
Historically, changes in technology or industrial output affected labor demand more than demographics, he
writes. Economic forecasters shouldn’t expect demand in
those jobs vacated by boomers to create a labor shortage
in those occupations. For instance, Freeman points out
that in the 1950s and 1960s, analysts failed to “foresee the
changing labor force behavior of women in response to
improved employment opportunities and wages.”
For boomers, excess labor meant worse earnings and
employment compared to older workers. Another example comes from the high-tech boom, which opened jobs
in the computer field only to be offshored to qualified
overseas workers. Although U.S. firms might want to hire
U.S. workers, they could go out of business if they do
because willing workers abroad would do the same work
for less.
While labor gaps can and will occur, the dramatic
shortages attributed to the mass retirements of a generation are overplayed. “The employment and earnings of
young workers depends more on macroeconomic conditions, wage setting institutions, and technological
developments than on demography.”
Freeman concludes that the market should be left
alone to raise wages, if necessary, rather than for government to adopt policies that may keep labor costs low.
— BETTY JOYCE NASH

5/30/08

11:38 AM

$30,000. And in a state where
per-capita personal income ranks 47th
at about $29,700, it’s a shame
for good-paying jobs for young
people to go begging.
Santee Cooper snared Sherrow, and
over the summer of 2007, he helped
troubleshoot machine problems, and
earned an hourly wage of $10. During
the school year, he attends classes
Mondays through Thursdays at
Trident Technical College, and on
Fridays (and weekends if there’s an
outage), he works at the plant. He’s
learned, among other skills, to read
blueprints. Santee Cooper foots the
bills and after two years in school, he’ll
work full-time if his grades and job
performance hold.
Sixteen students applied to the
program and four were selected in
2007. This year, Santee Cooper will
take twice as many. The hardest sell,
Cruce says, is parents who cherish the
notion of that four-year degree. While
Cruces sees plenty of liberal arts
resumes, she says, “we simply can’t
hire them.”
Sherrow spreads the word. “I have
told younger kids I know that they
need to put in for it because you learn,
you get an education, and your foot in
the door to a good company.”

Monitoring the Gap
It’s not just power plants that need
people. Lang, the Trident Tech dean,
says welding is hot. Two Charlestonarea defense contractors “snap them
up like crazy.” And that’s left construction and metalworking firms high and
dry. Those and other companies
also need machine tool operators,
industrial electrical techs and “people
who are multicrafted.”
Two area firms, Alcoa and Bosch,
offer full-fledged apprenticeships.
Alcoa operates a smelting plant that
employs 600 people. (An internal
study by Alcoa indicated 65 percent of

Page 25

its work force would be eligible to retire over the next
decade.) Even if technology
and productivity gains
eliminate some of these
positions, it would still
require a lot of people to
make up the difference.
The apprentice program
responds to this need.
These apprenticeships vary
in length, and date from
Automotive tech students at Piedmont Technical College build
a 1930s-era program, and
a replica of a 1965 Cobra muscle car as a class project. Proceeds
are registered with state
from the student-built car will be donated for scholarships.
labor departments. Alcoa
students work a 40-hour week and
Forecasting demand in the labor
then attend class for specific training.
market is a murky business. But stayTo sweeten incentives for these
ing ahead of labor trends remains
efforts, South Carolina legislators in
essential. “We also work closely with
2007 approved a $1,000 annual tax
the work by the research universities
deduction for every new apprentice
in the state to see where research may
that participating employers enroll.
take us to forecast these future opporLouie Roberts, technical training
tunities for South Carolina,” says
specialist at Robert Bosch, said findBarry Russell, president of SCTCS.
ing local talent for the firm’s
For instance, hydrogen fuel cell
manufacturing operations proved
research may yield developments.
difficult from the start, in 1974.
“We don’t have the resources to
“The attractiveness of the manufacrun every rabbit we see, but in this
turing sector is not as prevalent for
case we have enough confidence for
the generations following the baby
this to be developed in South Carolina
boomers,” he says. Bosch counts on
that we have several colleges right now
signing bonuses and on-site training as
that develop curriculum modules,”
well as its apprenticeships.
he says.
Santee Cooper, Alcoa, and Bosch
are polishing the image of the trained
Running Rabbits
worker. And the community colleges
It’s one thing for a firm to recruit and
hammer away at the skilled labor
train its own people, and another for
shortage too. “I can tell you South
the state to train workers. After all, who
Carolina is working to make sure that
knows which specialty will pay off?
gap is as narrow as we can make it,”
South Carolina has a growing aeroRussell says. South Carolina, since
space industry as well as automotive
2005, has required schools to expose
plants and suppliers, among others.
students to technical careers in
Ready S.C. trained 6,726 people last
addition to college options. Even in
year. Ready S.C. is a project of the
high school, students declare a major, a
South Carolina Technical College
first step toward a career.
System (SCTCS). Relocating firms
Jared Sherrow’s decision was a nocontract with the state for training.
brainer. “They said they were going to
The state foots the bill, but firms
pay for me to go to school, and start
promise jobs at competitive wages and
me off making good money.”
RF
benefits.
PHOTOGRAPHY: PIEDMONT TECHNICAL COLLEGE

REGION FOCUS WINTER_08_F1

READINGS
Freeman, Richard. “Is a Great Labor Shortage Coming?
Replacement Demand in the Global Economy.” NBER Working
Paper no. 12541, September 2006.

Veneri, Carolyn M. “ Can Occupational Labor Shortages Be
Identified Using Available Data?” Monthly Labor Review,
March 1999, pp. 15-21.

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Page 26

Is revenue sharing the best way
to keep major league baseball
competitive?
BY E R N I E S I C I L I A N O

T

he Baltimore Orioles spent
just over $95 million in payroll
for the 2007 season. Their
American League Eastern Division
rivals, the Boston Red Sox, spent over
$143 million.
So, most observers were not surprised when the Red Sox finished the
season 27 games ahead of the Orioles.
The Red Sox seemed to have simply
bought better players.
The issue of inequality in baseball
has attracted a wave of attention,
much like the issue of income inequality in American politics. In baseball,
the concern is that higher-revenue
teams will continue to monopolize all
the talent, resulting in a situation
where only the same few teams are
competitive year after year.
Andrew Zimbalist, a sports economist at Smith College, has discovered
that, since 1995, a team’s payroll has
indeed had a growing influence on a
team’s success on the field at a time
when revenue distribution has became
further skewed. As he notes, in 1989
the gap between the highest-revenue
and lowest-revenue teams was $30
million. By 1999 it had ballooned to
$163 million.
Television contracts have something to do with the revenue disparity.
For example, the New York Yankees
own 37 percent of the YES Network,
which broadcasts their games. Last
year, revenues at YES were $340.5
million. “When the Yankees win, there
are more people in the New York
media market who can spend more
money,” Zimbalist says. Indeed, over
a quarter of all official baseball
merchandise sold is Yankees gear.

26

R e g i o n F o c u s • Wi n t e r 2 0 0 8

What this means for the game of
baseball — and how to remedy this
situation — is something that sports
economists see differently than the
head honchos of major league baseball.

Is Equality a Good Thing
for the Game of Baseball?
If the outcome of a season is
essentially predicted by payroll, fans
might quickly lose interest in watching
the games. That’s the worry of Major
League Baseball (MLB) executives.
A July 2000 report issued by a panel
headed by baseball commissioner Bud
Selig; former Federal Reserve Bank
Chairman Paul Volcker; economist
and current Yale University President
Richard Levin; and columnist George
Will, concluded that “the prosperity of
some clubs is having perverse effects
that pose a threat to the game’s longterm vitality.”
Many economists who study the
game seem to agree that a sporting
league’s vitality is dependent on at
least a minimal level of competitive
balance. But they differ in how much is
necessary to spur fan interest.
“Uncertainty at some level is necessary for a sports league,” Zimbalist
said. “You want to have a situation
where fans in as many markets have a
chance to compete.”
However, to expect all 30 major
league baseball teams to have a
real chance may not be realistic
or profitable for the league,
says economist Raymond Sauer of
Clemson University who blogs at
TheSportsEconomist.com. He calls
the barometer of competitive balance
“overrated” in terms of explaining a

league’s financial success. For example,
the English Premier League — the top
soccer league in England — generated
profits for the 2007-2008 season that
were double the previous season. But
the 20-team EPL is dominated by just
four teams: Manchester United,
Chelsea, Arsenal, and Blackburn
Rovers. These “Big Four” are the only
teams in the Premier League’s history
to have won a league championship.
In the United States, parity advocates frequently cite the National
Football League as one that has drawn
fans by offering a high degree of
competitive balance. By most conventional metrics, NFL teams are more
competitive with each other and football is more popular than any other
American sport. The NFL typically
generates more revenue than major
league baseball. The MLB’s commission report specifically cited the NFL
as a successful model.
One way the NFL has accomplished competitive balance is by
maintaining a strict revenue-sharing
policy that has managed to eliminate
the disparities created by differing
market sizes. The league signs its television contracts as a league and
distributes the revenue equally to all
teams. The MLB, on the other hand,
allows teams to set up their contracts
individually. This means that large
market teams, like the Yankees, are
able to exploit their growing television
market without sharing all the revenue
they generate.

Sharing the Wealth
The 1997 collective bargaining agreement was baseball’s first attempt at

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revenue sharing. The agreement mandated that all teams pool a certain
percentage (currently 31 percent) of
local revenues, including television
money. The pool then gets divided
among all teams, but the largest chunk
— about 48 percent — is given to the
smallest-market teams. A team with a
large television deal like the Yankees
would share their revenue with a less
profitable team like the Kansas City
Royals. Ideally, the Royals would then
be able to spend as much money on
payroll as the Yankees.
But economists are skeptical that
revenue sharing produces such a
scenario. “It doesn’t equalize spending,” Sauer says of revenue sharing.
“It depresses spending.”
When a team’s management signs a
player, they estimate his salary based
on how much additional revenue the
team expects to gain from him. For
example, a player signed to a $5 million
contract is expected to bring in
$5 million worth of revenue in terms
of television ratings, higher attendance, and merchandise sales.
But if that revenue is shared across
all 30 teams, individual owners do not
receive all $5 million of the generated
revenue. Consequently, teams are less
inclined to spend on talent. This might
create competitive balance, but only
if the high-payroll teams reduced
spending. However, because revenue
sharing affects the behavior of all 30
teams, every team reduces spending.
In other words, the rich teams spend
less but so do the poor teams and the
gap in payroll remains the same.
Empirical studies specifically on
baseball’s most recent revenue-sharing
provisions have found little connection between increased revenue
sharing and enhanced competitiveness
in the league. In 2006, University of
Georgia economist Joel Maxcy found
that the most talented players were

Page 27

more likely to sign with the richest
quarter of baseball teams. His findings
suggest that progressive revenue
sharing does create an incentive
for low-revenue teams to divest their
talent.
Maxcy’s findings bring to light a
classic case of moral hazard. What
incentive do low-revenue teams have
to spend money on talent when they
could lose every game and still collect
a healthy check from the league’s highrevenue teams?
“It’s almost like a scam,” says
California State University Bakersfield
economist Dave Berri. “If you go buy a
team in Kansas City and get money
from revenue sharing … you can just
keep the money.”
Anecdotally, there are instances
of this disincentive mechanism at
work. The most flagrant example
occurred in 2006, when the Florida
Marlins cut their payroll from $60
million to $15 million, despite receiving $30 million in revenue-sharing
money.

A Better Solution:
The “Luxury Tax”
One thing that Sauer and other economists agree would work better is a
luxury tax on a team’s payroll. Such a
tax would be progressive in that it
affects only rich teams that spend
wildly. It only affects big market
teams, Sauer says. “That’s going to
cause [revenue] allocation away from
big teams.”
Many economists think this system
is preferable because it addresses
the real problem that the MLB is
trying to address — hefty payrolls that
sap competition — instead of focusing
on the revenue generated by any
specific team. In addition, a luxury tax
would not influence the spending
habits of the poorer teams the way
revenue sharing does. Thus, payrolls

should become more equal over time.
The luxury tax first entered the
baseball’s union agreements in 1996.
The agreement has recently been
amended so that the teams which
repeatedly spend more than a certain
threshold are subject to progressively
higher tax rates. For example, in
2007, a team that passed the $148
million payroll threshold for the first
time was taxed at only 22.5 percent,
while those who passed it a third time,
like the Red Sox and Yankees, paid
40 percent.
In fact, the Red Sox and Yankees
seem content to continually spend
gobs of money and pay the luxury tax.
For them, the tax is merely an impediment to spend more, not a ban. The
more those two teams spend, the more
revenue baseball collects.
For Sauer, that’s the ideal situation.
“That’s where you want to put your tax
burden,” he says.
This proposal doesn’t solve the
moral hazard problem of lowerrevenue teams sitting on their
revenue-sharing money, however. To
remedy that, Sauer says baseball
should rely on something else favored
by economists: competition.
With any form of revenue sharing,
he says, “you take away from teams
that are in demand and give it to
teams that aren’t producing, [and] they
just sit on the money,” he says. He
prefers the idea of sending underperforming teams down to the minor
leagues at the end of every season, and
calling up the best minor league teams
to replace them the next season.
“Every other country in the world
does that,” Sauer said. For example,
in the EPL of soccer, the bottom
four teams get “relegated” to a lesser
division if they finish the season with a
poor record. Perhaps that’s just the
sort of competition that baseball
needs too.
RF

READINGS
Maxcy, Joel. “Progressive Revenue Sharing in MLB: The Effect on
Player Transfers.” International Association of Sports Economists
Working Paper Series, Paper No. 07-28, October 2007.

Zimbalist, Andrew. May the Best Team Win. Washington, D.C.:
Brookings Institution Press, 2003.

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The theory of mechanism design teaches us how the right financial
contracts and intermediaries can give borrowers and lenders a helping hand
BY VA N E S S A S U M O

n his influential 1937 article, “The Nature of the Firm,”
economics Nobel Prize winner Ronald Coase asked
why firms exist. Firms typically combine different
activities such as production, marketing, inventory, or
human resources management under one roof. But these
activities could also be produced independently by subcontractors, for instance. Transactions between these different units could take place in markets, and price
movements would ensure that resources are allocated
efficiently. So, why do we need firms? Why do some transactions take place within firms and others between firms
or people in markets?
Coase’s answer was that there may be certain limitations
to relying entirely on the market’s invisible hand. Such con-

I

28

R e g i o n F o c u s • Wi n t e r 2 0 0 8

straints might make the price tag of obtaining a commodity
or service higher than its actual cost. For instance, there can
be significant costs to searching and bargaining with each
supplier. But certain costs may be avoided if the supply
of inputs, especially services, can be guaranteed over a
longer period. By bringing various activities under one roof,
a firm may be able to substantially reduce these transactions
costs. Thus, the size of the firm partly depends on how large
these costs are.
The theory of mechanism design — which has received
much attention since three of its pioneers (Leonid Hurwicz,
Eric Maskin, and Roger Myerson) won last year’s Nobel
Prize in economics — provides a framework for thinking
more generally about how such frictions affect the way a

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market, a firm, or any other mechanism
works in allocating the economy’s
resources. A market is a particular type
of mechanism, where the amount of a
commodity traded and its price are
determined by a large number of buyers
and sellers without any intervention.
Unfettered markets often perform best,
because the price signal that comes out
of these interactions ensures that no
resources are wasted.
However, when one party in a
transaction has more information
than the other, the invisible hand
may not work as well as it should.
Problems associated with such information frictions are particularly acute
in the market for providers and
users of funds, and this is one of the
many fields where applications of
mechanism design theory have made
significant contributions.
Say an investor decides to provide
funds to an entrepreneur, and he in
turn promises to pay the investor
some portion of a project’s output.
The tricky part is that the investor
may not always be able to observe
what the entrepreneur is doing, nor
can he be sure that the entrepreneur
will be truthful in reporting the project’s earnings. As such, a substantial
amount of effort will have to be spent
in trying to overcome this information
asymmetry.
But there could be a better way.
Mechanism design gives us the tools to
design the rules of the game in such
a way that it minimizes the costs
of limited information, while recognizing that people are always looking
out for their own self-interest, a basic
constraint of any type of mechanism.
This could lead to the emergence
of particular contracts and institutions
such as financial intermediaries. In the
end, the result may not have been
guided by the invisible hand, but given
the information constraints we face
everyday, it is certainly an outcome
that makes everyone better off.

Debt as the Optimal Contract
Financial markets offer a rich and
complex array of instruments to
finance business activities. Broadly

Page 29

speaking, however, one can divide
the means to provide funds into two
categories: debt, which is an amount
of money owed in the form of bank
loans or bonds; and equity, which are
ownership rights to a firm in the form
of shares.
Economists Franco Modigliani and
Merton Miller, both Nobel Prize winners, are well-known for showing that
the market value of a firm is unaffected by the way a company chooses to
fund its operations. “The cream plus
the skim milk would bring the same
price as the whole milk,” explained
Miller in Financial Innovations and
Market Volatility, a book that was published in 1991. For instance, a company
may prefer to issue more debt if the
cost of borrowing through issuing
bonds is lower than the required
return on issuing stocks. However, as
the amount of leverage increases, the
return on equity demanded by
investors will go up as well, because
the company is now perceived to be a
riskier bet. Thus, the overall cost of
capital of the new debt and equity mix
turns out to be the same. A company’s
choice of a capital structure should be
irrelevant.
But while the logic of Miller and
Modigliani’s proposition is certainly
true, there is something about the real
world that weakens this insight.
Companies and financial markets do
seem to care about a company’s mix of
debt and equity. The choice of financing matters.
This has prompted some economists to think about how entering
one type of contract could affect a
borrower’s behavior, particularly when
he has more information about his
project than the person financing it.
The theory of mechanism design is
helpful in answering this question.
In certain situations, the optimal
contract design will look like a debt
contract, according to economist
Robert Townsend of the University of
Chicago. To understand his 1979 analysis, one can think of an entrepreneur
who has an idea for a project but
doesn’t have enough funds to start the
business. The entrepreneur predicts

that the endeavor will generate a certain stream of income. In order to
finance this project, he can offer
investors a contract that pays a portion of its earnings. The difficult part
is that investors will not be able to
observe how well the business is doing
as accurately as the entrepreneur
can. Thus, investors will naturally want
to verify the entrepreneur’s output
because they will be reluctant to
finance the project otherwise.
But auditing entails an extra
expense, and if the investor incurs this
cost then he will likely demand a
higher return on his investment. So,
while the entrepreneur may be able to
secure the funds he needs, the cost of
undertaking the project will become
more expensive than if there were
some other way for investors to avoid
what Townsend calls “costly state verification.” One way to do this is to
design a contract that helps the
investor avoid auditing the project to
the fullest extent possible but will still
be willing to finance the project.
What would such a contract look
like? Townsend finds that it resembles
what we commonly know as debt. In
return for providing funds, an entrepreneur agrees to pay the investor a
fixed amount of money, which
includes some return on his investment. Because he’s receiving a flat
sum, the investor does not need to
verify the entrepreneur’s output under
all circumstances, as he would have
if his pay depended on a share of the
entrepreneur’s earnings. However,
if the entrepreneur cannot meet
this payment — that is, if
the project becomes insolvent—then the investor
will go in, audit the
project, and take
whatever is left.
In this mechanism, it is always
in the entrepreneur’s best interest
to tell the truth about
what he’s earned because
he knows that if he pretends to have a
lower output, the investor will be
forced to audit him. Townsend

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suggests this contract is optimal because the investor
doesn’t need to evaluate the
entrepreneur all the time,
nor does he have to worry too much
about getting less than he bargained
for. The entrepreneur is actually much
happier too. Because the investor
saves on the costs of verification, the
entrepreneur can obtain funds for his
project at a lower price.

When Equity is Better than Debt
An entrepreneur may have two reasons why he would want to raise funds
from an outsider. First, he may not
have enough money to fund the
project himself. Second, he probably
doesn’t like uncertainty (most people
don’t) and would prefer to share the
risk of running the business. If all
parties had equal information — that
is, if an outsider could see perfectly at
all times what the entrepreneur is
doing — then the best thing that the
entrepreneur can do is offload all of
the risk of the project. He could sell all
the ownership shares of the business
to as many people as possible, eliminate his risk entirely, and simply
receive a fixed salary. Investors would
happily buy these shares because they
could perfectly observe the project’s
results.
The problem again is that, in the
real world, the entrepreneur will typically have better information than his
investors. This prevents the entrepreneur from shedding all of the risk of
the project, because investors know
that he will have an incentive to lie
about his results. Thus, in order to
encourage investors to finance his
project, an entrepreneur will have to
assume some of the risk by owning
part of the business. How much risksharing would be stipulated in the
contract depends on how strong
the entrepreneur’s incentives are to
fudge the books, according to a 1989
analysis by a pair of economists at the
Richmond Fed, President Jeff Lacker
and John Weinberg. “That split
between inside and outside ownership
is determined by the cost of manipulating information,” Weinberg says.

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Manipulating information, or “falsification,” can exist in a number of
forms. In sharecropping, a landowner
lets a tenant farm his land in exchange
for a share of the crops, giving the
tenant an opportunity to hide some
of the crop before the landowner
comes to collect his share. In medieval
Venice, risky long-distance trade
voyages were financed by investors
on land, allowing the traveling merchant to unload valuable goods at
another location. The opportunity to
falsify results is present in modern
contractual settings as well, such as
when a manager might be tempted to
cook the company accounts.
But falsification comes at a cost.
“Falsifying records that are made
available to the public, if nothing else,
results in the cost of keeping two
sets of records,” wrote Lacker and
Weinberg. Even the sheer effort of
planning the logistics of hiding stolen
goods can be costly, as it might be for
someone who has to remain discrete
after diverting company funds. In a
world where falsification is tempting
but costly, investors would only be
willing to finance the entrepreneur’s
project if the risk of the project can
be shared between them. Thus, the
optimal contract is an equity contract.
The cheaper it is to cheat, the
larger the share of the risk that the
entrepreneur will need to hold. So,
ownership shares in an equity contract
would be based on how costly it is to
falsify results. A larger share held by
the entrepreneur will discourage him
from diverting a chunk of the project’s
output because his total income
depends not only on his “unofficial”
spoils but also on his “official” share of
the output. While he may be more
tempted to cheat when falsification is
easy, he would have to weigh this decision against the larger loss of income
from reporting a low official output.
So what is the best contract
between borrowers and lenders: debt
or equity? In Townsend’s model, debt
is the optimal contract because the
output cannot be publicly observed, so
the investors have to take a costly
action to verify the entrepreneur’s

results. In Lacker and Weinberg’s
analysis, the output is publicly
observed but can be altered by the
entrepreneur. It is the entrepreneur
who takes the costly action to falsify
results, such that the investors require
entrepreneurs to share some of the
risk of the project. “You might speculate that if the information structure is
yet more complicated where there are
aspects of both costly verification and
costly falsification, you might have a
combination of debt and equity,”
Weinberg explains.
That might illustrate the real world
more accurately. Companies do seem
to hold a mix of both types of contracts. But the question of how to
divide up the company’s cash flows
between its lenders and shareholders
is only one aspect of the company’s
choice of a capital structure. Another
important consideration has to do
with more complicated concerns of
what the chosen mix of debt and
equity implies for the right to govern
or make decisions in an organization.
Indeed, the distinction between debt
and equity encompasses all these
issues and continues to be a topic
of active research interest among
financial economists.

The Rise of the Intermediary
Borrowers and lenders can turn to
a financial intermediary, such as a
bank, whenever they have a hard time
finding each other. A lender puts
money in a bank, which will use these
funds to finance an entrepreneur’s
project. Without an intermediary, the
lender would need to figure out
whether a borrower is creditworthy. If
many lenders are involved,
perhaps to spread the risk
of financing a big project,
then each lender would
have to perform the
same task of monitoring the entrepreneur.
This is clearly a wasteful duplication of effort.
Thus, an intermediary
that makes it its business to know
what the entrepreneur is doing may be
the best arrangement for everybody.

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Intermediaries have the law of large
numbers on their side, according to a
1984 analysis by economist Douglas
Diamond of the Graduate School of
Business at the University of Chicago,
and visiting scholar at the Richmond
Fed. Not all borrowers are alike.
Lending to a large number of borrowers drives down the uncertainty of the
investment return. Thus, the presence
of intermediaries not only minimizes
the cost of monitoring but it also
reduces the costs of signaling to the
lender that it can be trusted. If the
lender has to make a decision
between entrusting his
funds to an entrepreneur
or through an intermediary, he will choose the
intermediary because diversification assures him of
getting his money back.
But intermediaries also
play an important role in addressing
the problem of adverse selection —
what happens when borrowers with
low-grade projects are inadvertently
chosen over those with high-quality
projects because a project’s true
quality may be known only to the
entrepreneur. Intermediaries guide
the allocation of resources by making
sure that good projects get funding
first. Intermediaries can achieve this
by designing so-called “incentive compatible” contracts, according to a 1986
paper by economist John Boyd of the
University of Minnesota and Nobel
Prize winner Edward C. Prescott of
Arizona State University and the
Minneapolis Fed.

Page 31

Incentive compatible contracts are
at the heart of mechanism design
theory. Entrepreneurs can be offered
contracts based on the project’s
quality and realized returns. The contract for good projects is designed so
that entrepreneurs with bad projects
have no incentive to pretend they have
good projects. Faking it would be more
costly to this entrepreneur. He may be
better off simply investing his money
in someone else’s project through an
intermediary.
With the intermediary at the
center of the transaction offering the
right menu of contracts, the result
is an effective separation of good
and bad projects. This outcome is
efficient in that the economy’s
resources are put to the best use
possible. The intermediary does not
have to waste time and money checking on those who are pretending to
have projects that are better than they
really are.
Another paper by Lacker and
Weinberg published in 1993 likewise
finds that an intermediary is essential
to an arrangement that allows funds
to be distributed to potential users
in the best possible way. Similar
to Boyd and Prescott, they conclude
that the optimal result would be
hard to achieve in a bond market
where borrowers issue bonds directly
to lenders. While an intermediary
can offer a menu of loan contracts
at different prices, which is a key element in separating project types,
competition in bond markets would
force those prices to converge. This

would lead to a less desirable outcome
since the bad projects would crowd
out the good ones. “A [bond market]
would lead to setting that threshold
too low so people with less productive
projects actually get funding,” explains
Weinberg. “An intermediary can
actually set the threshold higher
and screen off those less productive
projects.”
All of these contributions have
increased economists’ understanding
of how market outcomes can be
improved whenever the lack of information prevents markets from
achieving the most desirable
result. A market mechanism can
find the equilibrium where supply
equals demand. However,
as in bond markets, the
market outcome doesn’t
differentiate between
good and bad types.
And being able to distinguish between types is important
for efficiency, which is the
ultimate objective of a well-functioning economic mechanism.
But economists are still hard
at work trying to figure out all
the consequences of information
frictions. “Even to the extent of
knowing what we mean by equilibrium in a setting with adverse
selection is a harder question to
answer than it is in the simpler case of
symmetric
information,”
says
Weinberg. Fortunately, the theory
mechanism design has enriched the
way economists think about these
problems.
RF

READINGS
Boyd, John H., and Edward C. Prescott. “Financial Intermediary
Coalitions.” Journal of Economic Theory, April 1986, vol. 38, no. 2,
pp. 211-232.
Coase, Ronald H. “The Nature of the Firm.” Economica,
New Series, November 1937, vol. 4, no. 16. pp. 386-405.
Diamond, Douglas W. “Financial Intermediation and Delegated
Monitoring.” The Review of Economic Studies, July 1984, vol. 51,
vol. 3, no. 2, pp. 393-414.

____. “Optimal Contracts under Costly State Falsification,”
Journal of Political Economy, December 1989, vol. 97, pp.1345-1363.
Miller, Merton H. Financial Innovations and Market Volatility.
Cambridge, Massachusetts: Blackwell Publishers, 1991.
Townsend, Robert M. “Optimal Contracts and Competitive
Markets with Costly State Verification.” Journal of Economic Theory,
October 1979, vol. 21, no. 2, pp. 265-293.

Lacker, Jeffrey M., and John A. Weinberg. “A Coalition Proof
Equilibrium for a Private Information Credit Economy.”
Economic Theory, June 1993, vol. 3, no. 2, pp. 279-296.

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INTERVIEW
Christopher Ruhm

Christopher Ruhm readily admits that when he
was a graduate student under future Nobel laureate
George Akerlof, at the University of CaliforniaBerkeley, his research centered on the conventional
fare of labor economics. But once he started dabbling
in health economics, he realized that studying
how people enjoy time away from work can
actually shed light on a variety of issues.
Today, Ruhm is known for his research on what
might broadly be called “work/life balance.”
Encompassing both labor and health economics,
his work has explored provocative questions,
like whether economic growth really makes
us healthier. Other elements of his research
look at the implications of family leave policies for
both parents and children. Much of his recent work
has involved tracking the academic, health,
and behavioral benefits of attending preschool.
Dr. Ruhm is currently the Jefferson-Pilot Excellence
Professor of Economics at the University of
North Carolina at Greensboro. His research
has appeared in many of the major economic journals
such as the American Economic Review, the Quarterly
Journal of Economics, and the Journal of Economic
Perspectives. The work for which he is best known has
graced the pages of the Journal of Health Economics
and the Economics of Education Review. He has also
appeared in journals that are far from the stomping
grounds of many economists, like the International
Journal of Epidemiology. In addition, he has taught
economics at Boston University and served as a
senior staff economist on the President’s Council
of Economic Advisers from 1996 to 1997.
Region Focus senior editor Stephen Slivinski
interviewed Ruhm at his Greensboro office
on Feb. 7, 2008.

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R e g i o n F o c u s • Wi n t e r 2 0 0 8

RF: How does attending preschool influence the early
educational outcomes of children?
Ruhm: My work on the effects of preschool, almost all of it
co-authored with Jane Waldfogel [of Columbia University]
and Katherine Magnuson [of the University of WisconsinMadison], looks specifically at the effects on children of
attending preschool or types of center-based day care
programs a year prior to entering kindergarten.
There are a couple of results that are pretty clear. The
first is that — after controlling for lots of factors — there
seem to be benefits to attending preschool if you look at
academic performance, particularly in kindergarten.
They’re not huge, but there are certainly significant benefits
on cognitive test scores for children who attended
preschool. But if you then look at what happens after
kindergarten, there it gets a little bit more complicated. You
see a portion of that initial advantage fade by first grade. So,
there’s a benefit but part of it is short-lasting.
A second consideration is how advantaged the child is, in
terms of family income or their parents’ education, when
they start school. It seems that preschool gives a bigger
boost to poorer or otherwise less advantaged kids.

PHOTOGRAPHY: CHRIS ENGLISH/UNIVERSITY OF NORTH CAROLINA AT GREENSBORO

Editor’s Note: This is an abbreviated version of RF’s
conversation with Christopher Ruhm. For the full interview,
go to our Web site: www.richmondfed.org/publications

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Christopher Ruhm
mandate. But even with all that, the
entitlements to parental leave are
Jefferson-Pilot Excellence Professor in
quite weak in the United States
Economics, University of North
relative to other countries. So, what
Carolina at Greensboro
I did was go to European data
® Previous Faculty Appointments
because those countries had a
Assistant Professor of Economics,
long tradition with parental leave
Boston University (1984-1991)
mandates.
Ruhm: To start, it’s worth consider® Government Experience
At the time, there was no timeing what economics can’t teach us
Senior Staff Economist, Council of
series data that integrated what
about that. I don’t think that ecoEconomic Advisers (1996-1997)
types of policies were in place in difnomic analysis can tell us how we
® Education
ferent countries. So, with the help
balance work and family in the broadB.A., University of California-Davis
of Jackqueline Teague, a graduate
est sense. That said, economic factors
(1978); Ph.D., University of Californiastudent working with me, I started
certainly influence it very strongly.
Berkeley (1984)
to construct this sort of dataset.
One thing that seems true to me is if
® Selected Publications
Then I looked at the effects of
you were to compare most European
labor market outcomes for women.
“Health Outcomes: Economic
countries to the United States, you
Determinants” in The New Palgrave
Men were the control group in this
discover there are just different attiDictionary of Economics; “Are Recessions
research, because at the time men
tudes and ways of thinking about a lot
Good For Your Health?” in the Quarterly
almost never took parental leave.
of these issues. For example, if you
Journal of Economics; “The Economic
What I found was that in the
look at survey data, Americans who
Consequences of Parental Leave
presence of parental leave requireare employed are more likely to say
Mandates: Lessons from Europe” in the
ments, women were more likely to
they want to work more hours than to
Quarterly Journal of Economics
be employed. There are a lot of
say they want to work fewer hours,
® Offices
reasons why you would expect that
even though we have much less vacaBoard of Trustees, Southern Economic
to be true. The most obvious one is
tion time than Europeans. I think
Association; Associate Editor, Southern
the notion of job protection. If you
there’s a very large cultural compoEconomic Journal; Research Associate,
don’t have to quit your job to take
nent that is mostly outside the scope
National Bureau of Economic Research
leave, careers outside of the home
of economic analysis.
become more attractive to women.
What economics can say more
It’s not entirely obvious, however, that it had to work that
about is how people are going to respond if you have a
way. You can imagine the opposite outcome. Employers
certain environment and you change the incentives. For
might have been encouraged to discriminate against women
instance, we can analyze how people will respond to a new
because women are more likely to actually take the leave, for
law mandating a worker’s right to a certain amount of
instance. But there was pretty strong evidence that you
family leave. Or if we were to see a change in the availability
did find increased employment-to-population ratios
or cost of high-quality child care, we know, at least in theory,
for mothers — a larger percentage of mothers became
the direction of the change in behavior and we’ll probably
employed. Yet, I also found that if the leaves got sufficiently
get it right. Then we can look at the data and quantify how
long, there was some possible negative effect on wages. In
big those responses are.
some European countries, you’re talking about leave lengths
that can equal a few years.
RF: Tell us about your research into what sorts of
economic effects you find abroad in relation to mandated
RF: What sorts of child health measures correlate with
parental leave policies.
parental leave policies?
Ruhm: My work on parental leave policies has led to a lot of
my other work on health topics. How I got into it was a
Ruhm: When I use the term parental leave, I’m using it to
fluke. I was doing work on advance-notice provisions — the
broadly encompass all kinds of provisions, including matermandate [passed in 1988] that requires firms to tell their
nity leave — the initial period only available to mothers —
workers in advance if management is planning a mass layoff.
and broader forms of family leave, which in principle could
That issue got me interested in mandated benefits more
be available to either parent.
generally, and what happens when the government tells a
I used the same dataset and I looked at health outcomes
firm it has to do something.
for children, mainly infant mortality rates — deaths in the
When I got interested in the role of parental leave manfirst year. I also looked at neonatal fatalities, which is death
dates, there weren’t many in the United States. There were
of the baby in the first 30 days, versus post-neonatal
some states that had mandates and, of course, later the
fatalities, which is death in the rest of the first year. Then I
Family and Medical Leave Act was passed as a federal
extended the analysis out to age 5.
RF: Economists can usually tell us
a great deal about how and why we
work. But what can economic
analysis also tell us about how we
balance work and other aspects of
our lives?

® Present Position

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Page 34

It’s worth noting that if
The results were quite strikyou look at other nations,
ing and consistent with what I
When the economy weakens,
particularly European countries,
would have expected. In the
that is almost never the way it’s
first 30 days, you didn’t see
people smoke less, they are less
arranged. In virtually all Euromuch of a reduction in infant
likely to drink heavily, and
pean countries, the cost is borne
mortality, most likely because
by the government. Now, it may
neonatal deaths are unrelated
they tend to exercise more.
be paid for through some kind of
to how much leave the parents
payroll tax that supports social
are taking after the birth. It has
welfare programs of all kinds, not just paid parental leave
more to do with what type of hospital care you’re getting
benefits. But the cost of offering the paid leave is not director whether the baby is born with a congenital defect of
ly imposed on employers. You can think of it as sort of an
some kind. But in the post-neonatal period and after
insurance policy and the cost is being spread widely. Now
that, you see reductions in infant mortality correlated with
that doesn’t mean a system like that is costless to employers.
parental leave mandates.
For instance, it may cause some degree of disruption to
your business.
RF: If you assume employees would prefer to work at a
Of course, there are legitimate arguments to be made for
company that offers paid family leave benefits, you
the U.S. system. Americans tend to prefer smaller governmight also think that the labor market would be comment, and more comprehensive social insurance implies a
petitive enough to incentivize employers to offer those
bigger role for government. But I think it is fair to say that if
benefits. What barriers exist to the voluntary adoption
you wanted to create a system that would generate the most
of family leave options by private firms?
employer opposition, the mandate system is it. It also results
in the weakest level of benefits. I’ll note it’s not so different
Ruhm: That’s a really important issue. The basic question is:
than health insurance these days. The United States is the
When should we or should we not have mandates on
only country I know of where the primary burden of health
employers? The standard argument is that, if I as a worker
insurance is placed on employers. If we’re interested in
value parental leave benefits, employers are free to offer
greater social insurance, to help families, to balance these
that. Presumably, it’s also somewhat costly. So if my employcompeting needs without imposing excessive costs on
er provides leave, it might reduce my wages somewhat. But
employers, the current U.S. model is a pretty expensive way
if the value of the benefit to me of leave is higher than the
to provide it.
corresponding wage reduction, I’ll take the job and private
labor markets will give the desired outcome. Some people
RF: One of your articles is provocatively titled, “Are
believe that is true. There are a couple of issues with that,
Recessions Good for Your Health?” Discuss the relathough. One is that, administratively, it may not be possible
to reduce a worker’s wage if there’s institutional rigidity of
tionships you’ve discovered between economic growth
any kind — union contracts or internal personnel arrangeand health.
ments — and so wages may not be sufficiently flexible.
A second issue is asymmetric information. Let’s say an
Ruhm: Many years ago I did quite a lot of work examining
employer wants to offer a generous leave benefit package
the consequences of job turnover and labor displacement.
while his competitor does not. The problem is that the
One of the things you would read a lot about at the time was
employer doesn’t know whether a specific worker will take
that when the economy stagnates, lots of bad things would
advantage of the benefit. The employee himself does know
happen. Wages don’t go up and housing values fall. Then
(or at least has better information on the likelihood of this
you’d also see other things reported such as how more
than the employer), so you will have the individuals who are
marriages break up, crime increases, and health deteriorates.
more likely to use the benefit flocking to the employers who
That seemed plausible, so I read a bunch of studies that had
offer it. That bids up the cost of doing business quite
been done and realized they weren’t using state-of-the-art
dramatically, and the employer will eventually stop
methods. They were written by epidemiologists and social
offering the benefit because it places them at a competitive
psychologists but did seem to include plausible mechanisms:
disadvantage.
When the economy goes bad, for instance, people get
The other really important point when considering
stressed out and stress is bad for your health. In addition,
parental leave policies is that we often tend to think about
stress leads to people drinking more and smoking more and
putting mandates on employers. Of course, we have one
they engage in all this risky behavior as a consequence. I
with the Family and Medical Leave Act, which requires
doubted the specific estimates, but not the overall direction
many employers to provide a period of unpaid leave. And
of the effect. I wanted to come up with a better way to conwhen people talk about instituting paid family leave, it’s
firm the results and ended up finding something different.
almost always discussed in the context of the employers
In these early studies by others, there was a tendency to
bearing the full cost of providing it.
look at long time-series of aggregate data. They’d look at the

34

R e g i o n F o c u s • Wi n t e r 2 0 0 8

United States or Britain from the 1930s to the 1970s and
look to see, when the economy got better, whether the
health measures — hospital admissions or mortality rates —
were improving or deteriorating. The studies tended to find
that when the economy improved, health seemed to get
better. But lots of things were going on at once during that
period. For example, at roughly the same time the Great
Depression ended, there were improvements in nutrition
and in the availability of antibiotics.
So I looked at each state in the United States as a laboratory. I studied changes within states relative to what was
going on in other states. The advantage to this method is
that if there is a change in, say, medical technology,
it is likely to affect workers in all states. But the Virginia
economy might be improving at the same time the Texas
economy is worsening. You can use the fact that there was
independent variation in macroeconomic conditions across
states to estimate the effects on health.
My first analysis of mortality rates was not at all what I
expected. When times were good, mortality rates were
increasing and when times were bad they were decreasing.
When I first got the results, I didn’t particularly believe
them. I expanded the analysis in a variety of ways to see if
the results would change, but they didn’t.
What ultimately convinced me of the result is one of
those things that I always tell my students to do first. I made
a picture that overlaid the national mortality rates and
unemployment rates — after de-trending them and normalizing them so the scales matched — and when I did all that,
I found they were almost a mirror image. It was at that point
I really believed my results.
This says something about how economists actually
conduct research versus how we say we do. I tell my students
what we should do is look hard at our data before we do any
fancy statistical or econometric analysis. But it’s not
unusual to do some of that other work and get results you
don’t understand until you look really hard at the data.
The reasons for mortality increasing when the economy
strengthens vary by cause of death. If you look at motor
vehicle fatalities, they go up pretty dramatically when the
economy improves. That’s not so surprising. People drive
more when times are good. But it’s also true that deaths
from heart disease or flu and pneumonia go up when the
economy improves and down when the economy deteriorates. Across a wide variety of health measures I was finding
the same result.
There were a couple of exceptions. Cancer was unrelated
to economic trends. Since we were looking at relatively shortterm changes, it’s no surprise that we would see this result.
Whereas, for something like heart attacks, we do notice that
short-term macroeconomic changes can have a big effect.
Another exception was suicides. They went down when
the economy improved, and up when it deteriorated. That’s
consistent with a long line of work on suicides. That also
suggests to me, since suicide has a mental health component, it might be the case that economic patterns I had

identified mainly refer to physical health measures. That led
me to conclude that when the economy tanks, people are
healthier but they may not necessarily be happier.
RF: What sorts of mechanisms do you think drive
the health trends you studied?
Ruhm: In my research, I also look at behaviors, like drinking, smoking, and exercise. All of these trends exhibit a
consistent pattern. When the economy weakens, people
smoke less, they are less likely to drink heavily, and they tend
to exercise more.
If you look at drinking, you notice that heavy drinkers
become light drinkers when the economy deteriorates. Yet
light drinkers don’t abstain from drinking. For smoking, you
see the same result. People also shift from being sedentary
to being somewhat active, but not very active. We also don’t
see a big change in the number of people who are overweight, but we do see a reduction in severe obesity.
RF: How does your work fit in with the classical model
of economic man in which people are assumed to be
rational? Is it rational to engage in behavior that
jeopardizes your health when the economy is booming?
Ruhm: What I’m finding is that, on average, when there is
a short-term weakening of the economy — not a permanent
one — people get a little bit healthier. I think these results
are mostly consistent with the classic economic model.
Let’s say I offer you, for the next year, a tripling of your
hourly wage. It would just be for one year, and you can work as
many hours as you want. Most people are going to rationally
say they are going to work a lot while they can get the high
wages. But while they are working really hard, they may be
doing some other things that aren’t great for their health.
They won’t have time to exercise, or they’re going out and eating really fatty meals. That’s at least a partly rational response.
If, however, I say I’m going to triple your wage forever,
then you’re not going to respond in the same way. Maybe
you’re going to work a little bit more and maybe you won’t.
But you’re certainly not going to pack all that work into one
year. And to the extent that you do work more hours, you’re
probably going to make more time for your family and to
tend to your health. Maybe you’ll join the health club down
the street. Maybe you’ll learn how to eat better. I think the
crucial distinction is between the short-run and the long-run
incentives.
Also, while these results represent a predictable response
to changes in economic incentives, that does not mean
people don’t make mistakes. For instance, many individuals may not fully account for the negative health
effects of the extra work they undertake when receiving a
temporary wage increase, or when economic conditions
temporarily improve. So the responses reflect the efforts
by individuals to optimize but they may ultimately not be
fully rational.
RF

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ECONOMICHISTORY
Rice to Riches
BY B E T T Y J OYC E N A S H

Rice cultivation relied on coerced labor.
Slaves built massive banks, and then flooded
those fields so the rice seed could germinate.
Later, they drained the fields and hoed the
weeds from the young rice plants.

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R e g i o n F o c u s • Wi n t e r 2 0 0 8

“The Meadows are very proper for Rice,
Rape-seed, Lin-seed, etc., and may many
of them be made to overflow at pleasure
with a small charge.”
— a 1666 pamphlet advertising
Carolina, a territory granted by
Charles II in 1663 to his Lords
Proprietors
ampbell Coxe grows a pretty
serious rice crop, one of a
precious few located east of
the Mississippi. He cultivates Carolina Gold, a nutty-tasting heirloom
rice, on 200 acres along the Great Pee
Dee River in South Carolina.
Between the late 17th and late 19th
centuries, this crop gilded lowcountry
South Carolina’s fortunes, as the
colony led North American rice
production. In fact, rice couldn’t be
ferried to northern European markets
fast enough. Plentiful slave know-how
and labor, tide-flooded fields, and
savvy trade lobbying abroad created
South Carolina’s comparative advantage in rice production. Its prosperity
was unequaled in the New World.
“In no time in history has the state
been as wealthy financially, socially,
politically. In that era, South Carolina
ruled. It’s never happened before and
never happened
again,” notes Coxe,
who is an ardent
student of his pet
crop’s history.
But by the late
1800s, world trade
and transportation
(the Suez Canal
opened in 1869)
brought in cheaper
South Asian rice.
India, Java, and Burma usurped the
European market. South Carolina lost
its edge as the low-cost producer. This
cycle would repeat in the 20th century

C

for South Carolina — only this time,
the textile industry would go.
When the commercial rice industry
eroded, so did the backbone of the
economy.

First Crops
Where the first rice seed in South
Carolina originated remains an educated guess. However, the rice story
may begin with the earliest slaves, who
cultivated the cereal for their own use.
Early European and English
settlers from the West Indies, especially Barbados, sought land in
Carolina soon after the English
founded Charles Town in 1670, and
brought slaves with them. But the
settlers knew next to nothing about
rice, according to historian Judith
Carney, author of Black Rice. Many
West Africans from the rice-growing
regions of Senegal, Gambia, and Sierra
Leone were among slaves shipped to
South Carolina.
“The slaves that were brought to
South Carolina were brought for
one reason only,” Coxe says. “They
[planters] wanted them to already have
ideas about how to increase production;
they paid a premium for these people
who already knew how to grow rice.”
Early settlers planted rice first on
dry land, then swamplands, but by the
mid-1700s, planters were using the
lowcountry’s tidal rivers — the “great
rice rivers” — to naturally inundate
fields.
Elizabeth Allston Pringle took over
her father’s Cherokee plantation
shortly before the turn of the 20th
century. Her diary survives to describe
firsthand her fields:
The rice-field banks are about three feet
above the level of the river at high water,
and each field has a very small flood-gate
(called a trunk), which opens and closes to
let the water in and out; but when a gale or
freshet comes, all the trunk doors have to be

PHOTOGRAPHY: LIBRARY OF CONGRESS, LC-USZ62-26232

South Carolina
nourished a
wealth-generating
rice industry
until Asian
competition and
mechanization
killed its
comparative
advantage

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raised so as not to strain the banks, and the
water in the fields rises to the level of the
river outside.
Fast-forward to the present: Glenn
Roberts develops concepts for historic
properties, and founded Anson Mills
(to grind heirloom grains) as well as the
Carolina Gold Rice Foundation. He
cultivates rice using the “trunk and
dyke” system today on 300 acres. He
grows for gourmets, including Alice
Waters. “Our tidal trunks and dykes
are indigenous,” Roberts says. Recent
archeological discoveries indicate that
some of the cultivation technologies,
including the cypress “trunks” that
controlled the flooding, and evidence
of planting techniques (with the heel
of the foot), may be West African
in origin.
Slaves did the backbreaking work
of rice cultivation. They hand-built the
massive banks that lined rice fields.
They planted, then flooded the fields
for germination, and later drained and
weeded by hand, duties that largescale planters couldn’t have managed
without them. Few but the coerced
would have been willing to stand up to
that workload.
Within two years of the colony’s
founding, more than one-quarter of
the population were slaves. By 1770,
the proportion of black slaves to the
white population had jumped to 78
percent. But on the eve of the Civil
War, in 1860, the percentage of black
slaves in this lowcountry plantation
landscape had fallen to 65 percent.
The rice industry depended on
slave labor, with slaves working under
an incentive “task” system: Once a
slave completed an assigned job, he or
she could pursue personal activities.
This may have increased productivity.
The lowcountry’s wave of economic
productivity grew out of its institutions, including slavery.

Creating an Industry
By the early 1700s the planters had
gathered enough local knowledge and
the necessary capital to “transform the
land into a platform that would allow
them to basically have the best market
opportunity,” says Peter Coclanis. He

Page 37

wrote The Shadow of a Dream, a book
about the economic life of the South
Carolina lowcountry from 1670 to
1920. “Lots of African crops came over
and not all became as important as
rice. They [planters] created marketing channels and established links,
created a real industry out of a crop.”
South Carolina settlers had earned
money through trade, particularly
with the Caribbean islands, Barbados
specifically. South Carolinians traded
salted pork, grain, and other crops (as
well as Indian slaves) for rum, sugar,
and molasses from the Caribbean.
Early settlers also engaged in
extractive industries like lumber and
naval stores (tar and pitch). Indigo
supplemented rice for some 40 years
during the rice heyday, but precious
few farmers planted indigo and
processing machinery was scarce.
“Rice was the king of the kingdom,” Coclanis says. And the rice
industry came about as a conscious
market choice among the European
and British capitalists who settled the
colony. Growers exported rice as early
as the 1690s, and the real rice economy
picked up steam after the 1720s.
Institutions also leveraged rice
production, directly and indirectly.
The Crown took over the colony in
1730, and subsequently passed the
Land Act of 1731, which registered land
and secured titles. Coclanis points out
that it was only after 1731 that reliable
mortgage capital markets emerged,
benefiting planters.
Fiscal policies, too, boosted the rice
economy. Government-issued currency aided production in stressful times.
So did low taxes and spending on overhead such as law and order. Those
elements “seem in retrospect almost
ideally suited to foster growth and productivity in an export-oriented,
slave-labor staple colony,” Coclanis
writes.
By November 1747 through
November 1748, more than half — 55
percent — of South Carolina’s export
value lay in rice. Just before the
Revolution, the colony was exporting
more than 66 million pounds. In 1774,
the Charleston district’s total wealth

per capita (free, not slave) was nearly
180 pounds sterling, compared with 38
pounds in New England and 44
pounds in the Mid-Atlantic colonies,
according to Alice Hanson Jones in
Wealth of a Nation to Be.
The best markets lay in northern
Europe, and as long as transportation
was affordable, South Carolina rice
dominated: It was the most efficient
producer in the West, and rice built
the lowcountry plantations, many of
which exist today.

Mechanization and Competition
But even before the Civil War cut off
rice’s slave labor, rice had slid into
decline. Transportation improvements
opened European trade routes with
Asia, pushing South Carolina farther
from its best rice markets. South
Carolina exported 77 percent of its
rice crop to northern Europe from
1730 to 1739, but only 49 percent by
1850 to 1859.
The rice dynasty had begun to
erode well before many of the planters
noticed. An array of forces led to its
demise, and those intensified with the
Civil War and the decline of slavery.
Steam shipping cut cost and time,
and the Suez Canal brought Europe
closer to Asia. In addition to the
resulting global competition, changes
wrought by the Industrial Revolution
contributed to the shift in rice production to Western states. The internal
combustion engine that had revolutionized agriculture paved the way for
machinery that simply was useless
in the pluff mud fields of South
Carolina’s lowcountry. And the state’s
upcountry farms didn’t have the rivers
that could provide power to pump the
water necessary to grow rice.
While some of the more farsighted
planters had worried about Asia early
on, Coclanis says, it surprised many.
“It’s kind of like an early example
of globalization and how it affects
areas differently,” Coclanis says.
After the Civil War, the American
rice industry moved westward to
Louisiana, Texas, Arkansas, and, later,
to California. There, rather than
compete with cheap Asian labor,

Wi n t e r 2 0 0 8 • R e g i o n F o c u s

37

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Rice Production in the United States 1839–1919

TOTAL PERCENT OF U.S. PRODUCTION

probably sweep up more than
we grow here.”
70
Still, he aims to make his
60
rice pay. He used to send
50
his crop out to Arkansas for
40
milling, but has since built his
30
own mill, even though “every20
body thought we were crazy.”
10
And he’s trying to convince
Economic Development
0
Louisiana
Texas Arkansas California
South
Georgia North
other farmers that there’s a
Redux
Carolina
Carolina
growing gourmet market out
The cycle of boom and bust
1839
1859 1879
1899
1919
SOURCE: Peter Coclanis, “Economy and Society in the Early Modern South”
there for specialty rice. He
is older than the rice dream.
gloats a little bit when cusIt goes to show what a tricky
of their economies. He sees parallels
tomers in Korea and Japan order his
proposition economic development
between the fallen South Carolina rice
rice, which, by the way, they can on the
can be, Coclanis says. Early settlers
complex and the plight of those counInternet at $8.47 for two pounds. And
made choices about what they could
tries. Problems in Burma, which also
he feels pretty good about preserving
grow that would bring prosperity.
became overdependent on exports,
the heirloom Carolina Gold rice for
“They were right in their assessment,
serve as an example. “The whole area
future generations, he and the half
given the limitations of topography,
that became the rice exporting, producdozen or so others in the state who
that rice was the best bet,” he says.
tion area hardly settled till the British
grow it to collect the seed. Some peo“But they rolled the dice on rice and
came and … encouraged the Burmese
ple grow rice to attract waterfowl for
put their marbles on rice. And it did
to move from the upper to the lowhunters; some just like to revisit the
not factor into their minds that market
country area.”
history.
conditions could change.” In the end,
“We do think it’s historically benethere was no internal demand to pick
The Rice Niche
ficial — if nothing else to show people
up the slack when the export market
the great history behind the rice,”
collapsed.
While the old rice empire is gone for
Coxe says. “This one grain made South
Variations on this theme continue
good, specialty rice has gained ground.
Carolina the richest colony in the
today. Coclanis consults with Southeast
Campbell Coxe notes that in the
New World.
RF
Asian countries about the development
Western rice-growing states, “they
growers adopted machinery
and technology. Arkansas,
for example, today has a high
technology rice industry.
(The United States typically
ranks among the top three
rice exporters.)

80

READINGS
Carney, Judith A. Black Rice: The African Origins of Rice Cultivation
in the Americas. Cambridge, Mass., and London: Harvard University
Press, 2001.

Coclanis, Peter A. The Shadow of a Dream: Economic Life and Death
ork, N.Y.:
in the South Carolina Low Country 1670-1920. New Y
Oxford University Press, 1989.

Chaplin, Joyce E. An Anxious Pursuit: Agricultural Innovation and
Modernity in the Lower South, 1730-1815. Chapel Hill, N.C., and
London: The University of North Carolina Press, 1993.

Morgan, Kenneth. “The Organization of the Colonial American
Rice Trade.” The William and Mary Quarterly, July 1995, vol. 52,
no. 3, pp. 433-452.

P O L I C Y U P D A T E • continued from page 8

instead of the more expensive auction
for funds. But the discount rate does
not place a hard ceiling on the auction
rate. In fact, in the first auction in
April, the stop-out rate exceeded the
discount rate.
Early results suggested the auction
program may have been effective. The
LIBOR-OIS spread, for example, has
narrowed. When the two rates are
closer together, credit and liquidity
pressures are usually lower. However,

38

R e g i o n F o c u s • Wi n t e r 2 0 0 8

this spread widened again in the first
quarter of this year.
The auctions have been conducted
on a biweekly basis through February,
all were oversubscribed as bidding
institutions asked for more funds overall than was offered. Though the
identities of both bidding and winning
banks are not made public, the total
amount of borrowed funds going
to each Federal Reserve district is
reported. As of Feb. 27, for example,

banks in the Fifth District had $813
million of the $60 billion total outstanding in the auction credit program.
The Term Auction Facility program was introduced as a temporary
effort. Fed officials have been largely
positive, saying it seems to have
injected liquidity into the market
when it was needed the most. The Fed
has said it would seek public comment
before deciding whether to make the
program permanent.
RF

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BOOKREVIEW
Self-Help Economics
DISCOVER YOUR INNER ECONOMIST:
USE INCENTIVES TO FALL IN LOVE,
SURVIVE YOUR NEXT MEETING,
AND MOTIVATE YOUR DENTIST
BY TYLER COWEN
NEW YORK, N.Y.: DUTTON, 2007, 234 PAGES
REVIEWED BY BETTY JOYCE NASH

S

elf-help books typically fill psychology or religion or
parenting shelves, but here’s one in an unexpected
aisle: economics. It promises that life improves as one
cultivates economic intuition, one’s “inner economist.”
Quite a claim. A quick look at Discover Your Inner
Economist’s chapter headings will clue in the reader to the
book’s ambitions: For instance, Chapter Two, “How to
Control the World, the Basics” and Chapter Three, “How to
Control the World, Knowing When to Stop.” That’s a relief.
The point of economics, author/economist/polymath
Tyler Cowen observes, is to make the world a better place.
And it can start with enhanced opportunities and, heck, just
more mindful shopping. People need only apply reliable economic tools to discern underlying patterns.
Cowen is professor of economics at George Mason
University, and much more. He writes restaurant reviews for
his online ethnic dining guide to the Washington, D.C., area,
and eclectic entries at MarginalRevolution.com, a widely
read economics blog he co-authors. Cowen also writes for
the popular press on a wide variety of subjects as well as
on scholarly topics for economics journals. One of his books
is about Mexican amate painters and their foray into the
global marketplace.
Cowen admits at the get-go: “Economists cannot solve
all of our problems, but contemplating the complexity of
human motivation will help us make better decisions.”
Human motivation largely relies on incentives, so Cowen
suggests that one start by instructing his inner economist
about a basic human need, a sense of control that underpins
responses to incentives. If you’ve ever tried (in vain as I
have) to motivate adolescents to do chores for money, then
this is the book for you. Why, oh why, might teenagers work
diligently for others, but drag their feet for parents?
The inner economist, according to Cowen, knows that
money isn’t always the best motivator. The trick lies in
calculating if, when, and how much money matters. To
explain, he describes his experience in trying to get his
daughter to clean dirty dishes. Using money to bribe, er,
entice, offspring to wash the dishes probably won’t work.
“The failure of the bribe reflects the complexity of
human motivation,” he explains. People are motivated by

many factors, including money, but also internal rewards
like satisfaction, or perhaps “wanting to do a good job for its
own sake.” In other words, internal motivation sometimes
rules and a monetary payment can backfire. According to
Cowen, explain to the offspring that the chore is expected
for the good of the family, and the daughter may feel the
need to cooperate and “meet expectations.” But payment
transforms the cooperation into a “market relationship.”
A useful insight. And if that doesn’t work, there’s always
praise. (It’s amusing, though, to imagine a teenager’s reaction when a parent praises him or her for a particularly
stunning talent in dishwashing or vacuuming.) Again, while
there may be a gender problem — boys perhaps being less
cooperative than girls — with this particular example, it’s
hard to argue with the logic of thinking carefully about
incentives based on peoples’ need for control. Cowen puts it
all together with some tips on when and when not to offer
money: Money works best when “performance at a task is
highly responsive to extra effort,” like selling cars or for
work that is tedious but requires attention to detail.
The book’s final chapter examines the economics of
giving, from Christmas gifts to United Way, to handing
money to beggars on the streets of third-world countries.
Look inward, Cowen advises. Are we giving to feel good
ourselves or to do the world good? For instance, he suggests
not buying in to the professional beggar, who works so hard
to maintain his job. Give, if you must, to a street person who
isn’t working for your money — that way you’re not encouraging those needy people who have not made a career out of
chasing others’ money. How about tipping? Wasteful
beyond 15 percent. “If customers pay waiters more,
employers will get away with paying them less. Waiters
won’t receive more money, but restaurant owners will, and
at the expense of diners. Is that the kind of altruism we had
in mind?”
Cowen riffs on some of his favorite topics throughout
the book. Some of those hold a tenuous connection to nourishment of the inner economist, but that’s OK because
they’re entertaining, such as his advice on how to get the
most from an art gallery or how to look good at home, on a
date, or even while being tortured. Alas, the inner economist’s toolbox may be useless in this last case, as the captive,
perhaps innocent and willing to sing, can’t signal this to his
captors — they won’t believe him.
Sending signals is a concept seemingly ignored later on in
his chapter advising people not to bother buying “fair trade”
coffee because it may hurt other coffee farmers. Isn’t that
what buying is all about? Market signals? If I don’t buy it,
then how will the market know I prefer it? My inner
economist may still be confused, but at least Cowen got
her thinking.
RF

Wi n t e r 2 0 0 8 • R e g i o n F o c u s

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DISTRICT ECONOMIC OVERVIEW
BY M AT T H E W M A RT I N

conomic activity in the Fifth
District grew at a somewhat
slower pace in the third quarter
as weakness in housing and retail
sales offset some firming in manufacturing and continued strength in
much of the service sector. Employment and income growth remained
robust, though signs of some strains
on household balance sheets emerged
due in part to the pullback in housing
market activity.

E

Healthy Labor Markets
Labor market conditions remained
generally solid in the third quarter,
though reports from the household
survey were a bit weaker. Payroll
employment in the Fifth District was
up 1.7 percent over the past year, considerably more than the 1.0 percent
increase the national economy experienced over the same time period.
Most services-producing industries
added jobs as did the construction
industry on the goods-producing side.
On the other hand, manufacturing
payrolls declined again, though the
rate of job loss in that sector slowed in
the third quarter. In addition, healthy
employment growth accompanied
solid income growth in the third
quarter. Fifth District incomes were
up 3.8 percent at an annualized rate —
a slight uptick from last quarter’s pace,

but a touch below the national mark of
4.3 percent.
Data from the household employment survey was somewhat less
positive, however. The Fifth District
unemployment rate inched up to 4.3
percent, thanks to a concurrent rise in
the number of unemployed persons

Economic activity in the
Fifth District grew at a
somewhat slower pace in
the third quarter.
and a decline in the size of the labor
force. Nonetheless, the Fifth District
third-quarter unemployment rate was
lower than the national rate by 0.4
percentage point.

Service Sector Steady
The Fifth District service sector
remained the primary source of economic growth in the third quarter.
Revenue growth at services firms
remained healthy, though survey contacts indicated that the pace of
expansion eased somewhat since our
last report. On the employment front,
the pace of hiring at services firms
slowed — a result that was evident in
spotty payroll employment growth in
some key sectors. Professional and

Economic Indicators
3nd Qtr. 2007
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.

40

2nd Qtr. 2007

Percent Change
(Year Ago)

13,909
137,758

13,872
137,500

1.7
1.0

946.9
9,952.4

938.6
9,854.0

3.8
4.3

42.8
340.1

53.9
404.4

-20.8
-22.3

4.3%
4.7%

4.2%
4.5%

R e g i o n F o c u s • Wi n t e r 2 0 0 8

business services employment contracted in Virginia and South Carolina,
for example, while financial activities
employment declined in Maryland and
West Virginia. By comparison, the
retail sector was hard hit in the third
quarter. Sales of big-ticket items were
especially weak, including a further
drop-off in furniture and automobile
sales. Retail hiring in the District also
tapered off, though wage growth was
steady.

Real Estate Weakens
Residential real estate activity weakened further in the third quarter,
characterized by lower levels of home
building and sales activity. Permit
issuance declined 20.8 percent compared to the previous year, with
double-digit declines reported in all
jurisdictions except the District of
Columbia. Additionally, existing home
sales fell in all jurisdictions, with the
steepest declines in the northernmost
parts of the Fifth District.
Declining sales activity coincided
with increased home inventories and a
further cooling of home price growth,
with a few regions experiencing outright price declines. For example,
the house price index fell 0.3 percent
in Maryland in the third quarter,
though prices in the state remained 2.6
percent higher than the same quarter
a year earlier. Nonetheless, house
prices inched higher elsewhere in
the District, with North Carolina
seeing the most rapid appreciation —
6.6 percent — over the past year.
On the commercial side, conditions were relatively brighter. Leasing
activity slowed somewhat in the
second half of the third quarter, but
office vacancy rates remained near
cyclical lows. Retail and industrial leasing activity also remained generally
healthy. Though financing for new
projects still appeared to be available,
reports indicated little new commercial construction activity across the
Fifth District.

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Nonfarm Employment

Unemployment Rate

Real Personal Income

Change From Prior Year

First Quarter 1996 — Second Quarter 2007

Change From Prior Year

First Quarter 1996 — Second Quarter 2007

First Quarter 1996 — Second Quarter 2007

4%

8%

7%

7%
3%
6%

6%
2%

5%
4%

5%

1%

3%
0%

2%
4%
1%

-1%

0%
3%

-2%
96 97 98 99 00 01 02 03 04 05 06 07

-1%
96 97 98 99 00 01 02 03 04 05 06 07

Fifth District

96 97 98 99 00 01 02 03 04 05 06 07

United States

Nonfarm Employment
Metropolitan Areas

Unemployment Rate
Metropolitan Areas

Building Permits

Change From Prior Year

Change From Prior Year

First Quarter 1996 — Second Quarter 2007

First Quarter 1996 — Second Quarter 2007

First Quarter 1996 — Second Quarter 2007

Change From Prior Year

7%

30%

6%

20%

5%

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

10%

4%

0%

3%

-10%

2%

-20%

1%
96 97 98 99 00 01 02 03 04 05 06 07
Charlotte

Baltimore

-30%
96 97 98 99 00 01 02 03 04 05 06 07

96 97 98 99 00 01 02 03 04 05 06 07

Washington

Charlotte

Baltimore

Washington

FRB—Richmond
Services Revenues Index

FRB—Richmond
Manufacturing Composite Index

First Quarter 1996 — Second Quarter 2007

Fifth District

First Quarter 1996 — Second Quarter 2007

40

House Prices
Change From Prior Year
First Quarter 1996 — Second Quarter 2007

16%

30

30

United States

20

14%
12%

20

10

10%

0

8%

10
0

6%

-10
-10

4%
-20
2%

-20
-30

-30
96 97 98 99 00 01 02 03 04 05 06 07

96 97 98 99 00 01 02 03 04 05 06 07

0%
96 97 98 99 00 01 02 03 04 05 06 07
Fifth District

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 8 • R e g i o n F o c u s

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

U Maryland

T

he District of Columbia’s economy remained on generally
solid footing in the third quarter. Payroll employment growth
and unemployment rates were steady, while the housing market —
with a modest gain in residential permitting activity and an uptick in home prices — regained some stability. Steady income
growth buttressed household balance sheets, though increases
in mortgage delinquencies and foreclosures remained a concern.
Labor market conditions in the District of Columbia were
generally healthy in the third quarter. Firms in the region added
2,000 jobs in the third quarter, a 1.9 percent increase over the
previous quarter. Payroll growth in government employment and

U.S. and D.C. Employment Growth Since Jan. 2001
Index = Jan. 2001 = 100
110
108
INDEX LEVELS

106
104
102
100
98
96
01

02

03

04

05

06

District of Columbia

07
United States

SOURCE: Nonfarm Payroll Employment, BLS/Haver Analytics

many services-producing sectors fueled the increase, while job
losses in the information and financial activities sectors dampened
growth. At 5.7 percent, the unemployment rate remained
unchanged since the beginning of 2007, and was 0.1 percentage
point lower than the third quarter of 2006.
The District of Columbia’s housing market showed some
improvement. Its House Price Index rose 2.3 percent in the third
quarter, following a decline of 0.3 percent in the second quarter.
New residential construction also improved in the third quarter,
with the District of Columbia posting the only quarterly gain in
residential permit activity in the Fifth District. Still, other measures of real estate activity were less positive — the pace of existing
home sales declined 11.5 percent in the third quarter.
Modest housing market improvements were balanced by
increased delinquencies among mortgage borrowers. The
percentage of mortgages more than 90 days past due continued to creep up in the third quarter. The rate of
foreclosures also increased, though it remained below the
peak rate posted in 2001. Although mortgage data revealed
some problems, households remained in generally good
financial condition overall. Real income growth advanced at
a 3.9 percent annualized rate in the third quarter.

42

R e g i o n F o c u s • Wi n t e r 2 0 0 8

conomic conditions in Maryland were mixed in the third
quarter. The payroll survey continued to show positive
employment growth and household incomes grew at a healthy clip.
Still, Maryland’s unemployment rate edged up slightly and the
state experienced its first quarterly decline in home prices in
nearly a decade.
Conflicting reports from the two employment surveys
provided a mixed picture for the state’s labor market. On the positive side, the payroll survey reported that Maryland added 6,800
jobs to its economy in the third quarter, for a 0.3 percent increase
over the quarter and a 0.9 percent increase over the past 12
months. Gains were reported across the state’s services-producing
sectors, with the exception of a 0.8 percent (1,300 jobs) decline in
financial activities employment. Other than the financial activities, the only other sector to experience net job losses was
manufacturing, which lost 700 jobs over the quarter. The household survey, however, indicated that the unemployment rate
inched up 0.1 percentage point in the third quarter to end at 3.6
percent — still the second-lowest unemployment rate among
District jurisdictions. Reports on Maryland’s household incomes
were more encouraging, however: Household incomes increased at
a 2.7 percent annualized rate in the third quarter, up sharply from
the second quarter’s tepid 0.3 percent pace.
Residential real estate activity contracted further, compounded
by falling house prices and rising mortgage delinquencies.
Retreating housing market activity showed few signs of slowing in
the third quarter, with residential permitting activity down 25.5
percent over the quarter and 27.1 percent over the year. Existing
home sales were also sharply lower, raising the market inventory of
homes for sale to unusually high levels in markets across the state.
In addition, Maryland saw a decline in home prices for the first
time in almost 10 years. Its House Price Index indicated that
Maryland home prices edged lower 0.3 percent during the third

E

U.S. and MD Employment Growth Since Jan. 2001
Index = Jan. 2001 = 100
108
106
INDEX LEVELS

District of Columbia

104
102
100
98
96
01

02

03

04

05

06

Maryland

SOURCE: Nonfarm Payroll Employment, BLS/Haver Analytics

07
United States

REGION FOCUS WINTER_08_F1

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Page 43

quarter, though home prices in the state remained slightly above
year-ago levels.
The contraction of the housing market was also felt in mortgage delinquencies and foreclosure rates. The percentage of
mortgages more than 90 days past due — which had been at cyclically low levels recently — increased sharply in the third quarter to
an even 1.0 percent. The foreclosure rate also increased.
Nonetheless, both rates remained below peak rates reached
several years earlier.

h North Carolina
conomic conditions were mixed across North Carolina in the
third quarter. Residential home building and home sales were
down, but income and payroll employment grew at a healthy pace
and unemployment rates remained steady.
Payroll employment in North Carolina grew in the third quarter as the state added 15,500 jobs, a 0.4 percent increase over the
second quarter and a 2.3 percent increase over the past 12 months.
The gains were spread across sectors. The professional and business services sector accounted for the largest gain (3,900 jobs)
during the quarter, while only three sectors — manufacturing, construction, and financial activities — saw net job losses in the third

E

U.S. and NC Employment Growth Since Jan. 2001
Index = Jan. 2001 = 100
106

INDEX LEVELS

104
102
100
98
96
94
01

02

03

04

05

06

North Carolina

07
United States

SOURCE: Nonfarm Payroll Employment, BLS/Haver Analytics

quarter. Additionally, the state’s unemployment rate remained
steady at 4.7 percent in the third quarter — 0.2 percentage point
higher than at the beginning of 2007, but 0.1 percentage point
lower than the third quarter of 2006.
Household financial conditions remained generally healthy bolstered by solid real income growth. North Carolina household
incomes rose at an annualized 3.8 percent in the third quarter and
were up 4.5 percent over the past 12 months, the latter ranking as
the fastest pace among Fifth District jurisdictions. On the other
hand, higher levels of personal bankruptcy and mortgage delinquency indicated financial difficulties in some segments of the

state’s population, although both measures remained below peak
levels reached in the aftermath of the 2001 recession.
By any measure, residential real estate activity in North
Carolina declined further in the third quarter. The number of
permits issued was 16.7 percent lower than a year earlier as permit
levels fell to their lowest mark since the second quarter of 2003.
Previous declines in permit issuance had been concentrated in
coastal areas and some of the smaller MSAs. However, that trend
changed a bit in the third quarter as some of the larger MSAs,
especially Charlotte, experienced substantial declines in permitting activity. In addition, existing home sales declined by 13.0
percent since the same quarter in 2006. House price growth across
the state also slowed in the third quarter, though prices rose 6.6
percent over the past year.

o South Carolina
R

ecent readings on South Carolina’s economy varied. Payroll
employment expanded and incomes grew at a healthy clip,
while the state’s unemployment rate inched up and its housing markets weakened further.
South Carolina’s labor markets produced some mixed signals in
the third quarter. Payroll employment in the state grew 0.8 percent
in the third quarter. The bulk of the gains came in the leisure and
hospitality, and education and health services sectors, which
accounted for nearly half of the 16,300 jobs added in the period.
The government sector also posted solid employment gains,
adding approximately 3,000 jobs in the quarter. The only sector to
post net job losses was manufacturing — the sector lost an additional 400 jobs during the third quarter, marking its third
consecutive quarterly decline. On the other hand, the state’s unemployment rate edged higher 0.1 percentage point to finish the
quarter at 5.8 percent — the highest jobless rate among Fifth
District jurisdictions.
Reports on household financial conditions remained mostly
positive. Real income growth accelerated in the third quarter, both
in aggregate and per-capita terms. Annualized quarterly growth of
4.0 percent pushed the state’s year-over-year growth rate back
above 4.0 percent — the second-fastest growth rate among Fifth
District jurisdictions. Personal bankruptcy filings also provided little evidence of financial strain on household balance sheets in the
third quarter.
Modestly higher rates of mortgage delinquency and foreclosure
reflected worsening conditions in the state’s residential real estate
markets. The share of all South Carolina-held mortgages that were
at least 90 days delinquent moved higher in the third quarter. In
fact, at 1.2 percent, the rate was near its recent peak from the second quarter of 2003, though it remained lower than the national
rate of mortgage delinquency. In addition, home price growth in
the state decelerated sharply in the third quarter to just 0.4 percent

Wi n t e r 2 0 0 8 • R e g i o n F o c u s

43

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U.S. and SC Employment Growth Since Jan. 2001
Index = Jan. 2001 = 100
106

INDEX LEVELS

104
102
100
98
96
01

02

03

04

05

06

South Carolina

07
United States

SOURCE: Nonfarm Payroll Employment, BLS/Haver Analytics

activity continued in the third quarter. Residential permit issuance
in the state declined sharply again, falling 22.7 percent since the
second quarter. Additionally, existing home sales fell 12.6 percent in
the third quarter, pushing the months’ supply of homes above 10
months in some markets. The decline in homes sales contributed to
a notable deceleration in home price appreciation in the third quarter. Existing home prices in Virginia rose just 0.3 percent at an
annual rate, down from a peak annualized growth rate of 28.5
percent three years ago. Nonetheless, prices remained 2.9 percent
higher than a year earlier, which is larger than the 2.2 percent
increase experienced nationally over the same time period.
After a prolonged period of remaining relatively flat, mortgage
delinquency and foreclosure rates began to rise across the state in
the third quarter. The percentage of all mortgages past due by 90
days or more rose to 0.88 percent, which was low compared to the

at an annual rate. Coastal areas bore the brunt of slower price
growth, with the Charleston MSA posting home price growth
of just 0.7 percent in the third quarter on the heels of a slight price
decline in the second quarter. Many of the inland markets fared
a bit better, posting more modest declines in home sales and
home building.

Index = Jan. 2001 = 100
108
106
104

INDEX LEVELS

u Virginia

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

102
100
98

nother stretch of solid employment growth underpinned the
healthy Virginia economy in the third quarter. The state
retained the lowest unemployment rate in the Fifth District by a
wide margin, and experienced payroll growth across most sectors
of the economy, including construction. In contrast, Virginia’s
housing markets continued to languish with falling home sales and
sluggish home building activity weighing on growth.
Both the payroll and household surveys underscored healthy
labor market conditions in the state. Virginia added 5,300 jobs to
its economy in the third quarter, for a quarterly growth of 0.1 percent and a year-over-year growth of 0.9 percent. On the other
hand, Virginia’s goods-producing sectors experienced declines in
employment. Construction lost 2,900 jobs for its sixth consecutive quarter of payroll declines, while District factories cut 2,200
jobs for its 11th consecutive quarter of declines. Payroll performance on the services side was mixed. Job losses in financial services
and information sectors were more than compensated for by gains
in trade, professional and business services, education and health
services, and leisure and hospitality. The government sector also
posted employment growth in the third quarter. News from the
household survey was also generally positive despite a small uptick
in the state’s jobless rate. Virginia’s unemployment rate inched up
0.1 percentage point to 3.1 percent — a rate that matched the
state’s mark from a year-ago and was the lowest rate among
Fifth District jurisdictions.
Turning to housing, Virginia’s decline in residential real estate

A

44

R e g i o n F o c u s • Wi n t e r 2 0 0 8

96
01

02

03

04

05

06

Virginia

07
United States

SOURCE: Nonfarm Payroll Employment, BLS/Haver Analytics

national rate, but double the figure posted a year earlier. The
foreclosure rate also increased. Still, both marks were below recent
peaks from earlier in the decade.

w West Virginia
conomic conditions in West Virginia softened a bit in the third
quarter, with little change in employment and further weakness in the state’s housing markets. The state did see some
encouraging indicators, however, including the resumption of
positive income growth and relatively steady home price
appreciation.
Labor market conditions deteriorated somewhat in the third
quarter, characterized by weak job growth and higher unemployment. Employment gains in natural resources and mining, trade,
transportation and utilities, education and health services, and
leisure and hospitality were more than offset by losses in
the construction, manufacturing, and government payrolls.

E

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Page 45

U.S. and WV Employment Growth Since Jan. 2001
Index = Jan. 2001 = 100
106

INDEX LEVELS

104
102
100
98
96
94
01

02

03

04

05

06

07

West Virginia

United States

SOURCE: Nonfarm Payroll Employment, BLS/Haver Analytics

In addition, West Virginia’s unemployment rate edged higher by
0.2 percentage point to 4.7 percent, though it remained a touch

below the state’s mark — 4.9 percent — from the third quarter
of 2006.
On the real estate front, housing market activity declined
further across the state in the third quarter. Permit issuance fell
15.4 percent during the three-month period and the pace of existing home sales in the state slowed 15.8 percent. Moreover, the state
experienced a deceleration in year-over-year home price growth,
but the decline was relatively modest in comparison to other
Fifth District jurisdictions.
The financial condition of West Virginia households was
supported by positive income growth. Household incomes
grew 3.0 percent in the third quarter on the heels of a small
decline in the second quarter. Additionally, the number of personal
bankruptcies declined slightly. However, the state’s already
elevated rate of home foreclosures inched higher in the third
quarter, highlighting mortgage problems among some segments of
the populace.

Behind the Numbers: Which Price Index?

PERCENT CHANGE YEAR-OVER-YEAR

When the press talks about inflation, it
Tracking Inflation
usually cites the Consumer Price
5.0
Index, or CPI. This statistic measures
4.5
CPI
the average price of a basket of goods
Core CPI
4.0
PCE
and services regularly bought by a
3.5
Core PCE
typical American family. Core CPI, by
3.0
contrast, usually excludes food and
2.5
2.0
energy on the premise that prices for
1.5
these items tend to be volatile and lack
1.0
persistence, and thus may not reflect
0.5
the true source of inflation — too
0
2003
2002
2000
2004
2001
2005
2007
2006
much new money chasing too few
SOURCE: Bureau of Labor Statistics and Bureau of Economic Analysis
goods. As the graphic shows, the
subtraction of food and energy makes
mostly based on the same item prices in the CPI.) Also, the
core inflation much less volatile than “headline inflation.”
PCE applies different weights than the CPI to items in its
The Bureau of Labor Statistics releases the CPI data each
basket, captures some items not included in the CPI
month. The result is based on a massive collection
(but excludes others), and follows different seasonal
process, encompassing 87 urban areas across the nation, with
adjustment patterns.
prices on approximately 80,000 items gathered from superThere is a large body of economic research on the
markets, hospitals, stores, and gas stations, among many other
accuracy of the various price indices. In the end, careful
establishments.
analysts take the time to understand the differences
Economic policymakers, including those at the Federal
between the indices in determining the relative importance
Reserve, also closely monitor the Personal Consumption
of changes in any of them. Roy Webb, a senior economist
Expenditures (PCE) price index. The PCE is published by
with the Richmond Fed, says that in general, both the CPI
the Bureau of Economic Analysis. Its most frequently cited
and the PCE indexes do a good job. “Any index is going to
version uses a chain index, a formula that more accurately
have the same problems that the CPI and PCE do,” Webb
reflects the tendency of consumers to substitute away from
says. “I could make a good policy recommendation based
items with fast-rising prices. (However, the PCE index isn’t
on either the CPI or the PCE.”
the result of individual data collection; the index is
— DOUG CAMPBELL

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State Data, Q3:07
DC

MD

NC

SC

VA

WV

699.9
0.3
1.8

2,625.3
0.6
1.5

4,096.6
-0.1
1.7

1,934.3
0.5
1.9

3,794.3
0.4
1.8

758.6
-0.1
0.4

1.6
-4.1
-7.8

133.8
-0.3
-1.7

543.0
-0.7
-1.9

243.6
-0.5
-2.9

287.4
0.2
-0.2

59.4
-0.3
-2.3

Professional Business Services Employment (000’s)160.1
Q/Q Percent Change
0.2
Y/Y Percent Change
4.2

402.8
0.3
2.0

491.2
0.6
3.2

217.9
-0.1
-0.1

646.8
-0.1
2.9

61.4
0.8
2.7

Government Employment (000’s)

235.1

480.6

672.3

336.8

685.4

142.9

0.5
0.7

2.0
1.7

-2.1
0.0

1.1
2.5

0.7
1.4

-1.2
-1.1

315.4
-1.4
0.1

2,994.3
-0.1
-0.8

4,526.5
-0.1
1.1

2,145.2
-0.2
0.8

4,053.3
0.1
1.0

815.9
0.2
0.6

5.7
5.6
6.0

3.9
3.7
4.0

4.9
4.8
4.9

5.7
5..6
6.5

3.0
3.0
3.1

4.8
4.4
5.2

30,194.7
1.0
3.7

221,332.1
0.7
3.4

260,813.7
0.9
4.5

116,291.0
1.0
4.2

272,608.5
1.0
3.6

45,629.4
0.8
2.6

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

527
5.2
167.5

4,680
-25.5
-27.1

19,872
-14.0
-16.7

8,430
-29.8
-29.9

8,352
-22.7
-19.4

979
-15.4
-18.8

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

681.1
2.3
5.7

542.8
-0.3
2.6

344.9
0.9
6.6

317.3
0.1
4.9

481.2
0.1
2.9

234.8
1.4
3.8

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

9.2
-11.5
-11.5

78.0
-15.9
-28.6

202.8
-12.3
-13.0

101.6
-13.0
-10.6

108.4
-12.6
-19.1

25.6
-15.8
-19.0

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

Q/Q Percent Change
Y/Y Percent Change
Civilian Labor Force (000’s)
Q/Q Percent Change
Y/Y Percent Change
Unemployment Rate (%)
Q2:07
Q3:06
Real Personal Income ($Mil)
Q/Q Percent Change
Y/Y Percent Change

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®

46

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Metropolitan Area Data, Q3:07
Washington, DC MSA
Nonfarm Employment (000’s)
Q/Q Percent Change
Y/Y Percent Change
Unemployment Rate (%)
Q2:07
Q3:06
Building Permits
Q/Q Percent Change
Y/Y Percent Change

Baltimore, MD MSA

Charlotte, NC MSA

2,429.5
-0.3
1.5

1,313.3
-0.1
0.7

839.5
-0.5
0.0

3.1
3.0
3.3

4.1
3.8
4.4

4.9
4.7
4.9

4,530
-38.0
-30.5

1,741
5.9
-2.5

4,826
-23.5
-25.1

Raleigh, NC MSA
Nonfarm Employment (000’s)
Q/Q Percent Change
Y/Y Percent Change
Unemployment Rate (%)
Q2:07
Q3:06
Building Permits
Q/Q Percent Change
Y/Y Percent Change

Unemployment Rate (%)
Q2:07
Q3:06
Building Permits
Q/Q Percent Change
Y/Y Percent Change

Columbia, SC MSA

499.9
0.2
2.4

295.0
0.1
3.0

362.8
-0.8
1.1

3.7
3.7
3.8

4.7
4.2
5.5

5.2
4.7
5.9

4,541
7.8
25.7

1,601
-27.1
-19.3

1,372
-40.7
-24.7

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

Charleston, SC MSA

Richmond, VA MSA

Charleston, WV MSA

783.9
0.0
1.8

635.1
-0.5
1.1

151.6
-0.2
0.8

3.2
3.1
3.5

3.1
3.0
3.3

4.1
4.1
4.5

1,357
-13.8
-15.2

1,559
-27.0
-14.9

75
7.1
8.7

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

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OPINION
In Defense of Failure
BY ST E P H E N S L I V I N S K I

F

more money on their homes than on their cars. Besides,
ailure gets a bad rap these days. Nobody prefers it to
someone bringing his car back to the dealership is not a
success, of course, but people tend to underestimate
dramatic news story; a person sleeping in his car because he
the importance of failure.
lost his home is. Yet industry analysts frequently point out
It’s not hard to understand why. Failure isn’t often fun to
that foreclosure is often a more costly option to the lenders
watch. When we look at a shuttered storefront, we can’t help
than simply working out a solution with the borrowers, like
but feel bad for the newly unemployed workers. When we see
a new payment schedule. If that isn’t feasible, however, it’s
a foreclosed house, we sympathize with the family that had to
hard to make a case to keep that capital locked up in that
move. It’s human nature. We may not like to accept the idea
investment.
that failure is a necessary component of economic change.
Markets do indeed have a way of aligning the incentives
But this often clouds our ability to envision a future when
of two parties who are both self-interested and willing to
the capital that was poured into the failing business will be
enter into a contract or investment arrangement with one
put to even better use. A future in which those unemployed
another. But not every investment pays off. Markets are, at
workers instead become newly employed workers who build
their core, a discovery process. Ask any
new avenues to prosperity. Or where
successful entrepreneur how many
the family that couldn’t afford the
Ask any successful
times he failed before he found his
larger house finds themselves in a
more affordable one, which frees their
entrepreneur how many big idea and you’ll probably get many
stories of heartbreak.
income to pursue other investments
times he failed before
Yet, acknowledging that failure is
and activities.
an important component of eventual
That might be small consolation to
he found his big idea
success is a hard argument to make
some. Perhaps it’s even too close to the
when failure is staring you in the face.
attitude of Voltaire’s famous character,
and you’ll probably
And it’s often at this point that public
Dr. Pangloss, whose blind optimism
get many stories of
policy decisions are made. Public policy
limits him to seeing only the good in
should not impede the ability of a
everything. After all, we should prefer
heartbreak.
business or an investor to succeed.
a society in which contract law proBut policy should also not impede or
hibits the sort of failure that is caused
encourage their failure either by protecting them from comby fraudulent practices and duplicity. Luckily, that is indeed
petition or insulating them from a bad decision.
the world we inhabit. But maybe what motivates us to have
Unfortunately, the very understandable inclination of
an adverse reaction to failure generally might also be what
government to come to the aid of those against whom
helps markets work in the long run too — if we let it.
market trends have turned can also place the government in
Take the recent attention paid to the mortgage markets.
between those people and the consequences of their choices.
While the media’s reporting on the subject seems to suggest
The same human instinct that naturally repels us from
that we’re in a “crisis” of staggering proportions, most
wanting to face failure helps explain other policies too. Trade
borrowers of all varieties are making their mortgage paybarriers, for instance, are sometimes popular in part because
ments on time. The question hinges on what to do about
supporters claim that they will avoid today the unsightly
those who are in danger of losing their homes to foreclosure.
demise of yesterday’s industries, including perhaps one in
Such a question is best answered by the lenders and the
which you work.
borrowers themselves. They, after all, have the strongest
The 19th century French journalist, Frederic Bastiat,
incentives and best information with which to discover
wrote about the political impetus to focus on what is seen
whether the best solution really is foreclosure or not.
every day. But that doesn’t make for good policy. He noted
We assume the same is true of other purchases and
that good policy is instead based on recognizing what is not
investments. We probably wouldn’t hear reports of a car
seen immediately with your own eyes.
financing “crisis” if people bought SUVs and Hummers that
Bad policies opt to remedy the discomfort of what is
they soon discovered they couldn’t afford. In fact, there
is such a thing as subprime car loans, yet media attention
seen today at the expense of what is not seen immediately —
to them is scant. Why should the purchase of homes be
a more efficient and vibrant economy of tomorrow.
treated differently?
Impeding the learning and discovery process that results
The easy answer is that homes are different — it’s where
from our mistakes should be counted as one of those unseen
people live, not just an investment, and people spend much
costs too.
RF

48

R e g i o n F o c u s • Wi n t e r 2 0 0 8

Winter 08 Full Cover_F1

5/30/08

2:29 PM

Page 3

NEXTISSUE
Is Homo Economicus Extinct?

Interview

The burgeoning field of “behavioral economics” has called into
question the existence of Homo economicus, the species
of human that makes rational choices in a market setting.
Meanwhile, the field of “experimental economics” has shown
that, in a laboratory setting, even uninformed traders can
arrive at a result that looks very much like what the economics
textbooks say it should. Is it too soon to declare Homo
economicus extinct?

We talk with Charles Holt of the
University of Virginia, a pioneer in the
field of experimental economics and
auction design.

Federal Reserve
An excerpt from Richmond Fed economist
Robert Hetzel’s new book on the history of
monetary policy in the United States.

Economics for the Real World
In the 1980s, economics departments were said to be
“graduating a generation of idiot savants, brilliant at esoteric
mathematics yet innocent of actual economic life.” That
critique resonates even in 2008. Department chairs from some
of the Fifth District’s leading economics programs suggest that
their schools are creating innovative approaches to provide
richer training for new economists. Today, graduate economics
departments in particular are searching for ways to help
students become as good at real-world problem solving as they
are at math.

Economics Blogs
Economists can help people interpret current economic
events by authoring “web logs,” commonly referred to as
“blogs.” From airline delays to the mortgage market to gas
prices, these virtual economics classes can change how readers
digest common and controversial topics. Even professional
economists find blogs a useful way to expand the audience for
their research.

Visit us online:
www.richmondfed.org

The Return of Nuclear Power
After years of aversion by many, nuclear power seems to be
making a comeback. Some of this boost comes from the
prospect of using nuclear power as part of a strategy to limit
carbon emissions in the United States. Some power companies
are even expressing that they are no longer interested in building coal-burning plants in the foreseeable future. This trend has
the potential to lead to big changes in the energy industry in
the Fifth District.

• To view each issue’s articles
and web-exclusive content
• To add your name to our
mailing list
• To request an e-mail alert of
our online issue posting
• To check out our online
weekly update

Winter 08 Full Cover_F1

5/30/08

2:29 PM

Page 4

Region Focus 2007
WINTER 2007, VOL. 11, NO. 1

Cover Story

Stock Options
on the Outs

Academic
Alternatives

Cover Story

Federal Reserve
How Richmond Won a
Reserve Bank

Interview
Robert Fogel
Graduate School of Business
University of Chicago

SPRING 2007, VOL. 11, NO. 2

Cover Story

SUMMER 2007, VOL. 11, NO. 3

Highlighting Business Ac tivity in the Fifth Distric t

Federal Reserve
The Evolution of Fed
Communications

Interview
W. Kip Viscusi
Vanderbilt University

Cover Story
Downtown is Dead.
Long LiveDowntown!

Federal Reserve

FALL 2007, VOL. 11, NO. 4

Democracy and
Other Failures

Federal Reserve

The Great Depression

Interview
Russell Sobel
West Virginia University

Before the Fed

Interview
Susan Athey
Harvard University

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to subscribe or order back issues today!
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