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SPRING 2012
Volume 3 Number 1

F refront

New Ideas on Economic Policy from the FEDERAL RESERVE BANK
of CLEVELAND

Public Finances:

Shining Light on a Dark Corner
State and local pension plans illuminated

INSIDE:

How economics can
help design a tax code
Why flexibility is
key to neighborhood
stabilization

PLUS :

Interview with
Cleveland Fed
President Sandra Pianalto

F refront

New Ideas on Economic Policy from the FEDERAL RESERVE BANK
of CLEVELAND

		SPRING 2012

Volume 3 Number 1

		CONTENTS
1	President’s Message
2	Upfront

Bank Capital Requirements: A Conversation with the Experts

From the cover

		 Public Finances: Shining Light on a Dark Corner
4	Public Pensions Under Stress

State and local governments struggle to meet financial obligations to retirees

9	Monitoring the Risks of State and Local Government Finance
Insights from the Municipal Financial Monitoring Team

12	Navigating the Legal Landscape for Public Pension Reform
Travel at your own risk

14	New Consumer Watchdog Stands Guard
Q&A with Leonard Chanin

From the cover

16	The Economics of Taxation

An economist ponders the tradeoffs in tax system design

4

20	Meeting the Demand for Cash

The infrastructure of an evolving process

From the cover

24
20

24	Three Reasons Why Converting Vacant Homes
to Rentals Will Be a Challenge in Some Places
…and three ways it can succeed

28	Closing the Region’s Education Gaps
Community college as a bridge to business

32	Book Review

And the Money Kept Rolling In (and Out):
Wall Street, the IMF, and the Bankrupting of Argentina

From the cover

34	Interview with Sandra Pianalto

Federal Reserve Bank of Cleveland President and CEO opens up
on her policy views, economic outlook, and the differences between
Greenspan’s Fed and Bernanke’s

34
The views expressed in Forefront are not necessarily those of the
Federal Reserve Bank of Cleveland or the Federal Reserve System.
Content may be reprinted with the disclaimer above and credited
to Forefront. Send copies of reprinted material to the Public Affairs
Department of the Cleveland Fed.
Forefront
Federal Reserve Bank of Cleveland
PO Box 6387
Cleveland, OH 44101-1387
forefront@clev.frb.org
clevelandfed.org/forefront

President and CEO: Sandra Pianalto
Editor in Chief: M
 ark Sniderman
Executive Vice President and Chief Policy Officer
Executive Editor: Robin Ratliff
Editor: Doug Campbell
Managing Editor: Amy Koehnen
Associate Editor: Michele Lachman
Art Director: Michael Galka
Web Designer: Natalie Karrs
Digital Media Strategist: Lou Marich
Contributors:
Jean Burson
John Carlson
Daniel Carroll
Thomas Fitzpatrick IV

Moira Kearney-Marks
Dan Littman
April McClellan-Copeland
Nelson Oliver

Editorial Board:
Kelly Banks, Vice President, Community Relations
Paul Kaboth, Vice President, Community Development
Stephen Ong, Vice President, Supervision and Regulation
Mark Schweitzer, Senior Vice President, Research
James Thomson, Vice President, Research

PRESIDENT’S MESSAGE
Sandra Pianalto
President and Chief Executive Officer
Federal Reserve Bank of Cleveland

As we enter the spring of

In this issue of Forefront, researchers at the Cleveland Fed shed

2012, the national economy

some light on the sometimes overlooked sector of budget-

continues to improve on

crunched state and local governments. We are analyzing two

a slow but upward path.

categories of risk. First, we consider the risk that weak finances

Unemployment remains

may weigh down growth in certain regions of the country; second,

elevated and will likely

we examine the risk that defaults on their debt obligations

be that way for some time, but it too is improving. I expect the
moderate pace of growth to continue over the next few years.

could—at some point—threaten broader financial stability.
Also in this issue, I talk with the Cleveland Fed’s Mark Sniderman,

Much has been written about the various headwinds restraining

our chief policy officer, about some of my monetary policy

economic activity over the near term. However, our economy also

views. During my 28-year tenure at the Bank, I have had the

has other headwinds to confront over the medium- to-longer-

opportunity to experience a wide range of economic conditions

term. Households are still in the process of repaying debt and

and to learn many lessons. In my almost 10 years of participating

seeking a better balance between spending and saving—an

in the Federal Open Market Committee, I have come to strongly

essential adjustment for building an adequate financial buffer for

support the power of open and transparent communications

unplanned expenses and retirement. The federal government’s

with the public as the Federal Reserve pursues its dual mandate

budget deficit is still on an unsustainable path, and uncertainty

of stable prices and maximum employment. I hope that our

over its future course hinders economic growth. Finally, the

conversation helps you understand more about how I balance

finances of some state and local governments are also under stress

the objective of low and stable inflation with the objective of

and in need of serious adjustments.

more Americans finding jobs. The more you understand and
anticipate how the Federal Reserve operates, the more effective
our policies can be.

■

F refront

1

Upfr nt

Bank Capital Requirements:
A Conversation with the Experts
On November 18, 2011, the Federal Reserve Bank
of Cleveland invited three academic experts on bank
capital requirements to talk with Bank economists
and officials about their research. During a break
in the presentations, Executive Vice President and
Chief Policy Officer Mark Sniderman sat down for
this interview with the experts.

Sniderman: Anat, maybe you can talk
with us a little about bank capital—
what it is and some of the most common
misunderstandings about it.

Anat Admati, the
George G.C. Parker
Professor of Finance
and Economics at Stanford University:

People don’t know quite what that
word [capital] means. People use this
word differently elsewhere. Basically,
capital should be thought of as equity,
first and foremost. Think of buying
a house with, more or less, a down
payment of your own money, and
how much you use that versus
borrowing. The capital question is
whether the bank should fund with
just borrowing, borrowing, borrowing, and how much of the total investment should be funded with what’s
called “own money,” or equity. That’s
what capital is.

2

Spring 2012

The confusion arises when people
sometimes say that the banks have
to “hold capital” or “set aside capital”
in a reserve. They use these words,
“reserve” and “hold” and “set aside,”
that suggest this money is somehow a
rainy day fund, as if the money cannot
be lent or cannot be used. And that’s
the big fallacy.
What we’re talking about is not
promising as much, not taking on
as much debt to fund your lending—
it’s how you raise your money. It’s all
about the funding; it’s not what you
do with it. So on the side of the bank,
there is no holding or setting aside of
any sort. It’s basically just forcing the
banks to borrow less to fund what
they do.

Richard (Rick)
Carnell, Professor
of Law at Fordham
Law School: It’s just the amount by

which your assets exceed your
liabilities. It’s like your equity in the
house is the amount by which the
value of the house exceeds what you
owe on it.
Admati: It’s your cushion. It’s your
retained earnings plus equity that you
have. And if the value of the assets
goes down, you won’t go into distress
or trouble; you might still be able to
pay your debt back.

Sniderman: Bob, maybe you can tell
us about whether there are differences
in terms of how banks have debt and
equity versus other kinds of companies
that are not banks?

Robert (Bob)
McDonald, Erwin P.
Nemmers Professor
of Finance at Northwestern University:

When you compare banks to companies that are not banks, you see very
different patterns of debt and equity
usage. You have companies like Apple,
which essentially has no debt, whereas
most banks will have something
like 90 to 95 percent of their assets
financed by debt. If you were to ask
why that’s the case, one consideration
is that some of banks’ debt basically
serves as money. If you have a deposit,
for example, then that takes the place
of money for you. And if you look
at banks as a whole, something like
80 percent of assets are deposits.
But at the same time, there are other
reasons for banks to be so highly
levered. One of them is the fact that
the banking system is heavily regulated,
heavily protected by the government.
This reduces the cost to banks of
raising funds as debt and causes them
to increase their usage of debt. That’s
one of the reasons you see high debtto-asset ratios.

Sniderman: There’s a lot of talk these
days about what the right amount of
debt for banks ought to be. There’s a
general perception that banks should
have more equity and less debt.
Rick, how should we be thinking about
the proper ratios of equity for banks?
Where do we begin?
Carnell: I think we need to begin with
first principles, which is how much
equity, how much of a shareholder’s
investment, would market participants
expect if there were no federal deposit
insurance and there were no expectations of government bailouts. If we
were in a fully free market with our
banking sector, except that we have
the Federal Reserve there to meet
immediate needs for cash, how much
equity would market participants be
looking for?

That’s very different from the usual
debates about capital, where the
starting point is the capital levels
that we’re used to. Bankers are used
to capital levels where bank debts can
amount to 96 percent of the bank’s
total assets. So you have $24 in debt for
each dollar of equity. That’s in terms
of the regulatory minimums; what you
actually see is higher than that.
But the question is whether required
capital levels are high enough. The
failures and near failures that we’ve
seen in the banking system suggest that
they’re not. The fact that the taxpayers
had to come forward with guarantees
and cash bailouts is an indication that
we have been subsidizing the banking
system by not demanding high enough
capital in banks.
What we want to do is get bank capital
up to where it would be without the
subsidy.
Sniderman: If we look at the nonbank
sector—the Apples of the world are the
extreme with no debt at all, all equity—
we’d be talking about 50 percent debt
to equity, because that’s kind of the
average for nonbanks.
Carnell: That’s a different business,

though.

Sniderman: But we’re not talking as
high as 50 percent; we’re not talking
as low as 4.
Carnell: That’s right. Historically,

people have said that the return on
bank assets is more predictable than
the return on the assets of an industrial
company. But the nature of banking is
such that I would not expect 50 percent
equity in the usual bank. But it ought
to be a challenging question.

Sniderman: History suggests that we
should be thinking about higher equity
standards. One of the common refrains
you hear is that equity is very expensive
and that asking lenders to have a lot
more equity in their financing structure
is going to lead perhaps to less lending,
and it’s not a good time to be doing this.
Anat, you’ve written a lot about this.
What are your thoughts?
Admati: There’s no restriction, as I said
before, about lending. So the issue
becomes whether the cost of doing
business will somehow increase. Now,
bankers talk about return on equity
and they seem fixated on this concept,
which other companies are not fixated
on. The thing about return on equity
is it doesn’t really measure anything
unless you adjust for risk. And risk
includes how much debt you take.
The risk per dollar invested is much
higher the more you ‘lever’ on it. With
leverage, you have a higher risk on the
equity and therefore a higher required
return because the equity holders bear
more risk.

If you were to reduce the amount
of leverage, reduce the dependency
on debt, then the appropriate return
on equity should go down, and that
would be the appropriate return. If
shareholders want to take the risk, they
can borrow on their own account, they
can buy the margin, they can get their
own leverage and their own higher
return on equity if they’re willing to
take risk. That’s how it works in the
financial markets.
There is no entitlement for anybody
to get a particular return on equity.
If they generate value on their assets,
then the equity—however leveraged
it is—will earn the appropriate return.

There isn’t anything magical about
an unadjusted return on equity.
The return on equity is supposed to
represent the risk to which the equity
is put. The more risk and leverage
there is, the more should be the
expected return on equity. If you
can do better than that, then you’re
probably generating a better return
than the next guy. That’s what you
want to do—generate the higher
return on equity relative to the risk
that your equity is exposed to.
McDonald: If we’re talking about

anything, we should be talking about
return on assets.

Admati: Right, or some risk-adjusted
return on assets. In other words,
investors cannot be looking at raw
return on equity, because when they
do that, they encourage managers
to take on risk, not necessarily bring
in value. That’s a very dangerous
yardstick to use. No matter who the
shareholder is, that’s not a good way
to compensate managers. It’s not
used anywhere else. Investors, if they
are diversified, should look at their
return on their entire portfolio. And
if banks have a lot of indebtedness, it
makes the system very fragile. Then all
investors lose on their entire portfolio,
which I think we’ve all experienced in
the last few years! If you look at your
overall portfolio, we did not do very
well allowing the banks to be so thinly
capitalized. I suggest we do a little
better next time.
Sniderman: Thank you. ■

Watch this interview online
www.clevelandfed.org/forefront

Recommended reading
Learn more about this interview on bank
capital at www.clevelandfed.org/forefront/2012/
winter/ff_2012_winter_02.cfm

James Thomson and Joe Haubrich. 2011.
“Keeping Banks Strong: Countercyclical Capital
Requirements.” Forefront, Federal Reserve
Bank of Cleveland (winter).
www.clevelandfed.org/forefront/2011/
winter/ff_2011_winter_07.cfm
F refront

3

Public Finances: Shining Light on a Dark Corner
The financial crisis has made it all too clear that regulators

toward implications for the wider economy and financial

failed to see into the dark corners of th financial system.

system. What concerns should we have? In this package of

With that in mind, the Federal Reserve Banks of Cleveland

articles, we explain where risks could be building and how

and Atlanta have formed a Financial Monitoring Team to

reforms might help forestall their impact on the broader

study pension funds and municipal finance with an eye

economy and financial system.

Public Pensions Under Stress

John B. Carlson
Vice President and
Research Economist

Since 2007, state and local governments
have been caught in a perfect storm. The
confluence of the severe recession and

the collapse of the housing bubble dramatically slashed tax revenues. Although
some revenue sources have rebounded with the economy, the decline continues for
others. Property values, a major source of funding for local governments, remain
especially depressed.
4

Spring 2012

The toll has been particularly heavy on public pensions,
whose troubles with chronic underfunding predate the
financial crisis. By one estimate, the nation’s 126 largest
public pensions were underfunded by at least $800 billion
in 2010. By another, 54 percent of the country’s state and
local plans will have exhausted their funds as early as 2034.
It now seems inevitable that sacrifices will be required
from current employees, employers, and in some cases,
retirees. What remains unclear is the extent to which
changes in future investment returns and pension plan
designs can close the funding gap.
On that count, one key question is this: Without strong
remedies, at what point would pension plans run out of
money, leaving financially impaired state and local govern­
ments on the hook? That question is not quite settled.
The answer hinges on complex economic and legal
questions. The potential implications of adding financial
stress to already overburdened state and local governments
are all too clear. Up to this point, the consequences of
local pension plan insolvencies—though they inflict
hardship on citizens—have been isolated enough not
to become epidemic.
How it all shakes out depends on the success of future
reform efforts, not to mention the investment returns
on pension-fund portfolios.

The Scope of the Problem
First, a little background on pensions: About 80 percent
of public pensions are defined-benefit plans, meaning that
the plan’s sponsor promises to pay a specified income that
is predetermined by years of service, final average salary,
and other factors. To fund the promised income, both the
employee and employer typically contribute to a pension
trust. The trust invests these payments in a portfolio of
assets whose returns are expected to pay the lion’s share
of the benefit obligation.
Unfortunately, these expectations are not always met.
Historically, public pension plans have invested a large
share of funds in stocks, which have offered relatively high
returns when averaged over long periods. Since the stock

market’s peak in 2000, however, equity returns have been
sharply lower than expected. As a consequence, the value
of assets held in public pension trusts has not kept pace
with the growing promises the plans have made, leaving
them substantially underfunded.
How far under is a matter of debate. According to the
funding-status measure prescribed by the Government
Accounting Standards Board (GASB), the largest 126
pension plans were underfunded by around $800 billion
in 2010. On the other hand, some critics of GASB’s
accounting methods estimate the aggregate pension fund
shortfall to be as much as $4 trillion. (See sidebar, “The
Widely Ranging Estimates of Pension Underfunding.”)
Embedded in those aggregate estimates are individual
plans’ funding ratios—the amount of assets held relative to
the amount deemed necessary to pay for a fund’s promised
retirement packages. The funding ratio, however, does not
tell the whole story of a plan’s sustainability. It does not
take account of potential supplemental contributions that
could help restore a plan to fully funded status over some
reasonable period.
A recent study by the Center for Retirement Research
argues that judging the adequacy of pension funding
requires more than looking at a snapshot of the funding
ratio. A key issue is whether the sponsor has a funding plan
and is sticking to it. Under GASB rules, plan sponsors
must report an annual required contribution (ARC).
Effectively, this is the annual amount a plan sponsor would
have to pay to eliminate any shortfall over a period of
30 years.
Although public pension plans’ annual reports must
publish the percentage of ARC payments they are making,
not all states legally enforce such payments. Since 2008, the
average share of ARC paid has declined from 92 percent
to 87 percent, according to the Center for Retirement
Research, even though the same payments as a percentage
of payroll haveactually increased.

F refront

5

Most state budgets have been under too much stress to
make full ARC payments voluntarily. Without mandatory
ARC payments, the funding status of many pensions will
continue to deteriorate unless reforms increase employee
contributions or reduce benefits.
Percent of State and Local Plans Exhausted
Under Assumptions of 6 and 8 Percent Investment Returns
Percent
35
6 percent

30

8 percent

25
20
15
10
5
0

Before 2020 2020–24

2025–29

2030–34

2035–39

2040–44

2045–49 After 2049

Source: Alicia H. Munnell, Jean-Pierre Aubry, Josh Hurwitz, and Laura Quinby. 2011.
“Can State and Local Pensions Muddle Through?” Center for Retirement Research (March).

Estimating Plan Exhaustion Dates
The question then becomes how much time a plan has
before it runs out of money—the fund’s exhaustion date.
A pension plan with a 60 percent funding ratio, for example,
may not run out of funds for 12 years. This stretch of time
would give this plan’s administrators some breathing room
to implement necessary reforms.
How much breathing room do the more severely under­
funded plans have? One study estimated exhaustion dates
for the 126 largest pension plans, assuming the plans are
ongoing. Simply put, this means that employers and
employees continue to make contributions while benefits
are paid out of the trust fund. Of course, the exhaustion
date also depends on investment returns on assets.
The study considered funding situations for returns
of both 6 percent and 8 percent. Its results show that
although several plans will become insolvent in the next
decade, most would have some time to work out their difficulties (see figure above).
Other estimates paint a bleaker picture. Joshua Rauh,
Northwestern University professor, finds that seven states
would run out of money by 2020, and 30 more would
run out in the following decade, even assuming 8 percent

6

Spring 2012

investment returns. Unlike the study mentioned earlier,
Rauh assumes that employers make only enough contribu­
tions to the pension funds to pay for the present value of
newly accrued benefits, and no more. On the other hand,
a recent GAO study concludes that Rauh’s projected
exhaustion dates are not a realistic estimate of when the
funds might actually run out of money.

The Urgency of Pension Reform
If there is any hope that future investment returns will
offset losses following the financial crisis, it is slim indeed.
Most plan sponsors recognize this and have supported
reforms that increase new employees’ contributions and
reduce their future benefits. Between 2008 and 2011, the
National Conference of State Legislatures counted 40 states
that have implemented pension reforms.
But most of these changes have only a limited effect on
plan funding. Until recently, few states have attempted to
alter benefits or contribution levels of vested employees
or retirees, which could have a far greater positive impact
on pension funding. Although some state legislatures
have passed reforms that were upheld in the courts, the
fate of other efforts remains to be decided by the courts.
(See related article, “Navigating the Legal Landscape for
Public Pension Reform.”)
When funding ratios fall, the amount of cash generated
by interest and dividends from investments declines
relative to the amount needed to pay benefits. Without
sufficient contributions to offset the lower cash flow from
investments, the process becomes self-reinforcing—that
is, assets must be sold to pay benefits, further reducing the
cash generated by investments. This becomes especially
problematic when the funding ratio falls below 50 percent.
For example, the Rhode Island Employee Retirement
System recently recognized that its funding process could
not be sustained without urgent action. In late 2011, the
state legislature responded with sweeping pension reforms
that passed by an overwhelming bipartisan majority. Under
the new law, current employees’ benefits will be frozen,
modified, or even reduced, and retirees’ cost-of-living
adjustments will be suspended until the funding ratio
improves enough to satisfy sustainability conditions.
Whether these actions will be sufficient remains to be
seen, especially since they will probably be challenged in
the courts.

The Widely Ranging
Estimates of Pension Underfunding
Just how underfunded are America’s
public pension plans? It depends
who you ask.
In the language of economics, a
pension plan’s promised benefits are
liabilities. They will have to be paid
for someday with funds from the
asset side of the fund’s balance sheet.
These future liabilities should be
“discounted” so that they are
expressed in present-value terms.
That way, you can compare the
present value of the pension
obligations to the current level
of plan assets—essentially, a way
to measure whether today’s funds
on hand will be sufficient to pay
for all those retiree benefits when
they come due in the future. Often
this comparison is expressed as the
ratio of the present value of assets
over the present value of obligations.
Which method to use in discounting
future liabilities—that’s the crux of
the issue. Public pension plans follow
Government Accounting Standards
Board (GASB) guidelines. This
allows those plans to use the expected
return on their portfolio for determining the present value of their
promised payments.

Following GASB guidelines, public
pension funds are allowed to discount
their future pension obligations
by their expected rate of return,
which has been in the neighborhood
of 8 percent—approximately the
average return of their portfolio
over the past 30 years.
How Underfunded Are the
126 Largest Public Pensions?
It depends on the discount rate
Trillions of dollars
5
4
3
2
1
0

GASB guidelines—
8 percent
discount rate

Risk-free
discount rate

Sources: Munnell, Aubrey, and Quinby,
2010; Rauh, 2011.

According to that formula, the
nation’s largest 126 public pensions
have liabilities with a present value
(meaning they were discounted
at their assumed rate) in 2010 of
$3.5 trillion. The amount of assets
they held was $2.7 trillion in 2010,
leaving a shortfall of $800 billion.

Is a Liquidity Crisis Imminent?
At this point, it seems unlikely that any major pension
fund will run out of cash in the next few years, barring a
general worsening of economic and financial conditions.
Indeed, increased public attention on the underfunding
problem has motivated pension plan sponsors to work
with state legislators to implement substantive reforms.

Some economists, however, have
come up with a $4 trillion shortfall.
They have pointed out that for most
state and local plans, promised
pension benefits are protected by
constitutional, statutory, or common
law guarantees. (See related article,
“Navigating the Legal Landscape
for Public Pension Reform.”) By
definition, this ought to make them
riskless obligations to the pensioners.
Thus, the appropriate valuation
methodology should discount
promised benefits using the risk-free
interest rate, usually calculated as the
yield on long-term U.S. Treasuries.
This method, argued cogently by
Jeffrey Brown and David Wilcox
in “Discounting State and Local
Pension Liabilities” (2009), has
the virtue of being supported by
both economic and legal principles.
It also produces substantially higher
estimates of the present value of
pension liabilities. Given the currently
low yields on Treasury bonds, this
approach implies a present value
of accrued obligations as high as
$6.7 trillion, leaving an unfunded
liability of $4 trillion.
—John Carlson

But we are not out of the woods yet. Many funds will
require significant reforms to reduce underfunding
levels, with painful new contributions from employers
and employees. Over the long term, a stronger, steadier
economy would help a lot by supporting higher asset
returns. Meanwhile, an imminent collapse of several large
funds, accompanied by a shock to the financial system,
remains improbable—though not impossible.

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7

Pension Glossary
Terms that any public pension reformer
should know. Changes in any of these areas
could make a meaningful difference in a
plan’s funding level.

Average final salary: The salary on
which the employee’s benefits are based.
To prevent pension spiking (see below),
the final salary is often the average of the last
few years of the employee’s career.
Base benefit: The funds the member can
receive at retirement based on the factors in
the benefit formula (often years of service,
final salary, and so on).
Cost-of-living adjustment (COLA):
A strategy intended to preserve what
economists call the “real” value of the base
benefit, ideally by adjusting for inflation.
Unfortun­ately, some COLAs are not indexed
to inflation; they are simply nominal escalators
(like a 3 percent increase each year, which
may or may not be in line with inflation
changes) that can quickly increase a pension
fund’s liabilities.

Over the longer term, the current low-interest-rate
environment may be cause for concern. Fund managers
will struggle to achieve 8 percent yields without shifting
their portfolio composition toward higher-yielding assets,
which are inherently riskier. Managers’ “reach for yield,”
if practiced widely, would make pension plan sustainability
particularly vulnerable to another negative shock to
equity prices.
Another concern is that some states’ legal protections may
be too strong to give reforms enough time and flexibility
to put plans on sustainable paths. In that case, states
would ultimately be on the hook for covering pension
benefits out of general revenues. This scenario, by creating
crisis conditions in those states, could stress economic
conditions more generally. But we have by no means
reached that point yet. ■

Deferred-benefit pension: A form of
deferred income payable during one’s life
after retirement.
Increases in required retirement age and
years required to vest: A potent tool in the
pension-reform toolkit. Lengthening the
time it takes for pension benefits to vest
is usually less contentious than increasing
employees’ contributions.
Pension spiking: The practice of inflating
employees’ salaries to increase their benefit
base. This can be accom­plished through a
last-day “promotion,” where the employee
receives a new title and a salary far above
what he earned in the previous 364 days,
or where an employee nearing retirement
receives the lion’s share of available overtime.
—Moira Kearney-Marks,
Research Analyst

Recommended reading
Robert L. Clark, Lee A. Craig, and John Sabelhaus. 2011.
State and Local Retirement Plans in the United States.
Cheltenham, UK; Northampton, MA: Edward Elgar.
Alicia H. Munnell, Jean-Pierre Aubrey, and Laura Quinby.
2010. “The Impact of Public Pensions on State and Local
Budgets.” Center for Retirement Research (October).
http://crr.bc.edu/briefs/the_impact_of_public_pensions_on_
state_and_local_budgets.html

Robert Novy-Marx and Joshua Rauh. 2009. “The
Liabilities and Risks of State-Sponsored Pension Plans.”
Journal of Economic Perspectives 23(4): 191–210.
http://kellogg.northwestern.edu/faculty/rauh/research/
JEP_Fall2009.pdf

Pew Center on the States. 2010. “The Trillion Dollar Gap:
Underfunded State Retirement Systems and the Road to
Reform.” (February 18).
www.pewcenteronthestates.org/downloads/
The_Trillion_Dollar_Gap_final.pdf

Joshua Rauh. 2011. “The Pension Bomb.”
The Milken Institute Review 13(1): 26–37.
www.milkeninstitute.org/publications/review/2011_1/26-37.
mr49.pdf

Ronald Snell. 2011. “Pensions and Retirement Plan
Enactments in 2011 State Legislatures.” National
Conference of State Legislatures (January 31).
www.ncsl.org/?tabid=22763

8

Spring 2012

Public Finances: Shining Light on a Dark Corner

Monitoring the Risks of State
and Local Government Finance
Jean Burson
Policy Advisor

The finances of many state and local governments are in a
somewhat precarious condition. First came the financial
crisis and recession, which sapped tax revenue and stretched
budgets. Then came the painfully slow recovery, which
ramped up demand for social safety net services, especially
unemployment benefits. Despite some modest improvements, the blows to state and local governments have been
heavy. According to the Center on Budget and Policy
Priorities, 29 states will be facing budget shortfalls for fiscal
year 2013. On top of all this, governments are struggling
to address chronic underfunding of their pension plans.

Just how much should most Americans worry that some
state and local governments could go into default? That’s
what a team of researchers from the Federal Reserve
Banks of Cleveland and Atlanta has been studying over
the past year. The Municipal Financial Monitoring Team
has been looking at how shocks to the municipal bond
market, continued problems with pension funding, and
general fiscal stress could ripple into something much
larger—either in the form of a (rather unlikely) threat to
financial stability or perhaps as an aggravation of regional
economic woes.

F refront

9

While municipal bankruptcies are rare, Jefferson County,
Alabama, filed for financial reorganization last year, which
was the largest municipal bankruptcy in U.S. history.
To understand these issues, the Monitoring Team has
been exploring a number of areas where risks may be
building. These include:
	Connections to the financial system: Chronic underfunding of public pension funds and the effects of
the recession are straining municipal budgets. While
widespread default appears unlikely, should the financial
system’s exposure to municipal budget problems be
cause for concern?

■

	Investment portfolios: What are pension funds invested
in? Those that are counting on high investment returns
to close their funding gaps may be edging into riskier
bets, which in the long run may imperil them further.

■

	Defined-benefit versus defined-contribution plans:
Although the private sector has mostly moved into
defined-contribution—usually 401(k)—plans, the
public sector is dominated by defined-benefit plans.
This puts state and local governments on the hook
for providing the promised benefits. Would conversion
to defined-contribution plans be a step in the right
direction?

■

	Contagion in the municipal bond market: Downgrades
of municipal debt or shocks to sectors of the municipal
bond market could increase borrowing costs across the
board, further deepening fiscal distress and creating
additional headwinds for the recovery.

■

Getting a handle on the likelihood and severity of these
outcomes can be a difficult task. Up-to-date, comparable
data are scarce, especially at the county and city level. Most
public pensions report only on an annual basis; even then,
comprehensive data to support meaningful financial and
risk analysis are limited. Despite these challenges, our team
has made enough progress to arrive at some preliminary
findings.

10		

Spring 2012

The State Scenario
At the state level, the bottom line is that the probability
of a government defaulting on its financial obligations is
extremely low. After all, state governments maintain the
authority to raise taxes (however politically unpopular)
to cover any shortfalls. And these entities are subject to
the market discipline of higher borrowing costs should
they fail to meet their financial obligations.
Even so, as the financial crisis demonstrated, improbable
events can occur. So it’s a useful exercise to think through
what might happen if a government did fail, triggering a
contagion that could spread to players ranging from banks
to money market mutual funds. Or how investor concerns
that lead to higher borrowing costs might compound a
region’s economic struggle.
Under what circumstances might the default of a large
state government shock the financial system? It depends
primarily on the exposure of large, complex financial
institutions to the default. Our preliminary analysis suggests
that an isolated default is unlikely to trigger a systemic
event, but it might cause a temporary contraction of credit
as financial institutions reallocate their holdings and divest
downgraded municipal debt. And we’re still digging into
what might happen if more than one default were to take
place at the same time.

The Local Scenario
Trouble in the municipal bond market is another possible
risk to financial stability. It’s a difficult market to assess:
its transaction volume is typically low, since most investors
buy bonds and hold them. This lack of liquidity makes
it more difficult to accurately judge fair market prices.
Also, the availability of information on issuers’ financial
condition varies greatly. While it’s fairly easy to get reliable
information at the state level, disclosures by municipalities
or by other issuers, such as school and sewer districts,
are provided inconsistently and with considerable lags.
A sudden, unanticipated municipal bond default could
cause a sharp decline in investor confidence, potentially
leading to a rapid selloff. If investors thought that defaults
among multiple issuers were highly correlated, growing
uncertainty could fuel a downward spiral of selling and
investor losses.

Yet the potential for systemic risk seems low. To be sure,
a material decline in any given municipality’s debt would
put its taxpayers under stress and perhaps dampen the
local economy. And financial institutions with exposure
to those municipal bonds would take losses. Furthermore,
the financial crisis taught us that the context in which an
unanticipated default takes place matters greatly.
But the municipal bond market’s reaction to recent events
confirms some of our preliminary assessments. Several
municipal securities were downgraded last summer
after one credit-rating agency lowered its AAA rating on
U.S. sovereign debt. A flight-to-quality strategy, however,
actually increased investors’ demand for municipal bonds
more generally, producing yields that in some cases reached
record lows. Despite its opacity and low trade volume, the
market is clearly resilient. That’s not to say there is no need
for careful monitoring, particularly in light of the significant
fiscal challenges many state and local governments face.
While municipal bankruptcies are rare, Jefferson County,
Alabama, filed for financial reorganization under Chapter 9
of the U.S. Bankruptcy Code last year because of
$3.1 billion in defaulted sewer bonds, which made it the
largest municipal bankruptcy in U.S. history. This filing
followed the bankruptcy of the small town of Central
Falls, Rhode Island. Although neither of these events

Given the complexities of municipal bankruptcies, our team
concludes that filings will likely remain rare, isolated, and
last-resort events.
had a spillover impact on municipal bond markets, they
highlighted both the legal challenges associated with
municipal bankruptcy and the political and legal realities
of undertaking meaningful fiscal and public pension fund
reforms. All the same, given the complexities of municipal
bankruptcies, our team concludes that filings will likely
remain rare, isolated, and last-resort events.
Assessing the mounting pressures on state and local
govern­ment finance and evaluating the resulting
implications for the stability of our financial system and
regional economies is a complex, but important, challenge.
While the conclusions of preliminary analysis do not
suggest the risk of systemic threats, we remain vigilant
in monitoring conditions that could shock the financial
system or threaten the economy’s footing on its path
to recovery. ■

the drawing board

Public Finances Made Simple
For an animated take on public finances, check out the
latest episode of the Cleveland Fed’s Drawing Board.
Really bad drawings, real simple explanations—a
concise synopsis of a complicated issue in a brief video.
www.clevelandfed.org/forefront

F refront

11

Public Finances: Shining Light on a Dark Corner
State by State
It is comparatively easy to modify pension
plans in Texas, where they are still treated
as gratuities. This is also true in Indiana and
Montana, where employees are required to
participate in pension plans.

Navigating the
Legal Landscape for
Public Pension Reform:
Travel at Your Own Risk

Everywhere else, the law is far murkier. Legal
experts describe the area of public pension
law as “unsettled,” which makes it difficult to
spell out what reforms can be accomplished.
In at least 27 states, pension members’
past and future accruals are protected, 1
but to different degrees. (Past accruals
are benefits for services already performed,
and future accruals for benefits yet to be
earned.) These varying degrees of protection
complicate the task of modifying current
members’ pension plans.
These states treat public pension plans as
contracts that must conform to constitu­
tional, statutory, or common law (the last
of these was developed through court decisions interpreting statutes or constitutions).

1

Moira Kearney-Marks
Research Analyst

Meaningful reform of public pensions can happen in a number of
ways: You can alter cost-of-living adjustments. You can reduce future
benefits. Or you can raise the retirement age, to name just a few.
Before the 1970s, public pension reform along any of those lines
would have been a snap compared with today. Back then, public
pension plans were generally treated as gratuities, gifts from the
state. Legally, they could be easily modified or terminated at any
time (though politically might be another matter).
Those days are over. Today, nearly all states protect public pensions
to varying degrees, working in a complicated legal environment.
As a result, reform-minded policymakers have to tread carefully,
treating each state as a separate case. By no means is public pension
reform out of the question, but legal precedent in a given state
determines what reforms are realistic there.

Past and Future Accruals Protected
Alabama
Alaska
Arizona
California
Colorado
Delaware
Georgia
Idaho
Illinois

Kansas
North Dakota
Kentucky
Oregon
Massachusetts Pennsylvania
Mississippi
South Carolina
Montana
Tennessee
Nebraska
Utah
Nevada
Vermont
New Hampshire Washington
New York
West Virginia

2
		

Past and Future Accruals Protected
by Constitution

Alaska
		

Arizona
New York

Illinois

3
California Rule Followed
Alaska
California
Kansas

Mississippi
Nebraska
Nevada

Oklahoma
Vermont
Washington

4
Only Past Accruals Protected
Massachusetts
Ohio
Wyoming
New Mexico
Wisconsin
		
(and possibly New Jersey)

12		

Spring 2012

At least four of these states base this
2
protection on their own constitutions,
which provide the strongest form of legal
protection possible. The other 23 states base
this pro­tection on statutes or common law.
Under the contract approach, any modifi­
cation to a public pension plan must be
scrutinized under the Contracts Clause in
the state and federal constitutions, which
can set a high standard. The Clause prohibits
states from passing legislation that sub­
stantially impairs an existing contract, but
even a substantial impairment does not
violate the Contracts Clause if it is reasonable
and necessary to achieve an important
public purpose.
The “reasonable” bar is not set high. A
modification is deemed reasonable if it bears
some material relation to an important public
purpose. “Necessary” is another matter. To
establish that a modification is necessary,
the state must show that it could not achieve
its intended outcome through either a less
drastic measure or no action at all. This is
a more difficult legal standard to satisfy;
a financial crisis might be one of the few
events providing a “necessary” motivation
for reform, but this is untested in courts.
At least nine states follow the California
Rule, an important variant of the contract
approach. Adopted first in the California
courts and then in other states, this rule
provides contractual protection for
3
both past and future accrued pension
benefits from the time employment
begins. In other words, public pensioners in
states following the California Rule cannot
have their benefits reduced at any point.
Of course, the California Rule has an
exception: “Reasonable” changes, as defined
by the courts, are allowed. A modification is
considered reasonable if it “bear[s] some
material relation to the theory of a pension
system and its successful operation,” and if
any benefit reductions are offset by compa­
rable increases. To complicate matters further,
some states require a federal Contracts
Clause analysis—in addition to the analysis
provided in the California Rule—to determine
whether the proposed modifications would
deprive members of their contractual rights.

Case Studies

The Future of Reform

Different courts offer different opinions,
of course.

Despite increases in public pension plans’
unfunded liabilities, constraints on unilateral
public pension modifications may make
meaningful pension reform difficult or
impossible. The most immediate cost
savings would come from modifying retired
members’ pension plans, but this is usually
prohibited. In many instances, it is also
difficult to modify the terms for current
employees. Modifying plans for only new
hires may not provide all the financial relief
that states and municipalities need today.

For example, lower courts in Minnesota and
Colorado recently upheld legislation that
reduced cost-of-living-adjustments (COLAs)
for public pensions. The Colorado Supreme
Court had previously adopted the California
Rule, but it did not rule on whether the COLA
was a part of the contract. The lower court
found that the COLA was not a part of the
contract and therefore could be modified
by the state legislature. In Minnesota, the
court held that pensioners had no reasonable expec­tation of a particular COLA, and
therefore the legislature could modify it.
This is an important issue—COLAS are
expensive to fund, and reducing them
would help public pensions close their
funding gaps. In light of these recent
opinions, other states may also find that
COLAs are not part of the public pension
contract. But these cases are not controlling;
only higher courts can bind lower courts,
and decisions in one state are not binding
on others.
In states where only past accruals are
protected, current plan members’ future
accruals can be modified. At least five
4
of the states where only past accruals
are protected, including Ohio, view
public pension benefits not as contracts,
but as members’ property. Once members’
rights in a public pension plan are considered
property, they are entitled to protection
under the U.S. Constitution’s Due Process
(Fifth and Fourteenth Amendments) and
Takings (Fifth Amendment) clauses, and
relevant state constitution equivalents.
But this tends to work in favor of reformers.
Employees’ challenges to pension plan
modifications on due process grounds
and under the Takings Clause are usually
unsuccessful. (Takings occur when the
government seizes property, either
physically or by inhibiting its use.)

The bottom line is that the law is bound by
considerations that are completely different
from those reformers might have in mind.
And that may be the ultimate legal lesson:
If you want to help public pension plans
close their funding gaps by reducing benefits,
the law will probably work against you. ■

Recommended reading
Amy Monahan. 2010.
“Public Pension Plan Reform:
The Legal Framework.” University
of Minnesota Law School, Legal
Studies Research Paper Series,
Research Paper No. 10-13 (March).
http://ssrn.com/abstract=1573864

F refront

13

New Consumer
Watchdog Stands Guard:
Q&A with Leonard Chanin
Q: Why do we need a consumer
finance regulator? Aren’t our existing
regulators adequate?

Leonard Chanin
Associate Director, Regulations
Consumer Financial Protection Bureau

The Consumer Financial Protection Bureau is up and running. Created under
the Dodd–Frank Act of 2010, the Bureau—an independent agency, funded
through the Federal Reserve—is the American people’s watchdog over
financial services companies. Former Ohio Attorney General Richard Cordray
took over as the Bureau’s director in January. As required by the Dodd–Frank
Act, a string of proposed new rules covering mortgage lending practices is
set for rollout.
Among the Bureau’s top officials is Leonard Chanin, the former deputy
director of the Federal Reserve’s Consumer and Community Affairs Division.
He now heads the regulation unit, which is responsible for developing new
consumer finance protection rules in coordination with the Bureau’s market
analysts and economists, and others at the Bureau. We interviewed Chanin
on February 13, 2012. Here is an edited transcript.

14

Spring 2012

Chanin: We used to have seven
agencies responsible for different
consumer finance laws. The problem
was that no one agency had responsibility for all of those laws, so it
was difficult to assess the best
approaches. That also made it a
challenge to address events in a
quick fashion. Now, with one entity
responsible for developing rules,
supervising institutions, enforcing
rules, and educating consumers, we
can have consistency and continuity
across the board.
Q: What is unique about financial
products compared with other
consumer products?
Chanin: Financial products are
usually not an end in themselves.
They are a means of getting someplace else. A mortgage loan is used
to buy a house. A home equity line
of credit allows people to engage in
significant major expenses; things
like education, medical treatment,
and home repairs. And a credit card
is the same thing. These products
exist to help people achieve other
goals or needs. That makes financial
products different.

What’s also unique is that consumers
use these products for different
purposes. With credit cards, for
example, some use them as a monthto-month convenience and pay them
off every month. Those consumers
are looking for very different features
than consumers who use credit cards
as a true loan and make just the
minimum payment every month and
keep a running balance.
A consumer who pays a credit card
balance off every month may not
care about the interest rate, but he
or she may care about any annual
membership fee. The other household would definitely be concerned
about the interest rate. This makes
choosing a financial product a
complex decision, increasingly
so due to technological changes
that have opened up more ways to
access products.
Q: What role do you see for
disclosures in the Bureau’s rule­
making efforts?
Chanin: One of the things that the
Bureau seeks to achieve is to make
information clear so that consumers
can understand the costs and main
features of products. The way to
do that is with clear and meaningful
disclosures. We don’t want disclosures
that distract people from determining
what things are most important in
their choices.
As a result, the Bureau is committed
to consumer testing of disclosures.
We’re conducting one-on-one testing
with consumers for several of our
projects to see what they understand. This helps us know what
information consumers need and
how they use that information. That
will help us do a better job.

Q: Are you concerned that increased
regulation of consumer finance
products will dampen innovation?
Is there a risk that your office will
actually make it harder for consumers
to obtain the financial services they
need, now and in the future?

We keep in mind the impact that
regulations have on community banks
and small institutions.

Chanin: We are mindful of how
regulations can affect the options
that consumers have. For example,
we want to ensure that people have
the ability to use emerging or recent
technological developments with
financial products.

Q: Even though the Bureau’s
authority extends mainly over institu­
tions with more than $10 billion in
assets, many community bankers are
concerned about regulatory overstep.
How will the Bureau’s existence
affect community banks?

Some consumers use mobile phone
apps to send remittances; the issue
that arose here was that the under­
lying statute generally requires
written disclosures, but that doesn’t
make sense for mobile phones. If a
consumer is able to send a remittance
via his or her phone, requiring written
disclosures before a transaction can
be made would delay the ability of a
consumer to send the funds quickly.

Chanin: Our supervision authority
extends to depository institutions
with over $10 billion in assets, and,
of course, certain nondepository
institutions, such as finance companies. But the regulations generally
apply to nearly all institutions, subject
to certain exceptions established by
Congress in the Dodd–Frank Act.

The final regulation adopted by the
Bureau allows remittance providers
to send the disclosures via an app
or text directly to the consumer’s
phone. They do have to follow up
with a written disclosure, but that’s
after the fact, confirming the deal.
This is one example of how we look
at technological innovations and
balance the costs and risks of limiting
consumer preferences with the need
for consumer protection.

We keep in mind the impact that
regulations have on community
banks and small institutions. If it
is feasible to have special rules or
limited rules, or even exceptions for
community banks and for smaller
institutions more generally, we will
look at those possibilities. We know
that community banks have quite
limited ability to absorb additional
compliance costs and to hire people
to manage those matters. If they
can’t do these things, they may not
offer the products covered by the
regulations, which can pose hardships for consumers in rural areas
where there are fewer providers.
So within the overall process of rulemaking, we are looking to see which
rules will have impacts on community
banks and where flexibility can be
built into the process. ■
Interviewed by
Doug Campbell, Editor

F refront

15

The Economics
of Taxation

Daniel Carroll
Research Economist

Sure we need taxation—but how much?
An economist ponders the tradeoffs in tax system design.
America faces tough choices on fiscal policy. Pressures
from years of deficits have been amplified by the Great
Recession, which reduced taxable income and strained
social safety nets. Nonpartisan agencies like the Congressional Budget Office report that our aging population and
rising medical costs make current policy unsustainable.
Add 40 years of worsening income inequality, which has
raised cries for income redistribution, and our tax system
is more burdened now than it has been for a long time.
Yet our tax code is less able than ever to meet these
demands. Fresh exemptions and deductions shrink revenue
and favor some households, often for no clear economic
reason. Meanwhile, public debt keeps mounting. Although
still manageable, it will grow substantially unless we address
our projected fiscal imbalances. The current European
crisis shows the grim result of ignoring imbalances.

16

Spring 2012

Deficits can be closed by either raising taxes or cutting
spending, or some combination of both. On the tax side,
some basic economic principles can help get us there, and
can even help ensure continued economic growth. But
even though economics can tell us plenty about how to
build a good tax code, the decision is ultimately political.

Purposes of Taxation
Economists say taxation fulfills one or more of these
purposes:
	to discourage/encourage behavior whose social costs/
benefits are not priced by a market

■

	to raise revenue to pay for government spending

■

	to redistribute resources

■

Sometimes market prices do not fully account for behavior’s
social costs, so people engage in behaviors that are sub­
optimal for the economy. Pigouvian taxation (named after
the English economist Arthur Pigou) corrects market prices
by raising people’s costs. Take the carbon tax: People buy
gas at a market price that reflects the pressures of supply
and demand. But that price does not reflect externalities,
the costs that drivers impose on society but do not bear
directly or fully—in this case, air pollution and traffic
congestion. Because drivers fail to internalize the costs
of their behavior, we get more traffic and pollution than
we would like to see. A carbon tax increases the price
everyone pays and encourages people to reduce overall
consumption by driving less, carpooling, or switching to
vehicles with better gas mileage.

Understanding Efficiency
Pigouvian taxes can take us only so far. They cannot be
relied upon all by themselves to fully finance government
spending.
We know that taxes change people’s behavior, partly by
reducing the income available for consuming and saving.
This is unavoidable—if any given public project is desirable
enough, people find it less painful to hand that income over
to the government. But taxes can also change behavior
another way. They may influence people to trade consump­
tion for leisure by working fewer hours, or to consume
more and save less. Theoretically, one way to raise revenue
without imposing such distortion is through a lump-sum
tax. Such a tax is best for a public project because everyone
pays a fixed amount whatever their earnings, amassed
wealth, or consumption. The amount they pay does not
depend on their decisions, so they behave as they would
in a perfect, distortion-free world.
Unfortunately for those not living in a stylized model
(that is, everyone), a lump-sum tax is totally impractical.
Setting aside the political blowback from taxing the very
poor as much as the very rich, the numbers simply do
not add up. Given the amount to be raised, the poorest
individuals could not afford the required tax. Though
impractical, lump-sum taxes provide a useful benchmark
for judging how much an alternative tax scheme distorts
the economy.

Not All Tax Bases Are Created Equal
So how can we raise revenue while minimizing distortions?
There are multiple options using different bases. The
primary U.S. tax bases are general income, labor income,
capital income, consumption, and wealth (like property
and estate taxes). We also tax international trade, but
this contributes relatively little to total revenue. Each tax
incentivizes certain behaviors and discourages others,
distorting the economy. Labor income taxes, like those for
Social Security and Medicare, distort work decisions by
making leisure more attractive. Consumption taxes (such
as a sales tax) operate like a labor tax by reducing the
consumption value of an hour of labor. Capital income
taxes, based on returns from investments, discourage
investment and saving and encourage consumption.

Unfortunately for those not living in a stylized model
(that is, everyone), a lump-sum tax is totally impractical.
Capital income taxes impose especially severe distortion
because returns to capital accumulate over time, and
distortion from capital income taxes is compounded
(much like interest in a savings account). Small distortions
are magnified over time.
Wealth taxes introduce yet another wrinkle—time
inconsistency. What if the government decided to finance
its operations by suddenly appropriating all automobiles
in the country, selling them abroad, and then using the
proceeds to pay for projects, redistributing the remaining
revenue, and promising to never do it again? Does this
introduce distortions? It depends.
The key idea is that the current stock of automobiles is
what economists call inelastic, meaning that it cannot be
changed in an instant. It takes time for people to sell their
cars in response to changes in policy. However, if the
government were to forewarn people that it was going
to tax away 100 percent of all automobiles, drivers would
attempt to sell their cars and convert them into other
assets, or if possible, spend resources to hide their cars.
That’s why the last feature of the government’s plan is
critical: Unless it vows to never use this type of tax again,
car ownership will shrink drastically and remain low.

F refront

17

Average Federal Tax Rates for U.S. Households
Percent
35
Household income

35

Lowest 20 percent

Middle 20 percent

Highest 20 percent

30
25
20
15
10
5
0

1979

1984

1989

1994

1999

2004

2007

Source: Congressional Budget Office Study, 1979–2007.

Whether this scheme is distortionary depends on whether
people believe the government’s promise. If they do,
incentives shouldn’t be distorted. Nonetheless, the scheme
is likely to be distortionary because rational people will
recognize that if they believe the government’s promise
and buy new cars, they will give the government an
incentive to repeat the appropriation process. So they
will either reduce the effect of the tax by buying very lowquality cars or avoid the tax altogether by arranging for
other transportation methods (such as public transit,
for example). Either way, the value of the stock of cars
in the economy will shrink.
Most taxes on wealth are very distortionary, but that
doesn’t put them off limits. Although the United States
uses property and estate taxes, their effect on the capital
stock may be less severe because these two types of asset
aren’t easily shifted. It’s hard to move your house where
the government can’t find it, and a deceased person cannot
hide her wealth (though she may have saved less or paid
handsomely for advice on shielding it).

Redistribution
Redistribution is a politically charged issue, and fairness
is a subject more suited for social philosophers than for
economists; however, economists can help quantify the
tradeoffs from redistribution.
For instance, there is a widespread misconception that
income inequality, as measured by the share of before-tax
income held by a small percentage of the people, should
be corrected by taxes and transfers. Altering the before-tax
18

Spring 2012

income distribution is a proper goal for policies designed
to increase people’s opportunities to generate income
(through education reform, say). But it should not be the
target when the subject is how to reallocate income. In
fact, the extent to which redistributionary tax policy alters
before-tax income distribution is actually a measure of the
cost rather than the benefits of redistribution.
For tax policy to change the distribution in the before-tax
income, the rich must respond to redistribution by working
less and saving less. This would have two consequences:
a loss of productive economic activity, since both capital
and labor are reduced; and, because the rich have less
income, less will be available for future redistribution.
Instead, redistributionary policy should focus on changing
the income distribution after taxes and transfers have
been applied. Success is best measured by how the little
before-tax income distribution is altered to meet the
redistributionary target.

Policy Guidelines
What should we look for in a tax policy? First, it should
focus on the long run. Knowing what fiscal policy will be
for years to come allows households and businesses to
make long-term investment decisions. Frequent policy
changes create uncertainty. Typically, economists think of
optimal fiscal policy as setting the course for the long run,
and monetary policy as stabilizing the economy over the
business cycle.
The second general guideline is that, all else equal, a simpler
code is preferable to a more complicated one. Because we
are constrained to using distortionary taxes, good fiscal
policy should err on the side of simplicity. Each caveat,
exemption, and loophole encourages one behavior and
discourages another. Most often these complications are
rooted in short-term political calculations rather than
long-term economic ones. And as the tax code becomes
more complicated, it also becomes more confusing. This
unnecessarily generates large industries where highly
skilled labor is diverted toward helping people correctly
file (and avoid) taxes and toward helping the government
monitor taxpayers for compliance. Thus, a complicated
tax code introduces a greater “deadweight loss” because
the labor it requires could be better used to solve problems
that government has no direct power to control.

Two Types of Optimal Taxes
So what is the optimal tax? Yes, it’s complicated. And even
though economists have not discovered the perfect tax
policy (and almost certainly never will), several schemes
have proven optimal within wide classes of research efforts.
The first is a consumption tax. When constant over time,
a consumption tax has the desirable quality of not distorting
savings. It may seem counterintuitive at first, but consider
a person who gets some income today and is weighing
whether to spend it now or save it. If she spends it today,
she pays a consumption tax of x percent, reducing the
amount she can consume with the money. On the other
hand, if she saves the income for tomorrow, then when
she decides to spend it, the consumption she can afford
is reduced by the same x percent. The consumption
tax, then, does not favor consuming now or waiting and
consuming tomorrow. The only thing our hypothetical
person must consider is whether the interest paid on her
savings justifies the wait.
But the consumption tax is distortionary in its effect on
the labor/leisure decision. The tax makes consumption
costlier, so a dollar earned from working does not go as
far. Leisure becomes more attractive.
The biggest problem with a consumption tax is that it
is regressive. Poor households consume a much larger
fraction of their income than rich ones, so a consumption
tax is particularly onerous for them. Of course, a consump­
tion tax need not be flat. Rates that increase with total
consump­tion and sizeable tax rebates are two ways to
get the efficiency benefits of a consumption tax while
addressing progressivity concerns.
When economists limit available tax policies to income
taxes only, another prominent optimal tax emerges: a flat
income tax with a large exemption for initial earnings.
For all households, income below a given level would not
be taxed. Income above that would be taxed at the same
marginal rate. A flat tax at the upper end causes less
distortion for households that tend to save, compared to
a progressive schedule that keeps raising rates at higher
income levels. The exemption also makes this tax more
attractive to lower-income households that, under any
proportional tax, are likely to suffer a greater welfare loss
than their more affluent counterparts.

A tax policy should focus on the long run. Knowing what
fiscal policy will be for years to come allows households and
businesses to make long-term investment decisions.

That Said…
A good fiscal policy should be no more complicated than
necessary. It should generally be focused on longer horizons
and be credible, so that people can make long-term decisions
with confidence. Good fiscal policy should seek to meet
policymakers’ goals while imposing minimum distortion
on people’s economic decisions. Policies that distort savings
are particularly costly, and policymakers should give these
costs added weight in balancing the distortion of capital
taxes against the benefits of broader policy objectives.
Economics, however, can take us only so far in designing
a tax code. It can help whittle down the set of possibilities
to taxes that meet policy aims with less distortion, but
ultimately, the final choice is political. People disagree about
which behaviors should be incentivized or discouraged,
how much government spending is necessary, and whether
(and to what degree) resources should be redistributed.
These disagreements may be very difficult to resolve. While
economics cannot settle this conflict, it can at least focus
the debate by highlighting the tradeoffs inherent in any
tax proposal. ■

Resources
Daniel Carroll and John Linder. 2011. “Reducing the Federal Deficit:
Approaches in Some Other Countries.” Federal Reserve Bank of
Cleveland, Economic Commentary (October).
www.clevelandfed.org/research/commentary/2011/2011-22.cfm

Daniel Carroll. 2011. “The Demand for Income Tax Progressivity
in the Growth Model.” Working Paper No. 11-06. Federal Reserve
Bank of Cleveland, (February).
www.clevelandfed.org/research/workpaper/2011/wp1106.pdf

Congressional Budget Office. 2010. “Average Federal Tax Rates
by Income Group.” (June 1).
www.cbo.gov/publication/42870

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19

Meeting the
Demand for Cash
Nelson Oliver
Research Analyst

Dan Littman
Economist

When it comes to using cash, it’s like the flip of a coin:
Americans still use cash roughly one out of every two times they
buy something. And for transactions of less than $10, physical
currency—banknotes and coins—rules. Although less popular for
higher-value trans­actions and rarely used in the
fast-growing realm of online commerce,
cash remains the most common method
of payment for goods and services the
world over.
It takes a pretty big infrastructure to keep
cash flowing. Behind the scenes, players in the
“cash cycle” include the Bureau of Engraving and
Printing, armored carriers, cash vaults operated by
financial institutions and armored carrier companies,
bank branches and ATM networks, retailers—and yes,
the Fed.

20

Spring 2012

How Much Cash Are We Talking About?
Most U.S. paper currency by volume (number of notes)
is used in the United States, with the $1, $5, $10, and
$20 notes making up the lion’s share of all transactions.
But because the dollar is widely trusted abroad, most
U.S. currency (by value) is held in foreign countries,
primarily in $50 and $100 denominations. The Federal
Reserve Board of Governors reports that the volume
of cash in circulation has more than doubled (from
13.5 billion to 31.3 billion) in the past 20 years, and
the value of that cash has more than tripled (from
$268.2 billion to $1.03 trillion).
Cash is used as a medium of exchange in virtually all
aspects of the economy. In some minority and lowincome communities, whose residents are
disproportionately unbanked, cash is
used exclusively. In fact, a recent FDIC
study shows that 25.6 percent of all U.S.
households (30 million) are unbanked or
underbanked. So even though cash accounts
for only 0.2 percent of the total value of trans­
actions in the United States, the volume of cash
transactions clocks in at 49 percent.

Value and Volume by Payment Type
Payment		Percentage		 Percentage
type
Volume
of volume
Value
of value
ACH

19.1 billion

9.0%

$37.2 trillion

3.3%

Cash

107 billion

49.4%

$1.8 trillion

0.2%

Checks

24.4 billion

11.3%

$31.1 trillion

2.8%

Credit and
debit cards

65.5 billion

30.2%

$3.44 trillion

0.3%

Wire
transfer

222 million

0. 1%

$1,046 trillion

93.4%

Sources: Federal Reserve Payments Study; McKinsey Payments Map.

How Does the Cash Cycle Work?
With such large-scale demand, the cash cycle—and the
Federal Reserve’s role in it—continue to be vital to the
economy. Although the Fed doesn’t actually print money
(that is the job of the Bureau of Engraving and Printing,
or BEP), it is responsible for maintaining enough notes in
circulation to meet public demand. Each year the Federal
Reserve negotiates a print order with the BEP to fulfill
the next year’s anticipated demand for cash, replace worn
currency, and accommodate the production demands
associated with introducing new currency designs. The
Federal Reserve Board’s 2011 fiscal year print order
was 6.4 billion notes, with a face value of $165.3 billion.
The Fed also ensures the integrity and fitness of notes,
destroying those that come into the Fed dirty, torn, limp,
worn, or defaced.

Volume of Cash in Circulation
Billions of notes
35
$100

30

$50
$20

25

$10
$5

20

$1

15
10
5
0

1990

Source: Federal Reserve Board.

1995

2000

2005

2010
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21

The Cash Cycle

Federal Reserve Banks

When banks have excess currency, they can
deposit it at the nearest Fed office, where it will
be piece-counted, authenticated, evaluated for
fitness to be re-circulated, destroyed if unfit,
and readied for recirculation if fit.

Cash logistics

Currency is supplied to the banking system
on demand. Most of the notes are distributed
to U.S. financial institu­tions, and from them
to bank branches, ATM networks, retailers,
and other end users for transactional use.

Cash logistics

Deposits
Withdrawals
ATM use

Consumers and
other retail customers

Payments made to merchants

22

Spring 2012

Financial
institutions

Purchases
Point-of-sale cash back

Deposits
Withdrawals
Change orders

Retailers and
other businesses

Merchant interaction with banks

Five Key Methods
the Fed Uses to
Distribute Cash

1.	The 12 Federal Reserve Banks operate 28 cash-processing facilities housed in 11 main offices,
15 branch offices, and two satellite offices.
2.	Ten cash depots temporarily store cash supplied by the nearest full-service Fed office. This
reduces the costs and transit time to depository institutions located far from a full-service Fed
cash operation.
3.	The Federal Reserve Banks have contractual obligations with 168 coin terminals that store,
process, and distribute new and used coins to depository institutions.
4.	The Custodial Inventory program provides an incentive to depository institutions,
92 of which are currently participating, to hold $10 and $20 notes in their vaults to
meet customers’ demand. The higher denominations continue to be filtered through
Fed Banks to help reduce the circulation of counterfeit currency.
5.	The Currency Recirculation policy requires depository institutions to pay a fee for
making a deposit of $10s or $20s and ordering the same denomination during the
same business week (a practice known as cross-shipping).

Since the Fed began operations in 1914, its cash services
have provided security and storage, verified deposits from
financial institutions, identified suspected counterfeit
notes, differentiated fit from unfit notes, and prepared fit
and new notes for shipment to banks. For many years,
the Federal Reserve Banks provided these services only
to their member banks, but the Monetary Control Act of
1980 gave all depository institutions direct access to Fed
cash services.
The evolution of cash continues, and the Federal Reserve
System must keep pace. It has already implemented
opera­tional changes to improve the efficiency and flexibility
of cash services. The Fed uses three principal methods to
distribute and process currency and coin in the United
States—its own network of processing facilities, cash
depots in other cities, operated under contract with
armored carriers, and coin terminals—and two methods
to reduce the unnecessary movement of cash between
financial institutions and the Fed (see the five key methods
above).

credit cards in 1950, ATM and debit cards in 1970, and
ACH in 1974, to the emergence of online commerce and
online banking in the 1990s, competition in the payments
marketplace has eroded the dominance of cash. Debit
transactions since 1990 have soared by 2,700 percent, and
ACH by 680 percent, while cash volume has grown by
only 4 percent annually. Checks have been the hardest hit:
Usage has declined by more than 50 percent.
Cash still has one important advantage—a sense of
control and anonymity that many other payment forms
cannot offer. One of the major aims of central banking is
to sustain people’s confidence in the overall payments and
financial system. Cash, by providing a stable, safe form
of physical currency, remains an important component
of the Fed’s ability to maintain public confidence.
Cash isn’t going away anytime soon. Nor is the Fed’s role
in the cash cycle. ■

The Future of Cash
In a mixed economy of competing payment methods,
we believe that cash will continue to be a vital part of both
the U.S. and the global economy in the foreseeable future.
But cash is no longer the king it once was. Just 50 years ago,
cash was used in 80 percent of domestic payments. Now
that number is just 50 percent. From the invention of

Want to learn more?
Check out a blog dedicated entirely to cash, with regular posts
from the Cleveland Fed, at
www.countingoncurrency.com/wp/cash-per-diem

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23

Three Reasons Why Converting Vacant Homes to
Rentals Will Be a Challenge in Some Places…

…and Three Ways It Can Succeed

Thomas Fitzpatrick IV
Economist

When a lender takes ownership of foreclosed property,
it gets a new name—real estate owned—and goes back
into the hands of the lender. And for scores of lenders
and neighborhoods, that’s a problem. More often than
not, real-estate-owned properties (or REOs, for short)
in weak housing markets sit empty. For the lender, that
means steep carrying costs. For communities, that means
increased crime and decreased values for houses nearby.
The largest holders of REOs are Fannie Mae, Freddie Mac,
and the Federal Housing Administration. Last summer,
the government put out a call for possible solutions to the
mounting REO problem. One approach that has gathered
momentum is developing incentives to help turn REOs
into rentals.
24

Spring 2012

In some cases, the properties would be sold to investors
who intended to convert them to rentals; in others, new
programs would be set up to allow lenders to rent out their
stock of REO homes, at least ensuring they are occupied.
Decay is less likely, and communities get a fighting chance
to stabilize themselves.
Unfortunately, REO-to-rental isn’t a one-size-fits-all
solution. My research, along with that of my colleagues
at the Cleveland Fed, underlines three big reasons why
converting REOs to rentals in the industrial Midwest may
prove difficult. But our research also points to three other
ideas that could go a long way toward achieving the main
goal of neighborhood stabilization, while lowering REO
carrying costs.

Why REO-to-Rental
Will Be a Challenge in Weak Markets
1. There’s probably not enough demand in weak
markets to effectively or profitably convert significant
numbers of REO homes into rentals.
In the Fourth Federal Reserve District, which encompasses all of Ohio and parts of Pennsylvania, Kentucky,
and West Virginia, population loss has been a long-term
trend. Many of the region’s older cities are distressed, and
new residential building has outpaced household growth.
This has produced a significant oversupply of housing,
which depresses home values and leads to an abundance
of vacant and abandoned properties.
In this kind of environment, it’s hard to see sufficient
demand at prices high enough to make renting profitable.
Consider the severity of the vacancy problem: Five years
after auction, foreclosed homes in high-poverty areas
of Cuyahoga County (home to Cleveland) are about
20 percent more likely to be vacant than foreclosures in
low-poverty areas of the county. If there were strong rental
housing demand, we would expect people to buy these
homes and make them available for rent, not let them
stand vacant. And since REO portfolios consist mostly
of single-to-four-family units, there are few economies
of scale that might make the financial numbers work for
larger-scale rental buildings.
Finally, recently foreclosed properties, including REOs,
are often in poor condition. Coupled with the already
weak housing demand, it would cost new owners more
to bring the homes up to code than they could reasonably
expect to recoup in rent.
2. Compliance is a headache.
Converting bulk REO holdings to rentals all but guarantees
an operational nightmare of complying with numerous
local laws, depending on where the properties are located
across the United States. REO homes will have to be
inspected and brought up to code, and licenses will have
to be issued.
For both the lender and the buyer, this process makes
bulk transfers burdensome. They each will have to comply
with different local laws in different cities. They will have

to wait, sometimes months, for cash-strapped and underequipped municipalities to inspect the homes. And they
may face further delays or even fines and lawsuits if the
inspections reveal substantial property distress. These
delays might be lengthy with bulk transfers of REOs being
converted together.
Five years after auction, foreclosed homes in high-poverty
areas of Cuyahoga County are about 20 percent more
likely to be vacant than foreclosures in low-poverty areas
of the county.
3. Some bulk buyers are slow, and historically, many are
not dependable homeowners.
My Bank’s research has found that bulk property purchasers
tend to occupy homes—with themselves, renters, or even
friends and family—more slowly than people who buy
individual homes or small batches of them. The strategy
bulk buyers follow is either to make only cosmetic improve­
ments to distressed properties with the expectation they
will be quickly rented or resold, or to abandon the homes
when sale is impossible.
In weak markets, such homes often remain empty eyesores.
They might technically be converted to rentals, but they
will be no less vacant.

Three Promising Strategies for Weak Markets
1. Use a high-capacity “land bank.”
A land bank is a way for governments to acquire and
amass vacant and abandoned, tax-foreclosed properties.
From there, the land bank managers can make strategic
choices about the properties’ future—be it demolition,
rehabilitation, or repurposing. The main idea with a land
bank is that homes are not a permanent fixture in the
portfolio—they flow back into productive use in private,
nonprofit, or public hands.
Some properties may be in such a sorry state of decline
that the land bank needs extra funding to cover demolition
costs. Granted, REO holders may be reluctant to foot
the bill for demolition. But when demolition costs are
fully covered, it’s easier to scale demolition projects. This
results in faster disposition, which can substantially lower
the REO holder’s carrying costs.

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25

For reference, those carrying costs are heavy. Property
maintenance alone can cost more than $1,000 per
property per year, not to mention possibly thousands
more for taxes and transaction costs. Rehabilitation adds
on even more—potentially a lot more—for homes that
need repairs before they can sell to an owner-occupier.
Demolition costs can seem minor in comparison.
2. Screen potential purchasers.
Given the high stakes, an extra level of scrutiny is
warranted with purchasers of REOs. Screening the poten­
tial purchaser’s history of code compliance and tenant
complaints is a good first step. Some states forbid anyone
who has outstanding code violations from purchasing
foreclosed homes. Local governments, nonprofits, and
real estate brokers are good sources of information about
property manager track records. One promising screening
practice is placing the property deed in escrow, to be
released to the purchaser once agreed-upon maintenance
has been completed.

The home’s condition should play a role in deciding
whether to dedicate REO homes to sale or rental. A
poorly maintained home is a good candidate for a land
bank, as are those in need of moderate repair.
Neighborhood characteristics come into play in
determining the vibrancy of the local market. The more
demand in the market, of course, the better. Otherwise,
bulk sales may encourage harmful speculation that merely
prolongs vacancy and causes further blight.

The Bottom Line: Flexibility
The strategies outlined in this article are nothing new
to community development practitioners and housing
policymakers. But they do reinforce the fundamental
importance of allowing for local market customization
in neighborhood stabilization efforts. We know housing
markets are not identical and there is no one-size-fits-all
approach for any of the problems housing markets
currently face. But solutions in weak markets should be
focused on reducing supply rather than creating it. ■

3. Categorize REO homes based on physical
condition and neighborhood characteristics.
Assuming there are ready and qualified purchasers for
REOs, a final useful step is dividing the homes into cate­
gories. This can help lenders and government agencies
determine what should be done with the homes before
they are released.

Recommended reading
For more on the impact of foreclosures on vacancy rates, see
Cleveland Fed Economist Stephan Whitaker’s “Foreclosure-Related
Vacancy Rates, Economic Commentary.
www.clevelandfed.org/research/commentary/2011/2011-12.cfm

Also see this proposal to harness the Community Reinvestment
Act in the fight against speculative housing transactions:
“Slowing Speculation: A Proposal to Lessen Undesirable Housing
Transactions” Forefront, Winter 2011.
www.clevelandfed.org/forefront/2011/winter/ff_2011_winter_11.cfm

26

Spring 2012

federal reserve bank of cleveland

P O L I C Y

2 O 1 2

S U M M I T

Housing, Human Capital, and Inequality
June 28–29, 2012
InterContinental Hotel & Conference Center
Cleveland, Ohio
With neighborhoods and entire regions struggling to regain
their footing in the wake of a housing crisis and economic
recession, now is a critical time to implement community
rebuilding strategies that work.
	What are the most effective strategies, particularly
in older industrial cities and the weak-market regions
that surround them?
	How is the impact of programs
best measured?

The Policy Summit will delve into these and other key
questions. This year’s event also features Federal Reserve Bank
of Cleveland President and CEO Sandra Pianalto as the opening
keynote speaker. In 2012, President Pianalto again became a
voting member of the Federal Open Market Committee.
The Federal Reserve Bank of Cleveland’s annual Policy Summit
draws several hundred academics, bankers, practitioners,
funders, elected officials, and policymakers from across the
Great Lakes region for two days of interactive sessions aimed
at illuminating key community development issues.

	Where should community leaders direct
ever-scarcer funds to gain the greatest effect?
www.clevelandfed.org/2012policysummit
Sponsored by the Community Development and Research departments of the Federal Reserve Bank of Cleveland
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27

Closing the
Region’s Education Gaps:
Community College
as a Bridge to Business

April McClellan-Copeland
Community Relations
and Education Coordinator

Who says that higher education and business don’t mix?
	Cuyahoga County Community College in Cleveland
has allied health and bioscience programs that send
graduates to jobs in area hospitals and pharmaceutical
companies.

■

	Butler County Community College in western
Pennsylvania boasts a training program that prepares
students to drill for natural gas buried deep within
Marcellus shale.

■

28

Spring 2012

	And Sinclair Community College in Dayton—home
of Wright–Patterson Air Force Base—just rolled out
a certificate program in the field of unmanned aerial
vehicles.

■

With programs like these, community colleges are doing
more than ever to identify the types of workers that
businesses need and to train students for them. But these
colleges walk a fine line: On one side is their wish to
encourage enrollment to meet the needs of the business
community. On the other side is the reality that some
would-be students aren’t necessarily prepared for the rigor
of these new programs or the jobs they are intended to fill.

Of particular concern are gaps between points of transition
—from high school to college, then from college to the
workforce. Many are expecting community colleges to
play an important role in filling those gaps.

From Partnerships to Programs
Through the years, the mission of community colleges
has remained unchanged: to provide education for people
in all segments of society through an open admissions
policy. But that doesn’t mean that community colleges
haven’t altered their tactics to fit a changing world: Many
have strengthened existing ties—and forged new ones—
with their business communities. They aim to increase
students’ chances for employment and give local employers
access to a skilled pool of job candidates.

Cuyahoga Community College (Tri-C) has strong ties
with Greater Cleveland hospitals, which in turn support
the college’s bustling allied-health-careers programs.
“We work very closely with the health-careers programs,
and students are placed very quickly,” says Karen Miller,
vice president of enrollment management and student
affairs at Tri-C. “We have many partnerships, internships,
and clinicals. It’s booming.”
Partnerships with Pura Vida restaurant and the Rock and
Roll Hall of Fame and Museum have also helped strengthen
Tri-C’s programs in Cleveland’s growing culinary and film
industries.
Efforts to match employment needs with education are
widespread. Butler County Community College is an
approved training provider for ShaleNET, a coalition of
community colleges in Ohio, Pennsylvania, West Virginia,
and New York, which provide a comprehensive program
for high-priority occupations in the natural gas drilling
and production industry.

Experts say community college enrollment is “counter­
cyclical,” that is, when the economy is bad and jobs
are scarce, community college enrollment increases.
Enrollment has been booming since the recession.

In southwestern Ohio, Sinclair Community College’s new
certificate program in unmanned aerial vehicles (UAVs)
stands to boost the region’s economic development.
Adam Murka, director of public information, believes that
UAVs, which are currently used for missile strikes in the
military, will soon be strong in the civilian market as well.

In fact, the use of UAVs has already expanded into many
non-military roles, such as disaster response, search and
rescue operations, and geographic information services.
“We have all become well aware that in the last five to 10
years, workers’ skill sets have become inextricably linked
to workforce development,” Murka says. “The four-year
colleges have been part of that, and so have we.”

Bringing In—and Catching Up—Students
Experts say community college enrollment is “counter­
cyclical,” that is, when the economy is bad and jobs
are scarce, community college enrollment increases.
Enrollment has been booming since the recession,
says Miller.
But the accessibility of community colleges can also
attract students who are unprepared for the demands of
new programs. In fact, while community colleges have
gained 21.9 percent more students since fall 2007, they
have found that more students need to brush up on skills
that they should have learned in high school.

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29

Cuyahoga Community College Enrollment:
Selected Programs

Sinclair Community College Enrollment:
Selected Programs

Students
6,000

Students
3,000
Health careers

5,000

Nursing

4,000

Business
Engineering

3,000

Public service

1,000

500

Source: Cuyahoga Community College.

Business administration
Nursing

1,500
1,000

2005

Pre-nursing

2,000

2,000

0

Liberal arts and sciences

2,500

0

2010

2005

2010

Source: Sinclair Community College.

While community colleges have gained 21.9 percent more
students since fall 2007, they have found that more students
need to brush up on skills that they should have learned in
high school.

Butler County Community College also reports that
some of its students lack math skills when they arrive, so
the school provides tutoring and other services to bring
them up to speed. “Sometimes it comes down to basic
organizing skills, such as teamwork, showing up on time—
from basic levels to more sophisticated levels,” says
Stephen Catt, Butler’s executive director of workforce
development.

Moving On
“Community colleges across the nation are seeing more
students who struggle,” Tri-C’s Miller says. “We put a lot
of emphasis on wraparound services for the students who
are coming in unprepared. We have significantly reallocated
funds for mentoring programs and increased tutoring.”
For the last four years, Tri-C has been part of a national
initiative called Achieving the Dream, which measures the
effectiveness of mentoring programs and supplemental
instruction. Since the college began keeping stats on its
mentoring programs in 2008, retention from term to term
has increased anywhere from 4 to 24 percent, Miller adds.

30		

Spring 2012

It may be too soon to say whether these programs and
partnerships have been successful, but the potential is
exciting.
Butler County Community College has a contract with
an extraction company to help fill entry-level positions
working the Marcellus shale fields in Pennsylvania. The
school has also formed collaborations and partnerships
with world-renowned training agencies in the extraction
industry.

Butler Community College Enrollment:
Selected Programs
Students
300
Business management

250

Business administration
Criminology

200

Nursing

150
100
50
0

2005

2010

Source: Butler Community College.

And the emerging energy industry is hiring as many
accountants as laborers. The training agencies with which
Butler is partnering already have an oil/gas accounting
program. “Now [students] will have the vocabulary to
understand the industry,” Catt says. He thinks this is only
the beginning of workforce development in this field.
Catt believes the top 10 percent of students in America are
headed for success, and the bottom 10 percent may get
some sort of services to help them. Community colleges
aim at the middle 80 percent, who might otherwise fall
through the cracks. “That’s where we excel,” says Catt,
“taking unprepared students and preparing them to be
successful in the workforce.” ■

Recommended reading
Dionissi Aliprantis and Mary Zenker. 2011. “Recent Changes in the
Relationship between Education and Male Labor Market Outcomes.”
Federal Reserve Bank of Cleveland, Economic Trends (September).
www.clevelandfed.org/research/trends/2011/1011/01houcon.cfm

Dionissi Aliprantis, Timothy Dunne, and Kyle Fee. 2011. “The Growing
Difference in College Attainment between Women and Men.” Federal
Reserve Bank of Cleveland, Economic Trends (October).
www.clevelandfed.org/research/commentary/2011/2011-21.cfm?DCS.
nav=RSS

Speech
www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/2011/
Pianalto_20111020.cfm

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31

Book Review

And the Money
Kept Rolling In (and Out):

The World Bank, Wall Street, the IMF,
and the Bankrupting of Argentina
by Paul Blustein
Public Affairs Press, 2005

Reviewed by
Dan Littman
Economist

Sovereign-debt crises are nothing new. Indeed, Greece—
at the center of the current European meltdown—has
defaulted on its state debts five times since it became
independent of the Ottoman Empire in the 1820s. So it
is not hard to imagine that Greece’s difficulties could have
been predicted, or that remedies could have been put
in place ahead of time to short-circuit the crisis, or that
lessons from other debt crises could have been applied
to prevent this one from threatening the survival of the
European Union.

32		

Spring 2012

Economic policymakers need not stray too far back in
history for relevant examples. Argentina has endured
seven of its own sovereign-debt crises since it became
independent of Spain in 1816. In fact, it is remarkable
how much Argentina’s crisis of the 1990s has in common
with Greece’s crisis and with the related problems in
Portugal, Ireland, Italy, and Spain.

Greece and Argentina found themselves in self-imposed
straitjackets. They couldn’t devalue their currencies—
Greece because it abandoned the drachma when it joined
the European Union in 2000; and Argentina because it
linked its peso in lockstep with the dollar after a default in
1989 and hyperinflation in the early 1990s. The Greek and
Argentine experiences show how complex it can be to
come to terms with sovereign debt. Nations have to over­
come a mixture of seemingly intractable political, economic,
structural, domestic, and international relations issues.
Learning about a past sovereign-debt crisis can provide
useful perspective for understanding the current situation
in Europe. An excellent account of the Argentine crisis
comes from a book that predated the latest crisis: And the
Money Kept Rolling In (and Out) by Paul Blustein, once
a journalist at the Washington Post and now a fellow at
the Brookings Institution. Blustein provides a narrative of
the Argentine economic crisis of 2001–02, which ended
traumatically—with the abandonment of the peso–dollar
peg, the resignation of the president, the closure of the
banking system, and dramatic increases in unemployment
and poverty.
While the immediate aftermath was horrible, Argentina
staged a remarkable economic recovery later in the decade.
Sovereign-debt default did not end up being the end of
the world for Argentina, but rather a necessary and painful
adjustment so the country could start over with a blank slate.
Two interesting aspects of the Argentine case have partic­
ular resonance to the current situation in Europe: First,
the degree to which Argentina was viewed as having been
an economic miracle in the mid-1990s, just before the
crisis began. And second, the involvement of inter­national
organizations like the IMF and the World Bank and of
other countries like the United States, working with
Argentine authorities to try to avoid default, and then
helping the country get through to the other side.

Although Greece was not considered an economic miracle
during the past decade, its underlying economic and fiscal
problems were ignored by the rest of the EU, much as
Argentina’s problems were ignored by its trading partners
and foreign lenders while it was on the dollar peg. Once
the underlying problems were revealed, both Greece and
Argentina were subjected to intense rescue negotiations,
Argentina’s ending in failure, Greece’s still underway at
this writing.

Sovereign-debt default did not end up being the end of
the world for Argentina, but rather a necessary and painful
adjustment.
Blustein’s argument, that concerted effort by many parties
is necessary to make a successful rescue, is persuasive. The
most important party is always domestic—in Argentina,
the national government, provincial government, central
bank, and political apparatus. If accommodations cannot
be achieved among domestic institutions, then no amount
of accommodation on the part of foreign (and domestic)
lenders, and no amount of financial aid by international
organizations, can bring off a successful rescue.
It is fair to say that the Argentine crisis of 2001–02 is not
identical to that of Greece today, or to those of Portugal,
Ireland, Italy, and Spain. But Blustein provides helpful
perspectives on Europe from an analogous situation,
and does so with much narrative drive and interesting
anecdotal detail.
It may also be worth remembering that And the Money
Kept Rolling In has a relatively happy ending. We can
only hope that today’s world economic leaders take note
of Blustein’s lessons and use them to help their own
countries. ■

F refront

33

S

andra Pianalto was
named president and CEO
of the Federal Reserve Bank
of Cleveland in 2003. Today
she has the most consecutive
years of service among
participants on the nation’s
monetary policymaking
body, the Federal Open
Market Committee. And
in 2012, she has one of the
10 votes on the Committee.

Interview with
Sandra Pianalto

34

Spring 2012

Alan Greenspan was
chairman of the Federal
Reserve when Pianalto
started her current job.
Now, Ben Bernanke presides
over a group that has
navigated the financial crisis
and Great Recession. The
tools of monetary policy have
changed over the past few
years, and so has the sense
of urgency in employing
them. We asked Pianalto
to talk with Forefront about
a range of issues—how she
develops her policy views;
her current economic outlook; and the differences
between Greenspan’s Fed
and Bernanke’s. Mark
Sniderman, executive vice
president and chief policy
officer of the Cleveland Fed,
interviewed Pianalto on
March 7, 2012.

Sniderman: You have been a participant
on the Federal Open Market Committee
since 2003. How has the FOMC changed
since then?
Pianalto: Probably the biggest change

has been in the tools that we use
to conduct monetary policy. Our
country has been through the deepest
recession since the Great Depression.
We went through a financial crisis,
and monetary policy responded very
aggressively and creatively, with some
new ways of accomplishing traditional
objectives.
Also, we’ve changed the way we
communicate. We’ve continued to
look for ways to enhance our communication with the public. We’ve
increased the number of times we
share our economic projections
with the public to four times a year.
The chairman holds press briefings
following those meetings where we
release our projections.
In January, we took some truly
historic steps in the way we communicate. We issued a statement on our
longer-term goals and strategies for
monetary policy and we also, for the
very first time, shared with the public
our forecast for the federal funds rate.
I think these are tremendous strides
in the way we communicate with
the public.

CHRIS PAPPAS

Finally, I would note the change in
chairmen since I joined the committee
in 2003. Alan Greenspan was chairman
then, and now Ben Bernanke is chair.
And Ben has changed the way we
conduct our meetings. You can read the
transcripts—I’m not sharing anything
that’s confidential—but when Alan
Greenspan was chair, he would usually
go first in our policy go-round, when
we take turns explaining our views.

If you look at the transcripts, you’ll
see that oftentimes the conversation
following his recommendation on
policy would be, “I agree, Mr. Chairman,” “I agree, Mr. Chairman,” “I
agree, Mr. Chairman.” By contrast,
Ben goes last on the policy go-round.
That requires each one of us to give
our views on appropriate monetary
policy, and Ben listens to our views
and then presents his own perspective.
He then puts forward a recommen­
dation that he believes best reflects the
appropriate course for policy, consistent
with the views of the Committee.
We then act on that recommendation.
Sniderman: Let me follow up on some-

Therefore it’s not appropriate for
the central bank to set a numerical
objective for maximum employment.
The Federal Reserve can estimate the
maximum level of employment given
the economic circumstances we face
and then set policy that’s appropriate
for achieving an unemployment rate
that is consistent with maximum
employment.

I have been a longtime proponent
of establishing a numerical objective
for the Committee. It helps anchor
inflation expectati0ns. It provides
more certainty.

thing else you mentioned—the statement the Fed issued about its longer-

Sniderman: Let me ask you about

term goals and strategies for monetary

the way many people characterize

policy. I know this is a topic that you’ve

FOMC members, labeling some people

been interested in for a while. Can you

as hawks and others as doves. Do you

share some more thoughts about it?

think that’s a handy, simple way for

Pianalto: In that statement we, for the

very first time, agreed on a numerical
objective for inflation. We said that
the Committee believes our mandate
for stable prices translates into an
objective for inflation of 2 percent over
the longer term. I have been a longtime
proponent of establishing a numerical
objective for the Committee. It helps
anchor inflation expectations. It provides more certainty around the types
of actions and policies the Committee
would deem appropriate to achieve
that numerical objective of 2 percent
for inflation.
Inflation is a monetary phenomenon.
That’s why we’re actually able to
set a numerical objective for it, and
we should be held accountable for
achieving it. Maximum employment,
which is the other half of our dual
mandate, is not primarily a monetary
phenomenon. The maximum level of
employment that our economy can
achieve is determined by other factors,
such as demographics, technology,
and regulations.

the public to understand policymakers’
views? And where would you put
yourself on that spectrum?
Pianalto: I’ve been part of the Federal
Reserve for a long time, more than
28 years. Those labels actually came
into play when there wasn’t agreement
around an inflation objective. There
were some members of the Committee
who felt a higher rate of inflation was
appropriate. Those individuals were
dubbed doves. And there were some
that felt that we needed a lower rate of
inflation. In fact, one of my predecessors, Lee Hoskins, was focused on
achieving zero inflation. And he was
considered a hawk.

F refront

35

Sandra Pianalto
Position

Education

President and Chief Executive Officer,
Federal Reserve Bank of Cleveland

The University of Akron, BA in economics, 1976
The George Washington University, MA in economics, 1985

Former Positions

Select Civic Associations

Economist, Federal Reserve Board of Governors
Economist, U.S. House of Representatives Budget Committee

Past Chair and Life Director, United Way of Greater Cleveland
Board Member, Cleveland Foundation
Board Member, Greater Cleveland Partnership

We now have agreement and a statement by the Committee that 2 percent
is the appropriate level of inflation.
So I don’t think the titles of hawks and
doves are useful when the Committee
has stated that we have a 2 percent
inflation goal.

I think we have to strike a balance, and
I think we have a good balance with
our current policy.

If there are titles that people want
to use, I would like to be labeled
someone who is open-minded. Or
someone who is pragmatic. We’ve
been through some very unusual
circumstances. We’ve had a lot of
unexpected changes in economic
circumstances that have required us to
think differently about the appropriate
path for monetary policy. So I tend
to feel very comfortable being openminded and not dogmatic or being
an ideologue on appropriate policy.
I’ve been open-minded to changes
in policy as economic circumstances
have changed.

speeches that you think the Fed’s extra­

Sniderman: Let’s talk more directly
about current circumstances. If inflation
is near our goal right now, why not try
to go faster and get that unemployment
rate down sooner?
Pianalto: We always have to stay

focused on a balanced approach. I
would be concerned that if we were
to provide even more policy stimulus,
given my current outlook, we could
risk an unwelcome rise in inflation.
On the other hand, if we were to
remove our policy accommodation too
quickly, I would be concerned that we
would risk slowing the economy and
causing an unwelcome disinflation.
36

Spring 2012

Sniderman: It’s clear the economy is
growing and the unemployment rate
is coming down, but the pace of improvement is still slow. You’ve said in
ordinary actions have been successful.
What gives you that confidence that
the policy approach is actually making
a difference?
Pianalto: In more normal times,

the main tool we use in conducting
monetary policy is adjusting the
federal funds rate, our target rate.
Back in 2007, when the economy was
entering into a recession, we began
to lower the feds fund rate, and we
continued to lower it until 2008 when
we brought it down to near zero,
where it stands today. We felt that the
economy still needed further accommodation, so we used some new tools
[such as long-term asset purchases,
otherwise known as “quantitative
easing”] in providing accommodation.
When we adjust the federal funds target
rate, the rates at which consumers and
businesses borrow are also affected.
When we were bringing down the
fed funds rate, medium-term and
longer-term rates also came down. In
using our new tools, we have the same
objective of lowering rates at which
consumers and businesses borrow.

When you ask how I can determine
whether our policy accommodation
has been effective, you can look at
the path of medium- to longer-term
interest rates, and they have been
brought down significantly. On the
mere announcement that we were going
to be purchasing mortgage-backed
securities, mortgage rates fell almost
100 basis points. Those are the rates
at which consumers and businesses
borrow. By bringing those rates down,
we are providing stimulus to the
economy by encouraging consumers
and businesses to borrow money, and
that translates into more spending.
Sniderman: Is there any way from
history to try to get a sense of whether
that was the right thing to do or not?
Pianalto: I think we have a very good
example of not having been accommo­
dative at a time when the economy
needed more accommodation. That
was the Great Depression. It took us
quite a bit of time, a lot of studying,
to understand that the Federal Reserve
was not providing enough policy
accommodation during that time. The
Federal Reserve’s restrictive monetary
policy contributed to making what
might have been a severe recession into
the prolonged, 10-year downturn that
we now know as the Great Depression.
That was a good lesson for us. And I
think we learned from that episode, and
we have responded more aggressively
to the most recent severe recession.

Sniderman: You suggested that maybe

Sniderman: It is remarkable the number

it’s not such a good idea to be pushing

of employers who will tell you that

so hard on monetary policy because

the jobs they have open used to be

there’s an inflation risk. But clearly the

filled by high school graduates. Now,

unemployment rate is very high. Are

at a minimum, those jobs require an

there some other factors at work keeping

associate degree or something like that.

that unemployment rate up?

Pianalto: Yes, in fact, even the manufac­

Pianalto: I still believe that our current

turers I talk with say that for entry-level
jobs, they’re requiring at least two
years of post-high school education;
some additional training. The data
show that where we’ve seen gains
in manufacturing jobs, it’s been in
occupations that require a four-year
college degree. And in occupations
that require high school or less, jobs
have actually declined. So yes, this
is another important factor that’s
affecting our labor markets.

high unemployment is a cyclical
problem and not a structural one.
There’s been a longstanding relationship between the amount of growth
in the economy and the improvement
that it translates into in terms of job
creation. We’ve had a very weak
recovery that hasn’t created a lot of
jobs. So the slow pace of this recovery
is causing that unemployment rate to
move down more slowly than we’d like.
I’m reassured that this issue is cyclical
and not structural when I look at job
openings. Prior to the recession, there
were two individuals looking for every
job that was open, so it was a 2-for-1
ratio. During this recession, that
number has jumped to four people
looking for every one job opening.
So we just have a very slow pace of job
openings, which, again, is cyclical, in
my thinking.

Sniderman: Let’s turn attention to

But we’re also finding that it’s taking
longer to match the skills that people
have to the skills that are needed in
available jobs. It may be that because
these jobs require more training, more
skills, more education, it is taking a
little more time to make a match. That’s
another reason why it’s taking longer
to bring the unemployment rate down.

eries, investment in housing has been
positive and has helped the recovery.
Unfortunately, in this recession, investment in residential construction has
actually declined, so it’s been a drag.

another place that’s a notable headwind
in the expansion, and that’s the housing
sector. Do you think it’s appropriate for
the Fed to be purchasing governmentguaranteed, mortgage-backed securities
to strengthen the housing sector?
What are some other roles the Fed can
play to try to get the housing sector to
heal more quickly?
Pianalto: In almost all previous recov-

Monetary policy has helped the situation by bringing down mortgage rates,
and that has made housing more
affordable to many consumers. But
we’re in an unfortunate circumstance
in that not everyone can take advantage
of these lower interest rates. Because of
depressed housing markets, we’ve had
consumers lose a lot of wealth that was
associated with housing. And because

The data show that where we’ve seen
gains in manufacturing jobs, it’s been
in occupations that require a four-year
college degree. And in occupations that
require high school or less, jobs have
actually declined.
of the very challenging economic
environment that we’ve been through,
consumers have more difficulty
obtaining credit. Their credit scores
may have been lowered. So this transmission mechanism that monetary
policy operates through has been
blunted somewhat.
We have to look at other ways of
addressing some of these issues. The
Board of Governors recently sent
Congress a white paper with some
options about how we can address
some of the challenges that we’re
facing in the housing market. The
options range from some loan
modifi­cation programs that might be
available, to taking homes that are in
foreclosure and now owned by banks
and turning them into rental properties.
I hope that Congress can have some
debates around these various options
and come to some policy decisions
that will help the housing market.

F refront

37

Sniderman: If we get into the summer

Sniderman: Well, it’s certainly been a

and begin to see another one of these

challenging period for the Fed, as you’ve

patterns of the economy slowing down,

mentioned—unconventional actions,

do you think that would be the time

unconventional economic circumstances.

to support further easing in policy and

And certainly the Federal Reserve has

maybe be willing to take a little more

attracted its share of skeptics and

risk on the inflation side of things in

critics, it seems, on a number of different

Sniderman: Some of the most recent

order to get the economy moving again?

dimensions. Policy is too tight, too easy,

indicators show some signs of improve-

Pianalto: Right now my forecast is for

too much risk of inflation, not willing

ment in the pace of the expansion.

the economy to grow a little more than
2.5 percent this year and 3 percent
next year, with inflation staying close
to 2 percent. My forecast for either
economic growth or inflation would
have to change for me to want to make
a change in the stance of monetary
policy. Given my current outlook for
the economy, the current stance of
monetary policy is appropriate. If my
forecast were to change significantly,
then I would want to look at the appro­
priate policy response, and perhaps
make an adjustment to my monetary
policy stance in response to a change
in my forecast.

My forecast for either economic growth
or inflation would have to change for me
to want to make a change in the stance
of monetary policy.

Are you feeling more upbeat today than
you were a year ago or even six months
ago about the economy’s prospects?
Pianalto: I want to see more evidence

that the good economic data that we’re
seeing is more than transitory, that
it is sustained. We’ve seen two other
episodes in this recovery­— in early
2010 and then again in 2011—where
we thought the economy was gaining
some momentum only to be disappointed later on by addi­tional factors,
such as the European debt crisis, and
issues around the tsunami in Japan
that disrupted supply chains in the
auto industry, and so forth. I’m being
a little cautious about saying that this
stronger economic data that we’re
seeing is going to be sustained. I’d like
to see a little more evidence of that
strength.
Having said that, one difference that
I’m seeing this year from the two
previous episodes where we started to
see some strengthening in the economy
is that the employment picture does
look to be stronger. We’ve now had
several months of good employment
numbers. In conversations I’ve been
having with businesspeople, they
sound more optimistic. This time the
optimism is being supported—it’s
not just a feeling; they’re actually
seeing stronger orders, and they are
responding to those orders by doing
more hiring. That’s why I think we’re
seeing stronger numbers on the
employment front.

38

Spring 2012

Sniderman: In that context, some
people say the Committee is being
maybe way too conservative about the
inflation risk and that the emphasis on
price stability is holding the economy
back from getting this unemployment
rate down. What is your view?
Pianalto: I think it’s important for us

to maintain low and stable inflation in
order for the economy to grow. I think
our two objectives are complementary.
We’ve learned over a long period of
time that a low and stable inflation rate
actually is necessary for longer-term
economic growth. So I think it is appro­
priate for the Fed to stay focused on
maintaining a low and stable inflation
rate near our 2 percent objective in
order to provide an environment for
the economy to grow, and therefore
for employment to grow, for jobs to
be created.

to take enough risk to get the unemployment rate down, and so on. How do
you feel about all of the controversy
surrounding you as a voting member
this year?
Pianalto: When you are in such

unusual circumstances and you’ve been
through the challenges we’ve been
through as a country, it’s not surprising
that you’re going to have diverse views
on how to address these issues. As
I mentioned earlier, I want to have an
open mind about the appropriate
policy approach, so I do read various
people’s views and opinions about our
policy actions. I listen very carefully
to my colleagues’ views on appropriate
policy responses given current
economic circumstances and our
current outlook. And then I make a
judgment about what I believe should
be the appropriate monetary policy
response.
Sniderman: What are some of the things
you’ve learned over time in terms of
how you approach decision making?
Pianalto: When you’re part of the
process that creates these new tools and
implements them, you clearly are much
more familiar with them. It’s almost
like, rather than going back and reading
a textbook, you’re actually writing the
textbook. Therefore, because you’re
actually doing it, you feel much more
knowledgeable about it—you’re the
expert.

Sniderman: Maybe it’s the difference
between someone handing you a tool
and saying, “Here, use this,” versus
having a problem and then you have
to create the tool to help you solve
the problem?
Pianalto: With the first couple of years
on the Committee, I recall thinking
about what other Committees did
when they faced these types of
circumstances. But in the past few
years we have been facing a set of
circumstances that very few previous
Committees had to deal with. So I
no longer had the luxury of thinking
about what other Committees did.
I turned my attention more towards
creating the policy response to these
circumstances.

It’s a different approach. I spent less
time thinking about, “what do I need
to learn from others?” Rather, I had
to focus on being helpful in creating
the response. I’m sure that I’ve gained
wisdom by going through this episode.
That wisdom will be helpful, I’m sure,
in responding to challenging circumstances in the future. ■

Watch video clips from this interview
www.clevelandfed.org/forefront

Recommended reading
Sandra Pianalto. 2011. “Price Stability: Why We Seek It and How Best
to Achieve It.” Forefront, Federal Reserve Bank of Cleveland (Spring).
Speech transcripts
For transcripts of President Pianalto’s speeches, visit
www.clevelandfed.org/For_the_Public/News_and_Media/Speeches

F refront

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